Forex trading is like driving too fast without a seatbelt: intoxicating, sexy, and potentially lethal. It promises fast cash, a 24 hour market, and easy access. With brokers accepting lower initial investments, people are flocking to Forex as a means of creating side incomes. But is it all it’s cut out to be? I annoy an experienced trader with too many questions, and weigh the pros and cons:
How Does Forex Trading Work?
The Forex market involves the buying and selling of currencies. The strength of any one currency varies in relation to another; hence, the US dollar is worth more than the Singapore dollar. The idea of Forex trading is to buy a lot of a particular currency when it’s weak, and make a profit from it when it strengthens.
A few years ago, Forex was the exclusive playground of banks and corporations. But different technological factors, like wider net access, have opened the market to new investors (or victims).
The Pros of Forex Trading
Our anonymous trader, whom we’ll just call Harold, will go into detail on this. But for now, here’s a quick summary:
- 24 Hour Trading
- High Volatility
- Marginal Trading
- Resistant to External Controls
- Low Commission
- Easy to Start Investing
24 Hour Trading
Harold mentions that:
“Forex is different from other markets in that it’s open 24 / 7. The doors don’t close at 5 pm. So your trading practices are very flexible; you can decide yourself how often you want to be in the market.
The smallest time frame is a tick, which is one minute. You can watch it all the time if you like to be in the market. Or you can also trade in different time frames: daily, weekly, or monthly. Forex trading is very individual in that way; you can go with whatever suits your preferences.”
Isn’t high volatility a disadvantage? Harold thinks it’s a double-edged sword:
“Forex is very volatile, but that also means you can make a lot of money, in a very short time. Of course if you just jump into it without understanding, you can also lose a lot of money in a short time, so don’t do that. Your volatility can also change based on the time frames you use. The bigger the time frame, the higher the volatility.”
Harold isn’t big on this, but I’ll raise the possibility for you: Forex lets you trade with borrowed money. Marginal trading in Forex is done with lots, and a single lot is about $100,000. Getting one of these lots only requires an initial capital as low as $500.
So it’s easy to find large sums to trade with, and get correspondingly big returns. Even if your capital is a fart in a sewer. But remember: it’s a lot of borrowed money, and you’re playing with fire. See the cons below.
Resistance to External Controls
There is a theory that Forex trading, not being in any country’s jurisdiction, is resistant to external controls. This concept was somewhat shaken in ’98, when Malaysian Prime Minister Mahatir Mohamad imposed capital controls. But I’m not about to launch a three volume analysis on a blog post.
Suffice it to say that, most of the time, countries don’t have laws that restrict Forex trading. In fact, there’s no such thing as insider trading in Forex. All’s fair, short of stabbing your broker.
Harold tell us that:
“Stock brokers do charge, but we don’t call it a commission, we call it the spread. The standard is three pips, but some brokers have a variable spread.”
Um. In English, Harold?
“The pip, or the price increment, is the difference between the bid price (what the market maker or trading firms will pay you for the currency) and the asking price (what the broker’s offering to sell you the currency at). So if you see something like GBPUSD 1.5491 – 1.5494, that’s a difference of three pips.
In effect, the broker gets a little bit out of the transaction, but other than that, there are no fees. It’s cheaper than the transaction fees in, say, the NYSE.”
Easy to Start Investing
Harold says that:
“It used to be you would need a large amount, like $10,000, to start investing. But nowadays, there are organizations like POEMS, that make it easy to start out small. And so many people want to be stock brokers! Now there are brokers that will even accept amounts like $1,100.
After that, all you need is Internet access, and a phone. All the expensive software is actually optional.”
The downsides to Forex are actually easy to avoid, so long as you play it safe. What’s also odd is that some of the cons are the same as the pros:
- High Volatility
- Marginal Trading
Harold is fine with high volatility, because:
“I started five years ago, and all along I’ve been in finance and trading. And I started with equities.
But if you don’t like the whipsaw (the sharp up and down motions of Forex charts), if you tend to get emotional and panic…maybe you can’t handle the volatility of Forex. If you cannot plan ahead, and stay calm enough to stick to your plan, you can lose a lot of money.”
Harold doesn’t suggest that new investors trade “on the margin”. He mentions that:
“Marginal trading gives you a lot of leverage, but you stand to lose the most money. If the currency has a sharp fall, you can actually lose more than your initial investment. You won’t just lose money, you can lose until you end up owing money.
An important thing to remember about marginal trading: you are trading with borrowed capital.”
Harold explains that there are two schools of Forex trading:
“There are technical traders and fundamental traders. Technical traders, like me, just watch the graphs. We identify trends and make predictions. But another method is fundamental trading.
A fundamental trader has to read news reports, magazines, understand the economic climate. So if they read in the news that Japan is on the rise, they may start buying the yen. The economic climate has a lot of impact on Forex.
But either method is not as straightforward as other types of investments. For Forex trading, you need to be alright with numbers, and you have to do a lot of homework.”
Any parting advice for our readers Harold?
“Always have a plan, and be rational. Don’t respond in a panic or on the fly. And before worrying about making money, make sure you understand how not to lose money. For example, You have to calculate your risk of ruin.
Start with an amount you can afford to lose. Based on that, work out how many trades you will make. So let’s say you can afford to risk $5000, and you risk $100 each trade. Overall you have 50 trades. Even if you don’t earn, stop after those 50 trades; you’ve spent all you can afford.”
Are you a Forex trader? Comment and give us some tips!