Forex is the foreign exchange market and measures the relationship between currencies. A currency can be viewed as economic indicator of a countries economic strength. The forex market reflects the relationship between countries.
Traders all over the world look at these relationships and place trades that hope to capture the price movements between currencies. These traders are either long or are shorting the market. This ability to trade both directions without penalty is attractive for many traders.
Currencies are traded as pairs and each part of the pair represents a country. The USD/CAD currency pair shows the relationship between the US economy and the Canadian economy.
All commodities are bought and sold in US dollars. Because of this relationship the US dollar is the worlds reserve currency. Non reserve currencies will usually move in the opposite direction to the dollar. This inverse relationship can be exploited by currency traders.
Say the dollar devalues through excess money printing. Wealth is transferred from cash to assets that will hold their value. This protects the owners wealth. As the dollar declines the prices of commodities rise in relation to the number of dollars now needed to buy them. This allows you to trade by shorting the US dollar and by keeping your money safe by buying commodities.
Another way forex traders make money is on the difference between interest rates. This is called the "Carry Trade" and involves borrowing money from low interest rate countries and investing this borrowed money in a country with a higher bond yield. The difference between the bond yields are the profits on the trade.
As a private trader you do not have access to credit this cheap. You have to be able to borrow at the Libor, the London Interbank Offered Rate which is currently at 1.07%. This is only accessible by large finance companies. Without this access to cheap money it is should be impossible for the private trader to take advantage of this trade..
The good news is a private trader has a few different ways to capture the difference between bond yields. First you can use an exchange traded fund (ETF). The ETF is a fund that has been divided into shares and these shares are traded on the on the open market.
If you buy an ETF you will be paid a dividend payment for holding the ETF. Which comes from the difference between the bond yields. A trader could also expect capital growth on the ETF as the currencies value changes in relation to each other.
As money moves from the country with the lower bond yield to the higher bond yield country. This starts to increase the value of the currency in the higher bond rate country. This causes a trend in the currency pair.
Another way to take advantage of the difference between bond yields is to use a forex broker. You look at the bond yield charts to see who is paying the highest and lowest interest rates. Choose a currency pair that mirrors the high/low interest rate.
You would buy the currency pair if the first currency in the pair has a higher bond rate, You would sell if the first currency in the pair is the lower interest rate. You would use the 10 year bond yield to work out bond yields.
Example
AUD/JPY
2.72%/0.875% (10 year bond yields)
In the above example you would buy the AUD/JPY because the AUD has the strongest bond yield. If the % rates were the other way around you would sell the trade instead.
By using a forex broker you can earn the difference between the yields. Every time you hold a trade past 12 midnight you are either paid or you have a payment deducted from your trading account. Whether you receive money or not depends on the yields for the currency pair you are trading.
With this carry trade set up you are aiming to be paid the interest every day and also capture capital growth by trading with the trend. Which is trading with the flow of money.
I hope you found this useful and let the forex profits flow.
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