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Foreign currency trading is easy - an easy way to lose money (forex)

More and more Americans are dabbling in currency trading and losing in spectacular fashion. Experts say the structure of the currency market makes it hard for amateurs to beat the house.

April 03, 2011|By Nathaniel Popper, Los Angeles Times
nathaniel.popper@latimes.com

Dorothy Ouma began trading foreign currencies after seeing a TV commercial touting it as a way to make extra money, something she could use as a single mother raising three children.

"The ads made me think, 'This is easy,'" said Ouma, 52, an administrator with the Grand Prairie, Texas, police department.

Ouma used her credit card to fund an account with an online currency broker. Within a few weeks of swapping dollars for yen and euros, she said, her $3,000 of borrowed money was gone.

"Even if you make money for a little while, eventually you just end up losing," she said.

Ouma made two mistakes: investing on credit and trying to make a buck by predicting changes in currency exchange rates, something best left to professionals, according to personal finance experts. But she has plenty of company.

An estimated 615,000 Americans are dabbling in foreign currency trading, encouraged by advertising from the two biggest U.S. brokers, FXCM Inc. and Gain Capital Holdings Inc., both based in New York.

Combined, FXCM and Gain have about 260,000 accounts, a third of them in the U.S.

These customers are losing money in spectacular fashion.

At FXCM, 75% to 77% of customers lost money each quarter last year, according to newly required disclosures to the Commodity Futures Trading Commission. At Gain, which operates through http://www.forex.com, the number of unprofitable customers hovered between 72% and 79% every quarter last year, according to its filing.

Lots of leverage, lots of turnover

As if those statistics weren't scary enough, the rules of currency trading allow investors to leverage every dollar they bet on a 50-to-1 ratio. This allows them to bet money they don't have — a tactic that can boost profits but also losses.

The losses have triggered recent lawsuits and regulatory scrutiny — but haven't stopped the swift growth of the industry, which barely existed a decade ago. Gain and FXCM went public on the New York Stock Exchange last December.

Executives with both firms say that they simply provide a conduit for people who want to trade currency, and that customers are given full disclosure of the risk.

"The majority of people today are on a quarterly basis not doing well," Drew Niv, FXCM's chief executive, acknowledged in an interview. "There's lots of education showing, 'Here's how to do it right.' … Do most people heed the advice? No, of course not."

Trading experts, however, argue that the companies use aggressive advertising to lure inexperienced investors into an unusually opaque market.

"The business model for forex trading is to burn the customer and then find another one," said Larry Harris, a USC professor and the former chief economist at the Securities and Exchange Commission.

FXCM's own statistics show that its customer turnover is about four times higher than that of an ordinary retail stock broker. Gain does not release turnover statistics, but its securities filings show that most of its customers at the end of last year were different from the ones it started with, also suggesting high turnover.

'At the mercy of the dealer'

Experts say the unusual structure of the currency market makes it hard for amateurs to beat the house.

With stocks, brokerages typically send customer orders out to be executed at an independent exchange and charge a set commission for each trade, no matter whether the customer wins or loses.

That's not the case in foreign currency markets. Because there is no centralized currency exchange, the brokers must fill customer orders themselves. This enables them to make money in two ways.

The first is by buying a currency at one price and selling it at a higher price — netting the so-called spread between the two. Unlike the set commissions charged by stockbrokers, these spreads can be set at whatever level the currency broker chooses.

The second way the broker-dealers make money is by sitting on the opposite side of every customer trade, like a blackjack dealer sitting across from a gambler.

For instance, suppose a customer buys 10,000 euros at $1.45 each and sells them back to the broker at $1.50 apiece. That would net the customer a profit of $500 — and give the currency dealer a loss of $500.

More commonly, however, it's the customers who lose out on these transactions, despite required disclosure statements that warn investors: "Your dealer is your trading partner, which is a direct conflict of interest."

Gain ended up making an average of $2,913 from every active trader it had last year, even though the average customer account contained only $3,000, according to the company's financial data.

FXCM made $2,641 for every active trader, while the average customer had $3,658.

When foreign currency trading got going in the 1970s it was accessible only to banks and institutions. As a result, regulators allowed banks to swap currencies among themselves rather than on the type of regulated exchange that was standard for stocks, futures and commodities.

In the 1990s, a few fly-by-night companies began trading currencies for amateur investors, without any regulatory oversight.

Online trading technology exploded, and in 2000 Congress put currency brokers under the CFTC's watch. But there is still no transparent exchange for currencies, so brokers also serve as dealers for their customers. The lack of an exchange, where data on prices and trades would be stored, also makes it harder for customers to determine whether they are getting a good price from their dealer.

