Trading Strategies and Risk Management. Speculation in the Foreign Exchange Market

Elaboration , 2018 , 12 Pages

Economics - Foreign Trade Theory, Trade Policy

Trading is done in various commodities and is as well carried out in different markets. Amongst all the popular traded commodities like shares, gold, cryptocurrencies, trading in currency has seen to be the most popular. The Foreign Exchange market is the place where trading in currencies is carried out. The growing demand among most people of exchanging their domestic currencies in order to carry out any foreign trade or business has made this as the primary reason of the FX market being one the largest and most liquid financial market worldwide.

This report is based on the analysis conducted as per the results of a demo trading session undertaken over easyMarkets platform. The main aim of the analysis is to recognize the type of trading strategies that are applied by traders while carrying out transaction in various currency pairs along with the applying one of the strategies in the demo trading undertaken. The results are based on the 13 trades that were carried out. The later part of report also highlights the importance and application of risk management tool in order to hedge maximum amount of risk involved. The concluding statement put together the importance of hedging tools stating they might not be able to mitigate or eliminate the risk completely yet does make sure that some amount of it covered thus deceasing the risk of exposure to at least some extent.

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Executive Summary

Trading is done in various commodities and is as well carried out in different markets.

Amongst all the popular traded commodities like shares, gold, cryptocurrencies,

trading in currency has seen to be the most popular. The Foreign Exchange market is

the place where trading in currencies is carried out. The growing demand among most

people of exchanging their domestic currencies in order to carry out any foreign trade

or business has made this as the primary reason of the FX market being one the

largest and most liquid financial market worldwide. This report is based on the

analysis conducted as per the results of a demo trading session undertaken over

easyMarkets platform. The main aim of the analysis is to recognize the type of trading

strategies that are applied by traders while carrying out transaction in various

currency pairs along with the applying one of the strategies in the demo trading

undertaken. The results are based on the 13 trades that were carried out. The later part

of report also highlights the importance and application of risk management tool in

order to hedge maximum amount of risk involved. The concluding statement out

together the importance of hedging tools stating they might not be able to mitigate or

eliminate the risk completely yet does make sure that some amount of it covered thus

deceasing the risk of exposure to at least some extent.

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Introduction

There is no exact strategy or factors that could be used to analyze movements in the

exchange rate and enable efficient decision making. Since there are a lot of factors

that have to be measured and quantified that the most common strategy that the

traders tend to follow is the trend, i.e. timing of the market is kept into consideration

( Gencay, et al., 2003). It is generally believed by some of the most successful forex

traders that the foreign exchange market tends to have a cycle which is in process due

to the presence of human behavior in the exchange rate market. Successful

transactions can be carried out depending upon the trader's ability to chart the trends

and effective predictions for future movements (Castrén, et al., 2006). This report will

highlight the trading strategy that is used in carrying out transactions in the currencies

traded, with explanations for any profit or loss incurred while carrying out the

transaction along with any hedging activities undertaken in the process.

Trading Strategies

There are a variety of techniques and strategies that is used by the forex traders in

order to analyze the best available entry and exit points and the accurate timing

considered for buying and selling currencies. Now, there are quite a few trading

techniques that are existent in the foreign exchange market, which can be Active

trading technique, and the long term, buy and hold technique (Shiryaev, et al., 2008).

Where active trading involves the process where securities are bought and sold

depending upon the short-term movements in the securities towards profit by

analyzing the short-term stock chart. On the other hand, the buy and hold technique

suggest holding of securities over long period as the movements in the prices might

be able to outweigh the movements undergone in short term ( Ling, et al., 2014).

Since strategies under active technique believe on the fact that the most profits within

a market lies only when transaction are done taking into consideration short-term

movements in prices, which has led to this technique being most commonly used.

Listed below are the most common trading strategies under the Active technique:

Day Trading

One of the most popular and commonly used trading style is Day Trading. The style

as suggested by the name involves buying and selling transactions of securities within

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the same day. No position is supposed to be held overnight and all the traded

positions are supposed to be closed on the same day they are opened (Johnson, 2011).

This form of trading is also aimed at putting the market timing to test where trades are

traded within the same day. This strategy of trading is generally carried out by the

traders who are well-acquainted with the market like the professional traders and

specialist.

Position Trading

There has been a lot of speculations relating to this strategy of trading undertaken by

traders. As some consider it as a long-term, buy and hold strategy yet it has also been

argued that when this strategy is used by professional traders it is like an active

trading technique as well. The application of this strategy is based on the usage of

long term charts along with few other methods in determining the trends within the

prevailing price direction of the securities (Tharp, 2013). The trading under this type

is considered to prevail for weeks or longer, all dependent on the ongoing trend.

