Risk & reward

Volatility can bring home the bacon, but how can you manage the risks?

Fast-moving, multi-directional and ultra-sensitive, currencies experience the kind of intra-day swings that put equities to shame. But while volatility can help you stack up the cash, it also racks up the risk.

'The FX market is the riskiest of all the financial markets. You can't get crazier than this,' says IBFX's Marilyn McDonald. 'It really is designed only for the most disposable of your income.'

With the right risk management tools though – as well as discipline and some self knowledge– there is much a retail investor can do to secure himself a safer ride.

The high volatility in currencies can make for some potentially painful swings, says ODL Securities' Sandy Jadeja. Beginners with an equity background may be used to80-point daily moves on the FTSE – but with FX the shifts can be as wide as 200 to 400points. 'So if they don't have the discipline to get out when they're losing, they could really get hurt in this game.'

And if the relative volatility of FX markets increases their risk, so does the leverage afforded by online trading. 'It's more like futures in the way that the leverage can greatly amplify the risks – and the reward,' says Phil Sisca at E*Trade. 'People who are starting out doing this have to be very cognisant of that.'

'While all markets have some aspect of risk, the risky part of the forex markets lies in the use of leverage,' agrees GFT's Kelly Quintanilla. 'Because you can find 100-to-1(or even up to 400-to-1) leverage, losses as well as gains are magnified.'

He who dares

FX is not for everyone, says McDonald. If approached properly though, FX need not be riskier than other asset classes, some brokers argue. When you approach trading from a technical perspective, most instruments carry essentially the same risk, says James Hughes at CMC Markets. 'They will either go up or down, and you have to be caught on the right side of that.'

'I think [the risk] is the same,' agrees FXCM's Drew Niv. 'If you take a risk you suffer the consequences if it goes wrong.'

And in some ways, FX risk compares well with that of equities, says Deutsche Bank's Russell LaScala. 'If company news comes out, [shares] traders need to wait for the market to open in order to trade. Even when the market does open, that stock may have an “order imbalance” and experience a delayed opening,' he notes.

'In foreign exchange, the velocity of the moves may increase, but you will always have access to the prices 24 hours a day, five days a week.'

Many FX brokers also offer a debit balance guarantee, meaning investors never lose more than the principal in their account, Niv notes. 'You can't really offer that in futures or equities.'

'A crucial part of any trading plan is the risk management, and fortunately, forex traders have a number of options to help manage risk,' says Quintanilla.

Damage limitation

Stop orders can be set to help get out of the market at a specified price, while GFT also offers automated trailing stops, which traders can set to follow the market in real time, Quintanilla says. 'This type of order can help limit losses as well as help maximise profits, as your stop order is automatically adjusted as the market moves in your direction.

'We also offer guaranteed stops for an extra charge on selected markets, which allow you to exit the market at your specified price, even if a fast-moving market gaps past your stop price.'

Parent and contingent orders meanwhile allow a trader to set a stop and limit order to be triggered automatically. 'This type of order allows a trader to set up an entire trade and leave it, including entry, exit and risk management,' says Quintanilla. Orders are triggered automatically when the pricing conditions are met, meaning 'they don't have to sit at their desk and watch the market.'

GFT also offers its customers an automatic risk-notification system, which tells customers when their account equity reaches75% of their IM requirement, and again at 50%.

And protecting your positions needn't take much effort either, says Hughes. 'People tend to over-complicate things.' Most companies offer simple stop loss orders and using one on every position a trader takes on is the best risk management strategy around, he argues.

Stop losses don't, however, offer quite the same protection in FX as in many other markets , McDonald argues.

During times of heavy trading, for example with a fundamental news announcement, FX can enter what is described as a 'fast market'. 'Right before and right after the news announcements the major banks may stop trading. They may widen their spreads and wait to see what the market is doing before resuming trading activity,' she explains.

'What happens to the retail investor is everything gets converted to a market order and the customer sees slippage – even limit orders and stop losses,' she says.

'If the customer were in a trade on a nonfarm payroll announcement and had a stop loss 20 pips away from their entry point and the market gapped 100 points on the announcement, the customer may get filled 80 points away from where they had originally intended to get filled, resulting in a larger loss than they expected, or the dreaded margin call. This is not the broker being bad, or the market stealing from the trade – this is how the market works.'

Stop it out

This is no excuse for not using stop losses though, most brokers say. Regardless of how good a trader's technical or fundamental analysis is, 'if you don't put in the relevant risk and rewards strategies you might as well throw all that stuff out of the window,' says Hughes.

'Not using stop losses – that is a dangerous approach I think in any market, but particularly at the moment,' adds David Jones at IG Index.

There are a range of ways that stop losses can be used – plus other more straightforward strategies for managing your risk.

'Typically we read in text books that trades should only be entered if the perceived reward is at least three times as big as the perceived risk,' says Saxo Bank's Tom Nagle.

'While it's certainly advisable to look for larger rewards and smaller risks, I do not believe the three-to-one ratio should be seen as a hard rule. The problem is it can be difficult to gauge the likelihood of reaching the described levels. For example, just because your profit-target is 90 pips and your stop loss is 30 pips it may mean that the stop loss is three times as likely to get hit!

'One approach is to back-test your trading strategy ensuring you have an initial fixed stop loss and to utilise a flexible approach to taking profits,' Nagle adds. 'That way you can allow the good trades to reach healthy profit levels and the bad trades to be stopped out as early as possible'.

'From a risk perspective, I believe it is good to move your stop loss to break-even at the earliest opportunity and after that it's just a matter of managing your profit.'

Traders should also be careful not to abuse their leverage, warns Sisca. 'If a company is giving you 50 times leverage on a deposit to trade FX, that doesn't mean that you ramp up to 50 times on the first trade that you do. You've got to get into a comfort zone where you understand the risk – you understand the power of the leverage.'

Ultimately, however useful stop losses and such risk-control orders can be, the best risk control involves only putting on trades that you're comfortable with – and getting out the moment they turn sour, he argues.

'The best way to mitigate a loss is to cut it– there is no sense in hedging it with something else,' he advises. Only play with as much money as you can afford to lose and devise a careful strategy, he advises.

'The first move is generally the best move– just cut any losses as quickly as you can,' he says. And never risk more than a certain percentage of your capital in any one strategy. 'So that you can live for another day.'

Retail investors are 'really quick to get in, but they're really slow to get out,' says Jadeja, and this is one of their biggest mistakes. It is 'because their emotions are controlling their actions,' rather than the other way round, he says.

Getting to know your own emotions can be the best risk-management strategy of all, says Niv. 'Retail investors, primarily speaking, do not pick the wrong trades. They're not inaccurate about the dollar,' he says. They do, however, sometimes lie to themselves about why they're trading and take bigger risks than they need to.

Get to understand your trading personality, pick currency pairs that suit it and tailor your trading accordingly, he advises. If you're in it for your ego then open a separate trading account and play out your fantasies with small stakes – while your main account slowly brings in the big bucks.

©Taken from Shares Magazine Forex Feature 2008.