The first thing a trader must know is that most forex scams give the impression that it is easy to make money trading forex. Nothing can be further from the truth. This article explains:
1) Why forex trading is actually very hard for the retail forex trader
2) The types of scams out there that make forex trading seem easy
3) How forex regulations help to protect you
4) Why picking a regulated broker is not enough protection
Why Forex Trading Is Actually Very Hard
1) Zero sum game: Every dollar that a forex trader makes at forex trading is lost by another trader. Furthermore, there are transaction costs to forex trading, which can be significant due to the leverage that is used. This means that forex trading is actually worse than zero sum. Over time, forex traders as a group are losing money. Contrast this with the stock market. With stocks, the underlying companies are generating value, and over time the overall market is increasing in value. It is like a pie that must be shared between all the traders, but the pie is always growing so it is possible for more people to win. In forex, traders are fighting to get a piece from a pie that is always shrinking. This is a big disadvantage of forex trading vs stock trading.
2) Most efficient market: The forex market trades trillions of dollars worth of currency per day, which makes it the most traded asset class in the world. The result is deep liquidity, which is often cited as one of the biggest advantages of the forex market. However, this is also one of the greatest disadvantages because it makes the market very efficient. The only way to make money consistently over time trading anything is to find a market inefficiency that others don’t know about and to exploit it. If others know about the inefficiency, then they will also try to exploit it. When enough people do this, the inefficiency gets arbitraged away. A trading system that depends on the inefficiency therefore stops working.
3) Professional vs retail: Banks, forex hedge funds, investment management firms, and other institutions hire the very best professionals to find and exploit forex market inefficiencies. It is common for these professionals to have PhD’s in various fields including mathematics and physics (think rocket scientists and nuclear scientists). The firms also have the deep pockets to hire the best trading system developers and employ the best technology to give them an edge. The capabilities of the average retail forex trader do not compare, and this puts them at a big disadvantage.
4) Information disadvantage: In forex trading, retail traders only have access to historic data on prices, with few exceptions. However, forex brokers, as well as institutional traders also have access to a certain amount of past volume data, depth of market data, and data of open positions. The additional data available to the bigger players gives them an advantage for finding market inefficiencies that retail traders don’t have. This makes it more likely that the big players will make money. Because it is a zero sum game, that must mean that retail traders are more likely to lose money.
5) Discipline required: In order to be successful in the long run, a trader must be able to define a set of trading rules, execute those rules, and not deviate from those rules. However, trading is an emotional business for the retail forex trader. Hard earned money is being put at risk. It is difficult to control greed when trading goes well, and even more difficult to control fear when trading goes poorly. The result is a tendency for traders to end up making decisions to satisfy the short term emotional needs they feel, rather than long term financial goals. This is especially difficult for new traders who have been attracted to forex trading from promises of easy riches, only to get slapped in the face by the cold hard reality that forex trading is a very difficult business.
6) Too much misinformation. Most of what is published on the internet about forex is garbage that will lose you money. This is true even for the more reputable sources on the internet. Candlestick patterns, fibonacci, oscillators, elliott waves… they don’t work in the long run. Those techniques have been around for decades, even centuries in some cases. If there once was a market inefficiency that could be exploited with these techniques, that market inefficiency is now long gone. Any success with such techniques is mostly by chance, and unlikely to last very long. There are some useful nuggets of information about forex trading on the internet, but it is very difficult for the retail trader to separate the useful information from the misinformation that is harmful. Even if you can find an edge, there may still be a significant risk of ruin.
The above points explain why forex trading is hard, without even factoring in all the scammers trying to exploit the forex trader. The scams make it even more difficult for a retail forex trader to be successful.
Common Types Of Forex Scams
The following describes different kinds of forex scams that you need to avoid:
1) Automated trading programs: These can also be called trading robots or Expert Advisors (EAs). If a trader has the programming skill, then developing an automated trading program is an excellent way for the trader to determine if a set of trading rules is likely to be successful in the future. These automated programs can be backtested over many years of historical data for many different currency pairs, all within a matter of minutes. However, the vast majority of these will not make consistent profits in the long run, so it is good to rule them out before risking real money. The problem is that many people then try to sell these unprofitable systems on the internet, claiming that the systems make big profits. You only have only to install the system on a popular trading platform like MetaTrader, unleash the system on your trading account, and supposedly start reaping the profits. Often you can buy such a system for only a few hundred dollars. The system vendors may even be able to demonstrate strong past performance. The issue here is that these systems will typically suffer from over-optimization, also called data snooping bias or curve fitting. This essentially means that the system rules were selected to fit the historical data, so that they are only profitable if you look back at history. They will lose money in the long run looking forward because the price movement in the future will not repeat history.
2) Signal services: This is very similar to the trading programs mentioned above, except instead of selling an automated system, they are selling a service to tell you when to enter a trade, and then when to exit. Typically, the trade signals are generated by an automated trading program as described above. This means the service suffers from the same weaknesses as the program, and hence will lose money in the long run. Instead of charging a one time fixed fee, these services typically charge a recurring monthly fee.
3) Copy trading & social trading: These revolve around the concept of outsourcing the trading activity to somebody else. Successful traders can set up trading accounts that let others follow and copy their trades. The copied trades are usually executed automatically so little manual effort or monitoring is required. The traders that are being copied earn a commission for all the trades that are copying them, as does the platform or broker that is enabling the copy functionality of the website. In theory, everybody wins: the trader being copied earns extra income, the trader doing the copying makes money without having to learn how to be successful on their own, and the broker earns more money by attracting more business.
