Trading Tips

Is forex more predictable than other markets?


In a recent post at Zero Hedge, the following assertion was made:

“But the currency markets are easier to trade from a predictability standpoint compared to many other markets once one learns the relationships.”

The whole piece is essentially one long sales pitch in favor of trading forex over other markets, so it is perhaps no surprise to see a comment of this sort. I’m not here to agree or disagree with that general sentiment. The bottom line is that each trader should pick the market or markets which best suit them and their particular situation.

What I will challenge, however, is the above quote.

I don’t know if anyone has done any tests of market predictability, but if I were to hazard a guess as to which one tops the list I’d have to say stocks. Just look at any major index and the trend it’s had going back multiple decades. Just to be clear, I’m not talking individual stocks here, but rather the market as a whole.

Now, one might say something like, “But who trades in that kind of time frame?”

It’s true. Thinking in terms of decades is the realm of the investors, not traders. That brings me to the main point I want to make with respect to predictability.

The author of the statement above makes a valid point about central banks, etc. signaling their intentions. What they fails to consider, however, is the time frame variation involved.

The vast majority of retail (individual) forex traders operate in the hours to days range. They are day or swing traders, for the most part. The central bank signaling is something which works over significantly longer periods.

While it may be true that the BOJ wanting the JPY to be weaker results in a general down trend in the yen exchange rates, that path is anything but straight and smooth when considering normal trader time frames. Along the way toward yen devaluation there are any number of market influences at work in the shorter time scales.

To my mind, in the shorter term where traders tend to operate, no market really has a long-term predictability advantage.

Trading Book Reviews

Book Review: On the Brink by Hank Paulson

[easyazon-link asin=”0446561932″][/easyazon-link]I was asked earlier in the academic term if I would act as a 3rd-party reviewer of an independent study project being done by a student at the University of Rhode Island. The project has as its core former US Treasury Secretary Hank Paulson’s book [easyazon-link asin=”0446561932″]On the Brink[/easyazon-link]. Figuring that I probably should know what Mr. Paulson said prior to making any comment or reaction to the student’s project, I’ve gone ahead and given the book a read. Since it’s something very market-related, I figure it might be of interest to readers of this blog, so here are my thoughts.

[easyazon-link asin=”0446561932″]On the Brink[/easyazon-link] is basically a diary of Paulson’s time as Treasury Secretary, which ran from 2006 to 2008. That, of course, encompasses the most dramatic period of the financial crisis, running from when things started coming unglued in 2007 to the point at the end of the Bush administration when the financial markets were just about finally stabilized. The book details the sequence of events which covers the Bear Stearns take-over, the Lehman collapse, the receivership of Fannie Mae and Freddie Mac, the AIG bailout, TARP and just about everything in between.

This is NOT a history of the financial crisis. Paulson doesn’t really get into the “How did we get here?” in any dedicated or focused fashion (for something more along those lines you may want to read Financial Shock by Mark Zandi). This book is Paulson telling the story of how Treasury, the Fed, the FDIC, the SEC, Congress, the President and others worked together to try to resolve the problems facing the financial markets during the time frame in question from his perspective. As such, one may be inclined to think of it as an individual trying to establish his legacy. Perhaps it is, but I also found it to be a very honest telling. The book doesn’t shy away from Paulson’s insecurity at different points, or the impact the long hours and intense stress had. I didn’t come away from the book thinking Paulson had portrayed himself as the hero of the tale. If anything, he spends considerable time talking about the tireless work of the numerous people involved.

From a reading perspective, I found the book well-paced and fairly easy to get through in general terms. I think Paulson does a very good job of reflecting the uncertainty and rapid development of events during the time span in question. He also presents an interesting view of some of the major political movers of the time, many of whom are still involved in things today. We in the public don’t often get that sort of thing, as we mostly see the made-for-TV moments of press events and committee testimony.

On the negative side, my guess is that some subjects might trip up the reader who isn’t familiar with the deeper elements of the financial markets. The book could have probably done with explanations at a few points to make things more clear for the lay person – like why short selling was so bad, why AIG was bleeding cash, etc. The lack of such explanations does not detract from the main narrative, but no doubt some readers would find them useful in helping understand why things were the way they were.

Overall, I think [easyazon-link asin=”0446561932″]On the Brink[/easyazon-link] is a very worthwhile read for those interested in understanding how things developed and progressed during the financial crisis.

Make sure to check out all my trading book reviews.

