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Forex Spot Rates Article:

Trading Foreign Exchange The Black Box Way
By Justin Gunther
Theres an ongoing debate among financial experts about the determinants of portfolio returns. Some maintain that asset allocation accounts for up to 90 percent of long-term gains. Others are convinced that low costs are the magic bullet. Probably the best course of action is to keep your eye on both.

What this means is that investors with a high, or even moderate, tolerance for risk might consider allocating a tiny portion of their portfolio to commodities, including foreign exchange, commonly called forex.

Indeed, lackluster returns in the fixed income and equity markets over the past few years have sent investors in search of alternative investments like real estate and commodities. So not surprisingly, experts in foreign exchange trading have stepped up the marketing of their wares to savvy and neophyte investors alike.

Among these experts are black box traders. These professionals have a proven track record of success in trading foreign exchange. Their services are especially attractive to people with little knowledge of the vast and idiosyncratic foreign exchange market those who are comfortable relying on trading experts to lead the way.

The black box approach refers to a computerized system that automatically executes trades based on an algorithm or strategy. A black box trader develops a proprietary model through historical analysis of trading patterns. The trader then applies the model in real time to a computer program that generates buys and sells 24/7 in the global foreign exchange markets hopefully at a profit but, of course, theres no guarantee.

There are three types of black box trading models: fully disclosed, gray and undisclosed. A fully-disclosed model reveals all about the technical indicators that trigger trades and the relationships among various indicators so investors know exactly what prompted a trade.

The gray box approach discloses only some of the indicators that spark trades. And with undisclosed black box trading, nothing about the models logic is known so either the investor has a lot of confidence in it or so little money at risk that this leap of faith wont keep him or her awake at night.

It may seem counterintuitive,
but there are good reasons for black box traders to operate on an undisclosed basis. To do otherwise could invite other traders to replicate the strategy. So for the average investor, the most relevant consideration is the profitability of a particular black box model.

Proponents of black box trading think that this quantitative approach is the only way to make money over the long term and that taking emotion out of the equation in this way is key. In a volatile market, even seasoned traders react emotionally and sometimes change course. Black box trading is probably a good solution for investors who can let go and let the models discipline prevail.

Besides removing the human emotional component, there are other practical reasons for developing computer models to capture profits in foreign exchange trading. For one, its a 24/7 market and the computer never sleeps. So whenever the optimal conditions specified in the model present themselves, youre virtually guaranteed an execution.

And, unlike the equities markets, the market is very fragmented. There are scores of banks that make markets in currencies. Combine this with the explosion in available trading data (quotes, bids and offers) and the need to make split-second decisions and it becomes clear why working with a black box expert is a practical way to participate in this market.

If youre considering black box trading, be sure to use a trading system that features a demo account you can easily download and use without providing a lot of personal information. This will give you a chance to trade on a trial basis before you allocate a larger sum to the foreign exchange portion of your portfolio. Also, make sure the system has a track record of profitability.

Be wary of systems that require significant up-front fees to get started. This could be a red flag that the system is locking in its returns right away but you may end up struggling to turn a profit. Most reputable systems offer a money-back guarantee if youre dissatisfied.

The bottom line: If youre an investor with a medium to high tolerance for risk, foreign exchange black box trading could add a new dimension to your diversified portfolio.

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