Position size & liquidity

I hear conflicting things about the size of the foreign exchange market & the liquidity of positions taken in it. Supposedly more than US$2 trillion worth of currencies are traded every day, naturally that amount will vary given the relative strength of the US dollar, and yet I've read that a position with a notional value of just a few million USD can be difficult to close. Is someone telling porkies or are these two apparently irreconcilable facts both correct?

So...how big is the biggest position someone can take in the foreign exchange markets? If $2 trillion is thrown around every day I would have thought a $10 or $20 billion position would have relatively little impact on the market. Didn't Soros have a $10bn position on Black Wednesday?

What about synthetic positions, i.e. non-exchange bets made between banks, don't these often run into the hundreds of millions or billions in terms of notional value? Are they included in most of the daily volume figures which are given?

Sorry in advance if this is in the wrong sub-forum, it is not related to trading directly (or at least not the trading most people will be doing lol) but I couldn't see a better place to put it than in the Money Markets sub-forum.

A $10 or $20bn position will certainly have an impact on the mkt. The FX mkt is large and liquid, but the flip side of that is how leveraged it is. That implies that our "perception" of liquidity is very different.

The daily turn-over is closer to $4trln based on most recent BIS figures. It's worth noting, though, that a big chunk of the quoted volume is in swaps, not spot.

As for whether someone would have a problem getting out of a few million, that depends. Are we talking about a retail trader dealing with smaller liquidity pools, or an institutional trader playing in the inter-bank market. The latter would have no problem doing multi-million dollar trades. The former might, depending on the liquidity provider. You have to remember that it's a fragmented market.

Martinghoul said:

A $10 or $20bn position will certainly have an impact on the mkt. The FX mkt is large and liquid, but the flip side of that is how leveraged it is. That implies that our "perception" of liquidity is very different.

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How strong is the technical side v the fundamental side? Let's propose that someone, or more likely, a collection of entities, took out a $10bn position against the Euro; subsequently some devastating news arrives, something like Greece, Portugal, Italy and Ireland have all defaulted, would they be able to close out the position without too much slippage if enough people were dropping Euros? What I mean is, are very big positions best taken out based on fundamentals rather than the technical side?

It seems as though, and I could of course be wrong, the technical side is supported by the fundamental side; if you have made 1 or 2 pips on a position it is probably just a sign that there is momentarily more demand for the currency you are holding and if you (and others in your position) close out your position you may well find that there is sufficient slippage for you not to even make a profit.

Whereas if you have a position and the currency you are short falls 4% or 5% against the currency you are long you would probably be able to close it out at the current price?

Rhody Trader said:

The daily turn-over is closer to $4trln based on most recent BIS figures. It's worth noting, though, that a big chunk of the quoted volume is in swaps, not spot.

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Don't swaps set the tone for the market (i.e. spot price) so to speak? I.E. the banks determine how much of a given currency they will be needing for their utility functions (i.e. conducting exchanges of currencies, paying out balances) and they start swapping various currencies between themselves, ostensibly not for profit. Then the speculators use the rate at which various currencies are being swapped for one another as a starting point for trading. Do these swaps ever take place at rates which are considerably different to the spot market exchange rate?

Rhody Trader said:

As for whether someone would have a problem getting out of a few million, that depends. Are we talking about a retail trader dealing with smaller liquidity pools, or an institutional trader playing in the inter-bank market. The latter would have no problem doing multi-million dollar trades. The former might, depending on the liquidity provider. You have to remember that it's a fragmented market.

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I was thinking of a retail trader, I knew the big traders wouldn't have too much trouble. So, retail traders aren't trading in the same market as banks and others do?

