Forex Trading Risks & How to Manage Them

It is the risk in forex trading that makes it possible to earn large returns. Forex traders use risk management techniques to use forex trading risks to their advatnage.

How can you avoid risk in forex trading?

The short answer is you can’t avoid risk in forex trading, you can only understand and manage the risks. This means there will still be losing trades and things can go wrong but by making the right decision on each trade by using a good forex strategy and proper risk management system, disasters like account blow-ups can be avoided.

 

avoiding risk

Source: TheCEOMagazine.com

Risk management vs. Money management

Risk management and money management are closely related but different things. You will read different definitions from different sources. Here is our take (and the correct one!)

What does Money management mean in forex?

Money management is a part of overall risk management – it goes hand in hand with position sizing which is all about how much risk you take on each trade relative to the money you have in your trading account. It is like budgeting for forex trading.

What does risk management mean in forex?

Risk management is a system that controls for every risk that can affect your trading, one of which is how you manage your trades but there are other risks too that we will discuss next.

What is the risk in forex trading?

The overall risk that every forex trader wants to avoid in forex trading is losing their investment. Can forex trading make you rich? Yes, but it is not a get rich quick scheme and there are risks that must be avoided. When you put money into a forex trading account, you want to do everything that will help it grow and avoid everything that will make it decline. There are different types of risk to manage.

 

losing money

Source: Simpsons

Types of risk in trading

Here we outline the major forex risk factors and some ways to manage them.

Market risk

Definition: This is the risk that price of the market that you are trading moves in a way that you didn’t expect. For example, you buy EUR/USD in anticipation of it rising 20 pips but instead it drops 100 pips. It is impossible to perfectly predict the market in every trade – there are too many factors affecting market prices. Within market risk - there is equity risk, interest rate risk, currency risk and political risk.

For example, it might be that you were trading EUR/USD during an economic news event like an FOMC meeting and feeling very confident you know what the central bank will decide, but then a European politician says something unexpected and overrides the impact of the news event, ruining your trade in the process.

You will see some blogs talk about ‘currency risk’ as a risk to forex traders. This is obviously asinine because you are trading currencies. Currency risk is something for investors in other asset classes to manage. For example, if you are a stock trader in the United States investing in Swiss stocks, the value of USD/CHF could change – meaning any profit from your investment will change accordingly.

Solutions: Money management techniques outlined in our blog: 5 tactics for good forex trading money management

Operational risk

Definition: This is when something goes wrong with the internal or external systems you rely on to make your trades. Some of the most common risks relate to your internet connection and trading platform.

Solutions: If the internet drops or your trading platform has a technical problem, you need to work with a trusted broker that has a reliable phone or online chat service on which you can enter and close out trades. Your broker should also have alternative platform options, including web, downloaded and mobile to reduce your operational risk. A backup internet connection or a location where you are confident you can get internet if your drops is a good failsafe to have in place.

Liquidity risk

Definition: This basically means that you cannot close out a trade at the market price when you want to. This is typically not such an issue in the FX market, which sees $5 trillion in trading volume every day – and thus it is normally very easy to locate buyers or sellers.

Solutions: Typically, the major currency pairs are the most liquid, then cross pairs, then the exotic pairs involving lesser-known countries are least liquid.

However, it is worth asking the question when you open your online trading account, who the 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 liquidity.

Counterparty risk

Definition: This is when there is a problem with your bank or broker or even with the liquidity provider of your broker. In essence if the person you are trading with (in most cases, FX traders trade with their broker) cannot pay you back, you cannot access your funds.

Solution: This is why it is of the upmost importance to work with a trusted and regulated broker. FlowBank is registered as a Swiss Bank and full regulated by the FINMA, Switzerland’s well-respected regulatory authority.

Leverage risk

Definition: Placing a trade that is worth more than the funds available in your account leads to magnified gains and losses. It in effect amplifies the effect of all the other risks, especially the market risk on your forex trading account. Trading on margin means taking on more risk in each trade and should be undertaken with caution.

Solution: Trading with leverage is a useful but potentially dangerous tool for your trading account if not properly understood. Make sure to fully understand how the leverage in your trading account works.

Read our blog: How Leverage in Forex works to learn more

Risk of ruin

Definition: This concept is at the cornerstone of why risk management is important. It is the idea that you only have a finite supply of capital available to trade with. Although you may ultimately be proven correct on a trade idea, if the market moves too far against you before you are proven correct, your limited capital will sooner or later prevent you from sustaining the trade.

Solution: Always use a stop loss and risk only a small percentage of your account on each trade. Avoid martingale technique of buying more into a falling market or selling more into a rising market, which will always eventually fail.

How is risk management used in forex?

Here is a summary of the forex risks faced by forex traders and ways in which to manage them.

 

Forex trading risk

How to manage it

Market risk

Use a money management system

Includes: stop loss, R:R ratio

Operational risk

Broker with reliable phone service

Backup internet

Backup trading platform

Liquidity risk

Trade most liquid or major forex pairs

Broker with major liquidity providers

Counterparty risk

Trade with a regulated Broker

Leverage risk

Use a money management system

Monitor margin requirements

Risk of ruin

Use money management system

Limit risk per trade to 2% of account

Avoid martingale trading strategy

 

 

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