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Special Focus: Forex—Currency Trading For the Small Investor

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January 1, 2011
forex market currency trading
Fredrik Broden

You don't have to be a big fish to swim in the pool of currency trading anymore. It's certainly not shrouded in the mystique it once was, and advances in technology have helped to level the playing field by bringing it to the masses. But let's be clear. It's not for everyone, and we'll cover some of the specific risks a little later.

Also known as forex (or FX), currency trading is a vibrant marketplace. If you haven't looked at FX yet, perhaps it's because you were too afraid of it, or just didn't quite understand it. But the pool of currency to trade is expansive, and you don't have to be a rocket scientist to figure things out. In fact, when trading FX, you can rely on many of the same tools available on the thinkorswim® from TD Ameritrade platform that you already know and love. And if you understand what makes a stock tick, you more than likely understand what makes FX—ahem, pip.

What Makes the Dollar Move?

One way to think of a country's currency is the same way equity investors think of stocks. Higher stock prices typically reflect investor confidence in a company's future. Likewise, higher currency values typically reflect investor sentiment in the health of that country's economy relative to other countries. Earlier in 2010, when word spread that the U.S. Federal Reserve was planning to buy back Treasury bonds, the U.S. dollar (USD) sank. By October 2010, the greenback had buckled to new 15-year lows against the Japanese yen. By buying bonds, the Fed signaled to investors that it was taking serious action to keep interest rates in check. Lower rates in the U.S. make the dollar less interesting relative to other currencies. That is, as rates or yields fall, banks and other investors will move money into financial systems that offer higher rates. For instance, if rates are low in the U.S., investors might move money into Australia and invest in higher-yielding Australian bonds.

Capital movements across borders are like tides that flow in the ocean. These shifts of assets are powerful forces that drive currencies higher and lower. Economic data and interest rates are the key fundamental drivers for this capital movement. As a result, trends can last months or even years and provide both short- and long-term profit opportunities in the currency markets.

First, the Nuts and Bolts

Trading FX is essentially pairs trading. You are buying one currency and selling another. If you buy the EUR/USD pair, for example, you are long the euro and short the US dollar. Some of the more actively traded pairs today include the USD/JPY, GBP/USD, and EUR/JPY. Major currency pairs consist of any pair with two of the currencies listed below. All other pairs are considered “exotic.”

US – U.S. dollar
JPY – Japanese yen
EUR – Euro
AUD – Australian dollar
CAD – Canadian dollar
GBP – British pound
CHF – Swiss franc
DKK – Danish krone
NZD – New Zealand dollar
NOK – Norwegian krone
SEK – Swedish krona

The minimum price movement in a currency market is called a pip or tick. For example, let's say the quote for EUR/USD is 1.4165 bid to 1.4175 ask. Since one pip is 0.0001, this means that the difference in price between the bid and ask is two pips, which is another way of saying that the difference in price for €10,000 (euros) is $2 (U.S. dollars). Just as with stocks, investors can buy at the ask and sell on the bid.

For many currencies, the pip is equal to 1/100 of a cent, or 0.0001. This seems like a small amount, but a standard trade is $100,000, so a 0.0001 pip equals $10. If you capture 10 pips on a trade, you've made $100.

It's All About the Leverage

Forex trading at TD Ameritrade offers a fixed leverage of 50 to 1 on major pairs and 20 to 1 on exotic pairs. The rules surrounding leverage on FX are a bit different than margin on equities. Let's consider an example: Suppose the EUR/USD currency pair is trading at 1.41750 bidto 1.41850 ask, and you buy the pair on the 1.41850 ask. You are now long the euro and short the dollar. You're anticipating the euro will bounce higher against the dollar. Assume the euro gains against the dollar, and the quote is now 1.42050 bid to 1.42150 ask. You sell the position at the 1.42050 bid price. On a $100,000 transaction size, you net 20 pips, or a $200 profit. If you're trading on TD Ameritrade's non-commission feed, your transaction costs are included in the quotes.

($1.42050 - $1.41850) X 100,000 = 0.002 = 20 pips = $200

On the other hand, if the euro loses against the dollar, and the quote is lower, say 1.41650 bid to 1.41750 ask, on a $100,000 transaction size, you're down 20 pips, or a $200 loss.

