What is forex trading and why is it risky for most people?

What investors need to know about how FX trading works

13 December 2019 - 12:16
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The demand for retail FX is increasing in SA.
The demand for retail FX is increasing in SA.
Image: Supplied/Forex Brokers SA

Retail foreign exchange (forex) trading has drawn a lot of interest and grown in popularity in SA in recent years. There are about 190,000 retail forex traders who actively trade currencies in SA. This number is projected to rise in coming years.

According to the Bank for International Settlements’ (BIS) recent report, the rand was ranked the 18th most-traded currency in the world in April 2019, accounting for 1.1% of the average daily turnover of the forex exchange market’s daily volume of $6.6-trillion recorded in April 2019. This figure is comparable to other emerging economies such as India (1.7%), Russia (1.1%) and Brazil (1.1%).

The demand for retail FX is increasing in SA

Technological advances such as improved internet penetration, the automation of online trade processes and lowered transaction charges have helped popularise retail participation in forex about the world.

This is also true for SA’s forex trading market, which increased in daily trading volume to $19.1bn in 2017. 

Moreover, the recent tightened regulations in Europe about leverage and marketing of forex and CFD (a type of derivative trading) products has made the European brokers look outside Europe. And Asia, Africa and Middle East have become attractive growth markets for these brokers.

Since SA’s retail forex market was already regulated, many brokers are choosing to get regulated with Financial Sector Conduct Authority (FSCA) and have opened regional offices here. Retail forex trading in SA has benefited from strong local financial sector, local forex and CFD regulations by the FSCA.

SA’s strong business relationships with global economies, well-regulated local financial sector, and growing interest among the local population to trade online in forex and cryptocurrencies has made SA the industry leader and hub for forex brokerages and forex trading in Africa.

Though SA’s financial sector has benefited from this growth, it also has its risks.

Forex Brokers SA has tried to understand how the forex trading industry works, its risks and what investors in this space should know.

Forex trading is the trading of currencies against each other in pairs. Currency prices are mainly driven by a country’s economic factors, political environment and speculation

What is forex trading?

Forex trading, also called currency trading, is the trading of currencies. Unlike stocks, where one trades based on the value of a single underlying instrument, in forex trading currencies are traded against each other, in pairs.

In simple words, you buy the currency that you believe is going to appreciate or rise in value.

As an example, take rand-dollar as a currency pair. Here, rand is the base currency while the US dollar is the quote currency. Base currency represents how much of a quote currency is required to get one unit of base currency.

Suppose you expect the rand to appreciate in the near future, you would then buy rand-dollar, which means you buy the rand and sell the dollar simultaneously. If, as expected, the rand appreciates in future against the dollar, you will close the position by selling the rand-dollar pair, which means selling the rand and buying the dollar back, profiting in the process.

What exactly drives the currency prices?

Currency prices are driven by country’s economic factors such as employment index, inflation, economic growth rates, interest rates, monetary policy, unemployment and so on. Moreover, external factors such as wars and the political environment also influence currency movements, since they affect market sentiments.

For example, rand-dollar may decrease if there is a sharp decrease in the employment numbers in SA as this will be an indicator of currency’s economic environment. The rand could decrease due to market sentiment from this news, assuming the dollar value remains the same.

It is important for an investor to have the right knowledge to judge the affect of a certain event on the price of a certain currency pair.

Retail forex is risky, sudden market fluctuations can wipe out your investment. It’s essential that you invest with discipline, proper risk management and only with regulated brokers

How can you get started?

SA has an independent regulatory body, the FSCA, which oversees the market conduct of the financial institutions in SA. You can choose any FSCA-regulated South African forex brokers to trade forex and CFDs.

It is important to choose a reputed broker to trade. When choosing a broker, one must make sure to choose a broker that is licensed and regulated under tier 1 regulations like FSCA or FCA (UK) or ASIC.

Compliance to regulations allows brokers in the jurisdiction to operate with transparency and accountability, and protects the interests of investors. It will ensure the grievance redressal is as per the law of the country and limits the chance of getting scammed. Regulations ensure security is in place for the money deposited in the broker’s platform, and the broker is liable for moving the money without your approval.

Why do most traders lose?

It is important for investors to be aware that most forex traders lose money.

Forex markets are very volatile. And for retail traders, foreign-exchange fluctuations can be overwhelming and can wipe out their portfolio within seconds. As the fluctuations are driven by a range of global events, keeping track of everything around the clock is almost impossible. Retail traders lack the resources and access to information that global financial institutions possess to protect themselves.

Also, leverage offered by retail forex brokerages often ends up inflicting more pain. Let's say, a trader uses a 100x leverage on offer, just by making a small deposit, say R1,000, a retail investor can take a position of R100,000 rand (100 X R1,000). With a position size like that, profits may come quickly, but a few pip (percentage in point) moves against you can wipe out your entire trading account, and eventually will if you do not know what you are doing.

Finally, research in psychology and human behaviour has shown that humans are not fit for trading, and they are hard-wired to fail because of behavioural biases. Many biases like the bandwagon effect, herding, information bias, overconfidence and so on work against humans in trading, hence it is very important to develop discipline when you trade.

But can you make money with forex trading?

For retail traders, forex is risky and the odds are stacked against them. It is essential that would-be traders do not invest any money or invest only the amount they can afford to lose. But there are a few who make money consistently out of forex.

As always, experience is the best teacher. To become good at trading, it is important to cultivate discipline and implement effective risk-management principles. Remember, you should stay in the game longer to have any chance of winning it.

Knowledge is an important first step to becoming a good trader. Invest time in educational resources that some brokers offer. Learn along the way. Do not take any leverage until you are clear on various drivers of price movements. Understand that the market can go against you any time without your knowledge, and protect yourself at all costs. Be prepared to lose, ensure losses are small and win big each time you win.

Develop your own strategy and stick to it. Keep refining it from time to time by making small changes and adapt.

This article was paid for by Forex Brokers SA.