Risks of forex trading

Learn all about the risks of forex trading here – including how to mitigate them. Explore how volatility and leverage impact your bottom line, where to places stops and more.

Risk in forex trading is the same as risk in any other market. If your positions go against you, you may have to close them at a loss instead of a profit.

No trader gets it right 100% of the time, so learning how to manage and mitigate risk is a key part of achieving success. In this guide, we’re going to cover the forex trading risks you should be aware of, and how to keep them in check.

What are the risks of forex trading?

There are two main risk factors that come with forex trading: volatility and margin. Let’s examine what each is in turn, before we take a look at how to mitigate them.

1. Volatility

As we covered on the what is forex trading page, currency prices are constantly on the move due to the high liquidity of the foreign exchange markets.

High liquidity is usually a good thing – it makes it easier for you to find someone to trade with, so you can quickly get out of trades. But when it leads to high volatility, it means that markets can make big swings. These swings could work in your favour, or they could amplify your losses.

As with any market, greater potential profits come with greater risk. Highly volatile forex markets bring just that. They’re prized by some traders, but can hurt your bottom line if you’re not careful.

2. Margin

When you trade via spot forex or FX CFDs, chances are you’ll use margin to open your positions. Without it, you might have to spend hundreds of thousands of dollars, pounds or euros whenever you want to trade.

Margin means you only need a fraction of your trade’s full value in your account to open a position. Many of City Index’s FX markets only require 3.33% or 5%. Your profit or loss, though, will still be based on the full value of your trade, which magnifies both your profits and your losses.

Margin example

Say you want to buy one standard lot of AUD/USD at 0.7050.

The margin is calculated as 0.7050 multiplied by the lot size of AUD$100,000 and then divided by 30 (using the leverage factor of 30:1). This gives a margin of USD$2350.

AUD/USD moves up 50 points, making you USD$500. You’ve made USD$500 from USD$2350, a 21% profit. If you’d had to pay the full USD$70,500, you’d still have made USD$500 – but that’s only a return of 0.7%.

The same would have happened if AUD/USD moved down 50 points. You’d lose USD$500 from an initial deposit of USD$2350, instead of USD$70,500 Leverage has magnified your loss.

Risk-free forex trading

There’s no such thing as a risk-free forex trading strategy, but you can practice buying and selling currencies with zero risk. A City Index demo account gives you $20,000 in virtual funds, and access to our full range of FX markets.

If you want to see how successful you’d be on live markets, it’s the perfect place to start.

Try a City Index demo.

How to manage risk in forex trading

There are lots of different strategies and tools you can use to limit your forex trading risk. Here, we’re going to explore two: using stops and making a trading plan.

Want to find out more about managing risk? Head over to the City Index Academy.

Stop losses and take profits

Stop losses and take profits are orders that tell your broker to close a position once it hits a certain level. Stops close it once it reaches a set amount of loss, take profits close it once it reaches a set level of profit.

You’ll also often see take profits referred to as ‘limits’.

Stops provide a useful method of deciding your overall risk on any trade. For example, if you want to buy five GBP/USD CFDs but only risk $300 on the position, you can use a stop.

Your five cable CFDs will make or lose you $5 for every point that the pair moves, so if you place a stop 60 points below the opening price of your trade, it will close the position if it hits a $300 loss.

Stop loss example AUD

Take profits, on the other hand, can help you set profit targets. If you’re aiming for a $900 profit from your GBP/USD trade, you can place a limit 180 points above your opening price.

Guaranteed stop loss orders (GSLOs)

Stops will always execute at the best available price, which might not be the same as your chosen level. If your market gaps over your stop, for example, your trade will close at the first price available after the gap.

GSLOs prevent this, always executing at the level you set. To upgrade a stop to a GSLO, you’ll pay a small premium.

GSLOs are available with a live City Index account.

Tips for placing stops

1. Strike a balance

You might be tempted to set your stop as close to the market’s opening level as possible, to limit your potential losses from the trade. However, this will increase the likelihood of your stop being triggered.

Pay attention to current market conditions and try to strike a balance between giving the position room to move and risking too much capital.

2. You can move stops

Your position has moved in your favour, and you think it has further to run – but you’re worried about losing your profits if the market reverses. Instead of closing your trade, you could move your stop up to secure your profits now.

You can even set trailing stops. These will automatically follow your market if it moves in your favour. Then, if it turns, your stop remains in place.

3. Look for support or resistance levels

Applying technical analysis can be useful when deciding where to place your stops.

Say, for instance, that you’re considering selling EUR/USD at 1.1502. Looking at a EUR/USD chart, you notice that EUR/USD has previously moved up to 1.1540 multiple times but struggled to break beyond it.

If EUR/USD moves past 1.1540, a longer rally might be on the cards, so you know your planned short trade may have failed. You could place a stop just above 1.1540, and you potentially will not suffer any further losses.

Want to practise placing stops? Get started with a free City Index demo.

Creating a forex trading plan

Planning your strategy beforehand is crucial to limiting your risk. Otherwise, emotions can lead to bad habits in the heat of the markets.

Your trading plan should include how much to deposit into your account, and your accepted risk on each trade – including your risk/reward ratio.

Trade sizing is key to achieving this. If, for instance, you decide to risk 10% of your account on each position, then it will only take ten losing trades to clear your balance. Drop your risk to 2%, and that number goes up to 50.

Margin calls

What happens if you don’t have enough funds in your account to cover your margin? You’ll be placed on margin call, and we might automatically close your positions to lower your margin requirement.

You can learn more about margin calls with City Index here.

Your risk/reward ratio, meanwhile, dictates which opportunities you trade, and which you skip. Essentially, you’re deciding how much potential profit you need in return for the capital you’re risking.

A ratio of 1:2 means that you target twice as much profit as loss. Set a stop loss 100 points away, and you’d want a take profit 200 points away.

You should make double the profit from successful positions as losing ones, which means you don’t have to be right more than 50% of the time to earn a profit.

Find out more about creating a forex trading plan.

FAQs

What is forex risk management?

Forex risk management is the individual actions that you can take to protect yourself from the downside risks of a FX trade. The first step should always be to learn about the risks of forex and trading in general, as well as the tools your provider has available.

Is forex riskier than stocks?

Forex is considered riskier than stocks due to how volatile the market is and the fact it comes with much higher levels of leverage. However, a suitable risk management strategy can help to manage the adverse effects of the market.