Forex trading is the buying and selling of foreign currencies. People trade in forex either to try to make a quick profit by betting on the changing value of a currency, or to provide certainty about the cost of future foreign currency payments (called ‘hedging’).
You can trade in forex by:
Forex trading for profit is very risky. For every person who gains a dollar from forex trading, someone else loses a dollar. And that's before taking into account costs and fees, which can be significant.
Because changes in foreign exchange rates are often influenced by unexpected events, even highly experienced traders using specialist tools often get it wrong.
If you do choose to trade forex, you will need plenty of spare money to cover losses caused when exchange rates move against you.
Read our forex trading example to help you understand how trading for a profit really works.
1. Be wary of promotional offers for 'free' or 'no loss' trades.
Especially from online platforms that may not be based in New Zealand. These often have strings attached, so examine their terms and conditions closely before committing.
2. Beware of forex trading ‘training’ and ‘tools’.
You should be wary of anyone who tells you that a particular product or technique can give you access to better exchange rates or easy money. While software programmes and training courses can teach you how to make forex trades, no person or programme can ever accurately predict movement in foreign currencies.
3. Forex trading risk is hard to manage
Forex traders can use risk management techniques such as ‘stop loss orders’ to try to limit trading losses. For example, if you agree to a stop loss order to automatically close your trade when the exchange rate reached AUD$0.90, in theory this would cap the potential loss at NZ$1,800.
But it would not be guaranteed, as stop orders may not work at all when there are extreme movements in the markets. You might also have to pay additional fees or costs to have a stop loss order in place.
4. Borrowing to trade is extremely risky
‘Leverage’ or ‘margin’ trading are terms used to describe ways of trading with borrowed money. This can be riskier than borrowing to place a bet. You may pay only a small portion of the value of your trade up-front, but if you lose you will need to repay the full amount borrowed, plus any amount you’ve lost.
This means that even small movements in currency values can have a big impact on any gains or losses you make through forex trading.
In particular you should look for information on:
David wanted to make money from forex trading, so he found an online margin forex trading service, checked that it was a licensed derivatives issuer in New Zealand, and deposited NZ$1,000 to open an account.
He ended up losing not only the $1,000 but an extra $3,545. How?
The account required a 0.5% margin to trade. This means that for every dollar he had in his account, he could buy a trade worth $200. This can also be described as a ‘leverage’ of 200 times.
David thought the NZ dollar (NZD) would increase in value compared to the Australian dollar (AUD), so he purchased a contract linked to NZ$100,000 with the NZD/AUD currency pair at 0.92 (meaning NZ$1 dollar = AUD$0.92).
For this NZ$100,000 trade, David had to pay only 0.5% upfront (the margin), which was NZ$500. This came from the money he had deposited in his account.
Unfortunately the NZD decreased against the AUD. In a very short period the exchange rate dropped to 0.88 (NZ$1 dollar = AUD$0.88). This meant the value of David’s NZ$100,000 trade fell by NZ$4,545.
This was more than the initial ‘margin’ of $500 that David had paid, so the forex trading service deducted the remaining $500 that David still had in his account and asked him to pay an additional NZ$4,000 of margin – the $3,545 he owed plus a buffer against further losses. This is called a ‘margin call’.
David didn’t want to continue taking risk on the exchange rates, so he chose to close the transaction at the exchange rate of 0.88. He still had to pay the forex trading service NZ$3,545 in addition to the NZ$1,000 that he had originally paid to open the account.
Find this difficult to follow? Keep in mind that a basic rule of investing is never to take part if you don’t fully understand how an investment works.
TIP: Complexity usually means risk.
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