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Table of Contents
Chapter 1: Foreign ExchangeThe Fastest-Growing Market of Our Time.
Effects of Currencies on Stocks and Bonds.
Comparing the FX Market with Futures and Equities.
Who Are the Pa!ers in the FX Market"
Chapter !: "istorica# E$ents in the F% Market. 1&
Bretton Woods# Anointing the $oar as the Word Currenc! %&'(().
End of Bretton Woods# Free Market Capitaism *s Born %&'+&).
Pa,a Accord-$e.auation of /.S. $oar %&'01).
2eorge Soros-3he Man Who Broke the Bank of Engand.
Asian Financia Crisis %&''+4&''0).
*ntroduction of the Euro %&''').
Chapter ': (hat Mo$es the Currenc) Market in the *ong Term+ !,
Fundamenta Ana!sis.
3echnica Ana!sis.
Currenc! Forecasting-What Bookworms and Economists 5ook At.
Chapter : (hat Mo$es the Currenc) Market in the -hort Term+ .
6eati.e *mportance of $ata Changes o.er 3ime.
2ross $omestic Product-7o 5onger a Big $ea.
8ow Can 9ou /se 3his to 9our Benefit"
A $eeper 5ook into the FX Market.
Chapter /: (hat 0re the 1est Times to Tra2e for 3n2i$i2ua# Currenc) 4airs+
/5
Asian Session %3ok!o)# + P.M.4( A.M. ES3.
/.S. Session %7ew 9ork)# 0 A.M.41 P.M. ES3.
European Session %5ondon)# : A.M.4&: P.M. ES3.
/.S.4European ;.erap# 0 A.M.4&: P.M. ES3.
European4Asian ;.erap# : A.M.4( A.M. ES3.
Chapter .: (hat 0re Currenc) Corre#ations an2 "ow 6o Tra2ers 7se Them+
/.
Positi.e<7egati.e Correations# What 3he! Mean and 8ow to /se 3hem.
*mportant Fact a=out Correations# 3he! Change.
Cacuating Correations 9oursef.
Chapter &: Tra2e 4arameters for 6ifferent Market Con2itions. .1
>eeping a 3rading ?ourna.
8a.e a 3oo=o@-/se What Works for the Current Market En.ironment.
Step ;ne-Profie 3rading En.ironment.
Step 3wo-$etermine 3rading 3ime 8ori,on.
6isk Management.
Ps!choogica ;utook.
Chapter 8 Technica# Tra2ing -trategies. &.
Mutipe 3ime Frame Ana!sis.
Fading the $ou=e Aeros.
Waiting for the 6ea $ea.
:
*nside $a! Breakout Pa!.
3he Fader.
Fitering Fase Breakouts.
Channe Strateg!.
Perfect ;rder.
Chapter ,: Fun2amenta# Tra2ing -trategies. ,,
Picking the Strongest Pairing.
5e.eraged Carr! 3rade.
Fundamenta 3rading Strateg!# Sta!ing on 3op of Macroeconomic E.ents.
Commodit! Prices as a 5eading *ndicator.
/sing Bond Spreads as a 5eading *ndicator for FX.
Fundamenta 3rading Strateg!# 6isk 6e.ersas.
/sing ;ption Boatiities to 3ime Market Mo.ements.
Fundamenta 3rading Strateg!# *nter.ention.
Chapter 15: 4rofi#es an2 7ni9ue Characteristics of Ma:or Currenc) 4airs.
Currenc! Profie# /.S. $oar %/S$).
Currenc! Profie# Euro %E/6).
Currenc! Profie# British Pound %2BP).
Currenc! Profie# Swiss Franc %C8F).
Currenc! Profie# ?apanese 9en %?P9).
Currenc! Profie# Austraian $oar %A/$).
Currenc! Profie# 7ew Aeaand $oar %7A$).
Currenc! Profie# Canadian $oar %CA$).
0;out the 0uthor.
3n2ex.
C
Forei gn Exchange
The Fas t es t- Growi ng Market
of Our Ti me
3he foreign e@change market is the generic term for the wordwide institutions
that e@ist to e@change or trade currencies. Foreign e@change is often referred to as
Dfore@E or DFX.E 3he foreign e@change market is an o.erFtheFcounter %;3C) marketG
which means that there is no centra e@change and cearinghouse where orders are
matched. FX deaers and market makers around the word are inked to each other
around the cock .ia teephoneG computerG and fa@G creating one cohesi.e market.
;.er the past few !earsG currencies ha.e =ecome one of the most popuar
products to trade. 7o other market can caim a 1+ percent surge in .oume o.er a
threeF!ear time frame. According to the 3riennia Centra Bank Sur.e! of the foreign
e@change market conducted =! the Bank for *nternationa Settements and pu=ished
in Septem=er :HH(G dai! trading .oume hit a record of I&.' triionG up from I&.:
triion %or I&.( triion at constant e@change rates) in :HH&. 3his is estimated to =e
appro@imate! :H times arger than the dai! trading .oume of the 7ew 9ork Stock
E@change and the 7asdaq com=ined. Athough there are man! reasons that can =e
used to e@pain this surge in acti.it!G one of the most interesting is that the timing of
the surge in .oume coincides fair! we with the emergence of onine currenc!
trading for the indi.idua in.estor.
EFFEC3S ;F C/66E7C*ES ;7 S3;C>S A7$ B;7$S
*t is not the ad.ent of onine currenc! trading aone that has heped to increase
the o.era marketJs .oume. With the .oatiit! in the currenc! markets o.er the past
few !earsG man! traders are aso =ecoming more aware of the fact that currenc!
mo.ements aso impact the stock and =ond markets. 3hereforeG if stocksG =ondsG and
commodities traders want to make more educated trading decisionsG it is important
for them to foow the currenc! markets as we. 3he foowing are some of the
e@ampes of how currenc! mo.ements impacted stock and =ond market mo.ements
in the past.
EUR/USD an !or"orat e #rofi t a$i % i t &
For stock market tradersG particuar! those who in.est in European corporations
that e@port a tremendous amount of goods to the /nited StatesG monitoring e@change
rates are essentia to predicting earnings and corporate profita=iit!. 3hroughout :HHC
and :HH(G European manufacturers compained e@tensi.e! a=out the rapid rise in the
euro and the weakness in the /.S. doar. 3he main cuprit for the doarJs seFoff at
the time was the countr!Js rapid! growing trade and =udget deficits. 3his caused the
E/6</S$ %euroFtoFdoar) e@change rate to surgeG which took a significant to on
the profita=iit! of European corporations =ecause a higher e@change rate makes the
goods of European e@porters more e@pensi.e to /.S. consumers. *n :HHCG inadequate
hedging sha.ed appro@imate! & =iion euros from BokswagenJs profitsG whie
$utch State Mines %$SM)G a chemicas groupG warned that a & percent mo.e in the
E/6</S$ rate woud reduce profits =! =etween + miion and && miion euros.
(
/nfortunate!G inadequate hedging is sti a reait! in EuropeG which makes moniF
toring the E/6</S$ e@change rate e.en more important in forecasting the earnings
and profita=iit! of European e@porters.
'i kkei an U( S( Do%%ar
3raders e@posed to ?apanese equities aso need to =e aware of the de.eopments
that are occurring in the /.S. doar and how the! affect the 7ikkei ra!. ?apan has
recent! come out of &H !ears of stagnation. $uring this timeG /.S. mutua funds and
hedge funds were gross! underweight ?apanese equities. When the econom! =egan
to re=oundG these funds rushed in to make changes to their portfoios for fear of
missing a great opportunit! to take ad.antage of ?apanJs reco.er!. 8edge funds
=orrowed a ot of doars in order to pa! for increased e@posureG =ut the pro=em was
that their =orrowings are .er! sensiti.e to /.S. interest rates and the Federa 6eF
ser.eJs monetar! poic! tightening c!ce. *ncreased =orrowing costs for the doar
coud derai the 7ikkeiJs ra! =ecause higher rates wi raise the doarJs financing
costs. 9et with the huge current account deficitG the Fed might need to continue
raising rates to increase the attracti.eness of doarFdenominated assets. 3hereforeG
continua rate hikes couped with sowing growth in ?apan ma! make it ess
profita=e for funds to =e o.ere.eraged and o.er! e@posed to ?apanese stocks. As a
resutG how the /.S. doar mo.es aso pa!s a roe in the future direction of the
7ikkei.
George Soros
*n terms of =ondsG one of the most takedFa=out men in the histor! of the FX
markets is 2eorge Soros. 8e is notorious for =eing Dthe man who =roke the Bank of
Engand.E 3his is co.ered in more detai in our histor! section %Chapter :)G =ut in a
nutsheG in &''H the /.>. decided to Koin the E@change 6ate Mechanism %E6M) of
the European Monetar! S!stem in order to take part in the owFinfationar! !et sta=e
econom! generated =! the 2erman!Js centra =ankG which is aso known as the
Bundes=ank. 3his aiance tied the pound to the deutsche markG which meant that the
/.>. was su=Kect to the monetar! poicies enforced =! the Bundes=ank. *n the ear!
&''HsG 2erman! aggressi.e! increased interest rates to a.oid the infationar! effects
reated to 2erman reunification. 8owe.erG nationa pride and the commitment of
fi@ing e@change rates within the E6M pre.ented the /.>. from de.auing the pound.
;n Wednesda!G Septem=er &LG &'':G aso known as Back Wednesda!G 2eorge Soros
e.eraged the entire .aue of his fund %I& =iion) and sod I&H =iion worth of
pounds to =et against the E@change 6ate Mechanism. 3his essentia! D=rokeE the
Bank of Engand and forced the de.auation of its currenc!. *n a matter of :( hoursG
the British pound fe appro@imate! 1 percent or 1GHHH pips. 3he Bank of Engand
promised to raise rates in order to tempt specuators to =u! pounds. As a resutG the
=ond markets aso e@perienced tremendous .oatiit!G with the oneFmonth /.>.
5ondon *nter=ank ;ffered 6ate %5*B;6) increasing & percent and then retracing the
gain o.er the ne@t :( hours. *f =ond traders were compete! o=i.ious to what was
going on in the currenc! marketsG the! pro=a=! woud ha.e found themse.es dum=F
struck in the face of such a rapid g!ration in !ieds.
1
!hi nese )uan Re*a% uat i on an +ons
For /.S. go.ernment =ond tradersG there has aso =een a =rewing issue that has
made it imperati.e to earn to monitor the de.eopments in the currenc! markets.
;.er the past few !earsG there has =een a ot of specuation a=out the possi=e
re.auation of the Chinese !uan. $espite strong economic growth and a trade surpus
with man! countriesG China has artificia! maintained its currenc! within a tight
trading =and in order to ensure the continuation of rapid growth and moderni,ation.
3his has caused e@treme opposition from manufacturers and go.ernment officias
from countries around the wordG incuding the /nited States and ?apan. *t is
estimated that ChinaJs fi@ed e@change rate regime has artificia! kept the !uan &1
percent to (H percent =eow its true .aue. *n order to maintain a weak currenc! and
keep the e@change rate within a tight =andG the Chinese go.ernment has to se the
!uan and =u! /.S. doars each time its currenc! appreciates a=o.e the =andJs upper
imit. China then uses these doars to purchase /.S. 3reasuries. 3his practice has
earned China the status of =eing the wordJs second argest hoder of /.S. 3reasuries.
*ts demand has kept /.S. interest rates at historica ows. E.en though China has
made some changes to their currenc! regimeG since thenG the o.era re.auation was
modestG which means more is set to come. More re.auation spes trou=e for the
/.S. =ond marketG since it means that a =ig =u!er ma! =e puing awa!. An
announcement of this sort coud send !ieds soaring and prices tum=ing. 3hereforeG
in order for =ond traders to effecti.e! manage riskG it is aso important for them to
foow the de.eopments in the currenc! markets so that a shock of this t!pe does not
catch them =! surprise.
C;MPA6*72 38E FX MA6>E3 W*38 F/3/6ES A7$
EM/*3*ES
3raditiona! FX has not =een the most popuar market to trade =ecause access
to the foreign e@change market was primari! restricted to hedge fundsG Commodit!
3rading Ad.isors who manage arge amounts of capitaG maKor corporationsG and
institutiona in.estors due to reguationG capita requirementsG and technoog!. ;ne of
the primar! reasons wh! the foreign e@change market has traditiona! =een the
market of choice for these arge pa!ers is =ecause the risk that a trader takes is fu!
customi,a=e. 3hat isG one trader coud use a hundred times e.erage whie another
ma! choose to not =e e.eraged at a. 8owe.erG in recent !ears man! firms ha.e
opened up the foreign e@change market to retai tradersG pro.iding e.eraged trading
as we as free instantaneous e@ecution patformsG chartsG and reaFtime news. As a
resutG foreign e@change trading has surged in popuarit!G increasing its attracti.eness
as an aternati.e asset cass to trade.
Man! equit! and futures traders ha.e =egun to add currencies into the mi@ of
products that the! trade or ha.e e.en switched to trading currencies e@cusi.e!. 3he
reason wh! this trend is emerging is =ecause these traders are =eginning to reai,e
that there are man! attracti.e attri=utes to trading FX o.er equities or futures.
F, *ersus E-ui ti es
8ere are some of the ke! attri=utes of trading spot foreign e@change compared
to the equities market.
L
F, Market .e& /tt ri $ut es
Foreign e@change is the argest market in the word and has growing
iquidit!.
3here is :(Fhour aroundFtheFcock trading.
3raders can profit in =oth =u and =ear markets.
Short seing is permitted without an uptickG and there are no trading cur=s.
*nstant e@ecuta=e trading patform minimi,es sippage and errors.
E.en though higher e.erage increases riskG man! traders see trading the
FX market as getting more =ang for the =uck.
E-ui ti es Market /t t ri $ut es
3here is decent market iquidit!G =ut it depends main! on the stockJs dai!
.oume.
3he market is a.aia=e for trading on! from '#CH a.m. to (#HH p.m. 7ew 9ork
time with imited afterFhours trading.
3he e@istence of e@change fees resuts in higher costs and commissions.
3here is an uptick rue to short stocksG which man! da! traders find frustrating.
3he num=er of steps in.o.ed in competing a trade increases sippage and
error.
3he .oume and iquidit! present in the FX marketG one of the most iquid
markets in the wordG ha.e aowed traders to access a :(Fhour market with ow
transaction costsG high e.erageG the a=iit! to profit in =oth =u and =ear marketsG
minimi,ed error ratesG imited sippageG and no trading cur=s or uptick rues. 3raders
can impement in the FX market the same strategies that the! use in ana!,ing the
equit! markets. For fundamenta tradersG countries can =e ana!,ed ike stocks. For
technica tradersG the FX market is perfect for technica ana!sisG since it is aread!
the most common! used ana!sis too =! professiona traders. *t is therefore
important to take a coser ook at the indi.idua attri=utes of the FX market to rea!
understand wh! this is such an attracti.e market to trade.
/roun- the- !%ock 01- 2our Market ;ne of the primar! reasons wh! the FX
market is popuar is =ecause for acti.e traders it is the idea market to trade. *ts :(F
hour nature offers traders instant access to the markets at a hours of the da! for
immediate response to go=a de.eopments. 3his characteristic aso gi.es traders the
added fe@i=iit! of determining their trading da!. Acti.e da! traders no onger ha.e
to wait for the equities market to open at '#CH a.m. 7ew 9ork time to =egin trading.
*f there is a significant announcement or de.eopment either domestica! or o.erseas
=etween (#HH p.m. 7ew 9ork time and '#CH a.m. 7ew 9ork timeG most da! traders
wi ha.e to wait for the e@changes to open at '#CH a.m. to pace trades. B! that timeG
in a ikeihoodG uness !ou ha.e access to eectronic communication networks
%EC7s) such as *nstinet for premarket tradingG the market woud ha.e gapped up or
gapped down against !ou. A of the professionas woud ha.e aread! priced in the
e.ent =efore the a.erage trader can e.en access the market.
*n additionG most peope who want to trade aso ha.e a fuFtime Ko= during the
da!. 3he a=iit! to trade after hours makes the FX market a much more con.enient
+
market for a traders. $ifferent times of the da! wi offer different trading
opportunities as the go=a financia centers around the word are a acti.e!
in.o.ed in foreign e@change. With the FX marketG trading after hours with a arge
onine FX =roker pro.ides the same iquidit! and spread as at an! other time of da!.
As a guideineG at 1#HH p.m. Sunda!G 7ew 9ork timeG trading =egins as the
markets open in S!dne!G Austraia. 3hen the 3ok!o markets open at +#HH p.m. 7ew
9ork time. 7e@tG Singapore and 8ong >ong open at '#HH p.m. ES3G foowed =! the
European markets in Frankfurt %:#HH a.m.) and then 5ondon %C#HH a.m.). B! (#HH a.m.
the European markets are in fu swingG and Asia has concuded its trading da!. 3he
/.S. markets open first in 7ew 9ork around 0#HH a.m. Monda! as Europe winds
down. B! 1#HH p.m.G S!dne! is set to reopen once again.
3he most acti.e trading hours are when the markets o.erapN for e@ampeG Asia
and Europe trading o.eraps =etween :#HH a.m. and appro@imate! (#HH a.m.G Europe
and the /nited States o.erap =etween 0#HH a.m. and appro@imate! &&#HH a.m.G whie
the /nited States and Asia o.erap =etween 1#HH p.m. and '#HH p.m.. $uring 7ew
9ork and 5ondon hours a of the currenc! pairs trade acti.e!G whereas during the
Asian hours the trading acti.it! for pairs such as the 2BP<?P9 and A/$<?P9 tend to
peak.
3ower Trans act i on !ost s 3he e@istence of much ower transaction costs aso
makes the FX market particuar! attracti.e. *n the equities marketG traders must pa!
a spread %i.e.G the difference =etween the =u! and se price) and<or a commission.
With onine equit! =rokersG commissions can run upwards of I:H per trade. With
positions of I&HHGHHHG a.erage roundFtrip commissions coud =e as high as I&:H. 3he
o.erFtheFcounter structure of the FX market eiminates e@change and cearing feesG
which in turn owers transaction costs. Costs are further reduced =! the efficiencies
created =! a pure! eectronic marketpace that aows cients to dea direct! with the
market makerG eiminating =oth ticket costs and middemen. Because the currenc!
market offers aroundFtheFcock iquidit!G traders recei.e tight competiti.e spreads
=oth intrada! and at night. Equities traders are more .unera=e to iquidit! risk and
t!pica! recei.e wider deaing spreadsG especia! during afterFhours trading.
5ow transaction costs make onine FX trading the =est market to trade for shortF
term traders. For an acti.e equit! trader who t!pica! paces CH trades a da!G at a I:H
commission per trade !ou woud ha.e to pa! up to ILHH in dai! transaction costs.
3his is a significant amount of mone! that woud definite! take a arge cut out of
profits or deepen osses. 3he reason wh! costs are so high is =ecause there are se.era
peope in.o.ed in an equit! transaction. More specifica!G for each trade there is a
=rokerG the e@changeG and the speciaist. A of these parties need to =e paidG and their
pa!ment comes in the form of commission and cearing fees. *n the FX marketG
=ecause it is decentrai,ed with no e@change or cearinghouse %e.er!thing is taken
care of =! the market maker)G these fees are not appica=e.
!ustomi 4a$% e 3e*erage E.en though man! peope reai,e that higher e.erage
comes with risksG traders are humans and few of them find it eas! to turn awa! the
opportunit! to trade on someone eseJs mone!. 3he FX market caters perfect! to
these traders =! offering the highest e.erage a.aia=e for an! market. Most onine
currenc! firms offer &HH times e.erage on reguarFsi,ed accounts and up to :HH
times e.erage on the miniature accounts. Compare that to the : times e.erage
0
offered to the a.erage equit! in.estor and the &H times capita that is t!pica! offered
to the professiona traderG and !ou can see wh! man! traders ha.e turned to the
foreign e@change market. 3he margin deposit for e.erage in the FX market is not
seen as a down pa!ment on a purchase of equit!G as man! percei.e margins to =e in
the stock markets. 6atherG the margin is a performance =ondG or good faith depositG to
ensure against trading osses. 3his is .er! usefu to shortFterm da! traders who need
the enhancement in capita to generate quick returns. 5e.erage is actua!
customi,a=eG which means that the more riskFa.erse in.estor who fees comforta=e
using on! &H or :H times e.erage or no e.erage at a can eect to do so. 8owe.erG
e.erage is rea! a dou=eFedged sword. Without proper risk management a high
degree of e.erage can ead to arge osses as we.
#rof i t in +oth +u%% an +ear Market s 5n the F, mar ket 6 "rofi t "otent i a% s
e@ist in =oth =u and =ear markets. Since currenc! trading awa!s in.o.es =u!ing
one currenc! and seing anotherG there is no structura =ias to the market. 3hereforeG
if !ou are ong one currenc!G !ou are aso short another. As a resutG profit potentias
e@ist equa! in =oth upwardFtrending and downwardFtrending markets. 3his is
different from the equities marketG where most traders go ong instead of short stocksG
so the genera equit! in.estment communit! tends to suffer in a =ear market.
'o Trai ng !ur$s or U"tick Ru%e 3he FX market is the argest market in the
wordG forcing market makers to offer .er! competiti.e prices. /nike the equities
marketG there is ne.er a time in the FX markets when trading cur=s woud take effect
and trading woud =e hatedG on! to gap when reopened. 3his eiminates missed
profits due to archaic e@change reguations. *n the FX marketG traders woud =e a=e
to pace trades :( hours a da! with .irtua! no disruptions.
;ne of the =iggest anno!ances for da! traders in the equit! market is the fact
that traders are prohi=ited from shorting a stock in a downtrend uness there is an
uptick. 3his can =e .er! frustrating as traders wait to Koin short seers =ut are on!
eft with continua! watching the stock trend down =efore an uptick occurs. *n the
FX marketG there is no such rue. *f !ou want to short a currenc! pairG !ou can do so
immediate!N this aows for instant and efficient e@ecution.
On%ine Trai ng Reuces Error Rates *n generaG a shorter trade process
minimi,es errors. ;nine currenc! trading is t!pica! a threeFstep process. A trader
woud pace an order on the patformG the FX deaing desk woud automatica!
e@ecute it eectronica!G and the order confirmation woud =e posted or ogged on the
traderJs trading station. 3!pica!G these three steps woud =e competed in a matter
of seconds. For an equities tradeG on the other handG there is genera! a fi.eFstep
process. 3he cient woud ca his or her =roker to pace an orderG the =roker sends the
order to the e@change foorG the speciaist on the foor tries to match up orders %the
=roker competes with other =rokers to get the =est fi for the cient)G the speciaist
e@ecutes the tradeG and the cient recei.es a confirmation from the =roker. As a resutG
in currenc! trades the eimination of a middeman minimi,es the error rates and
increases the efficienc! of each transaction.
3i mi te S%i ""age /nike the equit! marketsG man! onine FX market makers
pro.ide instantaneous e@ecution from reaFtimeG twoFwa! quotes. 3hese quotes are
the prices at which the firms are wiing to =u! or se the quoted currenc!G rather
than .ague indications of where the market is tradingG which arenJt honored. ;rders
'
are e@ecuted and confirmed within seconds. 6o=ust s!stems woud ne.er request the
si,e of a traderJs potentia orderG or which side of the market heJs tradingG =efore
gi.ing a =id<offer quote. *nefficient deaers determine whether the in.estor is a =u!er
or a seerG and shade the price to increase their own profit on the transaction.
3he equit! market t!pica! operates under a Dne@t =est orderE s!stemG under
which !ou ma! not get e@ecuted at the price !ou wishG =ut rather at the ne@t =est
price a.aia=e. For e@ampeG etJs sa! Microsoft is trading at I1:.1H. *f !ou enter a
=u! order at this priceG =! the time it reaches the speciaist on the e@change foor the
price ma! ha.e risen to I1C.:1. *n this caseG !ou wi not get e@ecuted at I1:.1HN !ou
wi get e@ecuted at I1C.:1G which is essentia! a oss of threeFquarters of a point.
3he price transparenc! pro.ided =! some of the =etter market makers ensures that
traders awa!s recei.e a fair price.
#erf ect Market for Techni ca% /na% &s i s For technica ana!stsG currencies
rare! spend much time in tight trading ranges and ha.e the tendenc! to de.eop
strong trends. ;.er 0H percent of .oume is specuati.e in natureG and as a resut the
market frequent! o.ershoots and then corrects itsef. 3echnica ana!sis works we
for the FX market and a technica! trained trader can easi! identif! new trends and
=reakoutsG which pro.ide mutipe opportunities to enter and e@it positions. Charts
and indicators are used =! a professiona FX tradersG and candestick charts are
a.aia=e in most charting packages. *n additionG the most common! used
indicators-such as Fi=onacci retracementsG stochasticsG mo.ing a.erage
con.ergence<di.ergence %MAC$)G mo.ing a.eragesG %6S*)G and support<resistance
e.es-ha.e pro.en .aid in man! instances.
Figure &.& 2BP</S$ Chart
%Source# eSigna. www.eSigna.com)
*n the 2BP</S$ chart in Figure &.&G it is cear that Fi=onacci retracementsG
mo.ing a.eragesG and stochastics ha.e at one point or another gi.en successfu
&H
trading signas. For e@ampeG the 1H percent retracement e.e has ser.ed as support
for the 2BP</S$ throughout the month of ?anuar! and for a part of Fe=ruar! :HH1.
3he mo.ing a.erage crosso.ers of the &HFda! and :HFda! simpe mo.ing a.erages
aso successfu! forecasted the seFoff in the 2BP</S$ on March :&G :HH1. Equit!
traders who focus on technica ana!sis ha.e the easiest transition since the! can imF
pement in the FX market the same technica strategies that the! use in the equities
market.
/na% &4e Stocks 3i ke !ount ri es
3rading currencies is not difficut for fundamenta tradersG either. Countries can
=e ana!,ed Kust ike stocks. For e@ampeG if !ou ana!,e growth rates of stocksG !ou
can use gross domestic product %2$P) to ana!,e the growth rates of countries. *f
!ou ana!,e in.entor! and production ratiosG !ou can foow industria production or
dura=e goods data. *f !ou foow saes figuresG !ou can ana!,e retai saes data. As
with a stock in.estmentG it is =etter to in.est in the currenc! of a countr! that is
growing faster and is in a =etter economic condition than other countries. Currenc!
prices refect the =aance of supp! and demand for currencies. 3wo of the primar!
factors affecting supp! and demand of currencies are interest rates and the o.era
strength of the econom!. Economic indicators such as 2$PG foreign in.estmentG and
the trade =aance refect the genera heath of an econom! and are therefore
responsi=e for the under!ing shifts in supp! and demand for that currenc!. 3here is
a tremendous amount of data reeased at reguar inter.asG some of which is more
important than others. $ata reated to interest rates and internationa trade is ooked
at the most cose!.
*f the market has uncertaint! regarding interest ratesG then an! =it of news
reating to interest rates can direct! affect the currenc! market. 3raditiona!G if a
countr! raises its interest rateG the currenc! of that countr! wi strengthen in reation
to other countries as in.estors shift assets to that countr! to gain a higher return.
8ikes in interest rates are genera! =ad news for stock marketsG howe.er. Some
in.estors wi transfer mone! out of a countr!Js stock market when interest rates are
hikedG causing the countr!Js currenc! to weaken. $etermining which effect
dominates can =e trick!G =ut genera! there is a consensus =eforehand as to what the
interest rate mo.e wi do. *ndicators that ha.e the =iggest impact on interest rates are
the producer price inde@ %PP*)G consumer price inde@ %CP*)G and 2$P. 2enera! the
timing of interest rate mo.es is known in ad.ance. 3he! take pace after reguar!
schedued meetings =! the Bank of Engand %B;E)G the /.S. Federa 6eser.e %Fed)G
the European Centra Bank %ECB)G the Bank of ?apan %B;?)G and other centra =anks.
3he trade =aance shows the net difference o.er a period of time =etween a
nationJs e@ports and imports. When a countr! imports more than it e@ports the trade
=aance wi show a deficitG which is genera! considered unfa.ora=e. For e@ampeG
if /.S. doars are sod for other domestic nationa currencies %to pa! for imports)G the
fow of doars outside the countr! wi depreciate the .aue of the doar. Simiar!G if
trade figures show an increase in e@portsG doars wi fow into the /nited States and
appreciate the .aue of the doar. From the standpoint of a nationa econom!G a
deficit in and of itsef is not necessari! a =ad thing. *f the deficit is greater than
market e@pectationsG howe.erG then it wi trigger a negati.e price mo.ement.
&&
F, *ersus Fut ur es
3he FX market hods ad.antages o.er not on! the equit! marketG =ut aso the
futures market. Man! futures traders ha.e added currenc! spot trading to their
portfoios. After recapping the ke! spot foreign e@change attri=utesG we compare the
futures attri=utes.
F, Market .e& /tt ri $ut es
*t is the argest market in the word and has growing iquidit!.
3here is :(Fhour aroundFtheFcock trading.
3raders can profit in =oth =u and =ear markets.
Short seing is permitted without an uptickG and there are no trading cur=s.
*nstant e@ecuta=e trading patform minimi,es sippage and errors.
E.en though higher e.erage increases riskG man! traders see trading the FX
market as getting more =ang for the =uck.
Fut ur es /tt ri $ut es
Market iquidit! is imitedG depending on the month of the contract traded.
3he presence of e@change fees resuts in more costs and commissions.
dependent on the product tradedN each product ma! ha.e different opening and
cosing hoursG and there is imited afterFhours trading.
Futures e.erage is higher than e.erage for equitiesG =ut sti on! a fraction of
the e.erage offered in FX.
3here tend to =e proonged =ear markets.
Pit trading structure increases error and sippage.
5ike the! can in the equities marketG traders can impement in the FX market the
same strategies that the! use in ana!,ing the futures markets. Most futures traders
are technica tradersG and as mentioned in the equities sectionG the FX market is
perfect for technica ana!sis. *n factG it is the most common! used ana!sis too =!
professiona traders. 5etJs take a coser ook at how the futures market stacks up
against the FX market.
!om"ari ng Market 2ours an 3i-ui i t & 3he .oume traded in the FX market
is estimated to =e more than fi.e times that of the futures market. 3he FX market is
open for trading :( hours a da!G =ut the futures market has confusing market hours
that .ar! =ased on the product traded. For e@ampeG trading god futures is open on!
=etween +#:H a.m. and &#CH p.m. on the 7ew 9ork Commodities E@change
%C;MEX)G whereas if !ou trade crude oi futures on the 7ew 9ork Mercantie
E@changeG trading is open on! =etween 0#CH a.m. and :#&H p.m. 3hese .ar!ing hours
not on! create confusionG =ut aso make it difficut to act on =reakthrough anF
nouncements throughout the remainder of the da!.
*n additionG if !ou ha.e a fuFtime Ko= during the da! and can trade on! after
hoursG futures woud =e a .er! incon.enient market product for !ou to trade. 9ou
woud =asica! =e pacing orders =ased on past prices and not current market prices.
3his ack of transparenc! makes trading .er! cum=ersome. With the FX marketG if
!ou choose to trade after hours through the right market makersG !ou can =e assured
that !ou woud recei.e the same iquidit! and spread as at an! other time of da!. *n
&:
additionG each time ,one has its own unique news and de.eopments that coud mo.e
specific currenc! pairs.
3ow to 7ero Trans act i on !ost s *n the futures marketG traders must pa! a
spread and<or a commission. With futures =rokersG a.erage commissions can run
cose to I&LH per trade on positions of I&HHGHHH or greater. 3he o.erFtheFcounter
structure of the FX market eiminates e@change and cearing feesG which in turn
owers transaction costs. Costs are further reduced =! the efficiencies created =! a
pure! eectronic marketpace that aows cients to dea direct! with the market
makerG eiminating =oth ticket costs and middemen. Because the currenc! market
offers aroundFtheFcock iquidit!G traders recei.e tightG competiti.e spreads =oth
intrada! and at night. Futures traders are more .unera=e to iquidit! risk and
t!pica! recei.e wider deaing spreadsG especia! during afterFhours trading.
5ow to ,ero transaction costs make onine FX trading the =est market to trade
for shortFterm traders. *f !ou are an acti.e futures trader who t!pica! paces :H
trades a da!G at I&HH commission per tradeG !ou woud ha.e to pa! I:GHHH in dai!
transaction costs. A t!pica futures trade in.o.es a =rokerG a Futures Commission
Merchant %FCM) order deskG a cerk on the e@change foorG a runnerG and a pit trader.
A of these parties need to =e paidG and their pa!ment comes in the form of
commission and cearing feesG whereas the eectronic nature of the FX market
minimi,es these costs.
'o 3i mi t U" or Down Ru%es/#rof i t in +oth +u%% an +ear Market s 3here is
no imit down or imit up rue in the FX marketG unike the tight restriction on the
futures market. For e@ampeG on the SOP 1HH inde@ futuresG if the contract .aue fas
more than 1 percent from the pre.ious da!Js coseG imit down rues wi come in
effect where=! on a 1 percent mo.e the inde@ is aowed to trade on! at or a=o.e this
e.e for the ne@t &H minutes. For a :H percent decineG trading woud =e compete!
hated. $ue to the decentrai,ed nature of the FX marketG there are no e@changeF
enforced restrictions on dai! acti.it!. *n effectG this eiminates missed profits due to
archaic e@change reguations.
