Forex Risks: Is Forex Risk Free?

 Risks are the first thing to consider for anyone who plans to try themselves as a trader / investor. Risks of losing money due to force majeure, risks of getting into the “meat grinder” of market makers who will mix all the cards, risks of simply making a mistake in technical analysis or missing something in the fundamental. It is impossible to completely avoid risk, but it can be optimized or even minimized. Read on to learn more about risk management in Forex and how to minimize / optimize trading risks in trading and when building an investment portfolio.

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Types of trading risks and how to minimize them: a quick guide for beginners

On Thursday, January 15, 2015, the Swiss Central Bank shocked the foreign exchange market by lifting the ceiling of the franc-euro exchange rate, which had been held for more than 3 years. Immediately after the announcement of the Central Bank, the franc rate soared against the US dollar and the euro by more than 30%, the Swiss stock market, on the contrary, collapsed by 10%, which caused exporters to suffer. The consequences for traders were disastrous. Those who were shorting the franc (holding a pair of short positions) simply lost their deposits at the stop-out in an instant. Brokers who reported problems with liquidity were also not lucky. 

On Saturday, September 14, 2019, Saudi Arabia's oil facilities were attacked by drones, resulting in the withdrawal of capacities that make up about 50% of the country's total capacity and carry more than 5% of the world's oil supply. With the start of trading on Monday, Brent crude oil futures soared 19-20%. This marked the record intraday gains since the 1991 Gulf War. Those who did not close short trades before the weekend were out of luck.



Both of the above examples are trading risks. It is impossible to foresee them fully. Therefore, as always, there remains the possibility of force majeure. But you can minimize it; moreover, as the risk increases, the likelihood of profit increases. Take the same example with oil: if traders with short positions suffered losses, then those who bet on growth earned 20% in 1 day.

In this article, we will analyze:

  • Types of trading risks and how to minimize them: a quick guide for beginners
  • Types of risks in trading
  • The nature of the emergence of trading risks
  • Hedging and locking as a method of risk insurance
  • How to minimize trading risks (general recommendations for an investment portfolio)
  • Basic rules of Forex trading without risk

 Learning to minimize trading risks and protect your investments

There are many classifications of risks in trading. There is no strict delineation here. In addition, different sources use different terminology, which also introduces some confusion. 


Types of risks in trading

  • Trading risks. The risk of loss due to market factors affecting the direction of price movement, as well as due to an error in the analysis (forecast) of the market situation.
  • Technical risks. The risk of loss due to technical problems: platform freeze, order failure, broker fraud, etc.
  • Psychological (behavioural) risks. The risk of error due to the emotional state of a person: excitement, fatigue, euphoria, greed, etc.

I will only consider trading risks.

Trading risks are the uncertainty of future price changes under the influence of market and non-market factors. In fact, a trader has only one risk in the case of an already open deal - an error in determining the direction of price movement. If the price moves in the opposite direction to the open trade, the trader gets a loss. 


If the deal has not yet been opened, then the trading risk consists of an error in predicting the direction of the trend or its reversal. Note that as such, there is no clear definition of the term "trend", so its understanding by traders is subjective. The trader himself determines the value of the critical amplitude (price reversal), which is called the risk limit and depends on the amount of money on the deposit. In other words, one trader is ready to withstand, for example, a drawdown of 100 points, another - 20 points. Everyone determines the level (limit) of risk for himself, but for this, you need to understand the nature of its occurrence.


The nature of the emergence of trading risk


  • Error in analysis and forecast. Any publication of statistical information, release or results of a meeting of the Fed, Central Banks, etc. have a consequence. The only question is, did the investor correctly assess the significance of this or that news? And did the majority's predictions come true? A trader must take these and other factors into account in the forecast. And mistakes are not uncommon. And also quite often the trader releases something, forgets to foresee, which is why he makes a mistake in the forecast.
  • Force majeure. It can take any form: an unexpected political decision, a man-made disaster, a terrorist attack, the discovery of new deposits of minerals, the entry into the market of a new product that was not previously announced, a sudden bankruptcy. Force majeure can have both immediate and long-term consequences. Examples of long-term force majeure include the collapse of the dot-coms and the mortgage crisis in the United States, which has turned into a global one. By the way, some have managed to make money on the mortgage crisis. (I recommend watching the movie "Selling a Fall", which describes this situation well).
  • Human factor. An error in the interpretation of patterns, signals due to fatigue, inattention, etc.

