Using money to make money
Currency-trading opportunities expand, but risks are high
NEW YORK (MarketWatch) -- With over $3 trillion worth of foreign currencies changing hands every day, a growing number of retail investors who seek a boost to their portfolios and a hedge for the falling dollar are viewing the high liquidity of foreign exchange trading as a tonic for troubled times.
The reasons: a near-seamless 24-hour market, an opportunity to start with a low minimum account opening balance and the chance -- thanks to generous amounts of leverage -- to parlay as little as $100 of initial capital into massive purchasing power.
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Add to that a plethora of online platforms that put trading at the fingertips of anyone with a laptop, and you have the beginnings of a true democratization of the once high-rolling club of foreign currency trading, or FX for short.
Valued at more than 20 times the daily turnover of the New York Stock Exchange and driven by changes in national and international interest rates and inflation -- the chief factors that affect price movement for currencies -- retail FX has spurred such interest on Main Street that Wall Street's big players are getting in the game: Since 2006, Deutsche Bank, Citigroup, Merrill Lynch and UBS have all introduced proprietary retail FX services.
"We saw retail FX trading as a very large, growing segment of our client base," says Betsy Waters, director of Deutsche Bank's Web-based retail currency trading station dbFX. "This prompted us to launch dbFX, which gives traders institutional research and access to the largest foreign exchange liquidity provider, which means that you will be able to execute trades regardless of the level of market volatility."
Waters believes tumbling equity prices are causing more and more people to consider trading FX, which analysts are increasingly viewing as a legitimate asset class that can offset general market volatility.
According to Bank Technology News, a trade publication for the banking industry, FX trading has some way to go before it becomes a mass-appeal investment vehicle. Retail investors today make up only 2% to 3% of the market's client base -- but that's likely to change as both Web platforms and investor perceptions evolve.
Risks abound
Breaking into FX and developing a winning method for trading is not for the faint of heart. It hinges on understanding how the market works and accepting that in order to make a profit, your FX dealer, who acts as your counterparty, has to lose. That can take a lot of time, experimentation and some mad money one can afford to lose -- and even then success is not guaranteed.
"A lot of people don't understand that they should be sizing their positions based on how much personal capital they have," says Rich Paredes, an FX trader from Woodridge, N.J.
FX offers an opportunity to trade on margin -- essentially, to borrow money against a relatively small actual investment -- but carries a lot of risk, because if you lose on a trade, you can be responsible for losses that greatly exceed the amount you invested. Common margins for trading FX are 50:1 and 100:1, but some trading accounts will go up to 200:1 -- a strategy that lets you control $2,000,000 with $10,000 of risk capital.
"If you use 100:1 leverage on the wrong unregulated system, you can end up losing 60% to 70% of the value of your trades," says Paredes, who also discusses his strategies on his blog, www.forexproject.com. "But at the same time, some people like how foreign exchange trading is unregulated and they're able to trade with a very high leverage. It's a double-edged sword."
Lax oversight
Risks in the retail FX market are enhanced by a lack of regulation. Unlike the stock and futures exchanges, where the exchange guarantees the transactions of its members, in the over-the-counter, off-exchange retail currency market, there is such no clearinghouse. The Commodities Futures Trading Commission and the National Futures Association police currency trading to a degree, but they are both independent agencies, so FX firms are not bound by their rules.
The FX market's decentralized structure came into focus last December, when the NFA raised its capital requirements for retail brokerages to $5 million. The move was aimed to weed out companies without enough cash reserves to guarantee customer funds in the case of bankruptcy, trading losses, or fraud. Firms without the minimum net capital can still do business, but undercapitalization can hurt their chances to attract new customers because they're not vetted members of the NFA.
On the Web, where FX platforms aimed at retail traders flourish, it is often difficult to distinguish between regulated and unregulated FX firms. According to the NFA Web site, there are about 2,000 retail FX brokerages and solicitors of accounts that are not subject to the new rules. In contrast, the NFA has only 24 registered member firms.
With so much uncertainty out there, traders should be skeptical of claims that they will make a profit regardless of whether the market goes up or down, or promises they can recover any losses.
"We've all seen the Web sites that promise you can make $15,000 a week trading with them," says Chris Palmer, a marine biologist from Panama City Beach, Fl. Palmer used to trade with FXDD, an unregulated trading platform, and although he says he never experienced any problems he felt anxious to switch to a regulated dealer.
"But remember, unlike on the stock market, where it hurts when a stock in your portfolio goes down in value and the whole market is hurting with you, in FX if a trade goes against you, the money comes out of your account only."
Check your dealer
So play it safe and consider your risks before plunging any dollars into an FX account with dreams of multiplying them in British pounds, euros or some exotic currency -- like Turkish liras or South African rands. 
Watch more.
Watch more. Verify the CFTC registration and NFA membership status of a particular firm or individual and check their disciplinary history by phoning NFA at 800-621-3570 or by checking the broker information section BASIC on NFA's Web site at www.nfa.futures.org/basicnet/.
Finally, get as much information as you can about the firm's performance record on behalf of other clients and don't deal with anyone who won't give you their background. 
Gergana Koleva is a MarketWatch reporter based in New York.
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