Exchange-traded funds (ETFs) are a type of financial instrument whose unique advantages over mutual funds have caught the eye of many an investor. If you find the tasks of analyzing and picking stocks a little daunting, ETFs may be right for you. In this article we define ETFs, highlight their advantages, and list some of the most popular ETFs available to investors
What Is an ETF?
Think of an exchange-traded fund as a mutual fund that trades like a stock. Just like an index fund, an ETF represents a basket of stocks that reflect an index such as the S&P 500. (To read more on this subject, see our Index Investing tutorial.) An ETF, however, isn't a mutual fund; it trades just like any other company on a stock exchange. Unlike a mutual fund that has its net-asset value (NAV) calculated at the end of each trading day, an ETF's price changes throughout the day, fluctuating with supply and demand. It is important to remember that while ETFs attempt to replicate the return on indexes, there is no guarantee that they will do so exactly. It is not uncommon to see a 1% or more difference between the actual index's year-end return and that of an ETF.
By owning an ETF, you get the diversification of an index fund plus the flexibility of a stock. Because ETFs trade like stocks, you can short sell them, buy them on margin and purchase as little as one share. Another advantage is that the expense ratios of most ETFs are lower than that of the average mutual fund. When buying and selling ETFs, you pay your broker the same commission that you'd pay on any regular trade.
Varieties of ETFs
The first exchange-traded fund was the S&P 500 index fund (nicknamed spiders because of their SPDR ticker symbol), which began trading on the American Stock Exchange (AMEX) in 1993. Today - tracking a wide variety of sector-specific, country-specific and broad-market indexes - there are hundreds of ETFs trading on the open market.
You can pretty much find an ETF for just about any kind of sector of the market. For example, if you were interested in the healthcare sector, perhaps Vanguard’s Health Care Viper (ticker VHT) would be worth looking into. Does the Austrian market peak your interest? Then take a look at the ishares MSCI Austrian Index fund (ticker EWO). Or if you’d like exposure to the internet infrastructure sector, then maybe Merrill Lynch’s HOLDRs (ticker IIH0) might be for you.
Some of the more popular ETFs have nicknames like cubes (QQQQ), vipers (VIPERs) and diamonds (DIAs). All ETFs are passively managed, meaning investors save big on management fees. Below you will find a closer look at some of the more popular ETFs:
Nasdaq-100 Index Tracking Stock (QQQQ)
This ETF represents the Nasdaq-100 Index, which consists of the 100 largest and most actively traded non-financial stocks on the Nasdaq, QQQQ offers broad exposure to the tech sector. Because it curbs the risk that comes with investing in individual stocks, the QQQQ is a great way to invest in the long-term prospects of the technology industry. The diversification it offers can be a huge advantage when there’s volatility in the markets. If a tech company falls short of projected earnings, it will likely be hit hard. Between 2000 and 2004, QQQQ was by far the most heavily traded index fund.
SPDRs
Usually referred to as spiders, these investment instruments bundle the benchmark S&P 500 and give you ownership in the index. Imagine the trouble and expenses involved in trying to buy all 500 stocks in the S&P 500! SPDRs allow individual investors to own the index's stocks in a cost-effective manner.
Another nice feature of SPDRs is that they divide various sectors of the S&P 500 stocks and sell them as separate ETFs, there are literally dozens of these types of ETFs. The "technology select sector index", for example, contains over 85 stocks covering products developed by companies such as defense manufacturers, telecommunications equipment, microcomputer components, and integrated computer circuits. This ETF trades under the symbol XLK on the AMEX.
iShares
iShares is Barclay's (Barclay’s Global Investors “BGI”) brand of ETFs. In 2004 there were approximately 120 iShares trading on more than 10 different stock exchanges. Barclay has put out a number of technology-oriented iShares that follow Goldman Sachs's technology indexes. All of these particular ETFs trade on the AMEX.
Vipers
Just like iShares are Barclay’s brand of ETFs, VIPERs are Vanguard’s brand of the financial instrument. Vipers, or Vanguard Index Participation Receipts, are structured as share classes of open-end funds. Vanguard also offers dozens upon dozens of ETFs for many different areas of the market including the financial, healthcare and utilities sectors.
DIAMONDs
These ETF shares, Diamonds Trust Series I, track the Dow Jones Industrial Average. The fund is structured as a unit investment trust. The ticker symbol of the Dow Diamonds is DIA, and it trades on the AMEX.
