We often hear and read that currency trading or forex is the riskiest asset class amongst all other securities like stocks, options and futures. Many fund managers also agree on this statement fully. As one senior investment executive of an asset management firm in New York says, “I think individuals should allocate zero dollars to currency trading”. You may also share the same sentiments regarding forex. So, is forex too risky?
On the other spectrum, we also hear the necessity to include currencies with other asset classes to a have a balanced and risk-averse investment portfolio. “Investing in a variety of products and securities can be a strong, balance approach to growing your wealth” according to Zacks Investment Research. Furthermore, we also know foreign Central banks and governments hold forex or monetary assets to back liabilities on their own currency. So, should we include forex as an investment vehicle?
I wanted to discover the fact whether forex trading is too risky supported with a scientific fact and not just based on some personal experiences or hear say.
I have been trading stocks and ETFs for many years and later on, I moved over to forex because my trading strategies were more conducive to be traded on 24/5 market to avoid the sudden gap in prices that can have a big impact on my entries and exits as in stock market, when the stock market opens the next day. I always felt that trading forex, in general, is of a lower risk with having fewer and tamer price gapping and I can enter or exit the trades readily at the price I set. But, why many traders believe forex is having the highest risk and therefore encourage new traders to avoid it? My views on forex differ from many, and I would like to show how forex is not as risky as you might think.
To evaluate the risk level on forex is pretty straightforward. For example, we know, Volatility Index (VIX) is used to evaluate near term market risk in the S&P500 option index. VIX values greater than 30 are generally associated with a large amount of volatility as a result of investor fear or uncertainty, while values below 20 generally correspond to less stressful, even complacent, times in the stock market.
One can therefore, can look at the volatility of any underlying asset to gauge the riskiness of an asset. Volatility is a statistical measure of the tendency of a market to rise or fall sharply within a short period of time. A higher volatility indicates the value of the security or asset is spread out over a large range in either direction. And, a lower volatility means that a security’s value does not fluctuate dramatically in value in a given time. Higher the volatility, the riskier the asset.
Which is Riskier, Stocks or Forex? Let’s take a closer look at the actual price data between stocks and currencies over a period.
For this analysis, I picked 3 commonly traded stocks (Amazon - AMZN, Apple - AAPL, and Caterpillar CAT) and 3 commonly traded currency pairs (EUR/USD, AUD/USD and GBP/USD).
For the period of 3 months, from May through July, I am able to plot the spread of the daily price (in percentage) from the previous closing price. This chart plots the spread of the daily price from the previous day, and therefore the spread in the daily price can be termed as the volatility spread.
Below are the Stocks vs Forex price volatility charts. The scale of the charts are set at the same level on all charts so that the price spread can be easily compared to one another.
Here is the summary of what we see on these charts:
Amazon saw a 4.5% spread in late July, and there were seven other incidences with over 3% in price fluctuation
CAT stock saw a whopping 6.5% spread (Jul), and 4 other price fluctuation above 3% during 3-month period
AAPL had a 5% move once (May), and there were 4 others above 3% spread.
From the above charts we are able to compare and contrast the volatility outcome between stocks and forex. By looking at the spread of the price and the number of occurrences of a larger price fluctuations, we are able to see stocks are more volatile or have higher tendency to fall or rise when compared to forex. In fact, stocks are nearly four times (or 3.8x to be precise) more volatile than the currencies. So, the risk factor between stock and forex is 4. This result can come as a surprise that stocks are 4 times riskier than forex.
From the plots, none of the three currencies saw any price fluctuation above 2% on any given day, but on stocks, such variations are common occurrence.
As we know now, forex is about 4x less risky than stocks, it is easy to determine the maximum leverage it required to match equally to Stocks. Here, we want to have forex bench-marked with stock trading so that the risk between the two asset classes is equally balanced.
To do this, here is a simple calculation.
We know stocks trading are allowed to have up to twice the margin or leverage for overnight trades. So, for forex to match with the same risk tolerance, the maximum forex leverage can be set to twice of the risk factor we have seen between stock and forex. That will be 2 x 4 = 8x leverage, for forex to match stock risk level. For any forex leverage set above 8x will tip forex to be more risker than stock.
So, if you are trading forex greater than 8x or 10x the leverage, think again. If you do, then you are clearly trading with a riskier asset than stocks. If you maintain your leverage around 8x, the risk is matched.
In one of my favorite forex strategy, I use only 1.5x leverage per currency pair and I ensure that not hold all open trades to exceed 8x the account level at any time. And yet, my account has grown to triple digits within months into trading and am using it as a long term passive income growth.
You surely don’t require super high leverage in forex to produce strong growth. With smaller leverage, it is possible to meet your trading goals and also avoid the risk in the market to lose it all. Plan your trade strategy to have smaller leverage and design a system that can yield reasonable growth potential.
The one big negative setback in forex trading is that traders can easily crank up the leverage at will to a dangerous levels that can lead to much greater risk exposure to the market.
It is the trader who is actually creating an unwanted and unwarranted risk in trading. So, it is not correct to point the blame at the asset class for the cause of account ruin by over exposing the risk.
Do remember, stocks are more risky than forex.
About the author
Ramesh is the author of 2 trading books “Trade Smart with 10/20/30 Rule™” and “Trade Forex with Confidence” which are available on Amazon. He created 10/20/30 Rule™ for traders to build and test their next money making trading strategy fast.