The business of FX trading

On March 3, 2006, the Financial Services Commission (FSC) raided OLINT’s New Kingston offices charging breaches of sections 7 (1) (a) and 8 (1) (a) of the Securities Act. Section 7(1) (a) prohibits persons from dealing in securities without a licence, while Section 8 (1) (a) restricts involvement in the business of providing investment advice without an investment advisor's licence.

On August 2, 2006, Elaine Warner, personal financial advisor with Sterling Asset Management wrote “FX Trading – a viable investment alternative”. On September 29, 2006, the Jamaica Observer’s Caribbean Business Report reported Michael Lee Chin as predicting “…that foreign currency trading schemes…cannot be sustained and will end in ruin.” On October 4, 2006 the Business Observer reported that the regulated financial industry was calling on the FSC to allow the licencing of mutual funds to level the mutual fund field, as they have to compete with operations such as Cash Plus.

On Sunday November 5, 2006, the Observer reported that OLINT was granted a stay of execution for a stay and desist order from the FSC, with the condition that they not increase their membership pending the appeal by the company to be heard on March 26, 2007.

With all these contradictory reports, and no final decision, the investing public is of course left in a quandary as to what information is correct. On the one hand small investors have been reaping high returns from outfits such as OLINT and Cash Plus, and Sterling Asset Management (a registered securities dealer), through its Sterling Report, stated that FX trading is a viable investment alternative.

On the other hand, a well respected self made billionaire, has charged that FX trading schemes will end in ruin. The FSC has never stated that FX trading is illegitimate or illegal. They have only charged that OLINT was not authorized to carry on securities dealing or give investment advice. This is quite different from saying that the activity is a scheme, which will end in ruin. The FSC’s Brian Wynter has said that the public should be aware of schemes that promises high return and could end up in disaster, as it is his responsibility to do. The FSC is a regulator and must ensure the investing public is protected and has a responsibility to look into any unregulated entity they believe can damage the financial landscape. Our memories should not be too short to remember FINSAC in the 1990s.

So what is the investing public to believe? Is it possible to legitimately receive these high returns or is it just a scheme designed to take away their hard earned cash? I decided that the best way to ascertain the reality was to investigate the matter personally, and trade myself.

The facts
In order for us to properly understand FX trading we should look at some facts. After all FX trading is an international market and has been in existence since the early 1970s. The question then is why has it not resulted in economic financial ruin, and why countries such as the US and UK not shut down these operations to protect investors. The market does not operate under the cover of dark, so it is not difficult to find out who the main players are. In fact, news stations, such as MSNBC and CNBC, report on FX trading activity daily as a legitimate market.

Some of the facts surrounding FX trading are as follows:
The FX market is by far the largest trading market in the world. Trades across the globe currently exceeds US$1.9 trillion per day;

Rank-----------Name----------------------% of volume
--1-------------Deutsche Bank-------------------17.0
--2-------------UBS------------------------------12.5
--3-------------Citigroup--------------------------7.5
--4-------------HSBC-----------------------------6.4
--5-------------Barclays---------------------------5.9
--6-------------Merrill Lynch----------------------5.7
--7-------------J.P. Morgan Chase-----------------5.3
--8-------------Goldman Sachs--------------------4.4
--9-------------ABN AMRO-----------------------4.2
--10------------Morgan Stanley-------------------3.9

The top ten currency traders are large financial institutions (see table). The ten most active traders account for 73% of trading volumes and the impact of retail traders is minimal. Retail brokers are estimated at 2% of the entire market.
Currency prices are affected by economic and political conditions. The most significant effects are from interest rates, global trade, inflation and political stability. Traders watch commentary, and the economic calendar, to predict which trend the market will take;
Currencies are traded in pairs. On the spot market the most heavily traded pairs are (1) EUR/USD – 28%; (2) USD/JPY – 18%; and (3) GBP/USD – 14%. The top six most traded currencies are (i) United States dollar [USD]; (ii) Euro [EUR]; (iii) Japanese yen [JPY]; (iv) British Pound Sterling [GBP]; (v) Swiss franc [CHF]; and (vi) Australian dollar [AUD];
There is little or no inside information in FX markets. Fluctuations are driven by actual monetary flows, as well as expectations in monetary flows from economic or political information;
There is no single unified FX market, rather a number of interconnected marketplaces. The result is that there is no single dollar rate but a number of different rates, depending on the bank or market maker that is trading;
The main trading centers are London, New York and Tokyo. As the Asian trading session ends then the European session opens followed by the US session. This results in a 24 hour market. It closes on Friday afternoon (end of US session) and opens on Sunday afternoon (start of Asian session – Monday morning in Asia);
It is estimated that only about 15% of all traders are successful; and
Like many other markets and services the currency market has a lot of scams perpetrated.

