If you are like others who have lost their jobs or seen their employment situation change, you have likely been searching for alternative ways to make some income. In addition, with remote work the new preference, many people have been trying their hands at online forex trading, but is it only going to make your financial woes worse?
Considering all of the investment markets available to online traders, it can be argued that forex investing is among the least-safe (most risky) arena in which to delve. In fact, as forex markets are a zero-sum medium in which no wealth is created through an exchange, the term “trading” better applies to forex than “investing.”
While trading forex is a risky proposition for the inexperienced investor, there are plenty of ways to mitigate this risk and create favorable trading opportunities when dealing with forex. However, any gains you make in forex will be at the expense of someone else or some other entity, so the forex game can be very cutthroat.
The Complexity of Forex Trading
To understand why forex trading is risky, it is essential to remember that forex trading is not an “investment,” but, instead, a redistribution of purchasing power. Consider the following hypothetical example of how forex trading works:
Suppose that Trader A has 1,000 units of Country A’s currency (we will call it Currency A), and Trader B has 1,000 units of Country B’s currency (Currency B). For this model’s purposes, we will assume that one unit of each currency has the same value initially, creating a total of 2,000 units of currency.
An upcoming election in Country A creates some uneasiness in the currency market, and compared to Country B’s stable political environment, the strength of Currency A slips by 2%. Suppose Trader B detects that this depreciation of Currency A is a momentary blip that will soon pass after the election. In that case, he or she may offer to buy a quantity of Currency A and get 2% more than would have been possible before the political unrest deflated the value of Currency A.
So, for 100 units of Currency B, Trader B can purchase 102 units of Currency A. This transaction will leave Trader A with 998 units of currency (898 of the original, less valuable Currency A plus 100 units of the recently-acquired, more valuable Currency B). In comparison, Trader B will have 1,002 units of currency (900 of the original, more valuable Currency B plus 102 units of the recently-acquired, less valuable Currency A).
Although the amount of currency each trader holds is different, the total currency value in the market is still 2,000 units (998 units for Trader A plus 1,002 units for Trader B).
If Currency A continues to weaken amid the political unrest, Trader A has made a good trade, as the 100 units of the recently-acquired Currency B will strengthen his or her position by limiting the exposure to the weaker currency, creating more purchasing power. However, if Trader B’s suspicion is correct and Currency A quickly bounces back to pre-election levels, he or she has essentially won 2 free units of currency at the expense of Trader A.
While this example may seem confusing, it is actually about as simple as you can make a forex model. Consider some of the following factors that make currency exchange exceedingly complex:
- The exchange rate of a currency pair is never 1:1 as it was for most of this example. For instance, the exchange rate between the U.S. dollar and the Mexican peso is currently 1 to 22.40 but is continually changing and will be different by the time you finish reading this article.
- Various markets worldwide are open at different times of the day, so traders must have a meticulous strategy and detailed schedule in place to trade forex successfully.
- While political unrest will affect the purchasing power of a currency, it is one of the myriad factors that influence a currency’s price. While political turmoil and high unemployment may be pulling a currency down, strong foreign relations and low taxes may be driving it up. The trader must balance all these considerations to conclude the overall value of a currency relative to the chosen base currency in the currency pair.
As you can see, the factors that drive a currency’s value are manifold and can be very difficult to balance for those who are not mathematically inclined or who have powerful software. For that reason, this could be a risky endeavor for those new to forex trading or investing.
For the sake of this example, the critical point is that no matter what is going on with the exchange rate of a currency pair, the result is always zero-sum, meaning that the value of the currency in circulation is always the same but simply transfers hands.
Why is a Zero-Sum Market Risky?
The zero-sum nature of forex trading makes it risky because it cannot be classified as an investment, in the strictest sense. Forex often gets lumped with investing because forex traders operate in much the same way as day traders, who deal in stocks, but even day traders cannot be considered “investors.”
