02/09/20 Barbara Rockefeller
Part 1: Unknown Supply.
Trading FX is harder than trading oil or soybeans or equities. The central reason is that FX is money and therefore in virtually infinite supply. That leaves only demand as a price determinant. Nobody ever thinks of supply in FX, as they do in commodities like oil and also to a certain extent, equities.
In some instances, we see that other commodities can be treated as having infinite supply, too. Oil is a great case. At one point during the 2000’s, more oil was traded in futures contracts than existed in storage to be deliverable. Equities may be traded as though supply were infinite, too. This can be seen by prices rising to ridiculously high levels to induce the holders to release some more supply. There is always a price high enough to have that effect. This is why many traders watch volume alongside price.
Technically money is not in infinite supply, either, because it always lives in a bank account in some country. If you added up all the bank accounts in every country, you’d get a number far more than the $5-6 trillion per day traded in foreign exchange. And since much of what does get traded in FX is settled on a net basis, the total dollar volume that needs actual settlement is far lower than the amount traded back and forth a few dozen times per day.
Still, we know practically nothing useful about the supply of money for trading purposes. The only time we consider supply in FX is those rare occasions when a central bank intervenes. If a central bank perceives its currency is getting too strong, for example, it will sell a boatload of it in the FX market, meeting every bid. Intervention is over-supply to drive prices down. We have seen the Swiss National Bank and Bank of Japan intervene in this manner in recent years. The opposite side of the coin is when the currency is too weak in the eyes of the central bank. Then it wants to reduce supply, so it uses some of its other currencies held in reserve to buy its own currency and drive up its price. As a rule, the rumor of central bank intervention is enough to get the desired price effect. Supply is not actually changed and it is demand that does the trick.
Part 2: Unknown Demand
In most securities, the exchanges offer data on volume traded. Several very useful indicators have been invented to compare price changes with the associated volume. When a price starts flying sky-high and it is accompanied by commensurately rising volume, you can feel secure that the rally has legs. When the price keeps rising but volume falls off, some greater fool has just been suckered in and the price gain has lost its footing.
We do not have volume in the spot FX market. That’s because each trade in the professional market—banks and fund managers—is a private transaction. The banks do report trading volume to regulators, but not on a daily basis and the information is confidential. Some retail brokers (like Oanda) publish current trading volumes, but the retail FX market is a tiny fraction of total volume. That doesn’t mean it’s not useful to show some estimate of market sentiment, but it’s hardly an accurate measurement.
Then there’s the commitment of traders report or COT from the Chicago Mercantile Exchange. This is published on a Friday for the previous Tuesday close. Many analysts like the COT report as the only volume information we can get, but the COT has some major problems:
Another way to estimate demand is with technical indicators. Momentum is the top one, along with overbought/oversold indicators.You can also simply eyeball the size of the bars and when they contract to a fraction of the normal average true range for that currency, deduce that volume is falling. See the Japanese yen.
The price is failing to rise to the level of the previous high, despite a herculean effort near the end. Does this mean volume by buyers is fading and the upmove is fizzling? Maybe. It can also mean these bars are occurring near the end of the day on a Friday and many traders have already just quit for the weekend.
The problem with indicators is that they are not actual volume data but rather implied/deduced information. This information can be dirty—some traders are acting on a false rumor, or there is a timing issue that dictates positioning (month-end, quarterly rollover), or some big-shots are pulling a stunt like a short-squeeze. To infer demand from this information is dangerous. You can get misled all too easily.
Rocky’s Rule No. 5: There is no substitute for hard data on volume.
We embrace technical analysis but it’s no substitute for hard volume data. We like reading about sentiment but it’s no substitute for hard volume data. Does this mean FX traders are at a terrible disadvantage compared to traders in other securities? Yes.
Why do we persist with FX despite this awful, terrible, really bad drawback? First up, of course, is the extra leverage over other asset classes, including equities. Second, the matrix of factors that drive FX prices is wide and deep. There’s politics, economics, business, other assets (e.g., oil), history, public personalities, central banks, and a list as long as your arm. FX is just like any other asset from a trading management point of view—buy low and sell high—but unique as the pinnacle of high finance, and endlessly fascinating. In agricultural commodities, you have a handful of factors—weather, diseases, shipping costs, demand fads. In equities, you have earnings, inventions, management, the state of the sector or index. But in FX, you have anything and everything. It’s fun
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