Thursday, March 16, 2006

Forex: Know the Market You're Trading!

My recent article in Trading Markets emphasized the importance of the fit between the personality of a market--its degree of volatility and trending--and the trading style of the trader. Quite a few readers wrote to me, asking about which market would be best for them. Many asked specifically about currency (forex) trading, since instruments such as the Euro are known to be trending and volatile.

My next article for Trading Markets will examine whether the Euro truly is a superior trading instrument. I think you'll be surprised by the findings. Without giving away too many punch lines here, allow me to mention one important finding: I find no evidence of trending in the currency market on either a 30 minute or daily basis. In fact, up periods are modestly more likely to be followed by down periods (and vice versa) than by continuation.

Many brokerage houses specializing in currency trading--especially those going after retail customers--stress what wonderful trending markets currencies are. They also emphasize commission-free trading with "only" a three-pip spread and possible leverage of several hundred to one on your money.

Well, each pip in the Euro emini is like a tick in the S&P emini: worth $12.50. So the highly leveraged trader in a market he thinks is trending, buys a volatile period and what happens? He is down three ticks on size already even if he scratches the trade. But when the market reverses with high volatility, he quickly is in the red by a substantial amount.

I spoke with a very well placed industry insider who revealed to me that the average length of time from the opening of a trading account to the closing of that account was seven months. This was not because the trader was dissatisfied with the firm; rather, that was how long it took the average customer to blow through their capital.

Yale Hirsch says, "Investigate before you invest." That's wisdom that applies equally to traders.

8 comments:

John Wheatcroft said...

I can guarantee that forex is a good place to make bets with about the same expectation of success as one has at the racetrack (actually I do better at the racetrack - fewer crooks involved). The only time I could make money on the currency was when I gamed the US announcements regarding interest rates and inflation. If I believed that the interest rate announcement would be up I would short the Euro and as soon as it was announced I would take my profit down and do something else until the next announcement.

It is a hard way to make money. And if you get a couple of announcements that go against you - you can go broke quick. They run through the stops like a hot knife through melting butter.

Seriously - if you want to try it take advantage of the play accounts and see how you do. That should disuade you.

Brett Steenbarger, Ph.D. said...

Hey John,

I love your line about the racetracks; maybe I'll do a quantitative study looking at the crook ratio in various markets... :-)

Seriously, though, my experience FWIW is that a greater proportion of traders fail at currency trading than at trading other markets. I believe one important reason for this is that the cash market, which is dominant, is not centralized. It is thus impossible to get the same kind of handle on volume and supply/demand that you can get in equities or fixed income. The few successful forex traders I've known have been affiliated with large trading firms (hedge funds, banks) and have superior fundamental information to trade from. Those are not short-term traders, however.

Brett

John Wheatcroft said...

A little off this topic but on the main topic of trading and volatility. I was looking through some notes and came across an interesting proposition. If I had large resources I would simply watch the DOW Indu on a 10 minute basis and take positions in the XLI since the INDU precedes the XLI by a couple of seconds (or days on a daily scale). Here is where I think it gets interesting - since the action of the 30 DOW stocks make up the action of the INDU index if the XLI is purchased then the same stocks have to bought again (in an upwardly biased event) or sold again (in a downwardly biased event). Consequently small moves of the DOW stocks that move the index lead to larger moves of the same stocks when the XLI is grabbed up. I call this the "echo effect".

I'm not sure how this works with the futures as you mentioned earlier since my take on the futures is that there is really no stock buying/selling involved just a bet on direction.

Brett Steenbarger, Ph.D. said...

Interesting observation, John. An increasing proportion of automated trading has been devoted to exploiting such pricing inefficiencies. It's also interesting to watch SPY move (in penny increments) prior to moves in ES (in quarter point ticks).

Brett

Phil said...

I have been trading forex since 1981 and I have always thought (rightly or wrongly) that the Japanese Yen and Swiss Franc trended best in this sector. Perhaps you can extend your analysis to these currencies.
I always enjoy reading your work. Thank you.

Brett Steenbarger, Ph.D. said...

Thanks for your observation, Phil. The Swiss Franc has been pretty well correlated with the Euro in my prior studies, but those were a while ago and need updating. It would also be interesting to investigate trending in the various crosses, eliminating the USD as a variable. Thanks for your interest; I hope to be able to follow this up once my book is completed (and no longer occupying double-digit hours per day!)

Brett

Brandon Wilhite said...

Brett,

I would really like to see some research on the crosses since all the majors are highly correlated. I'm one of the newer retail clients (since May '05) and I've noticed that I seem to have a very hard time trading the majors. The crosses, however, tend to follow range-bound patterns pretty well with some very good moves. Thanks for sharing your work.

Brett Steenbarger, Ph.D. said...

Hi,

Thanks for your note. I do think looking at crosses that eliminate the USD would be most interesting and might turn up different patterns of trending and volatility.

Brett