Leverage as High as 50-1 Lures OTC Forex Traders Who Most

what does leverage mean in forex

It’s a Saturday afternoon in March, and more than 500 people have tuned in for a two-hour webinar that tells them they can become rich trading foreign currencies.

“Success in trading is not a fantasy; it’s a formula,” Jared Martinez, founder of Market Traders Institute Inc. the oldest and largest such school in the U.S. tells his audience. “We have that formula.”

The Lake Mary, Florida, company that Martinez founded in 1994 says it has educated 30,000 amateur foreign-exchange investors.

“How many people would like to learn a skill where, within two days, they could make a thousand dollars?” Martinez asks that afternoon. “I’m here to tell you I can teach you how to trade consistently.”

He introduces Jose Tormos, his son-in-law, who echoes Martinez’s advice, Bloomberg Markets will report in its December issue.

“It is the easiest, most predictable and safest way to invest,” Tormos says. “Many of you are missing out on opportunities to build a retirement nest egg.”

One person familiar with the webinar pitch is Dan Gratton, a 71-year-old retiree who lives on Social Security in Kingman, Arizona. He says he’s been a student of the institute for two years and had hoped that taking its home-study classes and watching webinars would help him succeed with forex trading. That hasn’t happened.

“Probably the most consistent thing is losing,” Gratton says.

He’s right.

Net Loss

Most retail currency investors lose money most of the time, according to the industry’s own data. Reports to clients by the two biggest publicly traded over-the-counter forex companies -- FXCM Inc. and Gain Capital Holdings Inc. -- show that, on average, 68 percent of investors had a net loss from trading in each of the past four quarters. These kinds of losses make for investor churn.

The average OTC forex investor drops out of the market after just four months, according to the National Futures Association. an industry self-regulatory group.

Retail forex investors, many of whom are well educated in fields other than finance, enter into a market that is lightly regulated, opaque and rife with conflicts of interest. They are enticed by pitches from coaches like Martinez, saying people can finance their retirements trading forex.

And they are allowed to supercharge their bets with the kind of leverage -- as much as 50:1 -- that investors in other asset classes can only dream of. That kind of juice can lead to wins, but more often than not, it leads to big losses. Investors can have their entire investment wiped out in a matter of days.

‘Roulette Table’

Forex trading is like gambling at a casino because the odds are always stacked against you, says Michael Greenberger, who was director of the Division of Trading and Markets at the Commodity Futures Trading Commission from 1997 to 1999.

“People are lured into forex trading the same way they’re attracted to a roulette table,” Greenberger says. “It’s a no-win proposition.”

Most people who trade currencies don’t do it on an exchange; they trade over the counter, usually online, using a broker. But currency brokers aren’t neutral parties; they’re also buyers and sellers, sometimes taking the opposite sides of their customers’ trades.

That’s how brokers can be in conflict with their own clients -- a disclosure brokers are required to make to clients in writing by the CFTC, which regulates forex trading. Brokers may offer any currency prices they wish and can give different rates to various customers at any time, the CFTC-required disclosure says.

Currency trading is the world’s largest financial market; $5.3 trillion changes hands every day, according to the Bank for International Settlements. That’s 100 times more than the daily dollar volume of the New York Stock Exchange. The forex market is dominated by professionals who make trades of as much as $10 million or more for pension funds and multinational corporations.

$400 Billion

For the past two years, regulators in Europe and the U.S. have been investigating whether the world’s biggest banks traded ahead of their clients and colluded to rig the benchmarks used to determine currency prices. Those probes aren’t looking into retail trading.

Twenty million individual investors, some making bets of just a few hundred dollars, globally trade $400 billion a day, estimates Javier Paz, an industry analyst at Aite Group LLC, a Boston-based financial research firm.

The great lure of forex trading has less to do with the movement of the currencies themselves and more to do with leverage. Using leverage of 50:1, an investor can amp up a $100 wager so it can pack the punch of a $5,000 bet. That means traders can double their investment on a 2 percent currency move in their favor.

‘Magically Turn’

“Would everyone want to take a $20 bill out of your wallet and magically turn it into $1,000?” Tormos asks in the March webinar. “Imagine if you took $2,000 from your bank account and traded it in the forex market. It would be worth $100,000 of buying power.”

