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Day Trading the Currency Market

John Wiley & Sons

Chapter One

The foreign exchange market is the generic term for the worldwide institutions that exist to exchange or trade currencies. Foreign exchange is often referred to as "forex" or "FX." The foreign exchange market is an over-the-counter (OTC) market, which means that there is no central exchange and clearinghouse where orders are matched. FX dealers and market makers around the world are linked to each other around the clock via telephone, computer, and fax, creating one cohesive market.

Over the past few years, currencies have become one of the most popular products to trade. No other market can claim a 57 percent surge in volume over a three-year time frame. According to the Triennial Central Bank Survey of the foreign exchange market conducted by the Bank for International Settlements and published in September 2004, daily trading volume hit a record of $1.9 trillion, up from $1.2 trillion (or $1.4 trillion at constant exchange rates) in 2001. This is estimated to be approximately 20 times larger than the daily trading volume of the New York Stock Exchange and the Nasdaq combined. Although there are many reasons that can be used to explain this surge in activity, one of the most interesting is that the timing of the surge in volume coincides fairly well with the emergence of online currency trading for the individual investor.

EFFECTS OF CURRENCIES ON STOCKS AND BONDS

It is not the advent of online currency trading alone that has helped to increase the overall market's volume. With the volatility in the currency aware of the fact that currency movements also impact the stock and bond markets. Therefore, if stocks, bonds, and commodities traders want to make more educated trading decisions, it is important for them to follow the currency markets as well. The following are some of the examples of how currency movements impacted stock and bond market movements in the past.

EUR/USD and Corporate Profitability

For stock market traders, particularly those who invest in European corporations that export a tremendous amount of goods to the United States, monitoring exchange rates are essential to predicting earnings and corporate profitability. Throughout 2003 and 2004, European manufacturers complained extensively about the rapid rise in the euro and the weakness in the U.S. dollar. The main culprit for the dollar's sell-off at the time was the country's rapidly growing trade and budget deficits. This caused the EUR/USD (euro-to-dollar) exchange rate to surge, which took a significant toll on the profitability of European corporations because a higher exchange rate makes the goods of European exporters more expensive to U.S. consumers. In 2003, inadequate hedging shaved approximately 1 billion euros from Volkswagen's profits, while Dutch State Mines (DSM), a chemicals group, warned that a 1 percent move in the EUR/USD rate would reduce profits by between 7 million and 11 million euros. Unfortunately, inadequate hedging is still a reality in Europe, which makes monitoring the EUR/USD exchange rate even more important in forecasting the earnings and profitability of European exporters.

Nikkei and U.S. Dollar

Traders exposed to Japanese equities also need to be aware of the developments that are occurring in the U.S. dollar and how they affect the Nikkei rally. Japan has recently come out of 10 years of stagnation. During this time, U.S. mutual funds and hedge funds were grossly underweight Japanese equities. When the economy began to rebound, these funds rushed in to make changes to their portfolios for fear of missing a great opportunity to take advantage of Japan's recovery. Hedge funds borrowed a lot of dollars in order to pay for increased exposure, but the problem was that their borrowings are very sensitive to U.S. interest rates and the Federal Reserve's monetary policy tightening cycle. Increased borrowing costs for the dollar could derail the Nikkei's rally because higher rates will raise the dollar's financing costs. Yet with the huge current account deficit, the Fed might need to continue raising rates to increase the attractiveness of dollar-denominated assets. Therefore, continual rate hikes coupled with slowing growth in Japan may make it less profitable for funds to be over-leveraged and overly exposed to Japanese stocks. As a result, how the U.S. dollar moves also plays a role in the future direction of the Nikkei.

