The forex market is arguably the largest market in the world in notional value. It trades more than $5 trillion in value every day which is more than the NYSE will trade in an entire year by a wide margin. Most of this trading is done at the institutional level, but since the late 1990s, there have been more individuals getting into the forex market as well.
Individual interest in the forex market peaked around 2007 but has since stabilized. Very disruptive regulatory reforms in the U.S. contributed to slowing growth as did the global recession. However, the few firms that have survived are still growing and likely to continue doing so in the near term.
The over-the-counter spot forex market is an interesting one because the “brokers” or dealers are also the counterparty to each transaction. They don’t generally charge a commission because they make money on the spread between the bid and ask prices for a particular currency pair. To understand how this works you have to know a little bit about how a trade is made.
Imagine that you think the British Pound is going to appreciate against the U.S. Dollar. That means you think the GBP/USD exchange rate is going to rise. You can ‘buy’ that exchange rate through a dealer. If the currency exchange rate for this currency pair is $1.6825 and a contract represents £100,000 in value then a single move from 1.6825 to 1.6826 will net you a profit of $10.
In reality, the dealer may have sold you that currency rate at 1.6825 but if you want to sell it back later for a profit you have to overcome the spread. Initially they may only be willing to buy the pair back from you at the ask-price for 1.6827. So, the exchange rate will have to rise .0003 in order for you to make your first $10 in profit.
The dealer will try to offset trades from its clients with trades from other clients or with banks that they have brokerage relationships with. Ideally, the dealer won’t carry any net risk and will just profit from the difference between the wider spread they charge their clients and the narrower spread they have to pay the banks they use on the other side of the transaction.
Dealers also collect a small percentage of the interest that accumulates when you hold a currency position. Depending on the currency pairs involved, you may be paid a small premium each day (minus the dealer’s cut) or you may have to pay a small premium (including a little extra for the dealer). If you have no experience with the forex market, this explanation may have been a little complicated. There are really just two things you have to remember.
- When clients trade currencies, the dealer makes money. The more active the client is the more money the dealer makes.
- The forex market is highly leveraged. Partially because of leverage, the large majority of individual traders in the U.S. are not profitable. Forex dealers have to replace clients that ‘burnout’ and that costs a lot. If trading revenue drops, the costs of acquiring new customers will be more difficult to cover.
Forex dealers include some names you might already be familiar with. Firms like TD Ameritrade (AMTD), Interactive Brokers (IBKR), or Schwab (SCHW) are all dealers – or they “white label” another dealer with their own brand. There are also a few small public dealers who specialize in forex almost exclusively.
The Problem
Forex dealers used to be much more profitable than they are now. Spreads were wider, clients were easier to get and the regulatory environment was figuratively the Wild-West. Times have changed – clients have been burning out and not coming back, spreads are tighter, regulations are stricter, and competition is much stiffer. However, the biggest problem is that volatility in the currency market has been dropping. No volatility means no trading and trade volume has been falling off a cliff.
The Solutions
The long term solution is to continue pushing into new markets for more clients, help individual traders to survive longer, and shift to a greater mix of institutional clients who don’t implode like individual traders. FXCM Inc. (FXCM) is one of those dealers that has been getting closer to solving these problems.
However, these are long term solutions and we think there is a short term opportunity that traders could plan for in the near future. The biggest problem plaguing dealers like FXCM is a lack of volatility in the currency market. There are versions of the CBOE Volatility Index (VIX) that track volatility in the currency market but we have found that an average true range indicator applied to the U.S. Dollar index works even better.
FXCM vs. Dollar Index Average True Range: Chart Courtesy of MetaStock Professional
You can see from the previous chart that there is a strong, positive-correlation between wider trading ranges in the dollar index and positive performance for FXCM. This isn’t an accident – its quarterly report this month highlighted how bad trading volumes have really dropped. The stock sunk from $15 as traders started worrying about the report and by the time their fears were confirmed on the May 8, it was hovering around $12.40.
Despite the bad news, we still think this is an opportunity for traders to prepare to take a long position in FXCM. Volatility has only been this low one other time in the last 20 years and the ECB is getting ready to start intervening in the currency market again. Combined with the taper in the U.S. (and a general level of uncertainty around the globe) we think it is reasonable to expect volatility to rise in the near term.
However, it’s not rising yet… so there may be some time to wait before the opportunity really arises. We suggest waiting until the average true range on the U.S. dollar index futures (DX) creep back up above .35. This is resistance (on the indicator) and a break above this level would be a good sign for trading volume. Similar scenarios played out nicely in 2013 and 2012.
Whether you decide to prepare for an opportunity like this or not, we thought this would be a good way to introduce some new trading and market concepts to our readers. The forex is a big market and it can be a little complicated. However, understanding why it works the way it does should help you to prepare for potential surprises the next time a big move in the Euro (or Yen, Pound, Dollar, Franc, etc.) triggers a reaction in the stock market as traders shift assets around.
John Jagerson and Wade Hansen are the editors of SlingShot Trader, helping investors capture options profits trading the news by using a proprietary 100% news-driven trading platform that turns event-driven pricing inefficiencies into fast profits. Get in on the next trade and get 1 free month today. New to options and need more personal guidance – try our online options course: Strategic Investing and receive your first two weeks free by clicking here.
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