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Sunday, March 12, 2017

Trading Foreign Exchange

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 FX Volatilian 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.


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