UK100

Who should consider trading FTSE 100/British pound?

1. Someone who believes that one asset will outperform the other and do so to the extent of making a trade worthwhile.

2. Anyone convinced they have figured out the short-term relationship between the FTSE 100 and sterling and can make their trade accordingly, adapting their strategy in future as the facts change.

3. Day traders. Backing short-term hunches on the relative movements of the two best-known and widely quoted indicators relating to the UK financial markets offers the chance of profit for those able to move swiftly.

What do I need to know about the British pound?

Sterling has been characterised as a large currency sitting on top of a medium-sized economy. It’s not the whole story but it does help to explain why sterling is prone to volatility and periodic crises, notably the devaluation traumas of 1967 and 1992.

It is one of the seven reserve currencies that make up the International Monetary Fund’s (IMF) ‘basket’ that underpins the ‘special drawing right’, an international currency issued by the IMF and used among governments. The UK economy is the smallest to be represented in the basket, the others being the Eurozone, the US, Japan and China.

In the two decades from the mid-80s, the pound’s dollar value swung between $1.06 and $2.05, a nearly 100 per cent differential.

What do I need to know about the FTSE 100 index?

Launched on the first trading day of 1984, the FTSE contains, broadly speaking, the 100 largest companies by capitalisation listed on the London Stock Exchange. As the name suggests, the FTSE started life as a joint venture between the Exchange and the Financial Times but is now entirely owned by the Exchange.

Every quarter, the FTSE is ‘refreshed’, which usually means replacing those companies whose market capitalisation has declined with those whose have increased. The FTSE is one of the most widely-quoted stock indices in the world, alongside the Dow Jones Industrial Average in the US, the Nikkei 225 in Japan and the DAX in Germany.

What are the factors driving the FTSE/pound relationship?

• More than 70 percent of the revenues of FTSE 100-listed companies are earned outside the UK. This helps to explain why the FTSE tends to perk up when sterling declines, because foreign revenues become more valuable when translated into weaker pounds.

• Some FTSE 100 member-companies are significant exporters, and a lower sterling exchange rate makes their goods and services more competitive when priced in local currency.

• A reduction in interest rates would tend to weaken the pound, because sterling assets have become less attractive, while bolstering share prices, because cheaper credit releases more funds for investment.

It would be a mistake to assume this inverse relationship holds on all occasions. A time of general economic buoyancy would see both rise together.

This happened in the summer of 2007, on the eve of the credit crunch, when the FTSE hit a recent peak of 6,732.40 on June 15, and the pound broke through to $2.01 on July 2. Conversely, after the crash, they were in the doldrums together, with the FTSE at a recent low 3,530.73 on March 6, 2009, and the pound languishing at $1.44 on January 26 of that year.

Bear in mind also that the FTSE contains a large number of mining and other extraction companies whose products may be priced in US dollars, adding a further layer of currency complexity to a trader’s calculations.

The basics of trading FTSE 100/British pound

There are three ways in which you can trade the FTSE 100 against sterling.

1. First, you can quite simply buy or sell one or the other, depending on which of these two assets you believe is likely to appreciate relative to the other. At its most basic, this would involve exchanging sterling for a FTSE tracker fund (should you expect the FTSE to outperform sterling) or cash out of such a fund (if you believe the reverse is more likely) into sterling.

2. Second, you could use futures and options, derivative products that allow you to take positions on the FTSE/sterling relationship without taking delivery of the assets in question.

3. Third, contracts for difference (CFDs) offer the chance to trade on movements in the FTSE and the pound. In a few short years, CFDs have become the most popular way to trade on financial markets. They are, quite simply, a contract between a trader and a broker to pay each other the difference in the price of an asset between when the contract is signed and the price at the point at which it is terminated. They are leveraged products, meaning you can gain exposure by investing only a percentage of the full value of the trade you want. Whilst this gives opportunity for greater profit, you risk losing more than your deposit if the market moves against you. A second risk is that rapid price changes can cause your account balance to change quickly. If you do not have enough funds in your account to cover these situations, there is a risk your position may be closed automatically when your balance falls below a certain level, known as the close-out level. Stop-orders can limit risk but, in fast moving markets, prices might rise above or fall below the desired level before a sale can be executed. This may increase losses.

eToro offers contracts for difference on both the FTSE 100 and the British Pound

What to consider about trading the FTSE 100/British pound

The market for both these asset classes is deep and liquid, so finding a buyer or seller ought not to be difficult. Furthermore, both the FTSE and the pound are priced second by second, in real time, so there is genuine transparency.

However, the FTSE/sterling relationship is not straightforward and a real grounding in how it works is advisable before trading it.

Is trading the FTSE 100 and the British pound right for you?

If you have studied the way the relationship has worked in the past and are reasonably sure that your view of the next movement is the correct one, then it may be.

*This content is intended for educational purposes only, and shouldn't be considered investment advice.

*Past performance is not an indication of future results. All trading carries risk. Only risk capital you're prepared to lose.