If you come to Forex believing that currency trading here is the same as if you would speculate on your own by changing currencies at your local bank, I may be your new upset for the day, because in this topic I’ll try to explain the difference and shed some light… errr, no (to shiny, not my style)… pour some dirt (that’s better)… on the expensiveness of the Forex trading for currency speculators.
Our heroes today are Peter and Tom - friends from US, each with $1000 in the pocket.
Both love the idea of making some profits by speculating on the difference in currency exchange rates.
Peter sticks to the old fashion way of growing his equity and puts his money into the bank account. Tom chooses to achieve profits by trading Forex and opens a live account with a Forex broker. Both agree to share their speculative ideas and take same decisions to buy/sell currencies.
Time to check pros and cons for both friends as they take their first step to buy the Euro and sell the US Dollar in expectations that Euro will grow in the next 2 months:
- Peter converts Dollars to Euro in his bank account.
- Tom buys EUR/USD pair at his Forex account.
- Peter pays the cost of converting one currency to another to a bank.
- Tom pays the spread cost to a broker.
- Peter sits back and waits for gains if any.
- Tom continues to work on his strategy in order to protect his account equity. E.g. sets and monitors trading Stops.
- Peter earns interest on his deposit with the bank every day.
- Tom pays rollovers to the broker every day.
Case 1. Euro appreciates against the Dollar.
Both friends are in profit.
Peter earns some modest profit, equal to the difference to which his Euros has appreciated.
Tom, depending on how much he traded with, (using the leverage in Forex, Tom could have traded anything from $10000 to $100000 or even more), Tom’s profits will be much higher.
Tom clearly benefits.
Case 2. Euro depreciates against the Dollar.
Peter is set back to certain extent, as he no longer can buy $1000 USD back with the Euro he holds.
Same is for Tom.
Peter has an option to hold on to Euro further, after all, the currency may be taking a temporary hit; or, possibly, Peter will travel to Europe this year and will spend those Euros there. Some value will be lost, but money stay to be money.
Tom is facing a Stop loss. He is forced to convert depreciated Euros back to Dollars in order to keep his trading account “alive”. Tom is bound to lose, even if the Euro has dropped against the Dollar temporarily.
Peter clearly benefits.
Case 3. Euro neither gained or lost against the Dollar.
Peter has the same equity. Plus he’s earned the interest on his deposit with the bank.
Tom had to pay rollover all the time. He’s less fortunate.
Peter clearly benefits.
As we can see, both Tom and Peter can be profitable if they were right about the currencies, but when they are not, Peter has the advantage.
Peter is not required to accept losses, e.g. convert money back to the base currency. He will still hold the money, even if they depreciate against the base currency; the currency may still grow against the other currencies, and at the same time, hold a strong position in the world overall.
Tom, on the other hand, is dependent on the rules of the game - he trades a leveraged account, which gives him a clear advantage when he wins, but when he loses - he is in trouble, because losses in a Forex account cannot be left unattended. Tom loses because he must accept the loss, and convert money back by closing a trade.
Peter will never lose it all.
Tom can lose it all, in fact, he can lose it all any day.
Now, my friend, you know why Forex is one of the riskiest businesses of all.