Top Reasons Forex Traders Fail

The forex market is the largest and most accessible financial market in the world, but although there are many forex investors, few are truly successful ones. Many traders fail for the same reasons that investors fail in other asset classes. In addition, the extreme amount of leverage - the use of borrowed capital to increase the potential return of investments - provided by the market, and the relatively small amounts of margin required when trading currencies, deny traders the opportunity to make numerous low-risk mistakes. Factors specific to trading currencies can cause some traders to expect greater investment returns than the market can consistently offer, or to take more risk than they would when trading in other markets.

Forex Market Trading Hazards

  Certain mistakes can keep traders from achieving their investment goals. Following are some of the common pitfalls that can plague forex traders:

• Not Maintaining Trading Discipline
  The largest mistake any trader can make is to let emotions control trading decisions. Becoming a successful forex trader means achieving a few big wins while suffering many smaller losses. Experiencing many consecutive losses is difficult to handle emotionally and can test a trader's patience and confidence. Trying to beat the market or giving in to fear and greed can lead to cutting winners short and letting losing trades run out of control. Conquering emotion is achieved by trading within a well-constructed trading plan that assists in maintaining trading discipline.

• Trading Without a Plan
  Whether one trades forex or any other asset class, the first step in achieving success is to create and follow a trading plan. "Failing to plan is planning to fail" is an adage that holds true for any type of trading. The successful trader works within a documented plan that includes risk management rules and specifies the expected return on investment (ROI). Adhering to a strategic trading plan can help investors evade some of the most common trading pitfalls; if you don't have a plan, you're selling yourself short in what you can accomplish in the forex market.

• Failing to Adapt to the Market
  Before the market even opens, you should create a plan for every trade. Conducting scenario analysis and planning the moves and countermoves for every potential market situation can significantly reduce the risk of large, unexpected losses. As the market changes, it presents new opportunities and risks. No panacea or foolproof "system" can persistently prevail over the long term. The most successful traders adapt to market changes and modify their strategies to conform to them. Successful traders plan for low probability events and are rarely surprised if they occur. Through an education and adaptation process, they stay ahead of the pack and continuously find new and creative ways to profit from the evolving market.
• Learning Through Trial and Error
  Without a doubt, the most expensive way to learn to trade the currency markets is through trial and error. Discovering the appropriate trading strategies by learning from your mistakes is not an efficient way to trade any market. Since forex is considerably different from the equity market, the probability of new traders sustaining account-crippling losses is high. The most efficient way to become a successful currency trader is to access the experience of successful traders. This can be done through a formal trading education or through a mentor relationship with someone who has a notable track record. One of the best ways to perfect your skills is to shadow a successful trader, especially when you add hours of practice on your own.
• Having Unrealistic Expectations
  No matter what anyone says, trading forex is not a get-rich-quick scheme. Becoming proficient enough to accumulate profits is not a sprint - it's a marathon. Success requires recurrent efforts to master the strategies involved. Swinging for the fences or trying to force the market to provide abnormal returns usually results in traders risking more capital than warranted by the potential profits. Foregoing trade discipline to gamble on unrealistic gains means abandoning risk and money management rules that are designed to prevent market remorse.
• Poor Risk and Money Management
  Traders should put as much focus on risk management as they do on developing strategy. Some naive individuals will trade without protection and abstain from using stop losses and similar tactics in fear of being stopped out too early. At any given time, successful traders know exactly how much of their investment capital is at risk and are satisfied that it is appropriate in relation to the projected benefits. As the trading account becomes larger, capital preservation becomes more important. Diversification among trading strategies and currency pairs, in concert with the appropriate position sizing, can insulate a trading account from unfixable losses. Superior traders will segment their accounts into separate risk/return tranches, where only a small portion of their account is used for high-risk trades and the balance is traded conservatively. This type of asset allocation strategy will also ensure that low-probability events and broken trades cannot devastate one's trading account.

Managing Leverage
Although these mistakes can afflict all types of traders and investors, issues inherent in the forex market can significantly increase trading risks. The significant amount of financial leverage afforded forex traders presents additional risk that must be managed.

Leverage provides traders with an opportunity to enhance returns. But leverage and the commensurate financial risk is a double-edged sword that amplifies the downside as much as it adds to potential gains. The forex market allows traders to leverage their accounts as much as 400:1, which can lead to massive trading gains in some cases - and account for crippling losses in others. The market allows traders to use vast amounts of financial risk, but in many cases it is in a trader's best interest to limit the amount of leverage used.

Most professional traders use about 2:1 leverage by trading one standard lot ($100,000) for every $50,000 in their trading accounts. This coincides with one mini lot ($10,000) for every $5,000 and one micro lot ($1,000) for every $500 of account value. The amount of leverage available comes from the amount of margin that brokers require for each trade. Margin is simply a good faith deposit that you make to insulate the broker from potential losses on a trade. The bank pools the margin deposits into one very large margin deposit that it uses to make trades with the interbank market. Anyone that has ever had a trade go horribly wrong knows about the dreadful margin call, where brokers demand additional cash deposits; if they don't get them, they will sell the position at a loss to mitigate further losses or recoup their capital.

