Do you have the heart for foreign exchange trading?

July 18, 2011

When he isn’t working as a Sacramento-area chiropractor, Neil Kalia likes to watch the currencies of other countries closely. Very closely.

Kalia, 34, estimates that he spends between 40 and 50 hours a week boning up on how the Euro, Australian dollar and British pound stack up against the U.S. dollar. When he trades, it’s usually quick: “anywhere between 24 hours to two weeks, I get out.”

Statistics confirm tremendous growth in foreign exchange trading by individuals such as Kalia in the past decade. According to the Bank of International Settlements (BIS), daily volume of foreign exchange trading has nearly quadrupled since 2001, from $1.2 trillion in 2001 to just below $4 trillion today. “That’s more than all the stock market volume combined on a daily basis, and that goes back to how liquid the currency market is,” says Brian Dolan, the chief currency strategist at FOREX.com and the co-author of “Currency Trading for Dummies.”

But it’s much more debatable to what extent currency belongs in the average investor’s portfolio, how trades should transpire — and who should execute them. Insiders stress that mapping the peaks and valleys of pounds and dollars is not for hobbyists, but well-equipped pros.

“The average investor should not speculate in currency, in much the same way I would say the average person should avoid going to Vegas,” says Steve Horan, head of Private Wealth at CFA Institute, and co-author of “The Forbes/CFA Institute Investment Course.” “There are a lot of smart people playing the currency market; they’ve got more tools, more data and more training — and I don’t want to play against them.”

“The increase is being driven by investors — hedge funds and alternative assets funds — looking for extra return over the market,” says John Mathis, a professor of global banking and finance at the Thunderbird School of Global Management.

Meanwhile, online trading platforms have exploded. According to FXWeek.com, Citi FX Pro enjoyed more than 10-fold growth in monthly trading volume between July 2009 and July 2010, a period during which it set up operations in Singapore and the United Kingdom. With as little as $10,000, users can set up non-collateralized accounts and trade on margin. FOREX.com also has brokerages worldwide, and you can even try out currency trading with a free account that has $50,000 virtual cash. Other players include TradeStation and Zecco (which uses FOREX’s platform, a practice known as “white labeling”).

Yet for all the growth, industry veterans caution that little-guy investors remain far outmatched. Expected returns don’t exist, because unlike stocks, for example, currency doesn’t pay dividends. And there’s a big difference between trading on emotional highs versus computer-driven models.

“Our execution is extremely automated and sophisticated,” says Jonathan H. Clark, vice chairman of FX Concepts in New York. Half of his 70 employees are in IT and research, and spend months building models that track currency data back 20 years. In typical trades, Clark might run between five and 20 models. Not exactly rolling dice in Vegas, you might say.

“It’s kind of an arms race, and when we execute our trades, we try to do them with as little a footprint as possible,” Clark says. “If you’re going to compare that to a little guy doing it on his own, we have 30 years of experience and 24 years of trading. It’s going to be an uphill battle.”

How uphill? “I’ve heard 80 percent of people who trade in futures market lose money, and of the 20 percent who make money, a lot of them are like us. Even some people you’d think would do well, like a head trader at a bank, when they try it and it’s a situation where it’s just them, it’s much harder,” Clark says.

Of course, the Internet has made forex trading tempting, since it’s much easier to track foreign currencies and global monetary policy. Plus, the real estate downturn and recent stock market turbulence has investors giving currencies a fresh look.

“With currency, the fluctuations are 1/2 percent to 1 percent per movement,” FOREX.com’s Dolan says. “If you buy a stock and the CEO’s having an affair with the copy boy, and the news hits, the stock might take a 10 percent dump and you’re stuck. With currencies, it’s going to be generally less volatile. A daily price move of more than 1 1/2 percent is the exception, not the rule.”

Risks remain, though, which is why experts are wary of big bets on forex in a portfolio. “During crisis periods, currencies can depreciate 25 to 100 percent in hours or minutes,” Mathis says. “The risk is high because of the greater volatility than the stock or bond markets.” Large institutional investors put a small amount of their exposure into a more volatile currency to maximize returns — but this may only be 5 to 10 percent of an overall portfolio, so the downside risk is controlled, he adds.

Dolan suggests investors do research, even if a pro is helping them. It also helps to stay with one or two “currency pairs,” using the U.S. dollar as an anchor. The dollar is involved in 85 percent of currency trades, followed by the Euro (39 percent), the Japanese Yen (19 percent) and the British Pound (13 percent), BIS statistics show. (The BIS also reports that China’s appetite for Forex trading has surged, jumping 113 percent between 2007 and 2010.)

Even among those playing common pairs, lone-wolf investors often get in and out of currencies quickly after a bad experience or two, experts say. “I can surmise it’s because people are seeking returns in a low-return environment,” CFA’s Horan says. “If we think about how returns look for currency trading, it’s not a normal distribution. It’s highly kurtotic, which means more extremes, positive and negative, than you would expect with a bell curve.”

Whether he’s on the happy end of a kurtotic curve, or doing his homework far more than the average Joe armed with just a laptop and a hunch, Kalia says he’ll stick with foreign exchange.

“I’m very busy with my practice, and my practice comes first,” he says. “But there are times during the day when I know news is coming and I won’t make myself available. … I’ll be up 5 to 5:30 a.m. — my time before the markets are open here, or I might be up at 11 p.m. to assess what’s going on in Europe.” Running on limited sleep is worth the upside, he says: “I’ve been averaging six figures every year.”

 

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