Page 107 - Ultimate Guide to Currency Trading

The Elements of FX Risk

The basic principle behind investing is that a portfolio that is fully insulated from risk will by definition
have a zero yield. To put it another way, in order to have the potential for gain, you must assume
some risk.

If you think of yourself like an investment bank, hedge fund, or even an FX trading house,
what you will then naturally do is think more profession-ally. You will enter into risk and then at a later
date exit out of that risk. You will also expect compensation for undertaking that risk.

Taking cash, exchanging it for a currency pair, and holding it for a length of time before
exiting the trade and going back to cash is a form of banking. This process is one of the
basic functions of financial intermediaries. It is called asset transformation.

This transformation is also the basis of the risk-return relationship in currency trading. While it
is true that you must assume risk in order to have the chance of a return, there are limits to the return
that can be made for the risk that you assume in your FX portfolio. In addition to this, there is an idea
that you should not go about investing in risky or very risky assets expecting returns, all while not
monitoring the quality of the risk. Rather than putting your money in high-risk assets and expecting
high rewards, there is a way to get the most for your risk. The idea should be to get the maximum
return for each unit of risk that you are undertaking.

This principle of seeking out the most return for the least amount of risk undertaken can be
measured. An investment's Sharpe ratio is the method of comparing how good an investment (or
investment portfolio) is performing compared to others. The Sharpe ratio is calculated using an
investment's daily up-and-down movement versus its overall return. The higher the Sharpe ratio, the
better and more efficient the investment is comparatively.

This more return for less risk is the driving force behind most investment systems. More
return for less risk can be the idea behind your currency-trading system also. If you know where the
risk comes from in trading currencies, then you can take steps to limit this risk and effectively get
more for your money. Additionally there are ways to tweak your FX investments to make your
currency portfolio detuned for a lower, slower, more manageable trading account. Conversely, you
can amp up your FX investments and turn your portfolio into a hands-on, high-return account.

Determining Your Risk Tolerance

Determining your risk tolerance can go a long way in helping you decide what type of currency trading
you would like to try, and what type of currency trading system you need to set up to keep you in the
FX game. It would not be right to become tame and dormant with your trades if you would like to