When it comes to forex, people scour the internet for the answer to a burning question:

“Can I make money trading forex”.

The short answer is of course you can. As a matter of fact, any instrument that has a volatile price and can be openly bought and sold on the market is capable of being used to generate money.
Unfortunately, there is a further question that needs to be asked. It’s not a question that’s asked as often, but it may come to the more astute trader:

“Can I be consistently profitable trading forex”.

This question requires the same factors mentioned before:

1.) Market Volatility: An instrument with a volatile price
2.) Market Liquidity: Can be openly bought and sold

Consistent profitability requires one more, crucial ingredient:

3.) The ability to exploit information advantages

 

Exploiting Information Advantages:

Unless you are exploiting an information advantage, you are gambling. Period.
An information advantage doesn’t mean that you have to know, with 100% certainty, where the market is going to go. No one knows that. If they do, they are likely extremely wealthy and/or inside traders.

If I could explain one concept to any aspiring trader it would be information advantages and how exploiting them is 100% necessary in order to trade profitably.

The Problem of the Efficient Market:

There is a theory in economics known as the Efficient Market Hypothesis. Quite simply, the theory states that the more efficient a market is, the faster new information is incorporated and reflected into the price. The “efficiency” of a market is measured in its liquidity (or volume). Therefore the more people that are actively buying and selling in a market, the more likely that all of the information impacting a market has been “priced-in”. The forex market is the most heavily traded market in the world, it wouldn’t be a stretch to assume it is also one of the most efficient.

Imagine that we’re looking at the NZD/USD currency pair. It’s widely expected that an upcoming data release on the New Zealand GDP will indicate that the economy is booming. This type of news will typically put inflationary pressures on the dollar through the attraction of foreign investment to an economy that is doing well. The official data is released and the dollar… hardly moves. Why? Because the market sentiment already knew that the economy was booming and the price had already adjusted itself long before the official result came in. On the flipside, if the data reflected that the economy was performing poorly, but market sentiment had incorrectly thought that the results would be more positive, we might see a downward shift in the value of NZD against USD. This is because the market was inefficient in reflecting the factors that influence the price.

This example was very basic in order to illustrate the point about market efficiencies and inefficiencies. In reality there are a myriad of factors that can influence the price of a currency pair. You might have one very strong indicator going in one direction, but it would be unwise to not consider several other indicators which may indicate a different price movement.

The take home point here is this: In order to be a consistently profitable trader you need to be able to exploit inefficiencies in a market. To put it simply, you need to be able to know something about the direction of the market, before the market participants have moved to price it in.

the news gets worse.

The market has undoubtedly become more efficient over time for two simple reasons:

1.) The ability for people to execute trades has become faster and easier:
Historically, trades used to be made by calling a broker on the trading floor or in a trading house. This of course created a natural inefficiency in the market as only so many trades could be processed at a given time. People could trade easier on fundamental events such as news releases or natural disasters by exploiting the ‘first in, first served’ mechanic. Now that the vast majority of trading occurs online and an effectively limitless number of orders can be filled simultaneously, this inefficiency has been all but eliminated.

2.) Information is absorbed by the market much faster:
Pre-internet, information that had the potential to influence the market travelled much slower. There were far fewer news sources and a much greater lag of information getting to all market participants. The ability for news to travel in today’s world is mind boggling. Almost anywhere in the world can be made aware of a significant news event instantaneously. This has resulted in markets pricing-in information significantly faster than has been the case throughout history.

The news gets even worse.

The Rise of Automated Trading:

There is another factor driving currency markets to be even more efficient. Automation.

Recent history has given rise to a new form of trading. Instead of an individual processing information to make a decision about the perceived movement of a market, computer programs are able to be programmed to run complex algorithms that can analyse huge amounts of data and place trades automatically. Not only this, but they are able to execute trades incredibly fast and frequently, hundreds of trades can be placed in a minute in order to effectively “snipe” any perceived inefficiencies in the market. Several of the large trading outlets in the world hire teams of mathematic PHD’s, finance professionals and programmers in order to develop trading algorithms with the goal of squeezing every last dollar out of the market. The competition has become so fierce amongst algorithmic traders that traders have purchased real estate closer to major stock exchanges in order to benefit from faster market information by mere milliseconds.

