Can Forex Trading Make You Rich?
Can forex trading make you rich? Although our instinctive reaction to that question would be an unequivocal “No,” we should qualify that response. Forex trading may make you rich if you are a
hedge fund with deep pockets or an unusually skilled currency trader. But for the average retail trader, rather than being an easy road to riches, forex trading can be a rocky highway to enormous losses and potential penury.
But first, the stats. A Bloomberg article in November 2014 noted that based on reports to their clients by two of the biggest publicly traded forex companies – Gain Capital Holdings Inc. (GCAP) and FXCM Inc. (FXCM) – 68% of investors had a net loss from trading currencies in each of the past four quarters. While this could be interpreted to mean that about one in three traders does not lose money trading currencies, that’s not the same as getting rich trading forex.
Note that those numbers were cited just two months before an unexpected seismic shock in the currency markets highlighted the risks of forex trading by retail investors. On January 15, 2015, the Swiss National Bank abandoned the Swiss franc’s cap of 1.20 against the euro that it had in place for three years. As a result, the Swiss franc soared as much as 41% against the euro and 38% versus the U.S. dollar on that day.
The surprise move inflicted losses running into the hundreds of millions of dollars on innumerable participants in forex trading, from small retail investors to large banks. Losses in retail trading accounts wiped out the capital of at least three brokerages, rendering them insolvent, and took FXCM, then the largest retail forex brokerage in the United States, to the verge of bankruptcy.
Here then, are seven reasons why the odds are stacked against the retail trader who wants to get rich through forex trading.
Excessive Leverage: Although currencies can be volatile, violent gyrations like that of the aforementioned Swiss franc are not that common. For example, a substantial move that takes the euro from 1.20 to 1.10 versus the USD over a week is still a change of less than 10%. Stocks, on the other hand, can easily trade up or down 20% or more in a single day. But the allure of forex trading lies in the huge leverage provided by forex brokerages, which can magnify gains (and losses).
A trader who shorts EUR 5,000 at 1.20 to the USD and then covers the short position at 1.10 would make a tidy profit of $500 or 8.33%. If the trader used the maximum leverage of 50:1 permitted in the U.S. for trading the euro, ignoring trading costs and commissions, the potential profit would have been $25,000, or 416.67%. (For an explanation of how to calculate forex P/L, see How leverage is used in forex trading.)
Of course, had the trader been long euro at 1.20, used 50:1 leverage, and exited the trade at 1.10 to the USD, the potential loss would have been $25,000. In some overseas jurisdictions, leverage can be as much as 200:1 or even higher. Because excessive leverage is the single-biggest risk factor in retail forex trading, regulators in a number of nations are clamping down on it.
Asymmetric Risk to Reward: Seasoned forex traders keep their losses small and offset these with sizeable gains when their currency call proves to be correct. Most retail traders, however, do it the other way around, making small profits on a number of positions but then holding on to a losing trade for too long and incurring a substantial loss. This can also result in losing more than your initial investment.
Platform or System Malfunction: Imagine your plight if you have a large position and are unable to close a trade because of a platform malfunction or system failure, which could be anything from a power outage to an Internet overload or computer crash. This category would also include exceptionally volatile times when orders such as stop-losses do not work. For instance, many traders had tight stop-losses in place on their short Swiss franc positions before the currency surged on January 15, 2015. However, these proved ineffective because liquidity dried up even as everyone stampeded to close his or her short franc positions.
No Information Edge: The biggest forex trading banks have massive trading operations that are plugged into the currency world and have an information edge (for example, commercial forex flows and covert government intervention) that is not available to the retail trader.
Currency Volatility: Recall the Swiss franc example. High degrees of leverage mean that trading capital can be depleted very quickly during periods of unusual currency volatility such as that witnessed in the first half of 2015.
OTC Market: The forex market is an over-the-counter market that is not centralized and regulated like the futures market. This means that forex trades are not guaranteed by a clearing organization, which gives rise to counterparty risk.
Fraud and Market Manipulation: There have been occasional cases of fraud in the forex market, such as that of Secure Investment, which disappeared with more than $1 billion of investor funds in 2014. Market manipulation of forex rates has also been rampant and has involved some of the biggest players. (For more, see How the forex “fix” may be rigged.) In May 2015, four major banks were fined nearly $6 billion for attempting to manipulate exchange rates between 2007 and 2013, bringing total fines levied on seven banks to over $10 billion.
The Bottom Line
If you still want to try your hand at forex trading, it would be prudent to use a few safeguards: limit your leverage, keep tight stop-losses and use a reputable forex brokerage. Although the odds are still stacked against you, at least these measures may help you level the playing field to some extent.
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What am I buying and selling in the forex market?
The forex market is the largest market in the world. According to the Triennial Central Bank Survey conducted by the Bank for International Settlements, the average daily trading volume reached $1.9 trillion in 2004. This huge trading volume provides the forex market with excellent liquidity, which benefits the large number of traders that invest there. The growth of the forex market has been spurred by the development of electronic trading networks and the increase in globalization.
