How to manage risk when trading

How to manage risk when trading


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By Chris Smith, CMC Markets

Having a risk-management strategy is essential in business. And in the fast-moving environment of financial markets, it’s even more important, says Chris Smith.

One of the key differences between an individual (retail) trader and a professional is how they approach a trade. 

The retail investor is most often focused on getting into a trade, while the professional understands that managing risk holds the real key. 

In fact, being a professional trader is more about managing risk than it is about being able to correctly predict the direction of the market.  

Surprisingly, some of the big names in the trading world get the direction wrong more often than they may get it right. It’s only through their risk-management abilities that they’re able to safeguard their profitability. Their risk strategies protect them from large losses and allow them to compound their net gains over time.  

The general perception of trading is that it’s a fast-moving, high-stakes, winner-takes-all environment. That may be true to some extent, but actually there are a wide range of traders with different approaches and time frames – from minute-by-minute price scalpers, to more strategic, theme-based, global macro traders.  

Traders do differ from the traditional ‘buy and hold’ investor, but the gap between these two worlds has narrowed over recent years. The length of time for both the average fund and the investor to hold shares is reducing, with more flexibility to holdings. Traders and investors are often exposed to similar risks too. Take, for example, liquidity risk. 

Liquidity risk

At this point in the market cycle, there are plenty of articles and headlines on market risks and ‘inflated’ valuations of stocks. 

However, investors may be unaware of the ‘concentration risk’ within their holdings – the risk that their portfolio has too many of the same categories of shares and exposures.

In the broader share market, much of the strong performance of individuals’ and money managers’ portfolios comes from only a handful of stocks. For example, Amazon, Facebook, and other tech darlings, which have enjoyed spectacular growth and high index weightings. 

So, investment risk is increased by many fund managers having disproportionate weightings to these stocks. These crowded trades are a concern, because investors could face big losses if the markets were to revert to more historical valuations and traders all start heading for the same exit.  

The ever-growing popularity of exchange-traded funds (ETFs) is also a worry. Famous investor Carl Icahn first raised warnings about the dangers and limitations of them in a 2015 video post. 

ETFs track an index, a commodity, bonds, or a basket of assets, and are traded on an exchange. Investors in ETFs often haven’t given much thought to the potential lack of liquidity of these funds. Steep losses can be incurred through a lack of buyers, when investors decide to sell and want to move out of these funds. 

Assess all outcomes

Traders and investors should always consider the downside before entering into any new trade. 

Too often, the trader’s focus is on the gains they could make. They overlook the pitfalls that could occur if they get the direction wrong. This process of looking at the gains first feeds insidiously into our natural tendencies – to act on what gives us pleasure and to avoid the pain. This makes retail traders and investors more impulsive. 

Position sizing

When it comes to trading in the financial markets, choosing the size of your ‘position’ (the amount you invest) in a stock is different for everyone. Position sizing is one the most important elements of any strategy for long-term success. It varies based on an investor’s risk profile and appetite, their expectations for returns, their wealth, and the diversification of their portfolio. 

However, there are statistical limits to trading safely. 

The ‘2 per cent rule’ is a commonly used technique by both new and experienced traders. The strategy is to invest no more than 2 per cent of available capital on any one position – as the portfolio grows, the 2 per cent increases in proportion and position size. 

For example, a trader with $100,000 trading capital should risk no more than $2,000 – or 2 per cent of the value of the account – on a position, or multiple positions. 

This risk-management technique does limit the speed of growth in a portfolio and requires discipline to follow and stay within the boundaries of a trading system. 

The VIX ‘fear gauge’ 

Since its inception in 1993, the CBOE Volatility Index, often known as the VIX, has become a popular tool to gauge investor sentiment and the level of risk in the market. 

The VIX is derived from option prices on the S&P 500 – the most globally traded and widely followed stock index in the world. It reflects the market’s expectations of volatility over 30 days.

Currently, global markets have been showing increasing levels of complacency, with overall risk tolerance increasing in many asset classes. 

The VIX is currently at a record low (see Figure 1), despite markets being faced with volatility in world news and events. 

HowToManageRisk Graph.jpg

Prevailing complacency

However, investment banks have been commenting on risks for investors, with Goldman Sachs research warning: “There is elevated valuation on almost every metric within the US stock market.” 

And well-known investor Howard Marks of Oaktree Capital’s latest memo noted: “Risk is high and prospective returns are low…I believe this is a time for caution.”

Financial markets will often be irrational from the historical average for much longer than expected, and do not care about expert forecasts and analysis. Sentiment can change without notice though, so having risk-management protection tools and position-sizing techniques in place allows you to be flexible when opportunities arise.

Traders are often perceived as big risk-takers. The truth of the matter is that the ‘wizards’ of the trading world, as described in Jack Schwager’s book, Market Wizards, share a common trait: they’re actually very risk-averse. 

They understand that to earn a return, you have to take risk. But they’ve learnt to effectively manage this risk. That’s their true skill as traders. 



CONCENTRATION RISK: Over-concentration can happen when one segment of a portfolio performs better than the rest. As the asset grows, it becomes a bigger proportion of the investor’s portfolio.

LIQUIDITY: The speed and ease at which an asset can be bought or sold.

MARKET WIZARDS: Author Jack Schwager interviewed the greatest hedge-fund managers of the last three decades for his book Market Wizards.

OPTION: The right (but not an obligation) to buy or sell a share at a certain price.

POSITION: An investment in a share, or a number of shares.