Trading in the Forex Market

This article follows on the Forex Market Intro available here

The Lure of Trading

People like to see the financial markets as a place where you can get fabulously rich - and quickly too. However, it is a total misconception that those exceptions to the rule are the normal experience of individual self-managing investors / traders in the markets.

It is undoubtedly so that there is a huge amount of luck involved if industry outsiders (like indivual traders) make it fabulously big in a short time.

There is another big misconception amongst outsiders, namely that professional traders who made it big can reduce their "trading system" to an instructional course which can easily be copied and repeated by anyone doing the minimum after paying the minimum.

In this way what includes a lot of very personal hardwork and time and dedication spent, mostly in a very supportive professional environment, disappears in the fogginess of "success stories", marketing slogans and slick online webinars and videos produced by well-oiled professional marketing machines driving the ages old sales pitch of the financial markets:

The Lure of Forex Trading

In short they say the main advantages are:

... and an array of other half truths!

The Lure of Margin Trading

Yesterday's market crash was one which largely affected rich men, institutions, investment trusts and others who participate in the stock market on a broad and intelligent scale. It was not the margin traders who were caught in the rush to sell, but the rich men of the country who are able to swing blocks of 5,000, 10,000 up to 100,000 shares of high-priced stocks. They went overboard with no more consideration than the little trader who was swept out on the first day of the market's upheaval ...

Margin trading in the stock market means to use the value of your existing stocks as security to borrow from the stock broker more money to buy more stocks. If the value of the stocks go up you can double your percentage gain as you can usually borrow up to the full market value of your own stocks.

Forex trading as we know it today is pure margin trading. Today you deposit your trading funds in a margin account (same thing, different name) and can then merrily buy and sell currencies up to the value of many multiples of your margin funds.

This is the big lure of forex trading according to the forex marketing maestros: Have $1,000, open margin account and make as if it is $100,000 (with leverage of 100:1).

The Lure of Small Accounts

The reason for this was the minimum transaction sizes which were in most cases 100,000 units or also known as 100K lots, or 1 lot. There was a particular company (still around) which had 250,000 minimum lot values, hence a $50,000 minimum account deposit.

While the minimum lot size of 100,000 units lasted for a while the forex brokers quickly dropped the account opening minimums to $2,000 or $3,000.

Since the margin to open a 100,000 unit lot was only 1% or even 0.5%, thus around $1,000 or $500 this sounded very feasible and attractive to unsuspecting retail forex traders who only saw the $10 per pip they could make and not the problem that $10 per pip relative to an $2,000 account is quite a lot if your 20 pip stop losses are hit regularly at $200 / trade or 10% of the $2,000 minimum account!

Since "everone" lost money hand over fist the leading brokers had a problem. They resolved the problem by offering mini lots. A mini lot is 10% of the size of a "lot", namely 10,000 currency units.

However, since the forex brokers wanted to make money primarily without having to take risk onto themselves they needed huge volumes of trades to go through their books and mini lots meant a 90% smaller revenue for them per trade.

So they needed many many more accounts and suddenly the $2,000 - $5,000 became a barrier to that. Some were even unscrupulously forcing traders who open accounts of more than $2,000 to trade on 100,000 units!

In order to get many more accounts they had to drop the minimum account opening margin substantially and so the mini account was born. Traders could start with only $200 - $500 in a mini account, trading "mini lots" (10,000 units).

Unfortunately many of these mini accounts also lost money hand over fist and the brokers responded with the micro lot account. The smallest transaction size was now 1,000 units of a currency and the minimum account opening amounts were $25, $50, $100. Small amounts.

While the smaller and smaller account minimums brought in hundreds of thousands of such small account holders the traders continued losing hand over fist.

The reason for that is pretty obvious. The one ratio which had not changed and which was the cause of the losses in the 100,000 lot accounts and the 10,000 lot accounts and the 1,000 lot accounts was the ratio between minimum deposit and minimum transaction value (lot size).

100,000 --> $2,000 - $5,000

10,000 --> $200 - $500

1,000 --> $25 - $50

This ratio, the ratio between the money in your account and the value of the trade you do is called the "leverage ratio".

Applied to the above general minimum account sizes and associated minimum lot sizes the minimum leverage ratio is:

100,000 --> $2,000 - $5,000 | 100,000 / 2,000 = 50:1

10,000 --> $200 - $500 | 10,000 / 200 = 50:1

1,000 --> $25 - $50 | 1,000 / 25 = 40:1

The Lure of High Leverage

In order to trade on margin you need money in a margin account. The forex broker determines how much margin you will need to buy or sell a lot of a certain currency pair. This is called the "margin requirement" and is usually expressed as a percentage. If you want to trade 100,000 EURUSD the margin requirement may be 1% which translates to $1,000.

You usually need less margin for the major currencies like euro, US dollar, British pound and so on and more for smaller and exotic currencies. This should tell you there is more risk in trading smaller and exotic currencies. The fact is they are not so liquid, because they are not traded so much. In fact they can become very illiquid at times. (That is a small example of the half truths of the forex industry's marketing machine.)

This margin required is usually expressed as a percentage of the transaction value (the full lot amount you trade). Typical percentages of margin in the forex market is 2% (USA), 1% (most common), 0.5% (smaller lots), 0.25 & 0.20% (micro accounts), 0.10% and 0.05% (loser factories).

The lower the margin required percentage the bigger is the amount you can trade with, i.e. the higher the leverage.

The forex trading industry likes to push high leverage (low margins) as a big benefit of forex trading, but that is just wrong.

As we have seen in the stock market margins of 50%, leverage of 2:1 (half is own stock value, half is borrowed) can wipe little traders out long before the "rich men". Consider now 2% margin for leverage of 50:1. This is the lure of leverage as it is promoted today: Make a lot of money with little money: Open a very small trading account of a few hundred or few thousand dollars and use leverage to make a lot of money, fast.

Leverage is promoted as something that increases profit / loss potential. This is false. Leverage increases potential profits / losses! Leverage can't make you a better trader or make your trade "better". It just amplifies whatever happens in the market in your account. If you trade EURUSD with leverage of 10:1 and the price changes 1% in the market (EURUSD changes from 1.1000 to 1.1110) that market move is amplified in your account to 10% change in your account value.

I hope you can see how problematic it would be to trade with something like 50:1 or 100:1 (maximum) leverage!