Investment implies fronting money to enterprises to spur growth, with debtors and lenders working side-by-side to make this growth a reality. Investment involves holding a position for a long time to allow this growth to be realized, creating wealth for all involved.
For example, buying stock is an investment because the lender provides money to a business venture in exchange for ownership shares in the company. The company then uses this money to grow operations and achieve profitability. In the end, both the investor and the company win because the growth is advantageous to both parties.
Even more conservative investments, such as bonds, demonstrate this mutually beneficial structure. Whether a city, government, or corporation, the bond issuer is willing to pay lenders a predetermined interest rate in exchange for the use of their funds to complete a worthwhile project.
However, with forex markets, there is always going to be a winner and a loser, as currencies are in a constant state of appreciating and deflating in comparison to one another.This means that any gains one party makes will be at the expense of another party, with no real growth or wealth creation.
In fact, since there will be some costs of entry when trading the forex market (transaction fees, brokerage fees, software, etc.), it can even be argued that forex is a net-negative proposition because even if you break even, the costs of trading will put you in the red.
Finally, due to the finite value present in the forex market, there is a cap to how much money even the most successful traders can make. Whereas stock market investments can be risky and cause lenders to lose significant amounts of money, there is ostensibly no cap to the amount of money that can be earned from a successful investment (just look at early investors in Amazon or Apple for proof). The chance at this astronomical reward mitigates much of the risk involved.
With forex, while one currency may get very strong in relation to other currencies worldwide, there will always be a limit to just how strong it can get, which may make the complexity and risk involved when dealing in forex not worth the hassle for amateur investors.
How Can a Zero-Sum Market Be Less Risky?
The upside (or, rather, lack of significant downside) to dealing in a zero-sum market is that while each transaction will involve a winner and loser, the likelihood that a transaction will result in a complete loser is minimal.
While the possibilities of limitless gains exist in the stock market or angel investing opportunities, these same forms of investment carry the real possibility of the investor losing everything.
For instance, while those investors who put $1,000 into Google during the dot-com bubble have seen that investment grow well into the six-figures, those investors who put $1,000 into the rival search engine AltaVista quickly saw that investment turn to smoke ($0).
With forex, the only way that you will lose everything on a trade (without getting into complex short-term option scenarios) is if the economy of the currency’s home country completely busts, creating a worthless currency.
Even extremely weak currencies—such as the Mexican peso—will have at least some value in every other scenario. You may need to travel to Mexico and buy Mexican goods to get a commensurate return on your “investment.” Still, it is highly unlikely that regular trading in forex will ever see you lose your entire portfolio.
How to Make Trading Forex Less Risky
Although trading forex is a generally risky proposition, there are some ways in which you can mitigate this risk. After all, many people and entities have made successful careers out of making profitable forex trades.
Use the following pieces of advice to keep your forex portfolio growing safely over time:
Become an Expert in the Countries of Your Currency Pairs
To be a successful retail (individual) forex trader, you must know as much as possible regarding the countries in which your currency pairs are located. You must read, watch the news, and do whatever else is necessary to stay up-to-date on any information that may influence that country’s currency valuation.
The following are a few of the factors that can influence the price of a country’s currency relative to another:
- Politics
- Weather/natural disasters
- Taxes
- Inflation
- Job creation
- Employment rate
- GDP
- Foreign diplomacy
- Social media (yes, social media posts from an influential person can influence the currency value of a nation)
Remember that Forex is a Short-Term Game
Traditional investing involves entering a position and holding it for an extended period (usually years), weathering a volatile market’s ups and downs to capture the growth that generally comes with time (most stock indexes average around 8% yearly growth).
However, as forex is not a true form of investment, your portfolio must be actively managed, with a high volume of short-term wins and small losses adding up to a net-positive result for the trader.
Due to the zero-sum nature of the forex market, there is not much upside to holding a position for an extended period. So, you must be ready to take advantage of frequent short-term fluctuations in currency pairs as part of a successful trading strategy.
