When people think of investments, they tend to think of the stock market. Stocks certainly get the most attention in the financial media. Other markets, such as bonds and commodities, also garner significant interest. However, there’s one financial market that is larger than all the rest put together in terms of trading volume. That is the foreign exchange market, or forex for short.
According to the Bank for International Settlements’ 2019 Triennial Central Bank Survey, the forex market handles more than $6 trillion of trading volume every business day. Foreign exchange encompasses a large variety of participants, including governments, banks, multinational companies, institutional investors, tourists and business travelers, retail traders, and more. The immense amount of trading volume leads to significant opportunities for shrewd traders.
However, it’s important to realize that forex trading is a zero-sum market, meaning that for every winner in a transaction, there is someone who lost an equal amount. That’s because currencies don’t produce profits or pay dividends as a company would. The stock market, being a positive-sum game due to increasing corporate earnings and economic growth, tends to produce better long-term returns for investors than forex trading.
However, while forex may not be an ideal way to build steadily compounding long-term wealth, it does offer a number of intriguing trading possibilities due to the unique characteristics of the currency market. And although there are plenty of legitimate ways to make money in the foreign exchange market, scams do exist and can sidetrack investors. Here are some factors to think about before engaging in forex trading:
— Advantages of forex trading now.
— Geopolitical events’ effects on forex trading.
— Scams to watch out for in forex trading.
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Advantages of Forex Trading Now
Forex trading has become particularly attractive in 2022 due to several factors, one of which is the sudden increases in interest rates and inflation. Much of currency trading is driven by differences in interest rates between different countries. A forex trader might buy a currency yielding 5% annually and sell short another one yielding 1% per year. That would result in an annual gain of 4% per year simply due to the interest rate differential. That interest rate difference is known as “carry.” Carry trading, or profiting from these interest rate differences, is an ever-popular forex strategy. With leverage, which is widely used in forex, that hypothetical 4% annual gain can be magnified many times over. It is important, however, to note that carry trades have significant risk, namely that the value of the underlying currencies could move by more than the interest rate spread, thus wiping out the potential profit.
Carry trading diminished in prominence after the 2008 financial crisis, as most major central banks set their interest rates at or near zero. This reduced opportunities for arbitrage among different interest rates around the world. Now, however, with central banks such as the U.S. Federal Reserve hiking rates quickly, opportunities are multiplying.
[READ: How to Build a Stock Portfolio]
Geopolitical Events’ Effects on Forex Trading
Geopolitical events are another key factor driving increasing interest in forex. The invasion of Ukraine has caused investors to seek safety in their portfolios. Traders turn to forex “in times of overall geopolitical uncertainty, as we have recently experienced with Russia, Ukraine and China,” says Stephen Akin, a registered investment advisor and founder of Akin Investments. “The safety trade, often referred to as ‘King Dollar,’ has been used to protect investors around the world seeking the safety of the U.S. dollar.”
Indeed, the dollar has appreciated sharply in recent months. For example, this summer, it reached parity against the euro. This means that, for the first time since 2002, $1 was equal to 1 euro. That’s a notable event, as historically the euro has generally been worth significantly more than the dollar. The dollar has also appreciated sharply against other leading currencies, such as the Japanese yen, Swiss franc and British pound.
Related to those geopolitical upheavals, there is also the surge in commodity prices and the inflationary impact associated with that. Countries that produce lots of raw materials, such as oil, copper and iron ore, benefit from the current inflationary environment. Meanwhile, nations that import raw materials are not faring as well on the global trade market.
Richard Gardner, CEO of leading M4 white-label forex trading platform Modulus, explains how this has played out in 2022: “This year, the events in Ukraine have increased the price of commodities, including oil and natural gas. That’s been a major boon for commodity-related currencies, especially in comparison to economies which tend to import those same commodities. You can see this play out, for example, by comparing the Norwegian krone to the Japanese yen this year.”
Given this dynamic, a forex trader might buy the currency of a commodity-producing country, such as Brazil, while betting against a commodity importer, such as Japan. Year to date, the Brazilian real has appreciated roughly 30% against the Japanese yen. Brazil also has a far higher interest rate than Japan, so this hypothetical trade would be benefiting from a high amount of positive carry interest on top of the capital gains. And then there’s leverage. It’s not uncommon for forex traders to use three-, five- or even tenfold leverage on positions, which could multiply a 30% gain into something much larger.
However, that leverage can be a doubled-edged sword. Akin explains: “There is significant risk in forex trading due to the leverage that it provides. That leverage allows you to control a large investment with a relatively small amount of money. This allows for strong potential returns, but can also result in significant losses.”
[SEE: 7 Tips to Stay Calm During a Stock Market Crash]
Scams to Watch Out For in Forex Trading
Although there are many legitimate ways to profit from the forex market, there are also pitfalls to be wary of. According to Angelo Ciaramello, CEO and co-founder of retail trading education company The Funded Trader, there are three types of scams to watch out for in forex. He describes them as the portfolio manager scam, pump-and-dump, and trading bots.
Portfolio manager scam. In this scam, an unregistered portfolio manager will contact investors via social media using an alias and promise unusually large returns. These bad actors can be avoided by doing business exclusively with licensed financial advisors, Ciaramello says.
Pump-and-dump. This type of scam is more prevalent in cryptocurrency markets at the moment, but pump-and-dumps can also occur in illiquid forex markets, where a chat room or social media group will drive the price one direction and then unload their positions onto people who bought into the artificial price movement.
Trading bots. Trading bots are software programs that execute trades on behalf of the trader, Ciaramello explains. “They claim they have an algorithm that will yield large results, such as being able to reach financial freedom just by using their bot.” However, these bots rarely live up to their promises, he says, adding that traders should only use firms that have legitimate quantitative trading strategies.
As a general rule, it makes sense to avoid forex brokers that promise abnormally large returns, and to make sure their funding methods are secure and reliable. “Watch out for a brokerage which doesn’t allow withdrawals, or, alternatively, makes withdrawals unreasonably difficult,” says Gardner. “A good way to avoid this type of scam is to make a small deposit, and then withdraw it to make sure that you can access your assets.”
Also beware of firms that have a limited history. “Beyond a deposit test, you’ll want to choose a regulated brokerage that has a track record of fairness and success,” Gardner says.
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How to Trade Currencies, Avoid Forex Trading Scams originally appeared on usnews.com
