Although forex is the largest financial market in the world, it is relatively unfamiliar terrain to retail traders. Until the popularization of internet trading a few years earlier, FX was primarily the preserve of multinational corporations, large financial institutions, and secretive hedge funds. But times have changed. Individual investors are hungry for information on this fascinating market. Whether you’re an FX novice or just need a refresher course on the foundations of currency trading, read on to find the responses to the most frequently asked questions about the forex market.
Unlike the trading of stocks, futures or options, currency trading doesn’t take place on a regulated exchange. It isn’t controlled by any central governing body, there are no clearing houses to guarantee the trades and there is no arbitration panel to adjudicate disputes. All members trade with each other based upon credit agreements. Essentially, business in the largest, most liquid market in the world depends on no more than a metaphorical handshake.
At first glimpse, this ad-hoc arrangement must seem bewildering to investors who’re used to structured exchanges such as the NYSE or CME. (To learn more, see Getting To Know Stock Exchanges.) However, this arrangement works extremely well in practice: because participants in FX must both compete and collaborate with each other, self regulation provides very effective control over the market. Furthermore, reputable retail FX dealers in the United States become members of the National Futures Association (NFA), and by doing so they agree to binding arbitration in case of any dispute. Therefore, it is critical that any retail customer who contemplates trading currencies do so only through an NFA member firm.
Currently only futures are traded on the commodity exchanges in India. Option contracts aren’t permitted to be traded.
Arbitrage Pricing History: And so much more…
The FX market is different from other markets in some other key ways that are sure to raise eyebrows. Think that the EUR/USD is going to spiral downward? Feel free to short the pair at will. There is no uptick rule in FX as there is in stocks. There are likewise no limitations on the size of your position (as there are in futures); so, in theory, you could sell $100 billion worth of currency if you got the capital to do it. If your biggest Japanese client, who also happens to golf with Toshihiko Fukui, the Governor of the Bank of Japan, told you on the golf course that BOJ is planning to raise rates at its next session, you could go right ahead and buy as much yen as you like. No one will ever prosecute you for insider trading should your bet pay off. There is no such thing as insider trading in FX; in fact, European economic data, such as German employment figures, are often leaked days before they’re officially released.
Before we leave you with the impression that FX is the Wild West of finance, we should note that it’s the most liquid and fluid market in the world. It trades 24 hours a day, from 5pm EST Sunday to 4pm EST Friday, and it rarely has any gaps in price. Its sheer size (it trades nearly US$2 trillion each day) and scope (from Asia to Europe to North America) makes the currency market the most accessible market in the world.
You need to begin by making assumptions about the drug’s market potential. Look at information provided by the firm and market research reports in order to identify the size of the patient group that will use the drug. Analysts typically focus on market potential in the industrialized countries, where people will pay the market price for drugs.
When making assumptions about a drug’s potential market penetration, you are required to use your own best judgment. If there is a competitive drug market, with limited advantage provided by the new drug in the area of increased effectiveness or reduced side effects, the drug will probably not win substantial market share in its product category. You might consider that it will capture 10 percent of this total market, or even less. On the other hand, if no other drug addresses the same needs, you might assume the drug will enjoy market penetration of 50 per cent or more.
Investors who trade stocks, futures or options typically use a broker, who acts as an officer in the transaction. The broker takes the company’s order to an exchange and is trying to execute it according to the customer’s instructions. The broker is paid a commission when the customer buys and sells the tradable instrument, for providing this service.
The FX market doesn’t have commissions. FX is a principals-only market unlike exchange-based markets. FX firms are dealers, not brokers. This is a critical distinction that all investors must understand. Dealers assume market risk by serving as a counterparty to the investor’s trade unlike brokers. They don’t charge commission; instead, they make their money through the bid-ask spread.
In FX, the investor cannot attempt to buy on the bid or sell at the offer like in exchange-based markets. On the other hand, once the price clears the expense of the spread, there’s no additional fees or commissions. Every single penny gain is pure profit to the investor. Nevertheless, the fact that traders must always overcome the bid/ask spread makes scalping much more difficult in FX.
Pip stands for ‘percentage in point’ and is the lowest increment of trade in FX. In the FX market, prices are quoted to the 4th decimal point. For example, if a bar of soap in the drugstore was priced at $1.20, in the FX market the same bar of soap would be quoted at 1.2000. The change in that fourth decimal point is called 1 pip and is typically equal to 1/100th of 1%. Among the major currencies, the only exception to that rule is the Japanese yen. Because the Japanese yen has never been revalued since the Second World War, 1 yen is now worth approximately US$0.08 ; So, in the USD/JPY pair, the quotation is only taken out to two decimal points (I.e. To 1/100th of yen, as opposed to 1/1000th with other major currencies).
The short answer is ‘nothing’. The retail FX market is purely a speculative market. No physical exchange of currencies ever takes place. All trades exist simply as computer entries and are netted out depending on market price. All profits or losses are calculated in dollars and recorded as such on the trader’s account, for dollar-denominated accounts.
The primary reason the FX market exists is to assist in the exchange of one currency into another for multinational corporations who need to trade currencies continually (for example, for payroll, merger and acquisition activity), and payment for costs of the products and services from foreign vendors. However, these day-to-day corporate needs comprise only approximately 20 per cent of the market volume. Fully 80% of trades in the currency market are speculative in nature, put on by large financial institutions, multi-billion dollar hedge funds and even individuals who want to express their views on the economic and geopolitical events of the day.