Swing Trading

This strategy is aimed at putting its focus on achieving smaller amounts of gains

spread over short term trends and avoid as much losses as possible. The trading

positions under this strategy is held for up to a few days and can be stretched over a

week. And the gains can be smaller at start yet the consistency in their flow can result

into significant returns at the end ( Ally Financial , 2017). The main goal involves

identifying the prevailing trend and then taking steps to capture those small gains with

this type of strategy. Most of the swing traders generally work keeping the main trend

as the base of their analysis that implies that if the trend in a security goes up, the

trader will opt for buying the shares, call options or go for future contracts ( Ally

Financial , 2017). And if the ongoing trend seems to fall the trader has the option for

shorting the shares or going for future contracts and buy put options.

Scalping

This strategy has reported to be considered the quickest one that is employed by the

active traders. This involves the process of exploiting the various price gaps that

occurs because of the bid-ask spreads. The main line of working of this strategy

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involves a transaction carrying out at the bid price and then closing it at the ask price.

The difference that arises out the two is the gain that is received between the two

prices (Robles, 2016). The positions under this are supposed to be held for a shorter

period so that the least amount of risk is being involved.

Analysis of the Approach Adopted

In order to carry out a trading transaction, one not only has to adopt a strategy that has

to be employed but also decide the markets that are available for trading in currencies

like the available foreign exchange market, the derivates market and the exchange-

traded funds market. In this analysis, transactions have been carried out in a forex

market, where 13 trades have been undertaken to form the base of the analysis.

Transactions carried out in the forex market involves large financial institutions who

are willing to trade in currencies either for getting immediate delivery or for a later

date. Out of the 12 trades that have been undertaken 6 out them are based on day-

trading strategy and rest 6 have been on Position trading, i.e. they are held for a more

than over a day before the decision of selling them off was undertaken and the rest

one got under pending orders.

It is generally considered that in currency trading, there are four major currency pairs

that are in existence, i.e., EUR/USD, USD/JPY, GBP/USD, USD/CHF (FXCM,

2018). It was made sure while putting day trading strategy in use that trading in at

least two out of the four stated currency pairs should be undertaken.

The EUR/USD

Since the United States and the European Union are considered to be the two of the

largest economies in the world, there percentage of being traded is also very high. In

the year 2016, the percentage of trades involved in this pair was accounted to be

around 23%. Being such a popular pair for trading among investors although it

doesn't provide much of arbitrage opportunities to its investors yet it offering the

most liquidity remains to be a popular choice for traders wanting to either buy or sell

(Yahoo Finance, 2018). Another aspect of this pair is the high amount of volatility

being involved. Therefore, this combination of highly liquid and highly volatile

makes this pair an appropriate choice for applying day trading strategy, resulting to

which a profit of 36 AUD was occurred as well. Here is the chart showing 5 year data

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of EUR/USD where the position of Euro in terms of US dollar is depicted (Appendix

1).

Figure 1 Chart showing the Euro weakened relative to the U.S dollar, Source: (XE

Corporation, 2018)

USD/JPY

As per reported by the World Bank, Japanese economy is as well considered to be

amongst the largest national economies. Since Japan has been largely involved with

huge amounts of trades with USA, Asia and Europe, majority of the MNCs have been

indulging into getting their local currency to yen and vice versa. Therefore, due to

availability of low interest rates USD/YEN is as well one of the preferred pairs for the

investors to trade in (FX , 2018). This currency pair as well offers the most liquidity

thus making it an excellent option for day trading as it is suitable for both new comers

and experienced investors. The factors that were taken into consideration while

trading in this currency pair was a close look on economic growth of the Japanese

economy which has a direct effect on its currency. Since Japan's economy is heavily

dependent on exports to its major trading partner, any slow growth in them will

automatically affect the yen to weaken (FX , 2018). After careful consideration the

trade was undertaken will resulted as a profit of 133.97 AUD (Appendix1). Following

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is the chart showing the 5 year data depicting the change in currency rate of USD to

JPY

Figure 2: XE Currency Charts: USD to JPY Source: (XE Corporation, 2018)

Now, when trading in currencies is undertaken along with the deciding the strategy to

be opted to carry out the transaction, another important thing that is to remember is

that transactions in foreign currency are highly volatile that makes me prone to

uncertain fluctuations leading to considerable risk. And mitigating that risk is as much

of importance as any other decision taken while carrying out the trading process.

Traders in the international markets make sure to hedge their foreign currency

exposure in order to get as much profits as possible with minimum amount of risk

involved.

In Brief, there are four type of hedging techniques that is used by traders to mitigate

any significant risks involved, i.e., Forward and future contracts, options and swaps.

The hedging technique that is being used in the analysis undertaken is the use of

forward contracts. This is the most commonly used hedging technique that involves

getting into a contract where the buying or selling price of a currency is pre specified

to be carried out at some time in future (Wu, 2018). Thus making the use of this

technique most popular and efficient for risk management.

