Today's comment is by Boris Schlossberg and Kathy Lien, top currency traders and editors of The Money Trader.
Dear A-Letter Reader:
Over the last few days, we've seen a little bit of how the spot currency market works. We've seen how this formerly exclusive, $1.9-trillion/day market is now available to individual investors and we've reviewed the three key factors affecting a currency's value.
Today, we're going to walk through a couple of different versions of a trade. One will be conservative; the other, risk-aggressive. In the process, we'll be looking at an example of the famous (but little understood) carry trade.
To start, let's consider which currencies we're going to trade. There are over a hundred currencies in the world-from the Brazilian real to the Thai baht . Yet, in the spot market, there are only eight major currencies.
These are the currencies that experience the most volume and therefore tend to have narrower spreads when paired with the dollar or each other. These are also the preferred currencies which almost every FX dealer trades. They are...
- The US dollar
- The euro
- The British pound
- The Japanese yen
- The Swiss franc (a.k.a. the "Swissie")
- The Canadian dollar (a.k.a. the "loonie")
- The Australian dollar (a.k.a. the "Aussie")
- The New Zealand dollar (a.k.a. the "kiwi")
Most trades in the spot market involve the dollar in one way or another. You're either long the USD (bullish on it) or short the USD (bearish on it). You can bet your bias with any one of these currencies. The most prevalent pairing, by far, is the euro-dollar.
In any case, whenever you trade currencies, you're always working in pairs. You're long one currency and short the other. When you trade two currencies other than the USD, that's called a "cross trade."
For instance, you might be long the Canadian dollar and short the Japanese yen. This trade would be referred to in writing as "CAD/JPY" because, by convention, that's how this currency pair is traded, with the Canadian dollar first and the Japanese yen second. To keep things simple, for this pairing, Canadian dollars are always quoted in terms of yen.
So, as we write, the CAD/JPY is at 101.8711. That means the Canadian dollar is worth about 102 yen. Now, logically, you could also say the yen is worth 0.98 Canadian cents. If you look at a table of cross rates, in fact, you'll se the CAD value in yen expressed as 101.8711 and the yen's value in CAD expressed as 0.0098.
But the convention is simpler. For this pair, the relationship between the currencies is expressed in terms of the Canadian dollar's worth in yen.
For all pairings, in fact, the convention is that the first currency mentioned is called the base currency while the second is called the counter currency. So, in writing, you might see someone mention they're "long the CAD/JPY" or "short the CAD/JPY." Verbally, you might hear these same positions referred to being "long the CAD-YEN" or "short the CAD-YEN."
In the first case, it simply means you expect the Canadian dollar to rise against the yen. In the second case, it means you expect the opposite: that the yen will rise against the Canadian dollar. But in both cases, the trade would be quoted in terms of CAD/JPY, the Canadian dollar's value in terms of yen. In fact, when looking at any pair the trade will always be expressed in terms of the counter currency, or to make even easier to remember the currency at the end of the pair.
So let's take a moment to walk through a CAD/JPY trade.
Two Ways to Profit: Net Interest and Appreciation
If you're long the CAD/JPY, that means you'll receive interest directly into your account on a daily basis at the Canadian central bank rate. Currently, that's 4.25%. At the same time, however, you'll be charged interest on Japanese yen. Currently, that's very close to 0%.
So if you entered this position with 100% cash (that is with no "leverage" or borrowed money) you would net the interest rate difference. In this case, you'd be on track to make 4.25% a year from the spread... as long as the exchange rate between the currencies didn't change.
Now if the Canadian dollar went down 4.25% against the yen over the course of a year, your net gain would be zero. You gained 4.25% in net interest but lost 4.25% in depreciation.
And if the Canadian dollar went up 5% against the yen over a year, your total gain would be nearly 10%. Half of that profit would be from interest and half from appreciation in capital.
That example is with all cash. If we add leverage to the mix, your returns can be greatly magnified.
Leverage: a Double-Edged Sword in the Spot Market
In the spot market you can borrow money, just as you can in the stock market. However, you can borrow a lot more money against your capital in the spot market. And you can choose among various interest rates.
In the stock market, maximum leverage is typically 2-to-1. For each dollar of cash you have you can invest up to a total of $2, with one of those dollars loaned to you by your brokerage at a given interest rate.
