The other main type of leveraged fund is known as a Commodity Trading Advisor (CTA). A CTA is principally active in the futures markets. But because the forex market operates around the clock, CTAs frequently trade spot FX as well.
The major difference between the two types of leveraged funds comes down to regulation and oversight. CTAs are regulated by the Commodity Futures Trading Commission (CFTC), the same governmental body that regulates retail FX firms. As a result, CTAs are subject to a raft of regulatory and reporting requirements. Hedge funds, on the other hand, remain largely unregulated. What’s important is that they all pursue similarly aggressive trading strategies in the forex market, treating currencies as a separate asset class, like stock or commodities.
Speculating with black boxes, models, and systems
Many leveraged funds have opted for a quantitative approach to trading financial markets. A quantitative approach is one that uses mathematical formulas and models to come up with buy and sell decisions. The black box refers to the proprietary quantitative formula used to generate the trading decisions. Data goes in, trading signals come out, and what’s inside the black box, no one knows. Black box funds are also referred to as models or system-based funds.
Some models are based on complex statistical relationships between various currencies, commodities, and fixed income securities. Others are based on macroeconomic data, such as relative growth rates, inflation rates, and geopolitical risks. Still others are based on technical indicators and price studies of the underlying currency pair. These are frequently referred to as rules-based trading systems, because the system employs defined rules to enter and exit trades.
These days there are also ready-made automated trading systems available, called expert advisors (EAs). Most currency brokers offer these to retail clients. If you’re happy to let someone else create a trading program, this could make your life easier, but all automated programs come with their own level of risk that you should be aware of.
Trading with discretion
The opposite of a black box trading system is a discretionary trading fund. The discretion, in this case, refers to the fund manager’s judgment and overall market view. The fund manager may follow a technical or system-based approach but prefer to have a human make the final decision on whether a trade is initiated. A more refined version of this approach accepts the trade signals but leaves the execution up to the discretionary fund manager’s trading staff, which tries to maximize position entry/exit based on short-term market dynamics.
Still another variation of discretionary funds is those that base their trading strategies on macroeconomic and political analysis, known as global-macro funds. This type of discretionary fund manager is typically playing with a longer time horizon in mind. The fund may be betting on a peak in the interest rate cycle or the prospect that an economy will slip into recession. Shorter-term variations on this theme may take positions based on a specific event risk, such as the outcome of the next central bank meeting or national election.
HIGH-FREQUENCY TRADING
High-frequency trading (HFT) is a type of algorithmic or black-box trading that has grown in significance in the last 20 years. It’s a rapid way to trade currencies and other asset classes. High-frequency traders move in and out of short-term positions in seconds or even fractions of seconds, sometimes aiming to capture a fraction of a cent of profit on every trade.
HFT has exploded onto the scene and has grown rapidly since 2000. However, it isn’t without its critics. Some people believe that HFT causes excessive market volatility — it was found to contribute to the 2010 “flash crash.”
Today HFT is mostly centered in the institutional and hedge-fund space. Most retail brokers don’t offer HFT and actively stop clients from using it for a couple of reasons:
Cost: HFT execution happens in just a fraction of a second, so it requires top-notch internet connections and hardware, which retail traders may not have. Any latency in your trading (for example, if there is a delay between placing your trade and execution because of a slow internet connection) could leave you exposed to losses.
Regulation: On balance, reputable retail brokers apply high standards to how they trade, and the reputational issues that currently surround HFT have thus far been a turnoff.
Day traders, big and small
Intraday trading was always the primary source of interbank market liquidity, providing fluid prices and an outlet for any institutional flows that hit the market. Day traders tend to be focused on the next 20 to 30 pips in the market, which makes them the source of most short-term price fluctuations.
When you’re looking at the market, look in the mirror and imagine several thousand similar faces looking back, all trying to capture the same currency trading gains that you’re shooting for. It helps to imagine this so you know you’re not alone and also so you know who you’re up against.
The rise of online currency trading has thrust individual retail traders into the mainstream of the forex market. Online currency brokerage firms are referred to as retail aggregators by the institutional interbank market, because brokerage firms typically aggregate the net positions of their clients for hedging purposes. The online brokerages then transact with the interbank market to manage their market exposure.
Governments and Central Banks
National governments are routinely active in the forex market, but not for purposes of attempting to realign or shift the values of the major currencies. (We discuss those currency policies in greater depth in Chapter 7.)
Instead, national governments are active in the forex market for routine funding of government operations, making transfer payments, and managing foreign currency reserves. The first two functions have generally little impact on the day-to-day forex market, so we won’t bore you with the details. But the last one has taken on increased prominence in recent years, and all indications are that it will continue to play a major role in the years ahead.
Currency