A great reason to consider ETFs is that they simplify index and sector investing in a way that is easy to understand. If you feel a turnaround is around the corner, go long. If, however, you think ominous clouds will be over the market for some time, you have the option of going short.
The combination of the instant diversification, low cost and the flexibility that ETFs offer, makes these instruments one of the most useful innovations and attractive pieces of financial engineering to date.
Monday, January 28, 2008
Currency ETFs Simplify Forex Trades
investors - that's why an increasing number of traders and investors are diversifying and hedging with currencies. Different currencies benefit from some of the same things that may hurt stock indexes, bonds or commodities and can be a great way to diversify a portfolio. However, digging into currencies as a trader or investor can be daunting.
New currency exchange-traded funds (ETFs) make it simpler to understand the forex market (the largest, most liquid market on the planet), and use it to diversify risk.
Now, you can have General Electric (NYSE:GE) and the British pound in your portfolio by holding the CurrencyShares British Pound ETF (PSE:FXB) in the same account. Have an IRA? Sprinkle some euros in there by holding the CurrencyShares Euro ETF (PSE:FXE), and offset some downside risk of your S&P 500 holdings. Read on to learn more about this unique way of using currencies to diversify your holdings. (For more on ETFs, see Introduction To Exchange-Traded Funds and Advantages Of Exchange-Traded Funds.)
Hedging Against Risk
Every investor is exposed to two types of risk: idiosyncratic risk and systemic risk. Idiosyncratic risk is the risk that an individual stock's price will fall, causing you to accumulate massive losses on that stock. Rooting this kind of risk out of your portfolio is quite simple. All you have to do is diversify your account across a broad range of stocks or stock-based ETFs, thus reducing your exposure to a particular stock. (To learn more, read The Importance Of Diversification and Do You Understand Investment Risk?)
However, diversifying across a broad range of stocks only addresses idiosyncratic risk. You still have to face your account's systemic risk.
Systemic risk is the exposure you have to the entire stock market falling, causing you to accumulate losses across your entire diversified portfolio. Minimizing the exposure of your portfolio to a bear market used to be difficult. You had to open a futures account or a forex account and try to manage both it and your stock accounts at the same time. While opening a forex account and trading it can be extremely profitable if you apply yourself, many investors aren't ready to take that step. Instead, they decide to leave all of their eggs in their stock market basket and hope the bulls win. Don't let that be you. (Want to give currencies a shot? Read Wading Into The Currency Market.)
Currency ETFs are opening doors for investors to diversify. You can now easily mitigate systematic risk in your account and take advantage of large macroeconomic trends around the world by putting your money not only into the stock market but also in the forex market through these funds. (For more see, A Beginner's Guide To Hedging.)
How Currency ETFs Work
ETF management firms buy and hold currencies in a fund. They then sell shares of that fund to the public. You can buy and sell ETF shares just like you buy and sell stock shares. Investors value the shares of the ETF at 100 times the current exchange rate for the currency being held. For example, let's assume that the CurrencyShares Euro Trust (PSE:FXE) is currently priced at $136.80 per share because the underlying exchange rate for the euro versus the U.S. dollar (EUR/USD) is 1.3680 (1.3680 × 100 = $136.80).
You can use ETFs to profit from the exchange rate of the dollar versus the euro, the British pound, the Canadian dollar, the Japanese yen, the Swiss franc, the Australian dollar and a few other major currencies. (For more on this market, see Common Questions About Currency Trading.)
What makes currencies move?
Unlike the stock market, which has a long-term propensity to rise in value, currencies will often channel in the very long term. Stocks are driven by economic and business growth and tend to trend. Conversely, inflation and issues around monetary policy may prevent a currency from growing in value indefinitely.
Currency pairs may trend as well, and there are simple factors that influence their value and movement. These factors include interest rates, stock market yields, economic growth and government policy. Most of these can be forecasted and used to guide traders as they hedge risk in the rest of the market and make profits in the forex.
Economic Factors and Currency Trends
Here are two examples of economic factors and the currency trends they inspire.
Oil and the Canadian Dollar
Each currency represents an individual economy. If an economy is a commodity producer and exporter, commodity prices will drive currency values. There are three major currencies that are known as "commodity" currencies that exhibit very strong correlations with oil, gold and other raw materials. The Canadian dollar (CAD) is one of these. (For more on how this works, read Commodity Prices And Currency Movements.)
