Arbitrage in Forex, the no-risk trades – Part 1

Posted on February 11, 2012 by David Frydman
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Since the first time I traded in Forex, I had arbitrage in mind, even before I knew the word. Arbitrage is the promise of risk free trade, of sure wins. But what is arbitrage?

Imagine that a product is sold $2 in Chicago and $10 in New York. You could buy it in Chicago, sell it in New York, and put $8 in your pocket. Of course there are costs like transport, finding a place to sell it, so you will earn less than $8 but this would still be very profitable and without risk.

Arbitrage is the same action. If one broker is cheaper than another, you buy long in the cheaper broker and sell short in the more expensive one.

For example, at the time I am writing could buy NZD/JPY for 64.199  (ask price) at Alpari(US) and sell it short for 64.23 (bid price) at FxPro. If the the price of NZD/JPY goes up, I would lose at Fxpro and win at Alpari(US). If the price goes down, this will be the inverse. When FxPro and Alpari(US) will have the same price, my gain would be 0.031.

What are the risks?

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The first risk is that the prices won’t converge. This happens when the products are not the same or when for some reason you cannot sell one security cannot be traded as the other. For Forex this doesn’t happen.

The second risk is that you won’t be able to open or close your positions at the price indicated. The prices change all the time and they can change between your order and the execution. This is why I wouldn’t enter into the previous trade: a gap 0.03 on NZD/JPY is too small, it could close in an instant.

The third risk is that that the gap open up before it will close. You are losing money when it open up and making money when it close. If it opened up too much and you have a large leverage, you can get ruined. This almost happen to me once.

Since each of the two brokers doesn’t know about the other account, there is a fourth risk. If the price goes up or down too much, you can get ruined in one broker, while making money in the other. If one broker close your account, you are at the risk of the movements of the market. This is another reason not to use too much leverage.

Arbitrage is another kind of trading. You must never use limit, take profit and stop loss orders. You have to trade at market price since you want the trades to be immediate.

It is almost impossible to find arbitrage opportunities without a computer. You need a robot that will check your accounts and make the trades. The gains are small, still they are always great opportunities.

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Brokers want you to win, really!

Posted on February 7, 2012 by David Frydman
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The first day of my first course on Forex, I was told that brokers want us to win. The reason is simple: the more we trade, the more they earn. A losing trader is a trader that will stop trading, a winning trader is a trader that will trade more and make them more money.

But this is not all the story… far from it.

Today’s money worth more than tomorrow money! When would you prefer to get money, today or in a year? Of course today and for three reasons:

  • You can invest todays money and earn with it.
  • You can buy less with next year money than today’s money. Inflation is almost always positive.
  • There is more risk you won’t get the money in a year than today. The one who should give you the money may change his mind, need the money, or even die.

So brokers prefers trade often. I went to three courses from three different brokers and receive trading training material from number others and they all taught short term trading, from day trading to a few days. None took a long term view even if very few short term traders are winners, and they know it. Andrew Niv, the chief executive of FXCM said: “If 15% of day traders are profitable, I’d be surprised.” (Wall Street Journal, 07/26/2005).

Worse, most (but not all) brokers as an incentive to make you lose. You may be thinking that when you buy for $100,000 the brokers buy for that sum from a bank. Well some do and this is called “No dealing desk” model. Most don’t systematically clean the trader with banks and they make their own market, this is the “Market Maker” model.

The “No deal desk” model have additional costs since they have to buy and sell each trade, from the small to a large, from a bank. They are looking for the best rate that give them number of banks, but this additional cost make them often a bit less competitive than market makers can be. The “No deal desk” is a boring business with very small gains (but they come all the time) and virtually no risks.

Market makers are another story, which start with: if one trader buy 10 lots and another sell 10 lots, why should I clean them with a bank? Since they cancel each other, it is better for the broker not to clean them and get the full profit from the spread. They make more earnings, and can give better spreads. To limit costs, the market makers are making the market inside the company: buyers and sellers from the same broker firm are trading from each other.  This works fine until there is a large imbalance between sellers and buyers.  If 90% of the traders want to be short on EUR/USD, they cannot sell the euro for $5 when the banks are selling around $1.3. They do:

  • Sell close to the price of the banks and take the risk of losing if they have to pay the winning traders
  • Come clean with a bank when the risk is too large. In fact they usually have internal limits in case of large imbalance to limit their risks.

Still when the market is fast, winners are an important risk for market makers and some bankrupt every year.

Market makers can make another action to limit its risk. Since they know the stop loss and take profit of every traders, they can push the price up or down a few pips to make sure that a large chunk of traders will lose or a large chunk of traders will not win. How can they do it? very easy, they make the market. They decide the price and they can do with it almost all they want.

What, as traders, should we do to avoid brokers to trick the prices? This is very easy. We should avoid market makers and trade only with “no deal desk” brokers.

 

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Examples of Random Walks

Posted on February 3, 2012 by David Frydman

The following are random walks. I built them with excel (of more exactly with openoffice).

