Applying rollovers

Rollover transactions are usually carried out automatically by your forex broker if you hold an open position past the change in value date.

Rollovers are applied to your open position by two offsetting trades that result in the same open position. Some online forex brokers apply the rollover rates by adjusting the average rate of your open position. Other forex brokers apply rollover rates by applying the rollover credit or debit directly to your margin balance. In terms of the math, it’s six of one, half a dozen of the other.

Here’s an example of how the rollover of an open position would work under each model:

Position: Long 100,000 AUD/JPY at a rate of 90.15 for a value date of January 10

At 5 p.m. ET, the rollover takes place and the following rollover trades hit your account. (Remember: This is done automatically by most online brokers.)

You sell 100,000 AUD,/JPY at 90.22 for a value date of January 10. (This trade closes the open position for the same value date.)

You buy 100,000 AUD/JPY at 90.206 for a value date of January 11. (This trade reopens the same position for the new value date.)

The difference in the rates represents the rollover points. (90.22- 90.206 = 0.014, which is expressed as 1.4 points.)

If the rollover is applied to your average rate on the open position, your new average rate on the position is 90.136. (Here’s the math: 90.15 - 0.014 = 90.136.) Because you’re now long from a lower average price, you earned money on the rollover.

If the rollover is applied directly to you margin balance, the rollover points are multiplied by the position size (100,000 x 0.014 = JPY 1,400 earned) and converted into USD (JPY 1,400 ÷ 116.00 [the USD/.JPY rate] = $12.07) and added to your margin balance.

Here’s what you need to remember about rollovers:

• Rollovers are applied to open positions after the 5 p.m. ET change in value date, or trade settlement date.
• Rollovers are not applied if you don’t carry a position over the change in value date. So if you’re square at the close of each trading day, you‘ll never have to worry about rollovers.
• Rollovers reflect the interest rate return or cost of holding an open position.
• Rollovers represent the difference in interest rates between the two currencies in your open position, but they’re applied in currency-rate terms.
• Rollovers constitute net interest earned or paid by you, depending on the direction of your position.
• Rollovers can earn you money if you’re long the currency with the higher interest rate and short the currency with the lower interest rate.
• Rollovers will cost you money if you’re short the currency with the higher interest rate and long the currency with the lower interest rates.
• Rollovers can have spreads applied to them by some forex brokers, which can reduce any interest earned by your position.
• Rollover costs/credits are based on position size - the larger the position, the larger the cost or gain to you.
• Rollovers should be considered a cost of doing business and rarely influence overall trading decisions.

If you're going to be trading a relatively large account with an online forex broker (say, over $25,000 in margin deposited), you’ll probably be able to negotiate a tighter rollover spread with your broker. This will enable you to capture more of the gains if you’re positioned the right way, or to reduce your cost of carry if you’re not. 

Value Dates and Trade Settlement

When we talk about currency trading, we’re implicitly referring to trading the spot forex market. A spot market is one that‘s trading for immediate delivery of whatever security is being traded. But in the real world, immediate means a few business days, to allow banks and financial firms time to settle a trade (make payment, deliver/receive a security).

In forex markets, spot refers to trade settlement in two business days, which is called the value date. That time is needed to allow for trade processing across global time zones and for currency payments to be wired around the world.

The forex market operates on a 24-hour trade date basis beginning at 5 p.m. eastern time (ET) and ending the next day at 5 p.m. ET. So if it’s a Monday, spot currencies are trading for value on Wednesday (assuming no holidays). At 5 p.m. ET on Monday, the trade date becomes Tuesday and the value date is shifted to Thursday. If you have an open position on Monday at 5 p.m. ET closing, your position will be rolled over to the next value date, in this case from Wednesday to Thursday, or a one-day rollover.

If you close your position the next day (Tuesday) and finish the trade date square, there are no rollovers because you have no position. The same is true if you never carry a position through the daily 5 p.m. ET close.

On Wednesday trade dates, spot currencies are normally trading for a Friday value date. At 5 p.m. ET on Wednesday, the value date changes from Friday to Monday, a weekend rollover. In rollover calculations, that’s a three-day rollover (Saturday, Sunday, and Monday), which means the rollover costs/gains are going to be three times as much as any other day.

The one exception to the two-day spot convention in FX are trades in USD/CAD. And that’s because the main financial centers in the United States and Canada share the same time zone, so communications and wire transfers can be made more quickly. USD/CAD trades settle in one business day. The weekend rollover for USD/CAD takes place on Thursday after the 5 p.m. ET close, when the value date shifts from Friday to Monday. This only applies to USD/CAD and not to other pairs involving CAD, such as CAD/JPY or EUR/CAD.

Market Holidays and Value Dates

Value dates are based on individual currency pairs to account for banking holidays in respective countries. Rollover periods can be longer if there is a banking holiday in one of the countries whose currency is part of the trade. For example, if it’s Wednesday and you’re trading GBP/USD, the normal spot value date would be Friday. But if there’s a banking holiday in the United Kingdom on Friday, UK banks are not open to settle the trade. So the value date is shifted to the next valid banking day common to the United Kingdom and the United States, typically the following Monday. In this case, the weekend rollover would take place at the close on Tuesday at 5 p.m. ET, when the value date would change from Thursday to Monday, skipping Friday‘s holiday. That‘s a four-day rollover (Friday, Saturday, Sunday, and Monday).