Execut i on 8ua%i t & an S"ee/3ow Error Rates 3he futures market is aso
known for inconsistent e@ecution in terms of =oth pricing and e@ecution time. E.er!
futures trader has at some point in time e@perienced a haf hour or so wait for a
market order to =e fiedG on! to then =e e@ecuted at a price that ma! =e far awa!
from where the market was trading when the initia order was paced. E.en with
eectronic trading and imited guarantees of e@ecution speedG the prices for fis on
market orders are far from certain. 3he reason for this inefficienc! is the num=er of
steps that are in.o.ed in pacing a futures trade. A futures trade is t!pica! a se.enF
step process#
&. 3he cient cas his or her =roker and paces a trade %or paces it onine).
:. 3he trading desk recei.es the orderG processes itG and routes it to the FCM
order desk on the e@change foor.
C. 3he FCM order desk passes the order to the order cerk.
(. 3he order cerk hands the order to a runner or signas it to the pit.
1. 3he trading cerk goes to the pit to e@ecute the trade.
L. 3he trade confirmation goes to the runner or is signaed to the order cerk
and processed =! the FCM order desk.
&C
+. 3he =roker recei.es the trade confirmation and passes it on to the cient.
An FX tradeG in comparisonG is t!pica! on! a threeFstep process. A trader
woud pace an order on the patformG the FX deaing desk woud automatica!
e@ecute it eectronica!G and the order confirmation woud =e posted or ogged on the
traderJs trading station. 3he eimination of the additiona parties in.o.ed in a futures
trade increases the speed of the FX trade e@ecution and decreases errors.
*n additionG the futures market t!pica! operates under a Dne@t =est orderE
s!stemG under which traders frequent! do not get e@ecuted at the initia market order
priceG =ut rather at the ne@t =est price a.aia=e. For e@ampeG etJs sa! a cient is ong
fi.e March $ow ?ones futures contracts at 00HH with a stop order at 0+HHN if the price
fas to this e.eG the order wi most ike! =e e@ecuted at 0L'H. 3his &HFpoint
difference woud =e attri=uted to sippageG which is .er! common in the futures
market.
;n most FX trading stationsG traders e@ecute direct! off of reaFtime streaming
prices. Barring an! unforeseen circumstancesG there is genera! no discrepanc!
=etween the dispa!ed price and the e@ecution price. 3his hods true e.en during
.oatie times and fastFmo.ing markets. *n the futures marketG in contrastG e@ecution
is uncertain =ecause a orders must =e done on the e@changeG creating a situation
where iquidit! is imited =! the num=er of participantsG which in turn imits
quantities that can =e traded at a gi.en price. 6eaFtime streaming prices ensure that
FX market ordersG stopsG and imits are e@ecuted with minima sippage and no partia
fis.
W8; A6E 38E P5A9E6S *7 38E FX MA6>E3"
Since the foreign e@change market is an o.erFtheFcounter %;3C) market without
a centrai,ed e@changeG competition =etween market makers prohi=its monopoistic
pricing strategies. *f one market maker attempts to drastica! skew the priceG then
traders simp! ha.e the option to find another market maker. Moreo.erG spreads are
cose! watched to ensure market makers are not whimsica! atering the cost of the
trade. Man! equit! marketsG in contrastG operate in a compete! different fashionN the
7ew 9ork Stock E@change %79SE)G for instanceG is the soe pace where companies
isted on the 79SE can ha.e their stocks traded. Centrai,ed markets are operated =!
what are referred to as specialists,whie marketmakersis the term used in reference
to decentrai,ed marketpaces. %See Figures &.: and &.C.) Since the 79SE is a
centrai,ed marketG a stock traded on the 79SE can ha.e on! & =id<ask quote at a
times. $ecentrai,ed marketsG such as foreign e@changeG can ha.e mutipe market
makers-a of whom ha.e the right to quote different prices. 5etJs ook at how =oth
centrai,ed and decentrai,ed markets operate.
!ent r a% i 4e Market s
B! their .er! natureG centrai,ed markets tend to =e monopoistic# with a singe
speciaist controing the marketG prices can easi! =e skewed to accommodate the
interests of the speciaistG not those of the traders. *fG for e@ampeG the market is fied
with seers from whom the speciaists must =u! =ut no prospecti.e =u!ers on the
&(
other sideG the speciaists wi =e forced to =u! from the seers and =e una=e to se a
commodit! that is =eing sod off and hence faing in .aue. *n such a situationG the
speciaist ma! simp! widen the spreadG there=! increasing the cost of the trade and
pre.enting additiona participants from entering the market. ;r speciaists can simp!
drastica! ater the quotes the! are offeringG thus manipuating the price to
accommodate their own needs.
Figure &.: Centrai,ed Market Structure
Figure &.C $ecentrai,ed Market Structure
2ierarch& of #art i ci "ant s in Decent r a% i 4e Market
Whie the foreign e@change market is decentrai,ed and hence empo!s mutipe
market makers rather than a singe speciaistG participants in the FX market are
organi,ed into a hierarch!N those with superior credit accessG .oume transactedG and
sophistication recei.e priorit! in the market.
At the top of the food chain is the inter=ank marketG which trades the highest
.oume per da! in reati.e! few %most! 2F+) currencies. *n the inter=ank marketG
the argest =anks can dea with each other direct!G .ia inter=ank =rokers or through
eectronic =rokering s!stems ike Eectronic Brokering Ser.ices %EBS) or 6euters.
3he inter=ank market is a creditFappro.ed s!stem where =anks trade =ased soe! on
the credit reationships the! ha.e esta=ished with one another. A the =anks can see
the rates e.er!one is deaing atN howe.erG each =ank must ha.e a specific credit reaF
tionship with another =ank in order to trade at the rates =eing offered.
&1
;ther institutions such as onine FX market makersG hedge fundsG and corF
porations must trade FX through commercia =anks.
Man! =anks %sma communit! =anksG =anks in emerging markets)G
corporationsG and institutiona in.estors do not ha.e access to these rates =ecause
the! ha.e no esta=ished credit ines with =ig =anks. 3his forces sma participants to
dea through Kust one =ank for their foreign e@change needsG and often this means
much ess competiti.e rates for the participants further down the participant
hierarch!. 3hose recei.ing the east competiti.e rates are customers of =anks and e@F
change agencies.
6ecent! technoog! has =roken down the =arriers that used to stand =etween the
end users of foreign e@change ser.ices and the inter=ank market. 3he onine trading
re.oution opened its doors to retai cientee =! connecting market makers and
market participants in an efficientG owFcost manner. *n essenceG the onine trading
patform ser.es as a gatewa! to the iquid FX market. A.erage traders can now trade
aongside the =iggest =anks in the wordG with simiar pricing and e@ecution. What
used to =e a game dominated and controed =! the =ig =o!s is sow! =ecoming a
e.e pa!ing fied where indi.iduas can profit and take ad.antage of the same
opportunities as =ig =anks. FX is no onger an od =o!s cu=G which means
opportunit! a=ounds for aspiring onine currenc! traders.
Dea%i ng St at i ons5nt er$ank Market 3he maKorit! of FX .oume is transacted
primari! through the inter=ank market. 3he eading =anks of the word trade with
each other eectronica! o.er two patforms-the EBS and 6euters $eaing CHHHF
Spot Matching. Both patforms offer trading in the maKor currenc! pairsN howe.erG
certain currenc! pairs are more iquid and genera! more frequent! traded o.er
either EBS or 6euters $CHHH. 3hese two companies are continua! tr!ing to capture
each otherJs market sharesG =ut as a guideG here is the =reakdown of which currencies
are most iquid o.er the indi.idua patforms#
E+S Reuters
E/6</S$ 2BP</S$
/S$<?P9 E/6<2BP
E/6<?P9 /S$<CA$
E/6<C8F A/$</S$
/S$<C8F 7A$</S$
CrossFcurrenc! pairs are genera! not traded o.er either patformG =ut instead
are cacuated =ased on the rates of the maKor currenc! pairs and then offset using the
Degs.E For e@ampeG if an inter=ank trader had a cient who wanted to go ong
A/$<?P9G the trader woud most ike! =u! A/$</S$ o.er the 6euters $CHHH
s!stem and =u! /S$<?P9 o.er EBS. 3he trader woud then mutip! these rates and
pro.ide the cient with the respecti.e A/$<?P9 rate. 3hese currenc! pairs are aso
known as s!nthetic currenciesG and this heps to e@pain wh! spreads for cross currenF
cies are genera! wider than spreads for the maKor currenc! pairs.
&L
2istori ca% E*ent s in the F,
Market
Before di.ing into the inner workings of currenc! tradingG it is important for
e.er! trader to understand a few of the ke! miestones in the foreign e@change
markerG since e.en to this da! the! sti represent e.ents that are referenced
repeated! =! professiona fore@ traders.
B6E33;7 W;;$S# A7;*73*72 38E $;55A6 AS 38E
W;65$ C/66E7C9 %&'(()
*n ?u! &'((G representati.es of (( nations met in Bretton WoodsG 7ew
8ampshireG to create a new institutiona arrangement for go.erning the internationa
econom! in the !ears after Word War **. After the warG most agreed that
internationa economic insta=iit! was one of the principa causes of the warG and that
such insta=iit! needed to =e pre.ented in the future. 3he agreementG which was
de.eoped =! renowned economists ?ohn Ma!nard >e!nes and 8arr! $e@ter WhiteG
was initia! proposed to 2reat Britain as a part of the 5endF5ease Act-an American
act designed to assist 2reat Britain in postwar rede.eopment efforts. After .arious
negotiationsG the fina form of the Bretton Woods Agreement consisted of se.era ke!
points#
&. 3he formation of ke! internationa authorities designed to promote fair trade
and internationa economic harmon!.
:. 3he fi@ing of e@change rates among currencies.
C. 3he con.erti=iit! =etween god and the /.S. doarG thus empowering the
/.S. doar as the reser.e currenc! of choice for the word.
;f the three aforementioned parametersG on! the first point is sti in e@istence
toda!. 3he organi,ations formed as a direct resut of Bretton Woods incude the
*nternationa Monetar! Fund %*MF)G Word BankG and 2enera Agreement on 3ariffs
and 3rade %2A33)G which are sti in e@istence toda! and pa! a crucia roe in the
de.eopment and reguation of internationa economies. 3he *MFG for instanceG
initia! enforced the price of IC1 per ounce of god that was to =e fi@ed under the
Bretton Woods s!stemG as we as the fi@ing of e@change rates that occurred whie
Bretton Woods was in operation %and the financing required to ensure that fi@ed
e@change rates woud not create fundamenta distortions in the internationa
econom!).
Since the demise of Bretton WoodsG the *MF has worked cose! with another
progen! of Bretton Woods# the Word Bank. 3ogetherG the two institutions now
reguar! end funds to de.eoping nationsG thus assisting them in the de.eopment of
a pu=ic infrastructure capa=e of supporting a sound mercantie econom! that can
contri=ute in an internationa arena. AndG in order to ensure that these nations can
actua! enKo! equa and egitimate access to trade with their industriai,ed
counterpartsG the Word Bank and *MF must work cose! with 2A33. Whie 2A33
was initia! meant to =e a temporar! organi,ationG it now operates to encourage the
dismanting of trade =arriers-name! tariffs and quotas.
3he Bretton Woods Agreement was in operation from &'(( to &'+& when it was
repaced with the Smithsonian AgreementG an internationa contract of sorts
&+
pioneered =! /.S. President 6ichard 7i@on out of the necessit! to accommodate for
Bretton WoodsP shortcomingsG unfortunate!G the Smithsonian Agreement possessed
the same critica weakness# whie it did not incude god</.S. doar con.erti=iit!G it
did maintain fi@ed e@change rates-a facet that did not accommodate the ongoing
/.S. trade deficit and the internationa need for a weaker /.S. doar. As a resutG the
Smithsonian Agreement was shortFi.ed.
/timate!G the e@change rates of the word e.o.ed into a free marketG where=!
supp! and demand were the soe criteria that determined the .aue of a currenc!.
Whie this did and sti does resut in a num=er of currenc! crises and greater
.oatiit! =etween currenciesG it aso aowed the market to =ecome sefFreguatingG
and thus the market coud dictate the appropriate .aue of a currenc! without an!
hindrances.
As for Bretton WoodsG perhaps its most memora=e contri=ution to the
internationa economic arena was its roe in changing the perception regarding the
/.S. doar. Whie the British pound is sti su=stantia! strongerG and whie the euro
is a re.outionar! currenc! =a,ing new frontiers in =oth socia =eha.ior and
internationa tradeG the /.S doar remains the wordJs reser.e currenc! of choiceG for
the time =eing. 3his is undenia=! due ate! in part to the Bretton Woods
Agreement# =! esta=ishing doar<god con.erti=iit!G the doars roe as the wordPs
most accessi=e and reia=e currenc! was firm! cemented. And thusG whie Bretton
Woods ma! =e a doctrine of !ester!earG its impact on the /.S. doar and
internationa economics sti resonates toda!.
E7$ ;F B6E33;7 W;;$S# F6EE MA6>E3 CAP*3A5*SM *S
B;67 %&'+&)
;n August &1G &'+&G it =ecame officia# the Bretton Woods s!stemG a s!stem
used to fi@ the .aue of a currenc! to the .aue of godG was a=andoned once and for
a. Whie it had =een e@orcised =eforeG on! to su=sequent! emerge in a new formG
this fina eradication of the Bretton Woods s!stem was tru! its ast stand# no onger
woud currencies =e fi@ed in .aue to godG aowed to fuctuate on! in a & percent
rangeG =ut instead their fair .auation coud =e determined =! free market =eha.ior
such as trade fows and foreign direct in.estment.
Whie /.S. President 7i@on was confident that the end of the Bretton Woods
s!stem woud =ring a=out =etter times for the internationa econom!G he was not a
=eie.er that the free market coud dictate a currenc!Ps true .auation in a fair and
catastropheFfree manner. 7i@onG as we as most economistsG reasoned that an entire!
unstructured foreign e@change market woud resut in competing de.auationsG which
in turn woud ead to the =reakdown of internationa trade and in.estment. 3he end
resutG 7i@on and his =oard of economic ad.isers reasonedG woud =e go=a
depression.
According!G a few months aterG the Smithsonian Agreement was introduced.
8aied =! President 7i@on as the Qgreatest monetar! agreement in the histor! of the
wordGQ the Smithsonian Agreement stri.ed to maintain fi@ed e@change ratesG =ut to
do so without the =acking of god. *ts ke! difference from the Bretton Woods s!stem
was that the .aue of the doar coud foat in a range of :.:1 percentG as opposed to
Kust & percent under Bretton Woods.
&0
/timate!G the Smithsonian Agreement pro.ed to =e unfeasi=e as we. Without
e@change rates fi@ed to godG the free market god price shot up to I:&1 per ounce.
Moreo.erG the /.S. trade deficit continued to growG and from a fundamenta
standpointG the /.S. doar needed to =e de.aued =e!ond the :.:1 percent parameters
esta=ished =! the Smithsonian Agreement. *n ight of these pro=ems the foreign
e@change markets were forced to cose in Fe=ruar! &'+:.
3he fore@ markets reopened in March &'+CG and this time the! were not =ound
=! a Smithsonian Agreement# the .aue of the /.S. doar was to =e determined
entire! =! the marketG as its .aue was not fi@ed to an! commodit!G nor was its
e@change rate fuctuation confined to certain parametric. Whie this did pro.ide the
/.S. doarG and other currencies =! defautG the agiit! required to adapt to a new and
rapid! e.oking internationa trading en.ironmentG it aso set the stage for
unprecedented infation. 3he end of Bretton Woods and the Smithsonian AgreementG
as we as conficts in the Midde East resuting in su=stantia! higher oi pricesG
heped to create stagfation-the s!nthesis of unempo!ment and infation-in the
/.S. econom!. *t woud not =e unti ater in the decadeG when Federa 6eser.e
Chairman Pau Bocker initiated new economic poicies and President 6onad
6eagan introduced a new fisca agendaG that the /.S. doar woud return to norma
.auations. And =! thenG the foreign e@change markets had thorough! de.eopedG
and were now capa=e of ser.ing a mutitude of purposes# in addition to empo!ing a
aisse,Ffaire st!e of reguation for internationa tradeG the! aso were =eginning to
attract specuators seeking to participate in a market with unri.aed iquidit! and
continued growth. /timate!G the death of Bretton Woods in &'+& marked the
=eginning of a new economic eraG one that i=erated internationa trading whie aso
proiferating specuati.e opportunities.
P5AAA ACC;6$-$EBA5/A3*;7 ;F /.S. $;55A6 %&'0S)
After the demise of a the .arious e@change rate reguator! mechanisms that
characteri,ed the twentieth centur!-the god standardG the Bretton Woods standardG
and the Smithsonian Agreement-the currenc! market was eft with .irtua! no
reguation other than the m!thica Qin.isi=e handQ of free market capitaismG one that
supposed! stri.ed to create economic =aance through supp! and demand.
/nfortunate!G due to a num=er of unforeseen economic e.ents-such as the
;rgani,ation of Petroeum E@porting Countries %;PEC) oi crisesG stagfation
throughout the &'+HsG and drastic changes in the /.S. Federa 6eser.ePs fisca
poic!-supp! and demandG in and of themse.esG =ecame insufficient means =!
which the currenc! markets coud =e reguated. A s!stem of sorts was neededG =ut
not one that was infe@i=e. Fi@ation of currenc! .aues to a commodit!G such as godG
pro.ed to =e too rigid for economic de.eopmentG as was aso the notion of fi@ing
ma@imum e@change rate fuctuations. 3he =aance =etween structure and rigidit! was
cute that had pagued the currenc! markets throughout the twentieth centur!G and
whie ad.ancements had =een madeG a definiti.e soution was sti great! needed.
And hence in &'01G the respecti.e ministers of finance and centra =ank
go.ernors of the wordPs eading economies-FranceG 2erman!. ?apanG the /nited
>ingdomG and the /nited Sates-con.ened in 7ew 9ork Cit! with the hopes of
arranging a dipomatic agreement of sorts that woud work to optimi,e the economic
&'
effecti.eness of the foreign e@change markets. Meeting at the Pa,a 8oteG the
internationa eaders came to certain agreements regarding specific economies and
the internationa econom! as a whoe.
Across the wordG infation was at .er! ow e.es. *n contrast to the stagfation
of the &'+Hs where infation was high and rea economic growth was ow-the go=a
econom! in &'01 had done a compete &0HFdegree turnG as infation was now ow =ut
growth was strong.
Whie ow infationG e.en when couped with ro=ust economic growthG sti
aowed for ow interest rates-a circumstance de.eoping countries particuar!
enKo!ed-there was an imminent danger of protectionist poicies ike tariffs entering
the econom!. 3he /nited States was e@periencing a arge and growing current
account deficitG whie ?apan and 2erman! were facing arge and growing surpuses.
An im=aance so fundamenta in nature coud create serious economic
disequii=riumG which in turn woud resut in a distortion of the foreign e@change
markets and thus the internationa econom!.
3he resuts of current account im=aancesG and the protectionist poicies that
ensuedG required action. /timate!G it was =eie.ed that the rapid acceeration in the
.aue of the /.S. doarG which appreciated more than 0H percent against the
currencies of its maKor trading partnersG was the primar! cuprit. 3he rising .aue of
the /.S. doar heped to create enormous trade deficits. A doar with a ower
.auationG on the other handG woud =e more conduci.e to sta=ii,ing the internationa
econom!G as if woud natura! =ring a=out a greater =aance =etween the e@porting
and importing capa=iities of a countries.
At the meeting in the Pa,a 8oteG the /nited States persuaded the other
attendees to coordinate a mutiatera inter.entionG and on Septem=er ::G &'01G the
Pa,a Accord was impemented. 3his agreement was designed to aow for a
controed decine of the doar and the appreciation of the main antidoar currencies.
Each countr! agreed to changes to its economic poicies and to inter.ene in currenc!
markets as necessar! to ge the doar down. 3he /nited Sates agreed to cut its
=udget deficit and to ower interest rates. FranceG the /nited >ingdomG 2erman!G and
?apan a agreed to raise interest ratesG 2erman! aso agreed to institute ta@ cuts whie
?apan agreed to et the .aue of the !en Qfu! refect the under!ing strength of the
?apanese econom!.Q 8owe.erG the pro=em with the actua impementation of the
Pa,a Accord was that not e.er! countr! adhered to its pedges. 3he /nited Staes in
particuar did not foow through with its initia promise to cut the =udget deficit.
?apan was se.ere! hurt =! the sharp rise in the !enG and its e@porters were una=e to
remain competiti.e o.erseasG and it is argued that this e.entua! triggered a &HF!ear
recession in ?apan. 3he /nited SatesG in contrastG enKo!ed considera=e growth and
price sta=iit! as a resut of the agreement.
3he effects of the mutiatera inter.ention were seen immediate!G and within
two !ears the doar had faen (L percent and 1H percent against the deutsche mark
%$EM) and the ?apanese !en %?P9)G respecti.e!. Figure :F& shows this depreciation
of the /.S. doar against the $EM and the ?P9. 3he /.S. econom! =ecame far more
e@portForiented as a resutG whie other industria countries ike 2erman! and ?apan
assumed the roe of importing. 3his gradua! reso.ed the current account deficits
for the time =eingG and aso ensured that protectionist poicies were minima and
:H
nonthreatening. But perhaps most important!G the Pa,a Accord cemented the roe of
the centra =anks in reguating e@change rate mo.ement# !esG the rates woud not =e
fi@edG and hence woud =e determined primari! =! supp! and demandN =ut
utimate!G such an in.isi=e hand is insufficientG and it was the right and responsi=iF
it! of the words centra =anks to inter.ene on =ehaf of the internationa econom!
when necessar!.
Figure :.& Pa,a Accord Price Action
2E;62E S;6;S-38E MA7 W8; B6;>E 38E BA7> ;F
E725A7$
When 2eorge Soros paced a I&H =iion specuati.e =et against the /.>. pound
and wonG he =ecame uni.ersa! known as Qthe man who =roke the Bank of
Engand.Q Whether !ou o.e him or hate himG Soros ed the charge in one of the most
fascinating e.ents in currenc! trading histor!.
The Uni te .ingom 9oi ns the Exchange Rate Mechani s m
*n &'+'G a FrancoF2erman initiati.e set up the European Monetar! S!stem
%EMS) in order to sta=ii,e e@change ratesG reduce infationG and prepare for monetar!
integration. 3he E@change 6ate Mechanism %E6M)G one of the EMSPs main
componentsG ga.e each participator! currenc! a centra e@change rate against a
=asket of currenciesG the European Currenc! /nit %EC/). Participants %initia!
FranceG 2erman!G *ta!G the 7etherandsG BegiumG $enmarkG *reandG and
5u@em=ourg) were then required to maintain their e@change rates within a :.:1
percent fuctuation =and a=o.e or =eow each =iatera centra rate. 3he E6M was an
adKusta=eFpeg s!stemG and nine reaignments woud occur =etween &'+' and &'01.
:&
Whie the /nited >ingdom was not one of the origina mem=ersG it woud e.entua!
Koin in &''H at a rate of :.'1 deutsche marks to the pound and with a fuctuation =and
of R<F L percent.
/nti midF&'':G the E6M appeared to =e a successG as a discipinar! effect had
reduced infation throughout Europe under the eadership of the 2erman
Bundes=ank. 3he sta=iit! woudnPt astG howe.erG as internationa in.estors started
worr!ing that the e@change rate .aues of se.era currencies within the E6M were
inappropriate. Foowing 2erman reunification in &'0'G the nationJs go.ernment
spending surgedG forcing the Bundes=ank to print more mone!. 3his ed to higher
infation and eft the 2erman centra hank with itte choice =ut to increase interest
rates. But the rate hike had additiona repercussions-=ecause it paced upward
pressure on the 2erman mark. 3his forced other centra =anks to raise their interest
rates as weG so as to maintain the pegged currenc! e@change rates %a direct apF
pication of *r.ing Fishers interest rate parit! theor!). 6eai,ing that the /nited
>ingdomPs weak econom! and high unempo!ment rate woud not permit the British
go.ernment to maintain this poic! for ongG 2eorge Soros stepped into action.
Soros +ets /gai ns t Success of U( .( 5n*o% *ement in ERM
3he Muantum hedge fund manager essentia! wanted to =et that the pound
woud depreciate =ecause the /nited >ingdom woud either de.aue the pound or
ea.e the E6M. 3hanks to the progressi.e remo.a of capita contros during the
EMS !earsG internationa in.estors at the time had more freedom than e.er to take
ad.antage of percei.ed disequii=riumsG so Soros esta=ished short positions in
pounds and ong positions in marks =! =orrowing pounds and in.esting in markF
denominated assets. 8e aso made great use of options and futures. *n aG his
positions accounted for a gargantuan I&H =iion. Soros was not the on! one# man!
other in.estors soon foowed suit. E.er!one was seing poundsG pacing tremendous
downward pressure on the currenc!.
At firstG the Bank of Engand tried to defend the pegged rates =! =u!ing &1
=iion pounds with its arge reser.e assetsG =ut its sterii,ed inter.entions %where=!
the monetar! =ase is hed constant thanks to open market inter.entions) were imited
in their effecti.eness. 3he pound was trading dangerous! cose to the ower e.es of
its fi@ed =and. ;n Septem=er &LG &'':G a da! that woud ater =e known as Back
Wednesda!G the =ank announced a : percent rise in interest rates %from &H percent to
&: percent) in an attempt to =oost the poundJs appea. A few hours aterG it promised
to raise rates againG to &1 percentG =ut internationa in.estors such as Soros coud not
=e swa!edG knowing that huge profits were right around the corner. 3raders kept
seing pounds in huge .oumesG and the Bank of Engand kept =u!ing them untiG
fina!G at +#HH p.m. that same da!G Chanceor 7orman 5amont announced Britain
woud ea.e the E6M and that rates woud return to their initia e.e of &H percent.
3he chaotic Back Wednesda! marked the =eginning of a steep depreciation in the
pounds effecti.e .aue.
Whether the return to a foating currenc! was due to the SorosFed attack on the
pound or =ecause of simpe fundamenta ana!sis is sti de=ated toda!. What is
certainG howe.er is that the poundPs depreciation of amost &1 percent against the
deutsche mark and :1 percent against the doar o.er the ne@t fi.e weeks %as seen in
::
Figure :.: and Figure :.C) resuted in tremendous profits for Soros and other traders.
Within a monthG the Muantum Fund rushed in on appro@imate! I: =iion =! seing
the now more e@pensi.e deutsche marks and =u!ing =ack the now cheaper pounds.
D3he man who =roke the Bank of EngandE showed how centra =anks can sti =e
.unera=e to specuati.e attacks.
Figure :.: 2BP<$EM After Soros
Figure :.C 2BP</S$ After Soros
AS*A7 F*7A7C*A5 C6*S*S %&''+F&''0)
Faing ike a set of dominos on ?u! :G &''+G the reati.e! nascent Asian tiger
economies created a perfect e@ampe in showing the interdependence of go=a
capita markets and their su=sequent effects throughout internationa currenc!
forums. Based on se.era fundamenta =reakdownsG the cause of the contagion
stemmed arge! from shrouded ending practicesG infated trade deficitsG mid
:C
immature capita markets. Added togetherG the factors contri=uted to a Qperfect
stormQ that eft maKor regiona markets incapacitated and onceFpri,ed currencies
de.aued to significant! ower e.es. With ad.erse effects easi! seen in the equities
marketsG currenc! market fuctuations were negati.e! impacted in much the same
manner during this time period.
The +u$$%e
5eading up to &''+G in.estors had =ecome increasing! attracted to Asian
in.estment prospectsG focusing on rea estate de.eopment and domestic equities. As
a resutG foreign in.estment capita fowed into the region as economic growth rates
cim=ed on impro.ed production in countries ike Maa!siaG the PhiippinesG
*ndonesiaG and South >orea. 3haiandG home of the =ahtG e@perienced a &C percent
growth rate in &'00 %faing to L.1 percent in &''L). Additiona ending support for a
stronger econom! came from the enactment of a fi@ed currenc! peg to the more
formida=e /.S. doar. With a fi@ed .auation to the green=ack countries ike
3haiand coud ensure financia sta=iit! in their own markets and a constant rate for
e@port trading purposes with the wordPs atest econom!. /timate!G the regions
nationa currencies appreciated as under!ing fundamentas were KustifiedG and
specuati.e positions in e@pectation of further cim=s in price mounted.
+a%%ooni ng !urrent /ccount Defici t s an 'on"erf or mi ng
3oans
8owe.erG in ear! &''+G a shift in sentiment had =egun to occur as internationa
account deficits =ecame increasing! difficut for respecti.e go.ernments to hande
and ending practices were re.eaed to =e detrimenta to the economic infrastructure.
*n particuarG economists were aerted to the fact that 3haiandPs current account
deficit had =aooned in &''L to I&(.+ =iion %it had =een cim=ing since &'':).
Athough comparati.e! smaer than the /.S. deficitG the gap represented 0 percent
of the countr!Ps gross domestic product. Shrouded ending practices aso contri=uted
hea.i! to these =reakdowns as cose persona reationships of =orrowers with highF
ranking =anking officias were we rewarded and surprising! common throughout
the region. 3his aspect affected man! of South >oreaPs high! e.eraged
congomerates as tota nonperforming oan .aues sk!Frocketed to +.1 percent of
gross domestic product.
Additiona e.idence of these practices coud =e o=ser.ed in financia institutions
throughout ?apan. After announcing a I&CL =iion tota in questiona=e and
nonperforming oans in &''(G ?apanese authorities admitted to an aarming I(HH
=iion tota a !ear ater. Couped with a then cripped stock marketG cooing rea
estate .auesG and dramatic sowdowns in the econom!G in.estors saw opportunit! in
a depreciating !en. su=sequent! adding seing pressure to neigh=or currencies.
When ?apanPs asset =u==e coapsedG asset prices fe =! I&H triionG with the fa in
rea estate prices accounting for near! L1 percent of the tota decineG which was
worth two !ears of nationa output. 3his fa in asset prices sparked the =anking crisis
in ?apan. *t =egan in the ear! &''Hs and then de.eoped into a fuF=own s!stemic
crisis in &''+ foowing the faiure of a num=er of highFprofie financia institutions.
*n responseG ?apanese monetar! authorities warned of potentia! increasing =enchF
mark interest rates in hopes of defending the domestic currenc! .auation.
:(
/nfortunate!G these considerations ne.er materiai,ed and a shortfa ensued.
Sparked main! =! an announcement of a managed foat of the 3hai =ahtG the side
snow=aed as centra =ank reser.es e.aporated and currenc! price e.es =ecame
unsustaina=e in ight of downside seing pressure.
!urrenc& !risi s
Foowing mass short specuation and attempted inter.entionG the aforeF
mentioned Asian economies were eft ruined and momentari! incapacitated. 3he
3haiand =ahtG once a pri,ed possessionG was de.aued =! as much as (0 percentG
e.en sumping coser to a &HH percent fa at the turn of the 7ew 9ear. 3he most
ad.erse! affected was the *ndonesian rupiah. 6eati.e! sta=e prior to the onset of a
Dcrawing pegQ with the 3hai =ahtG the rupiah fe a whopping ::0 percent from its
pre.ious high of &:G'1H to the fi@ed /.S. doar. 3hese particuar! .oatie price
actions are refected in Figure :.(. Among the maKorsG the ?apanese !en fe
appro@imate! :C percent from its high to its ow against the /.S. doar in &''+ and
&''0G its shown in Figure :.1.
Figure :.( Asian Crisis Price Action
3he financia crisis of &''+F&''0 re.eaed the interconnecti.it! of economies
and their effects on the go=a currenc! markets. Additiona!G it showed the ina=iit!
of centra =anks to successfu! inter.ene in currenc! .auations when confronted
with o.erwheming market forces aong with the a=sence of secure economic
fundamentas. 3oda!G with the assistance of *MF reparation packages and the
impementation of stricter requirementsG AsiaJs four itte dragons are churning awa!
once again. With infationar! =enchmarks and a re.i.ed e@porting marketG Southeast
Asia is =uiding =ack its once prominent stature among the wordJs industriai,ed
economic regions. With the e@perience of e.aporating currenc! reser.es under their
:1
=esG the Asian tigers now take acti.e initiati.es to ensure that the! ha.e a arge pot
of reser.es on hand in ease specuators attempt to attack their currencies once again.
Figure :.1 /S$<?P9 Asian Crisis Price Action
*736;$/C3*;7 ;F 38E E/6; %&''')
3he introduction of the euro was a monumenta achie.ementG marking the
argest monetar! changeo.er e.er. 3he euro was officia! aunched as an eectronic
trading currenc! on ?anuar! &G &'''. 3he && initia mem=er states of the European
Monetar! /nion %EM/) were BegiumG 2erman!G SpainG FranceG *reandG *ta!G
5u@em=ourgG the 7etherandsG AustriaG PortugaG and Finand. 2reece Koined two
!ears ater. Each countr! fi@ed its currenc! to a specific con.ersion rate against the
euroG and a common monetar!P poic! go.erned =! the European Centra Bank
%EC/) was adopted. 3o man! economistsG the s!stem woud idea! incude a of the
origina &1 European /nion %E/) nationsG =ut the /nited >ingdomG SwedenG and
$enmark decided to keep their own currencies for the time =eing. Euro notes and
coins did not =egin circuation unti the first two months of :HH:. *n deciding
whether to adopt the euroG E/ mem=ers a had to weigh the pros and cons of such an
important decision.
