Ask a commodity trading advisor (CTA) what makes a good market to trade and he will tell you any market that moves, is liquid and is non-correlated with the other markets they are trading. Well the foreign exchange sector has that in spades and a few other attributes as well, which makes it the anchor for many diversified trading programs and a stand alone sector that can be traded in many different ways.
It is the most liquid sector around and trades 24 hours, so although currencies are known for producing significant long-term trends, they are also perfect for short-term day trading and even high frequency strategies (see "Opportunities in the long(term) and short(term) of it," below). The euro often is quoted in less than one pip, with size. That gives traders confidence they can execute any scalp knowing that they can get out quickly.
High degrees of leverage are offered through futures but particularly through cash forex, giving traders more bang for the buck. "Futures exchanges and OTC banks have very aggressive margin requirements," Jamie Charles, founder of Greenwave Capital Management (see Trader Profile) says. "Compare that to what it takes to trade some other type of product whether it be cash fixed income or stocks. You have to post a great deal more initial margin to be involved."
Every foreign exchange trade is a spread, buying one currency against another. It usually involves the U.S. dollar versus another currency, though cross pairs such as euro/yen and euro/pound are extremely liquid. Multiply that by all of the different currencies offered and the opportunities are nearly endless. "There are different kinds of arbitrage trades that can be done in FX that can’t be done in other places," Tom Trimmer, an equity raiser for numerous forex-based CTAs, says. "There are three-way and four-way arbitrage trades. You can arbitrage the euro to the dollar to the yen where you trade the dollar/yen pair and the euro/yen pair and the euro/dollar pair against each other."
Charles recently launched his Greenwave Dollar Short (GDS) program, which shorts the dollar against a wide range of global currencies to protect against the loss of dollar purchasing power. "The dollar is going to lose purchasing power and therefore it will be inflationary for the U.S.-based investor. I am not predicting an inflationary environment in general, but we are an importing nation and if the dollar loses purchasing power against other currencies that will be inflationary," Charles says.
He offers two versions of the GDS. One is basically a static short dollar position against 20-25 global currencies and the other actively manages each position, calibrating the dollar short exposure based on his global macro view.
In forex you are measuring the currency of one country or region (in the case of the euro) against another. Each country or region has an interest rate associated with its currency. Holding a currency that is earning a higher interest rate than the opposite side of the pair earns you the interest differential. There are systems for simply earning that carried interest. This is called a carry trade and it can be lucrative (see "What currencies pay," right). Traders holding currencies earning a positive carry have the wind at their back, though that is no guarantee the currency they are holding will appreciate against the currency that they are short. It only guarantees that absent positive or negative movement in the pair, they will earn the interest differential.
"The spread might be 6% a year and you could lose 6% in a week if the market is going in the wrong direction, but it works out generally and it works out surprisingly well over time," John R. Taylor Jr., founder of FX Concepts LLC, says.
FX Concepts manages $7.4 billion, nearly all of it in currency strategies. They utilize trending strategies, carry strategies and volatility strategies.
Sometimes the carry trade works against you if it is oversubscribed. That has happened several times in the last decade but Taylor points out another opportunity currencies offer.
"Oversubscription is a very dangerous thing. It is one of those things that goes up the escalator and down the elevator. It goes up slowly and when it breaks, it comes down in a hurry," Taylor says. "If you only are earning 4% in a year and it goes down 2% in a day, you are losing your money in a hurry so the trick is to manage those elevator drops."
Not only do individual currencies trend, but the carry element also has its own trends traders can exploit. One of Futures’ Top Traders of 2007 attributed much of his success with taking the other end of a carry trade on steroids fat with hot money. He made money on the euro/yen carry trade then shorted it as the trade became too hot.
Option writing is a popular strategy for CTAs but is usually associated with equity index traders. Taylor added option writing to his toolbox of forex strategies in 2002 and it has proven to be a positive addition. FX Concepts’ options strategies are up 15% through July and 25% over the last 12 months. Taylor says currencies offer more diversification than equity indexes in premium collection strategies. "The correlation among equity markets is so high that you can’t get what you want from them, even if you are doing individual stocks," he says.
With all the variety within the forex arena, they can find more premium value, which is not the case when you are only selling premiums in the S&P 500.
