The Risks of Trading
You need to look at the risks that traders face before deciding to be a part of the trading world. The three general categories are market risks, investment risks, and trading risks.
Market risks are pretty much out of your control. Of course you know the risk that the markets are bound to rise and fall, but understanding the risks you face when they do helps you manage your money better. Three key risks that you can manage as a trader are
Inflation risk: Although inflation is a risk that traders rarely consider, it nevertheless impacts people who are afraid to take risks. You definitely can’t be a trader if you’re afraid of taking risks. Basically, the risk that this factor poses is that your money won’t grow fast enough to exceed the increases in costs that inflation causes.
As you know, the basics — housing, clothing, medical expenses, and food — increase in price each year. By investing in monetary vehicles that don’t keep pace with inflation, you actually end up losing money.
Marketability risk: This factor relates to how liquid your investment is. If you’re restricted from selling your investment when you want to do so, your target selling point won’t mean much.
For most stock traders, this factor isn’t an issue, but if, for example, you choose to invest in a small company whose stock isn’t traded on one of the major stock markets, you risk not being able to close your stock position when the time is right.
Currency translation risk: Currency translation refers to disparities in trading stocks of companies in foreign countries. It’s only a factor when you trade foreign stocks because you then must be concerned with fluctuations between the values of your local currency and the currency in the country where the company is located.
Even if the stock increases in price, you can still lose money based on the currency exchange rate. If the value of your currency falls against the other currency, your investment can be worth less when you convert it back.
Investment risks relate directly to how you invest your money and manage your entry and exit trades. Two critical risks you must manage are
Opportunity risk: This kind of risk involves balancing trade-offs. When you trade, you establish a position that ties up money that otherwise can be used elsewhere. After you choose a stock and buy it, you lose the opportunity to buy something else that may strike your fancy until you trade out of the first position. Essentially, you can miss other opportunities while your money’s tied up in another position.
Concentration risk: This kind of risk happens when you put too many eggs in one basket. You may think you’ve found that hot stock that’s going to make you a millionaire, so you invest a huge portion of your principal into that stock. By concentrating so much of your money on one investment, you also concentrate the risks associated with that investment and the possibility of losing it all.
Risks that are unique to trading increase simultaneously with increases in trading volume. Day traders and swing traders often see a greater impact caused by these risks than do position traders, but everyone needs to be aware of them. Risks associated with trading are
Slippage risk: Hidden costs associated with every transaction are the focus of this risk factor. Every time you enter or exit a position, your account balance dwindles by a small amount. Every time you execute a trade, you subject yourself to the problem of buying at the ask price but selling at the bid price. The ask price is the lowest price available for the stock that you want.
The bid price is the highest price someone is willing to pay for your shares. Unfortunately, the bid price is always less than the ask price. Although you can mitigate bid/ask problems with limit orders, doing so subjects you to the risk that your order won’t get filled. The amounts for each trade may at first seem small, but as your trading volume increases, so do the amounts you lose.
Poor execution risk: This problem occurs whenever your broker has a difficult time filling your order, which can result from any number of factors, including fast market conditions, poor availability of stock, and the absence of other buyers and sellers.
The result is always the same: The price you expect is somewhat different from the price you actually receive. Although you can mitigate this problem to a degree by using limit orders, you still risk having the stock trade through your limit price and not getting your order filled at all.
Gap risk: This kind of risk comes into play whenever a break in trading occurs. Sometimes a stock opens at a price significantly higher or lower than its previous close, and sometimes a stock trades right through your exit price. For example, a stock may close at $25 a share today and open tomorrow morning at $20.
If your planned exit price is $24, and you have a stop order in place, your order is likely to be filled at the opening price or worse. Price gaps created in this way occur most often at the open. And although relatively rare, a gap also can occur during the trading day whenever surprising news is reported or trading halts.