To prevent the gradual ingress of my trading charts into every thread, and because I want to look deeper into actual market structure and mechanics, I've started a specific thread and promise to stop littering all the other threads (except where very relevant of course) and try to keep it all in one place from now on.
The Forex market http://en.wikipedia.org/wiki/Foreign_exchange_market in particular, fascinates me because of it's sheer size and unavoidable importance globally to every aspect of international business. Just imagine taking even a small spread on a small portion of the $1.5 quadrillion worth of transactions that occur there annually. I've been reading up about the structure of Forex and will list all links at the bottom of this post but lets start with some givens.
1. What is a "market" ? - a market is simply a price feed that shows the current buy and sell price, known as the "Bid" or the "Ask". that is all. Wiki Bid Ask Spread
2. How does the Forex market structure work? - the definitive essay I have found on this, is here
http://www.forexfactory.com/showthread.php?t=7484 with quotes.
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Market Structure:
Now that we have established why the market exists, let’s take a look at how the transactions are facilitated:
The top tier of the Forex market is transacted on what is collectively known as the Interbank. Contrary to popular belief the Interbank is not an exchange; it is a collection of communication agreements between the world’s largest money center banks. To understand the structure of the Interbank market, it may be easier to grasp by way of analogy.
Consider that in an office (or maybe even someone’s home) there are multiple computers connected via a network cable. Each computer operates independently of the others until it needs a resource that another computer possesses. At that point it will contact the other computer and request access to the necessary resource. If the computer is working properly and its owner has given the requestor authorization to do so, the resource can be accessed and the initiating computers request can be fulfilled. By substituting computers for banks and resources for currency, you can easily grasp the relationships that exist on the Interbank.
Anyone who has ever tried to find resources on a computer network without a server can appreciate how difficult it can be to keep track of who has what resources. The same issue exists on the Interbank market with regard to prices and currency inventory. A bank in Singapore may only rarely transact business with a company that needs to exchange some Brazilian Real and it can be very difficult to establish what a proper exchange rate should be. It is for this purpose that EBS and Reuters (hereafter EBS) established their services.
Layered on top (in a manner of speaking) of the Interbank communication links, the EBS service enables banks to see how much and at what prices all the Interbank members are willing to transact. Pains should be taken to express that EBS is not a market or a market maker; it is an application used to see bids and offers from the various banks.
The second tier of the market exists essential within each bank. By calling your local Bank of America branch you can exchange any foreign currency you would like. More then likely they will just move some excess currency from one branch to another. Since this is a micro-exchange with a single counterparty, you are basically at their mercy as to what exchange rate they will quote you. Your choice is to accept their offer or shop a different bank. Everyone who trades the forex market should visit their bank at least once to get a few quotes. It would be very enlightening to see how lucrative these transactions really are.
Branching off of this second tier is the third tier retail market. When brokers like Oanda, Forex.com, FXCM, etc. desire to establish a retail operation the first thing they need is a liquidity provider. Nine in ten of these brokers will sign an agreement with just one bank. This bank will agree to provide liquidity if and only if they can hedge it on EBS inclusive of their desired spread. Because the volume will be significantly higher a single bank patron will transact, the spreads will be much more competitive. By no means should it be expected these tier 3 providers will be quoted precisely what exists on the Interbank. Remember the bank is in the business of collecting spreads and no agreement is going to suspend that priority.
Retail forex is almost akin to running a casino. The majority of its participants have zero understanding how to trade effectively and as a result are consistent losers. The spread system combined with a standard probability distribution of returns gives the broker a built in house advantage of a few percentage points. As a result, they have all built internal order matching systems that play one loser off against a winner and collect the spread. On the occasions when disequilibrium exists within the internal order book, the broker hedges any exposure with their tier 2 liquidity provider.
and here is a schematic of the structure of the market place
- The main players in the Forex market
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Commercial And Investment Banks
Let's start dissecting the bigger players: the banks. Though their scale is huge compared to the average retail Forex trader, their concerns are not dissimilar to those of the retail speculators. Whether a price maker or price taker, both seek to make a profit out of being involved in the Forex market.
What is a market maker? To be considered a foreign exchange market marker, a bank or broker must be prepared to quote a two-way price: a bid price which is the market makers' buying price and an offer price is their selling price to all inquiring market participants, whether or not they are themselves market makers.
Market markers capitalize on the difference between their buying price and their selling price, which is called the "spread". They are also compensated by their ability to manage their global FX risk using not only the mentioned spread revenues but also netting revenues and revenues on swaps and conversions of residual profits or losses.