The Basics

Looking at Volatility Across Markets

The other day I commented on a post on a personal finance blog. The article was an introduction to forex. I won’t link to it here because it was very poorly done, falling short on many points. One of the things that tripped off alarm bells early on about where the post was going was this statement:

However, it is important to note that forex trading is rather risky, and the currency market is quite volatile.

All trading is rather risky, so I won’t address that particular point. I will, however, speak to the issue of the currency market being quite volatile. Statements about the forex market being more volatile than others are made all the time – almost always by folks who are putting forex trading down in some fashion or another. As I’m going to show you, the numbers make it pretty clear that forex is in fact on the low end of the volatility scale when looking at all markets.

Here is a look at the last year worth of volatility in forex rates

Pair Daily StdDev Avg Daily Rng
EUR/USD 0.93% 1.41%
USD/JPY 0.91% 1.45%
GBP/USD 1.00% 1.65%
USD/CAD 1.02% 1.60%

The first column is the standard deviation (a commonly used volatility metric) of the daily % change for the one-year period beginning November 1, 2008. The second column is the average daily range, with each day’s range being expressed as a % of the prior day’s close ( [H-L]/C ). I went with % changes and ranges to make things directly comparable across markets. So from this data we can see that USD/CAD tends to see the biggest daily changes, though GBP/USD tends to have slightly wider daily ranges.

Now let’s compare that to the major US stock indices.

Index Daily StdDev Avg Daily Rng
Dow 2.01% 2.41%
S&P 500 2.26% 2.60%
NASDAQ 100 2.18% 2.69%
Russell 2000 2.89% 3.28%

Here we can see about what as we would expect in terms of the small cap Russell index being the most volatile in terms of both price changes and ranges.

And how about individual stocks?

Stock Daily StdDev Avg Daily Rng
IBM 2.18% 2.85%
GE 4.20% 5.59%
AAPL 2.66% 3.44%
GOOG 2.51% 3.33%
AMGN 2.33% 3.03%
XOM 5.95% 6.66%
JPM 2.23% 2.88%
KO 1.74% 2.45%

All of the above are clearly large-cap stocks which would generally be expected to show less volatility than mid- or small-cap stocks (as witnessed by the higher volatility in the Russell index). Even still, with the exception of KO, they are all much more volatile than the forex pairs.

So what about commodities?

Commodity Daily StdDev Avg Daily Rng
Gold 1.61% 2.38%
Oil 4.35% 6.01%
Nat Gas 4.91% 6.54%
Corn 2.70% 3.83%

Again, the commodities are clearly much more volatile on a day-to-day basis than are forex rates.

Now to add in a market that’s considered the least risky by many folks – interest rates.

Instrument Daily StdDev Avg Daily Rng
Eurodollar 0.05% 0.06%
2yr Treasury Note 0.13% 0.18%
10yr Treasury Note 0.63% 0.92%
30yr Treasury Bond 0.99% 1.50%

I’m using the futures for the prices above. Finally we have a market where volatility is lower than forex! As you can see, the shorter maturity instruments (Eurodollars are 3mo) are calm compared to the others we’ve looked at here. Bonds, though, are in line with the volatility readings we see for the forex pairs.

So the bottom line is that not only are forex prices NOT the most volatile, they are actually on the lower end of the spectrum when looking at available markets. The numbers demonstrate it pretty clearly, even in a 12-month period which has seen its fair share of volatile trading.

Now granted, the application of leverage in forex creates the opportunity for very high levels of volatility in one’s trading account – but that’s not the market’s fault. Traders don’t need to use leverage. You can trade forex without it.

Reader Questions Answered

Looking at Risk and Stops Across Markets

Here’s the core of a note I received from a member of my mailing list a short while back. It speaks to a subject some traders struggle with.

Have been studying trading for several years, traded a bit with various levels of success. Looked hard at Forex, but am now rather taking a liking to E-Minis: reason is risk. I find it relatively easy to limit your risk by catching a move with a tight hard s/l & moving s/l in the E-Mini, but for forex all strategies I normally see require a s/l of 20 – 35 pips. I do not like that at all.

What is your view?

It appears as though this individual is caught up in a faulty perspective. He’s focused on points (or pips) rather than what they represent.

In an S&P 500 e-mini contract a single point is worth $50, with the minimum price change of 0.25 being equal to $12.50. By comparisson a 20 pip move in the forex market could represent any number of possible values. Taking EUR/USD as an example, if we are trading a micro contract (1000 EUR) it would be $2.00. For a mini contract (10,000 EUR) it would move up to $20. When we get up to a full lot (100k EUR) it reaches $200.

