In the past, large financial institutions, major fund managers, large corporations and high net worth individuals were virtually the only participants in the huge forex market outside of national central banks. With the advent of forex trading with the internet, however, just about anyone can now open a forex trading account and begin trading currencies online.
Even though the forex market has been made available to a wide audience of retail forex traders, currency speculation remains a risky endeavor. Studies show that more than 3/4 of new forex traders still lose money. Trading in the forex market certainly has its advantages but it also poses a considerable risk, especially to the novice trader. Keep reading to get a better picture of the pros and cons of forex trading.
The Pros of Forex Trading
The foreign exchange market has a number of advantages not found in other markets. These include:
The forex market is now probably the easiest financial market to open an account and begin trading in. Opening an online forex trading account can be done from anywhere in the world with as little as $1 and an internet-connected smart device.
You can easily practice trading or gauge an online broker’s services and trading platform by opening a free demo account that almost all forex brokers offer.
Unlike the stock market that involves purchases, forex positions are based on an exchange of currencies. While you can only leverage stock trading positions in a margin account at a 2:1 ratio, forex trades can be leveraged up to 1000:1 in some jurisdictions. U.S. regulations that apply to retail forex traders have tightened maximum allowed leverage ratios to 50:1 for major currency pairs and 20:1 on minor pairs, while the E.U. now limits retail forex leverage ratios to 30:1 for majors and 20:1 for minors.
Once profitable forex positions are liquidated, the profits can be made available immediately for withdrawal, depending on the forex broker used.
Ease of Going Long or Short
Unlike in some stock markets, there are no uptick rules that prevent you from going short, so you can buy or sell currency pairs freely. When you take a position in the forex market, you take both long and short positions simultaneously by going long or short the base currency against the counter currency.
The liquidity in the forex market is unmatched by any other capital market and central banks oversee the markets in their national currencies. Special circumstances, like the sudden imposition of exchange rate regimes, the release of major economic data and geopolitical events, can adversely affect the liquidity in affected currency pairs while the forex market is reacting to the new information.
Less Chance of Market Manipulation
Due to the size and depth of the forex market, manipulation of this huge market can be very difficult even for hedge funds and large corporations. Even national central banks can have difficulty manipulating the forex market, although they do sometimes step in to mitigate sharp market movements in their currencies.
Low Trading Costs
Overall, trading costs for forex compare quite favorably to other markets. If you mainly trade in major currency pairs, then dealing spreads tend to be tight, which reduces your trading costs. Dealing spreads in the minor and exotic currency pairs are typically wider, however, which increases your trading costs in those pairs.
Simpler Tax Rules
As “988 traders” according to the Internal Revenue Code (IRC), U.S.-based forex traders can deduct all of their trading losses for a given year. They can be taxed as a futures and options trader of 1256 contracts under the 60/40 rule that specifies that 60% of gains or losses are treated as long-term capital gains or losses, while 40% of gains or losses are treated as short term. Consult with your accountant to see what rules apply and what tax plan makes the most sense for you.
Ability to Automate Your Trading
Many online forex brokers support the MetaTrader 4 or 5 trading platforms that allow you to run “expert advisor” or EA software that lets you automate your trading. Other trading platforms also offer this feature, so check with your broker to find out if their platform supports automation.
Open 24 Hours a Day During Trading Week
The forex market opens at 5 p.m. EST on Sunday and closes at 5 p.m. EST on Friday. The forex market remains open continuously 24 hours a day during that trading week. The various trading sessions that correspond to major global money centers, like London, Tokyo and New York, also provide different levels of liquidity in certain currency pairs. For example, currency pairs containing the Japanese yen, Singapore dollar and the Australasian currencies tend to be more liquid during the Tokyo trading session.
Thanks to high liquidity and lower trading costs, your overhead as a forex trader tends to be lower than if you traded in other financial markets. Since forex trading is typically commission free, you usually just need to pay away the dealing spread. Also, all you’ll need to get started trading forex is an internet-connected device and a modest amount of risk capital to use as a margin deposit.
The Cons of Forex Trading
Now let's take a look at the cons of forex trading.
Trading Against Professionals
As a retail forex trader, you basically trade against a host of professional traders, large multinational corporations, national central banks and hedge funds that always have a presence in the forex market.
Knowledge of World Events
Since the forex market consists of national currencies, a knowledge of macroeconomics and familiarity with world events can be extremely important to achieve consistent profits. Ideally, you would limit your trading to a handful of currency pairs, researching each country’s fundamentals to make more informed decisions on trade.
Due to the unregulated nature of the forex market, many online forex brokers operate with little or no oversight depending on the broker’s jurisdiction. While this may be an issue in some countries, if you’re based in the Eurozone, U.K. or U.S. jurisdictions, you may only be able to trade with forex brokers regulated by the Commodities Futures Trading Commission (CFTC) in the U.S., the Financial Conduct Authority (FCA) in the U.K. or the Cyprus Securities and Exchange Commission (CySEC) in the E.U.
Exchange Rate Valuations
Unlike stocks, the origin of currency valuations aren’t as apparent and rely on a series of factors that may or may not be readily apparent in the market. This works against retail traders who might not have access to this type of information.
Trading with leverage represents a double-edged sword for forex traders. On the one hand, you can magnify your profits, but by the same token your losses also increase with leverage. Leverage can be just as much of an advantage as a disadvantage to forex trades.
Another example of a two-edged sword, while volatility remains a staple of short-term traders, volatility can be difficult to deal with for traders looking at the medium and long terms and could catch them off guard.
Successful trading typically requires patience as you wait for good opportunities to arise. Most traders also need to “get into the groove,” which means they need time to get used to the forex market in order to trade profitably. Trading in a demo account could be helpful for novice traders with limited experience.