A Risky Money Game

Previously, small investors' use of risky techniques like these was confined to stock-trading accounts. There, investors are required to put up $1 with a broker for each $2 of trading, in accordance with Securities and Exchange Commission rules. In other words -- a ratio of 2-to-1. Currency trading lies outside the SEC's purview.

This is one reason, some industry executives say, the average life of an online currency-brokerage account is just 45 days. Even the big players have trouble with leverage: In recent months, disastrous trades made with borrowed money led to enormous losses at the giant hedge fund Amaranth Advisors.

The volatility of the trading world resonates with Tom Connelly, a skin-cancer surgeon in Stuart, Fla., who has been trading currencies for about two years. Within a few weeks of when he started trading in 2004, he says his brokerage firm forced him to undo all of his bets when the currency markets moved in the opposite direction. He lost more than $15,000.

Still, he says, he has kept at it and become successful, saying that he feels the playing field is relatively level. "I'm in no worse of a position than anyone else in the world when I trade currencies."

Others say currency-trading is simply a bad idea to begin with for small investors. David Darst, chief investment strategist at Morgan Stanley's Global Wealth Management Group, recommends individuals bet on currencies only when two governments -- say, Japan and the U.S. -- both publicly announce the intended direction of their currencies relative to each other. In the case of Japan and the U.S., this has happened only twice in the past 30 years, he says. "Otherwise it's just too crazy."

If investors are truly bent on playing currencies, Mr. Darst says they should consider simply buying exchange-traded funds that track currency moves.

These days, to attract customers in the increasingly competitive market, online currency brokerages advertise leverage of 200-to-1 and 100-to-1 on accounts as small as $250, while FX Solutions LLC and GTF Forex Trading offer up to 400-to-1. By contrast, the leverage at hedge-fund Amaranth was less than 5-to-1 on its ultimately failed bets on natural gas.

It works like this: A ratio of 400-to-1 means an investor can put up $2,500 -- known as margin -- to place a $1 million bet that, say, the dollar will strengthen against the yen.

The difference between the margin and the value of the overall bet is the leverage. Profits can be hefty, but if such trades go wrong, an investor can quickly lose a lot of money. If the dollar instead weakens (as it did this week after the U.S. central bank kept short-term interest rates unchanged) then that $1 million bet loses $100 for every 0.01 percentage point that the dollar falls against the yen.

On Thursday alone, the dollar fell 0.7% against the yen, for a potential loss of $7,000. Since most online brokerages have electronic systems that track customers' bets, and shut them down once losses reach or approach the margin, this customer would have lost the $2,500 margin, but no more.

Due to this protection, investors think it is a worthwhile risk because they can still make far more than they stand to lose. Industry executives say about 10% to 15% of brokerage accounts are profitable.

The industry's self-regulatory group, the National Futures Association, recommends 100-to-1 margin for trading major currencies like the euro and the yen and 25-to-1 margin for less widely traded denominations, says Daniel J. Roth, chief executive of the NFA. The NFA rules allow firms to offer higher ratios, as long as the risks are prominently disclosed.

More than 25,000 investors have been defrauded in currency-enforcement cases pursued by the federal Commodity Futures Trading Commission since Congress in late 2000 gave the regulator authority over a small slice of currency trading in the U.S. In those cases, federal courts have ordered brokerages to pay a total of $471.5 million in restitution and penalties, according to CFTC data.

Some brokers say regulators have a role in improving the market's bad reputation. "More regulation will increase customer confidence in the markets," said an FX Solutions spokeswoman.

The brokerages defend the use of leverage, saying that it lets traders risk only tiny amounts of money while learning the system, without losing their shirts, at least in most cases. "Unlike stocks, you're rarely going to see a 50% swing in a currency over a short period of time," says Patrick Pinschmidt, a brokerage analyst at Merrill Lynch & Co. in New York.

Yet leverage has a point of diminishing returns, says Todd Crosland, chief executive officer of Interbank FX. By analyzing trends among Interbank's some 10,000 accounts, he noticed "the good money managers who trade with us and make money in this market just use a little bit of leverage, like 5-to-1," he says.

Write to Karen Richardson at karen.richardson@awsj.com¹ and Peter A. McKay at peter.mckay@wsj.com²