Forex Benefits over Equities

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Forex Benefits and Risks

The FX market is so popular because of it's almost 24/7 easy access, good liquidity and the availability of leverage to manage large positions in any one market. Of course leverage can act as a double edged sword and you can lose large amounts of money if you haven't done your homework and if your money management is all wrong - It's extremely important to manage your risk.

Though currencies don't tend to move as sharply as equities on a percentage basis (where a company's stock can lose a large portion of its value in a matter of minutes after a bad announcement), it is the leverage in the spot market that creates the volatility. For example, if you are using 100:1 leverage on $1,000 invested, you control $100,000 in capital. If you put $100,000 into a currency and the currency's price moves 1% against you, the value of the capital will have decreased to $99,000 - a loss of $1,000, or all of your invested capital, representing a 100% loss. In the equities market, most traders do not use leverage, therefore a 1% loss in the stock's value on a $1,000 investment, would only mean a loss of $10. Therefore, it is important to take into account the risks involved in the forex market before diving in.

Generally, the major currency pairs - such as the EUR/USD, USD/JPY, USD/CHF and GBP/USD - have shown the greatest characteristics of trend, while the currency pairs that have historically shown a higher probability of becoming range-bound have been the currency crosses (pairs not involving the U.S. dollar).  It's important for every trader to be aware of the characteristics of trend and range, because they will not only affect what pairs are traded, but also what type of strategy should be used.

Benefits over Equities

There are very few currency pairs to trade compared to the thousands of equities out there.  This makes it easier to keep track of your trades.  It's best to trade the most liquid pairings.  The most liquid pairing all include The USD.  They are:

EUR/USD . GBP/USD . USD/JPY . USD/CHF . USD/CAD . AUD/USD

The above parings also have the tightest spreads, so reducing your trading costs.  All other currency pairs that don't include USD are called cross-currency pairs. Other popular currency pairs are AUD/NZD and GBP/JPY.  According to FXCM, these are the most popular along with EUR/USD.

The Forex market tends to have stable liquidity over time compared to the equity markets.  Equities and indexes can have declining liquidity from time to time, meaning volatility increases.  This liquidity and the ability to short sell in the FX market make it a very attractive market to trade.  Short selling is also practised in the equity markets, but there can be restrictions in some equity markets.

The Forex markets tend to have lower commissions, tighter spreads and in lower costs in general to the equity markets.  Although spread betting companies will offer spreads on certain equity and commodity markets now. 

The Carry Trade Benefits

When you buying a currency pair like AUD/USD you are buying the first currency (AUD) and selling the second currency (USD).  Basically The Carry Trade involves buying the currency with a high interest rate and selling the currency with a low interest rate - profiting from the interest rate differential.  

In effect you are sitting on a financial instrument with a higher interest rate than the one you sold.  The interest rate differential gained on a pair can be 3% or more.  When you introduce leverage, say of 10x leverage, that becomes 30%.  On 20x leverage, 3% becomes 60% - you get the idea?  This interest is added (or subtracted if you've bought the lower interest currency and sold the higher one - this is called the negative carry) from your position on a daily basis.

Important Considerations of The Carry Trade

The selection of the currency pair can make the difference between a losing and a profitable trade. When selecting the currency pair, traders want to observe the following: 
  • The trader wants to make sure he is buying the currency that has the higher interest rate and is selling the currency that has a lower interest rate in comparison.  
  • Understanding the role that interest rates play in the FX market is crucial. A country offering high interest rates will attract more capital as investors seek to capitalize on higher returns.  
  • The carry trade works best under 'risk on' trading environments and tends to break down under 'risk off' periods.  During 'risk off' periods traders fly to safe investments like the USD or JPY.  If the outlook of a country's economy looks as good, then chances are that that country's central bank will have to raise interest rates in order to control inflation - This is good for carry trade because a higher interest rate means a bigger interest rate differential.  On the other hand, if a country's economic prospects aren't looking too good, then nobody will be prepared to take on the currency if they think the central bank will have to lower interest rates to stimulate their economy - There's a flight to safety
  • The trader also wants to view the health of the economy for the currency pair to ensure the market will move to his/her favour.  Bond Spreads help here.  Technically we look for trending pairs.
  • Risk management rules still apply - you must always understand your potential losses.
  • This correlation is a long term strategy. Government policy takes time to implement, but nonetheless bond spreads can help to establish long run trend
  • Short term fluctuations in the market can create risk situations for traders.
Essentially, the trader will be buying a currency with a stronger economy and selling the currency with a weaker economy. the most commonly used currencies to fund carry trades are the Japanese yen and the Swiss franc because of their countries' exceptionally low interest rates. 

