Risks Involved in Forex Trading
As with all sorts of trading, forex trading carries high risks for the unseasoned pro aswell as for those who are long-term traders. The reason that so many still trade forex is that as with Newtons’ third law, ‘every action has an equal and opposite reaction’.
We say in this case that with high trading risk also gives us access to high trading reward. How to extract that reward is the fun part which we delve into details within our look at trading strategies.
Before we get carried away, first and foremost it is imperative for beginner traders to educate themselves on the market before starting to trade.
High Risk, High Reward – can we reduce risk but keep the reward?
The foreign exchange market is growing at an increasing pace, and offers high risk, and high reward for the informed trader but many novices to the industry are hesitant to dive into the world of forex or CFD trading as they fear that they lack the necessary knowledge to take the plunge. If this sounds like you, get accustomed to our top 3 tools for the beginner forex trader before moving on.
In the early years, the forex market was quite restrictive in that only national banks and large corporations had a hand in it. The rules started to relax during the 1980’s and allowed smaller investors to start trading via leveraged accounts. It is leverage that caused such a surge in forex trading as it allows a relatively small investor trading with $100 to move $10000 with a margin of 1:100.
Leverage restrictions are mostly guided by the local financial regulators of the market that you trade in. In some parts of the world leverage can be as high as 1:1000 whereas others restrict to 1:30. The difference in the underlying money controlled with a $100 trade would then range from $100,000 at the high down to $3,000 at the lower end of the leverage scale. With such large controlled amounts at stake little movement causes big rewards but you cant overlook forex risks.
Top 3 Forex Risks – Personal, Counterparty & Market related
There are lots of different things that would constitute risk when it comes to forex trading. You have your market risks which are linked to the many variables that have an impact on the value of the underlying currency pair being traded, we will deal with this in the sections below.
You also have your counterparty risk which is relating the broker (and associated third parties) you choose to handle your money and your trades.
The final and often crucially overlooked form of risk in forex trading we will look at is personal risk. This is the risk associated with you yourself and your ability to control emotions… yes you read it right and we will cover this off first so there are no lingering hard feelings, we like you.
Personal Risk – Controlling your use of leverage and controlling your emotions.
The art of self control and forex risk management primarily rests on us each individually as traders. As often emotionally led beings, we can be quite a risk to ourselves when things are going badly and sometimes even moreso when things are going well!
Controlling your use of leverage can be critical – some traders will look for the broker with the highest leverage possible and use this to the maximum on all occasions, a highly aggressive strategy and one not likely to last very long in the market without more than a handful of luck.
That being said, ESMA regulations in the EU have recently acted to help people control this exact scenario and have limited leverage of forex to 1:30 (down from as high as 1:400 in the region as recently as 2018).
If the regulators have had to resort to putting in place leverage restrictions in order to protect traders from themselves, even if you are outside of these restrictions and not bound by their rules it is worth considering whether you too should put in place measures to protect yourself by capping your use of leverage to a manageable level.
Risk management should be a vital part of your strategy it will pay not to overlook.
Psychology of Forex Trading – A topic too broad to complete today
Without delving too deep into the human psyche and turning this into a site dedicated to psychology, we can only skim the surface of the different things that can cause us as humans emotionally to behave erratically and out of sync with our predefined trading strategy.
It must be said that we are as at risk from ourselves when we are seeing sustained periods of trading success as we are when we are taking losses. Sustained success can lead to a feeling of omnipotence, that we are now all knowing and have stumbled across an infallible strategy – all that remains now is for us to keep increasing the value of our trades and we will reach our goals faster… wrong, please do not fall into this trap.
Stick to your strategy and your defined trade limits and it will serve you well during more difficult times ahead. Enjoy your success but do not let it fool you.
Keep short-term results in perspective
Times of struggle also should not be viewed from an emotional standpoint but from one of logic. If you have been a successful trader for the past 5 years and you are taking some hits for a quarter we typically see one of two reactions;
a) a feeling that the next good trade is just around the corner and you need to increase your trade values to maximise from the win when it comes or
b) a feeling that your strategy has broken, somehow not withstood the test of time and you need to look for an alternative
… both are wrong.
Whilst you should never stop looking for ways to improve your trading strategy, if you associate with risk b) and have been successful for years by sticking to a defined strategy, then you are actually in the top 10% of forex traders and will likely see success when conditions return to suit your model.
Stick to what works and congratulate yourself on being one of the successful ones in the first place.
Personal Risk fail-safes are a good idea
If you want to take some action it may be worth reducing the volume of trades you make by 50% until things return to status quo. If you associate more with a) from above, it would be worth reigning in your use of leverage until you see a turn in the tide rather than increasing it.
This will still give you the opportunity to make the same volume of trades to stick to your strategy but by reducing your use of leverage you are again giving the market some time to come around without taking too many hits in the short-term.
In both cases above, once you have seen a sustained period of success feel free to revert back to your previous trading volumes & values.
As you can see these are just two very crude examples of what can cause forex risk mismanagement from a personal perspective but anyone who has been trading long enough will recognise these patterns in themselves or their peers.
If the end results are not matching the goals typically the best way to overcome this in ourselves is to firstly ensure you keep a trading journal with trades made on the day and emotional state and then if you feel yourself deviate, look back at a period of sustained success and take yourself back to your mental state of success and ensure that the truth is not lost through those rose tints.
Counterparty Risk – know your broker, choose the right broker
Minimising counterparty risk can be done with relative ease by choosing one which has all necessary licenses and regulations to trade in your local jurisdiction, alongside one with strong management and operational systems to effectively handle your trades.
Providing that the broker has met these restrictions and has adequate reserves to mitigate even the fiercest market volatility then you can minimise your counterparty risk quickly and efficiently.
Do not overlook this aspect of risk; nobody wants to fall victim to a scam. Check our list of approved best brokers to be on the safe side.
Market Risks – Political, Interest rates, Devaluation, Volatility
Forex price movements are linked to the underlying perceived value of one currency versus another, therefore anything that could have a material impact on the strength of a country or group, (in instances where a currency is linked to multiple countries such as the Euro) can constitute a risk.
The main risks to consider in forex to either trading pair currency or economy would be those relating to politics, monetary policy, economic growth, currency devaluation and general volatility.
Political Forex Risk
Any change or potential change to the political structure of a country or its’ governing party can have a material impact on the economic strategy and therefore the value of the underlying currency used. The instability surrounding election periods can result in higher than usual volatility, both an opportunity and a risk for forex trading during such periods.
Interest rate changes (the rate of borrowing within a country) are often led by monetary policy of the central banks and can have a big impact on the movement within the forex market. The way interest rates are interpreted within a traders’ strategy can vary but it is definitely something to keep a watchful eye on.
Economic growth reports are a good indication of an economies’ strength and any deviation from expectations when the actual figures are announced will usually cause volatility and heightened risks in forex markes. Sometimes deviations from announced expectations can be ‘priced in’ to an asset in advance of amendments so it is another area on which to keep a watchful eye.
Beware Unexpected Devaluation
Currency devaluation is used as part of monetary policy usually as a means of strengthening import/export ratios but where currency devaluation happens without warning this can leave catastrophe or jubilation in its’ wake for obvious reasons.
The best way to keep ahead of most forex market risks is to monitor the economic calendar for announcements and make adjustments based on your expectations in advance of these events.
Surprises can still be expected from time to time with the recent British parliamentary suspension a prime example of something which leaves traders scrambling and reassessing their view on GBP in light of new potential outcomes so close to the current Brexit deadline.
Expect the unexpected, trade with this in mind and above all, never trade more than you can afford to risk… profit after all can be a fickle beast.