7 Major Forex Trading Risks Explained • Benzinga
“No risk, no reward” is the motto of these markets. Sure, you can earn risk-free income from FDIC-insured products like savings accounts and certificates of deposit, or even uninsured federal debt securities like Treasury bills, but the returns you get from these assets are small.
No matter what asset class or market you trade, you have to take some risk if you want to make good returns. Now, this does not mean that all assets face the same risks. Not only do forex traders have to monitor their transactions 24/7, but they also have to deal with many risks that forex traders do not.
What does forex trading involve?
Forex trading is the process of buying and selling currencies. Because currencies have volatile exchange rates, traders can profit by speculating on currency pairs. Forex is short for currency, so traders in this market must be vigilant as currencies are traded 24/7 throughout the week (like stock exchanges, forex markets are closed on weekends).
The foreign exchange market is the largest market on the planet with an estimated value of over $6 trillion per day. To trade currencies, an investor needs a forex trading account with a broker and an idea of what types of currencies they want to trade. Currencies are traded in pairs – an investor buys one currency and sells another, hoping to make a profit when the currency they bought rises in value against the currency they sold.
For example, suppose a forex trader thinks that the US dollar will appreciate against the Japanese yen. In this scenario, a long USD/short JPY position is opened. But because currency movements seem relatively small compared to movements in stocks or commodities, leverage is not only encouraged by forex traders, it’s almost mandatory. Leverage of 20/1 is normal in the forex markets and many brokers offer leverage of 500/1.
If you open a long USD/short JPY position with $1,000 at 20/1 leverage, you will control a $20,000 position with your initial investment of $1,000. If your trade wins 20%, you will make $4000 profit on just $1000 investment. But a 20% drop means your original $1,000 is gone and you still owe the broker $3,000. Leverage is a double-edged sword and one of the main risks that forex traders face.
7 Common Forex Trading Risks
Forex traders should keep several different risks on their radar. Unlike the sale of individual stocks, currencies are not affected by drug tests or earnings reports, but are affected by many micro and macro factors. This is far from an exhaustive list, but here are the main risks forex traders should consider when dipping their toes into the forex markets.
One of the most obvious risks that forex traders face is the exchange rate between currencies. Exchange rates are variable, that is, the amount of currency that can be exchanged for another currency changes daily. You can get 118 Yen for $1 USD one day, but only 114 JPY the next. Although this may seem like a small deviation, the movement of exchange rates can have a significant impact on a trader’s profit, as leverage is often used in forex trading.
Interest rates are another important influence on the profits of forex traders. Interest rates do not change with the speed of exchange rates, but they determine how profitable it is to trade certain currencies against others. Countries with high interest rates allow you to earn a profit on your currency, while countries with low interest rates make it difficult to earn interest on your money. If you invest in a currency with a high interest rate and that country’s central bank announces an unexpected rate cut, your profit margin will be severely affected – the currency you own will no longer generate the expected rate of return.
Credit risk or counterparty risk is the risk that another person, institution, or market maker you deal with will not be able to repay due to credit issues. Since forex trading is done with derivative contracts and leverage, the risk of insolvency of the parties on the other side of the trade is a reality that forex traders must live with. Currency markets are not as tightly regulated as other financial markets. If the counterparty fails to provide the appropriate currency, it may default and lose the benefits of the transaction.
Local or regional volatility
Like all securities, foreign exchange contracts may be exposed to volatility that exceeds the expected range. Currencies can be extremely volatile during unprecedented macroeconomic events, such as England’s vote to leave the European Union, which triggered a cascade of volatility in the sterling market. George Soros is famous for making more than $1 billion in a single transaction by shorting the pound in 1992 because he believed the currency was being over-inflated by the Bank of England (which raised interest rates in the teenage years).
Liquidity is essential in any market and the forex markets are no different. Trading 24 hours a day during the week provides plenty of liquidity to many corners of the market, but that doesn’t mean low liquidity never happens. Forex traders usually don’t have to worry about trades not being fully executed, but liquidity issues can cause significant slippage in forex contracts. Illiquid contracts have large spreads, which can deepen forex trading profits.
Margin and leverage
Borrowing money is a way of life in the forex markets, but too much leverage can lead to collapse (as in any market). Because currency movements seem small in percentage terms, traders often increase leverage to make large profits. As mentioned above, leverage levels of 500/1 are not uncommon among forex brokers. A leverage of 500/1 means that a $500,000 position can be managed with just $1,000. If your trade backfires with 500/1 leverage, you may be facing a very nasty margin call.
lose your money
Like stock trading, there is no recipe or secret formula for success in the forex markets. Each trade has different risk parameters and each individual must determine the level of risk that makes sense. There is always a risk of losing your entire investment, unlike stocks, because leverage is used in most forex transactions. Not only can you lose all your money, but you can lose it Control which you originally invested in.
Manage your risk with these best Forex brokers
Currencies can be traded at many traditional online brokers, along with stocks and bonds. However, some of the best forex brokers tailor their offerings to the forex asset class, giving users access to powerful platforms like MetaTrader 4. Here are some of Benzinga’s favorite forex brokers.
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CedarFX is not regulated by any major financial agency. The brokerage is owned by Cedar LLC and based in St. Vincent and the Grenadines.
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Forex trading involves unique risks
Forex trading is attractive for many reasons. Markets are open 24 hours a day, liquidity is high and margin requirements are significantly lower than those required by equity investors. Forex trading can provide diversification from U.S. stocks because currencies have different risks than stocks, but it’s important to know how to evaluate those risks.
Forex traders must keep an eye on changes in fiscal and monetary policy, geopolitical events and broader economic trends, as well as their leverage levels and risk tolerance. It’s a balancing act like no other, but traders who can juggle all of these factors at once can have a huge source of alpha.
Is Forex Trading Risky?
Forex trading involves many different risks, some of which are often overlooked by bond and stock traders. When excessive leverage is combined with limited knowledge, trading in any market can be high risk, but traders must contend with exchange rates, interest rates, creditworthiness and liquidity levels when trading. The “set it and forget it” strategy doesn’t work as well in the forex markets as it does in stocks.
Forex trading can be dangerous for inexperienced investors because leverage is a key part of the process. Stock traders can make huge profits without using a penny of margin, but forex traders often have to borrow money and trade with leverage to make big points. If you don’t understand how leverage affects your positions, you can face serious consequences (such as a complete loss of capital and/or a margin call).
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