How to spread and mitigate your risks in forex trading

Traders monitor realtme stocks trade. PHOTO | SHUTTERSTOCK

Market volatility is an investment term used when a market experiences periods of unpredictable, and sometimes sharp price movements. The term is not only limited to when prices fall, but also to sudden price rises.

Forex trading is prone to suffer from volatility from time to time as it deals with exchange rates, currency pairs, and global financial markets. As such, several risks are associated with forex trading. For the benefit of the investor, we will start by classifying the various risks inherent in forex trading.

The first is currency risk. This is associated with the fluctuation of currency prices. Currency movements can therefore wipe out or reduce a gain if the effect of the fluctuation is negative, but equally can enhance a gain if the currency movement is in the opposite direction.

Secondly is the interest rate risk which is related to the sudden increase or decrease of interest rates, which affects volatility. Interest rate changes affect forex trading prices because the level of spending and investment across an economy will increase or decrease, depending on the direction of the rate change.

Thirdly, investors als o face a liquidity risk, where a trader cannot buy or sell an asset quickly enough to prevent a loss. Even though forex trading operates in a highly liquid market, there can be periods of illiquidity, depending on the currency and government policies around foreign exchange.

Lastly is the leverage risk which is simply the risk of magnified losses when trading on margin. Where the initial outlay is smaller than the value of the forex trade, it’s easy to forget the capital you are putting at risk.

Mininising your risks

So then, how do you minimise the risk?

The first step a trader can take to mitigate risk and market volatility is through trading with regulated and licensed brokers only. Regulated brokers provide a guarantee of your money being used for your trading only and reduces the overall risk. Unregulated brokers can use investor’s money for the wrong purposes, and the investor has reduced legal recourse. In Kenya, only deal with brokers licensed by the Capital Markets Authority.

The next step is to understand the forex market fully and learn about risk management before starting your investment journey. Forex risk management enables a trader to implement a set of rules and measures to ensure that any negative impact of forex trade is manageable.

It is also important to build a good trading plan as part of the risk management strategy. A trading plan acts as your personal decision-making tool. The purpose of this plan is to answer important questions, such as what, when, why, and how much to trade with. It can also help you maintain discipline in the volatile forex market

When dealing with unpredictable markets, the risk-reward ratio should be calculated before investing as the markets are volatile and an investor should be sure of how much money is expected to be gained and what is the maximum loss that can be incurred.

The money invested in forex should be kept purely for trading purposes and the investor should be ready for both profit and loss.

Forex trading works like any other exchange where you are buying one asset using a currency – and the market price tells you how much of one currency you need to spend in order to buy another. The forex market is made up of currencies from all over the world and is primarily driven by the forces of supply and demand. It is therefore important to keep track of any economic or financial news that could affect the currency values and fluctuations.

Making predictions about the price movements of currency pairs can be difficult, as there are many factors that could cause the market to fluctuate. To make sure you’re not caught off guard, keep an eye on central bank decisions and announcements, political news and market sentiments.

And the rule of thumb is to always start with a demo account as it aims to recreate the experience of ‘real’ trading as closely as possible, enabling you to get a feel of how the forex market works. The main difference between a demo and a live account is that with a demo, you won’t lose any real money – meaning you can build your trading confidence in a risk-free environment.

It is also important to be in charge of your emotions in times of volatility. Emotions such as fear, greed, temptation, doubt and anxiety could either entice you to trade or cloud your judgment. Either way, if your feelings get in the way of your decision-making, it could harm the outcome of your trades.

And finally, be up to date on financial news such as inflation reports, economic performance, employment, central bank decisions. Major news events normally affect market and currency performance, and by extension forex trading.

Mr Karanja is the CEO, Scopes Markets Kenya

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