Another classification provides for a simplified separation of the causes of trading risks into the risks of forecast errors in technical, fundamental analysis and the human factor. I have already listed the reasons for the fundamental risks in the "Force Majeure" paragraph above; I will dwell on the risks arising from errors in technical analysis.


1. High volatility at the time of opening a trade. The greater the volatility, the greater the amplitude of price movement, the more and faster you can earn on it. It seems to be logical, but the risk lies in assessing this very volatility because, on the reverse price movement, you can lose more than earn. Indicator data is subjective, like volatility calculator data. 


  • Council. Define volatility visually. The price corridor can be determined by the amplitude between opposite fractal extremes or a cluster of candles. For a start, you can practice on history. At first, it will be difficult for beginner traders to do this (I know from experience). Therefore, the second piece of advice: increased volatility, different from the daily average, is observed at the time of the appearance of fundamental factors. Just don't open trades at this point.

2. Level trading. The trading strategy of trading by levels is individual: someone opens trades "for a rebound", someone - for a breakout. For some, this is a loss limiter. A "Turbulence Zone" is formed around fractal levels - a zone in which the price on short timeframes moves in different directions with a relatively small amplitude. Forecasting price movement in this zone is ineffective.


  • Tip: Use the levels only as a guide. Open trades outside the levels and try to avoid placing at resistance and support levels of stops, because this can be used by large traders (market makers, which will be discussed below). If the deal has already been opened in the direction of the levels, then it is better to close it before reaching it. Otherwise, slippage rebound may occur, which will impair the result.

In essence, the question boils down to determining whether the breakout/bounce of the level is true (trend) or false (correction). Sense of taking risks?


3. Opening deals in overbought and oversold zones. We are talking about the risk of entering the tail of the ending trend. The classic mistake is trying to "jump into the last car of a departing train." That is, to open one deal (and then, possibly, several more) at the moment when, for example, the uptrend has already accelerated. At the peak of growth, big players cut deals by "cutting hamsters." 


It seems logical to use the same RSI or stochastic, but they are ineffective to minimize risk: they often lag behind, reverse in the zones themselves, etc. Therefore, even using special indicators to determine zones, a trader runs the risk of making a mistake in the forecast.


  • Council. We define the signs of a trend slowdown as follows. We compare the amplitudes of three neighbouring fractal areas in the M1 time interval (the trend deceleration can be seen earlier on it). If you can see a decrease in the amplitude (the amplitude of each subsequent fractal decreases), then we can say that the trend has exhausted itself.

And the most sensible and simple advice: enter at the beginning of the trend, and do not try to follow the lead of the crowd. Be careful when interpreting indicator signals; there are no reliable indicators.


4. Opening deals when there is no clear-cut trend. We are talking about situations when a trader takes a correction or a local price surge as the beginning of a trend movement, which is often observed in a flat. It is difficult, especially without experience, to visually determine the border of a flat, since it does not have a clear beginning and end.


  • Council. I propose again to refer to the comparison of the price movement amplitude within a flat. If on a short timeframe there is a movement with an amplitude significantly deviating from the average value, you should get ready. Take your time to enter the market. The first movement may be a correction. Analyze several timeframes at once: signal - M1-M5, confirming - higher intervals.


Alas, there is no optimal risk mitigation advice in this situation. There is still a risk of both making a mistake in determining the trend and being late with a successful entry point if it is confirmed.


5. Errors in the selection of indicator parameters. The consequence is the wrong interpretation of the signals.


  • Council. Before running the indicator with the selected parameters on a real account, test the system ( MT4 tester, FxBlue ). Read more about testing and optimizing strategies in this review.

6. Application of pending orders. Pending orders are used in tactics based on opening deals when the price exits consolidation zones. Orders are placed on different sides in the expectation that one of them will work. The essence of the risk is that the place of placing a pending order is determined rather intuitively and has nothing to do with price dynamics. The distance is calculated, for example, as a percentage of the average value of the movement of quotations in the consolidation zone. There is still a risk that the price will leave the zone, touch the order, and then move in the opposite direction.

