Part 5 (1/2)
The model currency trader might make a dozen significant trades in a year a”by significant I mean not backing hunches but trades in which he/she backs conditions where aall the pieces fita, Two or three of these trades will account for most of the yearas net trading profit: of the remainder , perhaps 4 will make money and 5 will lose money and they may more or less cancel out. And this he will do year in year out a” shooting 69/71/70; very rarely 64, and when he shoots 64 it will probably be because he wasnat stretching himself and didnat feel he was running much risk a” like the Zen archer* who hits the target with actually taking aim.
CHAPTER NINE.
The most remarkable performances in the investment world in recent years have been achieved by people, or .funds, operating in the .futures markets a”and increasingly in financial. futures. George Soros* was a pioneer in what me might call aThe New Investment Way. a The currencies markets have been central to the investment approach of Sorosa Quantum* Fund, in which James Rogers was a partner for a time, and which grew from a few million to over $2bn. Currencies are the most important market for Bruce Kovneras Caxton Corporation, which has overtaken the Mint group in size. The success of these .funds should have changed the way people think about currencies. But the change is coming about very slowly.
A freight agent in the Persian Gulf was chartering planes to bring in electrical equipment. The agent paid his charter cost in dollars but agreed to accept payment for the freight in Belgian francs. On one occasion, a sharp rise in the dollar cost him all of his profit margin plus about the same amount again. He resolved never to expose himself to a comparable currency risk again. Moreover as he pondered the way a move in the dollar had amounted to twice the profit margin on the freight, he further resolved to study the currency markets in depth; and in due course, perceiving that there could be no half measures with currency risks, he left the freight agency business to devote all his time to the a.n.a.lysis and trading of currencies.
The first thing we have to decide in currencies is once and for all to separate occupational risk from performance aims. Occupational risk is exposure incurred as a by-product of your situation a”whether it be the commercialas problem of currency receivables and payables or the investoras risk in holding foreign a.s.sets or liabilities. Performance is to do with making money .Bankers usually blur the difference. But you and I should have no truck with fuzzy thinking which encourages one to muddle riska” perception and performance: you end up muddling fear and greed.
Itas up to you to decide what occupational risk you can stand: what you canat stand you should eliminate by hedging, taking into account the costs involved. Having done that, you are free to pursue performance any way you like. This book is about the pursuit of performance in the currency markets; and this chapter is about how to set about it in practice. Itas addressed to investors, to fund managers including treasurers, to other speculators, and to commercials concerned with the timing of currency purchases and sales. Youare already on your way to being knowledgeable a.n.a.lyst and a keen forecaster .
Trading forward, trading future
You can deal in the currency markets in 3 ways a” cash*, forward* or futures*. The cash (or aspota, as in cash-on-the-spot) and forward markets are made by banks: they decide the rates at which they will deal. They have no currency aexchangea, in the way you have a stock exchange, or a futures exchange. The equivalent of a quotations board is the video screen where the buying and selling rates of specific banks in specific financial centres are purveyed through the agency of Reuters, Knight-Ridder and others. This is the so-called ainter-banka market.
Interbank Market.
The banks provide a very compet.i.tive service to large clients who are able to pick and choose between their quotations, as multinationals are and as brokers are; and they provide the only service for the aspota market, and for all currencies other than the main areserve*a currencies. But for centuries, people have wanted to settle their commercial dealings at a future date a”to pay for the goods a after the s.h.i.+p comes ina, for example. However they often wished to settle the rate for conversion between two currencies now. This is just the kind of thing bankers are happy to do if they are handsomely remunerated.
So for centuries bankers have been quoting rates for forward dates. This is the forward* currency market, in which rates are quoted for almost any date in the future. The way forward rates differ from spot rates has been described in Chapter IV .It is determined mathematically by the difference in interest yields on the currencies in question: if 6-month interest rates on the two currencies happened to be exactly the same, the 6-month forward rate would be the same as the spot rate.
In the early 1970s, after currencies had begun to float, some luminaries in the futures markets of Chicago said aHey! Why donat we start up a futures markets in these currencies, just like in corn and hogs.a There was no reason why not. To Chicagoans, and Texans and Californians et al, foreign currencies were not that different from corn and hogs and copper and gold, and few Americans knew much about the interbank market in currencies. So they went ahead and the first financial futures were born a” to be followed by futures in T-Bonds and stock indices and Eurodollars and the rest.