Because currencies always trade in pairs, when a trader makes a trade he or she’s always long one currency and short the other. For example, if a trader sells one standard lot (equivalent to 100, 000 units) of EUR/USD, she would, in essence, have exchanged euros for dollars and would now be ‘short’ euro and ‘long’ dollars. To better understand this dynamic, let us use a concrete example. If you went into an electronics store and purchased a computer for $1, 000, what you’d be doing? You would be exchanging your dollars for a computer. You would basically be ‘short’ $1, 000 and ‘long’ 1 computer. The store would be ‘long’ $1, 000 but now ‘short’ 1 computer in its inventory. The exact same principle applies to the FX market, except that no physical exchange takes place. While all transactions are simply computer entries, the consequences are no less real.
These currency pairs, along with their various combinations (such as EUR/JPY, GBP/JPY and EUR/GBP) account for more than 95% of all speculative trading in FX. Given the small number of trading instruments-only 18 pairs and crosses are actively traded-the FX market is much more concentrated than the stock market.
Carry is the most popular trade in the currency market, practiced by both the largest hedge funds and the smallest retail speculators. The carry trade is based on the fact that every currency in the world has an interest rate attached to it. These short-term interest rates are established by the central banks of these states: the Federal Reserve in the U.S., the Bank of Japan in Japan and the Bank of England in the U.K.
The idea behind the carry is quite straightforward. The trader goes long the currency with a high interest rate and finances that purchase with a currency with a low interest rate. In 2005, one of the best pairings was the NZD/JPY cross. The New Zealand economy, spurred by huge commodity demand from China and a hot housing market, has seen its rates rise to 7.25% and stay there (at the time of writing), while Japanese rates have remained at 0%. A trader going long the NZD/JPY could have harvested 725 basis points in yield alone. On a 10:1 leverage basis, the carry trade in NZD/JPY could have produced a 72.5% annual return from interest rate differentials alone without any contribution from capital appreciation. Now you can understand that the carry trade is so popular! But before you rush out and buy the next high-yield pair, be aware of the fact that when the carry trade is unwound, the declines can be rapid and severe. This process is known as carry trade liquidation and occurs when most of the speculators decide that the carry trade may not have future potential. With every trader seeking to exit his or her position at once, bids disappear and the profits from interest rate differentials aren’t nearly enough to compensate for the capital losses. Anticipation is the key to success: the best time to position in the carry is at the beginning of the rate-tightening cycle, allowing the trader to ride the move as interest rate differentials increase.
Bernanke hoped to devalue the currency and provide market liquidity through both the national and foreign investment by lowering interest rates and creating price inflation. Once the real rate of interest was lower than the level of inflation, borrowing would be strongly encouraged as the value of the currency was falling more rapidly than the interest rate being charged.
The increased borrowing would stimulate business growth and the larger economy minimizing the deflationary impact of falling home prices. In theory, the lower interest rates would also be used to blunt the decrease in the housing prices as borrowers would again be able to finance large sums to support inflated prices.
The Ichimoku Kinko Hyo or equilibrium chart isolates higher probability trades in the forex market. It is new to the mainstream, but has been rising incrementally in popularity among novice and experienced traders. More known for its applications in the futures and equities forums, the Ichimoku displays a clearer picture because it shows more data points. These provide a more reliable price action. The application offers multiple tests and combines three indicators into one chart, allowing the trader to make the most informed decision. Learn how the Ichimoku works and how to add it to your own trading routine.
Before a trader can trade effectively on the chart, a basic knowledge of the components that make up the equilibrium chart need to be established. Created and revealed in 1968, the Ichimoku was developed in a way that is unlike most other technical indicators and chart applications. Usually formulated by statisticians or mathematicians in the industry, the indicator was constructed by a Tokyo newspaper writer named Goichi Hosoda and a small number of assistants running multiple calculations. What they came up with is now used by many Japanese trading rooms because it offers multiple tests on the price action, creating higher probability trades. Although many traders are intimidated by the wealth of lines drawn when the chart is actually applied, the components can be readily translated into more commonly accepted indicators.
Essentially made up of four major components, the application offers the trader key insight into FX market price action. First, we’ll take a look at both the Tenkan and Kijun Sens. Used as a moving average crossover, both lines are simple translations of the 20-and 50-day moving averages, although with slightly different time frames.
The Tenkan Sen-Calculated as the sum of the highest high and the lowest low divided by two. The Tenkan is calculated over the previous seven to eight time periods.
The Kijun Sen-Calculated as the sum of the highest high and the lowest low divided by two. Although the calculation is similar, the Kijun takes the past 22 time periods into account.
What the trader will want to do here is use the crossover to initiate the position-this is similar to a moving average crossover. Looking at our example in Figure 1, we see a clear crossover of the Tenkan Sen (black line) and the Kijun Sen (red line) at point X. This decline simply means that near-term prices are dipping below the longer term price trend, signaling a downtrending move lower.
Senkou Span A-The sum of the Tenkan Sen and the Kijun Sen divided by two. The calculation is then plotted 26 time periods ahead of the current price action.
