Forex is no place for greenhorns

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PART 1
THE BIG PICTURE Major North American stock indexes are trading at about where they were in 1999. Long-term government bonds offer a yield of around 3%. The real estate markets that haven't blown up yet are looking far too overheated for comfort.

Is there anything left that offers some real upside to the average investor? Suppose you could easily earn hundreds of dollars a day, possibly even thousands, trading foreign currencies online at home. Foreign exchange—forex—is the world's largest and most liquid market, with a global daily trading volume of about $4 trillion (U.S.). Yet all you need to get started is a computer, some cash and access to the Internet.

You'd at least be tempted, right?

Online forex trading is one of the last promising frontiers for day traders, the proverbial folks in bathrobes who sit glued to computer screens in their homes for hours at a stretch. The trouble is that forex trading isn't just risky—the provincial securities laws that govern it have major gaps. Worse, regulators warn that forex is still populated by out-and-out scams.

The attraction is obvious: quick and fat profits. Many day traders gave up on online stock trading after North American exchanges completed the switch to decimalized pricing in 2001. Price increments and profit margins shrank to fractions of a penny a share. But online forex dealers allow even individual investors to use a lot of leverage, which can greatly magnify profits from even tiny shifts in exchange rates. Until recently in the United States, leverage of 100-to-1 was common, meaning that you can buy a $10,000 currency contract by putting down only $100. If you buy the U.S. dollar at parity with the Canadian dollar and the greenback gains one cent, that's a 100% profit. Lately, the leverage has been moderated in Canada and the U.S. In Canada, trading between Canadian and U.S. dollars has been leveraged around 25-to-1 or 30-to 1.

Of course, leverage can also work in reverse. "You can make a lot of money quickly and you can lose a lot of money quickly," says Edward Kholodenko, president and CEO of Questrade Inc., Canada's largest discount brokerage firm—largest, that is, after the ones run by the Big Five banks.

Despite that risk, forex has other powerful attractions: You don't have to follow hundreds of stocks. There are a limited number of solid currencies, and most traders concentrate on the seven largest—including the greenback, the yen and the euro. Commissions are low—$7 a trade is common. Some dealers, like Questrade, waive commissions altogether, and profit from the wafer-thin spread between the bid and ask quotations of buyers and sellers.

Besides being huge and highly liquid, currency markets are something you can trade online 24 hours a day, six days a week. That figure of $4 trillion (U.S.) for daily volume, which is widely quoted, is a bit misleading, however. Because of the use of leverage and derivatives such as futures and options, only a minuscule fraction of that amount actually changes hands.

Still, it can all look awfully easy to a novice—sometimes too easy. Many traders believe in technical analysis and in the efficient markets hypothesis, which holds that all publicly available information about a currency is reflected in its market price—the exchange rate. That means you don't have to spend hours analyzing fundamentals such as trade balances and international capital flows. Just look at trends in exchange rates themselves on your computer screen.

The Big Five banks haven't jumped into the retail forex game: None of them offers online accounts targeted at day traders. (The banks are, however, active in foreign exchange: They have their own currency trading teams with vast amounts of capital and sophisticated technology at their disposal.)

Questrade began offering online forex trading in 2005. It gives individuals access to about 40 pairs of currencies. Kholodenko says the business has grown substantially from year to year. "Forex clients make up about 10% of our client base," he says. "It's not something that we're trying to go out and sell. We see a demand for it." He says forex definitely isn't for the prudent long-term investor. "You have to have an appetite for risk. It's not, you know, something that a grandmother should be investing in."

In addition to the risks in the market, there are risks from the holes in provincial securities laws. These laws protect investors in traditional instruments such as stocks, bonds and mutual funds in two key ways. One is disclosure: Dealers are required to give investors a prospectus describing the security and outlining its risks. The other is registration and supervision. Investment dealers and advisers have to register with provincial authorities and be a member of an industry self-regulatory body such as the Investment Industry Regulatory Organization of Canada.

Until recently, however, it wasn't clear that some popular forex investments—specifically, instruments known as Contracts for Difference—were securities under Ontario law. CFDs give traders exposure to the profit or loss from a trade in a currency, commodity, share, stock index or other investment without the trader actually buying the underlying asset. In 2009, the Ontario Securities Commission (OSC) issued a notice saying that it considers CFDs to be securities, and subject to prospectus and registration requirements.

Regulators are trying to crack down on operators who take advantage of forex's wild frontier. In March, the OSC announced a settlement that shut down Toronto-based QuantFX Asset Management Inc. and barred its CEO from trading securities on clients' behalf for two years, and from being a director for five years.

The company had lured investors into depositing money with an online dealer based in the United Kingdom, then persuaded them to sign over limited power of attorney to the accounts, which one of the company's principals then traded for the company's own purposes in the U.K. and Russia.

There is, meanwhile, a legitimate way to market forex instruments, since companies offering specialized investments to sophisticated investors can apply to the OSC for exemptions from provisions of the Securities Act. Thus the OSC has granted specific exemptions to its requirements to five forex dealers: Toronto's long-established Friedberg Mercantile Group Ltd. and the Canadian subsidiaries of four foreign-owned dealers.

