Why Trade Currencies?

Every website on currency trading seems to have the mandatory section on “why trade currencies?”. Sorry but I can’t leave this one alone on my blog as there is some smelly marketing hype going on here. The answer most sites provide for benefits of trading the currency markets usually include the following:

Every website on currency trading seems to have the mandatory section on “why trade currencies?”. Sorry but I can’t leave this one alone on my blog as there is some smelly marketing hype going on here. The answer most sites provide for benefits of trading the currency markets usually include the following:

 

24 hour market
Superior liquidity, with more than $3 trillion per day change hands every day
Access to high leverage (if you want it)
Market makers offer rapid execution of orders with low slippage and low spreads
There are no up tick rules for opening short position

Some of the uncommon reasons for trading currencies I have seen include:

The liquidity in the FX markets is such that it is near impossible for a specialist to dominate a currency market
Unlike in the stock market, where inside information is king, most traders have equal access to the underlying fundamental information driving the currency markets
I have to agree with the points listed above. The lack of insiders and specialists is one of the reasons why I love currencies. The other reasons why I love currencies is I can exercise my secret desire to play closet macro-economist and I must admit there is a real buzz in watching something unfold in the currency markets days or weeks before it hits the mainstream media.

Trends in the Currency Markets
One motivation I frequently see quoted about the forex markets is they “trend well”. Oh please … yes currency markets do trend … but my experience has been that currency markets are no more likely to trend more than any other market.

I went searching for this history of this piece of marketing hype. The most commonly cited source was from John Murphy’s book on “Technical Analysis of the Financial Markets“. Murphy’s book only makes a passing reference to the long term visible trends that were occurring in the currency markets in the nineties. Murphy hardly provided quantitative evidence on this topic.

If you go searching in the academic literature, the origin does become clearer. There is a commonly cited research paper published in the early nineties by Evans titled: “Trends and Excess Returns in Currency and Bond Markets“. The paper did indeed find that trends do occur:

“Recent empirical evidence finds that asset prices are characterized by processes subject to permanent shocks that cumulate into trends. By contrast, theoretical and empirical research usually treats excess returns as following processes subject to purely temporary shocks. The implicit assumption behind this treatment is that the permanent shocks to asset prices cancel out when they are combined to form excess returns. In this paper, we test this hypothesis for foreign exchange and bond returns. Surprisingly, we reject the hypothesis for a wide range of returns, suggesting that there are trends in excess returns. We offer two possible explanations for the presence of these trends.“

The explanation offers by Evans for the presence of tradeable trends include the widespread usage of trend following technical analysis techniques in the nineties and underlying differences between the countries economies.

However, when the same research was repeated in late 2006 by some researchers at San Diego State University, in a paper titled “Do Foreign Exchange Markets Still Trend“, the results are somewhat more sobering:

“We examine the major currency futures contracts which have been trading since the 1970s as well as more recent contracts on exotic currencies that have only begun to trade in the past few years. The main conclusion is that the era of easy profits from simple trend following strategies in major foreign currencies is over. The markets have adapted to the extent that profits from these simple trading strategies have vanished. Presumably, trending may be a feature confined to currencies in the early years of a floating rate regime. When we look at some newly trading currencies, we see more attractive profit opportunities. Newly trading currency futures prices, like their counterparts thirty years ago, appear susceptible to trend following trading strategies“

The “currency market trends well” is clearly just a sales pitch based on some dated research and is repeated to lour unsuspecting new traders into the market. The moral to the story is if you want long running trend trades be prepared to trade exotics, otherwise be prepared for a bumpy ride in the rest of the currency market.

Macrotactics is a blog devoted to recording a part time trader's journey into the world of trading currencies. In my day job I work as a manager in an Information Technology company. I live in sunny Queensland, Australia with my wife, a cat and a baby on the way. I have been banging my head on this trading thing for at least 3 years now and the deeper I dig into the topic of trading, the more I realise there is to learn. Trading for me has become... More