Forex trading has always been popular, and the forex market today is the largest in the world, with a daily trading volume of trillions of dollars. However, like all other forms of trading, forex traders face a certain level of risk.
Below are four dangers that forex traders may fall prey to and how you can stay on guard to protect your portfolio.
1. Not knowing how trading tools and strategies work
Most traders have an idea of how forex trading works and can do so fairly well. However, it is a very broad activity and there are many intricacies within, ranging from technical analysis to trading with CFDs and leverage.
Not knowing how trading works mostly applies to traders who want to try out new methods and strategies and use different types of trading tools. For example, scalping requires a slightly different skill compared to day trading, which requires a slightly different skill compared to swing trading.
The most important thing a trader can do before launching into trading with an entirely new strategy is to educate themselves. A little practice can also go a long way, and demo accounts are a great option for those who want some practical experience before taking to the real market.
2. Fear and greed
Having emotions makes you human and can work in your favour when trading, but they can also become a source of detriment when not managed properly. When you tap into negative emotions like fear and greed while trading, it may result in lower net profits or even catastrophic losses.
Fear can paralyse in traders and cause them to freeze up when prices begin dropping. They can also cause indecision when opening and closing trades. One way to prevent fear from messing up your trades is to set stop loss orders when you open a position. Stop loss orders close your positions when the price of a currency hits a certain level, and this is done automatically to minimise losses.
Greed needs little explanation. Often, forex traders find themselves being tempted to open bigger positions and take bigger risks after a first taste of winning. Ambition is not necessarily a bad thing, but greed can cause traders to stray from their trading plans and make impulsive decisions, which can lead to losses when the market moves against their favour. The most important thing is to be content with what you have and only enter trades that you have considered thoroughly.
Overtrading is another danger that forex traders may fall prey to over time, especially retail traders who participate in the market in their spare time. For many traders who have a limited amount of time each week dedicated to trading because of other responsibilities such as a job, children, or dependents, they may be tempted to ‘make the most out of’ the window of time they have by executing as many trades as they can.
Overtrading puts traders in a vulnerable position because having many positions open at a time is hard to manage. Traders should exercise restraint and focus on one trade at a time, or, depending on experience, up to a handful of trades at a time. This way, they can devote the proper amount of attention to each one and ensure they are not creating a dent in their account.
4. Not understanding currency pair correlations
Finally, currencies are traded in pairs in forex trading, and therefore they are inexplicably linked to each other – or, in other words, correlated. Not understanding this can lead to traders opening several positions that cancel out each other. For instance, going long on EUR/USD and USD/JPY essentially ‘cancels out’ your position on USD to some extent, depending on the amount of each currency pair you trade.
Not understanding currency pair correlations can also lead to traders opening positions with the same base or quote currency, which can greatly increase trading risks. For example, when a trader goes long EUR/USD and GBP/USD, the currency pairs will be positively correlated because they have the same quote currency – USD. If the USD weakens, it will have a big effect on the trader’s portfolio.
Understanding these correlations can help traders better control their positions and their exposure to market risk. It can also be used in their favour, as many traders take advantage of this correlation when utilising techniques such as currency hedging.
Though forex trading is relatively straightforward in theory, it is a little more complex when put into practice. At the end of the day, aside from having a thorough understanding of how trading works, it is important to be disciplined and steadfast in trading. Traders should also never take bigger risks than they can afford. Novices who are eager to start making money should remember that while profits can be exciting, it is more important to protect the capital they have.