As a sceptic of forex trading as it is portrayed in popular culture, I recently sat in on a discussion about the practice that really opened my eyes not to a glamorous reality but to the lies and half truths routinely pitched to the target audience.

I listened as a self proclaimed neutral third party argued that forex trading really serves as a tool for wealth creation because they once funded a forex trader with 200 USD and received back 1000 USD after two weeks. This claim, though immediately dubious, arouses even more suspicion when put in perspective. While FX markets can see a lot of price action on a daily basis, the movements in these markets are relatively small especially for highly liquid currency pairs. As a result, traders often use significant amounts of leverage to generate substantial returns. This increases the risk of permanent loss of capital. For a trader to return 400% in two weeks, they would need to take enormous amounts of risk placing trades that more often than not would result in total loss of capital. To make matters worse, the ‘third party’ implied that the trader was just very profitable stating that this was the first and only time they had funded this trader. Given the low likelihood of getting such exceptional results the only time you do something of this nature, it is possible that the trader paid out the profits from personal funds or funds from other ‘clients’ in order to convince the target to ‘invest’ even more money. Again the ‘third party’ dismissed this possibility claiming that they had never since funded the trader. This opens the door to an alternative inference: that the ‘third party’ is lying. It just does not seem rational for someone to fund a forex trader, achieve such outstanding results, retain a strongly positive view on forex trading yet opt to never fund the trader again.

Someone else then made the argument that there was lots of money to be made in forex trading because banks earn profits trading with the money deposited by their customers. While there is some truth to this statement, it is still largely a misconception. The core business of a bank is taking deposits and making loans. Banks primarily earn profits by paying less interest to depositors than they earn from borrowers. To the extent that they trade currencies, it is not all due to speculation but partly for the purposes of carrying out their business operations and hedging currency risk. Some financial institutions do speculate on currencies hoping to earn profits but the specifics of these cases make them different from the practice of day trading currencies as a way to double your money ten times over.

Sophisticated traders apply several strategies when trading currencies however these generally differ from the approach popularised by so-called forex trading gurus. By examining perhaps the most famous foreign exchange trade, Soros’ short of the British pound, we can quickly see how this is the case. Starting in August 1992, George Soros and Stanley Druckenmiller, both at Soros Fund Management, gradually built a position equivalent to 10 billion US dollars against weak European currencies, particularly the British pound. They did this by borrowing the weak currencies and selling them to buy German marks hoping to buy them back at lower rates to repay their debts and keep the difference as profit. At the time, the UK was a member of the European Exchange Rate Mechanism, a mechanism which fixed the exchange rates of European currencies relative to each other. In line with the monetary trilemma, a concept developed by economists Robert Mundell and Marcus Fleming in the early 1960s, British monetary policy was restricted by the fixed exchange rate. Lower interest rates were needed to stimulate a slowing economy but higher interest rates were needed to maintain the currency peg. Thus, a cut in interest rates would help the economy but devalue the currency. While the British government opted to maintain the currency peg, unfavourable economic conditions still resulted in the pound slowly sliding despite intervention efforts from the Bank of England.

On September 16, 1992, an interview from the president of the Bundesbank acted as the catalyst setting off mass selling of the British pound. The Bank of England responded by raising interest rates and using its foreign exchange reserves to defend the pound but its efforts ultimately proved ineffective. As a result, the pound fell by 15% against the German mark that day leading to profits equivalent to 1 billion US dollars for Soros Fund Management. An important thing to note about this trade was the structure of the payoffs. If the speculators were right, they stood to make a lot of money. However, if they turned out to be wrong, they would only need to bear the transaction costs and interest expenses on their debt.

Along the same lines, I executed a profitable foreign exchange trade around the naira devaluation. For a long time, the Nigerian government maintained a peg for the naira against the US dollar with occasional devaluations. I had however noticed violations of the core tenets of the monetary trilemma. The exchange rate was fixed yet there were inadequate capital restrictions – demonstrated by the presence of a prominent parallel market – and monetary policy was not always in line with what was necessary to maintain the peg. Following the outbreak of the Covid 19 pandemic, there was a steep decline in interest rates. These rate cuts would have been initiated to stimulate a recessionary economy but they inadvertently put pressure on the exchange rate peg. Between late 2022 to early 2023, I started reading reports about companies suspending their Nigerian operations due to inability to expatriate profits and a 7 billion USD FX backlog at the Central Bank of Nigeria. Seeing this, I started building a position against the naira selling the currency to buy US dollars and even borrowing to increase the size of my position. At the time, the index I had developed to track the strength of the naira relative to the US dollar hovered around 50 points, close to its all time low. Guided by the information and tools at my disposal, I remained a net seller of the naira throughout 2023 even after the first phase of devaluation and only started unwinding my position in February 2024 with my proprietary index hovering around 140 points. At the time of writing, my relative strength index is at 92 points and I am neither long nor short the naira as I do not have enough information to be comfortable betting that the index will rise to 120 points or fall to 60 points sometime soon.

It is not necessary for every profitable forex trade to follow this format. Some traders prefer to wait for big events from which they can make sizable profits while others are content to take small consistent profits that add up over time but in all cases, to be consistently profitable, traders need an edge – an approach or advantage which gives the trader a positive expected return. Trading in financial markets is adversarial therefore traders may expend a lot of resources finding and protecting their edge. While having an edge implies that the trader has a positive expected return, it does not say anything about the size of the return. It is difficult enough for foreign exchange traders to earn a positive return as day trading is very competitive and position traders may have to wait a long time for the right opportunities. I would be sceptical if someone not only promised a positive return but tried to sell me on the prospect of getting rich.

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Author: Ugonna Onyemere