Unmasking Hidden Perils: the Iceberg of Risks in Trading
Trading can be an enticing prospect, offering entrance to financial markets and financial independence. However, beneath the surface of trading opportunities lie hidden risks that can sink aspiring traders and even the most seasoned investors.
In this article, we will explore the importance of understanding these risks, define different types of market risks, and uncover strategies to mitigate them, ensuring a secure and thriving trading experience.
The tip of the iceberg: visible risks
Many traders, especially those just starting their journey, tend to focus on visible financial market risks like market volatility, economic indicators, and political instability. While these factors are undoubtedly crucial, they represent just the tip of the iceberg.
Market fluctuations are a fairly common occurrence in the financial world, making volatility one of the most well-known types of market risk. Prices of assets can swing wildly in response to various market events, news, and market sentiment. While volatility can present plenty of opportunities to profit, it also exposes traders to significant risks. Sudden drastic price movements can trigger Stop Loss orders or forced closure of trades, leading to missed profit potential. Moreover, emotional decision making during highly volatile periods can lead to impulsive, unfavorable trades.
Gross Domestic Product (GDP) growth, employment rates, inflation, interest rates, and other indicators provide valuable insights into the health of an economy. Changes in these indicators can influence market sentiment and asset prices. Traders must keep a close eye on economic data as it can significantly impact their trading decisions. Otherwise, ignoring these fundamental factors can leave them vulnerable to unexpected price swings and adverse market conditions.
Geopolitical events such as elections, trade disputes, and international conflicts can create uncertainty in financial markets. Political instability can lead to increased volatility and sudden market reversals, causing unforeseen losses for traders.
The iceberg below: hidden risks
Hidden risks can have significant and often unforeseen consequences. They may not be immediately apparent but can catch traders off guard and lead to unexpected losses. Recognizing and managing them is essential for those seeking long-term success and trading stability.
Leverage allows traders to control larger positions with a smaller amount of capital. While this magnifies potential profits, it also amplifies potential losses. Traders must use leverage wisely to avoid margin calls, especially in unstable market conditions.
Trading involves dealing with brokers, and counterparty risks may arise when one party fails to fulfill its obligations, leading to potential losses for the other party. While counterparty risks are usually small and manageable, unforeseen events such as bankruptcies or defaults can have far-reaching consequences. That is why choosing a regulated broker that guarantees the fulfillment of its obligations is crucial.
Liquidity risks refer to the potential for difficulty in executing trades at desired prices or the possibility of facing wider spreads due to insufficient trading activity or market participants. Liquidity risks are particularly relevant in markets or assets that have low trading volumes or are highly illiquid. A reliable broker uses a trusted liquidity provider to avoid such risks.
Case Studies: Real-world Examples of Hidden Risks
Flash crashes are the greatest examples of market risk, providing more highlights into the hidden risks associated with CFD trading.
Flash Crash of the British Pound in 2016
In October 2016, the British Pound experienced a sudden and sharp flash crash during the Asian trading session. The GBPUSD pair plummeted by over 6% within a few minutes, creating chaos in the currency market. Traders faced liquidity risks, as the sudden price decline resulted in wider spreads, increased slippage, and execution delays.
Collapse of Forex brokers in 2015
In 2015, some Forex brokers faced severe financial difficulties and went bankrupt overnight amid the EURCHF Flash Crash. Client funds held with these brokers were at risk, and many traders faced losses in their open positions. This incident highlighted the importance of conducting due diligence on the broker’s financial stability and regulatory compliance.
Oil price collapse in 2020
One of the most well-known examples of market risk occurred in April 2020. The price of crude oil experienced an unprecedented collapse, turning negative for the first time in history. As oil prices fell sharply, traders with leveraged CFD positions were exposed to losses exceeding their initial investment. The extreme price movement combined with high leverage led to margin calls and significant losses for traders who did not use proper risk management techniques.
Mitigating the risks: strategies and best practices
Navigating the complexities of financial markets requires more than identifying visible and hidden risks of trading; it also demands effective risk-mitigating strategies. Managing market risks is a must for a successful trading experience.
Diversifying a trading portfolio across different asset classes can reduce exposure to specific risks. A well-diversified portfolio is less likely to be severely affected by the adverse performance of any single asset. At FBS, you can trade over 650 CFD assets based on currencies, stocks, metals, energies, and more asset classes on Standard, Cent, and Pro accounts.
Regular market analysis
Staying informed about market trends, economic developments, and political events is crucial for making well-informed trading decisions. Conducting thorough market analysis helps identify potential risks and opportunities, allowing traders to adjust their strategies accordingly. You can monitor financial news, economic calendars, and expert analyses to obtain valuable insights and stay ahead in the markets.
Risk management tools
Implementing risk management techniques, such as setting Stop Loss orders, position sizing, and utilizing risk-reward ratios, can help control potential losses and protect trading capital. Setting clear tolerance levels and adhering to them consistently can prevent emotional decision making and impulsive actions during market volatility.
Trading in the financial markets may provide immense potential, yet it does not come without dangers. While visible risks such as market volatility or economic indicators are apparent, hidden risks lurk beneath the surface.
By recognizing the importance of managing both visible and hidden risks, traders can safeguard their funds, implement appropriate strategies, and improve their chances of long-term success through diversification, regular market analysis, and the use of risk management tools.
At FBS, we are always here to help you navigate the world of trading. Join us and enhance your skills.