So what happens at the change in value date at Wednesday’s 5 p.m. ET close? No rollovers in GBP/USD, that’s what. Because the value date for trades made on Wednesday is already Monday, no rollover is needed because trades made on Thursday are also for value on Monday. That’s called a double value date, meaning two trade dates (Wednesday and Thursday) are settling for the same value date (Monday).

A few times each year (mostly around Christmas, New Year's, and Golden Week spring holidays in Japan) when multiple banking holidays in various countries coincide over several days, rollover periods can be as long as seven or eight days. So you may earn or pay rollovers of seven or eight times normal on one day, but then not face any rollovers for the rest of the holiday period. 

Understanding Rollover and Interest Rates

One market convention unique to currencies is rollovers. A rollover is a transaction where an open position from one value date (settlement date) is rolled over into the next value date. Rollovers represent the intersection of interest rate markets and forex markets.

Currency Is money, after all

Rollover rates are based on the difference in interest rates of the two currencies in the pair you’re trading. That’s because what you‘re actually trading is good old-fashioned cash. That’s right: Currency is cold, hard cash with a fancy name. When you’re long a currency (cash), it’s like having a deposit in the bank. If you’re short a currency (cash), it’s like having borrowed a loan. Just as you would expect to earn interest on a bank deposit or pay interest on a loan, you should expect an interest gain/expense for holding a currency position over the change in value.

The catch in currency trading is that if you carry over an open position from one value date to the next, you have two bank accounts involved. Think of it as one account with a positive balance (the currency you’re long) and one with a negative balance (the currency you’re short). But because your accounts are in two different currencies, the two interest rates of the different countries will apply.

The difference between the interest rates in the two countries is called the interest-rate differential. The larger the interest-rate differential, the larger the impact from rollovers. The narrower the interest-rate differential, the smaller the effect from rollovers. You can find relevant interest-rate levels of the major currencies from any number of financial-market Web sites, but marketwatch.com  and fxstreet.com  have especially-good resources. Look for the base or benchmark lending rates in each country.

So how do interest rates get turned into currency rates? After all, interest in rates are in percent and currency rates are, well, not in percent. The answer  is that deposit rates yield actual cash returns, which are netted, producing a net cash return. That net cash return is then divided by the position size, which gives you the currency pips; which is rollover rate.

The following calculation illustrates how this works. I’ve simplified matters by using just one interest rate for each currency. In the real world, each currency would have a slightly different interest rate depending on whether you‘re borrowing or lending (depositing).

Position: Long EUR/USD 100,000 at 1.3000 (long EUR/ short USD 130,000)

EUR interest rate: 3.50 percent per annum → 1 day = 0.035 x (1 ÷ 365) =

0.009589 percent

Euro deposit earns: 100.000 x 0.00009589 = EUR +9.59

USD interest rate: 5.25 percent per annum →1 day = 0.0525 x (1 ÷ 365) =

0.01438 percent

USD loan costs: 130,000 x 0.0001438 = USD -18.70

Because EUR/USD pips are denominated in USD, convert the EUR to USD: EUR 9.59 x 1.3000 = USD 12.47

Net the USD amounts 12.47-18.70 = USD -6.23 ÷ 100,000 = 0.0000623 

On a long EUR 100,000 position, the rollover costs 0.0000623 or -0.623 pips. 

Profit and Loss

Profit and loss (P&L) is how traders measure success and failure. You don’t want to be looking at the forex market as some academic or thrill-seeking exercise. Real money is made and lost every minute of every day. If you’re going to trade currencies actively, you need to get up close and personal with P&L.

A clear understanding of how P&L works is especially critical to online margin trading, where your P&L directly affects the amount of margin you have to work with. Changes in your margin balance will determine how much you can trade and for how long you can trade if prices move against you.

Margin Balances and Liquidations

When you open an online currency trading account, you’ll need to pony up cash as collateral to support the margin requirements established by your broker. That initial margin deposit becomes your opening margin balance and is the basis on which all your subsequent trades are collateralized. Unlike futures markets or margin-based equity trading, online forex brokerages do not issue margin calls (requests for more collateral to support open positions). Instead, they establish ratios of margin balances to open positions that must be maintained at all times.

If your account’s margin balance falls below the required ratio, even for just a few seconds, your broker probably has the right to close out your positions without any notice to you. In most cases, that only happens when an account has losing positions. If your broker liquidates your positions that usually mean your losses are locked in and your margin balance just got smaller.

Be sure you completely understand your broker’s margin requirements and liquidation policies. Requirements may differ depending on account size and whether you’re trading standard lot sizes (1 00,000 currency units) or mini lot sizes (10,000 currency units). Some brokers’ liquidation policies allow for all positions to be liquidated if you fall below margin requirements. Others close out the biggest losing positions or portions of losing positions until the required ratio is satisfied again. You can find the details in the fine print of the account opening contract that you sign. Always read the fine print to be sure you understand your broker’s margin and trading policies.

