Strategies for Currency Investors

This is the best of times for investors who trade in foreign currencies.  The online trading platforms are refined and powerful, and competition has driven the price of buying and selling currency pairs down to a few pips.  Add to this the advent of ETF and ETN currency funds,  and we find ourselves with more trading options than we ever had in the past.  So, what strategy should be used to take advantage of this new freedom?  That is the question this note addresses.

For years trading in foreign currencies was the special province of professional traders.  The large, international banks and other financial institutions that supported  international trade were the ones who participated in the market.  The on-line trading platforms were mostly for this type of investor--those whose entire professional life was engaged in foreign currency trading.  They did large volumes of trades, often highly leveraged.  Ordinary investors are not suited for this environment, and it was not until exchange traded products became available that trading in single currencies was practical for them.  Prior to ETFs and ETNs, the non-professionals had to use more indirect ways of investing in foreign monies.

Now, however, things are different.  You can buy a relatively few dollars of unleveraged foreign currencies and then sit back and watch them along with the rest of your portfolio. 

How do these trading abilities fit in with overall trading strategies?  There are four primary strategies used by investors to make money in currency markets:

1.  The carry trade, which involves borrowing in low-interest rate countries and buying currencies in high-interest rate countries. This is an ancient strategy--there are references in Roman times of using this method.
2. Momentum trading, which attempts to read the immediate direction of currency markets and buy or sell short those currencies that are strongest in either direction.  A technical method, it is also touted by technical analysts in stock and bond trading.
3. Valuation trading, which attempts to find currencies that are trading above or below the trader’s perception of the underlying value of the currency.
4. Arbitrage is also an ancient strategy.  When currency pairs trade in different markets, it is always possible for there to be price discrepancies between various pairs.  An astute and close observer of these events can spot an opening, and jump in to profit from it.  For example, an arbitrageur could buy pound sterling on the Paris market and sell in London at a better pound/franc price.  Computer modeling used by the major trading banks, however, have made this strategy their sole province—I’m not sure individual investors can still take advantage of arbitrage opportunities like they could in past decades.

Professional currency traders use on-line trading platforms to execute the particular strategies they choose to follow.  An American could take money out of a U.S. money market account and invest these monies in, for example, Australian dollars.  This is a classic carry trade transaction, since the interest earned in an American money market account is far below that earned in Australia for Aussie dollars. The on-line trading platforms pay holders of foreign currency a “roll” for each overnight period the currency is held.  The roll is keyed to the interest rate prevailing in the country of the foreign currency.  Today, for example, if you bought Australian dollars with U.S. dollars, you could expect a daily roll that should total about 6%-7% annualized.

The carry trade is easy to translate into ETF or ETN buying.  Use your U.S. money market account balances to buy an Australian dollar ETF (FXA), hold it for a month, and you will earn about the same interest rate a roll would provide.  This is as straightforward a comparison as you will find between on-line trading platforms and exchange traded products.  The major difference, of course, is that with the on-line trading platform, you can use leverage to enhance earnings or exacerbate losses.  While technically by using options you can do about the same thing with exchange traded products, though not as easily and not as inexpensively. And, with an ETF you must hold the investment until the x-date for the dividend.  With the on-line platforms, roll is earned daily.

Momentum trading is done with greatest ease with the on-line trading platform.  You are getting quotes to the fourth or fifth decimal place in close to real time, so you can easily track momentum with their built in graphics capabilities.  While this strategy could conceivable be used with an exchange traded product, transactions costs could easily be higher, and ETNs and ETFs don’t give you the execution speeds and currency pairs to match the on-line platforms.

Valuation strategies are easily executed with either platform, but the number of currency pairs available for trading in exchange traded products are relative few.  Plus, all currency pairs available in American markets for exchange traded products are denominated in U.S. dollars.  With the on-line platforms, you can trade Australian dollars/Chinese Yuan pairs as easily as dollar denominated currencies.

Exchange traded instruments have recently added another dimension to currency trading that was not available from the on-line trading platforms in the past: packages of managed (strategy) currency accounts.  Already, both PowerShares (DBV) and Barclays (ICI) offer a carry-trade strategy account with the U.S. dollar vs. the Group of 10 currencies.  They borrow in low interest rate countries and buy currencies in the high-interest rate environments.   What is unique is that the package is offered to individual investors without having to risk large sums in the process.  If you can buy a single share in a strategy ETN, you can be a player.

