Foreign Exchange also known as FX and Forex is the most liquid and the largest financial market in the world. Currency trading attracts many investors and speculators due to the tight spreads, 24/5 trading hours, small initial deposit requirements and account appenining simplicity. What’s more, there’s a wide range of information available on the internet for beginner traders to advance.
Trading is associated with risks and unfortunately most traders lose money and blow up their trading accounts shortly after they start trading live. Depending on the broker, it is estimated that 60-90% of traders lose all their investments in Forex. On the upside, at least 1 out of 10 traders figures out how to make trading a profitable endeavor. The numbers are not so bad if we look at this fact from a different perspective. How many soccer player kids end up being professional players? How many students that go to study medicine in college end up being doctors later in their lives? The same can be said for many different undertakings. Hard work, perseverance and experience can turn losers into winners. However, most people use up all their resources by making avoidable mistakes before they get to a point where they are profitable.
In order to avoid making the same mistakes the majority of traders are making, we should take into account all the risks associated with trading upfront and take measures.
Wrong attitude towards Forex trading
Unrealistic expectations play an important role when it comes to trading profitably. For instance, in case you believe that you can turn 100 USD into a 100,000 USD overnight, there’s a good chance that you’ll lose it all. In investing as in life, high risks are associated with high rewards. While it is technically possible to turn 100 USD into 100,000 USD overnight, it takes great risks and it is highly unlikely to happen.
Another mistake many traders make is to think about trading as a job. Retail trading using your own money is more like running a self-employed business. All the risks and rewards are yours. Forex trading will not give you a steady paycheck at the end of each month. You should be ready for capital drawdown periods. Essentially the ideal time to plan your profit cashout is a year after you start trading. It’s even better if you can afford to let the profits compound. You want to trade profitably long term and aim to stay in the game even when drawdown periods appear.
Furthermore, keep in mind that Forex trading is not gambling. But it can very easily become a casino for certain individuals. If you toss a coin to determine a market direction or base your fundamental analysis on moon phases and star alignments, you should not be expecting a long term, constant profitability. By long term profitability we mean steady profits year after year, including sensible drawdown periods. There’s no trading strategy or system that doesn’t have a drawdown. The key is to stay in the game long enough to let your trading edge grow your balance.
In addition, most people start trading because they think it’s an easy way to make money. After a few profitable traders they start to believe that they have found a money printing machine. Unfortunately nothing could be further from the truth. Making money is difficult because there is a lot of competition. Trading Forex profitable requires a good understanding of markets, developing strategies with an edge and executing those strategies while managing emotions. Every beginner trader starts because they think it’s an easy way to make money but every trader that constantly makes money from trading Forex is a hard-working individual.
Risk of trading with little to no experience
Becoming good at trading takes time. Just like in any other profession, in trading the more experienced you are, the better you can trade. Even bad experiences are great if you can turn them into your teachers. In addition, it’s important to get educated as much as you can to speed up the learning curve. The internet is full of low and high quality information regarding trading. The more you learn and the more experienced you become the better you can tell a high quality content from a low quality one.
The biggest mistake many beginners make is to take huge risks while they’re still developing. It’s no secret that trading requires upfront capital and when traders sell their property to start with little to no experience and lose all their money, there’s a very little chance they’ll go back to trading in the future. It’s better to start small, get experienced, grow capital by compounding your profits to ensure you’ll stay in the business long term.
Risks related to human emotions
After traders learn how to conduct analysis, how to execute orders and gain experience, they can still become victims of their own emotions. Many believe that humans are not made for trading. Our emotions such as greed, fear, hope, jealousy and boredom can ruin order progress in trading in just one day. Novice traders lose money because they do not have the experience and make technical mistakes. Professional traders lose money due to losing control of their own emotions.
- Greedy trading will make traders take higher risks than usual and make more trades which results in eventually losing money.
- Fear limits a trader’s ability to make a move when a good trading opportunity presents itself.
- Hope means that a trader doesn’t trust his or her trading system. When you are trading by using a tested system, use proper risk management and execute orders flawlessly, there’s no room for hope. Hope is for gamblers.
- Jealousy trading can also be a big problem. For instance, let’s say you have made a thousand dollars from a trading setup and find out on the internet that some other trader has made 10 times more profit trading the same setup. Jealousy can make you take higher risks the next time you place an order, which is never a good idea.
- Boredom is another type of risk that can ruin your trading. When traders are bored, they tend to overtrade.
Furthermore, there’s always a risk of self sabotage. Never believe some of the popular opinions that traders are not creating anything and we are just taking advantage of a deeply flawed financial system. The system might be flawed but the traders make transfers of the funds from investors to businesses in the most efficient way possible. Financial markets are the most efficient. In addition, by placing orders, we are contributing to increased liquidity, which makes currency conversion much easier.
Risks related to laziness
As already mentioned, Forex trading requires hard work. Developing, improving, testing and backtesting strategies can take a lot of time and energy. Furthermore, if you are trading manually, the next challenge is to keep scanning the markets until the trading setup presents itself.
