The 3 Pillars of Forex
We’re here to explain you something that seems very basic, it seems like common things every investor should know. But for Forex, it’s different – as we explain in the book Splitting Pennies. Forex or “Foreign Exchange” is a completely different animal than stocks, or any other type of investing. We won’t even begin to compare it with Futures, Private Equity, or Real Estate. Forex is unique. Also note that when someone says “Forex” it can mean a lot of different things. Most traders, such as CTAs, CPOs, hedge funds, and other funds – refer to Forex as ‘day trading’ of Forex, that means, speculating on rate changes on an intra-day basis, usually using signals, algorithms, or combination therein. So for Forex, the stocks analogy suits well, because day trading of stocks is common, and most people understand the mechanisms behind it.
Let’s examine what are the 3 pillars of launching a successful Forex business – even if that business is just investing in Forex.
1) The Trading Strategy
Forex trading is extremely difficult. The only continued, consistent strategies that make consistent positive returns in Forex, usually have some sort of ‘edge’ on the market, meaning inside information (which is not illegal in Forex), a speed advantage such as latency arb, a statistical advantage like statistical arbitrage, or having knowledge of where all the client orders are (such as brokers have). Common types of trading strategies like swing trading, trend following, momentum, will eventually be crushed. Because the market changes so often, and sometimes is subject to black swan events like the recent surprise SNB abandonment of the CHF cap. So one needs to have a very robust strategy, built by those with years of experience, and probably some investment capital. A Forex strategy isn’t something you can create with an innovative idea, in a weekend with a slide rule. There are many types of Forex trading strategies that can work well – Forex is a very dynamic market, with huge liquidity, that trades in every corner of the planet Earth.
2) The broker or bank
Any strategy needs a place to execute – usually a broker. Banks typically will demand $50 Million or more to trade with them. Prime Brokers, have built a business by offering liquidity from multiple banks through one portal, sometimes called ECNs (Electronic Communication Networks) what they really are – Liquidity Networks (LNs). Brokers can have a number of rules that are different, such as rules of trading, the trading platform, pairs offered, and other differences. Literally – a broker can make or break a strategy. Even with platform standardization, often a strategy must be fine tuned to work with a particular broker. The fall-out of the Dodd-Frank act, it left a Forex void in the US. Few offer Forex trading to retail customers in the US (You can try an IB like Fortress Capital). Overseas – or ‘non-us’ as it’s referred to, a sea of Forex brokers, many who will even pay you to trade, give you account bonuses just for trying, free VPS, and a host of other incentives to open an account and trade (See OpenForexAccount for non-US brokers). “Selecting” a broker or bank is no longer a black and white, static process of compare & contrast, and process of elimination. It’s an ongoing job – brokers change, rules change, the market changes – it’s not a stable environment. Serious Forex operations utilize a combination of multiple banks, brokers, and Forex ECNs.
The problem with pre-Dodd Frank Forex was that there were many frauds, including but not limited to PFG, MFGlobal, Refco, CFG, and many others. Now that the smoke has cleared, the frauds are gone, there’s no one left. Some are still recovering their funds via class action lawsuits, and by other means. The problem post Dodd-Frank is that many have been chased out of the US, chased all the way to London, Sydney, Singapore, and other places. And explaining to a US investor who doesn’t have a passport, why we need to open a bank in Malta to trade Forex, is educationally prohibitive.
3) Trading Capital
Finally, trading capital is required. Due to generally larger return potential in Forex, a large amount of capital is not required, as it will grow. Also, because there are so many loser strategies, if you have a strategy that is winning, capital will find you. Although many Forex banks, brokers, & ECNs advertise their ‘anonymous’ trading venues, in Forex it’s impossible to continually make money and not have the whole Forex village know about it. Also, trading $100,000 in Forex is very different than trading $1,000,000 which is very different than trading $10,000,000 and so on. Larger capital accounts have a different set of execution issues, not only volume related. For example, if the offer is only showing 10M and your algo wants 20M, the additional 10M may come at a higher price, but meanwhile during the execution of the first 10M, the offer for the 2nd tranche of the trade may disappear. Such issues are not common on smaller trade sizes because frankly, the Liquidity Providers (LPs) don’t care. The reason for $50 Million minimums, is because in a $6 Trillion per day market, it doesn’t make sense to worry about a few pennies lying on the ground. People don’t pick up pennies anymore because they’re practically worthless – but if a crisp $100 bill was on the ground, you can bet someone would. In Forex, everything is multiplied by base 100, so banks may leave $10,000 on the ground in order to focus on their $100,000,000 order which if managed properly, can make them a cool $200,000 in profit.
Because of this, some Forex investments have ‘maximums’ instead of ‘minimums’ because there’s a limit to the amount of profit that can be acheived, without getting into the above mentioned execution issues.
If Forex is so good, why isn’t everyone doing it? Well, they are – it’s just that it’s not reported on the nightly news. So for 99% of the population, out of sight is out of mind. ‘What’s Forex? ..For Example?’
If you’re interested in learning more about what Forex is – the starting place is to checkout Splitting Pennies – Understanding Forex. It’s only $6.11 on Kindle, about $1 in 1970 when Forex was created. For those who remember when markets were traded on paper, there’s a paperback edition of the book Splitting Pennies for only $14.98. The book was published by Elite E Services, Inc. – a Forex technology company.