Weighing currency trading options

Any gains made by one trader in a currency position are a direct result of losses made by another trader who perhaps made the opposite (wrong) bet about movement in the subject currency.

The use of leverage in currency trading is perhaps the biggest source of opportunity and stunning returns but also a significant source of investment risk that traders must know about. The commonly presented picture of glowing investment performance is a selective choice by proponents to portray currency trading as heavily skewed in favor of forex traders.

Truth be told, currency trading is literally speaking a zero sum game in the sense that any gains made by one trader in a currency position are a direct result of losses made by another trader who perhaps made the opposite (wrong) bet about movement in the subject currency. Below, a simple illustration of the mechanics of currency trading especially including the use of margin should help bolster the understanding of the opportunities and challenges in this trade.

Suppose you observe the price of one euro at $1.200 and you think that it is a good price for the euro which should trade higher than that. You anticipate that the euro will go up (appreciate) and want to participate in the gains, so you decide to buy one contract (100,000 euros) or a mini contract (10,000 euros).

The transactional values here would be $120,000 and $12,000 respectively. If you were allowed a margin of 100:1, all you would need to put up of your own funds in your margin account is 1 per cent of the purchase (ignoring bid-ask spreads), in other words, $1,200 for the contract or $120 for the mini then wait for the euro to appreciate. Suppose further that your sentiments were right and the euro rose to $1.210 over some holding period, an increase of $0.010 per euro, your gains would be $1,000 or $100 respectively after paying the ‘loan’. You would have made a 83 per cent ($1,000/$1,200) return on investment!

Note that the percent return is a function of the amount of leverage you are able to get from the broker as it reduces how much you have to put up to participate in the trade. For instance, if you had 50:1 leverage or were required to put up 2 per cent of the transaction amount, your return would be 42 per cent ($1,000/$2,400). And if you did not have the opportunity to borrow, your return would be a measly 0.83 per cent. Now to the point of how possible those exciting returns (say 10 -20 per cent month) money managers promise you are, they are possible because of the ability to lever up your money 50, 100, or more times over. The point is that leverage helps an investor amplify their gains, but this is half the story.

As rosy as this looks, however, currencies are very unpredictable and are known to move erratically. Suppose you were wrong in the example above and the currency depreciated by that same amount ($0.010 per euro), all of a sudden the calculated gains above are losses, in other words your loss would be -83 per cent, -42 per cent, and -0.83 per cent respectively. Two observations can be vividly drawn from this illustration. First observation is that currenct trading is a zero-sum game, your gains are other traders’ losses and vice versa. The more important observation is that the fall is harder the more leverage you are able to take in a margin account.

As a matter of fact your broker has triggers that will ensure that your position is liquidated and their loan paid off before a declining currency wipes out your ability to pay them, by which time the equity in your account will have virtually vanished. This is especially true in fast moving markets. To protect themselves from the possibility of a margin account’s failure to ‘pay the loan’, as market prices change the broker constantly monitors clients’ accounts ability to cover the loan position and may dispose off assets to cover the loan when in dire straits.

Steering clear of losses
Note that the examples used here are only for illustrative purposes. It is possible to use what I call safeguards to stop losses in your account (these are a topic for another time). However, in fast moving markets, those safeguards may come to rescue at very unattractive prices at which time your losses may have piled up significantly. Moreover, readers can increase account amounts to say $10m (similar to what a money manager would have at their disposal) and see how this can lead to large trades and large dollar gains but also potentially large dollar loses depending on the leverage ratio used.

Now going back to the discussion of whether or not my friends should attempt to recapitalize in order to get back the principal. The discourse here is no different than one individuals must have when they are deciding whether or not they should invest in currency trading. The currency market does not remember whether or not you are a first time or seasoned investor. Its behavior is just what it is. Recapitalizing or putting up new money does not change the nature of the game, the trader is simply posting new money to try at currency trading again, with all the inherent opportunities and challenges discussed here. The decision should not be perceived as a promise to recoup capital previously invested, but rather as a new investment in currency trading.

Jimmy D. Senteza Ph.D Associate Professor of Finance Drake University (USA), Fulbright Scholar Uganda Martyrs University, Nkozi jimmy.
senteza@drake.edu