Forex : Currency Trading : Understanding Exchange-Rate Fluctuations and the Magnitude of Gain/Loss on your Positions

Currency Trading Basics : Understanding the Exposure Implications related to Exchange-Rate Fluctuations

NOTE: see below for my handy Visual Aid, the Quick-Reference Diagram: Currency-Move (Exchange-Rate Fluctuations) and the Implied Magnitude of potential Gain / Loss (impact on your portfolio) depending on Exchange-Rate Changes and your current Position Size.  Also, if using Currency-Trading for Hedging foreign-stocks, read my blog about Investing in ADR (American Depository Receipt) Stocks as a potential alternative approach.

Just type the word "Forex" into Google Search and see what comes back.  You will see countless ads for Online Forex Trading platforms, many of them advertising relatively very low initial account-opening deposit requirements (perhaps a few thousand dollars) and promising the opportunity to make huge gains and to allow you to leverage positions by a factor of up to 100:1, with relatively low "spreads" (the market difference between buy/sell prices of the currency pairs).

That all sounds wonderful! Or does it.  Let's look into this foreign exchange market, or currency market, and any thoughts of using swings in exchange-rates to make money, a bit further first.

Potential for Very Rapid and Large Gains OR Losses

You had better first understand the implications of this foreign currency exchange or Forex "trading" — I place the word trading in quotes, because, especially when you are trading leveraged positions, it is really nothing beyond betting, and betting using money you personally do not have (hence why it is called leverage).

Physical Positions (non-leveraged) in a Foreign Currency

If your particular broker / Forex-trading-platform allows, you can trade physical positions in foreign currencies (i.e., buy or sell one currency in exchange for direct holdings in another, and hold those balances in your account), but that is really what I would call "currency conversion" vs. currency trading, with the difference being that when you are holding a physical position in one or more currencies, it really isn't too much different than holding your US Dollars (USD) at a bank, more or less, because, if you wanted to transfer those physical holdings to a bank in a country that supported holding balances in that particular currency, you could do so, and you could (perhaps during a planned trip to a foreign country, or to a country where you own a vacation home, etc) withdrawal funds as you need in order to pay your expenses in the local currency.  An example might involve you maintaining an account at Deutsche Bank in the EU, in Euros, where you could transfer some EUR holdings to if you needed money (in Euros) to pay for your summer vacation home or whatever.

Your exposure to gains and losses is simply limited to the amount of each currency you hold physically (worst case), in the event you decide you need to convert any remaining physical positions back into USD or whatever.  There is no leverage, thus there is no drastic multiplier of currency-swing effects. And, presumably, you wouldn't be holding substantial positions in one or more foreign currency unless you expected to potentially need it for things like travel, real-estate, or even perhaps purchasing a business or other investment in a foreign country.

This is quite different from...

Leveraged Positions in a Foreign Currency : True Forex Trading

When you are simply looking at currency-market volatility as a vehicle for potentially producing income, the game changes considerably. I am not going to get into all the exotic trading possibilities of things like various CFD instruments (Contract for Difference) and other derivatives, but rather just focus on trading the change in relative price strengths between simple currency-pairs.  And, if you are venturing into these waters, you are most certainly doing so utilizing leveraged-positions.

When I say "currency pairs", I am referring to the quotation and pricing structure of the currencies traded on the forex market. The value of a currency is a market rate determined by its comparison to another currency. The first listed currency within a currency pair is called the base currency, and the second currency is referred to as the quote currency.  

Some common currency-pairs, which you can see on sites including Google Finance, include:

• EUR/USD (or EUR:USD if you prefer colon form) — where 1 unit in the base currency (in this case the Euro) is worth a certain number of the quote-currency (US Dollars here); a typical value for this in early 2017 would be perhaps around the 1.05 to 1.07 range, meaning that one Euro is worth (or buys you) between 1.05 and 1.07 Dollars.  
• USD/JPY — the US Dollar / Japonese Yen
• GBP/USD — the British Pound Sterling (or Cable, or Pound) / US Dollar
• USD/CAD — the US Dollar / Canadian Dollar
• AUD/USD — the Australian Dollar vs US Dollar

Pick whichever suits your interests and where you expect you can earn money off fluctuations between the components of the pair.

