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.
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.