With so much money at stake in such a liquid market, there are some serious risks you need to be aware of in the world of forex trading. Today we will look at some of those risks and see how you can mitigate and protect yourself from the most common risks in the foreign currency market.
As a beginner, you have probably heard of the risks of forex trading and other associated risks within this market and other markets, such as stocks and commodities. It is a risky and volatile business. There are several vital factors you must be aware of, including specific, common risks of forex trading, such as
- Currency risk
- Liquidity risk
- Leverage risk
- Market volatility risk
We will examine these in more detail today and suggest tips for preventing yourself from being caught up in volatility. This includes short-term and long-term strategies.
With so many foreign currencies trading over 24 hours, it can be easy to lose track of the movements of each currency. Currency risk encompasses this type of risk. A currency risk loss stems from severe fluctuations in the exchange rate you use.
A variety of different components can cause currency risk. Political risk is one of the main driving forces behind currency risk. If there is political instability within a country, this can cause the price of a currency to crash. In addition, economic risk is also something to factor in.
However, these two components can often go hand in hand. Political instability is usually fueled by a dire economic performance, outlook or underlying economic problems such as mass unemployment. Economic and political risks are serious risks of forex trading and tend to go hand in hand.
Although some central bank policies can cause the price of a currency to fluctuate on its own, rarely, these factors won’t combine to create a volatile currency risk situation. Risk in forex trading can be mitigated more efficiently when you know the indicators to look out for too.
Liquidity risk occurs when traders cannot easily convert their position into cash. For example, the forex market sees the most volume compared to other markets like stocks and cryptocurrency. Therefore, you likely see more issues with liquidity in these markets, cryptocurrency especially.
If you are privy to how futures trading works, you will know that the risks are gigantic. In standard investing, your money will go up or down, but futures trading can result in your investment disappearing completely. Futures trading accelerates your investment, in theory, it can explode in value, but it can also depreciate rapidly.
In forex, there are a few examples of enormous successful trades. For example, George Soros made hundreds of millions of dollars when he shorted the GBP during Black Wednesday in 1992.
The most traded forex pairings revolve around the US Dollar and other major world economies. Therefore, liquidity is rarely an issue in forex. If you are trading lesser-known currencies in emerging economies, this is one of many risks of forex trading. With lesser-known economies, it has the risk of becoming far more prevalent. However, it is scarce you would witness liquidity issues when trading forex, on the whole.
As discussed in today’s article, leverage risk (futures trading) is the most volatile way to trade any asset. In markets such as cryptocurrency, futures trading involves trading the most volatile asset with the most volatile instrument. The results can be disastrous.
You must ensure that you invest with capital you can afford to lose. Of course, nobody wants to lose money, but if you find yourself in a worst-case scenario where your trade has gone badly, you want to ensure it doesn’t put you into financial difficulty.
Trading with leverage and overleveraging can accelerate these losses, so you need to be extremely careful and try to avoid this method if you can. As a beginner, avoiding this type of trade is highly recommended. In forex, you can use a leverage of up to 25:1. This means you can get liquidated quickly. In some currency pairs, you can use even higher leverage, so the risks of forex trading are amplified if you don’t know what you’re doing.
One way to mitigate this risk is by employing practical risk management tools and advice. This can range from dollar cost averaging (where you buy your asset on the way down to lower your average entry price) to implementing stop loss and take profit measures.
Too often, traders, especially beginner traders, will need to set effective places to make a profit. But conversely, they will not have a reasonable limit to exit their trade if it doesn’t hit their chosen price and begins to drop dramatically. Having plans to help you manage this leveraged risk could be the difference between a steep learning curve and liquidating all your money.
As we segue from the point made in the final paragraph of the previous section, market volatility can often be the risk that catches a lot of traders out. However, even experienced traders with multiple years of experience operating in the market intimately know the dangers of forex trading.
Volatility can catch any trader out. Professionals will have a better strategy to protect themselves in a tough market retrace. However, there’s no way of predicting when an event on the cards will cause significant volatility.
How Risky Is Forex Trading?
All markets are risky; depending on how much due diligence you perform and how well you understand the market, you can minimise the trading risks you encounter. For example, with trillion dollars worth of currency traded over 24 hours, forex trading risks are considerable.
However, as far as it squares up against its counterparts, forex is not considered as risky as cryptocurrency trading. Cryptocurrency is the most volatile market as it hasn’t got the same specific regulations you can find in stocks, commodities and forex. You can use bots to help you trade forex, which enables you to establish good buy and sell points. However, this doesn’t mean you will turn a profit.
Forex trading risks can vary in severity. One of the critical risks of forex trading that you need to be aware of is needing to understand the news and how it moves the market. Although all calls are affected by the information, due to the 24/7 interconnected nature of forex, it can be more susceptible to specific economic and international news.
As we touched on earlier, political instability currency risk is what to look for when it comes to foreign currency trading. This is one of several risks to be wary of.
How To Manage The Risks Of Forex Trading
While you can learn dozens of techniques to assist you in trading forex, managing any trading risks is a universal set of criteria. Even legendary traders such as Warren Buffett implement effective risk management strategies to shield themselves from serious market volatility.
As we have already discussed, risk management is critical in any market. For example, you can choose to dollar cost average or set up take profit and stop loss limits to ensure that you aren’t holding your chosen asset for too long.
You can learn how chart patterns form and which ones to look out for, which can help complement your trading. There are a variety of different chart formations that professional traders use, such as
- Reversal patterns
- Head and shoulders patterns
- Triangle patterns
- Diamond chart patterns
- Doji star patterns
- Heikin Ashi candlestick patterns
- Fibonacci patterns
Diversify Your Assets
Many traders will have their favourite market or a market where they hold most of their assets. However, professional traders will often have a wide range of diverse assets, which can help protect you in the event of a market downturn in one specific asset class.
In the event of a stock market crash, if you hold other assets, you are in a position where you are better equipped to insulate yourself from financial loss. One example of a proven hedge against economic turbulence is when investors purchase gold to counteract inflation.
Only Use Instruments You Are Familiar With
When you’re first finding your feet in the forex market, it can be intimidating. However, using methods such as swing trading, novice traders will learn how the market works without exposing themselves to too much risk.
However, as we discussed earlier, specialist trading tools such as futures trading and other tools many professional traders implement, such as options trading, are also risky for a beginner.
Risks of forex trading don’t just mean specific tools once you have entered your trade. There are just as many risks when preparing to enter the market. These include timing your entry and the devices you use. Professional traders also use spreads to hedge their forex trades.
Don’t just have your focus on one specific area of knowledge either. You can find guides from people on social media, YouTube or online courses, but it is always best to supplement your understanding with proven literature on the topic as well. Even though you can find a lot of good information and resources online, finding books written by proven professionals with decades of experience will help bolster your knowledge.
The critical thing to remember when discussing the risks of forex trading is to remember that it is nowhere near as complicated as some of the methods used to understand how charts move. You can spend months or years studying charts, but it doesn’t mean you are guaranteed to make a profit. If it were as easy as studying charts, everybody would be doing it, surely?
Effective risk management is constructed of two things
- Understand the risks of forex trading
- Learn how to manage those risks properly
Today we have provided you with a practical guide to navigate these markets. Still, each trader or investor will have their own strategy, and you must settle on one you are comfortable with before you put your capital at risk.