George Soros

In terms of bonds, one of the most talked-about men in the history of the FX markets is George Soros. He is notorious for being "the man who broke the Bank of England." This is covered in more detail in our history section (Chapter 2), but in a nutshell, in 1990 the U.K. decided to join the Exchange Rate Mechanism (ERM) of the European Monetary System in order to take part in the low-inflationary yet stable economy generated by the Germany's central bank, which is also known as the Bundesbank. This alliance tied the pound to the deutsche mark, which meant that the U.K. was subject to the monetary policies enforced by the Bundesbank. In the early 1990s, Germany aggressively increased interest rates to avoid the inflationary effects related to German reunification. However, national pride and the commitment of fixing exchange rates within the ERM prevented the U.K. from devaluing the pound. On Wednesday, September 16, 1992, also known as Black Wednesday, George Soros leveraged the entire value of his fund ($1 billion) and sold $10 billion worth of pounds to bet against the Exchange Rate Mechanism. This essentially "broke" the Bank of England and forced the devaluation of its currency. In a matter of 24 hours, the British pound fell approximately 5 percent or 5,000 pips. The Bank of England promised to raise rates in order to tempt speculators to buy pounds. As a result, the bond markets also experienced tremendous volatility, with the one-month U.K. London Interbank Offered Rate (LIBOR) increasing 1 percent and then retracing the gain over the next 24 hours. If bond traders were completely oblivious to what was going on in the currency markets, they probably would have found themselves dumbstruck in the face of such a rapid gyration in yields.

Chinese Yuan Revaluation and Bonds

For U.S. government bond traders, there has also been a brewing issue that has made it imperative to learn to monitor the developments in the currency markets. Over the past few years, there has been a lot of speculation about the possible revaluation of the Chinese yuan. Despite strong economic growth and a trade surplus with many countries, China has artificially maintained its currency within a tight trading band in order to ensure the continuation of rapid growth and modernization. This has caused extreme opposition from manufacturers and government officials from countries around the world, including the United States and Japan. It is estimated that China's fixed exchange rate regime has artificially kept the yuan 15 percent to 40 percent below its true value. In order to maintain a weak currency and keep the exchange rate within a tight band, the Chinese government has to sell the yuan and buy U.S. dollars each time its currency appreciates above the band's upper limit. China then uses these dollars to purchase U.S. Treasuries. This practice has earned China the status of being the world's second largest holder of U.S. Treasuries. Its demand has kept U.S. interest rates at historical lows. Even though China has made some changes to their currency regime, since then, the overall revaluation was modest, which means more is set to come. More revaluation spells trouble for the U.S. bond market, since it means that a big buyer may be pulling away. An announcement of this sort could send yields soaring and prices tumbling. Therefore, in order for bond traders to effectively manage risk, it is also important for them to follow the developments in the currency markets so that a shock of this type does not catch them by surprise.

COMPARING THE FX MARKET WITH FUTURES AND EQUITIES

Traditionally FX has not been the most popular market to trade because access to the foreign exchange market was primarily restricted to hedge funds, Commodity Trading Advisors who manage large amounts of capital, major corporations, and institutional investors due to regulation, capital requirements, and technology. One of the primary reasons why the foreign exchange market has traditionally been the market of choice for these large players is because the risk that a trader takes is fully customizable. That is, one trader could use a hundred times leverage while another may choose to not be leveraged at all. However, in recent years many firms have opened up the foreign exchange market to retail traders, providing leveraged trading as well as free instantaneous execution platforms, charts, and real-time news. As a result, foreign exchange trading has surged in popularity, increasing its attractiveness as an alternative asset class to trade.

Many equity and futures traders have begun to add currencies into the mix of products that they trade or have even switched to trading currencies exclusively. The reason why this trend is emerging is because these traders are beginning to realize that there are many attractive attributes to trading FX over equities or futures.

FX versus Equities

Here are some of the key attributes of trading spot foreign exchange compared to the equities market.

FX Market Key Attributes

Foreign exchange is the largest market in the world and has growing liquidity.

There is 24-hour around-the-clock trading.

Traders can profit in both bull and bear markets.

Short selling is permitted without an uptick, and there are no trading curbs.

Instant executable trading platform minimizes slippage and errors.

Even though higher leverage increases risk, many traders see trading the FX market as getting more bang for the buck.

Equities Market Attributes

There is decent market liquidity, but it depends mainly on the stock's daily volume.

The market is available for trading only from 9:30 a.m. to 4:00 p.m. New York time with limited after-hours trading.

The existence of exchange fees results in higher costs and commissions.

There is an uptick rule to short stocks, which many day traders find frustrating.

The number of steps involved in completing a trade increases slippage and error.

