The forex (FX) market is a massive market, and an “inefficient” one where – as I pointed out in my last Insight – a lot of money is up for grabs. So if you’re looking to claim your own share of that pot, there are three simple strategies you need to know…
🎢 Strategy 1: FX Momentum
The rationale:
Momentum investing in FX is the same as other asset classes: buy currencies that have recently gone up and short those that have gone down. This simple strategy works because currency prices tend to trend in one direction over time, especially in the short and medium term.
The execution:
Here’s a good site where you can see the recent performance of the major currencies (click on the “Performance” tab to see all the currencies’ % changes over the past year). To implement the FX momentum strategy, just buy the currencies that have gone up the most over the past year and short the ones that have fallen the most over the same period.
💰 Strategy 2: FX Value
The rationale:
Value investing in FX is no different to value investing in any other asset class: buy undervalued currencies and short overvalued currencies, with the expectation that currencies tend to mean-revert to their long-run equilibrium values. In other words, currency movements in the short-to-medium term are due to a whole bunch of factors, such as sentiment, interest rates, technicals, and so on. But in the long term, they reflect what the currencies should be truly worth based on a country’s macroeconomic factors.
The execution:
The trick for this strategy is knowing how to gauge those equilibrium values in the first place.
One common way is using an economic model called purchasing power parity (PPP), which states that the exchange rate between two countries should be equal to the ratio between their respective prices of a fixed basket of goods. For example, if a basket of goods in the UK costs £1 and a similar basket in the US costs $2, the exchange rate should, according to PPP, be equal to $2 per £1. If the actual exchange rate is $1.50 per £1, that implies the pound is undervalued: it’s trading at only $1.50 when it should be worth $2.
The OECD keeps updated data on all currencies’ PPP values relative to the dollar (make sure you tick the “latest data available” box). Just note that the exchange rates are all displayed per $1. So we can see from the table that according to PPP, $1 should be worth 2.30 Brazilian reals (BRL). But at today’s actual exchange rate, $1 is worth 5.10 BRL. That means the dollar’s value is too high compared to BRL – that is, $1 buys a lot more BRL than it should. The other way to interpret this for the sake of implementing an FX value strategy is that BRL is undervalued.
👜 Strategy 3: FX Carry
The rationale:
In the medium term, returns from higher-yielding currencies – that is, those that have higher interest rates as set by their central banks – tend to outperform lower-yielding currencies when you factor in both currency price moves and income.
Just look at the table below: you can see that the US dollar, New Zealand dollar, and Canadian dollar have the highest interest rates out of the bunch, while the Swiss Franc, euro, and Japanese yen have the lowest.
Major central bank interest rates
The execution:
So if you were to construct a carry trade using the example above, you’d buy USD, NZD, and CAD, and short CHF, EUR, and JPY. Every day you hold the trade, your FX broker will deposit you the difference in interest rates between the currencies. And as an added bonus, the higher-yielding currencies usually tend to go up in value relative to the lower-yielding ones, as more investors flock to them to benefit from the higher interest rates. Just check out this website to take a look at the interest rates set by the world’s major central banks.
It’s worth noting that this crowding of investors is also what makes FX carry risky: it tends to get hit pretty hard during times of market stress, as investors rush to the exit at once. You’ll also want to make sure you’re not overly concentrated in emerging market (EM) currencies: they tend to offer higher interest rates, but they’re also more volatile.
💪 How do you put these strategies into practice?
First, you’ll need to decide on the list of currencies you want to trade. This is your “investable universe” and could be made up of developed market currencies (referred to as “G10”), EM currencies, or both. The list below should help you get started.
List of G10 (developed market) and EM (emerging market) currencies
Second, implement each strategy separately. That is, don’t try to pick currencies that cover carry, value, and momentum. So for FX value, buy/short the undervalued/overvalued currencies regardless of their carry and momentum characteristics. Do the same for carry and momentum.
Third, decide how many currencies you should pick to buy and short for each strategy. A good starting point is three. So in the carry trade, for example, buy the three currencies with the highest interest rates and short the three with the lowest. Finally, decide how often you’ll check the data and rebalance the strategies to factor in changes in your selected currencies. A good rule of thumb is monthly.
Now go ahead and put this into practice for yourself. It won’t be long before you’re wondering what all the fuss about cryptocurrencies was ever about.
