As the world’s most liquid market, it may come as a surprise to you that there is no one international supervisory body monitoring the daily activity of currency trades placed on the forex market. Instead, there are multiple governing bodies across the globe managing brokers and traders at a national level. While this form of monitoring is mostly effective, due to the scale of the international market it means that currency trading can be extremely volatile and pose various financial risks to those trading within it.
So, whether you’re new to the currency trading realm and are looking for tips to catapult your career, or you consider yourself a distinguished trader experienced in forex trading strategies (but want to touch up on the basics), we’re here to help. In today’s blog post, we’re stripping it back and exploring the most fundamental forex strategy – risk management – looking at what it is and how you can incorporate it into your daily activity.
What is risk?
Defined by the Cambridge Dictionary as “the possibility of something bad happening”, risk is commonly understood to be when a person puts themselves into a position where they are not in control of the outcome – therefore having to face any repercussions that arise from this, whether they be positive or negative. As a result, it’s fair to say that without preparing for all possible outcomes, a person who doesn’t effectively consider risk may face significant losses – either personally or financially.
What are risks in forex trading?
In relation to the currency market, risk is the associated unpredictability of whether a trade will make a profit or a loss. For example, if a trader was to decide to place a substantial sum of capital on a trade, the risk would be that they could lose it all if the market suddenly changed.
Risk in forex should be examined in accordance with the two factors below:
Simply put, leverage involves borrowing a smaller sum of money from a broker with the view of making a significant profit from the resulting trade. So, for example, with a 10:1 leverage, a deposit of $100 would equate to a $10,000 trade.
It’s important to remember, though, that leverage works two ways. As a result, while a successful trade in a leveraged position will see your profits rise, in comparison an unsuccessful trade could see you face substantial losses. So, in order to minimise the potential for such financial losses, the risk of leverage should be fully analysed and understood.
In forex, market liquidity is defined by whether there are enough active buyers and sellers to effectively open a trade using the present market prices.
Due to the sheer scale of this global, 24 hours a day 5 days a week market, liquidity rarely poses a threat. In contrast, while market liquidity is a risk you should be aware of but may never encounter, broker liquidity is where real risks are born.
Unless you’re trading as part of a large financial organisation, you’re likely to be trading on the market through an online broker. Given that different liquidity is offered to alternative brokers depending on your chosen currency pairs, it’s crucial you consider broker liquidity before opening a trade position.
Risk-reward ratio: what is it in forex?
Risk-reward ratio is a forex strategy implemented by many traders to measure the potential of financial returns against the original amount risked. For example, a risk-reward ratio of 1:10 simply means that you’d be risking $1 to potentially earn $10.
Calculating forex risk-reward ratio
In layman’s terms, calculating your risk-reward ratio involves dividing the potential profit by its potential loss. So, if you decided to set your stop loss at 20 pips with a desired outcome of 50 pips, your risk-reward calculation would be 20:50 or, in other words, 2:5 – see, easy right?
Essentially, in order to properly integrate this into your forex trading strategy, you need to look for potential trades where the financial reward overrides the associated risk. Naturally, it would be preferable to only trade in instances where positions are low risk and reward is high – unfortunately however, this can’t always be the case, especially if you’re looking to turn over substantial amounts of money. For instance, in the case that the market is especially volatile (you can learn more about this industry-specific jargon right here), gambling on a high risk-reward ratio could work in your favour – it all depends on the individual forex trader’s risk appetite…
What does risk appetite mean in forex?
Risk appetite in forex is the willingness of a trader to take risks – in essence, it’s how ‘risk-hungry’ a trader is. Generally, if risk sentiment is on the up, risk appetite increases and currency traders are willing to invest in more volatile assets.
As a result of this, higher investments in currencies that have higher interest rates and commodities (such as the GBP) occur – meaning, therefore, that there is a greater exposure to settlement risk.
What is a settlement risk in forex?
A historic issue in the currency market, settlement risk is the potential for one party not to deliver a security (either the cash value of the contract or the underlying asset) to the other party as per their agreement. Typically, this is found in cases where large amounts of capital are traded in highly volatile markets, as well as during periods of financial strain.
How can I manage and minimise forex risk?
There are a number of effective forex trading strategies that, if properly utilised, can be used to practise risk management on the currency market. Strategies such as the ones found in our blog post help you best understand how to reduce your risk exposure and reduce the possibility of losses as a result.
From simple habits you should get used to implementing day-to-day to more complex techniques such as hedging and risk aversion (that may take a little longer to master), by researching various strategies and testing them out to decipher what works for you, you’ll be best placed to make more informed decisions surrounding risk.
What is hedging risk in forex?
Hedging is a forex strategy used by traders to protect their position from an unexpected movement in a currency pair. This usually involves a trader buying a currency pair while, at the same time, placing a second trade and selling the same pair. Though this doesn’t tend to create net profit, with tactical market timing, financial gains are able to be made.
Put into more simplistic terms, traders are creating a win-win situation for themselves by avoiding potential losses from one trade due to the subsequent profits made from the contrasting trade. For more information on how to implement hedging into your forex trading strategy, check out our blog post here.
What is risk aversion?
Common practice in particularly volatile or otherwise uncertain market conditions, risk aversion is the act of unloading a position in higher-yielding assets in order to move capital to safer, more stable currencies.
How much should I risk per trade in forex?
Firstly, it’s important to note that there is no right or wrong answer here. However, as a general rule, the amount you’re looking to risk should only be a small percentage of your gross investment capital.
For those of you just starting out on the forex market, for example, it’s recommended that the most you look to risk is 2% – so, if your account has a total of £20,000 in capital, you shouldn’t look to risk any more than £400. This would allow you, therefore, to lose 50 trades in a row before using up all your funds – a very unlikely outcome (so long as you’re equipped with the right forex knowledge and advice).
Arguably one of the reasons you were first enticed into trading on the forex market was the potential for profitability and success. However, where this is substantial profit to be made, there is always a higher potential for significant losses to occur, too. So to ensure you’re ready to tackle this at-times volatile market, join us at one of our forex trading courses and learn from a selection of industry experts.