Trading News

Forex Trading – Volatility, Regulation, and Survivorship

There’s been considerable talk over the last few years about whether US regulators are killing (intentionally or otherwise) the retail forex business in the States. The latest round comes on the heels of word going around that the National Futures Association (NFA), the industry overseer of most US forex brokers, is looking to ban the use of credit cards (directly or indirectly via the likes of PayPal) for funding accounts [I’d love to hear your thoughts on that, by the way. Feel free to leave a comment on Facebook or Twitter @RhodyTrader]. Retail traders have been screaming about overly active regulators since at least 2009 when word came down that “hedge” accounting would no longer be permitted for US accounts and that FIFO accounting would be required (see No More “Hedging” for Forex Traders).

Here’s the thing, though. The figures actually don’t back up any “death of…” scenarios, at least from a regulatory perspective. The US brokers didn’t start reporting active trader accounts to the CFTC until Q3 2010 (with data retroactive to Q4 2009), so we don’t have good figures for the Q2 2009 period when the “no hedging” rules kicked-in, or for the quarter immediately thereafter. There is a dip in active accounts between Q4 2009 and Q1 2010, which may be attributable in some way to the subsequent 100:1 leverage restriction put in place at the end of November 2009 (see New NFA Retail Forex Leverage Restrictions), but that seems highly unlikely given that when the Commodity Futures Trading Commission (CFTC) lowered that leverage cap to 50:1 a year later (see New CFTC Rules for Retail Forex Trading) there was no noticeable impact on active accounts as we can see in this table:

Notice how the number of active US-broker accounts held quite level during the year from Q4 2010 when the lowered permissible leverage went into effect through Q3 2011 (figures derived from the quarterly reports compiled by Forex Magnates). The sharp drop in active accounts doesn’t come until Q4 2011, though there wasn’t any particular catalyst (Forex Magnates suggested the cumulative effect of increase regulation, but that seems unlikely given the sharp 1-quarter move) and the fall was across brokers.

What is really interesting to note in the table, though, is how stable the number of profitable accounts has been since about Q4 2010. It’s only twice dipped below 30k. This comes as we’ve seen persistent weakness in the number of active accounts, which could be attributable to reduced volatility in the forex market for the last year or so. We can see that in the Average True Range (ATR) reading in the weekly USD Index chart below.

Interestingly, the number of active accounts is now back down into the area it was in during late 2009 and early 2010 when volatility was also on the low end before it ramped up again as 2010 progressed, which is when we saw the jump in accounts. That may not be cause/effect, but if we see volatility rise and the active account numbers increase again we’ll know that it’s the markets (and increased competition, no doubt) which has put the US retail forex business under pressure, not regulation.

Getting back to the stable number of profitable accounts, though, we’ve got indications of survivorship in them. That means profitable traders are staying active (though as I noted a couple weeks ago, there is considerable turnover in the accounts making money each quarter) and unprofitable ones are dropping out, which is what you’d expect to see in any case. It’s just that these days we’re not seeing an influx of new accounts to replace the dropouts.

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Forex broker profitability figures likely overstate trader performance

A couple weeks ago I began a discussion of retail forex trader profitability with my post Starting to detail forex profitability data, which generated some meaningful exchanges in places like (Trade2Win, FXStreet, and BabyPips). That post was really the tip of the iceberg, however. I am going to continue to post on the subject moving forward as my PhD research unveils new, interesting and useful information. To that end, I want to expand on my first post.

The quarterly profitability figures reported to the CFTC by the US forex brokers are meant to provide a degree of transparency to prospective (and current) traders. As I noted before, however, they are extremely limited and don’t really do a good job of telling the story of trader profitability. They may, in fact, provide a distorted view of reality to those who don’t understand them properly. I previously looked at the rate at which profitable quarters were seen coming back-to-back – the degree of consistency in performance. To put it briefly, there isn’t much.

The data I used in that analysis was based on active brokerage accounts, just as the CFTC-reported data is also based on active accounts (defined as those doing at least 1 trade in a given quarter). Here’s the thing, though. Some traders have multiple accounts. This is not the majority of traders by any stretch of the imagination, but to the extent that these multiple accounts are active they can potentially influence the broker profitability figures.

That being the case, I re-ran my analysis using trader performance rather than account performance measurement. In the chart below I’ve differentiated the results from my data between the initial view based on accounts and the new one based on individuals, which aggregates all the accounts held by one person into a single reading.

You will notice that in all cases there is a noticeable drop between the By Accounts and By Traders figures. This tends to suggest that the best performing traders run multiple (profitable) accounts, which is interesting in and of itself. I’ll likely follow up on that tidbit later.

More importantly, though, it suggests the broker-reported figures may overstate actual trader profitability rates by at least a small degree. In my data there are nearly 5900 traders who have done trades in almost 8500 accounts. This likely represents an overstatement of how many accounts traders run, however, as sub-accounts for at least one major broker are each treated as separate accounts in my data set and are not likely done so in the CFTC-reported figures (though confirmation of that would be worthwhile). As a result, a shift from account-based metrics to trader-based metrics may not show as much of a variance as seen in my own data. Still, the broker figures do potentially overstate things a bit.

