Learning Your Risk Tolerance
The secret to successful investing is learning your own style, or in other words trading method(s) that work for you. There is no correct approach that everyone should learn. However, every trader needs to assess how much risk they can comfortably handle. It is the single most important investment issue for long-term success in the Forex market.
Are you able to stomach the risk when the markets are moving up or down as fast as your nervous heartbeat? Do you carefully consider the various risks that are associated with each trade you make? The fact is, many people either don't have a clue how or don't feel they need to protect themselves from unnecessary risk. In most cases they don't even understand all the types of risk their investing is exposed to. We will be reviewing the various types of risk and proper risk management to maximize your personal performance, including:
- What is risk?
- The different types of risk
- The risk/Return Balance
- Diversifying your trading
What is Risk?
Whether it is investing, driving, flying, swimming, or just walking down the street, everyone exposes themselves to risk. Your personality and lifestyle play a big role on how much risk you are comfortable with. For most investors, risk simply means "losing money." But if your investment choices leave you unable to sleep at night you are probably taking on too much risk.
The dictionary's definition of 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 enhanced daily price movements and the leverage available in the Forex market compared to other financial instruments like stocks is the reason the Forex market is categorized as a "high risk investment vehicle". 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. This is why identifying and adhering to a strict trading strategy is so important to the overall performance. Learn more about use of proper money management to minimize your risk exposure. Do you have a hard time giving money back to the market when you feel that you have worked so hard for every penny of profit? If so, you would find yourself amongst the "risk adverse" category of investors. On the other hand, super active day traders feel most comfortable making dozens of trades per day and are considered "risk loving". When investing in currencies, stocks, bonds, commodities, futures or any investment instrument there is a lot more risk than most investors think. Learn more about the different types of risk that effect your Forex trading.
The Different Types of Risk
There are two basic classifications of risk: Systematic Risk - A risk that influences a large number of currency pairs. Examples of systematic risk are global political events, natural disasters, or war. Unsystematic Risk - Sometimes referred to as "specific risk". Its risk affects a very small number of currencies and currency pairs. An example is economic news that affects a specific country or region, such as a sudden strike by employees or a change in the Canadian interest rate. Diversification across multiple non-related currency pairs is the only way to truly protect yourself from unsystematic risk.
Now that we've determined the two main classifications of risk lets take a closer look at more specific types of risk.
Default Risk - This is the risk that the company with whom you have your Forex trading account will be unable to pay out an investor's account balance when a withdrawal request is submitted. Many Forex traders remember the incident of Refco in the fall of 2005. Unfortunately Refco, one of the world's largest investment firms with brokerage arms within commodities, futures and foreign exchange filed for bankruptcy protection and each of the brokerages were auctioned off to competitors or former subsidiaries. Their clients were unable to withdraw profits and initial capital until the brokerages were sold off. As of yet the dust has not settled and it is still too early to tell if all former customers received complete compensation. Choosing a suitable, stable broker is more than choosing the biggest.
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.
Foreign Exchange 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. Deciding your potential return (target profit) while respecting risk is the age old decision that each investors must make.
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 trading strategy(s) and proper placement of entry and exit orders will assist in limiting your risk exposure while maximizing your profit potential.
The following chart shows an example of the risk/return balance for trading, meaning the higher the desired return typically requires a higher degree of risk:
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 to 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 are willing to take, and the amount of risk you can actually take. All too often investors think they are willing to take risk, but when it happens, they find out they aren't. Surviving in the market long-term is the most important way to make the market work for you. To do that, you need to learn your own risk tolerance ability. This could mean that you loose money during this learning process, but if this loss helps you achieve this level of understanding then you can financially afford the loss. This financial and emotional tuition is a valuable trading resource and something most experienced investors have paid through the process of trial and error.