Forex News | Currency News by Forexlive

I get asked a lot how I go about trading the order info we get, and I always answer that I wait for confirmation first that the orders are there and are sizeable. We do our best to ensure that our information comes from credible sources close to the market, but orders get cancelled all the time and often times aren’t as big as touted.

So in cases like the EUR/USD today, where sell orders are reported, I will wait until the level is tested and if the sellers appear in size as expected, then I will either sell immediately or more likely wait for the first small dip/rally to develop and then sell with a stop above the earlier highs. I know some people who make a very good living trading off order info alone, and they are very patient and very selective.

One observation noted over the years is the powerful magnetic attraction of market prices to large expiries of so-called vanilla (plain ordinary puts and calls) options.

All things being equal (are they ever?) prices tend to gravitate toward the strike price at the time of expiry.

Why?

Because each side of the trade has to actively hedge their exposure.

Let’s use the example of a $500 mln JPY put/USD call struck at 100.00.

One side has an exposure of $500 mln dollars when the market is at or above 100.00 and the other side has no exposure. At 99.99, the other side of the trade has a $500 mln exposure and the other side has zero. All the jockeying back and forth tends to draw prices close to the strike as each side tries to position themselves for the moment when the option is exercised or expires out of the money.

This action is most noticeable in the run-up to 10 am New York time when the vast majority of options expire.

It is not purely that traders want to stop-out customers in order to derive some perverse pleasure. A lot of it has to do with risk management.

Let’s suppose you have a large stop-loss order in EUR/USD and you are the spot trader at Snidely, Whiplash and Company.

The definition of a stop-loss is an order that becomes a market order once a certain price is dealt. So if you have an order to buy EUR 500 mln 2 pips above a key technical level, you need to be a buyer at a point when many others in the market are likely to be buyers as well.

What can you do?

Two things. You can wait for the market to deal at the price where the stop is set and then try and execute a large order at the next price, likely pushing the market against the customer. Customers hate sloppy fills on stops, so you may end up eating a loss…

Or you can begin buying once you get close to the stop in anticipation of the order being filled. As a dealer, you go long ahead of the buy-stop and fill the customer close to his order level. The customer is thankful that his stop was done at an attractive level and the dealers books a profit while limiting the risk that the market runs away from him.

But there is a downside. What if you buy ahead of the stop and it is never triggered. You have a position that you need to manage that very well could turn into a losing position.How often do we see markets get close to a level where there are lots of rumored stops only to reverse as dealers have to bailout of positions taken in anticipation of filling those orders having to liquidate? Pretty often.

Keep that in mind the next time you get ticked at your dealer for “running your stop”. Very often they’ve taken risks on your behalf that did not end up working out for them…

Please note: This piece is recycled from an earlier presentation. Market prices are for illustration only. They do not apply to present market conditions.

A. The last decade has seen exotic options rise to prominence. The impact of these options has mirrored the rise of China as a financial superpower. China uses these options in massive size at times when they want to drain the market of volatility. Rather than merely entering the forex market to diversify their massive dollar holdings into EUR or GBP, they also actively trade the market, often in conjunction with their considerable options portfolio. One of their favorite strategies is to purchase something called double-no-touches.

Why do speculators like strategies like the DNT? They tend to have an attractive risk/reward ratio. Putting up $1 in premium typically brings $5 in payouts if the trade is successful.

Let’s define terms: A double-no-touch (DNT) is a strategy that pays the owner of the structure so long as the spot price does not touch either of the predetermined strike prices before expiry. As long as prices stay within the predefined range, the trade is a winner for the buyer and a loser for the writer, or seller, of the structure. The tighter the range specified, the smaller the premium, as the odds of staying with a tight range are smaller than a wide range. The buyer puts up a fraction of the potential payout up front and receives a multiple of the wager if prices don’t violate the range.

At present, China is rumored to be sitting on a 1.3350/1.3850 double-no-touch, which comports with recent price action.

The incentives for the counterparties in these trades are diametrically opposed. The buyer wants to maintain the range to keep his structure alive until expiry. If it exceeds the range by even one pip, it is “knocked out”.

How is that tension manifested in the market? Often, by a fearsome two-way battle. Let’s say for the sake of illustration, the base of a 1.3350/1.3850 DNT is in play. What sort of price action can we expect? Typically, the owner of the option structure will want to preserve his investment and may be willing to take some risk to do so. He’ll do that by trying to support the market and prevent it from slipping to the 1.3350 level where he would be knocked out.

The writer, or seller, of the DNT will often take a fair bit of risk to try and push the market outside the range covered by the option. Why? Because the writer has even greater risk than the owner of the DNT. The owner may have risked $5 million to put the strategy in place for the opportunity to “win” $20 million, for example. Even if the bank which sold the option loses money on the spot trade needed to force the price out of the range, he eliminates the risk of having to make a $20 mln payout. The volumes turned over near these strike prices can be huge because the stakes can be so high.

Sophisticated investors with deep pockets can defend specific levels and make large profits if successful. For example, if the market is very short with traders looking to push the market below a barrier (or knockout or trigger, these terms are all interchangeable) in search of stop-loss orders or to break a technical support level but fails, the defender of the option has bought large amounts at the bottom of the market. Our Asian friend will often hold those positions for about a penny and a half before selling them back into the market, just as traders are starting to get bullish again after a bottom was put in place just ahead of 1.3350.

Next thing you know, the market is sliding again and the 1.3350 level comes back into focus. The whole process is repeated again. Often the positions acquired in these “defensive” operations are in the hundreds of millions of euros (or dollars, or AUD, etc, depending on the market). A few “round trips” and whether or not the option position is profitable becomes irrelevant. The defense makes huge profits all on its own, if successful.

