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The Inhospitable Forex

The Inhospitable Forex
Source: Zignox.com Conceptual 3D render of International global investment in foreign currency financial money markets and exchange of Euros, pounds, dollars and yen

CAPE TOWN — Foreign exchange trading has gone mainstream. In a recent trip to Panama, my Uber driver was placing orders from his phone as we departed from the airport to navigate the Amador Causeway. Probably without knowing it, he’s taking part in the world’s largest and most liquid market, one that unlike any other, it actually never sleeps, has no borders and it’s completely decentralized.

As we approach downtown, another thought crosses my mind. Chances are my driver is also unaware that the latest data from the Bank of International Settlements, the most comprehensive tracker of the global FX and derivative markets, shows that buying and selling currencies reached a staggering USD6.6 trillion in daily volume in 2019, a 29% increase compared with the previous three years.

At the end not much is needed to understand its popularity in this era of social media and ubiquitous cryptocurrencies: Etoro and Robinhood, to name a few, are always “at your fingertips”, and surely more firms will soon join the crowded social media trading arena. And, as with many things of the digital society, trading forex is nowadays wrapped and served with easiness – easy to open an account, simple to enter transactions, and it promises to make you rich quick. I, however, would like to offer five reasons to stay as far away from forex trading as possible.

1) The Forex Market Is Too Smart For You

Conventional wisdom tells you to follow the “smart money.” That is horrible advice. You should follow the dumb money. Why compete with the smart guys when you can compete with the dumb ones? So where is the smart and stupid money located? To answer this question, we need to go no further than the greatest financial mess in modern economic history – the Great Recession of 2008.

We are looking at the market that was the quickest and most efficient to assess the gravity of the crisis, discount all the immediate factors, and then project what would happen going forward. The markets that reacted quickest are smart and the markets that reacted slowest are dumb. And the four major markets are: equities (stocks), fixed income (bonds), currency/forex (U.S. dollar), and commodities. The fifth market is the derivatives market, but it derives its value from these four base markets.

According to data from Bloomberg, the first capital market to hit the bottom and then recover was the currency market. The U.S. dollar, as measured by the Dollar Index, cratered one week after the Lehman Brothers collapse in September 2008, and then rallied 17% through to March 5th, 2009. Gold reached its minimum point on November 12th, 2008, and then rallied 40% to February 20th, 2009. The third market to hit rock bottom was the U.S. Treasury market. The yield on the 3-month treasury dipped into negative territory for one day on December 4th, 2008. This was a point of extreme pessimism showing that people had lost confidence in the banks and were prepared to pay the U.S. Federal Reserve to look after their hard-earned cash. When did the stock market hit the bottom? Three months after the treasury market, and almost half a year after the currency market. Both the Dow Jones Industrial Average and the Standard and Poor’s 500 Index found their bottoms on March 9th, 2009.

2) The Forex Market is Manipulated

Most countries are either looking to weaken or prevent the strengthening of their currencies. This sounds ludicrous. Surely a strong currency is a sign that the economy is in good shape and therefore preferable to a weak currency? In reality, strong currencies do more harm than good. They crimp a country’s exports. If your local currency is strong, it makes your product relatively more expensive in the global marketplace. Assume you are a wine farmer in the Valle de Guadalupe in Mexico. Your bottle of Cabernet Sauvignon is priced at MXN300. If the peso is trading at 20 to the U.S. dollar, that bottle costs USD15. If the peso strengthens to 15 pesos to the dollar, that same bottle of wine now costs USD20 – or 33% more.

So what happens when a country exports less than it imports? It is akin to spending more than you earn. Think of exports as income and imports as expenses. When a country exports something, it receives money. When a country imports something, it needs to pay. When you spend more than you earn, you create a deficit. You need to fund this deficit by borrowing money. Given that the majority of global trade is denominated in U.S. dollars, most countries need to fund their deficits by borrowing money in U.S. dollars. They do this by issuing bonds and selling them to foreigners. They need to rely on the kindness of strangers. Deficits are perfectly useful provided that foreigners continue with their generosity of buying your bonds, but generosity can be fickle. Countries know this and therefore try to keep their deficits small by weakening their currencies.

This leads to currency wars. Currency wars could not be further removed from the reality of conventional warfare. They are stealth battles. No one ever admits to waging a currency war and only surfaces when policymakers are accused of deliberately driving down their exchange rate. Front and center of these wars are the banks – both central and large commercial ones. When you jump into forex, you are pitting yourself against a competitor that will outmatch you in intelligence, systems, and resources.

3) Forex Trading is Highly Leveraged

Forex trading platforms provide leverage and this is reflected in the deposit percentage. For example, if you are required to deposit 10% of the total transaction value as margin and you intend to trade one standard lot of USD/CHF, which is equivalent to USD100,000, the margin required would be USD10,000. Your leverage is 10 times. In other words, your USD10,000 gives you exposure to USD100,000. How does this happen? The forex platform is effectively lending you USD90,000. This is very generous of them, but why are they doing this and what does it mean?

