The risks of online Forex trading
Forex is by far the biggest trading market in the financial world. It accounts for roughly $5 trillion traded volume per day, which far surpasses other markets like stocks, commodities, etc. It is one of the most liquid markets as well, making it possible to buy or sell the currency at any time.
Thanks to such scale and liquidity, Forex is considered the easiest market to start trading. People with an internet connection and an internet-connected device can start buying and selling currencies at any time. However, with such ease comes lots of FX trade risks.
The most obvious risk that any trader is afraid of is losing money. It is exactly the opposite of their intentions for entering the market, which is to achieve success and get payouts. But unfortunately, various circumstances turn things against Forex traders and lead them towards a losing path.
There are lots of reasons why a trader would potentially lose money while trading Forex, be it leverage, spiking volatility, etc. In the following article, we will discuss five of the most rampant dangers that lead traders to a failure:
- High volatility
- High leverage
- Unexpected interest rate changes
- Low liquidity
- Untrustworthy counterparty
It is interesting to note that these factors are simultaneously beneficial and dangerous to traders. They are the main reason why trading is profitable in the first place, however, if they occur too intensively and traders aren’t careful, they can turn into Forex trading dangers.
The main risks of trading Forex explained
The risk of unpredictable market volatility
One of the key characteristics of any financial market, be it Forex, stocks, commodities, etc. is the continuous change of asset prices. This is shortly known as volatility.
On one hand, volatility is the main reason why traders are profitable. If the prices were static and unchanging, there would be no point in buying an asset; the whole point of trading is to buy a security at a lower price and sell it when the price increases. And without volatility, that would not have been possible.
On the other hand, however, the change in asset prices can also make traders lose money. They may buy an asset at a certain price and expect to sell it at a higher price to get a payout, however, the market can easily go against them and drop the price, making it unprofitable to sell an asset at that point.
The risks of Forex trading are even higher if the market volatility is skyrocketing. At that time, the losses experienced by traders with long positions (buyers) is far greater than it would be in normal conditions. Spiking volatility can be caused by sudden and drastic economic or political news that greatly impact the market. Therefore, it is always a good idea to be careful about position sizes and not open exceedingly large trades.
The risk of high leverage
Leverage is also one of the inherent features of Forex. The majority of Forex brokers offer it to their clients to make it easy for them to control larger position sizes. For instance, if they wanted to open a trade for $100,000 and the leverage rate was at 1:200, a trader would need to make a $500 deposit instead of the full $100,000.
It goes without saying that an increased position also increases prospective payouts. In the same example, the payout of 10 pips would be just 50 cents for a $500 position, whereas the $100,000 leveraged position would generate $100.
Unfortunately, however, leverage acts as a double-edged sword because it can also increase the size of prospective losses. A 5-pip loss, for example, would cost a trader just 25 cents if they opened a $500 trade. However, if they had used the leverage of 1:200, they would lose $50 from their position.
In short, using the leverage in your trades can be both beneficial and risky and it is up to you to choose the exact leverage ratio that you need.
The risk of unexpected changes in interest rates
The interest rate is yet another key characteristic of the currency market. It shows the percentage of returns people/institutions get for lending their money to others. It also has a big influence on currency exchange rates and presents one of the many risks of Forex investing.
If the central bank of a certain country decides to increase the interest rate, it will automatically attract new demand for that currency: those people who want to make deposits or investments in that currency because it gives them larger payouts. Because of that, the currency will strengthen and its price will increase against other currencies.
Conversely, if the central bank decides to decrease the interest rate, the demand for it will decrease as well. That’s because the deposits and investments in that currency will generate lower payouts than before. For that reason, the currency and its price against other currencies will weaken.
The biggest risk associated with interest rates is their unexpected change. Sometimes, central banks take drastic measures that include unexpected increases/decreases in interest rates. This, in turn, has an effect on the exchange rate of a certain currency, and ultimately, it goes against the traders’ interests.
The risk of low liquidity
As we pointed out in the article above, Forex is the most liquid market because there are always people who are ready to buy and sell currencies. This also means that individuals have little impact on the overall price of an asset because the scope of the market is so huge.
