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Financial markets are inherently volatile, so accurately predicting them is challenging. As such, trades that don’t work out are guaranteed to occur. However, traders can lessen their impact through risk management. Ready to learn more? Let’s dive deeper.
What Causes Volatility in Financial Markets?
Prices rise and fall daily, so volatility is a part of everyday life. However, certain factors can increase volatility above the usual. The leading cause is uncertainty. When investors are fearful of the market, large and unexpected price movements are more likely as people’s actions become harder to predict.
With uncertainty playing a foremost role in volatility, geopolitical events like war, sanctions, or elections are also significant contributors. Similarly, the release of key economic data like inflation or interest rates, employment levels, and Gross Domestic Product (GDP) growth can cause significant volatility.
Other events that can cause volatility include natural disasters, technological advancements, significant news, new regulations, changing commodity demand, and initiatives like net zero. Likewise, shifting investor sentiment can alter volatility levels, as discussed in the volatility in financial markets report.
Top Risk Management Strategies for a Volatile Market
Risk management is especially critical in a volatile market. Without employing a strategy, sudden, unpredictable moves could have serious consequences. Here are some of the best methods for reducing risk when trading unstable assets:
When considering the importance of risk management, we can learn from corporate or Enterprise Risk Management (ERM) frameworks: first determine your risk appetite, then identify potential risks, assess risks, and lastly respond to risks (this can include reducing or accepting risk).
Hedging is a popular risk-reduction method where traders take two positions roughly opposite each other to lessen the blow of negative moves by offsetting losses. It’s also advisable to risk sensible amounts (around 1% per trade) and to set stop-loss orders for short-term positions.
Diversification is another popular strategy that sees investors spread their capital between multiple assets or asset classes to reduce risk and single-sector exposure. For example, people with high-risk exposure could purchase bonds or commodities that are typically stable to reduce the risk impact.
Leveraging Commodities to Reduce Risk
Commodities are everyday goods like oil, gold, gas, wheat, and orange juice that traders can buy or sell on a commodity trading platform. People trade them in US dollars, so commodities can be used to hedge against inflation, because a weak dollar makes commodities more valuable.
They can make for excellent diversification assets because their stability and predictability enable commodities to protect against drawdowns. However, considering how a particular commodity moves in relation to your main position is crucial when deciding which commodities to use for diversification.
Risk management is an essential consideration for any trader or investor entering the financial markets. Many factors contribute to instability, so it’s advisable to follow a strategy like hedging or diversification to reduce risk. Assets like bonds or commodities are predictable, so they work well for diversification.
