The Importance of FX Risk Management
Many are afraid of being involved with forex trading because it is 'risky'. This appears to be a very common misnomer so here we will elaborate on the potential risks of forex trading vs. the risks of other investments and business in general, as well as outlining risk/reward and risk management policies.
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First of all, currency trading especially, is not so much about gaining and losing, picking entry and exit points, but risk management. But herein lies the problem: if you are not trading forex, you are still exposed to the risks in the currency market. Even if you are not an importer or exporter and do only domestic business, whatever your investment, it is exposed to currency risk as your investment is denominated in some dollars which are likely to appreciate or depreciate. This may not be reflected as a loss in your bank account, but you will quickly notice it in the purchasing power of your dollars, the interest rate you are getting at the bank, as well as the health of the overall economy. Therefore, it is only risky not to trade forex because then you have a static position in certain dollars, which may be severely depreciated very quickly, at which point you can do nothing but wait for them to return to value.
Consider that the US Dollar Index was once at 120 and is now at 85. Americans who have not been making 40% to 50% per year in the forex market (most likely buying Euros and selling their own US Dollars) are now exposed to high gas prices, increased commodity prices, skyrocketing real estate, and an overall shift which among other things, is destroying the middle class. It is no secret in the US that prices are increasing. However many brokers and economists are selling this to the public as profit, when in fact this is what is known as inflation. Now it costs in many places twice as much to purchase a home for your family as it did a few years ago. Wages and other income have not kept up with that price increase. This is the definition of inflation! Your dollars now can purchase less. They have less purchasing power than they did 3 or 4 years ago. So the fed says inflation is 3% a year, but really this is economic newspeak.
Americans have become divided into two classes in the last few years: 1) those who are making more money than they ever dreamed of and 2) those who are struggling to make ends meet. This is transparent to previous social class structure, in other words, these 2 categories apply to the rich as well as the poor. There are for example, extremely wealthy people who are struggling to make their monthly payments because of rising financing costs, and because their investments are not doing so well. As well, there are poor people who have reaped in huge profits never seen before by investing in real estate and other high yield investments. So it is not isolated to specific demographics of people. We have become polarized economically, not politically. This was highly seen in the last Presidential election. Finally, the US economy is a benchmark for the rest of the world, for many complex factors not to be mentioned here (being the reserve currency of the world, the Petro Dollar, and being a leader in market based capitalism).
Risk Management of a Forex Fund
Trading forex comes down to risk management. If a forex trader takes a position in a currency, and sits on it for 3 months, while he may profit, he is exposed to the same kind of risk as if he were not trading. In other words, during that 3 month period, many things can happen to make that position open to risk. Utilizing stop losses and actively trading, is in itself a risk management policy, rather than a strategy of knowing where the market will go. For a forex trader, the risk management side is inherently more important than guessing which direction the market will go. It is those funds and forex traders who are maxed to the hilt with high margins, with no stop losses, that expose their clients to the huge risks in the forex markets.
Consider purchasing 100k EUR/USD at 1.2020 expecting a rise to 1.2100 (with a stop at 1.2000). If you are trading 100,000, you have taken a 100% cash position. If the EUR/USD goes as expected, you would make a profit of $800, or .8%. If it goes against you, you would lose $200, or .2%. So you are risking .2% to gain .8%. What many traders might do is take a 1,000k (1 million) position, which is 10:1 margin. This increases your P/L by 10 x - so that .2% loss is 2%, and the .8% gain is 8%. This is where risk comes into the forex market. So, it is not the forex market itself, or forex trading itself, that is risky, but rather, the risk management policy of forex dealers. Good dealers will first have a solid risk management policy, and second, develop a trading strategy.
Finally, during volatile times, or if a trader just wants to have a go at making 100 points, it is possible to take a less than 100% cash position, totally limiting the risk of loss. Using the example above, where you have 100,000 in your account, it is possible to trade 10k lots instead of 100k lots, putting you in a position of only 10% cash, or negative margin. This means the above trade loss goes from .2% to .02% - as well, your gains are also limited to .08% instead of .8%. However during certain volatile times trying to make a small profit may be better than exposing funds to potential losses.
