If you ask many seasoned traders, the impact of a huge loss always outweighs a big win. This is why risk management is essential. Even when opting for derivate contracts like futures and options, you still need to manage your risk to maximise your profits. Read on to learn more!
Understanding Risk in Derivatives Trading
- Market Risks: Like any market-linked investment option, derivatives trading has risks. Traders must make decisions based on technical analysis and ascertain how much market conditions impact the derivative.
- Counterparty Risk: This is when any party in the trade cancels the contract. The risk is higher in OTC trades, – but it can be avoided by only engaging with dealers you know or find trustworthy.
- Liquidity Risk: This is important for derivative traders to check if it will be difficult to close the trade. Generally, companies with low liquidity risk can quickly turn their investments into cash.
You can measure a company’s liquidity risk by comparing its short-term liabilities to liquid assets.
- Interconnection Risk: This refers to the interconnections between derivatives instruments and dealers. For example, if a major bank acting as the dealer faces any issue, it can create a snowball effect that can threaten overall market stability.
The Importance of Risk Management
Good risk management leads to overall better returns. The goal is to maintain consistency when winning trades – no matter how small. This approach is better than having an occasional huge win with many losses.
It can involve planning your trades, following the 1% Rule, setting stop-loss and take-profit points on your trades to limit your losses and diversification.
Setting Risk Tolerance
Know how much risk you’re willing to take. This is because investing in stocks and other equities does require some level of risk tolerance, given how volatile the stock market can be.
For example, futures trading is subject to higher risk for a higher profit and loss at a set date. Options can also give you the same outcome, but since you have no obligation to buy or execute the contract at the set date, you can minimise your losses by letting the contract expire.
Hence, futures trading is better suited for seasoned investors or investors willing to take on more risk, while options may be better for beginners or risk-averse traders.
Traders use risk-reward ratios to compare expected stock returns with the risk they must take to make a profit. A higher risk-reward ratio means more returns at a higher risk, while a lower ratio means less risk for comparatively lower returns.
It is calculated as risk divided by reward, that is, dividing the amount you can lose if the price of a stock travels in an unanticipated direction by the profit you can expect to make upon closing the position. Many find an appropriate ratio to be 1:3 (3 units of expected return for every 1 unit of risk).
- When trading derivatives, you can pay a fee for the right to sell a stock at the same price you bought it. This is called a put option. You can sell the stock on or before the expiration date of the options contract.
- Diversification by holding different kinds of investments is a popular hedging strategy. This way, you don’t lose all your \money during a downturn. Lots of traders choose gold to hedge against inflation.
Many traders overlook risk management as it can be tedious. However, an effective risk management strategy can help you build discipline and minimise losses while maintaining consistent profits.
If you are new, it can be beneficial to go for full-service trading broker in India as they offer more personalised financial services until you gain enough expertise.