Trading foreign exchange is truly high risk – Here are the reasons why

Chris Lee

In this age of information overload, the obvious can easily become not so obvious when things get muddled. Forex trading is high risk, for example, but how many times do we get so caught up in everything going on in the market and the economy that we lose focus of that primary, overriding truth? There are mandated disclaimers that appear throughout every forex-related website to warn us that forex is a risky venture, but do we gloss over these warnings or do we always take them to heart? Let’s take a moment or two to remind ourselves of a few salient points, before we leap to our next trade.

Forex trades involve currency pairs, which means that, while someone is winning on one side of the trade, someone is losing on the other. After you deduct commissions and fees, most of which have been leveraged up for greater profit potential, the net result is not a zero-sum game. It is actually a negative-sum game, at best. The challenge is to beat the market by riding a trend for all it is worth, while cutting your losses at the knees. This strategy sounds simple enough, but the forex market can be ruthless in meting out its form of justice. As a result, casualty rates for beginners can run as high as 70% by most estimates. After a few more months, two-thirds of this remainder departs the scene, leaving only 10% to make a last stand, of sorts.

These facts are only part of the reason that foreign exchange has been classified as “high risk” in all investment circles. The high-risk connotation implies that our genre is complex, difficult, and requires specialized training, coupled with months of actual practice, before ever staking out your first position in the market. There are no shortcuts when it comes to experience, and the only acceptable method in the industry for shortening the learning curve is to find a mentor to guide your early learning process, much in the fashion of craft guilds from centuries past. Even with a guide at your side, you and only you can learn the lessons and develop the right habits to be successful in the forex profession, but persistence does pay off in the long run.

If successful forex trading were only dependent on knowledge and experience, then the casualty rates might actually be much less, but there is one other key component that needs to be addressed — the ability to control one’s emotions. You can have all of the talent in the world when it comes to feeling market forces and interpreting technical charts to your advantage, but, if you cannot control the inner workings of your mind, you can easily freeze in the headlights, as your emotional baggage, so to speak, undermines your decision-making process. You may or may not be cut out to be a trader. Not everyone is, and that is not a bad thing. It just means that you might be more successful in other fields of endeavor. Better to find that out early before losing big time!

How does forex trading rate with other investments when it comes to risk?

The foreign exchange market is the “Mother” of all markets, exceeding $5.3 trillion a day in turnover. When the total for international imports and exports combined for a year is less that $50 billion, one has to wonder why actual forex trading is thousands of multiples more? The answer is that there is a lot of speculation going on, as to how exchange rates might impact trade, investments, and capital flows across national borders. Even after backing out investment and hedging activities, some estimate that the amount of speculating in currency movements is easily over 80% of the activity.

Global banks, insurance companies, and hedge funds have a footprint in many markets across the globe, and, with this competitive advantage, they ply the carry-trade strategy to a great extent. Analysts estimate total current carry-trade positions to be in excess of $11 trillion, a coiled spring when it comes to forex risk, since a run for the exits would require enormous buying and selling, all at once. Volatility would go through the roof. The whipsaw effect could wipe out retail forex traders in a heartbeat. Similarly, when the Swiss National Bank removed the Swiss Franc peg to the Euro early this year, brokers and traders alike were wiped out in one gigantic tsunami of adverse market moves.

For these and many more reasons, textbooks rate foreign exchange as at the top of the investment risk pyramid (See Below):

In case you are wondering, forex trading falls within the category of “Futures Contracts” on the diagram. Speculation is at the tip of the investment risk/reward scheme of things. Yes, there is the potential for quick and great returns in the currency markets, but, with a high potential for reward, comes a high potential for risk, as well. Investors that wish to speculate are always advised to seek professional advice, get educated on the topic, and to never risk capital that they cannot afford to lose completely.

Is there a simple roadmap to follow to navigate safely in these risky waters?

As with most any investment activity, the three key factors for success in forex trading are knowledge, experience, and emotional control, with perhaps more emphasis placed on the latter factor due to the hyper-active and stressful trading environment that forex represents. These facts are often confirmed by surveys of successful forex traders that survive and thrive in this trading medium. Contrary to the public’s stereotype, forex traders are not necessarily all harried day traders. Many trading modalities exist, and many choose strategies that span days or even months to reach their financial objectives. Here is a simple roadmap for beginners that may seem obvious, but each of these three factors must be properly addressed and given the time it deserves:

  • Knowledge: Your first objective is to learn everything about your art as possible. Preparation is recommended before enrolling in a structured class or workshop. Read everything from books, to articles, or to websites devoted to the topic. The goal is to become so familiar with the material that when you do take a class, the subject matter will already make sense to you, and your ability to assimilate highly complex information will be greatly enhanced. Find a mentor that will guide your development, explain fundamental and technical analysis, help you design your personal trading plan, choose a broker, learn risk and money management techniques, and foremost, detail for you what a trading regimen looks like and how to determine if it is right for you;
  • Experience: It is said that the only shortcut for experience is to accept your “amateur” status and then find an expert to show you the ropes. Although this advice is highly recommended, a prospective forex trader must still invest hours practicing his trading plan until it becomes habitual. Fortunately, forex brokers have developed free demo account systems where you are given “virtual” cash to use with real-time currency quotes to trade on a hypothetical basis. Many experts swear by these systems and admit that they have practiced for months to achieve the level of consistency and confidence that the market demands;
  • Emotional Control: Although “demo” trading can go a long way to preparing you for the real thing, when real money is on the line and each decision is pressure packed with stress, the human mind does respond, but unfortunately, it tends to undermine even the best decision-making capacity known to man. Stressful conditions can bring out the worst in us all, and the only way to prevent this unnecessary mental intervention is with discipline. You must have a step-by-step plan that you will follow by the letter, leading to calm business-like decisions even when the heat is on.

The need for a step-by-step strategy cannot be over emphasized. If you do not fully grasp its importance, then you might want to read several articles regarding trading psychology and how the mind works when under stress. You will find that opening a forex position can be easy, but the true measure of your ability will come when it is time to close or extend your position. The echoes of every bad decision that you have ever made in life will rush forward from the recesses of your mind to freeze you in your tracks. The solution is to have something that you can follow with confidence in order to remove the distractions that will come.

Your practice regimen will be the only way to engrain healthy habits that will protect you when the market is moving in a chaotic fashion. Where can you find other healthy habits to live by? Veteran traders are more than happy to share their insights that have been garnered over years of being in the currency war trenches. There are often seminars, conventions, and scheduled meet-ups that involve the trading community. There is no need to trade in a vacuum. Find your trading “brothers and sisters” in your local area and share. As you talk to your brethren, a consensus will begin to form. Successful traders are patient – very, very patient! They have learned how to find their individual “edge” and how to use it for advantage in changing market conditions. Listen and learn.

Concluding Remarks

Do you want to be a veteran forex trader? The potential for fraud and risk is at every turn, but so to is the potential for gain and reward. The high-risk nature of this profession can cause high casualty rates for beginners, but, in many cases, it is the impatience of the newcomer that does him or her in after only a few months or even weeks of trading. If you do not wish to become one of these statistics, then invest the time necessary to develop prudent money and risk management skills, a mindset based on a disciplined approach, and a level of determination that is worthy of the task.

At the end of the day, you may or may not be cut out for this profession, but, if you are, be sure to have fun with it. Do not let it get you down. All traders have good days and bad ones, even the so-called experts. Losing streaks and anxiety are part of the game, and veterans have learned how to accept these conditions and move on. Healthy habits make wealthy traders! Good Luck!

Chris Lee

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