With most assets (the notable exception being commodities), there are two sources of profit: rents (in economics terminology) and appreciation. In the case of equities, that refers to a rise in the stock price and the receipt of periodic dividend payments. With bonds, it’s rising bond prices (also known as falling interest rates) and the receipt of interest. With real estate, it’s home price appreciation and rental income. With currencies, it’s appreciation and interest income. Simply, forex traders generate profit by selling a currency for a more favorable exchange rate than they paid to buy it, and by capturing interest in the interim. Exchange rates are quoted to at least four decimal places, and the smallest unit—equivalent to 1/10000th of one unit of currency—is referred to as a PIP, which is short for percentage in point. Forex traders will typically brag about how many PIPs they cleared on a trade, which is just another way of accounting for how much profit they earned.
Currency traders also earn interest on their open positions. For example, if the interest rate associated with one currency (i.e., the approximate rate paid on a savings account in the country where that currency is used) is higher than the corresponding rate for a second currency, a trader can earn interest on the difference by selling the second against the first. To make this example more concrete, let’s imagine that the current Eurozone interest rate is 5% while the corresponding US interest rate is only 1%. By buying the euro against the US dollar, you can effectively earn interest at an annualized rate of 4% (the difference between the two rates). Of course, the reverse is also true, as you would be charged interest on a long position in the dollar, against the euro. Ultimately, any positive interest income will either supplement or offset any gains or losses, respectively, from exchange rate fluctuations.
Well I am about the say something very important One of the peculiar features of forex is that there is never a bear market. That’s not to say that currencies can’t decline dramatically over a prolonged period of time. Rather, it means that when one currency is falling, another one is necessarily rising. When stocks are stagnating—as they have for most of the last decade—there is very little that long-term investors can do. Some intrepid traders will turn to shorting, but this is risky and complicated. In contrast, a forex bear market in one currency will create opportunities in another. Those that believe that the US dollar is due to depreciate, for example, need not sit around and twiddle their thumbs. They can turn to the euro or Japanese yen or an emerging currency, such as the Chinese yuan or Brazilian real. Currencies also compare favorably to equities in terms of simplicity. There are tens of thousands of equities. To be thoroughly fluent in a single equity requires complete dedication and constant vigilance.
Finally, there is the fact that forex trading is basically commission-free. Generally speaking, there are no transaction fees associated with exchanging currencies. Instead of earning money from trading commissions, brokers profit from the spread—the gap between the rate at which a currency can be bought and then later sold. (Brokers for other securities always charge a commission, on top of the spread that is earned by the market-maker, whose job it is to match up buyers and sellers.) Those of you who have exchanged currency at the airport have probably taken note of the exorbitant spreads of 5%–10% that are charged by foreign exchange dealers there.
Complex
While I hope you will excuse me for dwelling on the benefits of trading forex, I don’t want to ignore the drawbacks. First of all, competition in forex is fierce. The fact that retail penetration is so slight means that professional traders and financial institutions dominate trading. They are well-capitalized, have access to sophisticated research and rich data streams, and often have developed complex algorithmic trading systems that can make split-second decisions designed to outsmart other traders. To avoid becoming a victim in forex, then, you must practice the same dedication and vigilance that only a second ago I told you applied principally to equities. In order to profit consistently, you will also need to develop meaningful strategies based on a solid understanding of the markets. Moreover, forex is a zero-sum game. One could plausibly make the case that in a bull market, all equity investors will profit across-the-board. Credit market investors that hold their bonds to maturity similarly all end up with more money than they started with, thanks to interest payments. The same cannot be said for forex. An increase in one currency must be offset by a decline in another currency. If you make money on your EUR/USD bet, it means that someone else necessarily lost money on his USD/EUR position. Without accounting for transaction costs (i.e., spreads), only half of all forex trades will lead to a gain. Any profits are earned at the expense of another trader’s losses. As a result, only about 30% of retail forex trading accounts are profitable. In addition, the forex markets can be just as volatile as mainstream financial markets. With the inception of the global financial crisis, for example, market gyrations caused some currencies to lose a significant portion of their value in only a few months.