Senkou Span B-The sum of the highest high and the lowest low divided by two. This calculation is taken over the last 44 time periods and is plotted 22 periods ahead.
Once plotted on the chart, the area between the two lines is known as the Kumo, or cloud. Comparatively thicker than your run-of-the-mill support and resistance lines, the cloud offers the trader a thorough filter. The thicker cloud will tend to adopt the volatility of the currency markets into account instead of giving the trader a visually thin price level for support and resistance. A break through the cloud and a subsequent move above or below it will suggest a better and more probable trade. Let’s take a look Figure 2’s comparison.
Taking our USD/CAD example, we see a comparable difference between the two. Although we see a clear support at 1.1522 in our more standard chart (Figure 2), we subsequently see a retest of the level. At this point, some trades probably will be stopped out as the price action comes back against the level. This is somewhat concerning for even the most advanced trader. However, in our Ichimoku example (Figure 3), the cloud is used as an excellent filter. Taking the volatility and apparent take back into account, the cloud suggests a better trade opportunity on a break of the 1.1450 figure. Here, the price action doesn’t trade back, keeping the trade in the overall downtrend momentum.
Last is the Chikou Span. Seen as simple market sentiment, the Chikou is calculated according to the most recent closing price and is plotted 22 periods behind the price action. This feature suggests the market’s sentiment by showing the prevailing trend as it is linked to current price momentum. The interpretation is simple: as sellers dominate the market, the Chikou span will hover below the price trend while the opposite occurs on the buy side. When a pair remains bid in the market or is bought up, the span will rise and hover above the price action.
There’s no better substitute for learning but through application, like everything else. Let’s break down the best method of trading the Ichimoku cloud technique.
Taking our U.S. dollar/Japanese yen example in Figure 4, we’ll zoom in on a more recent scenario in Figure 5. With the currency pair fluctuating in a range between 116 and 119 figures for the beginning of the year, traders were anxious to display a breakout of the persistent range. Here, the cloud is the result of the range-bound scenario compared to the first four months and stands as a significant support/resistance barrier. With that established, we look to the Tenkan and Kijun Sen. As mentioned before, these two serve as a moving average crossover with the Tenkan representing a more short-term moving average and the Kijun acting as the base line. As a result, the Tenkan dips below the Kijun, signaling a reduction in price action. However, with the crossover occurring within the cloud at Point A in Figure 5, the signal remains unclear and will require to be clear of the cloud before an entry can be considered. We can also confirm the bearish sentiment through the Chikou Span. These at this point remains below the price action. Conversely, if the Chikou was above the price action, it would confirm bullish sentiment. Putting it all together, we’re now in the search for a short position in our U.S. dollar/Japanese yen currency pair.
Because we’re equating the cloud to a support/resistance barrier, we will want a close of the session below the cloud before initiating any type of short sell position. We will be entering at Point B on our chart, as a result. Here, we have a confirmed break of the cloud as the price action stalls on a support level at 114.56. The trader, at this point, can opt to place the entry at the support figure of 114.56 Or place the order one point below the low of the session. Placing the order one point below would act as confirmation that the momentum is always in place for another move lower. Subsequently, we place the stop just above the high of the candle within the cloud formation. In this example, it’d be at Point C or 116.65. The price action shouldn’t trade above this price if the momentum remains. Therefore, we have an entry at 114.22 and a corresponding stop at 116.65, Leaving our risk out at 243 pips. In keeping with sound money management, the trade will have to get a minimum of a 1:1 risk/reward ratio with a preferable 2:1 risk/reward for legitimate opportunities. In our example, we will maintain a 2:1 risk/reward ratio as the price moves lower to hit a low of 108.96 before pulling back. This equates to roughly 500 pips and a 2:1 risk to reward-a profitable opportunity. One key note to remember: notice how the Ichimoku is applied to longer time frames, in this instance the daily. The application will tend not to work as well as with many technical indicators with the volatility in shorter time frames.
Refer To The Kijun / Tenkan Cross-The potential crossover in both lines will act in similar fashion to the more recognized moving average crossover. This technical occurrence is great for isolating moves in the price action.
Confirm Down / Uptrend With Chikou-Confirming that the market sentiment is in line with the crossover will increase the probability of the trade as it acts in similar fashion with a momentum oscillator.
Price Action Should Break Through The Cloud-The impending down/uptrend should make a clear break through of the cloud of resistance/support. This decision will increase the probability of the trade are employed in the trader’s favor.
Follow Money Management When Placing Entries-By adhering to strict money management rules, the trader will be able to balance risk/reward ratios and control the position.
Intimidating at first, once the Ichimoku chart is broken down, every trader from novice to advanced will find the application helpful. Not only does it mesh three indicators into one, but it also provides a more filtered approach to the price action for the currency trader. Additionally, this approach won’t only increase the probability of the trade in the FX markets, but will assist in isolating only the true momentum plays. This is opposed to riskier trades where the position has a chance of trading back former profits.
