The Way of the Dollar

many smaller outfits which can offer a more personal service at competitive commission rates. See “broker*” in the Glossary. Some of these advertise from time to time in the financial papers.

The 24-hour day covers Singapore’s Simex* futures market as well as Chicago’s IMM: the currency contracts at Simex are interchangeable (“fungible” is the technical term) with the IMM’s. But in addition, the so- called EFP* market offers IMM quotations at most times when an active interbank market exists somewhere in the world. EFP stands for “exchange for physical”: the EFP market consists of a number of specialist market-makers, who are in the business of arbitraging between futures contracts and the “physical” interbank forward markets. Like the banks, they make their turn on the “spread” between offer and bid prices: the spread is usually 3 to 5 points (as opposed to 1 point in the IMM) – i.e. $37.50 to $62.50, on contracts of $70,000-$120,000 –which is very competitive with the spreads quoted by banks for such amounts.

The amount of currency exposure a bank will allow you to run is a matter for negotiation. The IMM operates a “margin*” system, as do all futures markets – margin being money you have to ante up to cover the risk in a

futures position. The margin for the currency contracts – DM, SF, Ј, Yen, Can $ and Aus $ – varies around $2,000, which is a mere 2 or 3% of the contract value. If you have any sense, you will never care – or even know – what this margin is. It bears no relationship to the kind of gearing or leverage with which you can expect to trade profitably. Not being in the business of blind gambling, our inflexible rule must be: never , ever, risk a margin call*. It’s difficult enough to win without such an extraneous constraint which abolishes the use of judgement.

We know the currencies can fluctuate up to 5% in a day, and we know we may well wish to hold our position in the event of such a fluctuation against us. It’s a good idea to hold a balance in your brokerage account of 10% of exposures ($10,000 per contract on average in round figures), in US dollars; and to limit overall exposures to a maximum of 3 times one’s overall liquid capital. In other words, keep 30% of your liquid capital in the brokerage account, if your exposures are likely to run up to the recommended limit. You should earn proper interest on funds in excess of margin requirements with your broker.

Position Size*.

Experience shows that to trade the multi-week swings successfully, you have to be prepared for drawdowns* (paper losses) in double figures if you’re running to 3 to 1 gearing (leverage), just as a result of the natural fluctuations in currency holdings –that is without even making mistakes. Getting reconciled to that is a major step on the road to winning, I think. If we cannot accept it, we cut back our gearing.

Achieving currency exposures of up to three times one’s liquid funds with a deposit of 300/0 of those funds with a broker is a reasonably conservative approach. At the other extreme is the investor who has a lump sum in cash and has settled for depositing it in one or more foreign currencies, aiming thus to secure diversification and protection from a decline in his own currency.

You can also do your sums by long division on paper, and go to work on a horse. If you chose to proceed in this way knowing about the capabilities of calculators and motor cars, that’s fine. But there are many people out there who think futures are just intrinsically dangerous – as people once thought about motor cars. And the fact is that not everyone knows that you can get all the currency exposures you want in the forward and futures markets without tying up all your cash. And once you know, you see that you can do much more in the futures and forward markets than you can do with cash. In fact, you can get all the exposure you want in the futures markets to most bond markets and most stock markets. And I personally can see many advantages and no disadvantages to going about it this way.

The New Way to Invest

Consider an investor in Britain – call him Altman – with Ј250,000 (say $420,000). He holds Ј100,000 in gilts, Ј50,000 in US bonds, Ј50,000 in D-marks and Ј50,000 in cash. His investment income (early 1991) is Ј25,000. He has cashed in his stock market holdings, and believes most stock markets are too risky. He also believes the dollar and sterling are both vulnerable against DM and Yen. So he thinks he may lose out on his US bond holdings.

Now consider another British investor with Ј250,000, called Newman. This is end-March 1991 and UK interest rates are still around 14%. He has Ј200,000 on deposit with Swiss Bank Corporation (an AAA-rated credit risk). The other Ј50,000 is held in a dollar account with a futures broker. His investment income is Ј32,000.

His investment views are much the same as Altman’s. In his brokerage account he is short a couple of Long Gilt futures (Ј90,000 –$175,000); long two US T-Bond contracts ($190,000) and a German Bund contract (DM 210,000 or $120,00). He also has 8 IMM Yen futures ($720,000) and 2 DM futures ($145,000) and is short 2 pound contracts ($240,000). He is planning a put option in the S & P US stock market future.

Altman is no fool. He knows that the kind of returns stock markets –and the property market – offered in the 1980s are non-recurrent. His target is a 15% total return on his money, and perhaps he’ll make it.

Newman is no fool either. In the past5 years, he has parlayed Ј100,000 into Ј250,000. He reads all the good books on investment as they appear –particularly those on trading futures. His target for the next 5 years is to turn his Ј250,000 into Јlm and for the next 10 years into Ј5m. He knows something about risk, having lost a bundle in high-tech stocks in the 1980s. I think maybe he’ll make it.

Using Currency Options

As a matter of course, currency options* are not a solution to the problem of currency risk, or of normal adverse fluctuation (drawdown) –though useful to traders who place a high value on having maximum loss defined. Ideally, options should be used as a tactical weapon, particularly when bottom– fishing. There is little to be lost and something to be gained by using more distant option maturity months –the most distant consistent with market liquidity. Beginners are drawn to the nearer option months, because the outlay is smaller. This tends to be a false economy.

Numerate readers may be drawn to the idea of selling options rather than buying them – feeling that this way you tip the odds in your favour.

From experience, I don’t recommend it, for two reasons. 1) The price of currency options doesn’t justify it. 2) It distorts your trading judgement: and we have too good a forecasting system for the dollar to want to jeopardise it for the sake of a couple of percentage points!

The best way to get a feeling for the valuation of options is to consult the pages of the Wall Street Journal regularly. The IMM options on futures are much more liquid than the Philadelphia variety, which are convertible into the cash currency: stick to the IMM. Three-month options ‘at-the-money*’ cost a little under 2.5% of contract price in normal times. My rule of thumb for valuing options is to take the 2 calls and 2 puts at strike* prices nearest to the current market price and divide by 4: then divide by the market price to get a percentage figure.

The tactical use of options? We want to use options when they are economical, relative to using outright futures or forward positions. The acid test is that they should reduce our stake, for a similar reward. Our stake is the amount we are prepared to lose if a trade goes wrong, and it can be defined by our stop-loss limit on outright futures. In cases where we see fit to place our stops rather deep, the use of options may prove more economical. You can calculate on the basis of 2 at-the-money 3-month options per futures contract or the equivalent in the forward market. It’s not a bad idea to calculate the sum in actual dollars. An IMM option standing at 100 costs $1,250.

The other aspect of options is psychological. Our system of analysing the currencies is designed to “get us