Archive for June, 2009

Classical economics has sought and failed to explain short-term exchange rate moves on a consistent basis. Currency economics is an attempt to fine tune economic theory to the practical relevance of the currency market. Broadly speaking, it seeks to analyse those aspects of the economy that are relevant to the exchange rate value, such as:
Trends within the balance of payments, including the current and capital accounts;
The accounting identity for economic adjustment ( S ? I = X ? M );
The Real Effective Exchange Rate (REER) and the external balance;
Relative productivity measures.
Naturally, all other aspects of the economy should be considered such as growth, inflation and so forth, but the ones mentioned above are the key indicators relevant for our purpose of currency analysis and strategy. Growth per se does not make a currency rise or fall on a consistent basis. Currency market practitioners, while keeping an eye on other parts of the economy as well, should seek to focus primarily on those specific aspects of the economy that affect the exchange rate.

Readers who are familiar with most serious works on currency markets, which deal with the issue of currency speculation, will be familiar with the fact that most do so from the perspective of economic theory. That is to say, most look at the act of currency speculation in terms of its role relative to the specific types of exchange rate regimes, within the context of the overall economy. For instance, there have been several works that look at currency speculation relative to “target exchange zones”. Optimal currency areas are in this specific sense those which are sufficiently strong and balanced to be able to deter most currency speculation and withstand that which is foolish enough to try.
There is nothing out there — and I have searched — on how to be a better currency speculator. Again, I realize this may cause a reaction within some. I must only reiterate that I see currency speculation neither as a benign nor as a malign force. Currency speculation does provide needed liquidity to those areas seen as productive within the economy. It also acts as a necessary arbiter of economic policy. Governments are answerable to the voters, but they are also answerable to financial markets, just as a board is answerable to its shareholders. Equally, governments must ensure against excess within those markets. The balance between the two is a delicate one, a dynamic one that changes over time. Both sides are cause and effect. There must be regulation and there must also be free markets, not least because all alternatives have been tried and have proved miserable failures. Completely unfettered, unregulated markets may prove chaotic and damaging. Equally, overly regulated markets may stagnate. Currency speculation plays a useful role as regards the overall health and vitality of the financial markets. Granted, this has been a role which has been little understood.
So, how to be a better currency speculator? As we have seen above, there are many techniques for currency speculation, depending on the framework one uses to analyse the market. I would suggest however that there are some guiding principles in the art of currency speculation, which should help speculators generate consistent excess returns. My perspective is that of an adviser rather than a trader. Having watched the currency markets for over a decade and in the process benefited from the knowledge and experience of the hundreds of currency market contacts that I have made or come into contact with, as an emerging market currency strategist I advise a bank’s traders, sales and clients on what are the best trading and hedging strategies within emerging market currencies. The recommendations that I have made are compiled in an EMFX leveraged model portfolio1 which produced annual cumulative simple returns of 46.3%, 25.9% and 47.1% in 1999, 2000 and 2001, respectively. As a result, I feel reasonably qualified to make some suggestions, which though they may undoubtedly not prove definitive at the very least add to the debate.
(1) An integrated approach — The most powerful, consistent form of currency analysis and therefore of currency speculation is that which brings together all the main analytical disciplines to create a combined trading signal. Fundamentals may or may not be enough on their own. However, currency speculators who want to create consistent outperformance and high excess returns do not deal with “maybes”. Fundamental, technical, flow and valuation analysis need to be coordinated and integrated to provide the clearest picture of what is going on in the market and how one can profit from it. This is the heart of currency economics that I have tried to impart. A very simple and effective discipline is to create a signal grid for these four types of analysis and stick to it rigorously. Only when at least 3 of 4 readings are showing “green” or “red” should one put on a major new position. The advantage of this is that it should greatly reduce the bias created by relying only on one analytical type.
(2) Risk appetite — Use a risk appetite indicator as a gauge of overall market sentiment and as a benchmark against which to measure your positions. The one I mentioned in earlier posts is an excellent one, the Instability Index, but there are others. When your signal grid is showing no clear signal, but the risk appetite indicator is in risk-neutral or risk-seeking mode, go long a basket of higher carry currencies, albeit selectively chosen, in order to boost the total return. When the risk appetite indicator moves from risk-seeking to risk-neutral, take half your profit. When it moves from risk-neutral to risk-averse, cut your position entirely and go short the carry basket of currencies you have used. This strategy, used in a disciplined way, can add significantly and consistently to your total return, particularly during periods when the signal grid is showing mixed signals (which will be most of the time).
