Myths and reality of the FOREX market or what a trader shouldn’t be afraid of

The author of the article: Andrey Vedikhin, «Alpari» Let me quote the classics — A.Elder «How to play and to win on the stock exchange»:

If your friend who doesn’t have a big experience in agriculture tells you he is going to feed himself from a rood you will decide that he is going to starve. We all know how much it is possible to extract from such a lot. But in the sphere of the stock exchange play adult people let their imagination flower.

As soon as an amateur receives several jolts and receives a requirement to deposit more money he becomes shy instead of assertive and begins to develop some awful ideas about the market. Losers sell, buy or stand aside proceeding form their dreams. They are like children who are afraid of walking through a cemetery or to peep under the bed as there might be ghosts. The unstructured market environment lets imagination flower.

Inventions influence our behavior even when we don’t realize that they exist. A successful player must reveal his inventions and get rid of them.«

A myth about kitchen or some words about work methods of brokerage companies.

There are three work methods of a brokerage company.

1) None of the client positions is covered at an external counterpart. In this case a brokerage company is interested in a client’s loss, as the brokerage company will have to pay his win out of its own pocket. A brokerage company that works using such a method is called a «kitchen». Usually in the first years of establishing the number of clients of a company is too small to make up from their positions a standard lot for inter-bank forex (0.5 mln) and to hedge the cumulative client position at the external counterpart. For «young» companies there is a high risk that one of its clients will win a large sum of money and the company won’t have enough money to pay with him and other clients. In order to decrease the possibility of such an outcome in the activity of «young» brokerage companies a tendency to help the client to loose is often observed, and this damages the reputation of the branch in whole.

It so happened that the word «kitchen» has become abusive in Russia. At the end of the 90-s there was a small number of brokerage companies in Russia, and most of them didn’t have enough clients for hedging the cumulative client position at the external counterpart. That’s why at the end of 90-s it was quite natural to see incorrect attitude of a brokerage company to the client: slippage at the closing and other methods of dishonest fight. But time zips along. The number of clients of companies founded in the 90-s increased considerably. Bad quotation damages the reputation of a company and that’s why large companies as a rule don’t work against the client. The unethical methods of work against the client are used only by small newly founded brokerage companies.

When a brokerage company «outgrows shorties», and the number of its clients exceeds several thousands the company management begins to understand that:

• The profit of a brokerage company - «kitchen» in the end turns out to be equal to the spread multiplied by the number of transactions which is directly proportional to the number of clients. The size of the client base in its turn depends on the reputation of the company.
• A good reputation of the company and long-term profit are more profitable than short-term wins from the work against the client that’s why a brokerage company (even remaining a kitchen) enters the maturity stage, i.e. they stop shifting quotations, «drawing stops» etc.
• The business itself has become costly and the founders of a brokerage company don’t want to loose it in case of an accidental win of several clients.
• The average size of deposit began to increase (the positive influence of a good reputation), large clients who mainly win as the size of their deposit allows to observe the rules of Money Management and as a rule they are prepared more professionally in terms of trading etc., began to appear.

As a result the management of the company begins to think about hedging clients positions and this means a move to the second type of technology.

2) To take out the cumulative client position. In this case if the overall client position exceeds some predetermined value (for example 5 mln), it is taken out to the inter-bank FOREX. As a result the company has no reason to work against the client. Business becomes more stable as large wins of clients don’t put the company onto the brink of ruin any longer.

3) To take out each transaction of a client to the inter-bank market. From the point of view of pluses for the client this technology doesn’t have any advantages over the second type. Among minuses for the client we can mention: а) big initial deposit and the minimum size of a transaction; б) it takes a minute and even more to make transactions.

As of the date of writing of this article Alpari had more than 7,200 of real clients that allowed the company to work using the technology number 2.

