An email came in from one of my list members the other day. It basically asks the question – inspired by a secondary source – whether the structure of the foreign exchange market is such that technical analysis cannot be used as it can in other markets.
Hi John,
I’ve been reading an interesting ebook that seems to state that we cannot use TA in FX as we would in other markets because the Forex market is completely unaffectable by retail traders and even by most institutions i.e. that it is a “controlled” rather than a “spontaneous” market, and we need to work out its rules and forget classic TA if we want to profit.
As someone who has seen both sides of the market I would be very keen to hear your thoughts on such matters as who controls how the markets move in FX, how all brokers have the same prices at all times, and if classic TA methodologies are of little use and that even if every trader in the world for example sold the GBP short it could just as easily go up as down! Is everything in the shorter term just “controlled” noise,a game to turn 90% of traders into losers on a consistent basis? Or, is this just another conspiracy theory?
I have copied and pasted a little of the book below: the authors english isn’t the best but the argument can be followed.
Hope you can shed some light on the workings of the market in FX.
Thanks,as always,for your excellent educative website.
Best Wishes,
Michael S.
Here is, I think, what Michael was referring to from what he forwarded to me:
He states that trends are created by traders, whereas brokers just realize these trends and place traders’ orders. According to B. Williams, the fact that now trends are made rather “off-floor” than “on floor” (as it was earlier) permits detecting what next will happen at the market (see “Trading Chaos”, Chapter 6).
Let me address this part first, then get back to Michael’s questions above.
Trends in the forex market are not created strictly by speculators (as I take “traders” to mean in the above statement), but it is definitely true that market makers and brokers do not create them either. That group merely facilitates. Trends are mainly created by the flow of money around the world. Some of that is trade flow, so when there is more demand for goods from a particular country there will tend to be an appreciation in that country’s currency. The other major part is capital flow, which is money moving around in pursuit of the best risk-adjusted returns. That’s why higher real interest rate (nominal rate – inflation rate)Â currencies will tend to see their values appreciate.
There is also a healthy dose of psychology in the movement of forex rates, which are driven by a combination of capital flows and speculation. If a market view develops which reflects an opinion that a certain currency will appreciate or depreciate, that will tend to become a self-fulfilling situation. This is why trends in forex can persist for a lot longer than one might expect.
I think that also addresses the first of Michael’s question regarding who controls the market.
Brokers having the same price.
By “broker” I’m going to take it to mean market maker or dealer. An ECN type of broker doesn’t actually quote prices, but rather just shows what others are quoting. A market maker/dealer broker is one which actually takes the other side of the trade, rather like a market maker on the floor of an exchange. Like the floor trader, though, the dealing broker is mainly looking to offset trades such that they end up with no net position and a risk free profit from the spread.
Now, while it’s true that these dealing brokers quote their own prices to the customers, they are constrained from venturing too far from what the general market is doing. If they did, they would run the risk of developing an unbalanced book. By that I mean if they were bidding too high, for example, they could get more sellers than buyers, putting them into a net long position they don’t want. Flip that around for offering too low. It’s pretty easy these days fors traders to set up accounts at multiple brokers to effectively arbitrage between them if any get out of line.
Controlled Noise in the Short-Term?
All it takes for one to see that the markets are not controlled is the reaction they often have to data releases and other news events. The volatility we can see after a surprise Non-Farm Payrolls figure, for example. is certainly not something one could ever label as controlled. Are there those who will attempt to manipulate things to their advantage? Most certainly. That is the case in all markets and in all areas of life. There is no more or less in forex than anywhere else.
If Everyone in the World Went Short GBP…
I’m not sure where this question/example is coming from. It can’t happen. For someone to be short a currency there must be someone else who is long. Think about it. If I short GBP/USD the trader on the other side is long GBP/USD. Any example with that as the basis has no reality to it and thus should be tossed aside.
Classic TA Methodologies are of Little Use
Technical analysis, at its core, is the evaluation of market psychology and supply/demand as expressed through the movement of price and in other statistics. As I noted above, forex is a very supply/demand oriented market with a big psychology element. That makes is a very good technical analysis candidate, which is probably why technicals are so popular among traders at all levels – including hedge funds and the large players. Granted, forex doesn’t have the same kind of volume related information as do stocks and futures, which removes some of the tools which could be used in other markets, but there’s plenty of price data to be had.
Actually, because technical analysis is so readily used in forex -Â and because many traders struggle with the fundamental side of things – it can become a rather self-fulfilling thing. I’m not saying it’s 100% self-fulfilling because different folks use different methods and varying timeframes, but well known levels can certainly become major trading focal points.
The bottom line is that technical analysis is most certainly of use in the forex market.
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About the Author
John Forman, author of this blog, has traded for more than 20 years, is a professional market analyst, and authored The Essentials of Trading. He is an active participant in trading forums, consults for trading related businesses, as published literally dozens of trading articles, and has been quoted in a number of books and in the media.
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