No Country for Individual Investors

Posted in: Economics, General, Stock Market, Thought of the Week

The foreign exchange market (Forex) is the largest financial market in the world, with over $5 trillion traded each day. This market is dominated by large banks, corporations, and investment funds as a way to hedge exposure to various currencies, and it is mostly unregulated.

Over the last few years, individual investors have entered the Forex market, thanks to the advent of online trading tools. Investors can now buy and sell currencies from all over the world with a click of a button in the comfort of their own home. In fact, the Forex market is open 24 hours a day and five days a week, so it’s in many ways easier to trade currencies than stocks.

The problem is that nearly every single individual investor will lose in the Forex market over time. Trading currencies is extremely challenging because investors are competing with big firms who have far more information and size. It’s analogous to a slot machine in Vegas, where the casino sets the payout ratio in the machine to stack the odds heavily in their favor.

According to the National Futures Association, roughly 72% of individual investors lose money in the Forex market. Although this statistic may appear to be quite staggering, it’s actually surprising that it’s not higher for three key reasons:

  1. Leverage is Mind Boggling: Since currencies don’t move that much on a daily basis, regulations in the U.S. allow leverage of 50 to 1. Meaning, if you were to deposit $1,000 into a Forex trading account, you could trade up to $50,000 by borrowing the other $49,000. Leverage significantly amplifies returns and losses, which can completely wipe out an investor in a matter of seconds.
  2. Brokers are Against You: Forex brokers know that most traders lose money so they often take the other side of a trade against you. As a result, when you lose money trading, your dealer wins on the trade AND charges a commission on the transaction.
  3. Zero Regulation: Forex is the Wild West and manipulation is rampant because there is no regulatory agency with actual authority to police the traders.

Simply put, individual investors have next to no chance of winning in the Forex market. In fact, according to Forbes, nearly 26,000 individuals in the U.S. lost $460 million from 2001 – 2007 alone.

Two weeks ago, the Swiss National Bank (SNB) announced that they were ending a strategy they had enacted years ago to peg the Swiss Franc against the Euro. This move shocked the investment world, particularly since a few days prior they had announced that the peg would stay in place, and the resulting volatility was some of the most violent ever witnessed in currency markets.

Several investment firms lost big money and had to shut down because they were betting that the SNB would be true to their word. A notable victim from this massive volatility spike was FXCM, which is one of the largest online currency trading firms and very popular with individual investors.

Investors that had accounts with FXCM lost so much money in a matter of seconds that they were completely wiped out. In fact, the move was so severe that not even stop losses saved investors, and FXCM had to cover losses that exceeded the amount of money in customer accounts. This move forced FXCM to then pursue a $300 million bailout loan to stay in business!

NOTE: The reason why FXCM had to cover losses that exceeded what their clients had in accounts was due to the leverage. Most client accounts had a fraction of the total amount lost as the remainder was borrowed cash. FXCM had to cover that borrowed cash.

FXCM’s troubles explain precisely why retail investors should avoid the Forex market entirely. Big swings like the one witnessed weeks ago can literally wipe an investor out in seconds. The bottom line is that there is simply no excuse for trading currencies because you are at an insurmountable disadvantage to the real players in the Forex market.

Read this week’s Thought of the Week to learn more about the foreign exchange market.

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As an Investment Advisory Representative working in conjunction with Global Financial Private Capital (GFPC) we are provided weekly thoughts on what is happening in the economy and the market. Written by our investment committee at GFPC we find these thoughts to be informative and interesting.