A Bank Trader’s Perspective on Forex Trading

[marc walton]

A Bank Trader’s Perspective on Forex Trading

Written by Julie Hawk. Here is Julies impressive resúme:

I worked for 12 years as a professional forex and currency options dealer and technical analyst in the dealing rooms of major international commercial and investment banks in London, New York and San Francisco. During that time, I developed world-class insider expertise in all aspects of foreign exchange and currency options, as well as considerable expertise in financial fundamentals and technical analysis, including expertly applying Elliott Wave Theory and technical trading signals to the forex market.

I also traded my own options and futures portfolio as part of a floor trading and market-making team on the LIFFE. In addition, I was one of the original consultants for the AP Dow Jones/Telerate technical analysis and programmable trading signal system known as Teletrac, as well as for FENICS, a professional currency option pricing system. I have also written my own currency option pricing, analysis and risk management software. Not only have I taught forex and options classes to other forex professionals, fund managers and corporate dealers, but I have written wide-circulation financial markets newsletters, columns for financial journals and articles for news wires like REUTERS.

Introduction:

Public interest in the forex market has exploded in recent years with the advent of Internet-based online forex trading systems that often allow people with very limited resources and background in forex trading to open accounts to speculate on forex rate movements.

Such people are largely unaware of what goes on inside the large banks that provide liquidity to the foreign exchange market and which are still the overwhelmingly predominant market players. This article will provide an insider’s perspective on how the interbank forex market operates and how bank traders profit from their forex-related activities.

In a typical foreign exchange department of a major commercial bank involved in forex trading, you will usually find a desk of spot traders, a sales desk, a forward desk and an option desk. All of these desks within the forex department work together to provide a general currency transaction service for customers which may include smaller banks, corporations and financial institutions like fund managers, as well as for private forex clients such as high-net-worth individuals.

These customers are generally looking to execute currency transactions on a spot or forward basis in order to hedge currency risk or to speculate on future movements in the forex market, and some also use forex options to achieve their goals.

The Spot Desk

Almost all major forex spot trading desks have at least one dedicated trader per major currency pair who usually works alongside an assistant that keeps track of the deals the trader does. Often, the spot desks also have additional traders specializing in particularly active crosses like Euro/Yen or Sterling/Euro, the commodity currencies like the Canadian, Australian or New Zealand Dollar or minor/exotic currencies like the Latin American and Asian currencies.

These spot traders listen to a set of voice boxes with brokers calling out live prices to make prices to traders at other banks, as well as to their bank’s own sales, forward and option desks. Such spot trading desks are often staffed by rough-and-ready individuals who are predominantly male and young. While they may have no higher educational background whatsoever, the best spot traders are capable of making quick decisions, work well under pressure, keep good records and are mentally quick with numbers.

The management at some banks, especially the larger investment banks, do encourage their forex traders to engage in longer-term strategic currency speculation based on technical or fundamental analysis. Nevertheless, most professional forex traders working at major financial institutions make the bulk of their money as market-makers providing two-way prices throughout their trading day in the hopes of capturing the bid/ask spread.

They typically scalp the market by going in and out of positions quickly, and they usually lay off excessive risk with other professional counterparties as soon as possible to avoid having the market go against them while they are still holding a position resulting from a customer transaction.

Such professional spot traders might elect to execute transactions by using the Interbank Spot Brokers or by taking advantage of the relatively recent technological innovation of electronic forex trade matching systems like Reuters Dealing 3000 Spot Matching or Electronic Broking Services (EBS), depending on which currency pair is involved.

Alternatively, they can decide to make calls out to other professional banking counterparties for spot prices on the outside phone, via direct phone lines or via the chat function of the Reuters Dealing system.

If a spot forex trader needs to lay off an especially large amount, for example a size greater than $25 million, they will often rally the rest of the spot desk around them to help them obtain a variety of two-way prices in smaller amounts from several interbank counterparties. Once they have their counterparties lined up, they then deal in unison at the best of the still-valid prices in as large a total amount as is needed to cut down their position risk to a more manageable size.

Sometimes, traders might also first strategically transact a smaller amount in the opposing direction of their interest publically through the interbank voice brokers before calling around for prices. They do this to fake out their professional counterparties in order to obtain better prices on the side they are actually interested in dealing on.

Basically, if an interbank trader being asked for a price from another professional trader thinks they are a seller because they heard selling going on through the Interbank voice brokers, they will lower their two-way price to that counterparty in an attempt to gain a greater trading edge. If that counterparty then refuses to deal, the trader being asked for the price often reasonably assumes the other trader was a seller and the price quoted was too low for them to be interested in.

Furthermore, if an interbank trader needs to buy a large quantity and wants to do it at the best possible pricing in order to maximize their profits, they might take advantage of this tendency by selling publically so that their counterparties might think they were a buyer and then slant or “read” their prices lower as a result. The savvy trader would then pick through the lower prices to choose the best offers to buy at to cut down their risk.