Whie ease of tra.eing is perhaps the most saient issue to EM/ citi,ensG the
euro aso =rings a=out numerous other =enefits#
*t eiminates e@change rate fuctuationsG there=! pro.iding a more sta=e
en.ironment to trade within the euro area.
3he purging of a e@change rate risk within the ,one aows =usinesses to pan
in.estment derisions with greater certaint!.
3ransaction costs diminish %main! those reating to foreign e@change
operationsG hedging operationsG crossF=order pa!mentsG and the management of
se.era currenc! accounts).
:L
Prices =ecome more transparent as consumers and =usinesses can compare
prices across countries more easi!. 3hisG in turnG increase competition.
3he huge singe currenc! market =ecomes more attracti.e for foreign
in.estors.
3he econom!Ps magnitude and sta=iit! aow the ECB to contro infation with
ower interest rates thanks to increased credi=iit!.
9et the euro is not without its imitationsG ea.ing aside poitica so.ereignt!
issuesG the main pro=em is thatG =! adopting the euroG a nation essentia! forfeits
an! independent monetar! poic!. Since each countr!Ps econom! is not perfect!
correated to the EM/Ps econom!G a nation might find the ECB hiking interest rates
during a domestic recession. 3his is especia! true for man! of the smaer nations.
As a resutG countries tr! to re! more hea.i! on fisca poic!G =ut the efficienc! of
fisca poic! is imited when it is not effecti.e! com=ined with monetar! poic!.
3his inefficienc! is on! further e@acer=ated =! the C percent of 2$P imit on =udget
deficitsG as stipuated =! the Sta=iit! and 2rowth Pact.
Some concerns aso e@ist regarding the ECBJs effecti.eness as a centra =ank.
Whie its target infation is sight! =eow : percentG the euro areas infation edged
a=o.e the =enchmark from :HHH to :HH:G and has of ate continued to surpass the
sefFimposed o=Kecti.e. From &''' to ate :HH:G a ack of confidence in the unions
currenc! %and in the union itsef) ed to a :( percent depreciationG from
appro@imate! I&.&1 to the doar in ?anuar! &''' to IH.00 in Ma! :HHHG forcing the
ECB to inter.ene in foreign e@change markets in the ast few mouths of :HHH. Since
thenG howe.erG things ha.e great! changedN the euro now trades at a premium to the
doarG and man! ana!sts caim that the euro wi someda! repace the doar as the
wordPs dominant internationa currenc! %Figure :.L shows a chart of the euro since it
was aunched in &''').
Figure :.1 E/6</S$ Price Since 5aunch
3here are &H more mem=ers stated to adopt the euro o.er the ne@t few !ears.
3he enargementG which wi grow the EM/Ps popuation =! oneFfithG is =oth a
:+
poitica and an economic andmark e.ent# ;f the new entrantsG a =ut two are
former So.iet repu=icsG Koining the E/ after &1 !ears of restructuring. ;nce
assimiatedG these countries wi =ecome part of the wordPs argest free trade ,oneG a
=oc of (1H miion peope. Consequent!G the three argest accession countriesG
PoandG 8ungar!G and the C,ech 6epu=ic-which comprise +' percent of new
mem=er com=ined 2$P-are not ike! in adopt the euro an!time soon. Whie euro
mem=ers are mandated to cap fisca deficits at C percent of 2$PG each of these three
countries current! runs a proKected deficit at or near L percent. *n a pro=a=e
scenarioG euro entr! for PoandG 8ungar!G and the C,ech 6epu=ic are ike! to =e
dea!ed unti :HH' at the eariest. E.en smaer states whose economies at present
meet E/ requirements fare a ong process in repacing their nationa currencies.
States that aread! maintain a fi@ed euro e@change rate-Estonia and 5ithuania-
coud participate in the E6M earierG =ut e.en on this reati.e! fast trackG the! woud
not =e a=e to adopt the euro unti :HH+.
3he &''C the Maastricht 3reat! set fi.e main con.ergence criteria for mem=er
states to Koin the EM/.
Maast ri cht Treat &: !on*ergence !riteri a
&. 3he countr!Ps go.ernment =udget deficit coud not =e greater than C percent of
2$P.
:. 3he countr!Ps go.ernment de=t coud not =e arger than LH percent of 2$P.
C. 3he countr!Js e@change rate had to =e maintained within E6M hands without
an! reaignment for two !ears prior to Koining.
(. 3he countr!Ps infation rate coud not =e higher than &.1 percent a=o.e the
a.erage infation rate of the three E/ countries with the owest infation rates.
1. 3he countr!Js ongFterm interest rate on go.ernment =onds coud not =e higher
than : percent a=o.e the a.erage of the compara=e rates in the three countries
with the owest infation.
:0
;hat Mo*es the !urrenc& Market
in the 3ong Ter m<
3here are two maKor wa!s to ana!,e financia markets# fundamenta ana!sis
and technica ana!sis. Fundamenta ana!sis is =ased on under!ing economic
conditionsG whieG technica ana!sis uses historica prices in an effort to predict
future mo.ements. E.er since technica ana!sis first surfacedG there has =een an
ongoing de=ate as to which methodoog! is more successfu. ShortFterm traders
prefer to use technica ana!sisG focusing their strategies primari! on price actionG
whie mediumFterm traders tend to use fundamenta ana!sis to determine a
currenc!Ps proper .auationG as we as its pro=a=eG future .auation.
Before impementing successfu trading strategiesG it is important to understand
what dri.es the mo.ements of currencies in the foreign e@change market. 3he =est
strategies tend to =e the ones that com=ine =oth fundamenta and technica ana!sis.
3oo often perfect technica formations ha.e faied =ecause of maKor fundamenta
e.ents. 3he same occurs with fundamentasN there ma! =e sharp g!rations in price
action one da! on the =ack of no economic news reeasedG which suggests that the
price action is random or =ased on nothing more than pattern formations. 3hereforeG
it is .er! important for technica traders to =e aware of the ke! economic data or
e.ents that are schedued for reease andG in turnG for fundamenta traders to =e aware
of important technica e.es on which the genera market ma! =e focusing.
Fundamental analysis
Fundamenta ana!sis focuses on the economicG sociaG and poitica forces that
dri.e supp! and demand. 3hose using fundamenta ana!sis as a trading too ook at
.arious macroeconomic indicators such as growth ratesG interest ratesG infationG and
unempo!ment. We ist the most important economic reeases in Chapter &H as we
as the most marketFmo.ing pieces of data for the /.S. doar in Chapter (.
Fundamenta ana!sts wi com=ine a of this information to assess current and future
performance. 3his requires a great dea of work and thorough ana!sisG as there is no
singe set of =eiefs that guides fundamenta ana!sis. 3raders empo!ing
fundamenta ana!sis need to continua! keep a=reast of news and announcements
that can indicate potentia changes to the economicG sociaG and poitica en.ironment.
A traders shoud ha.e some awareness of the =road economic conditions =efore
pacing trades. 3his is especia! important for da! traders who are tr!ing to make
trading decisions =ased on news e.ents =ecause e.en though Federa 6eser.e
monetar! poic! decisions are awa!s importantG if the rate mo.e is aread!
compete! priced into the marketG then the actua reaction in the E/6</S$G sa!G
coud =e nomina.
3aking a step =ackG currenc! prices mo.e primari! =ased on supp! and
demand. 3hat isG on the most fundamenta e.eG a currenc! raies =ecause there is
demand for that currenc!. 6egardess of whether the demand is for hedgingG
specuati.eG or con.ersion purposesG true mo.ements are =ased on the need for the
currenc!. Currenc! .aues decrease when there is e@cess supp!. Supp! and demand
shoud =e the rea determinants for predicting future mo.ements. 8owe.erG how to
:'
predict supp! and demand is not as simpe as man! woud think. 3here are man!
factors that contri=ute to the net supp! and demand for a currenc!G such as capita
fowsG trade fowsG specuati.e needsG and hedging needs.
For e@ampeG the /.S. doar was .er! strong %against the euro) from &''' to the
end of :HH&G a situation primari! dri.en =! the /.S. *nternet and equit! market =oom
and the desire for foreign in.estors to participate in these ee.ated returns. 3his
demand for /.S. assets required foreign in.estors to se their oca currencies and
purchase /.S. doars. Since the end of :HH&G when geopoitica uncertaint! roseG the
/nited States started cutting interest rates and foreign in.estors =egan to se /.S.
assets in search of higher !ieds esewhere. 3his required foreign in.estors to se
/.S. doarsG increasing supp! and owering the doars .aue against other maKor
currencies. 3he a.aia=iit! of funding or interest in =u!ing a currenc! is a maKor
factor that can impact the direction that a currenc! trades. *t has =een a primar!
determinant for the /.S. doar =etween :HH: and :HH1. Foreign officia purchases of
/.S. assets %aso known as the 3reasur! internationa capita fow or 3*C data) ha.e
=ecome one of the most important economic indicators anticipated =! the markets.
Capital and Trade Flows
Capita fows and trade fows constitute a countr!Ps =aance of pa!mentsG which
quantifies the amount of demand for a currenc! o.er a gi.en period of time.
3heoretica!G a =aance of pa!ments equa to ,ero is required for a currenc! to
maintain its current .auation. A negati.e =aance of pa!ments num=er indicates that
capita is ea.ing the econom! at a more rapid rate than it is enteringG and hence
theoretica! the currenc! shoud fa in .aue.
3his is particuar! important in current conditions %at the ime of this =ookPs
pu=ication) where the /nited States is running a consistent! arge trade deficit
without sufficient foreign infow to fund that deficit. As a resut of this .er! pro=emG
the tradeFweighted doar inde@ fe :: percent in .aue =etween :HHC and :HH1. 3he
?apanese !en is another good e@ampe. As one of the wordPs argest e@portersG ?apan
runs a .er! high trade surpus. 3hereforeG despite a ,ero interest rate poic! that
pre.ents capita fows from increasingG the !en has a natura tendenc! to trade higher
=ased on trade fowsG which is the other side of the equation. 3o =e more specificG
here is a detaied e@panation of what capita and trade fows encompass.
Capital Flows: Measuring Currency Bought
and Sold
Capita fows measure the net amount of a currenc! that is =eing purchased or
sod due to capita in.estments. A positi.e capita fow =aance impies that foreign
infows of ph!sica or portfoio in.estments into a countr! e@ceed outfows. A
negati.e capita fow =aance indicates that there are more ph!sica or portfoio
in.estments =ought =! domestic in.estors than foreign in.estors. 5etPs ook at these
two t!pes of capita fows-ph!sica fows and portfoio fows.
#h&si ca% F%ows ( Ph!sica fows encompass actua foreign direct in.estments =!
corporations such as in.estments in rea estateG manufacturingG and oca acquisitions.
A of these require that a foreign corporation se the oca currenc! and =u! the
CH
foreign currenc!G which eads to mo.ements in the FX market. 3his is particuar!
important for go=a corporate acquisitions that in.o.e more cash than stock.
Ph!sica fows are important to watchG as the! represent the under!ing changes
in actua ph!sica in.estment acti.it!. 3hese fows shift in response to changes in
each countr!Js financia heath and growth opportunities. Changes in oca aws that
encourage foreign in.estment aso ser.e to promote ph!sica fows. For e@ampeG due
to ChinaPs entr! into the Word 3rade ;rgani,ation %W3;)G its foreign in.estment
aws ha.e =een rea@ed. As a resut of its cheap a=or and attracti.e re.enue
opportunities %popuation of o.er & =iion)G corporations go=a! ha.e fooded China
with in.estments. From an FX perspecti.eG in order to fund in.estments in ChinaG
foreign corporations need to se their oca currenc! and =u! Chinese renmin=i
%6MB).
#ort f o% i o F%ows ( Portfoio fows in.o.e measuring capita infows and outfows
in equit! markets and fi@ed income markets.
EquityMarkets.As technoog! has ena=ed greater ease with respect to
transportation of capitaG in.esting in go=a equit! markets has =ecome far more
feasi=e. According!G a ra!ing stork market in an! part of the word ser.es as an
idea opportunit! for aG regardess of geographic ocation. 3he resut of this has
=ecome a strong correation =etween a countr!Ps equit! markets and its currenc!# if
the equit! market is risingG in.estment doars genera! come in to sei,e the
opportunit!. Aternati.e!G friing equit! market coud prompt domestic in.estors to
se their shares of oca pu=ic! traded firms to capture in.estment opportunities
a=road.
Figure C.& $ow ?ones *ndustria A.erage and /S$<E/6
3he attraction of equit! markets compared to fi@ed income markets has
increased across the !ears. Since the ear! &''HsG the ratio of foreign transactions in
/.S. go.ernment =onds o.er /.S. equities has decined from &H to & to : to &. As
indicated in Figure C.&G it is e.ident that the $ow ?ones *ndustria A.erage had a high
correation %of appro@imate! 0& percent) with the /.S. doar %against the deutsche
mark) =etween &''( and &'''. *n additionG from &''& to &''' the $ow increased
C&
CHH percentG whie the /.S. doar inde@ appreciated near! CH percent for the same
time period. As a resutG currenc! traders cose! foowed the go=a equit! markets
in an effort to predict shortFterm and intermediateFterm equit!F=ased capita fows.
8owe.erG this reationship has shifted since the tech =u==e =urst in the /nited
StatesG as foreign in.estors remained reati.e! riskFa.erseG causing a ower
correation =etween the performance of the /.S. equit! market and the /.S. doar.
7e.ertheessG a reationship does sti e@istG making it important for a traders to keep
an e!e on go=a market performances in search of intermarket opportunities.
FixedIncomeMarkets.?ust as the equit! market is correated to e@change rate
mo.ementG so too is the fi@ed income market. *n times of go=a uncertain!G fi@ed
income in.estments can =ecome particuar! appeaingG due to the inherent safet!
the! possess. As a resutG economies =oasting the most .aua=e fi@ed income
opportunities wi =e capa=e of attracting foreign in.estment-which wi natura!
first require the purchasing of the countr!Ps respecti.e currenc!.
A good gauge of fi@ed income capita fows are the shortF and ongFterm !ieds
of internationa go.ernment =onds. *t is usefu to monitor the spread differentias
=etween the !ied on the &HF!ear /.S. 3reasur! note and the !ieds on foreign =onds.
3he reason is that internationa in.estors tend to pace their funds in countries with
the highestF!ieding assets. *f /.S. assets ha.e one of the highest !iedsG this woud
encourage more in.estments in 3.S. financia instrumentsG hence =enefiting the /.S.
doar. *n.estors can aso use shortFterm !ieds such as the spreads on twoF!ear
go.ernment notes to gauge shortFterm fow of *nternationa funds. Aside from
go.ernment =ond !iedsG federa funds futures can aso =e used to estimate mo.ement
of /.S. fundsG as the! price in the e@pectation of future Fed interest rate poic!.
Euri=or futuresG or futures on the Euro *nter=ank ;ffered 6ateG are a =arometer for
the euro regionPs e@pected future interest rates and can gi.e an indication of euro
region future poic! mo.ements. We co.er using fi@ed income products to trade FX
further in Chapter '.
Trade
Imports
Flows: Measuring Exports versus
3rade fows are the =asis of the internationa transactions. ?ust its the in.estment
en.ironment of a gi.en econom! is a prime determinant of its currenc! .auationG
trade fows represent a countr!Ps net trade =aance. Countries that are net e@porters-
meaning the! e@port more to internationa cients than the! import from internationa
producers wi e@perience a net trade surpus. Countries that are net e@porters are
more ike! to ha.e their currenc! rise in .aueG since from the perspecti.e of
internationa tradeG their currenc! is =eing =ought more than it is sod# incinationa
cients intended in =u!ing the e@ported product<ser.ice mast first =u! the appropriate
currenc!G thus creating demand for the currenc! of the e@porter.
Countries that are net importers-meaning the! make more *nternationa
purchases than internationa saes e@perience what is known as a trade deficitG which
in turn has the potentia to dri.e the .aue of the currenc! down. *n order to engage in
internationa purchasesG importers must se their currenc! to purchase that of the
C:
retaier of the good or ser.iceN according!G on a arge scae this coud ha.e the effect
of dri.ing the currenc! down. 3his concept is important =ecause it is a primar!
reason wh! man! economists sa! that the doar needs to continue to fa o.er the
ne@t few !ears to sop the /nited States from repeated! hitting record high trade
deficits.
3o carif! this furtherG supposeG for e@ampeG that the /.>. econom! is =oomingG
and that its stock market is ra!ing as we. MeanwhieG in the /nited StatesG a
ackuster econom! is creating a shortage of in.estment opportunities. *n such a
scenarioG the natura resut woud =e for /.S. residents to se their doars and =u!
British pounds to take ad.antage of the ra!ing /.>. econom!. 3his woud resut in
capita outfow from the /nited States and capita infow for the /nited >ingdom.
From an e@change rate perspecti.eG this woud induce a fa in the /S$ couped with
a rise in the 2BP as demand for /S$ decines and demand for 2BP increasesN in
other wordsG the 2BP</S$ woud rise.
For da! and swing tradersG a tip for keeping on top of the =roader economic
picture is to figure out how economic data for a particuar countr! stacks up.
Trading Tip: Charting Economic Surprises
A good tip for traders is to stack up economic data surprises against price action
to hep e@pain and forecast the future mo.ement in currencies.
Figure C.: Charting Economic Surprises
Figure C.: presents a sampe of what can =e done. 3he =ar graph shows the
percentages of surprise that economic indicator ha.e compared to consensus
forecastsG whie the dark ine traces price action for the period during which the data
CC
was reeasedN the white ine is a simpe price regression ine. 3his charting can =e
done for a of the maKor currenc! pairsG pro.iding a .isua guide to understanding
whether price action has =een in ine with economic fundamentas and heping to
forecast future price action. 3hus data is pro.ided on a month! =asis on
www.dai!f@.comG isted under Charting Economic Fundamentas.
According to the chart in Figure C.: in 7o.em=er :HH(G there were &: out of &1
positi.e economic surprises and !et the doar sod off against the euro during the
month of $ecem=erG which was the month during which the economic data was
reeased. Athough this methodoog! is ine@actG the ana!sis is simpe and past charts
ha.e !ieded some e@treme! usefu cues to future price action. Figure C.C shows
how the E/6</S$ mo.ed in the foowing month. As !ou can seeG the E/6</S$
quick! corrected itsef during the month of ?anuar!G indicating that the fundamenta
di.ergence of price action that occurred in $ecem=er pro.ed to =e quite usefu to
doar ongsG who har.ested amost LHH pips as the euro quick! retracted a arge part
of its gains in ?anuar!. 3his method of ana!sisG caed Q.ariant perceptionQG was
in.ented =! the egendar! hedge fund manager Michae SteinhardtG who produced :(
percent a.erage rates of return for CH consecuti.e !ears.
Figure C.C E/6</S$ Chart
%Source# eSigna. www.eSigna.com)
Whie those charts rare! offer such cearFcut signasG their ana!tica .aue ma!
aso ie in spotting and interpreting the outier data. Ber! arge positi.e and negati.e
surprises of particuar economic statistics can often !ied cues to future price action.
*f !ou go =ack and ook at the E/6</S$ chartsG !ou wi see that the doar punged
=etween ;cto=er and $ecem=er. 3his was triggered =! a widening of the current
account deficit to a record high in ;cto=er :HH(. Economic fundamentas matter
perhaps more in the foreign e@change market than in an! other marketG and charts
C(
such as these coud pro.ide .aua=e cues to price direction. 2enera!G the &1 most
important economic indicators are chosen for each region and then a price regression
ine is superimposed o.er the past :H da!s of price data.
Technical Analysis
Prior to the midF&'0HsG the FX market was primari! dominated =! fundamenta
traders. 8owe.erG with the rising popuarit! of technica ana!sis and the ad.ent of
new technoogiesG the infuence of technica trading on the FX market has increased
significant!. 3he a.aia=iit! of high e.erage has ed to an increased num=er of
momentum or mode fundsG which ha.e =ecome important participants in the FX
market with the a=iit! to infuence currenc! prices.
3echnica ana!sis focuses on the stud! of price mo.ements. 3echnica ana!sis
use historica currenc! data to forecast the direction of future prices. 3he premise of
technica ana!sis is that a current market information is aread! refected in the
price of each currenc!N thereforeG stud!ing price action is a that is required to make
informed trading decisions. *n additionG technica ana!sis works under the
assumption that histor! tends to repeat itsef.
3echnica ana!sis is a .er! popuar too for shortFterm to mediumFterm traders.
*t works especia! we in the currenc! markets =ecause shortFterm currenc! price
fuctuations are primari! dri.en =! human emotions or market perceptionsG 3he
primar! too in technica ana!sis is charts. Charts are used to identif! trends and
patterns in order to find profit opportunities. 3he most =asic concept of technica
ana!sis is that markets ha.e a tendenc! to trend. Being a=e to identif! trends in their
eariest stage of de.eopment is the ke! to technica ana!sis. 3echnica ana!sis
integrates price action and momentum to construct a pictoria representation of past
currenc! price action to predict future performance. 3echnica ana!sis toos such as
Fi=onacci retracement e.esG mo.ing a.eragesG osciatorsG candestick chartsG and
Boinger =ands pro.ide further information on the .aue of emotiona e@tremes of
=u!ers and seers to direct traders to e.es where greed and fear are the strongest.
3here are =asica! two t!pes of marketsG trending and rangeF=oundN in the trade
parameters section %Chapter +)G we attempt to identif! rues that woud hep traders
determine what t!pe of market the! are current! trading in and what sort of trading
opportunities the! shoud =e ooking for.
Is Technical Analysis or Fundamental Analysis Better
3echnica .ersus fundamenta ana!sis is a ongtime =atteG and after man! !ears
there is sti no winner or oser. Most traders a=ide =! technica ana!sis =ecause it
does not require as man! hours of stud!. 3echnica ana!sts can foow man!
currencies at one time. Fundamenta ana!sisG in contrastG tend to speciai,e due to the
o.erwheming amount of data in the market. 3echnica ana!sis works we =ecause
the currenc! market tends to de.eop strong trends. ;nce technica ana!sis is
masteredG it can =e appied with equa ease to an! time frame or currenc! traded.
8owe.erG it is important to take into consideration =oth strategiesG as
fundamentas can trigger technica mo.ements such as =reakouts or trend re.ersasG
whie technica ana!sis can e@pain mo.es that fundamentas cannotG especia! in
C1
quiet marketsG such as resistance in trends. For e@ampeG as !ou can see in Figure C.(G
in the da!s eading up to Septem=er &&G :HH&G /S$<?P9 had Kust =roken out of a
triange formation and ooked poised to head higher. 8owe.erG as the chart indicatesG
instead of =reaking higher as technicians ma! ha.e e@pectedG /S$<?P9 =roke down
foowing the terrorist attacks and ended up hitting a ow of &&1.0& from a high of
&:&.00 on Septem=er &H.
Figure C.( /S$<?P9 Septem=er &&G :HH&G Chart
%Source# eSigna. www.eSigna.com)
C!""E#C$ F%"ECASTI#& ' ()AT B%%*(%"MS A#+
EC%#%MISTS ,%%* AT
For more a.id students of foreign e@change who want to earn more a=out
fundamenta ana!sis and .auing currenciesG this section e@amines the different
modes of currenc! forecasting empo!ed =! the ana!sts or the maKor in.estment
=anks. 3here are se.en maKor modes for forecasting currencies# the =aance of
pa!ments %B;P) theor!G purchasing power parit! %PPP)G interest rate parit!G the
monetar! modeG the rea interest rate differentia modeG the asset market modeG and
the currenc! su=stitution mode.
+a%ance of #a&ment s Theor&
3he =aance of pa!ments theor! states that e@change rates shoud =e at their
equii=rium e.eG which is the rate that produces a sta=e current account =aance.
Countries with trade deficits e@perience a run on their foreign e@change reser.es due
to the fact that e@porters to that nation must se that nationPs currenc! in order to
CL
recei.e pa!ment. 3he cheaper currenc! makes the nationPs e@ports ess e@pensi.e
a=roadG which in turn fues e@ports and =rings the currenc! into =aance.
;hat is the +a%ance of #a&ment s < 3he =aance of pa!ments account is di.ided
into two parts# the current account and the capita account. 3he current account
measures trade in tangi=eG .isi=e items such as cars and manufactured goodsN the
surpus or deficit =etween e@ports and imports is caed the trade =aance. 3he capita
account measures fows of mone!G such as in.estments for stocks or =onds. Baance
of pa!ments data can =e found on the we= site of the Bureau of Economic Ana!sis
%www.=ea.go.).
Trae F%ows ( 3he trade =aance of a countr! shows the net difference o.er a
period of time =etween a nations e@ports and imports. When a countr! imports more
then it e@ports the trade =aance is negati.e or is in a deficit. *f the countr! e@ports
more than it imports the trade =aance is positi.e or is in a surpus. 3he trade =aance
indicates the redistri=ution of weath among countries and is a maKor channe through
which the macroFeconomic poicies of a countr! ma! affect another countr!.
*n generaG it is considered to =e unfa.ora=e for a countr! to ha.e a trade deficitG
in that it negati.e! impacts the .aue of the nations currenc!. For e@ampeG if /.S.
trade figures show greater imports than e@portsG more doars fow out of the /nited
States and the .aue of the /.S. currenc! depreciates. A positi.e trade =aanceG in
comparisonG wi affect the doar =! causing it to appreciate against the other
currencies.
!a"i t a% F%ows ( *n addition to trade fowsG there are aso capita fows that occur
among countries. 3he! record a nationPs incoming and outgoing in.estment fows
such as pa!ments for entire %or for parts of) companiesG stocksG =ondsG =ank accountsG
rea estateG and factories. 3he capita fows are infuenced =! man! factorsG incuding
the financia and economic cimate of other countries. Capita fows can =e in the
form of ph!sica or portfoio in.estments. *n generaG in de.eoping countriesG the
composition of capita fows tends to =e skewed toward foreign direct in.estment
%F$*) and =ank oans. For de.eoped countriesG due to the strength of the equit! and
fi@ed income marketsG stocks and =onds appear to =e more important than =ank oans
and F$*.
EquityMarketsEquit! markets ha.e a significant impact on e@change rate
mo.ements =ecause the! are a maKor pace for highF.oume currenc! mo.ements.
3heir importance is considera=e for the currencies of countries with de.eoped
capita markets where great amounts of capita infows and outfows occurG and
where foreign in.estors are maKor participants. 3he amount of the foreign in.estment
fows in the equit! markets is dependent on the genera heath and growth of the
marketG refecting the weF=eing of companies and particuar sectors. Mo.ements of
currencies occur when foreign in.estors mo.e their mone! to a particuar equit!
market. 3hus the! con.ert their capita in a domestic currenc! and push the demand
for it higherG making the currenc! appreciate. When the equit! markets are
e@periencing recessionsG howe.erG foreign in.estors tend to feeG thus con.erting =ack
to their home currenc! and pushing the domestic currenc! down.
FixedIncome(Bond) Markets3he effect the fi@ed income markets ha.e on
currencies is simiar to that of the equit! markets and is a resut of capita
mo.ements. 3he in.estorPs interest in the fi@ed income market depends on the
C+
compan!Ps specifics and credit ratingG as we as on the genera heath of the econom!
and the countr!Ps interest rates. 3he mo.ement of foreign capita into and out of fi@ed
income markets eads to change in the demand and supp! for currenciesG hence
impacting the currenciesP e@change rates.
Summa r & of Trae an !a"i t a% F%ows $etermining and understanding a
countr!Ps =aance of pa!ments is perhaps the most important and usefu foo for those
interested in fundamenta ana!sis. An! internationa transaction gi.es rise to two
offsetting entriesG trade fow =aance %current account) and capita fow =aance
%capita account). *f the trade fow =aance is a negati.e outfowG the countr! is
=u!ing more from foreigners than it ses %imports e@ceed e@ports). When it is a
positi.e infowG the countr! is seing more than it =u!s %e@ports e@ceed imports).
3he capita fow =aance is positi.e when foreign infows of ph!sica or portfoio
in.estments into a countr! e@ceed that countr!Ps outfows. A capita fow is negati.e
when a countr! =u!s more ph!sica or portfoio in.estments than are sod to foreign
in.estors.
3hese two entriesG trade and capita fowG when added together signif! a
countr!Ps =aance of pa!ments. *n theor!G the two entries shoud =aance and add up
to ,ero in order to pro.ide for the maintenance of the status quo in a nationPs
econom! and currenc! raiPs.
*n generaG countries might e@perience positi.e or negati.e tradeG as we as
positi.e or negati.e capita fow =aances. *n order to minimi,e the net effect of the
two on the e@change ratesG a countr! shoud tr! to maintain a =aance =etween the
two. For e@ampeG in the /nited Sates there is a su=stantia trade deficitG as more is
imported than is e@ported. When the trade =aance is negati.eG the countr! is =u!ing
more from foreigners than it ses and therefore it needs to finance its deficit. 3his
negati.e trade fow might =e offset =! a positi.e capita fow into the countr!G as
foreigners =u! either ph!sica or portfoio in.estments. 3hereforeG the /nited States
seeks to minimi,e its trade deficit and ma@imi,eG its capita infows to the e@tent that
the two =aance out.
A change in this =aance is e@treme! significant and carries ramifications that
run deep into economic poic! and currenc! e@change e.es. 3he net resut of the
difference =etween the trade and capita fowsG positi.e or negati.eG wi impact the
direction in which the nationPs currenc! wi mo.e. *f the o.era trade and capita
=aance is negati.e it wi resut in a depreciation of the nationPs currenc!G and if
positi.e it wi ead to an appreciation of the currenc!.
Cear! a change in the =aance of pa!ments carries a direct effort for currenc!
e.es. *t is therefore possi=e for an! in.estor to o=ser.e economic data reating to
this =aance and interpret the resuts that wi occur. $ata reating to capita and trade
fows shoud =e foowed most cose!. For instanceG if an ana!st o=ser.es an
increase in the /.S. trade deficit and a decrease in the capita fowsG a =aance of
pa!ments deficit woud occur and as a resut an in.estor ma! anticipate a
depreciation of the doar.
3i mi t at i ons of +a%ance or #a&ment s Moe% 3he B;P mode focuses on traded
goods and ser.ices whie ignoring internationa capita fows. *ndeedG internationa
capita fows often dwarfed trade fows in the currenc! markets toward the end of the
C0
&''HsG thoughG and this often =aanced the current accounts of de=tor nations ike the
/nited Sates.
For e@ampeG in &'''G :HHH and :HH& the /nited States maintained a arge
current account deficit whie the ?apanese ran a arge current account surpus.
8owe.erG during i=is same period the /.S. doar rose against the !en e.en though
trade fows were running against the doar.
3he reason was that capita fows =aanced trade fowsG thus def!ing the B;PJs
forecasting mode for a period of time. *ndeedG the increase in capita fows has gi.en
rise to the asset market mode.
Note:*t is pro=a=! a misnomer to ca this approach the =aance of pa!ments
theor! since it takes into account on! the current account =aanceG not the actua
=aance of pa!ments. 8owe.erG unti the &''Hs capita fows pa!ed a .er! sma roe
in the word econom! so the trade =aance made up the =uk of the =aance of
pa!ments for most nations.
-urchasing -ower -arity
3he purchasing power parit! theor! is =ased on the =eief that foreign e@change
rates shoud =e determined =! the reati.e prices of a simiar =asket of goods =etween
two countries. An! change in a nationPs infation rate shoud =e =aanced =! an
opposite change in that nationPs e@change rate. 3hereforeG according to this theor!G
when a countr!Ps prices are rising due to infationG that countr!Ps e@change rate shoud
depreciate in order to return to parit!.
###= s +as ket of Goos 3he =asket of goods and ser.ices priced for the PPP
e@ercise is a sampe of a goods and ser.ices co.ered =! gross domestic product
%2$P). *t incudes consumer goods and ser.icesG go.ernment ser.icesG equipment
goodsG and construction proKects. More specifica!G consumer items incude foodG
=e.eragesG to=accoG cothingG footwearG rentsG water supp!G gasG eectricit!G medica
goods and ser.icesG furniture and furnishingsG househod appiancesG persona
transport equipmentG fueG transport ser.icesG recreationa equipmentG recreationa and
cutura ser.icesG teephone ser.icesG education ser.icesG goods and ser.ices for
persona care and househod operationG and repair and maintenance ser.ices.
+ig Mac 5nex ;ne of the most famous e@ampes of PPP is the Economist'sBig
Mac *nde@. 3he Big Mac PPP is the e@change rate that woud ea.e ham=urgers
costing the same in the /nited States as esewhereG comparing these with actua rates
signas if a currenc! is underF or o.er.aued. For e@ampeG in Apri :HH: the
e@change rate =etween the /nited States and Canada was &.1+. *n the /nited States a
Big Mac cost I:.('. *n CanadaG a Big Mac cost IC.CC in oca Canadian doars
%CA$)G which works out to on! I:.&: in /.S. doars. 3hereforeG the e@change rate
for /S$<CA$ is o.er.aued =! &1 percent using this theor! and shoud =e on! &.C(.
