Author Archives: John Forman

In an email exchange recently a friend of my working in the markets bemoaned the dull state of the forex market these days. I recall well how much grumbling there was in the middle 2000s about how little action there was in exchange rates at that time. I asked my friend if this was anything like that. His response was that the markets are the worst he’s ever known. No doubt there’s a fair bit of hyperbole in that statement, but this is a fellow who was a bank dealer in London back in the 1980s, so he’s seen a thing or two.

Overstated or not, the market has definitely gotten less volatile recently. As the weekly chart below shows, the USD Index has been in a quite narrow range for the last few months. That’s seen the Bollinger Bands get to their narrowest since 2006.

Weekly USD Index chart - click to enlarge

The range-bound dollar is linked to range-bound interest rates. As the 10-year Treasury Note yield chart below shows, the volatility there has dried up considerably of late as well. Exchange rates are closely tied to interest rates, and especially interest rate differentials. When those rates aren’t moving, it tends to keep the forex market quiet.

Weekly 10 year treasury chart - click to enlarge

Interestingly, though, the USD Index chart belies what’s been happening in the dollar exchange rates to a certain degree. If we look to the likes of EUR/USD and GBP/USD we can see weakening trends at work. These are being countered by an opposing trend in USD/CAD and USD/JPY (though in the latter case ranging is more the theme). That makes this a market where you want to be looking at specific pairs, not the major USD pattern as depicted by the index.

That said, however, the narrowness of the Bollinger Bands and interest rates suggests something big is building. One need only look at what has happened in the markets after the Bands got as narrow as they have become recently to see the potential for market mayhem this set-up represents. I’m definitely not calling for another Financial Crisis type experience for the markets. I think, however, that it won’t be too much longer before my friend is no longer complaining about dull markets.

Some noteworthy downside volatility in US stocks in the last couple of weeks has got the global markets quite nervous. Have we seen the top in the market? That risk is certainly there.

The first thing on the chart which jumps out negatively to me is the shooting star candlestick pattern on the weekly chart from last week. That was the result of the market making a new high, then failing and actually finishing low on the period. That’s visible in the weekly S&P 500 chart below.

Weekly S&P Chart - click to enlarge

The other thing I’m looking at which isn’t yet decisively bullish or bearish yet, but which represents potential either way, is the narrowness of the Bollinger Bands. As the lower plot on the graph above shows, that width is at its narrowest for quite some time – lower even than it got in late 2012 before the S&P 500 went on a 100 point rally over the next few months.

Narrow Bands worth both ways, of course. As such, if the market were to fall below about 1775 and get the Bands widening as a result, the implications would be negative. We are already seeing in the daily chart time frame that a relatively narrow Band situation there, combined with the break below the bottom of a key range, is seeing the S&P flip into a negative trend mode.

Daily S&P Chart - click to enlarge

It looks very likely from the daily chart set up that we’ll see the S&P 500 test the lower weekly time frame Bollinger Band. That would be a meaningful move at this point, so on a first go we may not quite see 1775 broken at this stage. That, however, could just set things up for a move through that level, and the widening of the Bollinger Bands which would happen as a result, signalling a likely longer-term bear trend move. Even then, though, the 1650-1700 area where the market ranged before would be a sticking point.

Let’s take a big picture look at the oil market for a moment. Below is the monthly chart of the front month futures contract. Since prices mailed their failed attempt to get back above 120 again in 2011, they have essentially gone nowhere. The market has been increasingly narrow in either side of about $100 for just about three years now. That has led the Bollinger Bands to become very narrow – even more narrow than they were before the Financial Crisis. Narrow Bands are generally an indication of a market getting ready to make a meaningful directional move.

Monthly chart - futures contracts - click to enlarge

Of course I’m not suggesting we start looking for another round of massive price moves and extreme volatility like we say in 2008 and 2009. Rather I’m suggesting it’s time for us to start looking for a range break to unfold in the long-term time horizon.

We may have to wait a while, though.

The weekly chart below shows us that range entrenchment is a major feature in that time frame. We can see a similar narrow Bollinger Band situation which has developed there, also suggesting that the market is poised to get more interesting in the weeks to come.

