As the biggest financial market in the world, forex presents plenty of opportunities for investors. But is it riskier than trading shares? Read on to find out.
Forex (short for foreign exchange) forms the biggest financial market in the world, with a daily turnaround exceeding $4 trillion. In contrast, the daily turnaround for shares is approximately only $60 billion. The forex market is also completely over-the-counter, which means it operates through online platforms alone and can be accessed 24/7. Without a physical market location, it has significantly greater freedom from regulation than the share market does.
As such, forex trading presents many opportunities for different kinds of investors. However, investors need to understand that trading forex is fundamentally riskier than trading shares.
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Taking a forex position is not an investment in the sense of holding a security medium to long term for appreciation. Large fluctuations in exchange rates occur very rarely. In forex trading an investor must take a short-term leveraged forex position to magnify any potential gains. While share brokers only allow a leveraged ratio of 2:1, forex platforms allow a leverage ratio of up to 50:1, or even 200:1 in some countries. Leveraging is done through borrowing money from a broker and is also referred to as “margin trading”.
While margin trading increases potential gains, it also steeply magnifies the risks involved. A small market movement can have an enormous impact upon the worth of a forex portfolio. If an investor cannot meet their margin calls, their position will also be closed out. Unlike leveraging in share trading, this closure is without any forewarning. All in all, leverage is highly risky in the forex context.
Forex trading also bears higher risk as forex movements are much harder to predict. Investors can use the fundamentals of a company’s shares to forecast their future prices, but there are countless factors that may affect the value of a country’s currency.
Some of these factors are systematic, such as the Gross Domestic Output (GDP), the Consumer Price Index (CPI) and the employment rate. However, it has been historically observed that it is totally unexpected, ad hoc events that most dramatically affect exchange rates. Brexit is a perfect example.
A political situation, a decision by the country’s central bank or a natural disaster can affect an exchange rate in unpredictable ways. Even the most skilled and up-to-date investors will struggle to fully foresee the effects of these factors.
In addition, a country’s currency is always quoted in relation to another, so, whilst a shareholder can primarily focus on the financial prospects of one company, a forex trader has to monitor the wellbeing of two countries. Likewise, unlike shares, forex has very few structured models and databases accessible by private investors.
The substantial risks of forex were clearly illustrated in the Asian Financial Crisis of 1997, where multiple Asian currencies spiralled out of control.
Unlike shares, forex trades are not guaranteed clearing by a physical exchange or clearing house. This means that an investor also faces significant counterparty risk. For example, their dealer might default in delivering the purchased currency.
Risk management strategies
An investor can use stop-loss orders and profit limit orders to reduce their forex risk exposure. Both of these close out a forex position if the exchange rate has reached a certain point.However, a fee will be charged for both of these orders and their utility is highly limited in comparison with the tools available for shares.
Hedging and diversification
Despite these risks, forex is recommendable to investors to complement their investment portfolio. The risk characteristics and international nature of forex offers an investor two layers of diversification. Holding a limited amount of a country’s currency can also be used to hedge against interest rate risks for said country’s fixed income securities.
The bottom line for retail investors is that despite the convenience of forex trading, forex should only be considered as a part of their investment portfolio if they have both the knowledge and the risk appetite.
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Comparing the risk between forex and shares - top tips for investors
Forex is fundamentally riskier than shares
You need to keep in mind that due to the country, leverage and counterparty risks mentioned above, currencies are riskier than shares for the private investor. It’s true that you don’t have to leverage to invest in forex, but this will render your potential gains virtually negligible. You’re better off focusing on what you can do to predict forex directions.
Know the countries of your currencies
With so many factors to consider when trading currencies, you should study the country pairs you are trading in depth. A crucial starting point will be seeing how your countries have reacted to historical events that have significantly affected their exchange rates. This will allow you to forecast your currencies’ price sensitivity to similar future events.
Keep up to date with the news
You should closely monitor the national, regional and international news for your countries on a daily basis.Pay close attention, as a small event may snowball to have a dramatic impact upon an exchange rate.
Use stop-loss orders and profit limit orders
You can use these orders to safeguard your forex portfolio through automatically closing off your positions. However, do keep in mind that these will limit your potential gains and you will be charged a fee for them.
Do not risk more than what you can afford to lose
Many currencies in the forex market have been going through a rollercoaster ride recently. You need to understand that if you are unable to meet a margin call, your position may be closed immediately and you might not be able to recover any of your initial investment.