  • Advice: avoid to reduce the risk of trading strategies for pending orders.

7. A sharp decline in quotations on the condition of opening a long position. There are examples when the price changed by 500-1000 points in a matter of minutes. It is logical that few people had time to react, let alone make a decision and carry out a deal.

  • Council. Use your feet.

8. Actions of market makers. The private trader is just a pawn in a big game. Market makers are large players who are able to influence quotes with their capital in the direction they need. They can form a preliminary necessary informational background, manipulating forecasts, analytics and information through the media, forums and other resources. 


But not only this is their main weapon. They can see the places of accumulation of buyers and sellers, that is, predetermined stops and limit orders. As practice shows, most of the traders place stops in the area of ​​local extremes and are tied to strong or round support/resistance levels. Pending orders can also be placed there. Market makers act against the crowd, pushing the price to the areas of congestion of orders, as a result of which, contrary to forecasts, half of the traders have their stops triggered.


Example. The market maker wants to sell the currency at a more attractive high price. He sees above the current quotes (green horizontal line in the screenshot below) the places of accumulation of stops, which are, in fact, buy orders. On the other hand, the market maker sees congestion of limit holders at the same level, which will not allow the price to rise even higher (volume balance). 

 



With small orders, it pushes the price up to the desired level, after which it satisfies its sell volumes due to buying orders (stop loss). Considering the number of short orders in response, the price is unlikely to go further up.

  • Council. It is pointless to oppose market makers. Therefore, you need to learn how to identify potential areas of order accumulation and try to avoid them. And also take into account that indicators cannot anticipate the sudden actions of market makers. Therefore, it makes sense to focus less on indicators and pay more attention to levels, patterns and exchange information (volumes, order book).

If you can suggest any more potential risks of technical analysis, write in the comments. We will look for options for their minimization and optimization together.


In terms of reducing the risks of forecast errors, there are few recommendations in fundamental analysis:


  • Do not blindly trust what is written in the media, especially the "author's" forecasts. Rely on official statistics from news agencies and official resources.
  • Use auxiliary analytical tools: economic calendar, stock screens.
  • Evaluate statistics over time, comparing them with analysts' expectations and with the results of the past.

And be ready to react to force majeure instantly.

Hedging and locking as a method of risk insurance

Hedging and locking essentially mean the same thing - creating a so-called lock, that is, opening two deals in opposite directions (I won't go into the fundamental difference between them - the essence is the same). Suppose a trader entered a long position, but the price went down. The trader opens the opposite position with the same volume. The gain on the second offsets the loss on the first position. 

Advantages of locking:


  • With the correct placement of "locks" and their timely unlocking (removal of a losing or safety position), you can even earn money on it. There is even an order grid trading strategy.
  • Locking allows you to manage a floating loss, which is not reflected in the balance sheet and does not spoil the trading statistics. 

There is only one drawback of locking: with inept opening and closing of insurance and basic transactions, the trader will more quickly get a loss both on transactions and on the spread. Therefore, locking for a novice trader belongs to the category of high-risk instruments by analogy with Martingale, while in the hands of a professional locking and hedging is a method of ensuring unprofitable transactions.

The locking strategy and rules should be highlighted in a separate article. And if there is a need for this, write about it in the comments.

 

How to minimize trading risks (general recommendations for an investment portfolio)

 

1. Diversification.

 So far, there is no better recommendation on how to protect investments from trading risks. But the ability to properly diversify an investment portfolio and periodically rebalance it is a kind of art.


Diversification types:


  • Separation by assets. The most obvious type of diversification. Moreover, the distribution of the portfolio can be not only for different currency pairs or stocks but also in the direction of deposits, precious metals, cryptocurrencies, antiques, real estate, etc.

  • Diversification by risk level. There are assets that, on the contrary, become more expensive in the event of force majeure (for example, gold). There are assets that, even in the event of sharp market fluctuations, hardly change in price. There are assets with a volatility of 5% per day. Distribution of investments between assets with different levels of volatility, risk (and, accordingly, profitability) is the diversification of risks. I advise you to read the article on defensive asset

  • Institutional diversification. Here we are talking about working with several counterparties: different brokers, Forex and stock exchanges, trust management, etc. If in the event of force majeure (as in the example with the Swiss franc) one counterparty goes bankrupt, then at least the rest of the money can be withdrawn from the other.

