Trading risk management strategies

Having previously looked at how traders can identify the key risks they are likely to encounter, here we look at some of the trading risk management techniques and strategies available.

Hedging is a common risk management strategy, but it’s important to factor in the potential costs.

That means the cost to trade, including the bid-offer spread, any charges levied by the platform and the ‘opportunity cost’ – what the cash could have been earning if deployed elsewhere (at the moment this is low, but could be higher if savings rates rose).

In general, it is expensive to buy insurance against the most obvious trading risks. In simple terms, if the Dollar has been rising for five years, it will be expensive to hedge against a rise in the Dollar. This can create a situation where traders are always paying a high price to hedge yesterday’s risks. When trying to hedge any portfolio risks, try to take this into consideration.

1. Hedging exchange rate risk

There are various risk management techniques to hedge exchange rate risk, which is one of the main risks traders will face.

The most straightforward option for traders is generally to go long or short the currency in question versus their home currency, but this can tie up your capital.

While professional traders will have options such as currency forwards – which give them the right to be able to buy or sell currency at a certain rate on a future date - currency - hedged exchange traded funds (ETFs) are a more widely available risk management strategy.

There are two routes: the first is a currency-hedged index option – one example (just for illustration) is the iShares currency hedge MSCI Japan ETF. This means that the trader gets the performance of the index, but with no currency exposure. The other is a pure currency ETF, such as (again, an example just for illustration) the Invesco DB US Dollar Index Bullish Fund. In this case, the ETF is a way to position for a rising Dollar.

2. Hedging interest rate risk

The other main trading risk is that many assets are exposed to changes in interest rates. While government bonds are perhaps the most obvious, dividend and high growth equities can also be sensitive to shifts in interest rates. Equally, anyone with floating rate debt is vulnerable to rising rates and therefore higher bills.

While swaps and options are widely used by professional traders, these markets aren’t widely available to retail traders. It is often possible though to use futures contracts on government bonds, or interest rate futures to lock in a specific interest rate, hedging a portfolio. Using inflation-linked bonds can also be a useful technique for managing interest rate risk because they move in line with inflation expectations.

3. Managing liquidity risk

A further trading risk is that you cannot trade at all, or at least not at a price that is acceptable to you. Liquidity can shift significantly in different markets. It tends to be abundant when you need it least and can dry up when you need it most (such as in times of crisis).

While liquidity is subject to daily changes, risk management techniques can help you to form a judgement. For example, looking at bid/offer spread – wider means less liquidity - and daily trading volumes. This can highlight declining liquidity in specific asset classes and should act as a warning to traders. Other trading risk management techniques can include holding cash, keeping some optionality in a portfolio and ensuring that you are not a forced seller in a difficult market. It may also be possible to substitute assets – a property ETF rather than an open-ended bricks and mortar property fund, for example.

It is particularly important to manage liquidity effectively when trading on margin. The worst possible situation is one where margin calls are mounting and you can’t unwind the trade. Risk management strategies here can include automated buying and selling which let you limit your level of risk without you having to be logged into your account. Stop losses let you set in advance a price at which to sell, limiting your losses, while take profits will sell your holding once you have reached a specified pre-set level of profit.

4. Facing up to behavioural risks

Human emotions and behaviours can make traders their own worst enemies, selling at the wrong time, following the herd, not wanting to let go of a bad trade. One of the key risk management strategies is being aware of your bad habits -doing so could improve your trading performance significantly. Be honest with yourself.

Practical risk management techniques which can help include setting a clear maximum loss value for your trading activities. This will depend on your assets, the amount you have available to trade (how much you are able to lose) and also how much you are willing to lose in pursuit of positive returns. For most people the psychological impact of a loss is greater than that of a gain.

Tools such as automated buy and sell orders can be useful here too as not making trading decisions in real time effectively removes emotions from the equation.

Finally, however attractive an investment may sound, only trade in products you fully understand and which fit with the rest of your portfolio.

Risk management is an imperfect science. However, employing trading risk management strategies and techniques effectively can improve incremental performance significantly.

The Fineco trading platform has the tools to support a broad range of trading risk management strategies. You can also learn more about trading risk and the various trading risk management techniques with our range of regular free webinars hosted by experts.