As you can determine from what I’ve addressed so far, trading is not the easy, gravy train that many forex trading websites (that have something to sell you) would have you believe. However, I don’t want you to be discouraged because it is still possible to trade the forex market profitably.

The (Not Quite) “Zero-Sum” Game:

You may have heard the phrase somewhere that forex is a “zero-sum” game. What people mean by this is that when you make a trade, someone has to be on the other side. If you’re selling NZD/USD, someone has to be buying it. In the end, price will move one way and one of you will win and the other will lose (this is simplistic, but you get the idea).

The truth is forex isn’t quite a “zero-sum” game. There is always a difference between the buy and sell prices known as a “spread”. The spread is effectively the commission for the broker to facilitate the trade. Spreads vary between brokers, markets and market conditions. However, they will always exist.

roulette-finlandsfarja-1

There is a powerful yet simple analogy to illustrate how spreads work in practice: consider a roulette table. We should all know that it’s impossible to be consistently profitable in roulette, and casinos have been in business for centuries so it’s quite reasonable to say that the house is the only consistent winner. Why is this? Well if we assume for the purposes of our example that the only betting options are red or black, and there are two green slots in the roulette board, then this translates into a 47.4% chance that a bet will win on either red or black. You might be tempted to think that this is effectively a 50/50 bet, however you would be surprised about the impact that this house advantage has over the long term. If you played the same bet on either red or black a thousand times on roulette, you would lose with over 99.99% certainty. The spread in any type of trading works the same way. If you want to purchase NZD/USD because you believe the price is going up, you will get a price a few points below the current level. In order to make a profit on the trade, the price has to increase over and above the spread before the trade begins to be “in the money”. Spreads can kill a lot of day-traders (traders that excute and close trades over a short time frame) because typically the expected price movements wont be as high as a longer term trade and therefore it can be like playing on a roulette table with a lot more green numbers.

How to Be Consistently Profitable:

I hope I haven’t scared you off trading yet because the same logic I’ve used about spreads and roulette can be extended to how to be a profitable trader. Remember early when I said that the trick to being consistently profitable is exploiting an information advantage. I also mentioned that it’s impossible to know with 100% certainty where the market is going to go. However, you don’t need to know exactly where the market is going, you simply need an information advantage about the probability of an outcome that exceeds the spread. Let’s go back to our roulette example. We know that our roulette table has two green slots resulting a 47.4% chance of winning any given red or black bet. Say that we also know that this particular table has an imperfection whereby red is likely to win 5% more than usual. If we place bets exclusively on red, we now have a 52.4% chance of winning. This is a huge advantage, if you played this table a thousand times you would be profitable with 99.9% certainty. This is because our information advantage exceeds the house advantage and puts the odds back in our favour. An edge, no matter how small, can be exploited through volume. You would be surprised just how much money can be made on an edge of this margin.

As a matter of fact, I’ve used the random number generator in excel to simulate the outcome of a 52% edge. I’ve taken the starting capital of $1,000 and risked 2% ($20) on each bet. If my random number generator results in a number of 52 or below, I win the bet. Based on my model, after 1000 trades the capital has increased to $2,360 (236% increase). After 5,000 trades we’re up to $6,280 (628% increase) and after 10,000 trades the return is $8,360 (836%). The odds in this situation are only slightly in our favour, and so we have to bet safely so that we can ride out the inevitable losing streaks, however we have evidenced that the 2% edge does indeed come out.

odds-calculator
Say that we instead have an edge of 60%. Knowing that we wont have to ride out such long and frequent losing streaks, we also increase our bet to $50. The results are staggering. After 1,000 bets our capital has increased to $10,300, after 5,000 it’s $44,500 and after 10,000 it’s $93,000.

Keep in my mind that if you experiment with this, your individual results may vary, however in the long run, statistically the results should be consistent. The more times you’re able to compete in the market with your edge, the more likely it is that your edge will come out to deliver a profit. This is why risk management is so critical in any trading environment.
What we can see is that if we control our risk exposure (bets) so that we can continue to participate in the market with our edge, over the long run we will be profitable. In following articles I will discuss the ability to actually find and exploit an edge, as well as methods that should be employed to control your risk and participate long enough in the market for your edge to develop a profit.