Maybe a simulation could be run to see how differently a retail trader with a position with a notional value of US$5 million and a paper profit of $100,000 and a prop trader for a bank with a similar position end up. Would the former find a lot of his profit eroded if he tried to close out his position all at once?

jthetrader said:

How strong is the technical side v the fundamental side? Let's propose that someone, or more likely, a collection of entities, took out a $10bn position against the Euro; subsequently some devastating news arrives, something like Greece, Portugal, Italy and Ireland have all defaulted, would they be able to close out the position without too much slippage if enough people were dropping Euros? What I mean is, are very big positions best taken out based on fundamentals rather than the technical side?

It seems as though, and I could of course be wrong, the technical side is supported by the fundamental side; if you have made 1 or 2 pips on a position it is probably just a sign that there is momentarily more demand for the currency you are holding and if you (and others in your position) close out your position you may well find that there is sufficient slippage for you not to even make a profit.

Whereas if you have a position and the currency you are short falls 4% or 5% against the currency you are long you would probably be able to close it out at the current price?

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I cannot tell you anything about the "technical" side. I don't do technical stuff and it's all mumbo-jumbo to me.

It's very difficult to generalize. The FX mkt is large and varied and all sorts of stuff goes on that is driven by different factors (and actors). Again in most cases, if you have a significant size position, you'll be able to get in and out without undue mkt impact, if you so desire. Sometimes that's not the case and large trades do get executed in one shot (e.g. M&A hedges). In that case, you'll see mkt moving quite a bit.

Martinghoul said:

I cannot tell you anything about the "technical" side. I don't do technical stuff and it's all mumbo-jumbo to me.

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Perhaps I used the wrong word when I said 'technical', what I meant was the effect of supply and demand on the eventual average exchange rate acheived for a given transaction.

I too find the mathematical side to be quite challenging, which is why I pay more attention to the news, history and gut instinct than anything else. However I can't help but think it is helpful to be aware of the power of supply & demand, particularly in the context of large positions.

Martinghoul said:

It's very difficult to generalize. The FX mkt is large and varied and all sorts of stuff goes on that is driven by different factors (and actors). Again in most cases, if you have a significant size position, you'll be able to get in and out without undue mkt impact, if you so desire. Sometimes that's not the case and large trades do get executed in one shot (e.g. M&A hedges). In that case, you'll see mkt moving quite a bit.

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What do you mean by if you so desire? As in if you're prepared to wait a while for the position to be unwound rather than dumping a large amount of a certain currency in one go?

If slippage is that bad wouldn't there come a point at which it would be advisable to purchase protective options to protect you against a fall in the value of what you are selling as you sell it off? Then again perhaps buying said options would force the price of those higher.

Sorry to keep pressing you about this, but when you say the market moves quite a bit do you mean from USD/GBP 1.60 to 1.55 or just by a few pips?

jthetrader said:

Don't swaps set the tone for the market (i.e. spot price) so to speak? I.E. the banks determine how much of a given currency they will be needing for their utility functions (i.e. conducting exchanges of currencies, paying out balances) and they start swapping various currencies between themselves, ostensibly not for profit. Then the speculators use the rate at which various currencies are being swapped for one another as a starting point for trading. Do these swaps ever take place at rates which are considerably different to the spot market exchange rate?

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I think you're confusing swaps as "instruments" with straight currency exchanges. Both spot and swaps are contributory to exchange rates. Whether one or the other dominates depends on market flows at the time.

I was thinking of a retail trader, I knew the big traders wouldn't have too much trouble. So, retail traders aren't trading in the same market as banks and others do?

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Not directly. Retail traders mainly transact with their broker, who acts as market maker. The brokers offset customer positions, then hedge imbalances in the inter-bank market. That does suggest the action of retail traders are reflected in the broader market, but it's an extremely small thing. I think the volume of retail trading is a couple percent of the total volume. Once you go through the broker netting process the actual reflection of retail on inter-bank is negligible.

Maybe a simulation could be run to see how differently a retail trader with a position with a notional value of US$5 million and a paper profit of $100,000 and a prop trader for a bank with a similar position end up. Would the former find a lot of his profit eroded if he tried to close out his position all at once?

