How to Understand and Minimize Currency Trading Risk

Understanding the risk involved in currency trading, can and will certainly help you become one of top ten percent traders that make huge money in this market. The remaining ninety percent end up losing their money because they are either uninformed about the market or because they do not understand the currency trading risk. Due to the ready availability of a lower investment threshold and because of availability of computer driven analysis tools there are more people entering this market than ever before.

Understanding the Finer Points

The trouble is that there is more than just one currency that a trader has to be aware about. They must be well educated about the nuances and finer points of this rather dynamic market where changes are constant and taking place very rapidly. The lure of high returns is often a reason why people risk their money and in most cases end up losing because they made personal choices instead of informed ones.

Minimize Currency Trading Risk

The first thing that a trader needs to learn in order to minimize risks is learning whether this dynamic market is well suited to their abilities. There are too many risks involved to just jump in blindly to take advantage of perceived opportunities to make huge money from a market that is open round the clock and which allows for computer driven virtual trading as well.

The right approach is one that will reduce the currency trading risk to a minimum. It includes making it a point to become familiar with the market and understand what downsides can potentially cause losses. In other words, the investor must be a good risk manager and must be able to constantly judge and determine the exact profitability of a trade.

Forex Risk Management

Forex risk management is an important tool that can help reduce currency trading risks. This form of management requires understanding exposure analysis. Exposure analysis in turn will look at some important aspects including foreign currency cash flows/schedules, variability of cash flows, inflow/outflow mismatches (gaps) and time mismatches (gaps) as well as current portfolio mix and even floating/fixed interest rate ratio.

Market forecasting is another important component of proper Forex risk management. Once the exposures have been analyzed and determined, the trader must then find out which direction the market will be heading in the next six months. This will involve understanding the direction or big trends in rates, knowledge of underlying assumptions of the forecast and the probability of such forecast coming true. Based on these forecasts, a trader can manage their risk in a more efficient and effective manner.

Next, he must perform a risk appraisal which is an exercise that helps to determine where the trader’s exposure stands in relation to market forecasts. There is more than one currency to be taken into account and includes risk to the exposure or Value at Risk, Forecast risk, Market as well as Transaction risk, and Systems risk.

It is also important to do some benchmarking without which reducing currency trading risk will be very difficult. These benchmarks include one for exposure management practices. The benchmarks must be set for a six month period and must incorporate:

  • Exposure management objectives
  • Forecasts
  • Forecast risks
  • Room for error

Remember to keep the benchmarks realistic and achievable. These are important aspects to cutting down currency trading risks and if these steps are followed carefully, chances of succeeding in the currency market will shoot up dramatically.