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Forex Trading – The Risks
The appeal of forex trading is down to a combination of factors such as accessibility – with the markets being open around the world 24 hours a day – the liquidity of the assets and the fact that currencies are generally much less volatile than other assets such as stocks and shares. All of these are amongst the reasons why brokers feel able to offer such appealing leverage rates for forex trades. Leverage refers to the fact that a capital deposit of £100 can be leveraged up, with a rate of 20:1 to choose a pretty standard figure, to £2,000 to fund the position a trader wants to take. Of course, if the trader in question takes a losing position then this same leverage can greatly increase the losses they suffer, and this is just one of the reasons why forex trading should never be approached as a get rich quick scheme or an ‘easy’ way of generating a return on investment. Some brokers offer no deposit accounts, enabling traders to trade without risking any of their own money and this, together with demo accounts, can help to delay the moment at which risk becomes a major factor. When it does, however, the risks listed below are among the most important:
This is the most obvious risk where forex trading is concerned, and it relates to the factor which all forex investments hinge upon – namely the exchange rate between the two currencies chosen for any given position. The factors which can impact upon the exchange rate at any given time are almost too numerous to list. When dealing with sterling, for example, a trader will have to be keenly aware of political events which could have an impact on the strength of the currency. In recent months the situation around Brexit in the UK has been, beyond doubt, the factor which has impacted most powerfully upon the strength of the pound. Put simply, anything which has made a hard, no deal Brexit seem more likely has caused the value of the pound to drop, while any signs of a softer Brexit, or of Brexit being delayed or even cancelled, have seen the currency rally. The same is true of currencies around the world, in as much as they can be affected by political or wider economic events in the area within which they operate. A predicted cut in interest rates, the election of a new president or a poor set of economic figures can all have a direct impact on the strength or otherwise of a currency.
For that reason alone, one of the best ways of mitigating this risk is simply to think very carefully about the positions you take and to constantly monitor conditions in the real world to try and spot, before they happen, circumstances which may lead to the position worsening.
Put simply, credit risk refers to the other party in any forex trade being unable to meet their obligations when it comes to paying out on an outstanding currency position. If, for example, the FX broker a trader uses goes into liquidation before a position pays out, that trader may find themselves being simply one individual in a very long list of creditors. For individual retail traders in Western Europe this is a fairly small risk, since countries in Europe follow the kind of rules set out by the Financial Services Authority (FSA) in the UK. These rules provide a framework which ensures that traders funds are secure in any set of circumstances. If you’re using a broker from a jurisdiction you’re not certain about, or if you simply want total peace of mind, you can check the record and trustworthiness of the company in question by visiting the website of one of the global authorities:
CFTC (Commodity Futures Trading Commission)
FCA (Financial Conduct Authority)
Most brokers will be only too happy to answer questions about the licences they hold and the steps they take to ensure the funds they handle are secure. If a broker is less than open on these topics, it’s a sign that you should be thinking of looking elsewhere.
The liquidity of the currency markets is one of the factors which makes forex trading so attractive, but it should not be taken for granted. Outside of Europe and the US, some countries have been through periods during which liquidity was impeded, because trading restrictions have been put in place, or the government has imposed limits on factors such as:
- The degree to which the price of particular foreign exchange rates can shift
- The amount which individuals are allowed to trade
- The length of time over which certain positions can be held.
Restrictions of this kind could, for example, stop a trader from closing poor positions and cutting their losses, leaving them to close at a later date with further losses having accrued. The chances of any of these impositions being put in place multiply hugely when traders move beyond the major currencies of Europe, the US and Japan, and take a risk on currencies from places which don’t enjoy the same levels of political stability. This lack of stability may be tempting, in that it opens up the chance of more extreme currency shifts, but the risk of liquidity being impacted has to seriously be weighed against this.
The offer of a big leverage is pretty hard to resist, in that it opens up the chance to set up much more lucrative positions than the amount being actually deposited could fund. With the possibilities of bigger profits comes the risk of bigger losses, however, which is why traders – particularly those with less experience – should think twice before opting for leverage higher than 20:1 or 30:1. If a trader only has to put up 5% of the price of a position, and the value of that position worsens by 5%, then the deposit has been eaten up and anything worse will see the margin wiped out and the position closed via a margin call. This situation could lead to the final risk…
Short term collapse
The best forex trading takes a long to medium term view of the markets, spotting trends and predicting shifts as they rise and fall. If the margin on a position is wiped out by short term changes, however, and the trader doesn’t have the funds to cover the loss, then a position may have to close before the longer term changes come into effect and the benefits can be enjoyed. In some ways this could be seen as being even worse than the risk of a loss - the risk of losing out on a profit that could have been.
All of these risks can be mitigated by a trading strategy which keeps the amount invested affordable, knows when to accept short term losses rather than chasing them, and uses tools such as stop loss orders to prevent losses running out of control. Risk can never be removed entirely of course, but it can be kept under control.
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