The Pros and Cons of Forex Trading (And Risks to be considered by Forex Traders)
Forex trading can be challenging to engage with but is often perceived as the highest and most popular moneymaking career. It is especially true for those with a good background in the forex exchange market.
The forex exchange is the largest and most lucrative and facilitates the buying and selling of currencies and other financial instruments. The aim of forex trading is synonymous with stock trading — to yield a very high return (profit) by purchasing securities at a low price and selling them at a higher price.
Assets in the forex market are considered highly liquid assets due to their high trading volume. Trades consists of options, foreign exchange swaps, spot transactions, currency swaps, and forwards. Trading forex assets also means higher risks that can generate substantial losses.
“Settlement risk is one of the major risks connected with forex trading. This occurs because of the difference in time zones on different continents. Forex currencies may be traded at different prices and hours during the trading day. The AUD and New Zealand Dollars are credited first, then comes the Japanese Yen, followed by the European currencies and ending with the US Dollar”, says Emilia Flores — a financial advisor at UKBadCreditLoans.
“In assessing credit risk, the trader must consider not only the market value of their currency portfolios but also the potential exposure of these portfolios”, she adds.
Some of the most prominent risks associated with forex trading include:
1. Interest Rate Risks:
Of course, interest rates could impact a country’s exchange rates, and if a country’s interest rate falls, its currency will be weakened due to the withdrawal of investments from that nation’s assets. The reason is that a weak currency results in lower or no returns, and the same rule applies if the country’s interest rate increases, the currency will strengthen due to an immediate influx of investments in the said country. A tremendous effect of interest rates on exchange rates, the difference between currency values would cause forex prices to change significantly.
2. Domestic or Country Risk:
Forex traders always need to assess the stability of their country when looking into their options to invest in currencies. Most countries have their own exchange rate except third world countries that create a fixed exchange rate for an advanced country, such as the United States Dollar. To sustain a fixed exchange rate, the Central Bank of the issuing country must improve adequate reserves to prevent a currency crisis. This happens when a constant deficit exists in a country’s balance of payments and causes the currency to be devalued, and results in a substantial effect on forex trading and prices.
Why? Because an investor might withdraw his assets if he believes a country’s currency will fall in value, thereby causing the further devaluation of such currency. A trader could continue trading with the currency, but doing this will incur a significant loss or insolvency from their dealers.
3. Transaction Risks:
These are risks associated with the timeframe to exchange currencies. It is the difference in time between the beginning of trading activity and when it is complete. Trading on the forex market happens within 24 hours and can cause exchange rates to change before trades have been completed. Also, currencies may not be traded the same as they could be exchanged at different prices and at separate times during active forex trading hours.
Transaction risks increase when the time difference between entering and settling a contract becomes greater. A change in time allows exchange rates to fluctuate while individuals and firms trading in currencies face outrageous transaction costs.
With so many risks involved in forex trading, there are some pros associated with it that every trader must consider.
1. There is a Low Barrier to Entry
There’s a big opportunity for traders of varying experience levels to make a swift entry into the forex market. New traders have access to countless forex technical indicators to draw on for their trading activities, and long-term forex traders have a selection of tools and fundamental analysis theories to choose from.
The forex market is the most flexible financial market to open an account and begin trading, and it can be done from anywhere in the world.
2. Small Amount of Capital Required
Pips usually give tight spreads making it easy for traders to start forex trading with a small amount of capital. It is harder to trade in other financial markets like futures or options without more capital. It is also easier for forex traders to gain a higher profit potential with limited capital on huge margins. This is true for margin trading with a high leverage factor in the contract size of (50:1), which acts as a sweet spot for traders.
3. Volatile Opportunities:
Some of the most popular currencies frequently go through high price swings and provide forex traders with good opportunities and higher yields from trading. This makes the foreign exchange market the perfect choice for day trading strategies because high volatility provides huge profit-making opportunities.
4. The Forex Market is Always Open
Unlike the stock market, the foreign exchange market is open 24 hours a day, 7 days a week, making it super-convenient for traders of all shapes and sizes to trade at their own times and market shifts. The time and location of a day trader do not make a difference. You can always resume trading activities as long as you have a computer and a stable internet connection.
