Posts Tagged ‘Finance’

It is debatable whether or not momentum traders are trend-followers. There is no debate when it comes to flow-based currency speculators. The very act of using order flow information for the purpose of trading in the currency markets requires that the user is following the trend suggested by that flow data. Currency speculators who focus on flow, use that information to anticipate the continuation or end of a trend. Clearly, with flow products, both the quality and the relevance of the flow data are crucial elements in deciding whether or not to use such products as one’s primary information source for trading. There is no point in using a flow product where the order flow is neither reflective of the currency market as a whole nor has any impact on it. Flow-based currency speculators can certainly earn excess returns, but as with other trading approaches discipline is needed. Unlike in the case of the momentum trader where the model creates the signal irrespective of all other factors and therefore the trader’s only job is to execute according to that signal, there is still a significant degree of discretion and interpretation in flow-based currency speculation. For instance, temporary seasonal factors can distort flow. If the flows model were passive, this would mean that a trading signal would be triggered irrespective of this important consideration. That said, the aspect of discretion automatically increases the possibility of misinterpretation and making mistakes. As with most types of trading or currency speculation, experience counts.

Momentum funds have a different trading approach as regards currency speculation. Rather than focusing on apparent disparities between the economics and the price, they use so-called momentum models to trigger buy or sell signals in currency pairs irrespective of the economics. Granted, one could argue that since economics affects the price of the currency, so it also affects their models and therefore their trading approach. However, it is fair to say that economics is not their primary focus. Their aim is to be disciplined to the extent that they rigorously follow the trading signals of their momentum models. As one might expect, the nature of these models varies. For instance, one such momentum model relies on technical analysis indicators to provide short-term moving averages. When a 5-day moving average crosses up through the 15-day moving average they buy and when the opposite happens they sell. Granted, this is a vast oversimplification and there are many significantly more sophisticated momentum models than this. That said, the principle is surely the correct one. Momentum models, however complex and whatever indicators they rely on, focus on changes in market prices as their key determinant for providing signals rather than economic fundamentals. Therefore, it is probably a reasonable generalization to say that they are more short term in their trading approach than macro-based currency speculators might be, depending of course on how long the momentum signal lasts.

As noted previously, there are a wide variety of currency speculators and therefore it is no easy task to explain their methods or techniques since they too vary widely. The techniques of currency speculation vary widely, just as with stock market speculation. Indeed, the analogy is a good one. Just as in equity investment where you have “top down”, “bottom up”, “value investing”, “growth or income” investing, so in currency markets you have speculators or investors — however one likes to term them — who focus on the macroeconomic “big picture”, long-term currency valuation, microeconomic factors affecting currencies, money flow and technical analysis. The titles are perhaps different but the guiding principle is the same; what separates and differentiates the framework within which they analyse the market. Below, we attempt to summarize the types of techniques and strategies with which currency speculators approach the currency markets.

The obvious answer is of course simply to make money. At a slightly more sophisticated level, market participants undertake currency speculation for the reason that they think they can earn excess returns by doing so. In turn, the reason they think that is because they or others have done so in the past.
Just as fashions and retail trends change over time, so does the idea of “conventional wisdom” within financial markets. In the 1970s, despite the break-up of the Bretton Woods financial system, the conventional wisdom was to have pegged currency regimes and maintain a significant degree of government control over the economy. In the 1980s, the US and the UK underwent substantial financial reform, opening up their economies and capital markets to the idea of free trade of goods, services and capital. With regards to currency or exchange rate regimes, the conventional wisdom has gone from governments trying to maintain control to allowing freely floating exchange rates. A slight fine tuning of this in the wake of the currency crises of the 1990s is the idea of the “bi-polar” world so eruditely explained by Stanley, former First Deputy Managing Director of the IMF, in speeches and written research notes. This argues that in a world of open capital accounts and free trade, exchange rates have to be managed according to either the hardest of pegs or the freest of free-floating principles, that anything in between these two poles will eventually prove unsustainable. Whatever the merits of this argument, there is little doubt that it has become the conventional exchange rate wisdom of the day, notwithstanding the protests of a few dissident voices.
The conventional exchange rate wisdom of the time of necessity affects the way markets operate, and thus how markets speculate for or against currencies. For instance, market participants who have been used to making good profits by speculating against pegged exchange rates may try to do so again, against a currency peg in a completely different part of the world. To a very large extent this is self-fulfilling. For this reason, a currency board regime that gets attacked in one part of the world can lead to markets attacking other currency boards on the other side of the world. For this very reason, the currency boards of Argentina and Hong Kong are often linked, although that link has been gradually reduced in the market’s mind as the Hong Kong authorities have proved time and again their determination to maintain the currency board. Currency speculators trade currencies to make money, pure and simple. They have a variety of methods, which we will look at subsequently, but the incentive is always the same. The fact that they can do so in the reasonable expectation of achieving their aim causes a problem with standard economic theory, not least because the theory suggests it is impossible over time. According to the theory, currency speculation is zero sum gain, which of necessity cannot result in consistent excess returns given the unpredictability of currency markets. The fact that excess returns can and have been achieved suggests this theory needs to be amended!