Unrealized and realized profit and loss

Most online forex brokers provide real-time mark-to-market calculations showing your margin balance. Mark-to-marker is the calculation that shows your unrealized P&L based on where you could close your open positions in the market at that instant. Depending on your broker’s trading platform, if you’re long, the calculation will typically be based on where you could sell at that moment. If you’re short, the price used will be where you can buy at that moment. Your margin balance is the sum of your initial margin deposit, your unrealized P&L, and your realized P&L.

Realized P&L is what you get when you close out a trade position, or a portion of a trade position. If you close out the full position and go flat, whatever you made or lost leaves the unrealized P&L calculation and goes into your margin balance. If you only close a portion of your open positions, only that part of the trade’s P&L is realized and goes into the margin balance. Your unrealized P&L will continue to fluctuate based on the remaining open positions and so will your total margin balance.

If you’ve got a winning position open, your unrealized P&L will be positive and your margin balance will increase. If the market is moving against your positions, your unrealized P&L will be negative and your margin balance will be reduced. FX prices are constantly changing, so your mark-to-market unrealized P&L and total margin balance will also be constantly changing.

Calculating profit and loss with pips

Profit-and-loss calculations are pretty straightforward in terms of math - it’s all based on position size and the number of pips you make or lose. A pip is the smallest increment of price fluctuation in currency prices. Pips can also be referred to as points, we use the two terms interchangeably.

I’m not sure where the term pip came from. Some say it's an abbreviation for percentage in point, but it could also be the FX answer to bond traders’ bips, which refers to bps, or basis points (meaning 1/100 or 1 percent).

Even the venerable pip is in the process of being updated as electronic trading continues to advance. Just a couple paragraphs earlier, i tell you that the pip is the smallest increment of currency price fluctuations. Not so fast. The online market is rapidly advancing to decimalizing pips (trading in  1/10 pips) and half-pip prices have been the norm in certain currency pairs in the interbank market for many years.

But for now, to get a handle on P&L calculations you’re better off sticking with pips. Let’s look at a few currency pairs to get an idea of what a pip is. Most currency pairs are quoted using five digits. The placement of the decimal point depends on whether it’s a JPY currency pair - if it is, there are two digits behind the decimal point. For all others currency pairs, there are four digits behind the decimal point. In all cases, that last itty-bitty digit is the pip.

Here are some major currency pairs and crosses, with the pip underlined:

EUR/USD: 1.2853

USD/CHF: 1.2267

USD/JPY:  117.23

GBP/USD: 1.9285

EUR/JPY:  150.65

Focus on the EUR/USD price first. Looking at EUR/USD, if the price moves from 1.2853 to 1.2873, it‘s just gone up by 20 pips. If it goes from 1.2853 down to 1.2792, it’s just gone down by 61 pips. Pips provide an easy way to calculate the P&L. To turn that pip movement into a P&L calculation, all you need to know is the size of the position. For a 100,000 EUR/USD position, the 20-pip move equates to $200 (EUR 100,000 x 0.0020 = $200). For a 50,000 EUR/USD position, the 61-point move translates into $305 (EUR 50,000 x 0.0061 = $305).

Whether the amounts are positive or negative depends on whether you were long or short for each move. If you were short for the move higher, that’s a - in front of the $200, if you were long, it’s a +. EUR/USD is easy to calculate, especially for USD-based traders, because the P&L accrues in dollars.

If you take USD/CHF, you’ve got another calculation to make before you can make sense of it. That’s because the P&L. is going to be denominated in Swiss francs (CHF) because CHF is the counter currency. If USD/CHF drops from 1.2267 to 1.2233 and you’re short USD 100,000 for the move lower, you’ve just caught a 34-pip decline. That‘s a profit worth CHF 340 (USD 100,000 x 0.0034 = CHF 340).  Yeah but how much is that in real money? To convert it into USD, you need to divide the CHF 340 by the USD/CHF rate. Use the closing rate of the trade (1.2233), because that’s where the market was last, and you get USD 277.94.

Factoring profit and loss into margin calculations

The good news is that online FX trading platforms calculate the P&L for you automatically, both unrealized while the trade is open and realized when the trade is closed. So why did I just drag- you through the math of calculating P&L using pips? Because online brokerages will only start calculating your P&L for you after you enter a trade.

To structure your trade and manage your risk effectively (How big a position and how much margin to risk?), you're going to need to calculate your P&L outcomes before you enter the trade. Understanding the P&L implications of a trade strategy you’re considering is critical to maintaining your margin balance and staying in control of your trading. This simple exercise can help prevent you from costly mistakes, like putting on a trade that’s too large, or putting stop-loss orders beyond prices where your account falls below the margin requirement. At the minimum, you need to calculate the price point at which your position will be liquidated when your margin balance falls below the required ratio. 

The Long and The Short Of It

Forex markets use the same terms to express market positioning as most other financial markets do. But because currency trading involves simultaneous buying and selling, being clear on the terms helps - especially if you‘re totally new to financial market trading.

