Forex - beaten by the spread
The largest market of the world is Forex, the foreign exchange of currencies. Traditionally a game of banks and other big institutions only, it has been opened to the private trader in the last years. Why? Because the banks found out that technology has become so advanced that it pays off to offer the necessary infrastructure to small traders and milk them.
No fees, but...
Those banks and other big players act as market makers, which means they make offers to sell to or to buy from other Forex traders. In the Forex market you can only buy at the higher ask price and sell at the lower bid price from and to the market makers. The difference of the bid and ask price for a given currency pair is called the spread and that is what you have to pay and what the market maker earns. Most brokers charge no explicit transaction fee, but they mark up the spread of the market maker by giving you altered quotes. Additionally these artificial quotes allow them to fool you when prices move fast.
Forex is not a regulated market
There is no central clearing house or exchange, and accordingly there is no regulatory institution like the SEC that imposes rules to establish an orderly market. Instead Forex is a complex over the counter market with different layers. The innermost circle is a private club of the world's top commercial banks.
What costs can you expect from this market?
The spread the small trader has to accept is of course the biggest of all the different spreads traders pay in Forex. The major currencies trade with spreads available to the retail customer usually within 1 to 5 pips where a pip is the last digit of the quote. This may seem small for the main currency pairs, e.g. the EUR/USD bid and ask quote may be 1.3000 to 1.3001 which would be a spread of 1 pip or about 0.01%. For pairs involving a secondary currency it is more like 10 pips and when the prices move fast, spreads can become easily bigger than that even for major pairs.
Is the Forex spread small enough for day trading?
The spread has to be seen relative to the movements prices make. Often the day range of a currency quote is only a few times bigger than the spread that has to be paid. Moreover, there has to be price action that is tradeable, for instance intraday trends or any other regularity that could be the base of a trading system. The inconvenient truth here is that prices within a day move mostly in a random fashion. A comparison of currency charts with stock charts reveals that pretty clearly.
It is human to identify patterns where none are, so be careful to spot trends or other chart patterns that emerge only in your mind and what are really regular looking patterns embedded in a sea of random. The idea to do the opposite and trade anticyclical, e.g. buy after the price dropped a bit and hope that it now may snap back is a futile attempt with random movements. If it is random, it is no cycle and there is no snapping back.
Why do Forex prices move randomly?
Most of the time currency quotes are purely driven by real demand and supply transforming the uncoordinated arrivals of buy and sell orders into a noisy chart looking like the ones of dull stocks. With real demand and supply I mean payments that have to be made as part of something real like physical trades of goods, sales of services or economical transactions of the government. Contrasting to that is speculative trading or price manipulation with the intent to rewind the money shifting later. But there are of course intermediate phases of regular price behavior.
Breaking news often induce a crystal clear trend
If something like the nonfarm payroll numbers hit the market once in a month the USD currency usually runs straight in one or the other direction for a few seconds or minutes. Unfortunately that is exactly the time when the spread widens enormously or worse the big guys won't let you in at all. Forex is no market where a market maker has the obligation to honor trading requests or to supply a quote, and in such cases where everybody wants to do the same, the market makers will let your order hang until the price movement reverses or slows down. It is hard to trade the news despite what your broker may have promised.
How brokers cheat when prices move
With the laconic excuse of fast market conditions brokers are able to shift their quotes in the direction of the trend, inflate their markup on top of an already widened base spread or delay the execution. Delaying is the standard scam of the financial industry: Make the transaction, wait some time and give the customer the worst price that occurred in the meantime. Widening the spread may trigger your stop order without the real market ever having been there. Some brokers discourage trading the news up to the point that they pretend technical problems and shut down their server temporarily or they close accounts of notorious news traders completely. They simply want the few reasonable fills they get during news release for themselves. Having a broker who routes your order directly to an ECN while charging a fixed fee does not help either, because the banks have swept the ECN's order book already when prices run. The outcome is a huge slippage for trading fast moving markets. If the applied trading style suggests a tight stop loss, closing the trade will often cause another slippage hit.
Tricks of the big players
The third type of price movement is caused by manipulation of the really big market players. They have the deep pockets to push prices through lines of resistance or support so that they look as breakouts or to create any other technical signal. Initiating the move gives them the best entry price. The small traders who try to extract some coherent pattern out of the masses of random jitters with their TA equipment incur the inevitable loss. The banks have some other sort of advantage, they see the order flow from their customers and this way they can differentiate better than others between price manipulation or speculative expectation and a changing sentiment of fundamental interpretation. They are thanking their customers by front running big orders from them with their own ones, causing higher execution prices for them and generating profits for themselves. Front running is forbidden in most regulated financial markets but not so in Forex.
What about riding longer trends in Forex?
Yes, longer trends do exist in Forex, but there are only a handful of currencies and thus they are rare. Furthermore, different currencies have different interest rate levels and to make up for the difference, accounts are credited or debited with interest payments on a daily basis. The slower a trend materializes the more you are dealing with interest payments than betting on a price change. Needless to say that brokers skew these adjustments in their favor, sometimes rather drastically. For a strong trend a rebalancing of different economies by a devaluation of one currency against the other is needed. Regrettably being long the stronger and short the weaker currency may result in a negative interest balance, because weak currencies are often accompanied by a high interest rate.
Trends in Forex compared with the stock market
Huge valuation changes and resulting strong trends do occur in the currency market, but there are many more and much better chances for long enduring trends in the stock market. The same is true for medium sized trends which could be exploited with technical analysis in a swing trading time frame. The stock market has much more to offer in terms of smoothness of swings or trends and number of possible trading candidates. It is the sheer number of stocks that dwarfs the number of currencies and it is something else:
Forex has no motor
Day trading in Forex is a fight against random, manipulation and the spread - in short it is nonsense. The more seldom events of news which rock the market and which are clearly a motor are hard to trade. The banks and brokers created the retail market to get a new cash cow -you- and not to give away the easy money. In news situations they front run you and execute your order essentially when the move is over, leaving you with a risky entry price level or, if you have been on the wrong side with a limit order, they grab that liquidity thanklessly in milliseconds.
Otherwise they want their customers to pay the spread as often as possible when there is nothing to win. For that purpose they offer quote blinking and signal generating software to make customers believe trading is playing a video game. Or they entice the system trader with so called Forex robots, which are trading on autopilot an infallible system while you are sleeping. One could try to trade the middle and longer moves, but their underlying fundamental reasons -the motor- look unexciting in comparison to the many stock market companies and their products.
If you still want to try Forex trading, read our article about a possibly working Forex trend system and how it compares to a stock trend system.
Below are some articles for those who are active in other markets and may want to reassess the idea to switch to stock trading: