Posts Tagged ‘risk’

Can trading forex make me rich?

Wednesday, December 2nd, 2009

Many people are attracted to the idea of trading in forex (or other financial instruments such as CFDs, shares, or spread betting) because they think it is an easy way to make money.

In theory it is very easy. All you have to do is to predict whether a price is going to go up or down. If you are right then you get make money. The degree to which you are right or wrong will determine how much money you make or lose.

pound sterling bank notes

It can seem all too easy when the papers or the TV news are running stories day after day about how a currency or a stock is going up or a currency or stock is going down. You may look at these stories and think that if only you had placed a bet a few days ago you’d be ‘in the money’.

Forex in particular seems to have a certain mystique about it. The major currencies are highly liquid, there is often a good amount of volatility, and the retail brokers will let you trade with large amounts of leverage.

It can also be enticing because rather than having to look at boring company reports and exotic financial ratios, you can read about how the economy is doing and make guesses on where economic policy is going to go.

So do people get rich from forex?

Of course they do. People can get rich from anything. People can get rich from winning the lottery or from betting on horse racing. That doesn’t however mean that *you* can get rich from doing these though.

Some people make a very good living from forex and win consistently week in, week out.

Some people trade forex for a few months and double or triple their money. Does this mean that they will become rich? Not necessarily. In fact if they are making money very quickly then it is extremely likely that they will lose it all even quicker.

Trying to become rich from doing a few trades in forex over a short period of time will not make you successful as pretty much the only way you can achieve very high percentage wins is by taking unmanageable risks. If you are taking unmanageable risks then the one thing which is almost certain is that you will get burnt – and probably badly. There is even a big chance that you will lose a lot more than you put in.

If you look at the forex bulletin boards then you can find many sorry accounts from people who make a large amount of money very quickly but then lost it all in a fraction of the time. Did they become rich? Even thought their account may for a few days have had $20,000 of winnings in it, they never got to enjoy the money as it was all lost too soon.

The odds are stacked against you from the start

Remember that as forex is a game of currency pairs, for one currency to go up, the opposing currency must go down. This means that where people are making money, others are losing money.

This is very different to trading in stocks and shares where it is possible for all the shares to go up in value at the same time if the economy is doing great, and for them all to go down at the same time if some major economic upset occurs.

Unfortunately the split of winners to losers is not an even 50:50. For starters for every trade that is made the broker is taking a small commission. This means that there is less money to win, than has been put into the ‘forex pot’.

On top of that professional forex traders, banks and other financial institutions will be taking an uneven percentage of the winnings.

This means that you as a beginner forex trader have the odds very much stacked against you.

As some people get rich from forex, can’t I?

I hope you can see that most people won’t be getting rich from forex. But some do – so could you be one of them?

Let’s think about this another way.

Private dentists can make lots of money. However it isn’t easy. You need to study for many years, practice all the various techniques, pass exams, and have the time and money to be able to go through all of this.

You can’t just become rich overnight by starting a dentist practice.

So why do you think it is any different for trading?

I think the reason for this perception is due to how easy it is to trade. No one (who is sane anyway) would think about having a go at doing a root canal procedure. Where would you even start! However anyone can make a trade on forex. You just have to open an account, press a few buttons, and you are making a trade!

The fact that it is easy to make a trade does not mean it is easy to consistently make winning trades every day, year after year.

To be a winning trader you will need to do large amounts of study, practice regularly, and have the right attributes to place and manage your forex trades.

In conclusion

Forex can indeed make you rich. It just probably won’t.

Always have a stop, and ideally a limit

Thursday, November 26th, 2009

When trading financial derivatives such as forex, CFDs should you always use a stop?

Short answer: Yes!

Long answer: Yes you should always have a stop in place – even if you think you really don’t need one.

Note that I’m only referring to financial derivatives such as forex and CFDs where you trade on margin. If you are trading or investing in instruments where you pay the full price up front (as you will usually do with shares) then this doesn’t apply to the same extent.

