How to Control Risks When Investing in Forex?
When we invest in retail forex we have quite a few different possibilities and each one of them carries different risks. We can decide to invest trough our forex broker alone. We can trade completely manual, semi-automatic or fully automatic (set and forget). We can buy (subscribe to) trading signals. We can join a trading group that can be free or payable. The best chance to invest is through trading systems’ evaluators. You can also have your funds individually managed by a registered account manager. You can send your money to a forex fund, managed by registered account managers or by forex brokers. You can also give your money to somebody that claims (s)he or the group she works for have found a holly grail of forex investing and promise you 10% profits per month or more. Although the last is forbidden in the UK and USA there are still places where the practise is completely legal.
Trading On Your Own
If we decide to work on our own through retail forex broker we have the least risks, and they are many. Forex is the biggest market on earth. Forex is a zero-sum-game. For every win there is a loss. There is no growth like the one in stocks. Off-exchange foreign currency trading carries a high level of risk and may not be suitable for all customers. The only funds that should ever be used to speculate in foreign currency trading, or any type of highly speculative investment, are funds that represent risk capital; in other words, funds you can afford to lose without affecting your financial situation.
Forex dealers can set their own minimum account sizes, so you will have to ask the dealer how much money you must put up to begin trading.
Most dealers will also require you to have a certain amount of money in your account for each transaction. This security deposit, sometimes called margin, is a percentage of the transaction value and may be different for different currencies.
Keep in mind that a security deposit acts as a performance bond and is not a down payment or partial payment for the transaction. Let s use an example of a dealer requiring a 1% security deposit. The formula for calculating the security deposit is:
The current price of the base currency X transaction size X security deposit % = security deposit requirement given in quote currency
Looking at the Euro example, multiply the current price of the base currency ($1.2178) times the transaction size of 100,000 times 1%. Your security deposit would be $1,217.80.
$1.2178 X 100,000 X .01 = $1,217.80
Security deposits allow customers to control transactions with a value many times larger than the funds in their accounts. In the previous example, $1,217.80 would control $121,780 worth of Euros.
This ability to control a large amount of one currency using a very small percentage of its value is called leverage. In our example, the leverage is 100:1 because the security deposit controls Euros worth 100 times the amount of the deposit.
Since leverage allows you to control large amounts of currency for a very small amount, it magnifies the percentage amount of your profits and losses. A profit or loss of $1,217.80 on the euro transaction is 1% of the full price but is 100% of the 1% security deposit.
The higher the leverage, the more likely you are to lose your entire investment if exchange rates go down when you expect them to go up or go up when you expect them to go down. Leverage of 100:1 means that you will lose your security deposit when the currency loses or gains 1% of its value, and you will lose more than your security deposit if the currency loses or gains more than 1% of its value. If you want to keep the position open, you may have to deposit additional funds to maintain a 1% security deposit.
For example, assume you buy or sell a contract worth $100,000 and it moves against you by $2,000. No matter how much money you put up, your dollar loss will always be the same “$2,000″ but the percentage loss varies with the amount of leverage. At 100:4 leverage, you will have lost half of your investment. At 100:2 leverage, you will have lost your entire investment. And at 100:1 leverage, you will have lost twice your investment and owe the dealer $1,000.
You should check your Account Agreement with the dealer to see if the Agreement limits your losses. Some dealers guarantee that you will not lose more than you invest, which includes both the initial deposit and any subsequent deposits to keep the position open. Other dealers may charge you for losses that are greater than your investment.
A forex broker can trade against you. A forex broker can file for bankruptcy. Both cases are risky for your funds. There is no central authority that would exclude the risks of delivery.
We did not mention, that you have to know when to go long, when to go short (entry trade signals), how big a position to open (money management), when to close the trade (take profit, trailing stop, stop loss) and all the things needed to make money. We call the above risks “basic risks of retail forex”.
Trading Using Paid Trading Signals, Trading Software or a Group
The risk of trading on your own using paid trading signals and semi-automatic software are reduced because trading signals providers should know when to go long or short, how big a position to open and when to close out. Unless they are crooked or ignorant which is another risk you are taking. Semi-automatic trading software is probably better but you need to know how to set it up. If fully automatic trading software was profitable when created, market conditions have most likely changed since its creation or they will change in the near future. Then you will suffer a loss that can be a complete wipe out of your trading account.
When trading semiautomatic you have a chance to set the parameters of your trading software to match market conditions. Although nothing and nobody can guarantee you profits on forex there is high probability that trading with correctly set semi-automatic software will put you in better position then trading fully automatic or completely manual.
Of course, your e-mail or phone can be out of order when you get important signal from your provider or your internet connection might fail when software tried to send orders to your retail forex trading platform. These are additional risks you are taking on if you trade like described above.
Trading groups are as good as their leaders are. Above mentioned risks with combined with the group leader’s style of trading and draw down tolerance can be added to the rest.
Trading Through Account or Fund Managers
If we give our funds to account manager we expect to profit from managers expertise. But again it depends on our contract. Account managers may be compensated for each trade they enter and as a part of profit they make. In the first case account managers can make huge profits even if we are even or take loss. The second case is much more favourable to investors. If they make money account managers make money. If they are taking a loss, account managers at least do not get paid for their “performance”.
Putting money in a fund will join the destiny of your investment with destiny of many others. Usually it looks like account management in first case. Fortunately, there is an easy way out. Withdraw the funds if fund performance is below par.
As long as account managers and fund managers are registered and your money is held by forex brokers, the funds are separate from the funds of broker or account or fund managers. They are held separately and all the accounts are audited. It is less likely that you lose your money through a staged bankruptcy or broker folding.
Trading Through Trading Systems’ Evaluators
If it is hard to measure real performance of individual forex account managers there are companies that rate participating trading systems through their performance. You can have your account traded automatically according to trading system or a mix of trading systems of your choice. I will mention Collective2 as being best in my opinion, compared to Tradingmatica, FX TradeLine or ZuluTrade. Additional risks are the scale of trades that make different money management procedures if your account is not the exact match of providers account and the risk of “ego trades”. Trading systems trade with hypothetical results. Although some of them trade real money, many just trade virtually. It is easy to lose demo account. It hurts much more if you lose real money. If you see a system with huge draw downs it usually means that it is trading with “funny money”. They are not to be completely trusted.
Throwing Your Money Trough a Window
The last possibility mentioned multiplies your risks immensely. If you give your money to somebody to invest in forex and promises you high return you can never be sure if your money went on forex or somewhere else. Is it funding illegal activity like drug trafficking or arms smuggling? Your government will confiscate it if it participated in illegal activity! Will the guy that you sent your money to be still around in six months? Who is auditing trading accounts? Is your money held separately from the companies funds? If the company goes bankrupt, are your funds separate? Is your contract enforceable in your country or it needs to be presented in some exotic jurisdiction? In a language you do not understand, under the law you are not familiar with?
There are profits to be made on forex, even on retail forex market. But every investor or speculator should be aware of inherent risks. Even issuers of the safest, mortgage backed securities sometimes do default. Forex has so many risks that you have to be prepared for the possibility of losing your entire investment at any time. Nobody likes losing but it is a part of the game. So invest in forex only the funds that won’t change your lifestyle if you lose them.
About the Author
Mordekai trades forex and writes related articles since 1997.
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