Forex and the Risk Element

By: Martin Bottomley

Time and time again I hear the statement that trading on a margin account is a risky business. In fact the NFA and CFTC require that all brokers and agents inform the public of the risks of trading on the foreign exchange.

So how much risk is actually involved in trading Forex? Is it any riskier than engaging in any other kind of business?

Let us first look at the hypothetical case of John and Mary. Each of them opened a forex trading account and funded it with $50,000. Both of them operated on a margin set at 100:1

John traded very conservatively using one regular lot per trade and applying reasonable money management principals. Unfortunately, John was a poor decision maker and did little to improve his trading skills. Over a period of time, John lost his entire investment.

Mary had no intention of being shackled by the constraints of money management and traded to the maximum of her account margin, each trade carrying the maximum lot size permitted. After a few spectacular gains, Mary's luck ran out and her account was wiped out. Despite being in profit to the tune of $2,500,000 she had lost it all and her original investment was gone too.

So who took the most risk?

If you answered Mary - you are wrong!

Mary is a multi-millionaire. She has several mansions two yachts and a private jet. Her main income is from oil and her company owns some of the largest oil reserves in the world. The possibility of losing $50,000 for Mary is a very small risk. It is similar for her to that of anyone purchasing a lottery ticket - nice if it gives you a few million dollars, but no big deal if it doesn't.

John on the other hand was in a very different situation. John had taken a mortgage on his house to fund his trading account. He had no savings and had even given up his job to start full time trading.

As you can see from the two tales above, risk is about more than what percentage of your account you put at risk.

In our next example, Mike and Sarah both open mini accounts with $5,000. Both are using a margin of 100:1. Neither Mike nor Sarah are independently wealthy but each can easily afford to lose their $5000 without it adversely affecting their lives.

Both start trading and due to lack of experience do not fare very well. After a short time Mike stops live trading and starts to practice in a demo account. Mike seeks help and knowledge and then practices in his demo account to hone those new found skills.

When Mike starts to trade his live account again he uses very strict money management and a well developed trading system. Mike has not yet made a fortune, but he is starting to recover some of the investment that he lost.

Sarah continued to trade without any help. She is still managing to stay afloat.

So who was at the most risk in this example? I would suggest that it was Sarah. Her luck is still holding but if your trading style is built upon luck. You are at great risk.

Trading the forex market requires that you develop a style of risk management. It is necessary to understand the true risk of each trade as it applies to both the market in general and to you in particular.

If you always trade with money that you can afford to lose, your total risk is reduced. If you learn how to trade effectively, then your risk is further reduced and likewise if you adopt a strict regime of money management your risk is again reduced.

Trading will always carry a level of risk. If you intend to adopt trading as a career or investment vehicle, it is up to you to do everything in your power to learn how to properly assess and manage the risk.

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