The elixir of leverage makes it possible to score big gains even in a market that often rises and falls in tiny increments, calibrated in fractions of cents.

“Currencies don’t move that much,” says Drew Niv, chief executive officer of FXCM, the largest OTC forex firm in the U.S. “So if you have no leverage, nobody would trade.”

While leverage can boost gains, it can also magnify losses.

“Leverage is a double-edged sword, of course, as it can significantly increase your losses as well as your gains,” FXCM’s website says. With 50:1 leverage on a currency trade, a 2 percent move against the investor would mean a 100 percent loss.

That’s what could have happened to a trader using 50:1 leverage to bet on a rise in the Japanese yen on Oct. 31, when the currency fell 2.8 percent against the U.S. dollar in one day. In September, the euro lost 2.07 percent compared with the dollar in three days.

Close Out

In theory, investors can lose more than 100 percent if a currency continues to move against them. In practice, brokers close out trades to prevent further losses.

“Leverage is wonderful if you win, but it kills you if you lose,” says Greenberger, the former CFTC regulator, who’s now a professor at the University of Maryland’s Francis King Carey School of Law. “It’s a selling tool to convince the customer how great retail forex is.”

The leverage forex investors can use dwarfs that allowed for trading stocks. The U.S. Federal Reserve, which sets stock margin requirements, limits individual stock investors’ leverage to 2:1. The investor borrows the amount leveraged from his broker. Forex investors using leverage, by contrast, don’t have to borrow any money.

In a typical OTC forex trade, an investor looks online at his broker’s listing of bid and offer prices for a currency pair such as the yen and the dollar. An investor with $1,000 in his account -- which he can fund using a credit card -- might, by using 10:1 leverage, bet $10,000 that the yen will rise against the dollar. The trade is open-ended, meaning the investor can close it and collect gains or take losses at any time.

Conflicting Interests

Because OTC trading isn’t done on an exchange, the forex broker becomes the client’s counterparty, taking the other side of the transaction. If an investor wagers the yen will rise, the broker bets it will fall.

Sometimes the broker keeps the trade on its own books, sometimes it matches the trade with that of another customer who’s speculating in the opposite direction, and sometimes the broker lays off risk by hedging with a bank.

The CFTC, which refers to brokers as dealers, requires them to tell clients in disclosures, all in capital letters: “YOUR DEALER IS YOUR TRADING PARTNER, WHICH IS A DIRECT CONFLICT OF INTEREST. WHEN YOU SELL, THE DEALER IS THE BUYER. WHEN YOU BUY, THE DEALER IS THE SELLER.”

The CEOs of the three largest OTC forex firms licensed to operate in the U.S. -- FXCM, Oanda Corp. and Gain Capital, which collectively have a 73 percent share of retail forex investor money held in the U.S. market -- say they minimize how often they take the opposite side of clients’ trades.

‘Small Amount’

“We will hold a small amount of trades,” says Ed Eger, CEO of privately held, Toronto-based Oanda. “We’ll build up a position, and then we’ll hedge it out.”

Forex brokers, unlike stock brokers, don’t have to keep client money segregated; they can commingle the funds with the firm’s money. If a forex broker goes bankrupt, investors have no priority in claims and aren’t covered by the Securities Investor Protection Corp.

But the biggest risk amateur forex investors face is their overzealous embrace of leverage.

“Leverage is the enemy; don’t overleverage,” FXCM’S Niv says. He recommends using no more than 10:1 leverage. Most clients, he says, use 15:1, and some use much more.

The CFTC has tried -- with mixed results -- to clamp down on leverage. Until 2010, the NFA set the limit at 100:1. Then, as part of the widespread financial rule-making overhaul that followed the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the CFTC proposed slashing allowable leverage to 10:1.

Overwhelming Pressure

The industry and its customers fought back, flooding the agency with letters of protest. In response, the CFTC set the limit at 50:1.

“Don’t underestimate the power of the industry to influence what the CFTC does,” says Greenberger, the former CFTC official. “The pressure is overwhelming.”

The CFTC declined to make any of its four commissioners (it normally has five, but one seat is vacant) or anyone else at the agency available to comment for this story.

Until 40 years ago, there wasn’t an OTC currency market in the U.S. Before that, exchange rates among major currencies were set in reference to the U.S. dollar -- which was backed by gold -- under the rules of the Bretton Woods agreement signed by 44 nations in 1944.

