If you are going to trade in foreign currencies or Forex, you must realize that there are many risks involved. As a beginning investor, you might overlook these risks. But what are the risks of investing in Forex? And how can you protect yourself against these risks?
How to manage risk when trading in Forex?
- Always use a stop loss to limit your losses.
- Be careful with high leverage: you can lose a lot of money.
- Check the broker's reliability: is the broker licensed?
- The exchange rate often moves according to a fixed pattern, but patterns can be broken.
- Do not aim for too high a return: risk and return are linked.
Tip: have a look at our selection of good brokers where you can try trading Forex with a demo!
What is Forex trading?
With Forex, you invest in foreign currencies. When you trade in EUR/USD, for example, you buy euros for dollars. If the value of the euro subsequently increases in relation to the dollar, you will make a profit. There are always extra costs connected to investing in foreign currencies; for every transaction, transaction costs are being charged. These costs are often not high, but can mount up considerably if you trade in foreign currency a lot.
Do you want to know more about Forex trading? Then read our comprehensive guide to Forex trading:
What are the risks of investing in Forex?
Many investors often paint a very rosy picture of forex trading, but in reality there are many risks involved.
Foreign exchange risk
When you invest in Forex, you are always subject to a foreign exchange risk. This is the risk that the currency you buy will change in value against the currency you sell. For example, if you buy dollars for pounds, the dollar may depreciate in relation to the pound. You will then lose money on your Forex trade.
Forex is the largest international market in the world. Under the influence of supply and demand, the prices of currencies fluctuate constantly. When more people want pounds, the rate of that currency will rise against other currencies.
Your loss is only final once you close the position. By applying a good strategy, you prevent losing your entire investment due to a falling exchange rate. You do this by limiting your investment positions and by using a stop limit order. With a stop limit order, your position is automatically closed at a certain loss.
Be careful with the leverage
In reality, there are risks involved when trading in foreign currencies. In many cases, investments in foreign currencies are made using leverage. When using leverage, the broker adds, for example, $9 for every extra $1 invested. If the price of that currency then rises by $0,10, the investor immediately earns $1. But the same happens the other way around; if the currency falls by $0,10, the investor loses $1.
Leverage thus increases not only the potential return, but also the potential loss. Therefore, be careful when using leverage!
The Forex market is the most liquid market in the world: everyone is constantly trading currencies. When, for instance, you take the plane to a sunny destination, you exchange your hard-earned money for the local currency. On average, it is therefore also easy to sell your currencies again, certainly when you trade in the major currency pairs such as combinations with the Euro, Dollar and Pound.
Nevertheless, there have been situations in which countries influence the currency markets. Especially in the case of currencies that are used less often, a government can actively manipulate the exchange rate. Sometimes governments can even prohibit the selling of currencies abroad. When you're going to trade in exotic currency pairs, the risk of a lack of liquidity will consequently be bigger. In that case, you could lose money when you're unable to sell the currency at the desired moment.
When you trade in Forex, you use derivatives. Derivates are sold by a counterparty which could go bankrupt. When this happens, the company might not be able to deliver, and you could lose your deposit. Fortunately, for private investors this risk is minimal. This is because brokers who provide services to individual investors have to follow strict rules.
You do run this risk when you trade in over-the-counter (OTC) products. These are contracts that are not traded on an exchange, but that are offered by a bank. It is not advisable to trade these types of products, as they are less transparent.
Risk of losing everything
You won't be the first Forex trader to lose your entire deposit. Outstanding losses can quickly mount up, causing you to lose your entire deposit. When you are no longer able to bear the loss-making positions, a margin call will normally follow. If you do not subsequently deposit additional funds, your positions are automatically closed and your Forex adventure is over.
Therefore, only trade in Forex with money you can afford to lose and realize that there are great risks associated with Forex trading.
Not for the long term
When trading in Forex, you generally pay financing costs on your position. This is due to the leverage described earlier. The broker deposits a large part of the amount, and you pay interest on this every day. This is why investments in Forex are only suitable for the short term.
Unexpected events can make the best Forex strategy fail. You always run the risk of rising interest rates, inflation or disasters that can suddenly send the price of a currency in a different direction. Therefore, always be prepared for the unknown and do not blindly trust your analyses or technical indicators.
It is important to not see trading in Forex as a guarantee. Only invest in foreign currencies with money you can afford to lose. Start with a small amount and practice until you have mastered the trade. By doing so, you can avoid making a huge loss.
Warning from supervisors
The FCA advises investors to avoid risks by always doing proper research before they start investing. For the novice investor, it is important to know whether they are running unnecessary risks. Therefore, as an investor, you should always first check whether the provider is properly licensed. This is possible by checking the register of your local financial regulator; a reliable broker always has a licence from a financial watchdog.
Furthermore, as an investor in foreign currencies, it is important to realize that the returns provided by providers do not guarantee that these will actually be achieved. Therefore, draw up a clear plan and consider for yourself what a realistic return could be.
Bear in mind that, in general, the rule is that a higher return also entails a higher risk. It is important to always use a stop loss. With a stop loss, you ensure that your positions are automatically closed in case of a certain loss. You can also use a take profit to automatically make a profit at a certain value. This way you minimize the risks of trading in Forex!
General lesson: don't aim too high!
Many Forex investors aim for too high a return when they are just starting out. It is important to remember that you can only achieve higher returns if you also take a higher risk.
Sure, there are examples of traders who make tens of percent in a month. However, many of these stories end in tears and the loss of the entire deposit. Therefore, be careful when using leverage and rather focus on lower, but stable returns.>