One ETF that can be traded to profit from the moves in the CAD/USD pair is CurrencyShares Canadian (PSE:FXC). Because the Canadian dollar is on the base side of this currency pair, it will pull the ETF up when oil prices are rising and it will fall when oil prices are declining. Of course, there are other factors at play in that currency's value but energy prices are a major influence, and can be surprisingly predictive of the trend.
This is especially useful for stock traders because of the effect that higher energy prices can have on stock values. Additionally, it provides another way for stock traders to speculate on rising commodity prices without having to venture into the futures market. (For on this topic, check out Currency Moves Highlight Equity Opportunities.)
In Figures 1 and 2, you can see 18 months of prices for the Canadian dollar compared to oil prices over the same period.
Figure 1: Crude oil (continuous)
Source: MetaStock Pro FX
Figure 2: Canadian dollar
Source: MetaStock Pro FX
As you can see, there is a strong positive correlation between these two markets. This is helpful as a hedge against stock volatility as well as the real day-to-day costs of higher energy prices.
Short-term traders may look for a breakout in oil prices that is not reflected in the value of the Canadian dollar immediately. When these imbalances occur, there is opportunity to take advantage of the move the market will make as it "catches up" with oil.
Long-term traders can use this as a way to diversify their holdings and speculate on rising energy prices. It is also possible to short the ETF to take advantage of falling oil prices.
Interest Rates and the Swiss Franc
There are several forex relationships that are impacted by interest rates, but a dramatic correlation exists between bond yields and the Swiss franc. One ETF that can be used to profit from the Swiss franc, or "Swissie", is the CurrencyShares Swiss Franc Trust (PSE:FXF). The currency pair is notated as CHF/USD. When the Swissie is rising in value, the ETF rises as well, as it costs more U.S. dollars to buy a Swiss franc.
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The correlation described here involves the 10-year bond yield. You will notice in Figures 3 and 4 that when bond yields are rising, the Swissie falls, and vice versa. Depending on interest rates, the value of the Swissie will frequently rise and fall with bond yields.
Figure 3: 10-Year Bond Yields (TNX)
Source: MetaStock Pro FX
Figure 4: Swiss franc
Source: MetaStock Pro FX
This relationship is useful not only as a way to find new trading opportunities but as a hedge against falling stock prices. The stock market has a positive correlation with bond yields; therefore, if yields are falling, the stock market should be falling as well. A savvy investor who is long the Swissie ETF can offset some of those losses.
Conclusion
Currency ETFs have opened the forex market to investors focused on stocks. They adds an additional layer of diversification and can also be used effectively by shorter term traders for quick profits. There are even options available for most of these ETFs.
New currency exchange-traded funds (ETFs) make it simpler to understand the forex market (the largest, most liquid market on the planet), and use it to diversify risk.
Now, you can have General Electric (NYSE:GE) and the British pound in your portfolio by holding the CurrencyShares British Pound ETF (PSE:FXB) in the same account. Have an IRA? Sprinkle some euros in there by holding the CurrencyShares Euro ETF (PSE:FXE), and offset some downside risk of your S&P 500 holdings. Read on to learn more about this unique way of using currencies to diversify your holdings. (For more on ETFs, see Introduction To Exchange-Traded Funds and Advantages Of Exchange-Traded Funds.)
Hedging Against Risk
Every investor is exposed to two types of risk: idiosyncratic risk and systemic risk. Idiosyncratic risk is the risk that an individual stock's price will fall, causing you to accumulate massive losses on that stock. Rooting this kind of risk out of your portfolio is quite simple. All you have to do is diversify your account across a broad range of stocks or stock-based ETFs, thus reducing your exposure to a particular stock. (To learn more, read The Importance Of Diversification and Do You Understand Investment Risk?)
However, diversifying across a broad range of stocks only addresses idiosyncratic risk. You still have to face your account's systemic risk.
Systemic risk is the exposure you have to the entire stock market falling, causing you to accumulate losses across your entire diversified portfolio. Minimizing the exposure of your portfolio to a bear market used to be difficult. You had to open a futures account or a forex account and try to manage both it and your stock accounts at the same time. While opening a forex account and trading it can be extremely profitable if you apply yourself, many investors aren't ready to take that step. Instead, they decide to leave all of their eggs in their stock market basket and hope the bulls win. Don't let that be you. (Want to give currencies a shot? Read Wading Into The Currency Market.)
