- 2002: Volume 11, No. 1 The Not So New Game... Forex

The proliferation of the Internet and, more importantly, broadband has opened up many new and exciting opportunities for the individual and small institutional investor. One of these opportunities is increased access to the foreign exchange market, also known as the FX or forex market.

While online equities and futures trading have enjoyed exponential growth and widespread notoriety over the past couple of years, online forex trading has just begun to hit its stride among seasoned active traders and small institutional investors.

Until recently, large international banks owned the forex market and only allowed access via telephone trading to a select few—e.g. Fortune 1000 companies, large funds, high net worth individuals, etc. Thankfully for the individual and small institutional investor, the tide has begun to turn. There are now reputable online trading firms that provide direct access to the largest, most liquid financial market in the world at very competitive prices.

The following article draws similarities between equities, exchange-traded products such as futures and options, and forex trading, and will explain the opportunities forex offers, not only as a profitable trading opportunity, but as an important diversification component in your financial portfolio.

Over-The-Counter or On An Exchange?
Why not both? Forex is considered an over-the-counter financial instrument. Most of the trading in the U.S. today is conducted on an exchange (NYSE, IMM, NASDAQ, etc.). Some of the characteristics that set forex apart from traditional exchange-traded instruments are as follows:

• 24 Hour Trading (ability to respond to breaking news immediately, day or night)
• Superior Market Liquidity (helps ensure price stability, less gapping and slippage)
• Narrower Dealing Spreads (bid/ ask spread is much tighter than a typical stock transaction)
• No Uptick Rule (easy to establish long and short positions)
• Increased Leverage (two percent margin, compared to 50 percent margin for equity markets)
• No Commissions or Fees

In the past, forex may have been viewed as risky compared with exchange-traded instruments due to little or no regulatory oversight. However, in recent months some online forex services have voluntary sought out regulation by the CFTC and are now regulated as Futures Commission Merchants, bound to the same rules, regulations, and reporting requirements as any futures broker in the United States.

Diversify Your Diversification Strategy
Most diversification strategies employed by individual and small institutional investors involve a combination of sector allocation, foreign and domestic equities, and fixed income. Some may have branched out into precious metals and/or energy products; however, few have considered expanding into forex. Why?.

The reason is that investors in the U.S. are under-exposed to foreign exchange. Unlike other areas of the world like Europe and Asia, foreign exchange does not impact the daily lives of most Americans, due to the lack of a bordering nation with an economy-influencing currency (sorry, Canada). Unfamiliarity typically breeds misconceptions and foreign exchange in the U.S. is no exception.

Popular Misconceptions About Forex

• Forex has a higher risk component than other investment alternatives.
• Technical analysis does not translate well into forex.
• Fundamental analysis is ineffective due to central bank intervention.

Figure 1:

Long-/Short-Term Moving Average: This hourly Euro chart shows a 10-period and 40-period moving average. Just as with equity or futures, forex chartists look for the shorter period to cross the longer period, particularly following a period when the two averages were far apart (as above). A trade is placed in the direction of the moving average crossover.

Figure 2:

Using this inverted head and shoulders formation a position is entered on a break of the neckline.

Risky Business?
Is forex as risky as everyone thinks? A reasonable way of comparing the level of risk inherent in any financial product is to compare each product's risk relative to its return. If you take the time to compare an investment in forex to common investments like equities and fixed income, you will find that from a risk/reward standpoint an investment in forex provides respectable returns and should be considered a viable portfolio diversification tool.

For example, 2001 annual volatilities for the Dow Jones Industrial Average, 30-year bond futures, and USD/JPY were roughly 21.5 percent, 10 percent, and 10.5 percent respectively. Considering equal investments, USD/JPY (or a basket of major currencies) clearly outpaced the negative returns generated by the Dow, and was comparable to 30-year bond futures (which was one of the best returns for the fixed income markets in years).

Figure 3:

Simple Trend Line: This hourly GBP chart shows an excellent opportunity to enter a short position on a trend line break of a previously strong upward trend.

The Trend Is Your Friend in Forex
Technical traders or "chartists" new to forex will be happy to find that all of the same charting techniques employed in equities and futures trading apply to forex as well.

Also important is the fact that 80 percent of all currency transactions involve a time horizon of seven days or less, while more than 40 percent last two days or less.

Given the extremely short lifespan of the typical trade, technical indicators heavily influence entry, exit and order placement decisions.

Furthermore, approximately 85 percent of all daily forex transactions involve "the Majors," which include the U.S. Dollar, Japanese Yen, Euro, British Pound, Swiss Franc, Canadian Dollar and Australian Dollar. The depth and concentration of the market in just seven currency pairs provides a statistically significant data set for trend analysis.

The three charts found on page three contain three examples of common forex price trends and analysis techniques used to predict future behavior of forex prices.

Figure 4:

USD/JPY Rate Supports Underlying Fundamentals: At the time period marked above, rumors surfaced stating that the Bank of Japan would support USD/JPY in and around the 118.00 level. The market tested the rumor, the Bank of Japan intervened, and the price of USD/JPY has since correctly reflected the weakness of the Japanese economy vis a vis the United States. Chart courtesy of Futuresource ProNet.

Fundamentally Sound
The forex market is unique in that central banks intervene from time to time to affect the price movements of their respective currencies. On the surface, this fact may disturb participants who use fundamentals to make investment decisions and trust that the "invisible hand" guiding free market behavior is not being manipulated.

However, it has been proven time and again that central banks can only influence currency values for short periods of time as fundamentals prove to hold over longer periods of time. Key values that fundamentalists should focus on when evaluating one currency versus another are: 1) relative interest rates; 2) relative economic stability; 3) relative political stability; and 4) the relative trade deficit/surplus.

The Japanese Yen is a good example of a currency whose price has behaved consistently with fundamentals.

Trade Forex Just Like The Professionals
If you're interested in trading forex for your own account, there are many firms that provide related products and services. Whether you are looking for a state-of-the art trading platform, a sophisticated charting or analytics package, or perhaps a forex training program, it is readily available.

If you'd like to invest in forex but are unable to watch the markets 24-hours-a-day, or simply prefer to have your risk capital managed by professionals, consider investing in a managed account or currency fund. Leading forex money managers reported returns of 20+ percent last year—an attractive alternative to equities over the same period. Furthermore, studies of professionally managed currency funds show uncorrelated returns compared to most other asset classes, including the major equity indexes. So, a partial allocation to forex can substantially reduce your portfolio's total return volatility and provide for better total return over time.

Conclusion
Of the over $1 trillion dollars a day transacted in the foreign exchange markets, an estimated 95 percent is trading for profit, or speculation. While large international banks are responsible for the majority of this volume, there are retail investors all over the globe trading forex on a daily basis. Without a doubt, investors in the United States are behind the curve with regard to learning about and participating in this market. Active equity and futures traders who appreciate liquidity, strong technical indicators, and a multitude of short-term trading opportunities will find the forex market especially appealing. But at the very least, forex deserves serious consideration as a diversification strategy in anyone's portfolio.

For more information regarding the forex market, visit the Federal Reserve Bank of New York's Web site: http://www.ny.frb.org/pihome/addpub/usfxm/.

Mark Galant is the CEO and founder of GAIN Capital, a Warren, NJ-based provider of foreign exchange services, including direct access trading and asset management. Visit www.gaincapital.com for more information about GAIN Capital.

Charts and Data Courtesy of GAIN Capital, unless otherwise noted.