Stock and Market Risks
Stock and CFD trading are inherently risky. Trading is a hazardous occupation and participants must gamble a part of their capital if they are to receive any return on their investment. Some gamblers win, but some lose too. It is important that you understand the chief risks that will confront you as a trader so that you can take steps to contain them as much as possible.
We will address the chief risks, yet traders confront many manifestations of risk in their everyday operations. Nobody can prepare you for all of them.
A trader with shares in Wal-Mart (WMT:xnys) has to know more than simply how Wal-Mart is performing on fundamentals. The general condition of economies around the world becomes crucial because Wal-Mart is multinational. The aforementioned trader needs to know how well the U.S. stock market is performing overall, since Wal-Mart's fortunes cannot be isolated from it, and whether the U.S. dollar is strong or weak, rising or falling. But that is only part of what this trader needs to know.
As you have already learned, understanding key risks enables you to counteract forces that are unhelpful to the prices of your shares and CFDs and minimise the impact of those forces on your investments' profitability.
Yet it is important to recognise that competent CFD traders welcome these risks because they constitute opportunities to make money though boom or bust. When risks are low and companies do well, CFD traders can profit as share prices soar. Conversely when risks are high and companies struggle, CFD traders can profit as share prices dive.
We will now address several types of risk and how you can contain them:
Systematic risk is, as the name implies, the inevitable consequence of operating within any system. In this case, the systems are stock and CFD markets. Traders may be able to hedge against certain risks, but they cannot hedge against systematic risk. (Compare it with playing soccer; avoiding being kicked is impossible.) Consequently, participation in the markets involves tacit acceptance of its systemic risks.
Systematic risk can, in extremes, involve stock market crises with far-reaching consequences. A few of the most sobering examples are the Wall Street Crash in 1929, Black Monday in 1987, and the Asian Financial Crisis in 1997. During such crises, all prices are likely to suffer.
Traders often refer to the benefits of the system with the oft-repeated adage "A rising tide floats all boats." Incoming tides certainly lift the entire stock market. Yet the self-same tide can also retreat and can leave the entire stock market marooned. It is when the latter happens that the ability to hedge is a useful riposte to the risk.
Unsystematic risk, in contrast with the wholesale and unavoidable risks of a system, is the intrinsic hazard associated with a particular stock or CFD.
Shares and CFDs inevitably align those who invest in them with the fate of the companies to which they correspond for better or for worse. Many factors influence company performance. Some present opportunities but others constitute risks. And, because these risks are tied to the performance of individual companies rather than all companies, they are termed unsystematic.
Below is just a representative (and certainly not exhaustive) list of unsystematic risks:
- Unexpectedly low earnings
- Lawsuits
- Scandals
- Technology obsolescence
- Employee strikes
Any one of these risks could cause a company's shares to plummet. Yet, as you must realise, the list of unsystematic risks to which an investment might be subjected is almost infinite and constantly lengthening. In the 21 st century UK , you might add, for example, the risks posed by terrorists, by Internet whispering campaigns, by bird flu, by power grid failure and by ethical protesters. This susceptibility to unsystematic risks is inevitable despite many larger companies employing dedicated staff to predict and address them.
Unlike systematic risks, you can counteract unsystematic risk by diversifying your investments across a swathe of companies, sectors and markets. It is also advisable to hedge your positions and thereby protect yourself, to some extent, against cumulative loss.
Credit/Default risk is the hazard that a company either actually defaults on its debts or is, for whatever reason, perceived to be a credit risk and therefore likely to default. Although it doesn't frequently happen, companies can become insolvent and unable to repay debts to banks or to the holders of company bonds.
Insolvency may result from credit crunches, as a consequence of corporate fraud, or due to anything from a fundamentally poor company performance to bad bookkeeping. Yet, regardless of the cause, when companies have cash-flow problems, they lose the ability to function effectively. Cash is, after all, a company's life-blood.
Whilst share and CFD holders are not directly hit by loan repayment issues, they are indirectly affected because other traders know a company is fundamentally in trouble when it is technically insolvent and this undermines the share price.
Exchange-rate risk is the hazard facing investors whenever they buy and hold investments in currencies other than their native currency. Like shares, currency prices fluctuate. So, ignoring an investment's performance, if it is held in a currency other than the investor's native currency, and that foreign currency outperforms the native currency, then the investment will profit from the favourable exchange rate. However, if the foreign currency in which that same investment is held loses ground against the investor's native currency, then the investment will suffer from the unfavourable exchange rate.
Exchange-rate risk can even offset any gains the investment may have made on its own. Here is a salutary example. Imagine a British investor buys a U.S. share for $30 when the exchange rate between the pound sterling and the U.S. dollar is 1.5000. So every £1 is worth $1.50. He would therefore pay £20 for the $30 share ($30 ÷ 1.5 = £20). Subsequently the share appreciates by 20 percent, rising from $30 to $36. Yet whilst this is happening, the British pound strengthens against the U.S. dollar so the £1 now buys not just $1.50 but $2.00. So the good news is that his share made $6. The bad news is that the $36 it is now worth will correspond to just £18 ($36 ÷ 2 = £18) if he now swaps those dollars back for pounds. In this case, the share gained 20 percent but the investor would (unless he waits or reinvests or whatever) have a net loss of £2 due to the 25 percent slippage caused by the exchange-rate risk.
Interest-rate decisions by central banks such as the Bank of England, the U.S. Federal Reserve and the European Central Bank have immense influence on global and local economies.
Rate increases generally make it more difficult for companies to borrow in order to expand. This makes their outlook bleaker and tends to undermine share values.
Conversely, when central banks cut interest rates it becomes easier for companies to borrow to expand. This positively influences outlook and tends to inflate share prices.
Political risk is the hazard you face that the political environment in the country (or countries) where a company operates may become less conducive to business growth.
At worst, political risk can involve a company being nationalized, losing shareholders most or all of their investments.
Yet political risk takes other forms. It might involve increasing corporate taxation. Or it might involve tariffs that erode a company's profit margins. Both of these would be detrimental to the best interests of shareholders as they would undermine prices.
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