Making Money in Forex Trading

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What the Forex do I Know

So you're thinking of trading currencies. Before diving in, consider this: that the first thing any economist learns about currencies implies that forex trading is a waste of time.

This thing is a theory called uncovered interest parity (UIP). It says expected returns on all currencies should be equal. If one currency offers a higher interest rate than another, it can only be because it is expected to fall.

Take the Japanese yen. It carries a three-month interest rate of just 0.0012 per cent. Why would anyone want to hold yen rather than sterling, which pays 1.18 per cent? It can only be because people expect the yen to rise by just under 1.18 per cent in the next three months. If people expected a smaller rise, they'd hold pounds. If they expected a bigger rise, they would all hold yen. The ¥/£ rate moves to a level from which the yen is expected to rise by just under 1.18 per cent.

On this thinking, all currencies offer the same expected returns as the pound. Dong, dinar, dollar or dalasi. They're all the same.

If UIP is right, your local building society offers a better deal than any forex spread-betting company, simply because the latter charges a spread.

Luckily, though, the first thing you learn in economics is often wrong. There's growing evidence that UIP doesn't describe actual currency moves. Over shortish horizons, currencies with high interest rates don't fall on average. Instead, many economists now think they follow a random walk. On this reckoning, the best returns come simply on the currencies offering the highest interest rates.

But this doesn't justify trading currencies. At best, it suggests a buy-and-hold strategy. And it might not even do this. The Turkish lira pays an annualised interest rate of 17 per cent. No one thinks this is a bargain. It's just a reward for taking a big risk - the risk the lira will fall by more than 17 per cent.

To justify forex trading, currency moves have to be predictable. And a lot of evidence suggests they are not.

Technical Analysis

One piece of evidence is the Meese-Rogoff puzzle, first pointed out by two US economists in 1983. All theoretical economic models of currencies, they said, were useless at predicting actual currency moves.

Menzie Chinn, an economist at the University of California at Santa Cruz recently re-tested this result, and found it still holds true. "No model consistently outperforms a random walk," he concluded. Models "that work well in one period will not necessarily work well in another".

Now, traders will not be surprised to learn that economists are useless forecasters. What should surprise them is other research showing that technical analysis doesn't work either.

Fernando Rubio, an economist at Fern Capital recently examined eight simple technical analysis rules for five exchange rates. "Most of these strategies require too many transactions and produce only marginal returns," he concluded. "Only an investor with the ability to get very low or null commissions and taxes would benefit."

All this confirms that old idea, the efficient market hypothesis. This says information is already embodied in asset prices, with the result that traders cannot make money without taking risks.

Anyone who has worked in the City will know there's a distinct hierarchy of intellect there. Equity salesmen and analysts are at the bottom and forex traders are near the top. These guys can process information quickly and efficiently. Given a choice, I would rather pit my wits against the average equity analyst than the average forex trader. Any day.

To put it another way, there are countless anomalies in the stock market: January effects, September effects, day-of-the-week effects, dog-stock anomalies, momentum, size and value anomalies, and so on. Sure, all of these are controversial. But there's no such long list for forex markets.

There's another reason to prefer equity trading to forex. Even bad share traders can benefit from the equity premium: the tendency for shares to outperform cash over the long run. Forex traders have no such fall-back. If we ignore dealing costs, forex is a zero-sum game and, if we include them, it turns negative.

How do Professional Traders make money?

One reason the professionals make money is that their trading costs are so low that they can use only marginally profitable strategies. They hoover up pennies.

Martin Evans, an economist at Georgetown University in Washington DC, gives another answer. Traders at big banks, he says, can see the flow of forex orders from counterparties. These orders convey information about economic fundamentals that is unavailable to others. This private information about the wisdom of crowds gives professionals an edge that ordinary traders lack.

And as every child knows, if you play with the big boys, you'll get a good kicking.