Making money off the difference between the values of currencies—“foreign exchange” or “forex” trading—isn’t for the faint of heart. For one thing, there are no centralized markets like the stock exchanges to facilitate your trades. For another, the risks go well beyond an individual company’s, or an entire industry’s, performance. However, if you understand the risks, and trade conservatively, you can effectively trade currencies.
Here are the basics to get you started forex trading responsibly.
- Exchange rate risk is the risk of loss due to the change in a currency pairs' relative values after you've agreed to buy or sell at a specific price.
- Country risk is the risk of loss due to instability or intentional devaluation of its currency.
- Margin risk is the risk of loss if you trade using your margin account and your trade falls through.
- Try to mitigate the risks by starting small, using a stop-loss, and trading across more than one currency pair.
What Is Forex Trading?
In the simplest terms, “forex” refers to a foreign exchange where you trade one currency against another in pairs. For example, you’ll often see currency pairs that look like “USD/CAD.” We call this the dollar-loonie trade, swapping the U.S. dollar against the Canadian dollar.
In a trade, you can be “long” one currency at the same time as being “short” another. This means you make money when one price rises (long) or can make money when one price falls (short). For example, if you’re long USD, you need the USD exchange rate to increase in order to profit on the trade. If you’re short CAD, you’d profit if CAD decreased in value against the USD. We call these exchange rate fluctuations percentage-in-point movement, or PIP.
The buy low, sell high dynamic so intuitive in stock trading isn’t quite as cut and dry in forex. The risks help illustrate why.
As with any trading and investing activity, it’s best to go into the venture debt-free, with an emergency fund, and a long-term investment plan in place. Don’t trade with money that belongs in your emergency fund or retirement account.
Exchange Rate Risk
Forex traders use one country’s currency to purchase the currency of another country. Changes in the relative value of the two currencies can affect your profit (or loss).
You likely do this when you take an international vacation. For example, if you were traveling from the U.S. to Canada, $1 USD would get you $1.31 CAD, as of October 27, 2020.
The International Trade Administration (ITA) describes this exchange rate risk at the company level amid a trade deal:
“The relative values of the two currencies could change between the time the deal is concluded and the time payment is received. If you are not properly protected, a devaluation or depreciation of the foreign currency could cause you to lose money. For example, if the buyer has agreed to pay 500,000 [euros] for a shipment, and the Euro is valued at $0.85, you would expect to receive $425,000. If the Euro later decreased in value to $0.84, payment under the new rate would be only $420,000, meaning a loss of $5,000 for you. If the foreign currency increased in value, however, you would get a windfall in extra profits.”
When you buy and sell currencies via foreign exchanges, you’re betting on how different countries’ currencies will change in value against one another. All else equal, if you purchase a currency that ends up increasing in value against the currency it’s paired with, you profit. If it decreases in value, you chalk up losses.
Exchange rate is linked closely to a country’s interest rate. Rising interest rates tend to attract investment in a country. Falling interest rates lead to disinvestment and a less valuable currency. Forex traders must pay attention to this relationship prior to heading into a trade, while managing one, and/or preparing to exit one.
We can divide country risk into two key categories.
The first is straightforward: Instability in a country can impact its currency. When an adverse event occurs—or traders fear one might take place—investors often move their money out of a country’s currency, which has the effect of devaluing it. You don’t want to be on the wrong side of the trade when devaluation occurs. It can happen fast (i.e., amid political turmoil) and lead to illiquid markets. You run the risk of finding yourself holding the bag, so to speak, stuck in a trade.
You can face another type of country risk when a nation intentionally devalues its currency. Some traders call this “devaluation” risk. It’s not inherently bad; it’s merely one form of monetary policy where a country purposefully decreases the value of its currency to compete more effectively from a trade standpoint. A cheaper currency makes a nation’s exports less expensive in the export market.
Using leverage in forex trading isn’t all that different from using it with stocks and options. When you trade on margin, you borrow money from your broker to finance trades that require funds in excess of your actual cash balance. If your trade goes south, you might face a margin call, requiring cash in excess of your original investment to come back into compliance.
While leverage can exponentially increase profits, it can do the same with losses. Currency markets can be volatile—even small price shifts can trigger margin calls. If you’re heavily leveraged, you might face substantial losses. If you’re a novice trader, consider the major risks of trading on margin before borrowing from your broker.
Don’t max out your available margin. Some brokers allow traders to access margin many times the cash value of their account. This can lead to serious trouble.
Tips for Mitigating Risk
When you trade stocks and options, you must be aware of broader market and macroeconomic trends that can impact the sector a company you own operates in. There’s always company-specific risk, from what happens on earnings to unexpected industry news. These risks are akin to factors such as country risk in forex trading.
This said, most investors perceive stock trading as more intuitive and, subsequently, less risky. This is probably a good attitude to head into forex trading with: It’s inherently more complicated and potentially dangerous—with more unpredictable moving parts—than stock trading. Nevertheless, there’s always risk when investing in any type of security, though you can try to mitigate it with a few smart moves.
Start forex trading with a small amount of money you can afford to lose. If you make winning trades early on, take that money off the table. Don’t let early success fuel overconfidence and bigger, riskier trades.
Consider using a practice account through a trading platform prior to entering actual forex trades.
Take Common Sense Precautions
When you initiate real trades, employ some of the same tools you do with stocks. Use stop-loss protections and spread your available cash across several trades rather than just one pair.
Have a Broader Plan in Place
Before you dive into forex trading, ensure it’s part of a well-thought out and diversified personal finance and investing plan. Don’t let a misstep in the newish world of forex trading damage your near- and long-term financial health. Consider working with a financial or investment advisor to ensure you make the right investing moves for your financial situation.
Before Getting Started With Forex Trading
First, be mindful of one more risk: broker risk.
To avoid dealing with an unscrupulous forex broker, choose a firm regulated by a government entity. In the U.S., look for brokers officially associated with the National Futures Association (NFA) or the Commodity Futures Trading Commission (CFTC). You can also verify a broker’s status by using BrokerCheck, a service provided by the Financial Industry Regulatory Authority (FINRA).
As the Securities and Exchange Commission (SEC) warns, there’s no central repository that acts as a forex exchange and clears forex trades. This is in contrast to stock and options trading, so take caution. You’re still dealing with market makers on the other side of the trade who likely have access to more and better pricing information with their own interests in mind.
Much like the bid/ask spread in stocks, find brokers with low spreads, measured by pips. This is simply the difference between what you can buy and sell a currency for at one point in time.
If you’re a beginner, try to open an account with a broker who offers ample research and education services, such as TD Ameritrade. You might need to access basic information early and often. It’s nice to have it in-house, easily accessed inside your trading account.