Continued Part 2

[marc walton]

The Sales or Customer Desk

Most large commercial banks involved in the foreign exchange market have a sales or customer desk that speaks to the bank’s large corporate and institutional clients. Often, the banks might also staff a Private Client Desk that speaks to and deals with individuals who are involved in forex transactions, often in smaller amounts than the main sales desk.

Together, these desks are typically staffed by more friendly people than the spot desk, including a notably higher percentage of females. Such forex sales people are generally well-versed in telling a convincing story about why the forex market moves and they can assimilate and condense the available newsworthy information into short recaps for their clients’ benefit.

Such customers call a bank sales desk on an outside phone line, via a dedicated direct phone line that flashes at the bank, or using an electronic dealing platform like Reuters Dealing 3000. Not only do they call in to request a transaction, but they also often call in to request information about the market, such as a market price estimate or “indication,” the salesperson’s opinion or “view” on the direction of the market, a review of relevant news items, etc.

If a customer needs to deal, they will first state their dealing amount and the currency pair involved. They will then either enter an order, or they will request a “live” price that can be either two- or one-sided, depending on their arrangement with the sales desk. If the required amount is significant, say over $500,000, the sales desk will then call over to the trader on the spot forex trading desk that handles the currency pair in question to obtain a live price so that they can quote their customer.

Some forex customers trade on more competitive prices than others, and this fact is usually kept track of by the salesperson who manages each client’s account so that pricing can be kept reasonably consistent when the customer calls in to deal.

The primary objective of the forex sales desk is to earn margin for the bank. Margin is the amount that the salesperson can alter — to their bank’s benefit, of course — the price dealt to their client relative to the bank trader’s quoted price. This makes some sense since forex transactions are generally commission-free and executed on the basis of credit lines extended by the bank.

Forex salespeople are also compensated, but to a lesser extent, based on the volume of foreign exchange transactions that their customers bring into the bank’s spot, forward and options trading desks since higher transaction volumes provide more opportunities for the bank’s traders to profit from.

This margin is usually based upon the salesperson’s detailed knowledge of the client’s needs and trading habits, and is often obtained by the salesperson either widening the spread on a two-way price, or by reading a two-way price against what they think the client’s interest is, or by outright asking the client which side they are looking to deal on and then showing them a worse one-sided price than their trader quotes.

Typically, forex salespeople will have phones equipped with a click button that mutes out all sound so that the relevant bank trader can quote their price out loud when the button is pushed but the client will not be able to hear it. The salesperson will then unclick the mute button to quote the client a wider spread or a price that is moved against their client’s interest in order to obtain the margin that is their primary objective. This same general margin-making technique is used by the sales desk for making forex spot, forward, swap and option quotations to the bank’s customers.

The Forward Desk

The forward desk at most major commercial banks consists of a group of traders that manage forward foreign exchange rate books and quote currency swaps in one or more currencies. Like the spot desks, one trader is usually designated for each of the major currencies, with a minors and maybe an exotic currency forward trader. They will often handle the tom/next rolls for the bank’s spot traders and will also quote the bank’s option desk forward prices, in addition to making prices to the customers of the sales desk.

A currency forward transaction is typically executed by quoting swap points for the desired maturity date, and then quoting the spot price for the transaction amount. Once the transaction is done, the swap points are added to or subtracted from the spot rate. On the other hand, a forex swap is transacted by buying one currency against another for one maturity date and selling for another date. The rates used for a swap are usually set to reflect current market rates for the dates calculated based on the current spot price.

The Currency Option Desk

Most major forex market-making banks also offer over-the-counter currency options that come in a wide range of maturity dates and in a variety of vanilla and exotic option styles. Traders on the bank’s currency option desk manage the risk on separate option portfolios maintained for each currency pair that the bank quotes option prices on.

When quoting customers, currency option traders specializing in the currency pair involved typically provide an implied volatility bid and offer to a sales or option liaison dealer for a specific option maturity, delta and direction (whether the option strike price is above or below the prevailing forward rate). The dealer then prices the option using an approved currency option pricing model like FENICS and adjusts the price to be shown to the client to include their desired margin.

If the resulting price is sufficiently acceptable for the client to deal, any necessary spot or forward hedge is executed and the linked deals are passed on to the currency option desk as a delta-neutral transaction. Sometimes, option orders are placed based on a certain level trading in the underlying spot market.

Conclusion:

In summary, the interbank forex market exists largely to spread the risk from and make money off the foreign exchange business arising from participating banking customers. As a result, the trading techniques used by such professionals are considerably different from those most beneficial to the profitability of the smaller currency speculators who are trading their own forex portfolio using online screen-based dealing systems and paying the bid/asked spread in the process.

Rather than attempting to emulate the bank traders, such private forex traders will generally be better served by developing a strong technical analysis and money management background in order to determine objective trading triggers and appropriate position sizes for their portfolio and risk tolerance. Once armed with a good technically-based trading plan and the discipline to follow it, smaller speculators will be far better situated to achieve long-term success as forex traders.