Foreign exchange (FX or forex) trading is when you buy and sell foreign currencies to try to make a profit. Even the most skilled and experienced traders have difficulty predicting movements in currencies.
How forex trading works
Foreign exchange trading attempts to make a profit by predicting the value of one currency compared to another.
FX trading is normally conducted through 'margin trading'. A small collateral deposit worth a percentage of a total trade's value is required to trade.
Trading in international currencies requires a huge amount of knowledge, research and monitoring. Before you put your money on the line, get independent advice from a licensed financial adviser.
Margin FX trading is one of the riskiest investments you can make. It raises the stakes further by letting you trade with borrowed money, but you'll be responsible for all losses. This may exceed your initial investment.
Contracts for difference (CFDs)
Contracts for difference (CFDs) are a way of betting on the change in value of a foreign exchange rate. CFDs can also bet on a change in share price or a market index. You're not buying the underlying asset, just betting on the price movement.
CFDs often use borrowed money, which can magnify gains or losses. For every person who wins, there is a person on the other side of the contract who loses the same amount. You will also have to pay expenses.
CFDs are generally highly geared products. The money you invest will generally only be a fraction of the market value of what you're 'contracting' for.
The contract is a legally binding agreement, no matter what the market value of the asset is. If the market turns against you, the issuer of the contract:
- will require you to pay extra money
- may close out your contract, for whatever it's worth at the time, to recover some money. If there's not enough money, you will still be legally obliged to make up the difference.
Risks of forex trading
- Small market movements can have a big impact. Most FX trading products are highly leveraged. You only pay a fraction of the value of your trade up-front, but you are still responsible for the full amount of the trade.
- Exchange rates are very volatile. They tend to move around a lot even within very short periods of time. There are significant investment risks as currency fluctuations may move against you, causing you to lose money.
- Currency markets are extremely difficult to predict. Many difference factors affect exchange rates
- Limited protection from risk management systems. Stop loss orders will only cap your losses. You may also pay a premium price to guarantee your stop loss order.
- Forex scams and fraud. Offers and advertisements that sound too good to be true probably are. Read what the US Commodity Futures Trading Commission has to say about foreign currency trading fraud.
- Forex provider risks. If your FX provider became insolvent, you may not get your money back.
- Trading delays can severely affect results. You may not be able to make trades when you'd like to, because of a lack of liquidity in the market, execution risk, or computer system problems.
Forex trading software programs, seminars and courses
Forex software programs available for forex trading. They may claim their programs can let you know when to make trades. But no person or program can ever accurately predict movements in foreign currencies.
Be wary of companies promoting a particular product that gives you access to better exchange rates or easy money. They may let you trial their trading platform for free at first. This is usually just a teaser for you to buy the software or platform.
A basic FX trading course or seminar won't give you enough information to start trading.
Do your own checks on forex providers
Different forex products involve different risks. Read the product disclosure statement (PDS) carefully before investing.
Check that the forex provider has an Australian Financial Services (AFS) Licence. ASIC Connect's Professional Registers will tell you if they do.
If the provider doesn't have an AFS licence, check it's regulated by an appropriate overseas authority. Trading with these providers may not give you recourse to Australian laws. See check an investment company or scheme.
Bruce loses $2,800 in an FX trade
Bruce wanted to trade in forex and so he deposited $A3,500 with a margin FX provider. Bruce decided to buy $100,000 Australian dollars (AUD) against US dollars (USD) at 0.9100, which was a contract worth $US91,000. He paid a 0.5% margin of $A500.
Unfortunately the value of AUD against USD fell to 0.8850 and Bruce closed out his position, losing about $A2,825 (including the margin of $A500 he paid). So out of his original $A3,500 he was left with about $A675, less any transaction costs.
If Bruce had not closed out this trade and the value of the AUD against USD continued to fall, he may have had to meet a margin call and lose many times his original investment.