Risk Management in Stock Market

Introduction

Risk has been an inseparable part of trade and investment of all types throughout history. Whether it be the possibility of loss due to harvest failures or wars or the loss of merchant ships, later on, traders had to deal with risk every step of the way in all their transactions. That led them to develop their strategies for managing risk. These early attempts were primarily informal. The study of risk management techniques in trading began in a formal and organised manner after the Second World War. At first, this was mainly regarding the value of market insurance as protection against fluctuations for individuals and companies. In the 1950s, such market insurance came at an increasing cost, leading to the development of alternative forms of insurance in the following decades, with international risk regulations and derivatives leading the charge.

Risk management in stock market

Risk management refers to analysing potential loss from investments that investors carry out and any appropriate action to mitigate the chances of incurring a said loss. Today, risk management forms an essential part of strategies used by investors while trading.

Strategies of risk management

The process of risk management in share market trading can be categorised into the following strategies:

• Adhering to market trends while trading is one strategy of risk management. That involves buying stocks when their price goes down and selling them when their price goes up. However, this strategy is challenging to follow due to the rapidly fluctuating nature of the stock market.
• Another strategy for risk management is the diversification of investment portfolios. Instead of investing in one particular stock or a single category of stocks, investors spread their investments across stocks in various financial sectors that are different in terms of the factors that affect them. This strategy helps in the mitigation of losses by minimising the effect of any single stock investment.
• Using stop-loss orders can be a particularly effective strategy for risk management. Stop-loss order is used by investors who authorise their brokers to sell stocks automatically when their price goes down to a specified level. That protects the investors from excessive loss.
• Investing in non-cyclical industries which produce essential goods is another risk management strategy. These industries are relatively stable, and thus investments in them are more insulated against market fluctuations.
• Hedging uses derivatives to fix the price of underlying assets and thus insulate them somewhat from price fluctuations. This strategy is often used in equity trade.
• Investing in blue-chip – stocks from large stable companies with a market reputation for efficiency and reliability – is another risk management strategy. That is effective since market fluctuations have less impact on such large companies than on smaller companies.
• Pairs trading involves buying stocks of a company and simultaneously short-selling the stocks of another company from the same sector to mitigate risk from an anticipated price fluctuation.

Conclusion

Risk management in trading involves the calculation of market risk and fluctuations. This can be done through many analytical tools which factor in various financial data in their assessments. Investors generally tend to combine data from a number of these analytical tools before formulating their response to market risk. These responses are also often combinations of different recognised strategies of risk management, the combination modifying them to suit the requirements of the investors in question.