Investing Versus Trading
For those with some previous exposure to forex, you may be under the impression that forex investing is an oxymoron. And with advertisements promoting 50:1 leverage, profits measured in cents, and so-called commission-free trading, you can certainly be forgiven for holding that belief. Anecdotally, it does indeed seem that the majority of those active in the forex market fall into the category of trader. What do I mean by this? In a nutshell, forex traders have very short time horizons and aim to generate only a modicum of profit per trade. The goal is to magnify gains through the use of leverage and/or dozens (or even hundreds) of trades per day. Traders pay very little attention to the news (and even then, only for the purpose of planning coffee breaks) and focus instead on market psychology—on the ebbs and flows in market sentiment that drives second-to-second and minute-to-minute fluctuations. Instead of trafficking terms like gross domestic product (GDP) and inflation, traders ply their trade with charts. Instead of models that are based on economic variables, they rely on technical analysis to discern barely perceptible patterns in exchange rates, with the intention of profiting from them before the majority of other traders discover them. I don’t have to tell you that forex trading is more difficult and more stressful than forex investing. With such short time horizons, there is intense pressure to time trades perfectly. In addition, the algorithms used by financial institutions are becoming increasingly adept at performing this same kind of analysis, and high-frequency trading is rapidly colonizing the forex markets in the same way that it came to dominate the other financial markets. It should come as no surprise then that a recent study by the Federal Reserve Bank concluded that the profitability of forex trading (as distinct from forex investing) is to decline,
It’s fair to say that my personal approach leans toward investing. That means that I have a longer time horizon and that I prefer fundamental economic and financial analysis to the technical analysis that is based solely on charts and price patterns. The time horizon for investors is necessarily longer than it is for traders, and is typically measured in weeks, months, or years. While exchange rates should revert to the mean over the long-term, multiyear rallies are not uncommon. There are certain strategies that will theoretically allow you to check your forex portfolio only once a week, as you would with a portfolio of stocks and bonds. The downside to this approach is that overall profit tends to be smaller, and it’s more suitable for padding your retirement account than as a means of generating substantial income. In addition, since currencies don’t directly pay dividends, a buy-and-hold strategy probably won’t generate the same returns as a similarly value-oriented approach to equities investing. Thus, the approach to the forex market that I have come to espouse is swing trading, or trend trading. This approach aims to blend the best aspects of technical and fundamental analysis, and of trading and investing. The time horizon is three to six weeks, and a small amount of leverage can be applied. The goal is to spot severe fundamental mis-valuations, and to profit from them with the aid of technical analysis.
The referred article/paper
Christopher J. Neely and Paul A. Weller, “Technical Analysis in the Foreign Exchange Market” (Working Paper 2011-001B, Federal Reserve Bank of St. Louis, January 2011), http://research.stlouisfed.org/wp/2011/2011-001.pdf.
Some inflation-prone emerging economies, such as Ecuador, have adopted the dollar as their official currency. Others, such as Jordan, peg their exchange rate to it. These official policies are one measure of the dollar’s international role. Messrs Subramanian and Kessler use a different measure, based on the way exchange rates behave in the market. They identify currencies that tend to move in sympathy with the dollar in its daily fluctuations against a third currency, such as the Swiss franc. This “co-movement” could reflect market forces, not official policies. It need not be a perfect correlation. It need only be close enough to rule out coincidence.Based on this measure, the dollar still exerts a significant pull over 31 of the 52 emerging-market currencies in their study. But a number of countries, including India, Malaysia, the Philippines and Russia, appear to have slipped anchor since the financial crisis. Comparing the past two years with the pre-crisis years (from July 2005 to July 2008), they show that the dollar’s influence has declined in 38 cases. Though 38 cases are too many for my belief but thier study could have the basis to say it.The greenback has in the past played a dominant role in East Asia. But if anything, the region is now on a yuan standard. Seven currencies in the region now follow the yuan, or redback, more closely than the green. When the dollar moves by 1%, East Asia’s currencies move in the same direction by 0.38% on average. When the yuan moves, they shift by 0.53%. Of course, the yuan does not yet float freely itself. Since June 2010 it has climbed by about 9% against the dollar, fluctuating within narrow daily bands. Its close relationship with the greenback poses a statistical conundrum for Messrs Subramanian and Kessler. How can they tell if a currency is following in the dollar’s footsteps or the yuan’s, if those two currencies are moving in close step with each other? In previous studies, wherever this ambiguity arose, currencies were assumed to be following the dollar. The authors relax this assumption, arguing that the yuan now moves independently enough to allow them to distinguish its influence. But some of the yuan’s apparent prominence may still be the dollar’s reflected glory. Outside East Asia, the redback’s influence is still limited. When the dollar moves by 1%, emerging-market currencies move by 0.45% on average. In response to the yuan, they move by only 0.19%. But China’s currency will continue to grow in stature as its economy and trading activity grow in size. Based on these two forces alone, China’s currency should surpass the dollar as a key currency some time around 2035, Mr Subramanian guesses.
