The Forex market is one of the most traded markets in the world, attracting an ever-increasing number of traders.
The last survey from the Bank for International Settlements shows that trading in the Foreign Exchange market reached USD 5.1 trillion per day between April 2013 and April 2016.
The main reason why more and more traders flock to the forex market is because the barrier to entry in trading currencies is so low. All you need to start trading is a computer, an Internet connection to access your online trading platforms, and (most importantly) trading knowledge.
Even though it’s pretty easy to start trading with an online Forex trading account, this doesn’t mean that it’s without risks. As a Forex trader, the most obvious risk is losing money, which is further amplified by the leverage that brokers provide (more on this is covered below).
But there are other risks you need to be aware of. So, let’s find out.
#1 The danger of uncontrollable market risk
Market risk, also called systematic risk, represents the risk inherent to the entire market, as opposed to the unsystematic risk that only affects a specific asset, market, sector, geographical region, etc. While unsystematic risk can be reduced with diversification, systematic risk is uncontrollable.
Simply put, market risk in the Forex market is linked to everything that can impact the price of the currency pairs you’re trading.
Market risk is also the most “useful” kind of risk for any trader – the one you want to have exposure to. Indeed, to make money in the market, you need prices to move around, so you can take advantage of the difference in prices when buying and selling. This is referred to as “market volatility”.
Consequently, volatility is what allows you to make profitable trades. It’s a risk, as you can lose money if the markets go against you, but it’s also because of this that you can make winning trades.
There are countless systematic risks that can affect prices:
- Inflation, growth, and employment figures, as they can impact Central Bank decisions about monetary policy, especially interest rates,
- Other financial and economical announcements
- Strikes, geopolitical conflicts, wars, terrorist attacks, and natural disasters,
- Changes in regulations, legislation, and tax policy.
#2 Leverage risk
One of the biggest advantages and risks of Forex trading is leverage.
Investors use leverage to considerably increase the returns on their investments. However, leverage also increases losses, as it magnifies the movements on the currency market – both upwards and downwards. That’s why leverage is often called a “double edged sword”.
How does leverage work?
Leverage works with margin trading, which allows you to take advantage of greater market exposure while only putting aside a small portion of the capital you would normally have to possess in your account to open such trading positions.
But remember – just because your broker offers a 400:1 leverage effect doesn’t mean that you have to use it. High leverage comes with high risk. Unfortunately, many traders, especially novices, do not understand how risky leverage can be, and they often use the highest possible leverage.
It’s important to realise that with an aggressive use of leverage, you are adding a very high level of risk to your trading account. This situation can easily end up with your account being quickly and completely wiped out when the markets evolve against you.
After the huge losses investors had to bear because of the increasing use of leverage, some authorities decided to limit the leverage they have access to.
Example: The European Securities and Markets Authority (ESMA) recently decided to further protect investors in E.U. countries by prohibiting binary options and the use of Contracts for Difference (CFDs), including Forex. The Authority also reduced the leverage effect offered by brokers to retail traders to 30:1 for major currency pairs, and 20:1 for non-major currency pairs.
#3 Liquidity risk
When a market is liquid, this means that it’s quite easy and fast to open and close your trading positions at the price you’re expecting.
Why? Because there are many buyers and sellers in the market.
A liquid market also means that any changes in the supply and demand relationship of an underlying asset will have a small impact on its price.
Even though the Forex market is one of the most liquid financial markets in the world, there are periods of low liquidity, especially outside of the American and European trading sessions, or during bank holidays and weekends.
This is an important risk that traders should take into consideration, as this usually means that their cost of trading will increase.
Consider the spreads
Indeed, when brokers face a low liquidity situation, they usually increase the size of their spreads. Remember that a spread is the difference between the selling price and the buying price. It’s the commission you pay to your broker for its services.
Increasing trading costs is a situation that only happens when your broker offers variable spreads, which change depending on the market and trading conditions. However, you can also look for a broker offering fixed spreads, especially if you’re uncertain about how a specific currency pair behaves, or if you intend to use an aggressive and active trading method such as scalping during news releases.
Liquidity risk can also be linked to more unpredictable situations.
Example: When the Swiss central bank (SNB) decided to unpegged the franc and cut interest rates deeper into negative territory, markets were caught off guard. This event strongly impacted volatility and liquidity on all currency pairs linked to the CHF, especially the EUR/CHF.
The wild price movements on the Swiss currency were a true liquidity issue.
Can you guess why?
Because there were so many stop-loss orders that couldn’t be matched by any bid offers. Indeed, Forex traders had no reason to think the CHF would strengthen because the SNB never said anything about its wish to abandon the floor for the EUR/CHF currency pair.
#4 Counterparty risk
In the Forex market, the counterparty is the entity with which you open and close trading positions: your broker.
The main risk here is that your counterparty doesn’t pay you, either because it went bankrupt, or because of poor regulatory enforcement.
This risk is quite difficult to measure as an individual trader, so they rely on regulatory bodies. By using a trustworthy broker that is subject to regulation from different authorities, you can be more confident when trading.
Tip: Depending where you’re trading from, you should make sure that your broker is regulated by either the Autorité des Marchés Financiers (AMF) in France, the Financial Conduct Authority (FCA) in the U.K., the U.S. Securities and Exchange Commission (SEC) in the U.S.A., or the Australian Securities & Investments Commission (ASIC) in Australia.
Following the 15th of January 2015, when the SNB surprised the markets by abandoning the EUR/CHF cap, the importance of managing counterparty risk was highlighted.
Not only should you be sure to work with a licensed and regulated broker, but you should also consider the financial strength of its counterparties, which should also be diversified. You need to know that the liquidity providers your broker works with will be able to survive during extreme market conditions, such as that of January 15th, 2015.
There is no such thing as risk-free financial instruments. There are also many dangers linked to Forex trading you need to be aware of before using real money to trade.
Linked to the four most important risks to Forex trading: market, leverage, liquidity, and counterparty, there are also margin calls, economic exposure, credit risk, inflationary risk, interest rate risk, exchange rate risk, volatility risk, political and legal risk, country risk, interconnection risk, operational risk, transactional risk, technology risk, and psychological risk.
So, you might be wondering: is Forex trading worth the risk?
Because as with any other type of activities, there are always benefits and risks. You just need to be sure that the benefits are greater than the risks.
START FOR FREE
CHAPTER QUICK LINKS
- 2.Why is Forex Popular?
- 3.Why Forex is (or isn’t) for You
- 4.How Does Forex Work?
- 5.Popular Traded Currencies
- 6.History of Forex Market
- 7.FX cash, CFD or Spread Bet?
- 8.How Margin Trading Works
- 9.Best Time of Day to Trade
- 10.Forex Regulation And Protection
- 11.Forex Trading Examples
- 12.Making a Living Trading Forex
- 13.Mind, Money, Method
- 14.Forex Risk Management Strategies
- 15.Winning Forex Strategies
- 16.Technical vs. Fundamental Analysis
- 17.New Forex Trader Mistakes
- 19.Next steps