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It will depend on the broker, but chances are the retail trader won't see any slippage because the automated broker systems will just absorb the trade in whole. The advantage to the prop trader is that they might be able to buy at the bid or sell at the offer, avoiding the spread cost.

jthetrader said:

Perhaps I used the wrong word when I said 'technical', what I meant was the effect of supply and demand on the eventual average exchange rate acheived for a given transaction.

I too find the mathematical side to be quite challenging, which is why I pay more attention to the news, history and gut instinct than anything else. However I can't help but think it is helpful to be aware of the power of supply & demand, particularly in the context of large positions.

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Well, it's v v difficult to formalize and quantify these supply/demand dynamics. I don't consider that technical indicators offer a sufficiently rigorous way to do it.

What do you mean by if you so desire? As in if you're prepared to wait a while for the position to be unwound rather than dumping a large amount of a certain currency in one go?

If slippage is that bad wouldn't there come a point at which it would be advisable to purchase protective options to protect you against a fall in the value of what you are selling as you sell it off? Then again perhaps buying said options would force the price of those higher.

Sorry to keep pressing you about this, but when you say the market moves quite a bit do you mean from USD/GBP 1.60 to 1.55 or just by a few pips?

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I mean that most large orders, unless there's some ulterior motive (for example, it's a "fixing"), would normally be worked in the mkt over a period of time to minimize mkt impact. So yes, in most cases, it's been shown empirically that, on average, waiting is cheaper than dumping. Hence, the various algorithmic methods, e.g. VWAP etc.

Forget about options in the context of slippage. Slippage is the fundamental price of liquidity and, if you're a liquidity taker, you can't avoid paying it one way or another.

When I say mkt moves quite a bit, I mean arnd a big figure, say, in GBPUSD. So let's say arnd 50-100 pips? This is a totally subjective estimate, so pls take with a large pinch of salt.

Rhody Trader said:

I think you're confusing swaps as "instruments" with straight currency exchanges. Both spot and swaps are contributory to exchange rates. Whether one or the other dominates depends on market flows at the time.

Not directly. Retail traders mainly transact with their broker, who acts as market maker. The brokers offset customer positions, then hedge imbalances in the inter-bank market. That does suggest the action of retail traders are reflected in the broader market, but it's an extremely small thing. I think the volume of retail trading is a couple percent of the total volume. Once you go through the broker netting process the actual reflection of retail on inter-bank is negligible.

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So brokers do assume a fair amount of risk? Presumably if the inter-bank market rates differ from the rates the broker offered to his customers then he could take a loss (or make a profit)?

Rhody Trader said:

It will depend on the broker, but chances are the retail trader won't see any slippage because the automated broker systems will just absorb the trade in whole. The advantage to the prop trader is that they might be able to buy at the bid or sell at the offer, avoiding the spread cost.

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So it is a negligible difference, but one which adds up over time?

Martinghoul said:

Well, it's v v difficult to formalize and quantify these supply/demand dynamics. I don't consider that technical indicators offer a sufficiently rigorous way to do it.

I mean that most large orders, unless there's some ulterior motive (for example, it's a "fixing"), would normally be worked in the mkt over a period of time to minimize mkt impact. So yes, in most cases, it's been shown empirically that, on average, waiting is cheaper than dumping. Hence, the various algorithmic methods, e.g. VWAP etc.

Forget about options in the context of slippage. Slippage is the fundamental price of liquidity and, if you're a liquidity taker, you can't avoid paying it one way or another.

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I just thought it would be a good way to insulate yourself from major slippage, essentially exercising an option involves an off market transaction; if you have options to cover selling £1 million into dollars @ 1.6 then you will get $1.6 million back, you don't have to look for a buyer, the option writer has already agreed to buy it off you at said price. So if you realise that at a certain critical mass dumping a certain number of units of currency (or shares) onto the open market will cause a severe price disturbance then you could cover the excess with options and avoid the slippage on the spot market. So, if you're exchanging £100 million into dollars and think that trying to do more than £75 million will unbalance the supply-demand equilibrium sufficiently to cause a severe price drop then you could option the remaining £25 million.

