In the past, large financial institutions, major fund managers, large corporations and high net worth individuals were virtually the only participants in the huge forex market outside of national central banks. With the advent of forex trading with the internet, however, just about anyone can now open a forex trading account and begin trading currencies online.
Even though the forex market has been made available to a wide audience of retail forex traders, currency speculation remains a risky endeavor. Studies show that more than 3/4 of new forex traders still lose money. Trading in the forex market certainly has its advantages but it also poses a considerable risk, especially to the novice trader. Keep reading to get a better picture of the pros and cons of forex trading.
What is Forex?
The foreign currency exchange market is typically known as the forex or FX market. The forex market is the largest capital market in the world with an average daily turnover of more than $5 billion in recent years. To put this in perspective, the U.S. stock market’s daily turnover is only about $260 billion.
Currencies trade in pairs in the forex market. The first currency appearing in a currency pair is called the base currency, while the second currency is called the counter currency. A fundamental characteristic of the forex market is that when you trade a currency pair, you take a position on a rate of exchange or “exchange rate” of a currency pair by agreeing to buy one currency and sell another.
This differs from the stock or commodity markets where you buy or sell a particular asset for currency at a quoted price. Unlike when you trade equities or other assets, taking a position in a currency pair means you are both long one currency and short the other in the pair at the same time.
If you sell the base currency, you’re effectively selling it against the counter currency, while if you buy the base currency, you’re using the counter currency for the purchase. This simplifies trading in the forex market considerably, since there are no stock splits or dividends like you might see in the equity market.
When trading currencies, you do have to take into account the interest rate differential between the currencies if you hold positions overnight or trade for delivery on dates outside the traditional spot value date. The spot value date is 2 business days for most currency pairs. An exception is the U.S. dollar quoted against the Canadian dollar that traditionally trades for delivery value funds, which is 1 business day from the transaction date.
The fundamental elements that most contribute to forex market moves consist of geopolitical events, central bank rate decisions and major economic data releases relevant to a particular currency pair. This typically makes currencies somewhat easier to research than stocks, bonds or commodities.
The Pros of Forex Trading
The foreign exchange market has a number of advantages not found in other markets. These include:
- Easy access: The forex market is now probably the easiest financial market to open an account and begin trading in. Opening an online forex trading account can be done from anywhere in the world with as little as $1 and an internet-connected smart device.
- Practice trading: You can easily practice trading or gauge an online broker’s services and trading platform by opening a free demo account that almost all forex brokers offer.
- Leverage: Unlike the stock market that involves purchases, forex positions are based on an exchange of currencies. While you can only leverage stock trading positions in a margin account at a 2:1 ratio, forex trades can be leveraged up to 1000:1 in some jurisdictions. U.S. regulations that apply to retail forex traders have tightened maximum allowed leverage ratios to 50:1 for major currency pairs and 20:1 on minor pairs, while the E.U. now limits retail forex leverage ratios to 30:1 for majors and 20:1 for minors.
- Quick returns: Once profitable forex positions are liquidated, the profits can be made available immediately for withdrawal, depending on the forex broker used.
- Ease of going long or short: Unlike in some stock markets, there are no uptick rules that prevent you from going short, so you can buy or sell currency pairs freely. When you take a position in the forex market, you take both long and short positions simultaneously by going long or short the base currency against the counter currency.
- High liquidity: The liquidity in the forex market is unmatched by any other capital market and central banks oversee the markets in their national currencies. Special circumstances, like the sudden imposition of exchange rate regimes, the release of major economic data and geopolitical events, can adversely affect the liquidity in affected currency pairs while the forex market is reacting to the new information.
- Less chance of market manipulation: Due to the size and depth of the forex market, manipulation of this huge market can be very difficult even for hedge funds and large corporations. Even national central banks can have difficulty manipulating the forex market, although they do sometimes step in to mitigate sharp market movements in their currencies.
- Low trading costs: Overall, trading costs for forex compare quite favorably to other markets. If you mainly trade in major currency pairs, then dealing spreads tend to be tight, which reduces your trading costs. Dealing spreads in the minor and exotic currency pairs are typically wider, however, which increases your trading costs in those pairs.
- Simpler tax rules: As “988 traders” according to the Internal Revenue Code (IRC), U.S.-based forex traders can deduct all of their trading losses for a given year. They can be taxed as a futures and options trader of 1256 contracts under the 60/40 rule that specifies that 60% of gains or losses are treated as long-term capital gains or losses, while 40% of gains or losses are treated as short term. Consult with your accountant to see what rules apply and what tax plan makes the most sense for you.
