Understanding the Risks of Forex and the Mistakes that New Traders Make

Pitfalls and Risks

Understanding the Risks of Forex and the Mistakes that New Traders Make

While I’ve tried to offer a balanced portrayal of forex, I think it’s natural that readers and aspiring traders will still have a rosy view of it. After all, investors have been known to have tremendous overconfidence in their own abilities, even in the face of contrary results. By definition, you wouldn’t start trading currencies unless you believed —or even expected—that you could earn a profit doing so, right?

Both because forex is a zero-sum game and because currency markets are more opaque than other securities markets, you should be aware of the risks. In this chapter, then, I’ll offer an overview of what can go wrong. As a forex trader, it’s important to understand that you will be vulnerable to forces both within and outside of your control.

I’ll also introduce some of the mistakes that new traders make, due both to lack of experience and overconfidence. I’ll explain further how you can avoid these pitfalls and the steps that you can take to minimize risk. Simply, those that aspire to succeed must internalize the old adage, “Hope for the best and prepare for the worst.”

Currency Risk

The most obvious risk in any investing or speculative activity is that the market will move against you, causing the value of your position to decline. Quite simply, if you have a long position in the AUD/USD, the most basic risk that you face is that the Australian dollar will decline relative to the US dollar, immediately causing you paper losses and ultimately resulting in actual losses. In forex, this risk is especially acute because the currency market represents a zero-sum game. By definition, when one trader wins, one or more other traders must lose. In short, as a forex investor, you must accept the fact that you will lose money on some of your trades.

In fact, currency risk will always be present in any international investment. When you own—or are exposed to price changes in—an asset or security that is denominated in a foreign currency, you take on currency risk. For example, if you are an American and you buy shares in Sony, you are exposing yourself to Japanese yen risk. While Sony could boost its profitability, causing its stock prices to rise in Japan, this would be a moot development if the yen simultaneously depreciates. Figure 10-1 shows how (net positive) currency fluctuations have contributed to asset price returns over the last 12 years.

Figure 10-1. Breakdown of international returns between currency fluctuations and movements in the underlying asset price (Source: Fidelity Investments).

There are several things that you can do to limit your exposure to currency risk. First of all, you should prepare yourself for the possibility that you will lose all of the funds that you apply to currency investing.

Accordingly, you should only invest money that, if lost, would not materially impact your standard of living or financial situation.

While no one in his or her right mind would plow ahead and invest in forex with the expectation of losing, it is a possibility that nonetheless must be accepted. As far as new traders are concerned, currency trading is not for the unemployed or the cash-strapped. Losing sucks, period. What would be worse than merely losing, however, is losing cash that you borrowed from your brother or that you cannot afford to part with.

Second, reduce your leverage to the smallest amount possible. When it comes to allowable leverage, currencies (and futures) are the exception in finance—not the norm. Leverage of 50:1 is not recommended, let alone leverage of 200:1. Simply, when you increase your leverage, you increase your risk. Smaller ripples in the underlying currencies will cause massive waves in your account balance, hopefully for the better, but potentially also for the worse. If you find that striving to meet your trading goals necessitates the use of excessive leverage (which I define as greater than 10:1), you should scale back your expectations, adjust your trading strategy, or wait until you have more risk capital before joining the currency trading fray.

Regardless of how much leverage you employ, you need to have a hedging strategy. For the majority of traders, this is as simple as a fixed 1% stop-loss order on all trades. Other traders may experiment with using options contracts to hedge risk, especially on long-term positions. Regardless, you need to have some method to limit potential losses. If you trade with little or no leverage and have a long-term outlook, you may not be bothered by a 5% paper loss in your position in the first month. On the other hand, if you are swing trading with 5:1 leverage, a 5% decline in the underlying currency pair would be unimaginable. By getting in the habit of using stops, you can nip any losses in the bud before they wreak havoc on your account balance.

As part of your hedging strategy, you might also consider scaling out of losing trades and scaling into positions that are in the black, perhaps with the use of leverage. Used properly, this strategy is a win-win. If your (winning or losing) position declines, you will have effectively decreased your losses. If it recovers or continues rising, your position will similarly increase in value.

