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.
Key Takeaways
- Many retail traders turn to the forex market in search of fast profits.
- Statistics show that most aspiring forex traders fail, and some even lose large amounts of money.
- Leverage is a double-edged sword, as it can lead to outsized profits but also substantial losses.
- Counterparty risks, platform malfunctions, and sudden bursts of volatility also pose challenges to would-be forex traders.
- Unlike stocks and futures that trade on exchanges, forex pairs trade in the over-the-counter market with no central clearing firm.
Unexpected Events
To better understand the danger of forex trading, consider a relatively recent example. On Jan. 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 on that day.
The surprise move from Switzerland's central bank 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.
Unexpected one-time events are not the only risk facing forex traders. Here are seven other reasons why the odds are stacked against the retail trader who wants to get rich trading the forex market.
Massive forex plays, such as George Soros' run on the British Pound that netted him over $1 billion, are very the exception and not the rule.
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 U.S. dollar 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 $5,000 worth of euros against the U.S. dollar at 1.20 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. (ignoring trading costs and commissions) the profit is $25,000, or 416.67%.
Of course, had the trader been long euro at 1.20, used 50:1 leverage, and exited the trade at 1.10, 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 sizable 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 Jan. 15, 2015. However, these proved ineffective because liquidity dried up even as everyone stampeded to close their 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. These events can come suddenly and move the markets before most individual traders have an opportunity to react.
OTC Market
The forex market is an over-the-counter market that is not centralized and regulated like the stock or futures markets. This also means that forex trades are not guaranteed by any type of clearing organization, which can give rise to counterparty risk.
$6 Trillion Daily
While the forex OTC market is decentralized, it is massive, with data from a 2019 Triennial Central Bank Survey of Foreign Exchange showing that more than $6 trillion worth of currencies trade each day.
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. In May 2015, for example, five major banks were fined nearly $6 billion for attempting to manipulate exchange rates between 2007 and 2013, bringing total fines levied on these five banks to nearly $9 billion.
A common way for market movers to manipulate the markets is through a strategy called stop-loss hunting. These large organizations will coordinate price drops or rises to where they anticipate retail traders will have set their stop-loss orders. When those are triggered automatically by price movement, the forex position is sold, and it can create a waterfall effect of selling as each stop-loss point is triggered, and can net large profits for the market mover.
Is Trading Forex Profitable?
Forex trading can be profitable but it is important to consider timeframes. It is easy to be profitable in the short-term, such as when measured in days or weeks. However, to be profitable over multiple years, it's usually much easier when you have a large amount of cash to leverage, and you have a system in place to manage risk. Many retail traders do not survive forex trading for more than a few months or years.
Is Forex High Risk?
Although forex trades are limited to percentages of a single point, they are very high risk. The amount needed to turn a significant profit in forex is substantial and so many traders are highly leveraged. The hope is that their leverage will result in profit but more often than not, leveraged positions increase losses exponentially.
Is Forex Riskier Than Stocks?
Forex trading is a different trading style than how most people trade stocks. The majority of stock traders will purchase stocks and hold them for sometimes years, whereas forex trading is done by the minute, hour, and day. The timeframes are much shorter and the price movements have a more pronounced effect due to leverage. A 1% move in a stock is not much, but a 1% move in a currency pair is fairly large.
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.
As an experienced financial expert with a deep understanding of forex trading, let me provide insights into the concepts discussed in the article.
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Forex Trading and Wealth Accumulation:
- The article rightly acknowledges that forex trading can lead to wealth accumulation for certain entities like hedge funds or exceptionally skilled traders. However, it emphasizes that for the average retail trader, forex trading is more likely to result in substantial losses.
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Retail Trader Statistics:
- The article mentions that statistics show a high failure rate among aspiring forex traders, indicating that success in forex trading is challenging for the average retail participant.
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Leverage Dynamics:
- Leverage is highlighted as a double-edged sword, capable of magnifying both profits and losses. The example of a trader using 50:1 leverage to make significant profits or incur substantial losses illustrates the potential impact of leverage in forex trading.
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Asymmetric Risk to Reward:
- The article discusses the importance of managing risk, emphasizing that successful forex traders tend to keep losses small and offset them with sizable gains. This is in contrast to a common retail trader behavior of making small profits but holding onto losing positions for too long, resulting in significant losses.
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Platform and System Risks:
- The potential risks associated with platform malfunctions or system failures are highlighted, emphasizing the importance of being able to execute trades efficiently, especially during volatile market conditions.
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Information Edge:
- The article points out that major forex trading banks have a significant information edge not available to retail traders. This includes insights into commercial forex flows and covert government interventions, highlighting the challenges faced by retail traders in accessing such information.
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Currency Volatility:
- The example of the Swiss franc's sudden and significant move underscores the risk of high currency volatility, especially when coupled with high leverage. This volatility can lead to rapid depletion of trading capital.
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OTC Market Structure:
- The decentralized and over-the-counter nature of the forex market is discussed, emphasizing that forex trades are not guaranteed by any clearing organization, introducing counterparty risk.
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Fraud and Market Manipulation:
- Instances of fraud and market manipulation in the forex market are mentioned, including a case of fraud in 2014 and a significant fine imposed on major banks for manipulating exchange rates in 2015. The article warns of the potential for market manipulation, such as stop-loss hunting.
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Forex Profitability and Risk Comparison:
- The article addresses the profitability of forex trading, highlighting the importance of considering timeframes and the challenges of sustaining profits over multiple years. It also compares the high-risk nature of forex trading, particularly due to leverage, with the different trading style of stocks.
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Risk Management Measures:
- The article concludes by providing practical safeguards for those still interested in forex trading. It recommends limiting leverage, maintaining tight stop-losses, and choosing a reputable forex brokerage to mitigate risks, although it acknowledges that the odds remain stacked against retail traders.
In summary, the article provides a comprehensive overview of the risks and challenges associated with forex trading, cautioning retail traders and offering practical advice to navigate this complex financial landscape.