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CURRENCY trading is as popular as ever, but does it have a place as part of a portfolio of stocks, bonds, and other asset classes? In order to answer it we need to look at a range of factors and cross-market correlations to see where it might fit in with a well-diversified investment programme.
We will be delving into this in more detail at the conference, but where do we start? In shares investing and fixed income, we always measure their performance via benchmarks. In equities this means the UK FTSE 100, the US S&P 500, and other stalwarts. Bonds are a bit more complicated, but there are a number of benchmark investments such as UK Treasury Gilts and US Treasury Bonds that give us a point of reference. What of FX?
Unlike stock or bond markets, there’s no “long only investing” for currency traders. When trading currencies, you take positions in one currency against another. For example: you might speculate that the euro will appreciate against the dollar. Yet there is no default position in this case – there is no natural reason for why the euro may always strengthen or the dollar or vice versa over the course of decades.
Thus, instead of individual currency investments we look to benchmark strategy performance. In FX there are tried–and-true currency trading strategies have seen impressive performance over several decades. In fact, a historical study shows that several FX strategies could significantly improve risk-adjusted returns in virtually any and every portfolio – especially those concentrated in shares markets.
THE ATTRACTION
At its base, the FX market is one of the largest and most liquid financial markets in the world; it seems natural to look for an investment opportunity. Its daily volumes dwarf even the largest global stock markets, and individual traders have access to unparalleled liquidity.
Another factor to keep strongly in mind is that there are no bull or bear markets in currencies. A bear market in shares means that most investors will lose money, while fast-rising interest rates will likely force losses in fixed income investments. Yet currency traders might actually do well in such market conditions with two important strategies. What are they?
FX TRADING STRATEGIES
One of the most popular and historically successful strategies has involved buying currencies with high interest rates and selling those with comparatively lower interest rates – also known as the FX carry trade, or forward rate bias. The aim of the approach is to collect interest rate differentials in order to boost returns, and long-term history has shown that currencies with higher interest rates outperform lower-yielding counterparts. This strategy is both simple in concept and implementation – interest rates for individual currencies are easy to find and slow-moving. It is not an active trading scheme.
The other is slightly more complex and in the realm of active traders – speculating on trends in currency markets.
And FX trading strategies compare well with other assets, as the graph (left) shows. Outside of the traditional safe-haven US Treasuries investments, carry trade and major measures of FX trader performances have shown superior risk-adjusted return rates of any major traditional portfolio.
David Rodriguez is a quantitative strategist for DailyFX and will be on the Masters of Forex panel on 24 May. To meet our forex panellists and dozens more trading gurus on 24 May, buy your £80 ticket today:
www.cityamactivetrader.com