OE!D #urchas i ng #ower #ari t & 5nex A more forma inde@ is put out =! the
;rgani,ation for Economic Cooperation and $e.eopment. /nder a Koint ;EC$F
Eurostat PPP programG the ;EC$ and Eurostat share the responsi=iit! for
cacuating PPPJs. 3his atest information on which currencies are underF or
o.er.aued against the /.S. doar can =e found on the ;EC$Js we= site at
www.oecd.org. 3he ;EC$ pu=ishes a ta=e that shows the price e.es for the maKor
C'
industriai,ed countries. Each coumn states the num=er of specified monetar! units
needed in each of the countries isted to =u! the same representati.e =asket of
consumer goods and ser.ices. *n each case the representati.e =asket costs &HH units
in the countr! whose currenc! is specified. 3he chart that is then created compares
the PPP of a currenc! with its actua e@change rate. 3he chart is updated week! to
refect the current e@change rate. *t is aso updated a=out twice a !ear to refect new
estimates of PPP. 3he PPP estimates are taken from studies carried out =! the ;EC$
howe.erG the! shoud not =e taken as definiti.e. $ifferent methods of cacuation wi
arri.e at different PPP rates. According to the ;EC$ information for Septem=er
:HH:G the e@change rate =etween the /nited States and Canada was &.10 whie the
price e.e for the /nited States .ersus Canada was &::G which transates to an
e@change rate of &.::. /sing this PPP modeG the /S$<CA$ is once again great!
o.er.aued %=! o.er :1 percentG not that far awa! from the Big Mac *nde@ after a).
3i mi t at i on to using #urchas i ng #ower #ari t & PPP theor! shoud =e used on!
for ongFterm fundamenta ana!sis. 3he economic forces =ehind PPP wi e.entua!
equai,e the purchasing power of currencies. 8owe.erG this can take man! !ears. A
time hori,on of 1 to &H !ears is t!pica.
PPPPs maKor weakness is that it assumes goods can =e traded easi!G without
regard to such things as tariffsG quotasG or ta@es. For e@ampeG when the /nited States
announces new tariffs on imports the cost of domesticG manufactured goods goes upN
=ut those increases wi not =e refected in the /.S. PPP ta=es.
3here are other factors that must aso =e considered when weighing PPP#
infationG interest rate differentiasG economic reeases<reportsG asset marketsG trade
fowsG and poitica de.eopments. *ndeedG PPP is Kust one of se.era theories traders
shoud use when determining e@change rates.
5nteres t Rate #ari t &
3he interest rate parit! theor! states that if two different currencies ha.e
different interest rates then that difference wi =e refected in the premium or
discount for the forward e@change rate in order to pre.ent riskess ar=itrage.
For e@ampeG if /.S. interest rates are C percent and ?apanese *nterest rates are &
percentG then the /.S. doar shoud depreciate against the ?apanese !en =! : percent
in order to pre.ent riskess ar=itrage. 3his future e@change rate is refected into the
forward e@change rate stated toda!. *n our e@ampeG the forward e@change rate of the
doar is said to =e at discount =ecause it =u!s fewer ?apanese !en in the forward rate
than it does in the spot rate. 3he !en is said to =e at a premium.
*nterest rate parit! has shown .er! itte proof of working in recent !ears. ;ften
currencies with higher interest rates rise due to the determination of centra =ankers
tr!ing to sow down a =ooming econom! =! hiking rates and ha.e nothing to do with
riskess ar=itrage.
Monetar & Moe%
3he monetar! mode hods that e@change rates are determined =! a nationPs
monetar! poic!. Countries that foow a sta=e monetar! poic! o.er time usua!
ha.e appreciating currencies according to the monetar! mode. Countries that ha.e
(H
erratic monetar! poicies or e@cessi.e! e@pansionist poicies shoud see the .aue of
their currenc! depreciate.
2ow to use the Monetar & Moe% 3here are se.era factors that infuence
e@change rates under this theor!#
&. A nationPs mone! supp!.
:. E@pected future e.es of a nationPs mone! supp!.
C. 3he growth rate of a nationPs mone! supp!.
A of these factors are ke! to understanding and spoiing a monetar! trend that
ma! force a change in e@change rates. For e@ampeG the ?apanese econom! has =een
sipping in and out of recession for o.er a decade. *nterest rates are near ,eroG and
annua =udget deficits pre.ent the ?apanese from spending their wa! out of recessionG
which ea.es on! one too eft at the disposa of ?apanese officias determined to
re.i.e their econom!# printing more mone!. B! =u!ing stocks and =ondsG the Bank
of ?apan is increasing the nationPs mone! supp!G which produces infationG which
forces a change in the e@change rate. 3he e@ampe in Figure C.1 iustrates the effect
of mone! supp! changes using the monetar! mode.
*ndeedG it is in the area of e@cessi.e e@pansionar! monetar! poic! that the
monetar! mode is most successfu. ;ne of the few wa!s a countr! can keep its
currenc! from sharp! de.auing is =! pursuing a tight monetar! poic!. For e@ampeG
during the Asian currenc! crisis the 8ong >ong doar came under attack from
specuators. 8ong >ong officias raised interest rates to CHH percent to hat the 8ong
>ong doar from =eing disodged from its peg to the /.S. doar. 3he tactic worked
perfect! as specuators were ceared out =! such sk!Fhigh interest rates. 3he
downside was the danger thatG the 8ong >ong econom! woud side into recession.
But in the end the peg hed and the monetar! mode worked.
/%&)3( $)
*-)(7
28PP97
7en is printed
/%&)3( $) P:$/(
9(;(9
$ncrease in 7en
/reates $nflation
/%&)3( $)
(</%&)3( :&T(
7en =epreciates
in ;alue
Figure C.1 Monetar! Mode
3i mi t at i ons of Monetar & Moe% Ber! few economists soe! stand =! this
mode an!more since it does not take into account trade fows and capita fows. For
e@ampeG throughout :HH: the /nited >ingdom had higher interest ratesG growth
ratesG and infation rates than =oth the /nited States and the European /nionG !et the
pound appreciated in .aue against =oth the doar and the euro. *ndeedG the monetar!
mode has great! strugged since the dawn of free! foating currencies. 3he mode
hods thatG high interest rates signa growing infationG which the! often doG foowed
=! a depreciating currenc!. But this does not take into account the capita infows
that woud take effect as a resut of higher interest !ieds or of an equit! market that
ma! =e thri.ing in a =ooming econom!-thus causing the currenc! to possi=!
appreciate.
*n an! caseG the monetar! mode is one of se.era usefu fundamenta toos that
can =e empo!ed in tandem with other modes to determine the direction an e@change
rate is heading.
(&
"eal Interest "ate +i..erential Model
3he rea interest rate differentia theor! states that e@change rate mo.ements are
determined =! a nationPs interest rate e.e. Countries that ha.e high interest rates
shoud see their currencies appreciate in .aueG whie countries with ow interest rates
shoud see their currencies depreciate in .aue.
+asics of the Moe% ;nce a nation raises its interest ratesG internationa
in.estors wi disco.er that the !ied for that nationPs currenc! is more attracti.e and
hence =u! up that nationPs currenc!. Figure C.L shows how we this theor! hed up in
:HHC when interest rate spreads were near their widest e.es in recent !ears.
3he data from this graph shows a mi@ed resut. 3he Austraian doar had the
argest =asis point spread and aso had the highest return against the /.S. doarG
which seems to .indicate the mode as in.estors =ought up higherF!ieding Aussie
currenc!. 3he same can =e said for the 7ew Aeaand doarG which aso had a higher
!ied than the /.S. doar and gained :+ percent against /S$. 9et the mode
=ecomes ess con.incing when comparing the euroG which gained :H percent against
the doar %more than e.er! currenc! e@cept 7A$) e.en though its =asis point differF
entia was on! &HH points. 3he mode then comes under serious question when
comparing the British pound and the ?apanese !en. 3he !en differentia is F&HH and
!et it appreciates amost &: percent against the doar. MeanwhieG the British pound
gained on! && percent against the doar e.en though it had a whopping :+1Fpoint
interest rate differentia.
$nterest :ates vs. 8.2.
/entral >ank :ate (nd
of #55"
? /hange #55" vs.
82=
(uro+one @apan
455
#5?
0455
4#?
8.A. /anad &ustralia
a
#BC 4BC '#C
#4? "'?
)ew Dealand
'55
#B? 44?
Figure C.L 6ea *nterest 6ate Mode
(:
3his mode aso stresses that one of the ke! factors in determining the se.erit!
of an e@change ratePs response to a shift in interest rates is the e@ported persistence of
that shift. Simp! putG a rise in interest rates that is e@pected to ast for fi.e !ears wi
ha.e a much arger impact on the e@change rate than if that rise were e@pected to ast
for on! one !ear.
3i mi t at i ons to 5nteres t Rate Moe% 3here is a great dea of de=ate among
internationa economists o.er whether there is a strong and statistica! significant
ink =etween changes in a nationPs interest rate and currenc! price. 3he main
weakness of this mode is dia it does not take into account a nationPs current account
=aanceG re!ing on capita fows instead. *ndeedG the mode tends to o.eremphasi,e
capita fows a the e@pense of numerous other factors# poitica sta=iit!G infationG
economic growthG and so on. A=sent these t!pes of factorsG the mode can =e .er!
usefu since it is quite ogica to concude that an in.estor wi natura! gra.itate
toward the in.estment .ehice that pa!s a higher reward.
Asset Mar/et Model
3he =asic premise of this theor! is that the fow of funds into other financia
assets of a countr! such as equities and =onds increases the demand for that countr!Ps
currenc! %and .ice .ersa). As proofG ad.ocates point out dia the amount of funds that
are paced in in.estment products such as stocks and =onds now dwarf the amount of
funds that are e@changed as a resut of the transactions in goods and ser.ices for
import and e@port purposes. 3he asset market theor! is =asica! the opposite of the
=aance of pa!ments theor! since it takes into account a nationPs capita account inF
stead of its current account.
/ Do%%ar- Dri*en Theor& 3hroughout &'''G man! e@perts argued that the doar
woud fa against the euro on the grounds of the e@panding /.S. current account
deficit and an o.er.aued Wa Street. 3hat was =ased on the rationae that nonF/.S.
in.estors woud =egin withdrawing their funds from /.S. stocks and =onds into more
economica! sound marketsG which woud weigh significant! on the doar. 9et
such fears ha.e ingered since the ear! *'0Hs when the /.S. current account soared
to a record high at the time of C.1 percent of 2$P.
3hroughout the past two decadesG the =aance of pa!ments approach in assessing
the doars =eha.ior has gi.en wa! to the asset market approach. 3his theor!
continues to hod the most swa! o.er pundits due to the enormit! of /.S. capita
markets. *n Ma! and ?une of :HH: the doar pummeted more titan a thousand points
.ersus the !en at the same time equit! in.estors fed /.S. equit! markets due to the
accounting scandas that were paguing Wa Street. As the scandas su=sided toward
the end of :HH: the doar rose 1HH =asis points from a ow of &&1.(C to cose at
&:H.HH against the !en e.en though the current accountG =aance remained in massi.e
deficit the entire time.
3i mi t at i ons to /sset Market Theor& 3he main imitation of the asset market
theor! is that it is untested and fair! new. *t is frequent! argued that o.er the ong
run there is no reationship =etween a nationPs equit! market performance and the
performance of its currenc!. See Figure C.+ for a comparison. Between &'0L and
(C
:HH(G the SOP 1HH inde@ and the /.S. $oar *nde@ had a correation of on! C'
percent.
AsoG what happens to a nationPs currenc! when the stock market is trading
sidewa!sG stuck =etween =uish and =earish sentiments" 3hat was the scenario in the
/nited States for much of :HH:G and currenc! traders found themse.es going =ack to
oder mone!making modesG such as interest rate ar=itrageG as a resut. ;n! time wi
te whether the asset market mode wi hod on or mere! =e a shortFterm =ip on the
currenc! forecasting radar.
Figure C.+ $oar *nde@ and SOP 1HH.
Currency Su0stitution Model
3his currenc! su=stitution mode is a continuation of the monetar! mode since
it takes into account a nationPs in.estor fows. *t posits that the shifting of pri.ate and
pu=ic portfoios from one nation to another can ha.e a significant effect on e@change
rates. 3he a=iit! of indi.iduas to change their assets from domestic and foreign
currencies is known as currenc! su=stitution. When this mode is added to the
monetar! modeG e.idence shows that shifts in e@pectations of a nationPs mone!
supp! can ha.e a decided impact on that nationPs e@change rates. *n.estors are
ooking at monetar! mode data and coming to the concusion that a change in mone!
fow is a=out to occurG thus changing the e@change rateG so the! are in.esting
according!G which turns the monetar! mode into a sefFfufiing prophec!.
*n.estors who su=scri=e to this theor! are mere! Kumping on the currenc!
su=stitution mode =andwagon on the wa! to the monetar! mode part!.
)en Exam"% e *n the monetar! mode e@ampe we showed that =! =u!ing stocks
and =onds in the market pace the ?apanese go.ernment was =asica! printing !en
%increasing the mone! supp!). Monetar! mode theorists woud concude this
monetar! growth woud in fact spark infation %more !en chasing fewer products)G
((
decrease demand for the !enG and fina! cause the !en to depreciate across the =oard.
A currenc! su=stitution theorist woud agree with this scenario and ook to take
ad.antage of this =! shorting the !en orG if ong the !enG =! prompt! getting out of
the position. B! taking this actionG our !en trader is heping to dri.e the market
precise! in that direction thus making the monetar! mode theor! a fait accompi.
3he stepF=!Fstep process is iustrated in Figure C.0.
Figure C.0 Currenc! Su=stitution Mode.
A. ?apan announces now stock and =ond =u!=ack pan. Economists are now
predicting ?apanPs mone! supp! wi dramatica! increase.
B. Economists are aso predicting a rise in infation with the introduction of this
now poic!. Specuators e@pert a change in the e@change rate as a resut.
C. Economists e@pect interest rates to rise aso as infation takes hod in the
econom!. Specuators start shorting the !en in anticipation of a change in the
e@change rate.
$. $emand for the !en pummets as mone! fows easi! through the ?apanese
econom! and specuators dump !en in the markets.
E. 3he e@change rate for ?apanese !en changes dramatica! as the !en fas in
.aue to foreign currenciesG especia! those that are easi! su=stituted =! in.estors
%read# iquid !en crosses).
3i mi t at i ons of !urrenc& Su$s t i t ut i on Moe% Among the maKorG acti.e!
traded currencies this mode has not !et shown itsef to =e a con.incingG singe
determinant for e@change rate mo.ements. Whie this theor! can =e used with more
confidence in underde.eoped countries where hot mone! rushes in and out of
emerging markets with enormous effectG there are sti too man! .aria=es not
accounted for =! the currenc! su=stitution mode. For e@ampeG using the earier !en
iustrationG e.en though ?apan ma! tr! to spark infation with its securities =u!=ack
panG it sti has an enormous current account surpus that wi continua! prop up the
!en. AsoG ?apan has numerous poitica and mines it must a.oid in its own
neigh=orhoodG and shoud ?apan make it cear it is tr!ing to de.aue its currenc! there
wi =e enormous repercussions. 3hese are Kust two of man! factors the su=stitution
mode does not take into consideration. 8owe.erG this mode %ike numerous other
currenc! modes) shoud =e considered part of an o.era =aanced FX forecasting
diet.
(1
;hat Mo*es the !urrenc& Market
in the Short Ter m<
For an! t!pe of traderG fundamenta or technicaG the importance of economic
data cannot =e underestimated. 8a.ing worked in the FX markets for man! !earsG *
ha.e earned that e.en though there are man! traders who caim to =e pure
technicians and do not factor fundamentas into their traiing strategiesG these same
traders ha.e aso frequent! sta!ed out of the markets ahead of ke! economic
reeases. *n factG man! s!stem traders turn their s!stems off ahead of =ig reeases
such as the /.S. nonfarm pa!ros reports. ;n the other side of the spectrumG there
are aso technicians who do factor fundamentas into their trading strategies and wait
on! for ke! economic reeases to put on =reakout trades. As a resutG it is important
for an! t!pe of acti.e market trader to know what the most important economic
reeases are for the /.S. doar. Since 'H percent of a currenc! trades are against the
/.S. doarG the currenc! mo.ements are natura! most sensiti.e to /.S. economic
reeases.
3AB5E. (.& 6ange of E/6</S$ Foowing Economic 6eeases for :HH(
First :H Minutes A.erage 3ota $ai! 6ange A.erage
6ange %Pips) 6ange %Pips)
)onfarm Parolls
F-*/ =ecisions
Trade >alance
$nflation E/P$F
:etail 2ales
3=P
/urrent &ccount
=urable 3oods
T$/ =ata
4#'
B'
G'
''
'"
'"
'"
"H
""
)onfarm Parolls
F-*/ =ecisions
T$/ =ata
Trade >alance
/urrent &ccount
=urable 3oods
:etail 2ales
$nflation E/P$F
3=P
4H"
4'5
4"#
4#H
4#B
4#G
4#C
4#"
no
Based on a stud! that * conductedG the most significant mo.ements in the doar
%against the euro) on the =ack of an economic reease in :HH( occurred in the first :H
minutes of trading foowing the reease. As shown in 3a=e (.&G the nonfarm pa!ros
report is hands down the most important piece of /.S. data. 3hroughout :HH( on
a.erageG the E/6</S$ woud mo.e &:( pips %points in FX) in the first :H minutes
foowing the reease. E@cuding an! reease that came in within &H percent of
estimatesG the a.erage mo.e was &CC pips. ;n a dai! =asisG the E/6</S$ mo.ed an
a.erage of &'C and :H0 pips e@cuding near! inFine e.es. ;n a.erageG the
E/6</S$ mo.ed &&& pips throughout the course of the trading da!. ;n the other
side of the spectrum is the gross domestic product %2$P) reportG which resuts in an
a.erage mo.e of on! (C pips in the first :H minutes and &&H pips on a dai! =asis.
3he 2$P ranking on the :HFminute ta=e is higher than on the dai! ta=e =ecause
prices do retrace throughout the course of the da!. 3he =iggest :HFminute mo.er for
the doar ma! not =e the most significant market mo.er for the entire trading.
According to our own ana!sis of :HF minute and dai! rangesG we ha.e created the
foowing rankings for economic data.
(L
3op MarketFMo.ing *ndicators for $oar as of :HH(#
Fi rs t 0> Minutes
&. /nempo!ment %nonfarm pa!ros).
:. *nterest rates %Federa ;pen Market Committee rate decisions).
C. 3rade =aance.
(. *nfation %consumer price inde@).
1. 6etai saes.
L. 2ross domestic productG
+. Current account.
0. $ura=e goods.
'. Foreign purchases of /.S. 3reasuries %3*C data).
Dai% &
&. /nempo!ment %nonfarm pa!ros).
:. *nterest rates %F;MC rate derisions).
C. Foreign purchases of /.S. 3reasuries %3*C data).
(. 3rade =aance.
1. Current accountG
L. $ura=e goods.
+. 6etai saesG
0. *nfation %consumer price inde@).
'. 2ross domestic product.
9ou can compare the =reakdowns of the a.erage pip ranges for the E/6</S$
that are shown in 3a=e (.& with the a.erage dai! range for the E/6</S$ in :HH(G
which was appro@imate! &&H pips.
"E,ATI1E IM-%"TA#CE %F +ATA C)A#&ES %1E"
TIME
With a d!namic marketG one ca.eat *s that the significance of economic data
reeases does change with time. According to a paper tited DMacroeconomic
*mpications of the Beiefs and Beha.iors of Foreign E@change 3radersE written =!
Cheung and Chinn of the 7ationa Bureau of Economic 6esearch %7BE6) in &'':G
the trade =aance was the num=er one marketFmo.ing /.S. economic reease on a :HF
minute =asisG whie nonFfarm pa!ros %and unempo!ment data) was the third. *n
&'''G unempo!ment took the top pace whie the trade =aance fe to the fourth. As
indicated in the earier ta=e for :HH( %3a=e (.&)G the trade =aance and infation
reports switched paces with the trade =aance =eing the third most marketFmo.ing
indicator in :HH( instead of infationG which took the ranking in &''+G whie the
significance of a=or market data hed stead!. *ntuiti.e!G this makes sense since the
market shifts its attention to different economic sectors and data =ased on the.
conditions of the domestic econom! - for e@ampeG trade =aances ma! =e more
important when a countr! is running unsustaina=e deficitsG whereas an econom! that
has difficut! creating Ko=s wi see unempo!ment data as more important.
(+
F, Dea%er .inki ng of 5m"ort ance of Economi c Data:
!hanges o*er ti me
As of &''+ As of &'':
&. /nempo!ment &. 3rade =aance
:. *nterest rates :. *nterest rates
C. *nfation C. /nempo!ment
(. 3rade =aance (. *nfation
1. 2$P 1. 2$P
6ankings are =ased on reaction one minute after data is reeased.
&"%SS +%MESTIC -"%+ICT ' #% ,%#&" A BI& +EAI2
Contrar! to popuar =eiefG the 2$P report has aso =ecome one of the esser
important# economic indicators on the /.S. caendar and has ed to one of the
smaest reati.e mo.ements in the E/6</S$. ;ne possi=e e@panation is that 2$P
reports are ess frequent! reeased than other data used in the stud! %quarter! .ersus
month!)G =ut in genera the 2$P data is more prone to am=iguit! and
misinterpretation. For e@ampeG surging 2$P =rought a=out =! rising e@ports wi =e
positi.e for the home currenc!N howe.erG if 2$P growth is a resut of in.entor!
=uidupG the effect on the currenc! ma! actua! =e negati.e. AsoG a arge num=er of
the components that comprise the 2$P report are known in ad.ance of the reease.
)%( CA# $%! !SE T)IS T% $%!" BE#EFIT
For =reakout tradersG the knowedge of which data has the potentia of eading to
the argest a.erage range can =e usefu in determining how to weight positions
according!. For e@ampeG in Figure (.&G which shows the dai! E/6</S$ chartG
there is a triange forming as prices consoidate significant!. A =reakout trader
woud pro=a=! o.erweight positions ahead of the August LG :HH(G nonfarm pa!ros
reease on the e.e prior in the anticipation of a arge =reakout mo.e foowing this
reease. *n contrastG the third =ar of the consoidation was the da! of the 2$P reease.
As !ou can seeG the rangeG was sti comparati.e! tightG and gi.en the knowedge
that the a.erage instantaneous :HFminute mo.e off of the 2$P reease is on! a third
of the nonfarm pa!ros mo.eG the same =reakout pa!ers hoping for a arge mo.e off
of that economic reease shoud pro=a=! put on on! 1H percent of the same position
that the! woud ha.e put on for a no aarm pa!rosF=ased =reakout. 3he same
guideines app! for range traders or s!stem traders. 7onfarm pa!ros da! woud =e
a perfect da! to stand on the sideines and wait for prices to setteG whereas 2$P da!
sti pro.ides an opportunit! for soid range or s!stemsF=ased trading.
;.era knowing what economic indicator mo.es the market the most is .er!
important for a traders. >nowing the :HFminute .ersus dai! range is aso .er!
important =ecause the e@change rate adKustment to economic news appears to =e .er!
swi. An! reaction =e!ond a &1FtoFCHFminute window after the data is reeased ma!
=e the resut of in.estor o.erreaction or trading reated to customer fow rather than
news aone. 3he 2$P is a perfect e@ampe-the :HFminute reaction ranking is higher
than the dai! ranking. *t is aso critica to sta! a=reast of which data the market
deems important at an! point in time =ecause the marketPs focus changes from period
(0
to periodN onceFree.ant data ma! end up ha.ing ess of an effect on currenc! .aues
ater onG and .ice .ersa.
Figure (.& E/6</S$ $ai! Chart
%Source# eSigna. www.eSigna.com)
6esource
QMacroeconomic impications of the Beiefs and Beha.ior of Foreign E@change
3radersGQ www.georgetown.edu<facut!<e.ansm<7ewS:HMicro<chinn.pdf.
A +EE- ,%%* I#T% T)E F3 MA"*ET
3he ne@t three chapters co.er some of the unique studies that * ha.e done on the
FX market that pro.ide some teing detais for =oth the no.ice and the ad.anced
trader. 3hee topics are#
What are the =est times to trade for indi.idua currenc! pairs"
What are the most marketFmo.ing economic data"
What are currenc! correations and how do traders use them"
('
;hat /re The +est Ti mes to
Trae for 5ni *i ua%
!urrenc& #ai rs <
3he foreign e@change market operates :( hours a da! and as a resut it is
impossi=e for a trader to track e.er! singe market mo.ement and make an
immediate response at a imes. 3iming is e.er!thing in currenc! trading. *n order to
de.ise an effecti.e and timeFefficient in.estment strateg!G it is important to note the
amount of market acti.it! around the cock in order to ma@imi,e the num=er of
trading opportunities during a traderPs own market hours. Besides iquidit!G a
currenc! pairPs trading range is aso hea.i! dependentG on geographica ocation and
macroeconomic factors. >nowing what time of da! a currenc! pair has the widest or
narrowest trading range wi undou=ted! hep traders impro.e their in.estment
utiit! due to =etter capita aocation. 3his chapter outines the t!pica trading
acti.it! of maKor currenc! pairs in different time ,ones to see when the! are the most
.oatie. 3a=e 1.& ta=uates the a.erage pip range for the different currenc! pairs
during .arious ime frames =etween :HH: and :HH(.
/S5 /' SES S5 O' ?TO.)O@ : A "( m( B 1 a( m( EST
FX trading in Asia is conducted in maKor regiona financia hu=sN during the
Asian trading sessionG 3ok!o takes the argest market shareG foowed =! 8ong >ong
and Singapore. $espite the fagging infuence of the ?apanese centra =ank on the FX
marketG 3ok!o remains one of the most important deaing centers in Asia. *t is the
first maKor Asian market to openG and man! arge participants often use the trade
momentum there as the =enchmark to gauge marketG d!namics as we as to de.ise
their trading strategies. 3rading in 3ok!o can =e thin from time to timeN =ut arge inF
.estment =anks and hedge funds are known to tr! to use the Asian session to run
important stop and option =arrier e.es. Figure 1.& pro.ides a ranking of the
different currenc! pairs and their ranges during the Asian trading session.
For the more riskFtoerant tradersG /S$<?P9G 2BP<C8FG and 2BP<?P9 are good
picks =ecause their =road ranges pro.ide shortFterm traders with ucrati.e profit
potentiasG a.eraging 'H pips. Foreign in.estmentG =anks and institutiona in.estorsG
which hod most! doarFdominated assetsG generate a significant amount of
/S$<?P9 transactions when the! enter the ?apanese equit! and =ond markets. ?apanPs
centra =ankG with more than I0HH =iion of /.S. 3reasur! securitiesG aso pa!s an
infuentia roe in affecting the supp! and demand of /S$<?P9 through its open
market operations. 5ast =ut not eastG arge ?apanese e@porters are known to use the
3ok!o trading hours to repatriate their foreign earnings heightening the fuctuation of
the currenc! pair. 2BP<C8F and 2BP<?P9 remain high! .oatie as centra =ankers
and arge pa!ers start to scae themse.es into positions in anticipation of the
opening of the European session.
For the more riskFa.erse tradersG A/$<?P9G 2BP</S$G and /S$<C8F are good
choices =ecause the! aow mediumFterm to ongFterm traders to take fundamenta
factors into account when making a decision. 3he moderate .oatiit! of the currenc!
1H
pairs wi hep to shied traders and their in.estment strategies from =eing prone to
irreguar market mo.ements due to intrada! specuati.e trades.
3AB5E 1.& Currenc! Pair 6anges
Currenc!
Pairs %ES3)
Asian Session
+ p.m.4( a.m.
European /.S. Session
Session
: a.m. 4 &: p.m. 0 a.m.41 p.m.
/.S. O Europe Europe O
;.erap Asia ;.erap
0 a.m. 4 &: a.m. : a.m.4( a.m.
E/6</S$
/S$<?P9
2BP</S$
/S$<C8F
E/6<C8F
A/$</S$
/S$<CA$
7A$</S$
E/6<2BP
2BP<?P9
2BP<C8F
A/$<?P9
1&
+0
L1
L0
1C
C0
(+
(:
:1
&&:
'L
11
0+
+'
&&:
&&+
1C
1'
'(
1:
(H
&(1
&1H
LC
+0
L'
'(
&H+
(H
(+
L(
(L
C(
&&'
&:'
1L
L1
10
+0
L0
(H
1'
+(
C0
:+
''
&H1
(+
C:
:'
(C
(C
:(
:H
:0
:H
&L
LH
L:
:L
Figure 1.& Asian Session Boatiit!
U( S( SES S5 O' ?'E; )OR.@ : C a( m( B D "( m( EST
7ew 9ork is the second argest FX market paceG encompassing &' percent of
tota FX market .oume turno.er according to the :HH( 3riennia Centra Bank
Sur.e! of Foreign E@change and $eri.ati.es Market Acti.it! in Apri :HH(
pu=ished =! the Bank for *nternationa Settements %B*S). *t is aso the financia
center that guards the =ack door of the wordPs FX market as trading acti.it! usua!
winds down to a minimum from its afternoon session unti the opening of the 3ok!o
market the ne@t da!. 3he maKorit! of the transactions during the /.S. session are
1&
e@ecuted =etween 0 a.m. and noonG a period with high iquidit! =ecause European
traders are sti in the market.
For the more riskFtoerant tradersG 2BP</S$G /S$<C8FG 2BP<?P9G and
2BP<C8F are good choices for da! traders since the dai! ranges a.erage a=out &:H
pips. %See Figure 1.:.) 3rading acti.ities in these currenc! pairs are particuar!
acti.e =ecause these transactions direct! in.o.e the /.S. doar. When the /.S.
equit! and =ond markets are open during the /.S. sessionG foreign in.estor ha.e to
con.ert their domestic currenc!G such as the ?apanese !enG the euroG and the Swiss
francG into doarFdominated assets in order to carr! out their transactions. With the
market o.erapG 2BP<?P9 and 2BP<C8F ha.e the widest dai! ranges.
Figure 1.: /.S. Session Boatiit!
Most currencies in the FX market are quoted with the /.S. doar as the =ase and
primari! traded against it =efore transating into other currencies. *n the 2BP<?P9
caseG for a British pound to =e con.erted into ?apanese !enG it has to =e traded against
the doar firstG then into !en. 3hereforeG a 2BP<?P9 trade in.o.es two different
currenc! transactionsG 2BP</S$ and /S$<?P9G and its .oatiit! is utimate! deterF
mined =! the correations of the two deri.ed currenc! pairs. Since 2BP</S$ and
/S$<?P9 ha.e negati.e correationsG which means their direction of mo.ements are
opposite to each otherG the .oatiit! of 2BP<?P9 is thus ampified. /S$<C8F
mo.ement can aso =e e@pained simiar! =ut has a greater intensit!. 3rading
currenc! pairs with high .oatiit! can =e .er! ucrati.eG =ut it is aso important to
=ear in mind that the risk in.o.ed is .er! high as we. 3raders shoud continuous!
re.ise their strategies in response to market conditions =ecause a=rupt mo.ements in
e@change rates can easi! stop out their trading orders or nuif! their ongFterm
strategies.
For the more riskFa.erse tradersG /S$<?P9G E/6</S$G and /S$<CA$ appear
to =e good choices since these pairs offer traders a decent amount of trading range to
gamer handsome profits with a smaer amount of risk. 3heir high! iquid nature
1:
aows an in.estor to secure profits or cut osses prompt! and efficient!. 3he modest
.oatiit! of these pairs aso pro.ides a fa.ora=e en.ironment for traders who want
to pursue ongFterm strategies.
EURO#E /' SES S5 O' ?3O'DO'@ : 0 a( m( B E0 "( m( EST
5ondon is the argest and most important deaing center in the wordG with a
market share at more than CH percent according to the B*S sur.e!. Most of the
deaing desks of arge =anks are ocated in 5ondonN the maKorit! of maKor FX
transactions are competed during 5ondon hours due to the marketPs high iquidit!
and efficienc!. 3he .ast num=er of market participants and their high transaction
.aue make 5ondon the most .oatie FX market of a. As shown in Figure 1.CG haf
of the &: maKor pairs surpass the 0H pips ineG the =enchmark that we used to identif!
.oatie pairs with 2BP<?P9 and 2BP<C8F reaching as high as &(H and &(L pips
respecti.e!.
Figure 1.C European Session Boatiit!
2BP<?P9 and 2BP<C8F are apt for the risk o.ers. 3hese two pairs ha.e an
a.erage dai! range of more than &(H pips and can =e used to generate a huge amount
of profits in a short period of time. Such high .oatiit! for the two pairs refects the
peak of dai! trade acti.it! as arge participants are a=out to compete their c!ce of
currenc! con.ersion around the word. 5ondon hours are direct! connected to =oth
the /.S. and the Asian sessions# as soon as arge =anks and institutiona in.estors are
finished repositioning their portfoiosG the! wi need to start con.erting the European
assets into doarFdenominated ones again in anticipation of the opening of the /.S.
market. 3he com=ination of the two recon.ersions =! the =ig pa!ers is the maKor
reason for the e@treme! high .oatiit! in the pairs.
