Chapter 1-2 Trading and Execution

As an individual investor, important points to consider when entering a market is how you as an investor fit into the big picture and how are you going to execute your transactions.  Most individuals participate in the Forex market through their broker/dealer, but online trading is becoming more and more popular.  Due to the immense liquidity provided by the Forex market many investors enter the market with highly leveraged accounts.  While this increases return, it also increases risk.  Interactive Brokers, a popular discount online broker, will provide 40:1 leverage for its clients to trade the seven most commonly traded currencies in the world (USD, EUR, JPY, CHF, GBP, AUD, and CAD). Whether or not to use leverage is certainly something all Forex investors will inevitably consider at some point.

Forex trading occurs through currency pairs that compare the value of one currency to another.  This comparison is what drives prices in the Forex markets and provides a basis for measuring success and failure for each individual Forex transaction.  Forex pairs exist between virtually any two currencies, but the most commonly traded pairs involve the US dollar, the Euro, and the United Kingdom’s pound sterling.  The Euro vs. the US dollar is the most heavily traded currency pair in the world right now.  Pairs are quoted as ratios with symbols that list the base currency followed by the quote currency.  Pair quotes are often carried out to four decimal places because ratios often stay in a relatively tight range.  These additional decimal places are known as “pips” and are often used to measure how successful a trade was.  If a currency pair appreciates from 1.2310 to 1.2320 the move is said to be worth 10 pips.

An example of a pairing is EUR/USD which represents the number of US dollars you can buy for 1 Euro.  The 52 week range of the EUR/USD is 1.1876-1.5144 which indicates that over the last year €1 was worth as much as $1.51 and as little as $1.19.  Quotes are commonly stated in terms of how many US dollars a foreign currency can purchase, as demonstrated above, but the opposing pairings exist and trade in the same fashion.  To convert from one to another, one simply takes the inverse of the original quote.  Here is a quick example of how this works:

The EUR/USD is currently at 1.3883 indicating that €1 can purchase $1.39.

The opposing pair would be USD/EUR and the value would be .7199 indicating that $1 can purchase €.72.

This can be verified because 1/1.38 = .72

Consider the following table that illustrates these points:

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Like most securities, Forex currency pairs trade through a bid-ask spread.  The bid price is the best price at which a counter party is willing to buy a currency and the offer price is the price at which a counter party is willing to sell.  There are two ways to interact with the bid-ask spread:  as a market maker or a market taker.  Market making, or proving liquidity to a market, is generally performed by banks and large financial institution with massive amounts of capital at work.  Market taking, or removing liquidity, is often how individual investors establish Forex positions.  Due to the extremely liquid nature of the Forex market, bid-ask spreads are often very tight, as little as 1 or 2 pips in some instances.  For example, the EUR/USD currency pair is trading at 1.3922 with an offer price of 1.3921 and a bid price at 1.3923.  This spread indicates that you, as a market taker, can buy the Euro for 1.3923 and sell the Euro for 1.3921.  It is important to consider the bid-offer spread when establishing Forex positions as you may not receive the exact price you are expecting.

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The most important thing to consider when making investment decisions is the risk of capital involved.  Unlike equity and bond markets that involve one type of security, there are a number of different ways investors tap into the Forex market.  The four most common methods for Forex investing are spot transactions, forwards, futures, and options.  Each of these investment types have unique risk characteristics that are important to understand before putting any capital to work.  Spot transactions are rarely used for investing; they are used to procure a foreign currency immediately.  If one were to use spot transactions to expose oneself to a currency the value at risk would be the entire amount of the foreign currency.  Forwards are individual contracts amongst two parties at a predetermined rate at a predetermined date sometime in the future.  The risk with forwards is overpaying for a currency by locking in a rate that is higher than the spot rate at some point in the future.  Futures contracts carry the same risk profile as forwards, but short positions technically have unlimited risk.  Foreign exchange options give the holder the right to complete a currency transaction at a predetermined rate at a predetermined date sometime in the future.  On the long side, the risk is equal to the premium paid for the option.  On the short side, as with futures, the risk is unlimited.