Currency ETFs are opening doors for investors to diversify. You can now easily mitigate systematic risk in your account and take advantage of large macroeconomic trends around the world by putting your money not only into the stock market but also in the forex market through these funds. (For more see, A Beginner's Guide To Hedging.)
How Currency ETFs Work
ETF management firms buy and hold currencies in a fund. They then sell shares of that fund to the public. You can buy and sell ETF shares just like you buy and sell stock shares. Investors value the shares of the ETF at 100 times the current exchange rate for the currency being held. For example, let's assume that the CurrencyShares Euro Trust (PSE:FXE) is currently priced at $136.80 per share because the underlying exchange rate for the euro versus the U.S. dollar (EUR/USD) is 1.3680 (1.3680 × 100 = $136.80).
You can use ETFs to profit from the exchange rate of the dollar versus the euro, the British pound, the Canadian dollar, the Japanese yen, the Swiss franc, the Australian dollar and a few other major currencies. (For more on this market, see Common Questions About Currency Trading.)
What makes currencies move?
Unlike the stock market, which has a long-term propensity to rise in value, currencies will often channel in the very long term. Stocks are driven by economic and business growth and tend to trend. Conversely, inflation and issues around monetary policy may prevent a currency from growing in value indefinitely.
Currency pairs may trend as well, and there are simple factors that influence their value and movement. These factors include interest rates, stock market yields, economic growth and government policy. Most of these can be forecasted and used to guide traders as they hedge risk in the rest of the market and make profits in the forex.
Economic Factors and Currency Trends
Here are two examples of economic factors and the currency trends they inspire.
Oil and the Canadian Dollar
Each currency represents an individual economy. If an economy is a commodity producer and exporter, commodity prices will drive currency values. There are three major currencies that are known as "commodity" currencies that exhibit very strong correlations with oil, gold and other raw materials. The Canadian dollar (CAD) is one of these. (For more on how this works, read Commodity Prices And Currency Movements.)
One ETF that can be traded to profit from the moves in the CAD/USD pair is CurrencyShares Canadian (PSE:FXC). Because the Canadian dollar is on the base side of this currency pair, it will pull the ETF up when oil prices are rising and it will fall when oil prices are declining. Of course, there are other factors at play in that currency's value but energy prices are a major influence, and can be surprisingly predictive of the trend.
This is especially useful for stock traders because of the effect that higher energy prices can have on stock values. Additionally, it provides another way for stock traders to speculate on rising commodity prices without having to venture into the futures market. (For on this topic, check out Currency Moves Highlight Equity Opportunities.)
In Figures 1 and 2, you can see 18 months of prices for the Canadian dollar compared to oil prices over the same period.
Figure 1: Crude oil (continuous)
Source: MetaStock Pro FX
Figure 2: Canadian dollar
Source: MetaStock Pro FX
As you can see, there is a strong positive correlation between these two markets. This is helpful as a hedge against stock volatility as well as the real day-to-day costs of higher energy prices.
Short-term traders may look for a breakout in oil prices that is not reflected in the value of the Canadian dollar immediately. When these imbalances occur, there is opportunity to take advantage of the move the market will make as it "catches up" with oil.
Long-term traders can use this as a way to diversify their holdings and speculate on rising energy prices. It is also possible to short the ETF to take advantage of falling oil prices.
Interest Rates and the Swiss Franc
There are several forex relationships that are impacted by interest rates, but a dramatic correlation exists between bond yields and the Swiss franc. One ETF that can be used to profit from the Swiss franc, or "Swissie", is the CurrencyShares Swiss Franc Trust (PSE:FXF). The currency pair is notated as CHF/USD. When the Swissie is rising in value, the ETF rises as well, as it costs more U.S. dollars to buy a Swiss franc.
FREE REPORT: The Five Things That Move the Currency Market
Year after year, key players in the Forex market make a killing by picking the right currencies – now it’s your turn. Access industry gurus Boris and Kathy’s exclusive FREE report, The Five Things That Move the Currency Market – And How to Profit From Them, right now!
