Forex | Forex Trading | Currency Trading

9 Tricks Of The Successful Trader

2009-07-12T00:23:00.000-07:00

by Selwyn Gishen

For all of its numbers, charts and ratios, trading is more art than science. And just as in artistic endeavors, there is talent involved, but talent will only take you so far. The best traders hone their skills through practice and discipline. They perform self analysis to see what drives their trades and learn how to keep fear and greed out of the equation. In this article we'll look at nine steps a novice trader can use to perfect his or her craft; for the experts out there, you might just find some tips that will help you make smarter, more profitable trades, too.

Step 1. Define your goals and then choose a style of trading that is compatible with those goals. Be sure your personality is a match for the style of trading you choose.

Before you set out on any journey, it is imperative that you have some idea of where your destination is and how you will get there. Consequently, it is imperative that you have clear goals in mind as to what you would like to achieve; you then have to be sure that your trading method is capable of achieving these goals. Each type of trading style requires a different approach and each style has a different risk profile, which requires a different attitude and approach to trade successfully. For example, if you cannot stomach going to sleep with an open position in the market then you might consider day trading. On the other hand, if you have funds that you think will benefit from the appreciation of a trade over a period of some months, then a position trader is what you want to consider becoming. But no matter what style of trading you choose, be sure that your personality fits the style of trading you undertake. A personality mismatch will lead to stress and certain losses.

Step 2. Choose a broker with whom you feel comfortable but also one who offers a trading platform that is appropriate for your style of trading.

It is important to choose a broker who offers a trading platform that will allow you to do the analysis you require. Choosing a reputable broker is of paramount importance and spending time researching the differences between brokers will be very helpful. You must know each broker's policies and how he or she goes about making a market. For example, trading in the over-the-counter market or spot market is different from trading the exchange-driven markets. In choosing a broker, it is important to read the broker documentation. Know your broker's policies. Also make sure that your broker's trading platform is suitable for the analysis you want to do. For example, if you like to trade off of Fibonacci numbers, be sure the broker's platform can draw Fibonacci lines. A good broker with a poor platform, or a good platform with a poor broker, can be a problem. Make sure you get the best of both.

Step 3. Choose a methodology and then be consistent in its application.

Before you enter any market as a trader, you need to have some idea of how you will make decisions to execute your trades. You must know what information you will need in order to make the appropriate decision about whether to enter or exit a trade. Some people choose to look at the underlying fundamentals of the company or economy, and then use a chart to determine the best time to execute the trade. Others use technical analysis; as a result they will only use charts to time a trade. Remember that fundamentals drive the trend in the long term, whereas chart patterns may offer trading opportunities in the short term. Whichever methodology you choose, remember to be consistent. And be sure your methodology is adaptive. Your system should keep up with the changing dynamics of a market.

Step 4. Choose a longer time frame for direction analysis and a shorter time frame to time entry or exit.

Many traders get confused because of conflicting information that occurs when looking at charts in different time frames. What shows up as a buying opportunity on a weekly chart could, in fact, show up as a sell signal on an intraday chart. Therefore, if you are taking your basic trading direction from a weekly chart and using a daily chart to time entry, be sure to synchronize the two. In other words, if the weekly chart is giving you a buy signal, wait until the daily chart also confirms a buy signal. Keep your timing in sync.

Step 5. Calculate your expectancy.

Expectancy is the formula you use to determine how reliable your system is. You should go back in time and measure all your trades that were winners, versus all your trades that were losers. Then determine how profitable your winning trades were versus how much your losing trades lost.

Take a look at your last 10 trades. If you haven't made actual trades yet, go back on your chart to where your system would have indicated that you should enter and exit a trade. Determine if you would have made a profit or a loss. Write these results down. Total all your winning trades and divide the answer by the number of winning trades you made. Here is the formula:

E= [1+ (W/L)] x P – 1

where:

W = Average Winning Trade
L = Average Losing Trade
P = Percentage Win Ratio

Example:
If you made 10 trades and six of them were winning trades and four were losing trades, your percentage win ratio would be 6/10 or 60%. If your six trades made $2,400, then your average win would be $2,400/6 = $400. If your losses were $1,200, then your average loss would be $1,200/4 = $300. Apply these results to the formula and you get; E= [1+ (400/300)] x 0.6 - 1 = 0.40 or 40%. A positive 40% expectancy means that your system will return you 40 cents per dollar over the long term.

Step 6. Focus on your trades and learn to love small losses.

Once you have funded your account, the most important thing to remember is that your money is at risk. Therefore, your money should not be needed for living or to pay bills etc. Consider your trading money as if it were vacation money. Once the vacation is over your money is spent. Have the same attitude toward trading. This will psychologically prepare you to accept small losses, which is key to managing your risk. By focusing on your trades and accepting small losses rather than constantly counting your equity, you will be much more successful.

Secondly, only leverage your trades to a maximum risk of 2% of your total funds. In other words, if you have $10,000 in your trading account, never let any trade lose more than 2% of the account value, or $200. If your stops are farther away than 2% of your account, trade shorter time frames or decrease the leverage.

Step 7. Build positive feedback loops.

A positive feedback loop is created as a result of a well-executed trade in accordance with your plan. When you plan a trade and then execute it well, you form a positive feedback pattern. Success breeds success, which in turn breeds confidence - especially if the trade is profitable. Even if you take a small loss but do so in accordance with a planned trade, then you will be building a positive feedback loop.

Step 8. Perform weekend analysis.

It is always good to prepare in advance. On the weekend, when the markets are closed, study weekly charts to look for patterns or news that could affect your trade. Perhaps a pattern is making a double top and the pundits and the news is suggesting a market reversal. This is a kind of reflexivity where the pattern could be prompting the pundits while the pundits are reinforcing the pattern. Or the pundits may be telling you that the market is about to explode. Perhaps these are pundits hoping to lure you into the market so that they can sell their positions on increased liquidity. These are the kinds of actions to look for to help you formulate your upcoming trading week. In the cool light of objectivity, you will make your best plans. Wait for your setups and learn to be patient.

If the market does not reach your point of entry, learn to sit on your hands. You might have to wait for the opportunity longer than you anticipated. If you miss a trade, remember that there will always be another. If you have patience and discipline you can become a good trader.

Step 9. Keep a printed record.

Keeping a printed record is one of the best learning tools a trader can have. Print out a chart and list all the reasons for the trade, including the fundamentals that sway your decisions. Mark the chart with your entry and your exit points. Make any relevant comments on the chart. File this record so you can refer to it over and over again. Note the emotional reasons for taking action. Did you panic? Were you too greedy? Were you full of anxiety? Note all these feelings on your record. It is only when you can objectify your trades that you will develop the mental control and discipline to execute according to your system instead of your habits.

Bottom Line

The steps above will lead you to a structured approach to trading and in return should help you become a more refined trader. Trading is an art and the only way to become increasingly proficient is through consistent and disciplined practice. Remember the expression: the harder you practice the luckier you'll get.

The Pure Fade Trade

2009-07-12T00:11:00.000-07:00

by Kathy Lien

Everyone wants to be the hero and claim that he or she picked the very top or bottom of a currency pair. However, aside from bragging rights, is there really anything that pleasant about repeatedly selling at every new high in the hope that this one will finally be the top?

One of the biggest pitfalls encountered by novice traders is arbitrarily picking a top or bottom with no indicator support. The pure fade trade is an intraday strategy that picks a top or bottom based on a clear recovery following an extreme move. Here we'll cover this strategy and show you how you can put it to use.

Overview

The strategy looks for an intraday reversal by using a combination of three sets of Bollinger bands and the relative strength index (RSI) on hourly charts. The trade sets up when the RSI hits either an overbought or oversold level. Overbought is defined as an RSI above 70, while oversold is defined as an RSI below 30. This signals that we can start looking for a possible reversal.

However, rather than just immediately buying in the top of a trend reversal based solely upon RSI, we add in three sets of Bollinger bands to help us identify the point of exhaustion. The reason we use three sets of Bollinger bands is because it helps us to gauge the extremity of the move along with the extent of the possible recovery.

Created in the 1980s by John Bollinger, the Bollinger bands strategy was originally based on two standard deviations (SD) above and below the 20-day moving average. The theory was then to buy or sell when the prices hit the Bollinger band because using two standard deviations ensures that 95% of the price action will fall between the two bands.

In our strategy, we add on a third standard deviation Bollinger band. When prices hit the third band on any side, we know that the move is within the 5% minority, which characterizes the move as "extreme". When we move away from the third standard deviation Bollinger band and into the zone between the first and second standard deviation Bollinger bands, we know that the currency pair has hit its extreme point at the moment and is moving into reversal phase. Finally, one last thing that we look for is for at least one candle to close fully between the second and first standard deviation bands. This last rule helps to screen out fake moves and ensures that the previous move is really an exhaustion. This is a low-risk, low-return trade for those who simply want to scalp the market for small profits. Only hourly charts are recommended for the strategy.

Rules for a Long Trade

Look for the relative strength index to be lower than 30.
Watch for the price to hit the three standard deviation Bollinger band (SD BB).
Wait for the candle to move from the 3SD-2SD BB zone into the 2SD-1SD BB zone on hourly charts.
After one candle closes fully within the 2SD-1SD BB zone, buy at market.
Place a stop at swing low minus 10 pips.
The first target for half of the position is the amount risked; move the stop to breakeven.
The second target is the tag of the second SD BB on the topside.

Rules for a Short Trade

Look for the relative strength index to be greater than 70.
Watch for the price to hit the three standard deviation Bollinger band (SD BB).
Wait for the candle to move from the 3SD-2SD BB zone into the 2SD-1SD BB zone on hourly charts.
After one candle closes fully within the 2SD-1SD BB zone, sell at market price.
Place stop at swing high plus 10 pips.
The first target for half of the position is the amount risked; move the stop to breakeven.
The second target is the tag of the second SD BB on the downside.

The Fade Trade in Action

Let's explore some examples:

The first example is the EUR/USD from February 22, 2006 (Figure 1). The currency pair started breaking down shortly after the London open and hit our radar screen when we saw RSI dip below 30, around 6am EST. We checked the Bollinger bands and saw that the price also hit our third standard deviation band at that time and was trading between the third and second standard deviation Bollinger bands.

We watched closely for a full close within the second and first standard deviation Bollinger bands, at which time we bought at market. Our trade was triggered at 9am EST, and we entered into a long position at 1.1884. We immediately placed our stop at the swing low of 1.1862, risking 22 pips on the trade.

Figure 1: Pure Fade, EUR/US

Source: FXtrek Intellichart

Because our first take-profit is the amount that we risked, we put in an order to sell half of the position at 1.1906. The order gets triggered four hours later at 1pm EST. We move our stop to breakeven and get ready to sell the second half when the price hits the second standard deviation Bollinger band on the topside. The remainder of the position is eventually closed out at 1.1939 for a total trade profit of 55 pips.

Figure 2: Pure Fade, NZD/USD

Source: FXtrek Intellichart

The next example is the NZD/USD on February 26, 2006. Like the EUR/USD in the previous example, the currency pair range traded down going into the open of the Asian markets, when New Zealand economic data is typically released. Our pure fade trade set up when we saw RSI dip below 30 at 6pm EST. We checked to see that the price had also hit our third standard deviation Bollinger band at that time.

We then watched carefully for a full bar close between the second and first standard deviation Bollinger bands. This happened at 9pm EST, at which time we went long at the open of the next bar, or at 0.6583. We placed our stop at the swing low of 0.6568, risking a total of 15 pips on the trade. The risk is very small, which puts our profit at a very achievable 0.6598. This level is reached at 8am EST the next day, at which time we move our stop to breakeven and target the second deviation Bollinger band on the top side for the remainder of our position. The band is hit and we exit at 0.6605, for a total trade profit of 18.5 pips.

Short Side

On the short side, we look at an example in USD/JPY from March 10, 2006. Going into the open of the U.S. markets, we watched USD/JPY trade quietly in a tight range. Shortly after the typical 8:30am EST U.S. numbers, the currency pair hit our radar screens when RSI broke above 70, the benchmark for overbought conditions. At the same time, the price hit the third standard deviation Bollinger band and we watched for a full close between the second and first standard deviation bands. This happened three hours later and we entered a short USD/JPY position at 119.03.

Our stop is the swing high of 119.13, putting our risk at a tiny 10 pips. Our first target was 118.93, which was triggered at 3pm EST. Once our target was hit, we moved our stop on the remainder of the position to breakeven and looked to take profit once we hit the second Bollinger band on the downside.

Figure 3: Pure Fade, USD/JPY

Source: FXtrek Intellichart

At 4am EST the following day, we exited the remainder of our position at 118.80 for a total trade profit of 16.5 pips, before the position reversed course and started rallying once again. As you can see, the pure fade trade takes small profits quickly in times of trend exhaustion; however, more often than not, the trend continues course after prices hit the second Bollinger band in the opposite direction.

Figure 4: Pure Fade, GBP/US

Source: FXtrek Intellichart

The GBP/USD chart above is another good example of a short fade trade. On March 16, 2006, we watched the GBP/USD trade in a tight range going into the release of February U.S. consumer prices. The dollar began to sell off shortly after 8:30am EST, after the softer-than-expected report, and continued to push the GBP/USD higher for the next seven hours.

The currency pair hit our radar screen at noon EST when RSI broke above 70. We checked to see that the price was also tagging the third standard deviation Bollinger band on the top side, and we began to look for an opportunity to go short the GBP/USD when we saw a full bar close below the third and second standard deviation Bollinger band zone. This occurred at 4pm EST at which time we went short at the open of the following bar, or 1.7569.

We placed our stop at the swing high of 1.7594, risking 25 pips. The target for the first half of our position is the entry minus the amount that we risked, or 1.7544. After we entered into our position, the GBP/USD began to gradually sell off, triggering our take-profit order at 10pm EST. We then looked to exit the remainder of the position when the price hit the first standard deviation Bollinger band on the opposite side. This occurred the following day, giving us an exit of 1.7527 and earning us a total of 33.5 pips on the entire trade.

At this point, some traders looking at the charts may say, "Oh wow, the second half was triggered at 3am EST. I'm asleep!" It is very likely that you will not be able to spend the entire wee hours with your eyes glued to the computer screen, so for those who just want a target to place the second take-profit order, two times risk would be a good level. In this case, we could have placed our second exit order at 1.7519.

When It Failed

Of course, no one strategy can be accurate 100% of the time, so the last example is one where the trade did not end up in a profit. The GBP/JPY chart above is from February 14, 2006. At 7pm EST, or at the Asian market open, GBP/JPY began to break out of its post-U.S./pre-Asian price consolidation. RSI breached the 30 oversold mark, and the price hit the third standard deviation Bollinger band, which put the currency on our radar screen, where we looked for an opportunity to go long.

Figure 5: Pure Fade, GBP/JPY

Source: FXtrek Intellichart

We waited until four hours later and saw a candle open and close fully within the first and second standard deviation Bollinger bands, so we looked to buy at the open of the next candle. Our entry price is 204.52. We put our stop at the swing low, or 204.34, risking a total of 18 pips. Following our rules of taking profit on the first half of our position by the amount risked, we put an entry order to sell half at 204.70. GBP/JPY, however, was unable to sustain its momentary relief rally and proceeded to extend its weakness. We were stopped out at 204.34, two hours later, but because the risk was small, the loss would have had a minimal impact on most trading accounts.

