As a result of recent controversy, the forex market has been under increased scrutiny. Four major banks were found guilty of conspiring to manipulate foreign exchange rates, which promised traders substantial revenues with relatively low risk. In particular, the world’s largest banks agreed to manipulate the price of the U.S. dollar and euro from 2007 through 2013.
The forex market is remarkably unregulated despite handling $5 trillion-worth of transactions each day. As a result, regulators have urged the adoption of algorithmic trading, a system that uses mathematical models in an electronic platform to execute trades in the financial market. Due to the high volume of daily transactions, forex algorithmic trading creates greater transparency, efficiency and eliminates human bias.
A number of different strategies can be pursued by traders or firms in the forex market. For example, auto hedging refers to the use of algorithms to hedge portfolio risk or to clear positions efficiently. Besides auto-hedging, algorithmic strategies include statistical trading, algorithmic execution, direct market access and high frequency trading, all of which can be applied to forex transactions.
In investing, hedging is a simply way of protecting your assets from significant losses by reducing the amount you can lose if something unexpected occurs. In algorithmic trading, hedging can be automated in order to reduce a trader’s exposure to risk. These automatically generated hedging orders follow specified models in order to manage and monitor the risk level of a portfolio.
Within the forex market, the primary methods of hedging trades are through spot contracts and currency options. Spot contracts are the purchase or sale of a foreign currency with immediate delivery. The fprex spot market has grown significantly from the early 2000s due to the influx of algorithmic platforms. In particular, the rapid proliferation of information, as reflected in market prices, allowsarbitrage opportunities to arise. Arbitrage opportunities occur when currency prices become misaligned. Triangular arbitrage, as it is known in the forex market, is the process of converting one currency back into itself through multiple different currencies. Algorithmic and high frequency traders can only identify these opportunities by way of automated programs.
As a derivative, forex options operate in a similar fashion as an option on other types of securities. The foreign currency options give the purchaser the right to buy or sell the currency pair at a particular exchange rate at some point in the future. Computer programs have automated binary options as an alternative way to hedge foreign currency trades. Binary options are a type of option where payoffs take one of two outcomes: either the trade settles at zero or at a pre-determined strike price.
Within the finance industry, statistical analysis remains a significant tool in measuring price movements of a security over time. In the forex market, technical indicators are used to identify patterns that can help predict future price movements. The principle that history repeats itself is fundamental to technical analysis. Since the FX markets operate 24 hours per day, the robust amount of information thereby increases the statistical significance of forecasts. Due to the increasing sophistication of computer programs, algorithms have been generated in accordance to technical indicators, including moving average convergence divergence (MACD) and relative strength index (RSI). Algorithmic programs suggest particular times at which currencies should be bought or sold.
Algorithmic trading requires an executable strategy that fund managers can use to buy or sell large amounts of assets. Trading systems follow a pre-specified set of rules and are programmed to execute an order under certain prices, risks and investment horizons. In the forex market, direct market access allows buy-side traders to execute forex orders directly to the market. Direct market accessoccurs through electronic platforms, which often lowers costs and trading errors. Typically, trading on the market is restricted to brokers and market makers; however, direct market access provides buy-side firms access to sell-side infrastructure, granting clients greater control over trades. Due to the nature of algorithmic trading and the FX markets, order execution is extremely fast, allowing traders to seize short-lived trading opportunities.
High Frequency Trading
As the most common subset of algorithmic trading, high frequency trading has become increasingly popular in the forex market. Based on complex algorithms, high frequency trading is the execution of a large number of transactions at very fast speeds. As the financial market continues to evolve, faster execution speeds allow traders to take advantage of profitable opportunities; in the forex market, a number of high frequency trading strategies are designed to recognize profitable arbitrage and liquidity situations. Provided orders are executed quickly, traders can leverage arbitrage to lock in risk-free profits. Due to the speed of high frequency trading, arbitrage can also be done across spot and future prices of the same currency pairs.
Advocates of high frequency trading in the currency market highlight its role in creating high degree of liquidity and transparency in trades and prices. Liquidity tends to be ongoing and concentrated as there is a limited number of products compared to equities. In the forex market, liquidity strategies aim to detect order imbalances and price differences among a particular currency pair. An order imbalance occurs when there is an excess number of buy or sell orders for a specific asset or currency. In this case, high frequency traders act as liquidity providers, earning the spread by arbitraging the difference between the buy and sell price.
The Bottom Line
Many are calling for greater regulation and transparency in the forex market in light of recent scandals. The growing adoption of forex algorithmic trading systems can effectively increase transparency in the forex market. Besides transparency, it is important that the forex market remains liquid with low price volatility. Algorithmic trading strategies, such as auto hedging, statistical analysis, algorithmic execution, direct market access and high frequency trading, can expose price inconsistencies, which pose profitable opportunities for traders.