Understanding the Seven Risks of Trading

Trading risks
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Trading is a risky business. Getting involved in the financial markets is not all smooth sailing! There are financial losses, all sorts of scams, and the possibility of addiction, to name a few perils.

And yet, warnings about the risks of trading—despite being legally required—are often displayed in tiny print, specifically designed to go unnoticed by the reader.

And even though the novice trader has a keen eye for these types of warnings, they are incomplete. On the one hand, they rarely include the exhaustive list of risks associated with trading, and on the other hand, they never attempt to explain in detail the origin of these risks.

What are the risks of trading? Where do they come from? How can you protect yourself?

Here are the seven risks associated with trading that you need to know and understand before you take the plunge.

WARNING

Trading exposes you to the risk of losing more than your initial investment and incurring financial liability. Trading is suitable only for well-informed, sophisticated clients able to understand how the products being traded work and having the financial ability to bear the aforementioned risk.

Transactions involving foreign exchange instruments (FOREX) and contracts for difference (CFD) are highly speculative and extremely complex. As such, they are subject to a high level of risk due to leverage. Please keep in mind that CDF trading is banned in the US.

Information published on the NewTrading.io website is for educational purposes only and should not be construed as offering investment advice or as an enticement to trade financial instruments.

#1 Market Risk

Trading is the buying and selling of financial products. 

Because market prices can go down as well as up, you can earn a profit when your bet is on target, but you can also lose money when you are not right.

Reselling a financial product for less than its purchase price (in a buy-and-sell transaction) or buying a financial product for more than its sale price (in a short-sale transaction) is indeed the market risk to which you are exposed as a trader.

All things being equal, the larger the size of your position, the greater the exposure to risk. In other words, for the same financial product, the greater the investment, the greater the risk.

Therefore, using leverage to invest in the markets on credit and artificially increase position size, dramatically increases the exposure to market risk.

Without leverage, your theoretical maximum loss as a trader is limited to the amount in your trading account. On the other hand, with leverage, your theoretical maximum loss is equal to your total position size (the amount in the account plus the amount invested on credit). As a result, you may end up in debt if things take a turn for the worse. 

Any financial product, even the stock of well-established companies, can suddenly fall by several dozen percentage points, perhaps dropping to zero, and in some cases, even begin to move into negative territory.

The leverage effect then becomes a sledgehammer effect.

You can use a stop-loss order to limit losses and close positions automatically when a certain price level is reached.

However, placing a stop order will not be sufficient in the event of a price gap, as your position could be closed at a lower price level.

Noteworthy

Although not an integral part of market risk, brokerage fees collected by financial intermediaries can add up in the event of a loss.

#2 Foreign Exchange Risk

Trading a financial product denominated in a foreign currency exposes the trader to a second risk: currency risk.

Currency risk is the possibility that the exchange rate between the trader’s home currency and the foreign currency used to make the investment moves unfavorably on the currency market (FOREX).

For example, a trader based in France holding a financial product denominated in US dollars will be exposed to currency risk, i.e., the possibility that the value of the greenback may fall against the single currency, reducing the value in euros of his investment made in dollars.

That’s right. Achieving a +1% return on an investment denominated in a foreign currency can be a poor transaction if the euro simultaneously appreciates more than +1%!

#3 Counterparty Risk

Trading in financial derivatives exposes you to a third risk: counterparty risk.

Unlike stocks or bonds, a derivative does not grant ownership rights but commits you to a financial contract.

On organized markets such as the futures market, your counterparty will be a clearing house (considered a sure thing). But in the OTC markets such as CFDs, your counterparty could well fail to keep their promise and default.

Therefore, counterparty risk is the possibility that one or more parties to a financial contract may fail to meet their commitments (or delay doing so).

#4 Execution Risk

Execution risk refers to the possibility that your broker might not correctly execute stock market orders you send, or might not execute them at all.

Many factors can complicate a financial intermediary’s job and reduce the execution quality they offer customers, including but not limited to high volatility, illiquid markets, and technical problems.

Therefore, when choosing your broker, be sure to ask how accurate their execution is and demand the best, even if it means accepting slightly higher brokerage fees to guarantee superior execution quality.

But the broker is not always the only one responsible when a stock market order ends up being executed at a lower price level.

In the financial markets, you still need an available counterparty for a buy or sell order to be executed under the conditions you have stipulated (direction, price level, quantity, etc.).

The more demanding the execution conditions of a stock market order, the greater the probability it will not be executed or will only be partially executed.

The least demanding stock market order, the market order, is routinely executed but does not include a price-level guarantee.

Limit orders, on the other hand, are more sophisticated and provide a price-level guarantee. However, they are only executed if a counterparty is available in the order book and the requested price conditions match. Partial execution may occur if conditions match, but the available quantity is insufficient.

#5 The Risk of Scams

Because the money involved is so great, the trading market generates greed, and unfortunately, some players are quick to break the law to enrich themselves at the expense of others.

Always review BrokerCheck, or any other website provided by regulators, and online customer reviews, to verify that your financial intermediary is reliable. And beware of tempting offers that are too good to be true!

#6 Legal Risk

It is a crime to attempt to manipulate market prices (either directly by placing stock market orders or indirectly by disseminating false information), just as it is a crime to buy or sell financial products based on insider information.

Professionals are not the only ones affected by the regulations. Individuals can also be fined and even imprisoned for insider trading or attempted price manipulation.

Never engage in any practice that you consider to be unfair to other traders or illegal under current regulations.

#7 Addictive risk

Trading is like gambling. 

Repeated financial betting triggers bursts of dopamine and adrenaline, a highly addictive cocktail for the human body. Although seldom discussed, the risk of addiction to trading is very real.

Do not hesitate to contact specialized associations such as Gamblers Anonymous or Gamers Anonymous for support and help.

Reckless risk-taking, emotional instability, and social isolation are but a few of the dire consequences of being addicted to trading. Make sure you stay in control at all times and establish a trading budget that you can stick to.

Is a trader forewarned, a trader forearmed? Perhaps. But one thing is certain: you now know all about the risks of trading. So, without getting paranoid, take steps right from the start to limit your exposure to risk and trade without jeopardizing yourself.

author
Maxime Parra

Maxime holds two master’s degrees from the SKEMA Business School and FFBC: a Master of Management and a Master of International Financial Analysis. As founder and editor-in-chief of NewTrading.fr, he writes daily about financial trading.

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