Understanding Price Behavior in the Forex Market – 2
In the first part of this article, we answered two of the six questions presented around the pricing of currencies in the forex market. Now we know how the price quotes displayed on the forex trading platforms are derived. We have also been able to determine that the liquidity providers (banks) set prices in an ECN environment, and the market makers set prices in a retail/dealing desk environment, and this is done in the context of what the demand and supply for each currency is at any given time.
Is it then possible for price anomalies to occur in forex trading? The answer is yes. Price anomalies do not occur in an ECN environment due to the direct market access that environment gives to traders. Pricing comes from different liquidity providers, and it is not unusual for an ECN trading platform to feature price quotes from as many as 10 liquidity providers.
In a dealing desk environment dominated by market makers, the picture is different. Market makers function exactly as their name implies: they “make” the market. A market maker is both a broker and a dealer. When they fill the liquidity gap in the market and purchase currencies in large volumes, they resell these to the trader. To be able to do this, the market maker will take two opposing positions on the same currency so as to be able to fill the orders of their traders who are on both sides of the divide. The implication of this is two-fold:
a) By assuming a contrarian position in the market as counterparty to the trader’s position, the market maker stands to gain if the trader’s position ends in a loss. Anytime someone makes money in the forex market, it is at a losing trader's expense. In this context, the market maker just happens to be that “some other trader” .
b) The market maker is functioning as a player and an umpire and there is an increased tendency to manipulate the market against the trader.
There have been complaints over the years about certain pricing anomalies seen on market maker platforms. Some of these pricing anomalies have been identified, and these are as follows:
a) Stop hunting: This is a practice in which the price of the currency pair is influenced to trigger the stop loss by the dealing desk even when the true price of the asset is still a few pips away. FXCM was implicated in this practice by the Commodities and Futures Trading Commission in the US and was fined $14million in penalties and compensatory restitution to affected traders.
b) Slippage: A very rare phenomenon in an ECN environment, slippage is rather common in dealing desk environments. Unlike in the ECN environment, only one set of quotes is available in a dealing desk environment and with everyone struggling to get in at a single price, larger orders which bring in more commissions to the brokers are fulfilled first, leaving retail traders with smaller orders being filled at more expensive prices. This happens very commonly during news trades when there is a global rush to fill in orders for the news release.
c) Price lag: This is usually as a result of deficient or absent colocation facilities, resulting in slower news feeds and delayed data. This also affects pricing and could lead to slippages during intense market volatility.
The fact is that those with more money at their disposal are always in the minority, and the majority of traders will only be able to muster a few hundreds to the lower thousands in terms of trading capital, so there will always be a need for market makers. However, this subjects the traders to some of the problems with pricing described above. As such, traders who find themselves with market makers will have to find ways of avoiding some of the problems associated with pricing of assets and trade conditions in the market.
Ways to Overcome Pricing Problems
There are ways of overcoming the pricing problems that have been identified. The first one is by getting an ECN forex account. With an ECN account, the trader will eliminate the setup that exists in a dealing desk environment where the broker is the player and the umpire, both working against the trader's interests. Every trader should aspire to get an ECN account. Lately, some brokers have started offering ECN accounts at much reduced initial costs to the trader. This is an option worth exploring.
Secondly, traders can try out ECN bridge software. This is software that has the potential of bypassing the dealing desk when sending a price quote for execution. The supposed rational behind their use is that by “blinding” the dealing desk to the trade, some degree of objectivity will be achieved in the order process and executions.
The use of virtual private servers located close to the seat of trading during trading hours will help reduce latency of price feeds and will aid the trader get better execution prices, especially during news trades.
Finally, nothing can be a substitute for common sense when trading. Trading with a longer time view will reduce the chances of a trade being subjected to the market noise of intraday movements. Traders should aim for better entries ( not going against the trend or for instance, not selling close to supports and buying close to resistance levels) for example.