Most importantly, you should always be aware of your potential exposure. If your position moved against you suddenly, what would be the impact? Is your position leveraged? Are you hedged? Can you afford this loss? These are questions that you should be able to answer at all times. A simple way to gauge your exposure is to look at the recent volatility of your currency pair(s) for the applicable time interval. Pay particular attention to volatility spikes that coincided with news releases.

In Figure 10-2, you can see that weekly volatility for the USD/CAD has averaged about 100 PIPs (1%) for more than one year and never exceeded 135 PIPs. Volatility peaked at this level toward the end of 2011 and is currently in a state of protracted decline. If you were to invest in the USD/CAD with an intended hold period of 3 weeks, your approximate risk exposure would be about 200 PIPs. While you can’t rule out the possibility of large, long-tail moves (so-called due to their presence at the far ends of any probability distribution curve), you can nonetheless develop an idea of how much you could possibly lose if your position moves against you, and plan accordingly.

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Figure 10-2. USD/CAD volatility chart can be used to gauge risk exposure. (Source: Forexticket.co.uk)

Volatility

In addition to being a useful tool for understanding risk, volatility can also be a risk in and of itself. As I have explained on several occasions already, volatility may spike around certain planned news releases. If you think that a big move is likely and you can’t afford the loss that the news might trigger, close your position or scale back your leverage. Even if you aren’t deliberately trading the news, you should always be aware of its potential impact on your portfolio.

Volatility is also a risk insofar as it can trigger the premature execution of stop orders. Remember that the main purpose of stops is to protect against excessive losses. However, it’s possible that sudden volatility could cause the currency pair to dip below your stop level due to otherwise unremarkable fluctuations. For example, setting up a stop-loss 100 PIPs (about 1%) below your entry price might seem like solid hedging. As you can see from Figure 10-2, however, a fluctuation in the USD/CAD of 100 PIPs would hardly be considered exceptional, and placing a stop-loss at this level could automatically lead to your position being closed before the pair has a chance to rebound. The lesson here is simply to be aware of the impact of volatility on your strategy and aim to strike a balance between aggressiveness and conservativeness when configuring stop levels.

Poor Strategy

The fact that forex is a zero-sum game is clearly a liability, but from another perspective, this reality can also be viewed as a plus. Simply, there is always the possibility of generating profits, regardless of the current market environment. The failure to do so may imply faults in your trading strategy.

After excessive leverage (a pitfall that will be reiterated in Chapter 11), the biggest strategic mistake committed by novice traders is overtrading. In fact, overtrading can bring to mind any number of related mistakes. Scalping, opening and closing positions too quickly without adequate thought and preparation, immediately comes to mind. Another example is trading too many positions at the same time. Regardless, quantity is not a substitute for quality. Increasing the size, frequency, and diversity of your trades is a recipe for disaster, not profits. In addition, while trading different currency pairs simultaneously as part of a broad-based strategy can reflect savvyness, it also exudes foolishness. When you first begin trading, stick to a handful of currency pairs and try to hold each position for a sustained period of time. If you find that you are able to manage multiple positions without becoming schizophrenic, then you can allow yourself greater latitude. Finally, there is no rule that says you need to be in the market at all times. If the market is gyrating wildly or your strategy is not producing any clear signals, consider staying on the sidelines and playing the waiting game.

The next strategic pitfall that stymies many beginner traders involves an overreliance on someone else’s strategy. Especially when you are first starting out, you may be enticed by advertisements that promote managed accounts, signal services, and robots, because of the fantastic profits that they promote. In my opinion, you should view such promises skeptically; if it seems too good to be true, it probably is. Ask yourself: Why would someone with a profitable trading system sell it to the public when he could just as easily keep it—and the chestful of profits that it purportedly generates—to himself? In short, blindly using systems that trade for you or merely provide trading ideas are not recommended. If you want to be a successful trader, you need to educate yourself and practice. If you aren’t confident enough or comfortable with the risks to trade on your own, buy a managed or passive ETF or mutual fund. It’s that simple.

The same goes for the thousands of technical reports and free signals that are published by most forex portals and forex brokers on an intraday basis. For novice traders, there is a real danger of information overload. These reports may contain a few nuggets of wisdom but probably also contain a handful of haphazard stabs and filler. Treat these ideas as you would any other source of information, as mere factors in your overall trading strategy. Before trading on the tips of others—regardless of their credentials— scrutinize them closely and backtest whenever possible.