"Once you have things that are done off exchange you are pretty much at the mercy of the dealer — telling you what the price is, telling you what you owe," said Michael Greenberger, a University of Maryland professor and former head of trading and markets at the CFTC. "Anybody I cared about — I'd say, 'Stay away from this.'"

An opaque market riddled with scams

The unusual structure of the market has made it a popular target for outright fraud. In a typical scam, clients are drawn in by advertisements promising big returns, but once the deposits are in, the company disappears.

CFTC Chairman Gary Gensler recently said it was the "largest area of retail fraud" his agency oversees.

Gensler's agency has tried to rein in the problems with a set of rules for currency trading that went into effect last October. These required the brokers to be more transparent but did not change the fundamental setup of the market.

The CFTC has delegated most of its regulatory responsibilities to the National Futures Assn., an agency established by Congress that is funded by the brokers themselves.

NFA spokesman Larry Dyekman said his group is trying to do more active supervision, but he said the NFA had a difficult job. "It's not as transparent" as other trading markets, he said.

Still, the NFA fined Gain $459,000 last October after issuing a complaint that detailed what it called abusive practices "that benefited Gain to the detriment of its customers."

The NFA complaint alleged that Gain set its trading program to allow certain trades when they went in Gain's favor, while not allowing the same trades when they went in the customer's favor, costing clients $169,502 during one three-month stretch in 2009.

The NFA also alleged that another Gain practice caused $425,000 in customer losses over three days.

Gain CEO Glenn Stevens said that the settings affected only a small portion of customer trades and that they "were since very quickly rectified and changed."

FXCM has tried to set itself apart from Gain and most other brokers by creating a system that it says removes the conflict of interest. FXCM is still always on the other side of every customer trade, but the company says that it takes trades only if it can immediately move them to outside banks so that FXCM does not stand to benefit from its customers' losses.

"Most people felt the market was less fair than the one for [stocks] — and that is a fair observation, historically, for sure," Niv said. "That is why we are trying to go public and differentiate from the pack."

FXCM has faced many of the same complaints as Gain, however, including in a lawsuit filed in federal court in New York in February by an Oklahoma man who claims to have lost more than $150,000.

FXCM operates "a platform predicated upon deceit and trickery that systematically looted the accounts of customers," and has used this to take "hundreds of millions of dollars from hundreds of thousands of unsuspecting customers," according to the suit, which seeks class-action status.

Niv said the suit is a form of "extortion" and "an utter fabrication."

Aside from concerns about fraud, market experts warn that the unusual rules of the foreign currency game make it an unsuitable investment strategy for anyone who cannot afford to lose money.

The leverage ratio of 50 to 1 was taken down by the CFTC from 100 to 1 a few years ago, but it is still 25 times as much leverage as retail stock traders are allowed to use, and many times more than what most professional currency traders employ.

"When things change, it's a sudden fall off the cliff," said Aswath Damodaran, a finance professor at New York University.

No limits on who can place a bet

Finally, while some types of risky investments, such as hedge funds, are restricted to so-called sophisticated investors, there are no limits on who can get involved in foreign currency trading.

FXCM allows customers to start trading with as little as $50, and its ads target novices — a recent banner on CNBC's website said, "Trading the Euro can be EASY! See how with a FREE PRACTICE ACCOUNT."

Both companies offer practice accounts designed to help customers learn how foreign currency trading works, but these practice accounts operate under simpler rules than the real accounts.

In another marketing effort, Gain and FXCM teamed up to sponsor a weekly show on CNBC about foreign exchange, which debuted Feb. 25. The show, "Money in Motion," hypes the wonders of currency trading. "Now, more than ever before, currencies are emerging as the everyday investor's weapon of choice in the battle to gain an edge," marketing material for the show said.

A CNBC spokesman pointed to the standard disclaimer that runs with the show and noted that the network has the most affluent and educated viewers of any cable network.

Ouma, the Texas woman who lost $3,000, began trading after seeing an ad during a local newscast. She said that when she was trading with FXCM, a number of problems cropped up whenever she was making any profit, resulting in sudden big losses.

"They always had tricks to take my money," Ouma said.

FXCM said it would not comment on individual customers. After The Times contacted the company, however, Ouma said FXCM called her and offered to refund her losses.

For some people, of course, the risk is part of the thrill.

Jeff Goodwin, a 23-year-old Internet entrepreneur in New Hampshire, said that after a few years of losing money in the market, he recently found a strategy that has been turning a steady profit. But the potential for big losses is what makes it fun.

"Is it gambling? Yeah," Goodwin said. "You easily get addicted."

http://articles.latimes.com/2011/apr/03/business/la-fi-amateur-currency-trading-20110403