Simple risk management tips for active traders

Risk management is crucial to investing, and online brokers can benefit their clients by teaching them some simple tips on how to perform this highly important function.

Regardless of what level of sophistication they are at, active traders can benefit from brushing up on their existing knowledge of some basic components for risk management.

Diversification is crucial

Investors of all shapes and sizes can benefit from knowing about diversification, and the important role it can play in managing risk. The basic idea of diversifying is not putting all of one’s eggs into a single basket.

On a more complex level, the idea is to combine different assets in a portfolio that do not follow one another in terms of their price movements. In other words, if one security rises 5 percent, having another one that appreciates by an equal amount does not provide diversification.

Alternatively, a diversified portfolio should result in depreciation in one asset being offset by appreciation in others. Ideally, the different components would move in opposite directions so that the volatility of the total group of assets is minimized.

Methods used for diversification

There are many different methods that active traders can harness in their efforts to create diversified portfolios, and online brokers can benefit their clients by providing them with education on such subjects.

Roger Wohlner, a finance blogger and fee-only planner, wrote in a U.S. News and World Report opinion piece that investors who want to diversify can do so by leveraging a wide range of assets. including stocks, bonds, real estate, private equity, exchange-traded funds and other securities.

As an example, he uses the benchmark S&P 500 Index and shows what the results would be of combining this group of stocks with other frequently-used assets like bonds. These debt-based instruments generally do not follow the price movements of stocks, and are therefore a good way of managing the risk of a portfolio largely composed of equities. In addition, they frequently have lower price fluctuations.

It is important to note that diversification can be challenging in bear markets, as investors can become very nervous and therefore sell off all asset classes simultaneously. The consequences of such an occurrences are widespread losses and high correlations between different asset classes.

Coping with such downturns in asset markets can be challenging, and there are specific techniques that people can harness in order to manage risk in these situations. For example, active traders might be able to pick out assets that rise in value as others depreciate. During the recent bear market between 2007 and 2009, gold enjoyed price gains every single year.

Derivatives and risk management

Another way that active traders can manage their risks is to harness derivatives. These tools are perfect for this particular job, as they are contracts that are used to either increase or decrease risk. Investors can use these tools to either hedge their existing exposures, or alternatively, speculate in an attempt to obtain higher profits.

For example, in a bear market, active traders can harness a technique called covered calls in order to help manage their downside risk. The basic strategy involves purchasing shares of a stock and then writing a call option for these securities. In doing so, investors that use this strategy can gain some income by selling the contract, and use these funds to help offset any potential losses resulting from declines in the market.

Alternatively, these active traders could buy shares of a stock, and then also purchase call options for those securities. In the event that the equity rises in value, its owners will benefit not only from the increase in stock price, but also the ability conferred from the call options to acquire the shares at a predetermined price.

Risk and reward

In order to effectively manage risk, active traders must know the tradeoff that exists between this potential to suffer loss and also the rewards that come along with it. For example, stocks have the highest returns of any asset class historically, appreciating at a higher average annual rate than these potential investments.

Morningstar reports that while these assets have been able to yield between 10 and 12 percent on average every year, they have also fluctuated substantially in value. While equities are only one example, such characteristics can be applied to all investments.

Assets that have strong potential for returns generally provide this benefit at the expense of having greater downside risk to their to principal, and securities that are considered safe in terms of not fluctuating much in value tend to have low potential to generate upside.

In addition to knowing these simple principles, investors can benefit greatly from not having unrealistic expectations, according to the news source. Online brokers can emphasize to active traders that in order to generate outstanding returns, they will most likely have to incur a great deal of risk, which may not be a wise road for them to go down.