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Main » 2008 » December » 19 » Risk Management
Risk Management
7:16 AM
Risk Warning
Trading foreign currencies is a challenging and potentially profitable opportunity for educated and experienced investors. However, before deciding to participate in the Forex market, you should carefully consider your investment objectives, level of experience and risk appetite. Most importantly, do not invest money you cannot afford to lose.
There is considerable exposure to risk in any foreign exchange transaction. Any transaction involving currencies involves risks including, but not limited to, the potential for changing political and/or economic conditions that may substantially affect the price or liquidity of a currency. Moreover, the leveraged nature of FX trading means that any market movement will have an effect on your deposited funds proportionally equal to the leverage factor. This may work against you as well as for you. The possibility exists that you could sustain a total loss of initial margin funds and be required to deposit additional funds to maintain your position. If you fail to meet any margin call within the time prescribed, your position will be liquidated and you will be responsible for any resulting losses. Investors may lower their exposure to risk by employing risk-reducing strategies such as 'stop-loss' or 'limit' orders.
There are also risks associated with utilizing an internet-based deal execution software application including, but not limited, to the failure of hardware and software and communications difficulties.
Risk Management
The Forex Market is the largest and most liquid financial market in the world. Since macroeconomic forces are one of the main drivers of the value of currencies in the global economy, currencies tend to have the most identifiable trend patterns. Therefore, the Forex market is a very attractive market for active traders, and presumably where they should be the most successful. However, success has been limited mainly for the following reasons:
Many traders come with false expectations of the profit potential, and lack the discipline required for trading. Short term trading is not an amateur's game and is not the way most people will achieve quick riches. Simply because Forex trading may seem exotic or less familiar then traditional markets (i.e. equities, futures, etc.), it does not mean that the rules of finance and simple logic are suspended. One cannot hope to make extraordinary gains without taking extraordinary risks, and that means suffering inconsistent trading performance that often leads to large losses. Trading currencies is not easy, and many traders with years of experience still incur periodic losses. One must realize that trading takes time to master and there are absolutely no short cuts to this process.
The most enticing aspect of trading Forex is the high degree of leverage used. Leverage seems very attractive to those who are expecting to turn small amounts of money into large amounts in a short period of time. However, leverage is a double-edged sword. Just because one lot ($10,000) of currency only requires $100 as a minimum margin deposit, it does not mean that a trader with $1,000 in his account should be easily able to trade 10 lots. One lot is $10,000 and should be treated as a $100,000 investment and not the $1000 put up as margin. Most traders analyze the charts correctly and place sensible trades, yet they tend to over leverage themselves (get in with a position that is too big for their portfolio), and as a consequence, often end up forced to exit a position at the wrong time.
For example, if your account value is $10,000 and you place a trade for 1 lot, you are in effect, leveraging yourself 10 to 1, which is a very significant level of leverage. Most professional money managers will leverage no more then 3 or 4 times. Trading in small increments with protective stops on your positions will allow one the opportunity to be successful in Forex trading.
Utilizing Stop Loss Order
A stop-loss is an order linked to a specific position for the purpose of closing that position and preventing the position from accruing additional losses. A stop-loss order placed on a Buy (or Long) position is a stop-loss order to Sell and close that position. A stop-loss order placed on a Sell (or Short) position is a stop-loss order to Buy and close that position. A stop-loss order remains in effect until the position is liquidated or the client cancels the stop-loss order. As an example, if an investor is Long (Buy) USD at 120.27, they might wish to put in a stop-loss order to Sell at 119.49, which would limit the loss on the position to the difference between the two rates (120.27-119.49) should the dollar depreciate below 119.49. A stop-loss would not be executed and the position would remain open until the market trades at the stop-loss level. Stop-loss orders are an essential tool for controlling your risk in currency trading.

Fast Market Policy
The spot foreign exchange market, at times, exhibits extreme price volatility, a condition known as a "fast market". Fast market conditions may be caused by various factors including, but not limited to, news releases such as non-farm payroll numbers, order imbalances-significantly greater orders of one type (e.g., "buys") than another type (e.g., "sells").
During the extreme price volatility in fast markets, currency pair prices will "gap" and spreads widen. A price gap occurs when the price of a currency pair either jumps or plummets from its last bid/offer quote to a new quote, without ever trading at prices in between those quotes. As an example, the Euro/US Dollar currency pair may move from a bid/offer of 1.1891 - 1.1894 and begin trading at 1.1941 - 1.1944, without ever trading at the prices between those quotes.
The standard industry practice for currency dealers, including dealers on the interbank market, during fast market conditions and price gaps, is to set market levels and execute orders manually without the use of automated systems or services. The process during fast markets is typically:

Initially, major money center banks and other online price providers halt all direct dealing and their pricing engines are suspended,
Currency dealers analyze event and determine the correct price,
Prices enter market 20-30 pips wide or more,
Spreads in market narrow as more currency dealers enter the market.
In such an event, there may be a delay in trade execution, which may be significant, while rates are cross-referenced to ensure valid execution. Further, stops placed close to a market that has traded through the stop price are re-priced on the next best tradable price. Thereby, a specified rate order does not provide a fixed-price guarantee to the counterparty.
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