Online trading risks are factors contributing to financial losses when buying and selling assets. Factors like market fluctuations, exchange rates, individual company setbacks, economic stresses, geopolitical events, regulatory changes and online security breaches are examples of risks online traders face when trading.
Understanding the fundamentals of risk management is essential to protect your investment from huge losses and make well-planned trading decisions. A recent research from Quantified Strategies states that the number of traders losing money is 70%-90%. The market is competitive and dynamic, that’s why only a few can gain money.
This article will introduce you to the key risks you need to understand and show you practical tips on how to manage them.
1. Market Risk
Market risk or systematic risk happens when the industry, economy, and geopolitical tensions affect the performance of the stock market. A good example was during 4.4% inflation on June 7, 2023. The Bank of Canada adjusted its lending rate by 25 basis points to 4.75 % overnight, causing the market to decline.
You have to prioritize market risk because it is unavoidable. It is not similar to company risk, which can be easily reduced if you have a diverse portfolio. Even “blue chips”, which were thought to be strong, were swept along in a widespread market downturn.
In 2008 financial crisis, companies like General Electric fell 75% of their stock value from 2007 to 2009 ($40-$10). Bank of America’s stocks dropped even bigger. It went from $50 per share in 2007 to $5 per share in 2009. Unexpected downturns can erode your portfolio if it’s not diversified properly.
Although market risk cannot be eliminated, setting realistic expectations and strategic planning can mitigate its impact.
How to manage market risks?
Factors affecting the market to downturn have major effects on your portfolio. To ease the impact of market risk in your portfolio, here are 4 risk management to keep in mind:
- Asset allocation: allocating your assets across different classes (stocks, bonds, real estate, cash equivalents, and real estate investment trusts) reduces the impact of stock market volatility in any single class. In case an asset downturns, the others might not be affected. This is a great way to offset your losses.
- Long-term mindset: focus on your investment goals in a bigger picture, preferably years or decades ahead. This helps with the risk of anxiety with short-term market fluctuations, which can be a false market.
Whenever the stock market trends upward, it is normal to have short-term ups and downs. Having a long-term mindset will help you make better decisions, potentially exceeding the amount you can earn when you panic sell because of fearing short-term trends.
- Dollar-cost averaging: DCA is an investment strategy where you invest a fixed amount regardless of the current market price into a particular investment at regular intervals. This strategy reduces the risk caused by investing a lump sum of money right before the market downturns.
The core idea of DCA is investing a fixed amount within a time frame consistently. You can take advantage of the ups and downs in the market because you can purchase more shares when the price is low and fewer shares when the price is high.
For example, you purchased 5 shares when the value per share was $20. The next month, the value per share went up to $30, so you only purchased 3.33 shares. You bought 5.56 shares on month 3 because it only cost $18 and purchased 4 shares on month 4 when the value per share went to $25.
With dollar-cost averaging, you average out the cost per share over time. DCA lowers your overall investment return if your calculations are accurate. To help you with your calculations, you can use a dollar-cost averaging calculator.
- Rebalancing: Rebalancing means maintaining your desired asset allocation periodically by adjusting your investment portfolio. Initially, the percentages allocated will shift since different asset classes experience varying returns. Rebalancing ensures your portfolio stays aligned with your risk profile during the shifts to accomplish your investment goals.
If you diversify on various asset classes, rebalancing stabilizes your portfolio. This prevents overexposure to asset classes that have outperformed other assets.
2. Individual Stock Risk
Individual stock risk is medium-level trading risk where the share of a company declines in value, which can also be a high-level risk if you don’t have a diverse portfolio. The decline usually occurs when the company or sector performance has issues within its industry. Also known as unsystematic risk, your investment could lose value if the company you invested in performs badly.
Check for earning reports, financial health, management changes, and product launches because these factors affect the price of a specific stock. Dropping of stocks can also happen due to poor management decisions, changing consumer preferences, increased competitions, and company scandals.
Analyzing company financials can help. However, it is important to consider that product recalls or changes in leadership can happen anytime. This can make the market unpredictable despite how well you analyze their earning reports, debt levels, and overall financial health.
It is dangerous to bet all your assets on just one or a few companies. It will leave you vulnerable to huge losses even when only one of them declines. Diversification is the key here. Spreading your portfolio strategically means that if one stock drops, its impact to your overall portfolio is reduced.
How to manage individual stock risk?
Although it is not as high-level as market risk, individual stock risk must still be considered, especially if you don’t have a diverse portfolio. Here are 4 ways you can mitigate individual stock risks.
- Company Financial Analysis: analyzing involves researching the financial statements of the company you want to invest in (income statement, balance sheet, and cash flow statement). Also check if the company consistently increases their sales (revenue growth).