As Albert Einstein once said, “the important thing is not to stop questioning.” While this advice probably wasn’t in reference to forex strategy, the fact remains that a diligent, probing trader is a good trader. Market conditions are always changing, and so should your strategy continue to evolve. I mentioned earlier that I have interviewed many professional traders that recorded their most profitable trades during the credit crisis, a period when the markets went haywire and all previous trading wisdom was thrown out the window. Forget trading signals and robots. Ask them what their secret was, and they will tell you that the years they spent educating themselves and trading beforehand enabled them to accurately and confidently assess the prevailing conditions—whatever they may be—and to trade accordingly.

Forex Addiction

Many of the pitfalls that I discussed above are merely a manifestation of an underlying disorder: forex addiction. I’m not using this term tongue-in-cheek. Trading forex (or any other security, for that matter) has many properties that make it addictive: immersive environment, fast pace, large amounts of money on the line, and so forth. For those that are looking for an escape from the daily rigors of life, stimulation in an otherwise dull routine, or a vehicle for diverting compulsive gambling tendencies, forex offers an easy outlet. It’s available 24 hours a day from the privacy and convenience of your home. Best of all, it’s completely legal.

Sadly, if and when you reach the point of actual addiction, it will already be too late. You will have ceased being accountable, even to yourself. You will trade compulsively and randomly, over very short time periods. You will trade with ever increasing amounts of money (and leverage), even as your account balance dwindles. You will become irrationally hopeful that a big win is just around the corner and fail to heed the warning signs and learning opportunities that come with losing trades. You probably won’t quit until your account balance falls below the sanctioned minimum or you have mentally hit rock bottom, or both.

There are a handful of steps that you can take to avoid becoming addicted to forex. First of all, limit the amount of time that you spend trading forex or even thinking about forex. Make an effort to trade over longer time frames and, in turn, make fewer overall trades. Don’t trade in thin markets, and don’t feel compelled to have an open position(s) at all times. Spend more time doing research and planning strategy than executing trades. Try to set reasonable trading goals and quash any hopes of windfall profits and fabulous wealth. Approach forex from the standpoint that it is a business—not a game.

If you can’t sleep at night because you are mulling your losses, if you feel compelled to monitor all of your open positions in real-time, if you find that your trading habits are becoming less disciplined and more idealistic, you should take some time off. In the end, if you ever reach the point where you depend on forex for your emotional well-being, you need to walk away and/or seek professional help.

Broker/Credit Risk

The next category of risk that I want to elucidate is not as easy to hedge: broker risk. Bank accountholders have the FDIC. Equity traders are guaranteed recourse by the Securities Investor Protection Corporation (SIPC) and the Securities and Exchange Commission (SEC). If HSBC or E*Trade went bankrupt tomorrow, the US government would by and large protect your money and investments.

Unfortunately, the same cannot be said for forex, which lacks a centralized marketplace and a clearinghouse (for retail trades). You must simply put your trust in the integrity of your broker and hope that the execution prices that you receive are fair and in line with actual market movements.

Since the financial crisis, the NFA has made great strides in regulating the forex industry. All brokers are held to strict standards and must meet specific registered capital thresholds. Complainants are finding that restitution is forthcoming in cases of clear malpractice. Still, the fact that such malpractice remains rampant speaks volumes about the state of the industry. Lawsuits have alleged flagrant improprieties that strike at the very core of the way in which forex brokers operate. Spreads are still somewhat arbitrary, and execution is far from transparent, even among the most reputable brokers. Liquidity may dry up during news releases, and slippage (in which orders are filled at prices worse than indicated quotes) is common, even among reputable brokers. If your broker declares bankruptcy, you will simply have to get in line with everyone else as an unsecured creditor and pray for the return of the funds in your account. It doesn’t exactly inspire confidence that, in their risk disclaimers, most brokers won’t even vouch for the information on their own websites and that they disavow all responsibility for the repercussions of any inaccuracies.

Among unregistered and offshore brokers, the situation is almost certainly worse. They probably engage in front-running (by trading their own accounts in advance of your orders) and may even manipulate trading, targeting your stop levels in order to lock in your losses. Given the abundance of Ponzi schemes and other scams that have been uncovered in the financial industry since 2008, it wouldn’t surprise me if certain unregistered brokers were also bucket shops, pretending to execute orders without actually doing so. With these brokers, you will find that it is easy to deposit funds but nearly impossible to withdraw them.

