The vast majority of forex traders lose money. In fact, according to one study, 96% of all forex traders ended up at a loss that eventually results in them quitting the game. With such massive amounts of failures, you’d be right to wonder why forex trading even exists and why anyone bothers to go into it.
Forex trading has exploded ever since online brokerages opened. Access to markets and ease of trading increased volumes, liquidity, and access. Before the mid-1990s, retail forex trading was virtually unheard of. Since then, it has grown with fits and starts while attracting greater attention and interest from speculators as a new opportunity to make money. They, as you would expect, usually fail at their goal.
The attractiveness of forex makes sense, however. Because currencies are literally global and are impacted by a tremendous array of macroeconomic and idiosyncratic factors, it is the kind of thing that speculators can pick up and buy or sell based on their own specific analysis of any amount of factors.
But finance is not speculating, and investing is not a matter of greedily hoping for big returns by gambling on the change of a commodity’s value in an unpredictable market. Forex traders are not investors or even financiers in the conventional senses of either term, which leads one to wonder what practical function forex markets have.
And they do. Forex markets exist for a good financial reason, and they provide services that large investors and corporations have used for decades.
The primary use of forex markets is to offset other investments that companies may have. Say, for instance, you are a Taiwanese semiconductor company and you sell to U.S. retailers exclusively. You are heavily exposed to the USD, which means your purchasing power may be negatively impacted by a stronger U.S. dollar, since you sell to American consumers who are buying your products in NTD. To offset that risk, you may want to have a savings account full of U.S. dollars to offset that exposure.
However, let’s say that you also take out a loan in euros, which means you have a short position on the EUR. If you are long USD in a savings account and short euros, you are now exposed to three currencies: your native NTD, your USD holdings, and your EUR loan. You may want to temporarily trade some USD for EUR to hedge your EUR loan and ensure a big forex swing doesn’t hit your cash flow.
But how much should you buy EUR and how much should you sell USD? This is a fine calculation based upon the length of the loan you are holding, the amount, and the likely range of price fluctuations to expect from the EUR—which can be calculated based upon past behavior.
From this perspective, you can see the forex markets for what they really are—and have been—for most of their existence: insurance.
Forex trading is a good and powerful tool large firms use to buy insurance to protect themselves from unexpected downside. Derivatives based on forex and leveraged forex trading become part of that larger calculus.
As you can see, when we get down to the heart of the forex market, it’s a lot less exciting but also a lot more responsible than it appears from its depiction in the popular media. So too does this apply to derivatives markets, commodities markets, and many other markets that get a bad reputation as they are democratized and face more attention from the public.