The Risks of Forex Trading
Forex Trading Isn't For the Fainthearted
Forex trading is not easy. Many online websites claim you can get rich quickly by implementing a few Forex strategies. Let's be honest. If it were that simple, there would not be a 95% failure rate for Forex traders.
The concept of Forex is clear. You make a profit from trading one currency against another. For instance, if you were buying GBP/USD, you assume the pound is strong, and the dollar is weak.
Unlike trading stocks, Forex has no centralised markets. No one can implement your trades except you, which means your success or failure is dependent on your performance alone. As a new trader, the risks of Forex outweigh your knowledge and skills. Like all risks in life, if you know what you are dealing with, you can find ways to manage the risk.
It's advisable to trade Forex only with money you can afford to lose. Start small. Commit to a long-term plan for your education and experience with Forex. We can give a cast-iron guarantee that if you rush into Forex, you WILL lose your money and fast. Play the long game, and you significantly reduce the risks of large losses.
In this article, we will give you the basics of how to manage your risk when trading Forex. With this knowledge, you will understand how to trade Forex responsibly by knowing what risks you face in Forex and how to trade like a professional Forex trader.
What is Forex Trading?
Forex is an acronym for Foreign Exchange.
Simply put, you are trading one currency against another. All pairs display as three-letter codes, like GBP/USD (Sterling Pound/United States Dollar), EUR/USD (Euro/ United States Dollar) and USD/CAD (United States Dollar/Canadian Dollar).
The first currency is called the base currency, and the second currency is the quote currency.
You make money by being on the right side of a trade when the price rises or falls.
As an example, you take a long trade for USD/CAD. Effectively, you expect the U.S. Dollar to strengthen and the Canadian dollar to weaken in value. On the chart, what this means is the price rises.
If you took the opposite trade, you expect the Canadian dollar to strengthen and the U.S. dollar to weaken. On the charts, the price falls. A Forex trader looks for the price fluctuations between currencies, called pips (percentage in point).
Trading Forex is not the same as buying or selling stocks. The buy low or sell high principles do not consistently work in Forex. For instance, novice traders see a high currency price, and they imagine it can't go higher. They may be using a technical indicator like the Relative Strength Index, which shows the price as over-bought or over-sold. Unfortunately, often at this point, momentum takes hold, and the price keeps rising.
Forex traders learn to recognise reversal signals in the Forex market with experience, but the price appearing over-bought or over-sold is not a good signal to take a trade.
Exchange Rate Risk
You've probably exchanged currency for your holiday. If you are in the United Kingdom and are travelling to the United States, you need to exchange your money for U.S. dollars. If the GBP/USD rate is 1.37, and you exchange £1000, you will likely receive $1370 (not including exchange fees).
Why do we say it is likely, and not a guarantee?
Because the exchange rate will depend on the currency price at the exact time the transaction takes place. At that moment, the pound may have fallen, and the currency rate is 1.32, so you will receive $1320.
This simple explanation is the basis of how Forex works. You buy at one price and exit the trade when the price has moved to your target price.
Traders are sometimes confused by buying (long) and selling (short). Whether you take the buy or the sell, you are still buying one half of the currency pair. If you enter a short trade for GBP/JPY, you are buying the Japanese Yen, expecting the currency pair price to fall.
How Does a Forex Trader Know which Currency Pair to Trade?
It may be helpful to learn Fundamental Analysis. Before trading, you check the economy of one or both countries. The exchange rate links to the interest rate of the country. When the interest rate is high, it attracts investors. When the interest rate is low, investors sell the currency, and if enough investors are exiting their investment, the price will drop on the exchange.
It's worth doing these pre-checks before trading.
- What is the state of the economy of both currency pairs?
- Is the country experiencing anything adverse that may affect currency strength?
- Check the economic calendar for upcoming financial news
- Is the pair in a trend? If so, which currency is strong?
- Is the currency pair consolidating? Showing on the chart as the price moving within a range
- Is the price approaching historical areas of support or resistance?
- If you are anticipating a long trade, analyse a short trade. This check helps to remove bias.
Novice traders often fling themselves into a trade impulsively. Other Forex traders' opinions may sway them. Or a big red or green candle appears, and FOMO kicks in.
Two traits will have a massive influence on your success or failure as a Forex trader – Patience and Discipline. It's always worth waiting, even if you miss a trade.
Read Also: Top 10 Forex Pairs To Trade
The Risks of a Country on Currency
If a country is experiencing instability of any kind, it will have an impact on the currency. For instance, if there is a war or instability of politics, its currency will be unstable. Even an act of nature, like an earthquake or a Tsunami, affect the currency.
Investors move their money out of a country if there is a risk of the currency devaluing. It's common sense.
By following the above list, you achieve two things:
- You reduce the risk of being on the wrong side of the trade
- You are doing what other novice traders fail to do
If you consistently do what the 95% of losing Forex traders are not doing and don't do what they are doing, you are already ahead of the Forex game.
Why do Countries Intentionally Devalue their Currency?
The central bank's responsibility is to manage monetary policy. They need to keep the economy buoyant. They dislike seeing their currency used for speculation. International exports depend on a price that makes exporting goods viable. If the currency is too high, it can significantly impact trade.
The central bank influences currency because they want to reduce volatility. The bank of Japan often steps in if there is a risk that currency price may affect their imports. Economic stability is at the forefront of every decision, and they do whatever they need to do to achieve that.
As we mentioned before, checking the interest rate situation is a big bonus to managing your risk before entering a Forex trade.
