Definition of risk
To better understand risk, one can recall the common phrases we often use in life:
- He who dares, wins
- Look before the leap
- Fortune favours the bold
- Nothing ventured, nothing gained
- The bigger the risk, the bigger the reward
- A ship in harbor is safe, but that is not what ships are built for
These sayings capture the dual nature of risk: it can lead to reward or ruin. Even inaction carries risk, as the world continues to evolve around us, potentially leaving us vulnerable to unforeseen changes. Either way, here’s a hard fact that Octa analysts learned over the years of providing access to financial markets for traders: without venturing into the unknown, significant rewards are out of reach.
But what exactly is risk? A formal definition from the Oxford Learner’s Dictionary describes risk as ‘the possibility of something bad happening at some time in the future; a situation that could be dangerous or have a bad result’. In finance, this translates to the possibility of suffering a loss. While this might sound daunting, the key is to recognise that not all risks are equal. According to Octa analysts, while each risk type presents unique challenges, a strategic approach to risk management is the first step toward success in trading and investing.
Main Types of Risk in Financial Markets
1. Market Risk
Market risk refers to the potential for losses due to various factors affecting the overall performance of the financial markets. It’s often broken down into three primary subtypes:
- Price Risk. This is the most common form of risk for traders. It’s the risk of losses due to adverse changes in market price of an asset—whether a stock, a commodity, or a currency pair.
- Interest Rate Risk. This is the risk that borrowing costs might increase. This type of risk is particularly relevant for bond investors, as a rise in rates typically causes the value of bonds to fall. However, the risk also affects currencies’ exchange rates, as changes in relative monetary policy of different countries can influence the flow of international capital.
- Currency Risk. Also known as ‘exchange rate risk’, is the risk that a foreign currency might devalue, negatively impacting an investment made in that currency or the price of that country’s products. This is the primary focus for a company that exports or imports large amounts of goods and services or has direct investments overseas.
2. Liquidity Risk
Liquidity risk relates to potential losses that might occur when a financial instrument or an asset cannot be bought or sold quickly enough without a significant change in its price due to low trading volumes. Highly liquid markets, like major currency pairs, have many buyers and sellers, making entering or exiting a position easy. Conversely, the market with fewer participants might force a trader to accept a much worse price than expected to complete a transaction, leading to a loss. This risk is especially relevant when dealing with large positions in relatively illiquid markets (for example, third-tier cryptocurrency) or during periods of market stress (for example, when important news is released during late-trading hours).
3. Operational Risk
Operational risk involves potential losses from inadequate processes, systems, people, or external events, including fraud and cyberattacks. This can comprise anything from human error in data entry, technical failures in a trading platform, or system breakdowns that prevent a trade from being executed. While it might seem less prominent than market risk, it’s still a critical consideration.
4. Counterparty Risk
Counterparty risk is the risk that any party in a transaction will fail to fulfil its obligations. This is one of the most critical risks for a retail trader.
Additional types of risk worth noting include inflation risk (erosion of purchasing power, impacting long-term investments), political/geopolitical risk (for example, sanctions or elections causing market disruptions), systemic risk (the potential collapse of an entire financial system due to interconnected failures, often amplified by leverage and contagion), and basis risk (occurs when hedging instruments don’t perfectly correlate with the underlying asset).
Minimizing risks
Risk is unavoidable, but it can be managed, which means that it can be minimised and a trader can partially protect himself or herself from it. Octa recommends applying two key principles for managing risk:
Principle 1. Maintain a reasonable amount of leverage and margin
It’s important to monitor an account’s total margin usage in real time. Continuously adjusting a balance to reflect current profits and losses allows a trader to always see their available leverage and monitor their risk level.
Principle 2. Minimise losses by setting stop-loss orders.
Stop-loss orders allow traders to easily define an exit point for a trade before placing it, whether based on a specific price level or a monetary value.
Risk avoidance
Some risks are beyond the trader’s control and are best avoided altogether. For example, a sudden glitch in a trading platform during a high-volatility event could cause a trader to lose a significant amount of money if they cannot close a position. Likewise, in the event of a broker’s bankruptcy, there is a very real possibility of losing the entire investment, regardless of trade performance. This risk is not something a trader can manage with a stop-loss order; it’s a risk trader must avoid entirely.
In this regard, choosing a reliable broker is essential. Look for brokers that are regulated which offer transparent trading conditions with no hidden fees, and have a track record of fast execution and fast withdrawals, confirmed by positive reviews on independent platforms. By selecting a stable and client-focused broker, traders can minimise avoidable risks and focus on profitable opportunities.
In conclusion, risk is the shadow side of opportunity in financial markets and trading. By understanding risk types and applying risk management techniques, individuals can navigate these waters with greater confidence and success.
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Disclaimer: This press release does not contain or constitute investment advice or recommendations and does not consider your investment objectives, financial situation, or needs. Any actions taken based on this content are at your sole discretion and risk—Octa does not accept any liability for any resulting losses or consequences.
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Octa
Octa is an international CFD broker that has been providing online trading services worldwide since 2011. It offers commission-free access to financial markets and various services used by clients from 180 countries who have opened more than 52 million trading accounts. To help its clients reach their investment goals, Octa offers free educational webinars, articles, and analytical tools.