Check their profit margins whether the company is profiting, as well as the company’s debt level. Are the debts heavily leveraged or is it managed properly? Make sure your price-to-earnings ratio and price-to-book ratio aligns with their stock price before investing.
Analyzing company financials helps you identify companies to invest in with solid fundamentals. This helps you avoid investing in companies with problems or weak prospects (declining revenue, shrinking margin, increasing debt, and low or negative cash flow) that will cost you to lose money.
You can research public companies in Canada using SEDAR.
- Diversification: closely related to asset allocation, diversification is a method of spreading your investments within each asset class for risk management. This means, you diversify your assets within an asset class to companies from different sectors or industries.
Diversification reduces exposure to specific risk of any company. Your other holdings won’t be affected in case your investment from one company downturns.
- Stop-Loss Orders: is an order you place with your broker to automatically sell a stock if the price falls below the amount you specified.
Stop-loss limits your losses if a stock takes an unexpected downturn, immediately triggers a market order to either buy or sell based on the conditions you specified.
This is an example of how it works. You buy a stock at $100 dollars and you set a stop-loss order at $90, triggering your investment to automatically exit when it reaches the amount. You will only lose 10%, preventing you from holding on to a losing investment. It controls your emotion, improving your decision making.
- Risk Tolerance: is a measurement of an individual’s ability and willingness to withstand potential losses in your investments. There are multiple classifications of tolerance on the internet. However, according to Investopedia, the best examples are conservative, moderate, and aggressive risk tolerance. Factors like age, investment goals, and financial situation influence this.
Understanding risk tolerance can help you choose the right stocks for you by appropriating which risk tolerance you are classified as. Experienced traders might be comfortable investing in high-risk stocks while beginners might lean towards lower-risk stocks.
3. Liquidity Risk
Liquidity risk occurs when you buy and sell a stock at the wrong time. It is when you haven’t bought or sold your assets quickly enough or at a price that reflects its true value. The risk is commonly higher in less popular stocks (low trading volume and volatile).
The type of asset, market conditions, trading strategy, and size of trade factors the level of risk.The risk level is higher when the trading volume is low, making it harder to find a buyer or seller quickly.
Also, some types of securities are inherently less liquid than others. For example, small cap stocks, certain types of bonds, or emerging securities are likely less liquid. Because of this, traders who use fast entry and exit strategies (i.e. swing and day traders) have higher liquidity risk.
Since the risk liquidity poses is high-level, it is important to have well-thought risk management to maximize the potential profits. If you can’t buy or sell at the desired price or in the timeframe you intended, you can get stuck in a losing position for no longer than anticipated.
How to manage liquidity risk?
To mitigate the risk of liquidity, here are 4 risk managements to keep in mind:
- Focusing on Liquid Stocks (High Volume): is a stock with high volume of active traders that tends to be more liquid. You are more likely to find buyers or sellers quickly every time you trade. Large, popular companies fall into this category.
With high liquidity, it is easier to enter or exit positions with ease, without affecting the price of stocks significantly. You can easily exit a trade you want or avoid settling for a lower price than you intended when selling.
- Limit Orders: is a setting of maximum price you are willing to pay when buying and minimum price of the asset you are okay with selling. Remember that this is different from a market order.
The limit you set provides price control. In case the market moves unfavorably, limit orders ensure to mitigate your losses by setting a buy and sell limit with discipline even during a sudden price move in a thinly traded stock.
- Trading during Peak Hours: is the time, usually during opening and closing hours, when markets are generally most liquid. This includes major economic news releases.
Most stock exchanges have peak trading hours.Trading during peak hours, activity and potential buyers and sellers are highest. This is your opportunity to find a counterparty for your trade and get a fair price
- Market Depth: is a measurement of supply and demand for a specific asset. According to the Corporate Finance Institute, Market depth shows pending buy and sell (‘order book’) at various price levels which buyers and sellers are willing to transact, as well as the volume of assets available during the price level agreed.
Market depth plays a crucial role in liquidity risk management because it helps gauge liquidity by indicating good liquidity when sizable orders near the suggested current price are in large numbers (order sizes) and suggesting potential problems when there are large gaps between bid (buy) and ask (sell) prices, called price gaps.
4. Margin Trading Risk
The risk in margin trading is high because you borrow money from your broker to buy more shares than you could afford with your own holdings. While this magnifies your potential returns, it is also the same case when the market declines.
Margin trading requires more advanced knowledge and a separate trading account than your regular ones. Before opening a margin account, traders, especially beginners, should be more deliberate before strategizing to margin trade.
Even for experienced traders, risk management in margin trading needs careful attention. That is why it is important that you understand your risk tolerance. Because if the stocks you purchased on margin money decline in value, you could face a margin call.
When your broker issues a margin call, you will have to deposit more funds to meet the requirements or else your holdings will be liquidated. In extreme cases, losses can exceed your personal investment.
How to manage margin trading risk?
