Online Forex Trading – It is a Risky Business for Beginner Investors

Stock exchanges worldwide are advancing in trade volume, attracting numerous players. Regulatory bodies are on the watch to weed out unethical trade practices.

However, the retail forex trading market is one such market where regulatory frameworks are minimal – especially in Africa, & the forces of demand & supply decide the performance of instruments.

With a $6.6 trillion trading volume, the FX market is the largest & most liquid financial market in the world.

The foreign exchange market or Forex is a decentralized global currency trading market where forex market participants i.e.: banks, institutions, businesses, retail traders buy/sell & exchange currencies at the current market price, which is dependent on supply & demand.

Forex Market is necessary for banks, international trade & global businesses. The trading opens with Australian stock exchange time & closes with North American exchange times.

During Covid times, more first-time African investors are getting attracted to Online Forex trading as a means to earn income, without fully understanding the risks.

South African website Forex Brokers SA in their recent report on African FX market reported that South Africa, Nigeria & Kenya saw the highest growth in new active retail traders in 2020. These are the biggest markets in Africa in terms of the number of forex traders & daily average trading volume.

But this is a very risky venture, as risks outweigh the returns & most traders lose, this risk is multiplied when traders trade with unregulated brokers.

What is Forex trading and how it works?

Forex trading is the practice of exchanging one country’s currency against others to profit from the exchange rates.

Currencies in the forex market are traded in pairs with the value of one currency (base currency) against the other (quote currency). A trader sells quote currency to buy the base currency. Currency pairs are quoted in pips (percentage in points), i.e., the difference between ask & bid price. (an ask is the value of quote currency for selling one unit of base currency & vice versa).

RetailForex Trading is offered as a leveraged product, i.e., brokerages offer borrowed funds to investors, who take up larger trade positions (higher than their capital), on currency pairs to amplify profits.

Even though there are many currency pairs, most of the trading volume is in seven US dollar currency pairs, which are called major pairs. Forex trading is a game of numbers. To master it, one has to understand some basic rules for predicting the market; and most retail traders rely on fundamental & technical analysis.

Fundamental analysis considers the economic & political factors that determine the demand & supply of a currency on an economic calendar, by analyzing Gross domestic product, inflation rate, employment rates & consumer price index. Which in turn predicts how strong or weak a currency is, and how the market will react to it.

The technical analysis relies on analyzing the price movements using different mathematical & statistical tools, such as trend lines &moving averages etc.

Profits are not guaranteed

The profit & loss in forex is calculated in Pips (price interest point), which is determined after closing of a trade or position.

There are two ways to enter a trade in the forex market, either by going long or short. A long position is owning a currency expecting the price to accelerate (bullish). A short position is selling a currency with an expectation of repurchasing it when the prices decelerate (bearish).

But the hard part is predicting the price movement. No one can predict with certainty every market movement. So, there is a high chance that the trader will end up losing the entire capital or even more if he/she is not following risk management.

It is estimated that 70-80% of retail traders lose while trading forex & other leveraged CFD instruments.

What makes forex trading risky for retail investors

Other than the fact that it is almost impossible to predict every market movement with certainty, there are some risks that most retail traders don’t understand.

First, there is a risk of losing more than your invested capital with margin trading. Forex or CFD is a leveraged product, using which, with small initial investments (margin), retail traders can take up larger positions, with the possibility of increasing profits substantially.

However, it can lead to losing more than initial investment if the prediction turns out to be contrary to the market movement.

Second, since Forex is leverage-based trading, there must be margin kept in the account to avoid the risk of closing out, i.e., if the trade fell below the margin, it will be closed out automatically. The investor has to bear the losses even if the market bounces back afterwards.

Third, macroeconomic indicators are the prime factors that drive the demand & supply of a currency in the market. Any incident, direct or indirect significance from anywhere in the world can affect a trader’s position.

Since the forex market is largely decentralized open to market forces; no daily price limits or caps on currency rates can be imposed on any currency; thus, making forex trading dependent on the crazy mix of fundamental & technical indicators.

Fourth, the forex market is the most liquid marketplace in the world. It offers quick & swift trading at expected price because of large trading volumes. However, there are times of low liquidity.

Trades outside the major trading sessions can be riskier due to lower liquidity, and also the cost of transactions is higher.

Also, there is a huge risk of your broker failing. Counterparty risk occurs when the trader does not realize the payment, because of the bankruptcy of the brokerage & insufficient regulatory frameworks. Selecting a trustworthy broker under regulatory frameworks can mitigate this risk to an extent.

There are only two major regulators in Africa that regulate online FX trading.e.: CMA in Kenya & FSCA in South Africa. FSCA is the oldest regulator in the continent, and there are more than60 forex brokers that have been licensed by FSCA for offering derivatives in South Africa under their ODP license scheme. Whereas CMA has licensed 5 Online Forex Brokers to offer CFDs to Kenyan investors.

There are no forex brokers regulated in Nigeria. It is important for investors to only choose regulated forex brokers in their country to reduce their risk related to the counterparty.

Moreover, a sudden shift in the interest rates by a central bank will affect the currency price. The interest rates decisions of a central bank can be unpredictable, and lead to huge losses like in case of Swiss Franc end of a peg in 2015 that led to the bankruptcy of many traders & large brokerages.

Remember

Online forex trading platforms have opened up global markets to retail investors like individuals, organizations – to use global macroeconomic fluctuations as an industry to make a profit or hedge their risks.

However, there are pitfalls in the system that everyone should be alert about.

It is only suited for professional investors who must formulate a proper trading plan and strategy to enter market positions.

A trader’s safety and the outcome is highly dependent on the conditions offered by the broker. So, forex traders must only trade with regulated & trustworthy brokers for their safety.

Only experienced investors who are willing to take the risks should take up this profession, keeping in mind that most retail forex traders lose their money.

By reflecting on this fact, investor education and regulatory mechanisms is the need of the hour to diversify the industry to be more just & safe for its participants.