Volatility opportunities with FX

38 yourTRADINGeDGe noV/DeC 2011

Volatility opportunities with FX

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Volatility opportunities with FX

noV/DeC 2011 yourTRADINGeDGe 39

Tim Waterer on the growing attraction of FX trading.

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Volatility opportunities with FX

40 yourTRADINGeDGe noV/DeC 2011

t is hard to believe that twenty years ago the currency market was virtually the sole domain of ‘the big end of town’, dominated by institutional traders. Over the past few months, there has been a rise in retail FX trading as traders begin

to take advantage of its low commissions, attractive spreads, 24-hour operation, and liquidity. Barriers to retail investment are beginning to break down and the appeal of trading the FX market is broader now than ever before. However, traders should be aware of the risks and have an appropriate risk-management procedure in place.

The rise of the retail traderThe meteoric rise of the retail FX trader can be traced back to speculative traders. A blend of hedgers and speculators has always existed in FX trading; hedgers place trades to take delivery of the foreign currency on a T+2 (trade date plus two days) basis in order to settle real-world transactions, and speculators look to profit from exchange-rate movements by buying and selling without taking physical delivery. That speculative trading aspect of FX paved the way for the expansion of the retail sector of the FX market. An increasing number of online FX providers created a competitive space in the market, with high leverage, low trading costs and in some cases no minimum trade size. All these combine to make FX trading increasingly accessible.

In the past several months there has been a noticeable increase in the number of share traders branching into FX. Traders are realising trading FX is commission free (with most providers) and the band of the spread to get in and out of the trade is far lower in percentage terms than is generally the case with shares. FX trading spreads have tightened dramatically in recent years. Not long ago a 3-pip spread on the AUD/USD rate (e.g. bid at 0.9650, offer at 0.9653) would have been considered good value. Nowadays, spreads can be offered from under one pip, which means that the market has to move far less for

your position to be at break-even than was previously the case.

The 24-hour operation of the FX market is a further reason for the increase in popularity of currency trading. People working 9-to-5 jobs may have little time to actively trade the stock market. However, with FX they can come home from work, put their feet up, jump onto a laptop and trade FX in real time. Many of the more critical currency market developments happen during European and US market hours, so it can an exciting time of day to trade.

The FX market is the most liquid in the world, with daily turnover in excess of US$4 trillion. The benefit of a market with high liquidity is that execution time is almost instant, and if you have a large position you need to acquire or dispose of, there will always be enough volume in the market for your transaction to take place. This is not always the case with share trading, particularly with smaller-cap stocks, for which it can take days or weeks to offload large positions if the order book in the market is thin.

Now that retail traders understand FX is not just for corporations and that you don’t need to invest millions, many of the imagined walls to the FX market have crumbled. In fact, those more accustomed to the stock market are finding that FX is just as easy, if not easier, to trade than other asset classes. The flexibility of the FX market sets it apart from others, whilst the same basic guidelines of trading remain; if you think something will rise, you buy and if you think it will fall, you sell.

Volatility leads to opportunityVolatility has been off the charts (pun intended) since the start of August due to greatly increased concerns about European and US financial systems. This ‘double whammy’ produced conditions similar to those at the onset of the GFC in late 2008 and early 2009. Currencies were moving three per cent to five per cent in one day – as much as they would normally move during a six-month period.

However, with exaggerated volatility come plenty of trading opportunities and the chance to make ultra-quick returns. Ease of access, liquidity and low trading costs made FX the ideal trading vehicle to take advantage of the daily moves in the global financial market in August and September.

The key is to be on the right side of the violent moves. Being short during the severe downturn was the way to go, but timing is everything when it comes to trading. Currency markets kept traders guessing as to what level represented a good buying opportunity, as picking the bottom of a market seemingly in freefall is far easier said than done.