Use Technology to Become a Technical Wizard
When dealing with short-term trading, it is essential to be a technical analysis expert. Technical analysis involves looking at charts, patterns, and statistical indicators to make educated predictions about the future direction of an asset’s price.
While many technical analysis tools and indicators are quite complex, there is plenty of software available to traders that can quickly and accurately provide traders with the desired technical data.
In fact, there are even forex “robots” that can fully automate and execute trades. For example, if you want to buy a specific currency when the 80-day moving average drops to a certain point, you can program your forex robot to make this trade for you if it occurs at a time when you are away from your computer.
Don’t Be Afraid to Cut Your Losses
One of the fundamental tenets of short-term trading is that you cannot allow losses to snowball and accumulate. As profits in forex are made by the aggregate of many small victories, allowing a losing trade to spiral out of control can quickly cause a forex trader’s portfolio to turn negative.
As such, every forex trader’s best friend is the stop-loss feature on his or her trading software or forex robot. The stop loss is the point where a trader exits a trade that does not go as planned, and it is usually very close to (as little as a few PIPs) away from the buy-in price.
The stop loss should be automatically set once a trade is entered and handled automatically by the software, as the “it will get better with time” approach with which long-term investors can fall back is the bane of the forex trader.
Volatility and fluctuations are the names of the game in forex. By cutting your losses with an unsuccessful trade in a timely manner, you will be well-positioned to move onto the next trade opportunity.
Treat Forex Trading as a Full-Time Job
This point may be controversial to some forex traders who have recently experienced tidy gains through a passive approach and the use of forex robots. However, while advances in software and automation have undoubtedly made life easier for forex traders, that does not make trading forex itself easy.
Like anything in life, making money and being successful requires a lot of hard work. If there were actually forex robots available that were foolproof, guaranteed means to make money without doing any work, developers would not be working so hard to market and sell them. They most likely would want to keep their tool proprietary and make all the money themselves.
As such, be prepared to grind out the gains in the forex market. Invest in the best computers, technology, and software that will allow you to trade most efficiently. Get yourself on a set schedule of when you plan to work on your trading. Get plenty of sleep to ensure that you are well-rested and capable of making sound decisions. When the opportunity presents itself, you must be ready to execute.
When and How to Trade Forex Safely
While we have already established that trading forex can be a risky endeavor for individuals likely to make trades with institutional investors who have a much better pulse on the movement of foreign currency markets, there are some situations in which trading forex can be a safer move.
Freelancers Who Do Business Overseas
As technology has opened the possibilities for remote work, digital freelancing has seen a massive increase in popularity as a career choice. Fields such as digital marketing, content creation, and graphic design have seen considerable increases in freelancers in one part of the world working for clients in another.
Therefore, if you are a U.S.-based freelancer and are working for a Chinese company that will pay you in Chinese renminbi upon completion of the project in six months, you can purchase a currency futures contract to ensure that the exchange rate in six months will be the same as it is on the day of your work agreement.
While this eliminates the possibility of gains in the event that the renminbi was to strengthen against the U.S. dollar in the interim, it effectively hedges against the Chinese currency depreciating.
Multinational Corporations
For multinational corporations, in which business production and revenue occur in one or more countries other than the home nation, active participation in the forex market is necessary to help maximize profitability.
The corporate finance department should continuously be monitoring the exchange rates of the countries in which business takes place, as getting the company’s capital allocated where the currency is strongest can be extremely beneficial when procuring raw materials. Even small differences in exchange rates can add up to significant savings when spread over large quantities.
Conclusion
The forex market is one of the riskier financial markets in which a retail investor can participate. From the zero-sum nature of the forex market to the immense complexity of juggling all the factors that can influence currency strength, traders are in for a lot of hard work to see consistent profits trading forex.
However, for those short-term traders who want a lot of action, there are ways to mitigate the risk of trading forex and consistently come out ahead. By keeping up-to-date with their currency pairs’ home countries and effectively leveraging forex software, traders can adroitly enter more successful trades than unsuccessful ones and come out ahead in the forex game.