There are hundreds of banks participating in the Forex network. Whether big or small scale, banks participate in the currency markets not only to offset their own foreign exchange risks and that of their clients, but also to increase wealth of their stock holders. Each bank, although differently organized, has a dealing desk responsible for order execution, market making and risk management. The role of the foreign exchange dealing desk can also be to make profits trading currency directly through hedging, arbitrage or a different array of strategies.
Accounting for the majority of the transacted volume, there are around 25 major banks such as Deutsche bank, UBS, and others such as Royal bank of Scotland, HSBC, Barclays, Merrill Lynch, JP Morgan Chase, and still others such as ABN Amro, Morgan Stanley, and so on, which are actively trading in the Forex market.
Among these major banks, huge amounts of funds are being traded in an instant. While it is standard to trade in 5 to 10 million Dollar parcels, quite often 100 to 500 million Dollar parcels get quoted. Deals are transacted by telephone with brokers or via an electronic dealing terminal connection to their counter
So clearly, not all banks are equal here? the 25 or so that trade the majority of the $1.5 Quadrillion market volume and often post 100% trading quarters might seem to have an edge of some sort?
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Trade Mechanics:
It is convenient to believe that in a $2tril [written in 2008, nearer $5 trillion now] per day market there is always enough liquidity to do what needs to be done. Unfortunately belief does not negate the reality that for every buyer there MUST be a seller or no transaction can occur. When an order is too large to transact at the current price, the price moves to the point where open interest is abundant enough to cover it. Every time you see price move a single pip, it means that an order was executed that consumed (or otherwise removed) the open interest at the current price. There is no other way that prices can move.
As we covered earlier, each bank lists on EBS how much and at what price they are willing to transact a currency. It is important to note that no Interbank participant is under any obligation to make a transaction if they do not feel it is in their best interest. There are no “market makers” on the Interbank; only speculators and hedgers.
Who are the main players in the Forex market
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Businesses & Corporations
Not all participants have the power to set prices as market makers. Some just buy and sell according to the prevailing exchange rate. They make up a substantial allotment of the volume being traded in the market.
This is the case of companies and businesses of any size from a small importer/exporter to a multi-billion Dollar cash flow enterprise. They are compelled by the nature of their business - to receive or make payments for goods or services they may have rendered - to engage in commercial or capital transactions that require them to either purchase or sell foreign currency. These so called "comercial traders" use financial markets to offset risk and hedge their operations. Non-commercial traders, instead, are the ones considered speculators. It includes large institutional investors, hedge funds and other entities that are trading in the financial markets for capital gains.
In an article taken from the Forex Journal, a special edition by Trader's Journal magazine in November 2007, Kevin Davey details in funny words why you should mimic non-comercial traders:
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One automobile company recently attributed a large portion of its earnings to its Forex trading activities. These groups should strike fear into the little minnows because these groups are the professional sharks. These organizations trade day and night, know the ins and outs of the market and eat the weak. Big moves in the market are usually the result of the activities of professionals, so following their lead and following the trends they start may be a good strategy.
In the same waters that the professional sharks swim, there are also a lot of minnows. They are also your competition, so knowing their tendencies can help you exploit them. For example, unsophisticated minnow'traders are likely to put stop-loss orders at obvious support or resistance levels. Knowing this, you can exploit this tendency and feed on them.
Also, think about the first sure thing chart formation that you ever learned about. Chances are that new traders are just learning about that formation now, so you could fade their trades and likely do all right. Think of it this way - defeating a foe sitting at his desk in his home office trading the Forex market in his bunny slippers is probably easier than defeating an MBA with a $5000 suit who trades via complex neural network arbitrage programs. So, try to mimic and follow the sharks and eat the minnows.'This is where having a plan to make you a more agile 'minnow' or even turn you into a 'shark' is critical.
3. How does "retail" trading work? (as it's all most of us are ever going to be able to do)
what we do know:
it is a zero sum game, actually less because of spreads/fees.
hence for every winner, there must be a loser, and vice versa.
an EDU study of a sample set of day trades gives some interesting stats
http://clem.mscd.edu/~mayest/FIN3600...rm.pdf?ptid=16
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Losing Accounts
Eighteen (18) of the twenty-six accounts (70% of the accounts), lost money. More importantly, all 18 accounts were traded in a manner that realized a Risk of Ruin of 100%. That is, 70% of the accounts would almost certainly lose any and all funds put at risk in them.
..
Eleven (11) of the seventeen (17) day trading accounts lost money. More importantly, all 11 accounts were traded in a manner that realized a Risk of Ruin of 100%. That is, 65% of these accounts would almost certainly lose any and all funds put at risk in them.
