Wednesday, December 05, 2007

How Financial Markets Really Function - What The Private Investor Does Not See

How do financial markets really function? Primarily by supply and demand - "more sellers than buyers" as some would put it. Only that sellers and buyers must be in balance for a market to function at all. Take the forex (foreign exchange) market - probably the most efficient market there is. $2 trillion is the normal daily turnover and price information is instantly transmitted to hundreds of thousands of end users all around the world. Likewise, all economic news is absorbed into the price. Therefore the price at any particular point of time is the sum total of all the factors as reflected on by all the traders in the world.

Until a new factor causes a trader in say, Hong Kong, to consider that the dollar is too cheap. Why? Because there is an economic advantage in buying dollars at that price - perhaps the short term Hong Kong dollar interest rate has dropped a few basis points, making it more attractive to buy U.S. dollars as a better investment. So he buys U.S. dollars, in the process moving the price higher.

The new price may trigger a London-based bank to cover some options they have written, thus creating new demand for the currency. Maybe the London bank sells Swiss francs for dollars. This ebb and flow is going on all day long, almost continuously.

Traders at the big money-center banks see these movements in the 'market-making' operations, where they will make trading prices to all comers to earn a 'spread', the difference between the buying and selling price. From these so-called flows, they believe they can preempt other customers jumping on the bandwagon and buy dollars in anticipation of selling them back to customers at a higher price a few minutes later. Big money is made here - the handful of banks who engage in the highly-automated market-making operations are probably turning over $100 BILLION per day. If they make just a 1 'pip' spread on each trade, they are making between $7-$10 million per day. Although sometimes they get 'steamrollered' - days of high volatility, when unexpected events create fast markets cause them to suffer losses. Therefore, they want to know the flows, and be the first to get wind of an upcoming large order - like a central bank deciding to switch some of its currency reserves from one currency to another. For example, China's forex reserves are over $700 billion dollars. If they switch just 1% of these reserves from dollars to Euros, then $7 billion will hit the market!

So, what about the poor retail forex trader. Is he doomed to be at the end of the food chain, where being last to know means always being in a losing trade? Yes, probably. Although the brokers update the news and gossip regularly, the small investor is always last to know. The large majority of these traders try to follow price charts and apply technical analysis to predict movements. Alas, the charts are only showing history and in the short term are poor predictors. There are simply too many seemingly random events, or so it seems.

The truth is that the small investor is not privy to what is really going on in the market, and neither can he ever be so. Many former Interbank traders go on to be very successful traders in their own right, running successful hedge funds. Yes, they have their contacts, but even more importantly they interpret what is going on from the price action in the market. They understand the inner workings of the market and the forces that are driving prices.

What can the private retail forex investor do about this? He or she would be wise to invest in a simulation that replicates the conditions in the Interbank market. Such a simulation is TraderMetrics, a software simulation originally designed for and used by banks to train their forex traders.

With TraderMetrics, users become market-makers in the forex market and learn how to handle the flows. They learn the factors that cause herd mentality, which has more to do with staying within limits than being 'scared'. They get the inside track on trading that will give them several 'aha!' moments.

They will be able to trade on live rates, subject to the availability of a price feed, with recorded rates or programmed trading scenarios.

The trading normally takes place against the computer, but by operating in a networked environment, they can participate in a 'virtual' market, which is driven entirely by customer orders and the actions and reactions of other traders logged into the session. One gets to trade against other traders, so it becomes a game of anticipating the anticipation - like a giant game of poker.

The best news is for all traders that once you have learnt this in forex trading, you can apply it to any market with success.

TraderMetrics has recently been re-released. It was previously only available to financial institutions, but is now available at a very reasonable price to the general public. As well as being highly educational, it is also a lot of fun and at the same time supported by hundreds of statistics monitoring trader behaviour, performance and risk management.

Go visit the website, register and download a fully-functioning evaluation from www.forextradermentor/tmsignup.html

About The Author
Steve Pickering is the forex trader mentor. He offers coaching and guidance to private investors who want to succeed as forex (foreign exchange) traders. He has been actively involved in forex trading since 1971 as a broker, trader and trainer. He is the author of articles designed to cut through the hype associated with marketing in this industry and give honest, useful information. He is British and lives in Copenhagen, Denmark.
His web site may be found at The mentoring service is available here at and the free evaluation of the TraderMetrics forex simulation is available at

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