It would be impossible to trade in forex without assuming some type of risk, according to several experts. Does this mean that risk-taking is part-and-parcel of forex trading and that being prepared to take risks without fear of the consequences is an essential part of the game?
On the contrary, experts say that the question is how you identify and manage risk to fit your individual circumstances. Whether it is stocks or forex traders on a platform like FXPro, all investors should draw up unique and comprehensive risk management plans that would stop them from trading within acceptable risk parameters according to Stockmarket College.
“High risk is typically associated with high returns, although this isn’t always the case; high risks can also mean incredible losses,” Stockmarket College warns, adding that you should get clarity on
Trading Academy defines forex or foreign exchange as the trading currency pairs. “When you go long on EUR/USD, for example, you are hoping that the value of the Euro will increase relative to the U.S. Dollar,” they explain.
The article added that as with any investment you could “guess wrong” or add additional risk to your trading by targeting less popular currency pairs.
“It’s useful to keep in mind that the vast majority of forex transactions are made by banks, not individuals, and they are actually using forex to reduce the risk of currency fluctuation,” Trading Academy explains. “As an individual, you are less subject to many of these risks, and others can be minimized through sound trade management.”
In an article on iForex, the authors write “risk is an important part of trading and – in the right hands – it’s a valuable tool that can help you make trading decisions.”
They describe risk management is a way to identify, measure and analyse risk before taking a decision. “Miscalculated risk management can have substantial impact on companies and individual traders alike,” the article continues.
iForex advises tailoring the size of investment to size of capital. “Why? Because no trader – not even the most professional, experienced, gifted trader in the world – achieves a 100% rate of trading success,” they added.They also advise the use of “Stop Loss” – a market order allowing traders to limit potential losses and calculating the risk/reward ratio for a specific investment by “dividing the amount the investor will lose if the price moves unexpectedly by the profit the investor expects to make when the position closes”.
Trading Academy identified the following risk factors in Forex trading:
EXCHANGE RATE RISK
This is caused by changes in the value of currency – due to shifts in demand. It can be significant The fact that off-exchange trading in foreign currency is not really regulated adds to the size of this particular type of risk as it means that there are no daily price limits, according to Trading Academy.
iForex explains that some types of currency are traditionally viewed as more risky than others but these have shown larger returns.
INTEREST RATE RISK
Interest rate risk refers to the profit and loss generated by fluctuations in price of currency including forward outright, futures, and options. Interest rate risk can be ameliorated by continuous analysis of the interest rate environment and timeous forecast of changes.
COUNTRY AND LIQUIDITY RISK
Periods of illiquidity have been observed in several countries and especially outside the United States and European markets. Countries can also impose trading limits or restrictions on the amount of Forex to be traded, the volume and penalties. This can stop a trader from liquidating an unfavourable position. In some countries foreign exchange prices are also government regulated, Trading Academy states.
Investopedia explains further that interest rates have an effect on countries’ exchange rates meaning that an increase in interest rates would strengthen domestic currency in that country. They add that the converse is also true. This, the authors explain, can cause dramatic fluctuations in forex.
They add that it would be good to assess the structure and stability of a country before investing. “In many developing and third world countries, exchange rates are fixed to a world leader such as the US dollar. In this circumstance, central banks must sustain adequate reserves to maintain a fixed exchange rate,” the article added. “A currency crisis can occur due to frequent balance of payment deficits and result in devaluation of the currency.”
MARGINAL OR LEVERAGE RISK
As low margin deposits or trade collateral are required in forex trading, it would allow for a high degree of leverage (using other people’s money to invest) – but this also means that small price fluctuations can lead to considerable losses.
Investopedia explains that leverage involves borrowing a certain amount of the money needed to invest in something – and adds that foreign exchange trades often offer high amounts of leverage.
This describes the risks of procedural mistakes and mishaps like errors in communications and problems with the handling of an order according to Trading Academy.
Investopedia adds that this type of risk is amplified by time differences between the beginning of a contract and when it settles. The greater the time that passes, the greater the risk, they explain, adding that the reason for this is that it allows for the exchange rate to fluctuate.
The greater the time differential between entering and settling a contract increases the transaction risk.
iForex advises tailoring the size of investment to size of capital. “Why? Because no trader – not even the most professional, experienced, gifted trader in the world – achieves a 100% rate of trading success,” they added.
They also advise the use of “Stop Loss” – a market order allowing traders to limit potential losses and calculating the risk/reward ratio for a specific investment by “dividing the amount the investor will lose if the price moves unexpectedly by the profit the investor expects to make when the position closes”.
There are many types of risks which are an inherent part of forex trading, from exchange rate and interest rate changes to marginal and transactional risks. However, this doesn’t mean that reckless risk-taking is a necessary or even advisable part of forex trading. Having a detailed plan and a strategic approach means you will be prepared to deal with risks and there consequences when and if things go awry.