Is Foreign Exchange Trading for You?

The foreign exchange market is spreading from a largely commercial/institutional market to one that includes the global retail community. This is occurring owing to technological advances, cheaper and more accessible global economic information, and the increased number of legitimate, reputable firms entering the arena. As an equity investor/trader, does foreign exchange have a place in your portfolio?

The answer depends on many factors—the key determinants being risk tolerance, investment objectives, and knowledge of the market. Before tackling the suitability question, an overview of the foreign exchange market is appropriate.

The forex market is by no means new. One could argue that cavemen from different regions had different forms of currency and traded them on a regular basis. One region may have had nice, smooth rocks that made for sturdy shelter. Others may have had fertile land that yielded abundant food. Depending on supply and demand for food versus rocks, the value of one varied in relation to the other. For example, rocks would have appreciated if cavemen decided to “modernize” their housing accommodations.

The dynamics are similar in the modern forex market, but instead of rocks and food, we have the value of one country’s currency versus another’s. The combination of the two is called a currency pair, and that currency pair trades at a price. The value of the U.S. dollar versus the Japanese yen is one such currency pair. As a traded instrument, that pair is referred to as USDJPY; USD is the standardized three-character code for the dollar, JPY for the yen.

For equity traders, buying or selling a currency pair like USDJPY is no different than buying Google shares. When you buy Google, you are really buying “GOOGUSD,” since you receive Google stock certificates in exchange for U.S. dollars. At the end of the transaction, after the GOOGUSD price goes up (hopefully), you exchange your Google stock certificates for more U.S. dollars and pocket the difference. So, just like buying Google, in order to be profitable, you want to buy the USDJPY cheap and sell it at a higher price.

Like anything else, forex trading is risky. Equity markets in the U.S. and abroad have been anything but friendly in the 21st century. Since Jan. 1, 2000, these have been the performances of the major equity averages from around the globe:

As the table indicates, it is not good enough to be diversified in a portfolio that mimics the major indices. Being a stock picker is also not the easiest thing in the world. Sure, there are winners that outperform, but the corrections in such stocks can be quite brutal: Google from $750 to $500 (-33% from the high), Apple from $200 to $120 (-40% from the high), and Goldman Sachs from $250 to $175 (-30% from the high) are the 21st century bellwethers that outperformed on the upside, but underperformed on the downside (as a comparison, the Dow lost 19.4% and NASDAQ lost 23% from the recent top). The equity markets of today demand a higher degree of risk tolerance and a lot of homework.

So what are the risks in forex trading? Like all markets, the foreign exchange market can have large ups and downs, which tend to be a function of the relative strength or weakness of one country’s “fundamentals” versus another’s. Included within that broad category are:
  • Trade balance
  • Budget deficit
  • Inflation
  • Real GDP
  • Interest rates and interest-rate expectations
  • Employment
  • Political backdrop
  • Population demographics
  • Credit or sovereign risk
  • Miscellaneous wild cards (wars, terrorist acts, natural disasters, etc.)

Generally speaking, a country’s currency will strengthen (appreciate) when the fundamentals are better, and weaken (depreciate) when they are worse. When fundamentals between countries are balanced, a currency pair will consolidate and go sideways.

The risk of trading currencies can be understood by looking at the past performance of currency movements. Below is a long-term graph going back to 1990 showing the value of the U.S. Dollar Index (a weighted average index of the dollar against the major currency pairs).

The dollar has had two long periods of trending markets in the last 13 years. Since July 2001, for instance, it has been steadily depreciating, moving from a high of 120.90 on July 5, 2001, to the recent low of 74.85 on Nov. 26, 2007, representing a 38% depreciation from the high (this downtrend has not signaled a bottom yet). Prior to that, the dollar enjoyed a nearly identical period of appreciation, going from 80.27 on April 18, 1995, to a high of 120.90 on July 5, 2001, representing a 50.6% appreciation. Although the moves are both material in regard to the change in value, the time periods of the trends encompassed six years and three months, and then six years and five months, respectively. The shorter periods for a trending currency pair tends to have the same characteristics of the longer term.

