With a mammoth $5 million traded on average each and every day on the forex market, it’s no surprise that the world’s most liquid and volatile market can, at times, pose a significant financial risk to its participants. As such, a solid understanding of how and why such risk is so frequently present is key to knowing how to manage and minimise your exposure to it.
That’s why, today, we’re taking a closer look at all the risks associated with trading on the currency exchange market, as well as detailing the different techniques and forex trading strategies you can use to reduce the possibility of shock losses on this often unpredictable trading platform.
What is risk?
In any context, risk can be defined as the potential for the uncontrolled loss of a product with value. As an intentional interaction with uncertainty, the one exposing themselves to risk often has no control of the outcome – as such, it is a purely speculative action that doesn’t factor calculated reason into the relevant considerations.
What is risk in forex?
Within the context of the forex market, risk can be understood as the uncertainty regarding the profitable returns of any given trade. If a trader is betting against market sentiment or placing large sums of capital on a position, for example, their actions would pose a risk.
This can be understood by observing a position using two objective parameters:
Liquidity (also commonly referred to as market liquidity) is understood as whether there is a sufficient quantity of buyers and sellers on the market to efficiently make a trade at current market prices.
As a global 24/5 market, market liquidity is rarely, if ever, a problem on the forex market. Where you may encounter risk, however, is with broker liquidity. Unless you’re trading directly with a large financial institution, it’s likely that you’ll be utilising an online brok er to execute your trades. As different liquidity is available to different brokers depending on your chosen currency pairs, it’s important to consider this factor before opening any position.
The second magnifying factor in forex risk is leverage. Leverage is understood as the use of a broker’s money to magnify your trade – for example, at a 100:1 leverage, a $1000 deposit would be the equivalent of a $100,000 trade.
The danger here though, of course, is that leverage works both ways. So, although a successful trade will enhance your profits in a leveraged position, an unsuccessful trade can see you exposed to sharp losses. The risk of leverage should therefore be fully understood and considered before opening a leveraged position.
An effective way to understand your risk exposure with each trade is risk-reward ratio
What is risk-reward ratio in forex?
Risk-reward ratio is one of the most useful forex trading strategies than involves a calculation, weighing up how much risk you’re willing to make against how much profit you desire.
How to calculate risk-reward ratio in forex
As an example, if you wanted to set your stop loss at 10 pips and your desired profit was 40 pips (you can learn more about this lingo right here), your risk-reward calculation would be 10:40 or, put more simply, 1:4.
The fundamentals of this application include looking for potential trades where the reward heavily outweighs the risk – essentially, it’s trading with the odds in your favour. Of course, it would be ideal to only trade in situations where positions have low risk and high reward, but this isn’t always the case – particularly if you’re looking to turn over large sums of capital. For example, if a market is particularly volatile, it can sometimes work in your favour to gamble on a high risk-reward ratio. It all depends on the trader’s risk appetite.
What is risk appetite in forex?
Risk appetite is defined as how willing a trader is to take risks. In times when risk sentiment is ripe, risk appetite is more evident in the market – with traders generally more willing to invest higher quantities of capital on more volatile assets.
Risk appetite is a gauge of how ‘risk-hungry’ traders are. If risk sentiment is up and times are good, risk appetite picks up and traders are more willing to invest in higher-yielding and/or potentially more volatile assets. More often than not, this sees a higher investment in currencies such as the GBP, which have higher interest rates and commodities. The danger in these circumstances, however, is a greater exposure to settlement risk.
What is settlement risk in forex?
Also referred to as delivery risk, settlement risk is the chance that one party involved in a trade will fail to deliver on the contractual terms agreed at the point of settlement. Though rare, this type of risk occurs more in instances of highly volatile trading with large sums of capital, as well as during times of particular financial strain.
How do you manage and minimise risk in forex?
There are a number of forex trading strategies that you can utilise to practise effective risk management on the market. Essentially, these strategies help you understand how to reduce exposure and minimise the likelihood of losses as a result.
How to apply risk management in forex
Applying risk management very much depends on finding the most effective strategy for you. These can range from useful habits that you can look to implement day-to-day (you can find out more about them by reading our blog post) to more technical forex trading strategies such as hedging and risk aversion.
How to hedge forex risk
The practice of hedging involves a trader buying a currency pair while simultaneously placing a second trade selling the same pair – though this creates no net profit, financial gains can be made with some tactical market timing.
In layman’s terms, a trader essentially creates a win-win situation by counteracting any potential losses of one trade with the subsequent profits of the contrasting trade. For an example of how this is put into action, why not check out our blog post all about hedging?
What is risk aversion in forex?
Risk aversion is the practice of unloading a position in higher-yielding assets in favour of moving capital to safer currencies. This is common practice in uncertain or particularly volatile market conditions.
How much should you risk per trade?
In short, the amount you’re willing to risk per trade should always be a small percentage of your total investment capital. For beginners, we recommend around 2% – for example, if your account has a total of £10,000 in funds, you should look to avoid risking losing more than £200 a trade. This way, you can place a losing trade 50 times in a row before draining all of your funds – an unlikely scenario when equipped with the right knowledge and forex trading strategies.
So, with all of this in mind… is forex trading just gambling?
Well, that’s an interesting one!
Profits made from the forex market aren’t taxed in the UK as it’s technically classed as gambling. This is because currency trading is basically spread betting – where traders speculate on the rise or fall of an asset’s price without owning the stock or commodity.
Of course, forex trading isn’t quite the same as taking a punt on the 1pm horse race, though, as traders are able to utilise charts, graphs and indicators to make an informed prediction of market direction. After obtaining the right knowledge and experience, forex trading is significantly less risky than an evening trip to the bookies or casino.
Photo by Michał Parzuchowski on Unsplash
There’s plenty of profit to be made on the forex market, but this means losses can be just as common. As a highly volatile and liquid market, risk is often There’s plenty of profit to be made on the forex market, but this means losses can be just as common. As a highly volatile and liquid market, risk is often high – and having a sufficient understanding of how to manage and minimise your exposure to it is vital to your success and longevity as a trader. To ensure you’re fully equipped with all the necessary know-how to trade, sign up to one of our free industry workshops and learn how to trade from the experts.