Online Forex Traders should watch out for these Risks. Image credit: AdobeStock
Retail forex trading has been experiencing a boom in South Africa since the beginning of the last decade. As per estimates, there are over 200,000 forex traders in South Africa.
Online Forex Traders should watch out for these Risks. Image credit: AdobeStock
The availability of popular third-party trading platforms like MetaTrader has made it possible for traders to trade & analyze the financial markets from their desktops & mobile.
Forex trading in South Africa is legal as it is regulated by the Financial Sector Conduct Authority, FSCA which licenses brokers to operate.
You should note that Forex trading is not a quick money making venture. In fact, most forex traders lose large amounts of money. It is estimated that not less than 70% to 80% of all Forex traders lose money.
Forex trading can be expensive and you need to have cash on standby in case you get a margin call. You also need to be ready to conduct analysis on currencies which means reading, researching and staying in tune with global events.
Some traders choose copy trading but even that has its risks too, because experienced traders you copy, can also make losses. Nobody has a permanent winning streak no matter what they tell you.
We will discuss five likely risks you will face in the forex market and how to manage them.
1. Counterparty Risk
In financial markets, a counterparty is the other party to a contract or transaction. In forex trading, your broker or other liquidity providers such as hedge funds and Banks, can be the counterparty.
Counterparty risk is the probability that your brokerage firm or another liquidity provider may fail to keep their own end of the bargain.
There could be a risk of your broker not paying you if he goes bankrupt and this is why you should patronize only FSCA regulated brokers. The FSCA will move to ensure the bankrupt broker refunds all monies where possible.
A counterparty could also default due to lack of regulatory supervision, or when some licensed brokers are not playing according to rules.
In South Africa, there are some cases of Forex brokers who were sanctioned by FSCA for going against rules. For example, the case of Oinvest, a forex broker which had its licensed withdrawn by the FSCA and their accounts frozen by court order for contravening sections of the FAIS Act.
We also have the case of ZAR X (PTY) whose license was also withdrawn by FSCA because of concerns bordering on capital adequacy and liquidity.
2. Exchange Rate Risk
This risk crops up as a result of dynamic changes in the value of currencies. When you open a trading position, you should note that it is subject to the dynamisms of price changes.
The exchange rate when you open a position might have changed before you close the position; and this may make you experience substantial losses.
Socio-political events, such as the Ukraine war, has resulted in fears of recession in the Eurozone, and rising inflation. This has caused the Euro to fall by nearly 11% against the US Dollar in the last 1 year.
Since the investors were in doubt about the safety of their investments, they sold off the Euro they had in exchange for currencies of more stable countries.
Also, when foreign donors reduce the amount of Aid they send to an emerging economy, it could weaken that currency. A lot of situations can affect the value of a currency, so traders face risk of sudden changes.
3. Interest Rate Risk
If the central bank increases the interest rate, the currency will strengthen because foreign investment will be attracted and also the demand for other currencies will reduce since people will be saving more.
However, if the central bank cuts interest rates, and the other central banks have higher rates, then the currency will likely weaken. This is because lower interest rates will scare away foreign investors who seek high return on investments.
Lower interest rates also discourage saving and encourage borrowing. This can cause excessive cash circulation which will result in inflation. Inflation weakens a currency.
Let us look at two scenarios:
Firstly, forex trading is mostly executed using CFD contracts which are leveraged instruments meaning they require you taking a loan from your broker.
This loan will need to be serviced by you and you will pay interest on it. Higher interest rates could mean paying higher margin interest on the loan.
Secondly, when you use a currency with a higher interest rate to buy a currency with a lower interest rate, you are charged an overnight holding fee which is debited from your account.
For example, if you’re trading EUR/USD the interest rate for USD is 0.75%, while the EUR interest rate is 0% so in this case you will be debited the overnight holding fee if you are holding Euro.
These are also some direct ways interest rates can affect your forex trading.
4. Leverage Risk
Trading on leverage simply means you are taking a loan from your broker to open a trading position. The broker would require an initial margin deposit from you while he borrows you the remainder.
Leverage is expressed in ratio. For example if you have $20 capital, and your broker allows you a 1:100 leverage, it means you can open an order 100 times large or $2,000
So, have it in mind that a higher leverage could mean that your loss could be higher. The degree of risk could be higher in South Africa because; the FSCA currently does not place strict restrictions on the amount of leverage a broker can offer you.
In the United Kingdom and European Union countries, the leverage on CFD products offered retail traders is restricted to 30:1. However, such restrictions are not applicable in South Africa.
As per this comparison of some of the best forex brokers in South Africa, most of the listed brokers offer very high leverage of 1:1000 & above for forex trading. It is very common for CFD brokers to offer high leverage to traders. But this can be dangerous as demonstrated in a practical example below:
If you are buying CFDs for 100,000 units of EUR/USD exchanging at 1.0602 the contract value should be $106,020
However if you use leverage if 1:1000 you only need to deposit an initial margin of (1/1000 x $106,020) = $106.02 while your broker covers the balance
A negative market move of 10 pips means that you lose 0.0010 x 100,000 units = $100 which is 94% of your initial margin investment
However if you had used a lesser leverage of 1:10, your initial margin requirement would have been (1/10 x $106,020) = $10,602
A negative market move of 10 pips would have also resulted in a loss of $100 but this time it would represent 0.943% of your initial margin
The second factor about leveraging risk is that in South Africa, many forex brokers don’t have provision for Negative Balance Protection, (NBP).
With NBP in place, you would not lose more than your initial margin capital; meaning that you would not be indebted to your broker.
5. Volatility Risk
Volatility is normal in the markets but when it is too high, currency prices rise very sharply and fall very steeply. You may have heard the media say things like ‘This is the lowest drop ever recorded in 10 years’. That is what volatility does – it makes conditions extreme.
Now if you are trading forex during periods of high volatility, you stand the risk of recording mega losses and also note that Stop-loss orders may not work during such periods.
A stop-Loss is a market order for your broker to exit you trading position if the exchange rate crosses a certain stop price that will be set by you. It is a risk control mechanism meant to limit your risk on a trade.
However when volatility is very high, the exchange rate of the currency you’re trading can jump or gap past your stop price without triggering your stop loss. This means your stop loss order will be triggered at an inferior price and you will record more loss than you anticipated.
Risk is part of forex trading and you have to manage it. Beware of counterparty risk and patronize only licensed brokers. Be up to date with the news and understand the economy of a country before trading its currency.
When using leverage don’t forget you still have to pay interest on the loan so use lower leverage. During periods of high volatility, you can choose to do nothing till volatility reduces. However you should use stop loss orders if you cannot resist the urge to trade.