Foundations of Forex

Foreign exchange trading or “forex” can be a complex trading topic and an unpredictable market. In this episode we look to explain some of the basics so our listeners can have a foundational understanding of the topic. Andrew Wilkinson, IBKR’s Director of Trading Education joins Cassidy Clement, Senior Manager of SEO and Content to discuss.

Summary – Cents of Security Podcasts Ep. 54

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Cassidy Clement

Welcome back to the Cents of Security podcast. I’m Cassidy Clement, Senior Manager of SEO and Content here at Interactive Brokers. So today, our guest is Andrew Wilkinson, the Director of Trading Education here at Interactive Brokers. Welcome, Andrew.

Andrew Wilkinson

Thank you, Cassidy. Always good to be back. How are you doing?

Cassidy Clement

I’m all right. Today, we’re going to talk about foreign exchange or Forex, so that can be a complex trading topic and usually an unpredictable market.

So in this episode, we’re going to look to give our listeners some basics and then some of the foundational topics, so they have an understanding of it in the most broad of ways.

So, I guess to kick it off, I know you’ve been on several episodes on our other channels and a few on this one, but, what exactly is your industry background and your exposure to this topic?

Andrew Wilkinson

I was an interest rate trader many years ago, and that looks at what central banks do, how interest rates and deposit rates are set by various central banks, and it does play a large part in the structure of foreign exchange curves kind of behind the scenes. We’ll get into that a little bit later on.

But I did trade interest rates and I monitored exchange rates as part and parcel of that. And then I did trade some currency pairs for myself.

Cassidy Clement

So when we’re talking about the topic, just foreign exchange in general, and how it works, some people may think about it in a similar sense to how I discussed it with Caleb Silver from Investopedia with emerging markets, you may initially think, yeah, I’m trading Vietnam or what have you, but you don’t sometimes go a step further.

You may think it’s foreign currency, so I’m going to take this currency and move it over here or convert it but, what exactly is foreign exchange currency to the beginner investor, and how would you explain the execution of it all?

Andrew Wilkinson

Okay, so foreign exchange trading is all about when you’re trading something, you’re trading something else against it. And for the large part, you’re trading the U. S. dollar against something else, whether it’s the Vietnamese currency, the Thai currency, or a bigger currency like the Euro. You’re always trading one against the other.

Now, let’s just take it back a little bit. If you’re trading stock, if you’re trading Apple, shares of Apple or Google or Interactive Brokers, you’re giving up currency. If you live here in the United States, you’re giving up dollars to buy equity in the company, so you’re really trading Apple versus the US dollar.

With any foreign currency transaction, you’re giving up one currency for another. So you don’t always have to be giving up the United States dollar just because you live in the United States.

You are transacting what is known as a pair and they’re either major pairs or minor pairs. A major pair always involves the US dollar against something, so the Euro or the British Pound against the dollar or a minor would be perhaps considered, as I say, the Vietnamese or the Thai currency, something like that.

What you’re doing here is you’re trading a price. The price is set by the market at all times. And the price can go up or it can go down, and it will be up and down in terms of the US dollar, primarily.

One dollar from the United States might buy two pesos in a different currency, and what you’re hoping for is that the value that you are long of, maybe the US dollar, will increase in value so that it buys two and a half or more than two pesos in the other currency.

The foreign exchange movement can be so rapid that, that your profit and loss, well your profit, goes up very quickly as opposed to maybe with a stock’s price that could go up over time.

So really you’re monitoring the value of a currency issued by one nation against another, brought together in the marketplace, based upon a whole string of criteria, and they could be, economic data or what the central bank is doing in the marketplace. We’ll get to those later on.

Cassidy Clement

So it really sounds pretty complex. So from an investor perspective, can anybody take part in this type of investment or is it mainly reserved for the more sophisticated traders?

Andrew Wilkinson

Sophisticated traders or institutions can move around large amounts of capital or currency pairs in this case. And the reason that happens is because they’re looking for that very small movement.

A lot of the foreign exchange market, I think the FX market, is worth about 6.6 trillion dollars in average daily turnover and that compares to less than 2 trillion in the U.S. equity market. So it’s three times, the world FX market is about three times the size of the combined U. S. equity market. So it’s a big market.