Or you could just wait and sell off over time butthat way you are running a risk of a price drop during said time, prices do change and a price change over days could easily wipe out a forex profit couldn't it? I suppose with shares things are a little different, if you bought stock in a company at an average price of $10 and it is trading at $20 you are unlikely to see it fall so far as to eliminate your profit while you sell off, forex profits are a lot more fragile.

Maringhoul said:

When I say mkt moves quite a bit, I mean arnd a big figure, say, in GBPUSD. So let's say arnd 50-100 pips? This is a totally subjective estimate, so pls take with a large pinch of salt.

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Well...its the best estimate I have so far, so

jthetrader said:

I just thought it would be a good way to insulate yourself from major slippage, essentially exercising an option involves an off market transaction; if you have options to cover selling £1 million into dollars @ 1.6 then you will get $1.6 million back, you don't have to look for a buyer, the option writer has already agreed to buy it off you at said price. So if you realise that at a certain critical mass dumping a certain number of units of currency (or shares) onto the open market will cause a severe price disturbance then you could cover the excess with options and avoid the slippage on the spot market. So, if you're exchanging £100 million into dollars and think that trying to do more than £75 million will unbalance the supply-demand equilibrium sufficiently to cause a severe price drop then you could option the remaining £25 million.

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Yeah, what you say makes sense, once you're long the option (to an extent, although there's fun to be had there as well). However, to get into that position, you'll incur far more slippage and transaction costs than the amount you're attempting to save. My point is that there's just no free lunch out there and nobody (unless they're stupid) will sell you free options (or even cheap options). There's really no way to avoid paying for liquidity, although there are ways to optimize the costs. Using options won't help, 'cause doing options consumes more liquidity than it produces.

Or you could just wait and sell off over time butthat way you are running a risk of a price drop during said time, prices do change and a price change over days could easily wipe out a forex profit couldn't it? I suppose with shares things are a little different, if you bought stock in a company at an average price of $10 and it is trading at $20 you are unlikely to see it fall so far as to eliminate your profit while you sell off, forex profits are a lot more fragile.

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Well, it all depends. If you got into a 10bn position, it's unlikely you're in it for a couple of ticks. Everything in any mkt is, generally, a consistent function of volatility: liquidity, slippage, mkt size, expected profits/drawdowns, etc.

jthetrader said:

So brokers do assume a fair amount of risk? Presumably if the inter-bank market rates differ from the rates the broker offered to his customers then he could take a loss (or make a profit)?

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Brokers adjust the prices they receive from their liquidity providers to keep themselves on the right side of the spread and use risk management algorithms to manage their exposure.

So it is a negligible difference, but one which adds up over time?

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Potentially so.

Martinghoul said:

Yeah, what you say makes sense, once you're long the option (to an extent, although there's fun to be had there as well). However, to get into that position, you'll incur far more slippage and transaction costs than the amount you're attempting to save. My point is that there's just no free lunch out there and nobody (unless they're stupid) will sell you free options (or even cheap options). There's really no way to avoid paying for liquidity, although there are ways to optimize the costs. Using options won't help, 'cause doing options consumes more liquidity than it produces.

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Do you mean it consumes more liquidity for the market in general or for one market actor in particular? Plus, isn't liquidity only important where you need to search the market for buyers at a certain price, if you have locked in a price then the market price is an afterthought (other than in terms of opportunity cost of using options, i.e. you can't take advantage of spot market price changes).

Martinghoul said:

Well, it all depends. If you got into a 10bn position, it's unlikely you're in it for a couple of ticks. Everything in any mkt is, generally, a consistent function of volatility: liquidity, slippage, mkt size, expected profits/drawdowns, etc.

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So if you wish to profit off small price differences then lots of trades but without any massive positions are a good idea? I suppose that is what the high frequency traders do, trying to remain agile enough to take advantage of minute price differences.