When retail trading using your finances, you are your own boss and can take as many day-offs as you’d like. However, taking too many vacations can negatively influence your results.
Risks related to bad money management
Bad money management is the number one reason why most beginner traders lose money. Forex trading is a highly leveraged activity. This means that traders gain many times higher purchasing power when placing orders. For instance, by choosing 500:1 leverage, a trader gains 500 times more purchasing power on his/her deposit. Leverage is a double edged sword and it can increase your profits as well as your losses. Therefore, it’s important to choose leverage wisely before opening an investment account.
Some currency pairs are more volatile than others, meaning they make sharper moves, which can result in increased risks.
Even when a trader chooses reasonable leverage and trades a stable currency market, there’s still a chance of taking higher risks by increasing the position size.
Losing is a part of the game when it comes to trading Forex pairs. When you are managing your risks, meaning not risking too much money on any given trade, you are protecting yourself from blowing up your account from a single losing trade. And it’s a guarantee that you will experience a certain number of losses.
To counter the risks associated with taking larger risks per trade, as a trader, you should start thinking in terms of percentage points and stop thinking in terms of numbers. Many professional traders recommend risking 1-5% of your account balance per trade. Furthermore, when a trading setup looks perfect and you have many other reasons to enter, you can take 5% risk. And when you have less reasons to enter, you can risk 1%. This type of approach guarantees that you’ll never blow up your account. In drawdown periods your balance will decrease gradually.
It’s important to keep risk and reward ratios optimal. In order to make money constantly, when the probability of a positive outcome is 50%, your rewards must be higher than your risks. And when risks and rewards are about the same amount, the probability of a positive outcome (price going in a predicted direction) needs to be higher than 50%.
Risks related to the markets
Markets are dynamic and they often change. They go from volatile to stable, from uptrending to ranging or downtrending, etc. As a result, trading strategies might stop working overtime. To counter this, professional traders are constantly improving their trading systems. As they keep tweaking their systems to get the best performance of their trading strategies, another risk arises: These overtweaked systems might be changed so much from the original versions that they may stop working altogether.
Furthermore, low liquidity can increase the risks. The reason behind is that high liquidity gives us the smallest difference between the ask and the bid prices and the spreads are the tightest. For this very reason traders choose highly liquid major currency pairs for trading such as EUR/USD, GBP/USD, USD/CHF, USD/CAD, AUD/USD, and NZD/USD.
Currency pairs vary in terms of how their prices move on the charts. And therefore, one should not use universal techniques to analyze each pair. Each currency pair requires different approaches.
Risks related to being ill prepared
In order to trade Forex profitably long term, it’s important to prepare accordingly. The first thing to take into account is that you need capital to trade. It’s very difficult to sit in front of a computer screen and trade sensibly if your initial investment is only 100 USD. Are you going to properly manage the risks? Will you be satisfied to make 1$ a day? Most likely you will take unreasonable risks and blow up the trading account, even if your system had an edge and you did everything else flawlessly. The number one reason why Forex has such terrible statistics when it comes to winners and losers is that most people invest small amounts, risk it all in a couple of trades and lose everything.
In addition to high upfront trading capital, you need money for the infrastructure. Traders need good, reliable internet connection, a nice computer screen for conducting any kind of analysis and a separated home office for concentrating on trading.
The main takeaways
To sum everything up, Forex trading is associated with a lot of risks and learning about those risks can help us better prepare for the trading journey.
The first risk is associated with having a wrong standpoint on what Forex trading is. Forex is not gambling or a job, it’s like running a business. The more experienced and educated you are about the topic, the better chances you have for trading profitably. It’s important to be disciplined and manage your emotions once you master the technical skills. Laziness is another challenge. All of the consistently profitable traders are hard-workers. It’s also very important to manage your risks. You should never make any given particular trade too significant by taking a large position. Losing is a part of the game and you need to develop an environment where it’s not a tragedy to lose a trade. It’s important to financially prepare accordingly before starting the trading journey as it can be quite costly upfront.
FAQs on the risks of Forex trading
What are the risks of forex trading?
There are multiple risks associated with Forex trading. Such as: having a wrong attitude towards Forex trading, trading with little to no experience, human emotions, laziness, bad money management, market risks, being ill prepared.
How do you manage risk in forex trading?
There are multiple strategies to manage risks in Forex. As a general rule, you should never risk more than you can afford to lose. In addition, you should always plan a trade and execute a plan to reduce risks.
What is the biggest risk in forex trading?
The biggest reason why most traders lose money trading Forex is that they fail to manage their risks. Usually they risk everything on several trades and blow up their trading accounts. Ideally risk should be lower than reward. Or if risks and rewards are about the same, the probability of positive outcomes should be higher than 50%. In addition, risks should not be too large in relation to total account balance.
Is Forex trading risky?
Yes. Depending on the broker, 60-90% of traders lose their investments in Forex trading. However, the small percentage of traders that prepare accordingly and approach trading as a business not as a casino, manage to consistently profit. In addition, everything is risky. Even some states may go bankrupt and fail to pay out bonds. The key to success is to reduce and manage your risks.