For the last few years, South Africans have been increasingly trading in foreign exchange (FX or Forex), and this demand is expected to increase further in coming years, as there is a growing interest among local investors who see it as an alternate asset class.
SA’s FX volume, which includes all instruments like Spot, Futures, Options, FX swaps and contract for difference (CFDs), was $20.3 billion per day in 2019, of which spot FX comprised 11% of the total volume.
Trading on ZAR in the South African FX Market also had a turnover of around US$20.6 billion per year in 2016.
Moreover, as regulations in European markets have tightened in recent times, international brokers are showing a great interest in South Africa and Africa as a whole, since local regulations in SA are more broker-friendly than in Europe, allowing them take in clients from anywhere in Africa.
We are also seeing rise in popularity of FX among many new small investors who are inspired by the stories of successful traders from South Africa.
This has led to an increase in overall local demand for FX in SA.
How Forex and CFDs work
The Forex market, also known as foreign exchange market or currency market, works on the principle of difference of prices between currencies in a currency pair, resulting in a trade on it between two parties for various reasons.
There are various players in the Forex market for different reasons. Banks take part to help with the global trade and providing liquidity in the market for the businesses, and institutional investors and retail traders speculate on the currency market movements to profit from it. This speculation is called Forex trading.
Speculating on currencies is a major part of the Forex market, in which retail Forex traders make up for 4% of the global share in terms of total volume.
In Forex trading, buyers expect one currency to rise in value against the other, while the sellers expect an opposite movement. The usefulness of this movement also comes into play when the buyer or seller has to deliver a payment in another currency, and needs to manage against the risk of price movements, due to currency value change in the case of exporters and importers.
Forex trading investments are generally based on these future market movements, and gain on the FX rate of the currency pair.
Let’s take an example of USD/ZAR.
The USD, being a stronger currency, means you would need an amount of investment in ZAR equal to the FX rate of USD/ZAR to buy a single unit of USD. If the investor is expecting the USD to get stronger in the future, selling the held units of USD would give a higher amount of ZAR than what was invested, hence earning a profit. To trade Forex, investors can use various instruments on FX such as Spot FX, Futures and Options through a Forex broker.
There are also other instruments available with brokers like CFDs.
A CFD is a contract for difference instrument, which is an agreement between two parties on an underlying asset for the difference in the value of the underlying asset, from the time the agreement starts until it closes. The underlying asset can be an equity, commodity or index that is settled by cash on expiry.
For example, if ABC Ltd has a share price of R100 and an investor enters into a CFD agreement with the broker for 100 shares, the total investment would be 10,000.
Unlike basic equity trading, with margin trading in CFDs, the only cash required to enter the trade here would be the initial margin amount of some percentage fixed by the brokerage. In other words, R500 would be 5%.
With the share price moving to R101 at the time of expiry of CFD, the trader makes a profit of R100 which is a 20% return on investment, way larger than what the trader would get otherwise. But so is the risk if you are on the losing side.
Can investors get return with Forex trading?
There are a few factors to be considered.
Traders often use margin and leverage as two main tools to try to make higher profits from the market. With lesser restrictions than compared to other trading instruments, Forex brokers offer very high leverage – as high as 1:1000.
Though high leverage allows investors to enter a trade with minimum investment, it also carry higher risks in case of any undesired currency movement.
As an example, if an investor opts for a high leverage of 1:500 to enter a USD/ZAR trade with a buy position of R100,000, the margin required or initial investment would be only a fraction of the position which is set by the brokerage based on the leverage selected by the trader, which would be R200 in this case.
If the position strengthens to R101,000 over a trade period, the upward movement of R1,000 in pair would have a return of 500%. In other words, R1,000 on a R200 investment as compared to trading directly without leverage with initial investment of R100,000 where a trader will only get 1% in profits.
However, if the currency moves lower against your initial position size of R100,000 by R1,000, then the losses too are 500%, in the case of leveraged trading.
Investors also have to understand that the movements in currency markets are very volatile, and are driven by factors related to GDP and economy, the political situation of the country, the trade movement across the globe, and speculation by retail and institutional investors. It is also common for human error to come into play while trading.
The volatile movements of a currency pair can either give you high profits, or make you lose a lot if the above factors are not factored in.
A prime example of investors losing money on wild movements in market is the CHF crisis.
The Swiss Franc (CHF) was considered a safe haven for investors. But the Swiss National Bank decided to end the cap on the CHF price and let it float, which made the CHF value against many major currencies. This resulted in many investors and brokers declaring insolvency due to large losses on their open CHF trades.
Similarly, in the case of the ZAR and USD, if there are any changes in the economic policy of South Africa or any international incident related to trade or political turmoil involving USD, it will affect the demand and supply of the USD/ZAR pair, and hence affect the investor’s position.
Overall, investors can get a good return on investment, provided the expectations are reassessed, as there is ample opportunity in the local and global financial markets for the South African investors who take the right approach.
Factors such as asset allocation, diversification, selection of the right currency pair, proper risk management methods and understanding the product before investing could lead to a good return over time.
To safeguard one’s investment against the volatility of the Forex market and minimising the risk of bad decisions, it is very important to trade in a regulated trading environment.
Investors should opt for a regulated broker which follows the regulations laid down to safeguard the trading environment.
The Financial Sector Conduct Authority (FSCA) in South Africa provides such an environment, and its regulated brokers are the safest brokers to invest with.
The regulated Forex brokers in South Africa must meet capital requirements, have a local office and local director in South Africa, meet professional indemnity insurance requirements, provide grievance redressal, and follow all regulations as laid down by FSCA.
Leverage capping is another method which can help in creating safe trading environment, as it caps the amount of loss an investor can incur. A leverage cap of 1:30 has been suggested by ESMA, ASIC, FCA and other regulatory bodies across the globe, after considering the risks involved in the leveraged margin trading.
An investor must also understand that one needs to educate oneself on market nuances and economic uncertainties, to be sure of the amount to be invested and the instrument in which the investment is to be done.
Hence investor education also becomes an important aspect, with many books and websites available on the subject.
Safer alternate instruments
Diversification is the key to a good investment portfolio.
Since Forex market is risky for most investors, there are other investment options in South Africa which can also be invested into, like mutual funds, government bonds and the stocks listed on JSE, which are less risky options.
There are a few mutual fund companies in SA which offer safer investment plans with many options, such as unit trust investments, wealth advice, news and insight.
Government bonds are considered the safest debt instruments, are backed by the State, and are generally based on fixed and floating interest rates.
The JSE has one of the most liquid bond markets in Africa and is considered less risky. It is the largest stock exchange in Africa, and investing in stocks can get you long term good returns, if as an investor you can predict the market movements well.