Take the case of the Australian dollar (AUD). Having hit a post-float record high of $US1.1081 in late July, it traded down to $US0.9926 and then back up to above $US1.0600 within the next month. Looking at the price action in retrospect, it is easy to say the trade of choice would have been to go short at $US1.1000, place a limit buy back at around $US0.9950 and watch the profit roll in. For traders who were convinced the AUD was punching above its weight circa the $US1.1000 level, there were plenty of opportunities to sell the Aussie and buy the Greenback on the descent from the record high to below parity. On the other side of the equation, those looking for a good entry point to go long the AUD were left scratching their heads. With the level at $US1.1000 only a week earlier, when the AUD/USD rate fell to US$1.0500, a trader could have been forgiven for thinking this represented excellent value. Buy at US$1.0500, take profit on an expected bounce back to somewhere in the $US1.0800 range. That train of thought would have made sense at the time, but as we now know, things panned out differently. Instead, a trader going long at the first fall to $US1.0500 then watched the currency fall another five cents in the space of 24 hours.

So yes, market movements in recent months have given rise to trading opportunities that come around perhaps

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42 yourTRADINGeDGe noV/DeC 2011

Volatility opportunities with FX

only every several years, but it was a tricky game to be on the right side of the wild swings. Having appropriate risk management in place through using smart stop orders will limit the damage should your instincts be at odds with prevailing market forces.

Risks for retail tradersThe highly leveraged nature of FX trading makes it very accessible. With leverage, gains are amplified, as are losses. The most common mistake made by average retail trader is over- commitment of equity on a single trade in a ‘hit and hope’ effort. Of course, if you strike it lucky by just blindly going into a trade (say, buying EUR/USD at whatever the current market rate is with no conviction or reasoning to your trade) and it happens to go in your favour, then great. But this outcome is the exception rather than the rule. Before entering a trading position on FX, be able to justify to yourself why you are about to take the trade. That justification can be arrived at from technical analysis, fundamental analysis, or a mix of both. I am a fundamentalist at heart, but rarely would I take a trade without also putting it through a technical examination. Even if it is just an exercise, I like to have all available information and use that to my advantage.

Another mistake made by retail traders is not leaving an equity buffer. Even though the trader gets the direction of the trade right over, say, the space of a week, they do not leave themselves with enough buffer to ride out any interim movements against them. Let’s take an example.

Assume that on a Monday the AUD/USD rate is 0.9550, and in the week ahead domestic retail sales data are due on Wednesday and GDP data are due Thursday, both of which I think will be stronger than forecast. This leads me to believe that the AUD/USD rate will be heading towards 0.9850 by the end of the week. I have $5000 in my trading account. I use all my equity on the trade and open a position of long one million AUD/USD at 200:1 leverage. I buy at 0.9550 on the Monday. All is going well by Tuesday as the rate has ticked up to 0.9670. I am making a $12,000 paper profit at that stage. But on Tuesday night in the US, stocks have a ‘risk off’ night and the AUD/USD slumps

to 0.9500 as sentiment takes a turn for the worse. Not only have I lost my $12K unrealised paper profit but I have also lost my $5000 initial investment. My trading position is closed and I am left with zero funds. Then the real kicker is that retail sales and GDP data are through the roof when they are released and the AUD jumps to 0.9850 at the close of trade Friday.

Overall, my trade idea was right. I did believe that the AUD would appreciate after strong domestic data, but I did not use my leverage smartly enough to ride out the short-term movement against my position.

How could I have played this better? If I have $5000 in my trading account, I do not need to go ‘all in’ on a trade. Maybe instead I use only $2000 of my available funds to open a position of 400,000 long AUD/USD. Then, if the trade had moved against my position between when I entered and my exit target, I could have absorbed the short-term loss. My equity would have fallen from $5000 to $3000, but importantly I would still be in the trade and could still be in the game when the market went where I expected. Sure, by using only $2000 and not my available $5000 my potential profit

is smaller, but by giving myself an equity ‘buffer’ I am able to remain in the trade. Markets rarely move in a linear fashion and there will be bumps along the road.

Trading FX in a volatile market can be like riding a rollercoaster. If you have a smart strategy and make effective use of stop orders and take profit orders, and manage your account so you can ride out a degree

of volatility, there are opportunities aplenty out there. FX trading is within reach of the educated retail investor.

Tim Waterer is a senior FX Dealer working at CMC Markets based in Sydney. Tim has over 10 years’ experience in financial markets. He commenced his financial markets career with four years in stockbroking before joining CMC Markets in 2004.

FiGure 1: three-month Daily Chart oF auD/usD startinG From July

Source: CMC Tracker

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