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6 Common Misconceptions Of Forex Trading

Forex trading is a global pastime that includes individuals from all walks of life and geographic locales. From the most experienced market veteran to the greenest novice, the foreign exchange markets facilitate the pursuit of a broad spectrum of financial goals.

Amid the massive numbers of traders and investors, a multitude of false beliefs are harboured. Misconceptions surrounding the basic function of the forex as well as other trade-related misnomers plague many participants. Unfortunately for some, misinformation and a lack of basic market education proves costly.

Empirical evidence shows that an overwhelming majority of traders end up losing money and opting for another profession within a relatively short period of time.[1] A primary reason behind the high washout rate is adherence to many common myths associated with the forex.

Before opening a brokerage account or placing another trade, it is a good idea to address several of the most prevalent falsehoods related to forex trading.

The Forex Is A Standardised Exchange

One of the most common fallacies attributed to the forex involves its function. The forex exists as an over-the-counter (OTC) marketplace, not a standardised exchange.

An OTC market is a decentralised venue that facilitates the trade of its participants. Liquidity providers, known as "dealers," act as market makers quoting prices in which they will buy or sell a specific currency. Traders and investors then place orders on the market and have trades executed accordingly. The forex has no physical base of operations, which means regulatory bodies function largely as regional entities. Conflict resolution can prove more difficult than simply filing a grievance against an exchange.

In contrast to exchanges, OTC markets are not subject to transparent clearing. Participants are able to interact with one another in a private capacity, without other traders and investors becoming aware of their dealings. Often, the private nature of transactions can lead to concerns regarding market transparency.

Discrepancies in regulation and transparency are capable of influencing the market dynamic in times of financial distress. More so than in the trade of exchange-based products, the selection of a competent, trustworthy broker can help reduce the negative aspects of engaging an OTC market such as the forex.

Forex Trading Is A Way To "Get Rich Quick"

The financial rewards of active forex trading attract an abundance of new participants to the marketplace. Readily available leverage, small margins, extensive market hours and a wealth of trading options are a few attributes that promote the notion of "easy money." Contrary to popular belief, success is not 100% guaranteed and losing capital is a daily part of doing business.

The forex is a hyper-competitive atmosphere defined by cutting-edge technologies and sophisticated participants. Sustaining profitability in the long-run can prove to be a monumental challenge. Aside from having the personal attributes of desire and dedication, achieving success in the forex requires that traders thoroughly address several elements. These include the following:

  • Technology: In order to compete, one must have adequate computing power, market connectivity and a robust trading platform.
  • Competent Brokerage: Minimal trade-related fees, dedicated customer service and reliable market access are vital elements necessary to efficiently engage the market.
  • Trading Strategy: A comprehensive strategy is the cornerstone of fruitful trading. Rules-based systems for market entry/exit and money management are crucial to achieving consistently positive returns.
  • Psychological Makeup: Forex trading is not for everyone. People prone to impulsive or reckless behaviour may not be cut out for the constant decision making required by active trading.

Any shortcomings in these areas will be exposed over time. Each has the potential to compromise the integrity of the entire trading operation and undermine profitability. Without these elements being accounted for, undue loss of capital is all but assured.

There Is Only One "Correct" Way To Trade

Forex trading is not a one-size-fits-all type of activity. Traders come in all shapes and sizes, each with a unique approach to the marketplace. There are nearly infinite trading strategies in practice, with consistent profitability being the only relevant measure of effectiveness.

A viable trading methodology is a combination of the following basic elements:

  • Technical or Fundamental Analysis: Strategies may be based on the study of price itself or the reasons driving price action. Many trading strategies are a combination of both technical and fundamental analysis.
  • Duration: The length of time a position is to be left open at market is a key element of strategy definition. Intraday, day, swing or longer-term trades all have different functions, goals and risk exposure.
  • Style: Fully automated trading or a manual discretionary approach are two examples of different trading styles. No matter which one is adopted, many nuances are present in its application to the markets.

It is important to realise that there is no right or wrong way to trade. As long as a proven strategy is adhered to with consistency and discipline, success in the forex is attainable. At the end of the day, the only "correct" way to trade is one that makes money.