So, you are ready to trade a currency-pair...

OK, time for some mathematics! You need to understand your exposure to market fluctuations in the currency-pair quotes, because markets can move fast, and when you are leveraged, the multipliers can become enormous.

I created this graphic / diagram / chart / visual-helper (below) to try to demonstrate how much a seemingly small move in an exchange-rate can impact you, in either a good way (profit) or a bad way (loss).

Quick-Reference Diagram: Currency-Move (Exchange-Rate Fluctuations) and
the Implied Magnitude of potential Gain / Loss (impact on your portfolio)
depending on the Price-Change and your current Position Size, visual aid.

I chose position-sizes that may sound large, but, considering that some Forex trading platforms allow you to leverage positions in currency-pairs up to a factor of 100:1, just think about that...  with USD $10,000, at 100-to-1 leverage, that multiplier factor means that you are betting on a position of USD $1 million!

Now, I decided to use a GBP:USD currency-pair example in my above chart.  Let's assume that at the point in time when I take a position in that pair, each British Pound cost $1.5432x (where "x" is some further decimal value if your trading platform goes down to that level of detail, which would be a fraction of a PIP).  Oh, and a PIP = "price interest point", which measures change in the exchange rate for a currency pair, which when displayed to four decimal places, one pip is equal to 0.0001, or in my GBP:USD price chart example above, the column with the value "2" in it, four positions to the right of the decimal point.

Exchange-Rate Changes and Implied Profit or Loss

Referring to my picture (diagram / visual aid) above, let's consider how changes in the currently-quoted exchange rate will affect our paper gain/loss, based on different position sizes (and, keep in mind, I am considering the value of the leveraged position, not the amount you risked in order to leverage that amount; I will use a 100:1 leverage here too, each starting at the purchase-price of the $1.5432 per GBP):

• Scenario #1: (upper-right table in my graphic will be helpful) you buy a £100,000 position in GBP:USD, which would have cost $154,320 (plus any transaction fees), but at 100:1 leverage, the "cost" (amount put up for this bet / trade) is really just $1,543 (plus fees / commissions).
  
  Now, the market value of the Pound increases by 20 PIPs, to $1.5452/GBP: your leveraged position is worth $154,520, thus, you have made $200 (less fees) if you sold at this point.  Notice how my visual cheat-sheet makes this easy to quickly see and compute by looking at the column with the "3" in it (which has changed to a "5" now), you can see that each digit-change in that column implies an overall position-value change of $100. Your gain, in percentage-terms, could be very substantial: $200(less-fees)/1543 => ~13% (not counting fees).  BUT, keep in mind, you could have just LOST that amount too!
  
• Scenario #2: (upper-right table in my graphic will be helpful) you buy a £1,000,000 position in GBP:USD, which would have cost $1,543,200 (plus any transaction fees), but at 100:1 leverage, the "cost" (amount put up for this bet / trade) is really "just" $15,430 (plus fees / commissions) — you now have the price of a low-end new car on the line for this substantial bet / trade position!  "
  
  Now, some reasonable volatility hits the market following Mark Carney opening his mouth about something regarding British interest rates or the post-Brexit economy, and the next thing you know, the market value of the Pound moves lower by a full 100 PIPs (one cent), to $1.5332/GBP: your leveraged position is now worth $1,533,200, thus, you have lost a rather whopping $10,000 (plus fees) if you sold at this point.
  
