Before we go into the five significant Forex trading risks, you should know that Forex trading risk management is the most critical factor to consider if you want to become a profitable trader.
Are you sick of losing money because of poor risk management? Then look no further because this article is meant to help you understand the secrets of Forex trading risk management.
Traders will always try to limit the amount of potential loss, but at the same time, get the most returns out of each trade.
Probably you heard the expression:
"With high risk comes high reward." However, that's not always the case because other factors are in play from time to time.
Also, one of the quotes I learned when it comes to Forex risks is this: ''The best traders are not the ones that know how to maximize their profits, it's those that know how to minimize their losses.''
And that is why I count forex trading risks as part of this quote because if you know how to minimize forex trading risks, then you know how to reduce your losses.
In other words, Forex trading risks refer to some factors that can be managed appropriately depending on the case.
Together we will explore the five most critical factors and how to deal with them as the markets are continually changing.
NOTING is RISK-FREE, and starting from this general rule of life, we learned how to adapt. Forex risks are no different, and with a little practice, you will get on the right path. Also, for beginner traders,
I recommend practicing on a DEMO account, various trading strategies before risking any percentage of their REAL money.
If you don't know any strategies, then you can take a look at our ''One-Two'' strategy for Forex trading, so you don't have to lose time by looking for plans.
Breaking Down Forex Trading Risks
Before exploring the five significant factors of Forex trading risks, let's understand who else is trading in this market. Starting from Investment banks, private institutions, hedge funds, insurance companies, and retail traders are part of the forex market.
The reason why I left the retail traders, in the end, it's because, on average, their trading funds are $5,000 to $10,000 while the Banks gives the top tier volumes.
Governments can also provide high volumes by imposing fiscal policies such as income taxes and expenditure monitoring.
From this information alone, you can guess who controls the outcome of the Forex market by manipulating the volume of trades or the demand and supply.
However, it doesn't mean we can't make money from trading. Check out our tips and tricks article for Forex trading.
An old saying goes like this: "Keep your friends close and your enemies closer."
Allow me to break that down for you: "Friends" is your broker because he's just the bridge between you and the "Enemies," banks, or liquidity providers.
Since your ''Friends'' are essential, we made a list of the top brokers that can help you on your quest to avoid Forex trading risks.
That said, let's start exploring the five most significant factors of Forex trading risks.
Types of risks include several factors of Forex trading risks that are the exchange rate risk. Below you will see all those factors.
1- The First Factor of Forex Trading Risks is the Exchange Rate Risk
The exchange rate risk refers to changes in the value of currencies daily. The Forex risk here is that all your open positions are subject to change every millisecond.
On a trading platform, this risk manifests as SPREAD, and it's the difference between the Bid and Ask.
Why is it necessary, you ask?
Allow me to demonstrate a tiny detail that you miss when trying to limit your Forex trading risks.
When placing a trade on a platform, you will always start with minus "X" pips.
That's called the spread, and your position will be open at the ASK line (RED). Let's assume you enter the market with a long position; the entry price is 0.75461, the ASK line (RED).
The white line BID is at 0,75440, making our trade -1,9 pips (SPREAD). Once the (BID) price moved up to our entry (ASK), we brake even, and only when it starts moving higher we will start making profits.
2- The Second Factor of Forex Trading Risks is the Interest Rate Risk
Interest rate risk can potentially increase the SPREAD range, especially when trading with floating spreads as opposed to fixing spreads.
Floating spreads are changing every millisecond, and it can significantly increase your Forex trading risks.
There are specific times when such floating spreads can jump as high as ten pips from your initial ASK price.
These times are known as interest rate decisions, and they occur monthly at specific dates for each participant country.
To reduce your Forex trading risks significantly, you have two options:
One is to don't open trades when those events are happening for a specific Forex pair.
Two is to choose a broker that can accommodate a fixed spread trading environment.
NOTE: if you are holding a position for long term (weeks or months), the two examples above will not affect you as much; because after these events, the spread starts to tighten, paying the broker a lower spread.
If you are wondering why interest rates are essential, I will explain it to you in just a few lines.
For example, a trader decides to buy EUR/USD at the price of 1.1190 (ASK) from the 1.1188 (BID) that's two pips.
The trader decides to hold this position for two weeks when FED has an interest rate decision. Assuming that the interest rate hikes, the US dollar will be appreciated making it more valuable.
That also means that the spread during that period will jump to 12 pips (YELLOW line in the chart).
Since we are trading EUR/USD, it means that the dollar is strengthening against the euro. Therefore the trade goes against the investor time when a lot of small accounts will be stoped out (BLUE bottom line).
3- The Third Factor of Forex Trading Risks is the Credit Risk
The credit risk falls into a broader and more complex category, however, limited by regulations for each country in the G-7 nations. It will not affect the average trader since he can take the other side of the trade.
The explanation for this sentence is that traders need a broker or institution to carry out trades. If the institutions in question are filing for bankruptcy, what do you think will happen to the investor's money?
The first thing to watch out for is if the institution is regulated: if yes, check for the compensation plan in case of bankruptcy.
Traders will find useful information if that kind of Forex trading risks happens with a full guide on the steps to follow for the money recovery.
The second thing is to make sure the regulated institution has segregated bank accounts for its investors, which means that the funds they use to run the institution are separate from the investors' funds.
4- The Fourth Factor of Forex Trading Risks is the Country and Liquidity Risk
The Forex liquidity is higher than the exchange currency futures, especially on the US and European trading hours.
More so, several countries or groups of nations in the past have enforced the trading restrictions or limits or on the amount by which the prices of specific Forex exchange rates may differ during a given period.
Such limits or restrictions can prevent trades from promptly liquidating unfavorable positions and accounts as the trader’s losses.
Usually, these sanctions or bans are remote but still pose significant Forex trading risks if your country is on the banned list.
Take India, for example; the retail trader is forced to traded internally; the reason behind this is to don't allow them as individuals to increase the inflation by injecting "SOME" money into the economy.
Central banks can also disrupt retail traders by applying higher spreads or by the printing of money devaluating the currency in question.
Banks can also interfere with investors trading by providing late quotes, which can reflect as a pip lost later during the day or trading session.
5- The Fifth Factor of Forex Trading Risks is the Leverage Risk
The part where traders tend to increase Forex trading risks without realizing it. Higher leverage is not always a bad thing if you know how to make use of it.
For instance, if at the time of buying, 20% of the price of a contract gets deposited as margin. A 20% decrease in the amount of the contract may if the deal got then closed.
Result in a total loss of the margin deposit before any deduction for a brokerage commission.
In other words, a decrease of more than 20% may cause total damage to the margin deposit.
Therefore, investors should be careful when using aggressive leverage, as it may increase losses during periods of unfavorable performances.
Forex Trade Plans
Do you know what Forex trade plans are?
Forex trade plans are quite any different from other trading plans you could think. It consists of an outline of your planned activities of trading, for instance, a to-do list when it comes to trading Forex online.
The base concept of trading is to have a strategy to help you in the future. Including rules, you are going to follow, as well as how you are going to execute them.
Once you have written all the strategies and layout, it would be much easier to implement them. You will have a clear plan of action to follow to avoid any misunderstandings.
Moreover, a trading plan can also help you in analyzing the market effectively. Besides, you can apply your analysis to your trading strategy.
With Forex trade plans, you can prevent yourself from making rash, irreversible decisions – something that is especially effective when emotions start to come into play.
Forex trade plans also stop you from committing foolish acts and silly mistakes as well as it allows you to evaluate your wins and losses.
Forex Trading Risk Management
With some authentic and practical tricks, you can lower the Forex tradings risks. Here’s how you can reduce those five significant Forex risks by using risk management.
How Can You Reduce Forex Trading Risks?
Before making a trade, investors should know precisely the amount they are willing to risk.
Therefore, understanding risks, permit the traders to make decisions that will help them develop more effective trading plans.
Limiting Forex Trading Risks
- Use the right tool – a fast and reliable internet connection, a fast computer, trading platforms, and advance analysis.
- Use a protective stop loss – Reduce your loss on every trade is an excellent way to preserve your trading capital. The only technique to figure out a superior-stop level for your trading plan is through optimization and trading.
- Use leverage and margin prudently – an investor should consider potential losses instead of focusing on potential gains.
- Use appropriate position sizing – trading in big lots allows investors to make more money. However, investors can lose more funds excessively. Therefore, if an investor has a new trading plan in the market, monitor it before increasing your position size.
- Treat trading like a business – trading plans need to stipulate how and what you will trade. The trading plans require thorough research and evaluation at regular intervals.
Most Common Blunders While Doing Forex Trading Risk Management
Well, one of the basic rules of trading risk management in the Forex market is that you must not take risk more than you can afford to lose. Usually, some said this mistake is exceedingly common.
And especially it is among the Forex traders who just started. Traders who are eager to put in more than they can afford make themselves susceptible to Forex trading risks.
Anything has the power to change the Forex market. Even the smallest news can influence the price of a specific currency in a negative or a positive sense.
It’s better to follow some medium level path and opt for conservative amounts of capital as compared to going for all.
Risk and Emotional Management Strategies
Other than controlling all the physical aspects, traders have to control their emotions as well.
If you are unable to keep a hold on your feelings, then you can never reach the level where you want to get profits from trading.
Traders can often get trapped in volatile market positions with market sentiments — another one of the most common Forex trading risks.
If you have a stubborn nature, then, unfortunately, you can never make the Forex trading the best option to earn.
To leave a position, these kinds of traders have a chance to wait too long.
With the small possible loss, traders have to leave the market when they get to know their mistakes. Traders may have to lose substantial capital if they have to wait too long.
On the other hand, when a solid deal is available in the market, then traders can re-enter the market until then they have to be patient.
To sum up, Forex trading is one of the biggest financial markets on earth. Therefore, individuals, banks, and business establishments have the potential to make massive profits and losses.
In other words, Forex risks are a potential loss or gain, which occurs as a result of a change in Forex exchange rates.
Therefore, to reduce the likelihood of financial failure, each trader needs to have in place some Forex tradings risk management strategies.
Before you go, while you should watch for those Forex trading risks, an important thing to do is to know everything about your broker. That is why we do thorough reviews on Forex brokers, so you don't have to worry about anything.