What is risk management?
According to Ben Cole: Risk management is the process of identifying assessing and controlling threats to an organization's capital and earnings. These threats, or risks, could stem from a wide variety of sources, including financial uncertainty, legal liabilities, strategic management errors, accidents and natural disasters.
Why is risk management important to traders?
Risk management is widely recognized among professional traders to be the most important aspect of your trading plan. There are many different ways to manage your risk and to manage your own money but in the end, it’s all about your risk tolerance and preferences:
By implementing a risk management plan and considering the various potential risks or events before they occur, an organization or trader can save money and protect their future or trade. This is because a robust risk management plan will help a company or trader establish procedures to avoid potential threats, minimize their impact should they occur and cope with the results. This ability to understand and control risk enables organizations to be more confident in their business decisions. Furthermore, strong corporate governance principles that focus specifically on risk management can help a company reach their goals or a great trader can also provide useful knowledge to upcoming traders.
Factors that affect risk management
Measurement of Risks
The increasing globalization and complexity of capital markets and the expanding range of esoteric financial instruments have made trading risk management more difficult to accomplish and evaluate. Fortunately, a number of commonly used risk-measurement systems have been developed to assist financial institutions in evaluating their unique combinations of risk exposures. These systems all aim to identify the risks associated with particular business activities and group them into generic components, resulting in a single measure for each type of risk. These systems also allow institutions to manage risks on a portfolio basis and to consider exposures in relation to the institution’s global strategy and risk profile.
Risk Limits
The risk-management system should include a sound system of integrated institution-wide risk limits that should be developed under the direction of and approved by senior management and the board of directors. The established limits structure should apply to all risks arising from an institution’s activities. For credit and market risk, in particular, limits on derivatives should be directly integrated with institution-wide limits on those risks as they arise in all other activities of the firm. When risks are not quantifiable, management should demonstrate an awareness of their potential impact.
Maintenance Issues
Complex instruments require sound analytical tools to assess their risk. These tools are grounded in rigorous financial theory and mathematics. As an institution commits more resources to structured products, complex cash instruments, or derivatives, existing staff will be required to develop an understanding of the methodologies applied. Institutions should not create an environment in which only trading staff can evaluate market risk; information on new products and their attendant risks should be widely disseminated. Concurrent with the review of the existing risk-management framework, the resources provided to maintain the integrity of the riskmeasurement system should be evaluated. Limits should be reviewed at least annually. Assumptions underlying the established limits should be reviewed in the context of changes in strategy, the risk tolerance of the institution, or market conditions. Automated systems should be upgraded to accommodate increased volumes and added financial complexity, either in applying new valuation methodologies or implementing tools to evaluate new products. Products that are recorded ‘‘off-line,’’ that is, not on the mainframe or LAN (linked personal computers), should provide automated data feeds to the risk-measurement systems to reduce the incidence of manual error.
Planning Your Trades
As Chinese military general Sun Tzu's famously said: "Every battle is won before it is fought." This phrase implies that planning and strategy—not the battles—win wars. Similarly, successful traders commonly quote the phrase: "Plan the trade and trade the plan." Just like in war, planning ahead can often mean the difference between success and failure.