Currency traders also earn interest on their open positions. For example, if the interest rate associated with one currency (i.e., the approximate rate paid on a savings account in the country where that currency is used) is higher than the corresponding rate for a second currency, a trader can earn interest on the difference by selling the second against the first. To make this example more concrete, let’s imagine that the current Eurozone interest rate is 5% while the corresponding US interest rate is only 1%. By buying the euro against the US dollar, you can effectively earn interest at an annualized rate of 4% (the difference between the two rates). Of course, the reverse is also true, as you would be charged interest on a long position in the dollar, against the euro. Ultimately, any positive interest income will either supplement or offset any gains or losses, respectively, from exchange rate fluctuations.
Well I am about the say something very important One of the peculiar features of forex is that there is never a bear market. That’s not to say that currencies can’t decline dramatically over a prolonged period of time. Rather, it means that when one currency is falling, another one is necessarily rising. When stocks are stagnating—as they have for most of the last decade—there is very little that long-term investors can do. Some intrepid traders will turn to shorting, but this is risky and complicated. In contrast, a forex bear market in one currency will create opportunities in another. Those that believe that the US dollar is due to depreciate, for example, need not sit around and twiddle their thumbs. They can turn to the euro or Japanese yen or an emerging currency, such as the Chinese yuan or Brazilian real. Currencies also compare favorably to equities in terms of simplicity. There are tens of thousands of equities. To be thoroughly fluent in a single equity requires complete dedication and constant vigilance.
Finally, there is the fact that forex trading is basically commission-free. Generally speaking, there are no transaction fees associated with exchanging currencies. Instead of earning money from trading commissions, brokers profit from the spread—the gap between the rate at which a currency can be bought and then later sold. (Brokers for other securities always charge a commission, on top of the spread that is earned by the market-maker, whose job it is to match up buyers and sellers.) Those of you who have exchanged currency at the airport have probably taken note of the exorbitant spreads of 5%–10% that are charged by foreign exchange dealers there.
Complex
While I hope you will excuse me for dwelling on the benefits of trading forex, I don’t want to ignore the drawbacks. First of all, competition in forex is fierce. The fact that retail penetration is so slight means that professional traders and financial institutions dominate trading. They are well-capitalized, have access to sophisticated research and rich data streams, and often have developed complex algorithmic trading systems that can make split-second decisions designed to outsmart other traders. To avoid becoming a victim in forex, then, you must practice the same dedication and vigilance that only a second ago I told you applied principally to equities. In order to profit consistently, you will also need to develop meaningful strategies based on a solid understanding of the markets. Moreover, forex is a zero-sum game. One could plausibly make the case that in a bull market, all equity investors will profit across-the-board. Credit market investors that hold their bonds to maturity similarly all end up with more money than they started with, thanks to interest payments. The same cannot be said for forex. An increase in one currency must be offset by a decline in another currency. If you make money on your EUR/USD bet, it means that someone else necessarily lost money on his USD/EUR position. Without accounting for transaction costs (i.e., spreads), only half of all forex trades will lead to a gain. Any profits are earned at the expense of another trader’s losses. As a result, only about 30% of retail forex trading accounts are profitable. In addition, the forex markets can be just as volatile as mainstream financial markets. With the inception of the global financial crisis, for example, market gyrations caused some currencies to lose a significant portion of their value in only a few months.
