The Lesson of Forex Trading: Learn From Your Losses

When I learned that Rabobank the Dutch agricultural bank ( remember the Dutch tulip bubble in the 1600’s one of the first financial meltdowns in recorded history) was providing leverage at 1000 times to individuals trading Foreign currency, it did not make sense. It was an enticement to get people into the market, allow them to make small returns, and get them comfortable then as they made larger trades to wipe them out. I wrote about this before and it now is coming to fruition. Aivars Lode

By Jason Zweig

This past week, six big banks paid $4.3 billion to settle allegations that they had conspired to rig the global currency markets. But even if the bad behavior has stopped, the little guy still has the cards stacked against him. A new study of more than 110,000 transactions finds that individual “forex” traders lose an average of 3% a week.

Yes, a week.

Even if you’ve never put money into the $5 trillion-a-day foreign-currency market and never will, there’s a broader lesson here. No matter what you invest in, you can’t get better at it unless you focus on the one thing nobody likes to pay attention to: your losing bets.

That’s the implication of recent research by Rawley Heimer, an economist at the Federal Reserve Bank of Cleveland, and David Simon of the Berkeley Research Group in Emeryville, Calif.

The researchers tracked activity on a social network operated for individual forex traders—one of many such websites that track traders’ positions, rank the traders relative to each other and enable them to chat online. The one that provided the data received anonymity as a condition of the study.

Messrs. Heimer and Simon found that the most successful traders are nearly 50% more likely to talk about their trades than the least successful are. More important, the other traders they tell about those winners trade about 20% more often than usual in the following week, although it isn’t possible to observe whether these other traders mimic the same transactions exactly.

“People talk to each other about their investing performance, and it’s only human to talk more about successes than failures,” says David Hirshleifer, a finance professor at the University of California, Irvine. “And people are more inclined to adopt a strategy that sounds like it did really well.”

When talking about their trades, losers use a muzzle while winners use a megaphone. If you hear a lot more about profitable trades than unprofitable ones, you get a distorted view of how good that particular trader is, how profitable this kind of trading is overall and your own chances of learning how to be good at it.

As a result, “it is more challenging for some people to learn how long to hang on [trading forex],” explains Mr. Heimer in an interview. “They say, ‘This guy’s doing really well, this market can make you rich, eventually I can be one of the people who make millions.’”

Javier Paz, a senior analyst at the Aite Group, a financial-research firm, estimates that individual forex traders in the U.S. generated about $12.6 billion in average daily volume in 2013 and are likely to surpass that level this year. That’s up from $10.7 billion in 2012.

Forex isn’t the only kind of trading on the rise. On Nov. 3, the Chicago-based North American Derivatives Exchange launched a series of specialized options contracts for individual traders who want to bet on the up-or-down direction of the S&P 500, the Russell 2000, the Nasdaq-100 or the Dow Jones Industrial Average over 20-minute periods.

“People were voting with their clicks,” says Nadex chief executive Timothy McDermott, explaining that the exchange created the new options to meet popular demand. Individuals are trading about $300,000 worth of these contracts daily.

You can’t lose more than your initial capital on such a trade, and trading costs are relatively low. But these contracts, which confer no ownership rights to the underlying assets, are all-or-nothing, either appreciating to $100 or expiring worthless. There is a seller on the other side of every buyer. They can’t both be right.

A simple set of skeptical questions can help you surface the vital information about losers that would otherwise be lost in the noise about winners—whether you speculate in forex or invest in stocks and other assets.

How does the average person do? The National Futures Association, the industry’s self-regulatory organization, recently found that 72% of individual forex accounts were unprofitable and that the average life of an account was only four months. Forex brokers catering to individuals must disclose the percentage of their customers’ accounts that are profitable—a number that rarely goes above 30%.

Regardless of how much bragging you might hear about somebody’s big score, two out of three people trading forex are going to lose money. By the same token, historical data show that approximately two out of three actively managed stock mutual funds will underperform the market average.

Who is on the other side of the trade? In forex, it’s probably an institutional trader at a giant global bank. In stocks, it could be a computerized high-frequency trader, a hedge fund or a mutual fund. In options, it’s often a market maker or other professional trader. You might know more than any of these people (or machines). But you probably don’t.

Is this the simplest, safest, cheapest approach? Let’s say you think the dollar is no longer likely to keep rising. You could buy or add to an international stock fund, which should appreciate if the dollar falls, making the profits that non-U.S. companies earn in other currencies more valuable to American investors. Or you could move up that vacation you’ve been thinking about taking in Europe, enjoying how much your dollars will buy while they are still strong.

Those are probably better trades than a plunge into the forex market. If you’re right, you’ll come out ahead. But if you’re wrong, you won’t end up wiping yourself out.