The popularity of the carry trade is one of the main reasons for the strength seen in pairs such as the Australian dollar and the Japanese yen (AUD/JPY), the Australian dollar and the U.S. dollar (AUD/USD), the New Zealand dollar and the U.S. dollar (NZD/USD), and the U.S. dollar and the Canadian dollar (USA/CAD).

The Simple Carry Trade Example

A Japanese Housewife borrows Yen 1000 from a bank at 1% and converts it to GBP.  She buys the GBP equivalent of Yen 1000 in UK Government Gilts that pay an interest of 4%.  The Housewife stands to make 3% per annum on this deal, all things being equal.  I hope you can see how this works with currency pairs?

Let's say a trader bought AUD/JPY a year ago.  There are a few possible outcomes on this trade.
  1. The AUD has fallen against The JPY.  Hopefully your stop loss has kicked in and your losses have been minimised, you've lost everything, or somewhere in between.
  2. The pair hasn't moved at all (A bit like the Japanese Housewife example above).  You will collect the interest rate differential on your position.  Note. Interest is paid on a daily basis.
  3. The AUD appreciates against JPY.  You pick up your profit plus The Carry.  The longer you are in your position the more interest you make.
To Sum Up

While you are paying the low interest rate on the financial instrument you borrowed/sold, you are collecting higher interest on the financial instrument you purchased. Your profit is the money you collect from the interest rate differential.  This is another way to make money in the forex market without having to buy low and sell high, which can be pretty tough to do day after day.

Remember this is a 'risk on' trade.  When economic conditions are uncertain, investors tend to put their investments in safe haven currencies, which tend to offer low interest rates like the U.S. dollar and the Japanese yen.

Technical analysis is not an exact science and although these ideas can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course.

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Forex Benefits and Risks

The FX market is so popular because of it's almost 24/7 easy access, good liquidity and the availability of leverage to manage large positions in any one market. Of course leverage can act as a double edged sword and you can lose large amounts of money if you haven't done your homework and if your money management is all wrong - It's extremely important to manage your risk.

Though currencies don't tend to move as sharply as equities on a percentage basis (where a company's stock can lose a large portion of its value in a matter of minutes after a bad announcement), it is the leverage in the spot market that creates the volatility. For example, if you are using 100:1 leverage on $1,000 invested, you control $100,000 in capital. If you put $100,000 into a currency and the currency's price moves 1% against you, the value of the capital will have decreased to $99,000 - a loss of $1,000, or all of your invested capital, representing a 100% loss. In the equities market, most traders do not use leverage, therefore a 1% loss in the stock's value on a $1,000 investment, would only mean a loss of $10. Therefore, it is important to take into account the risks involved in the forex market before diving in.

Generally, the major currency pairs - such as the EUR/USD, USD/JPY, USD/CHF and GBP/USD - have shown the greatest characteristics of trend, while the currency pairs that have historically shown a higher probability of becoming range-bound have been the currency crosses (pairs not involving the U.S. dollar).  It's important for every trader to be aware of the characteristics of trend and range, because they will not only affect what pairs are traded, but also what type of strategy should be used.

Benefits over Equities

There are very few currency pairs to trade compared to the thousands of equities out there.  This makes it easier to keep track of your trades.  It's best to trade the most liquid pairings.  The most liquid pairing all include The USD.  They are:

EUR/USD . GBP/USD . USD/JPY . USD/CHF . USD/CAD . AUD/USD

The above parings also have the tightest spreads, so reducing your trading costs.  All other currency pairs that don't include USD are called cross-currency pairs. Other popular currency pairs are AUD/NZD and GBP/JPY.  According to FXCM, these are the most popular along with EUR/USD.

The Forex market tends to have stable liquidity over time compared to the equity markets.  Equities and indexes can have declining liquidity from time to time, meaning volatility increases.  This liquidity and the ability to short sell in the FX market make it a very attractive market to trade.  Short selling is also practised in the equity markets, but there can be restrictions in some equity markets.

