Fallacies of Forex Trading and Risk Management Strategies

Forex also known as FX is the world’s most- traded financial market, with transactions worth up to trillions daily. The exchange of different currencies on a decentralised global market plays a vital role not only in foreign trade and businesses but also in the realm of wealth management. High liquidity with the ability to trade on margin coupled with a wide range of currencies makes it attractive to investors as they turn to forex trading to grow their wealth especially amidst volatile economic events.  For a successful forex venture, both a seasoned and budding trader must know whether a crisis drives the market, or there is a reason to panic.

Most Common Fallacies of Forex Trading

Similar to other investment and trading markets, there are various myths and misconceptions revolving around forex trading that can potentially emerge as pitfalls when making trade decisions. Being aware of these fallacies allow traders to navigate around trading risk and make informed and rational decisions. Moreover, in the current volatile trading market climate due to the Coronavirus pandemic, it is even more crucial for traders to broaden knowledge on common misconceptions.

Some fallacies that are most perilous from the trader’s viewpoint are the trader’s fallacy also known as the gambler’s fallacy, the fallacy of seeing patterns and the misconception that forex is designed for short-term trading (Refer to Figure 1). These delusions can disrupt the rational judgement of traders, leading them astray in trade decisions. 

Fallacies of Forex Trading and Risk Management Strategies
Figure 1 – Common Fallacies of Forex Trading

Three Risk Management Strategies

Besides learning about the fallacies, forex trading also comes with risks. Understanding the risk levels and mitigating it timely would be ideal to reduce pitfalls. Risk management is an essential tool to ensure that the trade portfolio matches your personal risk appetite and the envisioned financial growth goal.  

Know Your Risk Appetite  

This is the golden rule – never trade more than you are ready to lose. Trading beyond a trader’s ability to pay off compromises decision-making and this results in a losing trade. Before trading, reviewing one’s risk tolerance is vital in setting the trade volume limits.  A trader’s willingness to accept risk should include both present and future commitments, trading horizon, risk capital. For instance, if a trader shoulders heavy current and future commitments, choosing a safe-haven currency with a lower trade volume could be a plausible option. All three factors help to assess the risk level a trader is able to bear and keep the trade limits within the capability of paying off.    

Understand and Control Leverage

Leveraging is a key strategy in forex trading as it allows traders to gain a huge profit from a small starting investment. However, with heightened profit margin comes heightened risk. Renowned as a double edged sword concept, leverage can magnify your losses and bankruptcy risk. In a situation where a trader over-leverages and the investment moves against the trader, hefty losses can be exacerbated. By understanding how leverage and margin trading work, as well as the impact of overall performance and trading, traders are able to minimise the level of risk. Coupled with limiting leverages and starting trades with lower leverage ratio, controlling leverage can further mitigate risk. A good rule of thumb to remember for all traders is to use a leverage ratio that you are capable of paying off the losses. 

Stop-Loss Order/Limit

Even with proper management and strategy, traders can end up losing instead of gaining as market movements can be unpredictable. One of the few mechanisms that can enable traders to lock in profits or guard against loss is the stop-loss order or limit. The order or limit seeks to cap losses in volatile markets moving in a different direction to the initial trade. Stop-loss order is a market order to sell a security when it reaches a particular price immediately. On the other hand, the stop-loss limit sells a security when it reaches a specific price or better. In other words, trade purchases occur at a specific price or lower while trade sales will only transact at a set price or higher, within a range defined by the trader. Both mechanisms albeit different can be good gatekeepers to mitigate risk.   

A Trading Strategy for a World Crisis

Similar to other investments, there are various forex trading risks ranging from political, exchange rate, interest rate, credit and liquidity. Nonetheless, the remunerative nature does not deter new traders from foraying into the forex trading scene. Understanding the fallencies and risks associated with foreign exchange trading can allow traders to make better decisions in the way they manage their trading activity. Yet, it is always wise to seek advice from experts to mitigate and avoid potential pitfalls amidst increasingly volatile market conditions. Contact Desfran for more information.

References

Forex risk management strategies, Mytradingskills.com

Forex Trading Fallacies: What you should know, FXEmpire.com

FOREXAsian Forex Market Strengthens as US Virus Cases Soar, Securities.io

Gambler’s Fallacy, Investopedia

How to Trade Short-Term (Day-Trade), Dailyfx.com

Managing investment risk, Moneysense.gov.sg

Risk management in forex trading, Moneyweb.co.za

Stop-Loss vs. Stop-Limit Orders, Finance.yahoo.com

Top 5 most common trading fallacies and delusions, Capital.com

What Is Foreign Exchange (Forex)?, Investopedia

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