Today I want to address a few misconceptions most of us have when starting trading and by the same token provide you with some insights and some tips to help with in your journey. The focus of this article is FX (Forex) Trading but also trading in general.
Volume & Liquidity
You hear and read that the Currency market has a daily turnover of USD 5.3 Trillions a day. Good news for FX Traders we are told. Is that so? So, are traders buying and selling USD 5 Trillions a day? are these all speculators? The breakdown of the 5.3 Trillion FX market — according to the 2013 BIS survey — is as follows:
- Spot: 2.000 billion,
- Forwards: 700 billion,
- FX swaps: 2.200 billion,
- Currency Swaps: 54 billion,
- FX options: 300 billion
Does a high currency turnover — i.e. liquidity — creates opportunity?
When you buy or sell a currency pair with your broker you are doing a spot transaction. Do you know who are the big buyers? why is this important again? When you buy 100k and sell 100k in the next 10 minutes: this is called turnover. But are you moving the markets doing so? Not really. If you buy every 2 hours i.e. open positions and are piling on buying and buying and adding positions… Well now we are talking! Especially when you are buying 200 million every 2 hours. You are opening a position without subsequently closing it.
By the way, about the speculators’ market share: It’s very difficult to give you an accurate estimate but it seems like 60% of the FX trading activity is non-profit-motivated and that the other 40% are most likely speculators.
Does liquidity creates opportunity then? Well, from a retail trader’s point of view, more no then yes. Why? If a market is less liquid, it has higher probability to move violently. You will profit more in less time — if you are right (!) — about the upcoming move of a less liquid or a illiquid security. Example stocks or penny stocks.
FX is not the asset class that creates opportunity in that sense. Remember that the FX market is about 40-timex larger than the world’s largest stock market although volume is over reported due to inter-dealer transactions and the high currency turnover related to FX Swaps. The leverage you can use in this liquid market can help you profit more from certain setups… but with leverage comes great responsibility. To quote Howard Seidler. “You cannot win if you are trading at a leverage size that makes you fearful of the market.”
I read sometimes people writing something like: “The broker / market maker is always on the other side of my trade! Only trade with an ECN!”
In the old days it’s true that brokers tended to be the ones on the other side of your trades. This has changed a lot. So is ECN (Electronic Communication Network) the solution? ECN simply means “part of a network” it does not tell you how trades i.e. orders are being processed! Whatever you are being told, your broker always acts as a market maker… in the sense that he stands between you and the market. There is a good reason for that. When you buy or sell your currencies you might do so in trades of 1’000 units, 10’000 units or maybe 100’000 or 500’000 units. The orders need to be matched.
You are buying? <-> Who’s selling?
You are selling? <-> Who is buying?
But out there in the market, typical orders are more 10 million, 50 million, 100 million or 200 million units not 1’000 or 10’000 units. Do you see the order size mismatch? Your broker has to match the different order sizes, if he can’t perhaps he will take the opposite side but not necessarily for the whole size of the trade. The best brokers for instance can match orders between their own clients.
Brokers operate in all flavors. There are the ones simply processing your order i.e. sending your order to the market / to the liquidity providers and that’s it… nothing more. Which makes your broker actually a dealer. Then there is the broker that passes on your trade for processing but notices that you keep being on the wrong side of the trade… so he goes long when you go short and vice versa. Get it? He’s not on the other side of the trade: He trades “his account” and his strategy is: “I’ll do the opposite of what my client is doing”. The broker chooses to trade against you in as doing the opposite of what you with his trading account.
By the way a broker can also adapt this strategy. Say 20% of his clients are profitable. No need to trade against them. But the remaining 80% constantly loose money. This is more interesting from the broker’s viewpoint. Brokers earn the spread in any case and in this setup he generates income opening positions on his trading account doing the opposite of what the 80% of his clients who are loosing money are doing.
“But how does my broker know if I will be profitable or not from the start?”, you may ask. Well he (his software) only needs to check the first few trades for hints such as: the client uses full leverage, risks crazy amounts like 15% of his account for each trade and on top of that uses no stop loss. His software might even start with your account size as a first hint. If you are putting 100 EUR/USD/GBP/AUD in your account… well you just need one more ingredient like max leverage per trade and the alarm bells are ringing.
So is that bad that my broker operates like this. Well.. if you don’t experience any slippage… actually no, there is no problem. Another advantage could be that if your broker offers you fixed spreads you might benefit from if you trade the news since live spread can wild during major news announcements.
Another statement I hear often: “Banks are there to get me! I get stopped out and the the price always reverses?!”
Sorry, it doesn’t work like that. So there are many things to elaborate here but there’s something fundamental you need to keep in mind. Remember how we talked at the beginning of this article about the breakdown of the FX market? Well it’s important to understand the impact of options. But first — so that there is no misunderstanding — when you have placed a stop loss order for your 10´000 units trade… this doesn’t interests the banks. A big bank actually makes the market they handle orders of 50 to 500 millions dollars… they are the market (maker). When you trade with your broker the biggest problem is probably slippage. Even in standard market conditions slippage can be an issue. Here’s an example: The FX market doesn’t have a constant or uniform liquidity depth profile. This simply means that liquidity is more ample at certain times than at others.
