There are various risks you must account for when actively trading the foreign exchange market. The forex markets allow traders to leverage a considerable amount of money which can generate tremendous profits or incur large losses. The better you understand these risks, and how they can be monitored and contained, the more prepared you can be as a forex trader. This article will review some of the currency trading risks associated with the FX market and present some trading tips on how you can navigate and mitigate these risks as much as possible.
Forex Risk Management
As a forex trader, you are first and foremost a Risk Manager, responsible for managing your money and the level of risk within your portfolio. One of the fundamental rules in forex risk management is that you should not risk more than you can afford to lose. One of the biggest mistakes forex traders make on a consistent basis is the aggressive use of leverage; some often utilizing the maximum amount which their forex broker offers. This is clearly a recipe for disaster which will be realized sooner than later by overly aggressive traders.
In addition, controlling one’s emotions plays an important role in your overall risk management plan. If you are unable to control your emotions, you will make critical mistakes in your trade execution. When markets become volatile you need to control your emotions and respond objectively and with a cool head.
Becoming an informed trader with risk management in mind is not impossible but does take a good deal of discipline. You should have a structured well thought out plan which includes the various components of risk and how you intend to address each. Now’s lets take a closer look at some of the risks that forex traders need to pay careful attention to.
Margin or leverage risk can play a significant role in forex trading. What exactly is margin trading? Margin trading allows you to utilize leverage. Usually, when you are placing a forex trade, it is necessary for you to put up only a portion of the total value of the position as good faith. Your trade is considered leveraged if you are able to enhance your position size with borrowed capital. The amount which is required to be placed upfront is deemed as the margin requirement. Many forex brokers allow their forex trading clients to leverage up to 100:1. But just because they allow such high leverage, doesn’t necessarily mean that is it a good idea for you to use it.
Political and economic risk can play a significant role in how you trade within the spot forex market. Elections are taking place constantly throughout the world. Economic and political factors can alter the investment landscape within a specific country, which can generate risk for forex traders. During elections there can be moments of political instability and uncertainty within a country, which usually leads to greater volatility in the country’s exchange rate. As a rule of thumb, you should keep a close eye on pre-election polling so that you will not be surprised with the voting results.
When a change in government takes place within a country the ideology of the residents of the country may also change due to the new political environment. Changes in political parties can shift the new government’s approach to monetary and fiscal policy.
When unexpected elections take place within a country, additional uncertainties can arise. Unexpected elections can arise from various instances such as a vote of non-confidence, corruption or scandals. Usually, unplanned elections can be very problematic and increase the volatility of a country’s currency. In addition, unexpected elections can trigger other events such as protests or labor strikes. It is extremely difficult for you to anticipate these events, however the more cognizant you are regarding the political affairs within a country, the easier it will be for you to react to sudden changes.
Making use of an economic calendar will allow you to track when important scheduled news events are going to take place so that you can better plan and strategize your trades. In addition, most forex brokers offer their trading partners live streaming news. You should be monitoring current events and news which may impact your trading positions.
Interest Rate Risk
Another major component of Forex risk is interest rate fluctuations. We know that when an entity or institution borrows funds from a given lender, the lender will provide those funds in exchange for a given interest rate on the loan.
The rate of interest charged will typically be determined by the amount of risk the lender takes. Usually, borrowers who are considered high risk will pay a higher interest rate on a loan. Conversely, borrowers who have a lower risk profile will invariably pay lower interest rates over the life of the loan.
Central Banks are responsible for setting monetary policies within their counties to ensure economic growth and stability. These fluctuating interest rates in the foreign exchange markets drive numerous decisions for traders.
It is important to note that a country’s interest rates and currency exchange rates are often linked hand and hand. By carefully monitoring interest rate changes, you will know where big institutions are investing their assets in order to receive the greatest return possible. Many times big institutions focus on the carry trade, which is an interest rate differential based trade. Generally, the higher yielding interest rate currency pairs attract greater demand.
Exchange Rate Risk
Exchange rate risk in its simplest context is the risk exposure posed by the dynamic changes in the value of currency. Exchange Rate risk is of particular importance to companies that have operations in multiple countries or that regularly export their products. Often times, profits and margins that a multi-national company realizes is tied closely to the exchange rate changes in both their county and in the counties in which they do business.
Volatility plays a significant role in accessing foreign exchange risk. Volatility risk describes the degree of fluctuations within the markets and should certainly be included in a trader’s thought process. Although many forex traders generally look at volatility in terms of being a negative uncertain risk element, there are many positive components of volatility as well. Without at least a certain degree of volatility, it would be nearly impossible for a trader to benefit in their trading activities. It’s usually during high impact news events that volatility can spike and become inordinately high. It is especially during these times that volatility can adversely affect a trader’s position.
