UNIT A| Absolute Essentials

5. Advantages and Disadvantages

There are some significant differences between Forex and other markets we will cover in this section. While a good trader may be able to handle any market, structural differences in Forex can force a different approach. Moreover many of the so called "advantages" bring some inherent risks with them.

Not Regulated

The global nature of the interbank market, without an unified or centrally cleared market for the majority of FX trades, make it difficult to apply a cross-border regulation.

Central banks such as the Federal Reserve Bank of the US or the European Central Bank provide to some degree oversight. But in general, the currency markets are much more lightly regulated than equity or bond markets.

There are, nevertheless, several institutions which supervise and regulate key players at a national level. We will cover the subject of regulation in the next chapter.

No Exchanges

While it is true that there is exchange-based Forex trading in the form of futures, the opposite condition occurs in the OTC market via the spot market.

Trading in a decentralized environment may be seen as having advantages or not:

In a decentralized market, trading does not take place on a regulated exchange. It is not controlled by any central governing body, there are no structured clearing houses to guarantee the trades and there is no arbitration panel to adjudicate disputes. All members trade with each other based upon credit agreements. Essentially, business in the largest and most liquid market in the world depends on the so called "margin" accounts, a concept similar to good faith deposits. This fact can be considered as a disadvantage, while the lack of clearing fees or other exchange fees can be seen as an advantage. Most brokers don't make you pay fees to maintain an account regardless of your account balance or trading volume.

Besides, the lack of an exchange means a difference in how the exchange is actually done. In spot Forex much of the trading done by individuals is actually directly executed with their broker/dealer. That means the broker takes the other side of the trade. This is not always the case but it is the most common approach.

This doesn't mean the broker is deliberately trading against you - he still has to offset his risk in the overall market. We will talk extensively on false and true myths about brokers in the next chapter (see True and False Myths in Chapter A02).

In a centralized market, you have the benefit of seeing real volume information, for example, and you might find comfort in knowing that there is a regulated mechanism backing your market participation.
Besides, the lack of a centralized exchange can lead to a discrepancy among price information from one market maker to the next, leading to the possibility of unfair trading activities.

At first glance, this ad-hoc arrangement can look like the wild west to investors who are used to organized exchanges. But be reassured, this arrangement works exceedingly well in practice: because participants in Forex must both compete and cooperate with each others, self regulation provides very effective control over the market.

Furthermore, reputable retail Forex broker/dealers in many countries are supervised by their national financial authorities, and agree to binding arbitration in the event of any dispute. Therefore, it is critical that any retail customer who contemplates trading currencies do so only through a regulated firm.
We will extensively talk about broker/dealers in the next chapter and how to inform and protect yourself.

Instantaneous Order Execution and Market Transparency

In the Forex world, fast order execution and instant fill confirmation is usually routine because you'll be trading via an Internet-based platform. Market transparency is highly desired in any trading environment. With no exchanges, there are no traditional open-outcry pits, no floor brokers and, consequently, no delays. Obviously, you might have to absorb some slippage if you trade during news announcements or if you trade a high volume, but normally all the prices on your broker platform are executable and your profit potential is not compromised.

Given the multi million-Dollar exchange that takes place every day in the currency markets, manipulation of the price is rather inexistent compared to other less liquid markets. However combined actions may occur in which several of the major participants - like central banks - force the market in a certain direction. That being said, this is not a rule but rather an exception.

In this regard, you should be informed of the market hours that tend to be more or less liquid as well as of the dates and times of the year in which the major trading places are less active. During low liquidity times the market is more vulnerable to erratic volatility or manipulation, like during the Asian session, or during longer periods such as holiday seasons.

In the stock market there are restrictions imposed on selling short that you don't have in the Forex. It is just as easy to take a short position as it is to take a long one. In Chapter A03 you will learn the mechanics to trading.

24-Hour Trading

The Forex is the only market which can truly be viewed as a 24-hour market, which is one of the notorious differences you will notice if you came from another market. There is trading activity in all time zones during the week, and sometimes even on the weekends as well. In other markets traders must wait until the market opens the following day in order to open a new position.

However each hour of the day has a certain level of liquidity and each currency is associated with the trading session normally corresponding to its time zone and business hours. The Yen, for example, may show a greater liquidity during the Asian session. In contrast, a currency outside of its normal business hours can display more erratic movements in a chart.

A market operating 24 hours is surely attractive but you can easily fall into overtrading, taking far too many trades. Exercising some discipline will help you avoid falling into this trap. This 24 hour nature is an attribute you want to transform into an edge in your favor. As a trader, you can put on or take off positions literally any time of the day or night. That opens the game up to you if you don't have otherwise available time to trade.

There is a number of major currencies involved, each of which is continuously interacting with all the others. Chances are, at any given time, there is movement in at least one of those exchange rates simply based on the impact of global news events providing impetus to action and ultimately on the supply-demand equation.

Superior Liquidity

With such a tremendous daily trading volume, the Forex market can absorb trading sizes that dwarf the capacity of any other market. This means a lot of trading liquidity and flexibility specially at London time, New York and Tokyo (in this descending order).

There are always participants willing to buy or sell currencies in the Forex market. Its liquidity, particularly in major currencies, helps ensure price stability and market efficiency. Traders can almost always open or close a position at a fair market price.