IMM Futures Market.
The currency futures markets in Chicago thrived, partly because of the thinness of the interbank currency markets in North America. Of course they quoted the foreign currencies in dollars and cents, just as they quoted hogs and corn in dollars and cents. So their method was to quote the D-Mark as, say , l DM = 29.5c or $0.2950, rather than the European way of $1 = DM 3.390. And the future settlement dates were fixed at specific quarterly dates in March, June, September and December. But in other respects, the afuturea was much the same as the forward. And if the price of mid-June D-Marks got too high in relation to the forward interbank rate, someone would arbitrage* the difference by selling the future in the IMM* (International Money Market) exchange and buying the forward in the interbank market.
Contrary to the conventional wisdom prevailing in Europe, I suggest you donat deal in the forward interbank market, unless you deal in very large size, through a broker or through a fair selection of banks, who will accommodate you through most of your normal waking day (see Chapter One). If you deal in the futures market, one broker should suffice. The one essential you seek in your broker is immaculate execution. Thatas all. But it does include always answering the telephone instantly; being available from 7.30 am a” 8.30 p.m. London time; offering 24 hour execution of stops; and complete honesty in all things, notably in the matter of the price at which your trades are executed.
In addition to the big US brokers, such as Merrill Lynch, Prudential Securities, Shearson-Lehman, there are many smaller outfits which can offer a more personal service at compet.i.tive commission rates. See abroker*a in the Glossary. Some of these advertise from time to time in the financial papers.
The 24-hour day covers Singaporeas Simex* futures market as well as Chicagoas IMM: the currency contracts at Simex are interchangeable (afungiblea is the technical term) with the IMMas. But in addition, the so-called EFP* market offers IMM quotations at most times when an active interbank market exists somewhere in the world. EFP stands for aexchange for physicala: the EFP market consists of a number of specialist market-makers, who are in the business of arbitraging between futures contracts and the aphysicala interbank forward markets. Like the banks, they make their turn on the aspreada between offer and bid prices: the spread is usually 3 to 5 points (as opposed to 1 point in the IMM) a” i.e. $37.50 to $62.50, on contracts of $70,000-$120,000 a”which is very compet.i.tive with the spreads quoted by banks for such amounts.
The amount of currency exposure a bank will allow you to run is a matter for negotiation. The IMM operates a amargin*a system, as do all futures markets a” margin being money you have to ante up to cover the risk in a futures position. The margin for the currency contracts a” DM, SF, , Yen, Can $ and Aus $ a” varies around $2,000, which is a mere 2 or 3% of the contract value. If you have any sense, you will never care a” or even know a” what this margin is. It bears no relations.h.i.+p to the kind of gearing or leverage with which you can expect to trade profitably. Not being in the business of blind gambling, our inflexible rule must be: never , ever, risk a margin call*. Itas difficult enough to win without such an extraneous constraint which abolishes the use of judgement.
We know the currencies can fluctuate up to 5% in a day, and we know we may well wish to hold our position in the event of such a fluctuation against us. Itas a good idea to hold a balance in your brokerage account of 10% of exposures ($10,000 per contract on average in round figures), in US dollars; and to limit overall exposures to a maximum of 3 times oneas overall liquid capital. In other words, keep 30% of your liquid capital in the brokerage account, if your exposures are likely to run up to the recommended limit. You should earn proper interest on funds in excess of margin requirements with your broker.
Position Size*.
Experience shows that to trade the multi-week swings successfully, you have to be prepared for drawdowns* (paper losses) in double figures if youare running to 3 to 1 gearing (leverage), just as a result of the natural fluctuations in currency holdings a”that is without even making mistakes. Getting reconciled to that is a major step on the road to winning, I think. If we cannot accept it, we cut back our gearing.
Achieving currency exposures of up to three times oneas liquid funds with a deposit of 300/0 of those funds with a broker is a reasonably conservative approach. At the other extreme is the investor who has a lump sum in cash and has settled for depositing it in one or more foreign currencies, aiming thus to secure diversification and protection from a decline in his own currency.
You can also do your sums by long division on paper, and go to work on a horse. If you chose to proceed in this way knowing about the capabilities of calculators and motor cars, thatas fine. But there are many people out there who think futures are just intrinsically dangerous a” as people once thought about motor cars. And the fact is that not everyone knows that you can get all the currency exposures you want in the forward and futures markets without tying up all your cash. And once you know, you see that you can do much more in the futures and forward markets than you can do with cash. In fact, you can get all the exposure you want in the futures markets to most bond markets and most stock markets. And I personally can see many advantages and no disadvantages to going about it this way.
