What is risk and reward for traders and investors and why does it matter?

What is ‘risk’ in financial markets?

Risk in financial markets is seen as a measure of the uncertainty relating to the outcome of your trade or investment. This uncertainty exists because there’s no guarantee that markets will behave in the way you expect.

Furthermore, when uncertainty about the future value of an asset increases, the potential for monetary losses also increases. In other words, more uncertainty equals more risk. To compensate for the higher probability of loss, you’d want a more favourable expected RoR on your initial outlay.

What is ‘reward’ in financial markets?

Reward in financial markets is what you make from a trade or investment, eg possible profit. It can be defined as a benchmark RoR that has a reasonable possibility of materialising.

It’s usually referred to as the ‘expected return’, and how it’s derived depends on the risk-reward analysis you’re using. If you’re relying on historical data, for example, a common way of establishing the expected rate of return is to find an average RoR over a period. Note that historic returns are no guarantee of future outcomes.

What is the risk-reward ratio?

The risk-reward ratio (R/R ratio) is a way of assessing the expected return on a trade per unit of risk. As a trader or investor, you’d typically use the monetary amount you stand to lose as the risk input, and your expected profit as the reward. So, if you risk A$100 and expect to make A$300, your R/R ratio will be 1:3, or 0.33.

Let’s look at a trading example. Say you expect a company’s shares to increase in value from A$130 to A$200 due to a positive earnings report. You decide to buy 10 shares at A$130 and set a stop-loss order to automatically close your trade if the price drops to A$110.

Because the stop-loss caps your risk, the maximum amount you stand to lose is (A$130 - A$110) x 10 = A$200. Your expected return is (A$200 - A$130) x 10 = A$700. Your R/R ratio is 1:3.5, or 0.29.

In cases where your R/R ratio is greater than 1, each unit of capital at risk is potentially earning you less than one unit of an anticipated reward. Equally, when the R/R ratio is less than 1, each unit of capital at risk is potentially earning you more than one unit of anticipated reward.

So the general rule is a risk-to-reward ratio of over 1.0 means the possible risk is greater than the possible reward, and anything below 1.0 means the possible profits are greater than the potential risk.

Bear in mind that the R/R ratio is just a tool to help you understand the risk-reward trade-off and is by no means a watertight guide.

If your reward is very high compared to your risk, the chances of a successful outcome may decrease due to the effects of leverage. This is because leverage magnifies your exposure, and amplifies profits and losses. Therefore, risk management is critically important.

Value at Risk (VaR)

Value at Risk (VaR) is a way of quantifying risk by using statistical modelling to determine three things: the amount of potential loss, the probability of the loss occurring, and the time period over which the loss could occur in normal market conditions.

For instance, a portfolio of shares may have a one-day 95% VaR of A$100,000. This means that there’s a 5% probability that the portfolio will decrease in value by A$100,000 – or more – over the duration of one day. Another way of looking at it is that you should expect the portfolio to drop by at least the above amount (A$100,000) one in every 20 days (ie 5% of the time).

The above example can also be written as a 5% one-day VaR of A$100,000, depending on the convention used. Alternatively, this is also a one-day VaR equal to A$100,000 at 5%. The meaning, however, remains the same. Additionally, the value at risk is frequently expressed as a percentage rather than a nominal value.

Risk and leverage

Before placing any trade, you need to have a clear understanding of how leverage works and how it’ll impact the outcome of your trade.

Trading on leverage means that you’ll put down a deposit – called margin – to get exposure to the full value of the position. For example, if you’ve bought 10 share CFDs on a stock trading at A$100, your market exposure is A$1000 (10 x A$100). Because share CFDs might only require a margin deposit of 20%, your initial outlay will be A$200.

It’s important to note that leverage amplifies both the profits and losses on your deposit. So, because your full exposure is still A$1000, you can lose a lot more than your margin. It is therefore important to take steps to limit your risk.

At a deposit of 20%, your leverage ratio is 5:1. Here, every 1% change in the market price will result in a 5% change in your deposit. Referring to the above example, if the market price dropped to A$90 (a 10% decline), your loss of A$100 (-A$10 x 10 shares) is already 50% of your deposit.

Remember, CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage.

How to manage risk

To manage your risk, you have to take certain steps before opening a position – this includes the use of risk management tools, which we’ll explain below. Remember, risk management is essential when trading or investing in financial markets.

Types of trading and investment risk

• Systematic and unsystematic risk

Systematic risk involves the probability of loss related to changes in the market that can’t be controlled. These changes include macroeconomic factors like politics, interest rates, and social and economic conditions, which could potentially influence the price in an adverse way.

Unsystematic risk relates to the possibility of loss that takes place on a microeconomic level. It’s normally associated with uncertainty about things that could be controlled, like managerial decisions or supply and demand in the industry.

• Business risk

Business risk is a threat to a company’s ability to meet its financial goals or payment of its debt. This risk may be a result of fluctuations in market forces, a change in the supply or demand for goods and services, or regulation being amended.

Business risk also exists when management decisions affect the company’s bottom line. This type of risk poses a threat to shareholders, because if a company goes bankrupt, common shareholders will be the last in line to receive their share of the proceeds when assets are sold.

• Volatility risk

Volatility risk is the possibility of loss due to the unpredictability of the market. If there’s uncertainty in the market, the trading range between asset price highs and lows becomes wider – exposing you to heightened levels of volatility.

So, it becomes important to track asset classes that display historical volatility to gauge future price changes. You can measure volatility using standard deviations, beta and options pricing models.

• Liquidity risk

Liquidity risk is the possibility of incurring loss because of the inability to buy or sell financial assets fast enough to get out of a position and without significant price impact. When you have an open position but you can’t close it at your preferred level due to high liquidity, your position may result in a loss.

• Inflation risk

Inflation risk is the probability that the value of an asset (or your investment returns) will be affected by a decline in spending power. When inflation rises, there’s a threat that the cost of living will increase, plus a noticeable decline in buying power. As inflation rises, lenders change interest rates, which often leads to slow economic growth.

• Interest rate risk

Interest rate risk mostly affects long-term, fixed investments because fluctuations can cause a decline in the value of an asset. This type of risk the probability of an open position being adversely affected by exposure to changing interest rates.

When interest rates go up, the value of bonds will decline. On the other hand, when the interest rates go down, bonds will go up in value.

• Credit risk

Credit risk involves the probability of loss as a result of a company or individual defaulting on their repayment of a loan. A contractual obligation is created whereby the borrower agrees to repay a lender the principal amount, sometimes with interest included.

• Counterparty risk

Counterparty risk is the potential of an individual, company or institution that’s involved in a trade or investment defaulting on their contractual responsibilities.

It’s generally when one party fails to meet the repayment obligations to get rid of the debt. Parties that have exposure to this risk include lenders (like banks) because they extend credit.

• Currency risk

Currency risk involves the possibility of loss if you have exposure to foreign exchange (forex) pairs. This market is notoriously volatile, and there’s increased potential for unpredictable loss.

For example, if you buy shares in Amazon from the UK, you’ll have to convert your pounds to USD to purchase the shares – exposing you to currency risk. When the times comes that you want to sell your investment, the exchange rate might have changed quite significantly, and you’ll be at the mercy of the new rate.

• Call risk

Call risk relates to the possibility that a bond issuer may recall an investment before the maturity date. The more time that passes after a coupon was issued, the lower the probability that the bond will be recalled.

Additionally, interest rates also play a major role in call risk being exercised. When interest rates drop, the issuer may call back the bond because they want to amend the terms of the bond to reflect the current rates.