Forex Trading Overview
The Forex Market is where currencies are traded on a daily basis by various participants worldwide and it is by far the largest market with trades to the value of over $5 trillion occurring daily.
Forex Trading is done online Over-The-Counter, or more commonly known as OTC, by making use of various computer networks that connect these Forex Participants.
With the Forex market being one of the most liquid markets due to the high volumes of trading activity, there are great chances of significant profits, but there are also several risks involved when trading Forex online that traders need to evaluate and consider.
The risks involved with online Forex Trading
The end goal with trading Forex online is in yielding net profit through buying low while selling high and Forex traders are in an especially advantageous position when it comes to choosing between a variety of currencies which to trade.
It is imperative for traders to realize and familiarize themselves with the various risks involved with trading Forex as it may lead to substantial losses that could exceed their initial deposit.
Leverage or Margin
Forex is a leveraged financial instrument and leverage only requires a small initial investment, or margin, which provides traders with access to larger trades in foreign currencies.
Margin calls result when there are small price fluctuations and the trader is subjected to paying any additional margin.
Leverage aids traders in opening positions much larger than their initial deposit and may lead to great gains, but improper use of leverage may lead to aggressive use or abuse thereof and result in losses that exceed the trader’s initial deposit.
Leverage should always be used with caution. Due to the risks involved, various regulatory entities limited maximum leverage that traders have access to, for example, the FCA limits brokers under its jurisdiction to provide maximum leverage of 1:30.
Traders need to beware of brokers who offer offshore accounts as they have more leeway considering leverage and traders can have leverage up to 1:2000. Despite this, trading with offshore brokers may pose a threat to the safety of funds in itself.
Interest Rate and Exchange Rate
The exchange rate of different countries is determined by interest rates and the strengthening of currencies are attributed to the rise in interest rates where the lowering thereof will result in weaker currencies.
Due to the interest rate’s nature in addition to its circuitous effect on exchange rates, traders need to take note of the differential between currency values which may inevitably cause Forex prices to change and fluctuate.
The Forex Market is open 24/5 and this provides traders with ample opportunity to trade any time of the day.
One important factor that traders need to consider, is that the transaction risks involve exchange rate risks which are associated with time difference between the beginning of a contract and when the contract settles.
The longer a contract remains open, the greater the chances of being subjected to fluctuations in exchange rates.
The counterparty is the broker through which the trader trades financial instruments, Forex in this case and the risk pertaining to brokers involves the risk of default during a particular transaction.
When trading Forex, spot along with forward contracts specifically on currencies cannot be guaranteed by either an exchange or a clearing house. When traders trade Spot Currency, the broker risk origins from the solvency of the market maker.
When the Forex Market is experience significant volatile, the broker may be unable to adhere to contracts, or they may refuse to adherence.
Another risk factor concerning brokers is that there are a lot of scam brokers out there and traders risk the chance of losing their capital and more should they choose a scam broker by accident.
It is imperative to deal only through highly reputable and strictly regulated brokers.
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When traders look towards the option of trading Forex, they will need to thoroughly assess not only the structure, but also the stability of the currency in their issuing country.
Various third world, developing countries have their exchange rates fixed to a world leader such as the US Dollar and as result of this, central banks are obliged to sustain adequate reverses with which to maintain a fixed exchange rate.
Factors such as the frequent balance of payment deficits result in the devaluation of the currency and this in turn results in a currency crisis which may have substantial effects on the trading of Forex as well as the prices.
The liquidity of the Forex Market is in general much greater than for instance the exchange traded currency futures but there have been periods of illiquidity noted especially concerning trading hours outside of the USA and Europe.
There have also been trading limits or restrictions that have been imposed by several nations pertaining to the amount by which the price of certain Forex rates may vary given a certain time period along with the volume and carrying over of positions.
Limits such as these may adversely affect trades and limit them from being executed during a given trading period resulting in traders being prevented from promptly liquidating unfavourable positions, leading to substantial losses.
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Risk of Ruin
Forex traders who are more experienced than some are more aware of the risks involved with being able to sustain short-term unrealized losses which may lead in prematurely closing certain positions at a loss because they cannot meet a margin call.
Regardless of whether the trader can view the market correctly, a currency position may ultimately not turn around or become profitable and this poses a significant risk to traders who have insufficient capital to compensate for such losses.
This involves the inability of the trader to repay an outstanding currency position either due to voluntary or involuntary action by the broker, or counterparty.
Although retail traders are less at risk for this than banks and corporation, it is still a considerable factor when large trading volumes are considered on an individual trader level.
High volatility is one of the Forex Market’s most identifiable features and the volatility risk involves the degree of fluctuations within the markets with the exchange rate potentially spread out over a larger range of values.
High volatility results in the prices of currencies changing dramatically over a short period of time either in an upwards or a downwards direction and this is especially detrimental to traders who do not possess or use trading strategies to harness this market condition.
The risks associated with trading pose a significant psychological risk to a large amount of traders. Every time a trader executes a trade, there is a chance of great gains, but also substantial losses.
This may have a substantial impact on traders even when they are away from their trading terminal, and it may be one that lasts for a period of time if not managed and mitigated correctly.
The psychological effect of trading may also cause more sporadic, chaotic, and emotional trading patterns and it is therefore crucial that traders evaluate their response and exposure to the risks associated with trading before they enter the Forex Market.
The risks involved with online Forex Trading are inevitable, but traders have some level of control in their response to these risks by ensuring that they have a proper trading plan with the necessary guidelines in managing and minimizing the impacts of risks.
By formulating and adhering to a trading plan, and by thoroughly evaluating their financial position, what they can and cannot afford to lose, traders can minimize the losses incurred by trading activities and the different risk associated with trading and the Forex Market.