Learn to trade Forex with FXCM’s Free Trading Guide

Many forex brokers require various amounts of margin, which translates into the following popular leverage ratios:

Margin	Maximum Leverage
5%	20:1
3%	33:1
2%	50:1
1%	100:1
0.5%	200:1
0.25%	400:1

The reason many forex traders fail is that they are undercapitalized in relation to the size of the trades they make. It is either greed or the prospect of controlling vast amounts of money with only a small amount of capital that coerces forex traders to take on such huge and fragile financial risk. For example, at a 100:1 leverage (a rather common leverage ratio), it only takes a -1% change in price to result in a 100% loss. And every loss, even the small ones taken by being stopped out of a trade early, only exacerbates the problem by reducing the overall account balance and further increasing the leverage ratio.

Not only does leverage magnify losses, but it also increases transaction costs as a percent of account value. For example, if a trader with a mini account of $500 uses 100:1 leverage by buying five mini lots ($10,000) of a currency pair with a five-pip spread, the trader also incurs $25 in transaction costs [(1/pip x 5 pip spread) x 5 lots]. Before the trade even begins, he or she has to catch up, since the $25 in transaction costs represents 5% of the account value. The higher the leverage, the higher the transaction costs as a percentage of account value, and these costs increase as the account value drops.

While the forex market is expected to be less volatile in the long term than the equity market, it is obvious that the inability to withstand periodic losses and the negative effect of those periodic losses through high leverage levels are a disaster waiting to happen. These issues are compounded by the fact that the forex market contains a significant level of macroeconomic and political risks that can create short-term pricing inefficiencies and play havoc with the value of certain currency pairs.

Conclusion
Many of the factors that cause forex traders to fail are similar to those that plague investors in other asset classes. The simplest way to avoid some of these pitfalls is to build a relationship with other successful forex traders who can teach you the trading disciplines required by the asset class, including the risk and money management rules required to trade the forex market. Only then will you be able to plan appropriately and trade with the return expectations that keep you from taking excessive risk for the potential benefits.

While understanding the macroeconomic, technical and fundamental analysis necessary for trading forex is as important as the requisite trading psychology, one of the largest factors that separates success from failure is a trader's ability to manage a trading account. The keys to account management include making sure to be sufficiently capitalized, using appropriate trade sizing and limiting financial risk by using smart leverage levels

Why Forward Contracts Are The Foundation Of All Derivatives 

The most complex type of investment products fall under the broad category of derivative securities. For most investors, the derivative instrument concept is hard to understand. However, since derivatives are typically used by governmental agencies, banking institutions, asset management firms and other types of corporations to manage their investment risks, it is important for investors to have a general knowledge of what these products represent and how they are used by investment professionals.

Forward Derivative Contract Overview

As one type of derivative product, forward contracts can be used as an example to provide a general understanding of more complex derivative instruments such as futures contracts, options contracts and swaps contracts. Forward contracts are very popular because they are unregulated by the government, they provide privacy to both the buyer and seller, and they can be customized to meet both the buyer's and seller's specific needs. Unfortunately, due to the opaque features of forward contracts, the size of the forward market is basically unknown. This, in turn, makes forward markets the least understood of the various types of derivative markets.

Due to the overwhelming lack of transparency that is associated with the use of forward contracts, many potential issues may arise. For example, parties that utilize forward contracts are subject to default risk, their trade completion may be problematic due to the lack of a formalized clearinghouse, and they are exposed to potentially large losses if the derivatives contract is structured improperly. As a result, there is the potential for severe financial problems in the forward markets to overflow from the parties that engage in these types of transactions to society as a whole. To date, severe problems such as systemic default among the parties that engage in forward contracts have not come to fruition. Nevertheless, the economic concept of “too big to fail” will always be a concern, so long as forward contracts are allowed to be undertaken by large organizations. This problem becomes an even greater concern when both the options and swaps markets are taken into account.

Trading and Settlement Procedures for a Forward Derivative Contract

Forward contracts trade in the over-the-counter market. They do not trade on an exchange such as the NYSE, NYMEX, CME or CBOE. When a forward contract expires, the transaction is settled in one of two ways. The first way is through a process known as “delivery.” Under this type of settlement, the party that is long the forward contract position will pay the party that is short the position when the asset is delivered and the transaction is finalized. While the transactional concept of “delivery” is simple to understand, the implementation of delivering the underlying asset may be very difficult for the party holding the short position. As a result, a forward contract can also be completed through a process known as “cash settlement.”

