4. True And False Myths
Some traders do not feel comfortable with their broker being on the other side of their trades as they feel it presents a kind of conflict of interest. This is a worthwhile concern, certainly, but the fact of the matter is that the majority of Forex brokers are forced by competition to remain honest. There is no way for a broker to survive in the business unless the company keeps up its end of the deal.
As you already know, most countries have their own body or association that serves to regulate the sector in that country and ensure that clients' rights are protected. This body will insist on its members accepting the decisions of their arbitration panel in case of disputes. This should address the question about the safety of the funds and the lack of overall regulation. There is a lot being done recently in this regard and expect new regulations to come which will provide traders with more protection.
There is another common tendency amongst some retail currency traders to claim that Forex brokers trade against you and their main agenda is to wipe out your account hunting for stops. For an aspiring trader this information is very discouraging.
What happens is that, precisely because of the high leverage effect, most retail traders are forced to trade with stop losses. Otherwise, there is a risk of a forced liquidation in the form of a margin call.
As most of the stop orders are programed on the platform, the broker's dealing desk has access to this information. Not that the broker is watching your particular position, but rather the entire positions of the entire client base. This includes seeing where the most stop orders are clustered.
It's true that Forex broker-dealers, as market makers, can expand the spreads at any time. But more than often that is not what happens. You see, the information about price levels where stop orders are clustered is passed into the interbank market in the case of a non-dealing-desk broker. And the fact is that the market will react to those orders. In the Forex market stop losses are interpreted as orders, that is as a willingness from market participants to take action at a certain price level. A stop order always corresponds to a sell or buy order, and the market will react to it. This subject will result clearer to you studying the next chapters, as more pieces of the puzzle will be revealed.
Due to non-centralized pricing in the Forex, the broker, as a market maker, can expand the spreads at any time. An expansion of the spreads happens specially during the so-called news events or high volatility moments, when customer's stop orders are eventually filled. Take into account that during news events, the broker also experiments higher spreads in the interbank market.
Because of this unusual duality of the Forex market (high leverage and almost universal use of stops), 'stop hunting' is a very common practice. Although it may have negative connotations to some readers, stop hunting is a legitimate form of trading. It is nothing more than the art of flushing the losing players out of the market.
In Forex-speak, they are known as weak longs or weak shorts. Much like a strong poker player who may take out less capable opponents by raising stakes and buying the pot, large speculative players (like investment banks, hedge funds and money center banks) like to gun stops in the hope of generating further directional momentum. In fact, the practice is so common in the Forex markets that any trader unaware of these price dynamics will probably suffer unnecessary losses.
It should not be considered stop hunting when the price simply goes against you by 30 or 40 pips all the way to hit your stop order. To move the price by so many pips, the broker would have to accumulate a position of millions of Dollars in the process. Besides, their agenda is to get you to trade more and therefore earn more via spreads, commissions, rollovers, etc. If you wipe out your account they probably loose a costumer.
Richard Olsen explains why the Forex market over-shoots all the time in its pricing:
...The market maker has no psychological attachment to any price level; he only wants to balance his book and exit the position as quickly as possible. In the face of an instantaneous imbalance between buyers and sellers, the market maker will move the price as far as he needs to, in either direction, to solicit the trading action he desires. In extreme cases he will not only move prices but also widen spreads to fend off unwanted increases in position — an action that compounds uncertainty.
This self-interested action moves markets. The new price becomes the reference point for every other position in the marketplace. With way disproportionate consequences: a $200-million trade (which, with leverage, might require only $20 million in equity) can move EUR/USD, with cascading effects of triggering stop-losses that push prices well outside any “rational expectation.”
The hole in the story is that an artificial movement of the exchange rate represents a huge risk for the broker as well, as this position may have to be compensated in the real market. A different situation is, like Boris Schlossberg points out, that strong market players, like banks or hedge funds, coordinate their actions around key price levels. In such a case, a cascade of stop orders can eventually accelerate momentum and change the direction of a trend.