They are doing it for two reasons – firstly, they will charge you an interest rate on the USD90,000, and secondly, this leverage means you can make money quicker – and lose money faster. Currency pairs are volatile – on average they move between 1% and 2% every day. Developed country pairs (like the U.S. dollar versus the EURO) will move less than a developed currency pair versus an emerging currency (like the U.S. dollar versus the Mexican peso).

This leverage is a two-edged sword – it amplifies the movements of the underlying pair. If you are leveraged 10 times (some forex platforms offer leverage as high as 400 times), you can make and lose money 10 times quicker. If the underlying pair moves 1% in your favor, you make 10%. But if it moves 5% against you, you lose 50%. This leverage turns the forex market into a giant casino.

4) Trading is Actually Harder Than You Think

The American writer Samuel Langhorne Clemens, known by his pen name Mark Twain, had the following to say about trading and speculation: “There are two times in a man’s life when he should not speculate: when he can’t afford it, and when he can.” There is a big debate between short-term traders and long-term investors. Are humans better suited for the former or the latter? The average human is not a great trader, because he/she tends to be emotional, especially when it comes to money. When you trade, many emotions bubble to the surface – fear of losing and greed of winning are two of the strongest. It turns out that the fear of losing is greater than the joy of winning.

Most traders fall into the same trap – they cut their winning trades and hold onto their losing trades. For example, they enter a trade and quickly make 10%. They think they are geniuses, close the trade and realize the profit. The same is not true when the trade moves 10% against them. Their fear of realizing a loss forces them to hold onto the trade. It goes down another 10%, and that same fear paralyzes them further. Before they know it, they are down 30% and filled with remorse and self-hatred.

It is easier to invest than to trade. To understand this, consider the facts from the stock market. Two of the greatest long-term investors are Warren Edward Buffett, founder of Berkshire Hathaway Inc., and Stephen A. Schwarzman, co-founder of the private equity firm Blackstone Inc. Both men made their fortunes taking long-term investment bets on companies. As of the end of October, according to the Bloomberg Billionaire’s Index, Buffett was the 10th wealthiest man in the world with a net worth of USD105 billion and Schwarzman was 33rd with a net worth of USD39.8 billion.

Let’s move now across to the hedge fund billionaires. Hedge funds are unconstrained funds that have shorter time frames and therefore are more associated with trading. According to Forbes, the richest hedge fund manager as of September was James Harris Simons, the founder of quantitative investment management company Renaissance Technologies LLC, with a net worth of USD24.4 billion. Second on the list is Ray Dalio, the founder, and co-chief investment officer of Bridgewater Associates LP, a global investment management firm. He was worth USD20 billion.

So let’s do some averaging. The average wealth of the top two investors is USD72.4 billion while the average wealth of the top two traders is USD20.6 billion. The universe is clearly telling us that long-term investing is more profitable. This is a random exercise one thing is certain – it is easier to replicate the strategies of Buffett and Schwarzman than the strategies of Simons and Dalio.

You might say that you will settle for USD20.6 billion! Simons and Dalio have both taken trading to Olympic levels – they are the gold medal winners. They have dedicated their lives to their trade, and trading is a zero-sum game. If someone is making one million dollars a day, then someone else is losing one million dollars a day. The average trader is on the losing end of this game.

5) Technical Analysis is Flawed

Technical analysis is the most commonly used trading strategy in Forex. Technical analysis has many merits. Firstly it eliminates the one thing that makes human beings horrific investors and that is emotion. If you look back over the last 50 years, there is one attribute that great investors share – cold-blooded independent thinking. They do not get spooked by market turbulence and they do not get greedy in the face of market exuberance. They are cold, clinical, and unemotional.

By design, technical analysis does not allow you to be emotional. It strips out almost all emotions. Technicians do not read research reports that are filled with subjective opinions, they do not watch CNBC Television nor get misled by unscrupulous analysts, they do not look at macroeconomic metrics like interest rate cycles and inflation. They are glued to price graphs – squiggly lines on a computer screen that provide buy and sell signals.

However, forex technicians only make money when currency pairs break out and enter into a strong trend – be it to the upside or the downside. They typically lose money when pairs are range bound or when there is a decline in volatility. Unfortunately, the money they lose in these range-bound markets often exceeds the money they make in trending markets. Technical signals are lagging indicators. Signals are triggered after the fact, and this is not a strategy that is going to make you rich.

If you read financial news, the Google algorithm has in the past, or will at some point in the future, push you an ad for forex trading. Many people have clicked on the link and have dipped their toes, feet, or entire bodies into this market, probably like my Uber driver in Panama City. For every person that has used the profits to buy penthouses in Miami, there are a thousand that have been sideswiped by a brutally violent and efficient casino where the house always wins. 


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