The correlation described here involves the 10-year bond yield. You will notice in Figures 3 and 4 that when bond yields are rising, the Swissie falls, and vice versa. Depending on interest rates, the value of the Swissie will frequently rise and fall with bond yields.
Figure 3: 10-Year Bond Yields (TNX)
Source: MetaStock Pro FX
Figure 4: Swiss franc
Source: MetaStock Pro FX
This relationship is useful not only as a way to find new trading opportunities but as a hedge against falling stock prices. The stock market has a positive correlation with bond yields; therefore, if yields are falling, the stock market should be falling as well. A savvy investor who is long the Swissie ETF can offset some of those losses.
Conclusion
Currency ETFs have opened the forex market to investors focused on stocks. They adds an additional layer of diversification and can also be used effectively by shorter term traders for quick profits. There are even options available for most of these ETFs.
About Currency Trading
Although forex is the largest financial market in the world, it is relatively unfamiliar terrain to retail traders. Until the popularization of internet trading a few years ago, FX was primarily the domain of large financial institutions, multinational corporations and secretive hedge funds. But times have changed, and individual investors are hungry for information on this fascinating market. Whether you are an FX novice or just need a refresher course on the basics of currency trading, read on to find the answers to the most frequently asked questions about the forex market.
How does this market differ from other markets?
Unlike the trading of stocks, futures or options, currency trading does not take place on a regulated exchange. It is not controlled by any central governing body, there are no clearing houses to guarantee the trades and there is no arbitration panel to adjudicate disputes. All members trade with each other based upon credit agreements. Essentially, business in the largest, most liquid market in the world depends on nothing more than a metaphorical handshake.
At first glance, this ad-hoc arrangement must seem bewildering to investors who are used to structured exchanges such as the NYSE or CME. (To learn more, see Getting To Know Stock Exchanges.) However, this arrangement works exceedingly well in practice: because participants in FX must both compete and cooperate with each other, self regulation provides very effective control over the market. Furthermore, reputable retail FX dealers in the United States become members of the National Futures Association (NFA), and by doing so they agree to binding arbitration in the event of any dispute. Therefore, it is critical that any retail customer who contemplates trading currencies do so only through an NFA member firm.
The FX market is different from other markets in some other key ways that are sure to raise eyebrows. Think that the EUR/USD is going to spiral downward? Feel free to short the pair at will. There is no uptick rule in FX as there is in stocks. There are also no limits on the size of your position (as there are in futures); so, in theory, you could sell $100 billion worth of currency if you had the capital to do it. If your biggest Japanese client, who also happens to golf with Toshihiko Fukui, the Governor of the Bank of Japan, told you on the golf course that BOJ is planning to raise rates at its next meeting, you could go right ahead and buy as much yen as you like. No one will ever prosecute you for insider trading should your bet pay off. There is no such thing as insider trading in FX; in fact, European economic data, such as German employment figures, are often leaked days before they are officially released.
Before we leave you with the impression that FX is the Wild West of finance, we should note that this is the most liquid and fluid market in the world. It trades 24 hours a day, from 5pm EST Sunday to 4pm EST Friday, and it rarely has any gaps in price. Its sheer size (it trades nearly US$2 trillion each day) and scope (from Asia to Europe to North America) makes the currency market the most accessible market in the world.
Where is the commission in FX?
Investors who trade stocks, futures or options typically use a broker, who acts as an agent in the transaction. The broker takes the order to an exchange and attempts to execute it as per the customer's instructions. For providing this service, the broker is paid a commission when the customer buys and sells the tradable instrument. (For further reading, see our Brokers And Online Trading tutorial.)
The FX market does not have commissions. Unlike exchange-based markets, FX is a principals-only market. FX firms are dealers, not brokers. This is a critical distinction that all investors must understand. Unlike brokers, dealers assume market risk by serving as a counterparty to the investor's trade. They do not charge commission; instead, they make their money through the bid-ask spread.
In FX, the investor cannot attempt to buy on the bid or sell at the offer like in exchange-based markets. On the other hand, once the price clears the cost of the spread, there are no additional fees or commissions. Every single penny gain is pure profit to the investor. Nevertheless, the fact that traders must always overcome the bid/ask spread makes scalping much more difficult in FX. (To learn more, see Scalping: Small Quick Profits Can Add Up.)
What is a pip?
