The Forex market: myth and reality

Let me quote from one of the classics in literature for traders – Alexander Elder's "How to Play and Win on the Market":

"If a friend of yours with very little experience in farming comes to you and says that he is planning on feeding himself from what he can grow on a quarter acre plot, you'll know that he is going to be going hungry. We all have a sense of what can be gotten out of a plot of that size. But in the world of trading, full-grown adults allow themselves to harbor such fantasies."

As soon as an amateur gets roughed up a few times and has a few margin calls, he loses his assertiveness, becomes more timid and begins formulating all manner of frightening ideas about financial markets. Losers on the market buy, sell or stay on the sidelines all as result of their fantasies. They are like children who are afraid to walk through a cemetery or peek under the bed for fear that there could be ghosts lurking. The unstructured nature of financial markets is fertile ground for fantasy to take flight.

And our fantasies can affect our behavior even when we don't realize we have them. A successful trader must first recognize his fantasies and then rid himself of them.

Fly-by-night dealers and other myths about how brokers actually work

There are three ways a dealing center can operate.

1. Not a single client position is hedged with an external counteragent. In this case it is in the dealer's interest that the client lose – otherwise, the client is paid out of the dealer's own pocket.It is true that many dealing companies operate according to this model in the first years of their existence because they don't have enough trading volume to hedge their clients' net positions in the interbank Forex market (a standard lot being 0.5 mln). Less well-established dealers run the risk that one of their clients will win big and the company won't be able to meet its obligations. In order to reduce the risk of this happening, such dealers often take measures to "help" their clients lose, a practice which damages the reputation of the industry at large.

In the early days of Forex there were very few dealing centers and most of those that were operating didn't have enough clients to properly hedge client positions on the larger market. As a result, to minimize clients profiting at the expense of the company's bottom line, many dealers began throwing wrenches in their clients' trading. "Slippage", filling orders at a price slightly less profitable for the client, was one of any number of methods dealers used to subtlety sabotage their clients. But time doesn't stand still. Dealers who got their start and survived have managed to acquire a large client base. And since larger companies generally aren't willing to risk their reputations to make a quick buck at their clients' expense, shady dealing practices have generally been relegated to the ever-shifting world of low-budget, fly-by night dealing centers.

When a dealer has acquired a critical mass of clients and is able to take the training wheels off, certain things become clear:

• Over the long run the profit of "fly-by-night" operations (who are trading against their clients) turns out to be essentially the same as if they were just earning based on the spread (due to the fact that the company's winnings and loses against the client will even out over the long haul). In the end a larger client base is the only way to make progress – and that depends largely on the reputation of the company.
• A good reputation and long-term clients is ultimately more profitable than short-term profit from the losses of clients. Because of this, even those dealers who still process everything internally eventually move beyond unethical practices (poor execution, swooping up stop losses, etc.), that characterize the fly-by-night types.
• The company has come to be more valuable and management doesn't want to lose it all because of a few lucky clients.
• Client accounts are getting larger (a sure sign of a good reputation) and even some much larger clients are showing up, most of whom are generally successful due to having more professional experience and better training.

As a dealing center grows, management starts thinking about hedging client position, and as a result, moves to the second business model.

2. Hedge the net client position on the interbank market. This means that the net client position (of a certain previously agreed upon size) is hedged on the main market. This removes any motive for the company to trade against the client. Now, highly successful clients no longer put the company on the verge of ruin.

3. Hedging every client position on the interbank market. From the client's perspective this model carries no advantage compared the one listed above. Among its drawbacks:

• Large account balance and minimum trade requirements
• Slower execution

When this article was written, Alpari had more than 7,200 clients, which allows the company to use the second dealing model.

