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The Basics

It’s not your broker stop-hunting you

Stop-hunting is a very commonly discussed topic in the retail forex community – probably more so than it really deserves to be. It seems to come from a fundamental lack of understanding about how the markets operate. A prime example is a recent thread started on BabyPips where the poster asked if it was possible for ECN brokers to run stops.

Here’s the deal. Despite what some people would like you to believe – mostly because they refuse to accept blame for their own inability to perform in the markets – brokers do not make a habit of running customer stops. They really just pass prices through from the inter-bank market. ECN brokers don’t make markets at all (yes, there have been some cases of manipulation, but they are not nearly as prevalent as the blamers suggest). They just pass customer orders through into the market for execution in a way not dissimilar to the way stock or futures brokers operate. They have absolutely zero influence on the prices shown.

Stop-hunting, which really should be called order-hunting because they go after limit orders as well, happens in the inter-bank market. If the market price gets sufficiently close to a level where it is suspected that a high quantity of standing orders sit, certain types of traders from banks, hedge funds, etc. will attempt to get those orders triggered to benefit from the subsequent move.

Talk with anyone who’s been a professional trader in anything like a market maker or floor trader situation and they will have plenty of stories about stop-running. It happens in all markets, not just forex. The way to avoid it catching you out is to either not use standing orders or to place them at price levels away from chart points where a lot of other traders are likely to have their orders.

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Best Of The Basics

The Most Traded Currency Pairs

The question often comes up among forex traders (especially newer ones) as to which are the most traded currency pairs. There’s no central source of information from which we can figure out how the various currency pairs rank, but we can look to the periodic surveys done my the central banks and monetary authorities of the major global regions to get an idea. These reports are based on the survey of banks, so they don’t really capture activity on the retail level. That is currently only about 5% of total daily volume, though, and market prices are set in the inter-bank market in any case, so we’re not really missing much in the survey data.

Global Most Traded Currency Pairs

Coming up with a solid global ranking outside the top couple of forex pairs is a challenge because the regional reports tend to focus on the main pairs traded in those regions and don’t parse out some of the less active ones. For example, the USD/CAD and USD/CHF currency pairs are not reported individually in the Japanese data, so it’s hard to get them in the proper rank order. The list below is probably a pretty close representative of how things rank on a global basis, though (based on April 2011 data).

  1. EUR/USD
  2. USD/JPY
  3. GBP/USD
  4. AUD/USD
  5. USD/CHF
  6. USD/CAD
  7. EUR/JPY
  8. EUR/GBP

It should be noted that EUR/USD is way ahead of the other most traded currency pairs in terms of daily trading volume. That one pair does something like 50% more volume globally than both USD/JPY and GBP/USD combined.

You will notice that I did not include the more regionally-oriented forex pairs like USD/MXN, EUR/SEK, USD/KRW, etc. If you’re interested in them, I recommend exploring the individual report (links are provided below). Also, these figures are based on spot market volume, and do not include swaps, forwards, or options.


What Forex Pairs Should I Trade?

If you are a short-term trader then you’re going to want to focus on the most traded currency pairs because they are generally active enough in that time frame to be worthwhile, and also offer the best bid/ask spreads. If you are specifically a day trader or scalper, you’ll want to focus on the the top forex pairs for the region you trade in to further ensure the best trading conditions. Traders who operate in longer-term swing and position trades, though, need not concern themselves as much with focusing on the most traded currency pairs, though. The costs and requirements for short-term movement are not a real issue.


Most Traded Currency Pairs by Region

Here is a center-by-center breakdown of the top forex pairs for each region. Again, this is for spot trading only. Swaps, forwards, and options can add considerably to the volume totals (more in some regions than in others). If you want to see the full center totals you can follow the links to the individual reports.


London

London remains by far the highest volume trading center for foreign exchange. It therefor won’t come as much surprise that the global pair ranking is very similar to the one for this specific center. Based on the most recent data, here are the most traded currency pairs in for the London market.

  1. EUR/USD
  2. GBP/USD
  3. USD/JPY
  4. AUD/USD
  5. USD/CHF
  6. EUR/GBP
  7. USD/CAD
  8. EUR/JPY

As was the case with the global figures, EUR/USD does about 50% more volume itself than the next two pairs combined. There are a lot of pretty active regional pairs (non-Euro Zone continental currencies) as well as those listed above. See the Bank of England website for additional details.


U.S. (New York)

The second largest of the trading centers is the U.S., with New York still the main focal point. Here are the most traded currency pairs in for this region.