When President Richard Nixon ended the gold standard for the

dollar in 1971 because the U.S. gold supply was running low, the Bretton Woods system fell apart and currencies were traded freely. In 1974, Congress passed the Treasury Amendment to the Commodity Exchange Act, exempting all forex trading from regulation.

Bucket Shops

That was intended to smooth currency transactions between banks, which had their own regulators. But it created the opening for OTC forex trading. With no agencies minding the store, bucket shops and con artists pitched forex trading to naive investors, FXCM’s Niv says.

“In the late ’90s, the FX business was 100 percent made up of boiler rooms,” he says.

Most firms didn’t even trade foreign exchange; they just took in investor money and held it for themselves, Niv says.

In 2000, the CFTC won the authority to regulate forex trading when Congress passed the Commodity Futures Modernization Act. The agency filed almost 100 civil enforcement cases against forex fraudsters by 2008, winning more than $1 billion in penalties and orders for investor restitution.

The CFTC now has on its plate a proposal to tackle another controversial element of the OTC forex market: the use of credit cards. The combination of leverage and credit cards can be a perilous brew. By funding a trading account with a credit card and making a losing bet using leverage, an investor can find himself paying a 3 percent upfront fee, as well as a debt with an interest rate as high as 25 percent.

Credit Cards

The NFA, which is empowered by the CFTC to help regulate forex trading, has asked the CFTC to ban the use of credit cards.

“Retail forex customers overwhelmingly fund their trading accounts using a credit card,” the NFA wrote in a June letter to the CFTC.

FXCM and Gain’s websites tout the use of credit cards.

“The fastest way to fund your account is with a credit or debit card,” FXCM’s website says.

The NFA warns of the hazards of credit cards for forex investors.

“Given the highly volatile nature of the forex and futures markets, the substantial risk of loss and the possibility that a total loss may occur in a very short period of time, the Board has concluded that Members should be prohibited from permitting customers to use credit cards,” the NFA wrote.

In the same letter, the NFA noted that 72 percent of U.S. retail forex traders suffered a net loss in the fourth quarter of 2013.

Martinez, the Market Traders Institute CEO, tells students the odds of losing in forex trades are even worse. But therein, he says, lies an opportunity.

‘Zero-Sum’

“Ninety percent of all novice traders fail,” he says during MTI’s March webinar. “This is a zero-sum game, like playing poker, where the losers pay the winners,” he adds, speaking softly, patiently. “If you can land within this 10 percent, don’t you think you can make a lot of money trading forex?”

Martinez, 59, refers to himself as the “FX Chief .” He illustrates his presentation with slides of forex price charts interspersed with photos of himself wearing a dark pinstriped suit. He says he became a millionaire trading forex after growing up dirt-poor in Whitefish, Montana, on the Blackfoot American Indian reservation.

He displays a photo of a 5,897-square-foot (548-square-meter) mansion with a pillared portico and a semicircular driveway.

“This is how I live today,” he says.

Postcard Business

Martinez, whose school has 115 employees, says in an interview that before he opened MTI, he imported and sold high-quality postcards from Japan. When the dollar fell more than 40 percent against the yen from 1985 to 1986, he suffered losses in his postcard business. That’s when he realized he could make money in forex trading.

First, he spent thousands of dollars taking trading classes, but he says that didn’t lead to winning trades. So he trained himself through trial and error -- and then launched his academy to pass on his knowledge. About 1,000 students have received three college credit hours for MTI trading courses, Martinez says.

The CEO says he’s helping people fund their retirements. He makes no apologies for MTI graduates who lose money trading.

“If a client has a dream, it’s not my position to take it away,” he says. “I think colleges get their tuition whether people make money or not.” Forex trading isn’t for everyone, Martinez tells prospective students. He says MTI doesn’t track the trading performance of its graduates.

One graduate of Martinez’s school who’s pleased with what he’s learned is Ron Abrams, who paid $5,000 for a 16-lesson course in July 2013.

New Challenge

“Before that, I was losing all the time,” says Abrams, a retired inventory management specialist who lives in Bay Shore, New York. Abrams, 58, says he was a stock trader for more than 20 years. He got into forex in 2011 because he was looking for a new challenge, he says.

