A New Refuge for Day Traders?
By Robert Hunter
April 27, 2000
PERHAPS YOU'VE SEEN the commercials on CNBC or the streaming ad
banners on the Internet promising big profit opportunities in currency
trading. "Commission-free! Trade 24 hours a day! Interbank prices! While
you're thinking about it, others are doing it!"
What could be more seductive to beaten-down day traders who still fancy
themselves as financial whizzes but have seen their once-juicy assets
wither on the vine?
Since 1996, more than a dozen currency-trading sites have gone live,
many in just the last year, and many more are still in development. While
most say they cater primarily to corporations, money managers and
institutional investors, they've been more than willing to let individual
investors swim with the financial sharks. So willing, in fact, that
they're letting George Soros wannabees open accounts with as little as
$1,000 in capital.
"We got a huge influx of business in the last couple of weeks when the
Nasdaq tanked," says Josh Levy, director of marketing at currency broker
Matchbook FX. "Guys called up saying 'I'm
really hurt. What am I doing trading equities? Let me open an account and
What draws investors to the online currency markets? For many, it's the
constant fluctuations, the instant market reaction to news and economic
events. Others like the 24-hour trading schedule, which allows
caffeine-fueled traders to swap yen for dollars or dollars for euros at
ridiculous times of the day.
But mostly it's the leverage. Online currency brokerages let individual
investors take big punts in currencies with shockingly little up front.
All sites vary in their minimum margin requirements, but — believe it or
not — 4% is the most conservative out there. Some sites, with margin
requirements of 0.5%, let investors jack up their leverage ratios to 200
to 1. (By comparison, stocks can be traded with up to 50% margin, a
leverage ratio of 2 to 1.) Such leverage is necessary, the online firms
argue, because the currency markets are so massive — some put daily
trading volume at $1.5 trillion — and daily currency swings so small that
it takes huge positions to reap any kind of rewards. On virtually all of
the dozen-plus sites operating today, $100,000 is the smallest position a
trader can take. (Remember, with a 200-to-1 leverage ratio, that position
would require only $500 in cash.)
The paradox is striking: the smaller the account, the greater the
leverage needed to play in the market. One bad dollar-yen position at
$200,000 could blow out a $1,000 player in short order. All it would take
is a move of 50 basis points (or 0.5%) in the yen — something that can,
and does, happen daily.
If it were easy to make money trading currencies, this wouldn't be much
of a problem. But currency trading is complicated and the deck is
virtually always stacked against novices. It takes many professional
traders years to become profitable; for every George Soros out there (and
there's only one), there are thousands of tyro traders who've been burned
in the foreign exchange markets. Currency brokers admit that only a
delicate mixture of trading zen and market experience will see traders
through the market's choppy and changeable waters. Traditional trading
strategies — fundamental analysis, technical analysis and especially
momentum trading — fail equally for most beginners.
To complicate matters, online currency marts are completely
unregulated. When a day trader takes a stock position, he or she is at
least reasonably confident that the Securities and Exchange Commission is
actively patrolling the markets to protect against fraud and market
manipulation. No such authority oversees the currency markets, mainly
because they're international in scope and thus politically difficult to
regulate. The result: A financial Wild West, where the industry's rogues
and knaves can prey on unsuspecting traders at will.
There have been rumblings lately that the Commodity Futures Trading
Commission is preparing to step in to regulate the markets, perhaps in the
next year or two. If it does, it might have something to say about the
industry's basic trading practices, which serve brokers' interests far
more than those of investors.
The most common trade-execution system, known as the dealer or
market-maker model, involves the brokers themselves acting as
counterparties to the customers. Sites using this approach are frequently
— and usually derisively — called "bucket shops." In this case, the
investor trades directly with the broker, who then lays off his currency
exposure onto another investor, thus "bucketing" the trade.
Here's the rub: most online currency brokers control the prices (or
bid-asked spreads) at which they'll execute a trade. In the typical
scenario, a customer who wants to trade, say, $100,000 for the equivalent
in yen must request a price quote from the dealer. The dealer is happy to
provide one — after having studied the customer's portfolio and trading
history to guess which way he or she is playing and revising the price
accordingly. This practice, called "shading," ensures that the dealer
locks in the biggest profit possible, at the trader's expense.
Moreover, while some sites offer a "window" period in which the price
is locked, other unscrupulous dealers often revise their quotes upward at
the last minute, saying "the market has moved." This practice doesn't have
a formal name, but rip-off would suffice.
"The dealer model is predicated entirely on gouging the customer," says
Matchbook's Levy. "They know who you are and can guess with 90% confidence
what you're about to do when you call them up and request a price. They
try to lock in wider spreads with every deal."
So while many of these sites lure investors with promises of
zero-commission trades at interbank rates, they're actually charging
handsome fees in the form of wider-than-necessary spreads — and customers
are none the wiser because they don't have access to the interbank
markets. Brilliant traders can still make money via the dealer model, but
far less than they could in a true two-way market.
A few brokers, such as Matchbook and MG Financial, offer a trading model for currencies much
like the one that electronic communications networks (ECN) Instinet and
Island use for equities. The ECN-like model allows traders to post bids
and offers directly onto the trading screen, where everyone can see them.
The brokerages make money by charging fees to complete trades.
Predictably, however, these deals aren't cheap. Matchbook and MG charge up
to $5 to "passive" traders, whose posted bids are accepted, and up to $15
to "aggressive" traders who take someone else's bid. Since most currency
day traders are in and out of the market many times a day, those costs can
add up quickly.
Some online currency brokerages say they're trying hard to make sure
that they attract only appropriate customers. Many now provide copious
amounts of free educational material and require new investors to trade
with a demo account before going live. "The last thing we as a company
would want," says Levy, "is to be responsible for some 60-year-old
grandmother losing a significant percentage of her net worth because we
opened an account for her knowing she was undercapitalized,
undersophisticated and underexperienced."
Most sites also claim to screen potential investors before signing them
up. At Global Forex Trading, for example,
traders must have a net worth of at least $25,000 and an annual income of
$25,000, with at least $5,000 in risk capital available. Other sites are
even more stringent. Zsolt Sapy, president of Global Exchange
Networks, says his firm requires an
annual income of $100,000, with a net worth of at least $200,000. And
previous experience trading commodities or options helps.
"It's easy to turn away clients," he says. "We do it weekly." His worst
applicant? It had to be the unemployed guy with an income of zero and a
net worth of $15,000 who wanted to open up an $8,000 trading account.
A new site, Gain Capital, hopes to
become the Charles Schwab of online currency trading when it goes live
sometime next month. "We're trying to add a new level of professionalism
to the market," says Mark Gallant, the firm's president. While the site
will act as a market maker, it plans to broadcast its prices live for
anyone to act on. "I won't know that you've dealt on my price until after
you've dealt," he says. "So there's no way for me to tell that you're
about to deal on my price and therefore shade you lower accordingly."
Trades will be executed commission-free, and various charting and other
tools will be provided free as well.
But that doesn't mean the currency market will become easy prey for
displaced equity day traders. "Anyone who's lost their shirt [in stocks]
should think twice," says Matchbook FX's Levy. "They're obviously not good