Make The Currency Cross Your Boss

In the stock market, a trader has the opportunity to choose from more than 5,000 companies - hundreds of which will rally in the most vicious of bear markets and thousands of which will crash during the strongest of bull runs. But in the currency market, such divergent possibilities do not seem to exist. In this article, we'll look at how forex traders can use currency crosses to make a wide variety of trades that are unaffected by the day-to-day fluctuations of the greenback.

All Currency Bets Are the Same
When dealing in the major currency pairs, most traders are presented with only one choice: dollar bull or dollar bear? Regardless of whether a trader is long the GBP/USD (British pound-U.S. dollar) or the EUR/USD (euro-dollar), or short the USD/CHF (dollar-Swiss franc) or USD/JPY (dollar-Japanese yen), the unifying theme in all of these positions is that the trader is bearish on the greenback. Therefore, the question of which of the four trades should be taken is immaterial, since all of them will likely be profitable if the dollar is weak and all will lose money if the dollar is strong.

Granted, this may sound like a gross oversimplification of the forex market. We'll be the first to acknowledge that some currencies can and do challenge this paradigm - the Canadian dollar is one good recent example of such a dynamic. Buoyed by skyrocketing oil prices, the loonie has turned into a petrocurrency as Canada has become the United States' No.1 supplier of crude. As a result, while other major currencies like the euro, the yen and the pound have recently declined against the U.S. dollar, the Canadian dollar has gained in value. However, this is an exception that proves the rule.

To better understand how this works, let's take a look at the two charts below. Figure 1 looks at the performance of the seven most liquid currency pairs in forex, composed of the four majors:

• EUR/USD
• USD/JPY
• GBP/USD
• USD/CHF

and the three commodity pairs:

• USD/CAD
• AUD/USD
• NZD/USD

Figure 1 looks at activity on a single trading day - October 12, 2005. To normalize the data, we converted every pair so that its performance could be analyzed accurately. Typically, if the dollar were weak, the EUR/USD would rise and the USD/CHF would decline; however, in Figure 1 we have made the adjustment so that the returns are consistent vis a vis the dollar.

Figure 1: In forex, some currency pairs are quoted in terms of the U.S. dollar (e.g. EUR/USD), while others are not (e.g. USD/CHF). By inverting the pairs that are not expressed in terms of the dollar, we can compare the strength/weakness of each pair relative to the dollar.

Source: DailyFX.com

Figure 2 looks at activity on the same trading day - October 12, 2005 - for the Dow Jones Industrial Average.

Figure 2: In FX, most traders (those trading the seven most liquid currency pairs) are presented with only one choice - dollar bull or dollar bear - but the stock market is less straightforward. As this chart shows, even when an index like the DJIA is down overall, many of its stocks can be up, making it harder to take a purely bearish or bullish outlook.

Source: DowJones.com

Both of these charts clearly illustrate that while the stock market is truly a market of stocks, the currency market is really a market of dollars and anti-dollars. The central reason why this is so is that the dollar serves as the reserve currency for the world's central banks. Therefore, when speculators are bullish on the dollar, capital will flow from all the major currencies into the greenback and vice versa when the sentiment reverses.

Crosses Offer More Possibilities
If you look closely at Figure 1, however, you'll notice that the capital flows are far from uniform. Some currencies appreciate substantially against the dollar, while others gain barely a few basis points. This difference in performance against the greenback creates profit opportunities for market players who choose to trade in currency crosses. Crosses are simply a measure of the relative strength of an individual currency against the dollar. Crosses are distinguished by the fact that they do not include the dollar as either the numerator or the denominator of the pair. As such, they offer traders a tremendous opportunity to make far more nuanced bets in the currency market than the simple pro- or anti-dollar trade.

What makes crosses especially interesting to currency traders is the fact that they can provide much cleaner trend or range signals which will be unaffected by the day-to-day oscillations of the greenback.

To better understand how crosses work, let's examine the following two charts, which look at data over the same period of time (from July 1, 2005 to October 14, 2005). While the most liquid financial instrument in the world - the EUR/USD - has done nothing but range aimlessly during the period in question, frustrating both bulls and bears (see Fig. 3), the CAD/JPY has displayed one of the purest trends in recent memory, gaining almost 1,000 points without any material retracement (see Fig. 4).

Why did the CAD/JPY rally? As we mentioned earlier, the Canadian dollar is a petrocurrency that has received a tremendous boost from the stratospheric rise in the price of crude. The yen, on the other hand, is the principal victim of high oil prices because it is the only highly industrialized country in the world that must rely on imports for 99.5% of its petroleum needs. The CAD/JPY, therefore has an 89% correlation with the price of oil.

Canny traders who bet on an oil rally could have expressed that opinion very effectively in the currency market through a long CAD/JPY position. Even better, they would have harnessed a positive yield differential in the process. With the loonie currently yielding 2.75%, while the yen rates remain at 0%, the interest rate differential alone was 275 basis points or 27.5% annualized using a standard 10:1 leverage factor. (This essentially means that since FX traders can use $1 of capital to control $10 worth of currency, the gain from the 275 basis point differential will be 10 times larger than if traders did not use leverage.)

Carry or Capital Gains
Crosses can be as volatile as the most heavily-traded stocks during the heyday of the Nasdaq bubble or as sedate as a 'AAA'-rated dividend-yielding utility share on the NYSE. Trading in crosses can focus on carry strategies that try to profit from interest rate differentials between the currencies or it can be focused on pure capital gains speculation. Trades can also be based on economic analysis or political news. Some crosses can trend for months, while others will be highly range-bound. In short, the possibilities with currency crosses are endless. Let's look at the charts below to see some examples of recent trades in the crosses that demonstrate these ideas.

The Carry Trade
One of the most popular trades in foreign exchange is the carry trade, which involves going long a high-yielding currency against a low-yielding one. Looking at the seven most liquid crosses in the world, no pair has shown a greater interest rate differential than the NZD/JPY pair. In mid-October 2005, the New Zealand dollar, nicknamed the "kiwi", yielded 6.75% (the Reserve Bank of New Zealand subsequently increased that rate to 7% at the end of October). The Japanese yen., on the other hand, yielded 0% (as of October 2005), and the Bank of Japan's zero interest rate monetary policy is expected to remain in effect until all vestiges of deflation are gone from the Japanese economy. The spread between the currencies was a whopping 675 basis points, and as a result, carry trade speculator