The constantly fluctuating foreign exchange or forex is the marketplace where global currencies are traded and is the largest financial market in the world.
With daily transactions crossing over $6.6 trillion, it provides a crucial function for the global trade to take place.
Nevertheless, this volatile 24 hour currency market is also known for its inherent risks. From interest rate, exchange rate, and liquidity risks to political and leverage risks, create a challenging environment that keeps the forex traders at their toe.
Although the bulk of forex trades takes place among banks, institutions, and governments; brokerages and market makers also provide an avenue for retail trading.
Retail Investors place their orders through forex brokers, who, in turn, place their bids on the interbank market. However, being a highly leveraged financial product, there are plenty of risks associated with currency trading & CFD trading that can result in substantial losses for investors.
Currency Market Fluctuations
Forex market is where all the major currencies are exchanged against one another, and they are always represented in pairs such as USD/EUR and USD/ZAR.
Because this market works around the 24-hours clock, the time differences between the beginning of a contract and when it settles create an exchange rate risk.
Currency values can change for all sort of known and unknown reasons. For instance, when the news of Joe Biden’s victory surfaced, the USD-Renminbi (USD/CNY) exchange rate started to decline.
So, currency markets can reflect changing external political or economic changes. This is one of the reasons why currency values keep fluctuating in the forex market.
As the dollar remains the main currency of global trade, a change in the interest rate in the US can impact the exchange rate of all the major currency pairs.
In general, when a country raises its interest rate, its national currency starts to appreciate. Investors looking for better returns may buy more of that currency.
As the demand for that currency strengthens and supply becomes scarce, the exchange rate can become volatile. In opposite, when the interest rate declines, supply becomes abundant and investors start to pull out their money, causing currency value to deprecate.
High Leverage affects Retail Investors
One of the main reasons that small investors are attracted to retail forex trading is the availability of high leverage.
Trading in the forex market though a retail Forex broker doesn’t require a large amount of initial capital, anyone with as low as $100 or even less can start trading in volumes as high as $50000. But how does this work?
You deposit a small amount with a broker as margin money or trade collateral. Your broker provides you access to leverage, so you can trade in multiples of that margin money.
For example, suppose a broker provides leverage 500:1. You have deposited $100 as margin money, but the leverage enables you to place orders up to $50,000. This is what leverage & margin trading is all about.
But experts consider leverage as a double-edged sword & its use as very risky.
Any small fluctuations in currency pair can trigger a margin call. When it happens, the investors are required to pay an additional margin to keep their position open.
As explained in the above example, suppose you have placed an order for buy/long EUR/USD using the 1:500 leverage.
While placing the order EUR/USD was trading at 1 EUR = 1.2000 USD, but soon it changed to 1.1980 USD. And if your order value was USD 50,000 that means you would have lost USD 100 in one single trade, on a very small market fluctuation.
In that case, a margin call will trigger, and you will be required to supplement your account with more amount for further trades.
All retail brokers offer forex as a CFD instrument with leverage.
In unfavourable market conditions, leverage can result in substantial losses. That’s why some financial market regulators like FCA of UK, NFA of the US, BaFin of Germany and ESMA in Europe have put strict restrictions on the leverage provided by brokers.
ESMA & FCA have warned on risks of leveraged online CFD trading. And restricted leverage to 1:30 on forex pairs.
ASIC recently reported that majority of Australian retail traders lost their money this year due to high volatility in the markets due to Covid-19 which was magnified by high risk CFD instruments & leverage.
Such is the risk associated in margin trading, that it is bound for brokers by regulators to mention the percentage of retail traders that lose on their platform.
However, some regions such as Africa and some parts of Asia don’t have any such leverage restrictions for forex & CFD trading. Here in Africa, leading South African forex brokers and Kenya’s Forex Brokers like Hotforex, FXTM, FXPesa, Exness offer as high as 1:1000 leverage or more to its clients.
So, for their safety, African Traders must self-restrict themselves by using safe custom leverage recommended by ESMA or lower.
Unfair practices by brokerages
There are many players in the forex market including buyers and sellers, dealers, market makers, and brokers.
Retail investors usually trade through brokers who on behalf of their client place the quoted orders to the market maker or liquidity provider.
A broker can be best understood as an intermediary who facilitates trading for retail clients. Brokers buy and sell securities on behalf of clients and they charge a commission for that.
On the other hand, a market maker is usually not a trade facilitator, but a market participant. What it means is that a market maker is willing to take either side of the trade depending upon the all short of complicated calculations.
In general, the market maker wins when traders lose. Market makers are generally large banks or financial institutions such as BNP Paribas, Deutsche Bank, and Morgan Stanley.
Sometimes a trade facilitator can be both a broker and market maker. In that case, the market maker can recommend those financial instruments which are beneficial for them, not necessarily for clients.
Investors should do their due diligence to make sure that there is a clear separation between both.
An unregulated broker poses another risk for retail traders. The forex regulators like FSCA, FCA, CySEC, and ASIC make sure that brokers don’t get involved in unfair trade practices.
Those interested in forex trading must always opt for a well-regulated broker like in South Africa, traders must only trade with forex broker authorized by FSCA for offering derivative products.
How can one mitigate these risks?
As discussed above, forex trading involves a good amount of risk, and must be avoided by beginner investors.
However, there are plenty of tools and strategies that help traders & investors to mitigate risks and minimise losses.
- The wise use of leverage:
Unwise use of leverage in a very volatile condition can result in substantial losses. Using a safe leverage of not more than 5:1, should be the number one rule for every trader.
- Demo Account:
Beginners with limited knowledge of forex & CFDs can learn and get familiar with trading platforms by opening a demo account. A demo account is a risk-free account that allows new traders to use virtual capital, and practice trading without investing any real money.
- Stop Loss:
This is an important risk-mitigating tool for traders. A trade can place a stop-loss order with a broker to buy or sell a currency pair when it reaches a certain price, thus limiting losses.
- Risk-Reward Ratio
Its best practice to limit your max risk vs returns at 1:2 or 1:3 ratio. Knowing the potential gains and possible losses in trade is a good way to limit the risks associated with forex trading.
For example, if you know that the chances of maximum loss on a trade are $200, and the maximum gain is $600, then your risk-reward ratio is 1:3.
- Keep an eye on the News
Predicting a price movement in the forex market can be difficult, as many factors can cause the market to go south or north.
Any political or economic news or new economic data release can cause fluctuations in the currency market. These factors are beyond anyone’s control.
However, by keeping yourself updated about current affairs at least you won’t be caught off guard. Keep an eye on the news especially related to central bank announcements, US and European markets, regulations, and other global political or economic news.
- Emotional Control
Keep your emotions under control while trading. Emotions such as fear, anxiety, excitement, doubt can cloud your judgment. The forex market has no place for emotions, only numbers, and graphs.
Investing is risky, especially if you are investing in an instrument that you don’t understand. Forex CFDs are riskier than most other market instruments, and inexperienced investors must avoid it.
Risk Management must not be ignored by retail investors. Traders must educate themselves on the risks and all the risk management strategies.
All traders must always only trade with a well-regulated broker to ensure the safety of their capital.