Don’t trust your broker, but trust your forex counter party

Because the forex market is not a centralized exchange regulated by exchange rules which assure participants that their transaction will be honoured, you have to trust your counter party. What makes this dynamic so interesting is that your counter party also has to trust you and that if this mutual trust is violated someone is going to come short.

Unfortunately retail traders are prone to seek opportunities to exploit the perceived faults in their counter parties’ armour. The moment that this threatens the sustained profitability of the counter party these schemes fall flat – they always have and they always will.

Scalper arbitrage was probably the first of these schemes. As marketing wizards competed to lure more clients, they decreased spreads and margin requirements which opened opportunities for arbitrage pip scalpers to enter the fray using a variety of tricks at the expense of their counter party – the market maker. The pip scalpers had fantastic demo account track records. Things changed the moment the market makers’ (real) money was on the table. This was probably the first fight that the retail traders (the pip scalpers) lost hands down against the market makers, who simply instructed their dealers to identify the pip scalpers who didn’t heed the warnings, and take them out. Problem solved.

The second one was straddling news releases. The thing the retail traders tried to exploit was marketing wizards luring clients with guaranteed fixed spreads and guaranteed stops. It was basically just the US non-farm payrolls that really attracted this group a few years ago. They would place entry orders on both sides of the market just before the data release. Apparently a win-win scenario. So what did the market makers do? They refused to guarantee that they would execute your price on the level you had entered it. As a result they could enter you at a bad price and then take you out on the stop on the retracement and even if you then made money on the other leg of the straddle, it was hardly enough for you to cover your loss on the first stopped-out leg.

However, systemic risk for the market maker remained a problem. If a few hundred or thousand retail traders take 100:1 and 200:1 bets on a data release, the market maker became seriously exposed. Market makers are there to make money, not to run the risk of blowing up on one economic data release.

The problem was that they had to cover themselves against the positions taken by the non-farm payroll straddlers by hedging their exposure at their own clearing houses. Now you try to convince a big bank dealer to take a huge position one minute before non-farm payrolls release. He will send you packing. So the market makers couldn’t off-set their risk and thus had to carry the risk of huge and highly leveraged positions themselves. One bit of bad luck and a whole month’s profits could be wiped out.

The market maker makes the rules

There was a particular non-farm payrolls day a few years ago during which, just before the release, the market was run up about 60 or 70 points and on the data release it was run down about 150 points. Blood flowed on “Forex Street”. The shoot-out was rigged. Rumours abounded that a large futures company caused this outrageous price movement. The market makers had had enough and changed the rules of the game to restore order and prevent news release straddles that could harm them.

How did they do this? Well, they made adjustments to their business practices and their contractual arrangements with clients. Spreads are fixed under normal market conditions and so stops will be honoured under normal market conditions, but not under abnormal market conditions – market makers were free to widen their spreads and thereby pass the risk on to the trader. Sometimes they simply wouldn’t allow traders from entering orders shortly before keenly watched data releases. And the decision as to what constitutes normal and abnormal market conditions rests exclusively with the retail forex market maker. Problem solved.

The Class of 2006 News Traders vs Market Makers

Straddling is no longer an option, so News Traders do the next best thing. They try to beat the gun by guessing the direction of the market’s first move, and then they try to benefit with highly leveraged positions.

There are a few challenges, however:

Being fastest on the draw. This means you need to get a good price close to the pre-release price and before your market maker removes the arbitrage opportunity (initial price spike according to News Trading theory) in an instant.

Being fastest on the draw also means you have to draw faster than the rest of the mob trying the same thing. The risk of them jumping the gun enters the equation.

Before you can actually start drawing to shoot, you have to decide what this data release actually means and how all those who react after you, will react to the data release. What will have the main and immediate affect, the headline or the details?

In other words you must take a guess if this data release will indeed cause a large enough move for you to risk taking the highly leveraged position and secondly, you have to guess correctly the direction of this move vis-à-vis the US dollar.

Opportunists who can see what is going on don’t try to jump the gun but jump in counter the first spike, causing more erratic price movements.

Here is a challenge for anybody who thinks he is going to make a living by consistently beating the odds in a well-publicised shootout with the ever-evolving dynamics I have described above.

Let’s assume you will be able to beat the gun and regularly get an extremely good fill on your news trade. All you will be dependent on then is to analyse the market correctly to understand if the first spike will be up or down (let’s look at it from a USD perspective).

How do you determine that? Well that’s the question, and it doesn’t have a simple answer, despite what the News Trading gurus, analysts and TV talking heads say. There are simply too many factors playing a role: the history of this particular data release, expectations, how far expectations are off or might be off, the actual figures of the data release, the expectations’ reaction to its own expectations, the expectations reaction to the data, it just goes on and on until the final result is just another bout of randomness.

If you don’t believe me try tossing a coin over a period long enough to get a representative sample and then compare your results with that of your guru’s. News Traders – architects of their own demise.