Weekly chart - futures contracts - click to enlarge

The issue, though, is any sort of volatility expansion or trend move from here would only move oil toward the edge of its long-term range, not beyond it. There would still be a significant hurdle to overcome to get into new territory and start that bigger picture move. As such, what we need to see in the weekly timeframe is a two-stage trend move – one to get to the range limits, then a second one to push beyond.

Naturally, the longer a range is in force, the harder it is to break. At the same time, however, once the range does break, things can get really exciting very quickly.

As things stand, probably the best plan of action for market participants for now is to expect more of the general same in the intermediate term. For those with a longer-term aspect to their work, however, now may be the time to start planning for the eventual pattern change.

Over the weekend, coming on the heels of the NY attorney general calling for curbs, 60 Minutes ran a feature story focused on high frequency trading (HFT). It features outspoken Wall Street critic and author Michael Lewis and takes a hard look at what’s going in the US stock markets and the implications for investors. It’s well worth a viewing.

There’s a link here to what’s happening in the forex market as well.

The two biggest inter-bank dealing platform names, ICAP (EBS) and Thomson Reuters have both been implementing measures in recent years to achieve exactly the sort of thing IEX in the video looks to do – slow down the HFT shops. Some of the things being implemented along those lines is setting minimum quote life times (how long a quote must be made tradable by others in the market) to cut down on “flash” orders, randomizing the order in which orders are processed, and widening some spreads and/or implementing minimum price moves (it’s been suggested that the move to decimalization in the stock market was the first step toward HFT dominance there).

Unlike the stock market where HFT is said to represent the vast majority of US trading volume, in forex it has not yet crossed the 50% threshold according to recent estimates. It is interesting that the least regulated global market is the one where the big platforms are being proactive about curbing the influence of HFT. Stock markets have been HFT-friendly in the pursuit of volume, in forex the operators are thinking more in terms of fairness and transparency as a way to gain market share. Considering that trading in stocks is more directly linked to consumer welfare than is the case for exchange rates, one would think things would be the other way around.

Who would have thought the “wild west” currency markets would be the ones where the strongest measures are being made by the participants themselves (rather than regulators) to curb abusive practices? If only they’d been a bit more proactive with that pesky fixing manipulation problem!


About this time last year I authored a post titled You May Be Better Off Trading Less which looked at the link between trading activity and performance among retail forex traders. Specifically, it showed how much worse traders do when they have high levels of account turnover. Not a pretty picture for very active traders.

Of late I’ve been working on drilling down on those numbers a bit. The turnover measure I used is basically total traded volume for a given month divided by the average account balance that month. So if one did $500,000 in trades on a $10,000 account the turnover reading would register as 50.

Turnover is a function of two things – how often one trades and the size of those trades. Thus we have two decision points. One is how frequently to trade. The other is the amount of leverage to use in each trade. In my research I took a look at the impact of those two different decisions to see which one was the bigger influence on trading performance.

For the chart below I broke the monthly data I have into quintiles based on turnover. The lowest turnover trader-months (one monthly observation of one trader) went in the first quintile while the highest went into the fifth quintile. I then averaged the returns for each quintile. I used two different types of returns. One is the actual realized monthly returns. The other was a hypothetical set of returns I developed in which I removed the influence of leverage. By that I mean I just looked at the change in the exchange rate for each trade an individual did and did not factor in trade size. So basically I have on set of returns which include the actual leverage employed by the trader and one which assumes a leverage factor of 1:1 for all trades.

Leverage and retail forex trading returns

Before I get into an analysis of the results, I should take a second to speak to something you have probably picked up on looking at the chart. All the returns are negative, with the exception of the Q1 deleveraged ones. This is to be expected. Retail forex is a negative sum market because of the spread, so when looking at any large number of participants the average return will be negative. This does not mean there aren’t winning traders, as there are.

On to what the chart is telling us. The blue line is realized returns. We can see that they get very bad indeed as one moves out the turnover curve. The Q5 average turnover is above 1500 while the Q1 average is only 10. In fact, the Q4 turnover average is 304, so those trader-months included in Q5 represent very, very high levels of activity.

