Interesting article from FT.com on why Retail FX spread trading is a racket…its all in the volatility and ability to bear it.

FT.com (Jul 13 2012)

Long established as the global hub for wholesale currency trading, Britain is now also the centre of the retail FX margin trading business. And there’s a reason for this: in many key aspects, FX trading is largely unregulated.

In the US back in 2010 the Commodity Futures Trading Commission imposed a 50-1 leverage cap after seeing retail customers being offered deals of up to 200 times their initial margin downpayment, yet in the UK today it is common to see broker customers being offered up to 500-1.

You might ask, what’s wrong with that? Speculators should be free to speculate. Except that this is a racket where the higher the leverage ratio, the greater the certainty the client will lose and the firm will profit. Whether it happens instantly or less quickly, the business is structured so that the customer almost always comes out worst.

Here’s how it works. A mug punter clicks on an advert promising untold riches and boy-racer-style excitement, where they’ll be able to trade the currency markets “just like a pro”.

The punter will typically be offered “initial margin of 0.25 per cent”, presented as an inducement. For every £1 lodged with the broker the client can have £400 of exposure to any given currency pair. Putting up £2,500, the punter can establish a £1m trading position.

Now, usually by default, the new punter will have a stop/loss placed on their trade, ostensibly to protect them from untold losses if market prices move against them. But this actually has the opposite effect.

Here’s why. The client may have a view that the euro is going to parity against the dollar, and may well be proved right, in time. But what we can be sure of in the meantime is that the euro/dollar rate will go up and down, constantly and sometimes violently. The road to parity will be volatile.

Now, having perhaps sold the euro and bought the dollar, the client will be trading against his FX broker, who is now his trading counterparty. And that counterparty – the FX broker – can almost certainly wear far more volatility than an individual client.

The FX broker is trading against thousands of individual punters. Not only does it make money from the spread between actual retail and wholesale FX prices; it also sweeps up every time one of those clients hits the stop loss limit on their trading account.

Indeed, with some basic maths and a bit of historical data on volatility, an FX broker can predict how long a particular client will be with the firm before being wiped out.

Industry figures indicate retail FX trading has been growing at a compound annual rate of close to 100 per cent in recent years. Profitability has clearly grown exponentially.

It needs to be pointed out that Oanda, the world’s largest retail currency platform, and most of the so-called blue chip banks, offer no more than 50-1 leverage. For many others it seems that almost anything goes.

Where’s the regulator on all this? That’s not clear. For the Financial Services Authority, much of the rule-setting on such matters has migrated to the European Securities Markets Authority in Paris, which has yet to act.

Oanda would like them to, urgently. As its European managing director explains: “We see excess leverage as being harmful to traders as it increases the probability that normal market volatility will wipe out their positions, even if they have correctly traded on a directional market move. In other words it increases the chances of traders losing their money, even when they are right.”

FT.com

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