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How currency risk affects forex trading, and how to deal with it

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Risk is baked into the foreign exchange trading world at many levels. Without it, the speculation on which the
industry is based wouldn’t work: if everyone knew that they were going to receive a certain outcome or
amount of money, for example, it would be pointless participating, and there would be no incentive to put
down a stake. However, traders need to be aware of how currency risk can affect their trading.

The challenge, however, is that some forex traders don’t appreciate the serious levels of risk involved in
forex trading. They may, for example, think that it’s simple and easy to avoid risk, or that a risk management
plan is boring or unnecessary.

How currency risk affects trades and how to deal with it

This blog post will explain why currency risk is such an important issue to
understand – and why it should be acknowledged and dealt with by traders both large and small.

A definition of forex risk

First off, it’s worth defining clearly what forex risk is. A quick definition of currency risk from a trusted site
such as ForexTraders reveals that the definition is quite simple: it’s that the position you open may decline in
value after you opened it, leaving you with a lower amount of value than what you started with. In practice,
this is referring to what most people understand as the risk of loss.

For some institutions, the risk is inevitable. If you’re a business operating abroad, for example, there’s no
way of escaping the fact that moving profits back into your home currency could see value shaved off. For a
speculative trader, the risk is somewhat more academic as it’s not necessarily the only market that the trader
can participate in: those who want to avoid the risk altogether could, for example, trade only in domestic
asset classes. However, as this article will show, there are significant potential upsides to trading the
international forex market in a way that makes the most of the risk management tools available out there.

Risk-reward system

It’s also important to acknowledge that the rewards that a forex trader seeks are in many cases proportionate
to the amount of risk they put down. This is obvious mainly at an asset class level: the forex industry is
particularly volatile and risky compared to other markets such as those offering government bonds or similar,
so participation in the forex markets is in practice on the riskier end of the spectrum.

Risk-reward is also a factor when it comes to applying leverage, or trading on the forex margins, at the
transaction level. Foreign exchange trading is often carried out through the use of derivative products such
as contracts for difference, which track the underlying currency pair but don’t actually involve the transfer of
any ownership. It involves borrowing money to enhance the level of deposit, which means that the potential
reward in the event of a speculation proving correct is higher. It also, however, means risk of a higher loss –
so it works both ways.

Risk management tools

Fortunately, though, there are plenty of tools available to help those who want to manage their risk levels do
so. Risk management tools available with the average broker include tools such as stop losses, which allow
you to set (in advance) a level at which you order any loss-making open position to close. While this does
not remove risk altogether, it means that you can prevent a loss of more than a certain amount of money –
ideal if you want to prevent a big wipeout.

In many senses, however, the best way to manage risk is to make yourself as well informed as possible.
There are plenty of resources out there to help you do this: economic calendars, for example, can alert you
to potentially significant forex events – such as interest rate change announcements from central banks.

Risk is an inevitable part of the foreign exchange trading world, and there’s no point pretending that it doesn’t
exist. On the contrary, risk is an inevitable part of a forex trader’s life: it’s what fuels the risk-reward system
that can lead to gains. Those who want to avoid risk altogether are unlikely to ever find an asset class that
suits them fully, after all. For forex traders, by implementing quality risk management tools, it’s possible to
get a handle on your trading and manage the risk that will inevitably exist – and, if it all works out, secure a
profit for yourself at the end.

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