Make money from money with the three key tactics in Forex trading
Understand the basic trades and you can profit from foreign exchange, writes Phil Thornton
With equity, property and bond markets going through a rough time, investors are increasingly tempted to see currency trading as a safe haven.
However newcomers should remember that while the gains can be impressive, those without a clear strategy can suffer losses that would make share traders blanch.
The most famous example is the £3.3bn the Bank of England lost in 1992 betting against billionaire speculator George Soros’s position that the pound’s fixed exchange rate against the German bund was unsustainably high.
There are a whole host of factors that can push exchange rates around. Economic data, central bank decisions and political events can affect analysts’ view of a currency.
At the same time technical factors such as market interest rates, shifts in foreign investment and cross-border takeovers, commodity prices and international trade can influence how currencies trade against each other.
Increasingly, currency traders look for clear and transparent strategies to ensure they are not buffeted by one-off events.
Traders and analysts focus on three well-defined trading strategies – carry, momentum or trend following, and valuation.
The carry trade has hit the headlines in recent months – and for good reason. At the heart of the strategy is borrowing in a low interest rate currency and investing in a higher interest rate currency.
The most famous example was investors borrowing in Japanese yen while Tokyo kept interest rates close to zero and investing in New Zealand, where the official interest rate has risen from 7.25 per cent to 8.25 per cent since January last year.
The momentum strategy follows clearly identifiable movements in currencies, such as the long-term decline in the value of the dollar since 2002.
Lastly, valuation seeks to identify currencies that are overvalued and those that are undervalued. Since currency trading works by buying one currency and selling another, the way to execute this strategy is to take short positions in overvalued currencies and using the proceeds for long positions in undervalued currencies.
Each of the strategies is easily implemented, in part because they are so well known and straightforward, but also because execution costs in currency markets are so small.
A study of the performance of 113 professional currency managers between 1990 and 2006 by Richard Levich, professor of finance at New York University, found that two-thirds of their positive returns came from these strategies.
What all these three have in common is that they are long-term strategies based on a cool and calm assessment based on in-depth research.
The carry trade has been the most profitable in recent months as traders benefit from the large interest rate differentials as well as the movement in the exchange rate.
Betsy Waters, who is global director at dbFX, Deutsche Bank’s online currency platform, says that the carry trade is something of a double whammy. It has the advantage that traders receive the benefit of the interest rate on the high-yielding currency they have bought as well as any currency move.
“People have done very well with carry trade recently,” says Waters. “It depends what you are looking for. If you are looking for an interest rate play then carry makes sense.”
Valuation trading comes down to a fundamental view of whether a currency is over- or under-valued. Soros spotted that with sterling in the early 1990s but other examples tend to be less obvious than that event.
The most popular way to identify that is through purchasing power parity (PPP), a theory based on relationship between relative inflation performance of countries and longer-term exchange rate movements.
“Inflation under PPP theory has a long term effect on a currency,” says Ryan O’Doherty, trading education specialist at CMC Markets. “Low inflation is seen as a sign of a healthy economy that is likely to attract foreign investment, thus creating an upward pressure on the country’s exchange rate.”
When it comes to following a momentum strategy, such as a strong dollar or weaker pound, traders need both a fundamental view and the ability to read technical analysis.
“You need to look at and understand the deep relationship between a currency and its regional economy,” says Tony Celentano, head of sales at E*TRADE Securities.
Traders need to know how to interpret macroeconomic data on GDP, inflation, monetary policy and international trade and capital flows.
While that will help a trader to take a fundamental view, technical analysis enables them to decide when to enter and exit that trade and how large a position to take.
“You can have a fundamental view about a currency but if the technical chart is showing that it is overbought that would make you not buy it until you get a clear signal,” he says.
O’Doherty at CMC Markets agrees. “Fundamental analysis is concerned with the study of the influences of supply and demand on price, technical analysis is concerned only with price and direct measures of price action,” he says.
He says the advantage of technical analysis in the foreign exchange markets is its applicability to all floating and traded currencies and of use in almost any timeframe.
All major online platforms provide research and charting facilities that are designed to allow traders to carry out their own analysis.
Waters at dbFX says: “Forex trading is very technical so people who trade in other markets by staring at charts and comparing company A with company B will enjoy forex.
“But at the same time if you have a fundamental opinion you can do very well.”
One danger for new investors is getting caught up in the excitement of a fast-moving market. “The foreign exchange market consists of many participants who often over-react to situations and facts,” says O’Doherty.
“A trend that is not necessarily justified rationally can still move in an irrational direction over the short term.”
Waters at dbFX advises new traders stick to a long-term plan rather than trying to make a quick profit. “Good currency traders make money in the long term by being disciplined, not necessarily by making short-term bets.”
Celentano at E*TRADE Securities urges small investors to start out with small positions. “There’s no point opening big positions,” he says. “Dip your toe in the water – don’t jump in.”
Phil Thornton is lead consultant at research house Clarity Economics