A cash settlement is more complex than a delivery settlement, but it is still relatively straightforward to understand. For example, suppose that at the beginning of the year a cereal company agrees through a forward contract to buy 1 million bushels of corn at $5 per bushel from a farmer on Nov. 30 of the same year. At the end of November, suppose that corn is selling for $4 per bushel on the open market. In this example, the cereal company, which is long the forward contract position, is due to receive from the farmer an asset that is now worth $4 per bushel. However, since it was agreed at the beginning of the year that the cereal company would pay $5 per bushel, the cereal company could simply request that the farmer sell the corn in the open market at $4 per bushel, and the cereal company would make a cash payment of $1 per bushel to the farmer. Under this proposal, the farmer would still receive $5 per bushel of corn. In terms of the other side of the transaction, the cereal company would then simply purchase the necessary bushels of corn in the open market at $4 per bushel. The net effect of this process would be a $1 payment per bushel of corn from the cereal company to the farmer. In this case, a cash settlement was used for the sole purpose of simplifying the delivery process.

Currency Forward Derivative Contract Overview

Derivative contracts can be tailored in a manner that makes them complex financial instruments. A currency forward contract can be used to help illustrate this point. Before a currency forward contract transaction can be explained, it is first important to understand how currencies are quoted to the public, versus how they are used by institutional investors to conduct financial analysis.

If a tourist visits Times Square in New York City, he will likely find a currency exchange that posts exchange rates of foreign currency per U.S. dollar. This type of convention is used frequently. It is known as an indirect quote and is probably the manner in which most retail investors think in terms of exchanging money. However, when conducting financial analysis, institutional investors use the direct quotation method, which specifies the number of units of domestic currency per unit of foreign currency. This process was established by analysts in the securities industry, because institutional investors tend to think in terms of the amount of domestic currency required to buy one unit of a given stock, rather than how many shares of stock can be bought with one unit of the domestic currency. Given this convention standard, the direct quote will be utilized to explain how a forward contract can be used to implement a covered interest arbitrage strategy.

Assume that a U.S. currency trader works for a company that routinely sells products in Europe for euros, and that those euros ultimately need to be converted back to U.S. dollars. A trader in this type of position would likely know the spot rate and forward rate between the U.S. dollar and the euro in the open market, as well as the risk-free rate of return for both the U.S. dollar and the euro. For example, the currency trader knows that the U.S. dollar spot rate per euro in the open market is $1.35 U.S. dollars per euro, the annualized U.S. risk-free rate is 1% and the European annual risk-free rate is 4%. The one-year currency forward contract in the open market is quoted at a rate of $1.50 U.S. dollars per euro. With this information, it is possible for the currency trader to determine if a covered interest arbitrage opportunity is available, and how to establish a position that will earn a risk-free profit for the company by using a forward contract transaction.

Example of a Covered Interest Arbitrage Strategy

To initiate a covered interest arbitrage strategy, the currency trader would first need to determine what the forward contract between the U.S. dollar and euro should be in an efficient interest rate environment. To make this determination, the trader would divide the U.S. dollar spot rate per euro by one plus the European annual risk-free rate, and then multiply that result by one plus the annual U.S. risk-free rate.

[1.35 / (1 + 0.04)] x (1 + 0.01) = 1.311

In this case, the one-year forward contract between the U.S. dollar and the euro should be selling for $1.311 U.S. dollars per euro. Since the one-year forward contract in the open market is selling at $1.50 U.S. dollars per euro, the currency trader would know that the forward contract in the open market is overpriced. Accordingly, an astute currency trader would know that anything that is overpriced should be sold to make a profit, and therefore the currency trader would sell the forward contract and buy the euro currency in the spot market to earn a risk-free rate of return on the investment.

The covered interest arbitrage strategy can be achieved in four simple steps:

Learn to trade Forex with FXCM’s Free Trading Guide

Step 1: The currency trader would need to take $1.298 dollars and use it to buy €0.962 euros.

To determine the amount of U.S. dollars and euros needed to implement the covered interest arbitrage strategy, the currency trader would divide the spot contract price of $1.35 U.S. dollars per euro by one plus the European annual risk-free rate of 4%.

1.35 / (1 + 0.04) = 1.298

In this case, $1.298 U.S. dollars would be needed to facilitate the transaction. Next, the currency trader would determine how many euros are needed to facilitate this transaction, which is simply determined by dividing one by one plus the European annual risk-free rate of 4%.

1 / (1 + 0.04) = 0.962

The amount that is needed is €0.962 euros.

Step 2: The trader would need to sell a forward contract to deliver €1.0 euro at the end of the year for a price of $1.50 U.S. dollars.

Step 3: The trader would need to hold the euro position for the year, earning interest at the European risk-free rate of 4%. This euro position would increase in value from €0.962 euro to €1.00 euro.

0.962 x (1 + 0.04) = 1.000

Step 4: Finally, on the forward contract expiration date, the trader would deliver the €1.00 euro and receive $1.50 U.S. dollars. This transaction would equate to a risk-free rate of return of 15.6%, which can be determined by dividing $1.50 U.S. dollars by $1.298 U.S. dollars and then subtracting one from the answer to determine the rate of return in the proper units.

(1.50 / 1.298) – 1 = 0.156

The mechanics of this covered interest arbitrage strategy are very important for investors to understand, because they illustrate why interest rate parity must hold true at all times to keep investors from making unlimited risk-free profits.