As the Australian dollar soared like a midsummer temperature, the urge to trade it for profit spread like a heat rash. And little wonder. In the space of less than two months the currency  shot from US97.5c to $US1.10 on May 2nd 2011, a jump of 12.5 per cent. Just as spectacular has been the AUD’s retreat over the past two weeks to $1.05.

To put that 12.5% jump in a trading perspective, think of a standard retail sized mini contract in the leveraged foreign exchange market with a value of $A10,000. If you bought this amount of Australian dollars against the US dollar in mid-March this year it would have cost you $US9,750. Its value in early May was $US10,972, giving a profit of $US1,222 or almost AUD$1,341.

Foreign exchange markets are highly leveraged – you only need to put down about 1 per cent of the value of the contract as initial margin (deposit) and borrow the rest. So this contract would have netted profits over two months of more than 1,000 per cent, before costs, on the initial outlay of $100.

Sounds easy, but if you had bought Australian dollars late in 2010 you would have faced a sharp drop in the following weeks as the currency fell from around $US1.00 – parity -to US97.5c – a move which, without strict risk management, might have led to a loss of some $A260 on a similar contract. The four per cent drop over the past two weeks would similarly have left AUD bulls reeling.

However the big question is, where to from here for the AUD?

Foreign exchange (FX) traders are a mixed breed, according to the providers of FX trading in Australia, who include both CFD providers and retail foreign exchange dealers. They say the typical profile is a male in the 30-50 year age group, usually with some experience in the stock market or other financial markets.

But traders have a wide range of ages and backgrounds, from quite young traders in their 20s to retirees. Although they often have some experience trading stocks, providers are now seeing new entrants whose first leveraged trade will be in foreign exchange.

“Most people who open CFD accounts start off trading shares,” says Chris Weston, analyst at CFD provider IG Markets, a leading FX provider. “Many of them are professionals; most are males, 30 to 50 years of age, and they tend to be people who have been trading leveraged markets for some time.”

He warns that due to the amount of leverage in FX, it can be more risky than trading shares. “The currency market has a lot of moving parts. Momentum trading and technical analysis is usually applied to FX but traders also need to be au fait with how different currencies react to different situations – macro events and economic data. People who survive FX trading are the ones who have a disciplined nature and who have been in the markets for longer.”

Michael McCarthy, market strategist at CFD provider CMC Markets, has also seen new accounts opened in order to trade FX, but says the run of FX traders tend to be experienced, many of them having an investment background.

Boris Schlossberg, currency analyst with US-based FX and CFD provider GFT, agrees that most traders – up to 80 per cent – are middle-aged men, but notes that the women who do trade tend to be very passionate and often make better traders than the men.

“The typical FX trader has his own business or is a professional in the markets and uses trading either to supplement income or for recreation,” says Schlossberg. “One of the great things about the FX market is that it allows the average individual to participate in the great events of our time because the markets move on macro economic news. It can be exciting of itself to take opinions on various stgelopments and translate them into profit.”

Exciting, yes, but how easy is it to make money in practice? “You have to be realistic in terms of how long it takes you to become profitable,” says Dan Perry, managing director of US-based FXCM, referring to the years many traders spend learning to trade profitably.

“One thing about FX is that you have the ability to start small and learn as you go,” Perry says, warning new traders not to start with more funds at risk than they are comfortable with.

“Average investors who get into trouble try to do too much too early. A lot of them think the Australian dollar is overvalued; but if it’s a first-time trade you don’t come in with everything you have.”

McCarthy agrees. “It’s very important to employ discipline in trading, and it’s especially important in FX where leverage is high and markets can really move,” he says.

“The trading principles for other markets apply to FX and in some ways it’s easier because it’s just a single instrument so there is less analysis than in trading different shares. FX is a particular favourite of technical analysts. More than 80 per cent of traders in FX use charts compared with more than 65 per cent in other markets.

“One of the challenges is that there so many technical analysis tools, some useful and some not. It’s not hard to work out what each one does but it’s harder to know which ones to use in which markets.”

McCarthy emphasises the importance of stop losses to limit risk, and strongly suggests the use of trailing stops, in which an order to exit the market gets automatically moved to a higher level as the market moves up, protecting paper profits.

The Australian dollar’s trajectory has brought traders to the markets who have never traded FX before, says Chris Gore, currency analyst at FX specialist GO Markets.

“Since the global financial crisis there’s been a fundamental switch in the perception of equity markets and more willingness to move across to the currency markets. They understand the local economy so they’re willing to take a view.”

Standard wisdom in the FX markets is to limit losses on any one trade to no more than 1 per cent – some say 2 per cent – of your total risk capital on any one trade. On a $10,000 trading capital – small by the standards of most successful traders – that limits you to a total risk of $100 or $200 per trade.