Conclusion

Picking a top or bottom without indicator support is a recipe for failure. The pure fade trade is an intraday strategy that picks a top or bottom based on a clear recovery following an extreme move. It isn't foolproof, but if applied correctly, it can be a profitable strategy for forex traders.

The Currency Market Information Edge

2009-07-11T23:47:00.000-07:00

The global foreign exchange (forex) market had an average daily turnover of $3.2 trillion as of April 2007, an increase of 69% from the previous year, according to the 2007 Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity, conducted by the Bank for International Settlements. It is by far the largest financial market in the world, and its size and liquidity ensure that new information or news is disseminated within minutes. However, the forex market has some unique characteristics that distinguish it from other markets. These unique features may give some participants an "information edge" in some situations, resulting in new information being absorbed over a longer period.

Unique Characteristics of the Forex Market

Unlike stocks, which trade on a centralized exchange such as the New York Stock Exchange, currency trades are generally settled over the counter (OTC). The OTC nature of the global foreign exchange market means that rather than a single, centralized exchange (as is the case for stocks and commodities), currencies trade in a number of different geographical locations, most of which are linked to each other by state-of-the-art communications technology. OTC trading also means that at any point in time, there are likely to be a number of marginally different price quotations for a particular currency; a stock, on the other hand, only has one price quoted on an exchange at a particular instant.

The global forex market is also the only financial market to be open virtually around the clock, except for weekends. Another key distinguishing feature of the currency markets is the differing levels of price access enjoyed by market participants. This is unlike the stock and commodity markets, where all participants have access to a uniform price.

Market Participants

Currency markets have numerous participants in multiple time zones, ranging from very large banks and financial institutions at one end of the spectrum, to small retail brokers and individuals on the other. Central banks are among the largest and most influential participants in the forex market. However, on a daily basis, large commercial banks are the dominant players in the forex market, on account of their corporate customers and currency trading desks. Large corporations also account for a significant proportion of foreign exchange volume, especially companies that have substantial trade or capital flows. Investment managers and hedge funds are also major participants.

Differing Prices

Banks' currency trading desks trade in the interbank market, which is characterized by large deal size, huge volumes and tight bid/ask spreads. These currency trading desks take foreign exchange positions either to cover commercial demand (for example, if a large customer needs a currency such as the euro to pay for a sizable import), or for speculative purposes. Large commercial customers get prices from these banks that have a markup embedded in them; the markup or margin depends on the size of the customer and the size of the forex transaction. Retail customers who need foreign currency have to contend with bid/ask spreads that are much wider than those in the interbank market.

Speculative Positions Vs. Commercial Transactions

In the global foreign exchange market, speculative positions outnumber commercial foreign exchange transactions, which arise due to trade or capital flows, by a huge margin, although the exact extent is difficult to quantify. This makes the forex market very sensitive to new information, since an unexpected development will cause speculators to reassess their original trades and cause them to adjust these trades to reflect the new information. For example, if a company has to remit a payment to a foreign supplier, it has a finite window in which to do so. The company may try to time the purchase of the currency so as to obtain a favorable rate, or it may use a hedging strategy to cover its exchange risk; however, the transaction has to occur by a definite date, regardless of conditions in the foreign exchange market. On the other hand, a trader with a speculative currency position seeks to maximize his or her trading profit or minimize loss at all times; as such, the trader can choose to retain the position or close it at any point. In the event of new information, the adjustment process for such speculative positions is likely to be almost instantaneous. The proliferation of instant communications technology has caused reaction times to shorten dramatically in all financial markets, not just in the forex market. However, this "knee jerk" reaction is generally followed by a more gradual adjustment process as market participants digest the new information and analyze it in greater depth.

Information Edge

While there are numerous factors that affect exchange rates, from economic and political variables to supply/demand fundamentals and capital market conditions, the hierarchical structure of the forex market gives the biggest players a slight information edge over the smallest ones. In some situations, therefore, exchange rates take a little longer to adjust to new information.

For example, consider a case where the central bank of a major nation with a widely-traded currency decides to support it in the foreign exchange markets, a process known as "intervention." If this intervention is unexpected and covert, the major banks from which the central banks buy the currency have an information edge over other participants, because they know the identity and the intention of the buyer. Other participants, especially those with short positions in the currency, may be taken by surprise to see the currency suddenly strengthen. While they may or may not cover their short positions right away, the fact that the central bank is now intervening to support the currency may cause these participants to reassess the viability and implications of their short strategy.

Example – Forex Market Reaction to News

All financial markets react strongly to unexpected news or developments, and the foreign exchange market is no exception. Consider a situation in which the U.S. economy is weakening, and there is widespread expectation that the Federal Reserve will reduce the benchmark federal funds rate by 25 basis points (0.25%) at its next meeting. Currency exchange rates will factor in this rate reduction in the period leading up to the expected policy announcement. However, if the Federal Reserve decides at its meeting to leave rates unchanged, the U.S. dollar will in all likelihood react dramatically to this unexpected development. If the Federal Reserve implies in its policy announcement that the U.S. economy's prospects are improving, the U.S. dollar may also strengthen against major currencies.

Conclusion

While the massive size and liquidity of the foreign exchange market ensures that new information or news is generally absorbed within minutes, its unique features may result in new information being absorbed over a longer period in some situations. In addition, the hierarchical structure of the forex market can give the biggest players a slight information edge.

What Type Of Forex Trader Are You?

2009-07-10T03:12:00.000-07:00

by Richard Lee

What are some things that separate a good trader from a great one? Guts, instincts, intelligence and, most importantly, timing. Just as there are many types of traders, there is an equal number of different time frames that assist traders in developing their ideas and executing their strategies. At the same time, timing also helps market warriors take several things that are outside of a trader's control into account. Some of these items include position leveraging, nuances of different currency pairs, and the effects of scheduled and unscheduled news releases in the market. As a result, timing is always a major consideration when participating in the foreign exchange world, and is a crucial factor that is almost always ignored by novice traders.

Want to bring your trading skills to the next level? Read on to learn more about time frames and how to use them to your advantage.

Common Trader Time frames

In the grander scheme of things, there are plenty of names and designations that traders go by. But when taking time into consideration, traders and strategies tend to fall into three broader and more common categories: day trader, swing trader and position trader.
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1. The Day Trader

Let's begin with what seems to be the most appealing of the three designations, the day trader. A day trader will, for a lack of a better definition, trade for the day. These are market participants that will usually avoid holding anything after the session close and will trade in a high-volume fashion.

On a typical day, this short-term trader will generally aim for a quick turnover rate on one or more trades, anywhere from 10- to 100-times the normal transaction size. This is in order to capture more profit from a rather small swing. As a result, traders who work in proprietary shops in this fashion will tend to use shorter time-frame charts, using one-, five-, or 15-minute periods. In addition, day traders tend to rely more on technical trading patterns and volatile pairs to make their profits. Although a long-term fundamental bias can be helpful, these professionals are looking for opportunities in the short term.

Figure 1

Source: FX Trek Intellicharts

One such currency pair is the British pound/Japanese yen as shown in Figure 1, above. This pair is considered to be extremely volatile, and is great for short-term traders, as average hourly ranges can be as high as 100 pips. This fact overshadows the 10- to 20-pip ranges in slower moving currency pairs like the euro/U.S. dollar or euro/British pound.

2. Swing Trader

Taking advantage of a longer time frame, the swing trader will sometimes hold positions for a couple of hours - maybe even days or longer - in order to call a turn in the market. Unlike a day trader, the swing trader is looking to profit from an entry into the market, hoping the change in direction will help his or her position. In this respect, timing is more important in a swing trader's strategy compared to a day trader. However, both traders share the same preference for technical over fundamental analysis. A savvy swing trade will likely take place in a more liquid currency pair like the British pound/U.S. dollar. In the example below (Figure 2), notice how a swing trader would be able to capitalize on the double bottom that followed a precipitous drop in the GBP/USD currency pair. The entry would be placed on a test of support, helping the swing trader to capitalize on a shift in directional trend, netting a two-day profit of 1,400 pips.

Figure 2

Source: FX Trek Intellicharts

3. The Position Trader

Usually the longest time frame of the three, the position trader differs mainly in his or her perspective of the market. Instead of monitoring short-term market movements like the day and swing style, these traders tend to look at a longer term plan. Position strategies span days, weeks, months or even years. As a result, traders will look at technical formations but will more than likely adhere strictly to longer term fundamental models and opportunities. These FX portfolio managers will analyze and consider economic models, governmental decisions and interest rates to make trading decisions. The wide array of considerations will place the position trade in any of the major currencies that are considered liquid. This includes many of the G7 currencies as well as the emerging market favorites.

Additional Considerations

With three different categories of traders, there are also several different factors within these categories that contribute to success. Just knowing the time frame isn't enough. Every trader needs to understand some basic considerations that affect traders on an individual level.

Leverage

Widely considered a double-edged sword, leverage is a day trader's best friend. With the relatively small fluctuations that the currency market offers, a trader without leverage is like a fisherman without a fishing pole. In other words, without the proper tools, a professional is left unable to capitalize on a given opportunity. As a result, a day trader will always consider how much leverage or risk he or she is willing to take on before transacting in any trade. Similarly, a swing trader may also think about his or her risk parameters. Although their positions are sometimes meant for longer term fluctuations, in some situations, the swing trader will have to feel some pain before making any gain on a position. In the example below (Figure 3), notice how there are several points in the downtrend where a swing trader could have capitalized on the Australian dollar/U.S. dollar currency pair. Adding the slow stochastic oscillator, a swing strategy would have attempted to enter into the market at points surrounding each golden cross. However, over the span of two to three days, the trader would have had to withstand some losses before the actual market turn could be called correctly. Magnify these losses with leverage and the final profit/loss would be disastrous without proper risk assessment.

Figure 3

Source: FX Trek Intellicharts

Different Currency Pairs

In addition to leverage, currency pair volatility should also be considered. It's one thing to know how much you may potentially lose per trade, but it's just as important to know how fast your trade can lose. As a result, different time frames will call for different currency pairs. Knowing that the British pound/Japanese yen currency cross sometimes fluctuates 100 pips in an hour may be a great challenge for day traders, but it may not make sense for the swing trader who is trying to take advantage of a change in market direction. For this reason alone, swing traders will want to follow more widely recognized G7 major pairs as they tend to be more liquid than emerging market and cross currencies. For example, the euro/U.S. dollar is preferred over the Australian dollar/Japanese yen for this reason.

News Releases

Finally, traders in all three categories must always be aware of both unscheduled and scheduled news releases and how they affect the market. Whether these releases are economic announcements, central bank press conferences or the occasional surprise rate decision, traders in all three categories will have individual adjustments to make.

Short-term traders will tend to be the most affected, as losses can be exacerbated while swing trader directional bias will be corrupted. To this effect, some in the market will prefer the comfort of being a position trader. With a longer term perspective, and hopefully a more comprehensive portfolio, the position trader is somewhat filtered by these occurrences as they have already anticipated the temporary price disruption. As long as price continues to conform to the longer term view, position traders are rather shielded as they look ahead to their benchmark targets. A great example of this can be seen on the first Friday of every month in the U.S. non-farm payrolls report. Although short-term players have to deal with choppy and rather volatile trading following each release, the longer-term position player remains relatively sheltered as long as the longer term bias remains unchanged.

Figure 4

Source: FX Trek Intellicharts

Which Time Frame Is Right?

Which time frame is right really depends on the trader. Do you thrive in volatile currency pairs? Or do you have other commitments and prefer the sheltered, long-term profitability of a position trade? Fortunately, you don't have to be pigeon-holed into one category. Let's take a look at how different time frames can be combined to produce a profitable market position.

Like a Position Trader

As a position trader, the first thing to analyze is the economy - in this case, in the U.K. Let's assume that given global conditions, the U.K.'s economy will continue to show weakness in line with other countries. Manufacturing is on the downtrend with industrial production as consumer sentiment and spending continue to tick lower. Worsening the situation has been the fact that policymakers continue to use benchmark interest rates to boost liquidity and consumption, which causes the currency to sell off because lower interest rates mean cheaper money. Technically, the longer term picture also looks distressing against the U.S. dollar. Figure 5 shows two death crosses in our oscillators, combined with significant resistance that has already been tested and failed to offer a bearish signal.

Figure 5

Source: FX Trek Intellicharts

Like a Day Trader

After we establish the long-term trend, which in this case would be a continued deleveraging, or sell off, of the British pound, we isolate intraday opportunities that give us the ability to sell into this trend through simple technical analysis (support and resistance). A good strategy for this would be to look for great short opportunities at the London open after the price action has ranged from the Asian session.

Although too easy to believe, this process is widely overlooked for more complex strategies. Traders tend to analyze the longer term picture without assessing their risk when entering into the market, thus taking on more losses than they should. Bringing the action to the short-term charts helps us to see not only what is happening, but also to minimize longer and unnecessary drawdowns.

The Bottom Line

Timeframes are extremely important to any trader. Whether you're a day, swing, or even position trader, time frames are always a critical consideration in an individual's strategy and its implementation. Given its considerations and precautions, the knowledge of time in trading and execution can help every novice trader head toward greatness.

Protect Your Foreign Investments From Currency Risk

2009-07-10T03:04:00.000-07:00

by Cathy Pareto

Investing in foreign securities, while a good thing for your long-term portfolio, continues to pose new threats for investors. As more people broaden their investment universe by expanding into foreign stocks and bonds, they must also bear the risk associated with fluctuations in exchange rates.

Fluctuations in these currency values, whether the home currency or the foreign currency, can either enhance or reduce the returns associated with foreign investments. Currency plays a significant role in investing; read on to uncover potential strategies that might downplay its effects.

Pros of Foreign Diversification

There is simply no doubting the benefits of owning foreign securities in your portfolio. After all, modern portfolio theory (MPT) has established that the world's markets do not move in lockstep and that by mixing asset classes with low correlation to one another in the appropriate proportions, risk can be reduced at the portfolio level, despite the presence of volatile underlying securities. As a refresher, correlation coefficients range between -1 and +1. Anything less than perfect positive correlation (+1) is considered a good diversifier. The correlation matrix depicted below demonstrates the low correlation of foreign securities against domestic positions.

Monthly Correlations 1988 to 2006

Security Type	S&P 500 Index	Russell 2000 Index	Russell 2000 Value	MSCI EAFE	International Small Cap	International Small Cap Value	MSCI Emerging Markets
S&P 500	1	-	-	-	-	-	-
Russell 2000	0.731	1	-	-	-	-	-
Russell 2000 Value	0.694	0.927	1	-	-	-	-
MSCI EAFE	0.618	0.532	0.487	1	-	-	-
International Small Cap	0.432	0.466	0.414	0.857	1	-	-
International Small Cap Value	0.41	0.411	0.414	0.831	0.97	1	-
MSCI Emerging Markets	0.59	0.634	0.586	0.582	0.53	0.512	1

Source: Dimensional Fund Advisors

Combining foreign and domestic assets together tends to have a magical effect on long-term returns and portfolio volatility; however, these benefits also come with some underlying risks.