Going long

No, we’re not talking about running out deep for a football pass. A long position, or simply a long, refers to a market position in which you’ve bought a security. In FX, it refers to having bought a currency pair. When you’re long, you‘re looking for prices to move higher, so you can sell at a higher price than where you bought. When you want to close a long position, you have to sell what you bought if you’re buying at multiple price levels, you’re adding to longs and getting longer.

Getting Short

A short position or simply a short refers to a market position in which you’ve sold a security that you never owned. In the stock market, selling a stock short requires borrowing the stock (and paying a fee to the lending brokerage) so you can sell it. In forex markets, it means you’ve-sold a currency pair, meaning you’ve sold the base currency and bought the counter currency. So you’re still making an exchange, just in the opposite order and according to currency-pair quoting terms. When you’ve sold a currency pair, it’s called going short or getting short and it means you’re looking for the pair’s price to move lower so you can buy it back at a profit. If you sell at various price levels, you’re adding to shorts and getting shorter.

In most other markets, short selling either comes with restrictions or is considered too risky for most individual traders. In currency trading, going short is as common as going long. “Selling high and buying low” is a standard currency trading strategy.

Currency pair rates reflect relative values between two currencies and not an absolute price of a single stock or commodity. Because currencies can fall or rise relative to each other, both in medium and long-term trends and minute-to-minute fluctuations, currency pair price are as likely to be going down at any moment as they are up. To take advantage of such moves, forex traders routinely use short positions to exploit falling currency prices. Traders from other markets may feel uncomfortable with short selling, but it’s just something you have to get your head around.

Squaring up

If you have no position in the market it’s called being square or flat. If you have an open position and you want to close it, it’s called squaring up. If you’re short, you need to buy to square up. If you’re long, you need to sell to go flat. The only time you have no market exposure or financial risk is when you’re square. 

Major Cross-currency Pairs

Although the vast majority of currency trading takes place in the dollar pairs, cross-currency pairs serve as an alternative to always trading the U.S. dollar. A cross-currency pair, or cross or crosses for short, is any currency pair that does not include the U.S. dollar. Cross rates are derived from the respective USD pairs but are quoted independently and usually with a narrower spread than you could get by trading in the dollar pairs directly. The spread refers to the difference between the bid and offer, or the price at which you can sell and buy and spreads are applied in most financial markets.

Crosses enable traders to more directly target trades to specific individual currencies to take advantage of news or events. For example, your analysis may suggest that the Japanese yen has the worst prospects of all the major currencies going forward, based on interest rates or the economic outlook. To take advantage of this, you’d be looking to sell JPY, but against which other currency? You consider the USD, potentially buying USD/JPY (buying USD/selling JPY) but then you conclude that the USD prospects are not much better than the JPY. Further research on your part may point to another currency that has a much better outlook (such as high or rising interest rates or signs of a strengthening economy) say the Australian dollar (AUD). In this example, you would then be looking to buy the AUD/JPY cross (buying AUD/selling JPY) to target your view that AUD has the best prospects among major currencies and the JPY the worst.

Cross trades can be especially effective when major cross-border mergers and acquisitions (M&A) are announced. If a UK conglomerate is buying a Canadian utility company, the UK company is going to need to sell GBP and buy CAD to fund the purchase. The key to trading on M&A activity is to note the cash portion of the deal. If the deal is all stock, then you don’t need to exchange currencies to come up with the foreign cash.

The most actively traded crosses focus on the three major non-USD currencies (namely EUR, JPY, and GBP) and are referred to as euro crosses, yen crosses and sterling crosses. The remaining currencies (CHF, AUD, CAD, and NZD) are also traded in cross pairs. Tables below highlight the key cross pairs in the euro, yen, and sterling groupings, respectively, along with their market names. (Nicknames never quite caught on for the crosses.) 

Euro Crosses
ISO Currency Pair	Countries	Market Name
EUR/CHF	Eurozone/Switzerland	Euro-Swiss
EUR/GBP	Eurozone/United Kingdom	Euro-Sterling
EUR/CAD	Eurozone/Canada	Euro-Canada
EUR/AUD	Eurozone/Australia	Euro-Aussie
Euro-NZD	Euro/New Zealand	Euro-Kiwi

Yen Crosses
ISO Currency Pairs	Countries	Market Name
EUR/JPY	Eurozone/Japan	Euro-Yen
GBP/JPY	United Kingdom/Japan	Sterling-Yen
CHF/JPY	Switzeland/Japan	Swiss-Yen
AUD/JPY	Australia/Japan	Aussie-Yen
NZD/JPY	New Zealand/Japan	Kiwi-Yen
CAD/JPY	Canada/Japan	Canada-Yen

Sterling Crosses
ISO Currency Pairs	Countries	Market Name
GBP/CHF	United Kingdom/Switzerland	Sterling-Swiss
GBP/CAD	United Kingdom/Canada	Sterling-Canadian
GBP/AUD	United Kingdom/Australia	Sterling-Aussie
GBP/NZD	United Kingdom/New Zealand	Sterling-Kiwi

Other Crosses
ISO Currency Pairs	Countries	Market Name
AUD/CHF	Australia/Switzerland	Aussie-Swiss
AUD/CAD	Australia/Canada	Aussie-Canada
AUD/NZD	Australia/New Zealand	Aussie-Kiwi
CAD/CHF	Canada/Switzerland	Canada-Swiss

Major Currency Pairs

The major currency pairs all involve the U.S. dollar on one side of the deal. The designations of the major currencies are expressed using International Standardization Organization (ISO) codes for each currency. Table below lists the most frequently traded currency pairs, what they’re called in conventional terms, and what nicknames the market has given them.