Specifically, the forex market focuses on the trade of currencies by both large investment banks and individuals around the world. All trading is done over-the-counter, which adds to the market’s liquidity, allowing trades to be made 24 hours a day. Trading can be done in nearly all currencies, however, a small group known as the ‘majors’ is used in most trades. These currencies are the U.S. dollar, the euro, the British pound, the Japanese yen, the Swiss franc, the Canadian dollar and the Australian dollar. All currencies are quoted in currency pairs.
When a trade is made in forex, it has two sides – someone is buying one currency in the pair, while another individual is selling the other. Although the positions traded in forex are often in excess of 100,000 currency units, only a fraction of the total position comes from the investor. The remainder is provided by a broker, which offers the leverage needed to make the trade.
Traders look to make a profit by betting that a currency’s value will either appreciate or depreciate against another currency. For example, assume that you purchase US$100,000 by selling 80,000 euros. In this case, you are betting that the value of the dollar will increase against the euro. If your bet is correct and the value of the dollar increases, you will make a profit. In order to collect this profit, you will have to close your position. To do this, you must sell the US$100,000, in which case you will receive more than 80,000 euros in return.
Traders are not required to settle their positions on the delivery date, which usually arises two business days after the position is opened. Traders can roll over their positions to the next available delivery date. However, if a trader takes this route, he or she is left open to incurring a charge that can arise depending on his or her position and the difference between the interest rates on the two currencies in the pair.
How do you Fund a Forex Account?
The forex market is where currencies from around the world are traded.
In the past, currency trading was limited to certain individuals and institutions. That’s because the funds required are significantly higher than any other investment instrument. However, with the development of electronic trading networks and margin accounts, requirements have changed. Although nearly 75% of forex trading is done by large banks, individuals are now able to invest in forex with as little as $1,000.
The development of the margin account and the use of leverage has made it easier for individuals to trade in forex. By using a margin account, investors essentially borrow money from their brokers. Margin accounts can also be used by investors to trade in equity securities. The main difference between trading equities and trading forex on margin is the leverage that is provided.
For equity securities, brokers usually offer a 2:1 leverage to investors. On the other hand, forex traders are offered between 50:1 and 200:1 leverage. This means that traders need to deposit between $250 and $2,000 to trade positions of $50,000 to $100,000. (See also: Margin Trading.)
Credit card deposits have by far become the easiest way for investors to deposit funds into trading accounts. Since the development of online payment services, online credit card transfers have become increasingly efficient and secure. Investors can simply log in to their respective forex accounts, type in their credit card information and the funds will be posted in about one business day.
Forex traders are usually given several options when deciding how they will deposit funds into their margin accounts. Investors can simply deposit funds into their trading accounts from an existing bank account or send the funds through a wire transfer or online check. Traders are also usually able to write a check directly to their forex brokers. The only problem with using these other methods is the amount of time that is needed to process the payments. For example, paper checks can be held for up to 10 business days before being added to a trading account.
What types of accounts are available for forex trading?
There are many different types of forex accounts available to the retail forex trader. Demo accounts are offered by forex brokers as a way to introduce traders to their software and execution methods. After the trader has tried out demo accounts with a few different dealers, a funded trading account would be the next step.
Mini accounts, full accounts, and managed accounts are the most common types of funded accounts. Mini accounts are similar to regular trading accounts; however currency is traded in lots of 10,000 rather than 100,000. This allows for lower mandatory initial deposits, and greater customization of risk management.
It is important that the currency trader consider what they want to get out of their account, before deciding on the type to open. Demo accounts, and mini accounts, are great for the retail forex trader to learn a profitable system, and get used to the execution methods of the broker. For the currency speculator that doesn’t want to trade by themselves, a managed account would be better.
Forex Managed Trading
Forex managed trading involves a money manager that trades a forex account on behalf of a client for a fee. Managed forex accounts are similar to hiring an investment advisor to manage a traditional investment account of equities and bonds. Returns and fees between managed accounts can vary greatly; therefore, it is important to research your options thoroughly before assigning your account to a professional manager.
Managed Forex Account
Some managed forex accounts involve the trader “teaching” the manager what signals to look for and how to interpret them. It is thought that forex managed trading takes the psychology out of managing personal wins and losses.
Another managed forex account type uses the firm’s own proprietary trading systems. However, it is important to note that there is no such thing as the “holy grail” of trading systems. If a system is a perfect money maker, the seller will not want to share it. This is why big financial firms keep their “black box” trading programs under lock and key.
How does the foreign-exchange market trade 24 hours a day?
The forex market is the largest financial market in the world, trading around $1.5 trillion each day. Trading in the forex is not done at one central location but is conducted between participants through electronic communication networks (ECNs) and phone networks in various markets around the world.