Risks of International Investments

Several levels of investment risks are inherent in foreign investing: political risk, local tax implications and exchange rate risk. Exchange rate risk is especially important, because the returns associated with a particular foreign stock (or mutual fund with foreign stocks) must then be converted into U.S. dollars before an investor can spend the profits. Let's break each risk down.

* Portfolio Risk

The political climate of foreign countries creates portfolio risks because governments and political systems are constantly in flux. This typically has a very direct impact on economic and business sectors. Political risk is considered a type of unsystematic risk associated with specific countries, which can be diversified away by investing in a broad range of countries, effectively accomplished with broad-based foreign mutual funds or exchange-traded funds (ETFs).

* Taxation

Foreign taxation poses another complication. Just as foreign investors with U.S. securities are subject to U.S. government taxes, foreign investors are also taxed on foreign-based securities. Taxes on foreign investments are typically withheld at the source country before an investor can realize any gains. Profits are then taxed again when the investor repatriates the funds.

* Currency Risk

Finally, there's currency risk. Fluctuations in the value of currencies can directly impact foreign investments, and these fluctuations affect the risks of investing in non-U.S. assets. For example, let's say your foreign investment portfolio generated a 12% rate of return last year, but your home currency lost 10% of its value. In this case, your net return will be reduced when you convert your profits to U.S. dollars. But the reverse is also true; if a foreign stock declines but the value of the home currency strengthens sufficiently, the loss may be averted or otherwise minimized.

Minimizing Currency Risk

Despite the perceived dangers of foreign investing, an investor may reduce the risk of loss from fluctuations in exchange rates by hedging with currency futures. Simply stated, hedging involves taking on one risk to offset another. Futures contracts are advance orders to buy or sell an asset, in this case a currency. An investor expecting to receive cash flows denominated in a foreign currency on some future date can lock in the current exchange rate by entering into an offsetting currency futures position.

In the currency markets, speculators buy and sell foreign exchange futures to take advantage of changes in exchange rates. Investors can take long or short positions in their currency of choice depending on how they believe that currency will perform. For example, if a speculator believes that the euro will rise against the U.S. dollar, he or she will enter into a contract to buy the euro at some predetermined time in the future. This is called having a long position. Conversely, you could argue that the same speculator has taken a short position in the U.S. dollar.

There are two possible outcomes with this hedging strategy. If the speculator is correct and the euro rises against the dollar, then the value of the contract will rise too, and the speculator will earn a profit. However, if the euro declines against the dollar, the value of the contract decreases.

When you buy or sell a futures contract, as in our example above, the price of the good (in this case the currency) is fixed today, but payment is not made until later. Investors trading currency futures are asked to put up margin in the form of cash and the contracts are marked to market each day, so profits and losses on the contracts are calculated each day. Currency hedging can also be accomplished a different way. Rather than locking in a currency price for a later date, you can buy the currency immediately at the spot price instead. In either scenario, you end up buying the same currency, but in one scenario you do not pay for the asset up front.

Investing in the Currency Market

The value of currencies fluctuates with the global supply and demand for a specific currency. Demand for foreign stocks is also a demand for foreign currency, which has a positive effect on its price. Fortunately, there is an entire market dedicated to the trade of foreign currencies called the foreign exchange market (forex for short). This market has no central marketplace like the New York Stock Exchange; instead, all business is conducted electronically in what is considered one of the largest liquid markets in the world.

There are several ways to invest in the currency market, but some are riskier than others. Investors can trade currencies directly by setting up their own accounts or they can access currency investments through forex brokers.

However, margined currency trading is an extremely risky form of investment and is only suitable for individuals and institutions capable of handling the potential losses it entails. In fact, investors looking for exposure to currency investments might be best served acquiring them through funds or ETFs - and there are plenty to choose from. Some of these products make bets against the dollar - some bet in favor, while other funds simply buy a basket of global currencies. For example, you can buy an ETF made up of currency futures contracts on certain G10 currencies, which can be designed to exploit the trend that currencies associated with high interest rates tend to rise in value relative to currencies associated with low interest rates. Things to consider when incorporating currency into your portfolio are costs (both trading and fund fees), taxes (historically, currency investing has been very tax-inefficient) and finding the appropriate allocation percentage.

Conclusion

Investing in foreign stocks has a clear benefit in portfolio construction. However, foreign stocks also have unique risk traits that U.S.-based stocks do not. As investors expand their investments overseas, they may wish to implement some hedging strategies to protect themselves from ongoing fluctuations in currency values. Today, there is no shortage of investment products available to help you easily achieve this goal.

A Forex Trader's View Of The Aussie/Gold Relationship

2009-07-10T02:52:00.000-07:00

by Richard Lee

The relationships between different financial markets are almost as old as the markets themselves. For example, in many cases when benchmark equities rise, bonds fall. Many traders will watch for correlations like this and try to capitalize on the opportunity. The same types of relationships exist in the global foreign exchange market. Take for instance the closely related tie between the Australian dollar and gold. Due mostly to the fact that Australia remains a major producer of the yellow metal, the correlation is an opportunity that not only exists, but is one that traders on every level can capitalize on. Let's take a look at why this relationship exists, and how you can use it to produce solid gold returns.

Being Productive Is Key

The U.S. dollar/crude oil relationship exists for one simple reason: the commodity is priced in dollars. However, the same cannot be said about the Aussie correlation. The gold/Australian dollar relationship stems from production. As of 2008, Australia was ranked as the fourth-largest gold producer in the world, coming in behind China, South Africa and the United States. Even though it may not be the largest producer, the "Land Down Under" produces an estimated 225 metric tons of gold per year, according to the consultancy firm GFMS. As a result, it is only natural that the underlying currency of a major commodity producer follows a similar pattern to that commodity. With the ebb and flow of production, the exchange rate will follow supply and demand as money exchanges hands between miner and manufacturer.

According to a 2005 GFMS survey, the last time Australia was ranked second in production behind South Africa, gold production in the South Pacific economy was at a height of approximately 263 tons per year. This volume made up a commanding 10.4% of the market. However, steadily but surely, production has been decreasing year over year (YOY), helping to drive prices higher. Ultimately, the shorter supply of gold has helped to create demand for the Australian dollar, which moved in lockstep with the commodity until mid-2008. If an investor or trader had taken advantage of this simple correlation, he or she would have earned an approximate 30% rate of return on the currency price alone (aside from any rollover interest associated with the trade).

Capitalizing on the Relationship

Although the macro strategy does work on all levels, it is best suited for portfolios that are set in longer time frames. Traders are not going to see strong correlations on every single day of trading, much like other broader market dynamics. As a result, it's advantageous to cushion the blow of daily volatility and risk through a longer time horizon.

Fundamentally oriented traders will tend to trade one or both instruments, taking trading cues from the other. These cues can be gathered from a list of topics including:

1. Commodity Reserve Reports
2. COT Futures Reports
3. Australian Economic Developments
4. Interest Rates
5. Safe Haven Investing

As a result, these trades tend to be longer than day-trade considerations as the portfolio is looking to capture the overall market tone rather than just an intraday pop or drop.

Technically, traders tend to find their cues in technical formations with the hope that corresponding correlations will seep into the related market. Whether the formation is in the gold chart or the Aussie chart, it is better to find one solid formation first, rather than looking for both charts to correlate perfectly. An example of this is clearly seen in the chart examples below.

Figure 1

Source: FX Trek Intellicharts

Figure 2

Source: MetaTrader

As shown in Figure 2, with the market in turmoil and investor deleveraging that was "en vogue" in 2008, traders saw an opportunity to jump on the bandwagon as both Aussie and gold experienced a temporary uptick in price. Already knowing that this would be a blow-off top in an otherwise bearish market, the savvy technical investor could visibly see both assets moving in sync. As a result, technically speaking, a short opportunity shone through as the commodity approached the $905.50 figure, which corresponded with the pivotal 0.8500 figure in the FX market. The double top in gold all but ensured further depression in the Australian dollar/U.S. dollar currency pair.

Trying It Out: a Trade Setup

Now let's take a look at a shorter trade setup involving both the Australian dollar and gold.

First, the broad macro picture. Taking a look at Figure 2, we see that gold has taken a hard dive down as investors and traders have deleveraged and sold off riskier assets. Following this move, subsequent consolidation lends to the belief that a turnaround may be lingering in the market. The idea is supported by the likelihood that equity investors will elect to move some money into the safe haven characteristic of the commodity as global benchmark indexes continue to decline in value.

Figure 3 Source: MetaTrader

We see a similar position developing in the Australian dollar following a spike down to just below the 0.6045 figure, shown in Figure 4 below. At this time, the currency was under extreme pressure as global speculators deemed the Australian dollar a risky currency. Putting these two factors together, portfolio direction is looking to be upward.

Next, we take a look at our charts and apply basic support and resistance techniques. Following our initial trade idea with gold, we first project a textbook channel to our chart as price action has displayed three defining technical points (labeled A, B and C). The gold channel corresponds with a short-term channel developing in the AUD/USD currency pair in Figure 4.

Figure 4

Source: MetaTrader

The combination culminates on December 10, 2008 (Figure 3 Point C). Not only do both assets test the support or lower channel trendline, but we also have a bullish MACD convergence confirming the move higher in the AUD/USD currency pair.

Finally, we place the corresponding entry at the close of the session, 0.6561. The subsequent stop would be placed at the swing low. In this case, that would be the December 5 low of 0.6290, a roughly 271 pip stop. Taking proper risk/reward management into account, we place our target at 0.7103 to give us a 2:1 risk-to-reward ratio. Luckily, the trade takes no longer than a week as the target is triggered on December 18 for a 542 pip profit.

Conclusion

Intermarket strategies like the Australian dollar and gold present ample opportunities for the savvy investor and trader. Whether it's to produce a higher profit/loss ratio or increase overall portfolio returns, market correlations are sure to add value to a market participant's repertoire.

Introducing The Bearish Diamond Formation

2009-06-20T23:30:00.000-07:00

by Richard Lee

For years, market aficionados and forex traders alike have been using simple price patterns not only to forecast profitable trading opportunities but also to explain simple market dynamics. As a result, common formations such as pennants, flags and double bottoms and tops are often used in the currency markets, as well as many other trading markets. A less talked about, but equally useful, pattern that occurs in the currency markets is the bearish diamond top formation, commonly known as the diamond top. In this article, we'll explain how forex traders can quickly identify diamond tops in order to capitalize on various opportunities.

The diamond top occurs mostly at the top of considerable uptrends. It effectively signals impending shortfalls and retracements with relative accuracy and ease. Because of the increased liquidity of the currency market, this formation can be easier to identify in the currency market than in its equity-based counterpart, where gaps in price action frequently occur, displacing some of the requirements needed to recognize the diamond top. This formation can also be applied to any time frame, especially daily and hourly charts, as the wide swings often seen in the currency markets will offer traders plenty of opportunities to trade.

Identifying and Trading the Formation

The diamond top formation is established by first isolating an off-center head-and-shoulders formation and applying trendlines dependent on the subsequent peaks and troughs. It gets its name from the fact that the pattern bears a striking resemblance to a four-sided diamond.

Let's look at a step-by-step breakdown of how to trade the formation, using the Australian dollar/U.S. dollar (AUD/USD) currency pair (Figure 1) as our example. First, we identify an off-center head-and-shoulders formation in a currency pair. Next, we draw resistance trendlines, first from the left shoulder to the head (line A) and then from the head to the right shoulder (line B). This forms the top of the formation; as a result, the price action should not break above the upper trendline resistance formed by the right shoulder. The idea is that the price action consolidates before the impending shortfall, and any penetrations above the trendline would ultimately make the pattern ineffective, as it would mean that a new peak has been created. As a result, the trader would be forced to consider either reapplying the trendline (line B) that runs from the head to the right shoulder, or disregarding the diamond top formation altogether, since the pattern has been broken.

To establish lower trendline support, the technician will simply eye the lowest trough established in the formation. Bottomside support can then be drawn by connecting the bottom tail to the left shoulder (line C) and then connecting another support trendline from the tail to the right shoulder (line D). This connects the bottom half to the top and completes the pattern. Notice how the rightmost angle of the formation also resembles the apex of a symmetrical triangle pattern and is suggestive of a breakout.

Figure 1 - Identifying a diamond top formation using the AUD/USD.

Trading the diamond top isn't much harder than trading other formations. Here, the trader is simply looking for a break of the lower support line, suggesting increasing momentum for a probable shortfall. The theory is quite simple. Both upper resistance and lower support levels established by the right shoulder will contain the price action as each subsequent session's range diminishes, suggestive of a near-term breakout. Once a session closes below the support level, this indicates that selling momentum will continue because sellers have finally pushed the close below this significant mark. The trader will then want to place his/her entry shortly below this level to capture the subsequent decline in the price. This approach works especially well in the currency markets, where price action tends to be more fluid and trends are established more quickly once a certain significant support or resistance level is broken. Money management would be applied to this position through a stop-loss placed slightly above the previously broken support level to minimize any losses that might occur if the break is false and a temporary retracement takes place.

Figure 2 below shows a zoomed in view of Figure 1. We can see that a session candle closed below or "broke" the support trendline (line D.i.), indicating a move lower. The diamond top trader would profit from this by placing an entry order below the close of the support line at 0.7504, while also placing a stop-loss slightly above the same line to minimize any potential losses should the price bounce back above. The standard stop will be placed 50 pips higher at 0.7554. In our example, the stop order would not have been executed because the price did not bounce back, instead falling 150 pips lower in one session before falling even further later on.

Figure 2 - A closer look at the diamond top formation using the AUD/USD. Notice how the position of the entry is just below the support line (D.i.).

Finally, profit targets are calculated by taking the width of the formation from the head of the formation (the highest price) to the bottom of the tail (the lowest price). Staying with our example using the AUD/USD currency pair, Figure 3 shows how this would be done. In Figure 3, the AUD/USD exchange rate at the top of the formation is 0.8003. The bottom of the diamond top is exactly 0.7250. This leaves 753 pips between the two prices that we use to form the maximum price where we can take profits. To be safe, the trader will set two targets in which to take profits. The first target will require taking the full amount, 753 pips, and taking half that amount and subtracting it from our entry price. Then, the first target will be 0.7128. The price target that will maximize our profits will be 0.6751, calculated by subtracting the full 753 pips from the entry price.

Figure 3 - The price target is calculated on the same example of the AUD/USD.

Using a Price Oscillator Helps

One of the cardinal rules of successful trading is to always receive confirmation, and the diamond top pattern is no different. Adding a price oscillator such as moving average convergence divergence and the relative strength index can increase the accuracy of your trade, since tools like these can gauge price action momentum and be used to confirm the break of support or resistance.

Applying the stochastic oscillator to our example (Figure 4 below), the investor confirms the break below support through the downward cross that occurs in the price oscillator (point X).

Figure 4 - The cross of the stochastic momentum indicator (point X) is used to confirm the downward move.