1C
For the more riskFtoerant tradersG there are pent! of pairs to choose from.
E/6</S$G /S$<CA$G 2BP</S$G and /S$<C8FG with an a.erage range of &HH
pipsG are idea picks as their high .oatiities offer an a=undanceG of opportunit! to
enter the market. As mentioned earierG trade =etween the European currencies and
the doars picks up again =ecause the arge participants ha.e to reshuffe their
portfoios for the opening of the /.S. session.
For the more riskFa.erse participantsG the 7A$</S$G A/$</S$G E/6<C8F and
A/$<?P9G with an a.erage of a=out 1H pipsG are good choices as these pairs pro.ide
trader with high interest incomes in additiona to potentia trade profits. 3hese pairs
aow in.estors to determine their direction of mo.ements =ased on fundamenta
economic factors and =e ess prone to osses due to intrada! specuati.e trades.
U( S( - EURO#E /' OFER3 /#: C a( m( B E0 "( m( EST
3he FX markets end to =e most acti.e when the hours of the wordPs two argest
trading centers o.erap. %See Figure 1.(.) 3he range of trading =etween 0 a.m. and
noon ES3 constitutes on a.erage +H percent of the tota a.erage range of trading for
a of the currenc! pairs during the European trading hours and 0H percent of the tota
a.erage range of trading for a of the currenc! pairs during /.S. trading hours. ?ust
these percentages aone te da! traders that if the! are rea! ooking for .oatie
price action and wide ranges and cannot sit at the screen a da!G the time to trade is
the /.S. and European o.erap.
Figure 1.( /.S.FEuropean ;.erap
EURO#E /' - /S5 /' OFER3 /#: 0 a( m( B 1 a( m( EST
3he trade intensit! in the EuropeanFAsian o.erap is far ower than in an! other
session =ecause of the sow trading during the Asian morning. %See Figure 1.1) ;f
courseG the time period sur.e!ed is reati.e! smaer as we. With trading e@treme!
thin during these hoursG riskFtoerant and riskFo.ing traders can take a twoFhour nap
or spend the time positioning themse.es for a =reakout mo.e at the European or /.S.
open.
1(
Figure 1.1 European 4 Asian ;.erap
11
;hat /re !urrenc&
!orre% at i ons an
2ow Do Traers
Use Them<
When trading in the FX marketG one of the most important facts to remem=er in
creating a strateg! is that no currenc! pair is isoated. *n man! casesG foreign
economic conditionsG interest ratesG and price changes affect much more than Kust a
singe pairing. E.er!thing is interreated in the fore@ market to some e@tentG and
knowing the direction and how strong this reationship is can =e used to !our
ad.antageN it has the potentia to =e a great trading too. 3he =ottom ine is that uness
!ou on! want to trade one pair at a timeG it can =e .er! profita=e to take into
account how pairs mo.e reati.e to one another. 3o do thisG we can use correation
ana!sis. Correations are cacuations =ased on pricing dataG and these num=ers can
hep gauge the reationships that e@ist =etween different currenc! pairs. 3he
information that the num=ers gi.e us can =e a good aid for an! trader who wants to
di.ersif! his or her portfoioG dou=e up on positions without in.esting in the same
currenc! pairG or Kust get an idea of how much risk their trades are opening them up
to. *f used correct!G this method has the potentia to ma@imi,e gainsG gauge e@F
posureG and hep pre.ent counterproducti.e trading.
#OS5 T5 FE/'E G/T5 FE !ORRE3 /T5 O'S : ;2/T T2E) ME/'S /'D
2O; TO USE T2EM
>nowing how cose! correated the currenc! pairs are in !our portfoio is a
great wa! to measure !our e@posure and risk. 9ou might think that !ouPre
di.ersif!ing !our portfoio =! in.esting in different pairsG =ut man! of them ha.e a
tendenc! to mo.e in the same direction or opposite to one another. 3he correations
=etween pairs can =e strong or weak and ast for weeksG monthsG or e.en !ears.
Basica!G what a correation num=er gi.ers us is an estimate of how cose! pairs
mo.eG together or how opposite their actions are o.er a specified period of time. An!
correation cacuation wi =e in decima formN the coser the num=er is to & the
stronger the connection =etween the two currencies. For e@ampeG =! ooking at the
sampe data in 3a=e L.&G we can see a RH.'( correation =etween the E/6</S$ and
the 7A$</S$ o.er the ast month. *f !ou are not a fan of decimasG !ou can aso
think of the num=er as a percentage =! mutip!ing it =! &HH percent %in this case
getting '( percent correation =etween the E/6</S$ and the 7A$</S$). 8igh
decimas indicate currenc! pairs that cose! mirror one another whie ower num=ers
te us that the pairs do not usua! mo.e in a parae fashion. 3hereforeG =ecause
there is a high correation in this particuar pairG we can see that in.esting in =oth the
E/6</S$ and the 7A$</S$ is .er! simiar to dou=ing up on a position. 5ikewiseG
it might not =e the =est idea to go ong one of the currenc! pairs and short the other
=ecause a ra! to one has a high ikeihood of aso setting off a ra! in the other
currenc! pair. Whie this woud not make !our profits and osses e@act! ,ero
1L
=ecause the! ha.e different pip .auesG the two do mo.e in such a simiar fashion that
taking opposing positions coud take a =ite out of profits or e.en cause osses.
Positi.e correations arenPt the on! wa! to measure simiarities =etween
pairingsN negati.e correations can =e Kust as usefu. *n this caseG instead of a .er!
positi.e num=erG we are ooking for a high! negati.e one. ?ust as on the positi.e
sideG the coser the num=er is to F&G the increasing! connected the two currencies
mo.ements areG this time in the opposite direction. Again we can use the E/6</S$
as an e@ampe. Whie we Kust saw a strong positi.e correation with the 7A$</S$G
the E/6</S$ has a .er! negati.e reationship with the /S$<C8F. Between these
two currenc! pairsG the correation has =een FH.'0 o.er the ast !ear and FH.'' o.er
the past month. 3his num=er indicates that these two pairings ha.e a strong
propensit! to mo.e in opposite directions. 3hereforeG taking contrar! positions on the
two pairs coud act the same as taking the same position on two high! positi.e
correated pairs. *n this instance going ong in one and shorting the other woud =e
amost the same as dou=ing up on the positionG and as a resutG woud aso open !our
portfoio up to a higher amount of risk. 8owe.erG deciding to go ong or short on
=oth woud pro=a=! =e counterproducti.e and ead to near ,ero profit mid osses
=ecause the two currenc! pairs mo.e in opposite directions so if one side of the trade
=ecame profita=eG the other woud usua! resut in osses.
1+
T/++3E G( E Correation 3a=e# $ata for March :HH1
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5M#ORT/'T F/!T /+OUT !ORRE3 /T5 O'S: T2E) !2/'GE
An!one who has e.er traded the FX market knows that currencies are .er!
d!namicN economic conditionsG =oth sentiment and pricing change e.er! da!.
Because of this the most important aspect to remem=er when ana!,ing currenc!
correations is that the! can easi! change o.er time. 3he strong correations that are
cacuated toda! might not =e the same this time ne@t month. $ue to the constant
reshaping of the fore@ en.ironmentG it is imperati.e to keep current if !ou deride to
use this method for trading. For e@ampeG o.er a oneFmonth period that we o=ser.edG
the correation =etween /S$<CA$ and /S$<?P9 was H.HL. 3his is a .er! ow
num=er and woud indicate that the pairs do not rea! share an! definiti.e
reationship in their mo.ements. 8owe.erG if we ook at the threeFmonth data for the
same time periodG the num=er increases to H.&: and then to H.1' for si@ months and
fina! to H.0H for a !ear. 3hereforeG for this particuar e@ampe we can see that there
was a =atant recent =reakdown in the reationship =etween these two pairs. What
was once a strong! positi.e association in the ong run has amost tota!
deteriorated o.er the short term. ;n the other handG the /S$<C8F and A/$</S$
pairing has shown a strengthening trend in the most recent data. 3he correation
=etween these two pairs started at FH.+0 for the !ear and edged up to FH.'( for the ast
month. 3his suggests that there is an increasing pro=a=iit! that if one of the trades
=ecame profita=e the other woud incur a oss.
An e.en more dramatic e@ampe of the e@tent to which those num=ers can
change can =e found in the 2BP</S$ and A/$</S$ pairingN there was a FH.0+
correation =etween the two for the !earong data. 8owe.erG whie these two tended
to mo.e in reasona=! opposite directions in the ong termG =etween ?anuar! and
March of :HH1 the! were actua! positi.e! correated with a RH.:( reading. 3he
maKor e.ents that change the amount and e.en direction that pairs are correated are
usua! associated with maKor economic happenings such as interest rate changes.
!/3!U3/T5 'G !ORRE3 /T5 O'S )OURS E 3 F
Because correations ha.e the tendenc! to shift o.er imeG the =est wa! to keep
current on the direction and strength of !our pairings is to cacuate them !oursef.
Athough it might seem ike a trick! conceptG the actua process can =e made quite
eas!. 3he simpest wa! to cacuate the num=ers is to use Microsoft E@ce. *n E@ceG
!ou can take the currenc! pairs that !ou want to deri.e a correation from o.er a
specific time period and Kust use the correation function. 3he oneF!earG si@FmonthG
threeFmonthG oneFmonthG and si@FmonthFtraiing reading gi.es the most comprehenF
si.e .iew of the simiarities and differences =etween pairsN howe.erG !ou can decide
which or how man! of these readings !ou want to ana!,e. Breaking down the
process stepF=!FstepG weP find the correation =etween the 2BP</S$ and the
/S$<C8F. First !ouP need to get the pricing data for the two pairings. 3o keep
organi,edG a=e one coumn 2BP and the other C8F and then put in the week!
.aues of these currencies using the ast price and pairing them with the /S$ for
whate.er time period !ou want to use. At the =ottom of the two coumnsG go to an
empt! sot and t!pe in TC;66E5. 8ighight a of the data in one of the pricing
coumnsG t!pe in a commaG and then do the same thing for the other currenc!N the
num=er produced is !our correation. Athough it is not necessar! to update !our
1'
num=ers e.er! da!G updating them once e.er! coupe of weeks or at the .er! east
once a month is genera! a good idea.
LH
Trae #aramet er s for
Different Market !oni ti ons
After ha.ing gone through the emergence of the foreign e@change marketG who
the maKor pa!ers and significant historica miestonesG and what mo.es the marketsG
it is time to co.er some of m! fa.orite strategies for trading currencies. 8owe.erG
=efore * e.en =egin going o.er these strategiesG the most important first step for an!
traderG regardess of the market that !ou are trading inG is to create a trading Kourna.
.EE#5 'G / TR/D5 'G 9OUR'/3
3hrough m! e@perienceG * ha.e earned that =eing a successfu trader is not
a=out finding the ho! grai of indicators that can perfect! forecast mo.ements &HH
percent of the timeG =ut instead to de.eop discipine. * cannotG o.eremphasi,e the
importance of keeping a trading Kourna as the primar! first step to =ecoming a
successfu and professiona trader. Whie working on the inter=ank FX trading desk
at ?. P. Morgan and then on the crossFmarkets trading desk after the merger with
ChaseG the trading ?ourna mentait! was ingrained into the minds of e.er! deaer and
proprietar! trader on the trading foorsG regardess of rank. 3he reason was simpe#
the =ank was pro.iding the capita for trading and we needed to =e hed accounta=eG
especia! since each transaction in.o.ed miions of doars. For e.er! trade that
was e@ecutedG we needed to ha.e a soid rationae as we as Kustification for the
choice of entr! and e@it e.es. More specifica!G !ou had to know where to pace
!our e@it points =efore !ou paced the trade to appro@imate worstFcase osses and to
manage risk.
With this sort of accounta=iit!G the eading =anks of the word are a=e to =reed
successfu and professiona traders. For indi.idua tradersG this practice is e.en more
important =ecause !ou are trading with !our own mone! and not someone esePs. For
inter=ank tradersG when it comes down to the =ottom ineG it is someone esePs mone!
that the! are trading with and regardess of how poor! the! might ha.e performed
o.er the prior two weeksG the! wi sti =e recei.ing a pa!check twice a month. At a
=ankG traders ha.e pent! of time to make the mone! =ack without an! disruptions to
their dai! wa! of ife-uness of course the! ose I& miion in one da!. As an
*ndi.idua trader !ou do not ha.e this u@ur!. When !ou are trading with !our own
mone!G each doar earned or ost is !our mone!. 3hereforeG e.en though !ou shoud
=e trading on! with risk capitaG or mone! that woud not otherwise =e used for rent
or groceriesG one wa! or the otherG the pain is fet. 3o a.oid repeating the same
mistakes and taking huge ossesG * cannot stress enough the importance of keeping a
trading Kourna. 3he Kourna is designed to ensure that as a trader !ou take on!
cacuated osses and !ou earn from each one of !our mistakes. 3he trading Kourna
setup that * recommend is =roken up into three parts#
&. Currenc! Pair Checkist.
:. 3rades 3hat * Am Waiting For.
C. E@isting or Competed 3rades.
L&
Currency -air Chec/list
3he first section of !our trading Kourna shoud consist of a spreadsheet that can
=e printed out and competed e.er! da!. 3his purpose of this checkist is to get a fee
for the market and to identif! tradesG it shoud ist a of the currenc! pairs that are
offered for trading in the eft coumnG foowed =! three coumns for the currentG
highG and ow prices and then a series of triggers aid out sis a row on the rightFhand
side. 7ewer traders pro=a=! want to start off with foowing on! the four maKor
currenc! pairsG which are the E/6</S$G /S$<?P9G /S$<C8F and 2BP</S$ and
then gradua! add in the crosses. Athough the checkist that * ha.e created is fair!
detaiedG * find that it is a .er! usefu dai! e@ercise and shoud take no more than :H
minutes to compete once the appropriate indicators are sa.ed on the charts. 3he
purpose of this checkist is to get a cear .isua of which currencies are trending and
which are range trading. Comprehending the =ig picture is the first step to trading
successfu!. 3oo often ha.e seen traders fai =ecause the! ose sight of the o.era
en.ironment that the! are trading in. 3he worst thing to do is to trade =ind!. 3r!ing
to pick tops or =ottoms in a strong trend or =u!ing =reakouts in a rangeF=ound
en.ironment can ead to significant osses. 9ou can see in Figure +.& of the
E/6</S$ that tr!ing to pick tops in this pair woud ha.e ed to more than three
!ears of frustrating and unsuccessfu trading. For trending en.ironmentsG traders wi
find a higher success rate =! =u!ing on retracements in an uptrend or seing on
raies in a downtrend. Picking ops and =ottoms shoud =e a strateg! that is used on!
in cear rangeFtrading en.ironmentsG and e.en then traders need to =e carefu of conF
tracting ranges hiding to =reakout scenarios.
Figure +.& E/6</S$ 3hreeF9ear Chart
%Source# eSigna. www.eSigna.com)
A simpified .ersion of the dai! market o.er.iew sheet that * use is shown in
3a=e +.&. As !ou can sec in the ta=eG the first two coumns after the dai! high and
ow prices are the e.es of the &HFda! high and ow. 5isting these prices heps to
identit! where current prices are within pre.ious price notion. 3his heps traders
L:
gauge whether we are pressing toward a &HFda! high or ow or if we are simp!
trapped in the midde of the range. 9et Kust the prices aone do not pro.ide enough
information to determine if we are in a trending or a rangeFhound en.ironment. 3he
ne@t fi.e indicators pro.ide a checkist for determining a trending en.ironment. 3he
more X marks in this sectionG the stronger the trend.
3he first coumn in the trending indicator group is the DA$X %&() a=o.e :1.E
A$X is the A.erage $irectiona *nde@G which is the most popuar! used indicator
for determining the strength of a trend. *f the inde@ is a=o.e :1G this indicates that a
trend has de.eoped. 2enera! speakingG the greater the num=erG the stronger the
trend. 3he ne@t coumn uses Boinger =ands. When strong trends de.eopG the pair
wi frequent! tag and cross either the upper or ower Boinger =and. 3he ne@t three
trend indicators are the ongerFterm simpe mo.ing a.erages %SMAs). A =reak a=o.e
or =eow these mo.ing a.erages ma! aso =e indicati.e of a trending en.ironment.
With mo.ing a.eragesG crosso.ers in the direction of the trend can =e used as a
further confirmation. *f there are two or more Xs in this sectionG traders shoud =e
ooking for opportunities to =u! on dips in an uptrend or se on raies in a
downtrend rather than seing at the top and =u!ing =ack at the =ottom of the range.
3he ast section of the trading Kourna is the range group. 3he first indicator is
once again A$XG =ut this timeG we are ooking for A$X =eow :1G which woud
suggest that the currenc! pairPs trend is weak. 7e@tG we ook at the traditiona
osciatorsG the 6eati.e Strength *nde@ %6S*)G and stochastic. *f the A$X is weak and
there is significant technica resistance a=o.eG pro.ided =! indicators such as mo.ing
a.erages or Fi=onacci retracement e.esG and 6S* and<or stochastics are at
o.er=ought or o.ersod e.esG we identif! an en.ironment that is high! conduci.e to
range trading.
;f courseG the market o.er.iew sheet is not fooproofG and Kust =ecause !ou ha.e
numerous X marks in either the trend group or the range group doesnPt mean that a
trend wi not fade or a =reakout wi not occur. 9et what this spreadsheet wi do is
certain! pre.ent traders from trading =ind! and ignoring the =roader market
conditions. *t wi pro.ide traders with a aunching pad from which to identif! the
da!s trading opportunities.
LC
3a=e +.& Currenc! Checkist
=ate
/urrenc
Pair
9ast
Price
=ail
%igh
=ail
9ow
450da
high
450da
low
&=<
E4'F
above
#C
>ollinger
Trending
/rosses
C50da
/rosses
4550da
/rosses
#550da
&=<
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below
#C
:2$ E4'F
:ange
:2$ E4'F 2tochas0
tics
KB5
2tochas0
tics
L"5
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L(
Traes That 5 /m ;ai ti ng For
3he ne@t section in the trading Kourna ists the possi=e trades for the da!. Based
on an initia o.er.iew of the chartsG this section is where !ou shoud ist the trades
that !ou are waiting to make. A sampe entr! woud =e#
Apri 1G :HH1
Bu! A/$</S$ on a =reak of H.+01H %pre.ious da! high). Stop at H.+0HH %1HF
da! SMA).
3arget &-H.+H:1 %C0.:S Fi=onacci retracement or 7o..FMar. =u wa.e).
3arget :-H.0H+1 %upper Boinger).
3arget C-&HFda! traiing ow.
3hereforeG as soon as !our entr! e.e is reachedG !ou know e@act! how !ou
want to take action and where to pace !our stops and imits. ;f courseG it is aso
important to take a quick gance at the market to make sure that the trading
conditions that !ou were ooking for are sti intact. For e@ampeG if !ou were ooking
for a strong =reakout with no retracement to occur at the entr! e.eG when it does
=reakG !ou want to make sure that the scenario that !ou were ooking for pa!s out.
3his e@ercise is used to hep !ou de.eop a pan of action to tacke !our trading da!.
Before e.er! =atteG warriors regroup to go o.er the pan of attackN in trading !ou
want to ha.e the same mentait!. Pan and prepare for the worstFcase scenario and
know !our pan of attack for the da!U
Exist i ng or !om"% et e Traes
3his section is de.eoped and used to enforce discipine and to earn from !our
mistakes. At the end of each traiing da!G it is important to re.iew this section to
understand wh! certain trades resuted in osses and others resuted in profits. 3he
purpose of this section is to identif! trends. * wi use a compete! unreated e@ampe
to e@pain wh! this is important. ;n a norma da!G most peope wi su=conscious!
inKect a ot of DumsE or DuhsE into their dai! con.ersation. 8owe.erG * =et most of
these peope do not e.en reai,e that the! are e.en doing it unti someone records one
of their con.ersations and pa!s it =ack to them. 3his is one of the wa!s that
professiona presenters and newscasters train to kick the ha=it of using pacehoder
words. 8a.ing worked with more than L1GHHH tradersG too often ha.e * seen these
traders repeated! make the same mistakes. 3his coud =e taking profits too ear!G
etting osses runG getting emotiona a=out tradingG ignoring economic reeasesG or
getting into a trade premature!. 8a.ing a record of pre.ious trades is ike keeping a
recording of !our con.ersations. When !ou fip =ack to the trades that !ou ha.e
competedG !ou ha.e a perfect map of what strategies ha.e or ha.e not =een
profita=e for !ou. 3he reason wh! a Kourna is so important is =ecause it minimi,es
the emotiona component of trades. * frequent! see no.ice traders take profits ear!
=ut et osses run. 3he foowing are two sampes of trade Kourna entries that coud
pro.ide earning opportunities#
Fe$ruar & E06 0>>D
Trae: Short C ots of E/6</S$ V &.CH(1.
Sto": .CH'1%former aFtime high).
Target: &.:'HH.
L1
Resu% t: 3rade cosed on Fe=. &C :HH1F stopped out of the C ots V &.C&1H %F&H1
pips).
!omment s : 2ot margin caU E/6</S$ =roke the aFtime highG =ut * thought it
was going to re.erseG and did not stick to sop-kept etting osses runG unti
e.entua! margin rai cosed out a positions. 7ote to sef# Make suresticktostops
/"ri % H6 0>>D
Trae: 5ong : ots of /S$<CA$ V &.&'(1.
Sto": &.&0LH %strong technica support-confuence of 1HFda! mo.ing a.erage
and L0S Fi=onacci retracement of Fe=.FMar. ra!).
Target: First ot V &.:H'1 %upper Boinger and 1 pips sh! of &.:&HH
ps!choogica resistance)F
Second ot V &.::1H %former head and shouders support turned resistanceG &HHF
da! SMA).
Resu% t: 3rade cosed on Apr. 1G :HH1-stopped out of the : ots at &.&0LH %F01
pips).
!omment s : /S$<CA$ did not continue uptrend and was =ecoming o.er=oughtN
* didnPt see that A$X was weakening and faing from higher e.es and that then was
aso a di.ergence in stochastics. 7ote to sef# Make suretolook!ordi"er#encesnext
time
/nike man! tradersG * =eie.e the =est trades are where =oth the technica and
fundamenta pictures are teing the same stor!. *n ine with this premiseG * prefer to
sta! out of trades that contradict m! fundamenta outook. For e@ampeG if there is a
=uish formation in =oth the 2BP</S$ and the A/$</S$ due to /.S. doar
weaknessG =ut the =ank of Engand has finished raising interest ratesG whie the
6eser.e Bank of Austraia has fu intentions of raising rates to tame the strength of
the Austraian econom!G * woud most ike! choose to e@press m! =earish doar
.iew in the A/$</S$ rather than the 2BP</S$. M! =ias for choosing the
A/$</S$ o.er the 2BP</S$ woud =e e.en stronger if the A/$</S$ aread! ofF
fered a higher interest rate differentia than the 2BP</S$. 3oo often ha.e * seen
technicas thwarted =! fundamentasG so now * awa!s incorporate =oth into m!
trading strateg!. * use a com=ination of technicaG fundamentaG and positioning and
am genera! aso a trend foower. * aso t!pica! use a topFdown approach that
in.o.es the foowing#
&. First * wi take an o.era technica sur.e! of the market and pick the currenc!
pairs that ha.e retraced to attracti.e e.es for entr! in order to participate in a
mediumFterm trend.
:. For currencies with a doar component %i.e.G not the crosses)G * determine if m!
initia technica .iew for that pair coincides with m! fundamenta .iew on the doar
as we as m! .iew on how upcoming /.S. reeases ma! impact trading for the da!.
3he reason wh! * ook at the doar specifica! is ocaise 'H percent of a currenc!
trades in.o.e the doarG which makes /.S. fundamentas particuar! important.
C. *f it is a crossFcurrenc! pair such as 2BP<?P9G * wi proceed =! determining if
the technica .iew coincides with the fundamenta outook using Fi=onacci
retracementsG A$XG mo.ing a.eragesG osciatorsG and other technica toos.
LL
(. 3hen * ike to ook at positioning using the FXCM Specuati.e Sentiment inde@
to see if it supports the trade.
1. *f * am eft with two equa! compeing trade ideas. * wi choose the one with a
positi.e interest rate differentia.
2/FE / TOO3+O, USE ;2/T ;OR.S FOR
T2E !URRE'T M/R.ET E'F5 RO'ME 'T
;nce !ou ha.e created a trading KournaG it is time to figure out which indicators
to use on !our charts. 3he reason wh! a ot of traders fai is =ecause the! negect to
reai,e that their fa.orite indicators are not fooproof. Bu!ing when stochastics are in
o.ersod territor! and seing when the! are in o.er=ought territor! is a strateg! that
is used quite often =! range traders with a great dea of successG =ut once the market
stops range trading and =egins trendingG then re!ing on stochastics coud ead to a
tremendous amount of osses. *n order to =ecome consistent! profita=eG successfu
traders need to earn how to =e adapta=e.
;ne of the most important practices that e.er! trader must understand is to =e
conscious of the en.ironment that the! are trading in.
E.er! trader needs to ha.e some sort of checkist that wi hep them to cassif!
their trading en.ironment so that the! can determine whether the market is trending
or rangeF=ound. $efining trade parameters is one of the most important discipines of
trading. 3oo man! traders ha.e tried to pick the top within a trendG on! to wind up
with consistent! unprofita=e trades.
Athough defining trade parameters is important to traders in an! market
%currenciesG futuresG equities)G it is particuar! important in the currenc! market since
o.er 0H percent of the .oume is specuati.e in nature. 3his means that currencies can
spend a .er! ong time in a certain trading en.ironment. AsoG the currenc! market
o=e!s technica ana!sis particuar! we gi.en its arge scae and num=er of
participants.
3here are =asica! two t!pes of trading en.ironmentsG which means that at an!
point in time an instrument is either range trading or trending. 3he first step e.er!
trader needs to takeG is to define the current trading en.ironment. 3he shortest time
frame that traders shoud use in step one is dai! chartsG e.en if !ou are trading on a
fi.eFminute time frame.
STE# O'E B #ROF5 3E TR/D5 'G E'F5 RO'ME'T
3here are man! different wa!s that traders can determine whether a currenc!
pair is range trading or trending. ;f courseG man! peope do it .isua!G =ut ha.ing set
rues wi hep to keep traders out of trends that ma! =e fading or to pre.ent traders
from getting into a range trade in the midst of a possi=e =reakout. 3a=e +.: outines
some of rues that * ook for in order to cassif! a currenc! pairs trading en.ironment.
L+
3a=e +.: 3rend<6ange 3rading 6ues
Trade
:ange

:ules
&=< L #5
=ecreasing $mplied volatilit
:isk reversals near choice or
flipping between favoring calls
and puts
*oving averages, &=<, options, momentum
Trend &=< K #C
*omentum consistent with trend
direction
:isk reversals strongl bid for put
or call
$ndicators
>ollinger bands, &=<, options
Range
5ook for#
/D, ?/*er age Directi ona% 5nex@ 3ess Than 0> 3he a.erage directiona
inde@ is one of the primar! technica indicators used to determine the strength of a
trend. When A$X is ess than :HG this suggests that the trend is weakG which is
genera! characteristic of a rangeF=ound market. An A$X ess than :H and trending
downward pro.ides a further conformation that the trend not on! is weakG =ut wi
pro=a=! sta! in a range trading en.ironment for a whie onger.
Decreasi ng 5m"%ie Fo% at i % i t & 3here are man! wa!s to ana!,e .oatiit!. What
* ike to do is actua! track shortFterm .ersus ongFterm .oatiit!. When shortFterm
.oatiit! is faingG especia! ater a =urst a=o.e ongFterm .oatiit!G it is usua!
indicati.e of a re.ersion to range trading scenarios. Boatiit! usua! =ows out when
a currenc! pair e@periences sharpG quirk mo.es. *t contracts when ranges are narrow
and the trading is .er! quiet in the markets. 3he a,! mans .ersion of the wa! * track
.oatiit! is Boinger =andsG which pro.ide a fair! decent measure for determining
.oatiit! conditions. A narrow Boinger =and suggests that ranges are sma and
there is ow .oatiit! in the markets whie wide Boinger =ands are refecti.e of
arge ranges and a high! .oatie en.ironment. *n a range trading en.ironmentG we
are ooking for fair! narrow Boinger =ands idea! in a hori,onta formation simiar
to the /S$<?P9 chart in Figure +.:.
Ris k Re*ers a% s F%i""i ng $et ween !a%% s an #ut s A risk re.ersa consists of a
pair of optionsG a ca and a putG on the same currenc!. 6isk re.ersas ha.e =oth the
same e@piration %one month) and the same sensiti.it! to the under!ing spot rate.
3he! are quoted in terms of the difference in .oatiit! =etween the two options.
Whie in theor! these options shoud ha.e the same impied .oatiit!G in practice#
these .oatiities often differ in the market. 6isk re.ersas can =e seen as ha.ing a
market poing function. A num=er strong! in fa.or of cas or puts indicates that the
market prefers cas o.er puts. 3he re.erse is true if the num=er is strong! in fa.or of
puts .ersus cas. 3husG risk re.ersas can =e used as a su=stitute for gauging
positions in the FX market. *n an idea en.ironmentG far outFofFtheFmone! cas and
puts shoud ha.e the same .oatiit!. 8owe.erG this is rare! the case since there is
genera! a sentiment =ias in the markets that is refected in risk re.ersas. *n rangeF
=ound en.ironmentsG risk re.ersas tend to fip =etween fa.oring cas and puts at
L0
near! ,ero %or equa)G indicating that thereG is indecision among =us and =ears and
there is no strong =ias in the markets.
Figure +.: /S$<?P9 Boinger Band Chart
%Source# eSigna. www.eSigna.com)
;hat Does a Ris k Re*ers a% Ta$%e 3ook 3i ke< Affording to the risk re.ersas
shown in 3a=e +.CG we can see that the market is strong! fa.oring !en cas %?C) and
doar puts o.er the ong term. E/6</S$ shortFterm risk re.ersas are near ,eroG
which is what !ou are ooking for when profiing a rangeFhound en.ironment. 3he
most readi! a.aia=e free resource that * know of for upFtoFdate risk re.ersas is the
*F6 news pugFin which can =e found on the FX 3rading Station at www.f@cm.com.
T/+3E A( H 6isk 6e.ersas
&(#(H 2M3 Apri &'th
& Month to & 9ear 6isk 6e.ersa
& )R R/R !urrenc& EM R/R HM R/R GM R/R
/S$<?P9 H.C<H.L ?C H.+<&.H ?C &.&<&.C ?C &.C<&.L ?C
E/6</S$ H.&<H.C EC H.H<H.C EC H.H<H.C EC H.&<H.( EC
2BP</S$ H.H<H.C SP H.H<H.C SC H.H<H.C SC H.H<H.C SC
/S$<C8F H.:<H.: CC H.H<H.C CC H.H<H.( CC H.&<H.1 CC
?C T ?apanese 9en Ca
EC T Euro Ca
SP T Stering Put
SC T Stering Ca
CC T Swiss Ca
L'
Tren
5ook for
/D, ?/*er age Directi ona% 5nex@ Great er Than 0> As mentioned earier
when we taked a=out range trading conditionsG the A.erage $irectiona *nde@ is one
of the primar! technica indicators used to determine the strength of a trend. *n a
trending en.ironmentG we ook for A$X to =e greater than :H and rising. 8owe.erG if
A$X is greater then :1 =ut soping downwardG especia! off of the e@treme (H e.eG
!ou ha.e to =e carefu of aggressi.e trend positioning since the downward sope ma!
indicate that the trend is waning.
Moment um !onsi s t ent wi t h Tren Direction *n addition to using A$XG * aso
recommend ooking for a confirmation of a trending en.ironment through
momentum indicators. 3raders shoud ook for momentum to =e consistent with the
direction of the trend. Most currenc! traders wi ook for osciators to point strong!
in the direction of the trend. For e@ampeG in an uptrendG trend traders wi ook for
the mo.ing a.eragesG 6S*G stochasticsG and mo.ing a.erage con.ergence<di.ergence
%MAC$) to a point strong! upward. *n a downtrendG the! wi ook for these same
indicators to point downward. Some currenc! traders use the momentum inde@G =ut
on! to a esser e@tent. ;ne of the strongest momentum indicators is a perfect order in
mo.ing a.erages. A perfect order is when the mo.ing a.erages ine up perfect!N that
is for an uptrendG the &HFda! SMA is greater than the :HFda! SMAG which is greater
than the 1HFda! SMA. 3he &HHFda! SMA and the :HHFda! SMA are =eow the
shorterFterm mo.ing a.erages. *n a downtrendG a perfect order woud =e when the
shorterFterm mo.ing a.erages stack up =eow the ongerFterm mo.ing a.erages.
O"tions ?Ris k Re*ers a% s @ With a trending en.ironmentG we are ooking for risk
re.ersas to strong! fa.or cas or puts. When one side of the market is aden with
interestG it is usua! indicati.e of a strong! trending en.ironment or that a contraF
trend mo.e ma! =e =rewing if risk re.ersas are at e@treme e.es.
