What is financial risk and how does it affect trading?

The US stock markets were on an upward trend at the beginning of July 2025, with the US 500 and US Tech 100 closing 10 July at record highs. Then came 11 July, and President Trump's announcement of 35% tariffs on Canada, effective 1 August. The stock markets reversed almost immediately, with the US 500 shedding 0.3%, US 100 down 0.2% and the US Wall Street 30 plunging 0.6%.
Sudden unexpected developments are a reality of the markets, which makes financial risk an unavoidable part of trading. So, let’s look at what financial risk is, its types and assessment methods so that you can bolster your trading strategy with robust risk management measures.
What is financial risk?
Financial risk is the possibility of losing money on an investment or business venture. Every trade – from a simple stock purchase to complex derivatives – carries some level of risk.
Without careful management, risks can lead to heavy losses, even wiping out a trading account. Understanding and assessing financial risk allows you to make informed decisions, improve your risk-reward ratio, and navigate volatility with greater confidence.
Financial risk isn’t the only type of risk. For instance, general business risks include operational inefficiencies or reputational damage, while financial risk specifically refers to monetary losses.
Types of financial risk
Financial risk comes in many forms, with each having its unique characteristics and impact on trading.
Market risk
Also known as systemic risk, this is the risk of losses due to unfavourable price moves. For example, a sudden downturn in the broader stock market, due to economic data or geopolitical events, can lead to a sharp decline in the value of your equity portfolio. Market risk affects all asset classes.
Credit risk
This is the risk of loss to a lender (like a bank) when the borrower fails to repay a loan. This type of risk affects traders indirectly. For example, if a counterparty in a derivatives trade goes into default, you could suffer losses. In margin trading, the broker faces credit risk if the trader is unable to cover their losses.
Liquidity risk
This risk leads to traders finding it difficult to buy or sell an asset quickly, before its price moves. In a highly liquid market, you can easily enter or exit positions at your desired price point. However, when there is poor liquidity, finding a counterparty to your trade can take time, which could lead to slippage and, therefore, losses.
Operational risk
This is when loss occurs due to inadequate or failed internal processes, people, systems, or external events. It can include errors in trade execution, system failures or fraud.
Learn more about how to manage risk in trading with our risk management guide.
Assessing financial risk in trading
The first step is to understand your risk tolerance, or the level of loss you are able and willing to bear.
The next step is to analyse historical data, market trends, economic indicators and company-specific information to identify potential risks. Scenario analysis, where traders consider how their portfolio might perform under different market conditions, is also popular way to understand risks. Stress testing is a more rigorous form of scenario analysis.
Tools to assess financial risk
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Volatility: this is the degree to which an asset’s price moves over time. Higher volatility generally leads to higher risk.
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Value at risk (VaR): this is the maximum potential loss a portfolio could face over a specific period with a given confidence level.
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Beta: this is a stock’s volatility in relation to the overall market. A beta greater than 1 means higher volatility than the market, while less than 1 suggests lower volatility.
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Maximum drawdown: this is the largest percentage drop in funds from a peak to a trough in a trading account over a specific period. It is a good indicator of past risk exposure.
Open a demo account to practice assessing and managing risks without risking real money.
Tools and strategies to manage financial risk
After financial risk assessment, you need to minimise their impact. Popular strategies to achieve this include:
Stop loss
This is an instruction to automatically close a trade when the asset price reaches a pre-determined level. This limits potential losses when the market moves unfavourably.
Position sizing
It is important to decide on the appropriate amount of capital to allocate to each trade. Experienced traders follow the 1% rule. It means they don’t risk more than 1% of their trading capital on a single trade.
Hedging
Hedging involves taking an opposite position in a related asset to reduce the risk of adverse price movements in an existing position. For example, if you open a long position in a tech stock, you could open a smaller short position in a healthcare stock. Derivative instruments, such as contracts for difference (CFDs), are often used in hedging strategies.
Portfolio diversification
By spreading investments across different asset classes, industries and geographical regions, you can reduce the impact of any single asset on the overall portfolio.
Learn more about what financial risk is and how to manage risks.
Benefits of financial risk management
Diligent financial risk assessment and management practices offer significant benefits.
Improved trading decisions
By pre-determining acceptable loss levels and understanding potential scenarios, you can avoid impulsive decisions during periods of market volatility.
Protection against market volatility
Strategies like stop-loss orders and hedging provide a safety net against sharp and sudden market downturns. This is especially vital in dynamic environments like day trading.
Long-term sustainability of investments
By preserving capital during challenging periods, you are better positioned to capture future opportunities and achieve your financial goals.
Risks and limitations of financial risk control
While essential, risk management can also be challenging.
Challenges in predicting risks
The markets are influenced by numerous factors, the impact of which can be difficult to predict. Plus, unexpected black swan events can arise, defying even the most advanced risk models.
Over-reliance on financial models
Over-dependence on risk models can be disastrous because, being based on historical data and assumptions, they may fail to account for unprecedented market conditions.
Importance of continuous learning and adaptation
The financial landscape is constantly evolving with new financial products, regulations and market dynamics. Therefore, financial risk control requires continuous learning, adaptation and refinement of strategies.
Examples of financial risk in action
In 2020, an unprecedented market crash was triggered by the rapid global spread of the pandemic and the subsequent lockdowns and economic shutdowns. In early March 2020, as the true scale of the pandemic became apparent, the global stock markets plunged.
The US Wall Street 30, US 500 and other major indices saw their sharpest declines since 2008. On March 9, 2020, the US 500 fell 7% within minutes of opening, triggering circuit breakers and halting trading for the first time since the 2008 financial crisis.
In stock trading, you could face market risk if your portfolio is heavily weighted towards a particular sector that experiences a downturn. You might also face liquidity risk if you hold shares in thinly traded stocks. Volatility is a significant market risk in cryptocurrency trading, with prices often swinging wildly in short periods. Operational risks like exchange hacks or platform outages are also concerns.
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