In the spot market, however, you can use leverage of up to 100-to-1. So for every dollar you have in an account, you can control $100 worth of currency. And the interest rate you pay depends on which currency you're borrowing.
So let's get back to our CAD/JPY trade to see how this works.
Let's say you put $2,000 in your spot market account and went long CAD/JPY at leverage of 50-to-1. You're credited interest on a daily basis at a rate of 4.25% a year. Your cost of borrowing yen is basically zero. So your net credit is 4.25%. But it's 4.25% of $100,000, not 4.25% of $2,000.
At the same time, the Canadian dollar rose 5%, remember. But, because you used leverage, you're getting 5% of $100,000, not 5% of $2,000.
So now, your total gains are $10,000. And your total investment (and maximum risk on this trade) was just $2,000. You made 500% profits. And you pocketed five times your initial maximum risk.
But, of course, if the market went against you, you could have had your position closed out very quickly. Just a 1% move against you now equals a drawdown of $1,000 since 1% of $100,000 is $1,000. That $1,000 equals half your entire capital in the trade. So you're taken out. End of trade. You lost half of the capital you allocated here.
That's why you have to be careful with leverage. Most successful traders in the spot market don't employ leverage of more than 10 to 1. That gives you room for the market to fluctuate while keeping you in your trade.
For instance, at 10-to-1, your $1,000 controls $10,000 worth of Canadian dollars. If the market moves against you 5% initially, that's only a draw down of $500 since 5% of $10,000 is $500. You're still in the trade. If the market recovers and then goes your way, you can still double your initial investment on a 10% total gain (interest and appreciation).
The World-famous Carry Trade, Now Available to Individual Investors
The example we just used is a carry trade. That's when you borrow in a low-yielding currency and invest in a high-yielding currency to collect the net difference in interest, plus (hopefully) currency appreciation.
The carry trade has been a major money maker for hedge funds over the last ten years. These funds have borrowed yen at near zero interest rates and invested them in higher-yielding currencies as well as in the bonds of higher-yielding currencies.
Now, this same strategy is available to individual investors. But you have to be careful. Remember our point yesterday that it's not just the difference in interest rates that affects currencies - it's the direction in their difference.
Interest rates right now in the US are still much higher than in Japan. The Fed Funds rate is 5%, vs. a Japanese Central Bank of nearly 0%. So you could, theoretically, still do successful USD/JPY carry trades.
However, if the Fed stops raising rates soon while the Japanese central bank starts to raise rates (a real possibility), the carry trade could cease being profitable-even while U.S. rates remain higher than Japanese rates. That's because the net interest-rate-spread advantage you have could be lost to a depreciation of the dollar against the yen.
This is why it's a good idea to "demo trade." Most major online forex dealers have software you can download for free and trade a demo account, with no money at risk. This way, you can become comfortable with the basics and mechanics of the spot market before putting real money on the line.
Tomorrow, we're gong to wrap up our introductory series on the spot market by taking a look at a very special trading strategy. We call it "Option X." It's a way of constructing synthetic options that give you all the leveraged profit potential of options, but with added benefits. And it's available only in the spot market.
With the Option X Strategy, you can trade with virtually unlimited upside yet strictly limited risk. You can do it without paying the "time premium" that typically makes options so expensive. You can do it without commissions. And you can do it while constructing a virtual option that actually pays you interest and has no expiration date.
Until tomorrow ...
KATHY LIEN & BORIS SCHLOSSBERG,
Editors of The Money Trader, on behalf of The Sovereign Society
EDITOR'S NOTE: Boris Schlossberg and Kathy Lien are senior currency strategists with a top currency trading firm in New York. They are also co-editors of The Money Trader, a weekly currency trading advisory that posted an 83% winning percentage last year. Boris and Kathy have been rated in separate quarters this year and last by FX Magazine, a leading institutional publication, as the most accurate currency forecasters in the business. They beat out leading banks and institutions for the honor, including JP Morgan, Credit Lyonnaise, Merrill Lynch, and others. Boris and Kathy are also co-authors of the report Secrets of the Spot Market: How to Make 18% to 58% on Your Safe Cash. The report is written to make the spot currency market completely transparent and accessible for individual investors. To reserve a copy, on a risk-free basis, click here.