STE- T(% 4 +ETE"MI#& T"A+E TIME )%"I5%#E
;nce !ou ha.e determined that a currenc! pair is either rangeF=ound or trendingG
it is time to determine how ong !ou pan on hoding the trade. 3he foowing is a set
of guideines and indicators that * use for trading different time frames. 7ot a of the
guideines need to =e metG =ut the more guideines that are metG the more soid the
trading opportunit!.
5ntraa& Range Trae Ru%es
&. /se hour! charts to determine entr! points and dai! charts to confirm that a
range trade e@ists on a onger time frame.
:. /se osciators to determine entr! point within range.
C. 5ook for shortFdated risk re.ersas to =e near choice.
(. 5ook for re.ersa in osciators %6S* or stochastics at e@treme point).
1. *t is a stronger trade when prices fai at ke! resistance or hod ke! support e.es
%use Fi=onacci retracement points and mo.ing a.erages).
5nicat or s StochasticsG MAC$G 6S*G Boinger =andsG optionsG Fi=onacci
retracement e.es.
+H
Meium- Term Range Trae
6ues
&. /se dai! charts.
:. 3here are two wa!s to range trade in the medium term# position for upcoming
range trading opportunities or get in.o.ed in e@isting ranges#
$pcomin#ran#eopportunities:5ook for highF.oatiit! en.ironmentsG where
shortFterm impied .oatiities are significant! higher than ongerFterm .oatiitiesN
seek re.ersion =ack to the moan en.ironments.
Existin#ran#es:/se Boinger =ands to identif! e@isting ranges.
C. 5ook for re.ersas in osciators such as 6S* and stochastics.
(. Make sure A$X is =eow :1 and idea! faing.
1. 5ook for mediumFterm risk re.ersas near choice.
L. Confirm with price action-faiure at ke! range resistances and =ounces on ke!
range supports %using traditiona technica indicators).
5nicator s ;ptionsG Boinger =ondsG stochasticsG MAC$G 6S*G Fi=onacci
retracement e.es.
Meium- Ter m Tren trae
Ru%es
&. 5ook for de.eoping trend on dai! charts and use week! charts for
confirmation.
:. 6efer =ack to the characteristics of a trending en.ironment-ook for those
parameters to =e metG
C. Bu! =reakout<retracement scenarios on ke! Fi=onacci e.es or mo.ing
a.erages.
(. 5ook for no maKor resistance e.es in front of trade.
1. 5ook for candestick pattern confirmation.
L. 5ook for mo.ing a.erage confuence to =e on same side of trade.
+. Enter on a =reak of significant high or ow.
0. 3he idea is to wait for .oatiities to contract =efore geing in.
'. 5ook for fundamentas to aso =e supporti.e of trade-growth and interest rates.
9ou want to see a string of economic surprises or disappointmentsG depending on
directiona =ias.
5nicator s A$XG para=oic stop and re.ersa %SA6)G 6S*G *chimoku couds %a
?apanese formation)G Eiott wa.esG Fi=onacci.
Meium- Ter m +reakout Trae Ru%es
E( /se dai! charts.
:. 5ook for contraction in shortFterm .oatiit! to a point where it is sharp! =eow
ongFterm .oatiit!.
C. /se pi.ot points to determine whether a =reak is a true =reak or a fase =reak.
(. 5ook for mo.ing a.erage confuences to =e supporti.e of trade.
5nicat or s Boinger =andsG mo.ing a.eragesG Fi=onacci.
R5S. M/'/GEME 'T
+&
Athough risk management is one of the simper topics to graspG it seems to =e
the hardest to foow for most traders. 3oo often we ha.e seen traders turn winning
positions into osing positions and soid strategies resut in osses instead of profits.
6egardess of how inteigent and knowedgea=e traders ma! =e a=out the marketsG
their own ps!choog!Fwi cause them to ose mone!. What coud =e the cause of
this" Are the markets rea! so enigmatic that few can profit" ;r is there simp! a
common mistake that man! traders are prone to make" 3he answer is the atter. And
the good news is that the pro=emG whie it can =e an emotiona! and
ps!choogica! chaenging oneG is utimate! fair! eas! to grasp and so.e.
Most traders ose mone! simp! =ecause the! ha.e no understanding of or pace
no importance on rinkmana#ement.6isk management in.o.es essentia! knowing
how much !ou are wiing to risk and how much !ou are ooking to gain. Without a
sense of risk managementG most traders simp! hod on to osing positions for an
e@treme! ong amount of timeG =ut take profits on winning positions far too
premature!. 3he resut is a seeming! parado@ica scenario that in reait! is a too
common# the trader ends up ha.ing more winning positions than osing onesG =ut
ends up with a negati.e profit<oss %P<5). SoG what can traders do to ensure the! ha.e
soid risk management ha=its" 3here are a few ke! guideines that a tradersG
regardess of their strateg! or what the! are tradingG shoud keep in mind.
Ris k- Rewar Ratio
3raders shoud ook to esta=ish a riskFreward ratio for e.er! trade the! pace. *n
other wordsG the! shoud ha.e an idea of how much the! are wiing to oseG and how
much the! are ooking to gain. 2enera!G the riskFreward ratio shoud =eat east &#:G
if not more. 8a.ing a soid riskFreward ratio can pre.ent traders from entering
positions that utimate! are not worth the risk.
Sto"- 3oss Orers
3raders shoud aso empo! stopFoss orders as a wa! of specif!ing the
ma@imum oss the! are wiing to accept. B! using stopFoss ordersG traders can a.oid
the common predicament of =eing in a scenario where the! ha.e man! winning
trades =ut a singe oss arge enough to eiminate an! trace of profita=iit! in the
account. 3raiing stops to ock in profits are particuar! usefu. A good ha=it of more
successfu traders is to empo! the rue of mo.ing !our stop to =reak e.en as soon as
!our position has profited =! the same amount that !ou initia! risked through the
stop order. At the same timeG some traders ma! aso choose to cose a portion of their
position.
For those ooking to add to a winning position or go with a trendG the =est
strateg! is to treat the new transaction as if it were a new trade of its ownG
independent of the winning position. *f !ou are going to add to a winning positionG
perform the same ana!sis of the chart that !ou woud if !ou had no position at a. *f
a trade continues to go in !our fa.orG !ou can aso cose out part of the position whie
traiing !our stop higher on the remaining ots that !ou are hoding. 3r! thinking
a=out !our risk and reward on each separate ot that !ou ha.e =ought if the! are at
different entr! points as we. *f !ou =u! a second ot 1H pips a=o.e !our first entr!
+:
pointG donPt use the same stop price on =othG =ut manage the risk on the second ot
independent! from the first.
Usi ng Sto"- 3oss Orers to Manage Ris k 2i.en the importance of mone!
management to successfu tradingG using the stopFoss order is imperati.e for an!
trader ooking to succeed in the currenc! market. 3he stopFoss order aows traders
to specif! the ma@imum oss the! are wiing to accept on an! gi.en trade. *f the
market reaches the rate the trader specifies in his<her stopFoss orderG then the trade
wi =e cosed immediate!. As a resutG using stopFoss orders aows !ou to know
how much !ou are risking at the time !ou enter the trade.
3here are two parts to successfu! using a sopFoss order %&) initia! pacing
the stop at a reasona=e e.e and %:) traiing the stop-meaning mo.ing it forward
toward profita=iit!-as the trade progresses in !our fa.or.
#%aci ng the Sto"- 3oss 3here are two recommended wa!s of pacing a stopFoss
order.
Two- DayLowMethod3hese .oatiit!F=ased sops in.o.e pacing !our stopF
oss order appro@imate! &H pips =eow the twoFda! ow of the pair. For e@ampeG if
the ow on the E/6</S$Ps most recent cande# was &.&:HH and the pre.ious candePs
ow was &.&&HHG then the stop shoud =e paced around &.&H'H-&H pips =eow the
twoFda! ow-if a trader is ooking to get ong.
ParabolicStopandReversal (SAR) Another form of .oatiit!F=ased stop is the
para=oic SA6G an indicator that is found on man! currenc! trading charting
appications. 3he FX Power ChartsG for instanceG offer this indicatorG free! a.aia=e
to a course su=scri=ers %www.f@cm.com). Para=oic SA6 is a .oatiit!F=ased
indicator that graphica! dispa!s a sma dot at the point on the chart where the stop
shoud =e paced. Figure +.C is an e@ampe of a chart with para=oic SA6 paced on
it.
3here is no magic formua that works =est in e.er! situationG =ut the foowing is
an e@ampe of how these stops coud =e used. /pon entering a ong positionG
determine where support is and pace a stop :H pips =eow support. For e@ampeG
etJs sa! this is LH pips =eow the entr! point.
*f the trade earns a profit of LH pipsG cose haf of the position in a market orderG
then mo.e the stop up to the entr! point. At this timeG trai the stop LH pips =ehind the
mo.ing market price. *f the para=oic SA6 mo.ePs up so that it is a=o.e the entr!
pointG !ou coud switch to using the para=oic SA6 as the stop e.e. ;f courseG
during the da!G there can =e other signas that coud prompt !ou to mo.e !our stop. *f
the price =reaks through a new resistance e.eG that resistance then =ecomes support.
9ou can pace a stop :H pips =eow that support e.eG e.en if it is on! CH to (H pips
awa! from the current price. 3he under!ing principe !ou ha.e to use is to find a
point to pace !our stop where !ou woud no onger want to =e in the trade once the
price reaches that e.e. /sua! the stop fas at a point where the price goes =eow
support.
+C
Figure +.C Para=oic SA6
%Source# eSigna. www.eSigna.com)
#S)!2O3OG5 !/3 OUT3OO.
Aside from empo!ing proper risk management strategiesG one of the other most
crucia !et o.erooked eements of successfu trading is maintaining a heath!
ps!choogica outook. At the end of the da!G traders who are una=e to cope with the
stress of market fuctuations wi not stand the test of time-no matter how skied
the! ma! =e at the more scientific eements of trading.
Emot i ona% Detachment
3raders must make trading decisions =ased on strategies independent of fear and
greed. ;ne of the premier attri=utes good traders ha.e is that of emotiona
detachment# whie the! are dedicated and fu! in.o.ed in their tradesG the! are not
emotiona! married to themN the! accept osingG and make their in.estment decisions
on an inteectua e.e. 3raders who are emotiona! in.o.ed in trading often make
su=stantia errorsG as the! end to whimsica! change their strateg! after a few osing
tradesG or =ecome o.er! carefree after a few winning trades. A good trader must =e
emotiona! =aancedG and must =ase a trading decisions on strateg!- not fear or
greed.
.now ;hen to Take a +reak
*n the midst of a osing streakG consider taking a =reak from trading =efore fear
and greed dominate !our strateg!.
7ot e.er! trade can =e a winning one. As a resutG traders must =e
ps!choogica! capa=e of coping with osses. Most tradersG e.en successfu onesG go
through stretches of osing trades. 3he ke! to =eing a successfu trader thoughG is
=eing a=e to come through a osing stretch unfa,ed and undeterred. *f !ou are going
+(
through a =ad stretchG it ma! =e time to fake a =reak from trading. ;ftenG taking a few
da!s off from watching the market to cear !our mind can =e the =est remed! for a
osing streak. Continuing to trade reentess! during a tough market condition can
=reed greater osses as we as ruin !our ps!choogica trading condition. /timate!G
itJs awa!s =etter to acknowedge !our osses rather than continue to fight through
them and pretend that the! donPt e@ist. Make no mistake a=out it# regardess of how
much !ou stud!G practiceG or tradeG there wi =e osing trades throughout !our entire
career. 3he ke! is to make them sma enough that !ou can i.e to trade another da!G
whie aowing !our winning trades to sta! open. 9ou can o.ercome a ot of =ad uck
with proper mone! management techniques. 3his is wh! we stress a :#& rewardFtoF
risk ratioG as we as wh! * recommend not risking more than : percent of !our equit!
on an! singe trade.
Whether !ou are trading fore@G equitiesG or futuresG there are &H trading rues that
successfu traders shoud i.e =!#
&. 5imit !our osses.
:. 5et !our profits run.
C. >eep position si,es within reason.
(. >now !our riskFreward ratio.
1. Be adequate! capitai,ed.
L. $onPt fight the trend.
+. 7e.er add to osing positions.
0. >now market e@pectations.
'. 5earn from !our mistakes-keep a trading Kourna.
&H. 8a.e a ma@imum oss or retracement in profits.
+1
Techni ca% Trai ng
St rat egi es
M/53*P59 3*ME F6AME A7A59S*S
*n order to trade successfu! on an intrada! =asisG it is important to =e seecti.e.
3rend trading is one of the most popuar strategies empo!ed =! go=a macro hedge
funds. Athough there are man! traders who prefer to range tradeG the =ig profit
potentias tend to =e in trades that capture and participate in =ig market mo.ements.
*t was once said =! Mark BoucherG a hedge fund manager of Midas 3rust Fund and a
former num=er one mone! manager as ranked =! 7eson MarketpacePs WordPs 8ost
Mone! ManagersG that +H percent of a marketPs mo.es occurs :H percent of the time.
3his makes mutipe time frame ana!sis particuar! important =ecause no trader
wants to ose sight of the o.era =ig picture. A great comparison is taking a road * rip
from Chicago to Forida. 3here are certain! going to =e a ot of eft and right turns
during the road tripG =ut the dri.er needs to =e aware throughout the whoe trip that
he or she is headed south. *n tradingG ooking for opportunities to =u! in an uptrend or
se in a downtrend tends to =e much more profita=e than tr!ing to pick tops and
=ottoms.
3he most common form of mutipe time frame ana!sis is to use dai! charts to
identif! the o.era trend and then to use the hour! charts to determine specific entr!
e.es.
Figure 0.& A/$</S$ Mutipe 3ime Frame $ai! Chart
%Source# eSigna. www.eSigna.com)
3he A/$</S$ chart in Figure 0.& is a dai! chart of the Austraian doar
against the /.S. doar. As !ou can seeG the Austraian doar has =een trending higher
since ?anuar! :HH:. 6ange or contrarian traders who continua! ooked to pick tops
+L
woud ha.e =een faced with at east three !ears of unprofita=e and difficut tradingG
particuar! when the currenc! pair was hitting record highs in ate :HHC into ear!
:HH(. 3his area woud ha.e certain! attracted man! traders ooking to pick a top or
to fade the trend. $espite a dip in ate :HH( the A/$</S$ has remained strong going
into :HH1G which woud ha.e made it .er! difficut for mediumFterm range pa!ers to
trade.
Figure 0.: A/$</S$ Mutipe 3ime Frame 8our! Chart
%Source# eSigna. www.eSigna.com)
*nsteadG the more effecti.e trading strateg! is to actua! take a position in the
direction of the trend. *n the A/$</S$ e@ampeG this woud ha.e in.o.ed ooking
for opportunities to =u! on dips. Figure 0.: is an hour! chart with Fi=onacci
retracements drawn from the Fe=ruar! :HH( aFtime high and the ow of ?une &+G
:HH(. 6ather than ooking for opportunities to seG we use the +L percent Fi=onacci
retracement e.e as ke! support ,ones to go ong the Austraian doar. 3he
hori,onta ine in Figure 0.: represents the Fi=onacci retracement e.e. What we did
therefore was use the dai! charts to get a gauge of the o.era trend and then used the
hour! charts to pinpoint entr! e.es.
5etPs take a ook at another e@ampeG this one of the British pound. Figure 0.C is
the dai! chart of the 2BP</S$ for ?anuar! :HH: to Ma! :HH1. 5ike traders of the
Austraian doarG traders tr!ing to pick tops in the 2BP</S$ woud ha.e aso faced
at east three !ears of difficut tradingG particuar! when the 2BP</S$ was making
&HF!ear highs in ?anuar! :HH(. 3his e.e woud ha.e certain! attracted man!
skeptics ooking to pick tops. 3o the frustration of those who didG the 2BP</S$
raied up to &H percent =e!ond its &HF!ear highs post ?anuar!G which means that
those top picket woud ha.e incurred significant osses.
++
Figure 0.C 2BP</S$ Mutipe 3ime Frame $ai! Chart
%Source# eSigna. www.eSigna.com)
Figure 0.( 2BP</S$ Mutipe 3ime Frame 8our! Chart
%Source# eSigna. www.eSigna.com)
3aking a ook a the hour! chart for the 2BP</S$G we want to ook for
opportunities to =u! on dips rather than se on raies. Figure 0.( shows two
Fi=onacci retracement e.es drawn from the Septem=er :HH( and $ecem=er :HH(
=u wa.e. 3hose e.es hed prett! we on retracements =etween fourFtenths and
+0
fourFfourteenths whie the :C.L percent Fi=onacci e.e offered an opportunit! for
=reakout trading rather than a significant resistance e.e. *n that particuar scenarioG
keeping in mind the =igger picture woud ha.e shieded traders from tr!ing to engage
in re.ersa pa!s at those e.es.
Mutipe time frame ana!sis can aso =e empo!ed on a shorterFterm =asis. 5et
us take a ook at an e@ampe using C8F<?P9. First we start with our hour! chart of
C8F<?P9G which is shown in Figure 0.1. /sing Fi=onacci retracementsG we see on
our hour! charts that prices ha.e faied at the C0.: percent retracement of the
$ecem=er CHG :HH(G to Fe=ruar! 'G :HH1G =ear wa.e numerous timers. 3his indicates
that the pair is contained within a weekong downtrend =eow those e.es. 3hereforeG
we want to use our &1Fminute charts to ook for entr! e.es to participate in the o.erF
a downtrend. 8owe.erG in order to increase the success of this tradeG we want to
make sure that C8F<?P9 is aso in a downtrend on a dai! =asis.
Figure 0.1 C8F<?P9 Mutipe 3ime Frame 8our! Chart
%Source# eSigna. www.eSigna.com)
3aking a ook at Figure 0.LG we see that C8F<?P9 is indeed trading =eow the
:HHFda! simpe mo.ing a.erage with the :HFda! SMA crossing =eow the &HHFda!
SMA. 3his confirms the =earish momentum in the currenc! pair. So as a da! traderG
we mo.e on to the &1Fminute chart to pinpoint entr! e.es. Figure 0.+ is the &1F
minute chartN the hori,onta ine is the C0.: percent Fi=onacci retracement of the
earier downtrend. We see that C8F<?P9 =roke a=o.e the hori,onta ine on Ma! &&G
:HH1N howe.erG rather than =u!ing into a potentia =reakout tradeG the =earish =ig
picture refected on the hour! and dai! charts suggests a contrarian trade at this
point. *n factG there were two instances shown in Figure 0.+ where the currenc! pair
=roke a=o.e the Fi=onacci e.e on! to then trade significant! ower. $iscipined
da! traders woud use those opportunities to fade the =reakout.
+'
Figure 0.L C8F<?P9 Mutipe 3ime Frame $ai! Chart
%Source# eSigna. www.eSigna.com)
Figure 0.+ C8F<?P9 Mutipe 3ime Frame &1FMinute Chart
%Source# eSigna. www.eSigna.com)
3he importance of mutipe time frame ana!sis cannot =e o.erestimated.
3hinking a=out the =ig picture first wi keep traders out of numerous dangerous
trades. 3he maKorit! of new traders in the market are range traders for the simpe fact
that =u!ing at the ow and seing at the high is an eas! concept to grasp. ;f courseG
0H
this strateg! does workG =ut traders aso need to =e mindfu of the trading
en.ironment that the! are participating in. 5ooking =ack to Chapter +G traders shoud
tr! to range trade on! when the conditions for a rangeF=ound market are met. 3he
most important condition %=ut certain! not the on! one) is to ook for A$X to =e
ess than :1 and idea! trending downward.
FA$*72 38E $;/B5E AE6;S
;ne of the most wide! o.erooked !et ucrati.e areas of trading is market
structure. $e.eoping a keen understanding of micro structure and d!namics aows
traders to gain an un=eie.a=e ad.antage and is pro=a=! one of the most reia=e
tactic for profiting from intrada! fuctuations. $e.eoping a fee for and
understanding of market d!namics is ke! to profita=! taking ad.antage of shortFterm
fuctuations. *n foreign e@change trading this is especia! critica as the primar!
infuence of intrada! price action is order fow. 2i.en the fact that most indi.idua
traders are not pri.! to seFside =ank order fowG da! traders ooking to profit from
shortFterm fuctuations need to earn how to identif! and anticipate price ,ones where
arge order fows shoud =e triggered. 3his technique is .er! efficient for intrada!
traders as it aows them to get on the same side as the market maker.
When trading intrada!G it is impossi=e to ook for =ounces off of e.er! support
or resistance e.e and e@pect to =e profita=e. 3he ke! to successfu intrada! trading
requires that we =e more seecti.e and enter on! at those e.es where a reaction is
more ike!. 3rading off ps!choogica! important e.es such as the dou=e ,eros or
round num=ers is one good wa! of identif!ing such opportunities. $ou=e ,eros
represent num=ers where the ast two digits are ,eros-for e@ampeG &H+.HH in the
/S$<?P9 or &.:0HH in the E/6</S$. After noticing how man! times a currenc! pair
woud =ounce off of dou=e ,ero support or resistance e.es intrada! despite the
under!ing trendG we ha.e noticed that the =ounces are usua! much =igger and more
ree.ant than raies off other areas. 3his t!pe of reaction is perfect for intrada! FX
traders as it gi.es them the opportunit! to make 1H pips whie risking on! &1 to :H
pips.
*mpementing this methodoog! is not difficutG =ut it does require indi.idua
traders to de.eop a soid fee for deaing room and market participant ps!choog!.
3he idea =ehind wh! this methodoog! works is simpe. 5arge =anks with access to
conditiona order fow ha.e a .er! distinct ad.antage o.er other market participants.
3he =anksP order =ooks gi.e them direct insight into potentia reactions at different
price e.es. $eaers wi often use this strategic information themse.es to put on
shortFterm positions for their own accounts.
Market participants as a whoe tend to put conditiona orders near or around the
same e.es. Whie stopFoss orders are usua! paced Kust =e!ond the round
num=ersG traders wi custer their akeFprofit orders at the round num=er. 3he reason
wh! this occurs is =ecause traders are humans and humans tend to think in round
num=ers. As a resutG takeFprofit orders ha.e a .er! high tendenc! of =eing paced at
the dou=e ,ero e.e. Since the FX market is a nonstop continuous marketG specuaF
tors aso use stop and imit orders much more frequent! than in other markets. 5arge
=anks with access to conditiona order fowG ike stops and imitsG acti.e! seek to
e@poit these custering of positions to =asica! gun stops. 3he strateg! of fading the
0&
dou=e ,eros attempts to put traders on the same side as market makers and =asica!
positions traders for a quick contraFtrend mo.e at the dou=e ,ero e.e.
3his trade is most profita=e when there are other technica indicators that
confirm the significance or the dou=e ,ero e.e.
Strateg! 6ues
3ong
&. FirstG ocate a currenc! pair that is trading we =eow its intrada! :HFperiod
simpe mo.ing a.erage on a &HF or &1Fminute chart.
:. 7e@tG enter a ong position se.era pips =eow the figure %no more than &H).
C. Pace an initia protecti.e stop no more than :H pips =eow the entr! price.
(. When the position is profita=e =! dou=e the amount that !ou riskedG cose
haf of the position and mo.e !our stop on the remaining portion of the trade to
=reake.en. 3rai !our stop as the price mo.es in !our fa.or.
Shor t
&. FirstG ocate a currenc! pair that is trading we a=o.e its intrada! :HFperiod
simpe mo.ing a.erage on a &HF or &1Fminute chart.
:. 7e@tG short the currenc! pair se.era pips a=o.e the figure %no more than &H).
C. Pace an initia protecti.e stop no more than :H pips a=o.e the entr! price.
(. When the position is profita=e =! dou=e the amount that !ou riskedG cose
haf of the position and mo.e !our stop on the remaining portion of the trade to
=reake.en. 3rai !our stop as the price mo.es in !our fa.or.
Market Conditions
3his strateg! works =est when the mo.e happens without an! maKor economic
num=er as a cata!st in other wordsG in quieter market conditions. *t is used most
successfu! for pairs with tighter trading rangesG crossesG and commodit! currencies.
3his strateg! does work for the maKors =ut under quieter market conditions since the
stops are reati.e! tight.
Further ;ptimi,ation
3he ps!choogica! important round num=er e.es ha.e e.en greater sigF
nificance if the! coincide with a ke! technica e.e. 3herefore the strateg! tends to
ha.e an e.en higher pro=a=iit! of success when other important support or
resistance e.es con.erge at the figureG such as mo.ing a.eragesG ke! Fi=onacci
e.esG and Boinger =andsG Kust to name a few.
E@ampes
So et us take a ook at some of the e@ampes of this strateg! in action. 3he first
e@ampe that we wi go o.er is Figure 0.0G a &1Fminute chart of the E/6</S$.
According to the rues of the strateg!G we see that the E/6</S$ =roke down and was
trading we =eow its :HFperiod mo.ing a.erage. Prices continued to trend owerG
mo.ing toward &.:0HHG which is our dou=e ,ero num=er. *n accordance with the
ruesG we pace an entr! order a few pips =eow the =reake.en num=er at &.:+'1. ;ur
0:
order is triggered and we put our stop :H pips awa! at &.:++1. 3he currenc! pair hits
a ow of &.:+0L =efore mo.ing higher. We then se haf of the position when the
currenc! pair raies =! dou=e the amount that we risked at &.:0C1. 3he stop on the
remaining haf of the position is then mo.ed to =reake.en at &.:+'1. We proceed to
trai the stop. 3he traiing stop can =e done using a .ariet! of methods incuding a
monetar! or percentage =asis. We choose to trai the stop =! a twoF=ar ow for a
rea! shortFterm trade and end up getting out of the other haf of the position at
&.:0C&. 3herefore on this trade we earned (H pips on the first position and CL pips on
the second position.
Figure 0.0 E/6</S$ $ou=e Aeros E@ampe
%Source# eSigna. www.eSigna.com)
3he ne@t e@ampe is for /S$<?P9. *n Figure 0.'G we see that /S$<?P9 is
trading we =eow its :HFperiod mo.ing a.erage on a &1Fminute chart and is headed
toward the &H1 dou=e ,ero e.e. 3his trade is particuar! strong =ecause the &H1
e.e is .er! important in /S$<?P9. 7ot on! is it a ps!choogica! important e.eG
=ut it aso ser.ed as an important support and resistance e.e throughout :HH( and
into ear! :HH1. 3he &H1 e.e is aso the :C.L percent Fi=onacci retracement of the
Ma! &(G :HH(G high and ?anuar! &+G :HH1G ow. A of this pro.ides a strong signa
that ots of specuators ma! ha.e taken profit orders a that e.e and that a contraF
trend trade is .er! ike!. As a resutG we pace our imit order a few pips =eow
&H1.HH at &H(.'1. 3he trade is triggered and we pace our stop at &H(.+1. 3he
currenc! pair hits a ow of &H(.00 =efore mo.ing higher. We then se haf of our
position when the currenc! pair raies =! dou=e the amount that we risked at
&H1.C1. 3he stop on the remaining haf of the position is then mo.ed to =reake.en at
&H(.'1. We proceed to trai the stop =! a fi.eF=ar ow to fier our noise on the
shorter time frame. We end up seing the other haf of the position at &HC.+&. As a
resut on this tradeG we earned (H pips on the first position and +L pips on the second
0C
position. 3he reason wh! this second trade was more profita=e than the one in the
first e@ampe is =ecause the dou=e ,ero e.e was aso a significant technica e.e.
Figure 0.' /S$<?P9 $ou=e Aeros E@ampe
%Source# eSigna. www.eSigna.com)
Figure 0.&H /S$<CA$ $ou=e Aeros E@ampe
%Source# eSigna. www.eSigna.com)
Making sure that the dou=e ,ero e.e is a significant e.e is a ke! eement of
fitering for good trades. 3he ne@t e@ampeG shown in Figure 0.&HG is /S$<CA$ on a
&1Fminute chart. 3he great thing a=out this trade is that it is a tripe ,ero e.e rather
0(
than Kust a dou=e ,ero e.e. 3ripe ,ero e.es hod e.en more significance than
dou=e ,ero e.es =ecause of their ess frequent occurrence. *n Figure 0.&HG we see
that /S$<CA$ is aso trading we =eow its :HFperiod mo.ing a.erage and heading
toward &.:HHH. We ook to go ong a few pips =eow the dou=e ,ero e.e at &.&''1.
We pace our stop :H pips awa! at &.&'+1. 3he currenc! pair hits a ow of &.&'0H
=efore mo.ing higher. We then se haf of our position when the currenc! pair raies
=! dou=e the amount that we risked at &.:HC1. 3he stop on the remaining haf of the
position is then mo.ed to =reake.en at &.&''1. We proceed to trai the stop once
again =! the twoF=ar ow and end up e@iting the second haf of the position at &.:H0&.
As a resut we earned (H pips on the first position and 0L pips on the second position.
;nce againG this trade worked particuar! we =ecause &.:HHH was a tripe ,ero
e.e.
Athough the e@ampes co.ered in this chapter are a to the ong sideG the
strateg! aso works to the short side.
WA*3*72 F;6 38E 6EA5 $EA5
3he ark of .oume data in the FX market has forced da! traders to de.eop
different strategies that re! ess on the e.e of demand and more on the micro
structure of the market. ;ne of the most common characteristics that da! traders tr!
to e@poit is the marketPs :(Fhour aroundFtheFcock nature. Athough the market is
open for trading throughout the course of the da!G the e@tent of market acti.it! during
each trading session can .ar! significant!.
3raditiona!G trading tends to =e the quietest during the Asian market hoursG as
we indicated in Chapter (. 3his means that currencies such as the E/6</S$ and
2BP</S$ tend to trade within a .er! tight range during these hours. According to
the Bank for *nternationa SettementsP 3riennia Centra Bank Sur.e! of the FX
market pu=ished in Septem=er :HH(G the /nited >ingdom is the most acti.e trading
centerG capturing C& percent of tota .oume. Adding in 2erman!G FranceG and
Swit,erandG European trading as a whoe accounts for (: percent of tota FX traiing.
3he /nited StatesG on the other handG is second on! to the /ntied >ingdom for the
tite of most acti.e trading centerG =ut that amounts to on! appro@imate! &' percent
of tota turno.er. 3his makes the 5ondon open e@ceptiona! important =ecause it
gi.es the maKorit! of traders in the market an opportunit! to take ad.antage of e.ents
or announcements that ma! ha.e occurred during ate /.S. trading or in the o.ernight
Asian session. 3his =ecomes e.en more critica on da!s when the Federa ;pen
Market Committee %F;MC) of the Federa 6eser.e meets to discuss and announce
monetar! =ecause the announcement occurs at :#&1 p.m. 7ew 9ork timeG which is
past the 5ondon cose.
3he British pound trades most acti.e! against the /.S. doar during the
European and 5ondon trading hours. 3here is aso acti.e trading during the
/.S.<European o.erapG =ut =esides those time framesG the pair tends to trade
reati.e! ight! =ecause the maKorit! of 2BP</S$ trading is done through /.>. and
European market makers. 3his pro.ides a great opportunit! for da! traders to rapture
the initia directiona intrada! rea mo.e that genera! occurs within the first few
hours of trading in the 5ondon session. 3his strateg! e@poits the common perception
that /.>. traders are notorious stop hunters. 3his means that the initia mo.ement at
01
the 5ondon open ma! not awa!s =e the rea one. Since /.>. and European deaers
are the primar! market makers for the 2BP</S$G the! ha.e tremendous insight into
the e@tent of actua supp! and demand for the pair. 3he trading strateg! of waiing
for the rea dea first sets up when inter=ank deaing desks sur.e! their =ooks at the
onset of trading and use their cient data to trigger cose stops on =oth sides of the
markets to gain the pip differentia. ;nce these stops are taken out and the =ooks are
cearedG the rea directiona mo.e in the 2BP</S$ wi =egin to occurG at which point
we ook for the rues of this strateg! to =e met =efore entering into a ong or short
position. 3his strateg! works =est foowing the /.S. open or after a maKor economic
reease. With this strateg! !ou are ooking to wait for the noise in the markets to
sette down and to trade the rea market price action afterward.
Strateg! 6ues
3ong
&. Ear! European trading in 2BP</S$ =egins around &#HH a.m. 7ew 9ork time.
5ook for the pair to make a new range ow of at east :1 pips a=o.e the
opening price %the range is defined as the price action =etween the Frankfurt
and 5ondon power hour of & a.m. 7ew 9ork time to : am. 7ew 9ork time).
:. 3he pair then re.erses and penetrate the high.
C. Pace an entr! order to =u! &H pips a=o.e the high of the range.
(. Pace a protecti.e stop no more than :H pips awa! from !our entr!.
1. *f the position mo.es higher =! dou=e the amount that !ou riskedG co.er haf
and trai a stop on the remaining position.
Shor t
&. 2BP</S$ opens in Europe and trades more than :1 pips a=o.e the high of the
Frankfurt and 5ondon power hour.
:. 3he pair then re.erses and penetrates the ow.
C. Pace an entr! order to se &H pips =eow the ow of the range.
(. Pace a protecti.e stop no more than :H pips awa! from !our entr!.
1. *f the position mo.es ower =! dou=e the amount that !ou riskedG co.er haf
and trai a stop on the remaining position.
