Find your feet in foreign exchange and commodities

Joe McGrath helps you take the plunge from spread betting into deeper waters

As the spread betting market has grown, so too has the number of day traders trying their hand at more sophisticated markets for the first time. So it is, perhaps, unsurprising that people are eventually gaining the confidence to try the more complicated markets such as commodities and foreign exchange (forex) too.

Last week, dedicated forex broker FX Pro released its business volumes to market, noting that 2010 was another record year in business development terms for its platform.

The company confirmed that volumes had grown 20 per cent from $440bn (£276bn) in 2009 to more than $530bn year on year as more and more retail traders realised the potential in the sector.

Providers in these markets look set to increase their volumes still further this year as day traders wake up to iPhone, Android and Blackberry applications that make trading on the move easier. However, it is only recently that providers have started to spend more on customer education. This has happened in response to growing market competition and widespread recognition that customer acquisition and retention policies need to change.

Michael Hewson, market analyst at CMC Markets, explains that spread betting companies in the past have been poor at educating customers, particularly in markets that are perceived to be more complicated.

He says: "Spread betting as a rule has had a very high churn rate and clients have moved from one provider to another. There was no brand loyalty and, as soon as they were let down by one, they moved on to the next. Education was a big part of that. We are looking to teach people by not just introducing them to the market but placing importance on longevity. It makes sense – if we can keep a client on board for longer, they will trade more. I have never understood the concept of the providers who take the money and are not concerned when investors lose it."

Beyond the comfort zone

When the UK spread betting market was in its infancy, Hewson says there was snobbery around trading and this spilt over into education. He explains: "When I first started out in trading, I found it very difficult. A lot of people try to make out it is more difficult than it actually is. I have always been passionate about education." Hewson recommends that novice investors stick to small trades in the mainstream markets to build up their confidence before moving into more complex markets: "You must choose your markets carefully when you first start out. Foreign exchange is not for novices and you have to scale up your trading methods. You must always know what your worst-case scenario is."

However, for those people who are ready to take the next step, there is plenty of information across the internet about the current trends in each individual sector to help you get started with your research. When most people first start trading using contracts for difference (CFDs) or spread betting, they normally start with equities, because they are already familiar with dealing with an index like the FTSE 100 or with individual companies, such as Barclays or BP.

However, David Jones, chief market strategist at IG Group, says that forex has been the market that people have been keenest to move into over the past year, with big month-on-month increases linked to major news events.

"Volatility and the opportunities that it offers have been the big draw for most people. The past few months haven't been disappointing, with the Irish debt crisis ensuring there was seldom a dull day for many currencies.

"The euro was something of a one-way bet back in November, dropping 1,300 points in the month. It has come back into focus again over the past week, as traders seem to be taking the view that the worst-case scenario has been avoided. The euro is likely to remain a volatile currency and still be heavily traded for a few months to come as the sovereign debt crisis rolls on."

It is not just the euro that is experiencing an increase in trading patterns. Sterling is also popular at the moment, according to statistics from both IG Group and CMC Markets, and most companies have seen some steady buying of the currency since it fell to a three-month low in December.

With inflation running high and pressure continuing to build on the Bank of England to raise rates, traders are likely to be keeping a close watch on this currency. Daniel Harris, head of dealing at H20 Markets, expects sterling to fall back. "The Bank of England is less likely to raise interest rates so soon as it needs to see the domestic economy is healthy enough for it to do so. There are a range of factors that can cause slack in the economy – prolonged high unemployment, a slower pace of wage increases with inflation, rising input cost for UK manufacturers and high spare capacity margins."

Meanwhile, Jones believes that the Australian dollar is also likely to see considerable interest, because of its high correlations with commodity prices. "It had a great run-up last year from the summer of around 2,000 points – a rise of 25 per cent against the US dollar by the end of the year. However, it has been knocked back recently as traders weigh up the economic impact of the floods," he says.

