Why Trade FX?

April 10, 2017
April 10, 2017

Why Trade FX?

April 10, 2017      Beginners

The main reason to trade FX is to make a lot of money very fast. The ability to make a large return in a short period of time is a function of a fast moving market and leverage. FX prices are measured in points, so that in futures a ten-point move in the Canadian dollar is worth $100. If the average daily move in the C$ is 100 points and if you do everything exactly right, you can potentially make $1000 per day.

And you can do this by putting in a capital stake of only $4000, so you could conceivably make a 30% return every day. You can do the arithmetic—if you did that every day in a 240-day trading year, you’d have $240,000, or a return of 60 times your stake. You are able to do this because the contract you are trading is for a face amount of about $100,000, but you have to put in only about $4000. The broker is lending you the remaining $96,000 but if you win, you get to keep the entire gain. The broker takes only fees and commissions, or hides the fees and commission in the bid-offer spread.

This example is crude (and the numbers are only approximate) but they illustrate the point—the main reason to trade FX is greed. If you are like most people, who saw their savings in equities barely return to 1999 levels in 2010, trading FX sounds like a very good idea.

Like all things that sound too good to be true, however, trading successfully takes years of training and work. Many beginners do indeed make a bundle in their first forays, but hardly anyone manages to keep it. We are going to address this below and in our discussion of methodology.

The second reason to trade FX is that it’s more fun than another security. In the days of the tech boom, “idea stocks” were interesting, but FX offers an endless array of fascinating stories to trade on. FX market fundamentals range from the behavior of Japanese housewives to Big-Picture macroeconomics to foreign affairs. FX is the first and the last security to respond to world economic and financial events. When Lehman Brothers went bankrupt in September 2008, the currency market moved over 10% within the space of a few months. Again, when you are using trading leverage of 60X, that’s a potential return of as much as 600%.

You can’t trade currencies without knowing something about bonds, equities, gold, oil and sometimes other securities, too. FX is the top of the securities heap, the most sensitive barometer of global sentiment.

Having said that, trading on Big-Picture macroeconomics is a really bad idea that hardly ever works. You have to know the information without letting your ideological bias dictate your trades. For one thing, dispassionate objectivity is very hard to find, in yourself as well as in others’ commentary. For another, traders are acting on their own interpretation of global affairs and they can be wrong. You still need to follow the crowd and trade with the “idea of the day” even though your superior analysis tells you the crowd is wrong.

The purpose of trading is to make money, not to prove that you are “right” about some geopolitical event.

Eat Your Spinach

It’s nice to be holding a currency position when the price shoots the moon. Sometimes the forex market delivers 500 points in a single session. At (say) $10 per point, that’s a gain of $5,000 on a capital stake of as little as $2500, or 200%.

This is why so many Chart Hucksters are out promoting forex as a way to get rich quick. One broker advertises on the Reuters website that “Trading the euro is easy!” They claim they can identify in advance when big moves like this are going to occur. If anyone really did have such a secret, they sure wouldn’t be selling it to anyone, let alone you and me—they would be trading it themselves.

Then there is the Big Picture Guru who claims that his deep analysis means a big move must logically be in the works. The Guru neglects to tell you that he personally has never made a dime from his profound economic analysis and gets all his income from selling it instead of trading it.

This doesn’t mean the Chart Hucksters don’t have some good ideas worth learning or that the Big Picture Gurus don’t offer real food for thought. It does mean their goal is not to help you make money trading—it’s to sell reports.

Unfortunately, there is no fast and easy way to learn trading. Pretend for a moment that you don’t know how to cook. You sign up for a cooking class that will consist of 15 sessions of three hours each, or 45 hours. By the end of that time, you will know how to do more than boil water, but you will not be qualified to solicit capital from investors and open a restaurant.

Beginning traders are usually not willing to commit even 45 hours of time to learning how to trade, and yet an ounce of common sense should tell them that 45 hours is a bare minimum. To achieve real mastery in any endeavor takes 10,000 hours, according to Malcolm Gladwell in his book Outliers. Ten thousand hours is a huge amount of time—250 weeks or almost 5 years at a full 40-hour week.

Most people can’t make that commitment–but they forge ahead anyway on a wing and a prayer. They are desperate to make a little extra money, or they find trading entertaining, or trading feeds their adrenaline habit, or trading makes them feel important and connected to the world of finance, or trading provides a social networking opportunity.

No wonder most beginning traders lose money.

But here’s the good news. Education is cumulative. If you are persistent and work with true concentration, you can get to a high level of trading competence in less than 5 years. You won’t be a master, but you will make more money than you lose. It helps if you have certain personality and character traits, but not essential. See Chapter 5 from our book The Global Trader, “Just People Just Don’t Get It” elsewhere on the site (“Books”). Anyone can learn to trade successfully. But it won’t be instant and you won’t get rich quick.

How to Think About Trading Foreign Exchange

Trading foreign exchange is like trading any other security. You want to buy when it is going up and sell when it is going down. When a price is in a sideways move, you want to stay out of the market until you can detect a direction. Currencies are highly trended much of the time and if you can identify the trend, you can make a good profit.