Now, there are periods when even the most liquid Forex market can have low liquidity levels, which is yet another one of the FX trade risks. Low liquidity levels usually occur during
bank holidays, weekends, or financial crises, increasing the additional operational costs.
Usually, when the market is less liquid, Forex brokers tend to increase the size of spreads, which acts as a commission for their services. And as the reader may already know, large spreads reduce payouts received from trades, which is something that traders usually avoid.
The risk of the counterparty
When entering the Forex market, or any market for that matter, one of the first things traders do is find a service provider (a broker). The Forex broker provides them with various tools and indicators that are necessary to conduct a trade. Besides, they connect traders to liquidity providers - the ones that give traders assets to trade.
Unfortunately, one of the risks of trading Forex is being treated poorly by the other party - be it a broker or a liquidity provider. This means not getting paid when you need/want to take the money from your account.
The counterparty may be unable to pay you for various reasons. One of those reasons is that the liquidity provider simply defaulted or went bankrupt and has no financial means to pay you. But there are other cases when the counterparty isn’t obligated to pay you by any regulatory authority, therefore, it simply refuses to do that.
Either way, it is vital to find a regulated broker that abides by high financial standards and has proper reserves to fulfill your requirements should the liquidity provider be unable to pay out your earnings.
How these risks can be eliminated
When there is a problem, there is a solution. To eliminate or reduce trading related risks, traders employ various techniques. Risk management is key to success in trading. Now, let’s discuss how traders handle the risks mentioned in this article:
The risk of drastic and unpredictable volatility
In order to counter the risks coming from increased volatility, traders use volatility indicators to spot the start of high volatility early on and take measures before it can hurt the trading account balance. There are two major ways to counter high volatility: use of stop loss orders and hedging.
Hedging is somewhat better than simple stop losses, but it comes with certain drawbacks. A simple hedging strategy is to open a counter trading order in the opposite direction of the already established trade. This way, no matter how volatile markets are, traders get to keep the progress they made earlier and remain in an open position. Hedging is typically temporary and traders cancel it once the threat is gone. On the other hand, the main drawback is that traders get to pay additional trading fees such as spreads and commissions. The stop loss order on the other hand, doesn’t cost anything, but it closes the open position once hit.
The risk of high leverage and increased losses
To counter risks coming from the usage of high leverage, traders need discipline. Often when traders lose money, they get the desire to recover right away and fall in the trap of revenge trading. It’s important to have clear rules of position sizing and never risk more than what’s predetermined pre trade. Moreover, many traders have daily loss limits, meaning once they lose a certain amount, they stop trading completely. Keep in mind that there’s another effective way to limit leverage risks: simply select a low leverage 50:1 - 100:1 during the account opening process. Most brokers do offer a high leverage but enable customers to choose the optimal version for themselves.
The risk of fluctuating interest rates
Fundamentals such as political and economical events can cause high volatility and damage active trading positions. To mitigate these risks, traders can use hedging strategies. As mentioned earlier, hedging is a form of risk management that enables traders to cover their open positions by opening trades with similar size in the opposite direction. Highly correlated instruments can also be used to hedge positions. In addition, it should be mentioned that to limit these risks, most technical traders avoid placing orders during and before significant economic and political events.
The risk of low liquidity and high spreads
In order to avoid a low liquidity environment, professional traders choose active trading sessions such as New York and London. These trading sessions are the most liquid, meaning during the trading hours most contracts are exchanged and the trading opportunities are increased. In addition, to limit the fees traders pay in spreads, they pick the most liquid trading instruments. When it comes to trading currency pairs, the most liquid ones are major pairs, the least liquid pairs are exotics, and minors are in between the two groups. Major currency pairs are referred to currencies that include US Dollar as either quote or base currency coupled with currencies from major global economies such as Europe, Great Britain, Japan, etc.
The risk of not getting paid by the counterparty
To avoid such risks, it's best to always pick a broker that is regulated by top-tier financial institutions. In addition, make sure that your broker never takes the opposite side of its clients and always sends the orders straight to the market. Trustworthy brokers use a no-dealing desk execution model and are known as STP (Straight Through Processing) or ECN (Electronic Communications Network) brokers.