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Taking into context the trades, as mentioned above out of the 13 trades done, the later

6 trades were done on the basis of position trading strategy. Under which the trades

were held over a day and in order to mitigate any risk involved forward contracts

were used. Taking an example of a trade undertaken of currency pair EUR/JPY,

where the transaction was carried out at a Forward rate of 131.53 but it was noted to

went down to 131.0, which resulted into a considerable loss of -631.22 AUD

(Appendix 2). The possible reason leading to this loss in the currency pair could be,

since Yen is considered to be a low-yielding currency that played the part of attracting

traders that borrow at lower rate in Yen in order to buy currencies that would bring

them more returns like EUR. Now, this makes the currency pair highly sensitive to

swings in a prevailing market trend (Daily FX, 2018). Thus due to the Eurozone debt

crisis along with the anti-deflation policy introduced by the Bank of Japan might have

resulted into the making it highly volatile and thus justifying the loss occurred .

Figure 3 shows a chart of trends in the EUR/JPY over the years.

Figure 3: Chart showing EUR/YEN currency trend Source: (Daily FX, 2018)

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Conclusion

The foreign exchange market is considered to be one of the largest and the most

active in terms of trading, financial market worldwide. For a transaction to be

complete two different trades are to be involves, i.e., buying of the currency and then

selling it off. This report has highlighted the various strategies undertaken for carrying

our the trading process with focus on the one used while doing the trades for this

assignment. Also, the type of hedging technique adopted to mitigate any significant

risk. One important thing that was concluded was that although adopting a risk

management technique might or might not help in eliminating the risk completely yet

it is always preferred to undertake efficient hedging technique so that if not

completely at least to some level the risk should be mitigated.

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References

Ally Financial , 2017, Swing Trading Strategies, [Online], [Accessed 4 May 2018].

Available at: https://www.ally.com/do-it-right/investing/swing-trading-strategy-guide/

Gencay, R., Dacorogna, M., Olsen, R. & Pictet, O., 2003, Foreign exchange trading

models and market behavior, Journal of Economic Dynamics and Control, 27(1), pp.

909-911, retrieved 6 May 2018,

https://pdfs.semanticscholar.org/af34/341ea45dd7aa1aeb0e7d99dccde2fe9f6df6.pdf

Ling, F., Yat, D. & Muhamad , R., 2014, An Empirical Re-Investigation on the `Buy-

and-hold Strategy' in Four AsianMarkets: A 20 Years' Study, World Applied Sciences

Journal 3o, 1818(4952), pp. 226-237, retreived 6 May 2018,

https://umexpert.um.edu.my/file/publication/00004754_142448.pdf

Castrén, O., Osbat , C. & Sydow , M., 2006. WHAT DRIVES INVESTORS'

BEHAVIOUR IN DIFFERENT FX MARKET SEGMENTS? , European Central Bank,

Germany

Daily FX, 2018, EUR/JPY, [Online], [Accessed 6 May 2018].

Available at: https://www.dailyfx.com/eur-jpy

FX , 2018, USD/JPY: Dollar pares some of its gains as yields drop, [Online],

[Accessed 5 May 2018]

Available at: https://www.fxstreet.com/currencies/usdjpy.

FXCM, 2018, FXCM's Tradable Currency Pairs, [Online], [Accessed 6 May 2018]

Available at: https://www.fxcm.com/uk/forex/currency-pairs/

Johnson, R., 2011,Day Trading , Nassa Organisation. Florida

Robles, C., 2016. The Super Scalper Strategy, [Online], [Accessed 2 May 2018].

Available at: http://ww12.yourforexmentor.com/

Shiryaev, A., Zuoquon, X. & Zhuo, X., 2008, Thou Shalt Buy and Hold, University of

Columbia, New York

Tharp, V., 2013, Van Tharp's Definitive Guide to Position SizingSM Strategies,The

International Institute of Trading Mastery, New York

Wu, L., 2018, Forwards and Futures, [Online], [Accessed 6 May 2018].

Available at: http://faculty.baruch.cuny.edu/lwu/9797/lec1.pdf

XE Corporation, 2018, EUR to USD Chart, [Online], [Accessed 6 May 2018].

Available at: https://www.xe.com/currencycharts/?from=EUR&to=USD&view=5Y

XE Corporation, 2018, XE Currency Charts: USD to JPY, [Online], [Accessed 6 May

2018].

Available at: https://www.xe.com/currencycharts/?from=USD&to=JPY&view=5Y

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Yahoo Finance, 2018, EUR/USD, [Online], [Accessed 5 May 2018].

Available at: https://finance.yahoo.com/quote/EURUSD=X/

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Appendix

1. Day Trading

2. Forwards

3. Pending Orders

• Author: Suvidha Sehgal (Author)
• Publication Year: 2018
• Pages: 12
• Catalog Number: V427005
• ISBN (eBook): 9783668743441
• ISBN (Book): 9783668743458
• Language: English
• Tags: trading, strategies, risk, management, speculation, foreign, exchange, market