There are several risks associated with trading Forex. However, leverage and high volatility are two of the main risks.
Due to the high volatility in the forex market, currency prices are always swinging up and down constantly. Even in an upward trend, wild movements happen in the opposite direction.
Although volatility makes it possible to make profits, but can also amplify your loss if the currency price movement goes against you. Some other risks of trading forex include: transaction risk, interest rate risk, counterparty risk, and country risk.
As a result of a lack of proper risk management strategy, about 90% of traders lose money. Notwithstanding, the risk in Forex cannot be avoided, but can be managed and we will discuss 5 ways to go about it.
#1. Only Register With Regulated Brokers
A Forex broker is a financial service provider that provides the platform & technology, needed for you to trade currencies from the comfort of your home.
They serve as middlemen between you and liquidity providers. In some cases, they act as the liquidity provider, and take the opposite side of your trade (in case of market maker brokers). Your forex broker plays a key role in the trade cycle.
Regulation is what keeps brokers in check, and forces them to put your interest over their profits. Many scam brokers don’t like this, and would rather clone fake licenses, or out rightly operate without licenses.
The danger of you patronizing a scam broker is that should you lose your funds, there’s no compensation and furthermore chances of litigation and recovery of funds are slim.
The Investment Industry Regulatory Organization of Canada (IIROC) is the watchdog of the capital markets in Canada and issue and revoke licenses of market players including forex brokers.
Some critics will argue that it is not mandatory that all brokers must hold licenses from IIROC (since other countries also regulate forex brokers and issue licenses).
However, to ensure the safety of your funds, you must only trade via licensed brokers in your region. This will give you protection in case of any bad practice by the broker, and the regulator will have an oversight on the activities of the regulated broker.
There are a few dealers regulated by the IIROC that offer forex trading. Among the listed member dealers on IIROC’s website, some of them are subject to the specific current Terms & Conditions by IIROC as mentioned on their website which includes restrictions imposed on them. All other dealers have to comply with the standard rules & regulations set by the regulator in Canada.
There are clear benefits for clients trading with IIROC regulated broker over brokers regulated in other regions, as the regulation with the domestic regulator ensures the forex broker has to open physical offices in Canada, and have critical infrastructure that reduce latency or trading time delay.
Domestic regulation also ensures physical visits can be made by the regulators to the forex brokers’ office at any time, so as to take them unawares and conduct spot audit exercises.
Domestic regulation also ensures brokers don’t offer unsuitable leverage to traders. For example, the IIROC rules stipulate the margin requirements on forex positions which mean that brokers have to require clients to maintain minimum margin as per these rules. So, brokers in Canada can only offer from 1:3.5 to 1:30 leverage depending on currency group you are trading. Regulation prevents brokers from offering you high leverage (like 100:1), that can expose you to heavy losses, if the trade goes against your favour.
#2. Use Stop Loss Orders
Stop loss order is an order you place with your broker, to automatically close your position once the exchange rate of the currency pair in question, reaches the stop price.
For example, let’s say you go long on EUR/USD at 1.1600. The price falls to 1.1550 before you manually close the trade.
If you had placed a stop loss order at a stop price of 1.1585, the trade would have automatically closed at 1.1585, reducing your loss from 50 pips to 15 pips.
If you had entered this trade with $10,000, placing a stop loss at 1.1585 would have reduced your loss from $50 to $15.
However, during periods of high volatility, your trade may be closed at a different price other than what you set in your stop loss.
This is where GSLO (Guaranteed Stop-Loss Order) comes in. It helps to guarantee that your trade is closed at the exact stop price you choose irrespective of volatility, but you pay for the service. Whether you use GSLO or traditional stop loss, consider the following methods to help you decide where to place the stop loss:
#Method 1: 2% rule
One of the popular methods for determining stop price is the 2% rule. This rule means that you are not allowed to put more than 2% of your account equity at risk.
For example, if you have $10,000 in your equity account you can only risk $200 per trade. In our EUR/USD example, if you are opening the trade at $1.1600, the 2% rule requires that your stop price cannot be less than $1.1368.
#Method 2: Support and Resistance Level
Support level is the price at which a currency pair stops falling and begins to rise, while resistance level is the price at which a currency pair usually stops raising and begins to fall.