Putting It All Together

Not only do bearish diamond tops form in the major currency pairs like the Euro/U.S. dollar (EUR/USD), the British pound/U.S. dollar (GBP/USD) and the U.S. dollar/Japanese yen (USD/JPY), but they also form in lesser-known cross-currency pairs such as the Euro/Japanese yen (EUR/JPY). Although the formation occurs less in the cross-currency pairs, the swings tend to last longer, creating more profits. Let's look at a step-by-step example of this using the EUR/JPY:

Identify the head and shoulders pattern and confirm the offset nature of the formation by noticing that the head is slightly to the left, while the tail is set to the right.
Form the top resistance by connecting the left shoulder to the tip top of the head (line A) and the head to the right shoulder (line B). Next, draw the trendlines for support by connecting the left shoulder (line C) to the tail and the tail to the right shoulder (line D).
Calculate the width of the formation by taking the prices at the top of the head, 141.59, and the bottom of the tail, 132.94. This will give us a total of 865 pips of distance before we can take our full profits. Divide by two and our first point to take profits will be 432 pips below our entry.
Establish the entry point. Look to the apex of the right shoulder and notice the point where the candle closes below the support line, breaking through. Here, the close of the session is 137.79. The entry order should then be placed 50 pips below at 137.29, while our stop-loss order will be placed 50 pips above at 137.79.
Calculate the first take profit price by subtracting 432 pips from the entry. As a result, the first profit target will be at 133.45.
Finally, confirm the trade by using a price oscillator. Here, the stochastic oscillator signals ahead and confirms the opportunity as it breaks below overbought levels (point X).

If the first target is achieved, the trader will move his/her stop up to the first target, then place a trailing stop to protect any further profits.

Figure 5 - A different example of a diamond top formation using the EUR/JPY cross-currency pair. This chart shows all the trendlines, the highest and the lowest price, and the price target.

Conclusion

Although the bearish diamond top has been overlooked due to its infrequency, it remains very effective in displaying potential opportunities in the forex market. Smoother price action due to the enormous liquidity of the market offers traders a better context in which to apply this method and isolate better opportunities. When this formation is combined with a price oscillator, the trade becomes an even better catch - the price oscillator enhances the overall likelihood of a profitable trade by gauging price momentum and confirming weakness as well as weeding out false breakout/breakdown trades.

Trading The Non-Farm Payroll Report

2009-06-20T23:23:00.000-07:00

by Cory Mitchell

The non-farm payroll (NFP) report is a key economic indicator for the United States. It is intended to represent the total number of paid workers in the U.S. minus farm employees, government employees, private household employees and employees of nonprofit organizations.

The NFP report causes one of the consistently largest rate movements of any news announcement in the forex market. As a result, many analysts, traders, funds, investors and speculators anticipate the NFP number - and the directional movement it will cause. With so many different parties watching this report and interpreting it, even when the number comes in line with estimates it can cause large rate swings. Read on to find out how to trade this move without getting knocked out by the irrational volatility it can create.

Trading News Releases

Trading news releases can be very profitable, but it is not for the faint of the heart. This is because speculating on the direction of a given currency pair upon the release can be very dangerous. Fortunately, it is possible to wait for the wild rate swings to subside. Then, traders can attempt to capitalize on the real market move after the speculators have been wiped out or have taken profits or losses. The purpose of this is to attempt to capture rational movement after the announcement, instead of the irrational volatility that pervades the first few minutes after an announcement.

The release of the NFP generally occurs on the first Friday of every month at 8:30am EST. This news release creates a favorable environment for active traders in that it provides a near guarantee of a tradable move following the announcement. As with all aspects of trading, whether we make money on it is not assured. Approaching the trade from a logical standpoint based on how the market is reacting can provide us with more consistent results than simply anticipating the directional movement the event will cause.

The Strategy

The NFP report generally affects all major currency pairs, but one of the favorites among traders is the GBP/USD. Because the forex market is open 24 hours a day, all traders have the capability to trade the news event.

The logic behind the strategy is to wait for the market to digest the information's significance. After the initial swings have occurred, and after market participants have had a bit of time to reflect on what the number means, we will enter a trade in the direction of the dominating momentum. We wait for a signal that indicates the market may have chosen a direction to take rates. This avoids getting in too early and decreases the probability of being whipsawed out of the market before the market has chosen a direction.

The Rules

The strategy can be traded off of five- or 15-minute charts. For the rules and examples, a 15-minute chart will be used, although the same rules apply to a five-minute chart. Signals may appear on different time frames, so stick with one or the other.

1. Nothing is done during the first bar after the NFP report (8:30-8:45am in the case of the 15-minute chart).

2. The bar created at 8:30-8:45 will be wide ranging. We wait for an inside bar to occur after this initial bar (it does not need to be the very next bar). In other words, we are waiting for the most recent bar's range to be completely inside the previous bar's range.

3. This inside bar's high and low rate sets up our potential trade triggers. When a subsequent bar closes above or below the inside bar, we take a trade in the direction of the breakout. We can also enter a trade as soon as the bar moves past the high or low without waiting for the bar to close. Whichever method you choose, stick to it.

4. Place a 30-pip stop on the trade you entered.

5. Make up to a maximum of two trades. If both get stopped out, don't re-enter. The inside bar's high and low are used again for a second trade if needed.

6. Our target is a time target. Generally, most of the move occurs within four hours. Thus, we exit four hours after our entry time. A trailing stop is an alternative if traders wish to stay in the trade.

Example

Figure 1: February 6, 2009. GBP/USD 15-minute chart. Time is GMT.

Source: Forexyard

Looking at Figure 1, the vertical line marks the 8:30am EST (1:30pm GMT) release of the NFP report. As you can see from the chart, there are three bars, or 45 minutes, of back-and-forth action following the release. During this time, we do not trade until we see an inside bar. The inside bar has a square around it on the chart. This bar's price range is fully contained by the previous bar. We will enter when a bar closes higher or lower than the inside bar. The next bar's close is circled, as that is our entry; it closed above the inside bar's high. Our stop is 30 pips below the entry price, which is marked by a solid black horizontal bar.

Because our entry occurred at approximately at 9:45am EST (2:45pm GMT), we will close out our position four hours later. By entering the trade at 1.4670 and exiting four hours later at 1.4820, 150 pips were captured while risking only 30 pips. However, it should be noted that not every trade will be this profitable.

Strategy Downfall

While this strategy can be very profitable, it does have some pitfalls to be aware of. For one, the market may move in one direction aggressively and thus may be beginning to fade by the time we get an inside bar signal. In other words, if a strong move occurs prior to the inside bar, it is possible a move could exhaust itself before we get a signal. It is also important to note that in high volatility times, even after waiting for a pattern setup, rates can reverse quickly. This is why it very important to have a stop in place.

Summary

The logic behind this strategy of trading the NFP report is based on waiting for a small consolidation, the inside bar, after the initial volatility of the report has subsided and the market is choosing which direction it will go. By controlling risk with a moderate stop we are poised to make a potentially large profit from a huge move that almost always occurs each time the NFP is released.

The Myth Of Profit/Loss Ratios

2009-06-20T01:11:00.000-07:00

When trading the forex market or other markets, we are often told of a common money management strategy that requires that the average profit be more than the average loss per trade. It's easy to assume that something that has been so widely advised must be a good thing. However, if we take a deeper look at the relationship between profit and loss, it is clear that the "old," commonly-held ideas may need to be adjusted.

Profit/Loss Ratio

A profit/loss ratio refers to the size of the average profit compared to the size of the average loss per trade. For example, if your expected profit is $900 and your expected loss is $300 for a particular trade, your profit/loss ratio is 3:1 - which is $900 divided by $300.

Many trading books and "gurus" advocate a profit/loss ratio of at least 2:1 or 3:1, which means that for every $200 or $300 you make per trade, your potential loss should be capped at $100.

At first glance, most people would agree with this recommendation. After all, shouldn't any potential loss be kept as small as possible and any potential profit be as much as possible? The answer is: not always. In fact, this common piece of advice can be misleading, and can cause harm to your trading account.

The blanket advice of having a profit/loss ratio of at least 2:1 or 3:1 per trade is over-simplistic because it does not take into account the practical realities of the forex market (or any other markets), the individual's trading style and the individual's average profitability per trade (APPT) factor, which is also referred to as statistical expectancy.

APPT is Key to Profitability

Average profitability per trade basically refers to the average amount you can expect to win or lose per trade. Most people are so focused on either balancing their profit/loss ratios or on the accuracy of their trading approach that they are unaware that a bigger picture exists: Your trading performance depends largely on your APPT.

This is the formula for average profitability per trade:

Average Profitability Per Trade = (Probability of Win x Average Win) - (Probability of Loss x Average Loss)

Let's explore the APPT of the following hypothetical scenarios:

Scenario A:

Let's say that out of 10 trades you place, you profit on three of them and you realize a loss on seven. Your probability of a win is thus 30% or 0.3, while your probability of loss is 70% or 0.7. Your average winning trade makes $600 and your average loss is $300.

In this scenario, the APPT is:

(0.3 x $600) – (0.7 x $300) = - $30
As you can see, the APPT is a negative number, meaning that for every trade you place, you are likely to lose $30. That's a losing proposition!

Even though the profit/loss ratio is 2:1, this trading approach produces winning trades only 30% of the time, which negates the supposed benefit of having a 2:1 profit/loss ratio.

Scenario B:

Now let's explore the APPT of a trading approach that has a profit/loss ratio of 1:3, but has more winning trades than losing ones. Let's say out of the 10 trades you place, you make profit on eight of them, and you realize a loss on two trades.

Here is the APPT:

(0.8 x $100) – (0.2 x $300) = $20
In this case, even though this trading approach has a profit/loss ratio of 1:3, the APPT is positive, which means you can be profitable over time.

Many Ways of Becoming Profitable

When trading the forex market, there is no one-size-fits-all money management or trading approach. Traditional advice, such as making sure your profit is more than your loss per absolute trade, does not have much substantial value in the real trading world unless you have a high probability of realizing a winning trade. What matters is that your APPT comes up positive and that your overall profits are more than your overall losses.

Forex: Wading Into The Currency Market

2009-06-18T23:22:00.000-07:00

by Kathy Lien

Whenever you devote money to trading, it is important to take it seriously. For traders who are getting into the forex (FX) market for the first time, it basically means starting from square one. But new traders don't have to be left in the dark when it comes to learning to trade currencies; unlike with some of the other markets, there is a variety of free learning tools and resources available to light the way. You can become FX-savvy with the help of virtual demo accounts, mentoring services, online courses, print and online resources, signal services and charts. With so much to choose from, the question you're most likely to ask is, "Where do I start?" Here we cover the preliminary steps you need to take to find your footing in the FX market.

Finding a Broker

The first step is to pick a market maker with which to trade. Some are larger than others, some have tighter spreads and others offer additional bells and whistles. Each market maker has its own advantages and disadvantages, but here are some of the key questions to ask when doing your due diligence:

* Where is the FX market maker incorporated? Is it in a country such as the U.S. or the U.K., or is it offshore?
* Is the FX market maker regulated? If so, in how many countries?
* How large is the market maker? How much excess capital does it have? How many employees?
* Does the market maker have 24-hour telephone support?

In order to ensure that the money you are sending will be safe and that you have a jurisdiction to appeal to in the event of a bankruptcy, you want to find a large market maker that is regulated in at least one or two major countries. Furthermore, the larger the market maker, the more resources it can put toward making sure that its trading platforms and servers remain stable and do not crash when the market becomes very active. Third, you want a market maker with a larger number of employees so that you can place a trade over the phone without having to worry about getting a busy signal. Bottom line, you want to find someone legitimate to trade with and avoid a bucket shop.

Checking Their Stats

In the U.S., all registered futures commission merchants (FCMs) are required to meet strict financial standards, including capital adequacy requirements, and are required to submit monthly financial reports to regulators. You can visit the website of the Commodity Futures Trading Commission (an independent agency of the U.S. government) to access the latest financial statements of all registered FCMs in the U.S.

Another advantage of dealing with a registered FCM is greater transparency of business practices. The National Futures Association keeps records of all formal proceedings against FCMs, and traders can find out if the firm has had any serious problems with clients or regulators by checking the NFA's Background Affiliation Status Information Center (BASIC) online.

Test Drive

Once you've found a broker, the next step is to test drive its software by opening a demo account. The availability of demo or virtual trading accounts is something unique to this market and one that you'll want to exploit to your advantage. Your goal is to learn how to use the trading platform and, while you're doing that, to find the trading platform that suits you best. Most demo accounts have exactly the same functionalities as live accounts, with real-time market prices. The only difference, of course, is that you are not trading with real money.

Demo trading allows you not only to make sure that you fully understand how to use the trading platform, but also to practice some trading strategies and to make money in the paper account before you move on to a live account funded with real money. In other words, it gives you a chance to get a feel for the FX market.

Do Your Research

When you trade, you never want to trade impulsively. You need to be able to justify your trades, and the way to find justification is by doing your research. There are many books, newspapers and other publications with information about trading the FX market. When choosing a source to consult, make sure it covers:

* The basics of the FX market
* Technical analysis
* Key fundamental news and events

Because the FX market is primarily a technically driven market, the best book that you can read as a new trader is one on technical analysis. The better you get at technical analysis, the better you can trade the FX market from a speculative perspective.

When it comes to newspapers, seasoned foreign exchange traders typically refer to the Financial Times and the Wall Street Journal simply because they contain international news. Trading FX involves looking beyond mere economics, since politics and geopolitical risks can also affect a currency's trading behavior. Therefore, it's also important to keep up with major non-financial news sources such as the International Herald Tribune and the BBC (online, on TV or on the radio) for the big stories of the day.

One of the most popular magazines among FX traders is the Economist, because it covers many macro themes; however, currency-specific and trading magazines are also popular.

Once you have a solid foundation in FX trading, you need to keep up to date on daily fundamental and technical developments in the FX market. A variety of free FX-specific research websites, which can be found easily on the internet, will do the trick.

Education and Mentoring Programs - Are They Worth It?

The benefit of online or live courses over books, newspapers and magazines is that you can get answers to the questions that perplex you. Hearing or seeing other people's questions is also extremely valuable, since no one person can think of every possible question. In a classroom setting, either online or live, you can learn from the experiences and frustrations of others. As for a mentor, he or she can draw on personal experience and hopefully teach you to avoid the mistakes he or she has made in the past, saving you both time and money.

What About Trading Systems and Signals?

Many traders wonder whether it is worthwhile to buy into a system or a signal package. Systems and signals fall into three general categories depending on their methodology: trend, range or fundamental. Fundamental systems are very rare in the FX market; they are mostly used by large hedge funds or banks because they are very long term in nature and do not give many trading signals. The systems that are available to individual traders are typically trend systems or range systems - rarely will you get one system that is able to exploit both markets, because if you do, then you have pretty much found the holy grail of trading.

Even the largest hedge funds in the world are still looking for the switch that can identify whether they are in a trend or a range-bound market. Most large hedge funds tend to be trend following, which is why hedge funds as a group did so poorly in 2004, when the market was trapped in a tight trading range. Range-bound systems will only perform well in range-bound markets, while trend systems will make money in trending markets and lose money in range-bound markets. So, when you buy into a system or a signal provider, you should try to find out whether the signals are mostly range-bound signals or trend signals. This way you can know when to take the signals and when to avoid them.

