Currencies: How to Tap Into This World of Wealth
Wednesday, October 14, 2009 | Teeka TiwariRating:
These days it seems that, wherever you turn, you're hit in the face with another currencies commercial, promising quick riches and leverage ratios of 100-to-1.You know what, though?
What they are pitching is partially true.
A Case for Currencies
Trading currencies can be enormously profitable. The leverage offered is outrageous and, more so than any other financial product, currencies have strong tendencies to trend.
But -- like any giant opportunity -- plenty of pitfalls lie between you and your pot of gold at the end of the currency rainbow.
Although the foreign-exchange (forex, or simply FX) market wasn't necessarily designed for individual investors, its allure is hard to ignore.
So if you're looking to trade currencies -- something I plan to discuss with you here in the coming weeks -- I'll show you how to go into it with your eyes (and not your wallet) wide open.
Where to Trade this World of Wealth
When you're ready to trade currencies, where do you start?
The first decision you have to make is whether to trade with a forex broker or directly on a regulated exchange like the Chicago Mercantile Exchange (CME).
What's the difference between the two?
Trading the forex is conducted by a collection of "over the counter" (OTC) dealers made up of brokers and big banks that trade amongst themselves. It's all done electronically and over the phone. (On a related note, the CME has recently announced an initiative to be able to clear OTC forex products by year-end.)
This is the market that you see advertised on those big, splashy forex ads on CNBC and all over the pages of financial Web sites.
These forex brokers typically offer very robust trading tools, excellent online user interfaces that you use to enter your trades, and they typically run the trades commission-free.
Yes, I said commission-free.
That's not a typo; the big currency brokers make their money on the spreads between the bid and the offer prices.
'Spreading' the Wealth
On the surface, this may seem like a good deal -- especially considering that the most-active currencies trade with very small spreads.
However, much of the time, these brokers are not reflecting the best bid/offer spreads and, very often, they are acting as a principal in the transaction.
So, they directly trade against their customers' order flow.
The broker sees every single trade run through their platform and, very often, gets between the trades to profit from them.
Its a big knock against doing business in the forex markets because there is very little transparency.
Buyer Beware ... of Your Currencies Broker
Another issue is creditworthiness.
When trading forex, you live or die based upon the financial health of your broker.
Just ask the poor souls who had forex accounts with Refco, the $4 billion commodities-trading company whose wealth evaporated within the span of one week back in 2005, just two months after being taken public. Investors lost virtually every penny after Refco filed for bankruptcy.
Remember, Refco was no newcomer to the markets. It had been a thriving business for decades. But when it came liquidation time, those who had forex accounts were wiped out. (This was not the case for those customers who held exchange-traded futures contracts.)
This is because forex is an unregulated market that, again, was never intended to be traded by individuals.
Playing on the Big Boys' Turf
The biggest mistakes individuals make in forex is over-leveraging. It can be easy to do, because some firms allow leverage levels of up to 200-to-1!
With temptation that alluring, most individual forex traders trade too large for too long and end up "busting out."
It is a mathematical certainty that you will bust out of the markets if you trade for too long with too big a position size relative to your equity. The big forex brokers know this, and they make a killing from taking the other side of those retail trades.
That's really what the big forex brokers are: casinos that make money off the millions of would-be traders who don't understand the math behind position sizing and leverage ratios.
These unfortunate traders are doomed to failure before they ever begin. Lured by the siren call of quick riches, they approach currency trading the way a drunken gambler bets it all on black at the Roulette table.
Traders like these keep brokerage firm owners in champagne and private jets.
How to Achieve Currency Trading Success
However, this lucrative market is open to individuals, and plenty of people are making money. The key to winning in the currency game boils down to good old-fashioned hard work, study and having an explicit trading plan.
Like any endeavor, if you know what you're doing -- that is, if you have a definable trading strategy that has a measurable statistical edge that employs stop-loss points and position-sizing rules -- then trading forex can be extremely profitable, especially for day-trading strategies.
In fact, one of my favorite day-trading techniques is playing intraday retracements to pivot points. This involves taking a position intraday right above a key support level.
("Pivots" are support and resistance price levels that market insiders use on a daily basis to control how high or how low something will go on any given day.)
The advantage of this is that your stop-loss point is very small -- usually just a few pips.
("Pips" are the smallest unit of measurement that currencies are traded by -- i.e., if the Euro's bid/ask spread is quoted at 1.4755 by 1.4757, then it would have a two-pip spread.)
If I'm trading with a one- or two-pip stop-loss, I can employ truly massive leverage.
If I'm wrong, I'm only getting hit for small change. But if I'm right, I'm making gigantic percentage gains.
Be warned, when you're trading high-stakes position sizes, you can't leave your screen for bathroom breaks or social calls. You also have huge external-event risk while in the position. However, the holding times on those positions are measured in seconds and minutes -- never hours and days.
Stay Tuned...
Next week I'll take you through the pros and cons of exchange-traded currency contracts as well as explain an exciting new financial product from the CME called E-Micro currency contracts. Feel free to ask some questions below for next week's article.
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Teeka Tiwari
Chief Investment Officer
ETF Master Trader