  Again, my visual cheat-sheet makes this easy to quickly see and compute by looking at the column with the "4" in it (which has changed to a "3" now), you can see that each digit-change in that column, at a £1,000,000 position-size implies an overall position-value change of $10,000. Your loss, in percentage-terms, is simply huge! $10,000(plus-fees)/15430 => ~65%  loss (plus fees).  Sure, you could have just gained that amount too if the rate change had gone in your favor! 

But wait, there's more!

Don't overlook the overnight-interest-charges you will be hit with on your leveraged positions! Did you think you were going to get the implied-funds for 99% of your position for free?  Think again!  These can add up. And, especially keep in mind the cost of carrying these positions over weekends / holidays when markets will be closed!  I am not going to get into the details of all that here, but perhaps I will later.  My goal is to demonstrate the sheer magnitudes of potential movements in the value of your trading positions in relation to very small changes in the underlying exchange-rates.

Potential BUST!

Next, consider that, although you can open a Forex trading account with rather low amounts, notice how, if you had opened an account with what may have seemed like a "reasonable" amount of money to you, that sudden changes and large swings in currency exchange rates (i.e., large volatility) can wipe you out in no time when the broker / trading-platform operator liquidates your account when your physical currency holdings cannot cover the current implied market-price move (i.e., implied loss on your holdings), if even for a minute,... goodbye everything.

This is all the more reason you really need to understand the implied possible changes to your position when the market swings.  Think carefully about this.  Don't take on positions where unexpected market events (e.g., an unexpected rate-rise or cut by a central bank) could move rates 2%, and thus wipe you out if you are on the wrong side of things.

Continue to read this Software Development and Technology Blog for computer programming articles (including useful free / OSS source-code and algorithms), software development insights, and technology Techniques, How-To's, Fixes, Reviews, and News — focused on Dart Language, SQL Server, Delphi, Nvidia CUDA, VMware, TypeScript, SVG, other technology tips and how-to's, plus my varied political and economic opinions.

Currency Hedging with American Depository Receipts (ADRs)

For those of you who have already read my May, 2006 posting about Investing in ADR (American Depository Receipt) Stocks, you may have been able to make impressive investment returns, for two reasons. If you watched both the currency-rates and the stock prices during this time and jumped in when the stock market had a mini correction that bottomed out early-mid June:

• the stock markets, both here and abroad, performed rather well since that bottom;
• the United States Dollar (USD) tanked against the British Pound (GBP) and other currencies worldwide during that same period.

The overall stock market move is a bit irrelevant to the ADR thing, but the second ROI reason is all about currency fluctuations and how they affect your ADR share-price returns.

A couple of London Stock Exchange stocks that have ADRs here in the USA that I regularly follow are Barclays PLC and HSBC Bank (which I used as an example in the 5/13/06 article). Let's say you timed things very well and got into each at roughly their bottom in mid-June, and examine what your returns would be and why:

• Barclays (ADR ticker: BCS) - on the London Exchange, it was trading at 586 Pence at its low, and closed today at 653.5 Pence. Return on the London market: 11.52% . . . Impressive, but, the BCS ADR during the same time hit a $43.23 bottom, and a $49.64 close today, or a whopping 14.83% return, which is quite nice, especially considering we are talking about large blue-chip type banks that roll off a healthy 3-4% dividend! Your ADR returned an extra 3.3% on your investment during the same period! The difference in returns reflects the tanking USD during this period.
• HSBC (ADR ticker: HBC) - on the London Exchange, it was trading at 913 Pence at its low, and closed today at 951.5 Pence. Return on the London market: 4.22% ... and, the HSBC ADR during the same time hit a $84.34 bottom, and a $90.35 close today, or a 7.126% return, which is darn solid too for such a short timeframe. Your ADR returned an extra 2.9% on your investment during the same period! That extra return reflects the substantial drop in the purchasing power of the USD during this period.

Now, you may be asking why both stocks did not return the same 3.3% "extra" due to currency swings: simple, one stock hit its low on a different (later) date than the other, and the currency exchange rates had already changed some.