Something else to think about is the impact of copy/mirror/social trading. My data has specifically excluded it where such activity could be identified (which is a lot). I’m studying individual trader performance, after all. Those trades automatically be copied from someone else don’t really further my research. If, however, traders are having profitable trader trades copied in their accounts (which hopefully is the case if they are engaging in social trading) then this also will tend to skew the CFTC-reported profitability figures positively, overstating the performance of traders who actually make their own decisions.

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Starting to detail forex profitability data

Each quarter US forex brokers are required to report customer account profitability figures, a requirement which went in to force in 2010 (with data back to 2009). As of this writing, the most recent update available is for Q3 of 2012, which you can find over at Forex Magnates. On average, these reports show that about 30% of active customer accounts are profitable in a given quarter. These numbers often get trotted out as countering the oft-repeated suggestion that 95% of traders fail, a topic which always gets a lot of conversation going when brought up.

While these profitability figures provide some interesting information, they are severely limited. This is something which doesn’t seem to be understood by many forex traders. The broker numbers are only a snapshot view for a 3-month period. They include anyone who has done at least a single trade (the definition of “active”), and profitable can mean a gain of $0.01. As a result, they don’t give us a lot of useful information. Most importantly, they don’t give us any idea of what % of traders are successful in the long run, because we have no idea (from the data) what fraction of the 30% are consistently profitable from quarter to quarter.

In this post I want to address the consistency point using some data I have on-hand for use in my PhD research. It comprises the trades completed by nearly 8500 accounts between January 2009 and April 2012 – a total of over 2.7 million transactions.

To facilitate reasonable comparison, I’ve produced quarterly figures from the trade data which are comparable to the broker-reported figures – namely % of active accounts profitable. Here’s how the traders in my data set stack up:

The accounts in my data come from all over the world and a large number of different brokers. In acquiring the data set I was looking for something which would be fairly representative of general individual trader activity and performance. As you can see in the table above, though, the accounts in my data have consistently shown a higher profitability % each quarter than those reported by the US brokers. This isn’t enough data to call the difference statistically significant, but I think we can safely say that the traders in my account are somewhat better than average, at least using this % profitable metric.

I make mention of the above to frame what I’m about to present.

Since consistency of performance is not something we can get from the broker-reported figures, I decided to take a look at that. This is a very basic study, but it provides some insight, I think.

Basically, I looked at each trader account to see how often a winning quarter is followed by another winning quarter. My data covers 13 full quarters.

Here are some of the notable bits from the figures:

  • Out of the nearly 8500 accounts noted above, 4596 accounts (54%) had at least 1 profitable quarter somewhere along the way.
  • There were 7634 total profitable account-quarters – meaning if we add up the profitable quarters for each trader and sum that all together we get 7634. If we compare that with the 20,724 quarters in which accounts did at least 1 trade we get about a 37% quarterly profitability rate, which fits in pretty well with the figures from the table above.

Now, since the question is one of consistency, I broke things down based on traders winning in back-to-back quarters. Removing accounts which only traded in Quarter 13 (thus having no back-to-back quarters) gets me down to 7933 accounts.

  • A total of 4239 accounts (53%) had at least 1 winning quarter, and there were 6860 winning quarters out of 18,849 total quarters traded (36%), both about in line with the numbers above.
  • Only 4381 accounts actually traded in more than 1 quarter, and of that group 2930 had at least 1 profitable quarter, which is about 67%.
  • Of those with at least 1 profitable quarter, 1250 were able to have back-to-back winning quarters on at least one occasion, about 43%, producing 2211 total back-to-back winning quarters across all accounts.

In order to look further at the frequency at which back-to-back profitable quarters are seen we have to account for the fact that anyone with a first profitable quarter in a potential back-to-back as Q12 will not be counted because there is no Q14. By that I mean while the data will show a back-to-back for Q12 and Q13, it cannot show it for Q13 and Q14. As a result, while 1250 accounts had back-to-back winning quarters, thus at least 2 winning quarters overall, only 950 accounts can be evaluated in terms of going back-to-back multiple times.

  • Of the 950 accounts with at least 2 winning quarters we could test for repeat back-to-back, there were 434 (46%) who had better than a 50% rate of doing so.
  • There were 241 accounts (25%) with a 100% success rate in following one profitable quarter with another.
  • Among the 214 testable accounts with 4+ winning quarters, 171 (80%) were successful in going back-to-back more than half the time, with 67 being 100% successful (31%).

In other words, the consistency rate is low in general terms. On average, less than half of those who make a profit in one quarter do so again in the next quarter. That means we can expect less than 15% of accounts to be profitable in consecutive quarters, based on the broker-reported data. And seeing as the data I’m using here is from what looks to be a somewhat above average group of traders, we can probably shave a bit off even that 15%.

Furthermore, even among the 15% who are able to repeat, less than half are able to do it multiple times. That means not only is there no consistency among the profitable traders broadly, but there’s not a great deal among those who experience success – at least until you get further out into those who have a history of repeating.

This isn’t a complete analysis of the profitability figures, obviously, but it’s a start. In the future I’ll post some additional numbers to further the discussion. Comments, suggestions, and thoughts are both welcome and encouraged.