The currency markets tend to trend. As a result, risk can be managed by simply following the major trends along the way. If the market for a currency pair is not trending, it is best to sit out until the major trend continues, or play the ranges, but be prepared for a breakout outside the consolidation area.

Investment Objectives and Currency Trading
Everyone has different investment objectives. Some people are risk averse; others are not. Some only feel comfortable going long; others are just as comfortable going short. Some people trade on margin; others would never consider using a margined account. Generally speaking, active traders and longer-term traders with a keen understanding of risk tend to be the best suited for trading currencies. Traders who prefer a medium-term view generally are not.

For shorter-term traders, the daily ranges provide a number of trading opportunities for profit. There also tend to be good up and down movements intraday to work from both the long and short side, although following the major trend is always recommended. Leverage upwards of 100:1 allows a shorter trader to control a $10,000 position with $100 of margin and a $100,000 position with $1,000. The advancements in software, execution improvements, increased competition, and price transparency have compressed spreads, kept brokers honest, and legitimatized the business. For the shorter-term trader, the foreign exchange market has some real advantages. The market is open 24 hours a day, five days a week (opens on Sunday at 5 p.m. and closes on Friday at 4 p.m.). Liquidity is deep, and daily/weekly trading ranges give plenty of opportunity.

For longer-term traders, the trending nature of currencies can lead to favorable results with little activity. Having foreign currencies in a portfolio can enhance and diversify the returns. For example, assume your IRA is invested in a number of relatively safe domestic and multinational companies. Since the companies you own are exposed in the United States, you implicitly have U.S. dollar exposure. If you want to diversify or hedge your dollar exposure, selling the U.S. dollar against the euro might be a prudent move. If stocks do fall, the U.S. dollar may also fall, hedging your investment portfolio.

Knowledge of the Market is a Must
The Greek philosopher Epictetus said, “It is impossible for a man to learn what he thinks he already knows.”

Common sense contends that spending some time and learning about a market will go a long way with regard to success. However, many novice foreign exchange traders feel that because there are fewer currency pairs than equities, trading will be easier. If you think you already know how to trade currencies, you will never learn how to trade currencies.

Understanding and studying the fundamentals behind movements in the major currency pairs, such as EURUSD, GBPUSD, USDJPY and USDCHF, are basic prerequisites. To become successful and profitable, time must be spent learning about the cross-currency pairs, such as GBPJPY, EURJPY, and EURGBP, as they often give confirming signals to the strength of a currency. For example, a strong EURGBP can propel the EURUSD higher while keeping GBPUSD contained. Not seeing or understanding the EURGBP strength can frustrate most traders and lead to mistakes. Trending GBPJPY and EURJPY are other cross-currency pairs that provide insight into the movements of exchange rates.

Being informed about key intra-market relationships like those between oil, equities, and gold versus currency rates can also make you a better, more confident trader. In the January 2008 edition of EQUITIES, I wrote about the intra-market relationship between oil and foreign exchange values. Surging oil prices in 2007 propelled the Canadian dollar higher at the expense of the U.S. dollar, simply because Canada is a net exporter of oil while the U.S. is a net importer. Knowing this intra-market relationship could have led to trading gains from USDCAD’s move from 118 to 90.

The Alpha and the Omega
For some equity traders and investors, the currency market can provide an alternative, a supplement, a yield enhancer, or a level of protection in difficult markets. For others, investment objectives, risk tolerance, or lack of knowledge may dissuade them. But forex trading is easier than ever. Trading is commission-free, and though there is a bid/offer spread that has to be paid, the spread is narrow. Execution is done electronically on platforms that broadcast live two-way markets. Software with free charting services is available, and almost every broker offers free demo accounts that allow for testing and learning before trading live.

Markets don’t always do what they’re supposed to do, but if the conditions are right and the thirst for knowledge is there, the gains can come easy. Even a caveman could do it.

— By Greg Michalowski

About the Author:

Greg Michalowski is vice president of trading and chief FX analyst at FXDD, an online foreign exchange liquidity provider for retail traders and investment managers.