  1. EUR/USD
  2. USD/JPY
  3. GBP/USD
  4. AUD/USD
  5. USD/CAD
  6. EUR/JPY
  7. USD/CHF
  8. EUR/CHF
  9. EUR/GBP

The top non-majors currency pair in this region is USD/MXN, with USD/BRL only doing about a third of that volume. See the New York Fed website for additional details. Note that the Canadian Foreign Exchange Committee also does a volume survey, but it does not break the figures out into individual currency pairs.


Tokyo

Here are the most traded currency pairs in for the Japanese market. As indicated above, the Japanese report does not have very much depth in terms of specifically parsing out the most traded currency pairs, so the list isn’t as long as for other regions.

  1. USD/JPY
  2. EUR/USD
  3. EUR/JPY
  4. AUD/USD
  5. GBP/USD

There is a big drop off from USD/JPY to the EUR pairs,with the former doing between three and four times as much volume. Similarly, then another big drop to the other two most traded currency pairs from the EUR ones. See the Tokyo Foreign Exchange Market Committee website for further details.


Australia

Australia (primarily Sydney) has become a very significant market in global foreign exchange on a total volume basis. It’s not a broad market, however, in that trading in the Aussie dollar dominates (not surprisingly). Here are the most traded currency pairs.

  1. AUD/USD
  2. EUR/USD
  3. USD/JPY
  4. GBP/USD
  5. USD/CAD
  6. EUR/JPY
  7. EUR/GBP
  8. USD/CHF

Among the pairs trading in Australia, AUD/USD does about four times as much volume as EUR/USD, and it drops rapidly off even further after that. See the Reserve Bank of Australia website for further details.


Singapore

Singapore can’t compare to London or New York for sheer trading volume, but it is a broad-based market where most of the major Asian regional currencies trade. Here are the most traded forex pairs.

  1. EUR/USD
  2. USD/JPY
  3. GBP/USD
  4. AUD/USD
  5. EUR/JPY
  6. USD/CAD
  7. USD/CHF

The volume pattern in Singapore shows EUR/USD with nearly 2.5 times as much volume as USD/JPY. Interestingly, EUR/USD does about as much volume in Singapore as in Australia, both of which do about double the volume in Japan. See the SFEMC website for more details.

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The Basics

Noise Trading

One of the more interesting topics I’ve come across in my delving into research in the area of Behavioral Finance is the term “noise trader”. I’ve been reading a paper on the subject which has former Treasury Secretary Larry Summers as one of the co-authors. To put it simply, noise traders are those who do not operate on a strictly rationale valuation basis when making buy/sell decisions in the market. In other words, if you’re reading this blog post you are almost certainly a noise trader in the way academia defines the term.

One of the things I find interesting is how Summer & Co. refer to the non-noise set of market participants as “sophisticated investors”. The implication is that these folks can build a proper valuation model with the correct inputs that correctly account for risk. The implication is that noise traders can’t correctly estimate future risk (among other things), while the so-called sophisticated investors never makes any errors in estimating all the contributing factors which go into a valuation calcuation. Not very realistic in a world of failable human actors, in the latter case, or in terms of valuing the abilities of some very smart researchers on the other.

What’s kind of funny is the expressed observation of the paper that noise traders make value investing a sub-optimal course. One the one side, noise traders are said to increase volatility, and thus risk, reducing asset prices (stocks, really) in terms of their attractiveness to the non-noise set. On the other side, the added volatility actually increases the returns accruing to a noise trading approach. I think a lot of traders will feel vindicated in this. 🙂

I haven’t gotten all the way through the paper, and there’s a lot of very academic stuff, so it’s not the easiest read in the world. For those with an inclination, though, it’s an interesting bit of intellectual discourse.

Categories
The Basics

Influences on Price/Earnings Ratios

The Price/Earnings ratio (P/E) is a metric commonly used in fundamental analysis of stocks – both individually and in terms of indices. It can be a useful gauge of relative over- or under-valuation both in terms of looking at a stock or index singularly, or in comparison with others. For example, one could evaluate where the current P/E of JPM is in terms of it’s historical levels and/or in terms of how it compares to BAC, C, WFC, and others in the banking sector.

It’s not recommended that P/E be used in isolation – meaning low P/E = cheap stock, or vice versa. There are reasons why a P/E can be low or high, including changing expectations for growth rates which have not necessarily started showing up in the earning data. For that reason, you should only use the P/E in conjunction with other forms of analysis.

Looking at Stock Valuation Math
In thinking about doing so, it’s worth noting the two mathematical influences on the P/E ratio when looking at the valuation of a stock. They are the earnings growth rate and the interest rate. Stock valuations are done by determining what future earnings are expected to be, then discounting them back to the present by doing a Present Value (PV) calculation.

Earnings growth rate assumptions obviously factor into the expectations for future annual earnings per share figures. The table below shows the impact of different levels of growth rate expectations for earnings on valuation, and thus P/E.