The red line is the hypothetical returns assuming each trade was done at 1:1 leverage. The general pattern of returns being worse as one moves toward higher turnover is still there, but it’s much less stark. Things are markedly worse for Q5, but the middle three quintiles are pretty closely bunched and the first quintile actually shows an average monthly gain.

The gap between the two sets of returns represents the influence of leverage. My interpretation of what we see in the chart is that traders generally are not making bad trades, which in fact fits in with statistics I’ve seen showing about 60% of trades are winners. What we see here, though, is that they do make bad leverage decisions. To put it simply, they trade too big relative to their accounts.

They call leverage a two-edged sword, but the figures from retail forex traders suggests that most of the cutting is being done by the bad side of the blade.

The stock market has continued to chug along. The S&P 500 made new all-time highs just a short while back, extending the bull trend begun following the 2009 lows, and carrying on the momentum which really developed after the 2012 breakout.

S&P 500 bands are narrowing

One of the more interesting elements of the action in the last few month is that the Bollinger Bands have been narrowing on a relative basis. It’s been happening basically since the beginning of the year in the weekly timeframe. That may have actually aided the trend continuation process as the moves which really last a long time tend to do so on lower volatility. It’s when volatility starts moving higher that bullish trends start getting precarious.

We may just be on the cusp of volatility turning up, though. The Bands are now at their narrowest width in quite a while. This is generally an indication of a market ready to make a new trend move. The risk in this situation is that it means a market turning lower. The most recent move to new highs, if they are not extended, is that they represent a very minor new high and indicate declining momentum. If we get further new highs, and the Bands widen along with that extension, then that’s a positive. Should, however, the market fall down through 1800 or so and that gets the Bands moving wider once more then we’d be looking at good prospects for a meaningful correction.

So keep an eye on the stock market these next few weeks to see which scenario begins to play out. Since the USD Index is in a similar situation with regards to narrow Bands on the weekly chart, we very likely would be looking at corresponding moves, and thus would get a kind of confirmation.

In my post last week I took up the question of why someone would trade forex, looking a recent online debate of the subject. One of the aspects of said debate was the question of forex market efficiency. Perhaps coincidentally, there’s a new post up on the Liberty Street Economics blog (run by the NY Federal Reserve research group) which takes up the question of efficiency in exchange rates. The following graph is meant to be a visual depiction of that efficiency where EUR/USD is concerned:

Triangular Arbitrage on the Decline

What the chart shows is basically the frequency with which one could find triangular arbitrage opportunities in the market because of bid/ask quote discrepancies between forex dealers. In the early 2000s this was quite common, but that started to decline in the middle part of the decade and now is almost non-existent. The blog author cites increased automated and algorithmic trading in the market as the driving force. It’s hard to make a counter argument. Just looking at the rapid narrowing of spreads across all the major currency pairs backs up the increased efficiency in the markets these days from that perspective.

By the way, this improved efficiency is also a function of the competitiveness of the forex business overall. The estimates suggest high frequency trading in forex remains only a fraction of what is seen in the US equity markets, so it isn’t as big a force on things here. Lots of people piling into the market trying to earn a buck, however, definitely has had an impact. As the business of forex has grown, so has the battle for profits from it. That competition has helped motivate more efficient systems and narrower bid/ask spreads in the pursuit of customer business at all levels.

One of the other points made in the post is that unlike other markets, forex did not see a major efficiency issue during the Financial Crisis. The market continued to operate fairly smoothly. Certainly it was subject to volatility like everything else, but it wasn’t volatility driven by liquidity issues as seen in other places, like the fixed income markets. Certainly we’ve seen nothing like a Flash Crash.

That said, as I mentioned last week, market efficiency isn’t just about mechanical issues such as what the Liberty Street blog post evaluates. It’s also about how participants interpret and act upon in formation – the over/under-reaction question. Yes, forex might be a highly efficient market on a technical basis, but it is subject to psychological inefficiencies like any other.