E@ampes
5et us go ahead and take a ook at some e@ampes of this strateg! in action.
Figure 0.&& is a te@t=ook e@ampe of the strateg! of waiting for the rea dea. We see
that the 2BP</S$ =reaks upward on the 5ondon openG reaching a high of &.0'&:
appro@imate! two hours into trading. 3he currenc! pair then =egins to trend ower
ahead of the /.S. market open and we position for the trade =! putting an entr! order
to short &H pips =eow the Frankfurt open to the 5ondon open range of &.00H( at
&.0+'(. ;ur stop is then paced :H pips higher at &.00&( whie our takeFprofit order is
paced at &.0+1(G which is dou=e the amount risked. ;nce the takeFprofit order on
the first ot is fufiedG we mo.e the stop to =reake.en at &.0+'( and trai the stop =!
the twoF=ar high. 3he second ot e.entua! gets stopped out at &.0+(HG and we end
up earning (H pips on the first position and 1( pips on the second position.
0L
Figure 0.&& 2BP</S$ Ma! :HH1 6ea $ea E@ampe
%Source# eSigna. www.eSigna.com)
Figure 0.&: 2BP</S$ Apri :HH1 6ea $ea E@ampe
%Source# eSigna. www.eSigna.com)
3he ne@t e@ampe is shown in Figure 0.&:. *n this e@ampeG we aso see the
2BP</S$ =reak upward on the 5ondon openG reaching a high of &.0'++ right at the
/.S. open. 3he currenc! pair then =egins to trend ower during the ear! /.S. sessionG
=reaking the Frankfurt open to the 5ondon open range ow of &.001&. ;ur entr! point
is &H pips =eow that e.e at &.00&&. ;ur short position is triggeredG and we pace our
0+
stop :H pips higher at &.00L& and the first takeFprofit e.e at &.00H&G which is dou=e
the amount risked. ;nce our imit order is triggeredG we mo.e the stop to =reake.en
at &.00(& and trai the stop =! the twoF=ar high. 3he second ot gets stopped out at
&.0+0'G and we end up earning (H pips on the first position and 1: pips on the second
position.
Figure 0.&C 2BP</S$ March :HH1 6ea $ea E@ampe
%Source# eSigna. www.eSigna.com)
3he third e@ampe is shown in Figure 0.&C. *n this e@ampeG we aso see the
2BP</S$ =reak upward on the 5ondon openG reaching a high of .'H:C right =efore
the /.S. F;MC meeting. 3he currenc! pair then =reaks ower on the =ack of the
meetingG penetrating the Frankfurt open to the 5ondon open range ow of &.0'1C. ;ur
entr! order is aread! paced &H pips =eow that e.e at &.0'(C. ;ur short position is
triggered and we pace our stop :H pips higher at .0'LC and the first takeFprofit e.e
at &.0'HCG which is dou=e the amount risked. ;nce our imit order is triggeredG we
mo.e the stop to =reake.en at &.0'(C and trai the stop =! the twoF=ar high. 3he
second ot gets stopped out at &.001CG and we end up earning &H pips on the first
position and 'H pips on the second position.
*7S*$E $A9 B6EA>;/3 P5A9
3hroughout this =ookG .oatiit! trading has =een emphasi,ed as one of the most
popuar strategies empo!ed =! professiona traders. 3here are man! wa!s to
interpret changes in .oatiitiesG =ut one of the simpest strategies is actua! a .isua
one and requires nothing more than a keen e!e. Athough this is a strateg! that is
.er! popuar in the word of professiona tradingG new traders are frequent! ama,ed
=! its easeG accurac!G and reia=iit!. Breakout traders can identif! inside da!s with
nothing more than a =asic candestick chart.
00
An inside da! is defined as a da! where the dai! range has =een contained
within the prior da!s trading rangeG orG in other wordsG the da!Ps high and ow do not
e@ceed the pre.ious da!Ps high and ow. 3here need to =e at east two inside da!s
=efore the .oatiit! pa! can =e impemented. 3he more inside da!sG the higher the
ikeihood of an upside surge in
WWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWW
PA2E &&C
WWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWW
%rotecta#ainst!alse&reakouts:*f the stop and re.erse order is triggeredG pace a
stop a east &H pips &elo't(elo'of the nearest inside da! and protect an! profits
arger than what !ou risked with a traiing stop.
Fur t her O"ti mi 4at i on
For further optimi,ationG technica formations can =e used in conKunction with
the .isua identification to pace a higher weight on a specific direction of the
=reakout. For e@ampeG if the inside da!s are =uiding and contracting toward the top
of a recent range such as a =uish ascending triange formationG the =reakout has a
higher ikeihood of occurring to the upside. 3he opposite scenario is aso true# if
inside da!s are =uiding and contracting toward the =ottom of a recent range and we
=egin to see that a =earish descending triange is in formationG the =reakout has a
higher ikeihood of occurring to the downside. Aside from triangesG other technica
factors that can he considered incude significant support and resistance e.es. For
e@ampeG if there are significant Fi=onacci and mo.ing a.erage support ,ones resting
=eow the inside da! e.esG this indicates either a higher ikeihood of an upside
=reakout or at east a higher pro=a=iit! of a fase =reakout to the downside.
Exam"% es
5et us take a ook at a few e@ampes. Figure 0.&( is a dai! chart of the euro
against the British poundG or the E/6<2BP. 3he two inside da!s are identified on the
chart and it is cear .isua! that =oth of those da!sJ rangesG incuding the highs and
owsG are contained within the pre.ious da!Ps range. *n accordance with our ruesG we
pace an order to go ong &H pips a=o.e the high of the pre.ious inside da! at H.LLC(
and an order to se &H pips =eow the ow of the pre.ious inside da! at H.L1+'. ;ur
ong order gets triggered two =ars after the most recent inside da!. We then proceed
to pace a stop and re.erse order &H pips =eow the ow of the most recent inside da!
at H.L1+'. So =asica!G we went ong at H.LLC( with a stop at H.L1+'G which means
that we are risking (1 pips. When prices reach our target e.e of dou=e the amount
risked %'H pips) or H.L+:(G we ha.e two choices either cose out the entire trade or
=egin traiing the stop. More conser.ati.e traders shoud pro=a=! square positions at
this pointG whie more aggressi.e traders coud ook for more profit potentia. We
choose to cose out the trade for a 'HFpip profitG =ut those who sta!ed in and
weathered a =it of .oatiit! coud ha.e taken ad.antage of another &HH pips of profits
three weeks ater.
0'
Figure 0.&( E/6<2BP *nside $a! Chart
%Source# eSigna. www.eSigna.com)
Figure 0.&1 7A$</S$ *nside $a! Chart
%Source# eSigna. www.eSigna.com)
Figure 0.&1 is another e@ampe or inside da! tradingG this time using the dai!
chart of the 7ew Aeaand doar against the /.S. doar %7A$</S$). 3he difference
=etween this e@ampe and the pre.ious one is that our stop and re.erse order actua!
gets triggeredG indicating that the first mo.e was a fase =reakout. 3he two inside
da!s are a=eed on the chart. *n accordance with our ruesG after identif!ing the
inside da!sG we pace an order to =u! on the =reak of the high of the pre.ious inside
'H
da! and an order to se on the =reak of the ow of the pre.ious inside da!. 3he high
on the first or pre.ious inside da! is H.LLC0. We pace an order to go ong at H.LLC0
or to go short at H.H.LL&0. ;ur ong order gets triggered on the first da! of the =reak
at H.LLC0 and we pace a stop and re.erse order &H pips =eow the ow of the most
recent inside da! %or the dai! cande =efore the =reakout)G which is H.L1LH.
8owe.erG instead of continuing the =reakoutG the pair re.erses and we cose our first
position at H.L1LH with a +0Fpip oss. We then enter into a new short position with the
re.erse order at H.L1LH. 3he new stop is then &H pips a=o.e the high of the most
recent inside da! at H.LL&'. When 7A$</S$ mo.es =! dou=e the initia amount
riskedG conser.ati.e traders can take profit on the entire position whie aggressi.e
traders can trai the stop using .arious methodsG which ma! =e dependent on how
wide the trading range is. *n this e@ampeG since the dai! trading range is fair! wideG
we choose to cose the posit ion once the price reaches our imit of H.L(H( for a profit
of &1L pips and a tota profit on the entire trade of +0 pips.
Figure 0.&L E/6<CA$ *nside $a! Chart
%Source# eSigna. www.eSigna.com)
3he fina e@ampe uses technicas to hep determine a directiona =ias of the
inside da! =reakout. Figure 0.&+ is a dai! chart of E/6<CA$. 3he inside da!s are
once again identified direct! on the chart. 3he presence of higher ows suggests that
the =reakout coud .er! we =e to the upside. Adding in the MAC$ histogram to the
=ottom of the chartG we see that the histogram is aso in positi.e territor! right when
the inside da!s are forming. As suchG we choose to opt for an upside =reakout trade
=ased on technica indicators. *n accordance with the ruesG we go ong &H pips a=o.e
the high of the pre.ious inside da! at .LHH0. ;ur short trade gets triggered firstG =ut
then our stop and re.erse order kicks in. ;ur ong trade is then triggered and we
pace our new stop order &H pips =eow the ow of the most recent inside da! at
'&
&.1'H1. When prices mo.e =! dou=e the amount that we risked to &.L:H0G we e@it
the entire position for a :HHFpip profit.
With the inside da! =reakout strateg!G the risk is genera! prett! high if done on
dai! chartsG =ut the profit potentias foowing the =reakout are usua! fair! arge as
we. More aggressi.e traders can aso trade more than one positionG which woud
aow them to ock in profits on the first haf of the position when prices mo.e =!
dou=e the amount risked and then trai the stop on the remaining position. 2enera!
these =reakout trades are precursors to =ig trendsG and using traiing stops woud
aow traders to participate in the trend mo.e whie aso =anking some profits.
38E FA$E6
More often than notG traders wi find themse.es faced with a potentia =reakout
scenarioG position for itG and then on! end up seeing the trade fai misera=! and ha.e
prices re.ert =ack to range trading. *n factG e.en if prices do manage to =reak out
a=o.e a significant e.eG a continuation mo.e is not guaranteed. *f this e.e is .er!
significantG we frequent! see inter=ank deaers or other traders tr! to push prices
=e!ond those e.es momentari! in order to run stops. Breakout e.es are .er!
significant e.esG and for this .er! reason there is no hardFandFfast rue as to how
much force is needed to carr! prices =e!ond e.es into a sustaina=e trend.
3rading =reakouts at ke! e.es can in.o.e a ot of risk and as a resutG fase
=reakout scenarios appear more frequent! than actua =reakout scenarios. Sometimes
prices wi test the resistance e.e onceG twiceG or e.en three times =efore =reaking
out. 3his has fostered the de.eopment of a arge contingent of contraFtrend traders
who ook on! to fade =reakouts in the currenc! markets. 9et fading e.er! =reakout
can aso resut in some significant osses =ecause once a rea =reakout occursG the
trend is genera! strong and ongFasting. So what this =ois down to is that traders
need a methodoog! for screening out consoidation patterns for trades that ha.e a
higher potentia of resuting in a fase =reakout. 3he foowing rues pro.ide a good
=asis for screening such traders. 3he fader strateg! is a .ariation of the waiting for
the rea dea strateg!. *t uses the dai! charts to identif! the rangeF=ound en.ironment
and the hour! charts to pinpoint entr! e.es.
St rat eg& Ru%es
&.
3ong
5ocate a currenc! pair whose &(Fperiod A$X is ess than C1. *dea! the A$X
shoud aso =e trending downwardG indicating that the trend is weakening
further.
Wait for the market to =reak =eow the pre.ious da!Js ow =! at east &1 pips.
Pace an entr! order to =u! &1 pips a=o.e the pre.ious da!Js high.
After getting fiedG pace !our initia stop no more than CH pips awa!.
3ake profit on the position when prices increase =! dou=e !our riskG or LH pips.
Short
5ocate a currenc! pair whose &(Fperiod A$X is ess than C1. *dea! the A$X
shoud aso =e trending downwardG indicating that the trend is weakening
further.
':
:.
C.
(.
1.
&.
:.
C.
(.
5ook for a mo.e a=o.e the pre.ious da!Ps high =! at east &1 pips.
Pace an entr! order to se &1 pips =eow the pre.ious da!Js ow.
;nce fiedG pace the initia protecti.e stop no more than CH pips a=o.e !our
entr!.
1. 3ake profits on the position when it runs LH pips in !our fa.or.
Furt her O"ti mi 4at i on
3he fase =reakout strateg! works =est when there are no significant economic
data schedued for reease that coud trigger sharp une@pected mo.ements. For
e@ampeG prices often consoidate ahead of the /.S. nonFfarm pa!ros reease.
2enera! speakingG the! are consoidating for a reason and that reason is =ecause the
market is undecided and is either positioned aread! or wants to wait to react
foowing that reease. Either wa!G there is a higher ikeihood that an! =reakout on
the =ack or the reease woud =e a rea one and not one that !ou want to fade. 3his
strateg! works =est with currenc! pairs that are ess .oatie and ha.e narrower
trading ranges.
Exam"% es
Figure 0.&+ is an hour! chart of the E/6</S$. App!ing the rues Kust gi.enG
we see that the &(Fperiod A$X dips =eow C1G at which point we =egin ooking for
prices to =reak =eow the pre.ious da!Ps ow of .:&LL =! &1 pips. ;nce that occursG
we ook for a =reak =ack a=o.e the pre.ious da!Ps high of &.::1( =! &1 pipsG at
which point we enter into position at &.::L'. 3he stop is paced CH pips =eow the
entr! price at &.::C'G with the imit e@it order paced LH pips a=o.e the entr! at
&.:C:'. 3he e@it order gets triggered a few hours ater for a tota profit of LH pips
with a risk of CH pips.
Figure 0.&+ E/6</S$ Fader Chart
%Source# eSigna. www.eSigna.com)
'C
Figure 0.&0 is an e@ampe of the fader trading strateg! on the short side.
App!ing the rues to the hour! chart of the 2BP</S$G we see thatX
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F*53E6*72 FA5SE B6EA>;/3S
Xrues =ehind this strateg! are specifica! de.eoped to take ad.antage of strong
trending markets that make new highs that then proceed to fai =! taking out a recent
ow and then re.erse again to make other new highs. 3his t!pe of setup tends to ha.e
a .er! high success rate as it aows traders to enter strong! trending markets after
weaker pa!ers ha.e =een fushed outG on! to ha.e rea mone! pa!ers reenter the
market and push the pair up to make maKor highs.
St rat eg& Ru%es
3ong
&. 5ook for a currenc! pair that is making a :HFda! high.
:. 5ook for the pair to re.erse o.er the ne@t three da!s to make a twoFda! ow.
C. Bu! the pair if it takes out the :HFda! high within three da!s of making the twoF
da! ow.
(. Pace the initia stop a few pips =eow the origina twoFda! ow that was identified
in step :.
1. Protect an! profits with a traiing stop or take profit =! dou=e the amount risked.
Short
&. f. 5ook for a currenc! pair that is making a :HFda! ow.
:. 5ook for the pair to re.erse o.er the ne@t three da!s to make a twoFda! high.
C. Se the pair if it trades =eow the :Fda! ow within three da!s of making the twoF
da! high.
(. 6isk up to a few ticks a=o.e the origina twoFda! high that was identified in step :.
1. Protect profits with a traiing stop or take profit =! dou=e the amount risked.
E@ampes
3ake a ook at our first e@ampe in Figure 0.&'. 3he dai! chart of the 2BP</S$
shows that the currenc! pair made a new :HFda! high on 7o.em=er &+ at &.0LC&.
3his means that the currenc! pair gets onto our radar screens and we prepare to ook
for the pair to make a new twoFda! ow and then ra! =ack =e!ond the pre.ious :HF
da! high of &.0LC& o.er theX
'(
Figure 0.:H /S$<CA$ Fitering Fake Breakouts Chart
%Source# eSigna. www.eSigna.com)
Figure 0.:& /S$<?P9 Fitering Fake Breakouts Chart
%Source# eSigna. www.eSigna.com)
;ur ast e@ampe is on the short side. Figure 0.:& is a dai! chart of /S$<?P9.
3he chart iustrates that /S$<?P9 made a new :HFda! ow on ;cto=er && =eow
&H'.CH. 3he currenc! pair then proceeded to make a new twoFda! high on ;cto=er &C
of &&H.:&. Prices then re.ersed o.er the ne@t two da!s to =reak =eow the origina :HF
da! owG at which point our se order at &H'.:H %a few pips =eow the :HFda! ow)
'1
was triggered. We paced our stop a few pips a=o.e the twoFda! high at &&H.CH. As
the currenc! mo.es in our fa.orG we ha.e two choices# either to take profits =!
dou=e the amount that we riskedG which woud =e ::H pips in profitsG or to use a
traiing stop such as a twoF=ar high. 3he twoF=ar profit woud ha.e the trade e@ited at
&HL.+L on 7o.em=er :G whie the ::HFpip profit woud ha.e the trade e@ited at
&H+.HH on ;cto=er :1.
C8A77E5 S36A3E29
Channe trading is ess e@otic =ut ne.ertheess works .er! we with currencies.
3he primar! reason is =ecause currencies rare! spend much time in tight trading
range and ha.e the tendenc! to de.eop strong trends. B! Kust going through a few
chartsG traders can see that channes can easi! =e identified and occur frequent!. A
common scenario woud =e channe trading during the Asian session and a =reakout
in either the 5ondon or the /.S. session. 3here are man! instances where economic
reeases are triggers for a =reak of the channe. 3herefore it is imperati.e that traders
keep on top of economic reeases. *f a channe has formedG a =ig /.S. num=er is
e@pected to =e reeasedG and the currenc! pair is at the top of a channeG the
pro=a=iit! of a =reakout is highG so traders shoud =e ooking to =u! the =reakouts
not fade it.
Channes are created when we draw a trend ine and then draw a ine that is
parae to the trend ine. Most if not a of the price acti.it! of the currenc! pair
shoud fa =etween the two channe ines. We wi seek to identif! situations when
the price is trading within a narrow channeG and then trade in the direction of a
=reakout from the channe. 3his strateg! wi =e particuar! effecti.e when used
prior to a fundamenta market e.ent such as the reease of maKor economic newsG or
when used Kust prior to the open of a maKor financia market.
8ere are the rues for ong trades using this technique.
&. FirstG identif! a channe on either an intrada! or a dai! chart. 3he price shoud =e
contained within a narrow range.
:. Enter ong as the price =eaks a=o.e the upper channe ine.
C. Pace a stop Kust under the upper channe ine.
(. 3rai !our stop higher as the price mo.es in !our fa.or.
Exam"% es
5et us now e@amine a few e@ampes. 3he first is a /S$<CA$ &1Fminute chart
shown in Figure 0.::. 3he tota range of the channe is appro@imate! CH pips. *n
accordance with our strateg!G we pace entr! orders &H pips a=o.e and =eow the
channe at &.:C'1 and &.:C('. 3he order to go ong gets triggered first and amost
immediate! we pace a stop order &H pips under the upper channe ine at &.:C+1.
/S$<CA$ then proceeds to ra! and reaches our target of dou=e the range at
&.:(11. A traiing stop aso coud ha.e =een usedG simiar to the ones that we taked
a=out in our risk management section in Chapter +.
'L
Figure 0.:: /S$<CA$ Channe E@ampe
%Source# eSigna. www.eSigna.com)
3he ne@t e@ampeG shown in Figure 0.:C is a CHFminute chart of E/6<2BP. 3he
tota range =etween the two ines is &1 pips. *n accordance with our strateg!G we
pace entr! orders &H pips a=o.e and =eow the channe at H.L+'L and H.L+LC. 3he
order to go ong gets triggered first and amost immediate! we pace a stop order &H
pips under the upperX
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Figure 0.:( E/6</S$ Channe E@ampe
%Source# eSigna. www.eSigna.com)
'+
PE6FEC3 ;6$E6
Xprice e.e than the :HFda! SMAG which is higher than the 1HFda! SMA.
MeanwhieG the &HHFda! SMA woud =e =eow the 1HFda! SMAG whie the :HHFda!
SMA woud =e =eow the &HHFda! SMA. *n a downtrendG the opposite is trueG when
the :HHFda! SMA is at the highest e.e and the &HFda! SMA is at the owest e.e.
8a.ing the mo.ing a.erages stacked up in sequentia order is genera! a strong
indicator of a trending en.ironment. 7ot on! does it indicate that the momentum is
on the side of the trendG =ut the mo.ing a.erages aso ser.e as mutipe e.es of
support. 3o optimi,e the perfect order strateg!G traders shoud aso ook for A$X to
=e greater than :H and trending upward. Entr! and e@it e.es are difficut to
determine with this strateg!G =ut we genera! want to sta! in the trade as ong as the
perfect order hods and e@it once the perfect order no onger hods. Perfect orders do
not happen oftenG and the premise of this strateg! is to capture the perfect order when
it first happens.
3he perfect order seeks to take ad.antage of a trending en.ironment near the
=eginning of the trend. 8ere are the rues for using this technique.
&. 5ook for a currenc! pair with mo.ing a.erages in perfect order.
:. 5ook for A$X pointing upwardG idea! greater than :H.
X
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PA2ES &:0F&:'
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X
fect order no onger hods and the :HFda! SMA mo.es =eow the &HFda! SMA.
3his occurs on $ecem=er &LG:HH1G when prices open a &.&(:H. 3he tota profit on
this track is (&H pips. We risked '+ pips.
Figure 0.:+ is a perfect order formation in the /S$<CA$. 3he formation
materiai,ed on Septem=er CHG :HH(. We count fi.e =ars forward and enter into the
position at &.:100 with a stop at &.:100. 3he pair then proceeds to se off and we
ook to e@it the position when the perfect order formation no onger hods. 3his
occurs on $ecem=er 'G :HH1G at which time we =u! =ack our position at &.:&&1 for a
((CFpip profit whie risking &(' pips.
'0
Funament a% Trai ng St rat egi es
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PA2E &C&
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Picking the Strongest Pairing
X =ecause at the timeG BritainPs econom! had =een e@hi=iting a consistentG
impressi.e amount of economic growthG whichG after the compusi.e doar fren,!G
heped it gain hack some su=stantia ground within a matter of a few weeks. 3he
re=ound in the British pound against the doar can =e seen in Figure '.&. After
hitting a ow of &.01'1 on March :0G the pair proceeded to re=ound =ack toward its
preFF;MC e.e of &.':HH o.er the ne@t three weeks.
Figure '.& 2BP</S$ Post Fed Meeting
%Source# eSigna. www.eSigna.com)
;n the other handG the ?apanese !en saw a depreciation o.er a much onger
period of time with a continua upward mo.ement in the /S$<?P9 pair we into the
midde of Apri. 3his price action can =e seen in Figure '.:. After the F;MC
meetingG the doar proceeded to strengthen another CHH pips o.er the ne@t two
weeks. Part of the reason for the differences in these mo.ements was that market
watchers did not ha.e much faith in the ?apanese econom!G which had =een teetering
on the edge of recession and showing no signs of positi.e economic e@pansion.
3hereforeG the doar strength had a much higher impact and an increased amount of
sta!ing power with the strugging !en than with the consistent! strong pound.
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''
Figure '.C A/$<?P9 Post Fed Meeting
%Source# eSigna. www.eSigna.com)
Figure '.( E/6<?P9 Post Fed Meeting
%Source# eSigna. www.eSigna.com)
5EBE6A2E$ CA669 36A$E
38E e.eraged carr! trade strateg! is one of the fa.orite trading strategies of
go=a macro hedge funds and in.estment =anks. *t is the quintessentia go=a macro
trade. *n a nutsheG the carr! trade strateg! entais going ong or =u!ing a highF
&HH
!ieding currenc! and seing or shorting a owF!ieding currenc!. Aggressi.e
specuators wi ea.e the e@change rate e@posure unhedgedG which means that the
specuator is =etting that the highF!ieding currenc! is going to appreciate in addition
to earning the interest rate differentia =etween the two currencies. For those who
hedge the e@change rate e@posureG athough interest rate differentias tend to =e rather
smaG on the scae of & to 1 percentG if traders factor in 1 to &H times e.erageG the
profits from interest rates aone can =e su=stantia. ?ust think a=out it# A :.1 percent
interest rate differentia =ecomes :1 percent on &H times e.erage. 5e.erage can aso
=e .er! risk! if not managed proper! =ecause it can e@acer=ate osses. Capita
appreciation genera! occurs when a num=er of traders see this same opportunit!
and aso pie info the tradeG which ends up ra!ing the currenc! pair.
*n foreign e@change tradingG the carr! trade is an eas! wa! to take ad.antage of
this =asic economic principe that mone! is constant! fowing in and out of different
marketsG dri.en =! the economic aw of supp! and demand# markets that offer the
highest returns on in.estment wi in genera attract the most capita. Countries are no
different in the word of internationa capita fowsG nations that offer the highest
interest rates wi genera! attract the most in.estment and create the most demand
for their currencies. A .er! popuar trading strateg!G the carr! trade is simpe to
master. *f done correct!G it can earn a high return without an in.estor taking on a ot
of risk. 8owe.erG carr! trades do come with some risk. 3he chances of oss are great
if !ou do not understand howG wh!G and when carr! trades work =est.
2ow Do !arr & Traes ;or k<
3he wa! a carr! trade works is to =u! a currenc! that offers a high interest rate
whie seing a currenc! that offers a ow interest rate. Carr! trades are profita=e
=ecause an in.estor is a=e to earn the difference in interest-or spread-=etween the
two currencies.
An e@ampe# Assume that the Austraian doar offers an interest rate of (.+1
percentG whie the Swiss franc offers an interest rate of H.:1 percent. 3o e@ecute the
carr! tradeG an in.estor =u!s the Austraian doar and ses the Swiss franc. *n doing
soG he or she can earn a profit of (.1H percent %(.+1 percent in interest earned minus
H.:1 percent in interest paid)G as ong as the e@change rate =etween Austraian doars
and Swiss francs does not change. 3his return is =ased on ,ero e.erage. Fi.e times
e.erage equas a ::.1 percent return on Kust the interest rate differentia. 3o
iustrateG take a ook at the foowing e@ampe and Figure '.1 to see how an in.estor
woud actua! e@ecute the carr! trade#
Execut i ng the !arr& Tirae
Bu! A/$ and se C8F %ong A/$<C8F).
5ong A/$ position# in.estor earns (.+1 percent.
Short C8F position# in.estor pa!s H.:1 percent.
With spot rate hed constantG profit is (.1H percentG or (1H =asis points.
*f the currenc! pair aso increased in .aue due to other traders identif!ing this
opportunit!G the carr! trader woud earn not on! !ied =ut aso capita appreciation.
)o summari*e:A carr! trade works =! =u!ing a currenc! that offers a high
interest rate whie seing a currenc! that offers a ow interest rate.
&H&
;h& Do !arr& Traes ;ork<
Carr! trades work =ecause of the constant mo.ement of capita into and out of
countries. *nterest rates are a =ig reason wh! some countries attract a great dea of
in.estment as opposed to others. *f a countr!Js econom! is doing we %high growthG
high producti.it!G ow unempo!mentX
Figure '.1 5e.eraged Carr! 3rade E@ampe
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X=e a=e to pa! high interest rates. *ndeedG there is a cear chance that
something might happen to pre.ent the countr! from pa!ing this high interest rate.
/timate!G the in.estor must =e wiing to take this chance.
*f in.estors as a whoeG were not wiing to take on this riskG then capita woud
ne.er mo.e from one countr! to anotherG and the carr! trade opportunit! woud not
e@ist. 3hereforeG in order to workG carr! trades require that in.estors as a group ha.e
ow risk a.ersionG or are wiing to take the risk of in.esting in the higherFinterestF
rate currenc!.
)o summari*e:Carr! trades ha.e the most profit potentia during times when
in.estors are wiing to take the risk of in.esting in highFinterestFpa!ing currencies.
;hen ;i%% !arr & Traes 'ot ;ork<
So far we ha.e shown that a curr! trade wi work =est when in.estors ha.e ow
risk a.ersion. What happens when in.estors ha.e high risk a.ersion"
Carr! trades are the east profita=e when in.estors ha.e high risk a.ersion.
When in.estors ha.e high risk a.ersionG the! are ess wiing as a group to take
chances with their in.estments. 3hereforeG the! woud =e ess wiing to in.est in
riskier currencies that offer higher interest rates. *nsteadG when in.estors ha.e high
risk a.ersion the! woud actua! prefer to put their mone! in Qsafe ha.enQ currencies
that pa! ower interest rates. 3his woud =e equi.aent to doing the e@act opposite of
a carr! trade-in other wordsG in.estors are =u!ing the currenc! with the ow interest
rate and seing the currenc! with the high interest rate.
&H:
2oing =ack to our earier e@ampeG assume the in.estor sudden! fees
uncomforta=e hoding a foreign currenc!G the Austraian doar. 7owG instead of
ooking for the higher interest rateG she is more interested in keeping her in.estment
sae. As a resutG she swaps her Austraian doars for more famiiar Swiss francs.
3he net effect of miions of peope doing this transaction is that capita fows
out of Austraia and into Swit,erand as in.estors take their Austraian doar and
trade them in for Swiss francs. BecauseG of this high in.estor risk a.ersionG
Swit,erand attracts more capita due to the safet! its currenc! offers despite the
ower interest rates. 3his infow of capita increases the .aue of the Swiss franc %see
Figure '.+).
)o summari*e:Carr! trades wi he the east profita=e during times when
in.estors are unwiing to take the risk of in.esting in highFinterestFpa!ing currencies.
Figure '.+ Effects of a Carr! 3rade When *n.estors 8a.e 8igh 6isk A.ersion#
A/$<C8F Carr! 3rade E@ampe :
5m"ort ance of Ris k /*ersi on
Carr! trades wi genera! =e profita=e when in.estors ha.e ow risk a.ersionG
and unprofita=e when in.estors ha.e high risk a.ersion. 3hereforeG =efore pacing a
carr! trade it is critica to =e aware of the risk en.ironment-whether in.estors as a
whoe ha.e high or ow risk a.ersion-and when it c(an#es.
*ncreasing risk a.ersion is genera! =eneficia for owF interestFrateFpa!ing
currencies# Sometimes the mood of in.estors wi change rapid! - in.estorsJ
wiingness to make risk! trades can change dramatica! from one moment to the
ne@t. ;ften these arge shifts are caused =! significant go=a e.ents. When in.estor
risk a.ersion does rise quick!G the resut is genera! a arge capita infow into owF
interestFrateFpa!ing Qsafe ha.enQ currencies %see Figure '.L).
For e@ampeG in the summer of &''0 the ?apanese !en appreciated against the
doar =! o.er :H percent in the span of two monthsG due main! to the 6ussian de=t
crisis and 5ongF3erm Capita Management hedge fund =aiout. Simiar!G Kust ater
the Septem=er &&G :HH&G terrorist attacks the Swiss franc rose =! more than + percent
against the doar o.er a &HFda! period.
3hese sharp mo.ements in currenc! .aues often occur when risk a.ersion
quick! changes from ow to high. As a resutG when risk a.ersion shifts in this wa!G a
carr! trade can Kust as quick! turn from =eing profita=e to unprofita=e. Con.erse!G
as in.estor risk a.ersion goes from high to owG carr! trades =ecome more profita=eG
as detaied in Figure '.0.
&HC
8ow do !ou know if in.estors as a whoe ha.e high or ow risk a.ersion"
/nfortunate!G it is difficut to measure in.estor risk a.ersion with a singe num=er.
;ne wa! to get a =road idea of risk a.ersion e.es is to ook at the different !ieds
that =onds pa!. 3he wider the differenceG orX
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Ti me 2ori4on *n generaG a carr! trade is a ongFterm strateg!. Before entering
into a carrytradeG an in.estor shoud =e wiing to commit to a time hori,on or at
east si@ months. 3his commitment heps to make sure that the trade wi not =e
affected =! the QnoiseQ of shorterFterm currenc! price mo.ements. AsoG not using
e@cessi.e e.erage for carr! traders wi aow traders to hod onto their positions
onger and to =etter weather market fuctuations =! not getting stopped out.
)o summari*e:Carr! trade in.estors shoud =e aware of factors such as currenc!
appreciationG trade =aancesG and time hori,on =efore pacing a trade. An! or a of
these factors can cause a seeming! profita=e carr! trade to =ecome unprofita=eG
F/7$AME73A5 36A$*72 S36A3E29# S3A9*72 ;7 3;P ;F
MAC6;EC;7;M*C EBE73S
ShortFterm traders seem to =e focused on! on the economic reease of the week
and how it wi impact their da! trading acti.ities. 3his works we for man! tradersG
=ut it is aso important not to ose sight of the =ig macro e.ents that ma! =e =rewing
in the econom! - or the word for that matter. 3he reason is =ecause argeFscae
macroeconomic e.ents wi mo.e markets and wi mo.e them =ig time. 3heir impact
goes =e!ond a simpe price change for a da! or two =ecause depending on their si,e
and scopeG these occurrences ha.e the potentia to reshape the fundamenta
perception toward a currenc! for months or e.en !ears at a time. E.ents such as
warsG poitica uncertaint!G natura disastersG and maKor internationa meetings are so
potent due to their irreguarit! that the! ha.e widespread ps!choogica and ph!sica
impacts on the currenc! market. With these e.ents come =oth currencies that
appreciate .ast! and currencies that depreciate Kust as dramatica!. 3hereforeG
keeping on top of go=a de.eopmentsG understanding the under!ing direction of
market sentiment =efore and after these e.ents occurG and anticipating them coud =e
.er! profita=eG or at east can hep pre.ent significant osses.
