Confession: I normally don’t do much research outside of options and long stock.
Not because the other platforms are some terrible place where people are yelling about pork bellies and soybeans, but simply because I don’t really understand it.
So to make up for admitting my weaknesses in finance on my finance blog, I decided to learn.
I was recently given a project that involved looking at the valuation of the USD, so I thought that the research involved would be a perfect opportunity to understand some more about different sides of the finance world.
That’s what’s so incredible about finance – it’s a world that is CONSTANTLY changing and the learning curve is always getting steeper. No one really knows it all. (If you do, shoot me an email please)
There are so many tiers to investing. I could invest in private equity (if I was a lot richer) or I could do some hedge fund stuff (once again, if I was richer), I could go long stock, I could sell options, trade bonds, or I could do some futures trading.
I decided to check out the futures market- mostly because my project revolved around currencies, but also because I have always been intrigued by the secretive world that trades cheese and butter.
The futures market (as a bare bones definition) contains the future prices of different things: like market indexes (DJIA, SPX, FTSE), currencies (USD, CAD, YEN) and commodities – so your pork bellies, soybeans, cheese, butter, etc.
Futures contracts have some similarities to options (hedging, speculating), but they are also quite different (contract terms).
Both futures and options, as well as forwards, are derivatives of stocks. They are DERIVED from an underlying price, and that’s what people trade on. Trading primarily takes place on the Chicago Mercantile Exchange or the Chicago Board Options Exchange, but can also take place in other forms if you are a big corporation.
The analysis I’m talking about will be in terms of currency, but there are a lot of different futures that you can trade, as discussed previously. The world is your oyster (which is not actually a futures contract, so be careful).
Forward contracts are agreements specifically between corporations and institutions (not so much individuals) to exchange currency at some date in the future.
Just like bonds, forwards normally carry some sort of discount or premium.
For example, if the euro was trading spot (spot price= price right now) at $1.40 and the one year forward-rate was trading at a premium of 2%, the one year forward rate (price one year in the future) would simply be $1.40*(1+.02), or $1.428. That means the Euro will be more expensive in the future.
- Forward Rate = Spot Rate ( 1 + Premium)
Futures contracts are also an obligation to buy or sell currency at some day in the future but they are STANDARDIZED (vs the flexibility that forwards have underneath big corporations).
So the market is more liquid (because more people can do it), but they also are pretty inflexible, especially compared to what we see in options.
For currencies specifically, there are a set number of (very large) units per contract that each future entails. For example, the Korean Won is 125,000,000 contracts. The won is extremely expensive against the dollar, (currently 1 won is worth $0.00090 dollars) but hedging against that would be quite painful.
Image via Cengage Learning
Firms can lock in prices to for what they want to pay in the future for a certain currency (subsequently, hedging their payables) or they can lock in the price of what they want to sell a currency for (hedge receivables).
So let’s say that you had a 250,000,000 Won payment coming in a few months from a country in South Korea. The won is currently trading at 0.0009 dollar per 1 Won (7/6/18). So you want to makes sure to lock in that 0.00090 price so it doesn’t decrease further!
So, you would sell some Won contracts. Each contract is worth 125,000,000 wons, so you would need to sell 2 contracts to completely hedge your 250k.
Those two contracts would enable you to get paid your $225,000 (250m Won x 0.0009) even if the Won dips to 0.00089 or lower. Nice!
But if the won goes up, you are stuck. You don’t get paid a penny over that 0.0009 exchange rate. The contract expires worthless.
BUT THIS OKAY. It’s the same as options. Hedging with futures allows you to improve the odds, take some risk off the table, but you do sacrifice some potential profit.
There is an inherent risk/reward tradeoff. (I’m probably going to get that tattooed on my forehead)
So what if the firm had a payable?
For example, let’s say that they had a 100,000 payment going to some company in Canada. With the USD/CAD currently trading at $1.308 (7/6/18) they want to make sure that they don’t have to pay any more than that current spot price. No one wants to pay more bills.
So they would buy 1 contract of the Canadian dollar future (representing the contract size), making sure that they only had to pay that $1.308. If the price of the CAD increased to $1.4, the firm would be safe. But if it decreased to $1.2… they would still have to pay $1.3.
TRADEOFFS ARE LIFE.