According to an April 2004 report by the Bank for International Settlements, the foreign exchange market has an average daily volume of close to $2, 000 billion, making it the largest market in the world. The FX market isn’t a centralized market unlike most other exchanges such as the New York Stock Exchange or the Chicago Board of Trade. In a centralized market, each transaction is recorded by price dealt and volume traded. There is normally one central place back to which all trades can be traced and there’s often one specialist or market maker. The currency market, however, is a decentralized market. There is not one ‘exchange’ where every trade is recorded. Instead, each market maker records his or her own transactions and keeps it as proprietary information. The primary market makers who make bid and ask spreads in the currency market are the largest banks in the world. They deal with each other constantly either on behalf of themselves or their customers. This is why the market on which banks conduct transactions is known as the interbank market.
The competition between banks ensures tight spreads and fair pricing. This is the origin of price quotes and is where forex brokers offset their positions, for individual investors. Most individuals are not able to access the pricing available on the interbank market because the customers at the interbank desks tend to place the largest mutual and hedge funds in the world as well as large multinational corporations who’ve millions (if not billions) of dollars. Despite this, it is important for individual investors to figure out how the interbank market works, as it is one the best ways to understand how retail spreads are priced, and to determine whether you’re getting fair pricing from your broker. Read on to learn how this market works and how its inner workings can affect your investments.
Trading in a decentralized market has its benefits and disadvantages. In a centralized market, you have the advantage of seeing volume in the market as a whole however, at the same time, prices can easily be skewed to reflect the interests of the specialist and not the trader. The international character of the interbank market can make it difficult to regulate, however, with such important players in the market, self-regulation is sometimes even more effective than government regulations. A forex broker must be registered with the Commodity Futures Trading Commission as a futures commission merchant and constitute a member of the National Futures Association (NFA), for the individual investor. The CFTC regulates the broker and ensures that he or she meets strict financial standards.
73% of total forex volume is done through 10 banks according to the’ Wall Street Journal Europe’ (February 2006). These banks are the brand names that we all know well, including Deutsche Bank, UBS, Citigroup and HSBC. Each bank is structured differently but most banks will play a separate group known as the Foreign Exchange Sales and Trading Department. This group is responsible for making prices for the bank’s clients and for offsetting that risk with other banks. There is a sales and a trading desk within the Foreign Exchange group. The sales desk is generally responsible for having taken the orders from the client, getting a quote from the spot trader and relaying the quote to the client to determine if they want to deal on it. This three-step process is quite common because even though online foreign exchange trading is available, much of the large clients who deal anywhere from $10 million to $100 million at a time (cash on cash), think they can get better pricing dealing over the phone than over the trading platform. This is because most platforms offered by banks will have a trading size limit because the dealer wants to make sure that it’s able to counter the risk.
There are generally one or two market makers responsible for each currency pair, on a foreign exchange spot trading desk. That is, for the EUR/USD, there is just one primary dealer that will give quotes on the currency. He or she may have a secondary dealer that gives quotes on a smaller transaction size. This setup is mostly true for the four majors where the dealers see a lot of activity. For the commodity currencies, there may be one dealer responsible for all three commodity currencies or, depending upon how much volume the bank sees, there may be two dealers. This is important because the bank wants to make sure that each dealer knows its currency well and understands the behaviour of the other players in the market. Usually, the Australian dollar dealer is also responsible for the New Zealand dollar and there is usually a separate dealer making quotes for the Canadian dollar. There usually is not a ‘crosses’ dealer-the primary dealer responsible for the most liquid currency will make the quote. The Japanese yen trader will make quotes on all yen crosses, for example. Finally, there is one additional dealer that is responsible for the exotic currencies such as the Mexican peso and the South African rand. This setup is mimicked usually across three trading centers-London, New York and Tokyo. Each center passes the client orders and positions to another trading center at the expiration of the day to ensure that client orders are watched 24 hours a day.
Bank dealers will determine their prices based upon a number of factors including, their inventory positions, and the current market rate, how much volume is available at the current price level, their views on where the currency pair is headed. If they believe that the euro is headed higher, they may be willing to provide a more competitive rate for clients who wish to sell euros because they believe that once they’re given the euros, they can hold onto them for a few pips and offset at a better price. On the flip side, if they believe that the euro is headed lower and the client is giving them euros, they may offer a lower price because they’re not sure if they can sell the euro back to the market during the same level at which time it was given to them. This is something that is unique to market makers that don’t offer a fixed spread.
Similar to the way we see prices on an electronic forex broker’s platform, there are two primary platforms that interbank traders use: the first is offered by Reuters Dealing and the other is offered by the Electronic Brokerage Service (EBS). The interbank market is a credit-approved system in which banks trade based only on the credit relationships they have established with one another. All of the banks can see the best market rates currently available; however, each bank must have a special credit relationship with another bank, with a view to trade at the rates being offered. The bigger the banks, the more credit relationships they can have and the better pricing they’ll be able access. The same is true for clients such as retail forex brokers. The larger the retail forex broker in terms of capital available, the more favorable pricing it can get from the interbank market. If a client or even a bank is small, it is limited to dealing with only a select number of larger banks and seeks to get less favorable pricing.
Cross currency pairs are generally not quoted on either platform, but are prepared based on the rates of the major currency pairs and then offset through the legs. For example, if an interbank trader had a client who wished to go long EUR/CAD, the trader would most likely buy EUR/USD over the EBS system and buy USD/CAD over the Reuters platform. The trader then would multiply these rates and provide the client with the respective EUR/CAD rate. The two-currency-pair transaction is the reason why the spread for currency crosses, such as the EUR/CAD, tends to be wider than the spread for the EUR/USD.
