If we are to take to heart the famous one-liners of Gordon Gekko that “Greed is good” and “Money never sleeps”, then we must also remember that Risk never sleeps, as well. Risk also comes in many flavors, enough to give one a heavy dose of stomach acid and lousy sleep in any event. Risk in its many forms has been the pervasive theme of the foreign exchange industry for the past several years, but we suspect that many traders have looked the other way, hoping that the issues of risk were someone else’s problems.
If you are one of those traders, then you may also believe in the Tooth Fairy or you may have dumped a healthy wad of cash into the Iraqi Dinar, believing the marketing hype that promised wealth beyond your dreams. The truth is that when it comes to risk, you must always be on alert and on your toes. Choosing a broker is just one situation where risk can ruin your day. There are many others, and, since risk does not sleep, you must prepare for it, even if it never rains on your parade. To be prepared is to be forearmed.
What is one to do? The best recommendation is to set aside time on a regular basis to review where your exposures exist, go through a rudimentary assessment of each, evaluate your findings, and then decide on any corrective procedures. In many cases, you may only want to brush up on a few tried-and-true risk management techniques or modify how you approach each trading day from an information perspective. If red flags come up, then you may have to change brokers or at least spread the risk between two.
To help in this semi-annual review, we have listed a few critical areas to pique your curiosity, tweak a few brain cells to be more risk averse, and, hopefully, help you sleep while money and risk are dueling it out on the global stage.
Every forex related website is required to display a disclaimer that reads something like the following:
“Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest in foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite.”
Most sites will also counsel you that forex trading funds should only be a small part of your overall portfolio and be money that, if you lose it all, your financial standing will not be materially impacted. Concentration risk is all about not putting all of your eggs in one basket. The general idea is that, if you spread the risk across several investment types and items, then your overall exposure is reduced to a manageable level. The technical term for this approach is diversification. For the individual investor, Exchange-Traded Funds (ETFs) were created for this purpose. Each ETF invests in 20 or more securities, thereby spreading the risk in a way that the single investor could not manage.
This area is broad by nature. It often includes such things as their-party and counter-party risk, as well, but the general definition applies whenever “the person or institution with whom you have entered into a financial contract defaults on the obligation and fails to fulfill that side of the contractual agreement.” In the forex world, you may deal with a broker, a fund manager, or a service provider for example. Does each of these entities operate in a sound fiscal manner? Does each have adequate capital to support their business proposition? In other words, can they be trusted with your money?
These questions must be asked on a continuing basis because conditions change. The Swiss Banking Debacle rocked the industry when the Swiss National Bank removed its peg to the Euro. Many brokers across the globe sustained enormous losses and had to shut their doors. In some cases, national investor protection plans kicked in to refund a portion of client deposits. Firms that segregated deposits in separate Tier-1 bank accounts shielded customer deposits from the storm of bankruptcy in a few cases. The issue is that due diligence from time to time is necessary to ensure that your funds are safe and secure and that your business partners are on the up and up.
The forex industry is very competitive. You may often find that brokers outside of your country of residence offer enticements like greater leverage or larger bonuses that are difficult to ignore. Working with a foreign broker, however, can easily turn into a nightmare, if something goes wrong. Trying to enforce your legal rights in a foreign jurisdiction is next to impossible for a myriad of reasons. If you are going to use a foreign broker, you will need to be more thorough in your initial examination of its risk potential. Is the broker regulated? Does it have a long history of operational success, industry rewards, and favorable customer testimonials? Any problems with withdrawals? If you choose this route, start slow, test customer service, and ask for a withdrawal.
The Digital Age and the Internet have had a tremendous impact on our lives and how we access our accounts and information, but Cybercrime is growing like wildfire and is quickly approaching $1 trillion in annual losses. As one expert confided, “Today’s cybercriminals are talented, organized, efficient, and well-funded. In the last year, they have successfully attacked numerous retail and financial organizations, taking personal and financial data of hundreds of millions of consumers to fraudulently open new accounts, take over existing accounts and commit payment fraud.” Do you public wifi networks? Crooks congregate near such networks to intercept access codes and passwords, to be used later to access your account when least expected. Be aware!
In Forex Trading 101, we are taught the basics of risk and money management techniques for good reason. As the disclaimer states, “Trading foreign exchange on margin carries a high level of risk.” The forex market can be extremely volatile at times, and your approach to it must be prepared for surprises. Do you review the economic calendar for the day before you commence trading? Do you know at what time of day chaos might reign due to a scheduled release or event? Plan for event risk by keeping abreast of the news. Plan for volatility risk by estimating your risk/reward of a potential trade, planning for an appropriate stop-loss order in advance, and then gauging the size of your potential position based on sound money management principles. It is also advisable to stick with major currency pairs that you understand and to avoid any currency pairings that might involve a central bank “peg” of any kind.
If you do choose to dabble outside of the mainstream, whether with a minor or exotic currency pair or an over-the-counter instrument of some kind, you need to evaluate how liquidity issues might influence your exit down the road. Lower trading volumes in any security will lead to wider spreads and wilder swings in value when it comes time to sell, especially if the security is sensitive to economic, financial, political, and/or crisis shifts in the market. Central bankers at present are extremely worried that a large portion of the world’s capital is invested in low liquidity instruments that were perceived as high-return items when they were purchased. A dreaded liquidity crunch will occur if investors rush for the exits at the same time, as happened in 2008. In forex, the concern is that billions of dollars in Carry-Trade volume could unwind, instantly creating a tsunami of chaos.
Systemic or Systematic Risk
As per one authority, “Systematic risk refers to the risks that are an inevitable part of the market and cannot be eliminated. Systematic risk refers to events and occurrences that affect the market as a whole. Systematic risks in forex trading include wars, financial crises and so on. Systematic risk is not related to a particular currency pair, so it can’t be eliminated by diversifying over different pairs. That said, most systematic risks have winners and losers when it comes to currency.” Unlike stocks, a market crash will not drive all values to zero. Currency pairs are relative by nature, but extreme volatility can wreck the best trading strategy, no matter which side of the pair you have favored.
The crisis in Cyprus in 2013 and the Swiss Franc Debacle in January of this year represent two occasions where systemic risk built up over time, and then wreaked havoc on all market participants, some much more than others. Stop-loss orders and other risk management techniques are usually futile in these situations. Does your broker limit your losses to the position at hand or your full account balance? Are you responsible for negative balances that could occur when and if systemic risk hits? Are there national investor protection plans in force? Are client deposits segregated sufficiently?
These are just a few of the areas of risk that may give you cause for concern. There is no sure-fire method for determining absolute risk exposures, but investors have developed a number of mathematical tools (factor exposures, tracking error, value-at-risk (VaR), growth, value, momentum, alpha, beta, smart beta, etc.) to track price behavior on a relative basis to give some perspective on risk potential. The issue, however, as one analyst opines, is that, “These tools failed to predict the last crisis in 2008. In fact, historically, they have failed to predict every crisis. And they will fail to predict any crisis in the future. There is much more to risk than the observed movement of security prices.”
But, without risk, there is no potential for reward, and, as traders, we are trained to balance the two competing parts of the risk/reward equation. Awareness and ongoing vigilance are keys to winning the constant battle in the marketplace. Is there more risk now than in the past? Experts on the topic will state unequivocally that risk is truly greater now, primarily due to the complexities of investment instruments and their greater dependence on a growing economy, rather than collateral, to support their value.
At the end of the day, commit to regular risk reviews of your complete portfolio, list of service providers, and trading processes. Peace of mind does promote good sleep!
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