RISK MANAGEMENT IN FOREX
Any investment that offers potential profit also has downside risk, up to the point of losing much more than the value of your transaction when trading on margin. This article can help understand the risks so you trade successfully.
The following are the major risk factors in FX trading:
Exchange Rate Risk
Interest Rate Risk
Marginal or Leverage Risk
Margin or leverage risk can play a significant role in forex trading. What exactly is margin trading? Margin trading allows you to utilize leverage. Usually, when you are placing a forex trade, it is necessary for you to put up only a portion of the total value of the position as good faith. Your trade is considered leveraged if you are able to enhance your position size with borrowed capital. The amount which is required to be placed upfront is deemed as the margin requirement. Many forex brokers allow their forex trading clients to leverage up to 100:1. But just because they allow such high leverage, doesn’t necessarily mean that is it a good idea for you to use it.
Volatility risk describes the degree of fluctuations within the markets and should certainly be included in a trader’s thought process. Although many forex traders generally look at volatility in terms of being a negative uncertain risk element, there are many positive components of volatility as well. Without at least a certain degree of volatility, it would be nearly impossible for a trader to benefit in their trading activities. It’s usually during high impact news events that volatility can spike and become inordinately high. It is especially during these times that volatility can adversely affect a trader’s position.
Credit risk refers to the possibility that an outstanding currency position may not be repaid as agreed, due to a voluntary or involuntary action by a counterparty. Credit risk is usually something that is a concern of corporations and banks. For the individual trader (trading on margin), credit risk is very low as this also holds true for companies registered in and regulated by the authorities in G-7 countries. In recent years, the National Futures Association (NFA) and the Commodity Futures Trading Commission (CFTC) have asserted their jurisdiction over the FX markets in the US and continue to crack down on unregistered FX firms. Countries in Western Europe follow the guidelines of the Financial Services Authority in the UK. This authority has the strictest rules of any country in making sure that FX companies under their jurisdiction are keeping qualified customer funds secure. It is important for all individual traders to thoroughly check out companies before sending any funds for trading. It is fairly easy to check out the companies you are considering by visiting the authorities' websites:
Most companies are happy to answer inquiries from customers and often post notices pertaining to security of funds on their website. It should be noted, however, that minimum capital requirements for Futures Commission Merchants ("FCMs") registered with the CFTC are much less than those of banks, and under present CFTC regulations and NFA rules, protections related to the segregation of customer funds for regulated futures accounts do not extend fully to funds deposited to collateralize off-exchange currency trading. For these and other reasons, the CFTC and NFA discourage any representation that the registration status of a Futures Commission Merchant substantially reduces the risks inherent in over-the-counter Forex trading.
Exchange Rate Risk
Exchange rate risk is the risk caused by changes in the value of currency. It is based on the effect of continuous and usually volatile shifts in the worldwide supply and demand balance. For the period the trader’s position is outstanding, the position is subject to all price changes. This risk can be quite substantial and is based on the market's perception of which way the currencies will move based on all possible factors that happen (or could happen) at any given time, anywhere in the world. Additionally, because the off-exchange trading of Forex is largely unregulated, no daily price limits are imposed as exist for regulated futures exchanges.
The Position Limit
A position limit is the maximum amount of any currency a trader is allowed to carry, at any single time.
The Loss Limit
The loss limit is a measure designed to avoid unsustainable losses made by traders by means of setting stop loss levels. It is imperative that you have stop loss orders in place.
Simple Risk / Reward Ratios
A simple method traders use as a guideline when trying to control exchange rate risk is to measure their intended gains against their possible losses. The idea is that most traders will lose twice as many times as they profit, so a simple guide to trading is to keep your risk/reward ratio to 1:3. This is illustrated in detail in a later section.
Interest Rate Risk
Another major component of Forex risk is interest rate fluctuations. We know that when an entity or institution borrows funds from a given lender, the lender will provide those funds in exchange for a given interest rate on the loan.
The rate of interest charged will typically be determined by the amount of risk the lender takes. Usually, borrowers who are considered high risk will pay a higher interest rate on a loan. Conversely, borrowers who have a lower risk profile will invariably pay lower interest rates over the life of the loan.
Central Banks are responsible for setting monetary policies within their counties to ensure economic growth and stability. These fluctuating interest rates in the foreign exchange markets drive numerous decisions for traders.
It is important to note that a country’s interest rates and currency exchange rates are often linked hand and hand. By carefully monitoring interest rate changes, you will know where big institutions are investing their assets in order to receive the greatest return possible.
Many times big institutions focus on the carry trade, which is an interest rate differential based trade. Generally, the higher yielding interest rate currency pairs attract greater demand.
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