- Ability to automate your trading: Many online forex brokers support the MetaTrader 4 or 5 trading platforms that allow you to run “expert advisor” or EA software that lets you automate your trading. Other trading platforms also offer this feature, so check with your broker to find out if their platform supports automation.
- Open 24 hours a day during trading week: The forex market opens at 5 p.m. EST on Sunday and closes at 5 p.m. EST on Friday. The forex market remains open continuously 24 hours a day during that trading week. The various trading sessions that correspond to major global money centers, like London, Tokyo and New York, also provide different levels of liquidity in certain currency pairs. For example, currency pairs containing the Japanese yen, Singapore dollar and the Australasian currencies tend to be more liquid during the Tokyo trading session.
- Moderately volatile: Substantial volatility without excessive market shocks tends to provide traders with decent opportunities and more stable returns than a market with low or excessive volatility. This makes the forex market suitable for day trading strategies.
- Lower overhead: Thanks to high liquidity and lower trading costs, your overhead as a forex trader tends to be lower than if you traded in other financial markets. Since forex trading is typically commission free, you usually just need to pay away the dealing spread. Also, all you’ll need to get started trading forex is an internet-connected device and a modest amount of risk capital to use as a margin deposit.
The Cons of Forex Trading
- Trading against professionals: As a retail forex trader, you basically trade against a host of professional traders, large multinational corporations, national central banks and hedge funds that always have a presence in the forex market.
- Knowledge of world events: Since the forex market consists of national currencies, a knowledge of macroeconomics and familiarity with world events can be extremely important to achieve consistent profits. Ideally, you would limit your trading to a handful of currency pairs, researching each country’s fundamentals to make more informed decisions on trades.
- Lower regulation: Due to the unregulated nature of the forex market, many online forex brokers operate with little or no oversight depending on the broker’s jurisdiction. While this may be an issue in some countries, if you’re based in the Eurozone, U.K. or U.S. jurisdictions, you may only be able to trade with forex brokers regulated by the Commodities Futures Trading Commission (CFTC) in the U.S., the Financial Conduct Authority (FCA) in the U.K. or the Cyprus Securities and Exchange Commission (CySEC) in the E.U.
- Exchange rate valuations: Unlike stocks, the origin of currency valuations aren’t as apparent and rely on a series of factors that may or may not be readily apparent in the market. This works against retail traders who might not have access to this type of information.
- Leverage: Trading with leverage represents a double-edged sword for forex traders. On the one hand, you can magnify your profits, but by the same token your losses also increase with leverage. Leverage can be just as much of an advantage as a disadvantage to forex traders.
- Volatility: Another example of a two-edged sword, while volatility remains a staple of short-term traders, volatility can be difficult to deal with for traders looking at the medium and long terms and could catch them off guard.
- Patience required: Successful trading typically requires patience as you wait for good opportunities to arise. Most traders also need to “get into the groove,” which means they need time to get used to the forex market in order to trade profitably. Trading in a demo account could be helpful for novice traders with limited experience.
Best Online Forex Brokers
Forex brokers vary considerably with respect to their services, maximum leverage ratios, customer support and trading platforms. In Benzinga’s Best Forex Brokers list shown below, you should be able to find a reputable broker that will suit your needs and preferences.
Is Forex Trading for You?
Forex trading is a risk-taking endeavor, like trading in virtually any financial market, so risk-averse individuals may not find it suitable for them. On the bright side, trading forex lets you increase your market opportunities if you already trade other markets. Keep in mind, however, that most retail forex traders lose money and that you could even lose your entire account balance if you highly leverage a losing position. Basically, forex trading isn’t for everyone because it entails a considerable amount of learning, discipline, strategic risk-taking and patience to stand the best chances of success.
Frequently Asked Questions
Despite what some ads might imply, trading forex is by no means a get-rich-quick endeavor. While some people have made enormous profits trading in the forex market, the majority of retail forex traders wind up losing money.
Forex trading is legal for retail traders in most jurisdictions. Any online broker you approach as a potential client should be able to tell you if forex trading is not legally available where you live or if any trading restrictions, such as leverage ratio limits, apply to you. Keep in mind that different forex brokers can be overseen by different regulatory authorities and therefore operate under varying restrictions.
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