FX trading can seem like a recipe for printing money, but does anyone really know what they’re doing when trading the biggest and most explosive market in the world?
Hedge fund manager George Soros must have known a thing or two about currency markets when he made over USD 1 billion in a couple of days in 1992.
But then again traders only need consider the National Australia Bank currency scandal where a series of losing trades cost the bank $360 million to realise that currency trading is not all plain sailing. In fact, some criticise the FX market for being too large and way too unruly for smaller traders to make a buck.
The foreign currency market is an electronic network linking the buying and selling activities of banks, corporations, hedge funds and private investors around the world. Today anyone with an internet connection at home can open an account and start trading the euro, yen, US dollar, Thai Baht or Hungarian Forint.
Some argue that forex trading will be the next wave. Just as Mums and Dads signed up to online brokers during the technology boom in the late 1990s and early 2000, currency trading could one day claim a seat alongside shares for the active trader. Contracts for Difference (CFD) providers are noticing the shift. Many newcomers to CFDs, they say, are overlooking margin trading over shares for the prospect of trading currencies instead.
In the US, especially, there has been a marked pick-up in the number of traders. Once the stable currency of the world, and a rather drab currency to trade, the US dollar has been particularly volatile of late. Plagued by the sub-prime loan crisis, the US dollar has been on a rollercoaster ride against almost every major currency over the past year.
There’s no question that the foreign exchange market has its pluses. Nothing beats it on accessibility (it’s open 24 hours a day), or liquidity (it’s by far the largest market in the world). Unlike companies, foreign exchange doesn’t go bankrupt, and currencies don’t drop by 30 per cent in a day.
You often hear share traders bemoaning the weekend, but not forex traders. While the sharemarket is closed, market gyrations internationally can cast a gloomy cloud over open share positions. A large sell-off on gold over the weekend, for instance, would be a worrying trend for a trader with large open positions on gold stocks who can’t look to sell until Monday. Not so with forex. If you want to get out of your position at 3am on a Saturday morning, go ahead.
These merits aside, with a daily turnover of over $3.2 trillion dollars, the sheer volume of the FX market can make it unwieldy to trade. Indeed, market fluctuations can be caused by any number of factors: importers and exporters buying and selling currency to facilitate trade, hedge funds squaring positions or Governments making foreign debt payments. While forex commentators will praise its size, labelling it the most democratic market in the world, others view it as utterly unruly.
Opinion is divided on how a market that is affected by so many variables can be forecasted with any accuracy, and therefore traded for profit.
Over the past three months the AUD/USD plunged from a high of 98 cents to around 66 cents at present. Just shy of reaching parity with the US dollar, the Australian dollar tumbled on the back of falling commodity prices, the unwinding of the carry trade, a flight to safety to the US dollar and possibly a whole host of other reasons. Commentators like to come up with a list of reasons why currencies behave the way they do, usually after the event.
But the reality is, currencies are in constant flux and often behave in ways that you least expect.
Take the recent cut to official interest rates by the Reserve Bank of Australia. Instead of leading to a sell off in the AUD/USD, the reverse happened and the AUD/USD appreciated. These types of inconsistencies can make trading forex difficult or down right frustrating at times.
Presently, forex trading via the internet is offered by around a dozen contracts for difference (CFD) and forex specialists. Major online brokers are still shying away from the market, possibly due to the steep leverage involved.
Most firms offer forex trading on a 1 per cent margin, or 100 times leverage. This means that a $10 deposit can access $1,000 of currency, or $1,000 can access $100,000 worth. If a trader backs that the US dollar will rise against the Australian dollar, and the dollar increases 1 per cent, because of the leverage, the return works out to be 100 per cent – transforming a $1,000 deposit into $2,000, or if the currency moves in the opposite direction, the $1,000 is wiped out.
When trading at this sort of leverage, it’seasy to seewhy market gyrations can be catastrophic to a trader’s returns.
Over the past year, nervousness surrounding the so-called ‘yen carry trade’ has had forex traders and forecasters on the edge of their seats. Its implications for currency markets globally and even the equity market is significant.
The ‘carry trade’ is the practice of borrowing in a low yield currency (such as the yen or swiss franc) and then using the loan to purchase higher-yielding assets in countries such as Australia, Great Britain or New Zealand. For almost a decade banks, insurance companies, hedge funds, private investors and investment managers around the globe have been borrowing funds in yen to invest in higher-returning assets such as US Government bonds. Even Japanese retirees were adding to the carry trade by withdrawing their savings from bank accounts in Japan to invest internationally.
This behaviour led to the depreciation of the yen over the past few years and put upward pressure on currencies such as the Australian dollar.
But this trend has officially ended.
The recent depreciation of the AUD/USD is due in part to the unwinding of the carry trade, where investors pull funds out of high-yielding currencies such as Australia.
Traders who accurately predicted this event have made some handsome gains over the past few months.
As to where next for the AUD/USD – will it fall further as recession fears spark a further flight to the safety of US assets, or will a robust Asia lead to a pick up in commodity prices and a recovery of the AUD/USD?
Spotting the next trend in the AUD/USD and other major currencies is the difficult task of the forex hunter. As to which way the currency will move, only time will tell.