Unfortunately the reality is often very different:
- Inexperienced traders are often attracted to the traders with the greatest short term gains. This encourages the traders being copied to employ the riskiest strategies that may be successful in the short term but then fail miserably in the long term.
- The traders being copied will often run their accounts with very little real money, or even from a demo account, so if their big risk taking fails, they lose little or no money.
- The traders being copied usually earn a commission per trade, so the more they trade, the more money they make. This leads to a lot of overtrading.
- The platform that reports the performance of the traders being copied usually report that traders performance, NOT the performance of the traders that are doing the copying. The copiers will see worse performance because of the extra commissions. Also, they will perform worse because there is a lag between when the original trade is executed, and when the copied trade is executed. This slippage erodes the performance of the traders who are doing the copying.
- The platform offering the copy services gives a choice of thousands of traders to copy. It is inevitable that there will be high performing traders in that list. However, if you were to take a thousand monkeys flipping coins, there would be several who get tails many times in a row. The point here is that the success happens by chance, and at any time those traders will stop performing and become losers, and some other traders will float to the top of the list… and then become losers themselves.
- All traders, even very successful ones, have drawdowns where performance falls before recovering. Traders who outsource their trading tend to have very little stomach for drawdowns, so instead of riding it out, they will quit and and hope to recover by copying a different trader. But then the new trader has a drawdown, and so the copier switches again. The end result is performance that has frequent periods of poor performance, with relatively infrequent periods of profitability. This pattern results in significant loses for the trader who copies others.
4) Managed accounts: These can also be called Percent Allocation Management Module (PAMM) accounts. If a trader is very successful, becoming a money manager for a managed forex account is one of the best and most lucrative ways to compound his success. It is very easy to do these days, and requires relatively little promotion. It works much like copy trading, except the money manager earns a share of profits from the accounts he manages, rather than a commission per trade. This is potentially the most lucrative way for a successful trader to make more money, so it is a model that tends to attract the best traders. However, it also has most of the same problems described above for copy trading, so should generally be avoided. Also, managed accounts are the realm of the well known Ponzi scheme. A forex trader should only participate in a managed account if the money manager has achieved real long term performance that can be independently verified.
5) Forex broker scams: Unscrupulous brokers attempt to scam their customers in the following ways:
- Price slippage: when a trader places an order with a forex dealer at a quoted price, it is common for the dealer to offset the position with another liquidity provider to control their risk. Typically, the trader’s order won’t actually be executed until the dealer has been able to establish the offsetting position. If the dealer gets a worse price for their offsetting position, they will pass on that worse price so that the trader’s order is executed at a worse price than was quoted. This is called price slippage, and it is a legal practice. However, if the dealer is able to get a better price for their offsetting position, they are then supposed to pass on that price improvement to the trader’s order. Forex dealers have made millions from keeping that positive price improvement for themselves rather than passing them on to traders. Some were subsequently fined millions by the regulators, but they may not all have been caught.
- Not meeting minimum financial requirements: While not really a scam, this is a regulatory violation that should be important to a forex trader. Forex brokers in many countries are required by forex regulations to keep a minimum level of capital on hand to ensure enough liquidity to conduct its business. If a broker does not meets its regulatory requirements, it increases the risk of insolvency and bankruptcy. It is important to note that in the event that a forex broker declares bankruptcy, the forex trader may not be able to cash out his account balance. This is because forex traders are considered unsecured creditors in many countries such as the USA and the UK. The forex traders may get back a portion of their account balances only after secured creditors and preferential creditors have recovered their funds. The bankruptcy of MF Global is one example where this really happened and numerous forex traders had to wait years, only to be awarded a partial recovery of their account balances.
Most of the above forex scams can be easily avoided. Of the above, automated trading programs are the most likely to be scams. Just think about it: if somebody has a system that can consistently generate profits, they have something that is worth many millions of dollars. The minute they sell it on the internet for a few hundred dollars, they lose control of the system. The programming code can be figured out by anybody with programming knowledge. The secret is no longer a secret and anybody can then resell it, publish it, or start a managed fund with it. Once many are using it, the market inefficiency gets arbitraged away. Anybody with such a system could easily set up a managed account and make millions without giving away their secret. Don’t give in to greed and buy into promises of getting rich quick. Only deal with entities who are regulated.
However, the most difficult scams to avoid are those from the forex brokers. We have no choice but to deal with forex brokers, traders can’t trade foreign exchange without them. A lot goes on behind the scenes at the brokerage that creates opportunities to scam the forex trader.
How Forex Regulations Help To Protect You:
Forex regulations are mostly targeted towards organizations that deal directly with clients. See our coverage of US forex regulations for the details. The short version of this is to know that forex regulations seek to control how forex brokers operate to limit their capacity to defraud their clients, including those noted above. In many countries such as the USA, the regulations are very comprehensive, and the regulatory bodies are relentless in pursuing those who violate the regulations. As such, it is critical that a forex trader only do business with regulated forex brokers. But even that is not enough.
Why Simply Choosing A Regulated Forex Broker Does Not Offer You Enough Protection
Simply put, many forex brokers have violated US forex regulations. In many cases, forex brokers have repeatedly violated those regulations. In many cases, the regulatory violations appear have been deliberate, with the intent to break the rules to take more money from their customers.
On the other hand, there are some forex brokers who have never been subject to any regulatory action over all the years they have been dealing in foreign exchange. This would appear to represent an effort to run an honest business with fair treatment to customers.
What kind of forex broker do you want to deal with?
Take a look at our forex broker reviews to see which brokers have been subject to regulatory action and fines.