Regular investors, like me and you, can make the same directional hedges.
A lot of the hardcore futures investors use a lot of technical analysis, which isn’t something I personally do. I take a look at support and resistance, but head and shoulders, pivot points, etc. are beyond the scope of my knowledge. It is interesting to read, but I prefer my Greeks and mathematical analysis.
Image via Swing Trading Strategies
For currencies specifically, regular investors trade within the Forex market, and trade within currency pairs. This is different than the futures market. The futures market has a $5.3T market size vs the more institutionalized $30B futures market, so it really just boils down to liquidity.
No one wants to get stuck in a liquidity trap.
There are some fun equations to look at when evaluating a forex market, like hedge vs. speculator positions. So if a large majority of speculators (the regular people) are short and a lot of the hedgers (big institutions) are long, that means that a market reversal to the upside might be in sight. This can be calculated by the following equation:
Image via Baby Pips
For example if there are 5,000 short contracts and 20,000 long contracts, that means that there are 20% of people short, and 80% of people long. With so much weight towards the long side, it would be expected to top off in the near future, and begin a downward spiral.
Of course, that’s just a metric.
But the metrics are what gives the evaluation strength.
Image via Baby Pips
Baby Pips (where these two pictures are from) is where I learned most of these eval tricks (went through their entire high school and undergraduate program in a day. The things we do for learning)
They do a lot of things based on correlations: for example, the USD/CAD and oil have a pretty strong negative historic correlation. So if oil prices rise, the CAD/USD should decline (the inverse, USD/CAD, would rise). This is because Canada exports quite a bit of oil to the US.
But oil imports overall have decreased, because the US is actually becoming a pretty strong producer in oil due to the shale revolution. So the trade dispute might mess up this Canada relationship, as well as the fracking that the US engages in. That’s why we need a little bit more than just a correlation coefficient.
Image via Baby Pips
But there’s a lot to do outside of that. It’s important to stay mechanical in trading.
Essetnially, trading is about looking at relationships and examining numerical values to make sure that this is the trade you want to make.
Correlation DOES NOT equal causation, by the way. (I will also get that tattooed on my forehead).
Forex also has some pretty numerical analyses in the form of the interest rates. It is kind of like interest rate arbitrage.
It’s called the “carry trade”.
When entering a trade like this, you would examine the interest rates of the respective countries, and buy the currency with the higher rate, and sell the currency with the lower rate.
You can do this through a simple currency pair (like the USD/CAD we saw earlier), so all it would take is one click!
For a quick example, let’s say that country ABC has an interest rate of 4%. Country XYZ has an interest rate of 1%. You could buy XYZ/ABC, and receive a 3% interest rate differential, also known as a positive carry. You would pay the 1% interest rate, and receive the 4% interest rate (netting 3%) As long as the spot rate remains relatively constant, this seems like a pretty good deal!
You can also trade options in the Forex market. There are your traditional put/call options, but there are also the SPOT options (we all knew I would circle back to options eventually).
The premise of SPOT options are pretty interesting. You would input a scenario (USD/CAD will break 1.25 in 15 days), pay a debit for that, and get a payout if actually works. There are a bunch of different types, discussed in this excellent Investopedia article.
So even in the futures market, you have options – literally (ha-ha).
The main thing I wanted this blog to touch on was currencies, and how they tend to move. I am knee-deep in a big eval for the US Dollar, so I am hyper-conscious of any information that might move the dollar.
Let me tell you, there’s a lot of information that might move the dollar.
Interest rates. Job reports. Fed minutes. Trade War. German IFO Business Climate Survey.
As they say, if a butterfly flaps its wings in New Mexico, a hurricane will happen in China.
The world is extremely globalized. So much so that I don’t think there is anything in a vacuum anymore – it’s symbiotic, as my friend Beau put it.
So when you are looking to place a carry trade, or if you’re looking to hedge against your 250,000,000 Won receivable, the Forex/Futures market is the best place to go. It is a bit removed from the world of equities, but has the same sort of stimulation.
In a world that is constantly changing, it’s nice to know that you can just trade a futures contract against it, and keep everything the same.
Disclaimer: These views are not investment advice, and should not be interpreted as such. These views are my own, and do not represent my employer. Trading has risk. Big risk. Make sure that you can balance your risk/reward, and trade small, and trade often.