Market Storm Warning in Effect

Price volatility is hitting extreme levels in the foreign exchange market—so extreme that even seasoned professional forex traders have told me they’ve not seen markets like this in more than 30 years.

Just how extreme is extreme? Consider the unprecedented 8% single-day price movement of EUR/CHF on September 6, after the Swiss National Bank stated they would protect the currency exchange rate at 1.20.

The global economy is in flux. If you look at the data it’s clear that price volatility indicates a severe market storm brewing on the horizon. The forex market is extremely nervous. Trading has become far more dangerous than even six months ago—so dangerous, in fact, that I’d caution anyone without significant experience to stay out of the market until things calm down.

Why would I recommend that certain clients stay out of the market at present? It’s not what most would expect to hear from a company that makes money on clients trading. And, certainly, we generate more revenue in the short term the more clients do trade.

But we see it as a short term versus long term tradeoff. If our customers suffer excessive losses they will trade less in the long term. Unlike some other forex dealers, OANDA does not operate with a burn-and-churn model so it’s actually in our interest to caution inexperienced clients. We want them to survive the storm intact and trade with us for years after this volatile period has subsided.

A perfect market storm
The present volatility comes from two sources that, when combined, lead to overly nervous markets.

First, the global economic situation is highly uncertain given the European debt crisis, the faltering U.S. recovery, and rumored trouble in the Chinese economy.

Second, there has been a sea change in how the largest forex market makers do business in the aftermath of the 2008 crisis. These huge players—global banks like Deutsche, UBS, Citi, Barclays, Goldman Sachs, and Morgan Stanley—have gone from primarily being risk managers to primarily being flow managers. They are no longer willing to take on much exposure and its attendant risk, which has decreased their profits. 

The change in the behavior of banks has resulted in trades that once were considered relatively small—say, $20 million—to now be immediately laid off into the market, where they bounce around from market maker to market maker, causing prices to spike and spreads to temporarily widen. The $20 million trade thus snowballs into something with an effect of what a $100 million trade would have been pre-2008.

Hang ashore or be prepared to face the tempest
An inexperienced sailor would be crazy to venture out in stormy weather. Likewise, a novice trader courts disaster trying to navigate the volatile markets we are presently experiencing.

Traders with low risk tolerance should close open positions or even suspend trading activities until calm is restored. Given the conditions, even experienced traders should be careful and adjust their trading strategies to weather the turbulence. Consider:

• Adjusting your strategy. At times of extreme volatility, it’s usually wise to limit trading to one or two currency pairs and research the factors that impact exchange rates for these currencies. To reduce losses and preserve capital, understand the economic forces at play before venturing into a trade. Following too many currencies is time consuming and can distract you at the wrong moments.

• Reducing leverage. Trading with excessive leverage may accelerate losses and place your entire account at risk. When volatility is high, use lower leverage to reduce the risk of oversized losses—the volatility provides sufficient profit potential on its own. Most certainly, trading at 50:1 is far too dangerous during these times and anything higher is sheer madness.

• Building in sufficient margin headroom. As price volatility rises, so does the risk of a margin call on trades close to the edges or market peaks and troughs. Maintain sufficient margin headroom to avoid having to unexpectedly close open positions when volatility intensifies.

• That close stops are dangerous. Setting stops too close to the current price will close your position unintentionally because of market price gyrations due to general market nervousness.

• Closing trades overnight. Keeping positions open overnight is dangerous in extremely volatile markets. If you must keep some open trades overnight, make sure to set stop loss orders for each open position.

• Avoiding weekend trading. Liquidity is almost non-existent over the weekend, making it extremely dangerous to trade when markets are volatile because spreads may widen quickly and prices will move quickly.