The minimum transaction size of each unit that can be dealt on either platforms tends to one million of the base currency. The average one-ticket transaction size tends to five million of the base currency. This is why individual investors cannot access the interbank market-what would represent an extremely large trading amount (remember this is unleveraged) is the bare minimum quote that banks are prepared to give-and this is just for clients that trade usually between $10 million and $100 million and just need to clear up some loose change on their books.
Individual clients then rely on online market makers for pricing. The forex brokers use their own capital to gain credit with the banks that trade on the interbank market. The more well capitalized the market makers, the more credit relationships they can establish and the more competitive pricing they can access for themselves as well as their clients. This also means that when markets are volatile, the banks are more obligated to express their good clients continuously competitive pricing. Therefore, if a forex retail broker isn’t well capitalized, how they can access more competitive pricing than a well capitalized market maker remains questionable. The structure of the market makes it extremely difficult for this to become the case. It is extremely important for individual investors to do extensive due diligence on the forex broker with which they decide to trade, as a result.
The forex market is the most leveraged financial market in the world. In equities, standard margin is set at 2:1. This means that a trader must put up at least $50 cash to control $100 worth of stock. In options, the leverage increases to 10:1, with $10 controlling $100. In the futures markets, the leverage factor is increased to 20:1. For example, in a Dow Jones futures e-mini contract, a trader only needs $2, 500 to control $50, 000 worth of stock. However, none of these markets approaches the intensity of the forex market, where the default leverage at most dealers is set at 100:1 and can rise up to 200:1. That means that a mere $50 can control up to $10, 000 worth of currency. Why is this important? First and foremost, the high degree of leverage can make FX either extremely lucrative or extraordinarily dangerous, depending on which side of the trade you’re on. In FX, retail traders can literally double their accounts overnight or lose it all in the space of a few hours if they employ the full margin at their disposal, although most professional traders limit their leverage to no more than 10:1 and never assume such enormous risk. But regardless of whether they trade on 200:1 leverage or 2:1 leverage, most everyone in FX trades with stops. In this article, you will learn how to use stops to set up the ‘stop hunting with the big specs’ strategy.
Precisely because the forex market is so leveraged, most market players understand that stops are critical to long-term survival. The notion of ‘waiting it out ‘, as some equity investors might do, simply doesn’t exist for most forex traders. Trading without stops in the currency market meant that the trader will inevitably face forced liquidation in the shape of a margin call. With the exception of some long-term investors who may trade on a cash basis, a large portion of forex market participants are thought to be speculators, therefore, they simply don’t have the luxury of nursing a losing trade for too long because their positions are highly leveraged.
Because of this unusual duality of the FX market (high leverage and almost universal use of stops), stop hunting is a most common practice. Although it may have negative connotations to some readers, stop hunting is a legitimate form of trading. It is no more than the art of flushing the losing players outside of the market. In forex-speak they’re known as weak longs or weak shorts. Much like a strong poker player may take out less capable opponents by raising stakes and ‘buying the pot ‘, large speculative players (like investment banks, money center banks), and hedge funds like to gun stops in the hope of generating further directional momentum. In fact, the practice is so common in FX that any trader unaware of these price dynamics will probably suffer unnecessary losses.
Because the human mind naturally seeks order, most stops are clustered around round numbers ending in ’00’. For example, if the EUR/USD pair was trading at 1.2470 and rising in value, most stops would reside within one or two points of the 1.2500 price point rather than, say, 1.2517. This fact alone is valuable knowledge, as it clearly indicates that most retail traders should place their stops at less crowded and more unusual locations.
More interesting, however, is the opportunity of profit from this unique dynamic of the currency market. The fact that the FX market is so stop driven gives scope to several opportunistic setups for short-term traders. In her book ‘Day Trading The Currency Market’ (2005), Kathy Lien describes one such setup based on fading the ’00’ level. The approach discussed here is founded on the opposite notion of accession to the short-term momentum.
The ‘stop hunting with the big specs’ is an exceedingly simple setup, requiring no more than a price chart and one indicator. Here is the setup in a word: On a one-hour chart, mark lines 15 points of either side of the cycle number. For example, if the EUR/USD is approaching the 1.2500 figure, the trader would mark off 1.2485 and 1.2515 on the chart. This 30-point area is referred to as the ‘trade zone ‘, much like the 20-yard line on the football field is referred to as the ‘redzone’. Both names communicate the same idea-namely that the participants have a high probability of scoring once they enter that area.
