Forex Risks Investors Should Consider
Daniel White
July 2020
Investing in the Forex market is an effective option for passive income. However, any investment of funds has potential risks, and the global currency exchange market is no exception. In this article, you will learn about the various types of risks faced by participants in the Forex market and how to identify the main methods for their reduction and diversification.
What are the Risks of Forex?
The Forex market is a stable system of economic and organizational relations between banks and brokerage firms. The main features of this market are that anyone can participate in it; anyone can buy and sell currency; and anyone can bet on price increases for currency pairs, securities, precious metals, and other trading instruments.
A private player in the Forex market is called a trader. A trader cannot enter the interbank market on her or his own but rather must do so through a broker acting as an intermediary company. A trader also invests through a broker. An important feature of the Forex market is that it practically does not limit the investor in the direction and method of investment or the amount of investment. A direct consequence of which is the ability to receive a large passive income.
However, an investor in the foreign exchange market needs to understand that Forex has a high volatility parameter, which means that currency quotes change every minute and depend on an infinite number of micro- and macroeconomic factors, not all of which are predictable. The Forex market is a territory of truly highly profitable investment, but the risks are also very high. As usual, the magnitude of the risk directly depends on the size of the potential profit.
Risks are attendant with any investment option, not just in the Forex market. However, no other option allows you to manage your capital so flexibly and efficiently or provides such a wide range of opportunities for obtaining high profits within a relatively short time. It is this which attracts traders and investors — high risks, but also high profits.
Most Popular Forex Investment Types
The most obvious way to make money on Forex is through direct trading. This method of earning can also be called investing. Only in this case, the trader invests in himself — in his skills of forecasting changes in currency quotes. The Forex market offers the following investment options:
PAMM accounts.
These are accounts that are formed by linking the accounts of several investors to the account of the managing trader. Investors do not make trading decisions. The manager uses his or her trading acumen to initiate trades, and the profits (or losses) of all participants depend on the manager’s success.
LAMM accounts.
A slightly less common investment option, which differs from PAMM accounts in that the accounts of investors and the manager are not linked or combined into one financial portfolio. In this case, the manager’s trades are simply copied to the trading terminals of investors.
Trust management.
This option of investing in the Forex market involves a direct transfer of investor funds to another trader. Such a transfer may be made based on an agreement.-
Auto trading.
is another type of investment tool, sometimes called copying trades. With this option, the trader selects a signal provider (i.e., a more experienced trader) and, using a special service, completely or partially copies their trades. That is, the investor trades from his own terminal and, in case of a successful trade, gives a certain interest or a fixed amount to his signal provider.
The most popular Forex investment options are PAMM accounts and LAMM accounts. They differ in that they have lower risks when compared with other options, each of which has its own advantages and features.
PAMM Investment
The acronym PAMM stands for Percent Allocation Management Module. Compared to the LAMM system, PAMM accounts are a newer investment option. It was created based on LAMM as it is a simplified alternative, except for the mechanism for copying trades.
👍 Advantages of PAMM accounts:
- •the manager risks their own funds in the trade, so his or her co-investors may reasonably expect the manager to be more prudent when making trades;
- •the inclusion of the manager’s funds guarantees his or her focus is on success and the soundness of the trading strategy;
- •the manager cannot directly interact with the accounts of investors, which almost eliminates the risk of fraud;
- •PAMM accounts provide complete trading transparency and an investor can withdraw funds at will;
- •an investor can effectively diversify risks by allocating funds among several managers.
👎 Disadvantages of PAMM accounts:
- •the investor does not participate in decision-making on trades and bidding is completely dependent on the manager;
- •this investment option reduces risks but does not eliminate them, because even the most experienced traders sometimes lose trades.
Thus, the main risk when investing in a PAMM account is the same as if the investor would act as an ordinary trader and personally make all trades (but for the experience of the manager). There is the risk of making mistakes in forecasting and making the wrong bet, resulting in a financial loss. Only in this case, risk control goes from you to the PAMM-account manager-trader. But, according to the statistics, the risks on their part are much lower, since they are much more experienced in the Forex market.
LAMM investments
The acronym LAMM stands for Lot Allocation Management Module. The LAMM method of investing is completely different when compared to PAMM. Here, there are also investors and a manager. However, in PAMM accounts, the funds in the investor’s accounts are reserved and then sent to the manager. In LAMM accounts, this does not occur. Instead, the system automatically copies the manager’s trade to all investors, which is immediately displayed on the interbank account.
👍 Advantages of investing through LAMM:
- •the manager’s funds participate in trades along with the investor’s funds. Thus, the manager is motivated to trade wisely;
- •the manager neither directly nor indirectly interacts with the investor’s accounts, which protects against fraud;
- •there is also an option to diversify risks by allocating funds among several managers.
👎 Disadvantages of investing through LAMM:
- •as in the case of PAMM, the investor does not make personal decisions on trades, trusting the manager completely;
- •risks are reduced due to the professionalism and trading experience of the manager, but they do not disappear, and investors may occasionally lose part of the funds.