Would a $10bn position still remain profitable if say the EUR/USD dropped from 1.45 to 1.40ish, which it has in the last few weeks?

Rhody Trader said:

Brokers adjust the prices they receive from their liquidity providers to keep themselves on the right side of the spread and use risk management algorithms to manage their exposure.

Potentially so.

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So...can brokers lose? In the end they can't predict the future any better than anyone and if the unforseeable happens they would be as stuck as anyone, if a currency takes a serious plunge (i.e. loses all value) then they too would be done for, no?

jthetrader said:

Do you mean it consumes more liquidity for the market in general or for one market actor in particular? Plus, isn't liquidity only important where you need to search the market for buyers at a certain price, if you have locked in a price then the market price is an afterthought (other than in terms of opportunity cost of using options, i.e. you can't take advantage of spot market price changes).

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I mean it consumes more liquidity for a price taker... In order for me to have an option that's beneficial for my execution, a market-maker must have sold me that option at some point in the past. All I am saying is that this initial transaction involves costs that imply I still pay for liquidity. You see my point?

So if you wish to profit off small price differences then lots of trades but without any massive positions are a good idea? I suppose that is what the high frequency traders do, trying to remain agile enough to take advantage of minute price differences.

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Yes, if you think you have edge doing this sort of high-frequency thing, then yes, that's viable. In general, you have to realize that it's always a trade-off that can be defined (simplistically) in terms of Sharpe Ratio and frequency. You can do a few trades with extremely high SR or, equally, you can do many many trades with much lower SR. Both can make money.

Would a $10bn position still remain profitable if say the EUR/USD dropped from 1.45 to 1.40ish, which it has in the last few weeks?

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Yes, of course... Getting out of a $10bn position is not that painful a task, really.

Martinghoul said:

I mean it consumes more liquidity for a price taker... In order for me to have an option that's beneficial for my execution, a market-maker must have sold me that option at some point in the past. All I am saying is that this initial transaction involves costs that imply I still pay for liquidity. You see my point?

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I do indeed. It really is just a matter of shifting the cost around,

Martinghoul said:

Yes, if you think you have edge doing this sort of high-frequency thing, then yes, that's viable. In general, you have to realize that it's always a trade-off that can be defined (simplistically) in terms of Sharpe Ratio and frequency. You can do a few trades with extremely high SR or, equally, you can do many many trades with much lower SR. Both can make money.

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So it is true that the guy with the most computing power wins? If you can get in and steal the arbitrage opportunity before anyone else you will make money? I suppose the first person to invent a large scale quantum computer will be a very, very rich person indeed.

Martinghoul said:

Yes, of course... Getting out of a $10bn position is not that painful a task, really.

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LOL, unless it went the wrong way ouch

jthetrader said:

So...can brokers lose? In the end they can't predict the future any better than anyone and if the unforseeable happens they would be as stuck as anyone, if a currency takes a serious plunge (i.e. loses all value) then they too would be done for, no?

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To the extent that broker customer accounts have offsetting positions (longs and shorts are matched), the broker has no exposure to price change. They just make money on the spread. Of course complete offset isn't likely to happen, leaving the broker with a directional exposure. If it's small, they won't worry about it. If it's large, though, they'll hedge to remove the risk. The broker's business is to be a liquidity provider and to earn the spread by doing so. It doesn't want the directional risk.

Rhody Trader said:

To the extent that broker customer accounts have offsetting positions (longs and shorts are matched), the broker has no exposure to price change. They just make money on the spread. Of course complete offset isn't likely to happen, leaving the broker with a directional exposure. If it's small, they won't worry about it. If it's large, though, they'll hedge to remove the risk. The broker's business is to be a liquidity provider and to earn the spread by doing so. It doesn't want the directional risk.

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So brokers basically adjust what they are asking for a security and what they are offering for one depending upon supply and demand, e.g. if they have too much of one currency they will try to dispose of it by making it more attractive to people looking to change their currency into it?