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Risks of FOREX Trading

Despite the claims you may see on some FOREX web sites, FOREX is not risk-free. You are trading with substantial sums of money and there is always a possibility that trades will go against you. There are several trading tools, however, that can minimize your risk, and with caution, and above all education, the FOREX trader can learn how to trade profitably and while minimizing losses.

Scams

FOREX scams were fairly common a few years ago. The industry has cleaned up considerably since then, but you still need to exercise caution when signing up with a FOREX broker. Do some background checking – reputable FOREX brokers will be associated with large financial institutions like banks or insurance companies and they will be registered with the proper government agencies. In the United States brokers should be registered with the Commodities Futures Trading Commission (CFTC) or a member of the National Futures Association (NFA). You can also check with your local Consumer Protection Bureau and the Better Business Bureau.

Risks

Assuming you are dealing with a reputable broker, there are still risks to FOREX trading. Transactions are subject to unexpected rate changes, volatile markets and political events.

Exchange Rate Risk – refers to the fluctuations in currency prices over a trading period. Prices can fall rapidly resulting in substantial losses unless stop loss orders are used when trading FOREX. Stop loss orders specify that the open position should be closed if currency prices pass a predetermined level. Stop loss orders can be used in conjunction with limit orders to automate FOREX trading – limit orders specify an open position should be closed at a specified profit target.

Interest Rate Risk – can result from discrepancies between the interest rates in the two countries represented by the currency pair in a FOREX quote. This discrepancy can result in variations from the expected profit or loss of a particular FOREX transaction.

Credit Risk – is the possibility that one party in a FOREX transaction may not honor their debt when the deal is closed. This may happen when a bank or financial institution declares insolvency. Credit risk is minimized by dealing on regulated exchanges which require members to be monitored for credit worthiness.

Country Risk – is associated with governments that may become involved in foreign exchange markets by limiting the flow of currency. There is more country risk associated with 'exotic' currencies than with major currencies that allow the free trading of their currency.

Limiting Risk

FOREX trading can be risky, but there are ways to limit risk and financial exposure. Every FOREX trader should have a trading strategy – knowing when to enter and exit the market and what kind of movements to expect. Developing strategies requires education - the key to limiting FOREX risk. At all times follow the basic rule: Do not place money in the FOREX that you cannot afford to lose.

Every FOREX trader needs to know at least the basics about technical analysis and how to read financial charts. He should study chart movements and indicators and understand how charts are interpreted. There is a vast amount of information on FOREX trading available both on the Internet and in print. If you want to be successful at FOREX, know what you are doing.

Even the most knowledgeable traders, however, can't predict with absolute certainty how the market will behave. For this reason, every FOREX transaction should take advantage of available tools designed to minimize loss. Stop-loss orders are the most common ways of minimizing risk when placing an entry order. A stop-loss order contains instructions to exit your position if the currency price reaches a certain point. If you take a long position (expecting the price to rise) you would place a stop loss order below current market price. If you take a short position (expecting the price to fall) you would place a stop loss order above current market price.

As an example, if you take a short position on USD/CDN it means you expect the US dollar to fall against the Canadian dollar. The quote is USD/CDN 1.2138/43 - you can sell US$1 for 1.2138 CDN dollars or sell 1.2143 CDN dollars for US$1.

You place an order like this:

Sell USD: 1 standard lot USD/CDN @ 1.2138 = $121,380 CDN
Pip Value: 1 pip = $10
Stop-Loss: 1.2148
Margin: $1,000 (1%)

You are selling US$100,000 and buying CDN$121,380. Your stop loss order will be executed if the dollar goes above 1.2148, in which case you will lose $100.

However, USD/CDN falls to 1.2118/23. You can now sell $1 US for 1.2118 CDN or sell 1.2123 CDN for $1 US.

Because you entered the transaction by selling US dollars (buying short), you must now buy back US dollars and sell CDN dollars to realize your profit.

You buy back US$100,000 at the current USD/CDN rate of 1.2123 for a cost of 121,223 CDN. Since you originally sold them for CDN$121,380 you made a profit of $157 Canadian dollars or US$129.51 (157 divided by the current exchange rate of 1.2123).