Trading Strategy : Currency Crosses, Leverage and Position Sizing

Currency Crosses

A currency cross is a pair that doesn’t involve the US dollar. In the early days of the modern financial era, currency traders (especially those based in the United States) who wanted to place trades that didn’t involve the dollar had to perform some minor financial acrobatics. For example, if a trader wanted to short the Japanese yen against the euro, he would have had to make two simultaneous trades, shorting the yen against the dollar at the same time that he bought the euro against the dollar, as follows:

Closing a position would have similarly involved two trades. Nowadays, forex brokers offer a handful of the most liquid currency crosses, thus relieving traders of this headache. Those that want to trade less popular crosses, however, will have to resort to the method described above.

Some traders gravitate to crosses because they are more suited to technical analysis. For example, it would be very difficult to establish a model for the Japanese yen against the British pound—even though both are major currencies—because of the lack of a direct relationship between their financial economies. Thus, movements in the JPY/GBP are more likely to be technical than fundamental.

Of course, there are a handful of exceptions, most of which involve the euro. For instance, the CHF/EUR is arguably as important as the CHF/USD for a few reasons. First of all, the Swiss franc is easier to compare to the euro because of regional proximity and economic interdependence. Second, the Swiss National Bank has been more likely to measure the franc’s performance against the euro—rather than the dollar —which means that traders have no choice but to do the same. Recall that the infamous “line in the sand” that would trigger intervention was €1.50 and not $1.50.

Carry Trade

The carry trade is a trading strategy that seeks to profit from interest rate differentials. Such differentials are a factor in all overnight forex positions, and interest is automatically credited or debited to one’s account in the form of rollover. (This will be discussed more in Chapter 9.) Thus, all traders must at least be aware of the interest rate differential that corresponds to the particular currency pairs that they are trading.

Practitioners of the carry trade, however, seek out trades mainly on the basis of these interest rate differentials. The primary goal is to capture the interest rate spread rather than to profit from currency appreciation. For example, if the benchmark interest rate is 1% in Japan and 10% in Brazil, the annual expected interest earnings from a BRL/JPY position would be 9%. If this interest rate differential changes—because Brazilian rates rise and/or Japanese rates fall—interest earnings would change accordingly.

Since the carry trade is supposed to be a low-risk strategy, traders must also control for risk. Taken at face value, a 9% annual return seems fairly solid. However, if the standard deviation (also known as variability) of that return is 20%, then the actual return could very well turn out to be negative. As a result, currency pairs that are especially stable make the best candidates for the carry trade. In fact, the carry trade tends to thrive when volatility is low and to shrink during crises when uncertainty is high.

Figure 7-7 shows a breakdown of the returns earned from August 2007 to January 2012 from a carry trade strategy against the US dollar. You can see that in some cases (such as with the Brazilian real and the Australian dollar) returns from interest were supplemented by currency appreciation. In other cases (such as with the Mexican peso and the Turkish lira) high returns from interest were partially or completely offset by currency depreciation. Most currencies fell somewhere in the middle. Of course, the plot thickens when you adjust for risk. While returns were high for the Brazilian real and the Australian dollar, for example, so was volatility.

Figure 7-7. Returns and risk from USD carry trade, August 2007–January 2012

The carry trade also serves as a useful framework for understanding currency fluctuations as part of a plain vanilla fundamental strategy. For example, beginning in 2005, traders began to target the yen as a funding currency for carry trades due to its low interest rates and similarly low volatility. The massive capital outflows that followed caused the yen to decline more than 20% against the US dollar, bringing the price of the yen to a five-year low. (See Figure 7-8.) At the peak of this practice, outstanding yen-short carry trade positions were estimated at nearly $1 trillion!  

In 2007 the credit bubble began to deflate. With the inception of the financial crisis, risk appetite collapsed, and skyrocketing volatility caused a sudden unwinding of carry trade positions. A short squeeze ensued, and the yen finished the year up 25% in its strongest performance ever. As US interest rates fell to 0%, the dollar replaced the yen as the funding currency of choice for carry trades. Since then, the yen has risen continuously. Any long-term trader that discerned this sea change would have profited handsomely.