The problem, in my view, with these managed accounts is that they are constrained by an index rule for what to borrow and what to buy.  They are programmed to bring all G10 currencies into play, so they must make a buy or borrow decision on each currency.  Oddly enough, if you look at the current composition of each of these products, you will find a divergence in what to buy and what to borrow.  For example, ICI (using a Morgan Stanley Index) is buying Yen!  With interest rates in Japan near the zero mark, the classic play would be to borrow there and buy elsewhere.  I can’t figure how their trading algorithm works.  DBV (using the Deutsche Bank Index) is borrowing Yen.

Both the PowerShares and Barclays shares are down for the year.  The culprit is, as you might have guessed, the recovery (such as it is) of the U.S. dollar.  When the dollar is in free fall against all major currencies, as it has been for almost a decade, anyone can make money betting against it.  But when the pendulum swings, all the geniuses lose their bearings until things settle out. 

The only other exchange traded product that offers something vaguely akin to a strategy fund are the double-down and double-up products offering highly leveraged bets against the Euro or dollar, etc.  Van Eck offers two now (URR) and (DRR) which  double up or double down (short) on the Euro.  I can’t call this approach a strategy; it is more simply a raw bet.  Perhaps a better description would be to borrow the Japanese word we know as kamikaze.  For an investor who doesn’t spend all his or her time in the foreign exchange market to place such a super-powered bet is nothing more than hoping a divine wind will blow your shares in the right direction. 

The newest wrinkle I have found in the strategy-type investing is from Forex Capital Markets, FCXM, a relatively new forex trading firm that opened in 1999.  They offer traditional on-line trading accounts, highly leveraged with a number of trading pairs. But, they have now introduced four strategy accounts that allow an inexperienced investor to jump into the rarified air of currency speculation without having to make the specific buy and sell decisions.  They let the pros call the shots.  There are two basic strategies: a short-term program and a long-term one, but each strategy is also offered in a leveraged and unleveraged version.  Here are the four strategies: 

• Short-Term-Opportunity Aggressive Program (No leverage) (Last 12 months [May 2007 - April 2008]): 77.89%*^† growth. Minimum deposit: $1,000. (This program began live trading in March and achieved a 14.19% growth. Results prior to March represent hypothetical performance results.
• Dynamic Multi-Strategy Program (Leveraged) (Last 12 months [May 2007 - April 2008]): 82.91%*^† growth. Minimum Deposit: $1,000. (This program began live trading in April and achieved a -1.73 drawdown. Results prior to April represent hypothetical performance results.)
• Sentiment Program (No leverage)(Last 12 months [May 2007 - April 2008]): 18.25%* growth. (Live performance) Minimum deposit: $5,000.
• Sentiment Aggressive Program (Leveraged) (Since inception [July 2007 - April 2008]): 35.76%* growth. (Live performance) Minimum deposit: $5,000.

I have looked into these black boxes trying to divine their hearts: both are programmed traded units, i.e., all trading is automated—no portfolio manager is making decisions.  They have their strategy and their computers follow it by rules.  The short-term opportunity program uses a momentum strategy without leverage.  The Sentiment Program uses a longer term momentum strategy where their own database of sales and purchases in  the markets are used to spot market-wide trends.

It’s an interesting program, and the returns they post make it look great.  But, remember that some of their posted returns are hypothetical—always cause for suspicion.  The biggest cause for concern from my perspective are their high costs.  The monthly fee is quite reasonable.  It annualizes at about 2%.  But, they take 30% of the profits, with some relief if the account is recovering from a loss.  I am not a buyer, but I find it interesting as a concept.  I wonder if, in the future, other forex traders will offer some kind of managed accounts for small investors.

For purposes of full disclosure, I own two currency ETFs:  Mexican Pesos fund (FXM) and the Brazilian Real (BZF).  I own both as a classic carry trade play, and I am not hedged in either position—a valuation play of sorts.  I use money market funds for the purchase, and I hold them with a keen eye on economic conditions in Mexico and Brazil.  Things can change fast in Latin America.  I also limit these holdings to less than 10% of my total portfolio.