Now, having said that, a lot of those positions don’t necessarily stay around for very long. There could be movements trying to capitalize on a minute movement in currency pairs.

The more liquid something is, the easier it is in that marketplace to get in and out of a trade, hopefully for a profit. Now, retail investors do use a foreign exchange and it’s generally those that kind of find a passion for it because it’s a very, it is a really good market to watch. There are many drivers to it as we’ll discuss in a little while.

Whereas with equities, you might be fixated on why Google’s moving, or why Apple’s moving, or why GameStop’s moving, and whether you can jump on that trend very quickly. They don’t necessarily have a large amount of drivers. Companies like Apple and Google will have news a lot but other companies may have a lack of news to kind of move the individual share price and therefore you’re kind of left to the perils of the broad market movements, whereas economic data tends to drive the value of a currency and if it’s not driving the value of the currency that you’re looking at, it’s driving the currency on the other side, the dollar, so you’ve generally always got something to be interested in.

Cassidy Clement

So initially when you were describing your background and some of your experience, you mentioned that you did have some currency trading experience. So are there any examples of pieces of history that you witnessed or saw or some market trends that maybe listeners would be familiar with to say, oh yes, I actually did run into a foreign currency or foreign exchange event in my life and I just didn’t know that that involved foreign exchange? I just thought it was an economic event.

Andrew Wilkinson

One of the classics that I can remember in the last 10 years was Britain’s surprise decision to exit the European Union. So what happened was there was a referendum and I think people knew it was going to be roughly 50/50, but I think a lot of people, and particularly in the marketplace, did not think that the British people would vote to actually leave the EU.

And I remember arriving back home from work that afternoon when the results were coming in at 10 or 11 o’clock in Britain and it became apparent from a few particular areas of the country as the results rolled in that Britain was indeed about to leave the European Union. And this was a real shocker.

So we look at the pound against the dollar in terms of pound. The pound, one pound buys a certain amount of US dollars and at the time the pound bought, I think, $1.38. And there was, because of the shock, news on Brexit that was unfolding in front of our very eyes. The pound fell not just to $1.30, not to $1.25 or $1.20, but to about $1.15 and in fact, I think it got down to about $1.04 overnight. That was a seismic move.

You really don’t see that kind of thing very often but that was a market that could absorb live breaking news as it happened. And what an exchange rate does is it gives you, it’s a sign of life of the economy.

And the fact that the pound was losing value very, very quickly, spoke volumes about the potential implications of everything that people hadn’t thought about as a result of Britain’s decision to leave the Union.

Cassidy Clement

So you’re talking about this shift for one country then impacting the larger economics of, I guess you could say the developed world that all trades within these markets.

So, with that specific example in mind, you mentioned a few things about how large the impact could be seen, from the financial data perspective.

But what are some ways that the normal investor could say, oh, that impact that I see on my investment here is likely due to a Forex topic impacting it? What are some examples that you can give that people may be familiar with?

Andrew Wilkinson

Yeah, good question. So, the price that I mentioned earlier is the exchange rate, that’s what you can exchange $1.00 for any other currency for. That’s the price set in the marketplace.

Now, some of the drivers would include an expectation as to what’s going to happen with monetary policy. So, if we have the pound, and the central bank there is the Bank of England, and we have the US dollar, the central bank is the Federal Reserve.

What a foreign exchange trader will look at is the expected path in monetary policy over the next year. So they’re always trying to discount, is the Bank of England more likely to change interest rates in a particular direction versus what will the Federal Reserve do?

And all of the inputs that go into monetary policy setting are those things that we see on the screens every day or read in the newspapers that are impacting the US economy, the British economy.

And you can take them side by side. You can look at the unemployment reports or the nonfarm payrolls reading in the United States versus the unemployment report from over in the UK.

If Labor is being added to the market, if the unemployment rate is staying very low, that’s a positive. It means that economic growth is going to do extremely, is going to do well, and the respective central bank is not going to change interest rates.

In the United States, it’s very, very clear at this point in time that the jobs market is robust and that The Federal Reserve is unlikely to want to, or even can afford to, cut interest rates because you cut interest rates to stimulate the economy.

So, you’ve got this inherent, kind of forward curve of interest rate expectations that have an immediate impact on the value of each currency.

