Dangers Of Forex Trading

The foreign exchange (FX) currency market is the largest in the world and has been active since the beginning of financial markets.  Until rather recently (1996), the average person was unable to access any trading medium due to the control of the world's major financial institutions - namely the large international banks.

Today the so-called retail market is able to trade forex around the clock with hundreds of foreign exchange brokers through forex trading platforms. This is a profitable business because in many cases brokers are taking the opposite side of the trade.

In other words, they turn their client capital directly into broker profit as the average account loses money. Some brokers provide a matching service, charging a commission instead of taking the opposite site of the trade and "netting the spread", as it is referred to within the forex industry.

Quasi-regulatory bodies (the NFA and CFTC have only limited authority) are becoming increasingly concerned about the ability of brokers to maintain customer liquidity.  Minimum capital requirements of US $20,000,000 are now mandated in the United States.

In addition, more stringent capital requirements are now enforce within the markets in Germany and the United Kingdom. Switzlerand now requires forex brokers to become a bank before conducting fx brokerage business from Switzerland.

Nevertheless, the retail FX market is seeing continued explosive growth despite... or, perhaps because of... losses in other markets like global equities in 2008.

Algorythmic or machine based formula trading has become increasingly popular in the FX market... primarily due to online marketing.  A number of popular packages allowing the customer to program his own studies.  Artificial intelligence is becoming more prominently advertised.

The most traded currency is the pair known as the EUR/USD.  It's size is huge and it has median volatility with a relatively low spread.  This refers to the difference between the bid and the ask price. This is typically measured in "pips", which is normally 1/100 of a full point.

In online foreign currency exchange, practically no transactions actually end with physical delivery to the client.  Positions are eventually closed.

The market makers offer high amounts of leverage. While up to 4:1 leverage is available in equities and 20:1 in Futures, it is common to have 100:1 leverage in currencies.  Some brokers even offer 400:1 leverage.  Needless to say, the risk can be substantial.

Most retail Forex market makers permit 100:1 leverage, but require that you have a minimum amount of money in your account to protect against a critical loss point. For example, if a $100,000 position is held in EUR/USD on 100:1 leverage, the trader has to put up $1,000 to control the position.

However, should a position value decline forex market makers typically employ automatic systems to close out positions when their clients run out of margin (the amount of money in their account not tied to a position).

For example, if you have $2,000 in your account and you buy a $100,000 lot of EUR/USD, you have $1,000 of your $2,000 tied up in margin.  $1,000 is left to allow your position to fluctuate downward without being closed out.

Retail traders (that would be you) are typically undercapitalized. They always pay the bid/ask spread which makes their odds of winning less than those of a fair game. Additional costs may include margin interest or, if a spot position is kept open for more than one day, the trade may be resettled each day.  Each time this happens they pay the full bid/ask spread.

By offering high leverage, the market maker encourages traders to trade extremely large positions. This increases the trading volume cleared by the market maker and increases his profits, but increases the risk that the trader will receive a margin call. Professional currency dealers (banks, hedge funds) never use more than 10:1 leverage, but as previously noted most retail clients are offered leverage between 50:1 and 400:1.

The risk associated with forex is huge... no question about it.  Nevertheless, with proper education, training, discipline and the proper trading psychology it is certainly possible to make good money in the foreign exchange currency marketplace. 

Just remember... there is no holy grail.  It is not possible to buy some magical software product and guarantee positive results for your FX trading.  You will win some... and you will lose some.  The reality is that you have an excellent chance to win more than you lose if you prepare properly.

Closing caveat: Be aware of the risks you take by trading with any forex broker that has total net capital below $20 million. Some of the smaller forex brokers might unexpectedly (especially in today's environment) close up shop giving their customers very little notice. Here today, gone tomorrow.