The idea behind this setup is straightforward. Once prices approach the round-number level, speculators will try to target the stops clustered in that region. Because FX is a decentralized market, no one does the exact amount of stops at any particular ’00’ level, but traders hope that the size is large enough to trigger further liquidation of positions-a cascade of stop orders that will push price farther in that direction than it would move under normal conditions. Therefore, in the case of long setup, if the price in the EUR/USD was climbing toward the 1.2500 level, the trader would go long the pair with two units as soon as it crossed the 1.2485 threshold. The stop on the trade would be 15 points back of the entry as it is a strict momentum trade. If prices don’t immediately follow through, chances are the setup failed. The profit target with regard to the first unit would represent the amount of initial risk or approximately 1.2500, at which point the trader would move the stop on the second unit to breakeven to lock in profit. The target on the second unit would be two times initial risk or 1.2515, allowing the trader to exit on a momentum burst. There is only one other rule that a trader must follow in order to optimise the probability of success aside from watching these key chart levels. Because this setup is basically a derivative of momentum trading, it should be traded solely in the direction of the larger trend. There are numerous ways to ascertain direction using technical analysis. However, the 200-period simple moving average (SMA) on the hourly charts may be particularly effective in this case. You can remain on the right side of the price action without being subject to near-term whipsaw moves by using a longer term average on the short-term charts.
The ‘stop hunt with the big specs’ represents one of the simplest and most efficient FX setups available to short-term traders. It requires no more than focus and a basic understanding of currency market dynamics. Instead of being victims of stop hunting expeditions, retail traders can finally turn the tables and join the move with the big players, banking short-term profits in the process.
Prices at the upper Bollinger band are considered high and prices at the lower Bollinger band are considered low. However, just because prices have hit the upper Bollinger doesn’t necessarily mean that it’s a good time to sell. Strong trends will ‘ride’ these bands and wipe out any trader attempting to buy the ‘low’ prices in a downtrend or sell the ‘high’ prices in an uptrend. Therefore, just buying at the lower band and merchandising at the upper band is beyond the question. By definition, price makes new highs in an uptrend and new lows in a downtrend. This means that they’ll naturally be hitting the bands. Our filter will require that buy signals occur that, if the candle following the one that hits the Bollinger band doesn’t make a new high or low with this information in mind. This type of candle is commonly referred to as an inside day. The best time frames to look for the inside days are daily charts, but this strategy can also be used on hourly, weekly and monthly charts. Combining inside days with Bollinger bands increases the possibility that we’re only picking a top or bottom after prices have hit extreme levels. As a rule of thumb, the longer the time frame, the rarer the trade will be, but the signal will also be more significant.
Candlesticks and their respective patterns illustrate the psychology of the market at a given point in time. Specifically, the inside candle represents a period of contracted volatility. If, in an uptrend, volatility begins to slow and the market fails to make a new high (as shown by the inside candle), then we can deduce that strength is waning and that the chance for a reversal exists. When combined with a Bollinger band, we ensure that we’re trading a reversal only by either selling high prices (higher Bollinger band) are buying low prices (lower Bollinger band). In this way, we trade for the big move; not necessarily selling the low tick or buying the bottom tick but definitely buying near the relative bottom and selling near the relative top. The key is confirmation.
Since Bollinger bands typically use a length of 20, we can employ a 20-period simple moving average (SMA) as a target to take profit. The 20 period SMA will trade equidistant from the upper and lower Bollinger bands. To catch large moves, allow the pair to trade through the 20-period SMA and then trail your stop with the moving average, only closing trades on the close after the pair crosses the SMA again. The examples below will shed light on this process.
We have four guidelines. We’ll call these guidelines (rather than rules) as it is a strategy that involves discretion. The guidelines present a trade setup that may or may not result in a trade.
Wait for next candle and make sure that the next candle’s low is greater than or equal to the previous candle’s low and that the high is also lower than or equal to the previous period’s high. If so, go long at the open of the third candle.
Wait for next candle and make sure that the next candle’s high is lower than or equal to the previous candle’s high and that the low is also greater than or equal to the previous period’s low. If so, go short at the open of the third candle.
There are many benefits to the inside day Bollinger band strategy. The most obvious is its simplicity. Creating a trading strategy isn’t rocket science. However, those that treat it as such usually end up disappointed and confused and-worse still-with a losing trading record. We can easily measure risk with this strategy and place stops appropriately. In other words, we have distinct points of reference (the inside day’s high and low) from which to go into the trade and place stops. The setup is dynamic, meaning that it works on all time frames. Even a short-term day trader could use it on an hourly chart. However, the shorter the time frame, the less reliable the signal. Remember that candlesticks and their patterns shine light on the psychology of the market. An hourly chart encompasses a smaller amount of market data than a daily chart. An hourly chart isn’t as true an idea of mass psychology as a daily chart, as a result.
This setup is just that-a setup. The trade should be managed according to your risk parameters and your trading style. Some may prefer to sell on a retrace after a short signal occurs, while others may prefer to sell a break of a daily low after a short signal. As we mentioned above, alter the size of the trade and the exit strategy. For example, trade multiple lots (if account size permits) and take profit on one lot at the 20 SMA, take profit on another lot at the opposite Bollinger band, and trail another lot (s) with the 20 SMA. Regardless of how you decide to implement this strategy, keep in mind that the FX market is an extremely trending market. This makes it even more important for range traders to get confirmation before attempting to pick tops and bottoms. Combining inside days with Bollinger bands is a simple way of waiting for confirmation before taking the trade.