The New Way to Invest
Consider an investor in Britain a” call him Altman a” with 250,000 (say $420,000). He holds 100,000 in gilts, 50,000 in US bonds, 50,000 in D-marks and 50,000 in cash. His investment income (early 1991) is 25,000. He has cashed in his stock market holdings, and believes most stock markets are too risky. He also believes the dollar and sterling are both vulnerable against DM and Yen. So he thinks he may lose out on his US bond holdings.
Now consider another British investor with 250,000, called Newman. This is end-March 1991 and UK interest rates are still around 14%. He has 200,000 on deposit with Swiss Bank Corporation (an AAA-rated credit risk). The other 50,000 is held in a dollar account with a futures broker. His investment income is 32,000.
His investment views are much the same as Altmanas. In his brokerage account he is short a couple of Long Gilt futures (90,000 a”$175,000); long two US T-Bond contracts ($190,000) and a German Bund contract (DM 210,000 or $120,00). He also has 8 IMM Yen futures ($720,000) and 2 DM futures ($145,000) and is short 2 pound contracts ($240,000). He is planning a put option in the S & P US stock market future.
Altman is no fool. He knows that the kind of returns stock markets a”and the property market a” offered in the 1980s are non-recurrent. His target is a 15% total return on his money, and perhaps heall make it.
Newman is no fool either. In the past5 years, he has parlayed 100,000 into 250,000. He reads all the good books on investment as they appear a”particularly those on trading futures. His target for the next 5 years is to turn his 250,000 into lm and for the next 10 years into 5m. He knows something about risk, having lost a bundle in high-tech stocks in the 1980s. I think maybe heall make it.
Using Currency Options
As a matter of course, currency options* are not a solution to the problem of currency risk, or of normal adverse fluctuation (drawdown) a”though useful to traders who place a high value on having maximum loss defined. Ideally, options should be used as a tactical weapon, particularly when bottoma” fis.h.i.+ng. There is little to be lost and something to be gained by using more distant option maturity months a”the most distant consistent with market liquidity. Beginners are drawn to the nearer option months, because the outlay is smaller. This tends to be a false economy.
Numerate readers may be drawn to the idea of selling options rather than buying them a” feeling that this way you tip the odds in your favour.
From experience, I donat recommend it, for two reasons. 1) The price of currency options doesnat justify it. 2) It distorts your trading judgement: and we have too good a forecasting system for the dollar to want to jeopardise it for the sake of a couple of percentage points!
The best way to get a feeling for the valuation of options is to consult the pages of the Wall Street Journal regularly. The IMM options on futures are much more liquid than the Philadelphia variety, which are convertible into the cash currency: stick to the IMM. Three-month options aat-the-money*a cost a little under 2.5% of contract price in normal times. My rule of thumb for valuing options is to take the 2 calls and 2 puts at strike* prices nearest to the current market price and divide by 4: then divide by the market price to get a percentage figure.
The tactical use of options? We want to use options when they are economical, relative to using outright futures or forward positions. The acid test is that they should reduce our stake, for a similar reward. Our stake is the amount we are prepared to lose if a trade goes wrong, and it can be defined by our stop-loss limit on outright futures. In cases where we see fit to place our stops rather deep, the use of options may prove more economical. You can calculate on the basis of 2 at-the-money 3-month options per futures contract or the equivalent in the forward market. Itas not a bad idea to calculate the sum in actual dollars. An IMM option standing at 100 costs $1,250.
The other aspect of options is psychological. Our system of a.n.a.lysing the currencies is designed to aget us in at the starta of a new move. That means we are often abottom-fishersa whether we like it or not; and we know we canat catch absolute bottoms. So we have to cope with the kind of volatility you get at bottoms (or tops: thereas no distinction in currencies) a”which can be a stomach-churning exercise. With this, options can help greatly, because they lose value increasingly gradually in the event of adverse price movement. Conversely, when the script is right and the gamble pays off, options gain value at an increasing pace. Thus our dollar exposures increase and that can help to remind us a” when weare in danger of thinking weare smart a” that our risk has risen geometrically. So weare positively encouraged to take partial profits, which is alright as a percentage play.
CHAPTER TEN.