November 12, 2011

What kinds of Forex Scams should I be aware of?

If you're reading this article, odds are you discovered the forex market in one of two ways:
1) As a financial instrument for investment and speculation -- an alternative to trading in stock (company shares) and futures contracts; or,
2) as a get-rich-quick scheme that you discovered from an infomercial, or colorful sales web page, that promotes massive gains using small initial deposits.

Chances are, if your case is the former (case #1), you understand that forex is a market driven by professional speculators and banks, and that your ability to trade in it is a great opportunity for anyone who is willing to put in the effort to succeed. You might even have a background in economics or business (although this is actually not a prerequisite for becoming a consistently profitable trader.)

Unfortunately, the latter (case #2) is becoming more common in the recent decade. In that case, you're more likely to have learned a lot of misinformation from ruthless marketers. So it's time to spread a little truth about one of the world's largest financial markets. In case you had stumbled onto this article through some other unrelated search, then I'll just go ahead and give you a little primer: Forex stands for foreign exchange, which is also occasionally abbreviated as FX. It's the single most active market in the world -- it's daily turn-over makes the New York Stock Exchange look like a small town yard sale. On it, professional and retail traders from around the world buy and sell currencies like the US Dollar, British Pound, and Euro.

Forex is a business -- one that was once closed off to the public, but is now relatively more accessible to the public due to the growth of the online retail forex brokers. (I emphasize relatively, because transparency is still an issue for most retail traders but I won't delve into that yet.) In many ways, the online forex trading world presents a new and excellent opportunity for retail traders... but it's not, I repeat NOT, a get rich quick scheme.

If you treat it like one, you're more likely to find it a get-broke-quick scheme for your trading account.

Fundamentally, the forex market is a lot like a giant, global stock exchange on steroids -- where the participants trade currency instead of company stock. Technically, there is no exchange at all; it's just a network of the largest banks putting their client orders through (odds are, if you're an online retail trader, you're probably the client of the client of the client of these Tier 1 banks. Or, in some cases, your orders actually never touch the real market at all, depending on what kind of broker you're trading with.)

In and of itself, trading currencies can be equally as safe or risky as trading stocks. Actually, if you learn effective money management techniques, it could be argued that foreign exchange trading is actually a bit safer than trading in individual company stock since corporations are far more likely to declare bankruptcy (and cause its stock to be worth nearly zero) than a major world power like the UK, European Union, United States, or Japan. (For all intents and purposes, trading a currency is similar to trading "stock" in a country's economy.)

So what makes online forex dangerous (for some) then?

1. The majority of newcomers to the foreign exchange markets were introduced to it as a get-rich-quick scheme. Infomercial products and flashy single-page marketing web sites tend to sell products that encourage over-leveraged trading methods, or in some cases, outright dangerous methods that provide the illusion of high win rate (look up the Martingale fallacy if you want an example of this -- many automated robots do nothing but Martingale your account, which looks great... until the one big loss takes your account to zero.)

2. Unlike the stocks, futures, and options markets, the forex market has no centralized regulator. By its very nature, forex trading involves buying and selling the currencies of at least two different countries at a time. There isn't a single governing body that holds jurisdiction over the entire market so many brokers have gotten away with shady (in some cases completely illegal) practices that have long been wiped out of the stock trading world. For years, regulators have debated how to treat forex in their own country. A few have ruled it to be securities (in other words, financial instruments, like stocks and futures contracts) while the majority have taken half-measures or simply turned a blind eye to the rampant scams and questionable "brokers".

(With that said, a few governments are beginning to take steps in regulating spot forex within their own borders so things will slowly improve over time.)

3. Most beginners to forex have little to no knowledge of the financial markets. A casual search on Google makes it obvious that many people have more likely heard the term forex alongside internet marketing, diet products, and high yield scams; rather than a peer of stocks, futures, and options. Guess what: the real forex market is controlled by traders who specialize in the financial markets, not marketers who specialize in cheesy infomercials and ugly one-page sales web sites. Be careful who you learn from.

Forex scams are as common today as bucket shops were in the early 20th century.

That's right. The forex scamming trend isn't new. Brokers who engage in shady practices aren't new either. It's just the latest incarnation in the worst of human nature.

In the early 1900's, "bucket shops" offered ridiculous amounts of leverage to under-capitalized individuals just like the recent wave of shady online forex brokers. (To be fair, there are a few very reputable, and generally honest, forex brokers on the internet too. This isn't meant to be a blanket statement for all online brokers.)

The idea was the same: the bucket shops knew the odds and took advantage of the ignorance and greed of the public. A real brokerage would have never allowed a person to walk in with $20 and bet on a few thousand shares of stock, but the bucket shops offered this. To top it off, the trades were rarely even put through to the real market simply because they knew the odds of the game (that a retail trader with no knowledge or experience had very little chance of making a winning trade with such a small margin for error.)

And so, they "bucketed" the orders, hence the name.

Eventually, the government clamped down on those bucket shops, but not before the legendary Jesse Livermore took a few of them down by actually winning; and eventually became one of the most highly regarded stock traders of all time. (Some of his methods were questionable but the legend stands, and his ability to beat the bucket shops at their own game was a feat in and of itself.)

In recent years, many of the most well-known online forex brokers have been known to pull the same tricks as the bucket shops of old. The only difference is that the game is played on the internet.

In both cases, the market itself is a legitimate financial trading venue -- and in both cases, there are those who can beat the odds in spite of the scammers.

Today, many of my peers would argue that retail traders should only trade with legitimate brokers, specifically ECN's. Personally, I would recommend you find a broker who is regulated so that they're less likely to get away with reversing your profitable trades, and very unlikely to deny you from withdrawing your profits.

With those factors aside, the forex market continues to be one of the most active and potentially profitable markets in which to trade. Just don't gamble with large position sizes or fall victim to the kind of greed that the bucket shops counted on. Learning effective money management and price action trading skills will give you a better chance to beat the odds.

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