Profitable traders know that the secret to making money is managing risk. It’s a lot easier to lose money in the markets than it is to end a trade in the green. Traders know that analyzing the risk factors rather than the potential rewards is the better way to trade.
But what are those risk factors? How do you know what to analyze when it comes to risk?
This is the best known and probably the most feared. It’s the risk that something negative will happen causing a company, sector, or index to lose value.
Examples of business risk include a disappointing earnings report, bad economic data, changes in leadership, wrongdoing within the company, or disappointing products.
Possibly the most pronounced example is the biotech industry. If a company develops a drug that fails in clinical trials, that company could lose nearly all of its value in a single trading day.
It’s hard to forecast business risk. For that reason, responsible traders often hedge their positions instead of trying to predict the future.
If you want to gain a clear understanding of sociopolitical risk, spend some time in the commodity pits. Oil traders, for example, know that a single attack on a pipeline in a rarely-talked-about third world country is enough to send oil spiking.
As the name indicates, when countries or regions experience destabilization, it has an impact on certain investment types. For larger events, like the Greece crisis from years ago or the recent situation in Ukraine, sociopolitical risk can send entire markets plunging.
Traders fear this type of risk because it’s hard to forecast. Most traders don’t have the same level of knowledge of other countries as they do America and news coverage of third-world and communist countries is often spotty. For this reason, having tight stops in place for positions with international exposure is key.
Especially for companies that don’t have a lot of high-flying growth potential, the dividend is what keeps investors, personal and institutional, in the stock. If that dividend is cut or eliminated, the investment thesis is no longer valid and investors move out of the stock.
For traders, the dividend isn’t of such importance but if investors, especially institutional ones leave, the stock will likely drop sharply.
Longer-term investors mitigate this risk by keeping a well-diversified portfolio. When news breaks of the dividend cut, traders should exit until the news is priced into the stock.
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