Last week in this blog an exchange about the retail forex market was highlighted. It involved an article in the Financial Times asking the question why anyone would want to trade forex, with LeapRate offering up a counterpoint reply. Basically, what we have is a situation where one side (the FT) is listing all sorts of reasons why individuals should steer clear of the market while the other side is suggesting that most of those reasons are exactly the things which attract traders (there are also a number of comments on the original article, mainly in support). The points of conflict are interesting.

Market efficiency
One of the points the FT article seems to make is that the forex market, because of its size, is very efficient. The pro-efficiency argument being made here is that economic and political news is almost instantly reflected in exchange rates. While this is a classic efficient markets condition, if fails to take into consideration the way and how much markets react to new information.

If a market is truly efficient it would instantly move to the new price indicated by the news. It wouldn’t over/under-react ever. Anyone who’s ever watched exchange rates (or just about any other prices) after a major news release over any reasonable period of time knows they often have initial reactions which just don’t hold up. Over-reactions get reversed and under-reactions lead to new trends. Neither are indicative of market efficiency and by definition represent profitable trading opportunities if they can be spotted.

Small moves and leverage
The FT article makes note of the relatively small moves in the forex market. This lower level of volatility is something I’ve documented previously (initially here, then following up here). In this case it is viewed at as a driver of the use of leverage in forex trading since it’s hard to make any real money off of small moves. This is fair enough, especially when you talk about a market where even big trends are not major percentage moves. That said, however, if traders use leverage simply take the same size risks in forex trading as they would in stocks or any other market, then there’s nothing here making forex worse from that perspective.

Can the use of leverage get you into trouble? Certainly! You can get into just as much trouble trading stocks with less leverage than trading forex with more, though. It’s not the market. It’s how you trade.

Over-the-counter trading
The FT article brings up the fact that forex trading is not exchange-based, though doesn’t really drill down on what this means other than referencing action taken against one of the larger forex brokers. The implication here, I think, is that exchange-traded markets are more transparent and better regulated. That’s fair enough. Given all the controversy over dark pools , flash crashes, and the like in the stock market, though, one can ask some questions about just how strong the exchange model is these days. Additionally, the market for US Treasury debt is primarily OTC (putting aside futures), and it seems to function quite well – at least if you put aside the impact of all the Federal Reserve activity there. While there are certainly short-comings of OTC markets, we cannot say the one for forex is necessarily worse than the alternatives.

Few instruments
This ties a back to the efficiency argument, but is something I feel needs specific addressing from both sides. It is certainly true that forex trading is highly concentrated in just a few pairs. Beyond that, there are only so many traded currencies and all their relationships are linked mathematically. As the FT article says, that means you don’t have the hidden gem opportunities you can find in the stock market where there are thousands of securities. It’s an extremely valid point as there are areas of the market where the big players simply cannot operation which can give the little guy a better prospect of performance.

Here’s the problem, though. It takes a lot of time and effort to find those little nuggets in the stock market. That’s a cost to the investor. Also, investors are still untrusting of individual stocks after all the scandals and such of the last decade plus. So not only can trading individual stocks involve more work than trading forex, it also involves a trust which for many just isn’t there. I’m not saying these are necessarily good reasons to trade forex, but it’s certainly a factor in some minds.

The argument unspoken
The one thing the author of the FT article didn’t bring up is the negative-sum nature of retail forex trading. That underpins all performance and creates a massive skill game akin to poker where over time the money will tend to flow into the hands of the best traders. At least in stocks the little guy can work with the benefit of the long-term trends given a sufficiently long investing horizon.

The bottom line is that while I certainly admit there are major challenges to those involved in retail forex trading, the arguments made in the FT article are fairly weak. They could go much deeper and get more to the heart of the situation.

The other day figures were released showing ownership and net purchases of US Treasury debt in 2013. There’s a good set of graphs over at The Big Picture. The big headline in all this is that the Fed was far and away the largest net buyer, having account for over 70% of all issuance last year. Of course this is a function of the central bank’s ongoing quantitative easing program.

We should not be surprised by such big figures, and probably should look to see more of the same moving forward. Why? A couple reasons.

