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"Finding Fulfillment in the Forex Markets"

By Alan Farley
Special to RealMoney.com
01/27/2004 11:30 AM EST


"Imagine waking up just after midnight and trading a market that's more liquid than the NYSE and Nasdaq combined. Then imagine this market has all the excitement of tech stocks but has no uptick rules, pattern daytrading requirements or margin hassles.
As it turns out, this dream market is a fact of life for millions of currency traders around the world.



The foreign exchange markets, better known as forex, compose the largest speculative pool in the world. In Monday's column, I discussed many problems and drawbacks facing retail traders who want to play the forex markets while sitting at their home computers. As I noted, currency brokers tend to be unreliable or even hazardous to your health.

Many small traders are drawn to forex because it's a 24-hour market. They see currency trading as an opportunity to set schedules according to their own interests and biorhythms, rather than punching the clock for a New York, London or Hong Kong open. This freedom from exchange-mandated hours opens a whole realm of lifestyle possibilities.

But shady practices by unscrupulous brokers threaten to turn this dream into a nightmare. Fortunately, retail traders who have been burned in these quasibucket shops should see dramatic changes in the forex landscape in the next year or two. To begin with, forex brokers are facing growing competition from the Chicago Mercantile Exchange.

The CME now offers currency futures on all the major pairs and crosses. They've also introduced mini-sized contracts, but they're relatively illiquid. The standard contracts are priced near standard lot sizes offered by forex brokers.

For example, one euro/U.S. dollar futures contract translates into 125,000 euros. The spreads for these contracts are highly competitive, often a single "pip" (a pip equals $1 for every $10,000 traded). Even with futures commissions, the overall cost is highly competitive with that of forex brokers charging four-pip and five-pip spreads.

Futures contracts are also highly regulated, so you can avoid the forex broker shell games outlined in my last column. This is also a crossing market, so you're actually competing with other traders, not brokers that make markets against their customer base. The bad news is that the standard contract value is beyond the risk tolerance of many small traders.

Exactly how much money does a pip represent? Here's a common example. On the euro/U.S. dollar pair, one pip equals 0.0001, and a typical quote would be 1.2561/1.2566 bid/ask. If you bought one standard lot at 1.2566, you'd be holding $100,000 long in the trade. Each pip is worth $10 for each standard lot. So if you catch a rally and then sell at 1.2600, your profit would be 34 pips, or $340.

Forex brokers now offer mini-accounts that allow currency trading at one-tenth the value of a standard lot. In other words, you can trade in $10,000 increments instead of $100,000 increments. This cuts the pip value to $1 for each mini-lot. This scalability is one of the primary advantages of opening a forex account with a broker, rather than trading the futures markets.

There are other advantages to trading with a broker. Remember that Sunday morning last month when news reports emerged that Saddam Hussein had been captured? The currency markets were closed for the weekend but set to open on Sunday evening. Imagine you were long three or four standard euro lots over the weekend. The currency markets opened that evening with a 130-pip down gap.

Wouldn't this huge move trigger a loss of at least $4,000, with your carefully placed stop getting filled at the opening price? Not necessarily. Many forex brokers now offer "guaranteed" stops that execute at the requested price level, even if a weekend gap or breaking news takes over the markets. The price for this protection is usually an extra pip or two on the original spread.

Forex brokers also provide customers with some of the best charting programs found anywhere on the planet, at no additional cost. This complimentary software includes state-of-the-art technical indicators, full Fibonacci capacity and programmable trading systems. Add in free real-time quotes and traders can manage their costs efficiently so they can focus on taking money out of the market.

One last piece of news should hasten the demise of the typical forex broker: Banks are finally turning their attention to the retail market and may soon allow direct access to the Interbank system used by institutional traders. It's no surprise that this exciting prospect is meeting with stiff resistance from the current users. But most of us remember how Instinet was forced to open its doors to the public once a light was shone on its operations.

Economies of scale are reaching the level where banks can no longer ignore this booming market."

(in www.realmoney.com)

"A Perilous Foray Into Foreign Exchange Trading"


By Alan Farley
Special to RealMoney.com
01/26/2004 12:00 PM EST


"I opened a currency account last week, as if stocks and futures weren't enough to fill my trading day. When I began to research the subject, I knew almost nothing about the brokers, banks and the backroom games that fuel this booming industry.