The Forex markets tend to have lower commissions, tighter spreads and in lower costs in general to the equity markets.  Although spread betting companies will offer spreads on certain equity and commodity markets now. 

The Carry Trade Benefits

When you buying a currency pair like AUD/USD you are buying the first currency (AUD) and selling the second currency (USD).  Basically The Carry Trade involves buying the currency with a high interest rate and selling the currency with a low interest rate - profiting from the interest rate differential.  

In effect you are sitting on a financial instrument with a higher interest rate than the one you sold.  The interest rate differential gained on a pair can be 3% or more.  When you introduce leverage, say of 10x leverage, that becomes 30%.  On 20x leverage, 3% becomes 60% - you get the idea?  This interest is added (or subtracted if you've bought the lower interest currency and sold the higher one - this is called the negative carry) from your position on a daily basis.

Important Considerations of The Carry Trade

The selection of the currency pair can make the difference between a losing and a profitable trade. When selecting the currency pair, traders want to observe the following: 
  • The trader wants to make sure he is buying the currency that has the higher interest rate and is selling the currency that has a lower interest rate in comparison.  
  • Understanding the role that interest rates play in the FX market is crucial. A country offering high interest rates will attract more capital as investors seek to capitalize on higher returns.  
  • The carry trade works best under 'risk on' trading environments and tends to break down under 'risk off' periods.  During 'risk off' periods traders fly to safe investments like the USD or JPY.  If the outlook of a country's economy looks as good, then chances are that that country's central bank will have to raise interest rates in order to control inflation - This is good for carry trade because a higher interest rate means a bigger interest rate differential.  On the other hand, if a country's economic prospects aren't looking too good, then nobody will be prepared to take on the currency if they think the central bank will have to lower interest rates to stimulate their economy - There's a flight to safety
  • The trader also wants to view the health of the economy for the currency pair to ensure the market will move to his/her favour.  Bond Spreads help here.  Technically we look for trending pairs.
  • Risk management rules still apply - you must always understand your potential losses.
  • This correlation is a long term strategy. Government policy takes time to implement, but nonetheless bond spreads can help to establish long run trend
  • Short term fluctuations in the market can create risk situations for traders.
Essentially, the trader will be buying a currency with a stronger economy and selling the currency with a weaker economy. the most commonly used currencies to fund carry trades are the Japanese yen and the Swiss franc because of their countries' exceptionally low interest rates. 

The popularity of the carry trade is one of the main reasons for the strength seen in pairs such as the Australian dollar and the Japanese yen (AUD/JPY), the Australian dollar and the U.S. dollar (AUD/USD), the New Zealand dollar and the U.S. dollar (NZD/USD), and the U.S. dollar and the Canadian dollar (USA/CAD).

The Simple Carry Trade Example

A Japanese Housewife borrows Yen 1000 from a bank at 1% and converts it to GBP.  She buys the GBP equivalent of Yen 1000 in UK Government Gilts that pay an interest of 4%.  The Housewife stands to make 3% per annum on this deal, all things being equal.  I hope you can see how this works with currency pairs?

Let's say a trader bought AUD/JPY a year ago.  There are a few possible outcomes on this trade.
  1. The AUD has fallen against The JPY.  Hopefully your stop loss has kicked in and your losses have been minimised, you've lost everything, or somewhere in between.
  2. The pair hasn't moved at all (A bit like the Japanese Housewife example above).  You will collect the interest rate differential on your position.  Note. Interest is paid on a daily basis.
  3. The AUD appreciates against JPY.  You pick up your profit plus The Carry.  The longer you are in your position the more interest you make.
To Sum Up

While you are paying the low interest rate on the financial instrument you borrowed/sold, you are collecting higher interest on the financial instrument you purchased. Your profit is the money you collect from the interest rate differential.  This is another way to make money in the forex market without having to buy low and sell high, which can be pretty tough to do day after day.

Remember this is a 'risk on' trade.  When economic conditions are uncertain, investors tend to put their investments in safe haven currencies, which tend to offer low interest rates like the U.S. dollar and the Japanese yen.

Technical analysis is not an exact science and although these ideas can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course.

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