Forex trading: What are the risks?
FOREX TRADING : WHAT ARE THE RISKS?
Forex has the highest trading volume of all financial assets but it is also associated with severe losses. It’s a leverage product and, while leverage magnifies profits when the returns offset the cost of borrowing, leverage is also known to magnify losses.
Risk management in forex trading is the process of identifying, analysing and using tools to minimise the risk of loss in advance of a trade. Risk management requires discipline and is an essential component of forex to gain sustainable returns on your investment.
The four basic disciplines of risk management in forex are:
- Develop and stick to a comprehensive trading strategy
- Use the risk management tools that are designed to protect you
- Manage your risk to reward ratio
- Use the appropriate amount of leverage
To understand forex risks, you need to have a thorough understanding of how a leverage product works. Let’s look at the risks associated with forex.
MOST COMMON FOREX RISK
It’s obvious that the most common risk associated with forex trading is when value of a currency pair moves in the wrong direction.
If you go long on EUR/USD, you hope to make money from the base value increasing relative to the quote currency. In other words, the value of the Euro increasing relative to the US Dollar. If the value of the Euro decreases against the USD, you lose money if you don’t close your position fast enough.
There is additional risk trading less popular currency pairs, what they call exotic pairs. The South African Rand is an example of an exotic currency pair.
The most important thing you can do is be disciplined following your trading strategy and use the tools available to manage your risks. This includes automated Stop Loss and Stop Limit features that are available on all retail trading platforms.
What is leverage in forex trading?
Leverage in forex trading is the ratio of the trader’s funds to the size of the broker’s credit. It involves borrowing a certain amount of money from a broker to invest in an asset such as forex.
Forex trading offers high leverage which means a trader can build up and control a larger amount of money for an initial investment requirement. The size of leverage for forex is not fixed and usually depends on trading conditions and the value a forex broker places on an asset.
A leverage ratio of 50 : 1 means a trader can control a trade worth 50 times their initial investment. If you have $2 000 available to open a trade, you can effectively control a trade with a total value of $100 000.
Leverage is important in forex and is basically how forex works. It allows small price movements to be translated into large profits. At the same time, it can excessive leverage can also be extremely dangerous because it can result in excessive losses.
Leverage increases your opportunity to profit from forex trading but it also increases the risk. Leverage should be used with caution and managed properly.
What is a margin?
A margin is essentially the deposit a broker asks for before he’ll open a position for you on the forex market. It’s a small initial investment that is offered by brokers to their clients so that they can access substantial trades in foreign currency.
In other words, a trader borrows money from a broker to open a trade and then will use leverage to multiply the trade if they do not have the funds to trade the position. When you trade forex on margin, you are only required to pay a percentage of the full value of the position to open a trade. Margin is not a transaction cost.
Brokers do not charge you to ‘borrow’ the money to open a trade. Instead, they execute buy and sell orders for their clients and charge a commission per trade or on a spread. A spread is the difference between the bid price and the ask price of the trade. This difference is known as the broker’s spread.
When you trade forex on margin as most traders do, you are able to increase the size of your trading position. Margin gives you more exposure to the markets for a smaller initial capital outlay. This is where the risk lies with forex because margin can be a double-edged sword. This is because margin magnifies both profits and losses.
The link between leverage and margin is related to the broker’s requirements as well as leverage rules stipulated by the regulatory body in your region.
What is the margin level?
When a forex trader opens a position, the initial deposit required by the broker is held as security. The total amount of money that the broker locks up as collateral on a position is referred to as used margin.
As the trader continues to trade and open positions, more of the funds in a trader’s account become used margins (collateral). The amount of funds a trader has left in the account to open new positions is called available equity. This is used to calculate the margin level.
Margin level = (equity / used margin) x 100
In other words, the margin level is the ratio of equity in the account relative to used margin. It’s expressed as a percentage (x 100).
