Forex trading is risky, but what exactly are the risks? In this article, you’ll discover the five main risks and how to overcome them.
As Warren Buffett once put it, risk comes from not knowing what you’re doing. Forex trading seems highly risky to the untrained person, but only a lack of knowledge makes it so. Like any business, traders should be masters of risk management.
Ultimately, it’s all about incorporating various techniques to minimize losses. There are several types of risks that some may not fully appreciate in how they impact their psychology and overall performance.
It goes beyond the uncertainty of essentially predicting exchange rates. Some non-traders may consider forex too risky but may not exactly know what the dangers are. Let’s look at more of these individual risks in detail and their mitigation methods.
1. Exchange rate risk
Perhaps the most considerable risk in forex is the high variability of anticipating where price could go over a specific period. As a result, no matter the level of technical and fundamental analysis a trader may perform, there will always be a tiny element of error, resulting in losing trades.
No holy grail exists in forex because no one can always predict the behavior of millions of investors globally over any given period. To minimize these negative consequences, traders must allocate only a tiny portion of their trading account on a per-trade basis.
Not only does this reduce emotions, but it also results in more manageable losses. When risk on an individual position is too large, it is extremely difficult for traders to return to their previous equity point.
One of the big ‘aha moments’ for diminishing exchange rate risk is treating forex as a purely probabilistic activity where profits are realized over a series of trades rather than an individual position.
The ingredients for dealing with this challenge include applying a highly-tested trading strategy, consistent money management, and emotional discipline.
2. Risk of ruin
The risk of ruin is a concept rarely discussed in trading circles and extends from the previous section on exchange rate uncertainty. Most traders have a linear view of money management by only looking at their win percentage and risk-to-reward ratio.
The risk of ruin is merely a metric determining the odds of someone blowing their account or at least losing a substantial amount of it below a certain point where further trading would be impossible.
While appreciating exchange rate risk does involve some number-crunching, risk of ruin is a far more mathematical model investors should know about their trading approach. Fortunately, many calculators are available online for one to calculate this metric.
Aside from risking a small part of a trading account, traders should also seek to improve their reward potential by holding positions for longer. An important factor with risk of ruin is establishing a drawdown threshold, which most analysts limit to 20% of the equity.
Various simulation software can be used to project an estimated worst losing streak run of a trading system, which would serve as a reference point for formulating a safe monetary per-trade allocation.
3. Transactional cost risk
Trading costs are a part of any ‘trading business’ since they apply to every position taken. While these cannot be completely removed, traders should still understand a few things. The most constant cost is the spread, which is either fixed or variable.
One technique of minimizing spreads for most traders is considering a fixed spread account with low commission. Secondly, many will tend to stick with trading major and minor or cross pairs as they have lower spreads.
Although exotics do present unique trading opportunities, they are usually more suitable to long-term traders with large profit targets. Another aspect of transactional costs is the swap. Again, these cannot be nullified completely, though it’s still imperative to know their implications and understand how interest rates differ between currencies.
Interest swaps mainly affect anyone holding their positions overnight. Almost like shopping for deals, traders must compare swaps across multiple brokers to have confidence they are receiving the lowest.
4. Liquidity risk
It is well-known forex is the most liquid financial instrument. However, high liquidity isn’t always necessarily a feature of a conducive trading environment. For instance, during busy periods such as session overlaps and high-impact news releases, more market participants exist, an attribute representing volume and sometimes erratic volatility.
Due to an overwhelming number of orders being processed simultaneously, spreads tend to widen, making it more expensive to trade. As a result, some traders decide to switch to less active trading styles or avoid entering orders at these times.
However, for more active participants, one fix is, again, opting for a fixed spread account because it has more predictable fees. The second is generally sticking to the most actively traded pairs, namely the majors and minors. Conversely, when liquidity is low, it can also create issues.
The less busy period is the rollover usually occurring at the start of the Sydney session, where brokers allocate swaps to their traders. This is one instance where spreads increase substantially for about an hour or so, making it not a good time to enter any new orders. A similar circumstance occurs when the market opens after the weekend close.
5. Broker risk
The broker risk refers to traders choosing a safe and properly regulated broker. Any trader has the right to swift withdrawals, especially when they start making profits. To mitigate any possible issues, experts always recommended choosing a broker that’s reputable and appropriately licensed.
Scams with unregulated entities still exist where brokers purposefully delay or decline to process their clients’ withdrawals due to bad regulation or going insolvent.
While trading forex carries some form of risk, the most successful traders understand the risks individually and employ various methods of mitigating them. In the end, the venture of trading isn’t as intimidating as it may initially seem.
The formula for profiting involves limiting the downside as much as possible before finding methods of maximizing the upside.