Can forex be traded without risk? The answer is, of course, as plain as the nose on your face. In forex trading, as in life itself, there’s always a chance of things going wrong.
In many cases, though, it is possible to manage risks by understanding their nature, likelihood, and impact. In many cases, this means taking the long view: every single trade you make won’t succeed, and some may fail quite badly.
However, as long as you follow a consistent forex strategy and risk management system to make each decision, you’ll come out ahead in the end. In particular, disasters like account blow-ups can be avoided by allowing for the possibility of the occasional slip-up.
The difference between risk and money management
Risk management and money management are closely related but non-identical concepts. You will read different definitions in different sources. For the purposes of this article, let’s keep things simple.
Money management as applied to forex
Money management is effectively a subset of overall risk management. Key to doing it correctly is to keep an eye on position sizing, which is all about how much risk you take on each trade relative to the total amount you have in your trading account. It pretty much amounts to not putting all your eggs in one basket.
Risk management in the forex world
Risk management is a system that strategically assesses every risk that can affect your trading strategy. Part of this rests on how you manage your trades, but some other risks (discussed in a moment) have to be understood and gauged, too.
The many kinds of risk in forex trading
The outcome that every forex trader wants to avoid in forex trading is losing their whole investment. People have gotten rich from forex trading make you rich, sure. However, it is not a get-rich-quick scheme and there are risks that must be carefully avoided. More precisely, any trader has to learn how to balance these against probable opportunities for profit. Understanding the different types of risk that can cause the latter is the first step.
Let’s outline the major forex risk factors as well as outline some ways to manage each:
Market risk
This is the possibility that the price point of the market you are trading moves in an unforeseen way. Let’s say you buy EUR/USD in anticipation of it rising 20 pips, but it drops 100 pips instead. It is impossible to perfectly predict the market before each trade – there are too many factors affecting it. Market risk itself can be split into different categories – there is, for example, equity risk, interest rate risk, currency risk, and political risk.
It might be that you were trading EUR/USD just before an economic news event like a Federal Reserve meeting and feeling very confident about what the central bank will decide. Then, a European politician makes an unexpected statement and alters the impact of the news, ruining your trade in the process.
You will see some blogs talk about “currency risk” as something forex traders need to watch out for. This is tautological, if not asinine, because you are of course trading currencies. Currency risk, as such, applies mostly to investments in other asset classes. If, for instance, you are a stock trader in the United States investing in Swiss stocks, the USD/CHF could shift quite independently of your investment’s value, and your investment’s profitability will change accordingly.
Solutions: This is a complex and wide-ranging issue. Though we recommend you consult a variety of sources, Oba Davis’s book offers a useful introduction.
Operational risk
This term refers not to the trades you make but how you make them – specifically, the internal or external systems you rely on to trade effectively. Your internet connection going down or your chosen trading platform going bankrupt are examples of operational risks.
Solutions: More often than not, it’s worth paying a little extra for reliable service providers with a reputation for good customer support. When it comes to brokerage platforms, it is of course essential that they are licensed by the appropriate regulatory bodies. It is also helpful if they offer alternative channels on which you can enter and close out trades, including web, mobile, and perhaps a phone or online chat service. In addition, having plans in place for things like cyberattacks and power outages will stop you from having to scramble in worst-case scenarios.
Liquidity risk
It’s generally assumed that you can close out a position at market price whenever you want to, but what if nobody wants to buy what you’re selling or sell what you’re buying? In the foreign exchange market, on which roughly $5 trillion worth of currency changes hands every day, this rarely affects foreign exchange traders.
Solutions: The major currency pairs most amateur traders deal in are highly liquid, while cross pairs can usually be traded without any headaches. Only exotic pairs involving lesser-known countries are likely to ever present a problem.
However, you may want to find out who your forex broker uses as their liquidity providers. While there is lots of liquidity in the forex market, not all brokers have equal access to this flow of money.
Counterparty risk
Legal or financial problems should never really arise with your bank or broker, or even with the liquidity provider of your broker. Yet, this sometimes still happens. In essence, counterparty risk arises if the party you are trading with or through (in most cases, FX traders trade with their broker) cannot meet their obligations. Them not being able to pay you back, even temporarily, can make life very uncomfortable.
Solutions: This is why it is of the utmost importance to work with a trusted and regulated broker. Check, for instance, that your chosen forex platform can be found in the relevant authority’s database instead of just displaying their logo on its web page. Looking at independent customer reviews is rarely a waste of time.
Leverage risk
Most forex traders operate on margin; that is, they take on positions worth more than the amount they’ve actually deposited in their brokerage account. This magnifies your profits but also your exposure. In effect, leverage risk amplifies the effect of all other kinds of risk, especially market risks.
Solution: Trading on margin means taking on more risk in each trade and should be undertaken with caution. Though leverage is a useful tool, its proper use has to be understood before it’s used.
Risk of ruin
A somewhat ironic risk situation occurs when a trader has a great idea but not the resources to execute it effectively. The simple fact is that you only have a finite supply of capital available to trade with. If you know where the market will end up, but not when, the market may move quite a long way against your prediction before you are proven correct.
Solution: Learn about stop loss orders before risking any real money. Once you do move from a demo account to an active one, never risk any substantial portion of your portfolio on a single trade. Avoid the Martingale technique of buying ever more deeply into a falling market or selling when it rises, which will always lead you into an unsustainable position.
Risk management, forex, and peace of mind
This concept of risk management is not something you consider after you’ve already set your trading strategy; it should be its cornerstone. At the same time, this can be liberating: once you understand the different kinds of risk that apply to forex and how each factors into every individual trade you make, you’ll be that much better equipped to exploit opportunities as they arise.
