Why forex trading is hot now - Why not to get involved

May 20, 2006

Foreign exchange (forex) trading is growing - when last measured (2004), nearly $2 trillion was traded per day - and it has been growing at least 10% a year since then. In addition, forex volatility is declining. This includes historical volatility (how much prices actually went up and down) and implied volatility (how much future prices are expected to vary, as measured by futures options).

In the late ‘90’s, volatility was usually in the teens, sometimes as high as 20% (U.S. dollar vs yen). Today, volatility, especially with the Euro and the yen, is below 10%.

Why is volatility lower?

• Economic (GDP growth) volatility is less. Economies are more moderate...the last U.S. recession only lasted one quarter (as defined by negative growth). Only Japan experienced a severe downturn in the last decade.
• Inflation has been low and stable in most economies
  Central banks are learning how to measure, anticipate, and adjust for inflation.
• Central bank policies are more transparent, meaning they signal more clearly what they intend to do, so markets are less likely to overreact.
• Flexible exchange rates allow for natural, and gradual movements of exchange rates. More countries are adopting flexible exchange rates. Fixed exchange rates are more likely to let pressure build up, so that market forces overwhelm them and cause huge swings in exchange rates until they stabilize at a new, natural level.
• Many countries have also built up large foreign currency reserves, which discourages speculation in their currency. Speculation creates volatility.
• Better technology allows for faster response on the part of forex traders, which allows for more natural currency adjustments. It allows more traders, and more trades, which allows for additional smoothing in the market. It also allows more expertise in the currency markets, which reduces the risk that a few players can control the markets and cause large swings.

What it Means:
For the most part, it means that risk is lower in the global economy than it has been in years past. Why? - central banks have become smarter, while the forex markets are now more sophisticated, and therefore less likely to be manipulated. This means that, in all likelihood, dramatic losses based on currency fluctuations, like we saw in Asia in 1998, are less likely to happen.

Unfortunately, whenever one says “Things are different now,” that is when one is likely to be proven wrong. Act as if the current stability will continue, but put protections in place in case volatility returns.

Action Steps:
The best way to take advantage of good times (i.e. stable forex trends), and protect yourself from bad times (i.e. volatile forex disasters), is a well diversified portfolio that includes investments from many countries, and many currencies. The worst way is to get into forex trading yourself -  unless exchange rate volatility actually does keep you up at night.

Source:
Recent Volatility Trends in the Foreign Exchange Market Featured Topics View News and May 11, 2006 Printer version Dino Kos, Executive Vice President Remarks at the Forex Network New York conference, New York City