The Major U.S Dollar Currency Pairs
ISO Currency Pairs	Countries	Long Name	Nickname
EUR/USD	Eurozone*/United States	Euro-Dollar	N/A
USD/JPY	United States/Japan	Dollar-Yen	N/A
GBP/USD	United Kingdom/United States	Sterling-Dollar	Sterling or Cable
USD/CHF	United States/Switzerland	Dollar-Swiss	Swissy
USD/CAD	United States/Canada	Dollar-Canada	Loonie
AUD/USD	Australia/United States	Australian-Dollar	Aussie or Oz
NZD/USD	New Zealand/ United States	New Zealand-dollar	Kiwi

*The Eurozone is made up of all the countries in the European Union that have adopted the euro as their currency. The eurozone currently consists of Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Latvia, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain.

Currency names and nicknames can be confusing when you’re following the forex market or reading commentary and research. Be sure you understand whether the writer or analyst is referring to the individual currency or the currency pair.

• If a bank or a brokerage is putting out research suggesting that the Swiss franc will weaken in the future, the comment refers to the individual currency, in this case CHF, suggesting that USD/CHF will move higher (USD stronger/CHF weaker).

• If the comment suggests that Swissy is likely to weaken going forward, it's referring to the currency pair and amounts to a forecast that USD/CHF will move lower (USD weaker/CHF stronger).

The Mechanics of Currency Trading

The currency market has its own set of market trading conventions and related lingo, just like any other financial market. If you’re new to currency trading, the mechanics and terminology may take some getting used to. But at the end of the day, you’ll see that most currency trade conventions are pretty straightforward.

Buying and Selling Simultaneously

The biggest mental hurdle facing newcomers to currencies, especially traders’ familiar with other markets, is getting their head around the idea that each currency trade consists of a simultaneous purchase and sale. In the stock market, for instance, if you buy 100 shares of Google, it’s pretty clear that you now own 100 shares and hope to see the price go up. When you want to exit that position, you simply sell what you bought earlier. Easy right?

But in currencies, the purchase of one currency involves the simultaneous sale of another currency. This is the exchange in foreign exchange. To put it another way, if you‘re looking for the dollar to go higher, the question is “Higher against what?” The answer has to be another currency. In relative terms, if the dollar goes up against another currency, it also means that the other currency has gone down against the dollar. To think of it in stock-market terms, when you buy a stock, you’re selling cash, and when you sell a stock, you’re buying cash.

Currencies come in pairs

To make matters easier, Forex markets refer to trading currencies by pairs, with names that combine the two different currencies being traded against each other, or exchanged for one another. Additionally, forex markets have at given most currency pairs nicknames or abbreviations, which reference the pair and not necessarily the individual currencies involved.

The U.S. dollar is the central currency against which other currencies are traded. In triennial survey of the global foreign exchange market in 2004, the Bank for International Settlements (BIS) found that the U.S. dollar was on one side of 88 percent of all reported Forex market transactions.

The U.S. dollars central role in the Forex markets stems from a few basic factors:

• The U.S. economy is the largest national economy in the world.
• The U.S. dollar is the primary international reserve currency.
• The U.S. dollar is the medium of exchange for many cross-border transactions. For example, oil is priced in U.S. dollars. So even if you’re a Japanese oil importer buying crude from Saudi Arabia, you’re going to pay in U.S. dollars.
• The United States has the largest and most liquid financial markets in the world.
• The United States is a global military superpower, with a stable political system.

The Bank for International Settlements

The Bank for International Settlements (BIS) is the central bank for central banks. Located in Basel, Switzerland, the BlS also acts as the quasigovernment regulator of the international banking system. It was the BIS that established the capital adequacy requirements for banks that today underpin the international banking system.

As the bank to national governments and central banks, the BIS frequently acts as the market intermediary of those nations seeking to diversify their currency reserves. By going through the BIS, those countries can remain relatively anonymous and prevent speculation from driving the market against them.

Market talk of the BIS being active in the market is frequently interpreted as significant reserve interest to buy or sell. Keep an eye out for market rumors of the BIS, but also keep in mind that the BIS performs more routine and smaller trade execution on behalf of its clients.

The Group of Seven (G7)

The Group of Seven, or G7, is composed of the seven largest developed economies in the world: Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States. The G7 is the primary venue for the major global powers to express their collective will on relative currency values and the need for any adjustments. For forex markets, the big guns of the G7 are the hottest game in town.