Pip stands for "percentage in point" and is the smallest increment of trade in FX. In the FX market, prices are quoted to the fourth decimal point. For example, if a bar of soap in the drugstore was priced at $1.20, in the FX market the same bar of soap would be quoted at 1.2000. The change in that fourth decimal point is called 1 pip and is typically equal to 1/100th of 1%. Among the major currencies, the only exception to that rule is the Japanese yen. Because the Japanese yen has never been revalued since the Second World War, 1 yen is now worth approximately US$0.08; so, in the USD/JPY pair, the quotation is only taken out to two decimal points (i.e. to 1/100th of yen, as opposed to 1/1000th with other major currencies).
What are you really selling or buying in the currency market?
The short answer is "nothing". The retail FX market is purely a speculative market. No physical exchange of currencies ever takes place. All trades exist simply as computer entries and are netted out depending on market price. For dollar-denominated accounts, all profits or losses are calculated in dollars and recorded as such on the trader's account.
The primary reason the FX market exists is to facilitate the exchange of one currency into another for multinational corporations who need to trade currencies continually (for example, for payroll, payment for costs of goods and services from foreign vendors, and merger and acquisition activity). However, these day-to-day corporate needs comprise only about 20% of the market volume. Fully 80% of trades in the currency market are speculative in nature, put on by large financial institutions, multi-billion dollar hedge funds and even individuals who want to express their opinions on the economic and geopolitical events of the day.
Because currencies always trade in pairs, when a trader makes a trade he or she is always long one currency and short the other. For example, if a trader sells one standard lot (equivalent to 100,000 units) of EUR/USD, she would, in essence, have exchanged euros for dollars and would now be "short" euro and "long" dollars. To better understand this dynamic, let's use a concrete example. If you went into an electronics store and purchased a computer for $1,000, what would you be doing? You would be exchanging your dollars for a computer. You would basically be "short" $1,000 and "long" 1 computer. The store would be "long" $1,000 but now "short" 1 computer in its inventory. The exact same principle applies to the FX market, except that no physical exchange takes place. While all transactions are simply computer entries, the consequences are no less real.
Which currencies are traded?
Although some retail dealers trade exotic currencies such as the Thai baht or the Czech koruna, the majority trade the seven most liquid currency pairs in the world, which are the four majors:
EUR/USD (euro/dollar)
USD/JPY (dollar/Japanese yen)
GBP/USD (British pound/dollar)
USD/CHF (dollar/Swiss franc)
and the three commodity pairs:
AUD/USD (Australian dollar/dollar)
USD/CAD (dollar/Canadian dollar)
NZD/USD (New Zealand dollar/dollar)
These currency pairs, along with their various combinations (such as EUR/JPY, GBP/JPY and EUR/GBP) account for more than 95% of all speculative trading in FX. Given the small number of trading instruments - only 18 pairs and crosses are actively traded - the FX market is far more concentrated than the stock market.
What is carry?
Carry is the most popular trade in the currency market, practiced by both the largest hedge funds and the smallest retail speculators. The carry trade rests on the fact that every currency in the world has an interest rate attached to it. These short-term interest rates are set by the central banks of these countries: the Federal Reserve in the U.S., the Bank of Japan in Japan and the Bank of England in the U.K. (To learn more, see What Are Central Banks?)
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The idea behind the carry is quite straightforward. The trader goes long the currency with a high interest rate and finances that purchase with a currency with a low interest rate. In 2005, one of the best pairings was the NZD/JPY cross. The New Zealand economy, spurred by huge commodity demand from China and a hot housing market, has seen its rates rise to 7.25% and stay there (at the time of writing), while Japanese rates have remained at 0%. A trader going long the NZD/JPY could have harvested 725 basis points in yield alone. On a 10:1 leverage basis, the carry trade in NZD/JPY could have produced a 72.5% annual return from interest rate differentials alone without any contribution from capital appreciation. Now you can understand why the carry trade is so popular! But before you rush out and buy the next high-yield pair, be aware that when the carry trade is unwound, the declines can be rapid and severe. This process is known as carry trade liquidation and occurs when the majority of speculators decide that the carry trade may not have future potential. With every trader seeking to exit his or her position at once, bids disappear and the profits from interest rate differentials are not nearly enough to offset the capital losses. Anticipation is the key to success: the best time to position in the carry is at the beginning of the rate-tightening cycle, allowing the trader to ride the move as interest rate differentials increase.
