Currency Trading: Profit From The World's Biggest Casino

by: Nicholas Vardy

Currency trading is often derided as quintessential "casino capitalism." Leverage is high, costs are low, and liquidity is deep. With daily turnover exceeding $2.7 trillion, the value of currencies traded on world markets is 10 times that of stocks. The world's most famous trade -- the one that "broke the bank of England" -- was a currency trade. It was right down the street from me in London that the British press swarmed George Soros' house on the morning of September 16, 1992, when his bet against the English pound netted him over $1 billion.

The World's Biggest Casino: The Rules of The Game

We are all currency investors, whether we know it or not. By investing in GE or Microsoft, you are betting on a dollar-denominated stock. Foreign investors in U.S. stocks appreciate this situation better. Despite the S&P doubling over the past four years, foreign investors in the U.S. market have made minuscule returns. Once profits from U.S. dollars are converted into pound sterling or euros, nominal dollar profits quickly evaporate.

The rules of currency investing are hard to get your head around. Much like a three-dimensional chessboard, currency investing can be fascinating to some but annoyingly complex to others.

Here are a couple of the basics you should keep in mind...

First, currency is a zero sum game. In the stock market, a rising tide lifts all boats and all investors make money. But in currency markets, if you win, someone else has to lose.

Second, there is nothing inherently volatile about currencies. Like commodities, it's the leverage that makes all the difference. For every $50,000 you have, you can control one million dollars. Small swings in exchange rates can make you a mint -- or wipe you out -- overnight.

Third, macroeconomic indicators such as inflation, the balance of payments and money supply are what matter. High inflation, a growing balance of payments deficit and a weakening currency often go hand in hand. Print a lot of money, and its value will go down.

Although highly paid currency strategists will never admit it, the reality is that most currency trading is pure speculation. Currencies are a financial Rorschach test onto which analysts can project their own narrative fallacies. Animal spirits govern rationality. Perception trumps reality.

A good rule of thumb? Think of a currency as the stock of a country. The currency of a robust economy with stable prices is more valuable than a politically unstable country with high inflation. Another thing to keep in mind: once a currency starts to trend, it tends to last months, or even years.

The World's Biggest Casino: Where to Place Your Bets

The U.S. Dollar

If there is a "hate currency" out there, it's the U.S. dollar. The British pound hit a 26-year high of $2.01 against the greenback on April 18, and the dollar's downward slide recently culminated in the euro notching up a two-year high.

The conventional wisdom for the dollar decline is well-rehearsed. U.S. GDP growth slowed to a crawl -- expanding at a 0.6% annual rate during the first quarter of 2007 -- the slowest pace in four years. A stalling housing market and a tapped out consumer mean that the risks for the U.S. economy are on the downside.

With inflation numbers benign, the Federal Reserve may have to cut interest rates to maintain growth. This would further dent the dollar, compared with the United Kingdom and the Eurozone, where interest rates are rising.

With magazine covers trumpeting the demise of the dollar, no wisdom is more conventional than the case for a weakening dollar. That makes a bet on the dollar the #1 no-brainer in currency markets today. The only question is in which direction.

The Japanese Yen

Measured by the amount of Big Mac you get for your money in Tokyo, the Japanese yen is the most undervalued currency in the world. It's also the only currency in the world that has lost value against the dollar.

The reason? Interest rates. With Japanese interest rates still just 0.5%, investors are borrowing in yen to invest in higher-yielding investments overseas. Throw in that Japan's economy has performed below expectations, and it's unlikely that you'll see a reversal in the yen's fortunes anytime soon.

Yet that's all the more reason that I am tipping that the yen is Warren Buffett's mystery currency bet.

The Euro

Last December, the value of Euro notes circulating worldwide overtook the value of dollar bills. Worth seven times the largest dollar-denominated note -- and eight times Japan's ¥10,000 bill -- the five hundred Euro note is perfect for large, anonymous cash transactions. Hence, it's gaining popularity in Russia.

More importantly, the Eurozone economy is back. First quarter 2007 GDP growth came in at 3.1% year-over-year, beating original estimates of 2.9%. That led the European Central Bank to call for "strong vigilance" to stave off inflation -- a strong signal that interest rates are set to rise to 4% in June. All these are bullish for the Euro.

The Pound Sterling

The pound sterling recently hit a 26-year high against the U.S. dollar. British GDP growth is still robust -- and set to continue at 3% this year -- the fastest since 2004. The cost? The U.K. inflation rate has jumped above 3%, well above the bank's 2% target. As a result, Bank of England Governor Mervyn King has hiked interest rates four times since August 2006. That's all bullish for the pound. The downside is the U.K. housing bubble -- one that higher interest rates could prick at any moment.

Commodity Currencies (Canadian Dollar, Australian Dollar)

Commodity currencies are the currencies of countries benefiting from the commodities boom. Both the Canadian dollar and the Australian dollar have recently hit record highs against a wide range of currencies.

The World's Biggest Casino: Buying Your Chips

ETFs are a liquid and cheap way to track the movements of eight currencies against the U.S. dollar. Today, you can buy ETFs that track the Euro (NYSEARCA:FXE), Yen (NYSE:FXY), Sterling (NYSE:FXB), Swiss Franc (NYSE:FXF), Mexican Peso (NYSEARCA:FXM), Swedish Krona (NYSE:FXS), Australian (NYSE:FXA) and Canadian Dollars (NYSE:FXC). Because ETFs are unleveraged, and currencies are less volatile than stocks, changes in currency values will seem glacial. It's unlikely that you'll have a $1-billion day like George Soros. But you won't blow up like Long Term Capital Management either.