Recently, I spoke with FXCM (NYSE:FXCM) CEO Drew Niv on the phone. FXCM is a leading retail forex broker that recently went public.
Among other things, we discussed the profitability of FXCM trading accounts. Below are the highlights from the conversation, which sheds some valuable lessons for forex traders.
Lesson #1 - Retail profitability is between 20 to 30 percent, not 5 percent
Forex trading is not as unprofitable as some myths suggest. Niv said the profitability of US FXCM accounts is about 20 percent, contrary to the often-quoted statistic of 5 percent profitability. No one seems to know where the “95 percent of retail forex traders lose money” assertion originated from. Boris Schlossberg of GFT called it an “urban legend.”
Click here to see the disclosed profitability of the US-only accounts of FXCM and other brokers.
Lesson #2 – Take it seriously
Niv said for FXCM, the US profitability is skewed downward by the many micro accounts of the company. These micro accounts, which can be opened for as little as $50, are less profitable than averaged-sized accounts because the traders take their accounts less seriously and tend to “go for the moon,” said Niv.
Conversely, FXCM accounts larger than $10,000 have profitability that are double the average, said Niv. Part of it is likely due to the natural selection of profitable averaged-sized accounts surviving and becoming large accounts.
But it’s also because most large accounts probably take trading extremely seriously.
Lesson #3 – Understand leverage
In some countries, the law limits the leverage of retail forex accounts. In Hong Kong, it’s 20:1, compared to the industry high of 200:1 in some circumstances. Hong Kong profitability fluctuates around 50 percent, said Niv.
One explanation for this high profitability level is that many retail forex traders don’t understand the volatility of the forex market and fail to exercise proper risk management when 200:1 or 100:1 leverage is used. Thus, using lower leverage protects them from their ignorance.
Lesson #4 – Hedgers, don’t kid yourselves
Niv estimates that 15 percent of the people who opened accounts with FXCM are hedgers. However, after a few months, the overwhelming majority of them become speculators.
“Say you’re up 100 pips, so you say, ‘forget the hedge, let’s trade!’” said Niv.
One lesson of this amusing phenomenon is that if you think you’re going to open an account just for hedging, don’t kid yourself. But if you really need to hedge currency exposure, put safeguards in place or delegate the task to a trusted third party.
On a related note, Niv said 50 percent of US account holders are entrepreneurs and many people first learn about the forex market because of currency exposure in their business life (i.e. a small business selling products overseas). After this first contact, many of them eventually become forex speculators.
Niv didn’t say more on this subject. However, it’s reasonable to assume that these forex speculators who stumble upon the market this way are, at least in the beginning, less educated and less experienced than other players in the market. Therefore, they probably make up a large portion of the unprofitable traders.
Lesson #5 – Retail traders don’t do carry trades, but maybe they should
Currently, Niv said almost all FXCM accounts make directional trades instead of carry trades. Carry trades involve borrowing low-yielding currencies (like the yen) and lending high-yielding currencies. Traders who participate in this trade capture the interest rate differentials between the two currencies. Moreover, traders can profit if the high-yielding currency appreciates against the low-yield currency.
Of course, it can go horribly wrong when low-yielding safe-haven currencies rally against high-yielding ones in periods of extreme pessimism -- which happened, for example, during the height of the global financial crisis.
Over time, however, the carry trade performs well. One study shows it performed better than the US stock market in the last 10 years.
Niv calls the carry trade “one of the best leveraged fixed income instruments.”
Currently, interest rate differentials are still low because monetary policy around the world remains relatively loose. However, when the differentials widen, the carry trade will become more profitable – and perhaps retail traders should begin to consider this trade. Institutional forex managers certainly will.
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