Understanding Risk

Introduction

In order to trade successfully you must fully understand the risks involved. Each trader will approach the market slightly differently, underlying the fact that there is no right or wrong way to trade the market. Instead each trader must know the risk that they can comfortably take on.

Establishing the type of trader you are is very important. Are you a systematic trader or do you prefer being in the market during periods of volatility. Are you looking to be constantly involved or are you looking to smooth out the short term noise to capitalise on long term gains.

What is Risk?

Risk is 'The variability of returns from an investment or the chance that an investment's actual return will be different than expected. This includes the possibility of losing some or all of the original investment. It is usually measured using the historical returns or average returns for a specific investment. The greater the variability of an investment (i.e. fluctuation in price or interest), the greater the risk.'

The volatility we see in daily prices, combined with the leverage available in the off-exchange retail foreign currency (or Forex) market compared to other financial instruments- like stocks- is the reason why Forex is categorized as highly risky. As investors are generally averse to risk, investments with greater inherent risk must promise higher expected yields to warrant taking on additional risk. Others add that higher risk means a greater opportunity for high returns or a higher potential for loss. However, a higher potential for return doesn't always mean that it must have a higher degree of risk.

What risks do you face trading currencies?

There are two basic classifications of risk:

• Systematic Risk - also sometimes called market risk, aggregate risk, or undiversifiable risk, is the risk associated with overall aggregate market returns. Systematic risk is a risk of security that cannot be reduced through diversification.
• Unsystematic Risk - Sometimes referred to as 'specific risk'. An example is economic news that affects a specific country or region. Diversification across multiple non-related currency pairs is the only way to truly protect the portfolio from unsystematic risk.

Now that we've determined the two main classifications of risk let's take a closer look at more specific types of risk.

Country Risk

This refers to the risk that a country won't be able to honor its financial commitments. When a country defaults, it can harm the performance of all other financial instruments in that country as well as other countries, it has relations with. Country risk applies to stocks, bonds, mutual funds, options, futures and most importantly the currency that is issued within a particular country. This type of risk is most often seen in emerging markets or countries that have a severe deficit.

Forex Risk

When investing in foreign currencies you must consider that the currency exchange rate fluctuations of closely linked countries, can drastically move the price of the primary currency as well. For example, economic and political events directly tied to the British Pound (GBP) have an effect on the Euro's trading (i.e. the EUR/USD might have similar reaction as GBP/USD even though they are both separate currencies and are not in the same currency pair). Knowing what countries effect the currency pairs you trade is vital to your long-term success.

Interest Rate Risk

A rise or decline in interest rates during the term a trade is open, will affect the amount of interest you might pay per day until the trade is closed. Open trades at rollover are assessed either an interest charge or interest gain depending upon the direction of the open trade and the interest rate levels of the corresponding countries. If you sell the currency with the higher interest rate you will be charged daily interest at the time of rollover based on your broker's rollover/interest policy. For more specifics on understanding your interest risk, please consult your broker for complete details of their policy including time of rollover, interest price (also called swap) and account requirements to receive interest paid to your account.

Political/Economic Risk

This represents the risk that a country's economic or political events will cause immediate and drastic changes in the currency prices associated with that country. Another example of this risk is government intervention that we typically see with Japan and the need to maintain low currency prices to bolster their exports.

Market Risk

This is the most familiar of the risks we have discussed, and according to some, really the main risk to consider. Market risk is the day to day fluctuations in a currency pair's price; also referred to as volatility. Volatility is not so much a cause but an effect of certain market forces. Volatility is a measure of risk because it refers to the behavior, or 'temperament', of your investment rather than the reason for this behavior. Because market movement is the reason why people can make money, volatility is essential for returns, and the more unstable the currency pair, the higher the chance it can go dramatically either way.

Technology Risk

This is a particular risk that many traders don't think much about. However, with the majority of individual Forex traders executing trades online, we are all technology reliant. Are you protected against technology failure? Do you have an alternative internet service? Do you have back-up computers that you could use if your primary trading computer crashes?

As you can see, there are several types of risk that a smart investor should consider and pay careful attention to in their trading.

The Risk Reward Balance

The risk/return balance could easily be called the iron stomach test. Deciding what amount of risk you can take on while allowing yourself to walk away from your computer without worrying and to get sound rest at night while you have long-term trades open is a trader's foremost important decision. The risk/return balance is the balance a trader must decide on between the lowest possible risk for the highest possible return. Remember to keep in mind that low levels of uncertainty (low risk) are associated with low potential returns and high levels of uncertainty (high risk) are associated with high potential returns. Trading is all about risk and probabilities. Understanding the inner functions of your Forex trading strategy(s) and proper placement of entry and exit orders will assist in limiting your risk exposure while maximizing your profit potential.

What about how much of your account to place on each trade, or in other words the number of lots per trade? How much of your account have you lost in a single trade? Was it too much to swallow? If so, you might not have utilized proper risk management and over leveraged your trade. Establishing the right level of leverage and corresponding margin requirements are a big part of managing risk.

There is Not One Correct Risk Level

Just as there is no single favorite food for everyone, there is no right risk level for everyone. Only you can determine what level of risk is right for you. You need to find the right balance between the amount of risk you think you are willing to take, and the amount of risk you can actually stomach. All too often investors think they are willing to take risk, but when the worst happens, they find out they aren't.

You will likely lose money during this learning process, but if this loss helps you achieve this level of understanding then you can financially afford the loss. It is important to identify in advance the amount you are willing to 'pay' for this education. This financial and emotional tuition is a valuable trading resource and something most experienced investors have paid through the process of trial and error.

In Conclusion

Different individuals will have different tolerances for risk. Tolerance is not static; it will change along with your skills and knowledge. As you become more experienced, tolerance to risk may increase. Don't let this fool you into not adhering to and thinking about proper money management practices.

Diversification

We all hear diversification is the best policy for an overall investment portfolio. This is also true amongst our currency focused investments as well. To be well diversified, we should master the use of multiple trading strategies and multiple currency pairs to equalize our overall return. Some trading strategies boast 80% accuracy in specific market conditions. However, a full-time trader must utilize more than this single strategy as many times there are long periods of time when the trading conditions are not met, such intervals can last anywhere from a few days to several months. What good is a single strategy that can yield profits for only a small portion of the year? Diversification may be the answer.

Diversifying your investment is not the most popular of investment topics. In fact many people believe diversifying dilutes trading profits. But most investment professionals agree that while it does not guarantee against a loss, diversification is the most important component to helping you reach your long-term financial goals while minimizing your risk. But, remember that no matter how much diversification you do, it can never reduce risk down to zero.

A Well Defined Portfolio

What do you need to have a well diversified portfolio? Three aspects to ensure the best diversification:

• Your portfolio should be spread among many different trading strategies
• Your trades should vary in risk and time held. Picking different trade opportunities with different potential rates of return will help the gains offset losses of other trades. Keep in mind that this doesn't mean blindly placing trades all across the spectrum!
• Your currency pairs should vary by region and crosses, minimizing unsystematic risk to small groups of countries

Another question people always ask is how many currency pairs they should trade to reduce the risk of their portfolio. One portfolio theory for stocks tells us that after 10-12 diversified stocks you are very close to optimal diversification. However, in the currency market this doesn't mean buying 12 currency pairs will give you optimal diversification, instead, it has been recommended to trade currencies of different regions and importance levels (i.e. majors, crosses and more exotic currencies).