Forex Trading – Perspective from An Index Future Trader

Many beginners choose to start their trading career with forex. There are also traders who switch to trade forex from stock trading or index trading. Forex trading has been the trading vehicle in Asia for many years. However, it just gains mass appeal lately in North America.

How different is it from stock trading or index future trading? That is what I am going to talk about from the perspective of an index future trader.

Low Margin Requirement

Forex trading has greater leverage than even index future trading. For most forex trading brokerage, the margin requirement is 100 to 1. That means, you can trade at the size of ten thousand (10,000) dollars by having just one hundred (100) dollars in the account. Some firms even offer 200 to 1 margin. Comparing that to day trading margin for emini S&P, which has minimum margin requirement set by Chicago Mercantile Exchange at about 25 to 1, the forex trading margin requirement is very attractive to active traders. For stock traders, this type of margin requirement is just never heard of.

So, forex trading is more risky than stock trading or future trading because its leverage is so much higher. At 100 to 1 margin, you can make much more money when you are betting correctly. But, if you are wrong, the extremely high leverage will work against you at the same magnitude.

Many beginners in trading fail because they are not defensive enough to learn their tricks of the trade before running out of capital. For forex trading, it is especially true because a beginner can make a lot more mistakes and loss his/her capital at a much faster rate if care is not taken to protect the capital.

Dealer Market

Forex trading is done through a network of dealers, similar to the old Nasdaq dealer market environment in the 1990s. Thus forex orders at regular size round lots (usually start at a million dollar) can post as part of the bid or ask. For orders smaller than the regular size, either the brokerage bundle that with other orders before posting them, or, by employing electronic market making tools to facilitate the market for the smaller size clients.

Dealer market is not a centralized market. If you are well capitalized, and happen to open your account at a good firm, you are likely to be able to get better fill for your orders all the time. For small traders, whose accounts are not sufficient to trade the regular round lot size, then they are subjected to the market making capacity of the forex brokerage they are using. Usually, the ability to initiate a position is limited to market orders only. That means, you are subjected to the wider then normal spread for the currency pair you are trading.

If you do not understand what that means, consider the basic trading scenario – you buy at market and then sell at market right after. For stock market or very liquid index future market, you will simply lose an amount equal to the spread. For forex market, the spread you loss could be so wide that your trading bottom line is affected.

The other issue for smaller traders is that they cannot make any money if the price movement is less than the spread. It is simply an extension to the previous scenario. If you sell at the bid to initiate a short position, then you will need to wait for the asking price to drop to the point that equals your entry price before you can exit your trade at break even. Due to the wide size of the spread, you have to be correct in your initial call of the short term direction before you can even get a wash trade.

Extreme Liquidity

When trading stocks or futures, most traders like to trade something that is liquid. Liquidity is important because the ability to get in and out of the market anytime is very important for keeping the open profit or reducing losses.

For forex trading, liquidity is not an issue at all. For most situations, most traders can get in and out of the market if they are willing to do it at market.

But, there is a situation that liquidity could become a problem. When the whole market is in some form of panic situation, for example, back in the late 1990s, during the financial crisis, the Thai Baht can be moving in a single direction (down) day after day as the liquidity of the market is working against itself.

When such scenario happens, the market will move at much faster pace and catch many traders off-guard. For beginners, my advise is to stay away (stand at the sideline) from such market. Observing the price action is very educational, but participating in such market will require someone who is more experienced in dealing with such extreme volatility.

No Uptick Rule vs. Central Bank Intervention

Unlike stock trading, there is no uptick rule in forex markets. If you want to short, you can do so any time. That makes forex trading in the long side and the short side more a level playing field.

However, central banks can intervene the movement of a currency by participating in the market at critical price levels that it deems necessary to maintain the stability of the currency in question. It is not necessary that the central bank which intervened the market being the one whose country printed that currency. It could simply be the case that the particular central bank has special interest in doing so. For example, its been known that Japanese government is well known in its participation in the open market when US Dollar is dropping too fast against the other major currencies.

When a central bank intervene in the open forex market, it can push the price moving at extremely fast pace in a particular direction. If you stand at the wrong side of the market, no matter you are a big or small player, you will be adversely affected.

That is why many forex traders have active stop orders to protect their positions. Its not necessary that they wanted to do that, its just necessary in case something unexpected really happen.

Data Consistency

There is no real trade information for forex market. Most forex brokerage only broadcast a stream of bid and ask price updates. Thus there is no volume analysis for forex markets at all. There is also no tick volume analysis for the forex markets, something future traders like to use.

If you trade technically in instruments other than forex, you will likely find that forex data is noisier in general.

Forex data from one data vendor will not match another data vendor at all. The reason is that forex market is based on a dealer network thus different data vendor will get different set of data updates from a different group of dealers. That caused chart based indicator signals not consistent from one data vendor to the next.

When all the factors listed above are combined, you get a pretty messy picture for your technical indicators. It is especially true if you try to analyze the forex market at very small time frames like 1-minute bars. One solution is to work with higher time frame signals only so that you can have more confidence in the signals.

Summary

Forex trading is very different from stock trading or index future trading. Assuming you can simply transfer what you know in the other markets and applying that in the forex market is a big mistake.

When I get the chance, I will post more articles to talk about forex trading.

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