>Example: when London trades, there’s more liquidity available than in the Asian session. >Another example: with High Frequency Trading (HFT) getting bigger and bigger — estimation of around 70% of the equity market and 30% of the Forex market (EBS estimate) — the liquidity profile has changed / evolved. There is a clear pattern of liquidity simply evaporating before major news releases which translates into bigger moves simply because due to thin liquidity (just before the news are released) it takes less money to move the market which can therefore cause slippage. Algos go nuts just before the release in some cases and then really go nuts when news hit the tape. And then there is also the liquidity opportunity of the moment: Well let say you hold a massive position in a security that you either want to lighten up or get rid of. What are you going to do? When is the best moment you want to act? Well, after major news are released. You don’t care if the news is good or bad.. you don’t have any directional bias… all you want to do is use this moment because there is now deeper liquidity to get rid / lighten you position for as cheap as possible.
But back to my initial question about banks out there to get you. There are some market dynamics you need to understand before jumping to that claim. The word is risk management. A very important dynamic related to risk management is how options affect the spot market… or why stop loss levels seem to act like magnets.
Every day options expire. A vanilla option is the “standard” option where until X o’clock, the option will remain active — By the way we are talking here about options with a value of 500 mln dollars or so. Then you have your barrier option. In the case of the barrier option: once the barrier is breach it’s game over. So sometimes levels will be actively defended i.e if the EUR/USD is below 1.3099 or above 1.3100 at time X of expiry → it changes everything. Traders can defend that level by buying or selling spot but remember there is also hedging taking place. Without boring you with deltas, gammas and other greeks…. the point is that if you have such a sizable option you are most likely hedging it. How do you hedge? well here’s the problem.
The more the price moves against you the more you need to hedge… thus creating a kind of a feedback loop: You buy spot to hedge your position but you are also moving the market a bit in the direction you don’t want the price to move by making that spot hedge.
You may now ask. So how do I choose my broker with all that info?
The word is execution. It´s all about quality execution. But what about regulation? Sure but remember that regulation doesn’t safeguard your money from vaporizing. Don’t get me wrong. The benefits of a regulated company are undeniable but there are plenty of examples where regulation didn’t help the fact that funds were no paid out on time or even did partially vanished. Plus not all regulation is equal. Meaning being regulated in the UK, US, New Zealand, Australia, Switzerland or for example Malta can make a big difference… generally speaking but also depending what asset class you trade on what venue. A healthy, smart and forward thinking corporate culture can be more valuable than any regulation can be. I can tell you that we are at brokerfor.me on top of the news and keep tabs on the industry and brokers. Our database is updated daily with industry news and warnings from regulatory agencies. On top of that we discuss with the industry with colleagues. You’d be surprised what issues and problems we get wind of. Small shops, big brands even, from deplorable execution to clients not being able the access their funds. A good institution is also one that values customer relationship and offers them decent and knowledgable support. Experienced traders might only be interested in the execution or broadly speaking the technology backing up broker when making their decisions.
A novice and intermediate trader should not underestimate solid support. Which leads to the next question.
What about the services offering?
If you are starting out or already made your first steps, a broker can offer you added services. Many brokers started offering educational services which is a somewhat positive development. Others started to offer services such a trading signals. Which also brings us to the related subject of conflict of interest.
Conflict of interest? Quiet a broad subject but I’ll discuss it in conjecture with broker services. The broker offers you a tool: access to the markets. He is not the only one. He wants your business since he gets a commission for each transaction he facilitates. His incentive is therefor to offer you better services at a better price than his competitors. Nowadays the cost of trading is down to nothing. So he will in some cases increase his revenue by trading against you or will ask a markup for the service he offers. A professional trader has different requirements. Some only trade an asset class others trade across the entire spectrum of securities. They know exactly want they want.
In the retail business one could argue that brokers tend to offer new “shiny things” to attract new traders. By that I mean temptation and interest are created… but not necessarily value. Understand that this is a cut throat business and be aware how much you — the client — has also immensely benefited from it. The margins are thin, really thin… spreads are down to nothing. If you create “new shiny things” you will attract new clients but you will not keep them… because in the end those clients still need to know how to trade to make a buck. Creating value is what matters. When a broker offers you signals — for free — you should pause and think. First it´s for free. Trading is work. I mean real work. Treat it like a hobby or something casual and you will never make money. Strike that. You will loose money for sure. Let’s not sugarcoat it. “New shiny things” might make it look more attractive… but the core of trading is trading: Knowing the market, dealing with risk, knowing yourself. I’m not saying free equals bad. I’m telling you to pause and think. I know brokers who want to make sure the client trades day in and day out and make the commissions without any regard for risk and P&L. I know brokers that offer excellent education and work very hard to add value for theirs clients. What I want to convey to you is simple: the core business of the broker is being a broker. Nothing else. Some brokers actually add amazing value. But you need to know what you want and simply remember that nothing is ever for free. Do you want to trade for fun which equates more to gambling? Do you want to grow your account? Do you have professional aspirations?