Foreign exchange (forex) brokers are divided into two major business segments. At the top of the food chain are the futures commission merchants, who control the major trading platforms. These well-capitalized operations sell their services to the retail crowd and to "introducing brokers," who set up shop using the commission merchants' technology, but with their own white-label business entities.

Don't confuse retail forex brokers with the gargantuan Interbank system used by institutional traders around the world. These third-party providers brought small-scale currency trading to the masses during the darkest days of the bear market. They sprouted up like weeds at the time, benefiting from a confluence of beneficial market forces.

In 2001, new Securities and Exchange Commission rules limiting equity daytrading to accounts of more than $25,000 drove thousands of small traders out of the stock exchanges. Forex brokers took advantage of the exodus, offering bucket-shop requirements that let customers open trading accounts with as little as $300. To this day, the average retail forex account is funded with less than $1,000 of speculative capital.

Brokers also attracted new customers by showing them strong uptrends in the midst of a collapsing equity market. At the same time, online platforms were lowering the cost of trading currencies dramatically. Unfortunately, the brokers' business model put them at severe odds with their clientele. This conflict remains the darkest cloud hanging over retail forex to this day.


What They Trade

Small currency traders play five major instruments and dozens of minor crossing vehicles. Most of their attention focuses on the euro/U.S. dollar, the dollar/yen, the British pound/dollar, the dollar/Swiss franc and the U.S. dollar/Canadian dollar. A forex player can take a position on any of these pairs by hitting a button on the broker-supplied trading platform.


But these retail positions rarely make it into the deep liquidity pool of the Interbank system. Instead, forex brokers act as market makers, taking the other side of their customers' trades. In return, they offer commission-free dealing and keep the spread as their profit. This is where the trouble begins. Currency spreads are the biggest shell game in town.


The Pip Problem

Brokers typically offer spreads between four and five "pips" on the five majors (a pip equals $1 for every $10,000 traded). But spreads can stretch well beyond advertised levels during different times of the 24-hour trading day. In fact, the only way to see how a particular broker plays the spread is to watch their quoting systems through different market conditions. And make sure to take good notes at all times.

Forex traders may also face serious rebidding problems, even when the spreads stay narrow. This means the broker rejects the quoted price and demands more money to complete the transaction. This practice is highly pervasive at some brokers, but almost nonexistent at others. Even one rebid in 20 trades should raise suspicions about the broker's business practices.

A thousand other games can be played with the pip spread. In fact, I saw one interface where the euro was moving up and down so quickly that even an astute trader couldn't hit a market order within 20 pips of the intended price. And this Whack-a-Mole quoting happened during a dead market that showed no movement in the rest of the forex universe.



There's no central order book in currencies, with price discovery taking place through competing banks all over the world. This decentralization enables forex brokers to conduct relentless stop-gunning exercises if they choose. Remember that they're making markets against their customers and know where the stop orders have been placed. This conflict produces a wide price band that disreputable brokers will use to their advantage.


It's common for price to swoop around 20 pips or more to hit stops placed near support or resistance levels. Conspiracy theories abound about how stop-gunning fits into the forex brokers' secret business model. All stock traders can recall their unpleasant experiences with Nasdaq market makers and NYSE specialists. Then realize that forex brokers face the loosest regulatory oversight of any market operating in this country.

Then there's the issue of overnight carrying charges. Varying interest rates between currency pairs generate an obscure set of credits and fees for all positions held overnight. Some brokers even substitute this license to steal with flat charges that eventually bleed the profits out of long-term positions. Disclosure statements about these fees rely on technical jargon that's designed to confuse and infuriate forex customers.

Beyond spreads, stops and other forex scams, many brokers don't even insure their clientele against their own demise. This means you'll probably lose all your money if and when they go out of business. Just finding a plain English insurability statement is another exercise in extreme futility.

Now that you've been scared straight by the dark side of forex trading, it's time to look at the good side of currencies and their related trading platforms. Tomorrow I'll focus on the surprisingly bright outlook of this fast and furious business. "

(in www.realmoney.com)