While it is true that currency markets have superior liquidity, it is also a fact that there are periods when liquidity dries up. This can happen during very volatile times or periods of market uncertainty. A volatile movement in price does not necessary mean a lot of volume, it can be just the opposite: fewer traders in the market means a thiner liquidity, which can lead to a big imbalance between buyers and sellers, resulting in a quick price movement in form of a spike or gap.

Because of the lower trade volume during the Asian session or even more during holiday seasons, investors in the Forex market are also vulnerable to liquidity risk, which results in a wider dealing spread or larger price movements in response to any relatively large transaction happening during these times.

High Leverage

The subject on leverage will thoroughly explained in Chapter A03 and you will be taught how to take advantage of it. Leverage trading means, in short, that you are permitted to trade up to 100 times your margin deposit. This is primarily attributed to the higher levels of liquidity explained before.

A leverage of 1:100 means: in order to buy and benefit from one lot of 10,000 US Dollars you only have to commit your 100 Dollars, the rest of the amount is leveraged by the broker-dealer.

While certainly not for everyone, the substantial leverage available with most online retail brokers in the Forex market is an essential attribute of this market. Rather than merely loading up on risk as many people incorrectly assume, leverage is essential in the Forex market. This is because the average daily percentage move of a major currency is less than 1%, whereas a stock can easily have a 10% price move on any given day.

A 100:1 leverage is commonly available from online Forex dealers, and sometimes even higher. This is a both way weapon: on one hand it lets traders profit from a lot size much larger than their investments. But on the other hand, it exposes them to losses of equal magnitude. You can win or lose quicker - that's right - but that's not all: a too small leverage can be equally dangerous as you will learn in Practice Chapter A.

The most effective way to manage the risk associated with leveraged trading (also called margin trading) is to diligently implement risk management in your Trading Plan. You have to devise and adhere to a system where your controls kick in when emotion might otherwise take over.

Margin Trading

The Forex market is a 100% margin-based market. This concept is strongly associated with the previous one of leverage. Online Forex brokers offer many opportunities to open smaller accounts than in other markets. That sort of flexibility opens the door to essentially anyone who wants to explore financial trading. This isn't to say that all brokers are that flexible. There are, however, a great many which offer so-called mini-contracts and even smaller accounts traded with micro-lots.

In fact, spot Forex trading is essentially trading a 2-day delivery transaction. This trade involves a cash exchange between two currencies rather than a contract. For that, your broker requires a capital deposit to provide surety against any losses you may incur. How much of a deposit can vary. Some brokers will ask for as little as 0,5%. That is fairly aggressive, though. Expect 1%-2% on the value of the position in most cases.

Note that margin trading does not mean margin loans. Your broker will not be lending you money to trade currencies (at least not the way a stock broker does). As such, there is no margin interest charged. In fact, since you are the one putting money on deposit with your broker, you may earn interest in your margin funds. This is what is referred to as the interest rate carry (or rollover).

When opening a position, one is essentially borrowing a currency, exchanging it for another, and depositing it. This is all done on an overnight basis, so the trader is paying the overnight interest rate on the borrowed currency and at the same time earning the overnight rate on the currency being held.
If you are holding your position longer than one day, your broker rolls you forward into a new position for the next trading day. This is generally done transparently and automatically, but it also means that at the end of each day you will either pay or receive the interest differential on your position.

Some brokers will not apply the day's interest differential value on positions closed out during the trading day. In this case, if you open a position with a negative interest rate differential, but you close it during the same day, the differential is not applied.

Lower Transaction Costs

The over-the-counter structure of the Forex market eliminates exchange and clearing fees, which in turn lowers transaction costs. There are usually no commissions in Forex retail trading because the trader deals directly with a market maker.

The market-maker makes money from the spread, which is the difference between what he pays for a currency and the higher price at which he sells it. In other words, the spread is the width between the bid and ask prices, which can be quite small in the major currency pairs, ranging between 2 and 5pips.

Because of the currency market round-the-clock liquidity and the competition among market makers, you receive tight, competitive spreads both intra-day and night.

The question if it is more cost-efficient to trade Forex in terms of both commissions and transaction fees depends not only on your broker's conditions but also on your trading style. Forex is more efficient if you know how to balance the number of trades and the earnings ratios. The usual lack of commissions is another factor that, despite being an advantage, has to be well understood to make it work in your benefit.

Profit Potential in Both Rising and Falling Markets

Every open Forex position has two sides because currencies are quoted in terms of their value against each other. This is because currencies are traded in "pairs" (for example, US Dollar vs. Japanese Yen or US Dollar vs. Swiss franc), one side of every currency pair is constantly moving in relation to the other.
When a trader is short in one currency he/she is simultaneously long on the other. A short position is one in which the trader sells a currency in anticipation that it will depreciate. This means that potential exists in a rising as well as in a falling market. Richard Olsen explains this particular characteristic of the FX market:

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We will spend a lot more time instructing you in the mechanics -about pairs, pips, spreads and leverage- so don't worry if it sounds complicated here.

In some of the equity markets it is much more difficult to establish a short position due to the zero uptick rule, which prevents traders from shorting a stock unless the immediately preceding trade was equal to or lower than the price of the short sale.
This ability to sell currencies without any limitations can be seen as another distinct advantage of the Forex market. You have equal potential to profit in both a rising or falling market, as there is no structural bias to the market.

Valeria Bednarik contributes to question the real advantages of Forex in one of her educational reports:

In the next chapter we will cover important issues about several market participants like central banks, commercial banks and specially retail brokers in much detail. You will also learn to differentiate true and false myths about all of them. Keep learning!