Greater Leverage Equals Greater Returns

Extensive degrees of leverage are readily available in forex trading. Brokerages regularly offer small margins and upwards of 200/1 position leverage to attract clients. The ability to implement a high degree of leverage ensures that a large amount of currency may be controlled by a fractionally smaller account balance.

While the potential rewards of high leverage are lucrative, the risk is not always easily quantified. As the number of lots assigned to a specific trade is increased, the amount of currency risked per pip grows substantially. In the event that an imbalance develops between the size of the open position and the trading account balance, an exorbitant risk is being assumed.

If this is the case, the following elements of market behaviour can deem heightened leverage more of a liability than an asset:

  • Periodic Volatility: Pricing volatility can spring up at any time and prove catastrophic to a highly leveraged position.
  • Slippage: Entering and exiting large positions can be challenging amid less than ideal market conditions. If liquidity levels are limited, considerable loss due to slippage may occur.
  • Trade Liquidation: In the event that margin requirements set forth by the brokerage are violated, the open position will be liquidated. This can come as a surprise to the trader, as an eventual profitable trade may be exited prematurely.

No matter how great a trading opportunity appears to be, the old adage "leverage is a double-edged sword" encourages prudence in its engagement. While a sure thing may be attractive, larger positions increase possible losses exponentially. An unforeseen swing in pricing may serve to blow out a trading account before any expected gains are made.

Complex Strategies Outperform Simple Ones

The forex, and financial markets in general, are often found attractive by individuals with an academic background. Doctors, lawyers, engineers and technology professionals are drawn to the markets not only for financial reward but for intellectual challenge. It is due to the mental acuity of many participants that extremely sophisticated strategies are developed and championed.

For less experienced traders, an abstract approach may seem to be the best avenue for success. Combining intricate technical tools with proprietary software products appears to create an "edge" for the trader. However, this is not always the case.

The relative complexity of a trading strategy can have very little to do with its eventual effectiveness. A historical example of this idea is the late 1990s meltdown of Long Term Capital Management (LTCM). Nicknamed the "Genius Fund," LTCM was a company that implemented intricate currency arbitrage strategies built by Nobel Prize winners, Phds and other stars of the financial world. LTCM achieved annual returns of more than 40% before losing more than £3.3 billion in less than one year. [2] Although the strategy was on the cutting-edge of trade-related sophistication, it eventually failed.

Profitability in forex trading stems from interacting with the market efficiently. Obtaining market access via minimal fees, securing low trade-related latency and applying structured money management can be just as vital to a healthy bottom line as strategy performance. If these elements are in place, even the simplest trading plan can prove successful.

More Is Better

The forex is open on a 24/5 basis and offers more than 100 currency pairs to participants. The extensive market hours and availability of products provide seemingly infinite opportunities for active traders. However, attempting to trade everything around-the-clock can be detrimental to profitability.

In most cases, restricting trading operations to a specific time period and group of products is the best plan of attack. Several factors illustrate why more is not necessarily better:

  • Limited Resources: Adequate time is needed to prepare, actively trade and document results. Attempting to trade 24 hours a day places tremendous strain on the individual and is one of the most common mistakes made by forex newbies. In addition, holding open positions in multiple currency pairings can spread capital resources thin.
  • Liquidity Concerns: In order to trade efficiently, there must be adequate market liquidity. Less popular currency pairs are traded infrequently, meaning there is a shortage of both buyers and sellers. Bid/Ask spreads are larger and pricing moves are more dramatic.
  • Correlations: It is commonplace for currency pairs to show a correlation with one another. If true, taking trades in separate pairings may prove to offset gains or enhance losses.

With so many options, opportunity is seemingly always afoot. In most cases the opposite is true. The longer one stays in the market, the greater the chance of falling victim to many pitfalls. Overtrading, lapses in discipline, systemic risk and fatigue can all destroy profitability.

Summary

Misinformation and misconception are particularly costly themes in the forex marketplace. Developing a rock-solid knowledge base through trader education is a key element of engaging the market from a position of strength. Ultimately, the responsibility falls upon the individual to debunk many of the existing forex myths before entering the market.