Leveraged price moves

A stop is very important with derivatives because when you are trading on margin any moves in the market price is magnified (often by huge multiples –1:400 leveraged forex – are you insane!). A move in the wrong direction can easily wipe you out – along with any other unrelated positions that you currently have open. In the worst case you could even end up owing your broker money – and that is not a good place to be.

forex trading screen 4

Stops are for wimps!

If you talk to people or read the trading bulletin boards there is often a certain amount of bravado about trading without a stop. Some people seem to think that stops are for wimps or are irrelevant for the strategy they are using (“I don’t need a stop because if the market moves against me I manually close out the position in time”).

Emotional decision making

Some people may be disciplined enough to close out at a sensible price but most aren’t. When the numbers on your screen start moving against you it is all to tempting to think – “I’ll stay in a bit longer – the price might go in my favour again”. The chances are that it will just keep going against you making your loss bigger. If you have a stop then you remove your emotions from exiting at the right time.

You should decide your worst exit price when you place the trade when you are thinking more rationally. You of course always have the option to exit earlier if you realise you are wrong before you stop gets hit. Just whatever you do don’t start loosening your stop. Remember the reason you set it at that value in the first place.

My strategy doesn’t require stops

Some people (for our example we’ll call our trader ‘MrNoStop’) will argue that the strategy they are trading does not require stops. They talk about never leaving the screen when a trade is open. If something happens there are always at hand – and cool headed enough – to close that trade.

So what happens then if some huge incident occurs which has a massive impact on prices. For example an unprecedented terrorist attack. Imagine that due to the incident the internet grinds to a halt – as it did on 9/11.

Suddenly MrNoStop’s trading platform stops responding, his previously fast internet connection grinds to a slow trickle. Now MrNoStop can’t exit his trade using his computer. Never mind thinks MrNoStop – I’ll telephone my broker. I always have their number to hand.

MrNoStop calls the number. It is engaged. He keeps trying. Eventually the number rings but no one answers. What is going on? Well of course MrNoStop isn’t the only one affected by the internet outage – all the broker’s customers are affected and they are now phoning the company on mass to either find out what is going on or close their positions. If only MrNoStop had used a stop.

Even if his normal strategy didn’t need a stop he still should have used an ‘emergency contingency’ stop to prevent this kind of thing from happening. It could have saved him a lot of money.

It can be good to have a limit order in place

In the title for this post I mentioned that you should always have a limit as well. Why is this?

Well let’s go back to MrNoStop’s bad situation. It is entirely possible that the terrorist attack could have had a massive positive effect on MrNoStop’s position. The price could have spiked up and then headed back down whilst MrNoStop was unable to use the internet or get though on the phone. If he’d used a limit order as well for this trade then it is possible that he may have made it out with a profit.

Some caution suggested

Maybe I’ve convinced you that always having a stop and a limit order is a good idea.

Well I’ll give you some warnings as well. If your trading platform implements stops and limits as separate tickets from the main trade then you need to be very careful to make sure you know exactly what tickets you have open! Make sure that you don’t accidentally get into trades that you didn’t mean to. If you close your trade ticket then close any associated stops and limit orders as well. Ideally you should have a blotter listing all your open tickets permanently on screen. If you have enough monitors then using one of them for account information can be worthwhile.

If your trading platform implements the stops and limits as part of the same order (and automatically cancels the stop and limit when the trade is closed) then things are much easier. This is because you can’t end up with forgotten stops and limits that are waiting to trigger when you least expect them!

How much money could I lose trading CFDs?

Friday, July 17th, 2009

Before placing any contracts for difference (CFD) trades you should ask yourself the question of “How much money could I lose?”. If you are to trade responsibly you should always be focusing on what you could lose, not what you could win. If you are focusing on how much you could win then you are either at high risk of losing a lot of money, or you could even be a gambler rather than a trader.

There are several different ways of looking at how much money you could lose.