The myth that it's impossible to make money from Forex

It's often been said that 90% of those who trade with leverage on financial markets end up losing their money. Unfortunately, this is true. Let's see if we can make sense of why that is. If we analyze how the "90%" go about trading, we can come to a few conclusions as to what the unsuccessful trader does wrong:

• Doesn't have a grasp of the basics of analysis: Unsuccessful traders make poor use of technical and fundamental analysis.
• Doesn't understand the philosophy behind trading: I'll explain with an example from my own experience. Once when I was a young technical analyst I was analyzing a currency, let's say the Yen. I look at the "week" chart, the indicators are all pointing down, the day chart – same thing, four-hour chart – same thing, 5-minute – same. Great, I think, everything's pointing in one direction. I open a position. The result? Miserable. My faith in technical analysis was shaken to the core. I ran to get a beer and thought a lot about what had just happened. I realized that it isn't technical analysis that's at fault, but me. The week and day charts were showing that the overall trend was down. The shorter timeframes showed that movement in the direction of the trend was already happening and had apparently bottomed out. The ideal moment to sell would have been if the week and day charts were down but the 4-hour was bullish (bouncing off the bottom) and the hour chart is showing that the upwards movement has ended (for example, when the bulls are divided).
• Doesn't follow the rules of money management:
  • Doesn't set stop losses at all.
  • Sets stop losses too close to the entry price. A stop loss order on the Forex market should not be less than 40-50 pips from the entrance price. Stop losses that are placed closer are likely doomed to get triggered due to the fact that you are very unlikely to catch the top or bottom when you enter the market (i.e. even if you are correct in your analysis, there could be some initial price movement against you). This could be 10-15 pips. Plus 5 pips of spread. And if you count market noise (10-15 pips), a stop loss order placed less than 40-50 pips off the entry price has an unacceptably high chance of getting picked up.
  • Doesn't maintain a profit/loss ratio of 2/1.
  • Tries to record a profit of 5 pips but is willing to ride a bad trade down to a 100 or more pip loss. In this case you would need 20 profitable trades just to cancel out the loss sustained in the one bad trade. This would mean a success rate of over 95% -- something that not even Soros could pull off. Professional analysts are right 75-80% of the time.
  • etc.
• Base their trading on too small fluctuations: I think that the market reflects about 10 pips of noise (a large order is placed to a bank which bumps the price up or down by 5 pips after which the price returns to its previous level. Also, different market-makers show slightly different prices). Let's take this as an axiom (it can't be proven). That means:
  • Analysis of a 1-minute time-frame allows you to catch a movement of 15 pips. 66% of that is market noise (10 pips).
  • Analysis of a 5-minute time-frame allows you to catch a movement of 30 pips. 33% of that is market noise.
  • Analysis of an hour time-frame allows you to catch a movement of 100 pips. 10% of that is market noise.
  • Analysis of a day time-frame allows you to catch a movement of 500 pips. 2% of that is market noise.
• These numbers are hypothetical. It's the concept that's important. As it works out, a lot of the time we end up just trying to predict market noise when analyzing short periods of time. Market noise is unpredictable. The market, however, is predictable, which is why we should concentrate more on longer periods of time.
• If you haven't been having success trading on Forex, take a careful look at what I have laid out above and draw your own conclusions about what you need to do better. To be successful on the Forex market, you need certain knowledge but you also need to understand how to follow certain guidelines, notably those related to money management.

Myth: There aren't enough brokers in brokerage firms, otherwise why does it take so long for my trade to be executed during periods of greater price fluctuation?

A delay can be caused the following:

• Software or network is unable to handle increased traffic during periods of greater price movement.
• Broker insufficiently staffed.

The question remains, however, why do brokers that don't suffer from either of the above-mentioned shortcomings still sometimes experience delays when processing orders?

The most common business model in larger companies is # 2 (see above) – the company hedges client positions with an external counteragent. When the market is calm the broker is able to process the client's trade almost instantaneously and then worry about hedging it in the larger market (if need be). There's no reason to hurry and the broker might even be able to jump in a couple of pips better than the client had.

But everything is different during a volatile market. The client's position needs to be hedged immediately or else the market could move quickly and the broker could get left with a loss. As a result, client orders are filled at the same time that the company is attempting to hedge the positions on the larger market. Naturally, client orders will take longer to fill. But this should be seen as the price to pay for working with a reputable company that isn't working against the client.

The myth about not having enough capital

I will once again quote Elder:

"A lot of unsuccessful traders think that they would be more successful if they had more money at their disposal. Most such traders were thrown out of the game after a particularly bad stretch or perhaps even just one unsuccessful trade. It also happens often that as soon as the amateur has closed all his positions, the market moves in the direction that he had been anticipating. The hapless trader is either furious at himself or at his broker, "If I had been able to hold out for just another week, I would have made a fortune."

