Forex trading involves trading of currency pairs. When you go long on a currency pair, you hope that the price of one currency will increase relative to the other currency. If you go wrong with the prediction, the trade goes against you. This is one of the most common risks of forex trading. Sometimes when traders pick up the less popular currency pairs, they get themselves involved in additional risks.
Note that Banks makes the majority number of Forex transactions, and they use forex to reduce currency instability. Through the sound trading system, you can keep forex trading reasonably risk free. But first, it is important to understand the major risk of FX trading:
- Exchange rate risk – It is the risk caused due to the changes in the value of the currency. It is caused due to the volatile shift in the worldwide supply and demand of the currency. The risk such caused can be substantial. Additionally, off-exchange forex trading is unregulated; therefore, no daily price limits are imposed.
- Interest rate risk – It refers to the profit and loss caused by fluctuations in the forward spreads, along with the maturity gaps and the forward amount mismatches in the foreign exchange book. To minimize this risk, one needs to put limits on the total size of mismatches. The common practice is to separate the mismatches according to their maturity dates up to six months and past six months. Transactions are entered in the computerized system to calculate the gains, losses, and positions for the dates of the delivery.
- Leverage risk – In a forex trade, leverage needs a fraction of investment called a margin so as to gain access to trades in foreign currencies. Price fluctuations lead to margin call where investors are needed to pay the additional margin. During volatile conditions, excess use of leverage can cause huge losses in initial investments.
- Transaction risk – Transaction risk is associated with the difference in time between the beginning of the contract and when it ends. Forex trading takes 24 hours and in that duration exchange rates can change before the trades have settled. Currencies can be traded at a different time at different prices during trade hours. Huge time difference between entering and settling the contract leads to transaction risk.
- Counterparty Risk – Counterparty is the company that provides the assets to the investor. Counterparty risk means the risk of default from the broker. In forex trading, spot and forward contracts are not guaranteed by an exchange. Counterparty risk is the result of the solvency of the market maker in spot currency trading. When the market is volatile, the counterparty may refuse to stick to the contracts.
Risks associated with foreign exchange trading are high due to the nature of the leveraged trades. Political issues and time differences all contribute to making the condition worse. One of the best ways to minimize the risk is by selecting a good brokerage firm. AAATrade.com is one of the best investment firms which is regulated and licensed by CySEC, which makes it the most reliable firm in the world.