Trading currencies is supposed to be easy, right?
After all, everyone seems to be long the U.S. dollar, which has been trouncing both the yen and euro over the past few months.
But in reality, forex trading is one of the most humbling endeavors imaginable. The average retail foreign exchange trader fails after just four months.
In fact, around 70% of retail forex traders lose money on a quarterly basis, according to data from various over-the-counter forex brokers.
These statistics aren’t surprising, considering even global macro hedge funds have a difficult time trading currencies…
But the question is, what are all of these failed traders overlooking?
Sentiment and Positioning
The answer is psychology.
Trading is a psychological game at its core, and measuring the psychology of the market – specifically sentiment and speculative positioning – should be of paramount importance.
Ultimately, sentiment and positioning are very closely related. Sentiment refers to what percentage of market participants are bullish or bearish and how confident they are in their views, while positioning refers to how market participants express their views.
But even though sentiment and market positioning are similar, the latter is far easier to measure.
Each week, the U.S. Commodities Futures Trading Commission (CFTC) releases its Commitment of Traders report, which provides a breakdown of open interest for various futures contracts.
And as it turns out, the participants in the foreign exchange futures arena aren’t the most well-informed group. In fact, they’re usually very wrong, and very poorly positioned, at major turning points.
That’s good news for us, because we can use their aggregate positions as a contrarian indicator.
The Running of the Bulls
The following chart shows speculative positioning in U.S. dollar futures:
Back in March 2014, I said that the U.S. dollar would be fine, and that we should be worried about other currencies, such as the Japanese yen, instead. At the time, speculators were actually net short the U.S. dollar.
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Since then, the yen has lost over 15% of its value versus the dollar, and the USD/JPY exchange rate has now reached a seven-year high.
The U.S. Dollar Index, which is weighted heavily against the euro and yen, has risen from around 80 to above 87.
And what started as short covering has turned into a rather large bet that the strength in the dollar will continue.
Today, the U.S. dollar is what’s known as a “crowded trade.” The market herd loves the dollar, and speculative positioning has reached an extreme, which suggests that a correction in the dollar may be imminent.
A decline in the dollar would catch many off guard – precisely what the market seems to do at the most inopportune times. (Of course, this would also be a short-term positive for commodities prices, such as oil and gold, if it were to occur.)
Don’t get me wrong, the euro and the yen are still significantly flawed… but the dollar is, too.
Earlier this year, when I gave the opposite warning, prevailing sentiment on the dollar was bearish. Now, the prevailing sentiment is bullish. Based on this contrarian indicator, I could even see the levered long dollar bulls being taken out of the game in the next four months.
You see, even though the yen is going to lose a significant amount of value relative to the dollar over the next five years, it’s not going to decline in a straight line (though it’s seemed that way in the past month).
Bottom line: Trading currencies isn’t for the faint of heart. If you insist, though, it would be wise to employ modest amounts of leverage and lengthen your time horizon.
Successful foreign exchange traders not only have an overarching macroeconomic view, but also analyze market sentiment and positioning in order to manage risk and spot opportunities.
Basically, don’t be a lemming.
Safe (and high-yield) investing,
Alan Gula, CFA