Forex Risk Vs. Reward
When trading the financial markets, those with the greatest success understand the critical relationship between risk and reward. Too often, novice traders engage the markets with a focus only on the potential rewards, but the risks cause them great losses. In the foreign currency exchange market, or forex, traders apply risk management to fluctuations in currency exchange rates. Nearly anyone can trade forex, but few do so with consistent profit. You must understand both the potential risks and rewards of the forex market if you want to make a profit.
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Risk vs. Reward
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With every single forex trade, you have potential profit returns from and also potential risks. Technically, risk is exceptionally high unless you have a predetermined maximum loss tolerance where you know in advance where you will exit the trade if it moves against you. No trader should open a forex position without a plan of when to exit for either a profit or a loss. The best trading strategies take market entries where the potential risks are small compared to the potential rewards. If, for example, you know the trade has the potential to profit $300, and that you will exit for at most a $100 loss, then this is a three-to-one risk versus reward ratio in your favor. When potential rewards are greater than potential losses, the strategy is promising.
Strategy Example
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One of the most basic and effective strategies for minimizing risk and maximizing reward is with a simple "trend line." A trend is a consistent continuation in price in one direction with little fluctuation. The trend line helps identify and trade trends. You draw a line on the chart that connects at least three rising low points, and as prices drop to this line you buy into the market. The risk is minimal. If you wait to buy at the line, then you exit for a small loss if the trend breaks and prices penetrate the line. However, the upside is large. If the trend continues, prices will bounce off this line and move higher quickly, leading to profit. Such a strategy illustrates a responsible risk-to-reward ratio in the forex market, where the rewards are significantly greater than the risks.
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Forex Returns
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The positive or negative returns in forex trading are especially large, making this one of the most risky markets in the financial industry. It is important to understand the potential percentage returns, whether they be profit or loss. Forex brokers provide 50X leverage, which means that a $1,000 purchase covers $50,000 worth of foreign currency. If you spend $500 on a trade with a starting exchange rate (price) of 1.43, you have purchased approximately 17,500 units of the currency for a value of $25,000 with the leverage. If the exchange rate declines by just one penny to 1.42, this is a loss of approximately $175, or 35 percent of your original $500. A tiny fluctuation in rates results in a dramatic loss to an account. For this reason, trading low-risk, high-reward strategies is critical to long-term success.
Warning
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Few markets are as dangerous as the forex. The risks are exceptionally extreme compared to lower-leveraged markets such as stocks and bonds. It is impossible to sustain profits for too long if you do not master the balance between risk and reward. Just as you must cut your risks short, you must also have the endurance to let your winners ride out for large profits if you are to compensate for the inevitable losses that will occur on some trades.
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