A Forex trader's worst nightmare is to receive a margin call from their broker. You are about to lose your account, and there's nothing you can do about it other than deposit more funds.
When you open a broker account to trade Forex, they will offer leverage on your account. Trading with leverage means you borrow money from your broker to finance trades requiring more funds than your trading capital.
Leverage may seem like a good option, but it adds significantly to your risks as a novice trader. If your account is highly leveraged, one or two price shifts in the Forex market can trigger the dreaded margin call.
As a novice Forex trader, never accept the maximum leverage. Indeed, take the lowest leverage possible. An account with no leverage is ideal for managing risk.
Some brokers offer high leverage, and this is far too risky for a novice trader. It is best to open a broker account with a regulated broker, ideally, a broker that doesn't max you out with high leverage.
Currency markets are volatile. Some currency pairs are more volatile than others. One year, the Japanese Yen had a massive spike of 700 pips, taking out hundreds of thousands of stop-losses. The traders who thought it was clever to trade without a stop loss lost their accounts in minutes.
Tips for Managing the Risks of Forex Trading
Commit to your Forex Education
The more you can learn about Forex, the better.
Forex may appear complex and chaotic. But with Forex education, you know how to spot the patterns within the Forex market. Most novice traders fail to educate themselves and never achieve any level of consistency. Take a Forex course, read books and watch videos. Forex will become second nature in time, and you are doing what 95% of Forex traders fail to do.
Practice with a demo account
Spend at least three months practising with a demo account. The Forex market can move fast, and, at first, you won't understand why or how this happens. Trading Forex with a demo account is a superb foundation for preparing you for success as a Forex trader.
Open a demo account with a regulated broker. That way, by the time you come to open a live Forex account, you are familiar with the broker and can decide whether to remain with them.
Regulated brokers must follow the licencing rules of the countries Financial Governing Body. If you encounter any financial issues with your account, you can contact the Governing Body to report the broker.
It's expensive for a broker to achieve regulated status. They have to jump through a lot of hoops. So it is in their interest to make sure you are happy with their service. Too many complaints and they could lose their licence.
Avoid unregulated Forex brokers like the plague.
They do not have to follow any Governing Body rules, so they can do as they wish. We hear such horror stories like traders unable to withdraw their money or, worse, their money disappearing. A quick search on Google, and you will see the extent of the issue of having your money with an unregulated broker.
When you are on a broker's website, it is easy to find their licence details. They tend to display it openly. Never deposit your money with an unregulated broker.
Deposit a small amount of capital into your broker account and trade with micro-lots. Forget about how little money you make on micro-trading and focus on improving your trading skills. Be consistent and refrain from increasing your lot size after a few wins.
Always have a Stop Loss
Never enter a trade without a stop loss. Some novice traders say they don't need a stop loss because they're watching their trade. Well, that's just crazy talk. If nothing else, a lot of traders learned their lesson from the Japanese Yen 700 pip spike. The price can move exceedingly fast, especially if a country has announced economic news. You can be halfway to losing your account quicker than you can blink.
Have a Trading plan
Trading without a plan is to plan to fail. You must know where you are heading and why.
Identify your key strategies, have one or two that you know well and then only trade when you see a signal for one of these strategies.
Risk to Reward Ratio (RTR)
Having a good RTR will make or break your success as a Forex trader. Let's imagine you have a 50% win rate, and you routinely take trades with a 1 to 1 RTR. You will either be breakeven or losing. It will be almost impossible to grow your account.
Work with a minimum of 2 to 1 RTR. Your profit will be twice as much as your loss. If possible, aim for a 3 to 1 or 4 to 1 RTR. You don't need many wins to suck up the losses with a good RTR.
Have a goal to become a better trader
Stop focusing on how much money you can win and set your mind to continual improvement.
Keep a daily trading journal and document every trade. Read it back and see what patterns you are developing. Are you too impulsive? Is FOMO getting you into a trade too early? Do you plunge into a pit of doom with every loss?
Commit to the process. Patience and discipline are the foundations for EVERY professional Forex trader. It takes time to strengthen these qualities. At first, you may find Forex baffling and confusing. That's perfectly normal. We all struggle at first.
Practice as often as possible. Become familiar with every aspect of Forex and work out what sort of trader you are. Are you more disciplined on the longer timeframes? Or do you enjoy the lower timeframes where you can enter and exit a Forex trade quickly? Much will depend on your natural temperament.
There is no need to be afraid of risk. It's part of the process of Forex. We are typically more afraid of what we do not understand. This article has provided tips for increasing your knowledge of what risks you face as a Forex trader.
Approach Forex from a professional standpoint. At all costs, avoid a gambling mindset. If you find yourself becoming impulsive, shut down the trading platform and walk away. If you have a series of losses, stop chasing them. Novice traders try to regain what they have lost, and they end up losing more.
You cannot take a good trade if you are emotionally affected by a previous loss or losses. Stop trading and go for a walk, or jot your thoughts down in your trading journal. If possible, stop trading for twenty-four hours or until you feel calm.
Follow these guidelines for managing your risk, and you have a head start for a long and prosperous future as a Forex trader.
Risks do not ever go away. But, as you become familiar with them and work according to your plan, you know how to manage risk.
Please note that the above information is not providing advice on tax, investment, or financial services. We provide the above information without consideration for risk tolerance and a specific investor's financial circumstances.
Forex may not be suitable for all investors as it does involve risk and the possibility of a loss of capital.
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