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FOREX Trading - Is it too good to be True?

November 1, 2004

 

You can't open a trading magazine or surf the Internet for new investment ideas these days without being bombarded by FOREX advertisements.

Brokers who used to want you to trade e-minis, and trumpeted those as the next best thing are now telling you Forex is the best and brightest thing going. The market is huge, they say, with trillions of dollars in volume traded each day. It's the largest and most liquid financial market in the world, they say.

One particularly useless Forex ad asks "Why should you trade Forex?" - and answers: "New trends and breakout opportunities occur frequently because many market participants are momentum driven and overreact to news.

And best of all - there are often no commissions. "That's right", the ads say, "you can trade the largest, most liquid, easily traded market in the world for FREE". For those of you asking "What's wrong with this picture?" instead of "Where do I sign up?" - kudos to you. There is a lot more to Forex trading than meets the eye, and its time someone shed some light on how FOREX works.

What is FOREX?

FOREX or FX simply refers to transactions in 'foreign exchange', where one currency is exchanged for another currency at a certain "exchange rate". Anytime you go overseas or "exchange" currency at the airport, you are trading Forex. Forex trading is buying one currency and simultaneously selling another.

For example, if you could buy $1 Euro for $1.2745 Euros, and several hours or days later sell back that Euro for $1.2765 Dollars, you would make 0.0020 US dollars. As you can see, the movements in foreign exchange rates are minuscule on a single dollar basis, thus trading is usually done on a minimum basis of $100,000. In a $100,000 'lot', the profit on the above trade would have been $200.

Foreign exchange trading is done across any and all currency combinations, but most of the volume is on the so called 'majors', which are the cross currency rates between the United States dollar and the: Japanese Yen, Euro, Swiss Franc, Canadian Dollar, British Pound, and Australian Dollar.

Talking about the "FOREX Market" is a bit of a misnomer, as there is no actual Forex marketplace. You can not visit the Forex exchange as you can the Chicago Board of Trade or New York Stock Exchange. The Forex market is comprised of hundreds if not thousands of large banks, institutional investors, and investment houses. This "large money" has been at the Forex game for decades, assisting governments and large corporations in exchanging foreign monies into domestic currencies, but it has largely been the realm of $1 MM plus accounts.

Why the Popularity?

So if big banks and hedge funds have been trading foreign exchange for years, why is it becoming the vogue thing to do now. The answer is simple - follow the money.

Forex trading is very profitable for the brokers and dealers is the reason magazines are loaded with ads for Forex trading platforms. In a world of ever cheaper e-mini commission rates for online traders, the profit margin for e-mini brokers became razor thin. Retail brokers needed something to keep revenues flowing in, and Forex is just what the doctor ordered.

Forex profits are driven by their unique structure. Forex trading is not done on any exchange, as mentioned before. There is no central marketplace, and dealers therefore make their own market. The dealers take on the risk of the underlying exchange rate moving unfavorably away form the price they make a market at, and for that reason set a spread between the price a client can buy form them and the price a client can sell to them. This is where all of the broker/dealer profit lies.

A Forex broker, or dealer, will quote the customer one price, buy dollars, Euros, or whatever from the client at that price, then sell the dollars, etc. bought from the client at a higher price to a larger player such as a bank or other prime dealer. The spread you see between prices is the dealer's profit potential. Normal spreads in the Euro Currency/US Dollar are four pips, or $40 per $100,000 in trade size. A normally quoted EUR/USD price would look something like 1.2740 Bid, 1.2744 Offer, meaning a client has to buy from the dealer at 1.2744 and sell to the dealer at 1.2740. If the underlying market never moves, the client has to offset his trade at the opposite side of the spread, thereby losing $40.

While the client is buying and selling form the dealer at the inflated(or deflated) prices, the dealer is turning around to a larger dealer - usually a bank or large investment house - and offsetting the trade at a better price. The larger dealer usually has a 1 pip spread or no spread at all, meaning the "actual" market for the EUR/USD is somewhere between a 1.2742 bid and 1.2743 offer. In our example, the dealer could buy Euros from the client at 1.2740, and turn around and sell them to the larger dealer at 1.2742 or 1.2743, meaning a profit of $20 or $30 for every trade. Compare this to the $4 per R/T online e-mini commissions and you can start to see the allure of Forex for brokers.

Imagine if futures brokers did this to their customers. Imagine if S&P futures were trading at a bid of 1131.00 and and offer of 1131.50 at the Chicago Mercantile Exchange - meaning if you bought at the market you would pay 1131.50 and if you sold you would get 1131.00. If futures trading worked as Forex does, a client would see a quote from the "dealer" of an 1130.50 bid and 1132.00 offer. For a client looking to sell, they would have to sell at 1130.50. The dealer would buy from the client at this price, then turn around and sell at 1131.00 at the CME. This imaginary client would pay zero commission, but would get a fill price $125 worse than possible if selling in the CME market. As you can quickly see, this doesn't benefit the client a whole lot, and for that reason it is illegal in exchange traded futures markets.

Go Institutional

The question many of you should be asking is, why can't I deal directly with the larger dealer or prime dealer, and cut out the middle man and his 4 pips. The answer is money. You can deal directly with institutional dealers, and get spreads between 0 and 2 pips, but your account size must be at least $250,000 and you must do trade sizes of at least $1 MM. These accounts do pay a nominal fee of between $25 and $50 per $1 Million in trade size.

The smaller you are, the worse deal you get in Forex trading. Normal retail accounts of between $5,000 and $100,000 receive between a 3 and 4 pip wide spread in the EUR/USD marke.There are also mini Forex accounts - the new rage in the industry, which can be opened with as little as $300. These unfortunate souls pay a 5 pip spread.

Futures vs Forex

So where is the better value, Futures or Forex. As noted above, a 4 pip spread in the Euro/Dollar market has a true cost of $40, not zero as the ads would have you believe. The true cost of trading a Euro Currency futures contract, which has the same size, profit and loss potential of a $100,000 'lot' in Forex, is the difference between the spread, usually one tick in the EC ($12.50), plus the commission. So the better value between Forex and futures comes down to what commission you're paying on the futures side. A commission of $27.50 on the futures side is the breakeven point, anything more and Forex may make more sense, anything less, and you're better off sticking with futures. .

FOREX is also an off-exchange foreign currency market, meaning your trades are not guaranteed by a clearing corporation as they are on futures trades. This means you are not only betting on which way the Forex market will go, but also betting on the credit worthiness of the Forex dealer you are using. While most dealers these days are backed by huge firms and banks, trading in futures does give the investor an extra layer of protection.

- Jeff Eizenberg