The above calculations only go out to 5 years. Valuations are often done with an additional perpetual growth rate for the years beyond #5. For the purposes here, however, five years is enough to make the point.

Notice in the yellow Value row how the valuation of the stock in question (based on adding the PVs of the earnings forecasts for Years 1 through 5) rises as the assumed annual growth rate (left column) goes from 0% up to 20%. Using the Year 0 earnings (current year achieved result) as the E in the P/E, and the valuation as the P, we get the P/E listed in the right-most column. Notice how it rises in line with rising growth rates.

Now, this probably won’t come as a big surprise. It’s commonly understood that higher earnings growth rates translate to higher P/Es. That’s why the P/E of a perceived growth stock will generally be higher than the P/E of a more mature stock, like a utility. It also should be noted, however, that P/Es also vary because of interest rates. The discounting of future earning’s done in the valuation process employs an interest rate to calculate the PVs. Thus, interest rates impact P/Es.

The chart below provides an example.

The chart above shows the P/E value of a stock with a 5% annualized earnings growth rate with valuations determined using discount rates from 1% to 10th. Notice the steady decline as interest rates rise. It’s not a big change, of course. Changes in earnings growth rates are more impactful. This may be something very important for the stock market moving forward, however. If we think interest rates are going to be rising in the years ahead, then we have to factor in slightly lower P/E ratios.

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The Basics

Positive Points, Negative Profits

A subject of conversation in the blogosphere in recent weeks has been the idea that you can have a positive point or pip (I’ll use points for simplicity from now on) balance from your trading, but end up with a negative net P&L. This may sound like an impossibility, but I assure you, it isn’t. Let me provide an example.

Let’s say you do 10 trades. You have a 60% win rate and make 50 points on average for those winners while suffering 30 point losses on the other 40% of trades. That tallies up to a total gain of 120 points (6 x 40 – 4 x 30). This looks like a pretty good result, right?

The problem with the above is that it assumes all of the trades are the same size, the same value per point gained or lost. As soon as you start including trades of different sizes you cause problems with using point accounting to gauge performance. All I have to do is change the size of one of those losers to make something that looks quite positive into something with a negative bottom line.

Let’s say for 90% of your trades each point is worth $10, all of the winners and three of the losers. That translates into a net profit of $1500 (6 x 40 x $10 – 3 x 30 x $10). If, however, you had a really good feeling about the last trade and put on a position ten times the size you normally traded ($100/pt), then the 30 point loss for that final position would wipe out all the net gains from the other 9 trades and end up $1500 down ($1500 – $100 x 30pts). Suddenly the total point gain figure doesn’t seem so good anymore, does it?

You may be thinking you’d never trade 10 times your normal size, but that’s not really the point. You can create any number of scenarios in which the point tally is positive and the actually profits are negative or break-even or decidedly unimpressive because of variation in position size between trades (or just as easily the other way around where it results in much more impressive performance than the point tally suggests). That means unless you always trade the exact same point value, counting points doesn’t tell the real story of your trading.

This is exactly the reason why I’ve been a proponent of using other measure to gauge performance. Obviously, % return is a good one, though that doesn’t factor in risk. Using R is a good way to incorporate risk into comparative performance measurement. Whatever you use, though, just make sure to be aware of both its benefits and short-comings.

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The Basics

Taxes and Cutting Your Losers

I’ve been doing quite a bit of reading on the subject of Behavioral Finance of late (and will only being doing more and more in the future). I haven’t been in the academic finance arena since I did my MBA in the late 90s, so some of what I’m going it refreshing my knowledge base and reaquainting myself with the academic viewpoint. It’s really easy to slip away from that when you’re focused very closely on real world markets and regularly interacting with real-world traders, not just the ones imagined in the academic literature. (On the Behavioral Finance subject, I encourage you to watch Mind Over Money.)

One of the things that has come up fairly frequently in the articles and papers I’ve been reading is the idea of cutting your losses and letting your profits run. Now this is an academic discussion, so it has relatively little to do with what most traders think when that sort of advice is being offered. Instead, the academics are referring to the tax implications, especially since they most often are referring to stock trading/investing.

Here’s the logic
When you close a position you trigger a tax event. If you exit a profitable position you’ll have a tax liability – obviously – so it behooves one to hold on as long as possible to defer that event. This is particularly true near year-end when a shortly extended holding period can defer a tax bill by 12 months or more.

As for cutting your losses early, that’s the flip side. When you take a loss you reduce your tax liability. That means it behooves you to book your losses quickly. In effect, the tax impact reduces your net loss. For example, if you’re tax rate is 20% and you’ve taken a $1000 trading loss, you’ve effectively only lost $800. In other words, your account is effectively worth $200 more if you take that loss than if you hold on to the trade. The academics I’ve read seem genuinely incredulous that traders and investors would hold losing positions for exactly that reason.

