There are no investments without risks. As traders and/or investors, we are responsible for understanding and managing those risks.

A long time ago, I met with a friend from the USA in an investment forum. He asked me what kind of investment did I do? Because I am a forex trader, I said that, of course, my investment in forex trading. However, he seemed skeptical regarding forex trading. He mentioned that investment in forex trading is very high risk.

Thus, I asked him why he thought forex trading was very risky. He said there are several reasons made risk in forex trading becomes too much. 

Some forex trading risks that traders should be aware of are:

  1. Interest rate risk: The interest rate of each country can directly affect the currency.
  2. Counterparty risk: The risk that the party providing the asset in a transaction may fail to fulfill their obligations.
  3. Country risk: The stability of a currency depends on the country's stability.
  4. High leverage risk: Forex usually comes with leverage. This can be a benefit and risk at the same time.
  5. The risk of scams: Not all brokers can be trusted, which can pose a danger to unsuspecting traders.

So why do traders need to watch out for this risk? This article will talk deeper about this particular issue.

 

1. Interest Rate Risks

Interest rates play a significant role in the interplay between exchange rates and currencies. In introductory macroeconomics courses, it is taught that when a country's interest rates increase, its currency strengthens.

This occurs because higher interest rates attract more investments into the country's assets, leading to a perception of higher returns and subsequently bolstering the currency's value.

Conversely, when interest rates decrease, a country's currency weakens as investors withdraw their investments. The relationship between interest and exchange rates creates a dynamic environment where even small currency value differences can result in significant fluctuations in forex prices.

 

Example:

Let's consider a hypothetical case involving countries with different interest rate policies, Country A and Country B. Country A decides to raise its interest rates due to favorable economic conditions. At the same time, Country B maintains its current interest rates.

As a result, investors perceive Country A's assets to offer better returns and begin redirecting their investments there. The increased demand for Country A's currency causes its exchange rate to strengthen against Country B's currency.

In response to this situation, the forex market experiences significant changes. Traders and investors observing the interest rate differential between the two countries adjust their trading strategies accordingly. They may start selling Country B's currency in favor of Country A's currency, anticipating further strengthening of Country A's currency.

 

2. Counterparty Risk

Counterparty risk pertains to the potential risk associated with the broker's default involved in a financial transaction. In simpler terms, it refers to the risk that the party providing the asset in a transaction may fail to fulfill their obligations. In the context of forex trading, spot and forward contracts on currencies are not backed by an exchange or clearinghouse guarantee.

Consequently, counterparty risk arises from the solvency of the market maker or dealer involved in the trade. During periods of market volatility, there is a possibility that the counterparty may be unable or unwilling to fulfill its contractual commitments.  Thats why it's important to check out their regulation beforehand.

 

Example:

Let's consider a scenario where an investor engages in a spot currency trade with a market maker. The investor agrees to buy a certain currency at the prevailing exchange rate from the market maker. However, unforeseen economic events create extreme market volatility, causing the exchange rate to fluctuate rapidly.

In this situation, the market maker, who serves as the counterparty, may face financial difficulties due to their exposure to volatile market conditions. Consequently, the market maker could fail to honor the agreed-upon contract, leading to losses for the investor.

 

3. Country Risk

When considering currency investments, it is crucial to evaluate the structure and stability of the issuing country. In many developing and third-world nations, exchange rates are pegged to a dominant currency like the US dollar.

Under this arrangement, central banks must maintain sufficient reserves to uphold the fixed exchange rate. However, if a country frequently faces a balance of payment deficits, it can lead to a currency crisis and subsequent devaluation. Such events can have significant repercussions on forex trading and prices.

Given the speculative nature of the investment, if investors anticipate a currency's decline in value, they may begin withdrawing their assets, which further contributes to the devaluation of the currency.

Consequently, those investors who continue trading the currency may encounter challenges related to liquidity and face the risk of dealer insolvency. In the context of forex trading, currency crises amplify liquidity risks and credit risks while diminishing the appeal of a country's currency.

 

Example:

Let's consider a hypothetical scenario involving Country X, a developing nation whose currency is pegged to the US dollar. Country X's central bank maintains adequate reserves to support the fixed exchange rate. However, due to persistent balance of payment deficits and economic challenges, Country X experiences a currency crisis.

As news of the currency crisis spreads, investors become concerned about the stability of Country X's currency. They anticipate a potential devaluation and start withdrawing their assets from the country. This mass exodus of capital further weakens the currency and intensifies devaluation.

 

4. Risks of High Leverage

Many brokers indeed offer fantastic leverage. We know that leverage works to boost our power to trade. The higher the leverage, the higher our power in making trades. Of course, brokers are vying to be the ones to offer higher leverage because they, too, are competing with one another.

It is all right to accept their offer of high leverage. But we also have to remember the basic principle of investment: the higher the profit we expect, the higher the risk we have to bear.

To minimize risks related to leverage, there are some tips you could do:

  1. Adjust quantity per trade with the real amount of our balance.
  2. Control used margin and available margin to anticipate worst-case scenarios.

It is all back to margin and money management. Tailor the leverage used in your trading account to reflect your trading style. I still use 1:100 leverage because I have become accustomed to and feel comfortable. Therefore, the amount of leverage you will use is up to you.

 

Example:

Let's consider a trader who utilizes high leverage in forex trading. They have a trading account with a balance of $1,000 and choose to employ a leverage ratio of 1:100. This means they can control a position size of $100,000 in the market.

Initially, the trader opens a position on a currency pair, anticipating its price to rise. Unfortunately, the trade moves against their prediction due to unexpected market volatility. As a result, the value of the position starts to decline rapidly.

Due to the high leverage employed, even a small percentage decrease in the position's value can quickly deplete the trader's account. In this case, if the position loses just 1% of its value, it would result in a $1,000 loss, wiping out the entire trading account.

 

5. Risks of Forex Broker Scam

Who will not feel upset when one works hard daily and cannot withdraw funds from his account?

The bad news is many brokers out there might refuse withdrawal applications on pitiful excuses or it for an indefinite period. Not to mention the various other ways brokers could scam us.

To avoid wicked brokers and scam schemes, of course, we need to check the legitimacy of our broker. We should ascertain first whether they are bonafide or not. There are many ways to do that; some of them have been compiled by my friends in this article about how to choose the best forex broker.

Privately, I prefer to ask my friends who are more experienced in forex trading about a broker's honesty before joining them. That was much easier than searching for the information by myself.

 

Example:

Consider an investor who opens an account with an online forex broker that promises attractive trading conditions, low fees, and substantial profits. The investor deposits significant money into their trading account and starts executing trades based on the broker's platform.

However, the investor notices unusual practices and red flags over time. The broker consistently withdrawals, making it difficult for investors to access their funds.

Additionally, the platform's performance becomes unreliable, experiencing frequent technical glitches during critical trading moments. The broker's customer support is unresponsive or provides unsatisfactory explanations for these issues.

As the investor investigates further, they discover that the forex broker is not regulated by any reputable financial authority, despite claiming proper licensing. They realize that the broker was operating a fraudulent scheme, manipulating prices, and intentionally misleading investors to generate profits for themselves.

 

Conclusion

Well, those are some things we could do to minimize risks in forex trading. Nonetheless, the result of our trades will be influenced by many factors, including the trading system, strategy, our discipline in following trading plan, and our psychological drive.

There are no investments without risks. As traders and/or investors, we are responsible for understanding and managing those risks. Warren Buffet once said, Risk comes from not knowing what you are doing. So, understand well before you decide to do something, not excepting the risks of an investment.