In order to mitigate the risk when margin trading, here are the 4 risk management to keep in mind:
- Proper Education: thoroughly understand how margin trading works, the mechanics of interest, margin calls, and maintenance margin requirements.
Margin trading increases both gains and losses. Without proper education, your losses can exceed your initial investment, where you end up owing your broker money when you go below the margin equity.
- Trading Frequency: is how often you margin trade. More frequency amplifies the margin trading risk. So, it is important to margin trade strategically.
- Exit Plan: is setting an exit point before entering a margin trade. The exit plan includes a target profit level (you take your gains) and a stop-loss level to limit your losses in case the market moves against you.
- Position Monitoring: is a risk management where you closely monitor your margin trades and account balance based on your broker’s margin trading requirements. If the market is more volatile, it can trigger margin calls when the value drops drastically.
Being vigilant allows you to take action (either add funds or close positions) to avoid forced liquidation at unfavorable prices by the broker.
5. Credit Risk
Credit risk is the risk that a borrower in a trading transaction where they fail to meet their obligations. Although the risk low to medium level because the impact to traders is indirect, the risk still poses when you bond invest or margin trade.
If you own bonds, the issuer could default on interest payments or repayment of the principal. Bond investing is a form of lending where you lend money to the issuer (company or government). If they did not pay the regular interest nor pay the principal, your income will reduce and the bond value will decline.
How to manage credit risk?
As a trader, credit risk must not be overlooked. Here are 3 ways to help you manage credit risk:
- Focus on quality: prioritize bonds from financially stable companies or governments with strong credit ratings. They are less likely to miss their financial obligations.
Research the credit rating of bonds from agencies like Moody’s, S&P, or Fitch. Higher ratings indicate lower credit risk. For corporate bonds, focus on strong profitability, healthy cash flow, and manageable debts.
- Due diligence: research any counterparties you engage in financial transactions to minimize the risk of them falling to uphold their side of the deal. Look at their track record and reputation in the industry.
For larger counterparties, check their financial statements or credit ratings. Make sure you understand the terms and your potential liabilities before signing a contract.
- Margin trading caution: being mindful of the risks when margin trading or trading bonds can prevent significant loss. Utilize leverage ratios according to your risk tolerance, skills, and experience when margin trading. Lower leverage ratio provides a larger buffer against market fluctuations. Closely monitor the value of your margin positions and your margin balance. Prepare yourself for a margin call.
6. Operational Risk
Operational risk is a factor encompassing losses due to failures of internal processes, systems, or personnel of a company. The risk is broad, and it can affect the regular routine of a business, eventually harming its financial performance.
It is normal for traders to give full attention to market movements. Because of this, operational risk is often overlooked, which might lead to significant consequences.
A good example of this is the multiple outages and technical issues in the Robinhood trading platform. This happened in the early 2020s, when the high market was volatile. Traders suffered losses because they weren’t able to access their accounts. The Robinhood outages happened again during the meme-stock frenzy of 2021.
Human error can also be a culprit. Mistakes traders or brokerage staff made could lead to incorrect order entry, missed trades, or other losses.
How to manage it?
Although operational failures from companies you invested in is beyond your control, there are ways you can manage the risk. Here are 3 examples:
- Broker choice: ensure the broker is registered and regulated by IIROC. Look for reviews, discussion forums, or any complaints and unresolved issues before you decide. It is important to be proactive and informed. Never rush and always prioritize security and credibility.
- Personal cybersecurity: you must take personal actions as well. Use unique and complex passwords. If applicable, activate your two-factor authentication (2FA). Healthy skepticism and proper habits online helps minimizing the risk.
- Activity monitoring: operational risk management is a constant process. Stay updated of external threats that might affect the market in the future and regularly review your account statements for any suspicious or unauthorized behaviors. Don’t wait until something goes wrong before taking preventive measures.
7. Broker and Online Security Risks
Broker and online security risks refers to online threats that can compromise the security of brokers and traders’ data. The threats include potential data breaches, phishing attacks, malicious softwares, and server misconfiguration.
Sadly, there are brokers whose regulations might not fit well with your strategy and goal. Be careful with low-integrity brokers as well. Instead, look for highly accepted brokers like IBKR or Questrade and brokers recommended by authorized agencies (IIROC or OSC).
In cybersecurity, even legitimate brokers are targets for hackers. Accounts that have been breached can have their funds stolen. Make sure the broker you chose has security measures, data encryption, and has protocols in place in case cybersecurity has been compromised.
Scams like fraudulent websites are designed to look like legitimate brokerage platforms. Always do thorough research before visiting any platform or individual. Be careful of unsolicited offers or unrealistic offers that are too good to be true. Be wary of links you click as well. Some links on ads contain malwares, where they will redirect you to malicious websites that will look like your trusted platforms.
