1 place in the rating! Free trading training!
Forex, short for Foreign Exchange, is known as the largest money market that offers traders a bunch of benefits. However, forex trading also has obvious shortcomings they should be aware of before participating in the market.
Currency Trading: An Overview
Today, forex is among the most popular financial markets in the world. Historically, foreign currency trading was predominantly conducted by commercial banks across the globe for different purposes. Only a few high-net-worth individuals who maintained a long-standing association with banks were empowered to enter the market. Forex now is highly segmented with a particular trading volume contributed by retail traders. Still, the main participants are large commercial banks, followed by hedge funds and investment management companies.
In the retail trading market, individuals bet on the price movement of currency pairs for financial returns. When opening an account with a legitimate broker, retail investors implicitly enter in contracts for difference (CFDs) with the brokerage. Those agreements allow clients to buy and sell currencies on the over-the-counter (OTC) or decentralized market without the supervision of an exchange. If the market moves favorably with their expectation, they will earn profits without the ownership of traded currency pairs. However, ineffective trading strategies or inaccurate analyses of price action can result in a big failure.
In the currencies market, investors can enter a trade with major, minor (or called cross), and exotic pairs. Of which, the majors have higher liquidity and lower volatility because they are formed by top powerful currencies such as the US dollar, British sterling, Japanese yen, or Swiss franc. Inevitably, the whole forex market is profoundly influenced by the economic situation of issued countries and the geopolitical relationship between nations. In normal market conditions, traders can base prudent decisions of market trends on fundamental and technical analysis. The release of any major news can move the market in an unexpected direction accordingly.
Forex itself is a temptation to investors on the grounds that it enables the largest trading volume of US$6.6 trillion per day and then 24-hour access. Particularly, forex speculators are less worried about finding buyers or sellers for large transactions without any significant change in the exchange rate. Further, traders can open a position in different trading sessions during a business day, except for weekends and holidays.
Another reason behind traders’ involvement in forex is leverage. This financial tool allows speculators to magnify their initial investment multiple times without paying any interest. In other words, they can borrow money from brokers to open a position with higher trading capital for bigger gains. In addition, what strikes investors to forex is its transaction costs (or called spreads) which are considered the smallest of all financial markets and measured by pips.
Having said that, forex trading also places investors at a disadvantage. Without their awareness, they may bear unprecedented risks and worse, lose all investments.
1 place in the rating! Free trading training!
What are the Disadvantages of Forex Trading?
Nothing can help individuals get wealthier overnight faster than investment in financial markets, especially forex. Though, it also burns their whole accounts if they do not understand the market or have improper trading strategies. Therefore, forex trading can be sometimes disadvantageous for novice investors. Even professionals cannot avoid its adverse impacts.
No Centralized Exchange
As earlier stated, foreign currency trading operates on the over-the-counter OTC market which allows transactions to be directly executed in different financial centers around the world without the administration of formal exchanges. The absence of clearinghouse and exchange can increase the probability of counterparty risk, commonly known as a type of credit risk. Accordingly, when brokers or other counterparties lose their inability to fulfill obligations to OTC contracts, clients will face massive losses despite profitable market trends.
Foreign currency trading itself is legal but many countries now have yet to issue regulations regarding this type of trading. This means no minimum capital or charge requirements and provisions to protect individual players in the market. Consequently, when retail investors are confronted with fraudulent or deceptive acts and the risk of impossibly withdrawing profits, they are not protected by laws.
Further, although various legitimate brokers are regulated and licensed by national and international authorities, many scammers can exploit the decentralized nature of forex trading to trick novice investors into plying unprofitable trades and to charge them different unknown fees.
Inevitably, although deregulation reduces limitations on forex trading and promotes the trader’s approach to the market, it can render forex less transparent and pose retail participants to bigger financial threats. That is why the United States must heavily govern foreign currency trading to prevent the recurrence of the 2008 economic downturn. Though, that brokers are tightly monitored by US regulations makes many European and Australian brokerages no longer offer services to US citizens.
