the real action wasn't in the stock market, which ended flat for the session and slightly down for the quarter, or the bond market, which was volatile but lower only modestly on the day. It wasn't even in the commodities market, despite the fact corn was limit down on a bearish crop report.
Nope, the big move was in the currency market, where the dollar tumbled on news the U.S. would unveil a new protectionist trade policy designed to aid domestic paper producers against subsidized Chinese imports. From the Indian rupee to the Norwegian krone, the value of foreign currencies world-wide gained sharply on the good ol' greenback.
Those types of moves are now profit opportunities, amazing considering the reality that individual trading in the foreign-exchange market is still a relatively new phenomenon. As recently as 1970, the value of the world's currencies was still fixed based on the Bretton Woods agreement, crafted back in 1945. Foreign-exchange trading only took place at the official rates of exchange, and unlike the stock or bond markets, individuals were prohibited from participating. It's a well-known legend that Nobel-prize-winning economist Milton Friedman attempted to short the British pound with a local bank, but was refused by bankers because he did not have a legitimate commercial interest.
Thankfully, times have certainly changed. Foreign exchange is now the largest market in existence, with more than $1.5 trillion traded each day. That amounts to more than 100 times the daily trading volume on the NYSE. A large percentage of the trading is speculative, exactly what Friedman attempted to do just over a quarter century earlier.
Ironically, more of that foreign exchange now gets executed through the NYSE, using the innovative CurrencyShares products we've mentioned numerous times over the past year or so. As you might recall, these are ETFs that hold foreign currency, such as the euro, yen or Swiss franc. For most investors just getting started with the asset class, these offer an excellent, unleveraged way to gain exposure. There's also the PowerShares DB U.S. Dollar Bullish fund and PowerShares DB U.S. Dollar Bearish fund, profiled here last month, which are essentially bullish/bearish index funds for placing bets on the dollar.
For the more advanced trader, particularly one looking to trade overnight or deal in more exotic strategies, there are two additional alternatives. Since 1972, futures on foreign exchange have been traded at the Chicago Mercantile Exchange. Requiring initial margin requirements that start around $2,000, these futures function in a similar fashion to the e-Mini stock index futures popular with active traders. Contract sizes are standardized and, once the performance bond is deposited with a futures broker, they are available for electronic trading on Globex virtually around the clock.
More recently, however, a new breed of online foreign-exchange dealers have emerged offering "spot" FX to customers, ranging from large funds to tiny mom-and-pops. It's a high-risk, potentially high-reward endeavor that's gaining considerable attention from bored stock speculators looking to up their game. Given the vast advancement in technology and quickly emerging capital trends, I predict spot FX will soon become the hottest game in town. Shortly put, this is the new Wild West.
For those unfamiliar with the asset class, the first thing to note is that unlike the stock market, foreign exchange is not executed on a central exchange, but traded OTC (over-the-counter) among banks, dealers, funds and private investors all over the world. The global nature of FX means that, with the exception of a slight lull on the weekend, it is a 24-hour market that never sleeps.
Stocks are traded either between investors and dealers (market markers or specialists) or investors and other investors. But foreign exchange, specifically the online FX web sites catering to retail investors, is traded directly with a dealer. This explains why most online dealers offer commission-free trading: Customers are constantly buying and selling with the dealers, allowing them to make money simply by continuously posting two-sided markets. They profit on the difference between the bid/offer (the "spread"). From a trader's perspective, the best online dealers are those with the tightest spreads.
Even for neophyte investors, buying shares of stock is a fairly straightforward process. Buy 100 shares of General Electric and you own an equity interest in the company. Your profit (or loss) is determined to the extent that GE rises and falls, along with any dividends GE throws off during the period you own the stock. We're all quite familiar with that game.
Currency is fundamentally different, however, because trades involve relationships between two entities. Trading a currency involves the simultaneous buying of one currency while selling another. The hope is that one buys a currency that will appreciate relative to the currency that has been sold.
This difference makes even understanding how to quote currency a slightly more confusing endeavor. After all, stocks are quoted simply in terms of share price. But currencies are quoted in terms of the currency pair. For instance, one doesn't simply buy or sell the U.S. dollar, but trades it against another currency. When referencing the value of the U.S. dollar against the Canadian dollar, for example, a recent quote would be somewhere around USD/CAD=1.1528.
The quote specifies how many Canadian dollars you have to pay to buy one U.S. dollar, or, conversely, how many U.S. dollars you'd get when you'd sell one Canadian dollar. In a currency pair, the first currency quoted, which usually happens to be the U.S. dollar, is referred to as the base currency. The second currency, in this case, the Canadian Dollar, is referred to as the quote currency.
If you wanted to wager the U.S. dollar would rise against the Canadian dollar, you'd go long (buy) the USD/CAD pair. Conversely, if you felt the U.S. dollar would weaken relative to the Canadian dollar, you'd short USD/CAD. Of course, there are many active FX crosses, such as EUR/CZK (euro/Czech koruna), GBP/JPY (British pound/Japanese yen), AUD/NZD (Australian dollar/New Zealand dollar), that don't involve the U.S. dollar at all.
Almost all online FX dealers offer a real-time simulation where one can practice trading without using real money. This is vitally important to do, because while many of the basic elements of trading do transfer to foreign exchange, it is indeed another asset class with numerous differences. Regardless of how many years you've been trading stocks, I cannot stress how important it is to paper-trade for a few weeks to become more familiar with FX's terminology, nuances and execution.
Most notable is the leverage. In equities, trading on margin means an individual can borrow up to 50% of a stock's value. If you want to buy 100 shares of Johnson & Johnson at $60 a share, that will cost you $6,000. The maximum you can borrow would be 50%, meaning you put down $3,000 and borrow the remaining $3,000 from your broker, on which you'll pay interest.
In FX, however, margin represents the minimum balance required to take a position, and most dealers offer leverage that would make Aramanth's Brian Hunter blush. It isn't uncommon to see ratios of 20:1, 40:1, even 100:1. Using 100:1 leverage, which I would not recommend, allows you to control $100,000 worth of currency with just a $1,000 deposit. As you might expect, this greatly magnifies the potential profit (or loss) available on a small initial investment. For most traders, especially those just starting out, I think 20:1 is plenty of juice.
While I'm not going to specifically recommend any one broker, I think one should use a large, well-known name that's based in the U.S. and registered with one of the major regulatory agencies, such as the NFA or CFTC. Each offers its own set of online analysis and charting tools, so you'll want to find the platform you find most appealing before going ahead and opening an account.
Regardless of who you trade with, I'm of the mind this is an asset class whose time has come, and strongly believe we are in the early innings of a seriously big game.
Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC. At the time of writing, Hoenig's fund held positions in many of the securities mentioned.>