The Risks of Trading on the Forex Currency Markets

Foreign Currencies
••• Learn The Basics of Foreign Exchange Including Why Trading FX is Popular. Dimitri Otis/The Image Bank/Getty Images

The word forex, an acronym for "foreign exchange," represents the world's largest financial market, trading over $5 trillion of world currencies daily. forex currency trading involves risk in various forms, while also providing a valuable function for many investors and institutions. Light regulations, leverage, constantly fluctuating currency values and external market forces create an environment that keeps things challenging for forex traders.

Retail currency trading is typically handled through brokers and market makers. Traders place trades through brokers who, in turn, place corresponding trades on the interbank market.

Currency Value Fluctuations

Currency values can change quickly and often, for many reasons. Sometimes it's a reaction to external political and economic news, such as Great Britain's proposed exit from the European Union. Other times, the market itself drives value changes.

Often, both external and internal events drive currency value changes on the forex. The fluctuations aren't bad in themselves, but it's a trader's inability to accurately forecast those changes that create risk.

For example, when the U.S. Dollar is strong, companies in the United States may buy more European products, which have become correspondingly less expensive. To pay for these products, they exchange US dollars for euros. When large quantities of dollars are exchanged for euros over a short period this drives up demand for the euro.

Consequently, the euro's value increases and the value of the US Dollar relative to the euro decreases.

Investor Types and Risk Levels

Currencies are traded by individual retail investors, financial institutions, and corporations doing business internationally. Retail investors and banks trade to make profits, and corporations usually trade in the normal course of buying and selling goods and services across the globe.

Currency trading is typically highly leveraged, so with a small amount of cash investment and a certain amount of margin, investors can control a very large amount of money. forex is also lightly regulated, with certain types of trades not regulated at all. Both factors increase the risk of forex trading.

The key to successful currency trading is to trade conservatively while employing some means of risk management. Novice traders should begin trading on a practice trading platform that allows them to make hypothetical trades without risking their investment capital. When and if they see positive results, they can begin doing live forex trades.

How Successful Traders Operate

Typically, traders who make only a few large, concentrated trades are more apt to lose money. Traders who distribute their trading funds over many different trades diversify their risk and have a better chance of trading profitably. Similarly, traders who leverage their trades aggressively are more likely to have large losses than those who don't.

The risks of forex trading are genuine, and according to a 2014 Bloomberg report, almost 70 percent of forex traders lost money in each of the preceding four quarters. Unsurprisingly, data compiled by the National Futures Association, a forex self-regulatory institution similar the stock market's FINRA, shows that most retail forex traders drop out after about four months.

Making money trading on the forex involves a good deal of risk, but some traders do make money. Advisable risk-mitigation practices include:

  • Begin trading with a practice account

  • Diversify risk by making several small trades in different markets rather than a single trade.

  • Use stop loss orders to limit potential losses

  • Until you understand how to use it prudently, avoid using the available leverage, which can exceed 50 to 1. At 50 to 1 even a two-percent difference going against your trade results in a total loss of all invested funds.

Knowledge is power, and the forex market changes continually. Keep learning, testing new strategies and taking a conservative view so that you can minimize risk and maximize trading profits.