The majority of Forex activity takes place through spot and futures transactions.  Spot Forex transactions almost always take place through a broker/dealer.  The broker/dealer makes a market in an individual pairing allowing investors to expose themselves however they would like while earning a profit on the spread between the bid price and the offer price.  When an investor initiates a spot Forex trade cash changes hands and the asset (in this case money denominated in a foreign currency) is transferred from one owner to another at the current market price.  In many ways, this is similar to going to a money exchange booth upon entering a foreign country.  Most spot transactions take place in 100,000 units of the base currency which is known as a standard lot.  Some broker dealers will portion out these lots to make them accessible to a larger number of investors, 10,000 unit lots known as “minis” are common.

Futures trading of currencies in the United States occurs on the Chicago Mercantile Exchange, or CME.  Currency futures operate the same as commodity, index, and equity futures- they represent the obligation to exchange a certain asset at a predetermined price on a predetermined date sometime in the future.  The two most common uses of FX futures are hedging and speculation.  Hedging is generally done by companies and corporations to mitigate foreign exchange risk.  Companies can lock in an exchange rate for goods and services they purchase abroad in advance, avoiding the risk that unfavorable changes in exchange rates will increase the price of said goods.  The downside to hedging occurs when currencies fluctuate in a favorable direction effectively lowering the price of the aforementioned goods, but many companies feel that the security is worth the premium.  Most individual investors use currency futures for speculation, attempting to profit by predicting the direction of fluctuations in exchange rates.  Investors attempt to buy low and sell high on an hourly, daily, or monthly basis.  As futures are securities, they operate in many of the same ways as equities, bonds, etc.  As with all futures contracts, the difference between an investors cost basis and the closing price at the end of the day is reconciled on a daily basis and cash is exchanged.

Currency futures quotes are readily available on the Internet; consider this graphic from the Chicago Mercantile Exchange (CME) illustrating futures quotes for the CAD/USD currency pair:

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Notice that the contracts occur in 3 month intervals and the majority of the volume occurs in the front month (December 2010) contract.

Foreign exchange options, or FX options, are derivatives that provide the owner the right to complete a currency exchange at a predetermined rate on a predetermined date sometime in the future.  Most of the volume in FX options occurs over-the-counter; buyers and sellers interact with one another directly as opposed to through an exchange.  However, some trading does occur on the International Securities Exchange and the Philadelphia Stock Exchange.  Additionally, options on futures contracts are available for trade on the Chicago Mercantile Exchange.  The key difference between options and futures is that futures represent an obligation while options provide the option-holder a right.  In the case of index and equity options, options that give the holder the right to buy a security are known as calls, and options that give the holder the right to sell a security are known as puts.  Although FX options carry a name, either put or call, they are essentially both a put and call combined in one.  This is because any given option allows the holder to simultaneously sell one currency while buying another.

Here is a short example to help make this clearer:  A EURUSD FX option with a strike price of 1.50 gives the holder the right to sell €100,000 and buy $150,000 upon expiration.  This option is known as a EURUSD put, but it is also essentially a USDEUR call.  If upon expiration the rate is less than 1.50, say 1.45, the option will be exercised providing the holder with a profit of (1.5-1.45) * €100,000 = $5,000.

As with futures, the primary functions for FX options are hedging and speculation.  For the purpose of speculation, options behave in the same fashion as futures.  Investors often choose options over futures because the premiums, or cost of the option, may be more suited to their investment style or account size.  For the purpose of hedging, however, companies often have a decision to make.  Generally speaking, the more likely a foreign payment is the more appropriate hedging with futures becomes.  This makes sense because if a cash flow is uncertain a company is better off having the right to exchange the funds rather than the obligation.  Imagine if you were forced to convert a large amount of money into a foreign currency for a purpose you no longer needed!  Because of their elective nature, options provide their holders with the flexibility they desire, often enough to justify the premium paid.

