Disclaimer - Risks associated with currency trading
Trading foreign exchange (currencies) on margin carries a high level of risk, and may not be suitable for all investors. Before deciding to trade currencies you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some, all or even more than your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with currency trading, and seek advice from an independent financial advisor if you have any doubts.
An ever changing environment, economics conditions and political climate all could contribute towards change in liquidity, volume, price of a currency. No one can predict with certainty which way exchange rates will go, and the currency markets are volatile. Fluctuations in the foreign exchange (forex) rate between the time you place the trade and the time you attempt to liquidate it will affect the price of your forex contract and the potential profit and losses relating to it. To avoid losing all of your investment capital, you should have a pre-arrangement on your risk profile. A solid risk profile will limit the forex dealer not to take on risk that you cannot handle.
Exchange Rate Risk - refers to the fluctuations in currency prices over a trading period. Prices can fall rapidly resulting in substantial losses unless stop-loss orders are used when trading currencies. Stop loss orders specify that the open position should be closed if currency prices pass a predetermined level. Stop loss orders can be used in conjunction with limit orders to automate currency trading - limit orders specify an open position should be closed at a specified profit target.
Interest Rate Risk - can result from discrepancies between the interest rates in the two countries represented by the currency pair in a forex quote. This discrepancy can result in variations from the expected profit or loss of a particular currency transaction.
Credit Risk - is the possibility that one party in a trade may not honour their debt when the deal is closed. This may happen when a bank or financial institution declares insolvency. Credit risk is minimized by dealing on regulated exchanges which require members to be monitored for credit worthiness.
Country Risk - is associated with governments that may become involved in foreign exchange markets by limiting the flow of currency. There is more country risk associated with 'exotic' currencies than with major currencies that allow the free trading of their currency.
Limiting Risk in your currency trading system
Currency trading can be risky, but there are ways to limit risk and financial exposure. Every forex trader should have a trading strategy - knowing when to enter and exit the market and what kind of movements to expect. Developing strategies requires education - the key to limiting forex risk. At all times follow the basic rule: Do not trade money, in the markets, that you cannot afford to lose.
Every currency trader needs to know at least the basics about technical analysis and how to read financial charts. He should study chart movements and indicators and understand how charts are interpreted. There is a vast amount of information on forex trading available both on the Internet and in print. If you want to be successful at currency trading, you have to know what you are doing.
Even the most knowledgeable traders, however, can't predict with absolute certainty how the market will behave. For this reason, every forex transaction should take advantage of available tools designed to minimize loss. Stop-loss orders are the most common ways of minimizing risk when placing an entry order. A stop-loss order contains instructions to exit your position if the currency price reaches a certain point. If you take a long position (expecting the price to rise) you would place a stop-loss order below current market price. If you take a short position (expecting the price to fall) you would place a stop-loss order above current market price.