So, keeping these examples in mind, there can be opportunity to hedge against the falling dollar by purchasing American Depository Receipts (ADR) stocks. This is not as direct as simply playing the currency market on a ForEx trading platform or such, but it is probably less likely to cause you to lose all your money doing risky currency-swing trades. Do some research, and consider the options that are available. There are ADRs for UK stocks as well as German, Japanese, Israeli, and many other firms.

Keep in mind, as I pointed out in my prior article, you can play this swing both directions. If the US Dollar strengthens greatly while you hold an ADR, you can just as quickly see the multiplier working against you. If you want more information, read that first posting of mine. If you still need more, let me know and I will try to dive deeping into investing in foreign stocks in this manner, especially in order to hedge against any devaluation in the US currency.

The Dollar, Cheap Imports, and No US Savings...

A friend of mine, who has businesses in the USA and China, emailed me some wonderful feedback about my recent blog entry about “Currency Markets and the Falling Dollar”. His perspective and insight add further dimension to my discussion.

Here are some quotes and excerpts he provided, plus some commentary I offer in return:

“In regards to the Chinese currency revaluation, we need to first realize that there are two camps interested in the rate, the first are US investors who do not want to see the exchange rate change as that increases there costs of doing business [in China]. The second are those who want to try and make up gaps in the trade deficit and make Chinese goods more expensive so they can compete. In my opinion cheap Chinese goods are an asset to more people then poorly competing US firms that have higher production costs. Chinese have along history of not importing and it is not because the foreign goods are too expensive – it is that they do not cater to the Chinese culture. The US has been an expert in exporting its culture around the world, however when there are countries who are not willing buyers, they [US firms] resort to other means to try and force the issue. Imagine a 40% revaluation of the currency and how that will affect prices of everyday goods for Americans, versus how much revenue it will bring in for US companies that export a few more goods to China. The Chinese government is taking steps to change the exchange rate, and personally it has already cost me quite a bit of money as a US investor in China.”

“Since I have been here [in China] I have already seen a few percentage points drop [in Yuans / USD]. It’s a strange feeling because I understand the market fundamentals and how a revaluation will make things fairer for other competing nations, however I feel the side that wants to keep my costs low, and that influences my thinking. I can now see how big business/governments get so corrupt.”

True, the currency (the Chinese Yuan) is allowed to “float” now against the USD, though within certain parameters that limit the amount of float per day. Here is an article on the recent value of the Yuan, and how it is making gains against the dollar.

Regarding the comment about how big business and governments can get so corrupt, my friend is dealing with the influence of the exchange rate on a relatively small business and investment in China (< $5MM USD / year). And, even at his current investment level, he sees how keeping the value of the Chinese currency depressed works to his advantage and keeps his labor and direct costs in China low. Can you imagine how badly the largest corporations with huge investments in China must want the Yuan to remain week vs. other currencies? It is in their best interest for the Yuan to stay low, so long as countries like the USA continue their Chinese-imports-feeding-frenzy.

And, speaking of this import feeding frenzy, my friend has this to say:

“The fundamental problem with the US financial state is that it is a culture of [people who are] spenders and not savers. The savings rate in many Asian countries is near 40% and the US, I believe, is close to single digits [Mike comment: actually, it is ZERO – read this recent article about the savings rate in the USA hitting ZERO]. This creates a large need for capital in the US which cannot be supplied by the little saving Americans have. This by its very nature forces the US to export its money and other counties are willing buyers at a low price. The sucking sound you hear is the need for US capital because there is none here [in the USA], we have spent it all. This is why a large trade deficit isn’t a bad thing for the US. This is an indication of foreign countries willing to invest in US Dollars. The question is: are we doing the right things with the foreign capital? If we are buying expensive houses and sports cars, then the answer is no. If we are improving education, funding cutting-edge research, and so on, then yes. As we export our culture and turn these [other] societies into spenders and not savers, this competition for capital will increase, and with more competition, the Dollar will slide further against other currencies.”