Some investors wish to expose themselves to world currencies without actually participating in the Forex market.  Not all brokers offer Forex investing, and for those that do, not all accounts are permitted to trade currencies, options, and futures.  Fortunately, there is a simple way to gain Forex exposure available to virtually all investors- ETFs.  Electronically Traded Funds, or ETFs, are investment funds that are traded on exchanges similar to equities.  ETF’s buy, sell, and hold financial instruments in an effort to mimic the returns of the asset that they are attempting to represent.  For example, the most heavily traded ETF, SPY, holds the same equities in the same proportion as the S&P 500 index.  In the case of currency ETFs, trusts hold large amounts of the currency and the value of the ETF changes in lock-step with the spot exchange rate.  On occasion, trusts will buy and sell futures in an effort to better mimic changes in the underlying currency.  Currently, the most heavily traded currency ETFs on the New York Stock Exchange are the CurrencyShares Currency Trusts.

The following are the ticker symbols for the ETFs of the world’s most common currencies:

FXA – Australian Dollar                         FXY – Japanese Yen

FXB – British Pound                              FXM – Mexican Peso

FXC – Canadian Dollar                          XRU – Russian Ruble

FXE – Euro                                             FXF – Swiss Franc

FXS – Swedish Krona                            CYB – Chinese Yuan

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In addition to the CurrencyShares Currency Trusts, the company that produces the SPY ETF, PowerShares, offers an US Dollar index bullish fund with the symbol UUP.  This fund is used by investors who want exposure to the US Dollar in comparison with the six major world currencies- The Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona, and Swiss Franc.  Although the index consists of six currencies, the index represents the US dollar’s performance against 21 economies as there are 16 members of the European Union that use the Euro as their primary currency.  As a means of tracking changes in the value of the US Dollar, PowerShares invests in USDX, or US Dollar Index, futures.  As the US Dollar strengthens in the world market, the UUP appreciates.  For those that wish to bet against the US Dollar, the UDN is the US Dollar index bearish fund that operates in the exact same way as the UUP, only inverted so that as the US Dollar weakens the UDN appreciates.  Many investors prefer the convenience and simplicity of ETF currency investing to other currency instruments.  Investors are able to capitalize on fluctuations in currency values without worrying about spot rate spreads, expiration dates on futures and options, and other complexities that often deter investors from currency investing.  Furthermore, ETF investing allows investors with smaller accounts to expose themselves without putting as much capital at risk.  In addition to the ETFs themselves, options on the ETFs are available for trade on the Chicago Board Options Exchange (CBOE).

Outside of trading the UUP and the UDN, the US Dollar Index is a very valuable tool for all Forex traders.  The index is geometrically weighted based on economy size.  As a result, the Euro makes up almost 60% of the index value.  Japan comes in second at 13.5%, followed by Great Britain at 12%, and Canada at just over 9%.  The Swedish Krona and Swiss Franc combine to make up the remaining 8%.  The index originated in 1973 when finance representatives from the six included nations met in Washington DC and decided to allow currency rates to fluctuate in value against one another.  The index oscillates around a base value of 100 and has varied in value from above 160 to an all-time low at 70.698 on March 16th 2008.  For traders, the USDX is a key indicator for the strength and direction of the US dollar.  Due to the weighting, the USD/EUR (inversed for the EUR/USD) most closely follows the USDX however each of the six component pairs will react to fluctuations in the index.  Many traders look for laggers amongst the six as it is highly likely that that currency will follow suit shortly.  Regardless of the currency, it is important to know where the USDX is and what direction it is moving to better anticipate price action in the currency at hand.  If the pairing is US dollar based (USD/foreign) it will follow the USDX, if the pairing is foreign currency based (foreign/USD) then the two will move inversely.  In addition to the plain US Dollar Index, the Federal Reserve uses a trade-weighted dollar index.  This index differs from the original by including more currencies in the basket and weighting them differently.  The most significant difference is the inclusion of China as the second most heavily weighted currency at slightly more than 17%.  While the USDX is a great way to track the US dollar’s strength amongst the world’s most utilized currencies, the trade-weighted index more closely represents the US dollar’s strength around the world.

Consider the following chart that compares the UUP US Dollar index ETF to the Euro- the largest component in the index:

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Questions