The main risk with trading through the LAMM system is the same as for PAMM accounts, which is the probability of losing invested funds due to a manager’s error. Strictly speaking, this may not even be a mistake, because sometimes the Forex market behaves unpredictably, and then any forecast strategy — even very good forecast strategies — can suddenly lose their advantage.
Comparison of Risks in PAMM and LAMM Investing
Key risks associated with the possibility of losing part of the capital due to an error in decision-making can’t be completely excluded from any investment option in the Forex market. However, they can be minimized. Therefore, novice traders often choose PAMM or LAMM systems because decisions are made by an experienced trader.
| The risks | PAMM | LAMM |
|---|---|---|
| The probability of loss of funds on the order | Yes, because the trade completely depends on the manager’s decision. | Yes, because the trade completely depends on the manager’s decision. |
| Manager's remuneration | Yes, in the form of a commission from a successful trade or a fixed amount. | Yes, most often in the form of a commission. |
| Risk sharing | Equal, among the manager and investor(s). | Equal |
| Type of account capital | Share (equity) | No general account |
| Based on the manager’s decisions | It depends on the number of investors because the manager sees the aggregate balance of the account and bases its decision partly on that factor. | Depend only on the strategy of the manager |
| Deposit/withdraw capital | Rollover only | At any time |
| Profit/Loss allocation | In the last rollover of the month | At the end of the trading interval indicated in the offer |
| Investor participation in trades | Automatic | Some trades may not be copied if there is not enough capital in the investor’s account |
Conclusions on Risk Comparisons
The main differences between the two systems are how the trading tools interact between and among investors’ and a manager’s account. In the case of PAMM accounts, the manager focuses on investor accounts. In the case of LAMM, the manager does not have such an opportunity (or a need). For the same reason — due to the features of the trading mechanism — in the case of LAMM, an investor can exit the trade at any time, but this is not possible with the PAMM system. The LAMM system is considered by many to be more flexible to the investor, but PAMM accounts are simpler. Both systems contain risks, of course.
Another key factor of PAMM and LAMM accounts is that all trades are strictly transparent. It means that the investor has the opportunity to learn from the manager — both on successful transactions and on failed ones. And if you choose a PAMM portfolio, allocating funds between several managers, then within the minimum time you will get an enormous amount of experience that will help you in the future to make more balanced decisions should you start trading for yourself.
Main Types of Risks When Investing in Forex
Investors constantly face the risk of losing all or part of investments, simply based on the law of averages. Even when buying real estate, there is a chance that it will depreciate; or after making a bank deposit, the bank could file for bankruptcy. For the Forex market, this is especially true because of its high volatility. All risks on Forex are usually divided into two large groups — trading and non-trading risks.
Forex Trading Risks
Forex trading is carried out according to the margin type. In margin trading, funds are provided to the seller under the deposit or margin. Margins differ from loans in that they are significantly lower than potential profit. For example, to provide a contract for the purchase of 100 thousand euros for dollars, the broker requires a deposit (margin) of only 2000 dollars.
All trading risks for investors in the Forex market are directly related to this, i.e., the loss of capital due to incorrect decision making. For example, the thoughtless use of leverage may lead to a quick loss of the entire deposit. By the way, it’s easiest to predict trading risks for PAMM accounts, because the broker provides the investor with detailed statistics and a history of the manager’s trades.
There is only one option to minimize trading risks for a trader trading on their own: experience. Over time, the independent trader begins to understand the subtleties of the foreign exchange market, learns to project general economic events correctly, generate forecasts for quotes, and devises long-term strategies that take into account a maximum of factors. From this point of view, the stock market is, of course, less risky. At least because the leverage there is several times less (1:4 on average, while for Forex brokers the leverage can be 1:50 up to 1:1000).
Another important point is the trading instruments. Trading risks always depend on the type of instruments (types of currency pairs and precious metals, etc.) used. The simplest example is the volatility (changeability) of the euro/dollar pair is always higher than for the American dollar/Swiss franc pair. Because the Swiss franc is one of the most stable currencies, and the difference between the dollar and the euro fluctuates every minute. Precious metals are naturally more stable than currency pairs, but they also have their own idiosyncrasies.
Non-Trading Risks
Non-trading risks for investors in the Forex market are not connected with trading in any way. We may often talk about accidents, but all these are real situations that occur frequently. The problem with non-trading risks is that they are nearly impossible to predict. Here are the main non-trading risks:
Termination of the broker’s activity.
There can be many reasons for this, ranging from bankruptcy to license revocation. In any case, a trader may lose his entire deposit or have insufficient time to withdraw all or part of it.Judicial risks.
It is not frequent, but traders do sometimes sue brokers. And the trials are expensive and trial costs and attorney’s fees aren’t always reimbursable even in the case of a victory.Currency risks.
Investors cannot control the consequences of the largest group of non-trading risks. For example, the ruble is sagging against the dollar by 10%. This means that investors using the ruble as their base currency, in addition to other losses, automatically lose 10% of their capital.Other risks.