The higher the margin level, the more funds are available to use to open new positions. When the margin level drops to 100%, all available margin is in use and no more positions may be opened by the trader.
Example of a margin level
A trader places US$20 000 in a forex account and opens two forex trades.
The broker requires a margin of US$2 500 to keep both positions open ($2 500 is the margin).
The margin level = ($20 000 / $2 500) x 100 = 800%.
Why a margin level is important?
The margin level is important in forex trading because it acts as an early warning sign for a trader to check they have enough funds available in their forex account to open new positions.
The minimum amount of equity that should be kept in a trader’s account in order to keep positions open is known as the maintenance margin. The majority of forex brokers require a minimum maintenance margin level of 100%.
If a trader’s margin level drops below 100%, a broker will not allow any more trades to be opened by the trader.
What is a margin call?
Small price fluctuations can result in a margin call. This is where a broker requires the trader to pay an additional margin. A margin call occurs when the value of an investor’s margin account falls below the broker’s required amount.
A trader can incur substantial losses in volatile market conditions as a result of margin calls that are in excess of the initial investment. It would be the same as your banker calling you to demand you put more money into your home loan account when the value of your property is decreasing.
A margin call is required to bring up the minimum value of the trade account. As mentioned, this is called the maintenance margin (where the margin level cannot fall below 100%).
If you have positions opened in what they call negative territory, the margin level on your account will fall. If it falls below 100%, it means you no longer have funds available to open any new forex positions. The amount of funds you have available can no longer cover the broker’s margin requirements which means the equity has fallen below the used margin.
When this happens, your broker will ask you to ‘top up’ your account. This is known as the margin call and you’ll either be notified with a personal call or by email.
If you are unable to meet the requirements of the margin call (top up your trading account), some or all of your open positions will be closed and liquidated.
Margin calls can be avoided by keeping a check on your margin level on a regular basis. This is done by using Stop Loss Orders on each trade to manage losses and to keep your account adequately funded.
The difference between leverage and forex margin
Leverage and forex margin are more or less the same but are different. Leverage allows a trader to trade larger position sizes with a smaller capital outlay; and the margin is the deposit required by your broker to trade forex on your behalf and keep a position open. Where they are the same is both involve borrowing.
Leverage involves traders taking on debt to trade larger positions and amplify their returns on the investment. In other words, investors and traders use leverage to multiply their buying power in the forex market.
Margin is the minimum amount required by a broker to start a trade. In other words, it’s the amount held back by the broker as collateral. A margin is usually expressed as a percentage. Where the borrowing comes in, is traders often go take on debt (from the broker) to pay the margin, particularly if it’s for a larger trade.
The margin rate is 3.3%.
A trader wants to open a position worth $100 000.
The trader is required to pay a deposit (margin) of $3 300 to enter the trade.
The remaining $96 700 (96.7%) is provided by the broker.
The leverage for this trade is 30:1.
EXCHANGE RATE RISK
Exchange rate risk is caused by changes in the value of currency in the period that a trader’s position is open. It’s also known as currency risk and is a critical component of forex.
This component of risk is important because it affects the amount of money traders gain at the end of a trading day and their rate of return. Exchange rate risk creates trade opportunities where expected changes pushes up the value of a country’s currency. It can also result in substantial losses.
Exchange rate risk is based on the effect of continuous and volatile market shifts that affect supply and demand. While your trade position is open, it is subject to price changes. Price changes typically occur when the market’s perception of which way a currency will move (increase or decrease in value).
The strength of a country’s exchange rate may be influenced by internal factors or global factors. In other words, the market moves based on fundamental and technical factors. This is why it’s so important for traders to monitor fundamental and technical analysis which is provided on all retail trading platforms.
The following indicators are available to manage exchange rate risk:
A position limit is the maximum amount any currency a trader is allowed to carry at one single time.
The loss limit is a measure designed to avoid unsustainable losses that are incurred if traders do not set their Stop Loss limit.
