There should be a sign hanging outside the foreign-exchange market that reads: Amateurs need not apply.
Don’t be fooled by the sleepy nature of the currency world, where returns are typically measured in just fractions of a percent. The popularity of leverage — borrowing money to amplify those tiny returns — makes it exceedingly dangerous for retail investors.
Just look at what happened last week when the Swiss franc skyrocketed after the country’s central bank shocked the world by removing a ceiling on the currency.
Not only did the “smart money” on Wall Street lose out, but brokerages that cater to retail currency investors were crushed as well.
Clients of New York-based broker FXCM lost so much money that the company was over $200 million in the hole. The firm received an emergency loan to cover its losses, but that came with a steep interest rate.
“Almost any investment can be risky. Some, however, are more risky than others and may not be suitable for retail investors,” said Harvey Pitt, former chairman of the Securities and Exchange Commission. “Many retail investors simply had no idea about that kind of potential volatility.”
Dangerous game: The fallout of the Swiss currency shock continues to reverberate around financial markets. Shares of FXCM plummeted over 87% on Tuesday, the first day they resumed trading since the firm revealed its equity was wiped out by massive client losses.
FXCM’s financial trouble was amplified by the fact that many of its clients were using leverage.
“The FXCM situation demonstrates that playing around with foreign currencies is an extremely dangerous game. It’s not for the fainthearted,” said Anthony Sabino, a professor at St. John’s University. “Fortunes can be made, but fortunes more often are destroyed.”
Complex bets: Currency trading is not only highly leveraged, it’s also very difficult. Nearly three-quarters of customers trading currencies through brokerages lose money and the average life of an account is just four months, according to the National Futures Association.
The trickiest part about currency investing is the fact that investors need to understand many factors, including vague central bank statements, local politics and geopolitical threats.
“When you’re talking about foreign exchange, the key word is ‘foreign.’ Sitting in your living room in Oklahoma, it’s difficult to assess from a distance what’s going on over there,” Sabino said.
Even sophisticated investors on Wall Street were caught totally unprepared by the Swiss National Bank’s move to scrap its currency peg. If the smart money got it wrong, how are retail investors supposed to stand a chance?
“Whether you’re doing it as a hobby or for a living, it’s a very dangerous environment to play in. It’s very difficult to make that macro bet and then lever it up — and be on the right side of it,” said Art Hogan, chief market strategist at Wunderlich Securities.
Those risks are amplified by the lack of a safety net for investors should a firm collapse, like FXCM nearly did. While equity investors are protected by a federal insurance fund, there is no insurance for the futures, options and swaps currency traders typically deal with.