Forex is one of my personal interests and passions. Not really linked to the aviation world, but not many personal interests are usually linked to our full time jobs. Besides, being interested in something not closely related to our full time jobs can only help personal development and, in turns, it is going to help our professional development.
What are Forex Trading and the Forex Market?
The foreign exchange market (Forex, FX, or Currency Market) is a global, worldwide decentralized over-the-counter financial market for trading currencies. The foreign exchange market determines the relative values of different currencies. More information on Forex on wikipedia…
Currency trading and the access to the Forex capital markets, because of capital requirements and the technology involved, was in the past open only to hedge funds managers, large commodity trading advisors, institutional investors, and banks. In my (humble) opinion Forex markets are not random and the efficient market hypotheses and theories sustained by so many economists are flawed (Warren Buffet, regarding the Efficient Market Hypothesis, once said “I’d be a bum on the street with a tin cup if the markets were always efficient“); for this very reason it is possible to exploit the inefficiencies of the Forex capital markets and devise profitable currency trading strategies.
In recent years the development of the web has made possible for many brokerage firms to offer currency trading to small retail traders: the phenomenon has started in the mid-90s with stock market day traders and has rapidly evolved and spread to currency trading. The Forex capital markets are highly volatile: it is estimated that more than 80% of currency trading volume is speculative in nature and, as a result, the Forex market has frequent corrections, is very unpredictable but can also be very profitable.
However, for long term forecast trends in currency trading, fundamental analysis, analyzing and focusing on the economic, social and political forces that drive supply and demand, can be an invaluable instrument; indeed, the fundamental analysis focuses on (sometimes very complicated) theoretical models of currency exchange rate that are determined and based upon major economic factors and their probability to affect currency trading and the Forex capital markets. Fundamental analysis in currency trading is for this reason important and this is even truer as currencies markets, more than other markets tend to develop strong trends.
Nevertheless, most Forex traders do not trade positions over long periods, but tend to trade the Forex capital market opening and closing positions one (or more) times per day — thus leading, in some cases, to “overtrading”. This should be no surprise: currency trading and the Forex capital markets are well suited to price-based techniques, that is, technical and quantitative analysis. Technical analysis is the prediction of Forex capital market movements from the data and information obtained from the past, and it uses different types of charts.
However, an approach purely based on technical/quantitative analysis could be too restrictive and not lead to maximum profits: eventually, the most successful currency trading methods are the ones supported by both technical/quantitative and fundamental analysis. In fact, although testing and research in the Forex capital markets requires a rigorous approach, there is an element that is a little bit of art: do not believe everything you see but ask yourself why a particular system works and try to verify if the roots of it can be traced back in the behavior of the masses. The speed at which currency rates adjust to news is very high, even shorter than 15 o 30 minutes, and this is linked to the reaction (sometimes panicked and irrational) of people to particular news linked to exchange rates, or interest rates, or any other element affecting directly or indirectly the Forex marked and currency trading.
Forex capital markets, being still a relatively young and mostly underdeveloped compared to other segments of the financial markets, and given their intrinsic volatility, represents a remarkable opportunity to the educated currency trader. Elements that will help you to succeed are incessant practice, thorough knowledge of the history, science and art of currency trading, ability to deal with trade failures and the perseverance to be a Forex trader with discipline: the only people who will not win at currency trading will be the ones who quit.
An Interesting, Suggestive, and Easy-to-Explain Forex Technique: The Carry Trade
The Carry Trade is an interesting technique, certainly not available to everybody, yet when I first found about it I was fascinated by its simplicity and suggestive nature. Let us see more about it.
Forex traders have multiple – it could almost be said infinite – strategies to trade the Forex market and to take advantage of market; the carry trade is a Forex strategy that plays on the fact that different nations, being able to attract a higher flux of capital, and having different level of economical and industrial development, offer different interest rates, some higher than others. This fact, representing market inefficiency, is in turn a trading advantage that can be exploited by Forex traders.
The carry trade involve buying a currency of a Country that has a high interest rate and selling a currency of another Country that, on the other hand, has a lower interest rate. Forex traders are thus able to profit in two ways:
- Earn the difference in the spread (the difference between the two interest rates) of the two currencies, and
- Earn form capital appreciation
Usually the spread in interest rates is not very large and can be expected to be in the order of 3% to 4%; however, it should be regarded from the broader perspective of the leverage offered by Forex and by the lower risk that, at least compared to other Forex trading strategies, this system entails. In fact, when factoring in 20:1 or even higher leverage ratios (some Forex traders can trade these currency exchange rate inefficiencies with up to 200:1 leverage).
The carry trade can profit from two sources, as we saw. However, capital appreciation can work against the Forex trader; in fact, if capital depreciate, the Forex trader will be losing money on this part of the trade, and at the end of the day it is the sum of the two streams (difference in interest rate spread and capital appreciation/depreciation) that will give the verdict as to whether the overall Forex trade was successful or not.
Forex traders performing this type of strategy are obviously looking to earn both yield from the interest rates spread and the appreciation of the currency pairs: it is thus crucial to determine in which Countries (that is, which markets) carry trades will produce the higher returns with a level of risk in line with the returns expected by the currency trader.
This is indeed very difficult to answer; certainly, the Forex market is driven by fundamentals for a large extent, but it is the psychology of people and their swings in mood that most drives the Forex markets. Investing in a Country that pays high interest rates is riskier that investing in a country that pays lower interest rates because a developing country, thirsty for capitals and money will want to attract the resources it needs by encouraging investors and Forex traders with higher returns for their money.
Such a country has intrinsically a higher risk profile and ultimately it is the Forex trader that must be willing to take its chances after carefully evaluating the multiple factors coming into the picture.