"It is greatly diversified. We do options carry where you [write] options on currencies like Brazil, Indonesia and Turkey, which have high interest rates and the options structure payoffs are very different. We deal in about 20 different currencies. We can do cross currencies between the two and we have a lot of portfolio choices," Taylor says. "Every day the model runs and tells us what to write and every day it tells us to write different things or buy different things. It changes dramatically from day to day."
While the deep liquidity of forex allows CTAs to trade numerous strategies and time frames, it also allows them to take on additional assets without altering their approach. Scalability is one of the most important attributes of forex markets for Trimmer. "It is very deep. [If] you find a program that works, you can put a lot of money behind it before it runs into capacity issues," Trimmer says.
A manager could be the best pork belly trader around but once he gets to $15 or $20 million under management, he will not be able to grow because the strategy becomes too big for the market. This is a problem for many managers trading physical commodities — sometimes an approach works on other markets and sometimes it doesn’t but by building a strategy that trades the forex markets you are usually giving yourself room to grow.
FX Concepts, for example, grew to roughly a billion under management before expanding to carry and option writing strategies.
While forex allows a manager to grow, it also offers benefits to emerging managers struggling to gain assets. The spot forex markets allow managers to purchase a specific amount of a currency so they can offer lower minimum investments because not every customer has to be allocated a currency futures contract. This can be accomplished by offering a fund, but many investors like the safety and security of managed accounts, especially when dealing with emerging managers.
"In OTC forex you can trade any amount and get it evenly distributed among all clients," Charles says. "It is an advantage whether you are a small CTA or large CTA. You can size your trades exactly to how much risk you want to take. You can’t always size your trades exactly when you are trading futures because futures have a predetermined contract size."
Valhalla Capital Group executes a high frequency trading program that trades more than 70 currency pairs. "We have all these price feeds from ECNs [electronic communications networks] aggregated into our API. It is a culmination of strategies," co-founder Charles Campbell says.
"If we are long the euro we may use the cross between two other pairs to exit that trade. We would use the euro/pound and pound/dollar," Campbell says. "It is a little bit different than a traditional technical model. Very short term, most of the trades span a couple of minutes so there is minimal exposure."
Forex trading platforms send them their order flow and they work as quasi market makers though they have no obligation. "I can see the banks pricing and route my orders directly to the banks. If I can see through Currenex that JP Morgan is quoting me this price and I like it, I can route that order directly to JP Morgan," Campbell says.
Their models are based on price action. "We look at historical patterns on a very short-term basis. We are able to predict in the next couple of minutes where the markets are going to go and at that point it is about getting good entries and good executions on the exits," Campbell says.
It is complex and it all happens within milliseconds. Valhalla’s strategy is more akin to the type of trading occurring on proprietary trading desks of banks, but because they are operating as a CTA, the strategy is not as scalable. "If you are on a bank desk it is a different ball game. You have access to so much more liquidity than a CTA is going to have access to," Campbell says.
While most currency-based CTAs trade on technicals as opposed to fundamentals (see "The best sector," below) the universe of fundamental factors in currency markets is larger than most sectors. Interest rates are perhaps the most obvious fundamental but all economic factors that impact a country need to be watched. There is money supply, interest rates, purchasing power parity and politics. Central banks often are a large player in a nation’s currency. They, of course, are not attempting to make a profitable trade but affect the value of the currency for other purposes such as protecting their manufacturing sector against rising currency value that makes their products less competitive in the world.
Forex expert Osman Ghandour, who managed forex for sovereign governments and operated his own CTA, noted that this creates inefficient liquidity that can be exploited. Others acknowledge the effect of central banks on forex trading but believe it makes their lives more difficult.
"There is an inordinate amount of government intervention in the markets and that has made markets far more random because governments do not have a profit or loss incentive," Charles says. "We don’t know what their true incentives are and they create dislocations. Now maybe those dislocations create an exploitable opportunity." However, Charles thinks those interventions hurt more than help. "The participation of central banks in markets to the extent that they are today dulls the exploitable edges of traders on a regular basis."
Taylor agrees, noting their fundamental overlays underperform their mainly technical approach due to the vast array of fundamental inputs. "We happen to think it is too confusing. There are so many things that countries do to screw them around."
Forex markets have long been a benchmark for diversified trend following programs but the unique attributes of forex and its relationship to interest rates, along with its 24-hour liquidity, make it an ideal sector for stand alone programs. It is unlikely technical systems will pile up in the same location given the different ways to trade it and its fundamentals are dynamic, providing both challenges and opportunities for those trading it from that perspective.