How using currency pairs can help you trade on your attitude to risk

SINCE the start of the financial crisis, traders&rsquo; attitudes to risk have gone up and down almost as regularly and dramatically as their blood pressure. Uncertainty has been one of the major characteristics of the markets. As well as sending traders scuttling to their doctors, it has also meant that there has been an increased interest in the currency markets which, because they are so liquid, respond very quickly to changes in risk appetite.<br /><br />Covered warrants have an advantage over trading currencies with other tools for two reasons. Firstly, because of their precise expiry dates they allow traders to be more specific about the time frame over which they take a view. Secondly, because they have limited downside risk the most you can lose is the cost of the warrant. In this respect, covered warrant trading is preferable to, say, spread betting, where your losses can multiply quickly and massively.<br /><br />Currency covered warrants come in the form of currency pairs. Because you are dealing with the relationship between two currencies, there is a sense in which all currency warrants are at once both calls and puts, since if one side of the ratio rises, the other must fall. A sterling-dollar call is at once a call on sterling and a put on the US dollar, ie, the warrant should gain in value if sterling strengthens against the US dollar, or if the US dollar weakens against the pound. The result is the same.<br /><br />So, how has the recent attitude towards risk played out in this market? Over the summer, we have seen a decline in risk appetite, as macroeconomic data is pointing to the beginnings of an economic recovery by the end of 2009. Many strategists think that the current rally is overextended and are warning of an autumn dip in the markets. This means that there has been an increase in the value of put covered warrants linked to the performance of sterling-yen and US dollar-yen currency pairs, says Andrew McHattie, chairman of McHattie Investment Management.<br /><br />This is because sterling is seen as a relatively risky currency &ndash; that is, it will strengthen when investors have more appetite for risk, and weaken when they do not. Other risky currencies are commodity currencies such as the Australian dollar, New Zealand dollar, Canadian dollar and the South African rand. When risk appetite falls, then, they will suffer compared to perceived safe haven currencies like the US dollar and the Japanese yen.<br /><br />This opens up plenty of tactics for traders looking to use covered warrants to trade currencies. If you think that investors&rsquo; appetite for risk is likely to wane over the next few months, then you should look to buy put covered warrants on sterling crosses with the Japanese yen and the US dollar. If you think that risk appetite will remain muted for the rest of 2009 but could well pick up in 2010, then you would be best to choose put covered warrants that have about three months to expiry. Or if you want to play the currency markets intra-day (the viability of this trading strategy would depend on your broker fees) then you could select a currency covered warrant that is already in the money and with a high delta &ndash; the ratio comparing the change in the price of the underlying asset to the corresponding change in the price of a derivative &ndash; upwards of about 50 per cent.<br /><br /><strong>SPECULATIVE POSITION</strong><br />However, covered warrants traders have recently been particularly interested in longer-dated currency covered warrants says Alexandre Chesse, manager of Societe Generale&rsquo;s covered warrants team. This would suggest that traders at the moment are either looking to take a longer-term speculative position on a currency pair or are looking to hedge their positions in the currency markets or other asset classes.<br /><br />In the first instance, covered warrants traders would look to buy a slightly out of the money covered warrant with a delta below 50 per cent on the expectation that the covered warrant will move in to the money over the lifetime of the warrant. The precise expiry date chosen will depend on how long the trader hopes to speculate for.<br /><br />Longer-dated currency covered warrants are equally useful for investors who have assets denominated in, say, euros or US dollars. Chesse says that Societe Generale clients with liabilities in euros have been buying call covered warrants on sterling-euro to hedge themselves against adverse moves in the exchange rate. Employing this strategy effectively can ensure that the sterling value will not be less than the exercise price while allowing the company or individual to benefit from any favourable currency movements.<br /><br />With fluctuating risk appetite expected to remain a key driver of currency markets over the next few weeks, currency covered warrants are an ideal tool for the speculator looking to gain exposure to the world&rsquo;s biggest and most liquid market. And the added security might even help to lower that blood pressure.