Foreign exchange is, literally, money. You may think that means it has properties or characteristics that make trading it somehow different from trading equities or physical commodities. This is not true. Because foreign exchange is money, analysis of supply and demand is more complex and far-reaching than in cattle or wheat, but it’s still supply and demand analysis. And if you see an unlabelled chart, you can’t tell whether it’s IBM stock, soybeans or Swiss francs.

All securities trade in similar ways, since the main driver is not the nature of the securities, but the nature of the traders.

Just as in equities or other commodities, the FX market is dominated by the big players, which are banks, brokers, hedge funds, governments and tangentially-related parties who still have deep pockets like insurance companies that invest abroad. Also in FX as elsewhere, the big players sometimes use advanced and sophisticated automated trading models so that your opponent is not a human being, but rather a computer program that acts like a robot. They are even named “robots” or “bots.” To the extent that computer programs are modeled on past behavior that was generated by actual humans, it’s not clear that robots cannot be outsmarted. What we cannot do is beat them at speed. Your brain might be as fast as a program but your fingers will never be able to hit the buy and sell buttons as fast.

Two factors that do make trading foreign exchange different from trading other securities are:

government interference in the market

Intervention: Governments interfere in the foreign exchange market when they don’t like the effect that the current exchange rate will have on merchandise trade or capital flows. This occurs very rarely but it sometimes appears as a factor influencing prices. For example, when the Japanese yen becomes “too strong,” Japanese exports will fall. The Ministry of Finance orders the Bank of Japan to enter the market as a principal to sell yen in order to weaken it. To do this they buy dollars and pay for them with yen. On other occasions, the Japanese have intervened to prevent the yen from getting “too weak.” They do this by buying yen and paying for the yen with dollars.

Intervention of this sort by central banks is almost always signaled well in advance of actual market activity. In the case of the yen, the Ministry of Finance uses code words like “FX rates should follow fundamentals” and “FX rates should not be too volatile.” Although the Finance Minister seldom names a specific level, traders immediately deduce a “line in the sand” at which the Ministry will instruct the central bank to intervene, always a round number. Expectations of intervention usually have the intended effect of slowing the move to a level near the line in the sand, at least temporarily. Sometimes the line holds and sometimes it doesn’t. This is the fun part.

Conservative traders have plenty of warning that the risk of loss in a trading position is increased if they wish to trade against the expressed wishes of a country’s government. Intervention seldom occurs in other markets, although government agencies often have the same effect as outright intervention when they buy for strategic stockpiles and the like. During the Asian crisis in 1997-98, the Monetary Authority of Hong Kong intervened in the equity market as a tactic to maintain the HK dollar peg to the US dollar. (The best description of this strange event is by Paul Krugman in The Return of Depression Economics and the Crisis of 2008 (Norton, 2009).

Two-sidedness: In most securities trading, you are buying or selling the security in exchange for money. Foreign exchange is the exception. When you are buying one currency, you are selling some other currency. While this can be confusing, it also has the benefit of taking the curse off “short-selling” that is embedded in equity trading.

To avoid confusion, you need to keep your mind clear on whether you are going long (buying a currency) because you think it will go up, or shorting (selling) a currency because you think it will go down. Let’s say you like the euro because you think it will go up. If you are trading the euro/dollar pair, you are also by definition shorting the dollar. Many analysts go out of their way to find reasons to “talk trash” about the dollar because they have a preference for the euro. This is a kind of back-door way to express an opinion that we find troubling, chiefly because it results in one-sided evidence and a lack of even-handedness. In short, it’s too emotional. It’s also a form of inductive reasoning that we usually find harder to accept than deductive reasoning.

In any case, it is true that the market has for many years nursed an anti-dollar bias. Traders treat data asymmetrically. Traders shrug off bad data in the eurozone but punish the dollar with outsized downmoves on bad data. They buy euros on good data while failing to buy dollars on good US data.

This anti-dollar bias suggests that traders would have a clearer evaluation of news and data by trading cross-rates that do not involved the dollar, such as euro/yen or euro/pound. But in the Rockefeller trading reports, we trade only the major currencies against the dollar: UK pound, euro, Japanese yen, Swiss franc, Canadian dollar and Australian dollar. While we follow some of the key cross-rate pairs in the morning report, including the euro/yen, pound/yen and euro/pound, we do not trade them because keeping track of what you are doing gets overly complicated.

For example, you decide to buy the yen against the euro. It is a profitable trade and what you end up with in your account statement is (say) €100,000. Now you have to convert that €100,000 to dollars, assuming the dollar is your home currency. Okay, what’s the euro/dollar conversion rate today? If you keep it in euros, you want to be sure that the euro is not devaluing against the dollar. As you may imagine, this becomes time-consuming and potentially confusing and error-prone very fast. When your brokerage statement is denominated in five or six different currencies, you have no idea how much capital you have. (We once forgot about ¥1 million for nearly a week. It had gone in our favor but that was luck, not management.)

What you care about the most is your purchasing power in your home currency.

That is Rocky’s Rule #1: The only reason to make an investment or conduct a trade is to get a real return (after inflation, after brokerage fees and after tax) in your home currency.

Barbara Rockefeller

President + Author