Bonds yields are nil>. Gold is hardly a bargain. Blue chips are boring. Tired of the usual suspects and seeking bigger returns, more investors are shifting their focus overseas -- not to international companies or emerging markets, but to foreign currencies.
While many investors are still clinging to safety, a small but growing cohort is seeking out one of the riskiest trades around. With the help of new online trading technologies, the foreign currency markets called forex have become a popular playground for individual investors. Average daily volume in retail forex trading grew 25% from 2008 to 2009, to $125 billion -- up more than tenfold from eight years previous. And while retail trades make up only about 3.5% of the $4 trillion forex market, there are plenty of signs that currency trading is becoming more mainstream, including the fact that investors are asking their brokerages for it: In the last six months, customers have started asking for access to the currency markets on their Scottrade platform, a company rep says. Meanwhile, investor advocates are watching this trend with trepidation, noting that the currency markets are far more complex than the stock and bond markets, and that the potential losses are huge.
Not long ago, investors barely had access to the yen or the krona. Forex transactions were the provenance of people or firms who actually needed foreign currency to conduct business. But in the last few years, as the markets have become more technologically advanced you no longer need to pick up a phone and call a bank to check a price, for example investors have come to view currency as a way to make money, says Sang Lee, a managing partner at the Aite Group, a financial services consulting firm. If a trader believes the euro will rise against the dollar, he can buy euros and sell dollars today, with the hope that he ll be able to make the same trade in reverse in a few hours or days and come out ahead.
That can be very lucrative. Movements in the currency markets are small, so traders rely on leverage making their trades with money borrowed from the brokerage, sometimes at a ratio of as much as 50-to-1 to inflate the potential returns. If you buy $100,000 worth of euros at $1.3673 each and sell at $1.3683, the net gain is just $100, or 0.1%. But with leverage, an investor can put up less than $3,000 to make that $100,000 trade. Now that $100 represents a 3.3% return 33 times bigger than if you d invested the full $100,000, and not bad for a single day s investment. Currency speculation also attracts investors because it s considered to be uncorrelated to equity returns, Lee says: The stock markets can soar, tank, or stagnate, and there s still money to be made or lost in the currency markets.
And today, retail investors have access to these markets. Globally, dozens of online brokerages now offer forex trading platforms, most of which launched within the last 10 years. It functions something like options trading, where customers are asked to name the price at which they d buy and sell a specific currency pair. It s fairly complicated, and just as new to investors as it is to the brokerages. To encourage investors, the sites that offer forex trading platforms tend to provide a lot of education and coaching background information, demo videos, FAQs, and so on. Brokers like FXCM, GAIN Capital, or Oanda typically offer demo accounts so beginners can practice making trades, as well as a kind of mini account that allows a lower minimum balance than a standard account, Lee says.
But even those practice accounts won t make perfect investors, critics say. In addition to the regular risks inherent in currency trading, including the unpredictable actions of sovereign central banks, leverage compounds the risk individual traders take which is why many of the big online brokers say they don t offer it. We re running a brokerage firm, not a casino, says Don Montanaro, the chief executive of TradeKing, a discount brokerage that does not offer forex trading. The combination of speed, complexity and leverage creates a market where, Montanaro says, it appears more than half of retail traders lose all their money within the first six months of trading. And in spite of the extensive primers and educational materials the brokerages offer, all the FAQs in the world don t make up for the fact that the retail investor is at a serious disadvantage compared to institutional investors who likely have a whole team of data analysts to rely on, says Charles Rotblut, a vice president with the American Association of Individual Investors.
Still interested? Here are six things retail investors should know before taking the training wheels off a practice account:
Regulation is light
Some forex trades using futures and options, for example can be done on exchanges regulated by the Securities and Exchange Commission or the Commodity Futures Trading Commission. But much spot currency trading (that is, an immediate purchase of a currency, not a futures contract) is done over the counter, which means the customer is buying currency directly from a dealer, and relying on that dealer to set a fair price. It also means there s less regulatory oversight than there is for equity trading. The regulatory framework for this market is still a work in progress, Lee says.
It s expensive
Fee structures are also more complicated than they would be for a simple stock purchase. Unlike buying and selling stock, for which investors pay a commission or a flat fee, forex fees are generally based on the bid-ask spread. They ll be different for different currency pairs and can even vary across the course of a day, says Nick Britz, the president of Zecco Forex, the division of the online brokerage that offers currency trading. The markup is typically between $3 to $6 per trade, says Patrick O Shaughnessy, a Raymond James analyst who has studied this market. Relative to a $4.50 stock trade, that might not sound like much, but do it twice a day every day for a month, and you ve run up $270 in trading costs.
You can swing for the fences
It s standard practice in the industry to allow investors to make highly leveraged bets, as much as 50 to 1, meaning you could make a $100,000 bet with just $2,000 in your account. That s extreme: Bear Stearns was leveraged 38-to-1 before its collapse in 2008. The amount of leverage allowed is different for different currency pairs, with frequently-traded major pairs like the dollar-euro allowing more, Britz says. But just because you can bet $50 for every dollar you actually have doesn t mean you should. Using too much leverage guarantees failure no matter how smart or adept you are, says Kent Russell, a portfolio manager for Sterne Agee. Retail investors shouldn t take on more than five-to-one leverage, Russell says.
There s no crystal ball
After the Fed announced its $600 billion quantitative easing plan early this month, it might have seemed like a safe bet that the dollar would drop against other currencies, says Rodney Johnson, the president of HS Dent, an economic research firm. But renewed fears about sovereign debt in Europe sent the dollar higher against the euro. Unfortunately, to do this right now, you have to be something of a geopolitical analyst, Johnson says. Sovereign banks may want their currencies to rise or fall for internal political reasons, and an intervention can easily move a currency by as much as 3% in a matter of seconds, Russell says. You re putting yourself in front of a big macroeconomic train that can run you over, says TradeKing s Montanaro.
Currency trades 24 hours a day
That round-the-clock action can be a benefit for a small investor with a day job who can t watch the stock market during U.S. business hours, Britz says. It can also be devastating. While you re asleep in the United States, crazy things could happen in Asia or Europe, and you wake up and you ve lost a lot of money, Johnson says. If you re going to sleep, use stop-loss limit orders that will automatically sell off your position at a certain level, he says.
There might be an easier way
Investors looking for currency exposure don t have to jump right into the forex market. EverBank, for example, offers CDs denominated in foreign currencies they re FDIC insured, and if the currency gains against the dollar, the account s value grows. Currency ETFs also offer a chance to bet on currency moves without wading into the over-the-counter market. And investors can also buy emerging-market stocks in countries whose currencies appear undervalued, potentially seeing double gains from currency appreciation and stock price growth, Russell says. Of course, these vehicles aren t perfect the CDs can be costly and illiquid; ETFs and emerging market stocks don t offer pure currency exposure but they re a viable alternative.