Abrams places about a dozen trades a week with FXCM as his broker. He usually uses technical analysis in an attempt to recognize patterns, which he learned from MTI. The school teaches what it calls the ABCD method. The technique trains students to identify zigzagging lines in currency-price charts, the first three of which are dubbed A, B and C.

Those lines move down, up and down like the start of the letter W. Martinez tells investors to speculate when the C line hits bottom and then trade when they think the currency price will rise, which would be the D line.

On Sept. 9, Abrams made a trade speculating that the British pound would decline against the dollar, guessing the pound would drop if Scotland voted for independence from the U.K.

Abrams says Martinez mentioned that trade opportunity in a group online mentoring session -- part of the package he bought. Ten days later, after Scotland voted against secession, Abrams closed out his trade for a $2,000 loss.

‘Getting Confident’

“I was in the black until the Scottish vote,” he says. He remains confident he’ll succeed as a forex trader. “I feel like I’m getting better,” he says. “I’m still encouraged to continue.”

People like forex because currency markets are open 24 hours on weekdays, FXCM’s Niv says.

“It’s a luxury convenience,” he says. “You can do it after dinner. You can do it in the morning before you go to work.”

Glenn Stevens, CEO of Gain Capital. says individual forex traders rarely do the market and risk analysis necessary to win consistently. Most traders don’t have a disciplined approach, he says.

“Unfortunately, most people don’t like to do homework,” he says.

Forex firms such as FXCM and Gain Capital make money from trading volume, with small markups on many transactions. Although forex trading is a big market, it isn’t a big business.

Co-Founder Niv

FXCM’S stock market value was just $781 million as of Nov. 11. In 2013, it reported profit of $34.8 million on revenue of $481.9 million. FXCM, co-founded by Niv in 1999, went public in December 2010. Its shares were trading at $16.56 on Nov. 11, 18 percent above the IPO price.

Since the middle of last year, FXCM’s share price has swung up and down -- along with volatility in the currency market -- from a high of $19.97 in September 2013 to a low of $12.05 in August.

Because Oanda is privately held, it doesn’t release earnings. As required, it did report that in the last two quarters of 2013, 64.9 percent and 67.5 percent of its forex clients lost money trading. Those numbers dropped to 57.8 percent and 54.5 percent in the first two quarters of 2014 and increased to 62.6 percent in the third quarter.

Forex OTC brokers woo potential clients by offering them what they call practice accounts. These dummy accounts draw people in by allowing them to see bid and offer prices and make trades while not putting up cash. The demonstrations can make forex trading appear like a simple way to get rich.

‘Risk Free’

“Try forex trading RISK FREE with a free practice account” is the headline on Forex.com, the website of Gain Capital.

Michael Scalia, a used-car dealer, got great results trading in the practice account he opened with FXCM.

“When I traded my paper accounts, I did very well,” says Scalia, 60, who lives in Danvers, Massachusetts. It was a different story when he opened an actual account. He lost money. He says he took profits too soon and didn’t cut his losses early enough. “When I traded my real accounts, I was way more quick on the trigger,” he says.

Scalia says he had used 100:1 leverage until 2010. When the CFTC changed the rules, he used 50:1 leverage.

“I wasn’t making any money trading,” he says.

Royce Barron, a retiree in Spanish Fork, Utah, opened a practice account 14 years ago and then moved on to the real thing. He, too, was felled by leverage, and so were many of his trading buddies.

“Most of the people I started trading with -- there were 20 of us -- they don’t do it anymore, because the leverage blew them out,” Barron, 69, says.

‘Ban It’

Leverage has blown out a lot of OTC forex traders. So have broker conflicts, enticing pitches, practice accounts, credit card debts -- and taking risks in a market dominated by professionals that may not be suitable for amateurs.

Former CFTC official Greenberger says the only way to fix the market is to shut it down.

“There’s no good reason to allow it,” he says. “The way to get at it is to ban it.”

The closest the CFTC has come to doing that is requiring forex brokers to give clients dire risk warnings. Even with those, no matter how large the disclosures about leverage and conflicts are written, millions of people take the OTC forex plunge every year.

“A myth is that people think that they’re going to be insanely wealthy, guaranteed,” Niv says. “They understand that they’re unlikely to, but they think they could.”

Source: www.bloomberg.com

Category: Forex

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