(3) Trading discipline is at least as important as having the right view — A currency speculator can have the right view but bad trading discipline can reduce or even reverse trading profits. The view should be the unequivocal result of the combined trading signal from the four analytical disciplines, or as a result of the risk appetite indicator. There is nothing else to consider. “Gut feel” can earn excess returns for a period of time if you are a good and experienced currency speculator, but it is not enough on its own. Eventually it will result in you getting burned. The more overconfident you are, the more badly you are likely to get burned. As regards positions, the entry, exit and stop levels should be decided by flow and technical considerations. Run profits, depending on technical and flow developments. Always cut losses. The field of behavioural finance teaches us what we know intuitively, that it is much harder to cut a position, whether it is running a profit or a loss, than to initiate it. Hoping or wishing a position to come back in your favour is a beginner’s mistake. Be disciplined and that means at times being ruthless. Not cutting losses is the easiest and the most efficient way of destroying your total return.
(4) Emotion comes before a fall — Currency speculation is about making money pure and simple. There should be no emotional aspect to it. It is neither moral nor immoral. Furthermore, try to remain detached from your P&L to the extent that it does not affect your trading approach. Great danger lies in the making of both profit and loss. The more profit you make, the more your view of financial markets appears to be confirmed and the more overconfident you become. Many have produced incredible results speculating against market inconsistencies to the point where they appeared to believe they were the market. That is usually the signal that the good times are about to end. Losses can also be dangerous because they make you loss averse and thus reduce the amount of potentially profitable opportunities you can take advantage of.
(5) Less is more — Take fewer trading positions rather than more for two reasons. Firstly, a small number of trading positions is more easily managed than a larger number of positions, and that takes us back to point 3. Secondly, currency speculation is the pursuit of inconsistency in currency market pricing. There are rarely a very large number of inconsistencies at any one time, not least because if it were that easy we would all be doing it. The aim of creating the signal grid and using the discipline of the risk appetite indicator is to trade on sure-fire winners and nothing else. A portfolio that has a very large number of positions suggests a portfolio that is trading on more than sure-fire winners, a portfolio that is increasingly relying on such vague concepts as luck, hope, belief and emotion. Currency speculation is not a game, it is not betting and there should be no luck involved. If there is, you have the wrong position. Cut it.
(6) Speculators make predictable mistakes — Everyone makes mistakes and currency market practitioners are no different. However some mistakes are more predictable than others. In this regard, there are three key themes of behavioural finance that should be considered as a guide to the usual mistakes made, and therefore how to avoid making them in the future. Readers who have well understood the points above will of course note that the mistakes below refiect straying from the signal grid and the risk appetite indicator:
Heuristic-driven mistakes — Currency speculators frequently rely on “heuristics” or rules of thumb in relation to their approach to trading. For instance, one such heuristic or rule of thumb can be that previous trends will continue. If something has gone up for six weeks it will go up for a seventh and an eighth. Heuristic-driven trading is biased in that the very act of establishing a rule of thumb approach to one’s trading refiects one’s past experience. Because of their reliance on heuristics, or rules of thumb, currency speculators can hold biased beliefs that make them vulnerable to committing errors, errors which result in painful losses.
Frame dependence — This idea deals with the distinction between form and substance. Framing is about form. Frame dependence means that the results of one’s currency view are dependent on the frame or framework within which one focuses one’s view and thoughts. Frame dependence can deal not only with one’s fundamental view but also one’s approach to trading generally. One can be loss averse, meaning that one is far more reluctant to make a certain-sized loss rather than put on the risk necessary to make that level of profit. Losses result in emotion, which results in regret, which in turn alters the frame one uses to look at markets.
Markets are inherently inefficient — The idea offinancial markets being perfectly efficient is an elegant nonsense, which clearly deals with a perfect rather than a human being. Market mispricing happens all the time. Heuristic and frame dependence create consistent errors and therefore consistent losses. Learning how to distinguish such behavioural patterns means one can reduce such losses.
Heuristics, frame dependence and any belief in the supposed efficiency of financial markets are all aspects that lie outside of the rigorous trading discipline of the four analysis signal grid and the risk appetite indicator. For those currency speculators who use the rigorous, disciplined approach, there are no such things as “rules of thumb”. In addition, the very act of using four types of analysis rather than just one should eliminate the risk of frame dependence.

Let’s focus on currency speculators who use technical analysis, either primarily or solely in order to determine their trading in the currency markets. Again, I have found that it surprises some economists that such people exist, not least because it flies in the face of the view that markets are efficient and that pricing is therefore irrelevant. My answer and more importantly the answer of the technically-based currency speculators themselves is that markets are not perfectly efficient, though they are predictable to an extent and technical analysis helps with that. There are a number of schools of thought within technical analysis, such as Elliott Wave, Gann and Fibonacci. A good technically-based currency speculator would use a number of types of technical analysis, not least to test their core view before executing the position. As with other types of currency trading, technical traders can be short or long term in their approach. More generally however, all are looking for trading opportunities using existing market pricing, either for or against the existing trend.