The three lines are:

  • Blue: a random walk. I used the formlua: =IF(RAND()>0.5, A11+A$1, A11-A$1)
  • Red: average of 7 previous results
  • Yellow: average of 50 previous results

Using the average of 7 and 50 was one of the first trading strategy I learned:

  • When the yellow line is above the red line, it is a sign that the market is trending up
  • When the red line is above the yellow line, it is a sign that the market is trending down.

I had difficulties, when I first saw this, to realize that this is a random walk. The trends doesn’t exist, they are illusions built by my brain.

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A random walk to Forex

Posted on February 3, 2012 by David Frydman

Most Economists think that financial markets, like the stock market and Forex, are random. It is impossible to determine is they will move up or down, even if there is a higher probability that they will go up or down.

Imagine that “Mr Market” was flipping a coin and say “head I go up, tail I go down”. There will be no point to look at what the market does: it would be meaningless. Looking at the graph and analyze it wouldn’t tell you anything about the future. “Mr Market” would do a random walk and trying to find a pattern or a meaning would be a waste of time and efforts.

I discovered the random walk hypothesis from the book “A Random Walk Down Wall Street” and my first question was “What a random walk look like?”. I took excel and make a random walk, and saw something very similar to the market movements. I saw a like going up and down, with support and resistance lines, with trends up and down. I was in shock: my brain was giving a meaning to what I saw as if it was the market. More important I couldn’t see if there is any difference between the market movements and a random walk.

I turned to math to find if the market is a random walk. Random walks has a propriety that make them easier to spot: if there it is a random walk there should be clear relation between the average of the true range for two different time frame.

I checked with seven currencies, with graphs from month to minutes and I found that the correlation with is 99.4%.

In conclusion, the random walk hypothesis explain perfectly the price movements of the stock markets, at least up to the weekly graph. Technical analysis does not work. Looking at the graph is futile.

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How to choose your time frame?

Posted on February 2, 2012 by David Frydman

While I was sitting in my first course on Forex, I was told that that to make money you only to need to be right 51% of the time and the time frame is not important. From that course, I immediately realize that you need to look at the 1 Minute time frame. I was thinking that I will win more and more often… I was wrong.

How to determine the right time frame? The truth is, it will depends when you close your trade and how much money you win or lose on average. It depends on your trading style, so it is not possible to directly answer to this question, but it is possible to get that answer indirectly, by answering another question:

 How long should I keep my positions open?

You only need two informations to solve this question:

  1. the average change in price for the time frame you are checking.
  2. the cost of the transaction: commission, spread, …

With these information, you can calculate the percentage of winning trade you need to make to  start making money. The result I found are (click to enlarge):

Analyse of Forex time framesThis means that if you are trading EUR/USD and keep your positions open for 4 hours, you need to be right more than 52% of the time to start making money.

From this analyze comes number of conclusion:

  • The longer you hold your positions, the easier it is to make money
  • Currencies that have high spread are more difficult to trade
  •  The swap cost is not taken in consideration here, but positions with a positive swap would help your earnings and those with a negative swap would hurt them.

It is human nature to wish to look every times there is a change on the graph and to react to this change. For this reason, looking at a graph less than one hour is certainly an error and most traders should look at the 4 hours or daily graph.

 

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Volume indicators in Forex

Posted on January 30, 2012 by David Frydman

Many technical indicators use the volume and for a good reason. Volume is a great indicator for panic or enthusiasm. These emotions increase the

Within the many indicators that use them, I mostly looked at, MFI (Money Flow Index) and OBV (On-balance volume)

MFI look for the relation between up and down movement and their volume to find out if the market is overbought or oversold .

OBV is used to confirm the price move and trends.

There are many other indicators but as I check I found no correlation between their result and the market. It took me time to understand: volume as no meaning in Forex.

Why is that? The lack of meaning of volume comes to the structure of the Exchange Market. Money is not traded in a single place. It is traded by banks and by hundreds of market traders. Each keeping track the volume of his trades, each giving you its own volume.

For instance I took the volume of the last five days on two different broker:

  • Alpari(US): 84250 ,85553 ,89831, 83420, 91282
  • FXPro: 128902, 127345, 113876, 89935, 97651

The volume from different brokers are completely different. Each bring a piece of the puzzle but without all the pieces, they are useless. Taking a decision on them is no better than rolling a dice.

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It is easy to be a successful trader… really

Posted on January 28, 2012 by David Frydman

I took four courses on Forex trading. In all four of them I was told that being successful is easy. All you have to do is to control your emotions.

Well I have found that it is not true. Forex is a hard market, maybe the hardest to trade in.

I was happy to find out that experts agree with me: wikipedia quotes Paul Belogour, the Managing Director of a Boston based retail forex trader, was quoted by the Financial Times as saying, “Trading foreign exchange is an excellent way for investors to find out how tough the markets really are. But I say to customers: if this is money you have worked hard for – that you cannot afford to lose – never, never invest in foreign exchange.”

 

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