It is advisable that you avoid placing a stop loss at the support and resistance level. Preferably place your stop loss one or two pips above the resistance level, or below the support level.
#Method 3: Use volatility indicators
Volatility means the market is bumpy and prices are changing wildly. Moderate volatility is good but excess is bad. Volatility indicators are like speedometers in a car that tell you how fast things are going.
Activating the indicators while you trade, gives you a clearer picture ahead. When volatility is high, you can set wider stop loss to account for little price changes even when in an uptrend, so you don’t get stopped out of the market at every little price swing.
#3. Determine How Much Risk To Take
Before entering any trade, it is important for you to carry out proper analysis, to determine how much risk you are willing to take.
Firstly, the risk reward ratio is the comparison between the potential profits of a trade to its potential loss. Risk reward ratio is calculated by dividing the difference between the entry point and stop loss point by the difference between profit target and entry point.
RR ratio = (Entry price-stop price)/ (profit target-Entry price)
Trades that have RR ratio below 1.0 are believed to be less dangerous and risky, than those above 1.
Secondly, you need to know the right lot size to trade, given the capital you have in your account so you don’t over trade. This formula comes in handy:
LOT SIZE = (YOUR CAPITAL X ACCEPTABLE RISK)/ (STOP LOSS IN PIPS)
Thirdly, when trading multiple currency pairs, you should take the correlation coefficient between the two currency pairs into consideration.
Currency pairs with positive correlation coefficient move in the same direction, while those with negative correlation coefficient, move in opposing direction.
With this in mind, you can hedge against loss by trading currency pairs that are not positively correlated. For example, you decide to go short on one lot of EUR/USD (one pip = $10) and USD/CHF (one pip = $9.24). If the price of USD/CHF reduces by 10 points, you have lost $92.40.
However, seeing that USD/CHF and EUR/USD are negatively correlated, the fall in USD/CHF means a raise in EUR/USD, if EUR/USD raises by 10 points that would mean a profit of $100. At the end of both trades, you make a net profit of $7.60.
Another negative correlation is between crude oil prices, and the USD/CAD. Since Canada produces & exports a lot of crude oil and is the highest supplier to the USA, a rise in oil price means USD/CAD exchange rate will fall.
A positive correlation also exists between Gold price and AUD/USD because Australia is the 3rd biggest gold producer in the world and Gold (XAU) is majorly priced in US dollars.
As Gold goes up, AUD strengthens, meaning it takes more USD to buy AUD so the AUD/USD exchange rate also goes up.
#4. Do Not Over Leverage
Leverage involves using borrowed money to trade. It allows you to trade on a margin. Margin trading involves depositing a percentage of the actual size of trade, and borrowing the rest from your broker.
For example, a margin of 50% (2:1 leverage) would mean that to trade with $100,000, you have to deposit $50,000.
Leveraging gives you the opportunity to make more profits. Seeing that the higher your capital, the higher the size of profit.
If the market goes against you, leverage amplifies loss. This is why it is important that you keep track of your margin level. Margin level is calculated by dividing your equity by used margin and multiplying the quotient by 100.
When your margin level falls below a specific percent, you will receive a margin call from your broker to deposit more margin. Failure to satisfy margin call requirements, means your open positions will be closed at the prevailing market price which may be at a loss for you. As such, you want to avoid over leveraging.
#5. Trade During Sessions When Liquidity Is Good
The Forex market is usually more active when trading hours of major regions overlap. At these periods, the trading spread (differences between bid and ask price) is usually smaller, and liquidity is good.
There are four key time windows for good liquidity. They include:
- 8 a.m. to noon: The heaviest volume of trade occurs at this time because London and New York sessions overlap
- 7 p.m. to 2 a.m.: Tokyo and Sydney sessions overlap during this time. Currency price is not as volatile as London/New York overlap, but is a time to trade EUR/JPY.
- 3 a.m. to 4 a.m.: Tokyo and London overlap at this time, but traders in the US and most like in Canada would be asleep. It has the least volatility level.
Forex trading is risky, make sure to confirm all investment offers and dealers from the IIROC website, research currency pairs before trading, and have a trading plan before starting. Also remember that forex trading is not a get rich quick scheme and it takes time to become profitable.
Photo by Elena Rubtsova – pexels.com