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For a long time, the stock and bond market have always been the go-to option of many investors, particularly the newbies. Fusing them has been optimal for those who wish to balance risks and returns. They have been accustomed to observing and forecasting prices and yields due to their correlation with macroeconomic indicators. Unsurprisingly, they remain the most favored investments in the financial market. 

On the other hand, adventure seekers see the Forex market as the best place to train their decision-making skills. Ultimately, they aim to make swift moves in this volatile market. 

Risks are much higher, but trading rewards can be very attractive. Forex is also sensitive to monetary policy changes to hit the target range for inflation and interest rates. As such, the market has produced many millionaires, leading to bankruptcies. 

Today, more people are becoming more interested in crypto and fiat currency trading. Investors must be aware of the risks and opportunities in the market. It is more crucial today as we await the inflation report and the next Fed board meeting. Hence, this article will explain the potential risks and returns of venturing into the Forex market. 

Forex: Risks 

Over the years, the Forex market has been associated with extreme volatility, given its strong correlation with macroeconomic changes. It can be challenging to trade during a recession. As such, its share of crises depleted the wealth of businesses and people. These are the risks associated with forex trading. 

Vulnerability to external shocks 

Forex can be more susceptible to risks associated with macroeconomic shocks than the stock market. We can cite some events that disrupted the market to better understand it. 

The Brazilian currency crisis happened in the late ‘90s. Between 1994 and 1999, Brazil applied the crawling currency pegging to its Real with the US Dollar. This technique allowed the Brazilian Real to depreciate at a manageable rate. However, its policymakers did not consider external factors that led to a massive devaluation of their currency. 

The primary cause was Russia’s debt default in 1998, which caused panic among many international investors in Brazil. They lost confidence in Brazil’s capacity to sustain its crawling currency pegging, leading to massive capital outflows. Other factors included poor fiscal and monetary policy management, given its huge budget deficits and low foreign exchange reserves. 

In the end, the Brazilian Real lost its value relative to the USD. Investor withdrawals affected its Balance of Payment (BoP), leading to a severe economic crisis. 

Another example is the Sri Lankan Financial Crisis. It had always relied heavily on imports and external borrowings to produce goods and run the economy.  

However, the US currency unexpectedly appreciated more than it expected. And because it had inadequate forex reserves, Sri Lanka could not cover its external borrowings and imports. Its currency continued to drop, causing more problems in the following years. Today, it has over $4B in forex reserves but has yet to recover from the crisis. 

Asymmetric risk-to-reward tendencies 

The volatility of the forex market drives unfair risk-reward tendencies depending on the currency pairs you are trading. That is why traders should always study the macroeconomic landscape of the country first before picking its currency. 

For instance, if a trader picks the Canadian Dollar, he can pair it with the US Dollar. They can pair the Euro with the UK Pound if the choose the Euro. 

Of course, some adventure seekers opt to trade the USD with less popular currencies, which can be risky. There are promising rewards, though, which we will discuss in the next section. 

Unexpected Volatility 

Forex market volatility is a given. However, it can go overboard and lead to numerous bankruptcies in a single day. That is why many investors remain apprehensive about entering the Forex market. 

A popular example occurred on January 15, 2015. It was on the same day when the Swiss National Bank abandoned the Swiss Franc’s currency peg of 1.20 cap against the Euro. Note that the Swiss National Bank kept this rate for three years. This sudden change led to the 41% appreciation of the Swiss Franc against the Euro that day. It inflicted losses on traders, reaching as high as $100 million. 

Even worse, retail trading account losses exhausted the capital of three forex brokerages. Meanwhile, FXCM, formerly the US’s most prominent retail forex brokerage firm, went to the brink of bankruptcy. 

Forex: Rewards 

At this point, many interested traders may already be asking what is forex trading and how does it really works. But remember that high risks can carry high returns, which can be very rewarding. These can be much more enticing than the other financial markets. These are some factors that make the market appealing. 

Liquidity 

The forex market is well-known for being the most liquid financial market. It means that buying and selling currencies and realizing yields are much faster than in the stock and bond market. 

The bond market, for example, has very low liquidity since almost all of the stipulations are fixed. The maturity date, the set yield, and the price are all set even before they are offered and sold. 

In the same way, the stock market also tends to have a low liquidity level. You’ll often see this during periods of bearish price trends. Hence, it’s much riskier but faster to trade currencies in rising and falling markets. 

In addition, short selling, like in the stock market, also applies to the Forex market. Hence, traders can take advantage of falling currency value. For instance, the EUR/USD is valued at 1.09, and the trader sells it, expecting a decrease in value. If it closes at 1.07, he earns 2 or 200 pips. 

Leverage 

Many brokers provide leverage to traders. Often, many stock market brokers offer a leverage of 50:1 at most. But in the Forex market, a leverage of 100:1 is typical. Other brokers can even provide a 500:1 leverage. But traders must be wary of some fakers since the Forex market is decentralized, unlike the stock and bond markets. That is why looking for reliable trading platforms is essential. 

Traders must realize that leverage helps them take large positions despite their limited capital. They can open a $100,000 position even with just $1,000 in their bank accounts with the 100:1 leverage. As such, it can magnify trading profits and cuts. 

Unexpected volatility 

Volatility risks often scare investors away. Yet, it can be a double-edged sword as it can lead to high returns if traders pick the correct currency. 

Movements within 50-100 pips for primary currency pairs can happen daily. However, some currency pairs, such as the GBP/USD and USD/JPY, can move at a broader range per trading day. Suppose the GBP/USD moved by 90 pips, and a trader holds one standard lot or 100,000 currency units. He generates a gain of $900. But if he holds five standard lots, he earns $4,500. 

On the other hand, minor pairs, such as USD/AUD and GBP/AUD can gain over 200 pips per trading day due to higher volatility. Lastly, exotic pairs—the most volatile—can move by 400 pips daily. These may include pairs like USD/THB and GBP/MYR. 

Key Takeaways 

A trader must realize that generating earnings is the main objective of trading, and any investment type carries risks. This is much higher in forex trading. When done right, traders can go with the flow and have efficient risk-reward management. But in the end, the stability of currency pair earnings may depend on the capacity of a trader to cope with failure and stand up again.