Winning Accounts
Eight (8) of the twenty-six accounts, or 30% of the accounts, were profitable.
Despite being profitable, three of the accounts A2, A24, and A29, were traded in a manner that realized a high potential Risk of Ruin (A2 –74%, A24-24%, and A29-84%) and low average trades. More importantly, however, the performance of each of these accounts is highly dependent on just one trade.
...
Only six (6) of the seventeen (17) day trading accounts made a profit. Four of these six accounts realized a significant risk of ruin. Account A10- 27.6%, A18- 57.5%, A24-45.2%, and A28-45.2%. Clearly, accounts that have over a 25% chance of ruin are not successfully traded accounts.
The largest winning trade is a significant number as it relates to the net and gross profit. Trading (or a trading system) has a serious problem if a major portion of the profits comes from just one trade. The rule of thumb is that no more than 25% of the net profits should come from the largest trade.
Conclusions (Short-term Trading)
If this analysis is representative of short-term public trading, the individual and cumulative results show that most public traders will lose money attempting to short-term trade. In fact, this study shows that 70% of the public traders analyzed will not only lose, but almost certainly lose everything they invest.
Only three accounts of the 26 analyzed (11.5% of the sample) illustrated trading results and techniques sufficient to profit from short-term speculation. In sum, based on these findings, the vast majority of retail public investors (88.5%) would be best advised to refrain from short-term speculative trading.
So the big question (for me anyway) is not really so much who is winning all the time, (as we can never know, only speculate) but how are they doing so, and why is it so difficult for anyone else? Some believe its all random (Taleb etc), but I think it's actually more difficult than profiting from chance, much more, as the stats above seem to back up, after all, it's not a 50/50 distribution is it?
Trading introduces you to powerful emotions you might never have felt before, and certainly not in this context (unless you are progressing from gambling addiction :) ) , and many defer to their reptilian brain to actually make their decisions, while deluding themselves that they are acting logically. (I have been this retail trader and been caught in every way possible) It is actually incredibly difficult to retrain yourself to buy low and sell high, as the human psyche is programmed to chase moves, not press the buy button while the price is plummeting. I previously have illustrated this exact moment full post here and chart only shown below
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2. now we have seen the real manipulation, a sudden spike out well through the lows that rapidly retraces during the same bar, right where we want it. I took it immediately again on the close of the manipulation spike that got me at 1/3 size. ..price then loiters around a further 2 bars looking to all the world ('s retail traders) like it's about to fall off the edge of the world..
that http://fxpro.ctrader.com/c/b5B5n right there, is manipulation captured in action, all the early longs (me) have been stopped out already and are scared now, some of them even go short. ..this has been going down 4 days now, every indicator in the world is biased short, meanwhile, smart money are now out of their day's positions, as once again they were buying retail's sells and selling retail's buys, and the muppets just never seem to get it.
as history proved me correct, that was always a buy, but I guarantee you lots of the Herd were caught shorting at the bottom again, that's what they do. So logic (and studies) would therefore assume that most people should not even think about trying it, and of those who do, only a tiny percentage are going to get there, (but as I personally also have a long history of being that one in ten thousand and hate failure, so stats like this just motivate me more)
Anyway, all of the above I was mostly aware of, what I am struggling to find exact information on is HOW a trade actually works, ie what is traded, what money is transferred around the system during the trade. Because I have a strong inclination that in fact nothing is actually exchanged or moved around except instantaneous credit from the shadow banking industry, except at cashing out time whereby NET (win / loss) profits are paid, because:
The "Spot" FX markets are also just a 2 day currency future that is usually rolled anyway http://en.wikipedia.org/wiki/Foreign_exchange_spot
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A foreign exchange spot transaction, also known as FX spot, is an agreement between two parties to buy one currency against selling another currency at an agreed price for settlement on the spot date. The exchange rate at which the transaction is done is called the spot exchange rate.
and currency futures and just longer versions of the same thing http://en.wikipedia.org/wiki/Currency_future
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A currency future, also FX future or foreign exchange future, is a futures contract to exchange one currency for another at a specified date in the future at a price (exchange rate) that is fixed on the purchase date; see Foreign exchange derivative. Typically, one of the currencies is the US dollar. The price of a future is then in terms of US dollars per unit of other currency. This can be different from the standard way of quoting in the spot foreign exchange markets. The trade unit of each contract is then a certain amount of other currency, for instance €125,000. Most contracts have physical delivery, so for those held at the end of the last trading day, actual payments are made in each currency. However, most contracts are closed out before that. Investors can close out the contract at any time prior to the contract's delivery date.
and nobody takes any notice of what goes on in there anyway because nobody has any power to regulate it.
