As discussed in the previous part of this series, trading forex has become a popular way of taking advantage of financial markets for inexperienced traders and seasoned investors alike. And yet, before rushing to the foreign exchange market, investors need to be well acquainted both with the risks and benefits associated with the trading of forex currencies.
Forex Trading Advantages
Among the advantages associated with forex trading is that it can potentially provide excellent returns on a relatively small initial investment. It also has low barriers to entry, especially in comparison to share trading. In addition, forex trading is associated with low transaction costs; most forex brokers do not charge commissions, but instead make money on the basis of the spreads.
Besides being the largest financial market in the world, the forex market is also the world’s most liquid market, which is considered to be among its main advantages. Liquidity is usually defined as the proximity of a given asset to cash. With forex, the traded currency itself is already cash. The high liquidity of the forex market enables traders to instantly open and close positions. The other main benefit of liquidity is that pricing is more honest and since there are always plenty of buyers and sellers, the spreads of forex quotes remain narrow.
Forex trading disadvantages
Market volatility is yet another term which those interested in forex trading need to get acquainted with, since it is an important factor determining the nature of forex trading. Volatility is a measure indicating variation of price of a financial instrument for a given period of time. As a rule more volatile markets present better opportunities for short-term speculators who can quickly make returns out of price fluctuations. A less volatile market, on the other hand, is less risky and for that reason it is more beneficial to the long-term investor.
Forex is generally considered to be a market with a relatively low volatility, the main reason being that it is mostly governments and global banks that drive prices either up or down. This in turn means that since there is less movement, traders need to leverage their capital so as to be able to make profit on smaller market moves. Leverage therefore may be viewed as a way to offset the low volatility on the forex market.
The double-edged leverage sword
That in turn brings us to the concept of leverage, which can become the cause of both substantial profit and heavy losses in forex trading. In the case of forex trading, leverage may be defined as an automatic credit line extended by the forex broker to the trader. Or, in other words, you can trade with more capital than you actually have in your trading account. Due to the already mentioned low volatility of the forex market, traders use leverage as an instrument to capitalise on small market movements.
So, in short, leverage increases the efficiency of your capital and ensures a much better return on your investment over a short period of time.
And yet, when it comes to forex trading, leverage is often described as a double-edged sword. This is due to the fact that while leverage lets you generate higher profits with a small deposit, it can also lead to massive losses. As already mentioned, leverage lets you trade with more money than you have and while you get to keep the profits, you also need to bear the losses. For instance, if you are trading with a broker with 100:1 leverage, a loss of as little as 0.1 percent will actually mean a 10 percent loss.
In addition, you also face the risk of falling below the margin requirements set by your broker, which is often referred to as margin call risk. Falling below those requirements may result in liquidating your portfolio, which means closing profitable positions early and liquidating losing positions which still have a chance of recovering.
Mitigating risks – Stop Loss Order
Perhaps the most efficient way to manage the risks associated with leverage in forex trading is placing a stop loss order. A stop loss is a price level set by the trader on a particular position, which if reached, will automatically close the position and thus prevent any further losses. So, here is an example how a stop loss order works: you decide to buy EUR/USD at 1.2245, and place a stop loss order at 1.2230. If you were wrong in your prediction and the EUR/USD starts falling, the stop loss order will close your position as soon as the level reaches 1.2230, limiting your loss to 15 pips. Besides addressing the risks of leverage, a stop loss order also helps traders maintain control over their positions in a market which operates 24 hours a day.
The importance of research
As with any type of market in which you are investing, the forex market also requires both research as well as following news and trends with a potential impact on forex trading.
When doing your research, you need to focus on information which will induce market movements in either direction for one or more currency pairs. To get a broader perspective, you can study the underlying economy of a given currency. In addition, you can potentially benefit from looking at weekly and monthly statistics, which will give you a better idea about the price fluctuations of currency pairs over a longer period of time.