Trading in the forex market surely comes with its own risks for retail traders. The volatility of the forex market makes it unpredictable, with as high as 80% of retail forex traders recording loses while using leverage when trading FX & Contracts for Difference (CFDs).
Kenya has above 100,000 active forex traders. But there is no statistics on the number of Kenyan traders that lose because unlike what is mandated in the United Kingdom by FCA, Kenyan forex brokers are not mandated by the forex market regulator (The Capital Markets Authority, CMA) to publicly state the percentage of traders who lose money trading with them.
This topic will raise awareness on the major risks faced by a forex trader in Kenya.
In this article
1. Leverage Risk
When trading currency pairs, there is bound to be upward or downward fluctuation in the prices. However, these fluctuations can be in very small decimals so to make a reasonable profit, traders have to buy more units of currency pairs.
Since most traders don’t have very high capital to trade large units of currency, traders borrow money from the broker and this is the concept of leverage.
The amount of money the broker can lend to the trader depends on the leverage ratio. In Kenya, a maximum leverage of 1:400 is allowed by the Capital Markets regulator.
A leverage ratio of 1:400 means that for every KSh 1 a trader puts on the table, the broker can lend him/her a sort of loan of KSh 400.
However, before a buy or sell position is opened, the forex trader is asked to make a percentage deposit into his/her account and that deposit is inversely proportional to the leverage. In the case above, the percentage deposit will be 1/400 or 0.25% of the total contract sum. This deposit is called initial margin. KSh 1 is your margin money.
When trading with margin, money is borrowed from the broker to trade and your margin money acts as the collateral for the loan.
If contract sum is $100,000 and the leverage is 1:400 and the margin is 0.25%, it means the trader will have to deposit just $250 (0.25% of $100,000) to open a trading position while the broker borrows the rest to the trader.
As the trader keeps opening trading positions, the initial margin used to trade gradually becomes used margin, thereby reducing the initial margin.
As the initial margin keeps being used up, it gets to a point when it falls below the minimum acceptable requirement called the maintenance margin. At this point the trader is called to urgently pay in more money to his account or risk having all his trading positions whether winning or losing, closed. This call is referred to as a margin call.
If the trader cannot come up with this money soon enough all his open trading positions are closed irrespective of whether he was winning or losing in the trade.
This is the risk of using leverage to trade forex. While using leverage may be inevitable, it should be used carefully.
Always remember that the higher the leverage used, the higher the risk of a margin call.
2. Interest Rate Risk
Every currency traded belongs to a country and that country’s Central Bank may choose to review interest rates downward or upwards to suit their circumstances.
Since the USD is the reserve currency of the world, a sudden change in their interest rates that is higher or lower than expected is likely to affect other currencies.
Let us look at the effect of a downward and upward review of interest rates on a currency.
(a) Downward review of Interest Rates:
This means that interest paid on savings will be reduced and interest charged on spending money will also be reduced.
If a country lowers their interest rate, people will reduce the rate at which they save money in the Banks and will buy less of debt instruments like Bonds, Treasury bills, fixed deposits etc.
And people will also borrow more to increase their spending. People will start spending more thereby buying more goods. This will cause the supply of the currency to increase, hence the exchange rate of the currency will depreciate against other currencies.
Example, a trader who is betting on the GBP/USD exchange rate to appreciate may lose money when the UK lowers their interest rates.
(b) Upward review of interest rates:
This means that people who save money in the Bank will be paid more interest and people who spend money will be charged more interest. Since saving has become more attractive, this causes people to spend less and hence demand for goods and currency supply decreases and hence the currency becomes stronger.
Another point to note is that in forex trading, when a trader buys the currency of a country whose interest rate is higher than the quote currency’s own and holds the position open overnight, the trader is paid an interest.
However, when a trader buys the currency of a country with a lower interest rate than that of the quote currency country, the trader is charged an interest if he holds the position open overnight.
Let’s understand this with an example.
A trader buys a GBP/USD currency pair. The GBP is the base currency and the USD is the quote currency. If the interest rate in the UK is higher than that of the U.S., the trader earns interest on holding the position open overnight.
However, if the interest rate in the U.S. (the quote currency) is higher than the interest rate in the U.K. (base currency) then the forex trader is charged interest if he holds the trading position open overnight.
A forex trader who has an overnight open position when the interest rate of the base currency reduces to less than that of the quote currency could end up being charged and lose some money.
3. Counterparty Risk
Counterparty risk is the risk that the forex broker or any other party to a contract will default in meeting their contractual obligations at any point in time.
The Capital Markets Authority has set the minimum capital requirement for dealing and non-dealing forex brokers in Kenya at KSh. 50 million and Ksh. 30 million respectively. This is to make sure the brokers are solvent enough to meet their contractual obligations.
However, rogue brokers still operate online and they pose a risk to traders. Some of them operate without licenses and some with cloned licenses.
Karan from Safe Forex Brokers which compares regulated forex brokers in different regions advises that Kenyan forex traders should check the CMA website for a list of non-dealing licensed forex brokers to be sure of if a forex broker is licensed before doing business with them.
There are six CMA regulated non-dealing forex brokers that are licensed to accept traders in Kenya. The trader should also confirm from CMA’s list of licensees that the phone number and email address on the CMA website matches that of the forex broker in question.
Forex traders in Kenya should patronize only CMA licensed forex brokers so as to qualify for financial compensation from the Investor Compensation Fund should the trader suffer pecuniary loss due to the inability of a licensed broker to meet his contractual obligations.
Unlicensed online forex brokers pose great risks to forex traders as they could lose all their funds.
Also, when trading spot FX, and using OTC derivatives such as forward contracts there is a possibility that the other party can refuse to honor the contract since forward contracts and spot FX are not traded on an Exchange.
4. News Risk
The forex market is very volatile and it’s so unpredictable that a single news report could cause a currency to lose value immediately.
This is so because many forex traders ‘’trade the news” meaning they depend on the news for information on global activities like politics, conflict etc.
Negative news gotten from the media about a country can prompt forex traders to start selling off its currency and buying currency of other countries. This lack of demand for the country’s currency will cause it to lose value and any forex trader caught with an open position on that currency may have to sell at a loss to close his position.
Assume a forex trader had sold 10,000 units of the USD/TRY at an exchange rate of 10 before the Inflation data report in Turkey, expecting the USD to drop in value.
If after the news of the election protests broke out; and the inflation in Turkey is worse than expected, and the investors devise to divest their money out of Turkey. This causes the exchange rate to fall to 12 because there’s little demand for TRY), and the difference will be your unrealized loss.
5. Transaction Risk
The forex market is volatile and exchange rates change very quickly.
Between the times a forex trader enters a transaction and the time the transaction is settled, the exchange rate could suddenly change. This time could be as small as seconds.
When this happens, a trader could lose money due to the time delay between entering and settlement of the transaction.
Understand all the Risks before trading
Forex traders face several risks as we have seen and this is the reason why every trader must have a trading plan to address the risks awaiting him in the market.
Leverage must be used sparingly as borrowing money to trade exposes the trader to more profit as well as more loss.
Forex traders must also keep up with the news as events around the globe affect currencies.
Lastly, traders in Kenya should verify that their forex broker is licensed by the CMA.