In order to trade successfully, you must fully understand the risks involved. Each trader will approach the market differently, underscoring the fact that there is no right or wrong way to trade the market. Instead, traders must know the risk that they can comfortably take on.
Establishing the type of trader you are at the outset is very important. Are you a systematic trader? Or do you prefer being in the market during periods of volatility? Are you looking to be constantly involved, or are you looking to smooth out the short-term noise to capitalise on long-term gains?
Risk is defined as "the variability of returns from an investment or the chance that an investment's actual return will be different than expected. This includes the possibility of losing some or all of the original investment. It is usually measured using the historical returns or average returns for a specific investment. The greater the variability of an investment (i.e. fluctuation in price or interest), the greater the risk."
The volatility we see in daily prices, combined with the leverage available in the off-exchange retail forex market (compared with other financial instruments like stocks) is the reason why forex is categorised as highly risky. As investors are generally averse to risk, investments with greater inherent risk must promise higher expected yields to warrant taking on additional risk. Others add that higher risk means a greater opportunity for high returns or a higher potential for loss. However, a higher potential for return does not always mean that it must have a higher degree of risk.
There are two basic classifications of risk:
Let us now take a closer look at more specific types of risk.
This refers to the risk that a country would not be able to honour its financial commitments. When a country defaults, it can harm the performance of all other financial instruments in that country as well as other countries that it has relations with.
Country risk applies to stocks, bonds, mutual funds, options, futures and most importantly, the currency that is issued within that particular country. This type of risk is most often seen in emerging markets or countries that have severe budget or trade deficits.
When investing in foreign currencies you must consider that the currency exchange rate fluctuations of closely linked countries can drastically move the price of the primary currency as well.
For example, economic and political events directly tied to the British Pound (GBP) have an effect on the Euro's trading (i.e. the EUR/USD might have similar reactions as GBP/USD even though they are separate currencies and are not in the same currency pair). Knowing which countries affect the currency pairs you trade is vital to your long-term trading success.
A rise or decline in interest rates during the term a trade is open will affect the amount of interest you might pay per day until the trade is closed. Open trades at rollover are assessed either an interest charge or interest gain, depending on the direction of the open trade and the interest rate levels of the corresponding countries. If you sell the currency with the higher interest rate you will be charged daily interest at the time of rollover based on your broker's rollover/interest policy.
For more specifics on understanding your interest risk, please ask your broker for the complete details of their policy, including time of rollover, interest price (also called swap) and account requirements to receive interest paid to your account.
This represents the risk that a country's economic or political events will cause immediate and drastic changes in the currency prices associated with that country. Another example of this risk is government intervention that we typically see in Japan, a country that needs to maintain low currency prices to bolster their exports.
This is the most familiar of the risks we have discussed, and according to some, really the main risk to consider. Market risk is the day-to-day fluctuations in a currency pair's price (also called volatility). Volatility is not so much a cause, but an effect of certain market forces.
Volatility is a measure of risk because it refers to the behaviour or "temperament" of your investment, rather than the reason for this behaviour. Because market movement is the reason why people can make money, volatility is essential for returns, and the more unstable the currency pair, the higher the chance it can go dramatically either way.
This is a particular risk that many traders do not think much about. However, with the majority of individual traders executing trades online, we are all technology reliant. Are you protected against technological failures? Do you have an alternative Internet service? Do you have backup computers that you could use if your primary trading computer crashes?
As you can see, there are various risks that a smart investor should consider and pay close attention to in their trading.
The risk/return balance could easily be called the ‘iron stomach’ test. Deciding how much risk you can take on while allowing yourself to walk away from your computer without worrying and to get sound rest at night while you have long-term trades open is a trader's most important decision.
The risk/return balance is the balance a trader must decide on between the lowest possible risk for the highest possible returns. Keep in mind that low levels of uncertainty (low risk) are associated with low potential returns, whilst high levels of uncertainty (high risk) are associated with high potential returns.
Trading is all about risk and probabilities. Understanding the inner functions of your forex trading strategies and proper placement of entry and exit orders will assist in limiting your risk exposure whilst maximising your profit potential.
What about how much of your account to place on each trade (in other words, the number of lots per trade)? How much of your account have you lost in a single trade? Was it too much to swallow? If so, you might not have utilised proper risk management and overleveraged your trade. Establishing both the right level of leverage and the corresponding margin requirements are a big part of managing risk.
Just as there is no single favourite food for everyone, there is no right risk level for everyone. Only you can determine what level of risk is right for you. You need to find the right balance between the amount of risk you think you are willing to take, and the amount of risk you can actually stomach. All too often investors think they are willing to take risks, but when the worst happens, they find out they actually are not.
You will likely lose money during this learning process, but if this loss helps you achieve this level of understanding then you can financially afford the loss. It is important to identify in advance the amount you are willing to "pay" for this education. This financial and emotional tuition is a valuable trading resource and something most experienced investors have paid through the process of trial and error.
Different individuals will have different tolerances for risk. Tolerance is not static; it will change along with your skills and knowledge. As you become more experienced, tolerance for risk may increase. But do not let this fool you into not adhering to and thinking about proper money management practices.