And it’s a relative thing. If the UK releases unemployment data on Wednesday and the US does so on Friday, you can quickly come to a decision about which was better and which one is most likely to change expectations going forward.

If consumers are spending a lot money, the Retail Sales Report will tell that, and again, is it going to hold the Federal Reserve to, you know, is it going to keep them on pause?

Have you got weakening sales in the United Kingdom, and therefore is the Bank of England more likely to ease interest rates as a result? And a lot of this revolves around Inflation expectations, so only when inflation is beginning to come down and the central banks are happy with it, will they then kind of give a green light to perhaps relaxing monetary policy.

You’re looking at two countries side by side with, as I say, Apple or Google when you’re invested in the stock, you’re looking at one set of circumstances that drive that company’s share price.

You’ve got to consider, when trading for an exchange, you’ve got to consider the outlook and the backdrop, for the economy in, both situations.

Cassidy Clement

You mentioned a few drivers, as you called it, and then also you used the comparison of the two countries or the two companies, if you were going to look at it from maybe a perspective to draw a parallel from stocks.

Other than the obvious, which is more of the currency risk, geopolitical risk, are there any other things that people may not think of initially that can be a risk within doing this type of investment?

Andrew Wilkinson

That’s a good question. I mean, you’re always going to have outliers. Another thing you’re going to have is positioning in the marketplace. So you might think, based on everything I’ve said, you might be able to say, well, OK, looks like the Federal Reserve is going to cut interest rates at some point. And we think therefore that the dollar is going to lose relative value against the Australian dollar.

What you don’t know behind the scenes is whether some big institution is accumulating a position. They might be doing it not just through the spot market, which is the physical market. They may be doing it through a currency position, which requires other people to kind of feed that position.

And it’s acting in an opposite way to what logic would dictate. So you never know that kind of thing in the background. You also don’t know whether somebody is perhaps buying Australian dollars in order to invest physically in that country and maybe even buy a big company.

I’ve certainly seen that reported in the newspapers, that a takeover has been announced in the UK and you’ve actually seen the forex implication in the marketplace a few days before.

So you might have expected the Pound to actually drop, but because somebody was buying Pounds in order to substantiate a takeover position, you just don’t know about things like that.

Cassidy Clement

You mentioned the word expectation a handful of times, which I know we’ve covered in a lot of different type of, entry level investment concept type podcasts. So that type of thing usually goes into what I would call self-vetting, if you will, to see if the investment is right for yourself.

Seeing if you are working with something that is highly reliant on market expectations, or if it is more of a complex type of investment that involves a lot of research. How sufficient are you with that, and how proficient are you in that area?

So, from your perspective, what are some questions that investors should ask themselves if they’re considering a forex or a foreign exchange investment?

Andrew Wilkinson

I guess some of it comes down to your experience as an investor. As I say, fixating on a single stock or a sector if it’s technology and Apple and so on, I love the iPhone, therefore I’m going to buy the product, that’s one way of investing.

But with FX Trading, you generally need to keep your eye on the screens and the news an awful lot of the time because those markets are 24/7.

Is it right for you? Are you good with politics and policy? Are you good at understanding, not just whether the retail sales report was strong, but what’s behind it? And whether the central bank is going to read the report as being strong or not?

So it’s all kind of relative to a benchmark. You need to be on your toes, fast acting, and be able to pull the trigger on something. You don’t fall in love with a currency just because you think it’s going to go up. You’ve got to be able to do the opposite, turn it on its head and say, I’m wrong, or I’m wrong for these reasons, and be able to get out of the position.

You’ve got to be nimble, and you’ve got to be able to buy it and sell it very quickly.

Cassidy Clement

That’s funny, actually, because a lot of my research was showing that you need somewhat of a balance, or some authors were calling it, I think like a trading equilibrium, where you have to be able to be quick on your feet, if you will. There’s a lot of pivoting.

It’s a lot quicker than your standard issue, set it and forget it.

I’ll come back to my nest egg and hopefully it’s still there. There’s a lot more involved. But thanks for your expertise and thanks for coming on the pod today.

Andrew Wilkinson

Thanks for having me, Cassidy. Nice to see you.

Cassidy Clement

Sure. So, as always, listeners can learn more about an array of financial topics for free at ibkrcampus.com. Feel free to leave us a rating or review on any of the places you listen to our podcast.

Thanks for listening.