The forex market is not structured like a traditional exchange market such
as the New York Stock Exchange or the Chicago Mercantile Exchange.
Forex is a decentralized global marketplace where trades are cleared one
on one between trading partners. There is no central exchange, no pit full
of yelling traders, no big board of quotes on a New York street, and no
closing bell to ring. The pros and cons of an exchange-based market versus
off-exchange currency trading are debatable, but there are obvious differences
you should understand before trading in the forex market.
No Transparency
One clear advantage of an exchange-based market over off-exchange currency
trading is the transparency the exchange offers traders about the
market. Exchanges clear every trade through a central exchange, allowing
them to provide traders with a wealth of information about the market activity.
Common tools such as order flow and volume data are displayed on
trader’s charts, allowing them to gauge the strength or weakness of price
moves throughout the trading day.
Because the forex market is decentralized, there is little data available
on market activity. Market makers and retail dealers typically do not share
their order flow data, and those that do only represent their trading desk
activity and not the forex market at large. Volume is another popular indicator
used by stock and commodity traders on exchange markets that is
unavailable in the forex market because there is no central exchange on
which to measure volume. Currency traders must learn on their own to
read price action through their charts, without the aid of exchange-based
indicators.
Little Regulation
The forex market has been known as the “Wild West” of financial markets
due to the lack of regulatory oversight. The global nature of the forex
market presents a problem for local government agencies to police trading
activity around the world. Currently there are no regulatory requirements
for an institution to establish itself as an interbank participant; however,
any reputable retail currency dealer will register voluntarily with thelocal regulatory agencies. We already pointed out the CFTC has new regulatory
authority over the off-exchange retail currency market through the
2009 Farm Bill. As I write this, the CFTC is proposing new regulations that
would require all dealers to register as members of the NFA.
In the United States, the National Futures Association (NFA) has begun
implementing rules designed to protect currency traders, although some
of its recent decisions have been met with skepticism. In 2009, the NFA
banned a practice known as hedging, which allowed a currency trader to
maintain opposite positions in the same currency pair, and implemented
order execution rules, forcing changes in some dealers’ trading platforms.
Although the rules are designed to make trading operate closer to the futures
and equity markets, some traders resent the presence of regulators
making changes to a market that has been self-regulated since its creation.
No Trading Restrictions
Freedom to trade in whichever direction you see fit at any time you see fit
is a key feature of the forex market. For years the Securities and Exchange
Commission (SEC) enforced a rule against short-selling stocks known as
the uptick rule. The uptick rule attempted to prevent speculators from
intentionally driving down the value of a stock with relentless short selling.
Under the uptick rule a trader could only sell a stock if the current
price was above the sale price, or on an “uptick.” Once a stock was falling,
traders could not sell the stock again until the next uptick. Although the
uptick rule was suspended in June 2007, there have been plenty of calls to
reinstate it following the relentless stock market selling in 2008 and 2009.
The forex market has no restrictions on trading. If you believe the euro will
fall against the dollar, you can sell it without restrictions. Currency traders
are able to move in and out of positions freely, without an uptick rule or
other regulatory restrictions.
Having no restrictions on trading can also be a negative factor of the
forex market. Since the market is unregulated and there are no restrictions
on trading activity, the environment for manipulation exists. An extreme
example of manipulation is the intervention by central banks. Intervention
is a process of buying or selling tremendous amounts of currency to manipulate
the exchange rate. The Bank of Japan has a history of intervening
in the yen when its central bankers are displeased with the exchange
rate. Manipulation can take many forms, from intervention to requoting a
trader’s order to favor the dealer’s books. You should be aware of the risks
involved with trading off-exchange in the spot market before you commit
any live money to a trade. It’s called the Wild West of trading for good
reason.Contract Flexibility
Trading on exchange-based markets and the forex market is conducted
in standard contract or lot sizes. Unlike the exchange-based market, the
forex market doesn’t set restrictions on the size of a single contract. Theoretically
you could place a single trade worth $1,384,284,927,944.01, assuming
that you can find someone able and willing to take the other side of
your trade—Dr. Evil, perhaps? Currency dealers on the retail market have
carved up a standard $1 million interbank lot into three smaller lot sizes
accessible to smaller retail traders, known as standard lots, mini lots, and
micro lots.
