A sure thing? Trading often likely to cost you money

Nine out of 10 people who engage in foreign exchange trading lose money, according to a recent French survey. The finding will surprise no one with any experience of the practice – all too often, leveraged trading turns out to be a fast road to the poorhouse.

The French figures come from the Autorité des Marchés Financiers, France’s regulator, which last month revealed the findings of its investigation into foreign exchange (forex) and contracts for difference (CFD) trading. Between 2009 and 2012, 89 per cent of French clients lost money. The average loss per client was nearly €10,900. Losses totalled nearly €175 million for the 13,224 losing clients, compared to gains of €13.2 million for the remaining 1,575 clients. Furthermore, individuals learn little from their experiences, with the most active and regular traders seeing their losses mount over time.

Quick losses

It’s not that French traders are an especially clueless lot. A new US study of more than 110,000 forex transactions finds ordinary traders lose an average of 3 per cent per week. Unfortunately, the losing traders tend to keep schtum about their losses while winning traders are quick to brag about their gains, with the latter almost 50 per cent more likely to talk on social networks about their trades than their less fortunate counterparts. Traders who are told about other winning bets trade roughly 20 per cent more often over the following week.

Losses are not confined to the forex market. A study of day traders in Taiwan over the 1992-2006 period found that in an average year, 360,000 people engaged in day trading. The vast majority – 87 per cent – lose money in a given year. Less than 1,000 traders – fewer than 1 in 360 – are able to consistently outperform, the study found.

These figures may shock those who follow the quarterly client profitability statistics released by US forex providers. Here, the picture appears less ominous, with 38 per cent of forex traders making a profit in the second quarter of this year.

However, a number of caveats apply. Firstly, ordinary traders may well make a profit in one particular quarter only to lose a lot more in another. Certainly, the study of Taiwanese day traders suggests only a tiny minority maintain their outperformance. Secondly, there is a survivorship bias. The US profitability stats only look at accounts that were active in a particular quarter, so those who depleted their accounts in a prior quarter will not appear in the figures.

Most of the time, forex is a quick road to ruin, with the US-based National Futures Association (NFA) estimating the average retail trader gives up after four months. Accordingly, forex providers tend to spend lots of money on marketing – they need a continual stream of new customers to take the place of those who have just emptied their accounts.

Reasons for losing

Why do most traders lose? According to Forex Capital Markets (FXCM), one of the main players in the industry, forex traders are correct more than 50 per cent of the time. However, they lose roughly twice as much money on losing trades as they win on winning trades.

The solution, says FXCM, is to use stop-loss orders – that is, to exit a losing trade when a predetermined level is hit - and to look for trades with a decent risk/reward ratio.

That’s relatively standard advice in trading circles – cut your losses, let your winners run and practice sound money management.

However, this alone is no cure-all for losing trading behaviour. For one, it’s very difficult to do so, with countless studies showing humans are hardwired to take quick profits and gamble in order to avoid losses. Secondly, while stop-loss orders prevent losses from getting out of control, they greatly increase the probability of a losing trade. A trader may well be right that a given currency may be higher or lower in a week’s time, but that trader may be prematurely stopped out of the trade. Studies indicate stop-loss orders are not the panacea they are often made out to be, for this very reason.

In truth, ordinary traders are competing against professionals with better knowledge and resources. Indeed, the game is difficult enough for the pros. Psychologist, author and trading coach Brett Steenbarger, who runs the Traderfeed blog, estimates fewer than 5 per cent of the traders he worked with a decade ago, are currently trading and experiencing success. "In each case, they are doing something very different from what the standard trading books describe", he adds. "They have found sources of 'edge' in markets that they have made their own."

Ordinary traders rarely have this edge. Add in the fact they are offered gigantic leverage, and it’s little wonder forex trading is almost invariably unprofitable.

Leverage limits

In the US, there have been efforts to limit the dangers. Until 2010, ordinary forex traders could leverage their accounts 100:1; you could open an account with $50, and make a $5,000 bet. The NFA proposed a limit of 10:1, but industry opposition resulted in a 50:1 limit being imposed. More recently, the NFA proposed a ban on the use of credit cards to fund forex accounts. This followed a survey which found poorer people were predominantly using credit cards to fund their accounts, with the majority losing their money and being saddled with debts they could not afford.

None of this is enough for former Commodities Futures Trading Commission director Michael Greenberger, who recently called for the retail forex market to be shut down.

“People are lured into forex trading the same way they’re attracted to a roulette table,” he told Bloomberg earlier this month. “It’s a no-win proposition.”

While Greenberger may not like the US environment, forex trading is much less regulated again in Europe. According to a CitiFX report earlier this year, leverage ratios of 200:1 or more are the norm in Europe and the UK. Indeed, a number of UK providers offer leverage ratios of 500:1, meaning someone with €100 could make a €50,000 bet. (Contrast this with Japan, which reduced leverage limits to 25:1 in 2011.)

Some international brokerages, such as Interactive Brokers, insist accounts be funded with at least $10,000 (€8,000). Others, such as Plus500, which has seen its share price almost triple since listing on London’s Alternative Investment Market (Aim) last year, allow accounts to be opened with as little as €100 or via a credit card. Plus500 often offers cash promotions to entice potential customers.

The sheer ease of forex trading in Europe is presumably a factor in its popularity; according to CitiFX, there are 1.4 million retail forex traders in Europe, compared to just 150,000 in the US.

Popularity in Ireland

The dangers of leveraged trading should be obvious to Irish people, given Seán Quinn’s spectacularly costly punt on Anglo Irish Bank. Despite this, CFD trading remains extremely popular. Earlier this year, ETX Capital took over Dublin-based spread-betting and CFD firm Shelbourne Markets, citing the fact that about 50,000 people in Ireland trade CFDs.

Whether all of them are aware of the risks is a moot point. In 2011, the Central Bank expressed “considerable concern” that CFD traders were not being “adequately informed”, with some firms referring to CFD trading as “easy”.

It’s anything but. Leverage may be a tempting proposition, but the international evidence suggests those who cannot resist its allure will pay dearly for doing so.