At least there are now established channels for seeking redress in cases of broker malfeasance. If you encounter any questionable activity, the first step is to contact your broker. If that fails, you should file a formal complaint with the Commodity Futures Trading Commission (CFTC). The NFA also has an arbitration program, which has been known to mete out reparations to wronged accountholders. Even the court system has become amenable to accountholder rights, as evidenced by several class action lawsuits against brokers in recent years.

Ultimately, the best way to protect oneself is to open an account with a registered broker. Beyond that, just try to be vigilant. I know it’s asking a lot to suggest that in addition to monitoring the markets and plotting strategy, you should also monitor your broker. If you have the opportunity, check FXintel.com from time to time to make sure that your broker’s spreads are consistent with its competitors. If you suspect impropriety, check out some forex forums (see Appendix) in order to ascertain whether other traders have similar suspicions. If you are at all uncertain, don’t hesitate to contact your broker and even the CFTC or NFA if necessary. You’d be surprised that they care about your opinion.

Online Trading Risk

The final few risks to trading forex are more mundane but no less serious. First, there is online trading risk. The advantage of trading through an online platform is convenience. The disadvantage is that when your platform becomes unavailable, you will be vulnerable to losses. In the event of a power outage, Internet disruption, or server error, you will be unable to open new positions or close existing positions electronically. While this sounds far-fetched, most brokers acknowledge that their platforms crash from time to time. Mobile trading platforms take convenience to the next level but may still have some bugs and lack the same array of features offered by your desktop platform.

As part of your framework for risk management, you should plan for this possibility. If you have stops in place, you may be unaffected. Either way, you should make sure that you have your broker’s phone number handy so that you can make orders by telephone if need be. Make sure that your Internet connection is stable, and use a surge protector to protect your computer from electrical disruptions.

Interest Rate/Rollover Risk

Interest rates can strongly affect the profitability of your account. Most currency pairs are characterized by interest rate differentials, which generate rollover debits and credits for the position holder. Sometimes these differentials are quite small (less than 1%), which may be the case when a pair contains two major currencies. However, differentials can also be quite large, which is common in pairs that involve emerging currencies. In these cases, rollover may exceed 5% on an annualized basis. If you factor in hypothetical leverage of 5:1, this would be equivalent to $2,500 per year on a $10,000 account. Such a windfall would be cause for celebration, as long as you’ve opened a long position in the currency with the higher interest rate. If such a large amount of rollover were being subtracted from your account balance, however, you probably wouldn’t be so happy.

The best way to protect yourself against costly rollover debits is to monitor them constantly and make sure that you are aware of any interest rate changes. If you have a long position in a currency pair for which the differential is negative (or a short position on a pair with a positive differential), you should make sure you understand the resulting impact on your account balance. In this case, you will lose money every day that the pair doesn’t appreciate. On the flipside, you should understand that there is no free lunch in rollover. The theory of interest rate parity suggests that a positive interest rate differential (i.e., rollover credit) should eventually be accompanied by currency depreciation.

Country/Political Risk

The final risk in forex is that the country that prints each currency ultimately gets to decide how that currency can be exchanged. Governments can and do manipulate the money supply and impose rules that may be unfavorable to currency investors. They may engage in policies that spur inflation and impose capital controls that tax all short-term (currency) speculation. Central banks may intervene in forex markets without warning, causing exchange rates to jump by hundreds of PIPs or more. In some cases, there are difficulties in selling the currency (such as the Chinese yuan), while for other currencies there are doubts as to whether they will even continue to exist (namely the euro).

As a retail trader, there really isn’t much that you can do to guard against the possibility that a currency will structurally depreciate or even disappear. Instead, pay close attention to political developments and relevant news releases so that you can anticipate potential changes before they happen. You may want to (temporarily) avoid dealing with currencies for which there is a large degree of uncertainty.

Conclusion

As should now be clear, the risks in forex are real and numerous. The currencies themselves carry risk. Your broker carries risk. The central bank and monetary authority that issued the currency is a risk. In the end, however, all of these risks can be alleviated. Ironically, the one liability that is most difficult for you to hedge against is yourself. In Chapter 11, the final stop on this educational journey, I will look at this risk in more detail and offer some guidance on how to maximize your chances of success and avoid becoming just another sad forex statistic.