The last decade has seen significant changes in the foreign exchange markets. Most notable is the immense increase in the number of retail investors who’re entering the markets often with only limited experience and know how.
The internet has led to unprecedented access and taken away established monopolies from the large financial institutions. This has forged the way for much smaller online brokerage services offering retail traders easy access to the foreign exchange, CFD and the commodities markets.
While the financial institutions applied themselves predominantly towards the needs of institutional investors and high net worth clients, the online brokers seemed to distinctly target people of lesser financial means.
Lowering The Barriers to Entry
A first tactic with which to widen their appeal among the general public was that many brokerages have trading accounts with the ability to trade on very small contract sizes, have extremely high leverage, and have exceedingly low balance requirements. This make them accessible to the average man in the street.
Although this increased level of openness and accessibility to FOREX has broadly been a positive development, some people have argued that the influence of this new group of “irrational” traders is leading to excessive volatility and lack of stability.
It’s well known that retail traders predominantly make use of shorter term quick win strategies such as swing trading, scalping and to some extent carry trades.
It’s also accepted that so called irrational investors may indeed induce a destabilizing effect on currencies by pushing prices away from fundamental values. Yet this influence of irrational behavior has always been the case in any open financial market.
Standard economic theory tells us that those investors who perpetually make irrational financial decisions will eventually be removed from the picture due to increasing losses. They are ultimately replaced by more rational investors or so theory tells us and asset prices move to fair values.
Meanwhile the loss aspect is supported by many studies and empirical evidence. Like this one from MSN that points out the fact that most retail traders (in all retail areas) achieve poor returns at least in their initial learning period.
Inexperienced traders often don’t research or educate themselves to any degree. They make investment decisions based on limited or inaccurate information and generally have a “follow the crowd mentality”.
Emergence of “Auto Trading” Accounts
The second reason that online brokers have flourished is their providing of so called copy trading accounts. Copy trading allows automatic copying of positions opened by another trader into the account of the copier. In this respect a less experienced individual can piggyback the trades of more experienced traders and so duplicate in proportion their own profits or losses in their own accounts.
This can be implemented technically by means of two mechanisms: One method is through what’s know as PAMM (percentage allocation management module). With this method the manager’s trade orders are scaled up to represent the entire pool of capital as allocated by the group of investors.
In the second method known as a trade signal the order flow is exactly replicated into the accounts of all subscribing investors.
Steve Connell at Forexop.com provides an overview of these mechanism as well as their pitfalls and the risks involved. What this mechanism does is allow investors with little or no experience to enter the markets and benefit from the experience of the more successful traders with a proven track record.
Most brokers offer their copy trading services in a format similar to a social network. Whereby it is possible to compare and analyze the performance of individual traders and study their behavior, risk profile and trading strategy.
In view of these developments it’s clear that the foreign exchange market will continue to evolve and greater accessibility only looks likely to continue.
By Kiyoshi Tanaka