The Financial Markets Authority (FMA) has just released the following article with some sound advise for the unwary. You can view the original at http://fma.govt.nz/consumers/ways-to-invest/foreign-exchange-trading.
There's a lot of good stuff on the FMA's website, it's regularly updated and well worth checking out. If you're a Kiwi you might as well use it, as it's a Government body you're helping to pay for.
Foreign exchange trading
Online foreign exchange trading is used by some people to try to make a quick profit by betting on the changing value of foreign currencies. But they are just as likely to lose money as make it.
The risk is even higher if you trade with borrowed money, as this increases any gains or losses you make. We regularly receive complaints and enquiries from consumers who have lost money in online forex trading.
What is foreign exchange (forex) trading?
The value of currencies changes constantly. Forex trading is the buying and selling of foreign currencies. People do it for one of two basic reasons:
- to try to make a profit, which is risky, or
- to provide certainty about the cost of future foreign currency payments, which is a way of lowering risk. This is called ‘hedging’. An example of hedging is when you lock in an exchange rate today, for a payment that you need to make in that foreign currency next month.
Forex trading for profit is very risky
Forex trading for profit is when you bet that the value of one currency will change favourably against the value of another. You can trade in forex by:
- purchasing foreign money (that will need to be held in a foreign currency bank account) with the hope that the currency will increase in value against the NZ dollar, or
- buying and selling contracts linked to the exchange rates between two currencies from a licensed derivatives issuer. These contracts could be called things like forwards, swaps, options, contracts for difference (CFDs), and margin FX contracts.
For every person who gains a dollar from forex trading, someone else loses a dollar. And that's before taking into account costs and fees, which can be significant.
Because changes in foreign exchange rates are often influenced by unexpected events, even highly experienced traders using specialist tools often get it wrong.
Forex trading for profit is very risky. If you do want to do it, you should talk to an authorised financial adviser with expertise in this area before deciding to start. Ask them whether it is a sensible strategy for you, and ask for guidance on the level of loss you can afford.
If you do choose to trade forex, you will need plenty of spare money to cover losses caused when exchange rates move against you.
Read our forex trading example to help you understand how trading for a profit really works.
Borrowing to trade is even riskier
‘Leverage’ or ‘margin’ trading are terms used to describe ways of trading with borrowed money. This can be riskier than borrowing to place a bet. You may pay only a small portion of the value of your trade up-front, but if you lose you will need to repay the full amount borrowed, plus any amount you’ve lost. This means that even small movements in currency values can have a big impact on any gains or losses you make through forex trading.
Forex trading risk is hard to manage
Forex traders can use risk management techniques such as ‘stop loss orders’ to try to limit trading losses. In our example below, you may have been able to agree to a stop loss order to automatically close your trade when the exchange rate reached AUD$0.90. In theory this would have capped the potential loss at NZ$1,800. But it would not be guaranteed, as stop orders may not work at all when there are extreme movements in the markets. You might also have to pay additional fees or costs to have a stop loss order in place.
Beware of forex trading ‘training’ and ‘tools’
You should be wary of anyone who tells you that a particular product or technique can give you access to better exchange rates or easy money. While software programmes and training courses can teach you how to make forex trades, no person or programme can ever accurately predict movement in foreign currencies.
Use a licensed provider
Forex trading using contracts linked to the exchange rate between two currencies is classed as trading a ‘derivative’ financial product. A derivative product involves trading in the changing value of an underlying asset such as currencies, shares, bonds, commodities or interest rates. In New Zealand, individuals or businesses offering these contracts must hold a ‘derivatives issuer licence’ from the FMA. You can find a list of all licensed derivatives issuers on our website.
We recommend New Zealanders avoid overseas forex trading services not licensed by the FMA, even if they appear to be regulated by an overseas authority.
Visit our warnings and alerts page for warnings about forex dealers.
Read the product disclosure statement
Licensed derivatives providers must give you a product disclosure statement (PDS) before you trade with them. Different types of forex trading products involve different risks, so you should read the PDS carefully.
In particular you should look for information on:
- how the particular product you’re looking at works. If you don’t fully understand it, give it a miss. It may well be riskier than you realise
- 'counterparty risk’ - the risk that the forex provider won't be able to fulfil its obligations to you if something goes wrong. For example, if your provider became insolvent, you may be an unsecured creditor and have difficulty getting your money back
- how they handle market risks such as lack of liquidity in the market, and trading delays. You may not be able to make trades when you'd like to
- fees and other chargesinformation about leverage.
Be wary of promotional offers for 'free' or 'no loss' trades, especially from online platforms that may not be based in New Zealand. These often have strings attached, so examine their terms and conditions closely before committing your money.
David wanted to make money from forex trading, so he found an online margin forex trading service, checked that it was a licensed derivatives issuer in New Zealand, and deposited NZ$1,000 to open an account.
He ended up losing not only the $1,000 but an extra $3,545. How?
The account required a 0.5% margin to trade. This means that for every dollar he had in his account, he could buy a trade worth $200. This can also be described as a ‘leverage’ of 200 times.
David thought the NZ dollar (NZD) would increase in value compared to the Australian dollar (AUD), so he purchased a contract linked to NZ$100,000 with the NZD/AUD currency pair at 0.92 (meaning NZ$1 dollar = AUD$0.92).
For this NZ$100,000 trade, David had to pay only 0.5% upfront (the margin), which was NZ$500. This came from the money he had deposited in his account.
Unfortunately the NZD decreased against the AUD. In a very short period the exchange rate dropped to 0.88 (NZ$1 dollar = AUD$0.88). This meant the value of David’s NZ$100,000 trade fell by NZ$4,545.
This was more than the initial ‘margin’ of $500 that David had paid, so the forex trading service deducted the remaining $500 that David still had in his account and asked him to pay an additional NZ$4,000 of margin – the $3,545 he owed plus a buffer against further losses. This is called a ‘margin call’.
David didn’t want to continue taking risk on the exchange rates, so he chose to close the transaction at the exchange rate of 0.88. He still had to pay the forex trading service NZ$3,545 in addition to the NZ$1,000 that he had originally paid to open the account.
Find this difficult to follow? Keep in mind that a basic rule of investing is never to take part if you don’t fully understand how an investment works. Complexity usually means risk."
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