Complicated Pricing System
Most forex brokers act as dealers rather than merely intermediaries between purchasers and sellers. Particularly, when investors enter the market, it implicates that they are exchanging currencies with brokers. Further, in the OTC market, brokerage companies also play the role of market makers who quote the exchange rate of currency pairs. Therefore, such financial assets are differently priced out by distinct brokers.
Despite the slight difference between price levels set by brokerages, the quoting in the OTC Forex market is deregulated and opaque. In other words, traders only recognize that the exchange rate of currency pairs can be modified by the market’s supply and demand; still, they don’t know about the pricing policy of brokerage companies. Hence, if speculators carelessly choose a fraud or unregulated broker, they can suffer unreasonable prices and be drawn into unprofitable transactions.
In the 2008 article of Reuters, China’s banking regulator stated that more than 80% of participants in forex margin trading lost money, whilst banks offering such a service benefited from transactions with those clients. This repercussion led those banking institutions to halt their forex-related service. This result seemingly remains unchanged after over a decade. The recent survey of Contentworks concluded that 95% of traders failed in forex trades and 80% had to quit this job after the first two years. Many other countries also consider forex margin trading as an extremely risky factor to speculators and even the whole economy despite its potential benefits.
Indeed, compared to other financial markets, forex brokers offer higher leverage ratios that allow investors to magnify their original capital even up to 500 or 1000 times. Accordingly, the required margin to keep positions open is relatively small. Normally, if an investor has low capital yet uses a too-high leverage ratio, he or she may sustain a substantial loss from opening a large position.
For example, you fund a trading account with US$100. You decide to leverage the initial capital 1000 times, thus you will have the trading capital of US$100,000. When you buy one standard lot of EUR/USD, the one-pip change costs US$10. Only a loss of 10 pips can lead to a reduction of US$100 in your account balance. Consequently, if you don’t immediately fund the account, you cannot continue trading in the market.
Therefore, when forex investors learn about risk management, it is inadvisable for those who prefer starting small to augment their trading capital significantly and enter a large trade. This is because if they do so, they can unsurprisingly burn their account balance right after a few losing trades. This is elaborated in the given example. Unfortunately, not all traders get it right. The positive virtues of forex and its leverage tool encourage many individuals to engage in the market blindly. However, there is no such thing as a free lunch: accompanied by enormous benefits is always considerable shortcomings.
Apparently, leverage itself cannot be to blame for the failure of traders. Though, not many investors can anticipate the dangers of using this financial tool. Even counterparties such as banks or brokers impossibly choose the right clients or assess how risky their client’s trades can be. Because of that, many countries decide to cease forex-related services or regulate forex brokers more strictly to avoid unexpected leverage risks.
Forex is known to have the most liquid asset in the world. In comparison with other financial instruments, currency pairs, albeit major, minor or exotic, still have higher liquidity and lower volatility in normal market conditions.
However, as already mentioned, the price of currency pairs is predominantly adjusted by supply and demand which are impacted by a string of economic and political events. When major news is released or any turmoils occur, there will be a marked fluctuation in the pair value. In other words, the market will become more volatile and traders can suffer adverse influences of high volatility. As a result, those who are incapable of analyzing price actions in the volatile market may sustain massive losses.
Mastering Forex Trading Takes Time
It often takes investors half a year to learn about the fundamentals of forex trading. Nevertheless, traders must spend much more time and effort on becoming a forex master or at least, using the fundamental and technical analysis effectively to achieve gains. This requires investors to have a thorough knowledge, the exceptional ability of self-learning, the tremendous skill to analyze market trends, and so forth. Even they must allocate much of their time to revise and modify trading strategies before testing them hundreds of times on demo accounts to ensure they work well on live conditions. Those things may demotivate many traders to learn about forex though.
1 place in the rating! Free trading training!