"Another interesting problem that I think underpins many future issues will be that of investment in research. Currently the US has shifted from traditional production to high tech production, and this I believe will cause a fundamental problem in the future. The issues stems from the combination of government’s inability to fund long term science projects that will help keep the lead, so to speak, for the US in the technology sector, and market driven economies inherent weakness in encouraging long term investment. As “third world” countries invest more in higher education and at a higher rate than the US, the low hanging fruit the US currently eats will be going away very soon. I feel and this includes software development, technical management, and high tech production and research. The higher hanging fruit requires massive long term investment that just doesn’t seem to be a priority in a heavily market driven economy where the pressure is to meet quarterly expectation, and where no one cares about the company’s growth ten years from now. The government has been in a freefall of cutbacks on research since the 70’s and there doesn’t seem to be any comeback on the horizon. This, coupled with the inability to cut back spending in general, leaves us [the USA] in a bad situation; the government is spending far more on things that will not take us into the future […] it seems whenever countries historically get on top, they then look for ways to maximize their lifestyle and loose the “eye of the tiger” [that got them to the top to begin with]. The danger of this is that the US will find itself on equal ground with many new nations, and couple this will a falling dollar, it may cause countries currently holding dollars to start to sell, and we all know what that will do."


Wow! Those are all great points and wonderful insight! Keep it coming people!

The final comments from this friend also covers the topic of my other blog entry about stock market investing. His overall take on investing is an interesting one we should all keep in mind, since it focuses on the macro pseudo-psychological factors behind buying and selling stocks, currencies, and the likes (and, how their expectations drive price determination in the market):

"One observation you made [in your blog] which I think is critical for people investing to understand, is that relationship between good and bad news and the price of the stock, currency, or whatever instrument being trading. The point that I think is often misunderstood or forgotten is that the market price already reflects the expectations of that market on the instrument. Simply put: the dollar doesn’t go up much on good news because people are expecting good news! You expect good news from Microsoft, and not bad news, which is why it is a blue chip stock. Bad news on a stock that is expected to do well is really bad news for the pricing expectations, and therefore has a greater impact on the percentage change. People need to remember that when they invest in a stock that they think is going to really go up, that you are betting against the market, which sets the price based on what everyone thinks will happen. This [logic] is the same on the downside. [...and] why you find stable companies that have modest returns, and are expected to pay dividends. This [logic] is especially true in the case of the dollar, which has been such a large tool for countries to help stabilizer themselves with (by holding lots of US dollar reserves). As I said before, as more countries start down the road of spending as the US (such as the EU, China, etc.), there will be more competition for the money from countries that save, and this will push down prices paid for currencies currently held by [savings countries that move towards] spending countries."

Investing in ADR (American Depository Receipt) Stocks

Invest in Foreign Stocks from the USA

When a company's ordinary shares (ORD) are based in another country, and are home to a foreign country's stock exchange (such as the Tokyo or London Stock Exchange), and trade in a foreign currency, how can you easily invest in these non-US equities?

The answer may be ADRs (American Depository Receipts), which can be a great way of owning shares in foreign companies. Not all foreign companies have ADRs, but those that do give you a way to trade shares in these foreign firms right here in the USA on our own exchanges like the NYSE (New York Stock Exchange) for example, and trade in US Dollars (USD).

NOTE: see my related blog about Currency Trading Basics: Understanding the Exposure Implications (on your Forex holdings) Related to Exchange-Rate Fluctuations (includes a quick-reference diagram / visual-aid for magnitude-of-move comprehension).

Understand the Implications of Underlying Currencies on ADR Share-Prices

Before trading ADRs, you need to understand how they are priced, and the impact that currency-exchange-rates may have on your investment!

