The foreign exchange market is a decentralized global marketplace for trading currencies with a daily volume of $6.6 trillion. It is by far the largest and most liquid market in the world. It attracts vast numbers of professional and retail traders and is ripe with risks that should be taken into consideration when trading.
It is more common for retail traders to overlook the risks associated with FX trading, and their choice of brokers or trading platforms is often the source of unnecessary risks and even scams. Every year, BrokerChooser picks the best forex brokers based on more than 500 criteria. Working with these service providers can greatly help reduce trading risks. The BrokerChooser website features more than 100 brokers reviews and our team works with more than 40,000 data points overall.
How to reduce risks associated with FX trading
Forex trading risks
According to Krisztian Gatonyi, senior analyst at BrokerChooser, any trader who wants to reduce their FX trading risks should take into account the following 15 forex trading risks:
- FX broker: Choosing a reliable broker that specializes in forex is essential. Generally, a good FX broker is characterized by low fees, great trading platforms, outstanding research material and a broad product portfolio. Short of working with an excellent service provider, traders run the risk of significantly lowering their success ratio in the long run.
- Regulator: a large number of brokers have different legal entities to serve clients in various countries around the globe. These entities are regulated by different authorities. It is recommended to choose top-tier regulators such as FCA or SEC, as their oversight adds an additional layer of safety.
- Insurance: Being eligible for investor protection is key for any trader. It is very important to keep the amount of maximum deposit below the amount of available investor protection. Thus, if the broker goes bankrupt, clients will still receive the amount of their deposit. For example, FSCS is considered a top deposit insurance and investors compensation scheme.
- Negative balance protection: Negative balance protection is offered by most forex and CFD brokers in Europe, the UK and Australia. It is for leveraged products, but only retail clients are covered, professional traders are not. In certain extreme market situations, brokers may not provide this type of protection even for retail clients. Brokers typically examine extreme cases individually, meaning that clients might lose more money than what is on their account.
- Liquidity: The FX market has the highest liquidity, which is a warranty in itself that prices can hardly be manipulated. Generally, more liquidity means less volatility. On the other hand, there are exotic currency pairs and situations where liquidity dries up, spreads widen and traders may be forced to sell their assets for a lower price than what they paid upon purchase. Exotic currency pairs are more prone to this type of risk, which can be avoided by trading major pairs where liquidity is very high.
- Leverage: At some FX brokers, the maximum leverage may be as high as 1:3000, which can be extremely dangerous for beginners. Highly leveraged trades can often end in a margin call where the broker notifies the client that their margin level has fallen below the required minimum level. Traders should be careful with high leverage as it might cause serious losses. The ESMA has a restriction of 1:30 on major forex pairs.
- Execution: In forex trading, there are two big groups of order execution categories: dealing desk and no dealing desk. No dealing desk is recommended because in this case client orders are routed directly to liquidity providers/the interbank market. A dealing desk broker is a market maker. When trading with a market maker, clients interact directly with the broker/dealer. A dealing desk broker may intervene by re-quoting client orders. A re-quote is when the broker is not able or willing to execute an order based on the price entered by the client. In order to avoid that, it’s best to go with an ECN broker which has no dealing desk.
- Platform: Choosing a reliable FX trading platform is essential. A solid platform will execute market orders properly and provide a clear order panel where the most relevant order types are available. Such a platform is the MetaTrader 4, which is the world’s most popular forex trading platform. This platform was developed by MetaQuotes. I have been using MetaTrader 4 for more than 10 years and I am completely satisfied with it.
- Volatility: There is a general misconception that the forex market is the most volatile market. Most major currencies only trade in a range of a few percent within a trading day. This is because forex is the most liquid market. Exotic currency pairs have lower liquidity, therefore the difference between intraday highs and lows can be wider. The volatility of balance can be high, if you use extreme leverage.
- Swap: The interest rate that you earn or pay with respect to a trade that you keep open overnight can be high. Always double check it before entering into a trade.
- Commission: Always check commission levels before entering into a trade because commissions can eat up your profits if you trade a lot in a short period of time.
- Slippage: Forex slippage occurs when an order is executed at a different rate than the one requested by the client. Such instances occur during periods of high volatility or when there isn't enough volume for a large order to be executed at a chosen price. In order to reduce this risk, it's best to use ECN brokers where the slippage is generally low. There is a so-called asymmetric slippage when the broker passes on negative price movements to the client but seeks to capture positive slippage for itself. This practice is illegal. Clients who choose brokers with top-tier regulators can avoid this type of risk.
- Gap: These are sharp breaks in prices with no trading occurring in between. The highest gap risks are in illiquid or volatile leveraged products. Crypto CFDs are popular products involving such risk. These are leveraged products, not available 24/7 like cryptocurrencies. There are market openings and closings, therefore crypto CFDs can open with large gaps during high volatility. Cryptos are highly volatile products in themselves but when traded as a CFD, traders run the risk of losing more money than their initial capital, as losses are based on the full value of the position, rather than just the margin deposit.
- Exchange rate: Prices are constantly changing, therefore the use of Stop Loss is necessary, which is designed to minimize your losses. Concentrate on the direction of long term trends where favorable reward/risk opportunities emerge.
- Time frames: This is the designated unit of time in which trading takes place. One candle can involve for example 1 month of information, 1 day of information or 1 minute etc. (MN, W1, D1, M1, etc.) Short time frames include shorter trends, lower reward/risk opportunities with higher psychological pressure. Always ‘zoom out’ and check trends in longer time frames to see the main direction.