Foreign Exchange Risk Management Concepts
Veteran and amateur traders alike must understand forex risk management methods if they hope to have any chance of financial success in the long run.
Unfortunately, many traders do not think about foreign exchange risk management at all. Or if they do, they only think about market risk. Serious traders understand there are at least 5 types of risk associated with trading forex, and market risk is only one small one.
In this article we’ll explore the 5 different types of risk you’re exposed to when trading the forex markets, and ways you can lessen, or even eliminate, your exposure.
Please do not take this as an exhaustive list, nor as a deterrent to trading, it is only meant to help expand your awareness of foreign exchange risk management and prepare you for a long term, profitable run as a forex trader.
The 5 Major Risks in Forex and How To Manage Them
#1. Broker Risk: A broker is a business like any other, and as such they can face the same problems any regular business can, including bankruptcy.
Experienced traders might remember the 2005 Refco fiasco where one of the largest and most respected brokerage firms in the forex markets went bankrupt. The effects of this are still being felt today.
Always spend some time thoroughly investigating potential brokers before you get seriously involved with them.
#2. Technology Risk: In a trading world run almost entirely on computers, the effects of a hard drive crash, power loss or Internet connection drop out can be drastic.
I strongly suggest you backup your computer on a daily basis, preferably to an off-site location you can backup from in case of fire or theft. Traders with serious commitment to the markets, or sizable portfolios, should invest in fail-safe backup systems including generators and surge protectors.
Some people might laugh at going to these lengths, however anyone who has experienced a serious computer crash knows how devastating it can be, and it could be a lot worse if you were caught in a trade with no way of getting out.
#3 Market Risk: How market changes affect your positions. The most common type of risk people associate with forex.
The most sure-fire way to alleviate market risk is to trade using a proven trading system that integrates foreign exchange risk management strategies at the base level.
This includes having set entry and exit points, profit targets, and stop losses.
#4. Economic and Political Risks: Political policy changes, major economic emergencies and governing authority intervention can all have an impact on a country’s currency value.
You can avoid these type of risks by using a trading plan that integrates solid foreign exchange risk management methods and identifies issues before they impact your positions.
#5. Country Risk: Finally, there is the risk that a country won’t have the money to meets it’s financial commitments, and will default.
Defaults can have serious effects on many other financial instruments throughout the country, as well as in other countries doing business with that country.
You can avoid these risk by trading only the major currencies and staying clear of emerging markets and countries with serious financial deficits.
I hope it is now clear that the risks involved in trading forex are deeper than the surface market risk most people are familiar with.
Luckily, many existing trading systems have in-built foreign exchange risk management strategies to deal with, and eliminate, many of these risks.
However, even the most sound foreign currency risk management strategies are still not perfect, and there will always be some risk involved when trading. Always use your own best judgement about your risk tolerance levels and never trade above your head.
Risk and Your Forex Trading Style
The most critical part of any style of investing, is being aware of what level of risk you are comfortable with. Without a good understanding of this, it will be way too easy for you to loose all your capital. Each type of Forex trade carries its own risk parameters and these your choice will be defined by your risk tolerance. Then there is your style of trading, conservative, moderate, and aggressive.
When you first come to Forex trading you may decide to trade a day chart. The pip movement over a day can be hundreds of pips, so when you determine your stop position you have to assess what your drawdown risks are. If your money management stipulates a 3% funds exposure, you will find problems on day charts unless your account is substantial.
The 5M or 30M charts maybe more suitable since the pip variation tends to be less, so your stop positions can fall within your management range.
Yes, we all want to make money from out trades, but jeopardising ones account to wide stop positions and excessive draw-downs is going to clean out your account and trading career in the blink of an eye.
An avarage risk level is 3% or $300 on a $10,000 account. Convert this to pips, 1 standard lot ($100,000) has a pip value of $10 so if you trade end of day and your stop loss positioning, whether count-back or support and resistance or any other, dictates a 100 pip stop position, then you are not risking 3% but 30%! Three wrong trades and your account has gone!
An aggressive trader is prepared to take riskier trades that a conservative trader. They may be prepared to expose bigger sums or money in riskier trades with the hope of achieving larger returns – often over longer trading time frames but they may still use the similar strategies for shorter times as well. Very much the ‘crash and burn’ trader.
So where do you consider your trading style to be? Are you a highly controlled trader with good money management and risk rates, or a trader that will take high risks for big pips? If you are the latter, you won’t be around for long, that’s a guarantee.
If any of this leaves you a bit bewildered, you need to learn more, so begin by getting your Forex training with Top Dog Trading, you will learn a huge amount and it will help you trade with safety to win pips not risk everything.
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