FX During Recession: Manage FX Risk in a Recession
After almost two years, the world is finally starting to get a handle on the coronavirus pandemic. However, there is no denying the massive socio-economic toll it has taken across the globe. GDP forecasts are down in both developed and developing economies, and unemployment levels continue to rise.
These facts create a challenging situation for households worldwide, as they try to figure out how they can improve their cash flow and make money.
Some households look to generate additional income through trading options on forex markets, open 24 hours per day. The market is one of the largest globally, with nearly $6.6 trillion traded each day.
Because it is not directly tied to an economy, fluctuations in stock markets and international securities have little impact on currency prices. The market also trades on margin, meaning that investors can bet on currencies with borrowed money and rollover their debt as they continue to trade. These features mean that forex trading can be a good option in challenging economic times.
Today, we're going to explore how to manage FX risk in a recession. This is what you need to know:
2022 Recession in the UK
The UK has officially run into another recession, and their economy is not projected to improve in the near term. Part of the problem is that the Eurozone is in the process of going into recession, and the two economies are highly interdependent.
As the Eurozone struggles, goods and services produced outside the region become more expensive, which in turn lowers the purchasing power of the Euro. Goods produced in the UK become more expensive to trade, lowering demand. This can lead to a downward spiral, as the lower volume of goods sold in the region decreases demand for goods produced elsewhere.
As you know, when we talk about risk, there are several factors at play. First, we have systematic risk, which represents the risk that is inherent in the market as a whole. Then, we have market risk, which comes from the type of asset in question. For example, FX markets are highly volatile, so they are subject to strong fluctuations in the value of currencies.
This is where FX risk comes into play. It is the risk that comes from financial transactions, and specifically the bid-ask spread. This is the difference between the price at which a broker can buy the currency, and the price at which the broker can resell the currency. The larger this difference, the greater the risk of loss.
Essentially, when you trade options on forex markets, you are trading a spread - also known in this context as the bid-ask spread. You buy one currency on the bid and sell it on the ask.
As a rule of thumb, the more volatile a currency, the greater the spread. This is because the currency will have a greater risk of loss, and the broker will try to offset the risk by increasing the spread.
Several types of risk can be identified in the bid-ask spread. These are the interest rate risk, time risk, and liquidity risk. You can successfully manage the spread and reduce your FX risk by managing each of these risks.
What to Expect During This Recession
The UK is by no means the only country struggling with economic woes. Several countries in the Eurozone, the US, and Japan are also in recession. Traders are looking for ways to hedge their investments, where currency options can be a valuable tool.
The first thing to notice is that the change in Eurozone countries will have much more impact on the GBP/USD than UK economic issues. The UK and Europe trade over $700 billion in goods per year, and the UK has a trade deficit of almost $16 billion.
The UK is struggling because of the poor economic conditions in Europe, and a recession in the US will also have a negative impact on the British economy. As a result, it is important to consider four main factors when dealing with the GBP/USD in a recession:
The first factor we need to consider is the money supply. The money supply is the amount of currency held by the public in circulation and is one of the most important economic factors to monitor in a recession.
In a recession, interest rates are low, meaning less money flowing into the market. As a result, the demand for currency is reduced, leading to low supply. In this case, the monetary policies of the Bank of England will have a huge impact on the FX market.
The second factor we need to consider is inflation. In a recession, inflation will be higher than in normal times. In times of economic uncertainty, more people will hold cash instead of spending it.
This creates a substantial negative balance in the economy, and since the economy uses cash to measure its output, it will flood the market with currency. As a result, currency's purchasing power goes down, and inflation goes up.
The third factor we need to consider is government debt. In recent years, the global debt crisis has changed the perception of government debt. This has made it much more difficult for the central banks of developed countries to stimulate the economy.
In a recession, central banks will try to increase the money supply to stimulate the economy.
However, when interest rates are very low, the central banks will have difficulty expanding the money supply. This is because when interest rates are low, the government is paying less interest to investors, so the return on the investments is reduced. This, in turn, reduces the number of money investors are willing to put in the market.
How to Manage FX Risk During a Recession
Managing your FX risk during a recession is slightly different from when you are trading during a bull market. However, if you follow these three steps, you should be able to manage your risk, and increase your return on investment.
