Certain markets, particularly in Latin America, Eastern Europe and Asia, still have developing economies compared with Western countries which often means that they will have restrictions in the form of legal and regulatory frameworks designed to protect their currencies and economies from speculators. This makes trading in these currencies much more difficult than with the major world currencies and you may need to consider dealing in those countries in a ‘hard currency’ such as the U.S. dollar instead.
Managing Your Foreign Exchange Risk
Controlling risk is one of the most important ingredients of successful trading. While it is emotionally more appealing to focus on the upside of trading, every trader should know precisely how much he is willing to lose on each trade before cutting losses, and how much he is willing to lose in his account before ceasing trading and re-evaluating.
Risk will essentially be controlled in two ways:
1) by exiting losing trades before losses exceed your pre-determined maximum tolerance (or “cutting losses”), and
2) by limiting the “leverage” or position size you trade for a given account size.
Too often, the beginning trader will be overly concerned about incurring losing trades. He therefore lets losses mount, with the “hope” that the market will turn around and the loss will turn into a gain.
Almost all successful trading strategies include a disciplined procedure for cutting losses. When a trader is down on a positions, many emotions often come into play, making it difficult to cut losses at the right level. The best practice is to decide where losses will be cut before a trade is even initiated. This will assure the trader of the maximum amount he can expect to lose on the trade.
The other key element of risk control is overall account risk. In other words, a trader should know before he begins his trading endeavor how much of his account he is willing to lose before ceasing trading and re-evaluating his strategy. If you open an account with $2,000, are you willing to lose all $2,000? $1,000? As with risk control on individual trades, the most important discipline is to decide on a level and stick with it.
Once you have a clear idea of what your foreign exchange exposure will be and the currencies involved, you will be in a position to consider how best to manage the risk. The options available to you also fall into three categories:
Do Nothing: You might choose not to actively manage your risk, which means dealing in the spot market whenever the cash flow requirement arises. This is a very high-risk and speculative strategy, as you will never know the rate at which you will deal until the day and time the transaction takes place. Foreign exchange rates are notoriously volatile and movements make the difference between making a profit or a loss. It is impossible to properly budget and plan your business if you are relying on buying or selling your currency in the spot market.
Take out a Forward Foreign Exchange Contract: As soon as you know that a foreign exchange risk will occur, you could decide to book a forward foreign exchange contract with your bank. This will enable you to fix the exchange rate immediately to give you the certainty of knowing exactly how much that foreign currency will cost or how much you will receive at the time of settlement whenever this is due to occur. As a result, you can budget with complete confidence. However, you will not be able to benefit if the exchange rate then moves in your favour as you will have entered into a binding contract which you are obliged to fulfill. You will also need to agree a credit facility with your bank for you to enter into this kind of transaction.
Use Currency Options: A currency option will protect you against adverse exchange rate movements in the same way as a forward contract does, but it will also allow the potential for gains should the market move in your favor. For this reason, a currency option is often described as a forward contract that you can rip up and walk away from if you don’t need it. Many banks offer currency options which will give you protection and flexibility, but this type of product will always involve a premium of some sort. The premium involved might be a cash amount or it could be factored into the pricing of the transaction.
Finally, you may consider opening a Foreign Currency Account if you regularly trade in a particular currency and have both revenues and expenses in that currency as this will negate to need to exchange the currency in the first place. The method you decide to use to protect your business from foreign exchange risk will depend on what is right for you but you will probably decide to use a combination of all three methods to give you maximum protection and flexibility.