Monday, June 28, 2010

Forex Market Pitfalls (Guest Post)

From Bryan Sayers, a exclusive:

How Forex Market Manipulation can Affect You

A number of formerly innocent forex traders have become increasingly aware of the possibility of forex market manipulation, despite the market’s huge size. The manipulation game tends to be played by large and active forex market participants like market making financial institutions and hedge funds.In fact, one of the pitfalls of technical trading is that large market players familiar with your methods can often reasonably anticipate where your stop loss and take profit orders are going to be placed in the market. The low liquidity seen in thin markets also provides ample opportunity for forex market manipulation.The following sections discuss some of the types of forex market manipulation and the situations in which they tend to occur.

Thin Markets

Thin markets provide fertile ground for forex market manipulation since large traders can put less pressure on the market to make a bigger impact on the price. For example, the trading time just after the Sydney open at 5pm EST when other more liquid forex markets like London and Tokyo are closed and New York is closing down for the night can be especially thin.Bank holidays and economic data releases also thin down trading in the forex market since many players are either on vacation or standing aside while the news comes out.

Stop Hunting

Forex traders using technical analysis to base their trades on tend to look for certain conditions or price action occurring in the market. For example, this might be a classic chart pattern like a head and shoulders bottom or a double top. Since everyone is pretty much looking at the same price data, this means that large players can reasonably anticipate where stop orders may be placed in the market, even if they are not themselves watching those orders.This situation can arise even when using technical analysis packages that have the best forex software reviews. Unfortunately, the phenomenon provides fertile ground for forex market manipulation, especially by large players trading in thin markets.For example consider the situation of a market in AUD/USD in which the price action has been forming a triangular consolidation pattern over the last week trading between converging trend lines. Many technical traders knowledgeable about how to use chart patterns when trading will be able to observe this formation themselves on their own charts.They will then probably look to buy low and sell high within the consolidation pattern with stop and reverse orders placed outside the converging trend lines which define the pattern to profit from the triangle breakout’s measured move. As more and more traders observe this pattern and establish positions, orders begin to accumulate in certain price level regions.Market makers know this very well, and a large player can simply identify a place where the market is not too far away from key stop loss levels placed just outside the converging trend lines. They then transact large amounts in order to pressure the market into triggering these accumulated stop loss orders.Furthermore, once the stops have been triggered, the large player merely has to quietly cover their position in order to show significant profits from their intentional manipulation of the forex market.Of course, a more insidious type of stop hunting can occur when a forex market maker is holding a large amount of stop-loss orders within a certain narrow price region. If the market approaches this region, they simply have to coax it a little further in order to trigger all of the stop orders they are holding and therefore profit from any trades they may have executed in advance of those order levels. Many retail forex traders do not understand that these forms of market manipulation are standard operating procedure for professional currency traders working at large financial institutions. Sometimes, they accuse their forex broker of hunting for stops when they are only quoting the market prices which have been manipulated by the larger players who have the ability to control the forex market in some circumstances simply by virtue of their impressive size.

Front Running Orders

Like with stop hunting, front running involves the intentional manipulation of the forex market in order to profit from held or anticipated orders that have been placed in the market. For example, consider the case of a forex market maker in AUDUSD holding a large buy order for Australian Dollars at 0.8500. As the market approaches the order level, the market maker will often front run the order by purchasing AUDUSD at levels just ahead of the order price which tends to keep the market from reaching the order level. Nevertheless, if the market does continue on to trade at the order level, the market maker simply takes a small loss and fills the client with what they purchased slightly higher.Also, if the market does not trade at the order level in sufficient size to allow the market maker to fill the order in its entirety, then they often simply sell the AUDUSD they did manage to purchase out at a profit when the market recovers due to the buying pressure. The disadvantage of front running from a client’s perspective is that the market maker trading ahead of the order may result in the order never being filled. Of course, the market maker still profits from having been allowed to work the order for their customer.

Order Slippage

The primary situation in which order slippage occurs is with the execution of stop-loss orders. Most stop-loss orders will be entered into the market in such a way that if a certain level trades, then this triggers the order which will then be executed at the best available market price as quickly as possible.What this means is that the stop order may not actually be executed at the level at which the stop loss was triggered. The difference between the stop loss trigger level and the executed price for the stop loss order is commonly known as order slippage. As if being stopped out were not bad enough, unscrupulous market makers and dealing desk staff also routinely exploit what they see as the opportunity to make money from their clients who entrust them with stop loss orders. They do this by increasing the order slippage on the rate of their stop-loss order and showing the client an even worse execution rate. By doing so, they make a few extra pips off of their clients.Order slippage rarely occurs on take profit orders, although it has been reported to have occurred with some questionable online retail forex brokers. What is more common, however, is that the take profit order is simply not filled if the market reverses sharply from that level and any amount executed on behalf of the client is simply closed out by the market maker at a profit for them, but not the client of course.

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