It is the size of the market, the number of participants and highly speculative nature that makes the market unique. Over 50% of traders stay in the market for under one week and approximately 20% are estimated to be in the market for one hour or less on each trade.

Trading characteristics
Today one can trade by accessing any one of the many brokers via the internet, who provide their own trading platform. When one accesses these sites you can choose to trade a demo account, which allows access for a specified period of time. When you are ready to trade with real money you can do so through a mini or standard account, with a minimum of US$250, which trades in units of US$100,000 per trade, or mini-accounts, which trades in units of US$10,000.

The question may be asked, how does a retail client access that amount of money? The answer is that brokers provide margins. For example, if a margin of 200:1 is provided then if you put up US$500 you will be allowed to trade up to US$100,000. Financial houses usually trade margins of 10:1 but margins of up to 400:1 are provided for retail clients. For this reason FX trading can be very risky for retail clients, as if the market turns against the retail speculator then it could easily wipe our their capital.

Many retail clients use technical indicators, such as Japanese candlesticks, Relative Strength Index, Directional Movement Index, and Fibonacci to take advantage of trends. The other type is called fundamental analysis where traders predict based on economic and political information coming to the market. Traders use either fundamental or technical analysis based on current market information, or tend to stick to one or the other.

On executing a trade there is no commission charged. Brokers make money on the buy-sell spread. When one buys the EUR:USD pair, for example, you buy at say 1.2889 but the selling price is 1.2886, so the only way to profit is to wait until the sell price moves to 1.2890 and above, which at that time the buy price would be 1.2893. Conversely one could short the currency pair by selling it, at 1.2890 and wait until the buy price falls to 1.2889 or under and then buy to make a profit. Thus one can make money on going long (buying) and short (selling). The broker always makes a spread, which means that the only way that market volumes can sustain themselves is if new money constantly enters the market.

What are the risks?
FX trading, however, is very risky. Because of the highly speculative nature and the number of persons in the market, it is extremely volatile. This volatility means that the market can change directions quite easily and because of the highly emotional state of traders, as revealed by the candlesticks, a sudden change can occur that can wipe out retail speculators, especially with large margins. For this reason all “legitimate” brokers advise to only put up money one can afford to lose, and when trading use what is called a stop loss.

The problem, however, is that it is also very addictive. In fact many persons refer to it as gambling because of the highly speculative nature involved. The odds of winning or losing on a trade, however, are 50-50, that is the market can either go up or down. The odds of winning the lottery are very small and the odds of winning cash pot, for example, are approximately 36:1. So that even if forex is deemed to be gambling the odds are much better. In addition there are technical predictive tools, while the predictive tool with cash pot may be a dream.

Over time one can use fundamentals to predict with some amount of accuracy what rates will more than likely be, just as one predicts stocks and bond prices. It is therefore the high level of speculation, and the very short term nature of trades that makes FX trading so risky, as well as the high levels of margin provided. Similarly, US stock brokers do provide margin for trading stock, which can also be very risky.

Because of the large size of the market, and the interest in the high returns that can be made, the market is also victim to many scams. It is therefore important that retail speculators who may choose to enter the market understand this and ensure that they verify the legitimacy of the broker.

It is also because of the high level of risk, addictiveness and scams that the FSC has to try to protect Jamaicans. On the other hand, recent trends have indicated that Jamaicans are willing to accept this risk, as they have got used to a high return environment and when interest rates began falling it was difficult for many to adjust to the lower, although normal returns.

Is it legitimate?
The question then remains, is FX trading a legitimate activity? And if it is legitimate shouldn’t the regulators be seeking to regulate the industry, as it is evident from the call of the industry for mutual funds, that the market is moving towards higher returns, even if unregulated?

The fear of course is that a lot of money could eventually find itself leaving the shores of Jamaica. If we do nothing about legitimizing it then we will only see many inexperienced persons going online and losing their capital anyway. It may therefore be better to have professionals perform this service under the umbrella of the FSC to ensure regulation.

