Pricing in the FX Marketplace
By Chris Mark on The Capital
Having experienced almost everything (positive and negative) you can experience as a trader, I can say with complete conviction that quality analysis of a market is not what it appears to be. My turning point was when I realized that math formulas, algorithms, technicals, and calculations were absolutely worthless. They mean absolutely nothing to the market structure and how it works. I realized that if I base any kind of market interaction on any of these, I will continue losing.
Most successful traders will tell you that by far the most critical part of their success has been a high level of personal understanding. Successful traders know why they do what they do the way they do it. Equally important is a solid understanding of the bedrock underlying structure of the market they trade. They can tell you exactly what is creating price action and this is often something that has very little to do with market fundamentals or market technicals; it has to do with psychology.
There is a fundamental underlying structure to any market that is dynamic; it changes from moment to moment. Developing an understanding of those changes and applying that knowledge consistently is what will make your trading really reach its full potential.
Price displacement in the FX market is an artifact of market mechanics that have nothing to do with determining fundamental value. The inefficiency of over-shooting is disruptive, increases risk, and drives uncertainty.
The potential profitability of currency trading is a given. The trader who takes advantage of just a 0.2% price change once a day can make an annual profit of 40%. Succeed at trading a change as small as .05% 10 times a day and your annual profit is 100%. Betting on price moves is one thing, but where, exactly, is value? Price is always specific: it enables or disables a transaction, it sets a new benchmark for the pricing of all other positions in the market and sudden inexplicable price changes, accelerates cascading trends that destroy or dilute value.
Let’s say that in one year the price of USD goes up or down by 15%, this gives us a framework to speak of its “value.” But the more closely you analyze price changes, the greater interim displacement you find. If USD goes up or down by 0.01% in one second — which can happen several times every week — the annualized price change is 315,360%. Where, then, is the equilibrium value of the dollar? In FX there is no fixed frame of reference, and so traders get by with bidding and asking more than a rational assessment of value would dictate. They over-shoot. Over-shooting is a fact of life in FX, but it is hardly an efficient way to determine price.
So, what really drives currency pricing? And how do we reduce the uncertainty of that process and retrieve value?
The valuation of currencies is a mysterious business. But for the traders who come to the market with distinctly different expectations and time horizons, valuation is beside the point. In the fastest-moving, most active market in the world, the name of the game is price. Something different, somehow.
With only a tentative connection to fundamental value, currency prices move quickly and for the most opaque reasons. Yet, we rely on the market to exercise some degree of “efficiency” — to perpetuate trading, of course, but ultimately to provide a rational basis for the global investment and allocation of capital.
The mechanics of any market drives price evolution, but in FX — compared to equity and fixed-income markets, where institutional constraints continue to drive a long-only bias — we find a unique kind of uncertainty. The mechanics of FX makes more obvious sudden moments of disequilibrium that result in the unwilling reversal of positions (for example, when pricing moves against a trader who is long, gets a margin call or hits his personal stop-loss, and is forced to close out his position). As buyers and sellers move out of proportion, pricing can quickly jump to new extremes.
Currency investors range in a steep hierarchy from central bankers and large institutional traders to professional traders and CFOs managing cross-border capital exposures, to importers and exporters, to intra-day speculators. Across this hierarchy of diverse agents, only a few things are certain: they will take positions of dramatically different sizes, for periods ranging from less than a minute to two years, with totally different perceptions of risk and reward. More on this here: “Money Flows in the Intertwined Markets”.
Over longer periods of time, price changes are flatter and show fewer trends than in short-term intervals. The higher the resolution and the shorter the interval, the greater the number of relevant price changes. Thus, long- and short-term traders have different trading opportunities: the shorter the trading horizon, the greater the opportunity set.
