Key points in the formation of prices

Success in the Forex market depends to a large extent on a full understanding of the "rules of the game". Making sense of the actions of the broker – in particular assessing whether the dealer is manipulating the quotes you see or whether what you see actually is an honest reflection of the market – is a critical point of departure, not to mention a sore point, for many traders. Understanding price quoting can go a long way towards helping a trader realize that he isn't necessarily being cheated and help him avoid making common mistakes.

A few specific situations

Important news has flashed across your screen – without question an interesting time to jump in the market. And this is exactly the moment that many traders begin requesting quotes. It tends to happen, however, that at the moment that traders are looking to trade the recently released news, they start getting delayed quotes or unusually large spreads and interpret it as pure swindle on the part of their broker.

Let's look at this example, however, from the other point of view. As soon as important news hits the market, the broker starts trying to hedge its client positions with larger banks… and what does the broker see? None of the major banks are offering quotes. It is generally accepted practice to not chase after whatever price turns up immediately after the release of news; if you insist, you will likely get a 50 pip spread. Based on our experience, I can tell you that a lot of traders who manage to jump into the market immediately after a news release end up quite disappointed. The market often moves in an unexpected direction, often the opposite of what would be expected. Ninety percent of the time this leads to traders losing money – sometimes a lot of money.

A different situation: the market is calm and a trader repeatedly requests a quote and gets the actual market price (here the real market price is reflected which generally corresponds to what is shown on Reuters or Dow Jones, so this information can't be misinterpreted). But despite the repeated requests, the trader doesn't enter the market. So what does this look like from the broker's perspective? Due to the client's repeated requests, the broker has to make similar requests of its counterparty. The counterparty may give the broker what is called a "Choice" quote, i.e. a quote with no spread, as if to say "make up your mind, bud!" Seems great. Keep hounding and you get a Choice quote. But according to unwritten dealer's etiquette, you can't refuse to trade a Choice quote. If you refuse once, you can forget about ever seeing good prices again. Choice quotes aren't given often. Generally banks will just widen the spread as a way of saying that such a large number of requests during a calm market is out of the bounds of what is reasonable.

Nevertheless, a rather straightforward question arises: how can a regular trader see the actual market and what is the "actual market" anyway?

Let's start with what every trader sees on his screen from sources such as (Reuters, Dow, DBC, etc.). These quotes are indicative, which means that no bank is required to buy or sell at these prices. Such quotes may come from any number of places– from highly respected market makers to all manner of less reliable institutions. Some quote providers enter their quotes by hand, others use various automated methods. Both methods are susceptible to errors which may just so happen to move the price in a direction favorable to a particular speculator (there may be a big, juicy client stop-loss which can be picked up with an accompanying 5-7 pip profit. How can you resist?). It's also important how many counteragents a particular source of quotes has. Reuters, for example, uses data from around 2,600 banks. Dow Jones – from about 1,000 banks and DBC from about 500. We monitored quotes from these three sources over the course of several months and observed to what extent the quotes corresponded to the real market. Sometimes at night, DBC wouldn't update the Swiss Franc for as much as 20 minutes and the price would differ from Reuters' by some 70 pips. And this is during a calm market. Strange things happen with Dow Jones during moments of sharp movement. One got the impression that Dow Jones is its own brokerage firm and at certain moments shows an ever so slightly out-of-date market — only to bring their charts into perfect conformity with Reuters' a few minutes later. This tells you that they knew where the market was during those few minutes. It's not my desire to make accusations against Dow Jones – they have many advantages compared to other sources, especially in terms of analysis and streaming news about Forex. That their quotes come with a lag, however, is definitely the case.

How can you actually see the real market?

There are systems that serve to bring together only large banks, such as ELECTRONIC BROKER SYSTEM (EBS), DEALING2000/2 (D2). When providing quotes through such a system, the bank is required to execute a trade at the price that it has given. In this sense, such systems serve as a kind of electronic broker. Major banks automatically relay the quotes received from such systems. But there are pitfalls here too; the quotes are transmitted by machines, not humans. Let's suppose the market for CHF 1 second ago was 52-55, and then 52 and then the next bid price was 15 (a bid from 20 minutes ago). The program may simply take the average of 15 and 55, tack on 5 pips of spread and throw out a quote of 30-40. The actual market, however, is still around 50-52. At night such glitches can last for half an hour or an hour. Moreover, your screen will keep getting refreshed because other banks are also using these types of programs.

The above-described situation is quite rare with EUR, JPY, and GBP so you need to keep close track of the quotes provided by the more respected banks such as BANK ONE (USA), BARCLAYS (GB), RZB (AUSTRIA), ALLIED (IRISH), DEMIR (TURKISH), SOCIETE GENERALE (FRENCH), ANZ (AUSTRALIA ). Of course this won't be much help in figuring out the actual market of CHF, as described above.

You shouldn't forget about futures contracts for currencies (you can determine the spot price using the forward discount — this information is also available in the information systems). Using this you can solve the problem of figuring out what the real market is for EUR and GBP.

I wanted, however, to come back to the Swiss Franc. If we were to convert the price information in the futures market into spot market pricing, we would see a spread of about 12 pips, doing little to ease our suspicions about the credibility of our quote provider (after all, the standard spread on CHF is 5 pips). As a result of this, when determining the market level for this currency it's important to keep an eye on the EUR, and to a lesser extent, the GBP. You shouldn't react to fluctuations in CHF if the euro isn't doing anything. A lot of people trade CHF for the very reason that 5 pips on CHF is about the same as 3 pips on other currencies. But if you take into account what we have talked about above, the advantage turns out to be not all that great. In the long run, it's better it's probably a reasonable price to pay for not having to worry about the reliability of your broker.

To find the real market, pay attention to the quotes from the following sources:

  • EUR — SOCIETE GENERALE, ALLIED, BANK ONE, FUTURES;
  • GBP — BARCLAYS, BANK ONE, FUTURES;
  • JPY — SOCIETE GENERALE, RZB, ANZ;
  • CHF — FUTURES or CROSS RATE with EUR.

If you are an active trader, we recommend trading during the following times:

  • EUR, GBP, CHF — from 10:00 until 22:00;
  • JPY — from 15:00 until 22:00, 03:00 until 08:00.
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