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.
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.
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.
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.