I have already provided a list of exchange traded products in an earlier post.  Here is a short listing of some of the on-line trading platforms:

• Deutsche Bank Trading Station II [DBFX]
• CitiFX Pro
• FXCM Trading Station II (Same platform as DBFX, but a different provider of the service)
• DealBook 360

I close this brief description of trading currencies by passing on a suggestion I received in an e-mail from Deutsche Bank.  Their list of 10 trading tips is provided in a companion post, and I think it deserves a wide reading.  These suggestions are well thought out and has raised my esteem for this old German bank to a new level.  I urge anyone new to currency investing to read it carefully.  I believe that currency investing (as opposed to trading) is viable as part of one’s portfolio allocation—currencies are, in a simple way, an additional asset class that is somewhat independent of equity and fixed income markets.  But, the suggestions offered by Deutsche Bank give us some rules to follow before jumping into the deep waters of this highly liquid asset class. 

Good luck!

Disclosure: Author holds shares in FXM and BZF

Comments

[Desi:]

Dear Mr Hendon >>> I havent seen any posting related to currency trading on Seeking Alpha as detailed as yours. A posting like this definitely gives the tools and background for a small investor to explore different options in this world of PE, Hedge Funds, Institutional investors..Speculators etc.

Please keep up the good work. Thanks,

Desi

2008 Jun 15 08:24 AM

[User 86999:]

Thanks for a rich store of information on currencies. I'm curious about the taxation issues. For instance, will FXM send you a K-1? There are stories of how people didn't make any money on some futures based etfs and still received K-1 that showed some phantom revenues that they had to pay taxes on? I'm still researching this whole K-1 issue in general, on what kind of futures does it apply to; commodities are for sure, such as DBV, DUG and all.

2008 Jun 15 08:38 AM

[locke:]

This is one of the best articles on Seeking Alpha I have seen. My hat is off to you.

2008 Jun 15 02:20 PM

[Reinko:]

Indeed a nice article, I have tried some demo programs myself and that was big fun.

But the reason I give a reaction is the next:

When you start a demo program they always contact you by phone, to my surprise one of those 'advertising people' told me it was an advantage that they had leverages of up to one thousand times...

This is of course a stupid selling proposition because when you trade leveraged one thousand, you need a big big margin in order to pay that call when it comes.

All leverages above 10 are fake because you can make only smaller trades if you use a higher leverage (when you are a bank it is different, why pay the margin call when you can also classify it as a Level 3 asset?).

But it is great fun and you better use one of those demo's first because I can remember I wanted to buy Canadian dollars, but the pair was noted in reverse so I actually sold them.
So do your thinking because selling Euro/US$ is the same a buying US$/Euro.
And I was looking at my losses and I did not grasp it...

2008 Jun 15 04:29 PM

[ikkyu:]

nice post. I would recommend carry trading as the default strategy and maybe go from there if you are ambitious. Also OANDA is the best retail broker in my opinion. The have no minimum size trading lot, which has huge ramifications for P/L. You can make a one dollar trade if you wish. Oanda is a favorite for carry traders.

For instance, you could mirror the DBV strategy with no fund-fees just the spread. (also DBV is 2X fund).
cheers from osaka,
john

2008 Jun 16 04:15 AM

[Ray Hendon:]

Thank you all for your generous comments. I'll have another post within a week or so on the details of executing a carry trade strategy. User 86999: I am not a tax expert, so be careful in placing too much credibility in my views on the K-1 issue. As far as I know, K-1s are used by Trusts, and is their way of passing on capital gains to their owners--you. While the Rydex fund (FXM) is a trust, they do not engage in futures transactions--they own mexican pesos outright. So, their exposure to capital gains is small. Those trusts that engage in forward contracts, however, do have a large exposure since they must turn over their contracts on a periodic basic.
ikkyu, thank you for the infor on OANDA. I was not aware of this broker, and what I have found so far is good.

2008 Jun 17 11:26 AM

[Forex Funne...:]

Hey Ray. thanks for the brilliant article, i've been trying to learn about this stuff for the last few months and this has been a big help.

2008 Jun 23 12:12 PM