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“The FX market is like the Wild West,” said James McGeehan, who spent 12 years at banks before co-founding Framingham, Massachusetts-based FX Transparency LLC, which advises companies on foreign-exchange trading, in 2009. “It’s buyer beware.”
The $4.7-trillion-a-day currency market, the biggest in the financial system, is one of the least regulated. The conflict banks face between executing client orders and profiting from their own trades is exacerbated because most currency trading takes place away from exchanges.
...
While U.K. regulators require dealers to act with integrity and avoid conflicts, there are no specific rules or agencies governing spot foreign-exchange trading in Britain or the U.S. That may make it harder to bring prosecutions for market abuse, according to Srivastava, the Baker & McKenzie partner.
Spot foreign-exchange transactions aren’t considered financial instruments in the same way as stocks and bonds. They fall outside the European Union’s Markets in Financial Instruments Directive, or Mifid, which requires dealers to take all reasonable steps to ensure the best possible results for their clients. They’re also exempt from the Dodd-Frank Act, which seeks to regulate over-the-counter derivatives in the U.S.
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“Just because Mifid doesn’t apply, the spot FX market shouldn’t be a free-for-all for banks,” said Ash Saluja, a partner at CMS Cameron McKenna LLP in London. “Whenever you have a client relationship, there is a duty there.”
..it shouldn't be, but it is my contention that it very much is, but that's another thread really. and from the first paragraph again..
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The top tier of the Forex market is transacted on what is collectively known as the Interbank. Contrary to popular belief the Interbank is not an exchange; it is a collection of communication agreements between the world’s largest money center banks.
Big Four - Bloomberg
While hundreds of firms participate in the foreign-exchange market, four banks dominate, with a combined share of more than 50 percent, according to a May survey by Euromoney Institutional Investor Plc. Deutsche Bank AG (DBK), based in Frankfurt, is No. 1, with a 15.2 percent share, followed by New York-based Citigroup Inc. (C) with 14.9 percent, London-based Barclays Plc (BARC) with 10.2 percent and Zurich-based UBS AG (UBSN) with 10.1 percent.
So in summary, what have we got? A few powerful banks dominating their own unregulated opaque OTC market, which just happens to be one of the biggest in the world, through which all international trade must pass.
And when we look at what they're doing, all they're actually doing is supplying a bid/ask price via their black box HFT algorithms, whereby traders take a "position", based on shadow bank leverage on a Contract to Buy/Sell some currency at some point in the future (which for traders, never ever happens as the positions are just rolled over) through the interbank market ultimately, which is not an exchange, just a collection of agreements between the banks involved.
ie we watch these red and blue lines, but there is never any actual USD or EUR involved in that movement, only the value of a digital realm only proxy trading "instrument" (which isnt covered by any of the financial instrument rules) quoted by a few banks in their own opaque marketplace which isn't even a marketplace, but a bunch of communication agreements between themselves.
Nice business if you can get it, eh? clearly then, as a trader, we have only 2 options, either attempt to trade as the dominant market-making banks do, or lose.
although apparently threat of regulation and competition from private HFTs means it's not as good as it used to be, if they are to be believed, anyway..
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Banks are retreating from market-making, managers warn
Source: Risk magazine | 01 Mar 2012
Forex investment has became more challenging, as market-making banks facing new regulation have become less willing to take risk, say buy-side firms
Investing in currencies has become significantly more challenging as banks have reduced their market-making activities in preparation for new requirements for bank capital, as well as the proposed ban on proprietary trading under the Volcker rule, according to buy-side speakers at the FX Invest Europe conference in Zurich earlier this week.
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"Banks that were accustomed to being market-makers in the forex business were also accustomed to being lenders of last resort - or warehousers of risk - and operated as a valuable and timely shock absorber to moves in the foreign exchange market.
Regulatory changes and the potential introduction of the Volcker rule have diminished the opportunity for banks to run proprietary risk, and this has without question had a substantive effect on market characteristics,"
said Paul Chappell, founder and chief investment officer at UK currency management firm C-View.
Sources
http://en.wikipedia.org/wiki/Foreign_exchange_market
http://en.wikipedia.org/wiki/Currency_future
The Structure of Forex Brokers (Forex factory)
Structure of the Forex market FPA
The Main Players in the Forex Market - FXStreet
How Trading works Forex & the Interbank FX Street
An Analysis of Public Day Trading at a Retail Trading Firm - mscd.edu
Traders said to rig currency rates to profit off clients - Bloomberg
Banks retreating from market-making [lulz, as if] - Risk Magazine