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Dangers When Trading in the Forex Market

written by: Steve McFarlane•edited by: Jason C. Chavis•updated: 5/3/2010

Trading the forex market can be very profitable for the disciplined and determined trader, but there are dangers in trading Forex. In this article we explain what these dangers are and how you can side step them.

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    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.

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    High Leverage Accounts and Margin Calls

    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.

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    Central Bank Intervention

    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.

    Swiss Central Bank Intervention 

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    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.

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    Forex Trading - Forex Market Dangers and RisksThis article highlights some of the Forex market dangers and risks that day traders will encounter. They include: new release surprises, overnight market events and trading an un-diversified portfolio of currency pairs.
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    News Release Surprises

    At other times surprises can come by way of better or worse than expected economic data. By and large, market participants will be fully informed as to when economic data is due to be released and will be able to plan their trading activities around such events.

    Even when new release dates and their times are known, the actual data and rhetoric for the authorities has a way of surprising the market from time to time. This can be an issue, especially for new traders, who are often completely unaware of the impact certain news events can have on the price movements of currency pairs. It is not uncommon for a new trader to sit before the trading station wondering why the market is suddenly going against the newly entered trade position so quickly and by such a large amount.

    How to side step this risk - No serious Forex trader will start a trading day without knowing what economic data is due to be released and which market shaker and mover is due to speak and for how long. DailyFX provides a free, and a near comprehensive economic, calendar that shows the scheduled economic release for all the major economies. It also rates each of the news events as having a low, medium or high chance of moving the market.

    News events that usually move the market include: employment data (jobless claims and unemployment rates), inflation rate, interest rate changes, GDP numbers and any change in fiscal and monetary policy on the part of the governments and central banks.

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    Overnight Market Events

    One of the things that makes the forex market attractive to those who trade it, is the fact that it’s a 24-hour market. This translates to more trading opportunities and greater flexibility for choosing what times to trade. This positive is countered by the fact that any trade position that is left open overnight poses a risk to the trader. No one can know for sure what event will cause the market to move, and in a direction that doesn’t favor the trader.

    How to side step this risk - Don’t leave trades open overnight without a protective stop loss if you find it to your advantage to leave the trade open.

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    Trading an Un-diversified Portfolio of Currency Pairs

    Some currency pairs have a degree of correlation to other pairs. For example, if the AUD/USD is rallying, it is likely that the EUR/USD and GBP/USD are rallying as well, because they are both US dollar currency pairs. If your money management strategy dictates that you should have no more than one trade on one currency (at the same time), then entering a long trade on any of the two above mentioned pairs will in effect be double your exposure to the USD (the currency that is common in the pairs).

    How to side step this risk - When choosing currency pairs, for your trading portfolio, you should determine the correlation between the pairs before you proceed. Avoid trading two pairs that have a high correlation. You may want to look at a number of US dollar currencies to help you see, more clearly, the overall direction of the US dollar, but trading two similar pairs is asking for trouble.

    As an exception to this rule, you can use highly correlated pairs to hedge (offset) another trade. For example, buying the AUD/USD and shorting the GBP/USD is, in theory, taking a neutral position on the US dollar. Of course this is an advanced forex trading strategy for experienced and knowledgeable traders only. You can find a good currency correlation resource at Mataf.net.

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    Summary

    As with all things in this life, there are risks. If currency trading had only high rewards and no risk, everyone could become rich trading in this market. However, to be successful in this market you have to be aware the dangers and learn to side step them. We hope that this article has helped you to identify some forex market dangers.

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    Image Source

    Swiss Central Bank Intervention.(Image supplied by the author; all rights reserved.)