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."