I don’t buy the argument I have heard that FX trading services have affected the stock market performance. It is known that the stock market is mainly driven by institutional investors. If we assume that FX trading has affected the stock market then it means that institutional traders have also gone the way of placing funds on the currency market. If that is so then they would have recognized the legitimacy of the market also.

Based on these arguments, it seems to me that forex is legitimate. The problem with the market is not its legitimacy but rather the high level of risk involved. Because of the high level of risk it is very similar to gambling in my view. After all any speculative trade is taking a chance, which is what gambling is, whether it is FX trading, stocks or bonds. What makes an activity resemble gambling is the level of speculation involved, that is the odds.

My results
So what did my own personal experience reveal? Well in order to satisfy myself I looked at the various sites and tested around two different demos. After trading the demo accounts for approximately one month, I put up the minimum amount of money to make it more challenging. I started trading real money on October 3, 2006 and at the time of writing this article, November 9th, 2006, which is 27 trading days (there are about 240 trading days per annum), I showed a return of approximately 20%, as an inexperienced trader doing it only occasionally. That is an annualized rate of 178%, however, future losses could easily turn that around. One of the things you learn to do from early is develop your own trading strategy that works for you. As a result I focused on certain tools and followed specific rules I developed, and with my accounting training it was not difficult to adhere to the discipline required. While it may not be probable to make 10% per month, it is highly probable to make much more than 10% in a month. So from a marketing point of view it may be worthwhile to spread the return over a year, so that if one month you make 30% and the next month you make a loss of 10%, then you could make an average payment of 10% for each of the two months.

My knowledge of the market is from reading and practicing with demo accounts. Let me warn everyone though that even though these returns can be made the market is very risky if you do not (1) have the requisite technical skills to understand the tools and market movements; and (2) maintain the required discipline. After all, the market is driven by the same emotions behind most speculative traders, fear and greed, and if one does not maintain discipline then the market can easily turn against you. Because of the risk involved, however, I would not be trading with anyone else’s money.

In my view, however, the market is legitimate and is not a Pyramid or Ponzi scheme. But like any other lucrative business, these schemes exist as fraudsters try to take advantage of enthusiastic investors. The National Consumers League in the US, cited the top ten internet frauds for 2005 as:
Auction items never delivered, average loss of US$1,155 (42% of complaints);
General merchandise never delivered or misrepresented, average loss of US$2,258 (30% of complaints);
Nigerian money offers, average loss of US$6,937 (8% of complaints);
Fake cheque sent for goods and services and victim is told to wire back money, average loss of US$4,361 (6% of complaints);
Requests for payments to claim lottery winnings, average loss of US$2,919 (4% of complaints);
Phishing, at an average loss of US$612 (2% of all complaints);
Advance fee loans, at an average loss of US$1,426 (1% of all complaints);
Internet access services, at an average loss of US$1,262 (1% of complaints);
Information/adult services, average loss of US$504 (1% of complaints); and
Work at home plans, average loss of US$1,785 (1% of complaints).
The department of Homeland Security has also made predictions about the top frauds for 2006, and this list does not include forex. They have pointed to the emerging risk of hackers accessing on-line brokerage accounts, however.

This list has never included forex trading schemes, even though there are forex fraud schemes. What it shows, however, is that there are greater risks in other areas, which may be even more accessible and difficult to trace. Investors need to be made aware of all the risks, and warnings should be issued by the regulators.

I cannot say enough, however, that it is very risky and does require some amount of formal training, and wit. Some of the rules to follow are:
Only invest what you can afford to lose. A mortgage on the house or using your savings to invest in forex is not only very risky, but also stupid. Portfolio management is key, and while there is a place for high risk investments, one should also have low risk and long term investments such as fixed income and the equities market;
Ensure any advisor is a trusted source, with a good track record, just as you would with any other investment. Regulatory oversight is very important;
If you do not have the requisite skills to do the proper analysis then it is best to stay away because of the risk involved. Not because you have access to a computer and high speed internet does that mean you are a trader; and
Finally but very importantly, remember that under section 5 of the Income Tax Act, once you are resident in Jamaica for tax purposes you must pay taxes on any income earned, whether earned in Jamaica or not.

E-mail: dra_chung@hotmail.com