Forex trading allows for a great degree of risk management not available in other capital markets. Margin, being able to buy or sell without limit, high liquidity (2.3 trillion traded daily), and a 24/6 market, give only the forex market to be so flexible regarding risk. In other words it is not possible to have such a sophisticated risk management policy in other markets -
Buy OR sell (compared to stocks where you can not always go short)
Always find a buyer or seller (the forex market is the only real liquid market in the world. It is impossible you want to trade and cannot find a buyer or seller)
Use high margin, 200:1, or as little as you want 1:200
Take opposite positions at the same time
Take multiple positions (instead of selling EUR/USD, take multiple EUR positions against the crosses such as EUR/GBP, EUR/CHF, as a hedge against your first EUR/USD position)
Always find a buyer or seller (the forex market is the only real liquid market in the world. It is impossible you want to trade and cannot find a buyer or seller)
Use high margin, 200:1, or as little as you want 1:200
Take opposite positions at the same time
Take multiple positions (instead of selling EUR/USD, take multiple EUR positions against the crosses such as EUR/GBP, EUR/CHF, as a hedge against your first EUR/USD position)
The above factors are the real opportunities in the forex market, not the potential to make 100% that exist in other markets such as the stock market.
How stop-losses work
Whenever you take a forex position, you always have the ability to enter a stop-loss order. This means no matter what happens, if the position goes against you, you will exit at the pre defined stop loss order. If for example you purchase 100k of EUR/USD at 1.2050 expecting the EUR/USD to rise in value, and your stop is placed at 1.2020, you are guaranteed to be filled at your price, even if the EUR/USD drops to 1.1700. Using stop losses can be a great addition to a risk management policy.
Market conditions
There are times in the forex market where the market is extremely volatile, such as when the Fed makes an interest rate announcement, or during the first few hours of major market openings, such as 9:00 am - 11:00 am New York Time.
Risk Profile
Every trader or investor in the forex market should have a solid risk profile. Your risk capital will determine the risk-profile of your account. For example, if you have 10,000 to invest, you can say that you are willing to risk 1,000 of that capital with the potential to gain another 10,000. This can be easily implemented by a fund manager, so your losses can be limited to 10% or 5% of invested capital. It is not impossible, but would be very reckless, for someone to lose 100% or even 50% of invested capital in less than a year. That means they are using high margins and purchasing more than the account's risk profile can handle. This is not only unprofessional, it is dangerous and bad for the client and the industry. Clients may have pre-arranged agreements with their forex dealer what is the risk profile of their capital. It may be that you are willing to take high-risks, but it should all be discussed and agreed upon before your account is traded.
Risks of not trading
Business itself carries a high degree of risk. Clients may not come to your shop. Payments may not go through. Factories have malfunctions. For those who claim forex trading is risky, as explained above it can be (with a reckless dealer). But consider the risks of not trading. Consider a scenario where the EU dissolves, and the Euro is no more. Every investor who is in the Euro (such as the common European and foreign investors alike) would have huge, nearly incalculable losses. Americans are subject to the same risk. With a seemingly unstable political environment, a current account deficit and government deficit spiraling out of control, it is quite possible to see the US dollar lose 80% of its value in a very short time frame.
In conclusion, there is an inherit risk in forex which exists in any capital market, but the risk is not in the market itself, but rather in the risk management policy of the forex dealer, and in the structure of how the funds are traded. Before investing in the forex market discuss your risk profile with your funds manager, to make sure this is right for you, or if it can be adjusted to fit your risk profile.
* This article is meant to explain the risks of forex trading in more detail, it does not in any way suggest forex trading is risk free. Also it is not the recommendation that anyone puts more money into forex trading than they can afford to lose. This gives dealers the flexibility to relax and trade as they want (vs. trying to make 1% per week or a certain performance benchmark). A typical investment in the forex market may comprise 10% to 20% of an investors portfolio.
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