Forex trading is hailed as one of the money-making opportunities for the young and those who are adept. And that is fair, forex presents an opportunity that can provide high returns with very little additional investment in terms of access and equipment. You use the same internet connection and device that you use as your daily driver. However, forex trading does have dangers and risks. Many cautionary tales of how people have lost it all, or more in forex exist. Let’s look at these risks.
This is one of the most important risks in forex and it truly never disappears. When choosing currency pairs we are ultimately pitting two economies against each other. Furthermore, fiat currencies are purely based on the governments that back them and how well they manage their currencies. So while it may seem like just picking currencies you have to be aware of the state of the economies behind the currencies. The thing to watch out for would be accessibility to information about the management of the economies. Less or untimely information puts you at major risk of currency collapse.
One of the touted advantages of the forex market is leverage. For those who are not familiar this is where your broker lends you money to amplify your trades. Say your broker offered you 10 to 1 leverage. This means for every dollar you have the broker will lend you 10 to trade with. So if you had 100 dollars to trade with, this now gives you 1000 dollars. Great. Assuming your position has a profit of 10 dollars for every 100 you invested your profit would then be 100 dollars instead of just 10. So far so good. The broker will of course take a commission on the leverage. However, this goes both ways and if we reverse the details and say the position resulted in a loss of 10 dollars per every 100. This is a simplified version of what they call blowing your account. Leverage risk is big and good mentors and tutors will emphasise risk management to minimise this.
Interest rate risk
There is a concept, in finance and monetary economics called the International Fisher effect. Put as simply as possible the international Fisher effect tells us that the differential between two countries interest rates will closely approximate the change between the exchange rate between the two country currencies. So a country with a higher interest rate change will have a depreciating currency compared to a country with a lower interest rate change. Many other models approximate this relationship but the International Fisher Effect does a really good job of this approximation and the interest rate is updated at least quarterly by most reserve banks. This means the change can happen quite suddenly. This makes interest rates important data to keep an eye on.
A counterparty is any party that helps you in accessing and navigating the market. Two counterparties easily come to mind here. Brokers and mentors. Firstly the risk of brokers leading you astray or folding altogether. Remember brokers make money when you transact, not necessarily when you make money, so not all encouragement from your broker is to your advantage. Secondly, mentors are also a source of counterparty risk, if not the greatest. For example, a mentor will normally recommend you to a broker without disclosing to you that they make referral commissions from the recommendations. Many stories of trouble in the forex market involve some omission or commission on the part of a mentor. This is a real risk that affects many in forex and one you need to look out for.
Transaction risk is the final risk we will look at. This is a risk associated with transacting on the forex market. The forex market is the largest, widest, deepest and most liquid market in market in the world. It operates 24 hours a day and things happen very fast there. One expression of transaction risk is things happening while you sleep especially if you have positions open overnight. You can wake up to a nasty surprise. Another expression risk is slippage. This occurs when prices change rapidly as you enter a position reducing or eliminating the profitability of the position at the moment. This risk is ever-present in forex because of the set-up of the market.
These top risks in the forex market are ever-present. Some can be mitigated but never eliminated. In all cases it’s important to make sure you’re aware of them and how to minimise them.