Unspoken Risks in Doing Forex Trading
When you read about forex trading, most of the information will usually be about its benefits. However, just like any other investment vehicle, this business has its risks too. In fact, research shows that 90 percent of the traders who join this market are said to incur losses. The main reason why most people lose money when they start trading in this market is because they do not take their time to understand how the market operates first. They place their trades without understanding market trends as well as leverages very well.
Many people join this market with the notion they can make money faster. Even though it is true that you can make good profits when trading in this market, you can equally make huge losses if you don’t take your time to understand the trends very well. Reliable market trends are usually shown in longer time frames, so you will need to learn how to exercise patience when trading in this market if you would like to accumulate huge profits. Most people usually opt for short term day trading trends, and as a result they never generate good profits.
The problem with short term trading trends is that they are random and they usually get stopped most often. It is also possible to fail to make good profits from long term trends if you don’t know the right way to stop placement and also deal with volatility. So whether you prefer using the short term trends or long term trends, you just need to know the best way to maximize profits with them and also reduce the risk of losing money.
Another common forex trading risk is interest rate risk. It is simply the profit and loses that are generated when you are trading in this market there are fluctuations in spreads as well as amount mismatches and maturity gaps forex book. Currency swaps are the most common cause of this risk. To minimize it, you will be required to put a limit on all the mismatches in your trade. This can be done by separating the mismatches with respect to their maturity dates.
Other unspoken risks in doing forex trading especially for novice traders are day trading and intra trading. Even though it is beneficial to trade longer term in order to maximize your profits, you will need to have a clear understanding of volatility, how to manage risks as well as how to place stops if you want your trades to be profitable. By doing so, you will be increasing chances of staying in the longer trends while also remaining profitable in the trades that you will be placing.
Most successful forex traders usually have a clear understanding of the risks that they are likely to encounter when trading in the foreign exchange market.
Forex risk management involves a combination of responsible use of leverage, appropriate lot size, correct placement of a stop loss order and a profitable risk/reward ratio. When used correctly, all of these ingredients are combined into a recipe that does not risk more than 1-2% of your trading account for any single trade.
Leverage allows you to use a small amount of capital in your trading account to control large amounts of capital in your trades. If a forex broker offered a leverage of 200:1, it would only take a deposit of $50 to control a $10,000 trade. Likewise if a broker offered a leverage of 400:1, the same $50 deposit could control a $20,000 trade.
Forex leverage can be a double edged sword – it can work for you by amplifying your wins, or against you compounding your losses. Just because a broker offers high leverages of 200:1 or 400:1 doesn’t mean that you should use it all the time. When you are new to trading, a leverage of 20:1 or 50:1 is much better than a higher leverage.
Lot sizes determine the dollar value of each pip. Micro accounts offer $1000 ($0.10 per pip), mini accounts offer $10,000 ($1 per pip) and regular accounts offer $100,000 ($10 per pip) lot sizes. These pip values are based on trading EUR/USD.
Think of a stop loss order as trading insurance. Just as you wouldn’t drive without auto insurance – you shouldn’t trade without a stop loss as insurance against excessive losses. Correct stop loss placement is based on the trade entry, areas of support and resistance and risk/reward ratio.
A trade’s risk/reward ratio determines whether you should take a trade or wait for the next trading opportunity. The bare minimum risk/reward ratio is 1:2. In other words if the risk is 20 pips then the reward should be 40 pips. A risk/reward ratio of 1:3 would be a risk of 20 pips and a reward of 60 pips. Proper risk/reward ratio will allow you to be wrong 50% of the time and still be profitable.
Let’s look at an example trade using EUR/USD that follows sound risk management. We have determined that the overall trend is up so we are looking to go long (buy). We determine we want to buy at 1.3500. The last low point was at an area of support at 1.3480 which is 20 pips lower. We can see that the next area of resistance is 40 pips higher at 1.3540 which will serve as our target.
We have a micro account balance of $10,000 and we are using 50:1 leverage which would allow for a trade of 5 regular lots or a position size of $500,000. However, we want to use sound risk management so we only want to risk 2% of our trading account for this trade – 2% of $10,000 is $100. With a stop loss of 20 pips that would mean we could trade a position of $5000 – $5 per pip x 20 pips stop = $100. We place a limit order to trigger at our target of 1.3540 which is 40 pips. 40 pips x $5 per pip = $200 or a risk/reward ratio of $100/$200 or 1:2.
Trading forex carries with it a high level of risk – but it doesn’t have to be “risky” as long as you use solid forex risk management. Make protecting your account balance a priority over making a profit and you will find your account balance steadily increasing even with a number of losses.