Trading Setups - Finding What Works Best for You

Every trader is different, but the best trading style is probably a combination of both technical and fundamental analysis. Fundamentals can easily throw off technicals, while technicals can explain movements that fundamentals cannot. Smart traders will always be aware of the broader fundamental picture while using their technicals to pinpoint good entry and exit levels; combining both will keep you out of as many bad trades as possible, and it works for both day traders and swing traders. Most free charting packages have everything that a new trader needs, and many trading platforms offer real-time news feeds to keep you up to date on economic news.

Conclusion

Learning to trade in the FX market can seem like a daunting task when you're just starting out, but thanks to the many practical and educational resources available to the individual trader, it is not impossible. Learning as much as possible before you put actual money at risk should be at the forefront of your agenda. Print and online publications, trading magazines, personal mentors, online demo accounts and more can all act as invaluable guides on your journey into currency trading.

Forex Minis Shrink Risk Exposure

2009-06-15T22:39:00.000-07:00

by Selwyn Gishen

Trading currencies means buying one country's currency while simultaneously selling another country's currency. Every currency trade therefore involves two currencies. The usual size of a currency pair is 100,000 units, known as a "standard lot."

In most cases, beginner traders do not want to stomach the risk that comes with the exposure of a standard lot. As a result, most online forex brokers offer the ability to trade mini lots, which are 10,000 units of the currency rather than 100,000. For a new trader, these mini lots can be an especially effective tool for learning to trade forex.

What is a Pip?

Before one can fully understand the benefits of a mini lot, it is important to review the concept of a pip. A pip is the smallest increment that a currency pair can move. For most currency pairs, a pip is a change in the fourth decimal place of the currency quote. For example, if EUR/USD is quoted at 1.5567 and it moves to 1.5568, it has increased by 1 pip. The value of 1 pip is calculated by the size of the lot that is traded. So, if you buy a standard lot of 100,000 EUR/USD at 1.5567 and it goes to 1.5568, a 1-pip move, then the value of your trade has increased by $10 (or 100,000 x 0.0001).

If we did the exact same calculation using a mini lot, then we would multiply the 1 pip by the size of a 10,000 mini lot instead of the usual 100,000 lot. So 10,000 x 0.0001 = $1. When you trade a standard lot, the value of the pip is $10, but when trading a mini lot the value of a pip is $1. This is true when the U.S. dollar is the second, or quoted, currency in the pair.

Base Currency Vs. Quote Currency

One other piece of information to remember is that a currency pair is comprised of a base currency, which is the first currency listed in the pair, and the quote currency, which is the second currency listed in the pair. In the case of the EUR/USD, the euro is the base currency and the dollar is the quote currency.

The profit or loss is always expressed in terms of the quote currency. If the currency pair is the GBP/USD, then the base currency is the British pound and the quote currency is the U.S. dollar. For the USD/CAD, the base currency is the U.S. dollar and the quote currency is the Canadian dollar. Why the dollar is listed first in some instances but second in others is just a matter of convention.

The Value of a Pip

The last important point that should be noted before we talk about mini lots specifically is the value of a pip. Suppose you are trading the GBP/JPY; the British pound is the base currency and the Japanese yen is the quote currency. Now in this instance, we have an exception to the fourth decimal place rule for the size of a pip. In the case of the yen, 1 pip is measured in the second decimal place. The yen is the only exception. To calculate the value of the move, if we buy dollars against the yen and the dollar goes up from 103.45 to 103.46, then we have a 1-pip move. Multiplying by the standard lot of 100,000 x 0.01 = 1,000 yen. To bring this back to dollars, you would then divide the 1,000 yen by the dollar rate, let's say it's 103.46, which equals $9.66.

Why Trade Minis?

The real value of trading minis is in the versatility it provides in matching the trade size to an acceptable level of risk. For example, suppose you decide to take a long position in the USD/JPY. Let's assume that your entry point is 103.55 and that you've set your stop-loss order 15 pips away at 103.40. If you have $1,000 in your trading account, the maximum risk you should take in any trade is 3% of your trading capital. Because your capital is $1,000, 3% of your capital is $30. If you are stopped out of this trade and you are trading a mini lot, you will lose $15. But if you are prepared to risk $30, you can actually trade two mini lots and get the power and benefit of some leverage. If you were only trading standard lots, this trade would not be possible because a 15-pip loss, as per this example, would be $150, which is 15% of your $1,000 trading capital. Given a risk tolerance of 3% of the portfolio, this is too much risk for one trade.

Mini lots allow a trader to adjust the amount of effective leverage used in each trade. With mini contracts, you can trade the equivalent of one standard lot by simply trading 10 minis. If you only want to trade a half of a standard lot, you can do so by buying five mini lots.

The Bottom Line

Mini lots provide flexibility that standard lots cannot offer. A mini lot is simply 10% of a standard lot and therefore, by trading in minis you can trade in fractions of a standard lot, anywhere from 1 mini to 10 minis. Mini lots are useful if the natural stop loss for your trade is farther away than the maximum risk you feel comfortable taking. You can simply reduce the risk by decreasing the number of minis until that number would equate to the stop-loss risk. Of course, if your market maker offers you 100:1 leverage, then for an account of $1,000, you can trade up to 10 minis at a time. The number of minis traded should be governed by how much you can lose if your trade goes wrong, which should not exceed 2-3% per trade.

The Credit Crisis And The Carry Trade

2009-06-15T00:49:00.000-07:00

Broadly speaking, the term "carry trade" means borrowing at a low interest rate and investing in an asset that provides a higher rate of return. For example, assume that you can borrow $20,000 at an interest rate of 3% for one year; further assume that you invest the borrowed proceeds in a certificate of deposit that pays 6% for one year. After a year, your carry trade has earned you $600, or the difference between the return on your investment and the interest paid times the amount borrowed.

Of course, in the real world, opportunities like these rarely exist because the cost of borrowing funds is usually significantly higher than interest earned on deposits. But what if an investor wishes to invest low-cost funds in an asset that promises spectacular returns, albeit with a much greater degree of risk? In this case, we are referring to the currency, or forex, markets, where carry quickly became one of the most important strategies. These trades allowed some traders to rake in big profits, but they also played a part in the credit crisis that struck world economic systems in 2008. Read on to find out how to execute these trades.

A New Millennium for Carry Trades

In the 2000s, the term "carry trade" became synonymous with the "yen carry trade", which involved borrowing in the Japanese yen and investing the proceeds in virtually any asset class that promised a higher rate of return. The Japanese yen became a favored currency for the borrowing part of the carry trade because of the near-zero interest rates in Japan for much of this period. By early 2007, it was estimated that about US $1 trillion had been invested in the yen carry trade.

Carry trades involving riskier assets are successful when interest rates are low and there is ample global appetite for risky assets. This was the case in the period from 2003 until the summer of 2007, when interest rates in a number of nations were at their lowest levels in decades, while demand surged for relatively risky assets such as commodities and emerging markets.

The unusual appetite for risk during this period could be gauged by the abnormally low level of volatility in the U.S. stock market (as measured by the CBOE Volatility Index or VIX), as well as by the low risk premiums that investors were willing to accept (one measure of which was the historically low spreads of high-yield bonds and emerging market debt to U.S. government Treasuries).

Carry trades work on the premise that changes in the financial environment will occur gradually, allowing the investor or speculator ample time to close out the trade and lock in profits. But if the environment changes abruptly, investors and speculators could be forced to close their carry trades as expeditiously as possible. Unfortunately, such a reversal of innumerable carry trades can have unexpected and potentially devastating consequences for the global economy.

Why the Carry Trade Works

As noted earlier, during the boom years of 2003-2007, there was large-scale borrowing of Japanese yen by investors and speculators. The borrowed yen was then sold and invested in a variety of assets, ranging from higher-yielding currencies, such as the euro, to U.S. subprime mortgages and real estate, and including volatile assets such as commodities and emerging market stocks and bonds.

In order to get more bang for their buck, large investors such as hedge funds used a substantial degree of leverage in order to magnify returns. But leverage is a double-edged sword – just as it can enhance returns when markets are booming, it can also amplify losses when asset prices are sliding.

As the carry trade gained momentum, a virtuous circle developed, whereby borrowed currencies such as the yen steadily depreciated, while the demand for risky assets pushed their prices higher.

It is important to note that currency risk in a carry trade is seldom, if ever, hedged. This meant that the carry trade worked like a charm as long as the yen was depreciating, and mortgage and commodity portfolios were providing double-digit returns. Scant attention was paid to early warning signs such as the looming slowdown in the U.S. housing market, which peaked in the summer of 2006 and then commenced its long multiyear slide.

Example - Leverage Cuts Both Ways in Yen Carry Trade

Let's run through an example of a yen carry trade to see what can happen when the market is booming and when it goes bust.

Borrow 100 million yen for one year at 0.50% per annum
Sell the borrowed amount and buy U.S. dollars at an exchange rate of 115 yen per dollar
Use this amount (approximately US$870,000) as 10% margin to acquire a portfolio of mortgage bonds paying 15%
The size of the mortgage bond portfolio is therefore $8.7 million (i.e. $870,000 is used as 10% margin, and the remaining 90%, or $7.83 million, is borrowed at 5%).

After one year, assume the entire portfolio is liquidated and the yen loan is repaid. In this case, one of two things might occur:

Scenario 1 (Boom Times)
Assume the yen has depreciated to 120, and that the mortgage bond portfolio has appreciated by 20%.

Total Proceeds = Interest on Bond Portfolio + Proceeds on Sale of Bond Portfolio

= $1,305,000 + $10,440,000 = $11,745,000

Total Outflows = Margin Loan ($7.83 million principal + 5% interest) + Yen Loan (principal + 0.50% interest)

= $8,221,500 + 100,500,000 yen

= $8,221,500 + $837,500 = $9,059,000

Overall Profit = $2,686,000

Return on Investment = $2,686,000 / $870,000 = 310%

Scenario 2 (Boom Turns to Bust)
Assume the yen has appreciated to 100, and that the mortgage bond portfolio has depreciated by 20%.

Total Proceeds = Interest on Bond Portfolio + Proceeds on Sale of Bond Portfolio

= $1,305,000 + $6,960,000 = $8,265,000

Total Outflows = Margin Loan ($7.83 million principal + 5% interest)+ Yen Loan (principal + 0.50% interest)

= $8,221,500 + 100,500,000 yen

= $8,221,500 + $1,005,000 = $9,226,500

Overall Loss = $961,500

Return on Investment = -$961,500 / $870,000 = -110%

The Great Unraveling of the Yen Carry Trade

The yen carry trade became all the rage among investors and speculators, but by 2006, some experts began warning of the dangers that could arise if and when these carry trades were reversed or "unwound." These warnings went unheeded.

The global credit crunch that developed from August 2007 led to the gradual unraveling of the yen carry trade. A little over a year later, as the collapse of Lehman Brothers and the U.S. government rescue of AIG sent shockwaves through the global financial system, the unwinding of the yen carry trade commenced in earnest.

Speculators began to be hit with margin calls as prices of practically every asset began sliding. To meet these margin calls, assets had to be sold, putting even more downward pressure on their prices. As credit conditions tightened dramatically, banks began calling in the loans, many of which were yen-denominated. Speculators not only had to sell their investments at fire-sale prices, but also had to repay their yen loans even as the yen was surging. Repatriation of yen made the currency even stronger. In addition, the interest rate advantage enjoyed by higher-yielding currencies began to dwindle as a number of countries slashed interest rates to stimulate their economies.

The unwinding of the gigantic yen carry trade caused the Japanese currency to surge against major currencies. The yen rose as much as 29% against the euro in 2008. By February 2009, it had gained 19% against the U.S. dollar since September, rising to a 13-year high of about 90.

Using Bollinger Band "Bands" To Gauge Trends

2009-06-14T06:11:00.000-07:00

by Boris Schlossberg

Bollinger bands are one of the most popular technical indicators for traders in any financial market - stocks, bonds or foreign exchange (FX). Many traders use them primarily to determine overbought and oversold levels, selling when price touches the upper Bollinger band and buying when it hits the lower Bollinger band. In range-bound markets, this technique works well, as prices travel between the two bands like balls bouncing off the walls of a racquetball court.

Yet as John Bollinger was first to acknowledge, "tags of the bands are just that - tags, not signals. A tag of the upper Bollinger band is not in and of itself a sell signal. A tag of the lower Bollinger band is not in and of itself a buy signal". Price often can and does "walk the band". In those markets, traders who continuously try to "sell the top" or "buy the bottom" are faced with an excruciating series of stop-outs or worse, an ever-mounting floating loss as price moves further and further away from the original entry.

Perhaps a more useful way to trade with Bollinger bands is to use them to gauge trends. To understand why Bollinger bands may be a good tool for this task we first need to ask - what is a trend?

Trend as Deviance

One standard cliché in trading is that prices range 80% of the time. Like many clichés this one contains a good amount of truth since markets mostly consolidate as bulls and bears battle for supremacy. Market trends are rare, which is why trading them is not nearly as easy as it seems. Looking at price this way we can then define trend as deviation from the norm (range).

The Bollinger band formula consists of the following:
BOLU = Upper Bollinger Band
BOLD = Lower Bollinger Band
n = Smoothing Period
m = Number of Standard Deviations (SD)
SD = Standard Deviation over Last n Periods Typical Price (TP) = (HI + LO + CL) / 3
BOLU = MA(TP, n) + m * SD[TP, n]
BOLD = MA(TP, n) - m * SD[TP, n]

At the core, Bollinger bands measure deviation. This is the reason why they can be very helpful in diagnosing trend. By generating two sets of Bollinger bands - one set using the parameter of "1 standard deviation" and the other using the typical setting of "2 standard deviation" - we can look at price in a whole new way.

In the chart below we see that whenever price channels between the upper Bollinger bands +1 SD and +2 SD away from mean, the trend is up; therefore, we can define that channel as the "buy zone". Conversely, if price channels within Bollinger bands –1 SD and –2 SD, it is in the "sell zone". Finally, if price meanders between +1 SD band and –1 SD band, it is essentially in a neutral state, and we can say that it's in "no man's land".

One of the other great advantages of Bollinger bands is that they adapt dynamically to price expanding and contracting as volatility increases and decreases. Therefore, the bands naturally widen and narrow in sync with price action, creating a very accurate trending envelope.

A Tool for Trend Traders and Faders

Having established the basic rules for Bollinger band "bands", we can now demonstrate how this technical tool can be used by both trend traders who seek to exploit momentum and fade traders who like to profit from trend exhaustion. Returning back to the AUD/USD chart just above, we can see how trend traders would position long once price entered the "buy zone". They would then be able to stay in trend as the Bollinger band "bands" encapsulate most of the price action of the massive up-move.

What would be a logical stop-out point? The answer is different for each individual trader, but one reasonable possibility would be to close the long trade if the candle turned red and more than 75% of its body were below the "buy zone". Using the 75% rule is obvious since at that point price clearly falls out of trend, but why insist that the candle be red? The reason for the second condition is to prevent the trend trader from being "wiggled out" of a trend by a quick probative move to the downside that snaps back to the "buy zone" at the end of the trading period. Note how in the following chart the trader is able to stay with the move for most of the uptrend, exiting only when price starts to consolidate at the top of the new range.

Bollinger band "bands" can also be a valuable tool for traders who like to exploit trend exhaustion by picking the turn in price. Note, however, that counter-trend trading requires far larger margins of error as trends will often make several attempts at continuation before capitulating.

