Using Orders to Manage Risk in Forex
Forex risk management includes a robust set of rules and regulations that protect you against Forex's negative impacts. To mitigate the risk, you need to have an effective strategy in place that includes proper planning since the beginning, along with a clear mind that defines your motive in Forex trading. That is, if you trade in Forex with a motive to gain from speculation, your risk appetite is higher. However, if your goals are more conservative, it is best to calculate risks and minimize them as much as possible, and orders help you do that. Orders are one of the most effective tools that help you manage your risk in a more defined manner. Orders should always be considered a part of your overall trading strategy; however, one must understand that orders do not always limit your losses but surely help protect your profits. A trader shall always ensure to understand and determine their risk tolerance before they enter a trade, and use protective orders while entering into a position. The proper strategy analysis can assist the trader in using orders to manage risk.
What are the significant risks that a Forex trader faces?
- Exchange rate risk: This is an unavoidable risk caused due to fluctuations in the investor's local currency compared to the foreign investment currency. However, it can be mitigated to quite some level through robust hedging techniques and strategies.
- Interest rate risk: The higher the rate of return is, the more interest is accrued to the investor on the currency they invest. This results in higher profit. However, the opposite of this results in significant losses, exposing investors to increased risks.
- Credit risk: A credit risk is a risk that a counterparty defaults when they fail to make a promised payment. This decreases the creditworthiness of the borrower (in this case, the Forex trader). It also exposes lenders (in this case, the broker) the risk of not being able to recover the principal amount with interest, exposing them to the loss of the sum of money they borrowed.
- Country risk: Country risk is the risk that traders face on the occasion of investing or lending due to an intense economic crisis, political instability, or an overall disrupted environment in the buyer's country. This decreases the country's ability to pay for imports, degrading their currency value, imposing risks for traders who have invested in that currency's Forex.
- Liquidity risk: Such a type of risk occurs when an entity fails to meet its short-term debt obligations. When an individual or entity is not able to convert their asset into cash without giving up their capital and income due to a lack of buyers, the Forex market risk is enlarged.
- Leverage/marginal risk: It is that risk when a trader goes bankrupt after entering a forward Forex trade. The issuer then has to close the commitment of paying the marginal movement as mentioned in the forward contract, increasing his risk and losses.
- Transaction risk: It is the adverse effect that Forex rate fluctuations witness on a completed transaction. Such a risk is associated with the delay between entering the position and settling it and can lead to major losses if not identified on time.
What orders are used to manage risk?
Limit orders are used when you enter into a position, and their main aim is to protect profits. It lets you be in the winning position, and who does not love the fulfilling feeling of being in a comfortable place? However, Forex markets very rarely go in a particular direction for more than usual time. Hence, it becomes essential for a trader to determine their price point that fixes the position with gains before placing a trade position, if they want to manage and avoid risks related to a deteriorating Forex.
Stop orders are one of the most widely used orders that limit losses and successfully manage downside risk. Especially when a trader is under pressure, their mind tries every possible trick to get out of the stressful situation. However, if you enter a position without placing a stop order, you expose yourself to the psychological effects of 'just one more time' as there is no barrier that stops you after a specific limit/position.
Such orders allow you to guard against all your profits while also limiting the downside risks, providing you with the best of both worlds. If you are having a tough time making a particular level of profit and want to push the position along with limiting the losses, a trailing stop is an effective order type. It protects your earnings on the upside and attempts to mitigate losses on the downside as well. A trailing order enables the trader to specify the number of PIPs according to the current rate, which will then trigger the market order. These specified numbers of PIPs will then trial the trader's order as and when the market moves in the trader's favor. In case of the market moving against the trader, the triggered market order will execute the trade at the next available rate, also highly depending on the currency's liquidity.
We now know that foreign exchange risk occurs due to currency fluctuations in the international economy. This can happen due to various reasons, including but not restricted to a natural calamity, a big news announcement, an economic or financial crisis, political instability, a war breakout, and more. It affects not only investors trading in the foreign exchange market but also businesses that offer import/export of products and services. These risks, however, can be successfully managed through order types, as mentioned above. Our Forex trading platform ensures that your trades are secure and transparent and gives you the correct exposure that you need to succeed in the foreign exchange market.
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