FX Jargon
Every discipline has its own jargon, and the currency market is no different. Here are some terms to know that will make you sound like a seasoned currency trader:
Cable, sterling, pound - alternative names for the GBP
Greenback, buck - nicknames for the U.S. dollar
Swissie - nickname for the Swiss franc
Aussie - nickname for the Australian dollar
Kiwi - nickname for the New Zealand dollar
Loonie, the little dollar - nicknames for the Canadian dollar
Figure - FX term connoting a round number like 1.2000
Yard - a billion units, as in "I sold a couple of yards of sterling."
How does this market differ from other markets?
Unlike the trading of stocks, futures or options, currency trading does not take place on a regulated exchange. It is not controlled by any central governing body, there are no clearing houses to guarantee the trades and there is no arbitration panel to adjudicate disputes. All members trade with each other based upon credit agreements. Essentially, business in the largest, most liquid market in the world depends on nothing more than a metaphorical handshake.
At first glance, this ad-hoc arrangement must seem bewildering to investors who are used to structured exchanges such as the NYSE or CME. (To learn more, see Getting To Know Stock Exchanges.) However, this arrangement works exceedingly well in practice: because participants in FX must both compete and cooperate with each other, self regulation provides very effective control over the market. Furthermore, reputable retail FX dealers in the United States become members of the National Futures Association (NFA), and by doing so they agree to binding arbitration in the event of any dispute. Therefore, it is critical that any retail customer who contemplates trading currencies do so only through an NFA member firm.
The FX market is different from other markets in some other key ways that are sure to raise eyebrows. Think that the EUR/USD is going to spiral downward? Feel free to short the pair at will. There is no uptick rule in FX as there is in stocks. There are also no limits on the size of your position (as there are in futures); so, in theory, you could sell $100 billion worth of currency if you had the capital to do it. If your biggest Japanese client, who also happens to golf with Toshihiko Fukui, the Governor of the Bank of Japan, told you on the golf course that BOJ is planning to raise rates at its next meeting, you could go right ahead and buy as much yen as you like. No one will ever prosecute you for insider trading should your bet pay off. There is no such thing as insider trading in FX; in fact, European economic data, such as German employment figures, are often leaked days before they are officially released.
Before we leave you with the impression that FX is the Wild West of finance, we should note that this is the most liquid and fluid market in the world. It trades 24 hours a day, from 5pm EST Sunday to 4pm EST Friday, and it rarely has any gaps in price. Its sheer size (it trades nearly US$2 trillion each day) and scope (from Asia to Europe to North America) makes the currency market the most accessible market in the world.
Where is the commission in FX?
Investors who trade stocks, futures or options typically use a broker, who acts as an agent in the transaction. The broker takes the order to an exchange and attempts to execute it as per the customer's instructions. For providing this service, the broker is paid a commission when the customer buys and sells the tradable instrument. (For further reading, see our Brokers And Online Trading tutorial.)
The FX market does not have commissions. Unlike exchange-based markets, FX is a principals-only market. FX firms are dealers, not brokers. This is a critical distinction that all investors must understand. Unlike brokers, dealers assume market risk by serving as a counterparty to the investor's trade. They do not charge commission; instead, they make their money through the bid-ask spread.
In FX, the investor cannot attempt to buy on the bid or sell at the offer like in exchange-based markets. On the other hand, once the price clears the cost of the spread, there are no additional fees or commissions. Every single penny gain is pure profit to the investor. Nevertheless, the fact that traders must always overcome the bid/ask spread makes scalping much more difficult in FX. (To learn more, see Scalping: Small Quick Profits Can Add Up.)
What is a pip?
Pip stands for "percentage in point" and is the smallest increment of trade in FX. In the FX market, prices are quoted to the fourth decimal point. For example, if a bar of soap in the drugstore was priced at $1.20, in the FX market the same bar of soap would be quoted at 1.2000. The change in that fourth decimal point is called 1 pip and is typically equal to 1/100th of 1%. Among the major currencies, the only exception to that rule is the Japanese yen. Because the Japanese yen has never been revalued since the Second World War, 1 yen is now worth approximately US$0.08; so, in the USD/JPY pair, the quotation is only taken out to two decimal points (i.e. to 1/100th of yen, as opposed to 1/1000th with other major currencies).
