If you’re reading this guide, chances are you’re having a hard time making money from forex. Maybe you’re a new trader who ran into their first losing streak or maybe you’ve been trading for a while and tried everything without success.
Either way, you probably want to know: Can you really make money trading forex?
If trading ads are to be believed, it certainly is: Just follow a few simple trading signals or deploy a scalping robot and you’ll be rich in no time! However, the reality is a lot more complicated — and arguably more disappointing.
So, let’s find out what the reality is!
The Simple Nature of Trading
Trading forex is technically easy.
Multiple factors can affect the price of currency pairs, but at the end of the day, the market closes either higher or lower.
Even if you’re completely clueless, you can pick a random currency pair, place a buy order, and hope that the price will go up so you can make a profit.
In this sense, it is obviously possible to make money in forex. With some luck and elementary risk management, you might even produce a fairly astonishing performance just by randomly opening and closing positions.
Consider a simple coin toss championship in which the person who flips the greatest number of heads out of 50 trials wins. The expected outcome is obviously 50% heads and 50% tails for any contestant; however, it would not be surprising to find a few people who flipped more than 75% heads.
In fact, elementary statistics tells us that out of 10,000 contestants, the expected number of people flipping 75% or more heads would be two. Although these people might be proud of their “achievement,” there’s little doubt that they simply happened to get lucky.
In the world of trading, this phenomenon is called the lucky event issue. The internet abounds with stories about people who produced an exceptional track record over the recent past. While their superior returns are often taken as proof that anyone can make money trading forex, this conclusion is deceptive.
Granted, unlike our coin toss champions, traders have various tools to increase their odds of winning.
However, notice that unlike tossing a coin, trading is not actually a zero-sum game. This is because winners receive less than what losers lose due to commissions and trading costs. In other words, the inherent expectancy of trading is negative.
So, the question is not whether you can really make money trading forex, but whether you can do it consistently. Can active market analysis give you the edge to overcome the negative odds and make reliable profits over the long term?
The Risk-Return Tradeoff
When people talk about “making money with forex,” they usually think about your ability to grow your account. For example, if you deposited $10,000 a year ago and now your balance shows $13,000, people will congratulate you, ask about your strategy, and perhaps even want to trust you with their money.
In eyes of the general public, if you end up in the green, you must be a skilled trader.
Now, as we have already discussed, anyone can get lucky and turn in some profit. Therefore, judging someone’s performance according to total profits can be misleading.
If we want to have a meaningful discussion about whether or not it is possible to make money consistently from trading forex, we must first put returns into context based on the amount of risk involved.
An amount of risk is involved in every trade.
If you risk 0.5% of your account per transaction, your winners will obviously be smaller than if you risked, say, 20%. That’s bad but smaller risks safeguard your account when things go south. There’s nothing spectacular about making double-digit gains when your entire account is on the line.
In general, any trader who expects to make a disproportionately large return must take on significant risks, which naturally increases the possibility of a severe loss sooner or later. Therefore, excessively large returns are generally considered unsustainable.
You might be thinking: ‘It’s obvious that large risks are dangerous, but it’s not an issue for me because I keep my risks small and practice good psychology. That way, I can make a living trading forex.’
Not so fast.
The Challenges of Long-Term Profitability and Why It Just Might Be Impossible
No matter how good your risk management and psychology are, if you can’t find trades with positive expectancy, you’re in trouble. And finding trades with positive expectancy might be more challenging than you think.
Without getting into all the different stuff you can use for this purpose, let’s make one simple observation:
If you decide to open a trade, you must perceive that conditions are favorable and the trade is worth the risk.
It doesn’t matter how you reached this conclusion; if there’s a true profit opportunity, the situation tends to boil down to one of two things:
- The asset is overpriced.
- The asset is underpriced.
In other words, the asset deviated from its fair value. An asset that is at equilibrium doesn’t offer many profit opportunities. However, when deviations occur from the equilibrium value, the balance between the buying and selling pressure breaks and trading opportunities arise.
If you can identify such situations with great accuracy, you might have an edge.
Suppose you discover an equation that predicts over or undervaluations with certainty. For example, suppose that according to your model, the current GBP/USD rate at 1.40 is drastically overpriced and will fall back to 1.20 in the next few days.
What would traders with access to this model’s prediction do today?
Obviously, to cash in on the prospective decrease in price, they would immediately short sell the GBP/USD. The sudden selling pressure would send the price into a freefall, but no one on the short side would be willing to close their short position until the price went all the way down to 1.20.
The net effect would be an immediate drop to the foreshadowed rate of 1.20.
Simply put: The new information about future performance would immediately be reflected in the price as market participants rushed to be the first ones to get in on the action.
This is typical in so-called efficient markets. Market efficiency refers to the degree to which market prices reflect all available, relevant information. It should come as no surprise that the forex market is very efficient because a large number of well-equipped participants compete to make money.
Any information suggesting the favorable future performance of a currency is quickly reflected as traders act on it and bid up prices to their fair levels. Vice versa for negative expectations.
Of course, if you had a superior model, you wouldn’t share it with many people. But in reality, it’s impossible to predict the future with certainty and most information that could be used to shed light on the expected performance of a currency—such as interest rates, periodic GDP reports, inflation data, and so forth—is publicly available.
Past price data is also widely accessible to everyone, along with the assumptions of chart patterns and the readings of your favorite technical indicator.
In other words, none of this knowledge should put you at an advantage because it’s common knowledge and already priced in by the profit-seeking behavior of market participants.
If traders immediately bid prices to fair levels based on what all available information suggests, it must be that prices increase or decrease only in response to new information. New information, however, is unpredictable by definition. Consequently, anything that changes in response to new information must move unpredictably. Currency pairs fit right into this narrative.
This is the so-called random walk theory.
If prices indeed follow a random walk, it’s easy to see that there are no profit opportunities, and the long-term expectancy of any seemingly superior trading strategy will be close to zero.
Does Anyone Make Money Trading Forex?
Don’t let the above discussion break your spirit.
Although the forex market is very efficient, it’s easy to see that nobody would spend time and money on active market analysis if there was no way it could help them generate higher returns.
This is stressed by Grossman and Stiglitz, who argue that because information is costly to obtain, prices cannot perfectly reflect available information, as this would mean that those who spend resources to obtain it would receive no compensation.
Even the father of modern empirical finance and Nobel Laureate Eugene Fama agrees that superior market analysis can be profitable.
In the paper Random Walks in Stock Market Prices, he says that a market analyst can overperform the market if:
- He or she can, more quickly than other analysts, identify situations in which there are non-negligible discrepancies between actual prices and intrinsic values and,
- He or she can better predict the occurrence of important events and evaluate their effects on intrinsic values.
(See page 11)
That said, Fama also notes that if there are many well-capitalized and astute market analysts who can indeed overperform the market, they will help narrow discrepancies between actual prices and intrinsic values and push prices toward “instantaneous adjustment.”
That is, the existence of many sophisticated analysts makes the market more efficient and more difficult to predict. This shows just how difficult it is to trade forex profitably.
Conclusion
The performance of forex traders is broadly consistent with what you would expect from competitive markets. Most people lose money, but there are enough profitable traders to justify the attempts of new contestants.
The effort to develop superior trading strategies and uncover methods that others have not thought of clearly goes on.
However, it should not surprise you that casual efforts to choose trading strategies are not likely to pay off. Competition among market participants ensures that any easily implemented technique will be used widely enough so that any insights derived will already be reflected in prices.
The bulk of evidence suggests that markets are extremely efficient, and the easy pickings have been picked. Only the few most diligent and intelligent traders have the chance to really make money trading forex.