Forex trading risks

One of the reasons that currency markets are so appealing to both professional and first-time traders is that they are open 24 hours a day, five days a week, and gapping – which is sometimes evident in stock index markets – is extremely rare. Also, spreads between the bid and offer prices in forex pairs like EUR/USD and GBP/USD are extremely tight, so there doesn’t have to be a great deal of movement for a trader to generate a quick profit.

Although there are many benefits of forex trading, these also come with risks that need to managed with appropriate measures. These include the use of margin or leverage in forex, the liquidity of the forex market, and forex strategies that can be applied on a short-term basis. This articles explores forex trading risks and how to create an efficient risk management plan.

What are the risks of forex trading?

Currency pair correlations

With the advent of the financial crisis in 2008, and the monetary easing and stimulus methods employed by the US Federal Reserve and the Bank of England, the focus of many investors has shifted to alternative currency pairs in Asia, where interest rates are generally higher. However, one of the downsides to looking outside the main currency pairs is that dealing spreads are a little wider; for example, in GBP/AUD, it can be as high as 4 pips at 2.1950/2.1954. One of the main gainers in this shift of capital eastwards has been currencies like the Australian and New Zealand dollar, as investors go in search of yield in order to maximise their returns away from currencies like the pound and the US dollar, which currently have negative real interest rates.

Negative interest rates occur when the value of cash on deposit is exceeded by inflationary pressures in the economy, meaning that in real terms, the value of your cash is eroded over time. The UK economy was a case in point in 2012, where despite having ISA rates in the region of 3%, inflation was running in excess of 5%. This clearly isn’t the case now, with inflation falling back close to zero, but with ISA rates also closer to zero along with inflation, the benefits of holding cash remain negligible, which means that the attraction of a higher rate of return always retains a certain pull factor.

Interest rate risk

So, while the UK has base rates of 0.5%, and Australia still has interest rates in excess of that, the attractions of holding the higher yielding asset remain, even if they aren't as compelling. This disparity does become less of a pull if interest rates are falling, which has certainly been the case in the Australian dollar, which has seen its main interest rate fall from 4.5% to 2% in the last three years. This has reduced the attraction of the Australian dollar in terms of the interest rate differential, causing outflows out of the Australian currency, back into sterling, and has helped push the pound up from levels around 1.55 back in 2012.

As with any currency trading transaction, there is always a currency risk involved, especially if traders are looking at interest rate differentials, but recently this has been less of an issue, even if short-term price fluctuations have been quite volatile.

Carry trade risk

In terms of the carry trade, investors buy Australian dollars and then put them on deposit for a fixed term, whether it's overnight, or longer term, to earn interest at the higher rate available at the time. To offset that they sell sterling, and then borrow sterling to fund the overdraft on their sterling holdings at the lower rate for the same period. This equates to a positive carry as they earn interest at the higher rate and pay interest rate at the lower rate.

Interest rate outlook

When looking at entering a trade of this type, it is also important to look at the long-term outlook for interest rates. For example, is it likely that the outlook for rate expectations in both Australia and the UK is likely to change in the short term? This becomes important when deciding whether to go long or short on a particular currency, as the shorting of a carry trade currency gives rise to a negative carry, which means you have to balance the risks of losing money on the carry with the likelihood of a strong down move.

Central bank decisions

Looking at economic indicators and the narrative of central bank meetings for the European Central Bank, Federal Reserve and People’s Bank of China is extremely important in this case. For example, the general consensus is that the Bank of England is likely to keep interest rates unchanged at their current historically low levels, but could look to raise them at some time within the next 24 months, despite current low levels of inflation in the UK.

It is therefore important to look at the outlook for Australian interest rates over the next 6-12 months, as these seem more likely to move than UK ones at the moment. This means the forex spread between the two interest rates is likely to be driven by Australian monetary policy, as opposed to UK monetary policy.

Inflation risk

If inflationary pressures in Australia are low, speculation among economists could be that the next move in interest rates in Australia might be even lower, towards 1%, further narrowing the gap between Australian and UK rate differentials in favour of the pound. This would further strengthen the pound against the aussie, but if there is a pickup in Chinese growth, to which Australia is particularly exposed, then disinflationary pressures could ease as well. As a result the pressure for a rise in rates could ease as well. This would mean that the next move in rates in Australia could well be higher, and not lower.

This perception would change the interest-rate differentials between the two in the futures or forward markets, and the spreads would start to widen. This in turn would prompt profit-taking as traders buy their Australian dollars and sell back sterling to realise their capital gains.

Other currency pairs that can be traded this way include the New Zealand dollar against the US dollar, the pound or even the Swiss franc, where interest rates have also been cut to zero. Understanding how these foreign exchange flows work is extremely important to the novice and experienced trader alike.

Forex leverage

Leverage is always a concern when trading within the forex market. Also called margin trading, traders are only required to deposit a small percentage of the full trade value in order to gain exposure to the markets. This means that although profits can be magnified if successful, losses are equal. Just one small loss can wipe out a trader's entire capital over their trades, and this will result in a margin call and positions being closed. Read more about margin in forex and how to manage risks of leverage appropriately.

Forex risk management

Our online trading platform, Next Generation, comes with a range of order and execution types, including traditional stop-loss orders, trailing stop-losses and guaranteed stop-losses. We also offer take-profit and stop-entry orders so that your trades do not exceed the maximum price that you want to pay. Read more about our execution orders here.

How to manage risk in forex trading

Aside from our execution types to prevent loss of capital, it is also a good idea to do thorough research of your own. Before trading the forex markets, you should gather as much as knowledge as possible about forex currency pairs, the volume of the market, liquidity of certain trades, and find out when the best entry and exit points are. You should make use of both fundamental and technical analysis techniques, as they are equally important for forex risk management. Fundamental aspects, such as inflation and interest rates, can have an effect on foreign currencies, and technical analysis can help traders to interpret charts, graphs and price action when analysing trades.

Our news and analysis section is updated daily with news and economic announcements from our professional market analysts. Similarly, our news and insights section is full of Morningstar fundamental reports, market commentaries and data analysis from Reuters. Our award-winning platform comes with an economic calendar that you can filter and customise to suit your personal trading style.

Want to start trading the forex market but you're worried about the risks? Register below for a demo account to practise with £10,000 worth of virtual funds. You can take advantage of our execution orders, such as stop-losses and take profits before depositing funds into a live account.

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Disclaimer: CMC Markets is an execution-only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.

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