This article will discuss the major forex risk types that beginner traders should be aware of. It will ensure that traders are aware of current forex risks that occur on a daily basis, such as political risks. This article will provide traders with a better understanding of what the risks are and how they can be managed.
#1 - Transaction Risks
- Changing time zones have an effect on currency prices
- Longer times betweens the starts of trades and their conclusions = higher potential costs
A transaction risk is an exchange rate risk, and it occurs when there are significant differences in time, in terms of when a contract has begun and when it has been settled.
Since forex is a 24 hour market, exchange rates change several times before trades are finalized. As a result, currencies may be traded at all sorts of prices, at varying times within the trading windows.
The larger the gap between when the trade was started and when it is closed, the larger the transaction risk. These time differences allow for several price fluctuations to occur in the currencies, which can affect everyone from beginner traders to large corporations.
#2 - Credit Risks
- Check the credentials of the person you are trading with, make sure they can pay you
Trust is the key part of any relationship, and the trust between the buyer and the seller in the forex markets is no exception. If you place a trade, your expectation is that the other side will fulfill their part of the deal, yet there is always a risk that the other side might not be able to pay.
For example, bankruptcy can occur. Therefore, to avoid such risks, it is important that proper credit risk management has been implemented. It's a good idea to check if a company is a member of an authorized organisation, like the Financial Commission, for example.
#3 - Political Risks
- Statements and data released by politicians can affect markets
Forex trading political risks are among some of the most frequent and ever changing forex market risks, because there are constant announcements made by world governments that affect economies and society in general.
Therefore, political risks inevitably have an affect on forex markets, because traders will speculate based on the latest news developments, or they may anticipate what is coming and trade in response to it.
To give an example, when Donald Trump makes tweets on twitter, his words often have an impact on worldwide markets. Sometimes he makes official statements, but a lot of the time he posts general opinions, and even though these are just opinions and should not necessarily be taken as an indication of what may be coming in the future, they will still prompt traders to act differently in the forex markets.
For instance, some traders may react positively and start trading quickly and in large amounts as a response, whereas others might choose to wait and not trade, or perhaps trade later. The point is, because of Trump's position as the president of the USA, anything he tweets will always have a major impact on the markets.
#4 - Leverage Risks
- In a highly volatile market, you can lose more money
- You can also potentially make higher profits in a volatile market
When you are trading in the forex market you will be required to make a small initial investment which is known as a 'margin'. The purpose of this investment is to allow you access to a range of sizable trading opportunities in different foreign currencies.
During a trading window, there will be price fluctuations that can make a 'margin call'. A margin call is an instance whereby an investor must pay for a supplementary margin, when the value of the account decreases till a certain point.
When there is a lot of market volatility, there are significant forex leverage risks, meaning that traders can potentially lose a lot of money, and very quickly. This is because the market is moving so rapidly, and therefore, it could be difficult to recover losses or prevent further losses.
#5 - Interest Rate Risks
- Increases in interest rates lead to higher exchange rates
- Decreases in interest rates lead to lower exchange rates
Firstly, it's important to note that interest rates have an impact on the exchange rates of countries. If the interest rates of a country increase, the currency will likely strengthen too, due to the fact that there is likely to be an increase in foreign and domestic (home) investments in the assets of that country.
The reason for these increases in investments is that investors believe that a currency that has become stronger, and will very likely provide higher returns in the future.
In contrast, it can work the same way if a country's interest rates decrease. In this scenario, the country's currency would weaken when investors begin to withdraw their investments in that country's assets.
Because of these changes, forex market prices would also be affected dramatically. Therefore, at a time like this, the markets would likely be highly volatile, presenting opportunities to make higher profits, as well as larger losses simultaneously.
Expert Tip For Avoiding Forex Risks
Hedging forex risks is an effective way of reducing the potential of losing substantial amounts of capital when trading on the forex markets. But what is hedging?
Hedging in forex refers to the act of protecting your position on a currency pair from a move that could affect you negatively. Traders typically use two distinct strategies for hedging forex currency pairs.
1. They create a 'hedge', which means that they choose to hold 'long' and 'short' positions on the same currency pair (like placing the same bet twice, so that one bet will definitely win, and one bet will definitely lose). This strategy is also known as a 'perfect hedge'.
2. They create an 'imperfect hedge', which means that they go long or short on a currency pair, and then purchase options contracts. This reduces what is known as the 'downside risk'.
If the trader is 'going short' on a currency pair, they can instead choose to purchase all of the 'buy call option contracts' in order to lessen the risk involved with their move on the 'upside'.
If nothing else, this article should demonstrate to you that just like anything else in life, forex trading is not without its risks. But by making sure that you are careful and by implementing tools such as a stop loss, you can seek to reduce or even avoid risk entirely.
The key point is to not be afraid of risk, but rather, to understand it and overcome it. Be aware of the risks, do what you can to avoid them, and make sure to closely monitor your open positions.
If you are confident enough to take on the risks and potentially be successful in the forex markets, you can get started right now with the Metatrader 4 trading platform - provided by MTrading! What's more, you can practice with a free demo account and use virtual funds with real-time trading information, before you progress to a live account.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.