These days, forex trading is one of the most lucrative endeavors and many traders gravitate towards the forex market for its size, liquidity, and profitability. However, just as there are many traders who find success in the markets and make decent profits, many find themselves repeatedly losing money, effectively squandering all their capital without knowing why or how it happened.
The truth is, there are plenty of risks that come with forex trading. As currency rates fluctuate day-in and day-out, they are not entirely possible to predict with accuracy. However, there are certainly ways to minimize risks within trading.
First, we will take a look at some of the most common risks associated with forex trading, and then we will move onto how to mitigate them and what traders can do, additionally, to increase their chances of making a profit in the forex market.
Risks Associated with Forex Trading
There are three main risks associated with forex trading.They are market risk, country risk, and leverage risk.
Market risk is the possibility of losses in an ever-fluctuating market. Say you, as a forex trader, bought EUR/USD (effectively buying Euros and selling US dollars) because the Eurozone is coming close to landing a trade deal with Japan and you expect their currency to appreciate.
However, just hours later, you find that the deal has fallen through due to some minor disagreements and in the end, Japan ended up making the same deal with the US instead, causing the US dollar to appreciate. In this case, the market goes against you.
Country risk is the possibility of losses due to the economic and/or political environment in your country or the issuing country of the currencies you are trading.
As currency rates are highly tied to a country’s economic performance, political stability, and overall societal productivity, forex traders will experience country risk. If a country experiences war or a natural disaster, their currencies are more likely to depreciate along with their economy taking a dip.
Finally, in forex trading, traders can use leverage to increase their exposure to the market and their overall position size. Leverage requires only a small initial deposit from the trader (called the margin) to gain access to substantial trades that are ten, twenty, or even fifty times the size of their margin.
Leverage risk is the possibility of markets going against you, resulting in significant losses that may exceed your original investment, causing you to owe your broker or bank money.
How to Mitigate These Risks?
After understanding what these risks are, you can mitigate them more easily.
Market risk is inherent in all financial markets and all forms of trading, as it is based on fluctuations of the market that traders take profit. To best minimize your chances of losses, you should take time to do research on the forex market and ensure that you understand its mechanisms and how trading works.
You should also take time to learn about the different types of market analysis methods, such as fundamental analysis and technical analysis. This way, you can learn to better interpret current chart movements and better predict future trends, slimming the chances of the market going against you.
If you are just starting out as a forex trader and you don’t think you have quite gotten the hang of trading yet, you can minimize market risk by starting slow with smaller positions. This way, even if your hunches are wrong and your investment depreciates, you will not suffer a huge loss. Take your time to gain experience and gradually make bigger trades when you are ready and feel confident enough to do so.
Country risk is also inevitable when it comes to forex trading. To best shield your investments from souring, you should keep an eye on the news and stay informed of potential political risks.
For example, if you are in the US, you should understand that the dollar rate takes the biggest hit in times of uncertainty and unfavorable election results and plan your trading strategy accordingly. If there is an outbreak of war, it is best to sell the country’s currency as soon as possible as it is also bound to depreciate quickly and sharply.
Finally, it is perfectly acceptable to trade forex without leverage, removing leverage risk altogether.There are of course downsides to not using leverage, such as capping potential profits to a small percentage as movements in currency rates are rather small. However, for those who really cannot stand to tolerate any amount of risk, this may be a good move until you build up experience.
For others, lowering the amount of leverage you use is a good enough step taken to lower leverage risk. Instead of using a leverage of 1:100, you can start smaller with 1:50, or 1:20. The bottom line is that you should not be trading with money that you cannot afford to lose.
Other Risk Management Techniques
Aside from the three solutions posed above, there are other ways a forex trader can minimize the risk they take in each trade. The end goal is to become a better trader overall with a more consistent and better profit record, and this can only be done by paying attention to careless and small mistakes along the way and rectifying them as soon as possible.
Use Stop-Loss Orders
One of the most important risk management techniques has to do with having an exit strategy before placing a trade. Market orders can help traders set clear boundaries, which can be especially helpful for indecisive traders who have trouble letting go of unprofitable trades. A stop-loss order can be set when a position is opened, and it can be automatically executed when a currency dips below a certain point to cut a trade’s losses. This also means a trader will not have to monitor the charts all the time if he does not have the time to do so.
Have a Trading Plan and Stick to it?
Forex traders should always have a trading plan and stick to it consistently and with discipline. This trading plan should act as the road map and guideline, and it should contain details like the trading strategy one will use, the type of currency pair that will be traded, when to trade, and any trading goals and boundaries that the trader should work towards building. By having a clear vision of one’s trading aims, it will be easy to assess each trade and make the most informed decision that will serve you in the long run.
Manage your Emotions
While trading, even the most rational and sensible traders may find themselves being emotional. After all, this is your money on the line, and it makes sense to care a bit too much. Common emotions in forex trading include fear and greed, and both can lead to impulsive decisions that can cost the trader substantial capital.
For example, when the forex market takes an unexpected dive against your favour, fear will pop up on your radar instantly. This can cause you to panic trade, closing positions before accessing the situation fully, and then opening another position in an attempt to hedge your previous trade and recuperate your losses.However, hasty decisions made in the nick of time almost always never work. In times of extreme volatility in the market,you should sit back and carefully examine your options before making a move.
Alternatively, if you find that you have bought a small amount of a certain currency that is suddenly swinging high, you may be tempted by greed to take the momentum in stride and increase your position size by a lot. You may also be tempted to start opening more positions to capitalize on the trend. However, this is a dangerous approach, as opening too many positions will become hard to manage and opening too big a position will put you at risk of losing everything at once. The best thing to do is stay calm and be content with your profits, no matter their size.
Diversify your Portfolio
Speaking of the possibility of losing all your capital in one go, the age-old way to prevent this is to diversify your portfolio. By appropriately dividing your capital into several manageable trades, you can ensure that one sudden event or downturn of a currency will not wreck your portfolio completely. You can do this by purchasing currency pairs that are not directly related to each other,such as investing in EUR/USD and GBP/JPY.
Alternatively, you can branch out to trade beyond the forex market, and into investing in stocks, mutual funds, cryptocurrencies, real estate, commodities, and more, as long as you are comfortable in these markets and have time to manage multiple trades. This way, when the forex market is not doing so well, you will have your other investments to back you up.
Finally, all forex traders would do well to be realistic about trading, the forex market, their budget, their profits, and the currency pairs they trade. Many come into trading thinking it is a get-rich-quick scheme and that it is an easy one at that. They anticipate – and almost expect – instant and large profits.
The reality is that there is no guarantee of profits at all, and even if one does happen to take profit, they may not be consistent. Realistic trading involves both profits and losses, and traders should remember this.
One of the cornerstones of successful forex trading that is most overlooked is appropriate and effective risk management. A lot of the time, many forex traders dive straight into learning about how to trade and how to make the most profits that they do not take risk mitigation as seriously as they should do, resulting in substantial losses. Being a good forex trader requires taking a holistic approach to trading. With time and practice, you can weed out your bad habits and improve your success rate.