Trading risks you should be aware of

It is tempting to take a one-dimensional view of risk as simply the risk of losing money. The problem is that this approach doesn’t tell you enough about where that risk is coming from and how it should be mitigated. In reality, there are a kaleidoscope of risks, depending on the instruments traded and the broader macroeconomic environment. Here, we discuss the major risks traders are likely to encounter. In our next article we will look at risk analysis methods and effective risk management strategies.

Exchange rate risk

This is a clear risk when currency trading (and the main source of return), but any investments made outside your home market will bring exchange rate risk that needs to be factored into your trading decisions. US treasuries may look like an attractive investment, for example, but any gains could ebb if the currency moves against you.

For example, if a trader is looking to buy $1,500-worth of US treasuries, this would have cost £1,094 in January 2021, but the same trade would have cost £1,298 in March 2020. Currency can be hedged, but the costs of hedging need to be factored into your risk/reward assumption.

Interest rate risk

Interest rates affect a range of assets. Their most obvious effect is seen in bond pricing where the yield on any bond is determined by the yield available on ‘risk free’ assets such as cash. In general, bonds with longer maturities and lower coupons (the annual interest rate they will pay out) are more sensitive to shifts in official interest rates. It is worth remembering that it is not just interest rate changes that influence bond pricing, but expectations of interest rate changes.

Interest rates also play a role in equity pricing. If interest rates are low, it means the earnings generated by companies are more valuable. As such, high earning companies attract a high valuation. This has been seen recently with the pricing of high growth technology stocks, which have been assigned lofty valuations at a time of lower rates.

Interest rates can also affect the way different assets relate to each other: whereas investors might expect equities and high quality bonds to move in opposite directions, recent loose monetary policy (where interest rates have been lowered to stimulate borrowing) has favoured both bonds and high growth equities at the same time. This is counterintuitive and can affect the overall risk/reward balance of your portfolio.

Liquidity risk

This is the risk that you can’t move in or out of a trade at the time you want to or a price you consider reasonable. It is a clear risk in assets such as property, where the process of buying and selling is complex and lengthy. It can also appear in certain asset classes at times of market distress – the corporate bond market during the 2008/09 financial crisis is a good example. Some emerging markets also see relatively poor liquidity. Liquidity can be judged by metrics such as daily trading levels and bid/offer spread levels.

Liquidity risk can also be a peril when trading on margin. If a trade goes against them, traders may find they can no longer afford the margin payments and have to close out the trade at a loss. It was margin payments that sunk Nick Leeson and led to the collapse of Barings Bank in 1995.

Behavioural risk

Often traders are their own worst enemy: they follow the herd, they overestimate their ability, they hang on to losing trades, they over-trade. Most other risks can be quantified and monitored, but behavioural risks are less tangible. Being aware of these risks and monitoring them is a first step to managing them.

The importance of any of these risks will vary with the market environment and the individual securities. At times of crisis, liquidity risk becomes very important. In recent years, interest rate risk from low interest rates has significantly skewed asset pricing. Traders need to understand all the risks that can potentially influence the pricing of assets and be prepared with effective risk management strategies.

The Fineco trading platform has the financial risk tools to help you understand and mitigate various trading risks. You can also access a range of regular free webinars hosted by experts to help you develop your trading knowledge and skills.