The Currency Market

By Joe Gelet, CTA
www.elitefxsystems.com

Is it ironic that the currency market, driver of global trade and finance, without a doubt the most significant market in the world economy and politics, is the least known?  Why is there such a void of information, and why are there so many misnomers regarding currency trading and investing? 

From a traders perspective, the forex market is easier to trade in terms of execution and reporting, market hours (forex is 24/7), leverage (400:1), and ability to implement technical systems.  There are only 8 major currency pairs, which have limited range, and are correlated mathematically.

In the stock market, the largest concern is insider trading.  Insider trading is illegal in the stock market, because it is a specific unfair advantage that corporate officers have due to sensitive information they have.  However, insider trading is not illegal in the currency market, because there are no ‘insiders’, and also it is not unethical for a bank to sell currency because that is the business of the bank!  Insider trading does not apply to the currency market; in fact it is the least regulated market in the world – because it is a money market.  Currency traders are trading money for money, the highest form of trading.  Every currency trade is determining the value of money. 

At the bottom of the economic chain you have people who trade their manual labor for money.  Then you have people who trade their goods for money, such as seen in futures and commodities markets.  Finally you have those who trade pure information for money, which is information brokerage and some forms of Information Technology.  Finally you have people who trade money for money, which is banking.  Since we have abandoned the Breton Woods treaty and have a free floating currency exchange system, now another layer of complexity has been added, which is money being valued in terms of other money.

The reason for mentioning this is to illustrate that currency markets affect everyone.  When the dollar is going down, it is decreasing in its purchasing power, creating inflation.  This is not a commonly known mechanism because although the abandonment of Breton woods has completely changed our worldwide financial system, new books have not been written according to the new rules of the game.  People think inflation comes naturally from the business cycle, when in fact it comes from the printing of money which creates oversupply.  Now, with the new paradigm of money creation connected to forex trading, another element exists in the inflation equation that didn’t exist before.  Foreigners can buy your local currency and dry up supply.  This motivates local central banks to print more currency to compensate and, thus we have a new inflationary paradigm of currencies each competing for their own destruction – the game is who can inflate more, quicker.

Especially in a world of globalization heavily dependent on global trade, specifically in the G8 and industrialized nations, the value of a countries currency exactly determines how many goods and services can be purchased and imported.  Of course, if we can use our financial monopoly to decimate their currency and have more products for ourselves, all the better.  International trade can take place by exchanging goods for goods – a sophisticated form of bartering.  Or, we can manufacture money and purchase overseas goods backed by our banking system, which everyone is happy to accept so they can go out and purchase other goods from other countries (and a small % from us as well). 

This delicate balance of financial power is demonstrated in the currency market, because of the mechanical procedure involved in remitting funds overseas.  You need to exchange your dollars for Euros, and when you do so you pay the price.  Banks take no risk in the game and act as accountants for funds going back and forth from one currency to another. 

Maybe a reason that there is little knowledge about forex is because the focus has always been on the mechanical aspect and not the economic impact.  Maybe the financial establishment does not want to mention the fact that the reason the DOW is 13,000 is because the dollar is down, and a weak dollar is fuelling a real estate boom, and that real estate is just a gauge of inflation.  Or maybe few understand the new paradigm of foreign exchange and the real value of money.  Either way, there is little public information and understanding on the topic which is more significant than any other in modern finance.

Having said all of the above, you may wonder how to invest in such a market.  There are basically 2 sides to the forex market; hedgers and speculators.  Hedgers include any business or individual that is trading currency out of need – you sell your products overseas and require foreign currency or have multiple currencies budgeting in international markets.  The second group (which is by far the minority) is speculators such as hedge funds and investment banks who take positions in the currency market with the hope for financial profit.  The mechanism the speculators use to profit varies widely – from long term investment in a currency, to trading an automated ‘day trading’ system which takes many small trades in a day.  There are also many strategies traders use that can become quite complex due to the mathematical relationship between currencies.  For example there is triangular relationship between any 3 cross-pairs (for example EUR/USD, EUR/CHF, and USD/CHF).  A trader may develop a strategy to capitalize on that relationship, or use it to ‘hedge out’ of a position by reducing his net exposure without taking on new positions.  This type of strategy is unique to the forex market because of the cross pair system and the relationship between them.  Other markets require derivatives to create such strategies (such as equity futures and options).
When investing in the currency market, one can find a professional trader who knows what he is doing, and evaluate the performance of different strategies and select one which matches his investment goals and risk profile.  Some strategies are more risky than others, and there is a correlation between risk and reward.  Many so called ‘hedging systems’ can work for months gaining as much as 50% per month, but always risk wiping out the account completely.  Then there are more conservative strategies that may return 2% to 5% per month, less exciting but much less risky.  Of course every strategy involves risk, there is no such strategy that is risk free in trading, and that is why no fund or trader can offer a guaranteed return.  It is impossible to forecast a large amount of variables that could lead to losses.