If you are one of those guys who have spent some time trading in the currency market, you would understand that currency trading is a risky proposition. Also the risk involved in currency trading is not due to your limitations, it is in fact due to rapid changes and volatility in the market. So, one of the most important things when it comes to investing in the currency market is avoiding unnecessary risk.
But risk management is not as easy as it might sound. This is primarily due to the fact that risk mitigation and risk avoidance involves identification of risk; something that cannot be done very easily. Risk identification is difficult because the sources of risk are often hidden and unpredictable when it comes to currency trading. For example, the risk associated with market volatility is difficult to judge because there are no specific factors which may lead to market volatility. So what needs to be done is try to lower risk in areas where its identification is easy.
One of the most popularly used methods of risk mitigation is diversification. Diversification involves opening positions in various currency pairs at the same time; the only precondition is that the movement of currency pairs selected is not dependent on each other. With diversification you put in only a small fraction of your money into a single trade; thus even if the trade goes bad your losses are quite less.
Another great method that is generally used for the purpose of managing risk in the currency market is the use of forex options. An option is basically a contract which gives you the right to purchase or sell a currency pair at a future date. Options are used to mitigate the risk involved with currency trading. Let us take an example to illustrate this. Suppose you have entered in a trade in the currency market by purchasing EUR/USD at ‘x’ price hoping that the price would rise of ‘y’ in three months, where ‘y’ is greater than ‘x’. Now to protect yourself you buy an option that gives you the right to purchase the currency pair three months from now at a strike price of ‘z’. Now at the end of three months, if the price of currency pair is more than ‘z’ you exercise the option, buy the currency pair and sell in the market to garner a profit from the sale of the currency pair. But if the price is less than ‘z’ you let the option expire.
Apart from these, there are several other techniques such as hedging which can help you in mitigating risk in the currency market. In hedging you take a position opposite to what you have taken at the moment and profit if the market moves in either direction.
Thus it can be seen that there are several methods which can be used for the purpose of mitigation of risk in the currency market. The thing is that the currency market although risky has its pros and once the risk management methods are applied correctly chances of losing out in the market drastically reduce.