1. Manage Your Time Risk
Time risk refers to the volatility of the currency. The more volatile a currency, the greater the time risk. The way you manage time risk is to try to pick currencies with less volatility.
One way to do this is to look at the currency chart for a currency pair. If the pair has a downward trend or appears to be headed downward, then you should consider selling the pair. Look for currency pairs with a downward trend, as long as the trend line is consistent. Once you have identified a pair, do some research on the countries' economies that make up the pair.
For example, if you are looking at the US dollar vs. the British pound, look at what is going on with the economies of the US and the UK. If you see that the US is growing significantly faster than the UK, you may want to consider taking a short position on the USD vs. GBP.
2. Manage Your Spread Risk
Spread risk is a bit more challenging to manage because it is based on the bid-ask spread. The spread risk comes from the bid price being lower than the asking price. This creates a risk of loss because you don't know whether the price will rise or fall before you can resell the asset.
To manage spread risk, you'll need to know the precise prices at which you can buy and sell your asset. The easiest way is to use a charting program to create a moving average or a trend line. You can then use that trend line or moving average to determine where to buy and sell.
3. Manage Your Liquidity Risk
Liquidity risk is a bit difficult to manage, because it comes down to the market as a whole, and not a particular pair. FX markets are highly liquid, but stocks are even more fluid. Because they are so liquid, they are excellent barometers for whether or not a call is in a bear or bull market.
During a recession, people will be more hesitant to purchase securities. This means that not only is the bid-ask spread higher, but the actual stock market value will also be lower than it was in a bull market. This is why it is essential to keep your trading portfolio diversified and not invest too much money in any one sector.
4. Manage Your Interest Rate Risk
Interest rate risk is perhaps the most difficult of all the risks to manage. Changes in interest rates occur very slowly, and the amount of time it takes for the changes to be translated into currency prices is very difficult to predict.
Managing interest rate risk means looking at the currency chart and watching the trend lines. You want to make sure that interest rates are trending higher and trending up quickly. You can use these trend lines to determine where you should buy or sell your currency.
Once you have identified a pair, look at the bid-ask spread on the pair. You want to narrow the spread to have a larger profit margin. One way to do this is to set your stop-loss to slightly more than the spread. This way, you will only lose a small amount if the asset's price goes against you. If the price goes in your favor, you will make a large return on investment. Find out more about Hedging FX Against Raising Interest Rates.
The Impact of Recessions on Forex Trading
Forex trading is a bit different from other types of investing. Unlike stocks, bonds, and other assets, currencies are not as volatile. This is because the market determines the price of currencies.
During a recession, currency volatility will increase as investors look for a safe haven for their money. Currencies can be very profitable in times like these because the spread between the bid and the asking price will be greater. This means that you can make a nice profit on your investment if you are careful. F
However, if you don't understand the risks of the currency you are trading, you can easily lose an enormous amount of money. The key to successfully trading during a recession is to control the risks you take on carefully.
Being profitable in a recession is not easy. Still, if you pay close attention to the signals that the market is sending, you can take advantage of the opportunities that present themselves.
Planning for a Recession
Most people don't plan for a recession because they don't expect one ever to happen. However, if you want to stay profitable during a recession, you need to be prepared.
The first thing you need to do is look for ways to hedge FX risk during a recession. Many traders will advise you to diversify your portfolio but this isn't possible for many businesses who don't want a game of chance.
During a recession or any other instance that may cause volatility, you should review when these currency exchanges are needed. Once this has been done you can look for hedging strategies ideal for your business's personal needs.
In conclusion, it is essential to understand that a recession is a normal part of the business cycle. By diversifying your portfolio and focusing on the charts, you can take advantage of the short-term opportunities the market presents. However, you cannot sit back and expect to profit because you have to manage your portfolio actively.
If you are looking to trade forex, you need to know what a recession is and how it affects the market. You can learn more about recessions by talking to a professional forex trader who is also an expert in business planning.
By working with a person who has experience in the field, you can manage your risk and take advantage of short-term opportunities.
Bound is an auto hedging platform dedicated to making currency protection better for businesses. It's a great software program to help you look at the risk you have in any one currency. Watch a demo today to learn more, and contact us for more information!