We can use exactly the same approach as with a stock index: compare the return of the trading strategy to the return in the currency itself for the same given period of time. For example, if we look at the historical rates of EURUSD from January 2021 to January 2022, we can see that they declined from about 1.2240 to about 1.1290, which is down 8%. So, if you bought the euro at the beginning of 2021 and held it until the end of the same year, then your “investment” would have made about -8% (and in reality, even worse because of the difference in the interest rates). But if you actively managed your investment by closing long positions and opening short positions when the rates were going down, you would probably have made, say, only -5%. Technically, you could even say that you beat the market, although, from a practical standpoint, such an investment would hardly make sense.
The good news in FX trading is that you can easily buy and sell currencies – quite unlike stocks where selling short a stock that you don’t own (to profit from falling prices) may be problematic. So, the most reasonable way to generate alpha in FX trading is to change the direction of your positions according to the direction of the market price movements.
But what to do in case you trade not just one currency pair but a portfolio of currencies? Are there benchmarks that could be used to evaluate the alpha in such a case?
Yes, and one of the most acknowledged benchmarks of this kind is the US Dollar Index (USDX).
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