Figure 7-8. The carry trade dictates long-term movements in the USD/JPY

To deploy a carry trade strategy, you need only to identify a currency pair with a broad interest rate differential and low volatility, sit back, and start collecting interest. If volatility rises suddenly and/or the interest rate differential narrows, you may need to re-evaluate your position. There are a handful of currency ETFs (such as the iPath Optimized Currency Carry Fund and PowerShares DB G10 Currency Harvest Fund) that mimic carry trade strategies, though their performance records are spotty.

Advanced Strategy

There are no firm standards as to what constitutes an advanced strategy. Suffice it to say that such strategies take a long time to develop and must be executed meticulously. Still, advanced strategies may represent the most effective methods for beating the market, and outsized returns should accrue to those with the most sophisticated strategies.

Most institutional currency traders make use of advanced technical strategies. They use powerful computers and complex algorithms to sweep through hundreds of combinations of indicators in search of the strongest signals. These algorithms are closely guarded secrets and are so valuable that they have already become the subject of several high-profile lawsuits. Fortunately, the software that institutional traders use to develop their advanced strategies has begun to trickle down to the retail level and is available, free of charge, through many forex brokers, or for a fee from third-party providers. In Chapter 9, I will offer an introduction to using such programs.

Meanwhile, advanced fundamental strategies can be developed manually or with the aid of computers. For example, you could use regression analysis (a tool that is available through Microsoft Excel) to compare currency fluctuations with economic data. Or you could try to establish a tradable correlation between a particular currency pair and another asset, such as treasury bonds or gold prices. My personal favorite advanced strategy is based on the correlations between currencies.

For example, let’s say that you had been eyeing the AUD/USD in early 2007, when it was still rising. Worried that the credit bubble that was driving the gains in the AUD/USD was about to burst, you decided to seek out another currency pair to hedge your exposure. You pulled up the following table of correlations and identified the JPY/EUR as the best candidate.

The two pairs exhibited an inverse (weekly) correlation coefficient of 50.9%, which meant that an upward move in the AUD/USD had a 50% chance of driving a corresponding downward move in the JPY/EUR—and vice versa. In the event that the AUD/USD didn’t perform as expected, then, you would have been protected by your JPY/EUR position.

After opening two simultaneous long positions, you patted yourself on the back for the continued rise in the AUD/USD. If only you hadn’t been so stupid as to buy the JPY/EUR, whose modest decline was eroding your solid gains. But, wait! The credit crisis struck suddenly, and the AUD/USD collapsed! Fortunately, the inverse correlation held, and what would have been innumerable losses were offset by strong gains in the JPY/EUR. In fact, you can see from Figure 7-9 that while the performance of the AUD/USD and JPY/EUR have varied since 2007, their combined return has always been positive. Behold, the perfect trade!

Figure 7-9. Cumulative returns from investing in the AUD/USD and JPY/EUR, separately and together

Trading the News

Trading the news is arguably the most difficult strategy of all. When certain economic data is released, the news can have a sudden and unpredictable impact on the forex markets. For this reason, when big news announcements are brewing, the majority of short-term traders will deliberately close any positions that could potentially be impacted and/or stay out of the markets altogether rather than risk having their trading strategies undermined by an unexpected movement. Long-term fundamental analysts, meanwhile, pay attention to the content of the news but may wait several days after their release before acting.

At the same time, there are a handful of traders that thrive on the volatility that certain news releases engender and deliberately craft strategies that stand to profit from this phenomenon. Every day, there are literally dozens of economic indicators that are made public, and the majority of them have zero impact on the markets. A handful of them, such as employment indicators (e.g., nonfarm payrolls), interest rate decisions, trade data, inflation indices, retail sales, and a handful of others, however, can cause significant gyrations in the markets.

Typically, in the days or hours leading up to an important data release, a consensus expectation will form, and traders will consolidate their positions in the relevant currency pair(s). In the minutes before the release, the pair may break suddenly in a particular direction. When the data is finally released, investors become frantic. Their aim is to either buy the trend if the data release has conformed to expectations or to sell before the rest of the market in the event of a surprise.