Unsuccessful traders interpret this as a confirmation of their methods. So they put their hard-earned (or borrowed) money into opening another account. But the same story happens again. The trader is wiped out and watches from the sidelines as the market again heads in his direction, again proving his analysis, albeit too late. This is about where the fantasy "if I had a bigger account, I would stay alive longer and actually be able to make money" takes flight.

Some traders talk relatives into funding their next venture, showing them the charts as proof that they know what they're doing. But poor traders hardly fare better with well-funded accounts than they had before.

The biggest problem for the losing trader isn't a lack of capital but a lack of understanding of how to trade. A weak trader can run through a large account almost as quickly as a small one. He overplays his hand and his money management fails. Poor traders often take overly risky market positions even with larger accounts. Regardless of how well a trader's overall strategy is, subjecting one's account to excessive risk can be a recipe for disaster – if a couple of big trades go against you, you could be wiped out.

I am often asked how much money you need to get started trading. They want to have enough to survive a down period. They think that they will lose a bunch of money before they start making anything. It's like an engineer who plans on constructing a couple of bridges that will end up collapsing before building his masterpiece. Can a surgeon kill a few patients before becoming an expert at curing appendicitis?

The amateur doesn't think that he will suffer losses and isn't prepared to handle such a situation. The conviction that your failures are due to under-capitalization is a trap that makes it more difficult to notice two unpleasant things: lack of discipline and the lack of a realistic plan for managing one's funds.

One advantage of a larger account is that the start-up costs are smaller relative to your account. If you are managing a fund with a million dollars and spend $10,000 on computers and seminars, you only have to earn 1% to cover those expenses. But if you only have $20,000, those same expenses constitute 50% of your entire account.

The myth about autopilot

Let's assume that a stranger comes up to you while you're in your garage and tries to sell you a fully automated driving system, "for just a couple hundred dollars, you can get this computer chip which will drive your car for you." You can just sit and sleep while you are being driven to work. You would probably laugh at such an offer. But would you laugh if someone offered you an automated system for investing in the markets?

Traders who believe in the "autopilot" myth think that making money can be automated. Some try to create automated systems themselves, others try to buy ready-made ones. People who spend years crafting their trades as lawyers, doctors, or business then turn around and try to buy the equivalent of years worth of experience in the form of an automated trading system. These types are generally ruled by greed, laziness and profound misconceptions about mathematics.

In the old days, such systems were written down on scraps of paper; now they are on protected disks. Some are very primitive, others are quite complex with built-in optimizers and rules for money management. Many traders are looking for magic – a way to turn a few lines of code into an endless stream of money. Those who pay for automated trading systems are reminiscent of knights from the middle ages who paid alchemists for the secret of turning simple metals into gold.

Human behavior, with all of its complexity, doesn't allow itself to be automated. Computer programs haven't replaced teachers and computer-based accounting systems hasn't led to mass unemployment among accountants. Most human activities require the ability to make decisions – something computers can help with but can never fully replace humans.

If you had managed to get a hold of an automated system, you could retire to Tahiti and live the rest of your days in luxury, picking up a never-ending stream of checks from your broker. But so far the only people who have made money from automated trading systems are the people who sell them. They have created a small but quite attractive little niche for themselves. If their systems worked, why would they sell them? Instead of hawking their systems, they could have long ago themselves retired to Tahiti. Of course such salesmen have an answer ready. Some say that they like programming more than trading on the market. Others say they are selling their system just to acquire capital for making further investment.

But the market is always changing and what worked yesterday may not work today. A good trader is always correcting his methods when he sees that things are changing. An automated system will be unable to make the necessary adjustment and will inevitably crash and burn.

Take the airlines. Even though they all have autopilot systems in their airplanes, they all nevertheless continue to pay pilots rather large salaries. This is because the pilot, unlike the computer, can deal with an unexpected situation. When a plane flying over the Pacific suffers damage to the fuselage and needs to execute an emergency landing or when a plane flying over Canada unexpectedly runs out of fuel, only a human can deal with such a situation. Trusting your money to an autopilot system is a good way to have your account destroyed by the first unexpected event.

There are good systems out there but they have to be managed and their trades have to be watched. You can't simply turn it on and let it go.