Myth about impossibility to make money on the Forex market

As it is written in books 90% of people who work on the marginal financial markets loose their money. Unfortunately it is true. Let’s try to find out the reasons of this. If we try to analyze the work of these 90% we’ll see that a trader who lost:

• doesn’t know the basics of analysis (technical, fundamental or some other).
• doesn’t understand the philosophy of trading. I’ll explain this on my own example. Being a young technical analyst I once decided to analyze some financial instrument. Let it be the yen. I look at the weekly chart – indicators show downward, I look at the daily chart —downward, at the four hour chart — downward, .., at five minute chart — downward. Cool, no contradictions! I go short… The result is deplorable. The belief in technical analysis is lost forever. I run for beer… I think a lot… And I come to a conclusion that the reason is in me not in the technical analysis. The weekly and daily charts showed that the global trend is downward. At the same time small time-frames showed that the tend movement apparently has reached its bottom. The ideal moment for selling would be if the weekly and the daily chart indicated the downtrend while the four hour chart indicated the bull trend (retracement ), while the hourly chartа showed the ending of the bull trend (for example bullish divergence).
• doesn’t observe the rules of money management:
  • doesn’t place stop orders at all
  • places too short stop orders. A stop order on the forex market should be placed not closer than 40-50 pips from the entry. Closer stop orders are condemned, as entering the market you most likely won’t be able to catch the very bottom - top. Error usually constitutes 10-15 pips. Plus spread 5 pips. If we also take into account the market noise (10-15 pips), we will get that stop orders placed at the distance less than 40-50 pips off the entry point practically have no chances to survive the position, IMHO.
  • doesn’t observe the ratio profit/loss = 2/1.
  • tries to lock in profit of 5 pips, but are ready to sustain losses of 100 pips and more. In order not to loose using such a strategy it is necessary to make 20 profitable transactions (20×5 pips = 100 pips of profit) and only one loss-making transaction in 100 pips. I.e. the percentage of successful transaction must constitute 95.24%. Even Soros can’t do that. A professional analyst gives 75-80% of the right forecast.
  • etc.
  
  
• «small» periods are used for analysis. It seems to me that there exists noise in about 10 pips in the market (a bank received a large order from a client and it pressed the rate by 5 pips for example. In several minutes the rate returned to the previous level. Plus any indicative quote differs by several pips). We’ll consider this statement as an axiom (it is impossible to prove this). In this case:
  • Analysis of minute charts will allow to catch a movement in 15 pips (for example). From them 10 pips will be noise. I.e. 66%.
  • Analysis of 5-minute charts will allow to catch a movement in 30 pips. Noise constitutes 33%.
    …
    
  • Analysis of hourly charts will allow to catch a movement of 100 pips. Noise constitutes 10%.
  • Analysis of daily charts will allow to catch 500 pips. Noise will constitute 2%.
  
  The numbers are nominal, the main thing here is the principle. Thus when we analyze short periods we try to forecast noise, while when we analyze long periods we try to forecast the market. IMHO noise is unpredictable. The market is predictable. That’s why one should analyze long periods.

  If you fail to make money on the forex market read attentively and thoughtfully everything mentioned above and make respective conclusions. Namely: In order to work successfully and gainfully on the FOREX market it is necessary to have certain knowledge and to observe certain rules (for example money management).

  Myth of a lack of brokers in a brokerage company or why it takes so long to make a transaction at the moment of a strong movement of price

  Of course the delay may be caused by the following factors:

  • software or hardware doesn’t cope with the flow of request that increases tenfold at the moment of a strong movement.
  • a lack of staff — brokers.

    But as a rule brokerage companies that have worked in this market for several years don’t have neither technological nor staff problems. But delays still occur. Why?

    The most commonly encountered form of work in a large company will be the second one (see as above) — when the cumulative client position is taken out to an external counterpart. When the market is calm when a broker receives a request form a client he fixes the transaction almost immediately and only after that he begins to think about the problem of taking out of the cumulative client position (in case it exceeds the limit) to the external counterpart. He doesn’t need to hurry as the market is calm. The market will permit the broker to enter several pips better than the client (and then to exit several pips better).

    But when the market is volatile everything is different. It is necessary to hedge the position at the external counterpart at once otherwise the price will move away and the broker will work at a sacrifice. That’s why clients request are processed simultaneously with taking out of the excess of the client position to the external counterpart. The time of processing of the client’s request naturally increases. But this should be considered as a necessary «payment» for the reliability of the company, a payment for taking out clients positions to an external counterpart.

    Myth of a lack of lack of capital

    A quotation from the classics — A. Edler « How to play and to win on the stock exchange »:

    Many losers think that if they had more money they would achieve success. All losers were thrown out of the game by a series of unsuccessful transaction or by one but extremely destructive deal. Often after an amateur closes all the positions that are loss-making at the moment the market turns round and moves in the direction which the trader had in view. Such a loser is ready to beat himself or his broker: «If he had held out for a week more he could have earned a fortune!»

