Basics Of Risk Management

Become a crypto chef with Sushi (SushiSwap)! Sushi is one of the most used and reliable decentralized exchanges, deployed across 10+ blockchains and supporting thousands of tokens. You can trade, earn, stack yields and safely move assets across chains, all on one decentralized, community-driven platform.

Welcome to the home of DeFi: Sushi

Risk Management

Risk management is a fundamental part of our lives. We are consistently assessing and responding to risks in everyday situations, such as driving, traveling, and investing. Whether it is a simple task or a complex business decision, the process of evaluating risks and taking necessary actions is essential to minimize losses and achieve success.

In the fields of finance and business, risk assessment is a critical and intentional practice. In the context of economics, risk management refers to the framework that defines how businesses and investors handle financial risks, which are inherent to all kinds of ventures. It involves managing multiple asset classes like cryptocurrencies, Forex, commodities, shares, indices, and real estate.

There are several categories of financial risks, and it is crucial to identify, measure, and mitigate these risks to minimize losses and ensure profitability. This article provides an overview of the risk management process and offers some strategies that can assist traders and investors in managing financial risks.

Risk Management Process

Risk management can be explained through a five-step process. However, it is important to note that these steps may differ depending on the specific context.

Setting Objectives: The first step in risk management is setting objectives by defining primary goals. This is based on the individual or company's risk tolerance level to achieve their goals.
Identifying Risks: The second step involves identifying potential risks and defining them in detail. This step aims to uncover all events that could cause negative impacts and provide valuable information not directly related to financial risks.
Risk Assessment: The third step is risk assessment, the identified risks are evaluated in terms of their expected frequency and severity. These are then ranked in order of importance, to allow the creation of an appropriate response.
Defining Appropriate Responses: The fourth step involves defining appropriate responses to each type of risk based on its level of importance. This describes the measures that must be taken in the event the risk occurs.
Monitoring Effectiveness of Your Strategy: Lastly, the effectiveness of the risk management strategy must be monitored to assess its ability to manage response to certain events. This is accomplished by collecting and analyzing data continuously.

How to Manage Financial Risks

Effective management of financial risks is critical to achieve success in financial markets. A variety of factors can lead to an unsuccessful trade or strategy. An example of this is what occurs when the market moves against a futures contract position or traders succumb to emotional reactions and start selling out of panic. This is seen particularly during bear markets and periods of capitulation, when traders end up changing their initial strategies.

To mitigate such risks, traders can develop a robust risk management strategy that includes clear action plans, such as setting Stop-Loss or Take-Profit orders. An effective strategy should provide a comprehensive list of potential actions, so that traders can be better equipped to handle various scenarios. Various risk management techniques can be applied, but whatever strategy you choose, it is recommended that these strategies be reviewed and adjusted regularly.

Different financial risks can be minimized through specific risk management techniques.

Market risks can be reduced by setting Stop-Loss Orders. This prevents incurring bigger losses by automatically closing positions.
Liquidity risk can be mitigated by trading on high-volume markets.
Credit risk can be reduced by using trustworthy exchanges. This allows buyers and sellers to push through with their exchanges, without having to trust one another.
Operational risk can be mitigated through portfolio diversification and researching companies that are less likely to experience operational malfunctions
Systemic risk can be reduced through portfolio diversification that involves investing in projects with distinct proposals or companies from different industries with low correlation

Common Risk Management Strategies

Risk management does not have a one-size-fits-all approach. Traders and investors often utilize a variety of strategies and tools to manage risk in order to increase their chances of achieving portfolio growth. Presented below are some examples of risk mitigation strategies commonly used by traders.

Stop-Loss and Take-Profit orders

Traders can use stop-loss and take-profit orders to reduce their losses and lock in profits, respectively, when trading. It is recommended to set the prices for these orders before opening a position and to activate them immediately.

In a volatile market, it is crucial that traders know when to cut losses in order to avoid making hasty decisions based on emotions. The levels for stop-loss and take-profit are also significant factors in calculating the risk-reward ratio for each trade.

1% Trading Rule

Traders often use the 1% trading rule or 1% risk rule to limit their trading capital losses to a maximum of 1% per trade. This rule enables traders to execute a trade with either 1% of their portfolio value or a larger order with a stop-loss of 1% of their portfolio value. Day traders frequently use this rule, but swing traders can also use it.

However, some traders may adjust the 1% value based on other factors, such as their account size and individual risk tolerance. For example, an individual with a more conservative risk tolerance and larger account size may choose to limit their risk per trade to an even smaller percentage.

Risk-Reward Ratio

The risk-reward ratio is a measure that helps traders determine the risk they are taking compared to the potential reward they will gain. To compute this ratio for a potential trade, divide the possible loss by the expected profit. For example, if a trader's stop-loss is at 5% and their target is a profit of 15%, their risk-reward ratio would be 1:3. This implies that the potential profit is three times greater than the potential loss.

Hedging

Hedging is a method used by investors and traders to minimize financial risk. It involves opening two positions that cancel out each other. Essentially, traders can hedge one trade by making an opposing trade of a similar or identical size.

Although it may seem illogical to open positions in opposing directions, hedging can reduce the impact of market movements if executed correctly. For example, if you hold a long position in BTC in your personal wallet and the market enters a downtrend, you can take a short position to counterbalance your long position without having to move your BTC. This is known as a market-neutral strategy.

Diversification

Diversification is crucial in investing, as a diversified portfolio is considered to be more secure since it provides protection against huge losses compared to a portfolio consisting of only one asset. If you have a crypto asset in a diversified portfolio and its price falls, the maximum loss you would incur would only be a percentage of your portfolio. Conversely, if your portfolio is made up entirely of a single asset, you could potentially lose 100% of your portfolio's value.

Conclusion

Traders and investors are advised to develop a risk management plan before investing capital or opening a trade position. However, it's crucial to keep in mind that it's impossible to eliminate financial risks entirely.

Risk management involves developing strategies for handling risks, but it's not solely about avoiding risks altogether. It also involves strategic thinking to deal with unavoidable risks effectively. Therefore, it's essential to identify, evaluate, and monitor risks based on the situation and plan. The goal of managing risks is to analyze the risk-reward ratio to prioritize the most favorable positions.

💬 Still have questions?

Hit us up on Discord or on Twitter.

Sushi is building a decentralized, comprehensive DeFi ecosystem complete with AMM, cross-chain capabilities, NFT artist platform and more. Follow our socials to keep up with our product launches and find out more on how you can make the most of your cryptocurrency assets with Sushi’s secure and powerful DeFi tools!