How to Trade Forex like John Taylor

If you don’t know anything about John Taylor, you should probably go and find out. Taylor got involved in forex almost at the start of the market, founding the Foreign Exchange Advisory Service for Chemical Bank back in 1972. He was one of the first traders to apply technical analysis to the currency markets, pioneering the use of trend-following models. He also pioneered cyclical analysis for foreign exchange – looking at the combination of oscillating forces that drive currency movements. Today, he runs FX Concepts, which has more than $8 billion under management, most of which is in forex.

So, what changes has Taylor seen in the forex market over the last 40+ years, and what does he see as the opportunities today?

Smarter forex markets

When Taylor started out in the early 70s, he actually said that a lot of market participants were stupid. That isn’t pejorative – it’s just that major corporations, governments and central banks have different motives for entering the currency markets. Countries want to manage exchange levels, while large enterprises are more interested in managing foreign currency exchange risk than making profits. Early on, these were the biggest players in the market and provided many profit opportunities for forex traders. However, now, the markets have expanded so much that the majority of money is coming from investment professionals with one thing on their mind – to make money. That makes it more difficult today to make money in the forex market, as winners and losers balance out.

Trading volatility

Most volatility traders play in the equity markets, but Taylor is an exception. In fact, he claims to be the biggest factor in forex volatility trading. Options trading in the currency markets is still very limited, and his company provides the liquidity needed to make the markets work. Taylor claims that this is a great business model, by collecting premiums and working both sides. His company focuses on OTC options, which avoids issues with strike prices and expiry dates. As of 2011, around 12% of his company’s portfolio were in options. Their strategy goes beyond simple mean reversion, and is in fact – true to the man’s early experience – as much about following trends and tracking market cycles.

On carry trades

Taylor offers an interesting take on carry trades. He says that the trade should not work, but it does. Given the huge number of investors involved in carry trades, forward rates should exactly discount interest rate differentials – and no one should make any money. But they do. In fact, the reason for this, according to Taylor, is that high interest rates attract money inflows which in turn drive up the currencies. In other words, profitable carry trades are a self-fulfilling prophecy.

However, Taylor still cautions that you have to avoid the crashes. At some point, currencies with high interest rates rise to the point where overvaluation starts to affect the economy. At this point, the currency crashes as investors head for the door. The trick is to know when this is going to happen, which can be frequently with weak currencies, but much more infrequent with the major ones.

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