Yet regulators warn that forex scams still remain all too common. In October, 2010, the OSC issued a news bulletin titled "Thinking about trading forex? Know the risks before you invest." It pointed to a booklet issued by the Canadian Securities Administrators, the national umbrella group for provincial regulators. "What usually happens is that your money is not invested in anything, but simply is stolen by the scam artist," the booklet says.

Kholodenko is worried that many investors nonetheless open accounts with online dealers based in the U.S. or overseas, particularly in low-tax jurisdictions. "Those Canadians don't have the normal protections afforded to them by Canadian securities legislation," he says.

PART 2 THE LOCAL DISPUTE

In the summer of 2010, Asghar Naqvi, a 71-year-old retired Toronto camera-store owner, went to a free introductory seminar on a Saturday afternoon.

Originally from Pakistan, Naqvi had seen splashy ads for Money Plus Futures in a local South Asian newspaper and on television. Money Plus is run by a 62-year-old former civil engineer from Pakistan named Fawad Khan, who presents himself as a day-trading expert, and who, until recently, hosted a phone-in show on Sundays on an AM radio station. Money Plus has a website that says Khan will show you how to earn $200 to $500 a day trading in your own home using "our seven profitable strategies" that have "never failed in eight years."

The location of Khan's seminar isn't too promising: the basement of a shabby bungalow in Mississauga. And there, Khan explains that, to learn those profitable strategies, you have to pay for his trading course, which consists of eight days of formal instruction, followed by a week of trading alongside him. Khan sits in front of an array of 13 computer screens and has smaller stations for a handful of students. He says dozens of other Money Plus clients usually follow along via voice links to their homes.

In person, Khan is quite forthright that he is not an investment professional, that he is not trained or licensed, and that forex trading is risky.

Indeed, Naqvi's initial adventure in forex trading did not go well.

In a court filing, Naqvi says he paid his $800 fee to pursue Khan's program and, at Khan's request, deposited $10,000 in an online trading account with Chicago-based Global Futures. Khan had told him, the filing says, that he would recoup the cost of the course in the first week. But Naqvi lost money, and his losses swelled over the next several weeks. The filing goes on to claim that Khan then persuaded Naqvi to open a second account and bring its balance up to $25,000. Naqvi gave Khan power of attorney over that money, and Khan made trades on Naqvi's behalf via a dealer. But, according to the document, the losses grew even larger, reaching more than $6,000 in one day.

Naqvi pulled the plug a few weeks later, and is suing Khan for $36,000 in losses plus other costs.

Khan's statement of defence says that he never guaranteed returns and repeatedly warned Naqvi about trading risks. The filing also states that Naqvi repeatedly transferred funds to the first account without informing Khan, and lost the money himself. As for the second account, the statement simply says, "Mr. Naqvi never suffered [a]loss due to the actions of the defendants."

In an interview, Khan agrees that an industry rule of thumb is probably true: Nine out of 10 individuals who attempt online forex trading lose money. But he also says that he's taught hundreds of students, and the vast majority of them make money. Yes, he admits, some lose, but mostly because "they become fearful, they become greedy," or they don't follow his lessons properly.

Some of Khan's strategies don't look all that complicated or unorthodox. For instance, he urges students to ride current market trends—an old trading mantra that dates back decades, if not centuries. "If the bull is in command, you follow it. If the bear is in command, you follow it," he says. If a currency is rising, particularly on increasing volume, you keep buying. Of course, that's the opposite of what a long-term investor might do.

After one of Khan's Saturday seminars in early October, Rafia Soomro, a 21-year-old University of Toronto economics and political science student, explained to a reporter how she learned the risks of not following Khan's advice to the letter on her first real trade the day before. The euro was trading above its 15-minute mov-

ing average relative to the U.S. dollar—the so-called 15-minute trend line. She figured the euro had to come down, so she placed a short-sell order with a forex dealer. But it kept rising, and Soomro soon hit the stop-loss threshold of $100 she had set in her order, forcing her to close her short position by buying euros. "I bailed at a $150 loss," she said. She is a content customer of Khan's, as is her father.

At his weekly seminars and on Money Plus's website, Khan says he is not a registered investment adviser. Nor does he sell forex investments himself—he directs clients to dealers that do. In return, Khan says, those dealers give him a small break on his own trading costs. He also specifically warns about the dangers of CFDs. "Trading foreign exchange and Contracts for Difference on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you," says a disclaimer on Money Plus's website.

For all that, Naqvi's lawsuit shows how oversight of a particular type of transaction can fall through the regulatory cracks. Naqvi says he spoke to an investigator at the OSC about his case, but hasn't heard back from him. A call to the investigator and the OSC's public affairs department produces the standard response: "The OSC does not generally comment on the existence, status or nature of any complaint or investigation."

If Naqvi wants to pursue the matter with U.S. regulators, it's difficult to guess where he should start, or how much of a priority a Canadian complaint would be.

Forex day-trading: You might want to think twice about trying it at home.