What does the price action look like when option defense fails?

How often have you seen the market slip through a much-talked about level by a few pips only to turn around and rally strongly? Likely the culprit is an effort to trigger a barrier. If Bank A sold 500 mln EUR/USD to force the market lower and extinguish barrier options, it has to quickly turn around and cover that short, leading to whipsaw price action. It avoids the huge payout but could get hurt if it can’t cover its short profitably.

ForexLive is one of the few places where traders can pick up information of exotic options that are in play. We try and alert traders to these structures so they do not get caught selling what looks like a breakout only to see the market quickly reverse field.

Barrier options can also be added to plan vanilla options strategies to make them less expensive. For example, if you think EUR/USD is going straight up, you may be willing to buy a 1.45 euro call with a 1.3500 knockout. As long as EUR rallies through your strike price, you make money, but you will have paid a smaller premium because you assumed the risk that your option could be extinguished if prices fell below 1.3500 before expiry…

Mark asks, ‘why do dealers gun for stops, that doesn’t seem very nice to me?’. Fair point and fair question Mark which we can add to our Q and A section.

Lets look at an example of an interbank dealer who is looking at his order book and sees stop-loss orders to sell 200 million EUR/USD at rates below 1.3700 down to 1.3690. The current rate is 1.3730 say. He has some options:

1. He can do nothing. He waits until the market breaks below 1.3700 and then he starts selling. The danger with taking this course of action is that other dealers have similar order boards and the market gets fast below the level. The customers might be filled 10 pips or more below their stipulated level and they would not be happy. Plus the dealer doesn’t earn anything from this.

2. He sells 20 at 1.3730. The market starts drifting lower so he sells another 20 (if the market goes up he cuts the 20 short position for a small loss). He may buy 10 back but keep himself 20 or 30 short. Lets say his average entry rate for the 30 short is at 1.3730. When the market breaks below 1.3710, he sells another 30 and then he sells 100 at 1.3700 to ensure that the market trades at a rate below 1.3700. Then he sells the balance of the orders. He will have sold 200 EUR/USD at an average rate of 1.3706 say. He will fill the stop-loss sell orders on average at 1.3696, with each customer being filled at their stipulated level. The dealer will have ensured that the customers cannot complain about slippage and at the same time he’ll have earned $200,000.

All dealers will follow the second course of action which in essence means that all stops are targeted.

There is sometimes a downside risk in that the dealer may sell 100 EUR/USD but the market suddenly stalls at 1.3700 due to a barrier or a big Sovereign or corporate buyer. If this happens the dealer must act very quickly to start covering his shorts before the market races higher.

A. My guess is we will begin pricing in the phasing -out of QE in the next 60-90 days, or roughly 60-90 days before the program is scheduled to end in June.

Equity markets have clearly enjoyed a tailwind from the flood of liquidity, prompting inflation in asset prices, a boost in the wealth-effect and a moderate pick-up in economic growth. Since markets are forward looking, I’d anticipate a slowdown in equity gains later this spring. The traditional “sell in May and go away” until November/December seems particularly apt this year.

Conventional wisdom would tell us that the dollar will strengthen once the Fed turns off the liquidity spigot. That makes perfect sense, but don’t forget, the dollar strengthened 11% from the day the Fed announced it was instituting QE2.   Market are forward looking, so there is no guarantee that a firmer dollar will accompany an end to QE.

Same for commodities. The argument for owning commodities will be weakened by the end of QE, but markets don’t always cooperate.

A. A lot, if they are significant.

The most closely eyed revisions in US data are of the unemployment and GDP figures. Unemployment figures are compiled on the fly and released within days of the end of the month covered by the data. The subsequent revisions can be substantial and consequential.

The compilation of US GDP is sort of a jigsaw puzzle. Different pieces of the puzzle are released throughout the quarter so the more the data is revised, the closer to reality (the government version) we get. The first release of GDP (advance GDP) is subject to major revision..

A. Reuters, Bloomberg, Dow Jones.

We use them all. They all have strengths and weakness.

Another to add to our Q&A files and it regards market positioning; the question being why some of this data is so relevant when the market is by definition always square (for every buyer there’s a seller).

The relevant information that we need to look at is what the speculative community is doing. Corporate flows are one-way only and some Sovereign and real-money flows tend to be very long term as well. Speculative flows are much more short-term and we know that these positions will be closed out sooner rather than later. That doesn’t mean that a market cannot go up just because the speccies are long but it does mean that if the corporate/Sovereign/real-money flows are tending one-way and the speccies are heavily leaning the other way, the speccies are likely to get hurt.

When we see the commitment of traders reports or even better still the retail market’s positioning, this tells us primarily how the speculators are set up and as such is useful information. (One word of warning, in the past there have been some serious questions asked about the reliability of the retail broker’s information and I’m not sure whether this information has improved or not in recent years).

The core of the FX market is made up of a relatively small number of international banks, who have credit and trading limit agreements with each other. These banks may allow their bigger customers direct access to this market via a Prime Brokerage (PB) agreement. These customers include large hedge funds and individual traders, smaller banks and bigger retail brokers. The next level down includes customers who get direct access to the bank’s own pricing only.

All of these bank customers will leave market orders and the bank obviously sees them all. The best person to speak with in a bank is a salesperson who’s job it is to rustle up business and they will do this by calling their customers and telling them exactly what’s going on and who’s doing what. The absolute best person to speak to, without doubt, is the big hedge fund trader, because they get all the information from all of the big banks. Bank dealers are less willing to give out useful information as it may hurt their ability to clear their business, but friends look after friends and pass information along.

I get most of my  information from hedge fund sources. and whilst it could be in their interest to ‘colour’ the information, I don’t think they need to do so.

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