In other words, depending on the size of your position, a 20-35 pip forex trade risk could be substantially smaller than the smallest possible movement in the e-mini contract. If the trader above is risking 2 points on his e-mini trades (for example), which is $100, then he could trade 5 mini EUR/USD contracts risking 20 pips  and have exactly the same exposure.

You shouldn’t compare markets on point/pip a basis. Focus instead on a value basis, especially a % of portfolio one.

Reader Questions Answered

Picking a Broker

I got this broker question the other day.

The single most important question would be what broker do you use to trade your personal money(not a demo account)?  Secondly who would be someone there to contact you personally deal with?

For stocks and options I still have the original brokerage account I opened lo these many years ago. That’s with Charles Schwab. I’ve never seriously looked at anyone else because I’ve been satisfied with the service and all of that, so I was never motivated to make a switch. I’ve heard good things about others, but as I haven’t personally explored them yet myself, I do not feel comfortable commenting on them.

On the futures side, I currently trade with PFG Best. In the past I have used Lind Waldock and Interactive Brokers. I’ve been satisfied with all of them, though they will all appeal to different types of traders.

In forex I experimented with several different brokers before ending up with Oanda. I also use them exclusively in my trading education work. They are considerably different from other forex brokers in that they have no fixed lots or minimums of any kind.

I do not have personal contacts at any of the above brokerages except at PFG Best. In that case, however, my contact has move out of futures.

All the above said, I do not specifically recommend any of the above brokers for any given person. Each of us has different needs which some brokers address better than others. You should absolutely do your research and not just take my or anyone else’s advice without looking into things yourself.

One final note. Especially in the forex realm there is a lot of slamming of brokers on forum sites and whatnot. Some of it is legitimate, but if you just go by that stuff you’ll be scared of every broker out there. Keep in mind that people have a strong tendency to complain rather than praise and traders who have lost money are prone to wanting to place blame on someone other than themselves. In other words, take it all with a grain of salt.

Trading Tips

Picking the Right Market to Trade

Here’s a question I know a lot of new traders have – or at least they should have – as they are getting started in trading.

I am trying to figure out what market fits “me” or “my personality”. How can you do that without having tried to trade all those markets first?

In the end, it might come down to giving different markets a test drive of sorts, but before that point there are a couple of things to think about when selecting a market to trade.

Trading Timeframe
Some markets can be ruled out based on the timeframe you have to work with. For example, you aren’t going to day trade stocks or futures if you can only access the market outside of exchange hours. Generally speaking, the longer your trading timeframe term the more markets are open to you. The shorter the timeframe, the fewer become realistic options.

As much as the barriers to entry have been lowered in many markets, there are still things that have minimums which rule some traders out. The futures market is a notable example there. The contracts are of a fixed size with specific margin requirements. If you don’t have the margin capital, plus a heathy amount beyond that, then you can’t play that market. Even a market like stocks where you could play with relatively little money might not make sense for some people because of the transaction costs.

It helps to trade a market you have an interest in. It will make you more eager to learn and understand and not just make it some abstract thing. This can be an important contributor to having a long-term positive trading experience.

Access to Tools and Information
This is a fairly minor point at this stage, but in some cases you will have better access to what you need to trade in one market than you will another.

I think you’ll find that if you work through this list you’ll probably find a market which suits you without having to try them all out. And even if you can’t make a final selection between a couple of alternatives, you can always demo trade those markets to see which one feels most right.

The Basics Trading News

New Micro Forex Futures Contracts on the CME

Many forex traders (or would-be forex traders) look askance at trading in the spot market, especially through dealing brokers – those who make direct markets to their customers as opposed to the ECNs who are just pass-through conduits. The noted concerns are the idea that the broker is trading against them and that the market is unregulated. This leads them to the futures market.

I’ve discussed the the pluses and minuses of spot forex trading vs. forex futures trading previously. One of the major advantages of the former is that the existence of micro contracts and the like allows new traders and those with lightly capitalized accounts to play at a sufficiently small size. Futures don’t really offer those “micro” contracts.

Well, until now anyway.

The Chicago Merc is set to launch micros at the end of the first quarter this year. Those are contracts set at 1/10th the size of the normal contracts. Details can be found here.

One note at this point, however. The micro contracts only cover the major currencies against the USD. They do not include any crosses. Also 1/10th sized contracts may still be larger than ideal for small traders. The sizes are as follows:

EUR/USD: 12,500 EUR
USD/JPY: 10,000 USD
GBP/USD: 6,250 GBP
USD/CAD: 10,000 USD
AUD/USD: 10,000 AUD
USD/CHF: 10,000 CHF

As you can see, these are really what most spot forex traders would equate to mini contracts, not micros.