WhoTrades Live provides an integrated investment platform featuring thousands of traders where you can check out strategies of interest, track their progress over time, and generate trade ideas for your own portfolio. Various portfolios can be directly plugged into your own account through such features like Copy and Autoinvest. The performances and risks of these portfolios are entirely transparent by looking at yield and drawdown figures over various timeframes, from one month to one year. Today, we’re going to go outside the usual stuff like stocks and bonds and toward an underappreciated source of alpha, which is currencies. We’ll cover a few different strategies of how to extra risk premium from the currency markets. Extracting risk premium from the currency markets (also called forex or FX markets) involves a few main strategies. 1. Buying high yielding currencies while selling lower yielding currencies This is an obvious one. When you buy a currency, you earn the interest on the currency you buy and pay the interest on the currency you sell. (At least that’s the way it should work when you buy and sell currencies through your broker.) The interest rate (normally) will be equal to the overnight rate set by the central bank that regulates that particular currency. When you buy a high-yielding currency against a low-yielding currency, this creates “carry,” or the interest rate spread between the two currencies. Carry trades are generally a “risk on” proposition. This is because the higher-yielding currencies tend to be in emerging markets, while lower-yielding currencies are often in developed markets. When the global economy is doing well, carry trades tend to work. In more turbulent times, carry trades tend to do poorly. This is why the Japanese yen (JPY) and Swiss franc (CHF) are generally considered safe havens. Investors leverage returns using these currencies because borrowing in them is so cheap. However, when the economy turns down, they often need to liquidate, unwinding loans in these currencies. When people need cash, they sell. This unwinding often causes the JPY and CHF to increase and be considered “risk off” bets. Over time, carry trades tend to make money simply because investors are incentivized to hold assets that have higher yields than those with lower yields. This is why you typically see currencies trend over time. Moreover, when one talks about the interest rates earned by various currencies, the key is real (inflation-adjusted) rates, not nominal rates. Investors want to be able to receive a currency where the interest rate is high enough to offset the inflationary effects and any additional anticipated depreciation rate in the currency. Therefore, it comes down to whether the real interest rate is sufficiently high. Central banks are a key part of the picture. When they want a depreciating currency to stop falling, they can sell FX reserves (to buy their currency). Or, if it makes sense in light of their other mandates (inflation and/or output), they can raise interest rates. In certain situations, like Argentina and Pakistan, this could entail IMF loan support when domestic measures are inadequate. But to reiterate, given its importance, in order to identify tops and bottoms in currencies you have to understand whether a currency’s interest rate is sufficient to compensate for any inflationary effects and additional net selling pressure. As a whole, the carry trade is a type of risk premium that can be extracted from the market. The next two are perhaps more abstruse, but viable and not systematically exploited by most investors, as they come through the FX options market. 2. Long-dated options are expensive relative to future realized volatility, but cheap relative to expected trending movements in the currency Volatility and price are often seen as intimately connected since the former is a function of the latter. However, there’s a difference due to the dynamics of who’s buying and selling. The sellers of options (sometimes called the writers) are investment banks. They hedge their positions in order to extract premium from selling the options. Buyers do not uniformly delta hedge their positions and often seek to make money on the movements in the underlying currency. So sellers make money off the premium associated with the volatility while buyers make money from the fact that currencies tend to exhibit directional trending behavior over time – for reasons related to carry, as discussed in the previous section. 3. Short-dated options are expensive relative to future realized volatility, but allow for the potential to make a lot of money quickly Traders overpay for short-dated options. The upside is that if you are right, you will make a lot of money. But over time, if you buy short-dated options, you should expect to lose money. (This concerns the currency markets, but is going to be true with respect to equity, credit, commodity, and other markets as well.) On the other hand, those who sell short-dated options, will, on average, make money over time, though are susceptible to periodic big losses being short gamma. Why do sellers, in effect, have the advantage? Because implied volatility is higher than realized volatility. This needs to be true in order to incentivize the seller to write the option in the first place. There is a general distaste among many traders to sell options because of the unlimited risk; some accordingly avoid them altogether. But if that sentiment were universally true, it would be impossible to make a market. So the sellers need to believe they’ll profit – i.e., there’s a risk premium available – in order to engage in the transaction to begin with. However, options sellers – usually investment banks, though sometimes non-bank entities – will delta hedge their position to eliminate the tail risk. Options buyers usually won’t. And options buyers will compensate the seller (outside of whatever they, the seller, makes off the delta hedge) by paying a risk premium beyond what’s merited because, on average, the seller will charge the buyer too much for the embedded volatility. Basically it boils down to: 1) The seller will engage in the transaction because they get to overcharge the buyer for volatility and any move in the price won’t matter to them because they’ll be delta hedged, and 2) The buyer will engage in the transaction because they believe the underlying trending movement in the currency (or asset more broadly) will help to offset the premium. Hence they don’t mind overpaying for volatility. Getting Exposure to Currencies Through WhoTrades Live Having exposure to various currencies in your portfolio can go beyond what was discussed above. It can be related to spot moves in the currency. It can also be related to basic diversification. If you have your entire portfolio in US dollars, that creates a form of risk. Currencies move just like every other asset in your portfolio. And currencies’ standings and values in the world change through time. Seeing a 25%+ depreciation in the dollar would not be unprecedented.Example #1 On WhoTrades Live, this trader focuses exclusively on currencies and trades a variety of them, from the euro, Canadian dollar, ruble, and, to a lesser extent, Japanese yen. (Source: Portfolio Page) ___Example #2 This trader mixes it up and has a variety of different positions. Not through currency pairs like in the portfolio above, but by buying foreign stocks and ETFs, currency ETFs (e.g., FXA), gold, and gold miners. (Source: Portfolio Page) ___Example #3 This trader has an interesting setup where he’s bearish on the S&P 500 through put options, is long volatility (UVXY), short China, long emerging markets, long the US dollar, and long gold. (Source: Portfolio Page)___ Conclusion Even if you choose not to extract risk premia from the currencies markets, diversifying your currency exposure can be highly useful in the same way diversifying your financial asset exposure can be – by lowering your risk without necessarily lowering your returns provided the right balance. This can take the form of currency pairs, currency ETFs, foreign stocks and bonds, precious metals, and precious metals miners. In the meantime, if you are looking for additional ideas, WhoTrades Live offers a vast array of portfolios and strategies in how to manage your wealth. Each profile shows full transparency over virtually everything you need to know to make a decision as to whether it fits your personal money management needs and expectations. This includes returns, drawdowns, performance trends, holdings and percentage allocations, a computer- and/or user-generated synopsis of the trading style, popularity based on follower count, and any relevant trading activity.