Over the weekend the LA Times became the next major news outlook to tackle the forex market with a story titled Foreign currency trading is easy — an easy way to lose money. This one isn't quite so inflammatory as others I've blogged about in recent weeks, and I found the 615,000 estimate for American forex traders interesting. Maybe journalists are starting to get a better handle on things. That doesn't mean this particular article isn't without its issues, however.
Taking on forex marketing
I give the LA Times full marks for taking on the subject of marketing in the retail foreign exchange trading arena. In fact, I wish they would have gone a bit further with that topic. It is absolutely true that "easy" is often featured in the ads run by major forex brokers, leading the unaware to believe that they can just open an account and be on their way to riches or supplemental income.
The example provided in the article of a woman who got sucked in by this sort of marketing is an apt one. It offers us a couple of important lessons. Obviously, the first one is trading isn't as easy as some would lead you to believe. Certainly, it's easy to place trades and all that, but no one with any experience at all will call the path to successful trading a walk in the park. The second lesson is that new traders shouldn't open accounts with borrowed money (credit card charge in this case).
Betting money you don't have
Here's where things start going off the rails. The article describes trading on leverage as allowing traders to "bet money they don't have". This verbiage suggests a misunderstanding of how things operate in retail forex trading. It suggests a model like the one in the stock market where leveraged trading means borrowing to buy more shares than one could otherwise purchase. This simply isn't the case in forex. There's no borrowing to buy or sell anything.
The margin requirement in forex is a surety against loss. It effectively limits the amount of money a trader can lose on a single position, especially since most brokers these days have automatic closures that kick in when losses are too big. On top of that, many brokers indemnify customers against losing more than what's in their account on the off chance that some incredibly dramatic event causes a big gap move. Stock and futures brokers don't generally have these kinds of protections.
In other words, in forex the chances of you having money beyond what is in your account at risk are very, very, very small, if not non-existent. Traders who lose all their money don't generally do so because of one bad market move. They do it because of a series of poor trades.
Blaming it on the broker
The next step in the article is to focus blame on the brokers. We've all heard traders complain about their brokers. Most of the time it's sour grapes from someone who is looking to place the blame for their losses on someone other than themselves. The fact that the woman in the LA Times article said "They always had tricks to take my money" in talking about her broker lowers her credibility with me.
Yes. There absolutely are scammers out there. Anything popular in the way forex has become is going to attract an unsavory element. There's a steady stream of CFTC action against forex operations you've likely never heard of before. That latter part is the thing I'd focus on, though. It's not the big brokerage houses the regulators are constantly nailing for taking people's money. Certainly, there have been some issues with some of them, as the article notes, but the increased scrutiny they are under now is making for an increasingly fair market.
As for the higher turnover experienced by the forex brokers, I'll refer back to the marketing methods. Folks with unrealistic expectations don't tend to stick around long.
Brokers making money off their customers
Do forex brokers profit off their customers? You bet. Because these dealers make money on the spread, every time a customer buys at the offer price and sells at the bid they make a small profit. As I documented in my Cost of Trading post, however, the trader expenses for forex are competitive with those of other markets.
The LA Times article indicates that Gain (forex.com) made an average of $2913 per active trader customer in 2010 and FXCM made $2641. It then goes on to compare that against average customer account sizes of $3000 and $3658 respectively. I have three problems with this side-by-side analysis presumably to make us horrified at how greedy the brokers are and how they systematically bleed customers dry.
First, notice how the article uses the term "active trader" when looking at how much Gain and FXCM made, but only uses "average customer" to describe account size. That suggests to me looking at separate data sets which may not, in fact, be comparable.
Second, do we have specifics for how those revenues were made? Was that spread income. Was it carry interest? Was it something else?
Third, without having much more information about the distribution of the data for the average income and account size figures above, we really cannot make any judgments. The income figures could be seriously skewed by very active traders with large accounts while the account size figures could be weighed down by numerous inactive small accounts.
Also, the article tosses out the statistics that about 70% to 80% of Gain and FXCM customers lose money on a quarterly basis. That certainly sounds horrible, but do we have a comparison with other markets like stocks?
If you really want to see if the brokers are up to no good, figure out what they should be making based on transaction volumes and average spreads and compare that to what's being reported. If there's a big gap, then an explanation will be wanting.