Foreign Exchange Risk

Despite the claims you may see on some foreign exchange (or Forex) web sites, foreign exchange is not risk-free. You are trading with substantial sums of money and there is always a possibility that trades will go against you. You should therefore carefully consider whether such trading is suitable in light of your financial conditions. You may sustain a total loss of funds and any additional funds that you deposit with your broker to maintain a position in the foreign exchange market. Actual past performance is no guarantee of future results. Simulated performance results also have certain limitations unlike actual performance records; simulated results do not represent composite trading. Also, since trades have not actually been executed for this composite, the results may have under-or-over compensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated trading results, in general, are also subject to the fact that they are designed with the benefit of hindsight. No representation can be, or is being, made that any trading system will, or is likely to, achieve profits or losses similar to those shown in this simulated performance record.

The performance records have been calculated in a manner we believe to be reasonable and are based on the respective leverage factors intended to be used. Prospective investors must recognise that any simulation of a hypothetical record, even when based on actual trading systems, with qualified trade execution, has inherent limitations. We believe that the records as presented should be of interest to investors in determining whether to participate or not. Such rates of return should by no means be taken as an indication of how the system will perform or would have performed, even given the same trades. Any performance record compiled from individual performance records of any trading methodologies has certain hypothetical and artificial characteristics and must be evaluated accordingly.

Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk and no hypothetical trading record can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses is a material point which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results and all of which can adversely affect actual trading results.

If considering a trading in the foreign exchange market you should be aware of all the following foreign exchange risk factors:

1. Scams

Among foreign exchange risks, foreign exchange scams were fairly common a few years ago. The industry has cleaned up considerably since then, but you still need to exercise caution when signing up with a foreign exchange broker. Do some background checking – reputable foreign exchange brokers will be associated with large financial institutions like banks or insurance companies and they will be registered with the proper government agencies. In the United States brokers should be registered with the Commodities Futures Trading Commission (CFTC) or a member of the National Futures Association (NFA). You can also check with your local Consumer Protection Bureau and the Better Business Bureau.

2. Exchange Rate Risk

This foreign exchange risk is due the fact that currency prices are highly volatile. Price movements for currencies are influenced by, among other things: changing supply-demand relationships; trade, fiscal, monetary, exchange control programs and policies of governments; United States and foreign political and economic events and policies; changes in national and international interest rates and inflation; currency devaluation; and sentiment of the market place. None of these factors can be controlled by any individual advisor and no assurance can be given that an advisor’s advice will result in profitable trades for a participating customer or that a customer will not incur losses from such events.

The 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 foreign exchange (see below).

3. Interest Rate Risk

This foreign exchange risk can result from discrepancies between the interest rates in the 2 countries represented by the currency pair in a foreign exchange quote. This discrepancy can result in variations from the expected profit or loss of a particular foreign exchange transaction.

4. Credit Risk

This foreign exchange risk is represented by the possibility that 1 party in a foreign exchange transaction may not honour their debt when the deal is closed. This may happen when a bank or financial institution declares insolvency. Credit risk can be minimized by dealing on regulated exchanges, which require members to be monitored for credit worthiness.

5. Country Risk

This foreign exchange 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 countries that allow the free trading of their currency.

How to Limit Foreign exchange Risk

Foreign exchange trading can be risky, but there are ways to limit risk and financial exposure. Every foreign exchange 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 foreign exchange risk. At all times follow the basic rule: Do not place money in the foreign exchange that you cannot afford to lose.

Every foreign exchange 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 foreign exchange trading available both on the Internet and in print. If you want to be successful at foreign exchange, 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 foreign exchange transaction should take advantage of available tools designed to minimize loss. Stop-loss orders are the most common way for minimising foreign exchange risk. A stop-loss order contains instructions to exit your position if the price reaches a certain point. If you take a long position (expecting the price to rise) you would place a stop loss order below the current market price. If you take a short position (expecting the price to fall) you would place a stop loss order above the current market price.

Stop loss orders can be used in conjunction with limit orders to automate foreign exchange trading. Limit orders specify that an open position should be closed at a specified profit target.

As an example, if you take a short position on USD/CAD it means you expect the US dollar to fall against the Canadian dollar. The quote is USD/CAD 1.2138/43 - you can sell US$1 for 1.2138 CAD dollars or buy 1.2143 CAD dollars with US$1.

You place an order like this:

Sell USD: 1 standard lot USD/CAD @ 1.2138 = $121,380 CAD

Pip Value: 1 pip = $10

Stop-Loss: 1.2148

Margin: $1,000 (1%)

You are selling US$100,000 and buying CAD$121,380. Your stop loss order will be executed if the dollar goes above 1.2148, in which case you will lose $100.

Say, however, that USD/CAD falls to 1.2118/23. You can now sell $1 US for 1.2118 CAD or buy 1.2123 CAD with $1 US.

Because you entered the transaction by selling US dollars (buying short), you must now buy back US dollars and sell CAD dollars to realise your profit. You buy back US$100,000 at the current USD/CAD rate of 1.2123 for a cost of 121,223 CAD. Since you originally sold them for CAD$121,380 you made a profit of $157 Canadian dollars or US$129.51 (157 divided by the current exchange rate of 1.2123).

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