Depending on the circumstances, currency values may be on the agenda for these meetings and the communiqué, the official statement issued at the end of each gathering, may contain an explicit indication for a desired shift among the major currencies. lf currencies are not a hot-button topic, the G7 will include a standard boilerplate statement that currencies should reflect economic fundamentals and that excessive currency volatility is undesirable.

Forex markets closely follow the preparations leading up to the meetings for several weeks in advance. Traders are looking first to see if currencies will even be discussed, and then to see which currency or currencies will be on the agenda. The market will generally have a sense of whether currencies are an issue, and the general feeling of what the G7 would like to see done. Still, comments from ministers and their deputies holding the preparatory consultations set the stage for the market’s expectations and can provoke significant market reactions even before the G7 meets.

The power of G7 statements lies in the perception that all the participants are in agreement with what is contained in the communiqué. Most important, it is seen as giving the market a green light to carry out the G7’s expressed wishes. If the G7 indicates that a recently weak currency is not reflecting fundamentals, for example, it’s a signal to the market that the G7 would like to see that currency appreciate.

Government and Central Banks

National governments are routinely active in the forex market, but not for purposes of attempting to realign or shift the values of the major currencies.

Instead, national governments are active in the forex market for routine funding of government operations, making transfer payments, and managing foreign currency reserves. The first two functions have generally little impact on the day-to-day forex market, so I won’t bore you with the details. But the last one has taken on increased prominence in recent years, and all indications are that it will continue to play a major role in the years ahead.

Currency Reserve Management

Currency reserve management refers to how national governments develop and invest their foreign currency reserves. Foreign currency reserves are accumulated through international trade. Countries with large trade surpluses will accumulate reserves of foreign currency over time. Trade surpluses arise when a nation exports more than it imports. Because it is receiving more foreign currency for its exports than it is spending to buy imports, foreign currency balances accumulate.

The USD has historically been the primary currency for international reserve holdings of most countries. International Monetary Fund (IMF) data from April 2007 showed that the USD accounted for about 65 percent of global currency reserve holdings, with EUR and JPY as the next most widely held currencies.

ln recent years, however, the United States has run up massive trade and current account deficits with the rest of the world. The flip side has been the accumulation of large trade surpluses in other countries, most clearly in Asia.

The U.S. deficits essentially amount to the United States borrowing money from the countries with trade surpluses, while those other countries buy

lOUs in the form of U.S. Treasury debt securities.

The problem is one of perception and also of prudent portfolio management:

• The perception problem stems from the continuing growth of U.S. deficits, which equates to your continually borrowing money from a bank. At a certain point, no matter how good your credit is, the bank will stop lending you money because you’ve already borrowed so much in the first place. In the case of the United States, no one is sure exactly where that point is, but let’s just say we don’t want to find out.

• The portfolio-management problem arises from the need to diversify assets in the name of prudence. This point has taken on added urgency since the U.S. dollar began to weaken against other major currencies at the start of this decade. Not only had emerging market governments allowed their foreign currency reserves to reach massive levels and kept the proportion of USDs in them very high, but now the U.S. dollar was starting to weaken as well.

The result has been an effort by many national governments to begin to diversify their reserves away from the USD and into other major currencies. The euro, the Japanese yen, and, to a lesser extent, the British pound have been the principal beneficiaries of this shift. But before you think the sky is falling, the USD remains the primary reserve currency globally and most reserve diversification efforts are focused on new reserves being generated.

In terms of daily forex market trading, national governments (or their operatives) have become regular market participants over the last few years. Generally speaking, they appear to be engaging in active currency reserve management, selling USD on rallies, and buying EUR on weakness. But they’re also not averse to then selling EUR on subsequent strength and buying USD back on weakness.

Currency reserve management has taken on a market prominence in recent years that never existed before. Market talk of central bank buying or selling for reserve management purposes has become almost a daily occurrence. The impact of this in the market varies, but it can frequently lead to multiday highs and lows being maintained in the face of an otherwise compelling trend.

Traders need to closely follow real-time market commentaries for signs of central bank involvement.

Day Traders, Big and Small

This is where you and me fit into the big picture of the forex market. If the vast majority of currency trading volume is speculative in nature, then most of that speculation is short-term in nature. Short-term can be minute-to- minute or hour-to-hour, but rarely is it longer than a day or two. From the interbank traders who are scalping EUR/USD (high frequency in-and-out trading for few pips) to the online trader looking for the next move in USD/JPY, short-term day traders are the backbone of the market.

Intraday trading was always the primary source of interbank market liquidity, providing fluid prices and an outlet for any institutional flows that hit the market. Day traders tend to be focused on the next 20 to 30 pips in the market, which makes them the source of most short-term price fluctuations.

When you’re looking at the market, look in the mirror and imagine several thousand similar faces looking back, all trying to capture the same currency trading gains that you're shooting for. It helps to imagine this so you know you’re not alone and also so you know who you’re up against.

The rise of online currency trading has thrust individual retail traders into the mainstream of the forex market. Online currency brokerage firms are referred to as retail aggregators by the institutional interbank market, because brokerage firms typically aggregate the net positions of their clients for hedging purposes. The online brokerages then transact with the interbank market to managet heir market exposure.

