Foreign exchange (FOREX) investment is fraught with risk. You can, however, reduce and manage FOREX risks by controlling the amount of money you are willing to lose. Risk reduction requires you to use reputable brokers, avoid leverage (investing with borrowed money) and limit losses. Alternatively, you can invest in FOREX binary options, where the amount of potential loss is clearly defined. Finally, you can hedge your FOREX transactions, i.e. take partially offsetting opposite positions to reduce risk.
Select a reputable online broker. There are different types of FOREX brokers, some of whom bet against you when you trade. These are called market makers and you should avoid them – their interests don’t coincide with yours and they are under strong temptation to cut corners to your detriment. For instance, they may artificially lower prices just to have your position hit its stop-loss limit — the price which represents the maximum loss you are willing to accept — causing you to accept a loss. Instead, use what is called a non-dealing desk (NDD) broker; they don’t trade against their customers. You can research brokers on the Internet, see Tips.
Avoid margin buying, which is the purchase of an asset on partial credit. Margin is the percentage of collateral you put up to secure a trade. If you only put down a small amount of margin, brokers will quickly demand more if your position starts losing money. If you cannot supply more collateral, the broker will close out your position and lock in your loss. Don’t give them the opportunity – pay for trades in full with cash.
Place a stop-loss order for each position you trade. If the price of your FOREX currency pair – FOREX is always traded in pairs – hits the stop-loss price, your position will be automatically closed out. If you set your stops close to current prices, you limit your potential losses but increase the possibility of being stopped out. You must evaluate which of the two risks you dislike more.
Trade binary options instead of currency pairs. A binary FOREX option is a standardized contract that places a bet on the price of a currency pair at the option’s expiration. Expiration periods vary from a few hours to a week. If the option achieves the target price, it pays a given amount, usually $100. The amount you pay for a binary option (the premium) is situational, but is typically between $20 and $40. The premium is the most you can lose in a binary option trade. See Tips.
Hedge your positions. Hedging is a complex topic but is worth researching. Basically, you place counter-trades against your existing positions to lower risk – the loss in one position is (partially) offset by a gain in the counter-position. See Resources for additional information.
As of October 2010, all U.S. FOREX brokers are registered with the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA). You can use the resources of each organization to research potential brokers. See References 1 and 2. Binary options are traded on the North American Derivatives Exchange – see Reference 3 to learn about these important alternative investments.
Even if you adopt all of the precautions we mention above, you can still lose money trading in the FOREX market. You should always test any trading strategy with hypothetical trades over a period of a few months before committing cash to the real market. Knowledge is perhaps the best mitigation against risk. You should not trade in any market unless you understand precisely what you are doing and how much money is at risk. Do not assume that your initial investment is the upper bound of your potential loss.