The overall risk level in trading foreign exchange rates doesn’t have to be any worse than leveraged trading in the futures or bond markets of the world. All such trading is done on a “marked-to-market” basis (meaning that every time a price changes, that change will be reflected in your cash margin columns of your trading account) and all markets have periods of significant volatility. Where forex differs from other markets, however, is the sheer amount of leverage that may be available for trading purposes. This is due, primarily, to the fact that the forex industry is controlled by banks and these institutions have lots of cash to lend out, particularly if they can control how much you’re trading and how you’re trading (plus getting compensating for the “risk” that they are taking in letting you have such a long financial leash).
Make leverage work for you – not for the banks. Think defensively. Modulate how much you use and when. Always use stop losses and never “bet the farm”.
Why Foreign Exchange Rates Pose A Risk
Like any investment, there’s always the chance that you might waste your capital in trading forex. Usually, when this happens, it involves a bit of ego and, perhaps, some emotion (both of which should be nowhere near any investment decision, no matter how small). Here’s a classical example: you have decided that you need to go long the EUR/AUD (completely forgetting that such a situation puts you in a fee-paying situation after 24 hours, since you’re implicitly shorting a “high interest rate yielding” currency, i. e., the AUD). You leverage yourself to the hilt (because you know this is “the trade of the century”). A price spike hits. Your investment is toasted. Why? You forgot to set a stop loss.
Avoiding Losses In Foreign Exchange Rates Markets
There’s a variation on this theme of losing everything. It involves getting roasted even more quickly. Here’s how it usually happens: you leverage to at least 100:1 or, perhaps, even higher (completely forgetting that this means that just a 1% move against you evaporates your trading position and cash margin). Then, you go to sleep (in other words, you’re not “day trading”, but “swing” or “trend trading” – activities that demand reduced leverage positions). When you wake up, you discover that your trade is wiped out. Why? Well, you picked a pair that ranges more than 100 pips/per day. But, using 100:1 leverage, all you could afford was 99 pips/day. Next time, use an “Average True Range” indicator – before you trade.
Use Stop Losses When Trading Foreign Exchange Rates Positions
Stop losses are the collision insurance of the forex industry. Since they come free of charge, use them. Accidents happen, but with stop losses, at least you shouldn’t get totalled. Now, does that mean that they are always there to save your trade? No, unfortunately. Why? Well, there’s this problem with “slippage” that a lot of brokers do not want to tell you about. Slippage is when a stop loss order doesn’t get filled where you need it to get filled. Instead, it’s gets filled at some other price. This means that instead of getting toasted, you might get roasted. So, don’t expose your trades to “illiquid markets” where such a situation might arise. Trade defensively; assume the worst.