Risk management is critical to trading success. This starts with identifying the different types of risks you might face:
- Market risk: the potential losses you could experience if the asset loses value.
- Liquidity risk: the potential losses arising from illiquid markets, where you cannot easily find buyers for your assets.
- Operational risk: the potential losses that stem from operational failures. These may be due to human error, hardware/software failure, or intentional fraudulent conduct by employees.
- Systemic risk: the potential losses caused by the failure of players in the industry you operate in, which impacts all businesses in that sector. As was the case in 2008, the collapse of the Lehman Brothers had a cascading effect on worldwide financial systems.
As you can see, risk identification begins with your portfolio’s assets, but it must also consider both internal and external elements to be effective. After that, you’ll want to evaluate these dangers. How often do you think you’ll run into them? What is the severity of the situation? You can rank risks and determine appropriate strategies and actions by weighing them and determining their potential impact on your portfolio. Systemic risk, for example, can be reduced by diversifying into a variety of investments, and market risk can be reduced by using stop-losses.