Market Analysis

 

Making money off the difference between currency values, sometimes known as "foreign exchange" or "forex" trading, is not for the faint-hearted. For one thing, there are no centralized markets, such as stock exchanges, to assist trades. For another, the hazards extend far beyond an individual company's or an entire industry's performance. However, if you understand the risks and trade prudently, you can trade currencies successfully. 

Exchange Rate Risk 

Forex traders exchange one country's currency for another's currency. Changes in the relative value of the two currencies can impact your profits (or losses). 

You most certainly do this when you go on an international vacation. As of October 27, 2020, if you were traveling from the United States to Canada, $1 USD would be worth $1.31 CAD. 

 

The International Trade Administration (ITA) outlines this exchange rate risk at the corporate level during a trade agreement:

"The relative value of the two currencies may change between the time the deal is concluded and payment is received." Unprotected foreign currency devaluation or depreciation can lead to financial losses. For instance, if a buyer agrees to pay 500,000 [euros] for a shipment and the Euro is at $0.85, you can expect to get $425,000. If the Euro dropped to $0.84, the payment would be $420,000, resulting in a $5,000 loss for you. If the value of the foreign currency rises, it can result in larger profits. 

When you purchase and sell currencies on foreign exchanges, you are wagering on how the value of other countries' currencies will change relative to one another. All else being equal, if you buy a currency that rises in value versus the currency with which it is paired, you profit. If it loses value, you incur losses. 

The exchange rate is strongly tied to a country's interest rate. Rising interest rates encourage investment in a country. Falling interest rates lead to disinvestment and a devalued currency. Forex traders must consider this relationship while entering, controlling, or exiting a deal. 

Country Risk 

We can classify country risk into two groups. 

The first is simple: a country's currency can suffer as a result of instability. When an undesirable occurrence occurs—or traders think one may occur—investors frequently withdraw their funds from a country's currency, causing it to lose value. You don't want to be on the losing end of a trade when devaluation occurs. It can happen quickly (e.g., during political turbulence) and result in illiquid markets. You risk being left holding the bag, or engaged in a trade.

Another sort of country risk occurs when a country actively devalues its currency.Some traders refer to this as "devaluation" risk. It is not inherently evil; it is simply one type of monetary policy in which a country purposely lowers the value of its currency in order to compete more successfully in the trade market. A lower currency makes a country's exports less expensive in the international market. 
 

Margin Risk 

Using leverage in forex trading isn't much different than using it with stocks and options. When you trade on margin, you borrow money from your broker to cover trades that exceed your actual cash balance. If your deal goes south, you may face a margin call, which requires cash in excess of your original investment to bring you back into compliance. 

Leverage can raise earnings tremendously, but it can also increase losses. Currency markets can be unpredictable; even minor price fluctuations can result in margin calls. If you are severely indebted, you may incur significant losses. If you're a new trader, think about the key hazards of trading on margin before borrowing from your broker.

Tips for Mitigating Risk

When trading stocks and options, you must be aware of broader market and macroeconomic trends that may affect the sector in which the firm you own works. There is always company-specific risk, from earnings results to unexpected industry news. These hazards are similar to issues like nation risk in FX trading. 

However, most investors believe that stock trading is more intuitive and, as a result, less dangerous. This is probably a good mentality to enter forex trading with. It is fundamentally more sophisticated and more risky than stock trading due to the larger number of moving parts. Nonetheless, there is always risk when investing in any sort of asset, which you can try to limit with a few strategic measures. 

Start Small

Start by dipping your toes into forex trading with a modest amount of capital that you can afford to lose without significant financial strain. If you encounter early success, resist the urge to reinvest immediately. Instead, consider withdrawing profits to safeguard against overconfidence and impulsive decision-making.

 

Take Common Sense Precautions

Implement sensible precautions when executing trades, such as employing stop-loss measures and diversifying your investments across multiple currency pairs. This strategy helps mitigate potential losses and spreads risk effectively.

Have a Broader Plan in Place

Before delving into forex trading, integrate it into a comprehensive financial plan that aligns with your overall investment goals. Seek guidance from a financial advisor to ensure your trading endeavors complement your broader financial strategy, minimizing the risk of detrimental financial setbacks.

Before Getting Started With Forex Trading

 

One additional risk to be mindful of is broker risk.

To mitigate the risk of dealing with an untrustworthy forex broker, it's advisable to opt for a firm that is regulated by a government entity. In the United States, it's recommended to select brokers officially associated with either the National Futures Association (NFA) or the Commodity Futures Trading Commission (CFTC). Additionally, you can verify a broker's legitimacy by utilizing BrokerCheck, a service provided by the Financial Industry Regulatory Authority (FINRA).

It's important to note, as highlighted by the Securities and Exchange Commission (SEC), that unlike stock and options trading, there isn't a central repository that serves as a forex exchange and clears forex trades. This distinction necessitates caution. When engaging in forex trading, you're still interacting with market makers on the opposite side of the trade, who likely possess more comprehensive and favorable pricing information driven by their own interests.

Similar to considering bid/ask spreads in stock trading, it's prudent to seek out brokers offering low spreads, measured in pips. This refers to the difference between the buying and selling prices of a currency at a particular point in time.

 

Disclaimer

Derivative investments involve significant risks that may result in the loss of your invested capital. You are advised to carefully read and study the legality of the company, products, and trading rules before deciding to invest your money. Be responsible and accountable in your trading.

RISK WARNING IN TRADING

Transactions via margin involve leverage mechanisms, have high risks, and may not be suitable for all investors. THERE IS NO GUARANTEE OF PROFIT on your investment, so be cautious of those who promise profits in trading. It's recommended not to use funds if you're not ready to incur losses. Before deciding to trade, make sure you understand the risks involved and also consider your experience.