'No risk, no gain' still holds ground

Risk is a word most of us don't like to associate ourselves with, unless of course it involves a board game and the conquest of world domination during weekly games night. But other than fulfilling our Napoleonic fantasies every Tuesday night, most of us are quiet content to distance ourselves from all things risky, particularly when it comes to the financial risk linked to our investment portfolios and businesses. This risk-averse temperament most people possess is perfectly human nature, yet without taking on risk, how can one expect any return?

One doesn't need to look at a risk curve diagram or study Bernoulli's hypothesis in too much detail to realise that this age old saying has some truth to it. Higher risk, higher returns. We've all heard it before – from the punters who were flipping properties as if they were the ones with the really weird hair saying "you're fired!" on NBC; to the telemarketers and salesmen trying to sell you some kind of fund or financial product as if your life depended on it. Being a victim of several such calls myself, every time I inquired about the risks and the potential for loss, and I was met with a more than disappointing response; "Sir there is very little risk, the trend is up. No chance of loss in current market condition." Like most investors, I don't like to hear that word chance when it comes to my investments. Of course, it would help if the person on the other line could properly explain me the risks instead of selling me the usual jump-on-the-bandwagon, everyone-is-doing-it sales pitch. But how can we protect ourselves from unwanted, unnecessary risk? All forms of investments carry their respective risk-to-reward ratios, yet the same risk management tools can be applied across the various investment avenues to reduce this unwanted, unnecessary exposure to risk. Trading in the commodity and currency markets is no different; and entails a great deal of financial risk. It's in the fine print that most clients skip over, it's printed on the bottom of all advertising and promotional material and very frankly, your broker should tell you that before entering into a relationship with you.

The risk in these markets emanates from the highly leveraged nature of the business. Because the minimum movement of a currency pair or a commodity is so tiny [ten-thousandth of a place in currencies or a tenth of a place in most commodities], financial exchanges tend to offer larger [more leveraged] contracts which can be bought or sold for a percentage of the actual contract size to make this point movements worth our time. Sure this sounds great, particularly if you listened to Nostradamus from the above example, the all future-seeing-turned-financial salesman and you're sitting sweetly in the market after buying on the bottom and riding the trend to the top. However, it's not so pretty if caught on the wrong end of the market with losses piling up and you're soon a phone call with those dreaded words "margin call."

When investing in currency and commodity markets [or dealing in any leveraged products], investors should rarely expose themselves more than 10-15 per cent at any given time. That remaining 85-90 per cent of unused capital acts as a buffer and increases one's holding power and avoids margin call situations. This addition comes in handy if the markets take a turn for the worse. During such times, this buffer gives the investor the power to hold their positions, seeing them through any unwanted price volatility. This additional capital also allows more trading flexibility-building more positions to average or taking positions in other products to hedge against further losses attached to your position.

Too many times has a client got burnt by not planning their trade. It's helpful to ask certain questions before entering the market and be clear of certain parametres such as the time frame, expected return and your risk appetite. A trader should have a clear picture of their planned entry/exit points, what they plan to earn [realistically] from the trade and what kind of levels would they be ready to exit the market, even in the worst case scenario. And once you plan your trade, you must ensure to trade your plan. Finally, leave all emotions at the door.

Your broker can offer you several tools that you can use to reduce your risk exposure. Employment of stop-losses and proper management of leverage are just but a few tools to mitigate such risks. Work with your broker to properly assess your risk profile before deciding to enter the market because risk appetite differs from investor to investor. That's why brokers are required to have a 'know-your-client' section in their paperwork. That's the really obtrusive part of the account opening form which asks about your annual income, average assets, and other such sensitive financial information. And that's also why your broker requests a bank statement to monitor your financial strength. Intrusive yes, but important information nonetheless to properly gauge your risk profile.

Trading in highly leveraged markets entails a great deal of risk, but with a few simple tools and the help of your broker, these risks can be conquered every time you invest in the market. Then, even if you can't conquer the world on games night, it won't feel so bad.

- The writer heads the DGCX Futures and Options trading desk at ACM ME DMCC. The views expressed are his own

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