Since that doesn’t leave much room for manoeuvring, especially when markets are volatile,  a number of providers now offer micro FX contracts of $A1,000 value so that learners can get started without too much of their capital at stake.

So how are traders taking advantage of the volatile Australian dollar? They can trade long-term trends, holding positions for weeks or even months, since trends in the currency markets tend to be long lasting, providing further gains if traders can ride out the short-term swings. Or they can trade shorter-term dips and peaks, sometimes holding positions for as little as a few hours or days.

Each of these takes specific skills and knowledge, including knowledge of the technical indicators FX traders use and of the fundamental factors that affect the markets. If you haven’t traded before, there is also a learning curve associated with the safe use of leverage through risk management.

Opinions vary on the short-term outlook for the Australian dollar, although in the long term many commentators see it sticking near $US1.10 based on the growth outlook for the global economy and the strength of demand for the commodities Australia exports.

“It could get stronger and the global environment remains favourable for the Aussie dollar in the near term. Analysts are suggesting we could be looking at $US1.10 to $US1.15. But at the end of the day, no matter how much research you do, unforeseen events can throw projections off kilter,” says Chris Gore at GO Markets.

He adds that “It’s important to be a bit ahead of the curve. Currency markets are known to be forward looking. They’re not thinking about what happens today so much as what’s likely in six month’s time.”

Chris Weston of IG Markets says that in the short term there is nothing to suggest a correction for the dollar, although there may be dips below its current value as a result of profit taking. “But nothing too aggressive,” he says. He sees a dip to perhaps $US1.04 or $1.035 in the short term – over the next few weeks – “still a sizeable move,” he says.

Offshore money has been wary of buying Australian equities – and in turn buying our dollars to fund them – because there has been a feeling that it is overvalued, having moved up so far.

“They’re starting to realise that’s not the case and it’s still pushing up, so we may be seeing early signs of foreign money coming in. Any dip is seen as just a buying opportunity…speculative activity in the Australian dollar is at record levels,” Weston says.

One driver of the Australian dollar’s strength is interest rates, which are much higher in Australia than elsewhere, and which propels buying of Australian dollars to earn a higher rate – what is known in the FX business as a carry trade. That differential – especially compared to interest rates the US – is not likely to change soon, observers say.

Dan Perry at FXCM agrees that the Australian dollar is at “eye-popping” levels, but notes that when the Canadian dollar broke through parity with the US dollar in 2008, it later moved to the equivalent of $US1.08 to the Canadian dollar (actually quoted as 92 Canadian cents to the US dollar).

He says that underpinning our currency is the strength of the Australian economy and its export market, and demand from China. “As long as those factors are not changing, it’s hard to make an argument why it shouldn’t stay above $US1.05.”

But Boris Schlossberg, currency analyst at GFT, warns that global economic recovery is still fragile, and is at risk from higher oil prices. Recent commodity price volatility adds fuel to this argument.

“The bet on whether the Australian dollar goes higher is a bet on the notion that economic recovery can continue. There are some signs that the Aussie may have topped. In order for it to go higher the market will have to be convinced that economic recovery will pick up in the second half of the year.

“Critically high oil prices are a big danger because they are a major dampener on consumer demand. There is a question whether growth in the second quarter of 2011 will be as strong as the first, and the recovery may sputter, so $US1.05 is a strong resistance level.” Resistance is where an upward moving price meets fresh selling, hindering further rises.

Nevertheless, he says, this may only be a pause.  “Unless we see a massive exogenous shock that could send all markets into a tailspin it’s unlikely the $A will come under assault. It’s the premier carry-trade currency; the economy is rock solid and with the rise in gold it has support from commodity prices.”

The top providers

No current figures are available for market share in the FX market, but a quick survey of providers enabled TheBull to draw up this list of the top Australian FX providers listed in approximate order of rank from the most active down. All these companies have offices in Australia and are licensed by the Australian regulator, the Australian Securities and Investment Commission (ASIC).

IG Markets. A London-based CFD provider that started in Australia in 2002.

CMC Markets. Also based in the UK, a CFD provider in Australia since 2003.

GFT, an FX specialist that also offers CFDs over indices and commodities. Operating in Australia since 2008.

FXCM, another US-based retail provider that started in Australia in 2008.

GO Markets, a Singapore-owned, Melbourne-based provider that has held an Australian financial services license since 2004.

VantageFX, is an Australian-registered company and authorised representative of Enfinium that started in Australia in 2009.

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STOCKS: 18 Share Tips – 16 May 2011

COMMODITIES: As we predicted back in March, silver comes crashing down

US – What S&P’s warning on US debt really means

Trading – How to trade the head and shoulders pattern

Investing – Is Warren Buffett really a value investor?

Forex – Top 7 questions about forex trading answered

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