If you answered the last two questions with yes, then you need to take this seriously and you get the right tools.
The tools
If you are starting out you need to learn. Plain and simple. There are books of course. Many bad ones and of course good and excellent ones.
There’s mentoring. It seems the web is full of market and forex trading wizards. I’ll leave it to that.There are seminars. I don’t have much to say. I’m afraid I met so many charlatans that I’m too bias to give you a fair answer. There are some excellent mentors out there but you’ll need a bit of experience to know what to look for and how to spot a quality service.
There’s learning by doing. Nothing bad to say there, I encourage you to do so: learn, feel pain, learn, feel more pain, learn, get smart(er). It’s all about that. The journey will be very rewarding. You will learn a lot about yourself in a short time. This by the way how we teach over at the Traders’ Lounge. We provide a framework that you can use as such or adapt it to your trading style, to who you are. The person you are, the experiences that shaped you, that made who you are and who you are trying / working to be… all are reflected in the way you trade. There are many trader “profiles” / types. The conservative, the cowboy / risk takers, the investor, the scalper, etc… You will realize one day, looking back, that it is not primarily the skill sets you acquired over time that made you a good trader but more how good you got to know yourself i.e your psychological skills.
There are no shortcuts.. no magic pills, no magic combination of indicators out there. There is only you. Your skills and what you know about yourself.
So back to the tools. Broker + Skills + You. The choice of the right broker is important: Decent execution is a minimum, good services a bonus. When you will evolve as a trader you will have identified your trading style and learned more about yourself. Therefore you might want or need to switch to another broker. Nothing wrong with that.
If you are just starting out there’s definitely a big advantage to opt for mentoring. But gather experience first.. even with a demo account. I mean gather some real experience: make notes, evaluate your trades, dissect your mistakes, formulate your trading strategy. Take this test seriously. The amount you see on your demo account.. should match what you intend to invest with your real account. Every time you are about to make trade on this demo account you have to have a checklist you go through first. Why I am doing this trade? What is your rational? What’s the logic applied? Am I just influenced by some news I read or am I actually executing a strategy?
“And the most important thing is: remember, this the money I worked hard for, you treat it with immense respect. I understand I might risk X amount of pips on that trade which equates to X percent of my account, yet I make this trade because I have carefully thought it through. Never forget that aspect: Your account is extremely valuable but you understand that you need to risk a small fraction of it to trade and make it grow. Because you need to risk a small fraction of it you have planned this trade carefully.”
If this is your mindset with your demo account, you will have an immense advantage when trading your real account. Actually you know what, write down those lats lines above your Trade Checklist. I want you to read that and think of that before each trade you make.
Ok. I went a bit of tracks here but I felt writing that because if you are reading this you might be starting out and why not write something of practical use.
So I was talking about services you can use when starting out. Signals! Signals and in some cases market analysis can also give you a head start. Just don’t forget to do the work on your side. Getting results gives you motivation but signals have a limited learning affect: you tend to be overconfident since it’s not your trade and therefore you are not improving the important skill of making your own trade and applying your risk management rule on your own trades.
It’s important to understand what you want in the end. If you intend to trade long term, mentoring is what brings you more value. Don’t forget to gather practical experience first. If time is an issue then signals can be a good comprise.
Food for thought
I’ll finish this article with a question that has many implications but that will require knowledge on your side to be able to answer it. Keep it in mind and think about it now and then later on as you evolve as a trader. We talked about the importance of the choice of the right broker, the quality of trade execution and the safety of funds. There is one more important aspect: The choice of trading vehicles i.e are you going to trade Forex through spot, futures, CFDs, Binaries, ETPs, Options, etc… Let’s make a quick test. Take a piece of paper or open a word document and try to answers these questions:
- What is the difference — Risk wise — between trading the EUR/USD over spot vs CFD? why?
- What trading style is appropriate when trading binaries? why?
- What’s the difference between order routing in the equity markets vs forex markets?
- Which one these vehicles — spot, futures, CFDs, Binaries, Options — is/are a derivative of a derivative?
- Which one these vehicles — spot, futures, CFDs, Binaries, Options — are traded in a centralized manner?
- Are you able to draw the EURUSD monthly or daily chart from memory?
- Can you do the same with the dollar index? or any other security you follow?
Ok. I must concede the last two questions are only remotely related to the question of the choice of trading vehicles but more questions to ask yourself to see how good of a chartist and/or price action observer your are.
I want to thank you for taking the time to read this entire article. I hope it has been of value to you and more importantly I hope that it gave you something to think about.
If you want to get in touch with me, simply drop me an email at contact@brokerfor.me or contact@traders-lounge.com or get in touch through LinkedIn or Google+.
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