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Risk management in forex trading

Forex trading can be rewarding but does carry a fair amount of risk. Here’s what you need to know about risk management in forex trading.
Understanding the levels of risk is the first step in being able to mitigate against them where possible. Image: Shutterstock

While you can never completely eliminate risk, you can make sure you understand the risk levels and mitigate them where possible. One of the first things you need to understand is the role of and risks associated with leverage.

Leverage is essentially borrowed capital from brokers allowing you to invest more money in the market. Justin Grossbard, executive director at Compare Forex Brokers, explains that if you are trading forex and movement between currency pairs is in your favour, leverage can lead to significant profits with little of your own capital. “Without leverage, the typically small daily movements between currency pairs would not lead to worthwhile returns for most retail traders due to the large capital one would need to invest to make a significant profit,” he says.

However, Grossbard cautions that while leverage can lead to greatly increased profits, it can also result in large losses when currency movements do not move in your favour. “The value between currency pairs naturally fluctuates. Some of these fluctuations are predictable, such as interest rate decisions, but other fluctuations less so. The use of leverage can lead to larger than anticipated losses when these unexpected events occur,” he explains. In order to protect retail traders from large losses, regulators are limiting the amount of leverage brokers can offer.

How much is enough?

The leverage that you select will depend on your risk appetite and the forex broker you choose. “Focusing on the forex broker, you need to consider what risk management tools they offer. For example, some brokers offer negative balance protection which means you can’t lose more than your deposit.

“If the broker does not offer negative balance protection then you may want to select a lower leverage level to reduce your risk,” Grossbard says.

He says a second factor could be your level of trading experience and your risk appetite. If you are an aggressive investor and are comfortable with a high level of risk, you may choose a higher leverage.

“Manual trading or algorithmic trading can also make a difference. The latter typically requires more leverage for your strategies to be implemented,” he says.

Risk management tools you can use

There are a few tools you can use to manage your risk:

  • Stop-loss orders: These allow you to set the maximum amount you are willing to lose on an individual trade. Grossbard says in most cases, you will exit the market when your set price is triggered but in a highly turbulent market, such as the current Covid-19 environment, a currency can fluctuate too fast to exit the market at the exact set price. “When this happens you have slippage, because there is a gap between your set exit price and the actual exit price. If you are using a broker with slow infrastructure then you may be vulnerable to slippage as there will be a lag between the time when you execute your order and when your order is actually completed,” he explains.
  • Guaranteed stop-losses: These guarantee you won’t lose more than the maximum amount you are willing to lose. Grossbard notes that use of a guarantee does come with additional fees and often the lowest spread brokers don’t offer it.
  • Negative balance protection: “Different brokers have a different interpretation of negative balance protection so it is important to read the fine print of the broker to understand what type of protection they offer. If it is guaranteed, then your balance will be returned to zero and you won’t need to bear the debt you owe,” Grossbard explains.

Common mistakes to avoid

The most common mistake you can make is selecting the wrong leverage level when opening an account. Grossbard recommends that you open a free trial account first and trial different leverage levels and strategies before trading with real money.

“Another mistake you can make is to assume you only lose a set amount on a trade or your deposit when trading. Unless the broker offers the risk management safeguards mentioned above, this isn’t the case so it’s important to understand your risk exposure,” he cautions.

When it comes to choosing a broker, Grossbard notes that regulation plays a large role. “Any broker that doesn’t have ‘Tier 1’ [accreditation] from a regulatory body such as the FSCA [Financial Sector Conduct Authority] in South Africa, FCA in the UK or ASIC in Australia shouldn’t be considered,” he says.

Brokerage is another factor to consider when choosing a broker. Grossbard explains that these are the spreads and commissions a broker charges when trading. “Fees add up due to leverage and other factors leading to large costs over time. Spreads can also be difficult to compare between brokers,” he says. Compare Forex Brokers has a low spread table, which is updated monthly and you can use it to compare spreads.

You also need to look at what forex trading platforms the broker offers, their level of support and their minimum deposit requirements.

Regulation of forex trading to protect you

“We are currently in what I would call interesting times when it comes to regulation globally. In Europe, there have been very large changes limiting leverage to just 30:1. Brokers are also required to publish the percentage of traders that lose money and promotions of any kind have been banned. Singapore and Hong Kong have also made some changes while the Australian regulator has flagged some possible changes in 2020,” Grossbard notes.

He says the main feature of the regulations for forex brokers in South Africa is the requirement of a local office. “I expect leverage to be reviewed by the FSCA as some brokers are now offering leverage of up to 2 000:1 which I consider to be way too extreme, especially for retail traders.”

Brought to you by Compare Forex Brokers.

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