Lose as much as you put in

A small number of CFD providers will cap your losses at the amount of money you have in your account (or offer a lower risk account which guarantees this). If you have an account with a company who does this then your worst case loss is obviously whatever money you put into your account.

Even if your CFD provider doesn’t cap your losses then you may be able to fix your maximum risk by using a guaranteed stop. Unfortunately there is usually an extra charge for these, often in the form of a larger spread.

Lose your entire position size – going long

Most CFD account providers have agreements that say you must cover all your loses – which can be larger than your account balance. They will usually close out your trade before your account balance hits ‘0’ but in a very fast moving market you might be closed out with a negative balance.

If you are betting long then your theoretical maximum loss will be your total position size. If you bought £10,000 of Vodaphone shares using CFDs then you may have only needed to put down a £100 deposit (if we assume a 1% deposit requirement) but your loses could far exceed that £100. Your maximum loss would occur in a situation where the share price went down to 0. If you’d used CFDs to buy £10,000 of shares and the price suddenly plummeted to 0 then you could owe £10,000 if your trade wasn’t automatically closed out.

Could this happen in real life? Certainly share prices can go down to 0 – recent cases of large companies collapsing include Enron and Lehman Brothers.

If you were going long on indicies, such as the FTSE 100 then your theoretical loss would be the loss that would be incurred if the index went down to 0. As I write this the FTSE100 is at 4365. If I bought at £1 a point then my theoretical risk is £4365.

Unlike shares which can go down to 0 a share index is very unlikely to. It the FTSE 100 ever dropped to 0 then that would probably mean that the UK had been nuked to oblivion. In which case you may well be dead and your CFD broker wouldn’t exist either! Very unlikely but it is always worth bearing in mind just how much money you are playing with.

Could the value collapse so fast that you would end up owing far more than your account balance? You can end up owing your CFD provider more than you balance if you have a very large and highly leveraged position, and things move fast. In this case it may simply not be possible to liquidate your position fast enough to prevent your loses.

Losing a fortune – going short

The amount you can lose is often defined in terms of prices going down. Of course with CFDs we can bet on prices going up and down. How much could you lose by going short?

In theory you could lose an infinite amount of money!

I’m not saying it is likely – just theoretically possible. Lets imagine that you think UselessPowerPLC is going down. It is at 5p per share and you think it will fall further. You sell £10,000 worth – this is 200,000 shares. It is a small share and you need a 10% deposit. In other words you have to put down a £1000 deposit. They make an unexpected announcement – they have perfected fusion power, using patented technology, and can now produce almost unlimited amounts of power extremely cheaply. The company will make billions! The share price rockets to £20 and moves so fast that your CFD provider can’t close your position out in time. Suddenly you owe your CFD provider £3,990,000 (200,000 * (£20 – £0.05)). Yes – nearly £4 million. Crikey. Stretching the bounds of believability perhaps, but it makes a point about how risky the CFD game could be. Especially if you make stupid bets!

Is any of this really likely to affect me?

How fast could prices move? Very fast. Look at the stock market crash page on Wikipedia. How would your account have coped during one of those days?

My doom-munging scenarios wouldn’t normally happen of course. You CFD provider knows that trying to claw back debts from customers is much harder, and more expensive than simply deducting the money from their account. This is why they have automated systems in place to try to automatically close your positions before you get into this predicament. If you do find yourself in this predicament then you should look at the way you are trading – it probably means you did something very stupid, i.e. holding positions that were far too large and highly leveraged.

Although the unlikely is by definition ‘unlikely’, is always worth thinking beyond your usual risk scenarios. Don’t forget that a factor of the current credit crunch was that banks rejected the sudden default of hundreds of thousands of mortgages as being such an unlikely thing to happen that it wasn’t worth taking seriously. Ooops! Fortunately the banks had the government to bail them out. If you mess up then the banks certainly won’t be bailing you out.

The simple moral – consider the usual risks, and then consider beyond the usual risks. If you are still happy then you can play the CFD game. If you aren’t happy then maybe you should put you money in the bank.