    Losers take the change of the market directions as the confirmation of their methods. They earn, borrow or save money to open again a small account. And the story recurs: a loser is swept away and then the market moves in the opposite direction «proving», that he was right but it is too late, the account is empty again. At this moment the following idea appears: «If I had had a bigger account I would have held out for a little longer and would have won».

    Some losers gather money from their relatives and friends showing them their records. It would seem that they confirm that if the loser had had more money he would have won. But if they get more money they will loose it as well, as if the market laughs at them!

    A loser suffers not from a lack of the capital but from underdeveloped consciousness. He can destroy a big account almost as quickly as a small one. He overplays and his system of money management is unsatisfactory. He accepts too high risk irrespective of the size of the account. Regardless of to what extent his system is good the series of unsuccessful transactions will throw him out of the game.

    Players ask me often what amount of money it is necessary to start playing. They want to have possibility to survive fall, temporary decline of the value of their assets. They expect that they will loose a lot of money before they earn something! They remind me an engineer who is going to build several bridges doomed to ruin and then to erect a masterpiece. Can a surgeon intend to kill several patients before he becomes an expert in excising appendix?

    An amateur neither suppose he will have losses nor prepare for them. His conviction that he doesn’t have enough money is a trick that allows not to notice two unpleasant things: the lack of discipline and the lack of a realistic plan of money management.

    One of the advantages of a big account is the fact that the cost of equipment and services is less in comparison with your capital. He who manages a fund of million dollars and spends 10000 dollars for computers and seminars must earn only 1 % to compensate this. The same expenses will constitute 50% for a player with the capital of 20000 dollars.

    Myth of autopilot

    A quotation from the classics — A. Edler « How to play and to win on the stock exchange »:

    Imagine that a stranger comes to your garage and tries to sell an automatic system for driving your car. Pay only several hundreds dollars for a computer chip, fix it in the car and stop expending energy for driving, he says. You will be able to sleep in the driver’s chair while «Clever driver» is getting you to work. Most probably you will laugh in face of such a seller. But will you laugh if he offers you an automatic system for the stock exchange play?

    Players who believe in the myth of autopilot consider that a race for wealth can be automated. Some of them try to develop their own automated system other buy such a system from specialists. People who acquire their skill of a lawyer, a doctor or a businessman for years spend thousands dollars for conserve competence. They are led by greediness, laziness and mathematical ignorance.

    Earlier systems were written on sheet of papers, now they assume the form of copy-protected floppy discs. Some of them are primitive and some of them are very complicated and have built-in optimizers and rules of money management. A lot of players are looking for magic that can turn several pages of computer code into an endless flow of money. They who pay for automated systems remind me mediaeval knights who paid for the secret of turning elementary metals into gold.

    Complicated human activity can’t be automated. Education software didn’t supersede teachers, accounting systems didn’t lead to unemployment among book-keepers. Most human activities require experience in taking decisions that’s why machines and software can help but not replace a man.

    If you could buy a working automated system you could go to Tahiti and spend the rest of your life in luxury and comfort receiving an endless flow of cheques. But so far the only people who earn money on automated systems remain the sellers of software. They formed a small but colorful cottage industry. If their system worked what for they would sell them? They could move to Tahiti themselves and collect cheques from brokers! But each seller has a prepared answer. Some of them assert that they like programming more than play on the stock exchange. Other say they sell the system only to receive capital for the stock exchange play.

    The market changes each time and overplays the automated system. The strictest yesterday’s rules work badly today and most likely won’t work tomorrow. A competent player can correct his methods if he discovers alert signals. Automates system can’t adapt and self-destruct so easily.

    Having autopilots air companies pay high salaries to pilots. They do this because people can cope with unforeseen situations. When the body of a jetliner is damaged above the Pacific Ocean, or the fuel runs out above the reserved places of Canada only a man can cope with crisis situation. Such cases were described in newspapers and in the both cases experienced pilots managed to land their liners because they improvised. And no autopilot could do this. To entrust one’s money to an automated system is like to entrust one’s life to autopilot. The first unforeseen event will crush your account.

    There are good automated system but it is necessary to look after them and to correct each their decision. You must follow the process by yourself not shifting the responsibility on the system.