May

20

 FX trading has become huge and very popular with the public, system sellers, and brokers. This report is from a dear friend.

I recently spoke to one of the largest Forex FCM's in the country, who has thousands of clients. He made a statement to me that is very telling. Out of the thousands of clients who have accounts with them, only about 60 - 80 are profitable this year so far. A majority are down significantly.

From Riz Din: 

Welcome to my world. FX does not afford sufficient protection to the public, and unscrupulous brokers abound. I hear complaints of trading platforms freezing up around the big numbers (payrolls etc), of orders being slipped, and of stops not being honored. I will not question the validity of these complaints but I do not believe they lie at the heart of the problem. Instead, I attribute most retail level blow-ups to inadequate capital and excessive leverage — with just 10k the inexperienced retail investor can command up to 4m of underlying.

There is also a high level of price uncertainty due to the lack of an underlying marketplace (this is being addressed). Also, while the manipulative marketing by brokers and system sellers is worrying, I have faith in the development of the market over the long-term. Spreads have tightened considerably over the past five years, and banks are moving into the retail space, offering trading platforms with more credibility than the off-shore broker who sends marketing e-mails offering 'price guarantees,' 'no slippage,' etc.

Also, while this may be less relevant to the day trader, another factor that makes FX trading a tricky proposition is the absence of a clear upward drift. Individual exchange rates may appear to exhibit long-term trends. But at their core, we are just dealing in relative prices and there is no such thing as a built-in reward for the entrepreneur such as is found in the equity market. Banks are now launching various ETF-type products that claim to capture the exchange rate beta — incorporating strategies that have proved rewarding over the longer-term, such as the carry trade. But I believe this is far more questionable than equity beta.

I find the dynamics of this marketplace fascinating, but there is no doubt that it's a tough racket. Still, I am surprised by those numbers.

From Chris Cooper: 

I, too, have been trading a lot of forex recently. I don't find it too hard to believe that there are very few profitable retail traders. Most retail brokers run operations designed to milk money from their customers. That, plus the leverage available, pretty much guarantees that few will profit. My commissions are not high, but since I trade fairly frequently (not scalping) I know that commissions alone cost me 50% of my equity annually. Slippage is even more costly. That's a pretty big nut to overcome.

There are retail brokers who are built with ECN technology, and these tend to give their customers a better deal. I would recommend either Interactive Brokers or EFX Group.

Once you move past the retail stage, I have noticed that another serious issue is liquidity. Because of the lack of a central exchange, you end up having to execute in multiple locations to find liquidity and that complicates the trading. Claims about forex being the biggest market in the world (trillions!) are so much hogwash. I can see that my trades have a brief but visible effect on the market occasionally, more than I see by trading index futures. It doesn't take much to buy the entire amount offered at the best ask.

I am optimistic about the industry, and one of the reasons is the big increase in numbers of small retail traders. They are certainly losing more than they have a right to lose, but the competition engendered for their accounts will ultimately better the experience for all customers.

Alan Millhone writes:

You all talk of 'slippage', lack of liquidity, costly commissions, retail brokers who milk their customers. Do all of you stay in the market as a challenge, make a living, just something to do to pass time?

In construction we also have 'fly by nights' who prey on the elderly and the unsuspecting and give the good builders a bad rap. Perhaps it is the same in any business. I have had plenty of experiences in the construction business where on the other end some people run out of money and simply will not pay you. Because the court always assumes the builder is making a fortune, 99% of the time it rules against the builder.

Chris Cooper replies:

To be fair, one must distinguish between the costs of doing business, which are simply features of the marketplace, and those which are borderline fraudulent.

Commissions, slippage, and lack of liquidity are all costs of trading which are fair in principle, and the magnitude is determined ultimately by competition among providers. Also, brokers in the forex markets artificially widen the spreads and take the difference for themselves, and trade against their customers. While perhaps not unethical, such practices don't enhance the perception of fairness that will ultimately lead to increased participation. Traders can educate themselves to avoid these brokers, but for now plenty do not. 

From Yishen Kuik: 

This brings to mind epidemic models. If account fatality rates are so high, should one assume that marketing is a key driver in this business (to renew the population of accounts)? 

Vincent Andres adds: 

My experience in the market is short. For what I understand from this retail market, I don't see that brokers need to do great marketing. In fact FX customers are too optimistic. They see what they want to see, e.g., "Mr. X won the FX contest with 1000%." They don't see what they should see, that 99% of participants loose their account.

I posit that some of the overconfidence may be due to the presumed knowledge each of us has about currencies, which seems simply better than what we have about stocks, etc. I believe I understand the Euro better than Merck & Co./Soybeans etc, simply because I practice/use/own them everyday.

The FX market is a closed finite market, with ten main currencies, 10×10 main vehicles. This may calm people, the liquidity meme, forgetting to look at the granularity of this liquidity. FX is de facto an oligopoly archetype, the guru. I understand nothing. But I rely on somebody who understands. In fact, the simili-pro is like one of Mr. Rafter's nice examples. The only thing the simili-pro understands is how to dupe his customers.

The reading of FX forums is a 4th dimension experience. The customer's innocence/ignorance/unwillingness to try to understand/learn/look seems without limits. At the retail level, there are few attempts to know the market, the brokers, who are the players, what is the leverage, the spread, etc. It seems like people want deliberately to play blindly. When they buy a piece of fish at the fish market, they will carefully compare, weigh, smell, touch, remember, etc. When they buy 10,000 euros with leverage 10, they will base it on two crossing lines from a surrealist Picasso like painting.

It is not so hard to quantitatively verify that a great part of the losses is not due to the market, but to the broker. People focus on the market (even completely wrongly), while the real play is not there. A great percent of trades/plays don't happen at the market level, but stay intra broker. (Hence, if you want to make money, you'll strongly have to make it from your broker, and not from the market. That's a rather different game.)

Despite all the above remarks, I found the FX a very nice teaching and training field. Since the broker's big obstacle, an oligopoly, etc, searching edges is quite hard. It's thus quite formidable. I do not pretend other markets are marshmallows, but the FX is specific. 


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