Simple Risk/Reward Ratios
This indicator is used by traders as a guideline to control exchange rate risk. It measures their intended gains against possible losses. Where most traders lose twice as much as they profit, the Simple Risk/Reward Ration is set to 1:3.
INTEREST RATE RISK
Interest rate risk involves gains and losses on forex trading that are caused by fluctuations in forward spreads. It goes hand-in-hand with mismatches of forward amounts and maturity gaps in transactions.
Interest rate risk applies to currency swaps, forward outright, currency futures and currency trading options.
- Currency swaps is a simultaneous purchase and sale of identical amounts of one currency for another with two different value dates. Currency swaps are used for foreign exchange derivatives.
- Forward outright defines an exchange rate with fixed forward points and a future delivery date. It’s the simplest type of foreign exchange forward contract and allows a trader to buy or sell currency, either on a specific date or within a range of dates.
- A currency future is a futures contract to exchange one currency for another at a specified date in the future at a price that is fixed on the purchase date. Most often, one of the currencies is the US Dollar.
- Currency trading options are securities that allow currency traders to realise gains without having to place an actual trade in the underlying currency pair.
A trader can minimise interest rate risk by setting limits on the total size of mismatches. The most common approach is to separate the mismatches. This is done on their maturity dates, up to 6 months and past 6 months. A formula is used to calculate the positions for all the dates of the delivery, gains and losses.
It’s vitally important that traders continuously analyse the interest rate environment in order to forecast changes to trade orders that will impact on the maturity gaps.
Credit risk relates to the possibility that an outstanding currency position may not be repaid as agreed. This is due either to a voluntary or involuntary action on the part of the other party.
Credit risk is low for an individual traders but high for brokerage houses and banks who allow traders to trade forex on leverage (borrow to open a trade).
The forex market as a whole is unregulated but financial services regulatory bodies in the different countries impose strict rules to make sure forex trading companies keep the funds of qualified customers secure.
When looking into which broker to use for forex trading, it’s important you check their credentials. Only use a forex brokerage that is fully regulated and licensed to operate under the regulatory body in the jurisdictions in which it operates.
The following are the known forms of credit risk”
Replacement risk occurs when counterparties of a failed brokerage house or bank find they are at risk of not receiving funds from their trading account.
Settlement risk occurs as a result of different time zones on different continents. Currencies are traded at different prices at different times of the trading day. Payment may be paid to a brokerage house that declares itself insolvent or is declared insolvent before it pays out funds owed to its clients.
Counterparty Default Risk
Forex is traded over-the-counter (OTC) and is not traded through the global exchanges. The banks and brokerage houses act as principles in the market. Counterparty risk occurs because a performance of spot and forward contracts on currencies are not guaranteed.
The risk is that the principles are unable or unwilling to perform with respect to these contracts. The brokerage house is under no obligation to continue to trade the spot and forward contracts.
In addition, a broker may refuse to execute an order in a currency market deemed to be too high risk. Every brokerage house applies its own risk analysis which it uses to decide if it will or won’t participate in a particular market where its credit must stand behind each trade.
COUNTRY AND LIQUIDITY RISKS
Periods of illiquidity are experienced in the forex market and several nations or groups of nations have in the past imposed trading limits or restrictions on the volume of forex that may be traded. They have also imposed restrictions or penalties on traders for carrying positions in certain currencies.
Country limits imposed by either governments or the General Partner prevent trades form being executed during a given trading period, particularly volatile periods. If it happens when a trader has an open position, it can prevent a trader from promptly liquidating unfavourable positions. This can result in substantial losses.
What also happens, albeit rarely, is a nation or group of nations restricts the transfer of currencies across national borders. Or they may suspend or restrict the exchange or trading of a particular currency by a nation. This typically happens when sanctions are imposed on a country.
Other actions by government that raise the level of country and liquidity risk is an entirely new currency is issued to supplant old ones, they order the immediate settlement of a particular currency oblictation or they order that trading in a particular currency must be conducted for liquidation only.
Forex is traded over-the-counter in a number of countries with exotic currencies. These currency markets are more prone to periods of illiquidity than the major markets such as the United States, United Kingdom and Eurozone.
This risk is still real even where traders have placed Stop Loss and Limit Orders on open positions. Despite the precaution, the trade order may still not be executed in a very illiquid market.
Mistakes happen in the forex market. Communications between traders and brokers break down and the handling and confirmation of traders’ orders go wrong. This may result in unforeseen and substantial losses.
Forex is traded over-the-counter and is largely unregulated. For this reason, traders can find it very difficult to recover their losses on poorly-handled or faulty transactions.
The general rule of forex is the greater the time differential between entering and settling a contract, the greater the transaction risk. Time differences increase the risk because the exchange rate may increase or decrease in that space of time which pushes up the cost of transaction.
RISK OF RUIN
Risk of ruin is where traders are not able to financially carry short-term unrealized losses. They then close out a position at a loss in order to meet the margin call. Traders with insufficient capital face ‘risk of ruin’ if they cannot sustain their positions, regardless of whether their view of the market trend is correct and the currency position eventually turns and moves in the right position.
HOW TO MANAGE RISK IN FOREX TRADING
Fortunately, the trading platforms offer a bundle of risk management tools that are designed to protect you. They help control your risk and should help you make money out of forex trading. The problem is many forex traders, particularly beginners, overlook how critical it is to manage one’s risks.
Investing in your trading education and understanding how the forex market works and what the risks are is the greatest investment you can make. You need to manage your expectations of how much money you can make trading forex and don’t fall into the trap of ‘getting greedy’.
Top 10 risk management strategies
Do your online research and watch video tutorials on forex. It’s important that you understand what the risks of forex trading are and what tools you have available to you on the popular trading platforms to minimise your losses.
Here are the Top 10 tips the experts offer to manage your forex risk:
- Hedge your forex positions
- Use a proper position size calculation process to calculate the correct lot size.
- Only trade in more profitable periods; keep a trading journal and identify times (hours, days and weeks) that are more profitable to trade in.
- Diversify across many currency pairs to create a balanced forex portfolio; but don’t diversify too widely.
- Set an optimal Stop Loss level; backtest it to check it’s right.
- Trade the more predictable pairs; if you’re a beginner, avoid the exotic currency pairs.
- Only trade and invest in assets that you understand; this means trading education plus research.
- Determine the maximum drawdown or risk per trade.
- Maintain an appropriate Risk to Return ratio; ideally it should be 1:1 where the risk is equal to the reward.
- Use appropriate leverage; even if higher leverage is offered, don’t use it unless it’s the right thing to do (the maximum leverage for beginners is 1:20).
The foreign exchange market is one of the most traded markets in the world. The Bank of International Settlements estimates that over USD 5 trillion is traded every day on the forex market. It’s a leveraged product, meaning most traders borrow money to open trades and this makes it one of the highest-risk instruments on the market.
The forex market has a very low barrier to entry, meaning traders can start trading forex with a small capital investment. Basically, a trader needs some knowledge of how forex trading works, a good Internet connection and an account with a broker that offers a free trading platform such as MetaTrader 4.
Just because it’s easy to open an account with leverage and start trading forex, it doesn’t mean that you should. The most important thing to consider before embarking on your forex trading journey is whether you have an appetite for risk and the financial capacity to carry substantial losses.
Risk management is the one thing that separates professional traders from retail traders who are not making money.
Forex Trading Africa Disclaimer
Trading foreign exchange on margin is risky. Forex trading is not suitable for all investors and traders and a high degree of leverage can result in significant financial losses. With forex trading, there is the possibility that you could sustain a loss of some or all of your initial investment.
22nd Oct 2020
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