their returns, options traders regularly engage in delta hedging and gamma trading. Without getting into a major options discussion here (we cover currency call and put options in Chapter 15), option portfolios generate a synthetic, or hypothetical, spot position based on spot price movements.
To maximize the return on their options portfolios, they regularly trade the synthetic spot position as though it were a real spot position. Trading the synthetic positions generated by options is called delta hedging or gamma trading.
Global investment flows
Financial investors are the other main group of nonspeculative players in the forex market. As far as the forex market is concerned, financial investors are mostly just passing through on their way to another investment. More often than not, financial investors look at currencies as an afterthought, because they’re more focused on the ultimate investment target, be it Japanese equities, German government bonds, or French real estate.
Mergers and acquisitions (M&A) activity is often international and shows no sign of abating. International firms are now involved in a global race to gain and expand market share, and cross-border acquisitions are frequently the easiest and fastest way to do that.
Which countries and which currencies are involved? If a French electrical utility buys an Austrian power company, there are no currency implications because both countries use the euro (EUR). But if a Swiss pharmaceutical company announces a takeover of a Dutch chemical firm, the Swiss company may need to buy EUR and sell Swiss francs (CHF) to pay for the deal.
How much of the transaction will be in cash? Again, if it’s an all stock deal, then there are no forex market implications. But if the cash portion is large, forex markets will take note and begin to speculate on the currency pair involved.
Speculators: Running the Forex Show
Speculators are market participants who are involved in the market for one reason only: to make money. In contrast to hedgers, who have some form of existing currency market risk, speculators have no currency risk until they enter the market. Hedgers enter the market to neutralize or reduce risk. Speculators embrace risk taking as a means of profiting from long-term or short-term price movements.
Speculators (specs for short) are what really make a market efficient. They add liquidity to the market by bringing their views and, most important, their capital into the market. That liquidity is what smooths out price movements, keeps trading spreads narrow, and allows a market to expand.
In the forex market, speculators are running the show. Conventional market estimates are that upwards of 90 percent of daily trading volume is speculative in nature. If you’re trading currencies for your own account, welcome to the club. If you’re trading currencies to hedge a financial risk, you can thank the specs for giving you a liquid market and reducing your transaction costs.
Speculators come in all types and sizes and pursue all different manner of trading strategies. In this section, we take a look at some of the main types of speculators to give you an idea of who they are and how they go about their business. Along the way, you may pick up some ideas to improve your own approach to the market. At the minimum, we hope this information will allow you to better understand market commentaries about who’s buying and who’s selling.
Hedge funds
Hedge funds are a type of leveraged fund, which refers to any number of different forms of speculative asset management funds that borrow money for speculation based on real assets under management. For instance, a hedge fund with $100 million under management can leverage those assets (through margin agreements with their trading counterparties) to give them trading limits of anywhere from $500 million to $2 billion. Hedge funds are subject to the same type of margin requirements as you or we are, just with a whole lot more zeroes involved.
The other main type of leveraged fund is known as a Commodity Trading Advisor (CTA). A CTA is principally active in the futures markets. But because the forex market operates around the clock, CTAs frequently trade spot FX as well.
The major difference between the two types of leveraged funds comes down to regulation and oversight. CTAs are regulated by the Commodity Futures Trading Commission (CFTC), the same governmental body that regulates retail FX firms. As a result, CTAs are subject to a raft of regulatory and reporting requirements. Hedge funds, on the other hand, remain largely unregulated. What’s important is that they all pursue similarly aggressive trading strategies in the forex market, treating currencies as a separate asset class, like stock or commodities.
Speculating with black boxes, models, and systems
Many leveraged funds have opted for a quantitative approach to trading financial markets. A quantitative approach is one that uses mathematical formulas and models to come up with buy and sell decisions. The black box refers to the proprietary quantitative formula used to generate the trading decisions. Data goes in, trading signals come out, and what’s inside the black box, no one knows. Black box funds