.now ;hen +ig E*ent s Occur
Significant 2F+ or 2F0 finance ministers meetings.
Presidentia eections.
*mportant summits.
MaKor centra =ank meetings.
Potentia changes to currenc! regimes.
Possi=e de=t defauts =! arge countries.
Possi=e wars as a resut of rising geopoitica tensions.
Federa 6eser.e chairmanPs semiannua testimon! to Congress on the
econom!.
&H(
3he =est wa! to highight the significance of these e.ents is through e@ampes.
G-A Meeting6 Du$ai6 Se"tem$er 0>>H
3he countries that constitute the 2F+ are the /nited StatesG /nited >ingdomG
?apanG CanadaG *ta!G 2erman!G and France. Coecti.e!G these countries account for
twoFthirds of the wordPs tota economic output. 7ot a 2F+ meetings are important.
3he on! time the market rea! hones in on the 2F+ finance ministers meeting is
when =ig changes are e@pected. 3he 2F+ finance ministers meeting on Septem=er ::G
:HHCG was a .er! important turning point for the markets. 3he doar coapsed
significant! foowing the meeting at which the 2F+ finance ministers wanted to see
Dmore fe@i=iit! in e@change ratesE. $espite the rather tame nature of these wordsG
the market interpreted this ine to =e a maKor shift in poic!. 3he ast time changes to
this degree had =een made was =ack in :HHH.
Figure '.' E/6</S$ Post 2F+ Chart
%Source# eSigna. www.eSigna.com)
*n :HHHG the market paid particuar attention to the upcoming meeting =ecause
there was strong inter.ention in the E/6</S$ the da! =efore the meeting. 3he
meeting in Septem=er :HHC was aso important =ecause the /.S. trade deficit was
=aooning and =ecoming a huge issue. 3he E/6</S$ =ore the =runt of the doar
depreciation whie ?apan and China were inter.ening aggressi.e! in their currencies.
As a resutG it was wide! e@acted that the 2F+ finance ministers as a whoe woud
issue a statement that was high! critica of ?apans and Chinas inter.ention poiciesG
eading up to the meetingG the /.S. doar had aread! =egun to se offG as indicated
=! the chart in Figure '.'. At the time of the announcementG the E/6</S$ shot up
&1H pips. 3hough this initia mo.e was not .er! su=stantia =etween Septem=er :HHC
and Fe=ruar! :HH( %the ne@t 2F+ meeting)G the doar fe 0 percent on a tradeF
weighted =asisG ' percent against the British poundG && percent against the euroG +
percent against the !enG and &.1 percent against the Canadian doar. 3o put the
&H1
percentages into perspecti.eG a mo.e of && percent is equi.aent to appro@imate!
&.&HH pips. 3herefore the ongerFterm impact is much more significant than the
immediate impactG as the e.ent itsef has the a=iit! to change the o.era sentiment in
the market. Figure '.' is a week! chart of the E/6</S$ that iustrates how the
currenc! pair performed foowing the Septem=er ::G :HHCG 2F+ meeting.
#o%i tica% Uncert ai nt &: 0>>1 U( S( #resi ent i a%
E%ection
Another e@ampe of a maKor e.ent impacting the currenc! market is the :HH(
/.S. presidentia eection. *n generaG poitica insta=iit! causes percei.ed weakness
in currencies. 3he hot! contested presidentia eection in 7o.em=er :HH( com=ined
with the differences in the candidatesP stances on the growing =udget deficit resuted
in o.era doar =earishness. 3he sentiment was e@acer=ated e.en further gi.en the
ack of internationa support for the incum=ent president %2eorge W. Bush) due to
the administrations decision to o.erthrow Saddam 8ussein. As a resutG in the three
weeks eading up to the eectionG the euro rose LHH pips against the /.S. doar. 3his
can =e seen in Figure '.&H. With a Bush .ictor! =ecoming increasing! cear and ater
confirmedG the doar sod off against the maKors as the market ooked ahead to what
woud pro=a=! end up =eing the maintenance of the status quo. ;n the da!
foowing the eectionG the E/6</S$ rose another :HH pips and then continued to
rise an additiona +HH pips =efore peaking si@ weeks ater. 3his entire mo.e took
pace o.er the course of two monthsG which ma! seem ike eternit! to man!G =ut this
macroeconomic e.ent rea! shaped the marketsN for those who were foowing itG =ig
profits coud ha.e =een made. 8owe.erG this is important e.en for shortFterm traders
=ecause gi.en that the market was =earish doars in genera eading up to the /.S.
presidentia eectionG a more prudent trade woud ha.e =een to ook for opportunities
to =u! the E/6</S$ on dips rather than tr!ing to se raies and ook for tops.
Figure '.&H E/6</S$ /.S. Eection
%Source# eSigna. www.eSigna.com)
&HL
;ars: U( S( ;ar in 5ra-
2eopoitica risks such as wars can aso ha.e a pronounced impact on the
currenc! market. Figure '.&& shows that =etween $ecem=er :HH: and Fe=ruar!
:HHCG the doar depreciated ' percent against the Swiss franc %/S$<C8F) in the
months eading up to the in.asion of *raq. 3he doar sod off =ecause the war itsef
was incredi=! unpopuar among the internationa communit!. 3he Swiss franc was
one of the primar! =eneficiaries due to the countr!Ps poitica neutrait! and safe
ha.en status. Between Fe=ruar! and MarchG the market =egan to =eie.e that the
ine.ita=e war woud turn into a quick and decisi.e /.S. .ictor!G so the! =egan to
unwind the war trade. 3his e.entua! ed to a 0 percent ra! in /S$<C8F as inF
.estors e@ited their short doar positions.
Each of these e.ents caused argeFscae mo.ement in the currenc! marketsG
which makes them important e.ents to foow for a t!pes ofX
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PA2E &(+
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X
a ha.e soid correations with god pricesN natura god reser.es and currenc!
aws in these countries resut in amost mirrorFike mo.ements. 3he CA$ aso tends
to mo.e somewhat in ine with oi pricesN howe.erG the connection here is much more
compicated and ficke. Each currenc! has a specific correation and reason as to wh!
its actions refect commodit! prices so we. >nowedge of the fundamentas =ehind
these mo.ementsG their directionG and the strength of the parae coud he an
effecti.e wa! to disco.er trends in =oth markets.
The Re%ati ons hi "
Go% Before ana!,ing the reationship god has with the commodit! currenciesG
it is important to first understand the connection =etween god and the /.S. doar.
Athough the /nited States is the words second argest producer of god %=ehind
South Africa)G a ra! in god prices does not produce an appreciation of the doar.
Actua!G when the doar goes downG god tends to go upG and .ice .ersa. 3his seemF
ing! iogica occurrence is a =!Fproduct of the perception in.estors hod of god.
$uring unsta=e geopoitica timesG traders tend to sh! awa! from the doar and
instead turn to god as a safe ha.en for their in.estments. *n factG man! traders ca
god the Qantidoar.Q 3hereforeG if the doar depreciatesG god gets pushed up as war!
in.estors fock from the decining green=ack to the stead! commodit!. 3he
A/$</S$G 7A$</S$G and /S$<C8F currenc! pairs tend to mirror godJs mo.eF
ments the cosest =ecause these other currencies a ha.e significant natura and
poitica connections to the meta.
Starting in the South PacificG the A/$</S$ has a .er! strong positi.e
correation %H.0H) with god as shown in Figure '.&:N thereforeG whene.er god prices
go upG the A/$</S$ aso tends to go up as the Austraian doar appreciates against
the /.S. doar. 3he reason for this reationship is that Austraia is the words third
argest producer of godG e@porting a=out I1 =iion worth of the precious meta
annua!. Because of thisG the currenc! pair ampifies the effects of god prices
twofod. *f insta=iit! is causing an increase in pricesG this pro=a=! signas that the
/S$ has aread! =egun to depreciate. 3he pairing wi then =e pushed down further
&H+
as importers of god demand more of AustraiaPs currenc! to co.er higher costs. 3he
7ew Aeaand doar tends to foow the same path in the A/$</S$ pairing =ecause
7ew AeaandPs econom! is .er! cose! inked to AustraiaPs. 3he correation in this
pairing is aso appro@imate! H.0H with god %see Figure '.&C for the chart).
Figure '.&: A/$</S$ and 2od
Figure '.&C 7A$</S$ and 2od
3he CA$</S$ has an e.en stronger correation with god prices at H.0(G X
WWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWW
PA2E &1H
WWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWWW
X
&H0
Figure '.&C CA$</S$ and ;i
Trai ng O""ort uni t &
7ow that the reationships ha.e =een e@painedG there are two wa!s to e@poit
this knowedge. 3aking a ook at Figures '.&:G '.&C and '.&(G !ou can see that
genera! speakingG commodit! prices are a eading indicator for currenc! prices.
3his is most apparent in the 7A$</S$Fgod reationship shown in Figure '.&C and
the CA$</S$Foi reationship shown in Figure '.&(. As suchG commodit! =ock
traders can monitor god and oi prices to forecast mo.ements in the currenc! pairs.
3he second wa! to e@poit this knowedge is to para! the same .iew using different
productsG which does hep to di.ersif! risk a =it e.en with the high correation. *n
factG there is one ke! ad.antage to e@pressing the .iew in currencies o.er
commoditiesG and that is that it offers traders the a=iit! to earn interest on their
positions =ased on the interest rate differentia =etween the two countriesG whie god
and oi futures positions do not.
/S*72 B;7$ SP6EA$S AS A 5EA$*72 *7$*CA3;6 F;6 FX
An! trader can attest that interest rates are an integra part of in.estment
decisions and can dri.e markets in either direction. F;MC rate decisions are the
second argest currenc!FmarketFmo.ing reeaseG =ehind unempo!ment data. 3he
effects of interest rate changes ha.e not on! shortFterm impicationsG =ut aso ongF
term consequences on the currenc! markets. ;ne centra =anks rate decision can
affect more than a singe pairing in the interreated fore@ market. 9ied differentias
fi@ed income instruments such as 5ondon *nter=ank ;ffered 6ates %5*B;6) and &HF
!ear =ond !ieds can =e used as eading indicators for currenc! mo.ements. *n FX
tradingG an interest rate differentia is the difference =etween the interest rate on a
=ase currenc! %appearing first in the pair) ess the interest rate on the quoted currenc!
%appearing second in the pair). Each da! at 1#HH p.m. ES3 the cose of the da! for
currenc! marketsG funds are either paid out or recei.ed to adKust for interest rate
&H'
differences. /nderstanding the correation =etween interest rate differentias and
currenc! pairs can =e .er! profita=e. *n addition to centra =ank o.ernight rate
decisionsG e@pected future o.ernight rates aong with the e@pected timing of rate
changes are aso critica to currenc! pair mo.ements. 3he reason wh! this works is
that the maKorit! of internationa in.estors are !ied seekers. 5arge in.estment =anksG
hedge fundsG and institutiona in.estors ha.e the a=iit! capitaFwise to access go=a
markets. 3hereforeG the! are acti.e! shifting funds from owerF!ieding assets to
higherF!ieding assets.
5nteres t Rate Different i a% s: 3eai ng 5nicat or6 !oincient 5nicator6 or
3aggi ng 5nicator <
Since most currenc! traders consider present and future interest rate differentias
when making in.estment decisionsG there shoud theoretica! =e some correation
=etween !ied differences and currenc! pair prices. 8owe.erG do currenc! pair prices
predict rate decisionsG or do rate decisions affect currenc! pair prices" 5eading
indicators are economic indicators that predict future e.entsN coincident indicator are
economic indicators that .ar! with economic e.entsN agging indicators are economic
indicator that foow an economic e.ent. For instanceG if interest rate differentias
predict future currenc! pair pricesG interest rate differentias arc said to =e eading
indicators of currenc! pair prices. Whether interest rate differentias are a eadingG
coincidentG or agging indicator of currenc! pair prices depends on how much traders
care a=out future rates .ersus current rates. Assuming efficient marketsG if currenc!
traders care on! a=out current interest rates and not a=out future ratesG one woud
e@pect a coincident reationship. *f currenc! traders consider =oth current and future
ratesG one woud e@pect interest rate differentias to =e a eading indicator of future
currenc! prices.
3he rue of thum= is that when the !ied spread increases in fa.or of a certain
currenc! that currenc! wi genera! appreciate against other currencies. For
e@ampeG if the current Austraian &HF!ear go.ernment =ond !ied is 1.1H percent and
the current /.S. &HF!ear go.ernment =ond !ied is :.HH percentG then the !ied spread
woud =e C1H =asis points in fa.or of Austraia. *f Austraia raised its interest rates =!
:1 =asis points and the &HF!ear go.ernment =ond !ied appreciated to 1.+1 percentG
then the new !ied spread woud =e C+1 =asis points in fa.or of Austraia. Based on
historica e.idenceG the Austraian doar is aso e@acted to appreciate against the /.S.
doar in this scenario.
Based on a stud! of three !ears of empirica data starting from ?anuar! :HH: and
ending ?anuar! :HH1G we find that interest rate differentias tend to =e a eading
indicator of currenc! pairs. Figures '.&1G '.&LG and '.&+ are graphica representations
of this finding.
3hese figures show three e@ampes of currenc! pairs where =ond spreads ha.e
the cearest eadingFedge correation. As one woud e@pect from the fact that traders
trade on a .ariet! of information and not Kust interest ratesG the correationG though
goodG is not perfect. *n generaG interest rate differentia ana!sis seems to work =etter
o.er a onger period of time. 8owe.erG shifts in sentiment for the outook for the path
of interest rates o.er the shorter term can sti =e a eading indicator for currenc!
prices.
&&H
Figure '.&1 A/$</S$ and Bond Spread
Figure '.&1 2BP</S$ and Bond Spread
Figure '.&+ /S$<CA$ and Bond Spread
&&&
!a%cu% at i ng 5nteres t Rate Different i a% s an Fo%%owi ng the !urrenc& #ai r
Trens
3he =est wa! to use interest rate differentias for trading is =! keeping track of
oneFmonth 5*B;6 rates or &HF!ear =ond !ieds in Microsoft E@ce.
T/+3E I( E +on S"reas
&H<:'<:HH(
8.2. 45 ear
ield
/>PI82=
8.A. 450ear
ield
8A.08.2. rate
differential
82=I@P7
@P7 450ear
ield
8.2.0@P7 rate
differential
:.HH
&.0C+:
(.0C
:.0C
&H1.0&
H.H(
&.'L
&&<CH<:HH(
:.:'
&.'H'1
(.0:
:.1C
&HC.H+
H.HC'
:.:1
$ate
&:<:&<:HH(
:.(H
&.'&0&
(.0L
:.(L
&H:.LC
H.HC'
:.CL
&<C&<:HH1
:.1'
&.00:'
(.0C
:.:(
&HC.+H
H.H(
:.11
:<:L<:HH1
:.+&
&.':&H
(.0+
:.&1
&H(.LC
H.HC0
:.L+
3hese rates are pu=ic! a.aia=e on we= sites such as Boom=erg.com. *nterest
rate differentias are then cacuated =! su=tracting the !ied of the second currenc!
in the pair from the !ied of the first. *t is important to make sure that interest rate
differentias are cacuated in the order in which the! appear for the pair. For
instanceG the interest rate differentias in 2BP</S$ shoud =e the &HF!ear gift rate
minus the &HF!ear /.S. 3reasur! note rate. For euro dataG use data from the 2erman
&HF!ear =ond. Form a ta=e that ooks simiar to the one shown in 3a=e '.&.
After sufficient data is gatheredG !ou can graph currenc! pair .aues and !ieds
using a graph with two a@es to see an! correations or trends. 3he sampe graphs in
Figures '.&1G '.&LG and '.&+ use the date in the XFa@is and currenc! pair price and
interest rate differentias on two !Fa@is graphs. 3o fu! utii,e this data in tradingG
!ou want to pa! cose attention to trends in the interest rate differentias of the
currenc! pairs !ou trade.
F/7$AME73A5 36A$*72 S36A3E29# 6*S> 6EBE6SA5S
6isk re.ersas are a usefu fundamentasF=ased too to add to !our mi@ of
indicators for trading. ;ne of the weaknesses of currenc! trading is the ack of
.oume data and accurate indicators for gauging sentiment. 3he on! pu=ic!
a.aia=e report on positioning is the DCommitments of 3radersQ report pu=ished =!
the Commodit! Futures 3rading CommissionG and e.en that is reeased with a threeF
da! dea!. A usefu aternati.e is to use risk re.ersasG which are pro.ided on a reaF
time =asis on the Fore@ Capita Markets %FXCM) news pugFinG under ;ptions. As
we first introduced in Chapter +G a risk re.ersa consists of a pair of options for the
&&:
same currenc! %a ca and a put). Based on put<ca parit!G far outFofFtheFmone!
options %:1 deta) with the same e@piration and strike price shoud aso ha.e the same
impied .oatiit!. 8owe.erG in reait! this is not true. Sentiment is em=edded in
.oatiitiesG which makes risk re.ersas a good too to gauge market sentiment. A
num=er strong! in fa.or of cas o.er puts indicates that there is more demand for
cas than puts. 3he opposite is aso true# a num=er strong! in fa.or of puts o.er cas
indicates that there is a premium =uit in put options as a resut of the higher demand.
*f risk re.ersas are near ,eroG this indicates that there is indecision among =us and
=ears and that there is no strong =ias in the markets.
;hat Does a Ris k Re*ers a% Ta$%e 3ook 3i ke<
We showed a risk re.ersa ta=e =efore in Chapter +G %3a=e +.C)G =ut want to
descri=e it again to make sure that it is we understood. Each of the a==re.iations for
the currenc! options are istedG andG as indicatedG most risk re.ersas are near ,eroG
which indicates no significant =ias. For /S$<?P9G thoughG the ongerFterm risk
re.ersas indicate that the market is strong! fa.oring !en cas %?C) and doar puts.
2ow !an )ou Use Thi s 5nfor mat i on<
For easier graphing and tracking purposesG we use positi.e and negati.e integers
for ca and put premiumsG respecti.e!G in Figure '.&0. 3herefore a positi.e num=er
indicates that cas are preferred o.er puts and that the market as a whoe is e@pecting
an upward mo.ement in the under!ing currenc!. 5ikewiseG a negati.e num=er
indicates that puts are preferred o.er cas and that the market is e@acting a
downward mo.e in the under!ing currenc!. /sed prudent!G risk re.ersas can =e a
.aua=e too in Kudging market positioning. Whie the signas generated =! a risk
re.ersa s!stem wi not =e compete! accurateG the! can specif! when the marker is
=uish or =earish.
6isk re.ersas =ecome quite important when the .aues are at e@treme e.es.
We identif! e@treme e.es as one standard de.iation pus or minus the a.erage risk
re.ersa. When risk re.ersas are at these e.esG the! gi.e off contrarian signasG
indicating that a currenc! pair is o.er=ought or o.ersod =ased on sentiment. 3he
indicator is percei.ed as a contrarian signa =ecause when the entire market is
positioned for a riseX
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&&C
Figure '.&' 2BP</S$ 6isk 6e.ersa Chart
X
once again a month ater to &.'H. We saw another top in the E/6</S$G which
ater =ecame a much deeper descent.
3he ne@t e@ampe is the 2BP</S$. As can =e seen in Figure '.&'G risk re.ersas
do a .er! good Ko= of identif!ing e@treme o.er=ought and o.ersod conditions. Bu!
and soi e.es are added to the 2BP</S$ chart for further carification of how risk
re.ersas can aso =e used to time market turns. With the ack of price and .oume
data to gi.e us a sense of where the market is positionedG risk re.ersas can =e hepfu
in gauging genera market sentiment.
/S*72 ;P3*;7 B;5A3*5*3*ES 3; 3*ME MA6>E3 M;BEME73S
/sing option .oatiities to time foreign e@change spot mo.ements is a topicG
that we touched upon =rief! in Chapter +. Since this is a .er! usefu strateg! that is a
fa.orite among professiona hedge fundsG it certain! warrants a more detaied
e@panation. *mpied .oatiit! can =e defined as a measure of a currenc!Ps e@pected
fuctuation o.er a gi.en time period =ased on past price fuctuations. 3his is t!pica!
cacuated =! taking the historic annua standard de.iation of dai! price changes.
Future prices hep to determine impied .oatiit!G which is used to cacuate option
premiums. Athough this sounds fair! compicatedG its appication is not. BasicFa!G
option .oatiities measure the rate and magnitude of a currenc!Ps price o.er a gi.en
period of time =ased on historica fuctuations. 3hereforeG if the a.erage dai! trading
range of the E/6</S$ contracted from &HH pips to LH pips and sta!ed there for two
weeksG in a ikeihood shortFterm .oatiit! aso contracted significant! compared
to ongerFterm .oatiit! during the same time period.
&&(
Ru%es
As a guideineG there are two simpe rues to foow. 3he first one is that if shortF
term option .oatiities are significant! ower than ongFterm .oatiitiesG one shoud
e@pect a =reakoutG though the direction of the =reakout is not defined =! this rue.
SecondG if shortFterm option .oatiities are significant! higher than ongFterm
.oatiitiesG one shoud e@pect a re.ersion to trading range.
;h& Do These Ru%es ;ork<
$uring a ranging periodG impied option .oatiities are either ow or on the
decine. 3he inspiration for these rues is that in periods of range tradingG there tends
to =e itte mo.ement. We care most a=out when option .oatiities drop sharp!G
which coud =e a sign that a profita=e =reakout is under wa!. When shortFterm
.oatiit! is a=o.e ongFterm .oatiit!G it means that nearFterm price action is more
.oatie than the ongFterm a.erage price action. 3his suggests that the ranges wi
e.entua! contract =ack toward a.erage e.es. 3he trend is most noticea=e in
empirica data. 8ere are a few e@ampes of when this rue accurate! predicted trends
or =reaks.
Before ana!,ing the chartsG it is important to note that we use oneFmonth
.oatiities as our shortFterm .oatiities and threeFmonth .oatiities as our ongerF
term .oatiities.
Figure '.:H A/$<CA$ Boatiit! Chart
*n the A/$<CA$ .oatiit! chart in Figure '.:HG for the most part shorterFterm
.oatiit! is fair! cose to the ongerFterm .oatiit!. 8owe.erG the first arrow shows
an instance where shortFterm .oatiit! spiked we =eow ongFterm .oatiit!G whichG
as indicated =! our rueG suggests an upcoming =reakout scenario in the currenc!
pair. A/$<CA$ did e.entua! =reak upward significant! into a strong uptrend.
3he same trend is .isi=e in the /S$<?P9 .oatiit! chart in Figure '.:&. 3he
eftmost arrow shows an instance where oneFmonth impied .oatiit! spiked
significant! higher than threeFmonth .oatiit!N as e@pectedG the spot price continued
&&1
to range. 3he ne@t downward arrow points to an area where shortFterm .oatiit! fe
=eow ongFterm .oatiit!G eading to a =reakout that sent spot prices up.
Figure '.:& /S$<?P9 Boatiit! Chart
;ho !an +enef i t from These Ru%es<
3his strateg! is not on! usefu for =reakout tradersG =ut range traders can aso
utii,e this information to predict a potentia =reakout scenario. *f .oatiit! contracts
fa significant! or =ecome .er! owN the ikeihood of continued range trading
decreases. After e!eing a historica range traders shoud ook at .oatiities to
estimate the ikeihood that the spot wi remain within this range. Shoud the trader
decide to go ong or short this rangeG he or she shoud continue to monitor .oatiit!
as ong as he or she has an open position in the pair to assist them in determining
when to cose out that position. *f shortFterm .oatiities fa we =eow ongFterm
.oatiities the trader shoud consider cosing the position if the suspected =reakout is
not in the traderPs fa.or. 3he potentia =reak is ike! to work in the fa.or of the trader
if the current spot is cose to the imit and far from the stop. *n this h!pothetica
situationG it ma! =e profita=e to mo.e imit prices awa! from current spot prices to
increase profits from the potentia =reak. *f the spot price is cose to the stop price
and far from the imit priceG the =reak is ike! to work against the traderG and the
trader shoud cose the position immediate!.
Breakout traders can monitor .oatiities to .erif! a =reakout. *f a trader suspects
a =reakoutG he or she can .erif! this =reakout through impied .oatiities. Shoud
impied .oatiit! =e constant or risingG there is a higher pro=a=iit! that the currenc!
wi continue to trade in range than if .oatiit! is ow or faing. *n other wordsG
=reakout traders shoud ook for shortFterm .oatiities to =e significant! ower than
ongFterm .oatiities =efore making a =reakout trade.
Aside from =eing a ke! component for pricingG option .oatiities can aso =e a
usefu too for forecasting market acti.ities. ;ption .oatiities measure the rue and
magnitude of the changes in a currenc!Ps prices. *mpied option .oatiitiesG on the
other handG measure the e@pected fuctuation of a currenc!Ps price o.er a gi.en period
of time =ased on historica fuctuations.
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Tracki ng Fo% at i % i t i es on )our Own
Boatiit! tracking t!pica! in.o.es taking the historic annua standard
de.iation of dai! price changes. Boatiities can =e o=tained from the FXCM news
pugFin a.aia=e at www.f@cm.com<fore@FnewsFsoftwareFe@change.Ksp. 2enera!
speakingG we use threeFmonth .oatiities for ongFterm .oatiities num=ers and oneF
month .oatiities for the short term. Figure '.:: shows how the .oatiities woud
ook on the news pugFin.
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F/7$AME73A5 36A$*72 S36A3E29# *73E6BE73*;7
Xtain directiona mo.e in its currenc!. 3here are =asica! two t!pes of inF
ter.entionG sterii,ed and unsterii,ed. Sterii,ed inter.ention requires offsetting
inter.ention with the =u!ing or seing of go.ernment =ondsG whie unsterii,ed
inter.ention in.o.es no changes to the monetar! =ase to offFset inter.ention. Man!
argue that unsterii,ed inter.ention has a more asting effect on the currenc! than
sterii,ed inter.ention.
3aking a ook at some of the foowing case studiesG it is apparent that
inter.entions in genera are important to watch and ran ha.e arge impacts on a
currenc! pairPs price action. Athough the actua timing of inter.ention tends to =e a
surpriseG quite often the market wi =egin taking a=out the need for inter.ention
da!s or weeks =efore the actua inter.ention occurs. 3he direction of inter.ention is
genera! awa!s known in ad.ance =ecause the centra =ank wi t!pica! come
across the newswires compaining a=out too much strength or weakness in its curF
renc!. 3hese warnings gi.e traders a window of opportunit! to participate in what
coud =e significant profit potentias or to sta! out of the markets. 3he on! thing to
watch out forG which !ou wi see in a case stud!G is that the sharp inter.entionF=ased
raies or seFoffs can quick! =e re.ersed as specuators come into the market to fade
the centra =ank. Whether or not the market fades the centra =ank depends on the
frequenc! of centra =atik inter.entionG the success rateG the magnitude of the
inter.entionG the timing of the inter.entionG and whether fundamentas support
inter.ention. ;.era thoughG inter.ention is much more pre.aent in emerging
market currencies than in the 2F+ currencies since countries such as 3haiandG
Maa!siaG and South >orea need to pre.ent their oca currencies from appreciating
too significant! such that the appreciation woud hinder economic reco.er! and
reduce the competiti.eness of the countr!Ps e@ports. 3he rarit! of 2F+ inter.ention
makes the instances e.en more significant.
9a"an
3he =iggest cuprit of inter.ention in the 2F+ markets o.er the past few !ears
has =een the Bank of ?apan %B;?). *n :HHCG the ?apanese go.ernment spent a record
9:H.& triion on inter.ention. 3his compares to the pre.ious record of 9+.L( triion
that was spent in &'''. *n the mouth of $ecem=er :HHC %=etween 7o.em=er :+ and
$ecem=er :L) aoneG the ?apanese go.ernment sod 9:.:1 triion. 3he amount it
spent on inter.ention that !ear represented 0( percent of the countr!Ps trade surpus.
As an e@portF=ased econom!G e@cess strength in the ?apanese !en poses a significant
&&+
risk to the countr!Ps manufacturers. 3he frequenc! and strength of B;? inter.ention
o.er the past few !ears created an in.isi=e foor under /S$<?P9. Athough this foor
has gradua! descended from &&1 to &HH =etween :HH: and :HH1G the market sti
has an ingrained fear of seeing the hand of the B;? and the ?apanese Ministr! of
Finance once again. 3his fear is we Kustified =ecause in the e.ent of B;?
inter.entionG the a.erage &HHFpip dai! range can easi! tripe. Additiona!G at the
e@act time of inter.entionG /S$<?P9 has easi! sk!rocketed &HH pips in a matter of
minutes.
*n the first case stud! shown in Figure '.:CG the ?apanese go.ernment came into
the market and =ought /.S. doars and sod &.H( triion !en %appro@imate! /SI'
=iion) on Ma! &'G :HHC. 3he inter.ention happened around +#HH a.m. ES3. Prior to
the inter.entionG /S$<?P9 was trading around &&1.:&&. When inter.ention occurred
at +#HH a.m.G prices Kumped CH pips in one minute. B! +#CHG /S$<?P9 was a fu &HH
pips higher. At :#CH p.m. ES3G /S$<?P9 was ::H pips higher. *nter.ention genera!
resuts in an!where =etween &HHF and :HHFpip mo.ements. 3rading on the side of
inter.ention can =e .er! profita=e %though risk!) e.en if prices end up re.ersing.
Figure '.:C /S$<?P9 Ma! &'G :HHC
3he second /S$<?P9 e@ampe %Figure '.:() shows how a trader coud sti =e
on the side of inter.ention and profit e.en though prices re.ersed ater in the da!. ;n
?anuar! 'G :HH(G the ?apanese go.ernment came into the market to =u! doars and
se .LL( triion !en %appro@imate! /SI&1 =iion). Prior to the inter.entionG
/S$<?P9 was trading at appro@imate! &HL.LH. When the B;? came into the market
at &:#:: a.m. ES3G pricesX
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Figure '.:1 /S$<?P9 7o.em=er &'G :HHC
Euro4one
?apan is not the on! maKor countr! to ha.e inter.ened in its currenc! in recent
!ears. 3he centra =ank of the Euro,one aso came into the market to =u! euros in
:HHHG when the singe currenc! depreciated from 'H cents to 0( cents. *n ?anuar!
&'''G when the euro was first aunchedG it was .aued at &.&+ against the /.S. doar.
$ue to the sharp sideG the European Centra Bank %ECB) con.inced the /nited
StatesG ?apanG the /nited >ingdomG and Canada to Koin it in coordinated inter.ention
to prop up the euro for the first time e.er. 3he Euro,one fet concerned that the
market was acking confidence in its new currenc! =ut aso feared that the side in the
currenc! was increasing the cost of the regionJs oi imports. With energ! prices
hitting &HF!ear highs at the timeG EuropeJs hea.! dependence on oi imports
necessitated a stronger currenc!. 3he /nited States agreed to inter.ention =ecause
=u!ing euros and seing doars woud hep to =oost the .aue of European imports
and aid in the funding of an aread! growing /.S. trade deficit. 3ok!o Koined in the
inter.ention =ecause it was =ecoming concerned that the weaker euro was posing a
threat to ?apanPs own e@ports. Athough the ECB did not reease detais on the
magnitude of its inter.entionG the Federa 6eser.e reported ha.ing purchased &.1 =iF
ion euros against the doar on =ehaf of the ECB. E.en though the actua
inter.ention itsef caught the market =! surpriseG the ECB ga.e good warning to the
market with numerous =outs of .er=a support from the ECB and European /nion
officias. For trading purposesG this woud ha.e gi.en traders an opportunit! to =u!
euros in anticipation of inter.ention or to a.oid shorting the E/6</S$.
Figure '.:L shows the price action of the E/6</S$ on the da! of inter.ention.
/nfortunate!G there is no minute data a.aia=e dating =ack to Septem=er :HHHG =ut
from the dai! chart we can see that on the da! that the EC/ inter.ened in the euro
&&'
%Septem=er ::G :HHH) with the hep of its trade partnersG the E/6</S$ had a highF
ow range of more than (HH pips.
Figure '.:L E/6</S$ Septem=er :HHH
E.en though inter.ention does not happen oftenG it is a .er! important
fundamenta trading strateg! =ecause each time it occursG price mo.ements are
su=stantia.
For tradersG inter.ention has three maKor impications for trading#
&. %lay inter"ention./se concerted warnings from centra =ank officias as a signa
for possi=e inter.ention - the in.isi=e foor created =! the ?apanese go.ernment
has gi.en /S$<?P9 =us pent! of opportunit! to pick shortFterm =ottoms.
+"oidtradest(at'ould!adeinter"ention.3here wi awa!s =e contrarians
among usG =ut fading inter.entionG though sometimes profita=eG entais a significant
amount of risk. ;ne =out of inter.ention =!X
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&:H