Dangers When Trading in the Forex Market

The forex market offers much opportunity to profit from the fluctuation in prices of currency pairs. Similarly there are some attending dangers in trading the forex market. Among those forex market dangers are: the risk of central bank intervention, trading an un-diversified basket of currencies and getting a margin call as a result of using too much leverage.

One of the biggest draws for investing when thinking of trading the forex market is the high leverage that is offered by forex brokers. In some cases, brokers offer leverage (margin facilities) in excess of 200:1. A trader who uses such a facility will be able to enter a trade for an amount of up to 200 times the free cash in his or her trading account. For example, with only $1,000 in a margin account a trader will be able to open a trade for up to $400,000.

Using a margin facility allows the trader to maximize the chance of making big profits from small moves in the market. The problem with highly leveraged accounts is that they also magnify trading losses, especially in the forex market where the market can move quite quickly. Depending on how much leveraging you are using, your forex broker will allow you to incur a certain amount of unrealized loss, beyond which they will close all your trades, leaving you with a huge loss. As an example, using a 50:1 leverage will cause you greater than 50% in losses after a margin call, should you not use a stop loss and good money management.

How to side step this risk – Margin calls are one of the biggest Forex market dangers that day traders can encounter. However, they can avoid margin calls by keeping their trading leverage below 3:1. If you use higher leverage it may just give the advantage to the market and your forex broker. Fast money has its pitfalls, but timely growth is tried and true.

Sometimes huge exchange rate moves can be anticipated or even predicted; in other instances it is impossible to do so. An example of this would be an instance where a central bank intervenes in the market to influence the exchange rate of its currency. In some cases a central bank may use rhetoric to accomplish its goals, but when talk fails it may take decisive action such as changing its monetary policy and/or directly intervene in the market.

For obvious reasons, a central bank won't always let the market know what it is going to do before it actually makes a move. The danger to forex traders is that such a move can completely upset the way exhange rates are behaving, including invalidating all technical analysis and previous trend of the currency pair involved. In a worse case scenario, a central bank's intervention can cause a trade to go against the trader by a huge margin and without warning. Figure 1 shows a rapid price reversal that occurred when the Swiss Central bank decided to intervene in the Market (March 2009), to halt the unrelenting appreciation of its currency against the Euro.

How to side step this risk – Your best protection against this risk is good money management, i.e. use a stop loss at all times and never over leverage your account.

Figure 1. Swiss Central Bank Intervention.

click to enlarge

On the next page we conclude by taking a look at two other forex market dangers, namely: news release surprises, overnight events and trading an un-diversified portfolio of currency pairs.