The question is: is such a myth really unbiased or is it written by traders who emptied their accounts because of lack of experience? After all, we only tend to complain when things go bad!
Taking responsibility not only for your wins, but also for your losses is a personal trait any trader should develop. Learn from your losses and accept them as valuable lessons and you will progress faster on your journey to become a trader.
A dealing desk is the place at an institution where contracts are bought and sold. Your dealer may imply that by trading with them you will not have to work through a dealing desk, giving you better pricing. This is not true. It may be correct that your order won't be handled by your dealer's own dealing desk, but your order will eventually wind up on someone's dealing desk at one of your dealer's broker banks. If it is going to cost you the same amount of money in the end, does it matter to you whether your order is handled on your dealer's own dealing desk or Goldman Sachs' dealing desk? The dealer you work through and your dealer's broker banks will be compensated for the service they offer, and it will be a cost to you.
And they go on writing:
ECNs are electronic clearing networks that list the orders from professional and retail traders in one place. This adds some nice transparency into where orders are listed, but the actual fills you will get are not usually any better than working with a dealing desk.
The idea behind ECNs is that it should be possible for a retail customer to save some money by setting a limit order in between the normal bid and ask spread. However, you can do the same thing using a regular dealer. Just because an ECN shows you that there are bid and ask orders above and below the current price of the currency pair does not mean that you have any better chance of being filled at one of those levels by trading through an ECN. Those same orders are influencing prices at regular dealers too, even if you can't see them displayed.
ECNs are managed by clearing firms, which are similar to dealers. And just like dealers, the clearing firms that operate ECNs are looking to be compensated for the service they provide. That translates into a trading cost for you.
To every dark side, there is a plus. In the case of retail brokers, they provide an advantage: you can open an account with very little investment and get very high leverage. With an ECN Forex broker the leverage is generally much lower and the minimum account deposits are higher.
These are some criteria that you can follow on your due diligence and that will protect you from the rare but possible event you experience major problems with a broker-dealer. Another measure you can adopt is to split your funds among few brokers. Sometimes even apparently good companies go bankrupt and it can catch you unprepared. Besides, by working with more than one broker, you can profit from more features and get to know which of them make you feel comfortable.
What you have learned from this chapter:
- The conditions resulting from Bretton Woods make international currencies set their value depending on the Dollar, leaving the economies of these countries somehow dependent on the monetary, and also political, decisions of the United States. While this is only part of the big picture, you have learned that building a macro view on the financial markets, is essential to conduct your business as a trader.
- Central banks or national monetary authorities are active in the markets, buying and selling currencies to influence exchange rates, as a means to control interest rates. You have seen that these interventions can take the form of direct buying or selling to push prices up and down, or using the so called jawboning tactic.
- The wholesale currency market works thanks to credit agreements between main players. It could be not otherwise in a decentralized market- where trading does not take place through an exchange. These credit arrangements are similar to the ones you find on a broker's margin account.
- Not all broker-dealers intermediate the same way. Some do it through their own dealing desk, others route the orders through another market maker, while still others function as a market maker network.
- Concerning the trading costs, one thing is certain: as a trader you always pay the cost and the intermediary always earns its revenue, be it a market maker, a non-dealing-desk broker or an electronic currency network. This means that trading costs should be considered as a part of the business and never taken as a primary reason for choosing a certain broker/dealer.
- There are a few things that you can do to protect yourself as a trader besides objectively investigating a broker in terms of capitalization and regulation: for instance, diversify your trading capital among several brokers; have direct phone access to their trading desk or support team; and keep investigating, interrogating and cross-examining brokers as you develop your trading profile.
This chapter involves a lot of due diligence work on market players and also an awareness of global politics, as the ramifications reach beyond diplomatic relations and go straight into the markets. Feel free to share your findings and questions about this second chapter in our social network!