  • Applied diversification. Distribution of investments among strategies with different levels of risk: Martingale and conservative tactics, scalping and long-term strategies, manual and algorithmic trading.

  • Statistical diversification. We are talking about direct and inverse correlation. For example, corn and wheat futures most often have the same price direction; the USD and gold are different. A portfolio with inversely correlated assets will be less profitable, but more protected since, at the moment of a fall in the price of one asset, an increase in the price of another asset compensates for the loss.

Diversification of investments is limited only by the imagination of a person and his ability to feel and analyze the market. And also the appetite for risk, since the higher the risk, the higher the potential profit. Therefore, trading risks are often intertwined with psychological risks.


2. Technical insurance of trade risks:


Setting a stop loss. It is appropriate here to compare with drivers who for some reason, ignore the mandatory rule to wear seat belts. It is difficult to say what motivates people who do not use protective tools. On the one hand, market makers know the approximate places where stops are accumulated and specifically push quotes to catch them. On the other hand, it is precisely the stop that will save you from the gap that has arisen in the event of force majeure. And one more argument: in a volatile market, a trader may simply not have time to react to a sharp price change, but a stop-loss will partially save the situation.


Closing deals before the weekend. Sometimes the situation on the Forex market changes dramatically within an hour. On weekdays (let's assume that a trader works 24 hours a day), you can still have time to react to force majeure. On the other hand, weekends, when markets are closed, can bring unpleasant surprises. An example is drone attacks on Saudi Arabia. It is even worse if the market opens with a gap (price gap) after the weekend.


The moderate use of leverage. Everything is logical. On a long shoulder, a small force majeure is enough to close with a stop out . 


Calculation of the lot size in accordance with the volume of your deposit, the level of risk for the transaction and the deposit, and other factors. More on this in this article .


Basic rules of Forex trading without risk


  • Before opening a position, conduct a thorough market analysis. In this case, we mean that the signals of trading indicators alone will not be enough, even if they have been confirmed. You must understand what is happening in the market. Be sure to follow analyst reviews and follow economic news. Don't neglect the economic calendar.

  • Your trading strategy should spell out your every move in the market. If you feel the need for something that is not supported by your trading system, you should improve it. It should represent a clear plan, a guide to action with strictly specified conditions for each of them and methods for their determination.

  • Risk diversification is the most important point in any trading strategy. Use no more than five percent of your deposit in trading. Let your trading instruments correlate with each other to a minimum - then your risks will be less. There are many ways to diversify risks - learn them.

  • Stop losses are your everything. Not showing them is bad form. In addition, they perfectly protect against drawdowns and allow you to maintain the maximum profitability of the transaction. Methods for placing stop orders are varied and numerous - choose what you understand best, so you can correctly apply them.

  • Even though trend trading may seem boring and you want something original, it is a classic, and therefore the most reliable and predictable. Despite the fact that trading with the trend is recommended for beginners, many experienced currency trading professionals have chosen this type of strategy for themselves because of their fundamental nature.

  • Losses are part of your earnings in Forex. You shouldn't try to recoup or stubbornly wait for the trend to get back on track. A professional suffers losses and exits a losing trade on time, because he knows that a trader's income is a positive difference between losses and profits

  • Keep yourself together! Leave all emotions aside - rely on a trading strategy. It is she who should guide you as a trader, and not feelings (greed, resentment, fear, and so on).

Conclusion. 

There is no risk-free Forex strategy. Is it necessary to minimize trading risks on Forex? My opinion is no. Those who want to minimize risks may not engage in trading at all, investing money in a deposit. Risks need to be optimized by adequately assessing your abilities and the ability to come to terms with losses. Risk limitation policy and their balancing is a risk management policy, the development of which is mandatory before starting trading on a real account. Only you yourself can develop a risk management system, because there are no uniform mandatory recommendations here. I hope that the links in this review will help you to some extent in developing your own risk optimization policy. 


There are questions, there are comments, you disagree with something or would like to add something - write comments! And good luck with your trading! 

 

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