ADR "shares" will represent some multiple or fraction of an ORD share. This ratio of ADR:ORD is important to understand, especially if you trying to figure out how the ADR is priced as compared to the ORD. The ADR:ORD ratio will be one of the following:

• (1:1) — meaning, a single ADR share is equivalent to a single ORD share. E.g., Bayer AG (ADR ticker: BAY) whose ADR trades 1:1 with the underlying ORD share trading on the German Stock Exchange in Euros;
• (1:n) — meaning it takes multiple (n) ORD shares to equal 1 ADR share. E.g., HSBC Bank ADRs (NYSE ticker "HBC") trades at a ratio of 1:5, with the underlying ORD share trading on the London Exchange in Pence (i.e., 1/100 Pounds, or a British Penny in essence)
• (n:1) — meaning it takes n ADR shares to equal 1 ORD share. E.g., SAP AG (Ticker SAP), trades at a ratio of 4:1, with the underlying ORD share trading on the German Stock Exchange in Euros;

Though ADR prices are quoted on US Exchanges in USD, you may wonder how they come up with the price. And, this will be important for the next point I'll make, which is: the rather substantial potential impact of currency fluctuations on your ADR price.

Using HSBC (ADR: HBC) as an example, whose closing price was approx. $90.00 USD, here is how that ADR price value is arrived at from the ORD price:

1. Start with the ORD price (in Pence) was approximately 950. I.e., 9.50 Pounds;
2. Now, obtain the ADR:ORD ratio, which is 1:5 in this case;
3. Obtain the currency-pair exchange rate: e.g., the British Pound (GBP) was trading at approximately $1.89 USD per GBP;
4. Finally, perform the calculation.  Start by multiply the ORD price by the ADR:ORD ratio (5 in this case), since one ADR represents 5 ORD shares, giving us 47.5 Pounds (i.e., 9.50 x 5). Next, convert to our local USD currency by multiplying the prior result (GBP 47.5) by the current effective currency exchange rate of 1.89 USD : GBP, which yields the current value that foreign share should be worth in local currency equivalent, or $89.775 USD.

Voilá!, it really does come out to the price the ADR is trading at!

So, one thing that should become quite clear in this "lesson" is the impact of the foreign-currency-exchange-rate in the pricing of the ADR. You may choose a wonderful foreign company to invest in, but, depending on whether the dollar strengthens or weakens against the currency that foreign stock's ORD shares are priced in, you could still lose money. Conversely, a poorly performing foreign stock could make you money on your ADR holdings if the dollar tanked against the currency the ORD shares are priced in.

To make this fact clear to you: Presume you buy HSBC stock at an ADR price of $100.00/share. Even if the HSBC stock underlying ORD shares on the London Exchange never move at all, but the dollar swings downward by 2% against the pound, you will have made 2% on your ADRs, since it now takes more dollars to buy the same amount of HSBC stock ORD shares in Pounds. Likewise, if the dollar gains 5% against the pound, it takes fewer dollars to purchase an ORD share of HSBC, and you will have lost money on your ADR shares. So, be sure to keep currency fluctuations in mind when investing in ADR shares!

Useful ADR Resources

Check out foreign stock exchanges to get quotes (in base currency for ORD shares) for the stock you are researching. For example, to see HSBC quoted on the London Exchange, go here: HSBC Bank, PLC (ticker HSBA) on its native London Stock Exchange website, quoted in pence (i.e., pennies in the GBP or Pounds Sterling currency system).

A nice resource for checking out ADRs is the Bank of New York Mellon (BNY Mellon) Depository Receipts web site. They have a rather comprehensive DR directory that allows searching by region, industry, and many other criteria. It also shows ADR:ORD ratios, underlying country, and more.

Continue to read this Software Development and Technology Blog for computer programming articles (including useful free / OSS source-code and algorithms), software development insights, and technology Techniques, How-To's, Fixes, Reviews, and News — focused on Dart Language, SQL Server, Delphi, Nvidia CUDA, VMware, TypeScript, SVG, other technology tips and how-to's, plus my varied political and economic opinions.