The volume and liquidity present in the FX market, one of the most liquid markets in the world, have allowed traders to access a 24-hour market with low transaction costs, high leverage, the ability to profit in both bull and bear markets, minimized error rates, limited slippage, and no trading curbs or uptick rules. Traders can implement in the FX market the same strategies that they use in analyzing the equity markets. For fundamental traders, countries can be analyzed like stocks. For technical traders, the FX market is perfect for technical analysis, since it is already the most commonly used analysis tool by professional traders. It is therefore important to take a closer look at the individual attributes of the FX market to really understand why this is such an attractive market to trade.

Around-the-Clock 24-Hour Market One of the primary reasons why the FX market is popular is because for active traders it is the ideal market to trade. Its 24-hour nature offers traders instant access to the markets at all hours of the day for immediate response to global developments. This characteristic also gives traders the added flexibility of determining their trading day. Active day traders no longer have to wait for the equities market to open at 9:30 a.m. New York time to begin trading. If there is a significant announcement or development either domestically or overseas between 4:00 p.m. New York time and 9:30 a.m. New York time, most day traders will have to wait for the exchanges to open at 9:30 a.m. to place trades. By that time, in all likelihood, unless you have access to electronic communication networks (ECNs) such as Instinet for premarket trading, the market would have gapped up or gapped down against you. All of the professionals would have already priced in the event before the average trader can even access the market.

In addition, most people who want to trade also have a full-time job during the day. The ability to trade after hours makes the FX market a much more convenient market for all traders. Different times of the day will offer different trading opportunities as the global financial centers around the world are all actively involved in foreign exchange. With the FX market, trading after hours with a large online FX broker provides the same liquidity and spread as at any other time of day.

As a guideline, at 5:00 p.m. Sunday, New York time, trading begins as the markets open in Sydney, Australia. Then the Tokyo markets open at 7:00 p.m. New York time. Next, Singapore and Hong Kong open at 9:00 p.m. EST, followed by the European markets in Frankfurt (2:00 a.m.) and then London (3:00 a.m.). By 4:00 a.m. the European markets are in full swing, and Asia has concluded its trading day. The U.S. markets open first in New York around 8:00 a.m. Monday as Europe winds down. By 5:00 p.m., Sydney is set to reopen once again.

The most active trading hours are when the markets overlap; for example, Asia and Europe trading overlaps between 2:00 a.m. and approximately 4:00 a.m., Europe and the United States overlap between 8:00 a.m. and approximately 11:00 a.m., while the United States and Asia overlap between 5:00 p.m. and 9:00 p.m.. During New York and London hours all of the currency pairs trade actively, whereas during the Asian hours the trading activity for pairs such as the GBP/JPY and AUD/JPY tend to peak.

Lower Transaction Costs The existence of much lower transaction costs also makes the FX market particularly attractive. In the equities market, traders must pay a spread (i.e., the difference between the buy and sell price) and/or a commission. With online equity brokers, commissions can run upwards of $20 per trade. With positions of $100,000, average round-trip commissions could be as high as $120. The over-the-counter structure of the FX market eliminates exchange and clearing fees, which in turn lowers transaction costs. Costs are further reduced by the efficiencies created by a purely electronic marketplace that allows clients to deal directly with the market maker, eliminating both ticket costs and middlemen. Because the currency market offers around-the-clock liquidity, traders receive tight competitive spreads both intraday and at night. Equities traders are more vulnerable to liquidity risk and typically receive wider dealing spreads, especially during after-hours trading.

Low transaction costs make online FX trading the best market to trade for short-term traders. For an active equity trader who typically places 30 trades a day, at a $20 commission per trade you would have to pay up to $600 in daily transaction costs. This is a significant amount of money that would definitely take a large cut out of profits or deepen losses. The reason why costs are so high is because there are several people involved in an equity transaction. More specifically, for each trade there is a broker, the exchange, and the specialist. All of these parties need to be paid, and their payment comes in the form of commission and clearing fees. In the FX market, because it is decentralized with no exchange or clearinghouse (everything is taken care of by the market maker), these fees are not applicable.

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Excerpted from Day Trading the Currency Market by Kathy Lien Excerpted by permission.
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