5. High Liquidity
The forex market cannot be matched or compared with any capital market as it has the biggest liquidity or notional trading value in the world. The level of high liquidity gives traders an edge of having big orders of currency traded and exchanged with ease without large price fluctuations. Therefore, price manipulations are out of reach and give room for tighter spreads which lead to efficiency in the pricing of assets in the market.
Sometimes, unexpected events can happen. An example of this is a sudden drop in the exchange rate of a currency which negatively impacts the liquidity in affected currency pairs while the forex market reacts to the sudden market shift. Other than that, forex traders will experience simple price patterns throughout the continuous trading sessions, whether high, mid, or low market volatility.
The foreign exchange market also has a list of disadvantages compared to other financial markets which include:
1. Presence of Professionals
One of the downsides of the trading industry is that forex traders are always up against professionals such as multinational corporations or central banks of major countries in the world. They play an important role and could directly impact the foreign exchange market. New and upcoming forex traders might feel intimated by them and don’t stand a chance to succeed in the market when faced with these giants.
2. Lack of transparency
The foreign exchange market may lack transparency due to its deregulated nature and the dominance of brokers with multiple interests in the financial market. Each broker has a separate jurisdiction and operates differently, which means forex traders might not have total control over the fulfillment of trade orders or the best price of the financial instruments to trade with. So it’s always wise for traders to seek options from brokers that operate under regulatory standards.
3. Knowledge of Macroeconomics
Forex trading is all about trading multiple national currencies and is always affected by economic or world events. Traders need to have a background and expertise in macroeconomics to make informed trading decisions and generate consistent profits. Lack of thereof might result in losses while dealing with international currencies and other financial instruments.
4. Valuation of Exchange Rates
“Exchange rate risk is the risk associated with currency value fluctuations. It is predicated using the effect of ongoing and typically dynamic fluctuations in the global supply and demand balance. This risk can be huge and is based on the market’s assessment of how currencies will move in response to all possible events occurring (or potentially occurring) at any one time, wherever in the globe”, says Veronica Miller — Director of Marketing at VPN Overview.
There is a difference in currency valuations in the stock market and the foreign exchange market. The nature of multinational currency valuations is not as visual in the forex market and relies on macroeconomic policies and economic factors that may not be readily available to traders to predict a market shift. Forex traders who don’t have access to this information or knowledge would find themselves on the losing side of the market with no way to turn. Forex trading usually happens with the help of technical indicators and results in high volatility. Traders that use the wrong technical indicators will suffer a loss.
“Moreover, While OTC Forex is often significantly more liquid than exchange-traded currency futures, periods of illiquidity have occurred, particularly outside of US and European trading hours”, she adds.
5. High Leverage
Forex markets use high leverage. This means a trader can achieve profitable gains or losses multiple times the initial trading capital. Leverage, on the other hand, means borrowing money to make a trade and in the forex market, this money is borrowed from a broker. A basic leverage trading ratio in the forex market is 50:1, which means a forex trader only needs to stake $1 to gain a position in the forex market worth $50. Leverage provides benefits for a trader, but the loss is also increased. You need to have an experience in leverage and an effective strategy for capital allocation; otherwise, traders in the forex market will experience multiple losses.
Traders in the stock market have access to advise and professional assistance from portfolio managers and relationship managers. Forex traders have little to no assistance that could help them carry out their trading activities successfully because forex traders are self-taught. Self-education is helpful for traders to become talented and disciplined traders throughout their careers. New forex traders quit during their first stage because they incur huge losses caused by improper trading and lack of forex trading knowledge.
7. Highly Volatile Market
The forex market is highly volatile, causing traders to suffer huge losses because there is no control or prediction pattern of macroeconomic conditions. It can be challenging to monitor changes in prices and volatility because the forex market is always open 24/7. The best way to curb this issue is to initiate strict stop losses for all trades in the forex market and carry out trading effectively by making informed trading decisions and following a strictly proven trading regimen.