($1.41650 - $1.41850) X 100,000 = -0.002 = -20 pips = -$200

What's important to understand about FX leverage is that you don't need to put up the entire $100,000 to trade EUR/USD. The leverage varies by firm, but it's not uncommon to see leverage rates of 5 to 1 or even 50 to 1 (as with TD Ameritrade). If, for example, you've put down $2,000 (50 to 1) and capture 20 pips on a currency trade, you've made $200 or 10 % on your investment. However, leverage like this is a double-edged sword: The more you have, the higher the potential rewards, and the greater the risk of hefty percentage losses.

The Other Bits

FX has some unique features that appeal to equity and options traders, in particular. The following is a short list.

Same Board, Different Game. Adding FX to your game plan gives you another product to trade, but it's not like you'll be starting from scratch. You can use many of the same analysis techniques that you do for equities. After all, a chart is a chart. Chances are, many of the indicators that you use to trade stocks, futures, or options can be applied to FX charts as well. In Figure 1, notice the trend in the USD/JPY currency pair from May to November 2010. Even simple trendlines can be useful when looking for the next major trend in a currency pair.

dollar yen spot

FIGURE 1: A CHART IS A CHART.

Does this chart look familiar? Most of the technical indicators that stock and options traders use are shared by FX as well. This chart happens to show the dollar/yen (USD/JPY), but it could just as well be SPX. For illustrative purposes only. For illustrative purposes only. Source: thinkorswim from TD Ameritrade

Trading currencies can also provide some portfolio diversification. It's another asset class and another opportunity to initiate positions to build a portfolio. If, for example, your stock portfolio isn't doing well, some of those losses might be offset by positive results from a profitable currency position. There's a lot to be said for trading asset groups that do not have a high degree of correlation.

The Long and Short of It. Since currency markets tend to move in trends, they can offer both short- and long-term trading opportunities. For example, the investor focused on fundamental factors such as interest rates and economic data can trade on information from news releases in search of short-term profits, or even intraday moves. Economic news releases tend to cause very short bursts of activity in financial markets, including volatile moves in currency pairs. The idea is to capture a few pips here and there. Remember, hit for singles, not home runs.

Some currencies trend nicely over time and are sometimes used for longer-term positions. For example, an investor who expects the dollar to rebound against the yen through 2012 might initiate a long position in the USD/JPY and place a stop-loss above a recent low that is a predetermined price designed to get him out of the trade when that price is reached— something you can program right into the thinkorswim from TD Ameritrade trading platform. A long-term, trend-following approach can be just as useful in trading currency pairs as it is in equities. Frequently, the key is to correctly assess longer-term macro trends by reading the news and economic reports, just as you would equities.

Rock and Roll Around the Clock. Since international currency markets overlap, you can trade currencies day and night. For the week, markets are normally open from 6:00 p.m. Sunday to 4:00 p.m. Friday (Central time). The continuous trading helps to ensure that there are no “speed bumps” or big moves when markets are closed. The largest volume and most liquid markets exist when multiple international markets are trading.

Because there is no daily close for the currency market, the value of any open FX position is calculated at 2:00 p.m. Central time every day and adjusted due to rollover rates. The rollover is simply the interest rate differential between the currency you're long versus the currency you're short. If you pay more than you earn, the rollover will result in a debit. If you earn more than you pay, you get a credit. So, the daily adjustment is a net debit or credit to the position. Essentially, automatically and behind the scenes, at the end of the day (2:00 p.m.), one position is closed and a new one is opened reflecting the debit or credit. This process is sometimes called the overnight roll or the Tom-next procedure. (See page 42 for more on the overnight roll.)

Finally, it's worth mentioning that although every investment involves some risk, the risk of loss in trading off-exchange forex contracts can be substantial. So before jumping in with both feet, understand that the only funds that should ever be used to speculate in foreign currency trading are funds that represent risk capital—i.e., funds you can afford to lose without affecting your financial situation. The reality is that no one can predict which way exchange rates will go, and the forex market is volatile. Leverage can produce large losses in relation to your initial deposit. In fact, even a small move against your position may result in a large loss, including the loss of your entire deposit. And, depending on your agreement with your dealer, you could also be required to pay additional losses.

Understanding the risks of trading FX is key, and if it's a new concept for you, sure, it will take a little time and education to learn the ins and outs. Yet, for many investors, FX is an exciting and liquid market to trade. The key drivers—economic data and changes in interest rates—are easy to follow. Just as we've seen with the U.S. dollar, currency prices can trend over time and provide both long-term and short-term trading opportunities. If you're already trading equities, you don't need to reinvent the wheel. You can use many of the thinkorswim from TD Ameritrade tools that you already know and love.

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