First, even though the Fed has begun tapering it is still replacing maturing Treasury securities in its portfolio. That means even if the Fed balance sheet is not expanding as rapidly as before, it is still a big player in the market just because of portfolio turnover.

Second, as the US federal deficit shrinks so too does the amount of Treasury issuance. That means the denominator in the Fed’s fraction of net Treasury purchase will be lower, helping to keep that percentage somewhat inflated. In other words, this is a case where it’s probably not a great idea to be too caught up in these ratios and percentages.

Another interesting element of the report is the ownership data. It shows that even though the Fed owns a whole lot of Treasury debt, it is still only the 3rd largest representative group. The U.S. public owns nearly twice as much, and foreign governments and central banks aren’t very far behind. Combined they account for nearly 70% of outstanding Treasury paper. For the reasons noted above regarding portfolio turnover, the Fed will continue to own a meaningful fraction of the US national debt, and the fraction could even rise a bit.

This supports something I talked about back in August when I described the Fed as basically being a big portfolio manager in the debt market.

Market MicrostructureI spent last weekend with an old market friend of mine. He was actually my manager back when I first became a forex market analyst all those years ago. Before that he was a forex dealer who got his start working in London back in the 1980s. Much of his career as a trader and an analyst was talking to people and getting a feel for where the market flows were in terms of big players, major pending order levels, etc. We talked a bit the other day about the value of having good contacts in the market, but how they have been drying up as a simple function of the fact that there are fewer and fewer actual people involved in forex at the professional level these days – at least when we talk about the banks who sit in the middle of the major transactional flows.

The shrinkage of employment in the forex market is something recently brought up on the Market Pulse blog with regards to the development of electronic trading. The suggestion there is that electronic trading platforms are doing to dealers in the currency markets the same thing they’ve done to floor or pit traders at stock and commodity exchanges the world over – making them obsolete. In forex, though, the industry shrinkage began in earnest with the introduction of the euro currency. Practically overnight a whole bunch of currencies disappeared – currencies that were quite actively traded in what was still a largely pre-electronic market system. That meant a lot of people were made surplus to requirements. Electronic trading, which is indicated as being 66% of the market volume now (vs. only 20% in 2001), has only continued the shrinking of bank currency desk employment.

Further piling on to the situation is all the regulatory focus on banks and other financial institutions these days thanks to things like the LIBOR fixing scandal and the push to reduce risk-taking through the likes of proprietary trading. This is further thinning the ranks at the major banks in the currency markets.

So what does this mean for forex trading?

Well, for one it means if you’re thinking to land a trading job at a major bank you’re probably going to struggle to find many opportunities. Hedge funds are the more likely employer these days, but that’s a highly competitive arena.

As for the markets, the question is one similar to that faced by the stock market. Does the move to an increasingly electronic market – especially in a situation where there is a fair bit of segmentation – increase the prospects for major volatility events? Think Flash Crash. An interesting book on this subject is Broken Markets, which might be worth a look.

Markets which lack a strong market-making element to them - which is the role banks have long held in currencies - can certainly be at risk of just such occurrences. Market making cannot prevent major moves from happening (like the Crash of ’87), but if it’s strong it can smooth things out and slow things down. The problem we have in the global markets at this point is that the market-making facility has been somewhat undermined in recent years by regulatory and technological developments at the same time as volumes have continued to increase. That’s not a great combination.

Also not helping the situation is the interconnectedness of the global financial markets. We saw that during the Flash Crash. What started off as being an issue with a few individual stocks actually fed through all of the markets. Once upon a time we wouldn’t have seen strongly correlated movements like that, but with computerized systems (algos) effectively creating strong linkages between the likes of stocks, bonds, and currencies the volatility of one market these days quickly spreads to others.

This isn’t to suggest the change in market structure is something which is likely to influence long-term exchange rate trends. It’s not. Those are driven by macro level fundamental drivers. It’s in the short-term where microstructure evolutions become evident in the form of different volatility profiles. This is something to which traders must adapt, as recently suggested by Brett Steenbarger.