When trading the financial markets, your expectation should be that the person or institution on the other side of the trade will make good if the trade goes your way.
Credit risk is the risk where one party to a trade is unable to pay the other party. This could be because one party defaults or goes into bankruptcy. The goal of credit risk management is to mitigate these risks though proper credit risk exposure. When you are trading you should be aware of the rules and regulations that the forex broker abides by. It is of the utmost importance that a forex broker is regulated appropriately in the country that they do business in and maintain the proper reserves in case the other party associated to the trade cannot cover their trading loses.
Another form of risk associated with forex trading is operational risk. Operational risk takes place when internal processes, systems and people are involved. In addition, operational risk can be include legal risks, fraud and security. Operational risk and management usually go hand in hand. When a broker, for example, has a strong management team the degree of operational risk decreases. Conversely, when management is weak within a business environment, operational risk increases. As a forex trader it is not always easy to determine the amount of operational risk that you are exposed to, however, as a trader it is your responsibility to research and evaluate a business’s operation in an effort to reduce operational risk as much as possible.
Prior to handing over your capital, you want to make sure you do your homework and find a reputable forex broker. Broker risk, can impact you and your working capital in numerous ways. Some forex brokers are not regulated and unfortunately some do not have you best interest in mind. Today, there are numerous forex brokers competing for your business and it is your responsibility to do the appropriate research and due diligence to find the most suitable forex broker for you. While most of the big name forex brokers are regulated, some of the smaller forex brokers are based in offshore locations where regulatory bodies are non-existent.
One reason some forex brokers choose to operate their businesses in an un-regulated territory is that by doing so the broker can significantly decreases their overall operating costs. The costs of obtaining and maintaining a regulatory license can be expensive. In addition, capital requirements which are created by regulatory bodies can create a barrier to entry for many brokers who are unable to raise the necessary capital.
As a general rule, it is usually best to try to work with a forex broker who is regulated by a government body. When working with a regulated forex broker, proper oversight can often protect you from bad business practices or downright fraudulent activity. In addition, finding the right broker will also help you minimize credit risk. There are several forex regulatory bodies throughout the world. The list below represents those regulators by country;
|Australia||Australian Securities and Investment|
|United States||Commodity Futures Trading Commission, National Futures Association|
|Great Britain||Financial Services Agency|
|New Zealand||Financial Markets Authority|
|Canada||Investment Industry Regulatory Association|
|Hong Kong||Hong Kong Securities Futures Commission|
|Singapore||Monetary Authority of Singapore|
|Japan||Financial Services Agency|
What is devaluation or devaluation risk? Devaluation takes place when a country deliberately adjusts its country’s currency downward relative to another country’s currency.
Devaluation is a monetary policy tool utilized by countries that have a fixed rate of exchange. Devaluation is determined by the government which issues the currency and is the direct result of governmental activity. One of the primary reasons a country devalues its currency is to prevent trade imbalances. When a country devalues its currency it reduces the value in the country’s exports which makes the exports less expensive and in turn makes the exports more competitive on the open global markets.
If a country devalues its currency downward the country may have to raise its interest rates to control inflation. Devaluation makes the items sold in another country more attractive as the price of the item declines relatively in their currency.
Another significant FX risk associated with devaluation is psychological in nature. Devaluation can be viewed as as a sign of economic weakness which can lead to jeopardizing the creditworthiness of a country. At times, devaluation can lead to a domino effect in which other countries devalue their currency in response to the neighboring country devaluing its currency. This type of situation only exacerbates economic problems in the global markets. When trading the forex markets, it is your responsibility to be aware of which countries are devaluing their currency and how you can take advantage of this situation.
Another type of risk which you need to be aware of as a forex trader is fraud risk. In the early days of on-line trading fraud was more rampant in the forex industry. In recent times, there have been significant improvements in weeding out unscrupulous brokers. In an attempt to reduce your chances of working with an unscrupulous broker, you should research the forex broker that you doing business with.
Also as noted earlier, you should find out if the broker is regulated within the country that they are doing business in. With a little research online you can find a good deal of information pertaining to well established and not so well established forex brokers.
In closing, to be successful as a forex trader you need to fully understand the different type of risks you face, and how these risks can affect your trading positions. Managing risks in forex is your primary task as a trader. Many of the risks discussed within this article, if properly monitored and factored into your trading strategy, can help you protect and grow your trading portfolio.
However, many traders simply do not factor in any of the important risks discussed in this lesson. Yes it can be overwhelming trying to understand margin risk, political and economic risk, interest rate risk, exchange rate risk, volatility risk, credit risk, operational risk, broker risk and devaluation risk. But who said a trader’s job is easy? These risks should be carefully monitored and considered as part of your trading plan.
In closing keep in mind the wise words of a Great Trader who said:
“I am not so much concerned about the return on my capital as I am on the return of my capital”. –Will Rogers