How to manage broker and online security risks?
The risk is higher the more assets you have in your portfolio. Protecting your financial assets requires attention not only to market movements but also to the broker. Here are 3 examples of broker risk management:
- Vetting your broker: your broker must be registered with IIROC and/or your authorized provincial securities commission. You can use the Canadian National Search Registration tool to check for the broker’s company info. Also ensure that the trading platform have insurance coverage like the Canadian Investor Protection Fund (CIPF).
Investigate brokers’ reputation, security features, due diligence, and compliance to regulations. Check third-party reviews and see if there are significant complaints or unresolved issues. Ultimately, check out our list of the 5 best online trading brokers in Canada, as we only list trading platforms there that we trust.
- Account activity monitoring: be vigilant. Regularly review your statements. See if you have transactions (trades, withdrawals, or cash-ins) that are unauthorized or suspicious. Some brokerage platforms have account activity alerts. Utilize that feature.
- Online security practices: includes using strong passwords, two-factor authentication (2FA), email vigilance, and using secured devices & networks.
Using unique passwords and changing them regularly helps prevent unauthorized access and adds an extra layer of protection because unique passwords are harder to crack in brute force attacks. The same goes with 2FA if enabled. 2FA usually requires a code sent to your phone or confirmation from authenticator apps in addition to your password when logging in.
Also, don’t click on links that are suspicious, or emails that are not from your broker. Always beware of unsolicited investment offers.
8. Emotional Risk
In online trading, emotional risk refers to the tendency of traders to negatively influence their decision making with psychological factors like greed, anxiety, regret, frustration, overconfidence, and even cognitive biases. This makes emotional risk high-level because it can happen subconsciously that even experienced traders can be affected.
Although trading is seen as rational, judgements can be clouded by overconfidence and cognitive biases. Beginners and experienced traders can experience the illusion of control, traders overestimating their prediction because previous trades were predictable and obvious (hindsight bias), or anchoring their mindset around a reference point (anchoring bias), which forces a poor trading decision.
For beginners, FOMO and confirmation bias is more common. They will usually rely on trending topics and seek confirmation from pre-existing beliefs and ignore any current information that contradicts them to make a decision. These traders are also susceptible to panic buying or selling whenever they see a stock skyrocket, urging them to buy, only to end up as a false market. Also, they sell their assets when the market temporarily turns against them.
After a few successful trades, be aware of your overconfidence. It is easy to overestimate your abilities when you are winning, but remember, every trade is different and the market can always turn against you. With greed, overconfidence can trigger taking risks that are excessive to your risk tolerance profile.
On the other hand, factors like stress, regret, and frustration can influence in making bad future trades when you are losing. There is also this bias called loss aversion where people focus on avoiding losing instead of finding a strategy to gain in the long run.
How to manage and overcome emotional risk?
While it is impossible to eliminate emotions entirely, here are 4 ways you can minimize their impact:
- Proper planning: well-defined trading plan should outline your goals, risk tolerance, entry & exit points, and position sizing rules. Keep a record of your trades and there should be logic behind those actions. Analyze the records and spot patterns of decision making you think is influenced by your emotions.
Trading plans keep you focused and objective, eliminating impulsive decision-making in the future. When you feel like your emotions are getting in the way, you can always refer back to your plan.
- Self-awareness: learn to recognize emotions, cognitive biases, or any factors that can negatively affect your decision-making. Emotions are contagious, most often than not, it occurs subconsciously.
Be mindful. Regularly check in with yourself. Do you notice physical sensations? Do you feel a rush? What is your mental state? If you feel overwhelmed, step away from trading for a while to regain perspective.
- Position sizing: is the practice of determining how much capital to allocate to each trade. You can express them as percentages of your overall portfolio or an actual value.
Proper position sizing limits the impact of emotional decisions. In case you made a trade influenced by emotions, you can prevent a huge loss because you are trading in smaller positions.
You can set a limit of no more than 1-2% of your overall holdings on any single transaction. As you gain more experience, you can always adjust this based on logical reasoning.
- Realistic expectations: expect that trading is not a get-rich-quick scheme. Remember that in behavioral finance, even the market outcomes can be influenced by emotions and psychological behavior. At the end of the day, you cannot inherently predict the future. There will always be external factors that can affect the trajectory of the market without you knowing it. It is a journey, and you will always experience major wins, losses, and periods of sideways movement. Impatience and unrealistic expectations will just trigger your emotions.
Conclusion
While you cannot eliminate risk, being fully aware of factors that cause the risks you commonly face aids you to counterstep bad decisions under pressure. Understanding the risks mentioned earlier provides you with a better foundation to navigate the ups and downs of online trading.
This knowledge should not discourage you from investing, but rather set you with realistic expectations. Success in trading lies in developing strategies and methods driven by data to counterstep the risks, not avoiding them.
