Risk refers to the potential financial loss or uncertainty of investment returns.
Actual returns from an investment may differ from expected returns.
This potential for loss is why investing or trading opportunities are often evaluated in terms of risk versus reward.
What is risk?
Risk, in its simplest form, represents the possibility of losing money or not achieving the expected return on an investment or trade.
Risk is an inherent part of trading, but traders can use a variety of strategies and tools to manage risk.
These include diversifying bets, using stop-loss orders, and only trading money they can afford to lose (also known as "risk capital").
Proper risk management helps mitigate potential losses and makes trading more predictable and profitable in the long term.
What are the different types of risks?
Traders face many types of risks:
1. Market risk
Market risk, also known as systemic risk, is the risk that the entire market will decline, dragging down the value of almost all investments. This is largely unavoidable because it stems from wider economic, political or social factors.
For example, political instability, global pandemic, or news of major policy changes could cause a general market downturn.
Think about the global financial crisis of 2008. Triggered by the collapse of the U.S. real estate market, global stock markets generally fell, and the value of investors' portfolios shrank significantly.
2. Liquidity risk
Liquidity risk involves the potential inability to buy or sell investments quickly enough to prevent or minimize losses.
It is especially useful in thinly traded or niche markets where finding buyers or sellers can be challenging.
Lack of liquidity may lead to price manipulation or cause you to liquidate your position at an unfavorable price.
An example would be if you invested in a small cap stock that doesn't have a lot of trading volume. If negative news comes out about the company and you decide to sell your stock, you may have trouble finding a buyer, forcing you to sell at a much lower price than you expected.
3. Credit risk
Credit risk, or default risk, comes into play when a bond issuer or other obligor fails to meet its payment obligations.
If you invest in corporate or government bonds, there is a risk that the entity may default on interest payments or even return principal.
For example, if you hold bonds from a company that declares bankruptcy, the company may default on its scheduled interest or fail to return the principal, causing you a loss.
3. Operational risk
Operational risks include risks arising from various operational failures, such as transaction failures, human errors, or fraudulent activity. This is especially important in high-frequency trading, where milliseconds can affect trading results.
A well-known example is the "Knight Capital Incident" in 2012, where a software glitch in the company's high-frequency trading algorithm resulted in a loss of more than $440 million in just 45 minutes, ultimately leading to the company's collapse.
4. Inflation risk
Inflation risk refers to the risk that the return on investment will not keep up with the inflation rate. In other words, the purchasing power of your investment returns may decrease over time due to inflation.
For example, if you invest in a bond that returns 2% annually, but inflation is 3%, the real value (or purchasing power) of your investment is actually decreasing.
5. Currency Risk
In the world of Forex trading, currency risk is an important factor. This is the risk that changes in currency exchange rates will negatively affect the value of your investments. It is not limited to Forex traders but also affects investors holding international investments.
For example, if a U.S. investor owns stocks in Europe, the value of the euro will fall relative to the dollar. dollars, when investors sell their shares and convert euros back into dollars, they receive less than expected even if the share price does not move.
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