Forex Vs Exchange Markets
The Forex market is not structured like a traditional exchange market such as the New York Stock Exchange or the Chicago Mercantile Exchange. Forex is a decentralized global marketplace where trades are cleared one on one between trading partners. There is no central exchange, no pit full of yelling traders, no big board of quotes on a New York street, and no closing bell to ring. The pros and cons of an exchange-based market versus off-exchange currency trading are debatable, but there are obvious differences that traders should be aware of.
No Transparency
One clear advantage of an exchange-based market over off-exchange currency trading is the transparency the exchange offers traders about the market. Exchanges clear every trade through a central exchange, allowing them to provide traders with a wealth of information about the market activity. Common tools such as order flow and volume data are available to traders, allowing them to gauge the strength or weakness of price moves. Because the Forex market is decentralized, there is little data available on market activity. Market makers and retail dealers typically do not share their order flow data, and those that do only represent their trading desk activity and not the Forex market at large.
Volume is another popular indicator used by stock and commodity traders on that is unavailable in the Forex market because there is no central exchange on which to measure volume. Currency traders are tasked with learning how to read price action, without the aid of exchange-based indicators.
Little Regulation
The Forex market has been known as the “Wild West” of financial markets due to the lack of regulatory oversight in the past. The global nature of the Forex market presents a problem for local government agencies to police trading activity around the world. Currently there are no regulatory requirements for an institution to establish itself as an interbank participant. However, any reputable retail currency dealer will register voluntarily with the local regulatory agencies.
There are a few regulators of Forex dealers that have, in recent years, started making positive changes for the retail client. The Financial Conduct Authority (FCA) of the United Kingdom is at the forefront of creating positive change for retail traders and institutional traders alike. Any dealer registered with the FCA is held to the highest level of compliance and customer care and these are the safest companies to deal with at current.
In the United States, the National Futures Association (NFA) has begun implementing rules designed to protect currency traders, although some of its recent decisions have been met with skepticism. In 2009, the NFA banned a practice known as hedging, which allowed a currency trader to maintain opposite positions in the same currency pair, and implemented order execution rules, forcing changes in some dealers’ trading platforms. Although the rules are designed to make trading operate closer to the futures and equity markets, some traders resent the presence of regulators making changes to a market that has been self-regulated since its creation.
No Trading Restrictions
In Forex, traders have the freedom to trade in whichever direction or time they see fit. For years the Securities and Exchange Commission (SEC) enforced a rule against short-selling stocks known as the uptick rule. The uptick rule attempted to prevent speculators from intentionally driving down the value of a stock with relentless short selling. Under the uptick rule a trader could only sell a stock if the current price was above the sale price, or on an “uptick.” Once a stock was falling, traders could not sell the stock again until the next uptick. Although the uptick rule was suspended in June 2007, there have been plenty of calls to reinstate it following the relentless stock market selling in 2008 and 2009. Other stock markets enforce similar rules.
The Forex market has no restrictions on trading. If you believe the euro will fall against the dollar, you can sell it without restrictions. Currency traders are able to move in and out of positions freely, without an uptick rule or other regulatory restrictions. Having no restrictions on trading can also be a negative factor of the Forex market. Since the market is unregulated and there are no restrictions on trading activity, the environment for manipulation exists.
An extreme example of manipulation is the intervention by central banks. Intervention is a process of buying or selling tremendous amounts of currency to manipulate the exchange rate. The Bank of Japan has a history of intervening in the yen when its central bankers are displeased with the exchange rate. In recent years we have seen the Swiss National Bank manipulate with enforcing a price limit on the EURCHF currency pair at the 1.2000 level and then in a historic move pull that limit causing volatility that has not been witnessed in the currency markets for decades.
Manipulation can take many forms, from intervention to requoting a trader’s order to favor the dealer’s books. You should be aware of the risks involved with trading off-exchange in the spot market before you commit any live money to a trade. It’s called the Wild West of trading for good reason.
Contract Flexibility
Trading on exchange-based markets and the Forex market is conducted in standard contract or lot sizes. Unlike the exchange-based market, the Forex market doesn’t set restrictions on the size of a single contract. Currency dealers on the retail market have carved up a standard $1 million interbank lot into three smaller lot sizes accessible to smaller retail traders, known as standard lots, mini lots, and micro lots.
Standard lots on the retail side of the currency market are equal to 100,000 units of the base currency . Mini lots are equal to 10,000 units of the base currency and micro lots are equal to 1,000 units of the base currency. This gives the trader very precise position sizing capability that’s unavailable in traditional exchange-based markets. A unit might be in dollars, euros, yen, or whatever the denomination of your account. For example, a trade of 10,000 units is synonymous with a $10,000 position if your account is denominated in U.S. dollars.
Micro accounts offer new traders the ability to trade real money without placing a tremendous amount of money at risk. Typically a micro account measures profit and loss in terms of a single dollar per pip or even less, depending on the margin requirement for the account. These small lots are a great place for a new trader to cut his teeth on live money trading. They are also useful accounts for testing strategies with a live money account.
Transaction Costs
Currency dealers heavily advertise that there are no commissions for trading currency, but that doesn’t mean the Forex market is cheap to trade. Currency dealers earn their money through the spread, which is the difference between the price at which a dealer will sell a currency and the price at which the dealer is willing to buy it back. For most major currency pairs, the spread is very small, but the costs associated with that spread vary depending on the margin and leverage your account has used.
For traders who trade frequently, transaction costs can be a significant amount of money to overcome to reach profitability. Fortunately the Forex market is a fast-moving one, and once you clear the price of the spread there are no further transaction costs. The more interbank trading partners a currency dealer has, the better that dealer’s pricing will be.
Some dealers are now opting to give clients the raw interbank spreads they receive and then charging a commission on to make their money. This has become a bit more popular in recent years but many traders are divided on whether they want a higher spread and no commission or a lower spread and a commission. For this reason many brokers are now giving both options for account types to traders.
Trading Hours
The Forex market is a global marketplace and trades 24 hours a day, five days a week. This around-the-clock trading environment is not unique to the Forex market but certainly does make it easier to manage trades around a schedule that fits your lifestyle rather than certain market hours. The Forex market begins trading Sunday at 5:00 pm EST as Asian markets open for business and continues to trade until the New York markets close on Friday afternoon at 5:00 pm EST.
There are three major trading sessions that account for the majority of volume seen throughout the trading day. The largest trading session by volume is the London session. London is uniquely positioned in a time zone that’s open for business during work hours stretching from Dubai to New York. The London trading session accounts for the most price action and volume in the Forex market by a long shot. New York follows London as the second largest trading session then Tokyo or the Asian trading session.
Best Trading Session Times in Eastern Standard Time:
- London: 3:00 a.m. 12:00 p.m.
- New York: 8:00 a.m. 5:00 p.m.
- Tokyo: 7:00 p.m. 4:00 a.m.
Many trading strategies depend on the activity seen during the higher volume trading sessions. For many traders who work at day jobs, it is impractical to trade during a trading session that happens while they sleep or are at work.
No Middlemen
Centralized exchanges provide many advantages to the trader. However, one of the problems with any centralized exchange is the involvement of middlemen. Any party located in between the trader and the buyer or seller of the security or instrument traded will ultimately cost the trader more money. The cost can be either in time or in fees.
Trading the currency market, on the other hand, is decentralized, which means quotes can vary from different currency dealers. Competition between dealers is so strong that the trader is almost always assured to get the best deals. The average forex traders get quicker access and cheaper transaction costs then they would in exchange trading. However, as the trader increases size the costs get much larger in Forex but so goes the same for buying your favorite stocks.
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