Hedge funds

Hedge funds are a type of leveraged fund, which refers to any number of different forms of speculative asset management funds that borrow money for speculation based on real assets under management. For instance, a hedge fund with $100 million under management can leverage those assets (through margin agreements with their trading counterparties) to give them trading limits of anywhere from $500 million to $2 billion. Hedge funds are subject to the same type of margin requirements as you or we are, just with a whole lot more zeroes involved.

The other main type of leveraged fund is known as a Commodity Trading Advisor (CTA). A CTA is principally active in the futures markets. But because the forex market operates around the clock, CTAs frequently trade spot FX as well.

The major difference between the two types of leveraged funds comes down to regulation and oversight. CTAs are regulated by the Commodity Futures Trading Commission (CFTC), the same governmental body that regulates retail FX firms.

As a result, CTAs are subject to a raft of regulatory and reporting requirements. Hedge funds, on the other hand, remain largely unregulated. What important is that they all pursue similarly aggressive trading strategies in the forex market, treating currencies as a separate asset class, like stock or commodities.

In 1990, there were about 100 hedge funds with about $40 billion in assets under management. That industry has absolutely exploded in the last few years. Today, there are over 10,000 hedge funds managing over $1.5 trillion in assets. How’s that for a growth industry?

In the forex market, leveraged funds can hold positions anywhere from a few hours to days or weeks. When you hear that leveraged names are buying or selling, it’s an indication of short-term speculative interest that can provide clues as to where prices are going in the near future.

Speculating with black boxes, models, and systems

Many leveraged funds have opted for a quantitative approach to trading financial markets. A quantitative approach is one that uses mathematical formulas and models to come up with buy and sell decisions. The black box refers to the proprietary quantitative formula used to generate the trading decisions. Data goes in, trading signals come out, and what’s inside the black box, no one knows. Black box funds are also referred to as models or system-based funds.

Some models are based on complex statistical relationships between various currencies, commodities, and fixed income securities. Others are based on macroeconomic data, such as relative growth rates, inflation rates, and geopolitical risks. Still others are based on technical indicators and price studies of the underlying currency pair. These are frequently referred to as rules-based trading systems, because the system will employ defined rules to enter and exit trades.

If you’re technically or statistically inclined, you can create your own model or rules-based trading system. Many online trading platforms offer Application Programming interface (API) access to their trading platforms, allowing you to draw price data from the platform, filter it through your trading system, and generate trading signals. Some even allow for automated trade execution without any further user action. Check with your online currency brokerage firm  to see if it has an API and supports automated trade executions. 

Trading with discretion

The opposite of a black box trading system is a discretionary trading fund. The discretion, in this case, refers to the fund manager’s judgment and overall market view. The fund manager may follow a technical or system-based approach but prefer to have a human make the final decision on whether a trade is initiated. A more refined version of this approach accepts the trade signals but leaves the execution up to the discretionary fund managers trading staff, which tries to maximize position entry/exit based on short-term market dynamics.

Still another variation of discretionary funds is those that base their trading strategies on macroeconomic and political analysis, known as global-macro funds. This type of discretionary fund manager is typically playing with a longer-time horizon in mind. The fund may be betting on a peak in the interest rate cycle or the prospect that an economy will slip into recession. Shorter-term variations on this theme may take positions based on a specific event risk, such as the outcome of the next central bank meeting or national election.

Speculators

Speculators are market participants who are involved in the market for one reason only: to make money. In contrast to hedgers, who have some form of existing currency market risk, speculators have no currency risk until they enter the market. Hedgers enter the market to neutralize or reduce risk. A Speculators embrace risk taking as a means of profiting from long-term or short-term price movements.

Speculators (specs for short) are what really make a market efficient. They add liquidity to the market by bringing their views and, most important, their capital into the market. That liquidity is what smoother out price movements, keeps trading spreads narrow, and allows a market to expand.

In the forex market, speculators are running the show. Conventional market estimates are that upwards of 90 percent of daily trading volume is speculative in nature. lf you're trading currencies for your own account, welcome to the club. lf you’re trading currencies to hedge a financial risk, you can thank the specs for giving you a liquid market and reducing your transaction costs.

Speculators come in all types and sizes and pursue all different manner of trading strategies. In this section, we take a look at some of the main types of speculators to give you an idea of who they are and how they go about their business. Along the way, you may pick up some ideas to improve your own approach to the market. At the minimum, we hope this information will allow you to better understand market commentaries about who‘s buying and who's selling.

Global Investment Flows

One of the reasons forex markets remain as lightly regulated as they are is that no developed nation wants to impose restrictions on the flow of global capital. International capital is the lifeblood of the developed economies and the principal factor behind the rapid rise of developing economies like China, Brazil, Russia, and India. The forex market is central to the smooth functioning of international debt and equity markets, allowing investors to easily obtain the currency of the nation they want to invest in.

Financial investors are the other main group of nonspeculative players in the forex market. As far as the forex market is concerned, financial investors are mostly just passing through on their way to another investment. More often than not, financial investors look at currencies as an afterthought, because they’re more focused on the ultimate investment target, be it Japanese equities, German government bonds, or French real estate.

