FX Risk Management Methods
October 25th, 2009
Whether you’re a rank beginner or experienced trader, if you want long term success in the markets then you need to seriously consider your foreign exchange risk management strategies.
Unfortunately, many traders do not think about foreign exchange risk management at all. Or if they do, they only think about market risk. Serious traders understand there are at least 5 types of risk associated with trading forex, and market risk is only one small one.
In this article we’ll explore the 5 different types of risk you’re exposed to when trading the forex markets, and ways you can lessen, or even eliminate, your exposure.
While some traders may be scared off when they see the true risks involved in forex, seasoned traders realize that being aware of the risks is the first step in eliminating them. You should look at this list not as something that turns you off trading, but simply as a tool in your arsenal to put you one step ahead of the competition.
The Five Different Types of Risk When Trading Forex
#1. Broker Risk: A broker is a business like any other, and as such they can face the same problems any regular business can, including bankruptcy.
As you might remember, in 2005 Refco went bankrupt and they were one of the world’s largest investment and brokerage firms involved in forex.
Always spend some time thoroughly investigating potential brokers before you get seriously involved with them.
#2 Tech Risks: There’s no doubt that computer, power or Internet issues could seriously dampen your results in the markets. With trades sometimes needing to be made at precise times, and Murphy’s law in full effect, you should always prepare for the worst when it comes to technology.
I strongly suggest you backup your computer on a daily basis, preferably to an off-site location you can backup from in case of fire or theft. Traders with serious commitment to the markets, or sizable portfolios, should invest in fail-safe backup systems including generators and surge protectors.
Some people might laugh at going to these lengths, however anyone who has experienced a serious computer crash knows how devastating it can be, and it could be a lot worse if you were caught in a trade with no way of getting out.
#3. Market Risk: This is the only type of foreign exchange risk management most traders think about — how daily fluctuations of currency values affect our positions.
The most sure-fire way to alleviate market risk is to trade using a proven trading system that integrates foreign exchange risk management strategies at the base level.
This includes having set entry and exit points, profit targets, and stop losses.
#4. Political Risks and Economic Risks: Major changes in political policies, large scale economical emergencies and intervention from a country’s governing authority can all effect the value of a currency.
You can avoid these type of risks by using a trading plan that integrates solid foreign exchange risk management methods and identifies issues before they impact your positions.
#5. Country Risk: Finally, there is the risk that a country won’t have the money to meets it’s financial commitments, and will default.
Defaults can have serious effects on many other financial instruments throughout the country, as well as in other countries doing business with that country.
These risks can be minimized simply by sticking to the major currencies while avoiding new, less-stable markets.
As you can see, there are many more risks involved with forex than just market risk. Broker, technology, market, economic and country risk must all be taken into account and mitigated.
Luckily, many existing trading systems have in-built foreign exchange risk management strategies to deal with, and eliminate, many of these risks.
However, even the most sound foreign currency risk management strategies are still not perfect, and there will always be some risk involved when trading. Always use your own best judgement about your risk tolerance levels and never trade above your head.