"That said, in recent days there seems to be a feeling that this is just a buying opportunity before the next spurt higher against the US dollar. Commodity prices, China and mining activity are all going to have an impact on the Australian dollar and these are big themes for the economic recovery and likely to be popular this year."

Although forex trading is gaining in popularity, it is not the only sector. Precious metals have seen a rise in activity by retail traders, which has also driven by news events.

Hewson explains: "Gold, silver, oil and copper are the ones that have been in the news. We have also seen some interest in soft commodities, even though liquidity can be difficult. Also, the spreads are quite wide."

However, Ed Ennis, head of commodities research at Rothschild Private Bank, says traders may have been surprised with the relatively poor performance of gold since the beginning of the year. He says: "Gold prices have struggled to gain new ground, falling back by 3.8 per cent from their year-end level. This happened in an environment of US dollar strength and encouraging US macro data."

However, Harris believes that gold and silver prices will climb again through the year. He says: "Macroeconomic factors raising metal prices from previously high levels are likely to remain in place as ongoing drivers this year. These factors include the rising inflation and currency appreciation of China, the second largest gold consumer and robust demand for bullion as a hedge."

Harris argues that there may also be opportunities in other areas. He says: "The rally in commodity prices, particularly in copper and iron ore, has been driven by a combination of anaemic supply and robust demand from emerging markets, particularly China.

"Speculation that China may raise interest rates to address rising inflation have made commodity miners vulnerable to a consequential fall in metal prices. However, China seems to favour administrative tools rather than interest rate rises.

"Such measures include a rise in the reserve requirement ratio, subsidies for consumers and a crackdown on hoarding agricultural commodities. These policies are less likely to constrain the nation's appetite for investment, therefore putting less pressure on commodity prices this year."

Understand this

These market analyses illustrate the level of understanding that commodity and forex traders need before placing their trades and further underline the points that novice investors should steer clear of.

However, there is no question that spread betting providers have opened up access to these markets, which traditionally were closed to the retail community because of the large cost barriers to entry. Despite this, novice traders can all too easily be swept up in the excitement of making gains, only to lose them very soon after.

Hewson explains: "You see both sides. You remember clients who have a hot streak. I remember one client who made six-figure sums very quickly and then just as quickly gave them back again. You are going to have bad trades, but you need to acknowledge that you will lose money from time to time. You must have an exit strategy."

Hewson recommends using your own money to build confidence in new markets instead of practice accounts, however. He says that demonstration accounts may be useful for starting out, but stresses that investor behaviour can be very different when they are trading with their own money. "Using a demo account is completely different to using your own money. Your mindset is go long, go short and you don't care if it goes up or down. You tend to call right, because you are in a relaxed frame of mind," says Hewson.

"When it is your wallet, you can't work out why you are losing money. It is because you are a lot more cautious. If you employ trend lines, start small and understand why markets trend and range, you will do better. Employ the use of risk management tools and know what is a realistic stop loss. It can also help to get training from people who are well regarded [in the industry]."

Researching the available training in new markets can be just as beneficial as researching the providers, says Hewson. "This is a big concern. All spread betting companies offer training and all the books talk about risk/reward strategies, but if you have a small capital amount, these may not work," he explains. "You have to use your discretion. If you use a financial adviser, you research the available advisers, so why should trading be any different?"

Specialist social networks, made available by providers such as eToro, have become popular more recently. With these, new traders are able to ask questions in a forum environment and network with other traders to pool knowledge and share their experiences.

Jonathan Asfia, chief executive officer of eToro, says traders believe that social networking leads to greater trading volumes. "According to Datamonitor, 50 per cent of consumers are using online tools to make their financial decisions today," he says. "Through the use of social media a novice trader [is able to] interact directly with other more experienced traders, to learn from their advice, observe and copy their trading choices [as well as] to gather useful hints and tips from other similar traders on the network."

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