Crossing borders with mergers and acquisitions

Mergers and acquisitions (M&A) activity is becoming increasingly international and shows no sign of abating. International firms are now involved in a global race to gain and expand market share, and cross-border acquisitions are frequently the easiest and fastest way to do that.

When a company seeks to buy a foreign business, there can be a substantial foreign exchange implication from the trade. When large M&A deals are announced, note the answers to the following two questions:

• Which countries and which currencies are involved? if a French electrical utility buys an Austrian power company, there are no currency  implications because both countries use the euro (EUR). But if a Swiss pharmaceutical company announces a takeover of a Dutch chemical firm, the Swiss company may need to buy EUR and sell Swiss francs (CHF) to pay for the deal.

• How much of the transaction will be in cash? Again, if it's an all stock deal, then there are no forex market implications. But if the cash portion is large, forex markets will take note and begin to speculate on the currency pair involved.

Hedging your bets

Hedgers come in all shapes and sizes, but don’t confuse them with hedge funds.  (Despite the name, a hedge fund is typically 100% speculative in its investments.)

Hedging is about eliminating or reducing risk. In financial markets, hedging refers to a transaction designed to insure against an adverse price move in some underlying asset. In the forex market, hedgers are looking to insure themselves against an adverse price movement in a specific currency rate.

Hedging for international trade purposes 

One of the more traditional reasons for hedging in the forex market is to facilitate international trade. Let's say you’re a widget maker in Germany and you just won a large order from a UK-based manufacturer to supply it with a large quantity of widgets. To make your bid more attractive, you agreed to be paid in British pounds (GBP).

But because your production cost base is denominated in euros (EUR), you face the exchange rate risk that GBP will weaken against the EUR. That would make the amount of GBP in the contract worth fewer EUR back home, reducing or even eliminating your profit margin on the deal. To insure, or hedge, against that possibility, you would seek to sell GBP against EUR in the forex market. lf the pound weakened against the euro, the value of your market hedge would rise, compensating you for the lower value of the GBP you’ll receive. If the pound strengthens against the euro, your loss on the hedge is offset by gains in the currency conversions. (Each pound would be worth more euros.)

Trade hedgers follow a variety of hedging strategies and can utilize several different currency hedging instruments. Currency options can be used to eliminate downside currency risk and sometimes allow the hedger to participate in advantageous price movements. Currency forward transactions essentially lock in a currency price for a future date, based on the current spot rate and the interest rate differentials between the two currencies.

Trade related hedging regularly comes into the spot market in two main forms:

• At several of the daily currency fixings: The largest is the London afternoon fixing, which takes place each day at 4 p.m. local time, which corresponds to 11 a.m. eastern time (ET). The Tokyo fixing takes place each day at 8:55 a.m. Tokyo time, which corresponds to 6:55 pm eastern time (ET). A firing is a process sponsored by an exchange or central bank where commercial hedgers submit orders to buy or sell currencies in advance. The orders are then filled at the prevailing spot rate (the rate is fixed) at the time of the fixing. The difference between the amount of buying and selling orders typically results in a net amount that needs to be bought or sold in the market prior to the fixing time. On some days, this can see large amounts (several hundred million dollars to a billion dollars, or more) being bought or sold in the hour or so leading up to the fixing time. After the fix, that market interest has been satisfied and disappears. Month-end and quarter-end fixings typically see the largest amounts.Short-term traders need to closely follow live market commentaries to see when there is a substantial buying or selling interest for a fixing.

• Mostly in USD/JPY, where Japanese exporters typically have large amounts of USD/JPY to sell: Japanese exporters receive dollars for their exports, which must then be converted into JPY (sell USD/buy JPY). The Japanese export community tends to be closely knit and their orders are likely to appear together in large amounts at similar levels. Again, real-time market commentaries are the most likely source for individual traders to hear about Japanese exporter selling interest.

Hedging for currency options

The currency option market is a massive counterpart to the spot market and can heavily influence day-to-day spot trading. Currency option traders are typically trading a portfolio of option positions. To maximize their returns, options traders regularly engage in delta hedging and gamma trading. Without getting into a major options discussion here (we cover currency options in later post), option portfolios generate a synthetic, or hypothetical, spot position based on spot price movements.

To maximize the return on their options portfolios, they regularly trade the synthetic spot position as though it were a real spot position. Trading the synthetic positions generated by options is called delta hedging or gamma trading.

Option hedgers are frequently found selling at technical resistance levels or buying on support levels. When a currency pair stays in a range, it can do quite nicely. But when range breakouts occur, options traders frequently need to rush to cover those range bets, adding to the force of the directional breakout. Keep an eye out for reports of option-related buying and selling as technical levels are tested.

Another daily feature of the spot market is the 10 a.m. ET option expiry, when options due to expire that day that finish out of the money cease to exist. Any related hedging that was done for the option then needs to be unwound, though this is likely to have been done prior to the expiry if the option is well out of the money. Traders need to follow market commentaries to see if large option interest is set to expire on any given day and generally anticipate a flurry of option related buying/selling that may suddenly reverse course after the I0 a.m. expiry.