Trading in financial markets comes with inherent risks that traders must be aware of. Understanding these risks is crucial for making informed investment decisions. This article explores the various risks involved in trading financial markets, including market volatility, liquidity risk, leverage risk, and geopolitical factors. By being aware of these risks, traders can develop effective risk management strategies to protect their capital and optimize their trading experience.
What is the risk?
In a financial market, risk entails the degree of uncertainty and the probable financial loss that investment acts inherently carry. Although it sounds intimidating, the risk is in fact the incentive that allows an investor to seek higher returns from his venture. As such, the higher the risk in an investment, the higher the profit margins he would set for himself to compensate for the uncertainty or potential loss involved.
There are a number of risks that challenge an investment decision and as such should be kept in mind while taking the same. Some of those are discussed below.
Types of Risks and How to Combat Them:
Inflation Risk:
Inflation is the upward movement in price levels which in turn reduces the purchasing power of consumers. Therefore it threatens the future value of investment since investors expect low returns during inflation. It is however a speculative risk and associated with long-term trades such as in stocks and treasuries.
Market or Volatility Risk:
These risks are unpredictable and out of one’s control like the former but relatively short-lived. It signifies that external events can cause fluctuations in the price of assets, which can last from a single day (or less) to a few days. Market risks are pretty much inherent in any business or investment but seen mostly in currency markets or other liquid markets.
Currency Translation Risk:
This risk arises out of the difference in currency values between the two countries while investing in stocks of foreign companies. While dealing in foreign stocks one must be aware of the exchange rates between one’s local currency and the currency of where the company is. You run the risk of losing money if your currency value falls against the latter even after the stock price remains the same or increases.
A risk similar to this but not quite is the Sovereign Risk. It occurs when a country defaults on its loans to the IMF or other international banks thus causing their currency values to fall. The adverse effects are pretty much the same as with any other loan defaulter but on a national scale.
Credit Default Risk:
It is a common risk category that comes with dealing in corporate or government bonds but can be easily avoided. It involves the threat of a company defaulting on its loans, that is, being unable to repay its financial debts to the bank or otherwise. That adversely affects the value of its bonds or shares and before it does the investor needs to be in the safe. It is easily doable since the market always has information about how a company is or isn’t meeting its debt obligations and the investor can thus act accordingly.
Opportunity Risk:
Opportunity risk is similar to the concept of opportunity cost in economics. Investing your money in one particular venture ties it up for a specific time period, preventing it from being in allocation to other investments. Therefore it is easy to miss out on more profitable business once you have already committed to another one. It is easy to abate opportunity risk with experience and being strategic.
Concentration Risk:
Concentrating too much money on one company’s shares or a particular kind of stock also involves the risk of losing it all at once. Wisely investing small portions of your principal in diverse stocks can easily avoid concentration risk, even if one stock looks too lucrative.
Conclusion
These are only a few risks among many more that are involved while investing in the financial markets. There are more trading risks like slippage or poor execution and rare unforeseen ones like Black Swan Events. Some of these risks are avoidable, as we saw, while some are beyond the control of any investor. They are an inherent part of the financial market but having a better understanding of them can make the risks manageable and you a better trader.