Investing Versus Trading
For those with some previous exposure to forex, you may be under the impression that forex investing is an oxymoron. And with advertisements promoting 50:1 leverage, profits measured in cents, and so-called commission-free trading, you can certainly be forgiven for holding that belief. Anecdotally, it does indeed seem that the majority of those active in the forex market fall into the category of trader. What do I mean by this? In a nutshell, forex traders have very short time horizons and aim to generate only a modicum of profit per trade. The goal is to magnify gains through the use of leverage and/or dozens (or even hundreds) of trades per day. Traders pay very little attention to the news (and even then, only for the purpose of planning coffee breaks) and focus instead on market psychology—on the ebbs and flows in market sentiment that drives second-to-second and minute-to-minute fluctuations. Instead of trafficking terms like gross domestic product (GDP) and inflation, traders ply their trade with charts. Instead of models that are based on economic variables, they rely on technical analysis to discern barely perceptible patterns in exchange rates, with the intention of profiting from them before the majority of other traders discover them. I don’t have to tell you that forex trading is more difficult and more stressful than forex investing. With such short time horizons, there is intense pressure to time trades perfectly. In addition, the algorithms used by financial institutions are becoming increasingly adept at performing this same kind of analysis, and high-frequency trading is rapidly colonizing the forex markets in the same way that it came to dominate the other financial markets. It should come as no surprise then that a recent study by the Federal Reserve Bank concluded that the profitability of forex trading (as distinct from forex investing) is to decline,
It’s fair to say that my personal approach leans toward investing. That means that I have a longer time horizon and that I prefer fundamental economic and financial analysis to the technical analysis that is based solely on charts and price patterns. The time horizon for investors is necessarily longer than it is for traders, and is typically measured in weeks, months, or years. While exchange rates should revert to the mean over the long-term, multiyear rallies are not uncommon. There are certain strategies that will theoretically allow you to check your forex portfolio only once a week, as you would with a portfolio of stocks and bonds. The downside to this approach is that overall profit tends to be smaller, and it’s more suitable for padding your retirement account than as a means of generating substantial income. In addition, since currencies don’t directly pay dividends, a buy-and-hold strategy probably won’t generate the same returns as a similarly value-oriented approach to equities investing. Thus, the approach to the forex market that I have come to espouse is swing trading, or trend trading. This approach aims to blend the best aspects of technical and fundamental analysis, and of trading and investing. The time horizon is three to six weeks, and a small amount of leverage can be applied. The goal is to spot severe fundamental mis-valuations, and to profit from them with the aid of technical analysis.
The referred article/paper
Christopher J. Neely and Paul A. Weller, “Technical Analysis in the Foreign Exchange Market” (Working Paper 2011-001B, Federal Reserve Bank of St. Louis, January 2011), http://research.stlouisfed.org/wp/2011/2011-001.pdf.
Some inflation-prone emerging economies, such as Ecuador, have adopted the dollar as their official currency. Others, such as Jordan, peg their exchange rate to it. These official policies are one measure of the dollar’s international role. Messrs Subramanian and Kessler use a different measure, based on the way exchange rates behave in the market. They identify currencies that tend to move in sympathy with the dollar in its daily fluctuations against a third currency, such as the Swiss franc. This “co-movement” could reflect market forces, not official policies. It need not be a perfect correlation. It need only be close enough to rule out coincidence.Based on this measure, the dollar still exerts a significant pull over 31 of the 52 emerging-market currencies in their study. But a number of countries, including India, Malaysia, the Philippines and Russia, appear to have slipped anchor since the financial crisis. Comparing the past two years with the pre-crisis years (from July 2005 to July 2008), they show that the dollar’s influence has declined in 38 cases. Though 38 cases are too many for my belief but thier study could have the basis to say it.The greenback has in the past played a dominant role in East Asia. But if anything, the region is now on a yuan standard. Seven currencies in the region now follow the yuan, or redback, more closely than the green. When the dollar moves by 1%, East Asia’s currencies move in the same direction by 0.38% on average. When the yuan moves, they shift by 0.53%. Of course, the yuan does not yet float freely itself. Since June 2010 it has climbed by about 9% against the dollar, fluctuating within narrow daily bands. Its close relationship with the greenback poses a statistical conundrum for Messrs Subramanian and Kessler. How can they tell if a currency is following in the dollar’s footsteps or the yuan’s, if those two currencies are moving in close step with each other? In previous studies, wherever this ambiguity arose, currencies were assumed to be following the dollar. The authors relax this assumption, arguing that the yuan now moves independently enough to allow them to distinguish its influence. But some of the yuan’s apparent prominence may still be the dollar’s reflected glory. Outside East Asia, the redback’s influence is still limited. When the dollar moves by 1%, emerging-market currencies move by 0.45% on average. In response to the yuan, they move by only 0.19%. But China’s currency will continue to grow in stature as its economy and trading activity grow in size. Based on these two forces alone, China’s currency should surpass the dollar as a key currency some time around 2035, Mr Subramanian guesses.
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