The market is open 24 hours a day from 5pm EST on Sunday until 4pm EST Friday. The reason that the markets are open 24 hours a day is that currencies are in high demand. The international scope of currency trading means that there are always traders somewhere who are making and meeting demands for a particular currency.
[Many day traders are focused on equity markets, but the foreign exchange market has become increasingly attractive due to its leverage, volatility, and 24/6 access. If you’re interested in day trading in the forex market, Investopedia’s Become a Day Trader course provides an excellent introduction to day trading to help you get started on the right foot.]
Currency is also needed around the world for international trade, as well as by central banks and global businesses. Central banks have relied on foreign-exchange markets since 1971 – when fixed-currency markets ceased to exist because the gold standard was dropped. Since that time, most international currencies have been “floated”, rather than pegged to the value of gold.
At each second of every day, countries’ economies are growing and shrinking because of economic and political instability and infinite other perpetual changes. Central banks seek to stabilize their country’s currency by trading it on the open market and keeping a relative value compared to other world currencies. Businesses that operate in many countries seek to mitigate the risks of doing business in foreign markets and hedge currency risk.
To do this, they enter into currency swaps, giving them the right, but not necessarily the obligation to buy a set amount of a foreign currency for a set price in another currency at a date in the future. By doing this, they are limiting their exposure to large fluctuations in currency valuations. Due to the importance of currencies on the international stage there needs to be round-the-clock trading at all times. Domestic stock, bond and commodityexchanges are not as relevant, or in need, on the international stage and are not required to trade beyond the standard business day in the issuer’s home country. Due to the focus on the domestic market, demand for trade in these markets is not high enough to justify opening 24 hours a day, as few shares would be traded at 3am, for example.
The ability of the forex to trade over a 24-hour period is due in part to different time zones and the fact it is comprised of a network of computers, rather than any one physical exchange that closes at a particular time. When you hear that the U.S. dollar closed at a certain rate, it simply means that that was the rate at market close in New York. But it continues to be traded around the world long after New York’s close, unlike securities.
The forex market can be split into three main regions: Australasia, Europe and North America. Within each of these main areas there are several major financial centers. For example, Europe is comprised of major centers like London, Paris, Frankfurt and Zurich. Banks, institutions and dealers all conduct forex trading for themselves and their clients in each of these markets.
Each day of forex trading starts with the opening of the Australasia area, followed by Europe and then North America. As one region’s markets close another opens, or has already opened, and continues to trade in the forex market. Often these markets will overlap for a couple hours providing some of the most active forex trading. So if a forex trader in Australia wakes up at 3am and decides to trade currency, they will be unable to do so through forex dealers located in Australasia but they can make as many trades as they want through European or North American dealers. With all of this action happening across borders with little attention to time and space, the sum is that there is no point during the trading week that a participant in the forex market can’t potentially make a currency trade.
How does leverage work in the forex market?
The concept of leverage is used by both investors and companies. Investors use leverage to significantly increase the returns that can be provided on an investment. They lever their investments by using various instruments that include options, futures, and margin accounts. Companies can use leverage to finance their assets. In other words, instead of issuing stock to raise capital, companies can use debt financing to invest in business operations in an attempt to increase shareholder value.
In forex, investors use leverage to profit from the fluctuations in exchange rates between two different countries. The leverage that is achievable in the forex market is one of the highest that investors can obtain. Leverage is a loan that is provided to an investor by the brokerthat is handling the investor’s or trader’s forex account. When a trader decides to trade in the forex market, he or she must first open a margin account with a forex broker. Usually, the amount of leverage provided is either 50:1, 100:1 or 200:1, depending on the broker and the size of the position that the investor is trading. what does this mean? A 50:1 leverage ratio means that the minimum margin requirement for the trader is 1/50 = 2%. A 100:1 ratio means that the trader is required to have at least 1/100 = 1% of the total value of trade available as cash in the trading account, and so on. Standard trading is done on 100,000 units of currency, so for a trade of this size, the leverage provided is usually 50:1 or 100:1. Leverage of 200:1 is usually used for positions of $50,000 or less.
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To trade $100,000 of currency, with a margin of 1%, an investor will only have to deposit $1,000 into his or her margin account. The leverage provided on a trade like this is 100:1. Leverage of this size is significantly larger than the 2:1 leverage commonly provided on equities and the 15:1 leverage provided in the futures market. Although 100:1 leverage may seem extremely risky, the risk is significantly less when you consider that currency prices usually change by less than 1% during intraday trading. If currencies fluctuated as much as equities, brokers would not be able to provide as much leverage.
Although the ability to earn significant profits by using leverage is substantial, leverage can also work against investors. For example, if the currency underlying one of your trades moves in the opposite direction of what you believed would happen, leverage will greatly amplify the potential losses. To avoid such a catastrophe, forex traders usually implement a strict trading style that includes the use of stop and limit orders.
