Guest post: Advanced forex trading strategies

 US-PD

By Sara Mackey

Advanced forex trading strategies can vary considerably from trader to trader, often depending on the sophistication of the trader and their dealing size.

The huge and highly liquid forex market lends itself to a number of different advanced trading strategies and styles. Two of those — triangular arbitrage and the carry trade — will be discussed further in the sections below.

Triangular arbitrage

Triangular arbitrage is a form of arbitrage often employed by professional cross rate forex traders. The triangular arbitrage trade consists of three transactions made in three different currency pairs that are preferably made as simultaneously as possible in order to avoid market risk.

The result of these three transactions — if correctly executed — should result in a net flat position and a locked in profit. Nevertheless, a credit risk always exists with third party transactions, and the timing of the transactions can also incur market risk that can be substantial in the volatile markets where such arbitrage opportunities are more common.

In essence, the arbitrage results in largely offsetting forex trades in the three currency pairs when market conditions allow for a net profit to be taken on the position. This opportunity generally occurs when market conditions are temporarily out of line.

The fact that one currency pair has a direct relationship with two other currency pairs makes up the market aberration which this technique exploits. The formula for this arbitrage consists of:

CC1/CC2 * CC3/CC1 = CC3/CC2

As described in the above formula, CC1 refers to the first currency pair, CC2 the second and CC3 the third. As trading in two active currency pairs heats up, the third currency pair may get out of line or “left behind”, therefore setting up an arbitrage opportunity.

An example of triangular arbitrage could involve the EURUSD, USDCHF and EURCHF currency pairs. While the first two currency pairs tend to be more active, an imbalance in the EURCHF rate can result in the arbitrage opportunity. The arbitrageur then takes on a position in the first two currency pairs, which will be offset by an inverse position in the third currency pair, thereby allowing for a risk free profit. 

The Carry trade

Another advanced forex trading strategy involves the differences in the interest rates paid on currencies. Basically, the carry trade involves the purchase of a high interest currency funded by a currency which carries a low interest rate.

Holding currencies for more than one day earns interest, while being short a currency incurs an interest charge. The net of these two interest rates applied to the amount of days from tomorrow or spot value until the following value date is generally called the “rollover” and will have a trader earning or paying interest on positions carried for every day included in the rollover period.

Therefore, the rate of interest in the currency’s country of origin will determine the amount of interest earned or paid out. This can turn into a large sum if market conditions favor the interest bearing currency.   

An example of a recent popular carry trade is buying the AUDJPY currency pair. The rate paid on the Australian Dollar is 4.75%, while the amount of interest paid to borrow Japanese funds is 0.10%.

Accordingly, buying the currency pair will net the AUDJPY carry trader 4.65% in annual interest, as well as any market gains if the Australian Dollar appreciates versus the Japanese Yen. 

Sara Mackey works for Forexfraud.com, a leading guide in the field of Forex trading. 

An Overview of Vanilla Foreign Exchange Options

Vanilla foreign exchange options are a type of option that allow two currencies to be exchanged at a  pre-authorized date using a pre-determined currency exchange rate. Vanilla foreign exchange options   are similar to stock options in the sense the option owner does not have to exercise the right to exchange and can either sell or buy a financial instrument, but different because two currencies are exchanged rather than shares of a single company.

Vanilla foreign exchange currency options are bought and sold via options brokers and implemented on foreign exchanges. The National Futures Association recommends doing so through regulated foreign exchange services such as the Chicago Mercantile Exchange (CME) and the Philadelphia Stock Exchange . Vanilla foreign exchange options are not the same as vanilla forward or swap contracts which follow similar principles, but are not the same financial instruments.

To illustrate how a vanilla foreign exchange option works, Mr. Jones enters into an agreement to sell 10,000.00 Singapore Dollars (SGD)at a specific rate of exchange for U.S. Dollars (USD) at a rate of  .7721. If on the date of exchange, the exchange rate between the Singapore Dollar and U.S. Dollar declines, Mr. Jones can still sell the 10,000 SGD at the previous rate making a profit if the difference in exchange rate exceeds the cost of the option.

Depending on which exchange is issuing the vanilla foreign exchange options, the choice to exercise the option may occur either on the expiration date only, or anytime prior and including the expiration date. Like stock options, vanilla foreign exchange options can either be written or purchased. When the currency options are written as a put order i.e. sell for the option purchaser, the writer must pay the difference between the market price and strike rate if the currency exchange devalues, and the buyer must pay the difference if the value of the currency exchange appreciates.

Using the same example as above, suppose instead, that Mr. Jones decides to write the option. In such case he finances the option buyers right to sell the 10,000 Singapore Dollars at an exchange rate of  .7721 with the U.S. Dollar. For this, the buyer, Mr. Smith, pays a contract fee that is paid to Mr. Jones. If the exchange rate does not become 'in the money' i.e. the exchange rate of the currency pair yields less dollars, then the option expires worthless for Mr. Smith who loses his fee to Mr. Jones.

Volatility risk can be a problem with vanilla foreign exchange options. This volatility increases in proportion to leverage. For example, if Mr. Jones writes a put option for 100,000 Singapore Dollars instead of 10,000 and is using a 10:2 margin rate, then Mr. Jones is 80 percent leveraged at the time of writing the option. If the currency pair becomes in the money beyond the 20 percent, a margin call or additional funds may be required from Mr. Jones to cover the cost of exercising the option at the lower exchange rate regardless of whether Mr. Smith exercise the option.  This is so the exchange does not have to cover the cost should Mr. Jones not have the funds to pay the difference between the market and the strike rate at which Mr. Smith sells.

Sources:

1. http://bit.ly/9qQRyn  (National Futures Association)
2. http://bit.ly/bRMBwv (MathFinance)
3. http://bit.ly/9tmvZA   (Travelex)
4. http://bit.ly/9tmvZA   (Yahoo Finance)
5. http://bit.ly/cdJDKV (Federal Reserve)