Financial markets have existed for eons, but perhaps in the last two decades, more ordinary people have caught wind of them. As a result, investors are spoilt for choice at the scope of instruments, ranging from equities, indices, futures, bonds to commodities, metals, and cryptocurrencies.
One market which is one of the most prominent presently is a foreign exchange or forex. In many ways, some might consider it an almost perfect market as it presents many appealing advantages and few disadvantages.
It is this attribute attracting traders from all walks of life to invest in this market. Some might wonder why forex is so popular. In this article, we’ll break down the pros and cons of trading currencies.
Like any assessment, it’s only natural beginning with the notable benefits of currency speculation not found in many other securities.
Low barrier to entry and low trading costs
Perhaps the first appeal of forex is its low barrier to entry regarding capital. While many other instruments also share this attribute to some extent, it’s quite distinct with currencies due to the high leverage.
Most understand the concept of leverage, a mechanism allowing traders to control a much larger position with only a small amount down. Though the real appeal of this quality is also that investors can start with small capital and have the potential to profit.
Brokers have broadened the playing field. A long time ago, forex traders could only trade millions of units, which were the large financial institutions. Nowadays, ordinary people can also participate.
Because of the global competitiveness, spreads and commissions are consequently cheap for most markets, further adding to the low barrier to entry.
At a fundamental level, the demand for currencies is universal. Somewhere in the world, some form of currency exchange is constantly occurring. It is for these reasons why online trading is open 24/5.
Unlike other instruments, like stocks, which open for limited hours, forex is a lot more flexible. This abundance of time means traders can trade at virtually any time anywhere globally with little restriction. Forex accommodates a seemingly infinite number of trading strategies and styles at numerous times during a trading day.
The efficiency of this system boils down to the substantial liquidity for trading currencies, which is in the trillions every day. Liquidity allows traders to open huge and frequent positions within seconds, making it easy to get in and out with ease and speed.
Variety of markets
There are 180 currencies as recognized by the United Nations. If we make pairs for only a fraction of this amount, tens of distinct markets come about, namely major, cross, and exotic pairs.
Most brokers average at least 50, though some go above 100. This sizable variety is quite balanced in that it’s not too large and not too thin either. Some traders specialize in only a handful, while others trade far more.
Another unique element with forex is the pair duality. Since exchange rates are quoted in twos, traders can forecast potential movements in one currency by looking at another. For instance, if EUR/USD is trending up, other pairs where the dollar is the base are likely to go down.
Forex is an over-the-counter or off-exchange market. Rather than trading occurring in one place, currencies are facilitated by a plethora of dealers or liquidity providers in distributed ECNs (electronic communication networks).
The mechanism allows efficient pricing, ultra-fast execution, and reduced trading costs. However, decentralization does also present some challenges, which will be explored later.
The bad and the ugly
Unfortunately, trading is not without risks. Getting to grips with the downsides is crucial for traders to deal with the realities of forex.
Some chance of over-leveraging
Investors have the option of setting their preferred leverage ratio with a broker. Though in some cases, many will erroneously use more of it, leading to unrecoverable losses. The common theory of leverage being a double-edged sword is true. So, even though gains can be amplified, losses can potentially be magnified to the same extent.
Lack of transparency
Although forex is a decentralized market, this does present a lack of transparency. Retail traders cannot tell exactly where their orders are filled because of the different execution models.
With an unregulated or poorly regulated broker, the openness issue could lead to a conflict of interest, widening of spreads, and price manipulation. Overall, there are more counterparty risks than in other markets like stocks.
Secondly, since there is no central exchange, having access to the real order flow or trading volume is nigh on impossible. Therefore, there is no foolproof method to know precisely the number of buyers and sellers at any given moment for the entire market.
High volatility could lead to increased trading costs
Technically, the volatility in forex is more stable compared to cryptocurrencies. Still, some periods like during high-impact news releases, session overlaps, and towards the end of the trading day may become too erratic.
This instability could lead to increased spreads or negative slippage, providing unfavorable entries and potentially bigger losses than desired.
The complexity of online trading in general
The complexity of trading any CFD (contract for difference), whether commodities, metals, or energies, is relatively high; forex is no exception. Getting to a competent level of consistent profits takes years of persistence and experience.
No official institution or authority like a university exists for learning forex. So, for the most part, traders are on their own and need to collate information from various sources, many of which may not be fruitful.
Numerous factors drive the forex markets at any given time, most of which need to be scrutinized. Overall, the learning curve is quite steep.
Being successful in an endeavor is a combination of exploiting the advantages while simultaneously being aware and mitigating the downsides. Unfortunately, much of the literature does make trading forex seem like a breeze, neglecting much of the hard work needed to prosper.