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July 18, 2006

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Trading Forex...  How Great is My Risk?
Name: Marilyn McDonald

Company: Interbank FX

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Favorite Movie: Anything by Miyazaki

Trading Forex...  How Great is My Risk?

If you want to see people squirm uncomfortably then talk about the risks associated with forex trading.  This is one of those 'pink elephant in the middle of the room' moments.  No one really wants to point it out but everyone is alluding to its presence.  You will hear things like: 'We offer 400:1 leverage,' or 'Forex is more lucrative because you are trading on margin!'

The truth is that forex trading is risky, very risky.  You can make money very, very quickly.  You can also lose your entire account (and sometimes more) just as easily.  And it's not just you that can lose your shirt.  If you have been interested in forex for more than a few weeks you will recall the headlines: “21st Century Bank run - Watching a $4 billion company fall apart in a week”

If you have ever watched forex charts (which you should do using a demo account), you will notice that the forex market can react like a squirrel on speed.  The speed and volatility of this market can and will kick you in the pants if you are not careful.  The big upside here is that no single country, event, individual, or any one factor can rule the currency market.

So, what are the risks you can run into?  Well, you may see things such as:
- unexpected fluctuations in exchange rates, or
- volatile market swings due to news or nothing perceivable at all

One of the reasons that the market can be risky/lucrative is that most of the trading is done on margin and traders can enter the market for as low as $250.

Margin essentially means that a broker will 'lend' funds to the client based upon their relationship.  So, if your broker offers you 100:1 leverage, that means for every $1 you put in you can control $100 of the base currency being traded. By taking your $1,000 investment and buying one lot of a $.01 move in the currency price you could double your investment. Don't celebrate yet though - that same $.01 move in the opposite direction could wipe out your entire investment.  Most brokers have processes in place to keep this from happening but in a fast-moving currency market and entire portfolio can be lost in minutes.

Sounds daunting? Don't despair too much. Trading in the forex market can be very lucrative and for this reason many people have taken an interest. Those volatile swings and lightning speeds mean that the potential for profits are just as dramatic.  The above examples are extreme and you can do a number of things to limit your risk.

Testing, testing...
If you have never traded forex before I wouldn't suggest diving into the deep end of the pool without dipping your toes a bit first.  Most brokers offer free demo accounts.  What I would suggest doing is to find two or three brokers that look interesting, offer the features you like and have a free demo.

Download their platforms and set up a realistic demo account (no sense learning on a $50,000 demo account if you only have $500 to risk).  Try to place the same trades on each platform.  Initially it will be a bit of a learning curve but you will finish your 30 days with a greater understanding of each broker's offerings, customer service and specific features.  You will also have a handle if you are ready to with a live account.

Don't abuse your broker's leverage
Many brokers have standard leverage levels - 100:1, 200:1, even 400:1.  Many will also let you set your own leverage upon request.  I have heard someone say, "I don't trade with your firm because you don't offer 400:1 leverage." From that statement alone I have made assumptions about what type of trader he is.  The higher the leverage, the higher the risk, and the easier for you to lose your account.  For example, if you have a $1,000 account with 400:1
leverage and entered into a 4 lot trade and the market moved 20 pips (very easily done) against you, your account would be wiped out.  You will be better served by lower leverage.

Don't abuse your margin deposit
There are several reasons not to do this. If you put everything you own into the ring it is more likely to get taken off of you, and you could also be up for a margin call.  When your margin percentage level gets down to a certain amount (at Interbank FX it is 50%) your broker has the right to start closing out your trades.  So, if you are in a bunch of losing trades waiting for a turn around you are exposed and could have your biggest losers closed out on you. Yes, this is legal.  The fact that you have 'borrowed money' from your broker means he is simply foreclosing to protect both of your interests.

Personally, I think that using 10 - 20% of your margin is a good rule of thumb.  This means on a standard account with $10,000 in it you will never trade more than two lots at the same time.  You will need to make your own decision based upon your personal trading style and risk levels.

Trading the micros
Congratulations - you are now swimming with the sharks, so to speak.  One clever little trick that will let you get comfortable with your surroundings is trading with micro lots.  Essentially you will be risking about .10 cents of your margin deposit.  Now that you are trading real money the emotions will start kicking in.  Better to be emotional over a -.50 cent trade than a -$50 trade.

Hedging your bets
A hedge is a trade that is taken out specifically to reduce or cancel out the risk in another trade.  The term comes 'hedging your bets' which is a gambling term.

So you take a position, say long on the EUR/USD, and you can feel a big move is coming up.  But you are not sure which way the market will go, so you also take a short trade on the EUR/USD, effectively canceling out your other trade.  When you see how the market is moving you can close one trade or another or you can choose to place stops or even a trailing stop on each trade to automatically exit a trade when the price moves too far against you.

Trailing stop
A trailing stop is essentially a stop that trails along behind you.  Not too difficult, right?  Let's say you have placed a trade, you know the market will go up (we always now, don't we??) and you want to go to bed.  You can apply a 15 pip trailing stop to your trade.  Once you hit 15 pips plus one on your trade, this stop will follow along behind you as your trade advances.  And halfway through the night if the momentum turns and prices start retracing, your profits are locked-in by your trailing stop.

All signs point to...
The heart of your chart watching and analysis should be your indicators.  An indicator is a statistical value that provides an indication of the condition or direction over time of performance of a defined process.  Or in plain English, lines and graphs that you can plot on your price chart to help you figure out what is going on.

Everyone has a favorite indicator.  Many people even sell their indicators for tons of money.  But essentially there are four types of indicators; those that measure velocity, volume, trend, and momentum.  In order to get a balanced view of the market you should now what type of indicator you are looking at and why it is trying to tell you.  Most new indicators are really old indicators with a few settings changed and then renamed to create sales. You are better off doing a bit of homework and understanding what your charts are trying to tell you.

In summary
There is enormous risk in currency trading.  The simple fact is, that to get rich quick in the forex game you will need to take enormous risks and be very lucky.  If you are looking at the forex market as a way to get rich quick you may be better off taking your money to the World Series of Poker - you will have more fun.

However, if you are willing to learn, practice some dedication, and use the tools that are available to limit your risk you will increase your chances of getting a good return from trading currencies.

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