Almost everyone who has ever traded has scaled down into a trade at least once during his or her career. This very common mistake arises from the need to be proved right. The thinking usually goes like this: if you liked the EUR/USD long at 1.2000, you will love it even better at 1.1900-it is a better bargain! Of course, the market eventually teaches all traders the folly of such thought. There are situations in which markets simply don’t turn around. Profits accumulated through years of trading can disappear within days. Follow the scale down strategy long enough. You’ll eventually go broke. Scaling down can be a valid strategy, but only when it is practiced with inviolable discipline-which, regrettably, most traders don’t possess. Far rarer than the scaling down strategy, yet potentially far more lucrative, is its exact opposite-scaling up. Among traders, scaling up is also recognized as ‘pressing the trade’. In this article, we’ll explain the strategy of scaling up, show you an example of how it works and discuss the risks that came with this approach.
The idea of scaling up into a trade is relatively straightforward. The trader would only add as the position becomes increasingly profitable instead of adding to a position as it moves against him or her. For example, if a trader went long EUR/USD at 1.2000, he would only add to his trade if the currency pair moved to 1.2200. This appears to be an eminently reasonable course of action, on the surface. It is what Dennis Gartman-investing guru and writer of the famous daily stock market newsletter’ The Gartman Letter’-refers to as ‘doing more of what’s working and less of what isn’t’.
So, why do so many traders employ scaling down strategies, while so few traders engage in scaling up trades? The key reason may be our innate predilection for bargain hunting. It is said that real New Yorkers never pay retail. And it is indeed true that many denizens of Wall Street will ruthlessly search out the best deals for anything from a cup of street vendor’s coffee to a designer suit. However, this trait is as common among farmers in Happy, Texas as it is among investment bankers in Manhattan. Most people hate to ‘pay up’. that’s the reason why they will not ‘scale up’ into trades.
Nevertheless, scaling up can be an extremely profitable endeavor. Here is a description taken from the Elite Trader bulletin board about how a very famous pit trader, Richard Dennis, employed just such a strategy with bond futures.
One trade, $100 million dollars in profit. While most of us can never aim to success on such an enormous scale, the profit opportunities for scale up trades present themselves to retail FX traders on a regular basis. Let’s take a look at the recent price action in the USD/JPY pair for a good example of this strategy in action.
If you’re a trader, you may be thinking at this point that scaling up seems like a pretty good way to make a tidy profit. But before you rush to initiate scale up trade strategies, it is critical that you understand the drawbacks. While the scale up trade may indeed be very lucrative, it is also very rare. There is a reason why, in the quote about Richard Dennis, the person posting refers to the trade as a ‘5 percenter’. Scale up trades are in fact successful only 5 percent of the time, if not less.
In order to work, scale up trades require two key ingredients: a propitious entry that becomes profitable almost from the beginning of the trade and a strong uninterrupted trend with virtually no retraces along the way. The description of the scale up strategy as ‘pressing the trade’ is actually very apropos, because the trader is in fact pushing the position further and further as price action moves his or her way. Imagine a situation in which the USD/JPY trade didn’t go as smoothly as shown, but instead retraced back to 113.50 After the third unit was sold short at 111.50. The trader would then have to meet the position at breakeven, faced with the awareness that a guaranteed profit of 600 points disappeared instantly as the scale up trade went awry. Unfortunately, this type of price action happens more frequently than not, as the strategy of ‘pressing the trade’ often presses back on the trader.
The scale up trade can be an invaluable strategy, for traders capable of withstanding the psychological pressure of losing massive open profits to the whims of the market. Clearly, it has produced some of the major trading successes in the story of the financial markets, but anyone who attempts this approach must prepare for many moments of failure and frustration. Imagine that you have worked on a complex jigsaw puzzle for a few weeks and are in a matter of a few pieces of finishing it, when someone intentionally comes by and scrambles all the pieces. If you can accept such turns of events with quietude and calmly begin the assembly process once again, then the scale up trade may be right for you.
If you are interested in getting into the forex market, there is one relationship of which you ought to be aware before you even start trading. This is the relationship between the euro and the Swiss franc currency pairs-a correlation too strong to be ignored. In the article Using Currency Correlations To Your Advantage, we note that the correlation between these two currency pairs can be upwards of negative 95%. This is known as an inverse relationship, which means that-generally speaking-when the EUR/USD (euro/U.S. Dollar) rallies, the USD/CHF (U.S. Dollar/Swiss franc) sells off the bulk of the time and vice versa. When you are dealing with two separate and distinct financial instruments, a 95% correlation is as close to perfection as you can hope for. In this article we explain what causes this relationship, what it means for trading, how the correlation differs on an intraday basis and when such a strong relationship can decouple. Read on and you will also discover why, contrary to popular belief, arbitraging the two currencies to earn the interest rate differential doesn’t work.
In the article Using Currency Correlations To Your Advantage, we see that, during the long term (one year) most currencies that trade against the U.S. dollar have an above 50% correlation. This is the case because the U.S. dollar is a dominant currency that is involved in 90 per cent of all currency transactions. Furthermore, the U.S. economy is the largest in the world, which means that its health has an effect on the health of many other nations. Although the strong relationship between the EUR/USD and USD/CHF is partly due to the common dollar factor in the two currency pairs, the fact that the relationship is far stronger than that of other currency pairs comes from the close ties between the eurozone and Switzerland.
