Just like any kind of investing/trading, forex is certainly not without risks. With the right mindset and good training, however, all of these risks can be identified and mitigated.

Broker Fraud

Simply, OTC forex is not regulated to the same extent/rigor as other areas of the capital markets. For this reason, broker fraud – while increasingly rare – is still a concern. The main issue is a lack of transparency, since forex is not traded on a centralized exchange (like stocks and bonds), but rather over-the-counter, such that individual brokers also act as market makers. Some of the less reputable brokers are frequently charged with “sniping’ (making trades just ahead of customers to take advantage of imminent momentum), “front-running” (taking positions against customers), and concealing bid/ask offers in order to inflate spreads. The latter is particularly problematic because it is basically impossible to detect. In this regard, the smartest thing you can do is to choose a broker with a good reputation, that is registered with CFTC, well-capitalized (to guard against insolvency), and hasn’t been involved in any recent disputes with customers. After all, when you’ve got thousands of dollars on the line, the last thing you want to be worried about is whether you can trust your broker.

Strategy

The second pitfall in forex is connected to trading strategy. It should come as no surprise that novice traders are bad at designing trading strategies. Either they will design strategies that are too simplistic to be profitable, or too complicated to be workable. Ideally, you want a strategy that is easy to execute, but still clever enough that you can be sure that not too many other people are trading based on the same strategy. Try not to combine too many different types of analysis into one strategy; while it’s good to be aware of fundamentals when trading based on technical analysis (and vice versa), it’s hard to blend them together unless you’re swing (medium-term) trading.

In addition, no strategy will be foolproof; your goal is simply to win more than you lose (in terms of cash, not necessarily in terms of the number of trades). If it turns out your strategy is not profitable, consider tweaking it, and if necessary, abandoning it. At the same time, if you have a specific strategy, stick to it! While sometimes it will be necessary to “pull an audible,” these situations should be rare, and you should be as mechanical as possible in your trading. If you have objectives, stick to them. Avoid the dual temptations of excessive fear and greed, and execute your stop-loss orders and take-profit orders at the levels that you initially set.

Finally, make sure that your strategy has your name on it. While forex newsletters and daily commentary can be good for generating ideas, avoid copying their strategies outright. This is basically common sense; if a strategy was as solid as the author professed, than wouldn’t he be using it himself, and presumably already have enough money to retire from giving advice? The same goes for forex robots, which are basically computer programs that seek to do the trading for you. While not all robots are created equal, consider again that a legitimately good robot would probably be worth more to its creator if it was a secret and would never be released to the public.

Leverage

It seems this tutorial has come full circle as leverage is both one of the greatest draws of forex and its biggest risk. The fact that profits can be generated very quickly with such a small capital base also means that losses can rack up just as fast on the same base. In short, if you were to poll “failed” forex traders on the causes of their respective insolvency, I guarantee you that 99% of them would cite leverage as the primary factor.

To alleviate the risk of leverage-induced losses, you should be well capitalized and employ minimal leverage. By starting with plenty of money, you will avoid the temptation of taking excessive risk by imprudently leveraging your portfolio. For example, if you start with $1,000, you will need 100:1 leverage to buy 1 standard $100,000 lot. If your position moves against you by a slight 1%, you will be wiped out. If you start with $10,000, meanwhile, it would take an impossibly large move of 10% to bankrupt you. In addition, since commissions are assessed on each unit that you trade in the form of a bid/ask spread, increasing leverage also has the effect of increasing your relative commissions. Consider that making a round-trip forex trade with 200:1 leverage (assuming a 2.5 pip bid/ask spread) will require 5% of your capital. That means just to recoup your transaction costs on this trade alone, you will need to make a 5% return!

The forex markets are very volatile, especially on a relative basis. Even if you have strong discipline and a solid strategy, a sudden drop will inevitably (aka unluckily) take place from time to time. In such a situation, remember that the higher the leverage, the higher the loss. To protect yourself from such sudden “market panics,” it’s good to get in the habit of setting stop-losses on all of your positions, so that even if you leave the computer to go to the bathroom, your account will be safe. Finally, by using less leverage that your broker allows, you limit the possibility of a margin call, whereby your position might be closed against your will in order to protect your account from sliding into the red.

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