Standard lots on the retail side of the currency market are equal to
100,000 units of the base currency. Mini lots are equal to 10,000 units of
the base currency; micro lots are equal to 1,000 units of the base currency.
Some currency dealers even offer trades in single units, allowing a trader
to place an order for 13,428 units rather than a conventional lot size. This
gives the trader very precise position sizing capability that’s unavailable in
traditional exchange-based markets. A unit might be a single dollar, euro,
yen, or whatever the denomination of your account. For example, a trade
of 10,000 units is synonymous with a $10,000 position if your account is
denominated in U.S. dollars.
Micro accounts offer new traders the ability to trade real money without
placing a tremendous amount of money at risk. Typically a micro account
measures profit and loss in terms of a single dollar per pip or even
less, depending on the margin requirement deployed. These small lots are a
great place for a new trader to cut his teeth on live money trading once he
has demonstrated he can trade profitably on a demo account. They are also
useful accounts for testing theories with a live money account. I keep a micro
account with less than $1,000 in it for testing strategies on live markets
with live money. Overall, micro accounts are a great option to get started
with, even if you have $100,000.
Transaction Costs
Currency dealers heavily advertise that there are no commissions for trading
currency, but that doesn’t mean the forex market is cheap to trade.
Currency dealers earn their money through the spread, which is the difference
between the price at which a dealer will sell a currency and the
price at which the dealer is willing to buy it back. For most major currency
pairs, the spread is very small, but the costs associated with that spread
vary depending on the margin and leverage your account has used.
You’ll learn more about currency pricing shortly, but for now understand
that the transaction costs of trading currency on the forex marketcan be significant. For traders who trade frequently, transaction costs can
be a significant amount of money to overcome to reach profitability. Fortunately
the forex market is a fast-moving one, and once you clear the price
of the spread there are no further transaction costs. The more interbank
trading partners a currency dealer has, the better that dealer’s pricing will
be. Dealers with more than one or two interbank partners are able to take
advantage of more quotes and pass them on to you.
Table 1.2 illustrates the difference in transaction costs for trading
10 different contracts across various market types. Although there is no
commission, the forex market is certainly not a cheap market to trade.
These prices were taken from the published commissions of a major broker’s
web site. The cost of the currency spread assumes a euro/U.S. dollar
transaction using leverage of 100:1.
Trading Hours
The forex market is a global marketplace and trades 24 hours a day, five
days a week. This around-the-clock trading environment is not unique to
the forex market but certainly does make it easier to manage trades around
a schedule that fits your lifestyle rather than certain market hours. In the
United States the forex market begins trading Sunday evening as Asian
markets open for business and continues to trade until the New York markets
close on Friday afternoon. However, just because the market is open
24 hours a day doesn’t necessarily mean anything interesting is happening.
There are three major trading sessions that account for the majority
of volume seen throughout the trading day. The largest trading session by
volume is the London session. London is uniquely positioned in a time zone
that’s open for business during work hours stretching from Dubai to New
York. The London trading session accounts for the most price action and
volume in the forex market by a long shot. New York follows London as the
second largest trading session; Tokyo, or the Asian trading session, rounds
out the top three.and the times during which they are active. The times are listed in Eastern
Standard Time.
Many trading strategies depend on the activity seen during the highervolume
trading sessions. For many traders who work at day jobs, it is impractical
to trade during a trading session that happens while they sleep
or are at work. This book focuses on placing trades around supply and demand
levels during the quiet times of the market, around your schedule. It
is better to plan and enter long-term trades during the quiet hours of the
market and leave the trading sessions to day traders who enjoy staring at
charts all day.