The Hindu Business Line : Into the world of currency trading

"Ow! That hurts," David winced. Kim, the visiting home nurse, tied the bandages as gently as she could. Recovering slightly, David asked her, "Do you know something that works non-stop like you do?" Kim simply smiled.

"Forex trading," said David supplying the answer. "The largest trading market in the world works non-stop. On an average, around $2 trillion are traded in the foreign exchange market on a daily basis. It operates 24 hours a day. It opens on Sunday at 5 p.m. Eastern Standard Time (EST) and closes on Friday 4 p.m. EST. Currency traders trade throughout the week. Kim, though bone-tired from work, volunteered, "I have heard about the equity market where you buy or sell stocks."

David was impressed. "Yes. In currency exchange trading, two types of currencies are involved — base currency and counter currency.

"For example, when you see a quote like USD/JPY 116 that essentially means one US dollar can buy 116 yen. In this case, the base currency is the dollar and the counter currency, the Japanese yen.

"In currency trading, since two currencies are involved, you got to buy one and sell the other. In other words, you are long on one currency and short on the other." When Kim returned home, her daughter Amy was seething with anger. "It is bad enough you have to work all day and night, on top of it you neglect your daughter to take care of another man." Kim knew that Amy's deep-seated anger was more to do with her father leaving home. She explained why she was late. While they were eating, Kim's jaw dropped when her daughter said, "Mom, to continue where your patient left off, let us take the example of USD/JPY. In this case, if you expect the US dollar to get stronger, then you buy USD and sell Japanese yen. Thus, you are long on the dollar and short on the yen.

"In the morning USD/JPY may have been at 116 but if the dollar gets stronger and the yen weaker, at the end of the day USD/JPY might be at 117. This means that one dollar, which was able to buy 116 yen in the morning, could buy 117 yen now. With the same dollar, you can buy more yen now."

"How on earth do you know these things?" exclaimed Kim.

Amy simply shrugged and went on, "If you expect the dollar to get weaker against the yen, you buy yen and sell dollar. Thus, you go long on yen and short on dollar."

Later that night, Kim wondered whether the thin thread of `knowledge about currency trading' would bring three lonely people together.

"Ah! I have company," exclaimed David, forgetting the extreme discomfort that he had been experiencing all night.

Amy shifted uneasily. She asked, "My mom says you love to talk about currency trading. I have some questions for you." I would love to answer them, but not until I am clean," said David.

They laughed and once Kim finished with David, Amy asked him, "How is forex trading different from the equity market?" David answered, "Unlike the equity market, where you can analyse a company's details either fundamentally or technically, currency trading is a lot more volatile. More than 40 per cent of currency trading is done within two days. Around 80 per cent of the trading is completed within two weeks. Actually, most of the trading that takes place in the foreign exchange is done by traders and not by investors." "I see," said Amy "Don't equity investors, that is, mutual funds and major institutions, hold positions of companies for years together?"

"That's true," agreed David. "But a trader doesn't hold any position for a long term. Currency trading is done almost on a daily basis by many big hedge funds and major banks. In equity trading, before investing, the fund analyses the risks involved in the company and understands the various factors, including future earnings potential, cash flow, debt to equity ratio, etc., before making a decision to invest.

"However, in currency trading, no such calculations are involved. But those who trade in the foreign exchange market are expected to keep themselves abreast of political and other developments in the world that might trigger fluctuations in currency rates. Events such as Katrina and the war in Iraq would affect the dollar immediately in a big way, whereas such events will have less impact on the stock market and even that might be only in the long run.

"Oh, another question," Amy said in her excitement but checked herself. "If your health permits," she added cautiously.

"My dear," David said, if your mom nursed me to good health, shouldn't I help you with your financial health?"

Kim smiled. Amy turned to David. "In equities, price fluctuations are quoted in real currencies, how about currency trading?" David said, "Yes, price fluctuations in equities are discussed in real currencies. For example, if General Electric was trading at $34.25 yesterday and is trading at $34.50 today, we would say that GE went up by $0.25.

"However, in currency trading, fluctuations are measured in what are called PIPs. PIP stands for price interest point or percentage in point. It is the smallest price change that a given exchange rate can make. For example, trading yen with dollar is quoted in changes of 0.01 and it is known as one pip. Thus, if dollar traded at 106 yen yesterday and is trading at 106.05 yen today, then we say that yen gained five pips. However, all other currencies are quoted in 0.0001 units. Thus, when euro jumps from 1.0030 to 1.0040, it means that it has gained 10 pips."Kim finished her work but was reluctant to leave. She asked, "What factors contribute to these currency changes?"

David said, "A politically stable country would have a stronger currency compared to one that is politically weak. In addition, the `interest rates' are an important factor in determining the value of a particular currency. Interest rates are not only useful in controlling inflation but also make a big impact on currency rates. Any increase in interest rates attracts foreign capital and causes the exchange rates to rise." Amy said, "I remember something. No brokers are involved in currency trading, right?"

David nodded. "Yes. All trades are carried without any commissions. The foreign exchange market is basically traded by dealers and not by brokers. Unlike stock trading, where the quote of a particular company is the last trade, in currency trading, the value of a currency varies across various other currencies it is being traded."

Amy, quite concerned about David, asked him, "Will you recover soon?"

David became reminiscent. He said, "Robert Frost said, `I have ... miles to go before I sleep.' I say `I have ... millions to make before I sleep.'"

The authors are publishers of www.wisepen.com

Racy@TheHindu.co.in

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