Risk management refers to the process of minimizing risks in a project or enterprise. It is accomplished by understanding, measuring, and analyzing risks while also dealing with them strategically. Those who successfully manage risk strive to obtain the greatest safety guarantees with the lowest possible costs.
When individuals or companies enter the open markets, they often face regulations, new innovations, and a plethora of other issues which all add to the potential risks. Proper risk management helps to reduce the probability of making mistakes and decreases the likelihood of incurring losses.
Risk Management in the Financial Markets
Risk management in the financial markets focuses particularly on the management of risk when trading.
Some common types of risks include systemic risk, liquidity risk, market risk, credit risk, and operational risk. Proper risk management strategies could help you to reduce your potential losses while also protecting your account from losing funds.
Here you will find a brief breakdown of the most common types of financial risks and how to mitigate them properly.
Systemic risk refers to the possibility that an event at the company level could trigger severe instability or collapse an entire industry.
This form of risk can be reduced by diversifying your investment portfolio. The different assets you hold should have low levels of correlation in order to ensure proper risk management.
Liquidity risk generally arises from the lack of liquidity in an investment that cannot be bought or sold quickly enough to prevent a loss. It is typically reflected by unusually wide bid-ask spreads or large price movements.
This risk can be mitigated by trading assets that have high liquidity. By doing so you avoid holding an asset that you cannot offload due to low liquidity.
Market risk is the possibility of an investor incurring losses due to factors that affect the overall performance of the crypto market. Examples include civil unrest, natural disasters, etc.
The risk here can be reduced by setting up a proper system in which an investor deploys stop-loss or take-profit orders. By doing this, investors can ensure that they do not experience large losses.
Credit risk refers to the possibility of a borrower failing to repay a lender. For instance, if you trade on an exchange that is not very trustworthy, they may not be able to meet your obligations when you trade on leverage.
To reduce the odds of such issues it is recommended that you always trade on major and trustworthy exchanges.
Operational risk generally refers to the uncertainty a project faces from aspects such as internal company breakdowns with respect to its systems or its workforce.
It is best to always do extensive research into projects before investing and to only deploy your capital into industries that you are familiar way. By doing this you can avoid falling victim to potential operational risks.
The General Process of Managing Risk
The basic steps to risk management are as follows: identifying risks, risk assessment, and responding to risk.
This is where you determine which risks exist and work to classify the potential risks.
This refers to assessing the probability of risk by analyzing a large amount of data collected over time. Risk assessment mainly consists of predicting the frequency of loss and the degree of loss.
Responding to Risk
Savvy investors respond to risk by finding ways to avoid, reduce or share the risk.
This process includes the collection and analysis of data in order to ensure that all potential responses are on the right track.
Strategies for Managing Financial Risks
There are a multitude of ways to manage risk. A few of these avenues are explored below.
The one-percent rule is widely used in daily trading. Basically, the rule suggests that you should never put more than 1% of your capital into a single trade. For example, if you have $1,000, your position in any trade should not exceed $10 (1% of your capital).
However, if you have a higher level of risk tolerance, then this aforementioned 1% could rise to 2% of higher. This strategy is common among both traders who have accounts with less than $100,000 and traders who have a more short-term outlook.
Stop-Loss and Take-Profit Orders
Setting stop-loss and take-profit orders could help traders in controlling their potential losses and profits at the right time. This is done since it is very difficult to assess when the crypto markets may suddenly change direction.
A stop-loss order is a price at which a trader will close a position to incur a loss. This is done to mitigate potentially larger losses. For example, if Bitcoin breaks a key support level, traders will often sell as soon as possible.
On the other hand, a take-profit order is a the price at which traders will close a position in order to take a profit in case the market decides to take a turn for the worse. This helps traders to realize some gains while reducing the potential risk levels associated with holding an asset long term. For example, if Bitcoin is approaching a key resistance level after a jump upwards, traders may want to sell at a price that is just below that resistance level.
Diversification and Hedging
Diversification helps traders to ensure that their portfolio is properly weighted across different asset types which each contain unique risk profiles.
Placing a majority of your capital into one asset for instance can drastically increase your overall levels of risk since a downturn in that asset will have an outsized negative impact on your overall portfolio. Not only does diversification help you to manage risk but it also enables you to take part in new investment opportunities that would not be possible had you locked most of your capital into one particular investment.
Another way to avoid risk is to hedge your position. For example, if you are long Bitcoin you may consider owning some put options to hedge against that position.
Every investment involves some degree of risk. Often high potential returns are associated with high risk. A keen understanding of risk can help investors to better capitalize on potential opportunities, while helping to prevent potential setbacks.
In general, risk management refers to the practice of identifying potential risks, analyzing them, and taking precautionary steps to curb the risk in the field of finance.
Injective was created to support the trading of limitless markets, which allows traders to properly diversify their portfolio while being able to hedge against potential losses. Moving forward, the plan is to also include sophisticated order types such as stop-loss orders in order to further equip users with avenues to manage risk.
Injective is a custom interoperable layer one protocol for building powerful exchange, DeFi, derivatives & Web3 applications. Injective was created using the Cosmos SDK and is able to achieve instant transaction finality while sustaining lightning fast speeds. INJ is the native deflationary scarce asset that powers the Injective Protocol and its rapidly growing ecosystem. Injective is incubated by Binance and is backed by Pantera Capital.