Know the Law
Now there are all kinds of different tax rules in the global array of jurisdictions and markets. For example, in the US securities (stocks, bonds, options, etc.) fall under normal capital gains where the tax impact is only felt when a trade is closed. Futures and forex are treated differently in that your positions are marked-to-market at year-end. That means the timing of your exits doesn’t really matter. The rules are different in other countries, though, especially when you bring in things like spreadbetting, so make sure you know how your country’s tax laws impact your bottom line.

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The Basics

The Cost of Trading

Last week I wrote a post for the Currensee blog addressing a recent SmartMoney article attacking forex trading from the perspective of costs. The article was full of misinformation of the sort I’m coming to expect from those writing about forex (and trading in general) from a journalistic point of view. I wasn’t shy about taking the author and her editor(s) to task for the piece’s short-comings.

One of the core elements of the discussion in my post was the impact of spreads on one’s trading. In the spot forex market spreads are readily visible because that’s how the market presents price feeds. In exchange-traded markets, however, spreads are often quite opaque because it’s traded prices that are the dominant presented part of prices feeds. The fact of the matter is, however, that bid/ask spreads exist in all markets.

Over the last couple days I’ve been collecting spread indications from a wide array of markets at random 15-30 minute intervals during the NYSE trading day (to ensure that all markets involved are open and active rather than including pre-market and other non-primary sessions). Here is the result of the study including some of the most actively traded market instruments.

The equity instruments were selected based on regular inclusion among the most actively traded securities (on a shares basis), so the list includes a couple of index ETFs as well has high profile individual stocks. The Treasuries list includes the current on-the-run securities, meaning the ones most recently auctioned. The futures prices are for the standard contracts except where specifically noted. Prices for the noted forex exchange rates are from the EBS dealing system. All of the above information was derived from real-time prices. (Keep in mind that markets less active than the ones presented here will tend to have wider spreads.)

The Data
I’ve a couple of primary sets of information in the above table. One is the spread. In order to standardize the comparison, I’ve expressed that in terms of the dollar value of the spread relative to a $100,000 trade. Obviously, these securities trade in a wide array of different contract and position sizes, so this isn’t meant to indicate some real-world fixed contract value. The $100,000 was just selected to make the spread values as expressed in dollar terms easy to understand and compare side-by-side. The “Avg $ Sprd/$100k” column shows what the average spread was based on about 30 intraday observations, with the “$ Sprd Rng” column indicating the range of spreads observed.

On the right side of the table I’ve incorporated broker commission estimates to provide a second set of comparative information by way of total trading cost. I’ve used $7.95 per side for the equity trades and $7.95 per round turn for the futures contracts. Brokers often will do commission-free transactions for Treasury trades, so no commission is factored in there. Similarly, zero-commisson trading is readily available for retail forex trading, so no commission is factored in there either. Obviously, the reader can replace what I’ve listed with their own numbers for a more personal comparison.

And the winner is…
If you want lowest cost trading then you want to stick to the short-term interest rate market. Spreads on 2yr and 5yr Treasury Notes are under $10 for a $100k trade, and they average under $3 for 3mo Eurodollar futures (note that this is Eurodollar, not the EUR/USD exchange rate). It’s worth noting that these are the very same markets where my volatility comparison between markets shows the lowest levels of volatility.

Beyond the short-term rates securities, the all-in cost of trading for the major forex pairs holds a modest edge over most of the other instruments included in the study. The futures markets, however, are mostly fairly close. It’s in the individual stocks where we start to see the total costs extend away from the overall group average, largely because of the broker commissions.

Market maker’s dream
Of course the one figure jumping off the page is the spread cost of Citi (C) stock. The bid/ask spread is $0.01, and the stock is (at this writing) trading below $5. That means the spread value is quite a bit higher than the same spread for the Qs trading in the $50s. Now consider that 350-400mln shares of C traded during the period of the study. That’s better than $1.7bln worth of volume. At about $205/$100,000 we’re talking about something around $3.5mln in spread differential per day!

It’s good to be a market maker in Citi shares these days!

Factoring in leverage
Note that in now way is leveraged trading factored into the figures above. They only reflect costs per $100,000 traded. That means costs as related to the value of one’s account is going to depend on how much leverage is being applied. For example, someone trading $100,000 worth of EUR/USD on a $10,000 account (10:1 leverage) will have a cost of about 0.1% ($11.10/$10,000). Similarly, someone trading $100,000 of the SPY on a $25,000 account (4:1 leverage) would have a cost of about 0.09% ($23.14/$25,000). To fairly judge the cost comparison between markets, one needs to do so on the basis of how much leverage is being applied and how frequently trades are being done.