What are you really selling or buying in the currency market?
The short answer is "nothing". The retail FX market is purely a speculative market. No physical exchange of currencies ever takes place. All trades exist simply as computer entries and are netted out depending on market price. For dollar-denominated accounts, all profits or losses are calculated in dollars and recorded as such on the trader's account.
The primary reason the FX market exists is to facilitate the exchange of one currency into another for multinational corporations who need to trade currencies continually (for example, for payroll, payment for costs of goods and services from foreign vendors, and merger and acquisition activity). However, these day-to-day corporate needs comprise only about 20% of the market volume. Fully 80% of trades in the currency market are speculative in nature, put on by large financial institutions, multi-billion dollar hedge funds and even individuals who want to express their opinions on the economic and geopolitical events of the day.
Because currencies always trade in pairs, when a trader makes a trade he or she is always long one currency and short the other. For example, if a trader sells one standard lot (equivalent to 100,000 units) of EUR/USD, she would, in essence, have exchanged euros for dollars and would now be "short" euro and "long" dollars. To better understand this dynamic, let's use a concrete example. If you went into an electronics store and purchased a computer for $1,000, what would you be doing? You would be exchanging your dollars for a computer. You would basically be "short" $1,000 and "long" 1 computer. The store would be "long" $1,000 but now "short" 1 computer in its inventory. The exact same principle applies to the FX market, except that no physical exchange takes place. While all transactions are simply computer entries, the consequences are no less real.
Which currencies are traded?
Although some retail dealers trade exotic currencies such as the Thai baht or the Czech koruna, the majority trade the seven most liquid currency pairs in the world, which are the four majors:
EUR/USD (euro/dollar)
USD/JPY (dollar/Japanese yen)
GBP/USD (British pound/dollar)
USD/CHF (dollar/Swiss franc)
and the three commodity pairs:
AUD/USD (Australian dollar/dollar)
USD/CAD (dollar/Canadian dollar)
NZD/USD (New Zealand dollar/dollar)
These currency pairs, along with their various combinations (such as EUR/JPY, GBP/JPY and EUR/GBP) account for more than 95% of all speculative trading in FX. Given the small number of trading instruments - only 18 pairs and crosses are actively traded - the FX market is far more concentrated than the stock market.
What is carry?
Carry is the most popular trade in the currency market, practiced by both the largest hedge funds and the smallest retail speculators. The carry trade rests on the fact that every currency in the world has an interest rate attached to it. These short-term interest rates are set by the central banks of these countries: the Federal Reserve in the U.S., the Bank of Japan in Japan and the Bank of England in the U.K. (To learn more, see What Are Central Banks?)
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The idea behind the carry is quite straightforward. The trader goes long the currency with a high interest rate and finances that purchase with a currency with a low interest rate. In 2005, one of the best pairings was the NZD/JPY cross. The New Zealand economy, spurred by huge commodity demand from China and a hot housing market, has seen its rates rise to 7.25% and stay there (at the time of writing), while Japanese rates have remained at 0%. A trader going long the NZD/JPY could have harvested 725 basis points in yield alone. On a 10:1 leverage basis, the carry trade in NZD/JPY could have produced a 72.5% annual return from interest rate differentials alone without any contribution from capital appreciation. Now you can understand why the carry trade is so popular! But before you rush out and buy the next high-yield pair, be aware that when the carry trade is unwound, the declines can be rapid and severe. This process is known as carry trade liquidation and occurs when the majority of speculators decide that the carry trade may not have future potential. With every trader seeking to exit his or her position at once, bids disappear and the profits from interest rate differentials are not nearly enough to offset the capital losses. Anticipation is the key to success: the best time to position in the carry is at the beginning of the rate-tightening cycle, allowing the trader to ride the move as interest rate differentials increase.
FX Jargon
Every discipline has its own jargon, and the currency market is no different. Here are some terms to know that will make you sound like a seasoned currency trader:
Cable, sterling, pound - alternative names for the GBP
Greenback, buck - nicknames for the U.S. dollar
Swissie - nickname for the Swiss franc
Aussie - nickname for the Australian dollar
Kiwi - nickname for the New Zealand dollar
Loonie, the little dollar - nicknames for the Canadian dollar
Figure - FX term connoting a round number like 1.2000
Yard - a billion units, as in "I sold a couple of yards of sterling."
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