The foreign exchange market, also known as the forex market, enables individual traders to buy and sell currencies around the world. Forex trading aims to buy low and sell high to get a net profit.
The forex market has an enormous trading volume in the world. Forex assets are highly liquid assets because of the high trading volume. Mainly foreign exchange trades include spot transactions, forwards, foreign exchange swaps, currency swaps, and options.
Foreign exchange trading can be profitable, but it takes time to achieve that level of success because the market is so volatile, and the prices can fluctuate at any time. You can trade currencies 24 hours a day and almost seven days a week in the foreign exchange market.
Trading forex may be thrilling, but it is not for everyone. There is not a single formula for good performance in the financial market. Many risks are associated while investing in forex that can bring substantial losses. You should be aware of some of the dangers during trading are given below.
1. Leverage Risks
In forex trading, one can get high leverage. The leverage can magnify your profit, but it can bring substantial losses if the trade does not go in your favor. It gives an extensive exposure to the market, which means that if you have $1000 in your trading account, you can trade $100000. Here, the leverage ratio is 100:1.
Leverage is not the best practice, especially for beginners, as they use high leverages. You will need a small initial investment known as margin to approach high trades for leverage in the forex market.
If margin calls happen due to a slight price fluctuation, a trader pays an extra margin. High leverage in the volatile market can be dangerous for your initial capital.
2. Interest Rate Risks
According to macroeconomics, interest rates affect the country’s exchange rates. When the country’s interest rate rises, its currency will strengthen due to the flow of investment in its assets, as potential currency offers higher returns.
However, if the interest rates fall, its currency will weaken because the investors start to withdraw their money. In this way, the interest rates affect exchange rates, affecting the forex values.
3. Transaction Risks
These are exchange rate risks related to time differences between the start of a deal and when it happens. Forex trading occurs twenty-four hours a day, resulting in exchange rates fluctuating before trades have been made.
Therefore, currencies might be traded at different rates at different times during trading hours. With the increase of the time between entering and making a deal, the transaction risks also increase.
Anytime the exchange prices can change, creating an issue for individuals and corporations trading in currencies due to increased transaction costs.
4. Counterparty Risk
The function of a counterparty company in a financial transaction is to provide assets to the investor. It means that the counterparty risk is the default risk from the dealer or broker. Spot and forward contracts on currencies are not an assurance by exchange and clearinghouse in forex trades.
In the spot currency buying and selling process, the counterparty risk usually comes from the solvency of the market creator. When the market is volatile, it is possible that the counterparty is unable to fulfill the conditions and promises and may refuse the contracts.
5. Country Risk
When you are going to invest in currencies, it is essential to know about the structure and stability of the country. Exchange rates are decided by a world leader such as the US dollar in most developing and third world countries.
In that situation, central banks must keep suitable reserves to maintain fixed exchange rates. A currency catastrophe can happen due to the regular balance of payment deficiency and, so, the devaluation of the currency. Due to this, forex trading and prices can be affected badly.
As we all know, if the investor understands that the currency will decrease in value, they start to withdraw the investment from the currency, further devaluing the currency. Those traders who are continuously involved in buying and selling the currencies may find their assets to be illiquid or incur insolvency from dealers.
Currency crises enhance the liquidity dangers and credit risks and reduce the attractiveness of the country’s currency.
From the article, you can see that many risks are related to foreign exchange trading and may be greater than initially expected. The use of aggressive leverage can put you in trouble and wipe out your account. It is recommended when using leverage; you must have some strategies to trade in the market.
Moreover, global political issues and time differences can affect the foreign exchange market. Keep in mind that the losses are also severe due to the highest trading volume in the forex market.