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Beginner

What are the 3 Main Types of Risk in Trading?

Whenever you trade, you’re exposed to risk. Learn more about the three main types of risk every trader faces and the risk management techniques for each one.

As the saying goes, there is no reward without risk. As a trader, your goal shouldn’t be to eliminate the risk factor, but rather to mitigate its negative side effects while taking advantage of their positives. Here, we unpack the three main types of financial risks you’ll face as a trader, and outline what you can do about each one to hopefully minimise their effects on your positions.

The three main categories of trading risk

  1. Market Risk
  2. Liquidity Risk
  3. Systemic Risk

What is Market Risk? The possibility of external, market-wide shifts

Market risk is the potential for your position to make a loss due to changes in overall market conditions, causing your underlying asset’s pricing to move against you in a way you hadn’t foreseen.

This type of risk is also known as systematic risk (in other words, the opposite of unsystematic risk, which is a risk unique to that particular market). This is a different thing to systemic risk, which we'll cover later.

Examples of these changing macro variables may include price volatility in the stock price or the forex pair you’re speculating on, caused by related news or another external event; or sudden uncertainty in market sentiment, or a change in interest rates of exchange rates.

For example, in February 2023, JP Morgan forecasted that, on the back of interest rates nearing the end of their tightening cycle, the EUR/USD currency pair would reach 1.10 in March 2023, before declining to 1.08 in September 2023 and holding at that rate through to December 2023 as interest rates were held steady by the Fed.1

For instance, the World Economic Forum named ‘rising inflation’ as a predominant risk facing the world’s financial systems in 2023, which is inflationary risk.

This is an inherent risk that all markets are susceptible to, and that all traders face when participating in financial markets. Market risk is an inherent factor that cannot be eliminated, nor should we desire to do so. Without the price fluctuations stemming from market shifts, there would be little chance for traders to engage in speculative activities based on these movements.

How you can manage against market (systematic) risk

  • Consider setting up stop-loss orders, which can help limit potential losses by automatically closing your trade if the price of a security reaches a predetermined level
  • Likewise, consider using take-profit orders to lock in profits when the markets do go your way. These exit your trade for you when a predefined amount of profit’s been reached, preventing you from losing it should the market turn against you
  • Try hedging, which involves taking offsetting positions with other trades in different, non correlated markets, to reduce the impact of adverse market movements
  • Regularly assess and analyse market conditions, economic indicators, and any factors contributing to that underlying asset’s pricing
  • Ensure that you optimise your position size based on risk tolerance and market conditions, which can help you to better manage your exposure to market risk
  • Stay informed about market news, trends and events, which can help traders to identify potential risks and take appropriate actions to manage their exposure.

Liquidity Risk: the possibility of slippage

Liquidity is a characteristic of markets, and it’s determined by how easily that market’s underlying asset can be traded, or converted into cash, without significantly impacting on its price. This is caused by how much capital is moving in and out of a market. How much buying, selling and speculating overall is taking place, with how much money, at any given time.

You can get markets with ‘deep liquidity’, which usually have high amounts being bought and sold by a large number of players constantly. You can also get ‘illiquid’ markets, in which there are less buyers and sellers and/or low amounts of capital being traded.

When a market is illiquid, you face liquidity risk. This is the chance that, due to the low amount circulating in the system when you open a trade, your order is filled at a different price than the one you asked for. Because of this, the price has shifted slightly, or ‘slipped’, in the time it takes to execute and fill your order. Negative slippage is when the client received a worsen price than requested.

How you can manage against liquidity risk

  • Ensure that you’re trading on markets known for their deep liquidity, for example by performing calculations to assess liquidity ratios. These markets will very seldom have slippage
  • Likewise, choose markets that historically have shown resilience of market liquidity during times of macroeconomic stress (if a market has low liquidity, it’s usually less able to deal with unforeseen disruptions quickly and seamlessly, which is what causes you slippage)
  • Choose a broker that is known for their very fast execution times.
  • Sometimes, you might think that another cause of ‘slippage’ might actually be a slow or unreliable internet connectivity on your side, which causes a delay in your computer or device being able to make that order. So, also ensure you’re trading on a fast and dependable connection and device

Systemic Risk: the possibility of financial system failure

Systemic risk is the chance that significant macro shocks and internal vulnerability will bring about a partial or complete collapse of the entire market, or financial system. This is the most unlikely of the three types of potential risks - but it's also the most serious threat.

The failure of both Silicon Valley Bank and Credit Suisse in March 2023 are two recent significant market events which raised concerns about systemic risk in the financial services industry. Both banks were storied, longtime fixtures in the industry which had survived the 2008 global financial crisis, only to collapse within weeks of each other, albeit for separate reasons.

Then there was the 2008 global financial crisis itself, which brought the world closer to systemic financial collapse than any other event since the Great Depression of the early 20th century. The stock market, housing market, asset management firms, insurers and even the banking system teetered on the brink of chaos. Fortunately, a number of financial regulation reforms came out of this time, hoping to prevent a similar threat of systemic risk in the future.

How you can manage against systemic risk

The short answer is that you, as an individual trader or investor, cannot guard against systemic risk (which, when on a macro scale, may also be called ‘world risk’ as it affects the entire planet systemically).

However, while you cannot prevent systemic risk from happening, you can limit its impact on you by ensuring that you are never risking capital you cannot ultimately afford to lose, should the market turn against you:

  • Carefully calculate the sizes on your positions to ensure you’re not opening trades (particularly when it comes to leveraged financial instruments) that would represent a substantial loss for you to recover from, should the market shift unfavourably
  • Have a stress-tested and well thought-out risk management plan ready to go at all times, that can work for a variety of different asset classes and scenarios, from economic downturns to potential systemic uncertainty
  • Always consider setting up stop-loss orders and take-profit orders that can help protect you against excessive losses or secure profits at predetermined profit targets.
  • Keep up to date with significant macroeconomic news of the financial markets, as well as leading economic indicators, to know early on when uncertainty may be brewing in the markets

In conclusion: the TL;DR summary

Some level of risk-taking is inevitable if you want to make a profit when speculating on financial markets. However, just because risk is a fact of trading life, doesn’t mean you can’t limit the financial risks you’re exposed to and how much loss they signify.

There are three main categories of risk every trader is exposed to - market risk, liquidity risk and systemic risk. To paraphrase the famous Alcoholics Anonymous prayer, there are some trading risks that you can change your exposure to, and some you can’t. It’s all about having the necessary information on each one so that you know the difference.

Sources:

1 J.P. Morgan Chase, 2023

The material provided here has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Whilst it is not subject to any prohibition on dealing ahead of the dissemination of investment research we will not seek to take any advantage before providing it to our clients.

Pepperstone doesn’t represent that the material provided here is accurate, current or complete, and therefore shouldn’t be relied upon as such. The information, whether from a third party or not, isn’t to be considered as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product or instrument; or to participate in any particular trading strategy. It does not take into account readers’ financial situation or investment objectives. We advise any readers of this content to seek their own advice. Without the approval of Pepperstone, reproduction or redistribution of this information isn’t permitted.