Anyone looking at the economic calendar for February 3, 2012, as seen in Figure 7-10, would have noticed that a handful of employment indicators were scheduled for release at 1:30 p.m. (GMT). In the half day leading up to these data releases, the EUR/USD consolidated upward as traders planned for a continuation of the status quo via the previous month’s figures. In fact, the actual data beat expectations, and only 30 minutes later the USD had already rallied by 100 PIPs. Apparently, the sell-off was too steep, and traders spent the rest of the day building back up long positions.

Figure 7-10. Charting the impact of the release of employment data on the EUR/USD

Those that sought to profit from this chain of events could have entered the market on any number of occasions. If you subscribe to the idea, “Buy the rumor, sell the news,” then you probably would have bought the EUR/USD (and sold the USD/EUR) in the hours leading up to the news release and then dumped it (and even opened the opposite position) immediately after the news announcement. Alternatively, you might not have any opinion on the data itself and might merely be interested in a volatility play. In this case you could place simultaneous buy and sell orders slightly above and below the consolidation channel (indicated by the red horizontal lines in Figure 7-10). With the use of a One-Cancels-Other trade (which will be explained in Chapter 9), your trading platform will automatically open a position for you, depending on the direction of the breakout. If the breakout is to the upside, then the buy order will be triggered and the sell order will be cancelled, and vice versa is true for a downside breakout. Of course, if you set your bands too close together, you run the risk of falling victim to a false breakout, as in Figure 7-10.

Basic Options Strategies

The main source of appeal for options boils down to leverage. For most securities, the ability to make long/short bets without having to buy/sell the security itself is a huge benefit. For example, with $25,000 you could only afford 40 shares of Google stock, assuming a current share price of $630. Alternatively, you could buy 2,500 Google call options for $10 each, and achieve significantly larger gains if the share price increases than if you had merely bought the stock itself. Given the open availability and low cost of leverage in the forex market, however, options really aren’t much of a perk. Any retail trader can buy a $100,000 block of currency with a modest amount of equity capital. For this reason, options represent only a small part of forex activity.

At the same time, traders prize options for their flexibility and unique structure. Hedging, for example, is a risk management strategy designed to limit losses. In options parlance, hedging usually means taking on a secondary position to minimize losses from a primary position. For example, let’s say that you have an open position consisting of 100,000 units of EUR/USD and the current spot price is 1.30. In order to protect yourself from a downside move, you could buy put options for an equivalent amount of currency at a strike price of 1.25, thereby limiting your potential losses to 500 PIPs. You might be wondering why you shouldn’t just input a stop-loss order instead, which would achieve the same purpose. The answer is that a put option will not automatically exercise while a stop-loss order will. In other words, if you take out put options and the EUR/USD falls to 1.24 before rising to 1.40, you will be able to capture all of this upside. Conversely, you would have irrevocably locked in a 500-PIP loss with an equivalent stop-loss order. The difference, of course, is that put options cost money (money that could otherwise have been used for your spot position) while a stop-loss order is free. In addition, as retail forex brokers do not typically offer currency options, trading them requires a separate account and a separate platform. This may prove to be more trouble than it’s worth.

Still, options are conducive to a many types of unique forex trading strategies, many of which are simply impossible to execute in the spot market. My favorite is the straddle. A long straddle involves the simultaneous purchase of call and put options, such that profit is earned if the spot currency price rises or falls significantly. The long straddle is basically a volatility play that is based on the expectation that the price of a given currency will fluctuate significantly. Which way it moves is irrelevant—just as long as it is a big move.

Let’s imagine that you were looking at a real-time chart of the USD/MXN (as depicted in the first panel of Figure 7-11) and observed that the pair has been ranging wildly over the last few months. While you know that a slight correction is already underway, you aren’t sure whether it will continue or whether it will swing upward suddenly. The only thing you feel relatively certain of is that it will continue to move in big swings. The pair is currently trading at 13.70 (indicated by the dotted red line in Figure 7-11), and you zero in on the 13.60 call and 13.80 put option (whose strike prices are also indicated in Figure 7-11), both of which are conveniently trading for 0.10 each. In order for you to earn a profit, the price will need to rise or fall by at least 20 basis points so that you can earn the premiums back. You calculate that if it breaks above 13.90 or below 13.50 (outside of the gray envelope), you will be in the black. As can be seen from Figure 7-11, it ultimately does so on several occasions, providing good opportunities to profitably close out your options position. With a long straddle, your maximum loss is equal to the combined premiums that you paid for the two options.