These risks include a global economic crisis; the collapse of some state leaving its currency sagging on the world market; the creation of new international trade associations; armed conflicts, and many other unpredictable factors.
Unfortunately, it is impossible to completely eliminate non-trading risks. The investor should nevertheless try to predict some of them (e.g., currency sagging) and this could save the trader’s capital. It also makes sense to work only with reliable brokers, this reduces the risk of litigation or a sudden revocation of the broker’s license by regulators.
Difficulties an Investor May Face
Here are a few positions from the global Forex market that do not identify risks, per se, but pinpoint the conceptual difficulties that every Forex investor eventually learns:
- ●unpredictable fluctuations of an asset in the market (frequent changes in its value);
- ●the dependence of quotes on all trading instruments on a variety of micro- and macroeconomic factors;
- ●the possibility that leverage may lead to a loss of capital if the trader is inexperienced or not careful;
- ●sometimes an unreliable broker can adjust a trader’s strategy for personal benefit;
- ●Unfortunately, PAMM, LAMM, and trust management fraud aren’t completely eradicated yet;
- ●the incompetence of the approach to the trading process will always bring losses, and the higher they are, the more funds the investor loses;
- ●rushing is the main scourge of most investors because it leads to hasty decisions that result in losses of capital.
The main difficulties for a novice investor in the Forex market coincide with the main risks, and one is always either the cause or the consequence of the other. But all these risks (excluding foreign exchange and general economic non-trading) can be minimized if you choose a reliable broker who is experienced, licensed, and is skilled at detecting favorable market conditions.
TOP 5 Reliable Forex Brokers for Investing
-
FxPro
The regulator of this broker is CySEC. The minimum investment deposit is $1. -
IC Markets
The minimum deposit is $200. PAMM trading services are offered. -
RoboForex
The broker's activities are regulated by IFSC. The minimum deposit for investing in RAMM is $100. -
Exness
The regulator of this broker is CySEC. The broker offers a convenient and safe service for investing in PAMM accounts, plus it can copy trades. -
InstaForex
The regulator of this broker is BVI FSC and the minimum deposit for the investment segment is $10. Modern PAMM and auto trading services are offered.
How to Minimize Forex Risks for the Investor?
Today, an investor in the Forex market has many more opportunities to minimize risks than 5-10 years ago. Some mechanisms are universal. Below, is a basic list of solutions to reduce, and sometimes eliminate, trade and non-trade risks:
you can invest not in a specific PAMM or LAMM account, but in an investment portfolio prepared by a broker to make up for the loss on one account with profits from other accounts;
it is important to carefully select a Forex broker because you will be increasing or decreasing investment risks depending directly on its reliability and the opportunities it provides;
it is necessary to constantly monitor the global economic situation, follow the news and, if possible, receive advice from more experienced traders;
The trader and the investor need to listen to their intuition, which naturally intensifies over time, and which allows you to avoid non-trading risks.
For PAMM or LAMM accounts, it is important and necessary to use portfolios. Indeed, it is obligatory for novice investors. You can create your own portfolios by selecting top managers based on their broker ratings.
You can, for example, use one manager who specializes in a standard euro/dollar pair, and another broker who specializes in trading precious metals. Then, if the foreign exchange market is destabilized by a crisis, you are unlikely to lose funds invested in precious metals. Moreover, you may win.
An alternative way to get a portfolio to reduce investment risks is to adopt a ready-made portfolio. Many brokers provide investors with free portfolios set up to achieve different goals.
Risks are diversified in independent trading by applying three components — (i) competent and meticulous elaboration of a trading strategy; (ii) monitoring global political and economic news; and (iii) obtaining advice from professional traders. Sometimes brokers provide such advice for free, but more often it is a paid service that pays for itself.
Minimizing risks when investing in trusts presents two options. The first is do not invest your funds with little-known private traders. Instead, do so with employees of licensed and established brokerage companies that provide such services. The second option is to carefully learn ratings and statistics of the top traders, choosing only the most reliable. Of course, it’s more profitable to use both options at once.
FAQs about Forex Trading Risks
What is more profitable - trading or investing?
Only 11-25% of the total number of novice traders become successful. For Forex investors, this figure is almost 40%. In terms of profit, both options can give good income, the difference is that investing is a passive income.
What type of Forex investing is best?
All investment options are currently popular — PAMM, MAM, and RAMM accounts; LAMM systems; trust management; auto trading (copying trades based on providers' signals). Each option has distinct advantages, as well as risks, and is selected based on the personal preferences of the investor.
How realistic is it to reduce risks when investing?
Very. Choosing a reliable broker and successful managers, allocating capital between several accounts, monitoring news, and the global market. Several other methods can help to significantly reduce trading and non-trading risks.
How to choose a good broker?
Top brokers may be analyzed according to the following indicators: (i) experience in the Forex market; (ii) trading instruments; (iii) trading conditions; (iv) regulations (e.g., licensing); and (v) advantages of investment programs. To simplify the task, you can use the ratings of the independent Traders Union.