The Smart Way to Make Money From Forex Trading

David Goodboy's picture

Thursday, June 21, 2012 - 8:30am

by David Goodboy

If you have been following the markets for very long, then you have probably noticed all the flashy ads for foreign exchange trading, or "forex" for short. They seem to be everywhere, from the business TV channels and magazines to billboards and the Internet. I have even seen them places you wouldn't expect, like during the game on Sunday. 

But did you know there's a way to profit from the massive amount of forex trading that's going on without bearing much of the excessive risk that goes along with it?

Let me explain... 

Forex trading refers to the over-the-counter market in which the foreign currencies of the world are traded. It's also a rapidly-growing segment of the online trading industry. 

But rather than dive into forex trading yourself, you should consider investing in the forex industry itself.

Here's what I mean...

Amazing growth...
The average daily retail trading volume has expanded at a compound annual growth rate of 37.1% from 2000 to 2009, according to a 2010 analysis by the Aite Group. 

That's massive growth no matter how you cut it. 

Most interestingly, even with this growth, retail forex traders still represent a tiny sliver of all retail traders. There are more than 100 million retail traders globally, but only 1.25 million who trade forex. So the market could easily continue to grow. Provided the international markets, 24 hours a day, six-day a week access, and very low access costs for the trader, this market is custom made for expansion. 

Betting with the house
Despite the popularity, not surprisingly, most retail forex traders lose money. In fact, in a recent interview, Drew Niv, CEO of FXCM Inc. (NYSE: FXCM), stated that only about 20-30% of traders make a profit. 

This means that at least 70% of all traders lose money in the retail forex market. These losses are primarily due to the ultra-high leverage provided to forex traders. Combine leverage with new, inexperienced traders, and it's a recipe for disaster -- at least on the trader side of things... On the business side, it's great.

Depending on the model used by the dealer, these losses may add to their bottom line. Here's how it works... 

There's the direct-access model, also known as "no dealing desk," and the counterparty model. Put simply, the "no dealing desk" model matches trader's positions with other traders or banks. However, some dealers act as the counterparty to their customer's trades. This means the dealer takes the opposite side of the transaction, and if the trader losses, the dealer wins.  

In addition, many dealers control their own trading platforms, which open up an entirely new avenue for profiting from traders. 

Regardless of the model used, all retail forex dealers make money from the spread between the "bid" and "ask" of the different currency pairs. The dealer marks up the spread, which becomes profit. To put it bluntly, the more traders trade, the more money the dealer makes. This is why dealers encourage short-term trading by offering free technical analysis chart packages, education, news feeds and other tools to keep traders active in the market. 

The dealers
There are two main U.S.-based forex dealers that are also public companies. One, I've already mentioned, is FXCM. The other is GAIN Capital Holdings (NYSE: GCAP)

FXCM claims to be a "no dealing desk" model, except for its micro-accounts where it acts as the counterparty. On the other hand, GAIN Capital Holdings acts as the counterparty for most of its retail business, according to its 10-K filing with the SEC. 

Let's take a closer look at the larger of the two forex dealers, FXCM.

FXCM posted first quarter revenue of nearly $103 million, up 8% compared with the same period last year. Net income was up 4%, and most interestingly, customer equity spiked 47% from the same time last year. Active accounts jumped 22% from same time period. 

The company is actively seeking new markets and acquisitions. Just recently, it purchased 50% of Lucid Markets, a private U.K.-based proprietary trading group, in an effort to make deeper inroads into the institutional forex market. Adding icing to the cake, FXCM just announced a small quarterly dividend of $0.06 per share.

Taking a look at the chart, the company is trading above both its 50 and 200-day moving average. However, the stock hit resistance in the $12.50 range, and it has since fallen back, setting up a solid buying opportunity on a pullback.  

Risks to Consider: Just like in the forex market itself, there are risks in betting on the dealers. The primary risk is regulatory. Recently, the U.S. capped the amount of leverage domestic forex dealers can offer their clients. This sent many traders overseas in search of higher leverage. Although forex remains lightly regulated, tighter controls may be on their way. 

Action to Take --> The recent pull back from FXCM's highs has placed the stock on my radar screen for a potential buy in the near future. My target price for this stock would be about $15.

David Goodboy does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.