In the chart below, we see that a fade trader using Bollinger band "bands" will be able to diagnose quickly the first hint of trend weakness. Having seen prices fall out of the trend channel, the fader may decide to make classic use of Bollinger bands by shorting the next tag of the upper Bollinger band. But where to place the stop? Putting it just above the swing high will practically assure the trader of a stop-out as price will often make many probative forays to the top of the range, with buyers trying to extend the trend. Here is where the volatility property of Bollinger bands becomes an enormous benefit to the trader. By measuring the width of the "no man's land" area, which is simply the range of +1 to –1 SD from the mean, the trader can create a quick and very effective projection zone which will prevent him or her from being stopped out on market noise and yet protect his or her capital if trend truly regains its momentum.

Conclusion

As one the most popular technical-analysis indicators, Bollinger bands have become crucial to many technically oriented traders. By extending their functionality through the use of Bollinger band "bands", traders can achieve a greater level of analytical sophistication using this simple and elegant tool for both trending and fading strategies.

Todays Forex Rates

2009-06-12T05:29:00.001-07:00

FOREX RATES Pakistan Open Market Forex Rates Updated at : 12/6/2009 6:08 PM (PST)
Currency	Buying	Selling
Australian Dollar	65.30	66.30
Canadian Dollar	72.40	73.40
China Yuan	11.25	12.00
Euro	112.80	114.50
Japanese Yen	0.8180	0.8280
Saudi Riyal	21.40	21.60
U.A.E Dirham	21.95	22.15
UK Pound Sterling	133.00	135.00
US Dollar	80.95	81.25

Tweezers Provide Short-Term Precision For Forex Traders

2009-06-12T05:13:00.000-07:00

by Richard Lee

It's better to get in on the start of a trend, rather than to be at the end of it. That's why traders are always looking to get in the door once the market signals a potential turn. And some even desire a better edge, maybe looking to get in before a trend reversal starts.

For those of us who can't predict the future, there are certain technical formations that can help support our inclinations that the herd may be changing directions. One such pattern is the tweezer. Although relatively unknown to the broader market, the tweezer may be one of the best indications that a short- (or long-) term trend may be nearing its end. Drawing similarities with the more popular double top/bottom, the tweezer can produce high probability setups in the foreign exchange market.

Double Tops/Bottoms: A Classic

One of the first technical formations that some are taught as students of technical analysis is the double top or bottom. The longer-term study is right up there with support and resistance, flags and pennants, and the doji. And it remains popular even today.

Simply, the double top (or bottom) reversal is a pattern that tends to form after a prolonged extension upward (or downward). It signifies that the energetic momentum from the previous uptrend has stalled, leaving the door open to potential weakness through significant selling pressure. The following battle between buyers and sellers lasts temporarily and ends with a final push upward before we see the price action decline. This final push creates a second peak in an otherwise stable channel pattern, forming a double top.

A textbook example of a double top appears in the EUR/USD currency pair shown in Figure 1. Here, the euro makes a high against the U.S. dollar just shy of the $1.6050 figure in April 2008. After two and a half months of stable, range-bound trading, buyers make a final push higher in July before surrendering to sellers. The result is a violent drop until final support is reached at just above the $1.2250 figure.

Figure 1

Source: FX Intellicharts

Tweezers: The New

Similar to the bearish diamond formation in popularity, tweezers (or kenuki) are relative unknown, partly because they are strikingly similar to double tops/bottoms. The key difference is in the timing of these two formations. Relatively reserved for the short term, tweezers are composed of two or more consecutive candle sessions. Any more than approximately eight to 10 candle sessions and we may well be looking at a double top or bottom percolating. However, given the short time frame, complete tweezer formations tend to happen quickly. Price is another important factor with the tweezer. In a top or bottom formation, the prongs have exactly the same high prices (in a tweezer top) or low prices (in a tweezer bottom). This idea is key as it establishes the fact that the price level itself was not broken.

Play Foreign Currencies Against The U.S. Dollar - And Win

2009-06-11T00:33:00.000-07:00

by Todd Shriber

For decades, if not longer, the U.S. dollar has been known as the world's reserve currency. Foreign investors and central banks have gobbled up greenbacks and debt issued by the U.S. government on the premise that the dollar is the world's dominant currency and American economic strength will bolster returns on dollar-denominated investments.

While the conventional wisdom regarding dollar strength has proved to be true over the years, it is important that investors remember that currencies act just like stocks or other financial instruments. They enjoy runs of success and suffer through periods of doldrums. And while the dollar has been a highly desired currency for the international investing community, it experiences periods of decline.

A fall in the dollar isn't cause for panic, though. Savvy investors can exploit the mighty greenback's decline when it happens and profit from it. Best of all, the avenues to profit from a dollar drop continue to increase.

Where to Turn When the Dollar Tumbles

There are generally a few key warning signs that indicate a decline in the dollar is on the horizon. A consistent pattern of key interest rate cuts by the Federal Reserve, a surge in the national debt and rising commodity prices, especially among gold and oil, can all help investors identify potential peril for the dollar.

And when the dollar falls, that likely means other key currencies are rising, because investors are flocking to perceived quality. For example, a tumble in the dollar combined with rising exports and economic growth in Japan would lead investors to the Japanese yen. On the other hand, if U.S. economic growth is stagnant, but Europe and the U.K. are performing well, the euro and British pound become safe havens for currency investors.

Another avenue to consider is the Swiss franc. While Switzerland is in Europe, the country doesn't participate in the common currency and likely never will. In addition, the Swiss government and central bank take almost painstaking efforts to keep the franc strong relative to competing currencies. As such, in 2009 the franc ranked as the world's fifth most-traded currency behind the U.S. dollar, euro, pound and yen.

Watching the Dollar? Watch Commodities, Too

Because many commodities are denominated in dollars, meaning their quoted price is in dollars, investors should watch certain commodity markets to get a sense of where the dollar is headed. For example, rising oil prices have generally resulted in dollar weakness because the dollar's purchasing power suffers and consumers get less gas for their cars and heating oil for their homes when crude oil prices rise.

To hedge against the dollar's fall when commodities are in a bull market, look toward commodity-based currencies such as the Australian and Canadian dollars. When precious metals, such as gold, are in high demand, the Australian dollar often benefits. Likewise, Canada's dollar rises when demand for crude oil surges. Another more recent play on a commodity currency is the Brazilian real. Formerly an emerging market, in 2009 Brazil stands as the 10th largest economy in the world and is rich with natural resources, particularly oil.

Plenty of Options to Profit From the Dollar Decline

Trading in the foreign currency markets can be daunting as the daily dollar volume in these markets dwarfs that of U.S. equity markets. Investors need to be aware that playing in FX markets is not for the faint of heart and they can lose more than their initial investment. For many, the best choice is to leave this arena to the professionals and seek out other methods for profiting from a fall in the dollar.

Fortunately, there is no shortage of products to help investors do this. One is the U.S. Dollar Index, which tracks the dollar against a basket of foreign currencies. It is updated 24 hours a day, seven days a week and trades on the New York Board of Trade. There is also a plethora of mutual funds that track foreign bonds or short the dollar against the other currencies. These funds give investors the international exposure their portfolios need without the headache of directly tracking wild intraday swings in the currency markets.

Equities, both international and domestic, provide another area for investors to profit from a dollar slide. If the forecast appears grim for U.S. equity markets, certain foreign markets may be poised to benefit. Of course, there are U.S. stocks that can benefit from a fall in the dollar, too. Large multinational firms that count on overseas markets for a fair amount of their profits benefit when the dollar is weak as they convert a British pound or Japanese yen back into a greater amount of U.S. dollars. Names like Procter & Gamble (NYSE:PG), General Electric (NYSE:GE) and PepsiCo (NYSE:PEP) come to mind.

Conclusion

Investors need not suffer at the hands of a weak dollar. The methods to protect one's dollar-based investments are plenty and effective hedging can serve as more than just protection: it can boost a portfolio's bottom line. In addition, the global economy means there are global opportunities to help investors sleep a little easier when the dollar drops.

The "Duck-And-Jab" Approach To Forex

2009-06-11T00:26:00.000-07:00

by David Hunt

Wouldn't it be great to increase the probability that your trade will be successful while simultaneously spending less time analyzing chart patterns? By putting the forex market in perspective and realizing your role as an individual trader, it is possible.

Most traders don't realize that the money they contribute to the spot market has virtually no impact on price movement, so playing by the same rules as the "big players" may not be your most profitable option. When you jump in and out of the market quickly on a calculated and highly economic regimen - a strategy called fundamental speed - you can make an impact on your own investments.

Who are the "big players"?

Banks and governments are the big players that make the forex market move.

* Banks transfer money to and from global institutions and stock reserves of every major currency. (The policies of these banks affect the currency market in a big way. See what makes them tick in Get To Know The Major Central Banks.)
* Governments set the interest rate that determines bank lending power and have the ability to sway the market by releasing key economic information.

The role of a forex trader is not to trade to move the market, but to realize the relatively undecipherable impact their trades make. Keeping this in perspective, a trader can profit through the timing of their trades - the fundamental speed process.

Fundamental Speed: The What and the How

Fundamental speed is the process of keeping an eye on key economic indicators that impact the currencies you trade, placing your trade and then exiting in a systematic way. Here is a rundown on how the process works:

1. Pick high-impact economic releases only.

Each day dozens of economic releases are made globally but only a few - if any - are worth trading. Currencies tend to make big movements when an economic release is tied directly to their rate of transfer in relation to another country's currency (Central banks' rate changes are one of the biggest influences on the forex market, see Interest Rates Matter For Forex Traders)
Here are a few releases you should keep an eye on:

* CPI
* Trade balance
* Interest rate statement
* Retail sales
* Home sales
* Consumer confidence
* Unemployment claims

Most economic calendars online show the high-impact releases in red, with a basic explanation of how they move the market. This can be a handy tool when deciding which releases to trade.

2. Set a time limit to move in and out of the market.

Realizing that the money you put in the foreign-exchange market will not make a substantial impact, you should have an exit strategy that is based on a system, not emotion.

After an economic release, a reliable price movement occurs for one to two minutes. Depending on whether the release is hawkish or dovish you will see that the price typically goes in the expected direction - but many times it spirals out in what seems to be a random direction after the first 60 to 120 seconds.

This is not so much a random movement as it is a government trying to steady their currency or a bank pushing money through to get the best transfer rate - things that are out of your control. If the release points in the direction of the daily moving average you may feel comfortable staying on the trade for up to five minutes. Treat this on a trade-by-trade basis however.

3. Do nothing in a neutral situation.

If the predicted or forecasted figure is accurate to the actual don't jump in to a trade just to put money down. Trading the fundamental speed process only gives you a few trade options on any given day (less if you trade specific currencies) and there is a temptation to risk money in a neutral situation. It is important to keep your emotions in check.

More Probable, More Profits

As a trader it is important to emphasize increasing the probability of a successful trade. The higher percentage of profitable trades you make typically gives you a higher rate of overall return - that is, more cash in your pocket. By sticking to a system you will be trading in a fashion that allows you to track the probability of your trades and to gauge which ones are profitable and which ones are not. A few more benefits of the fundamental speed process include:

* Less time analyzing charts: Technical trading can be a complex arena for beginning traders and, although it is systematic, it can be difficult to use successfully. As you grow as a trader you can merge technical trading with fundamental speed to maximize your exit strategy. But if you are just starting out, you can avoid charts altogether by focusing on the fundamentals, which are black and white.

* The ability to set a forex schedule: The forex market is a 24-hour-a-day operation, but obviously you cannot expect to trade nonstop. For many traders the most difficult part of trading is figuring out the best time to trade. Some traders work day jobs and must trade after-hours; others are full-time traders but realize the importance of sticking to a regimen. By using the fundamental speed process you know the exact times you need to trade.

The Bottom Line

Many traders learn forex through instruction manuals that treat individual traders like the "big players". Individuals trade with limited capital, meaning their impact reaches far less than the governments and banks that run the market. By harnessing this knowledge and trading in a way that uses it effectively, a trader can maximize his or her potential.

Top 4 Things Successful Forex Traders Do

2009-06-10T23:04:00.001-07:00

by Selwyn Gishen

Trading in the financial markets is surrounded by a certain amount of mystique because there is no single formula for trading successfully. Think of the markets as being like the ocean and the trader as a surfer. Surfing requires talent, balance, patience, proper equipment and astute discrimination. Would you go into the water if there were sharks swimming all around you or dangerous rip tides? Hopefully not.

The attitude to trading in the markets is no different to that required for surfing. By blending good analysis with effective implementation, your success rate will improve dramatically and, like many skill sets, good trading comes from a combination of talent and hard work. Here are the four legs of the stool that you can build into a strategy to serve you well in all markets.

Leg No.1 - Approach

Before you start to trade, recognize the value of proper preparation. The first step is to align your personal goals and temperament with the instruments and markets that you can comfortably relate to. For example, if you know something about retailing, then look to trade retail stocks rather than oil futures, about which you may know nothing. Begin by assessing the following three components.

1. Time Frame

The time frame indicates the type of trading that is appropriate for your temperament. Trading off of a five-minute chart suggests that you are more comfortable being in a position without the exposure to overnight risk. On the other hand, choosing weekly charts indicates a comfort with overnight risk and a willingness to see some days go contrary to your position.

In addition, decide if you have the willingness and time to sit in front of a screen all day or if you would prefer to do your research quietly over the weekend and then make a trading decision for the coming week based on your analysis. Remember that the opportunity to make substantial money in the markets requires time. Short-term scalping, by definition, means small profits or losses. In this case you will have to trade more frequently.

2. Methodology

Once you choose a time frame, find a consistent methodology. For example, some traders like to buy support and sell resistance. Others prefer buying or selling breakouts. Yet others like to trade using indicators such as MACD, crossovers etc.

Once you choose a system or methodology, test it to see if it works on a consistent basis and provides you with an edge. If your system is reliable more than 50% of the time, you will have an edge, even if it's a small one. If you backtest your system and discover that had you traded every time you were given a signal and your profits were more than your losses, chances are very good that you have a winning strategy. Test a few strategies and when you find one that delivers a consistently positive outcome, stay with it and test it with a variety of instruments and various time frames.

3. Market (Instrument)

You will find that certain instruments trade much more orderly than others. Erratic trading instruments make it difficult to produce a winning system. Therefore, it is necessary to test your system on multiple instruments to determine that your system's "personality" matches with the instrument being traded. For example, if you were trading the USD/JPY currency pair in the forex market, you may find that Fibonacci support and resistance levels are more reliable in this instrument than in some others. You should also test multiple time frames to find those that match your trading system best.

Leg No.2 - Attitude

Attitude in trading means ensuring that you develop your mindset to reflect the following four attributes:

1. Patience

Once you know what to expect from your system, then have the patience to wait for the price to reach the levels that your system indicates for either the point of entry or exit. If your system indicates an entry at a certain level but the market never reaches it, then move on to the next opportunity. There will always be another trade. In other words, don't chase the bus after it has left the terminal; wait for the next bus.

2. Discipline

Discipline is the ability to be patient – to sit on your hands until your system triggers an action point. Sometimes the price action won't reach your anticipated price point. At this time you must have the discipline to believe in your system and not to second-guess it. Discipline is also the ability to pull the trigger when your system indicates to do so. This is especially true for stop losses.

