Education

ForexLive anniversary: Knowing the different types of risk will keep you out of bar room brawls in the markets

Anyone can get in a bar room brawl. It is those that stay out of them that survive.

The post that sticks out is the one I wrote that reminded me of the importance of not only understanding how to define risk, but also understanding the three types of risk we as traders face each day. 

The three types of risk are:

  • Market risk
  • Event risk
  • Liquidity risk.

Market risk is the risk we all face when the market is open.  Will the price go higher or will it go lower from the action of traders. 

Event risk is the risk from things like economic releases, central bank decisions, scheduled speeches.  Most events are on a schedule. so we as traders can be aware of the risk – and avoid it if it is “too risky”.  However, there are events that are random and not scheduled.  No one expected Elon Musk tweet about going private, but it sure had a price impact.  A Trump tweet, a natural disaster, a stock market plunge are other events that increase our trading risk. Sometimes we can expect random event risk (i.e., Turkish lira risk might be an event that might make you more cautious about trading).

Liquidity risk is risk from gapping markets as a result of less liquidity in the market (from your broker). Generally speaking, liquidity risk is high when event and market risk is high.  

The levels of risk in the three types can vary.  

When risk is sky high and more random, trading can be like getting in a bar room brawl.  

I like to say that anyone can get in a fight in a bar.  It is not that hard when alcohol, testosterone, pride, and verbal insults, all collide to create a volatile cocktail.  

The other thing about bar room fights, however, is apart from the fact you might be arrested, and charged with lots of stuff, you may also think you know the enemy, but there is a lot of uncertainty as well.  A glass pitcher or pint glass can be an equalizer as could the goons in the corner who were high school buddies with the little guy you know you can take. 

So it is just not a good idea.

In trading there are times when we want to avoid the bar room fights.  

The EURCHFs plunge was one of those times (assuming you were not in the fight as a result of a pre-existing position), where staying out was the best decision. Market risk, event risk and liquidity risk was simply sky high.   

Anyway, CLICK HERE to read the post and remember, bar room fights, rarely pay off in the end.   

ForexLive

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