Let’s look at the dynamic the Class of 2006 News Traders cause in the FX market:

They don’t straddle the market beforehand. They jump in the market on the data release mostly in the same direction (there aren’t many gurus promoting this loony method to lose money). What happens? They cause a sudden great demand for a currency, let’s say euro. As a result euro’s price spikes up - I am talking a few seconds. Our news traders’ orders get filled usually at a worse price than they had hoped for but nevertheless they are in the market and then two things happen – this is before most professionals, still looking at the details of the release, even paid attention to the immediate price action. First this sudden demand just vanishes, so there is no upwards momentum to cause the follow-through the news traders hope will give them their measly pip target on their highly leveraged position. Secondly the weak “highly leveraged” hands with a few pips profit decide to get out, and in a wink there is suddenly euro supply and a turnaround materialises.

During all of this you have a market maker trying to make a decent market for decent clients and now having to manage this crazy action in a traditionally illiquid market. It took a very prominent forex market maker specialist - in fact the one currently with the highest net capital according to the CFTC reporting - about two months to figure out that they have a bunch of hooligan traders on their hands that could cause them serious damage. Their response, as I mentioned above, was to start fooling around with the spreads in order to discourage and chase away News Traders.

Fixed and floating spreads are a topic of a future newsletter, but understand this: widening spreads, thus increasing the cost and the risk to deal, is a basic protection mechanism of the forex market. In the week following 9/11 the New York Stock Exchange was closed as a protective measure against market meltdown. The forex market increased the spreads to 30 - 40 pips on the most popular pairs and 80 – 100 pips on the less liquid pairs.

News Trading is fundamentally an arbitrage opportunity, but like all arbitrage opportunities it will vanish very quickly if the market catches on. There is already evidence that this is happening and this evidence is clear from the reporting of the sudden change in fortunes of some of the gurus now selling this as a subscription opportunity. Whereas past records are reportedly flawless, recent records are certainly not.

In this case, just as with the initial pip scalpers, the arbitrage is basically a duel between the mob of retail traders and their market maker. There will only be one winner. The death knell for News Trading as a popular strategy



Why do people latch on to News Trading? Because they buy the pitch sold to them by marketing wizards that News Trading is the new way to become a consistent winner. There is no other reason. Unfortunately marketing wizards have already realized that News Trading can make good money for them (but not for you). Here is the proof:

One of the biggest forex marketing wizard companies is behind the popularisation of the 2006 News Trading fad. You must understand that News Trading only makes sense if it is done highly leveraged and very regularly. According to this specific crowd you must push the leverage and you must, wait for this, “place close stops”, because “it will be suicide to use the high leverage without close stops”. (And this is true, but it is only a half-truth, and as with all half-truths it is the other half that kills you.) If this strategy were to be put forward by an individual he would appear foolish. But touted and encouraged by a market maker and their introducing brokers it appears legitimate and savvy.

I downloaded a free report some two years ago from a company. The report gave statistical evidence regarding very short-term price behaviour and supports my contention that it is basically random and that there is no edge to be derived from searching for repetitive linear patterns in these very short-time frames. This company has now changed its view on the randomness of short-term price behaviour. Needless to say they now push News Trading. Unlike some outfits who ask subscription fees for their services (guessing which way the market will go after data releases) everything is free, but you must open a trading account to use their automated News Trading service at the big marketing wizards mentioned above. Even documentation prepared by the big marketing wizards above is provided by this company.

It is pretty clear who sits behind the current popularisation of News Trading. The beneficiaries of regular highly-leveraged-tight-stop trading strategies are the market makers and their marketing agents who promote the viability of this kind of hair-brained trading.

(I again want to point out that while professionals may even play along and have a punt on some data releases it will never be a consistent feature of their professional strategy to expose themselves to any great degree. Yet this is what you are encouraged do: take all your trading capital, gear it up like crazy and take a punt on what is essentially an event with a 50 / 50 probability of satisfying your highly leveraged bet. The placement of a close stop practically ensures that in every instance you do not make money, the market maker gets a nice pay out in addition to whatever he made on the spread.)

And that is why I say you can bet your bottom dollar that most fools who try News Trading will lose. Different game, but the same people are selling it. Here is an example of why you should be very afraid.

A prominent and respected analyst at one of the largest market makers (and marketing wizards) wrote an article on News Trading in which the technical analysis approach to intra-day trading is debunked. Now this should make your ears prick up because they were (and still are) the very ones punting it – to take your money. Ever innovative, they have come up with News Trading as the big new thing, though in this research article news trading in the spot forex market is discouraged. So what is the solution – can retail traders win?



Yes they can win. They can win if they first of all do not fall for the tricks of marketing wizards. In order to be able to do that you must understand the market very well. Secondly you need to have a strategy that is, or has aspects of it, used by professionals.

Thirdly, and this is very important - you must not catch the unwanted attention of a market maker.

Do not violate the trust relationship that is supposed to exist by trying to exploit weaknesses in the system and create a scenario where your market maker can only lose. He holds the aces because he can change the rules of the game. If you have a strategy that offers a winning edge, you will be able to negotiate this market and make money without resorting to any fundamentally flawed concepts and tactics which attract the sort of attention from your counter party that will end up costing you money.
There is more than one way to make money trading any market and there are a myriad of factors playing a role in being successful, including having a scientific edge, being a master of relevant analysis and working through the constant changes in the markets. Success as a trader does not come cheaply, it does not come overnight and it does not come from running after every fad touted by marketing wizards. Success is hard earned, requiring application of, and dedication to, sound trading and business principles.