I was discussing how the market has changed with an ex-colleague the other day and we both concluded that the increase in liquidity caused by the euro, the fact that trading to five decimal places where every 0.00001 trades and the advent of retail traders who have no experience of exceptional market volatility has let loose a genie from a bottle from which the cap can never be replaced.
There are two major issues which sit above even those factors I mentioned above and they are flash crashes and the understanding of cross currency trades.
First, flash crashes.
In a market that is used to trading, every 1/10th of a pip amove of one big figure (one hundred pips in Eur/Usd) is a huge move. The trading to five decimal places provides a phoney sense of security to inexperienced traders. Many have been seduced by get rich quick schemes promulgated by unscrupulous unregulated “teachers” who have apparently “seen it all before” and will help you avoid the pitfalls.
In truth, these purveyors of wisdom are leading the gullible headlong towards the pitfalls. I doubt that a single course that costs anything up top $5,000 or more even discusses flash crashes or why they happen as they are not something that should feature in the cosy world of simplicity that the FX market is portrayed as.
There is one simple matter to consider for anyone thinking of “taking the plunge”. Depending on where you look, between 75% and 95% of new traders lose their entire initial deposit in the first three months of trading. Now, it used to be that the brokers ran A & B books and depending on the experience of the trader would either pass the risk direct to a liquidity provider and “back to back” the trade with them. That is the “A” book and the only profit made would be the margin between the rate given to the customer and the rate obtained from the liquidity provider. In the case of an inexperienced trader, his trade would most likely be “B” booked. That is to say, the risk would be taken by the broker and his profit would equal the traders' losses.
The situation that happened when the Swiss National Bank removed its peg on its currency versus the Euro put paid to ost “B” books. This made the market better for the traders as at least he wasn’t battling against his broker, just the vagaries of the market.
When the market was trading only to four decimal places, a one hundred pip move in major currency like Eur/Usd or Gbp/Usd was common as liquidity, while building, was still not as plentiful as it was today. If we take the story of liquidity back a stage further and the nineteen currencies that make up the single currency were all trading separately, you can imagine just how much less liquidity there was in even the major pairs like Usd/Dem and Usd/Frf. You could say that there was a natural p[rogression towards the Euro (manufactured by those creating the EU) as the market for Usd/Frf, Usd/Itl, and Usd/Esp etc. quickly became Dem/Frf, Dem, Itl and Dem/Esp.
Even when trading to four decimal places, not every pip traded. That was another factor of liquidity and brokers (mostly voice brokers) were often found to be without a bid or offer to show the market. I would estimate that a 100 pip move today was the equivalent of a five hundred pip move twenty years ago.
I was working as a trader on the overnight desk at a bank in 1992 when the UK withdrew from the ERM. The link explains the background but, basically, the Bank of England was desperately defending the 2.9500 level for the GBP versus the DEM and had been for a couple of weeks, raising interest rates several times and supporting virtually the only bid in the market.
Eventually, the floodgates burst on my shift and the pound collapsed. That is an expression you will hear often from brokers, commentators and analysts but until you have seen a move from 2.9500 to 2.6800 you haven’t seen a collapse.
That rather long piece of dialogue brings me to todays flash crashes. Flash Crashes are an overhang from other asset markets and the term has been coined as a way give a name to and go some way to explain what happens when the market is either “one way round” or the bids or offers evaporate and lead to a snowball down a mountain effect.
Anyone who starts to tell you some hard to understand explanation, that involves other assets, risk appetite or some other set of factors, either doesn’t understand or lacks the knowledge or experience to have lived through a proper market move.
Flash crashes will continue to happen as liquidity will never be perfect. One way to prove my liquidity based explanation is to take a look at when they tend to happen. Often in Asia where the market has odd market nuances, like Tokyo lunchtime and still more often at either the change of value dates or the change of predominant time zone.
Another subject we touched upon was cross currency trading. I have always maintained and even in the new market paradigm that exists that cross-currency trading is a product and not a driver of dollar-based positioning.
I see so many analysts telling me that there is a formation coming together is Aud/Chf or Cad/Nzd that should potentially reap dividends. That is maybe but for me, crosses are a bit of a double-edged sword. On the one hand, using fundamental analysis (which I realize is an anathema to most tech traders) to decide a currency which is going to weaken and selling it against a currency which is going to strength using similar fundamental criteria is a sensible strategy.
However, the cost of getting into or out of the position is often prohibitive, particularly as an unusual cross can be a flag to a broker and give them an opportunity to “read” you.
That is why many traders who are mathematical wizards can't get their heads around why the publicized rates for the two legs of a cross often do not equate to the prices versus the dollar and it is never in their favour.
Cross trades rarely drive the market. Occasionally there will be an instance where Eur/Jpy drives the two Eur/Usd and Usd/Jpy rate but nowhere near as much as the other way round.
Years ago I had a colleague who traded Usd/Jpy and more often than not when he was wrong in his position, he would blame the Dem/Jpy (shows how long ago it was) cross. Eventually, The Dem/Jpy trader convinced him to swap over for a week and he found that his “excuse” only worked in Asian time and then very rarely when a large order was being executed.
Simplicity is the watchword for every trader in this market who trades with less than a one week time horizon. Above that, you are close to becoming an investor and are entitled to study the interaction between various asset markets and where the complimentary flows exist.
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