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Financial markets are notoriously volatile and can sometimes move in ways that do not always make sense. A given trading pair may suddenly swing in a different direction, seemingly out of nowhere, immediately wiping out an ill-defended position. Such a harsh environment can quickly overwhelm new traders, which is why it is crucial to protect open trades as much as possible. An effective risk management strategy can easily save a given trade. In fact, it can save an entire portfolio.
Before going any further, it is worth exploring what kind of risks FOREX traders are likely to face. The main types of risk are detailed below, along with examples:
A fundamental aspect of FOREX trading, market risk is simply the risk of adverse market movements. As mentioned above, sometimes markets can move against traders in unexpected ways. Sudden news events, economic data, central bank decisions and many other factors can cause sudden market movements. This type of risk is inherent to FOREX trading and cannot be avoided entirely.
Example: The Bank of England unexpectedly cuts interest rates on the Pound Sterling. This will typically cause a sudden drop in the Pound because such a move was not previously priced in.
Caused by the delay between when a trade is placed and when the trade is actually settled. FOREX trading is not instant. A trader has to submit an order, which is then broadcast to a wider network of traders before being handled by a matching engine, which has to find a corresponding order. These operations take time. It is possible that the market can move in the opposite direction before the entire chain of operations has a chance to complete.
Example: A trader takes a long position on EUR/USD, expecting the Euro to strengthen. Unfortunately, the Euro instead weakens before the position has a chance to fill, resulting in a loss instead of a profit.
Caused by a lack of liquidity in a given currency pair. This is typically not a problem for major pairs including the Dollar or the Euro, but it can be a problem in more exotic currency markets. A trader switching in and out of the Turkish Lira or the Malaysian Ringgit may find there are very few people on the other side of the trade and may struggle to fill the desired order as a result. This can lead to the trader getting a very unsatisfactory price, potentially affecting overall profit.
Example: A trader wants to buy Mexican Pesos with Euros. The order is only partially filled at the desired price point because the books lack sufficient depth. The rest of the order is filled at a higher price, leading to fewer Pesos acquired.
Caused by too high leverage. Traders use leverage as a tool to multiply market movements. This is very useful when markets are calm but can be lethal during times of high volatility. A sharp movement in the wrong direction can result in an almost instant loss if the leverage is too high.
Example: A trader goes long on USDJPY at 500 leverage but the Japanese Yen makes a sudden move higher. The position runs out of margin before the trader can react.
Caused by the FOREX broker. A good trader may still lose out if the other party in a transaction fails to fulfil their side of the trade. Brokers following less stringent regulations or lacking proper liquidity may not be able to fill their traders’ orders, or in extreme cases may go bankrupt or even vanish off the face of the Earth.
Example: An unregistered broker goes bankrupt, offering no protection to their clients, resulting in a permanent loss of funds for all traders involved.
There are many good practices that traders can employ for better risk management, as follows:
The cornerstone of FOREX trading. A stop loss will automatically close a trade if the currency pair does not move in the desired direction. This simple tool can cut short a bad trade, resulting in a very minor loss and allowing the trader to try again at another time. Stop-losses are generally seen as good practice no matter the situation and should be used liberally. The exact positioning of the stop-loss does require a level of understanding and finesse, which new traders will acquire as they gain more trading experience.
Traders should only risk a small percentage of their capital with each trade, ideally no more than 5% at the absolute maximum. The most important part of trading is the strategy. The overall strategy may yield positive results over time, while still producing occasional bad trades. This is why traders need some degree of flexibility. Traders should be able to afford losses, while achieving success in the long run. Traders using their entire balance have no such flexibility.
Trading has a steep learning curve that can be ruinous to new traders. Using low leverage is an excellent way to make things easier for traders who are learning the ropes. Beginners may also try out a demo account in order to understand trading without risking real capital. As traders become more confident and more familiar with financial markets, leverage can then become a great tool to enhance their trading performance.
As mentioned previously, exotic pairs can often lack sufficient liquidity. Unless traders have specific knowledge on one of the lesser traded currencies, such pairs are better left alone. Moreover, because commonly traded pairs have better liquidity, not only are orders easier to fill, they are also typically cheaper to trade compared to their more esoteric counterparts.
Major economic events can have an enormous impact on financial markets. Unexpected central bank decisions, economic data, labour market reports can all send shockwaves throughout the foreign exchange markets, causing extreme price action across currency pairs. Traders need to be aware of such economic events in order to avoid getting caught out by the resulting fallout. The economic calendar is crucial to success in this regard, as is staying on top of financial news in general. Trading during times of high volatility is simply more dangerous, which is why many traders simply opt to close their positions before any major economic data release such as Non-Farm Payrolls.
FOREX markets can present a challenge to new and experienced traders alike. Understanding the risks involved is important; implementing the strategies necessary to mitigating such risks is crucial. Foreign exchange markets are by their very nature unpredictable and sudden price fluctuations can catch beginners off guard. The good practices described above will ensure new traders ease into the FOREX industry on sure footing and help orient beginners towards lasting success.
Forex risk, or FX risk, is the potential for financial loss due to unexpected currency exchange rate movements in FOREX trading. Beginners should pay attention to this risk because these fluctuations could lead to significant losses. Implementing stop-loss orders and maintaining low leverage are effective ways to protect your investment.
Major pairs like EUR/USD or USD/JPY offer high liquidity and tighter spreads, reducing costs and avoiding extreme price swings compared to exotic pairs like USD/TRY. Trading on more liquid pairs also increases the likelihood of filling orders at the desired price point, whereas less liquid pairs may offer sub-optimal pricing.
Beginners should focus on high-impact indicators like interest rate decisions, non-farm payrolls, GDP reports, and inflation data. These announcements can cause significant volatility. Use an economic calendar to identify upcoming events, avoid trading during major releases until you gain experience, and understand how different currencies typically react to specific data drops.
Use a demo account to test risk management strategies without financial consequences. Practice setting appropriate stop-loss orders, experiment with position sizing (limiting each trade to 1-2% of your account), and learn to diversify across different currency pairs. Track your results meticulously to identify which approach works best for your trading style before transitioning to live trading.
No. FOREX trading is unpredictable by its very nature. It is impossible to completely eliminate risk because financial movements are downstream from human emotion and behaviour. The best a trader can do is to use tools and strategies that protect their trades when things do not go to plan.
Leverage is essentially a multiplier. It takes small market movements and turns them into larger ones. A trade at 100 leverage is not the same as a trade at 500 leverage. Potential profits increase with leverage, but so too do potential losses. Margin requirements increase with leverage. Risk increases with leverage, as such it is a tool to be used cautiously.
Risk Warning : Trading derivatives and leveraged products carries a high level of risk.
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