Switzerland has very close political and economic ties with its larger neighbors, as a country surrounded by other members of the eurozone. The close economic relationship began with the free trade agreement established back in 1972 and was then followed by more than 100 bilateral agreements. These agreements have enabled the free flow of Swiss citizens into the hands of the European Union (EU) and the gradual opening of the Swiss labor market to citizens of the EU. In fact, 20% of the Swiss workforce now comes from EU member states. But the ties don’t end there. Sixty percent of Swiss exports are destined for the EU, while 80 percent of the imports come from the EU. The two economies are very intimately linked, especially since exports account for more than 40 percent of Swiss GDP. Therefore, if the eurozone contracts, Switzerland will feel the ripple effects.
Nevertheless, with such strong correlation, you’ll often hear novice traders say that they are able to hedge one currency pair with the other and capture the pure interest spread. What they’re talking about is the interest rate differential between the two currency pairs. At the time of writing (May 2006), the EUR/USD had an interest rate spread of negative 2.50 %, with the eurozone yielding 2.50% and the U.S. yielding 5%. This meant that if you were long the EUR, you would earn 2.50% interest per year, while paying 5% interest on the U.S. dollar short. By contrast, the interest rate spread between the U.S. dollar and the Swiss franc, which yields 1.25 %, is positive 3.75%. As a result, many new traders will ask why they cannot just go long the EUR/USD and pay 2.50% interest and long USD/CHF to earn 3.75% interest-netting a neat 1.25% interest with zero risk. This may appear to be a lot of work to you for a mere 1.25 %, but bear in mind that extreme leverage in the FX market can in some instances, be upwards of 100 times capital-therefore, even a conservative 10 times capital turns the 1.25% to 12.5% per year.
The general idea is that leverage is risky, but in this case, novices will argue that it isn’t because you’re perfectly hedged! Unfortunately, there is no free lunch in any market, so even though it may seem like this may work out, it doesn’t. The key lies in the differing pip values between the two currency pairs and the fact that just because the EUR/USD moves one point, that doesn’t mean that USD/CHF will move one point too.
The EUR/USD and USD/CHF have different point or pip values. This means that each tick in each currency is worth different dollar amounts. The EUR/USD has a point value of US$10 [ ((.0001/1.2795) X 100, 000) x 1.2795 ], while USD/CHF has a pip value of $8.20 [ (.0001/1.2195) X 100, 000]. Therefore, when these two pairs move in opposite directions, they’re not necessarily doing so to the same degree. The best way to get rid of the misconceptions that some traders may have about possible arbitrage opportunities is to look at examples of monthly returns for the 12 months of 2005.
Some may argue that you need to neutralize the U.S. dollar exposure in order to properly hedge. So we run the same scenario and hedge the USD/CHF by the dollar equivalent amount for a euro each month. We do this by multiplying the USD/CHF return by the EUR/USD rate at the beginning of each month. This means that if one euro is equal to US$1.14 At the beginning of the month, we hedge by buying US$1.14 Against the Swiss franc.
The relationship between the EUR/USD and USD/CHF decouples when there are divergent political or monetary policies. For example, if elections bring on uncertainty in Europe while Switzerland chugs merrily along, the EUR/USD might slide further in value than the USD/CHF rallies. Conversely, if the eurozone raises interest rates aggressively and Switzerland does n’t, the EUR/USD might appreciate more in value than the USD/CHF slides. Basically, the fact that ranges of the two currencies can vary more or fewer than the point difference, as shown in Figure 8, is the primary reason why interest rate arbitrage in the FX market using these two currency pairs doesn’t work. The ratio of the range is produced by cutting the USD/CHF range by the EUR/USD range.
While technical analysis is critical to currency trading-especially for pinpointing entries and exits-it is insufficient on its own for the establishment of a comprehensive trading game plan. Market sentiment in FX is driven mainly by the economic and geopolitical news of the day. The key players in the currency market-Fortune 500 multinationals, the world’s central banks, multibillion-dollar hedge funds and the top tier investment banks that service them-don’t care if there’s a double top in the EUR/JPY on the hourly candles. Instead, they formulate their trades by analyzing the most recent economic news and geopolitical developments, as same as the latest pronouncements from G-7 monetary authorities. Therefore, the proper approach to FX trading can be summarised as follows: trigger fundamentally, enter and exit technically.
Popular wisdom in the market states that traders who wish to trade fundamentally should choose a longer time frame involving daily, or even weekly, charts. Those traders who wish to trade more short term (hourly charts, for example) should focus strictly on technical setups. This bit of advice could not be more wrong, as with so much conventional wisdom in FX. For the application of this article, we define scalping in FX as using short-term time frames (usually hourly charts or smaller) to make trades with targets and stops approximately 20-30 points in length. Not only is it possible to scalp FX fundamentally, but retail traders actually have a significant advantage over larger market players when it is a question of executing their trades.
Not only is the issuance of the present data planned well in advance, but it is further reported instantaneously through a series of news outlets including Bloomberg, Reuters, Dow Jones and CNBC, making it universally accessible. There’s no need for traders to know about a secret contract that Intel may have negotiated, or the super-cool new product that a firm like Apple just prototyped at its labs in Cupertino, California. In FX, headline economic data really does move markets, and currency traders can take advantage of that fact. More importantly, individual traders often have a decided advantage in reacting to the news more rapidly than the larger corporate and hedge fund players.