3. Objectivity

Objectivity or "emotional detachment" also depends on the reliability of your system or methodology. If you have a system that provides entry and exit levels that you know have a high reliability factor, then you don’t need to become emotional or allow yourself to be influenced by the opinion of pundits who are watching their levels and not yours. Your system should be reliable enough so that you can be confident in acting on its signals.

4. Realistic Expectations

Even though the market can sometimes make a much bigger move than you anticipate, being realistic means that you cannot expect to invest $250 in your trading account and expect to make $1,000 each trade. Short-term time frames provide less profit opportunities than longer term, but the risk with longer-term time frames is higher. It's a question of risk versus reward.

Leg No.3 - Discrimination

Different instruments trade differently depending on who the major players are and why they are trading that particular instrument. Hedge funds are motivated differently than mutual funds. Large banks that are trading the spot currency market in specific currencies usually have a different objective than currency traders buying or selling futures contracts. If you can determine what motivates the large players then you can often piggy-back them and profit accordingly.

* Alignment

Pick a few currencies, stocks or commodities and chart them all in a variety of time frames. Then apply your particular methodology to all of them and see which time frame and which instrument is most responsive to your system. This is how you discover a "personality" match for your system. Repeat this exercise regularly to adapt to changing market conditions.

Leg No.4 - Management (Implementation)

Since there is no such thing as only profitable trades, no system will trigger a 100% sure thing. Even a profitable system, say with a 65% profit to loss ratio, still has 35% losing trades. Therefore, the art of profitability is in the management and execution of the trade.

* Risk Control

In the end, successful trading is all about risk control. Take losses quickly and often if necessary. Try to get your trade in the correct direction right out of the gate. If it backs off, cut out and try again. Often it is on the second or third attempt that your trade will move immediately in the right direction. This practice requires patience and discipline but when you get the direction right you can trail your stops and almost always be profitable at best, or break even at worst.

The Bottom Line

There are as many nuanced methods of trading as there are traders. There is no right or wrong way to trade. There is only a profit-making trade or a loss-making trade. Warren Buffet says there are two rules in trading: Rule 1: Never lose money. Rule 2: Remember Rule 1. Stick a note on your computer that will remind you to take small losses often and quickly - don't wait for the big losses.

Currency Exchange: Floating Rate Vs. Fixed Rate

2009-06-10T02:54:00.000-07:00

by Reem Heakal

Did you know that the foreign exchange market (also known as FX or forex) is the largest market in the world? In fact, more than $3 trillion is traded in the currency markets on a daily basis as of 2009. This article is certainly not a primer for currency trading, but it will help you understand exchange rates and why some fluctuate while others do not.

What Is an Exchange Rate?

An exchange rate is the rate at which one currency can be exchanged for another. In other words, it is the value of another country's currency compared to that of your own. If you are traveling to another country, you need to "buy" the local currency. Just like the price of any asset, the exchange rate is the price at which you can buy that currency. If you are traveling to Egypt, for example, and the exchange rate for U.S. dollars 1:5.5 Egyptian pounds, this means that for every U.S. dollar, you can buy five and a half Egyptian pounds. Theoretically, identical assets should sell at the same price in different countries, because the exchange rate must maintain the inherent value of one currency against the other.

Fixed Exchange Rates

There are two ways the price of a currency can be determined against another. A fixed, or pegged, rate is a rate the government (central bank) sets and maintains as the official exchange rate. A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the yen or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged. (To learn more, read What Are Central Banks? and Get To Know The Major Central Banks.)

If, for example, it is determined that the value of a single unit of local currency is equal to US$3, the central bank will have to ensure that it can supply the market with those dollars. In order to maintain the rate, the central bank must keep a high level of foreign reserves. This is a reserved amount of foreign currency held by the central bank that it can use to release (or absorb) extra funds into (or out of) the market. This ensures an appropriate money supply, appropriate fluctuations in the market (inflation/deflation), and ultimately, the exchange rate. The central bank can also adjust the official exchange rate when necessary.

Floating Exchange Rates

Unlike the fixed rate, a floating exchange rate is determined by the private market through supply and demand. A floating rate is often termed "self-correcting", as any differences in supply and demand will automatically be corrected in the market. Take a look at this simplified model: if demand for a currency is low, its value will decrease, thus making imported goods more expensive and stimulating demand for local goods and services. This in turn will generate more jobs, causing an auto-correction in the market. A floating exchange rate is constantly changing.

In reality, no currency is wholly fixed or floating. In a fixed regime, market pressures can also influence changes in the exchange rate. Sometimes, when a local currency does reflect its true value against its pegged currency, a "black market", which is more reflective of actual supply and demand, may develop. A central bank will often then be forced to revalue or devalue the official rate so that the rate is in line with the unofficial one, thereby halting the activity of the black market.

In a floating regime, the central bank may also intervene when it is necessary to ensure stability and to avoid inflation; however, it is less often that the central bank of a floating regime will interfere.

The World Once Pegged

Between 1870 and 1914, there was a global fixed exchange rate. Currencies were linked to gold, meaning that the value of a local currency was fixed at a set exchange rate to gold ounces. This was known as the gold standard. This allowed for unrestricted capital mobility as well as global stability in currencies and trade; however, with the start of World War I, the gold standard was abandoned. (For more on the gold standard, see The Gold Standard Revisited.)

At the end of World War II, the conference at Bretton Woods, an effort to generate global economic stability and increase global trade, established the basic rules and regulations governing international exchange. As such, an international monetary system, embodied in the International Monetary Fund (IMF), was established to promote foreign trade and to maintain the monetary stability of countries and therefore that of the global economy. (For further reading on the IMF, see What Is The International Monetary Fund?)

It was agreed that currencies would once again be fixed, or pegged, but this time to the U.S. dollar, which in turn was pegged to gold at US$35 per ounce. What this meant was that the value of a currency was directly linked with the value of the U.S. dollar. So, if you needed to buy Japanese yen, the value of the yen would be expressed in U.S. dollars, whose value in turn was determined in the value of gold. If a country needed to readjust the value of its currency, it could approach the IMF to adjust the pegged value of its currency. The peg was maintained until 1971, when the U.S. dollar could no longer hold the value of the pegged rate of US$35 per ounce of gold.

From then on, major governments adopted a floating system, and all attempts to move back to a global peg were eventually abandoned in 1985. Since then, no major economies have gone back to a peg, and the use of gold as a peg has been completely abandoned.

Why Peg?

The reasons to peg a currency are linked to stability. Especially in today's developing nations, a country may decide to peg its currency to create a stable atmosphere for foreign investment. With a peg, the investor will always know what his or her investment's value is, and therefore will not have to worry about daily fluctuations. A pegged currency can also help to lower inflation rates and generate demand, which results from greater confidence in the stability of the currency.

Fixed regimes, however, can often lead to severe financial crises since a peg is difficult to maintain in the long run. This was seen in the Mexican (1995), Asian (1997) and Russian (1997) financial crises: an attempt to maintain a high value of the local currency to the peg resulted in the currencies eventually becoming overvalued. This meant that the governments could no longer meet the demands to convert the local currency into the foreign currency at the pegged rate. With speculation and panic, investors scrambled to get their money out and convert it into foreign currency before the local currency was devalued against the peg; foreign reserve supplies eventually became depleted. In Mexico's case, the government was forced to devalue the peso by 30%. In Thailand, the government eventually had to allow the currency to float, and by the end of 1997, the Thai bhat had lost 50% of its as the market's demand and supply readjusted the value of the local currency. (For more insight, see What Causes A Currency Crisis?)

Countries with pegs are often associated with having unsophisticated capital markets and weak regulating institutions. The peg is therefore there to help create stability in such an environment. It takes a stronger system as well as a mature market to maintain a float. When a country is forced to devalue its currency, it is also required to proceed with some form of economic reform, like implementing greater transparency, in an effort to strengthen its financial institutions.

Some governments may choose to have a "floating," or "crawling" peg, whereby the government reassesses the value of the peg periodically and then changes the peg rate accordingly. Usually this causes devaluation, but it is controlled to avoid market panic. This method is often used in the transition from a peg to a floating regime, and it allows the government to "save face" by not being forced to devalue in an uncontrollable crisis.

Conclusion

Although the peg has worked in creating global trade and monetary stability, it was used only at a time when all the major economies were a part of it. And while a floating regime is not without its flaws, it has proved to be a more efficient means of determining the long-term value of a currency and creating equilibrium in the international market.

Currency ETFs Simplify Forex Trades

2009-06-10T02:48:00.000-07:00

by John Jagerson

Investing in any market can be volatile. Minimizing risk while retaining upside potential is paramount for most investors - that's why an increasing number of traders and investors are diversifying and hedging with currencies. Different currencies benefit from some of the same things that may hurt stock indexes, bonds or commodities and can be a great way to diversify a portfolio. However, digging into currencies as a trader or investor can be daunting.

New currency exchange-traded funds (ETFs) make it simpler to understand the forex market (the largest, most liquid market on the planet), and use it to diversify risk.

Now, you can have General Electric (NYSE:GE) and the British pound in your portfolio by holding the CurrencyShares British Pound ETF (PSE:FXB) in the same account. Have an IRA? Sprinkle some euros in there by holding the CurrencyShares Euro ETF (PSE:FXE), and offset some downside risk of your S&P 500 holdings. Read on to learn more about this unique way of using currencies to diversify your holdings. (For more on ETFs, see Introduction To Exchange-Traded Funds and Advantages Of Exchange-Traded Funds.)
Click Here

Hedging Against Risk

Every investor is exposed to two types of risk: idiosyncratic risk and systemic risk. Idiosyncratic risk is the risk that an individual stock's price will fall, causing you to accumulate massive losses on that stock. Rooting this kind of risk out of your portfolio is quite simple. All you have to do is diversify your account across a broad range of stocks or stock-based ETFs, thus reducing your exposure to a particular stock. (To learn more, read The Importance Of Diversification and Do You Understand Investment Risk?)

However, diversifying across a broad range of stocks only addresses idiosyncratic risk. You still have to face your account's systemic risk.

Systemic risk is the exposure you have to the entire stock market falling, causing you to accumulate losses across your entire diversified portfolio. Minimizing the exposure of your portfolio to a bear market used to be difficult. You had to open a futures account or a forex account and try to manage both it and your stock accounts at the same time. While opening a forex account and trading it can be extremely profitable if you apply yourself, many investors aren't ready to take that step. Instead, they decide to leave all of their eggs in their stock market basket and hope the bulls win. Don't let that be you. (Want to give currencies a shot? Read Wading Into The Currency Market.)

Currency ETFs are opening doors for investors to diversify. You can now easily mitigate systematic risk in your account and take advantage of large macroeconomic trends around the world by putting your money not only into the stock market but also in the forex market through these funds. (For more see, A Beginner's Guide To Hedging.)

How Currency ETFs Work

ETF management firms buy and hold currencies in a fund. They then sell shares of that fund to the public. You can buy and sell ETF shares just like you buy and sell stock shares. Investors value the shares of the ETF at 100 times the current exchange rate for the currency being held. For example, let's assume that the CurrencyShares Euro Trust (PSE:FXE) is currently priced at $136.80 per share because the underlying exchange rate for the euro versus the U.S. dollar (EUR/USD) is 1.3680 (1.3680 × 100 = $136.80).

You can use ETFs to profit from the exchange rate of the dollar versus the euro, the British pound, the Canadian dollar, the Japanese yen, the Swiss franc, the Australian dollar and a few other major currencies. (For more on this market, see Common Questions About Currency Trading.)

What makes currencies move?

Unlike the stock market, which has a long-term propensity to rise in value, currencies will often channel in the very long term. Stocks are driven by economic and business growth and tend to trend. Conversely, inflation and issues around monetary policy may prevent a currency from growing in value indefinitely.

Currency pairs may trend as well, and there are simple factors that influence their value and movement. These factors include interest rates, stock market yields, economic growth and government policy. Most of these can be forecasted and used to guide traders as they hedge risk in the rest of the market and make profits in the forex.

Economic Factors and Currency Trends

Here are two examples of economic factors and the currency trends they inspire.

Oil and the Canadian Dollar

Each currency represents an individual economy. If an economy is a commodity producer and exporter, commodity prices will drive currency values. There are three major currencies that are known as "commodity" currencies that exhibit very strong correlations with oil, gold and other raw materials. The Canadian dollar (CAD) is one of these. (For more on how this works, read Commodity Prices And Currency Movements.)

One ETF that can be traded to profit from the moves in the CAD/USD pair is CurrencyShares Canadian (PSE:FXC). Because the Canadian dollar is on the base side of this currency pair, it will pull the ETF up when oil prices are rising and it will fall when oil prices are declining. Of course, there are other factors at play in that currency's value but energy prices are a major influence, and can be surprisingly predictive of the trend.

This is especially useful for stock traders because of the effect that higher energy prices can have on stock values. Additionally, it provides another way for stock traders to speculate on rising commodity prices without having to venture into the futures market. (For on this topic, check out Currency Moves Highlight Equity Opportunities.)

In Figures 1 and 2, you can see 18 months of prices for the Canadian dollar compared to oil prices over the same period.

Figure 1: Crude oil (continuous)

Source: MetaStock Pro FX

Figure 2: Canadian dollar

Source: MetaStock Pro FX

As you can see, there is a strong positive correlation between these two markets. This is helpful as a hedge against stock volatility as well as the real day-to-day costs of higher energy prices.

Short-term traders may look for a breakout in oil prices that is not reflected in the value of the Canadian dollar immediately. When these imbalances occur, there is opportunity to take advantage of the move the market will make as it "catches up" with oil.

Long-term traders can use this as a way to diversify their holdings and speculate on rising energy prices. It is also possible to short the ETF to take advantage of falling oil prices.

Interest Rates and the Swiss Franc
There are several forex relationships that are impacted by interest rates, but a dramatic correlation exists between bond yields and the Swiss franc. One ETF that can be used to profit from the Swiss franc, or "Swissie", is the CurrencyShares Swiss Franc Trust (PSE:FXF). The currency pair is notated as CHF/USD. When the Swissie is rising in value, the ETF rises as well, as it costs more U.S. dollars to buy a Swiss franc.

The correlation described here involves the 10-year bond yield. You will notice in Figures 3 and 4 that when bond yields are rising, the Swissie falls, and vice versa. Depending on interest rates, the value of the Swissie will frequently rise and fall with bond yields.

Figure 3: 10-Year Bond Yields (TNX)

Source: MetaStock Pro FX

Figure 4: Swiss franc

Source: MetaStock Pro FX

This relationship is useful not only as a way to find new trading opportunities but as a hedge against falling stock prices. The stock market has a positive correlation with bond yields; therefore, if yields are falling, the stock market should be falling as well. A savvy investor who is long the Swissie ETF can offset some of those losses.

Conclusion

Currency ETFs have opened the forex market to investors focused on stocks. They adds an additional layer of diversification and can also be used effectively by shorter term traders for quick profits. There are even options available for most of these ETFs.

Corporate Currency Risks Explained

2009-06-10T02:41:00.000-07:00

by Permjit Singh

Businesses that trade internationally or domestically must deal with various risks when trading in currencies other than their home currency.