Figure 7-11. Hypothetical options long straddle strategy and theoretical P&L chart

A short straddle, meanwhile, is based on the same concept but executed in reverse. The goal of a short straddle is to profit from a lack of volatility by simultaneously selling put and call options. For example, let’s say that the USD/JPY has traded in a very tight (not volatile) range over the last two months, as indicated in the left panel of Figure 7-12. As long as it remains range bound, you can lock in profits by selling a 77.10 put option and 77.70 call option. Then, you can sit back and wait. In a nutshell, if the USD/JPY price is within the gray area when the options contracts expire, then the trade will be profitable. To close out the position prematurely, you must buy the options back at market prices. As with a long straddle, potential profits and losses will vary accordingly. It’s that simple.

Figure 7-12. Hypothetical options straddle strategy and theoretical P&L chart

At the same time, there is no free lunch. Currency pairs that are less volatile will have smaller premiums while currency pairs with greater volatility will command proportionately higher premiums. You can play around with different strike prices and expiration dates, and most options trading platforms can automatically generate potential profit and loss charts so that you can forecast how the impact on the underlying spot price (which is what you are ultimately watching) will affect the profitability of your options positions.

As I indicated in Chapter 2, hedging and straddles represent only the tip of the iceberg. There are dozens of basic options strategies, hundreds of combinations of strategies, and an infinite number of actual trades that you can make. For better or worse, however, options tend to exist in their own separate world. As a result, in addition to monitoring movements and volatility levels in the spot market, options traders must also have a nuanced understanding and specialized knowledge of their own market. In short, those of you that are interested in trading currency options would benefit from purchasing a book devoted exclusively to that subject.

Leverage and Position Sizing

The final step of executing any forex strategy involves figuring out how much to buy or sell. Consider, first of all, that the minimum position size is $10,000 for a micro lot and $100,000 for a standard lot. As a result, most traders will have to develop a certain amount of comfort with leverage. At the same time, leverage is expensive. I’ve already discussed how leverage can amplify gains and losses, but I also need to emphasize the fact that leverage magnifies transaction costs. With 20 times the leverage (i.e., $5,000 equity for a $100,000 trade), for instance, a trader can expect to spend 0.2% to 2% of account equity on a single round-trip trade. That might not sound like much, but it can quickly add up after a series of losing trades. From Figure 7-13, it should immediately be clear that trading a currency pair with 100x the leverage where the spread is 5 PIPs is extraordinarily risky. While leveraged transaction costs will seem trivial on winning trades, they magnify the pain of losing trades.

 

Figure 7-13. Relative transaction costs (as a percentage of account equity) increase in proportion with leverage

In the end, position sizing is more of an art than a science and depends on many factors, including risk tolerance, confidence, and strategy. Those that have a long-term outlook may feel more comfortable risking more of their account equity on individual trades. On the other hand, holding multiple open positions at the same time requires smaller positions and/or increased leverage. Those that like the possibility of scaling into losing trades while keeping leverage at a reasonable level should plan to open smaller initial positions. Also, it’s better to be safe than sorry. If, after acquiring several months of experience, you feel confident in your strategy and approach to trading, you may wish to experiment with greater leverage and larger position sizes.

Conclusion

As with analysis, strategy can be as simple or as complex as you desire. The most basic strategy involves the opening of a long position that you ultimately close (hopefully, not at a loss!) with an offsetting trade. More sophisticated traders will incorporate scaling and different types of orders into their trading plans as part of a risk management strategy. They may trade over multiple time frames or trade many different types of securities together as part of an integrated cross-market strategy. Whether you decide to move up the ladder of complexity and sophistication will depend on both how much success you achieve and the amount of time that you are prepared to devote to trading forex.