Different players in the market are subject to different imperatives: some are voluntary…the trader can wait for an acceptable price; some are opportunistic…the trader is in a big hurry to profit from a micro-trend. But the most damaging imperatives are involuntary: traders who get a margin call or hit predefined limits, or Market Makers who hit hard limits and have to move prices in order to comply with their exposure controls. It is this slight difference in pressure that makes prices move; because only one side of the market is in a state where they must enter an order. Therefore, a large amount of price action represents people taking losses; whether they want to or not. Some of the order flow moment to moment represents losing trades being liquidated.
All of these events are quite real, and each contributes to pricing uncertainty. In the most dramatic cases, this uncertainty can tip the scales and move pricing action into a new orbit, creating a completely different price history. But in the daily moments of imbalance, we see opportunity. Traders who have stayed on the sidelines can trade against the flow, taking the informed risk that they will be rewarded for providing indispensable liquidity. Because over-shooting exists, “flow traders” can make money. Read “The Tape Reader — Not an Average Trader”.
In FX you have a wide range of players…with a correspondingly wide range of perceived opportunity sets. But the player with the shortest-term interest is the Market Maker. And as a counterparty to every trade, he is the master. The Market Maker earns his profit from an infinitesimally small spread, and that spread has a brief shelf life. If at a given price equal portions of buyers and sellers come into the market, the Market Maker has it easy.
But this is a fast, over-the-counter market; buyers and sellers don’t come in regular, offsetting waves, and when they do come, they all have to deal through the Market Maker, whose primary objective is to limit risk (his own) and cover costs (his own). He needs to clear his books as quickly as possible; to reduce his risk he will lay off trades within five seconds, 10 seconds, or 10 minutes. And, to offload his inventory he will move the price to attract buyers and sellers.
Let’s say we have $50 million of volume every 10 seconds. That means $25 million of sellers and $25 million of buyers have to be matched or the market is imbalanced. (We recognize that volume is not evenly distributed over time; it clusters. Nevertheless, at any moment a change in market price — no matter how slight the volume — triggers the re-pricing of all open positions in the underlying instrument. And this short-term disruption further triggers a recalculation of exposure: are margin requirements still being met?)
Here at the heart of the action, trickling volumes have to pass through the Market Maker. But as he re-prices, the trickle can become a flood. As all positions are re-priced, margin calls close out positions; involuntary sales add momentum and scope to the unexpected change; market imbalance accelerates; an anecdotal effect has become a fundamental cause.
The bad news is that such relatively small amounts of volume can have such disproportionate and irrational effects; the good news, especially for “flow traders”, is that small interventions can have a meaningful effect by restoring balance and reducing the extremes of price movement.
There is no fixed frame of reference, no “fair price,” and any change in price redefines value. Any price is biased by the specific states of the traders who take part in the transaction. The Market Maker has no psychological attachment to any price level; he only wants to balance his book and exit the position as quickly as possible. In the face of an instantaneous imbalance between buyers and sellers, the Market Maker will move the price as far as he needs to, in either direction, to solicit the trading action he desires, and not only move prices but also widen spreads to fend.
However, when they detect that Institutional Traders are coming in heavily on one side of the book they will then pull their liquidity from that side of the order book and this is when you get fast moving bars away from balance areas. They pull their liquidity as they do not want to be on the other side of the trade that is about to break out and will only provide the minimum amount of liquidity they are contracted to provide. IT traders are directionally biased. They try to take the market in one direction and will try to manipulate the market to gain enough volume on their books without spooking the MM.
Because pricing is dynamic, you should focus on how different market participants’ reactions unfold over time in response to every change in price. Do not obsess over any one price change (as the beginning, end, or perpetuation of a trend) but anticipate how different components of market participants are likely to align in front of the next price change. Look at who is trading and how often and under what precise conditions.
What to do next becomes much more definable when you see the market as a dynamic unfolding event rather than just a series of prices. Once you have a better understanding of the market structure and how it changes you can develop the skill and confidence to do the things that successful traders do without hesitation. At the very least it can help you stay out of trades that don’t have a high probability of success.
Originally published at www.trading-manifesto.com