Companies typically generate capital by borrowing debt or issuing equity, and then use this to invest in assets and try to generate a return on the investment. The investment might be in assets overseas and financed in foreign currencies, or the company's products might be sold to customers overseas who pay in their local currencies.

Domestic companies that sell only to domestic customers might still face currency risk because the raw materials they buy are priced in a foreign currency. Companies who trade in just their home currency can still face currency risk if their competitors trade in a different home currency. So what are a company's various currency risks? (Baffled by exchange rates? Wonder why some currencies fluctuate while others don't? This article has the answers: Currency Exchange: Floating Rate Vs. Fixed Rate.)

Transaction Risk

Transaction risk arises whenever a company has a committed cash flow to be paid or received in a foreign currency. The risk often arises when a company sells its products or services on credit and it receives payment after a delay, such as 90 or 120 days. It is a risk for the company because in the period between sale and receipt of funds, the value of the foreign payment when it is exchanged for home currency terms could result in a loss for the company. The reduced home currency value would arise because the exchange rate has moved against the company during the period of credit granted. (Learn more in Protect Your Foreign Investments From Currency Risk and What is a currency converter and how do I use one?)

The example below illustrates a transaction risk:

	Spot Rate	AUD Received From Sale	USD Received After Exchange
Scenario A (Now)	USD1 = AUD2.00	2 million	1 million
Scenario B (After 90 days)	USD1 = AUD2.50	2 million	800,000

For the sake of the example, let's say a company called USA Printing has a home currency of U.S.dollars (USD) and it sells a printing machine to an Australian customer, Koala Corp., which pays in its home currency of Australian dollars (AUD) in the amount of $2 million.

In scenario A, the sales invoice is paid on delivery of the machine. USA Printing receives $2 million Australian dollars, and converts them at the spot rate of 1:2 and so receives US$1 million.

In scenario B, the customer is allowed credit by the company, so $2 million AUD is paid after 90 days. USA Printing still receives A$2 million but the spot rate quoted at that time is 1:2.50, so when USA Printing converts the payment, it is worth only US$800,000, a difference of US$200,000.

If the USA Printing had intended to make a profit of US$200,000 from the sale, this would have been totally lost in scenario B due to the depreciation of the AUD during the 90-day period. (Companies know all about these risks, learn how they avoid them in Corporate Use Of Derivatives For Hedging.)

Translation Risk

A company that has operations overseas will need to translate the foreign currency values of each of these assets and liabilities into its home currency. It will then have to consolidate them with its home currency assets and liabilities before it can publish its consolidated financial accounts - its balance sheet and profit and loss account. The translation process can result in unfavorable equivalent home currency values of assets and liabilities. A simple balance sheet example of a company whose home (and reporting) currency is in pounds (£) will illustrate translation risk:

	Pre-Consolidation	Year 1	Year 2
£1:$ Exchange Rate	n/a	1.50	3.00
Assets
Foreign	$300	£200	£100
Home	£100	£100	£100
Total	n/a	£300	£200
Liabilities
Foreign	0	0	0
Home (debt)	£200	£200	£200
Equity	£100	£100	0
Total	n/a	£300	£200
D/E ratio	n/a	2	--

In Year 1, with an exchange rate of £1:1.50, the company's foreign assets are worth £200 in home currency terms and total assets and liabilities are each £300. The debt/equity ratio, is 2:1. In Year 2, the dollar has depreciated and is now trading at the exchange rate of £1:$3.00. When Year 2's assets and liabilities are consolidated, the foreign asset is worth £100 (a 50% fall in value in £ terms). For the balance sheet to balance, liabilities must equal assets. The adjustment is made to the value of equity, which must decrease by £100 so liabilities also total £200. (Learn about the components of the statement of financial position and how they relate to each other; see Reading The Balance Sheet.)

The adverse effect of this equity adjustment is that the D/E, or gearing ratio, is now substantially changed. This would be a serious problem for the company if it had given a covenant (promise) to keep this ratio below an agreed figure. The consequence for the company might be that the bank that provided the £200 of debt demands it back or it applies penal terms for a waiver of the covenant.

Another unpleasant effect caused by translation is that the value of equity is much lower - not a pleasant situation for shareholders whose investment was worth £100 last year, and some (not seeing the balance sheet when published) might try to sell their shares. This selling might depress the company's market share price, or make it difficult for the company to attract additional equity investment. (Learn how to evaluate a company based on its financial statements, check out our Fundamental Analysis Tutorial.)

Some companies would argue that the value of the foreign assets has not changed in local currency terms; it is still worth $300 and its operations and profitability might also be as valuable as they were last year. This means that there is no intrinsic deterioration in value to shareholders. All that has happened is an accounting effect of translating foreign currency. Some companies, therefore, take a relatively relaxed view of translation risk since there is no actual cash flow effect. If the company were to sell its assets at the depreciated exchange rate in year two, this would create a cash flow impact and the translation risk would become transaction risk.

Economic Risk

Like transaction risk, economic risk has a cash flow effect on a company. Unlike transaction risk, economic risk relates to uncommitted cash flows, or those from expected but not yet committed future product sales. These future sales, and hence future cash flows, might be reduced when they are exchanged for home currency if a foreign competitor selling to the same customer as the company (but in the competitor's currency) sees its exchange rate move favorably (versus that of the customer) while the company's exchange rate versus that of the customer, moves unfavorably. Note that the customer could be in the same country as the company (and so have the same home currency) and the company would still have an exposure to economic risk. (Investing overseas begins with a determination of the risk of the country's investment climate Evaluating Country Risk For International Investing.)

The company would therefore lose value (in home currency terms) through no direct fault of its own; its product, for example, could be just as good or better than the competitor's product, it just now costs more to the customer in the customer's currency.

The Bottom Line

Currency risks can have various effects on a company, whether it trades domestically or internationally. Transaction and economic risks affect a company's cash flows, while transaction risk represents future and known cash flows. Economic risk represents future but unknown cash flows. Translation risk has no cash flow effect, although it could be transformed into transaction risk or economic risk if the company were to realize the value of its foreign currency assets or liabilities. Risk can be tricky to understand, but by breaking it up into these categories, it is easier to see how that risk affects a company's balance sheet.

Currency Trading Summary

2009-06-08T23:46:00.000-07:00

While this online forex tutorial only represents a fraction of all there is to know about forex trading, we hope that you've gained some insight into this topic. We also encourage those of you who are interested in potentially trading in the online forex market to learn more about the complexities and intricacies that make this market unique.

Let's recap:

* The forex market represents the electronic over-the-counter markets where currencies are traded worldwide 24 hours a day, five and a half days a week. The typical means of trading forex are on the spot, futures and forwards markets.
* Currencies are "priced" in currency pairs and are quoted either directly or indirectly.
* Currencies typically have two prices: bid (the amount that the market will buy the quote currency for in relation to the base currency); and ask (the amount the market will sell one unit of the base currency for in relation to the quote currency). The bid price is always smaller than the ask price.
* Unlike conventional equity and debt markets, forex investors have access to large amounts of leverage, which allows substantial positions to be taken without making a large initial investment.
* The adoption and elimination of several global currency systems over time led to the formation of the present currency exchange system, in which most countries use some measure of floating exchange rates.
* Governments, central banks, banks and other financial institutions, hedgers, and speculators are the main players in the forex market.
* The main economic theories found in the foreign exchange deal with parity conditions such as those involving interest rates and inflation. Overall, a country's qualitative and quantitative factors are seen as large influences on its currency in the forex market.
* Forex traders use fundamental analysis to view currencies and their countries like companies, thereby using economic announcements to gain an idea of the currency's true value.
* Forex traders use technical analysis to look at currencies the same way they would any other asset and, therefore, use technical tools such as trends, charts and indicators in their trading strategies.
* Unlike stock trades, forex trades have minimal commissions and related fees. But new forex traders should take a conservative approach and use orders, such as the take-profit or stop-loss, to minimize losses.

How To Trade & Open A Forex Account

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So, you think you are ready to trade? Make sure you read this section to learn how you can go about setting up a forex account so that you can start trading currencies. We'll also mention other factors that you should be aware of before you take this step. We will then discuss how to trade forex and the different types of orders that can be placed.

Opening A Forex Brokerage Account

Trading forex is similar to the equity market because individuals interested in trading need to open up a trading account. Like the equity market, each forex account and the services it provides differ, so it is important that you find the right one. Below we will talk about some of the factors that should be considered when selecting a forex account.

Leverage

Leverage is basically the ability to control large amounts of capital, using very little of your own capital; the higher the leverage, the higher the level of risk. The amount of leverage on an account differs depending on the account itself, but most use a factor of at least 50:1, with some being as high as 250:1. A leverage factor of 50:1 means that for every dollar you have in your account you control up to $50. For example, if a trader has $1,000 in his or her account, the broker will lend that person $50,000 to trade in the market. This leverage also makes your margin, or the amount you have to have in the account to trade a certain amount, very low. In equities, margin is usually at least 50%, while the leverage of 50:1 is equivalent to 2%.

Leverage is seen as a major benefit of forex trading, as it allows you to make large gains with a small investment. However, leverage can also be an extreme negative if a trade moves against you because your losses also are amplified by the leverage. With this kind of leverage, there is the real possibility that you can lose more than you invested - although most firms have protective stops preventing an account from going negative. For this reason, it is vital that you remember this when opening an account and that when you determine your desired leverage you understand the risks involved.

Commissions and Fees

Another major benefit of forex accounts is that trading within them is done on a commission-free basis. This is unlike equity accounts, in which you pay the broker a fee for each trade. The reason for this is that you are dealing directly with market makers and do not have to go through other parties like brokers.

This may sound too good to be true, but rest assured that market makers are still making money each time you trade. Remember the bid and ask from the previous section? Each time a trade is made, it is the market makers that capture the spread between these two. Therefore, if the bid/ask for a foreign currency is 1.5200/50, the market maker captures the difference (50 basis points).

If you are planning on opening a forex account, it is important to know that each firm has different spreads on foreign currency pairs traded through them. While they will often differ by only a few pips (0.0001), this can be meaningful if you trade a lot over time. So when opening an account make sure to find out the pip spread that it has on foreign currency pairs you are looking to trade.

Other Factors

There are a lot of differences between each forex firm and the accounts they offer, so it is important to review each before making a commitment. Each company will offer different levels of services and programs along with fees above and beyond actual trading costs. Also, due to the less regulated nature of the forex market, it is important to go with a reputable company. (For more information on what to look for when opening an account, read Wading Into The Currency Market. If you are not ready to open a "real money" account but want to try your hand at forex trading, read Demo Before You Dive In.)

How to Trade Forex

Now that you know some important factors to be aware of when opening a forex account, we will take a look at what exactly you can trade within that account. The two main ways to trade in the foreign currency market is the simple buying and selling of currency pairs, where you go long one currency and short another. The second way is through the purchasing of derivatives that track the movements of a specific currency pair. Both of these techniques are highly similar to techniques in the equities market.The most common way is to simply buy and sell currency pairs, much in the same way most individuals buy and sell stocks. In this case, you are hoping the value of the pair itself changes in a favorable manner. If you go long a currency pair, you are hoping that the value of the pair increases. For example, let's say that you took a long position in the USD/CAD pair - you will make money if the value of this pair goes up, and lose money if it falls. This pair rises when the U.S. dollar increases in value against the Canadian dollar, so it is a bet on the U.S. dollar.

The other option is to use derivative products, such as options and futures, to profit from changes in the value of currencies. If you buy an option on a currency pair, you are gaining the right to purchase a currency pair at a set rate before a set point in time. A futures contract, on the other hand, creates the obligation to buy the currency at a set point in time. Both of these trading techniques are usually only used by more advanced traders, but it is important to at least be familiar with them. (For more on this, try Getting Started in Forex Options and our tutorials, Option Spread Strategies and Options Basics Tutorial.)

Types of Orders

A trader looking to open a new position will likely use either a market order or a limit order. The incorporation of these order types remains the same as when they are used in the equity markets. A market order gives a forex trader the ability to obtain the currency at whatever exchange rate it is currently trading at in the market, while a limit order allows the trader to specify a certain entry price. (For a brief refresher of these orders, see The Basics of Order Entry.)

Forex traders who already hold an open position may want to consider using a take-profit order to lock in a profit. Say, for example, that a trader is confident that the GBP/USD rate will reach 1.7800, but is not as sure that the rate could climb any higher. A trader could use a take-profit order, which would automatically close his or her position when the rate reaches 1.7800, locking in their profits.

Another tool that can be used when traders hold open positions is the stop-loss order. This order allows traders to determine how much the rate can decline before the position is closed and further losses are accumulated. Therefore, if the GBP/USD rate begins to drop, an investor can place a stop-loss that will close the position (for example at 1.7787), in order to prevent any further losses.

As you can see, the type of orders that you can enter in your forex trading account are similar to those found in equity accounts. Having a good understanding of these orders is critical before placing your first trade.

Technical Analysis & TechnicaI Indicators

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One of the underlying tenets of technical analysis is that historical price action predicts future price action. Since the forex is a 24-hour market, there tends to be a large amount of data that can be used to gauge future price activity, thereby increasing the statistical significance of the forecast. This makes it the perfect market for traders that use technical tools, such as trends, charts and indicators. (To learn more, see Introduction to Technical Analysis and Charting Your Way To Better Returns.)

It is important to note that, in general, the interpretation of technical analysis remains the same regardless of the asset being monitored. There are literally hundreds of books dedicated to this field of study, but in this tutorial we will only touch on the basics of why technical analysis is such a popular tool in the forex market.

As the specific techniques of technical analysis are discussed in other tutorials, we will focus on the more forex-specific aspects of technical analysis.

Technical Analysis Discounts Everything; Especially in Forex

Minimal Rate Inconsistency
There are many large players in the forex market, such as hedge funds and large banks, that all have advanced computer systems to constantly monitor any inconsistencies between the different currency pairs. Given these programs, it is rare to see any major inconsistency last longer than a matter of seconds. Many traders turn to forex technical analysis because it presumes that all the factors that influence a price - economic, political, social and psychological - have already been factored into the current exchange rate by the market. With so many investors and so much money exchanging hands each day, the trend and flow of capital is what becomes important, rather than attempting to identify a mispriced rate.

Trend or Range
One of the greatest goals of technical traders in the FX market is to determine whether a given pair will trend in a certain direction, or if it will travel sideways and remain range-bound. The most common method to determine these characteristics is to draw trend lines that connect historical levels that have prevented a rate from heading higher or lower. These levels of support and resistance are used by technical traders to determine whether or not the given trend, or lack of trend, will continue.

Generally, the major currency pairs - such as the EUR/USD, USD/JPY, USD/CHF and GBP/USD - have shown the greatest characteristics of trend, while the currency pairs that have historically shown a higher probability of becoming range-bound have been the currency crosses (pairs not involving the U.S. dollar). The two charts below show the strong trending nature of USD/JPY in contrast to the range-bound nature of EUR/CHF. It is important for every trader to be aware of the characteristics of trend and range, because they will not only affect what pairs are traded, but also what type of strategy should be used.

Common Indicators
Technical traders use many different indicators in combination with support and resistance to aid them in predicting the future direction of exchange rates. Again, learning how to interpret various forex technical indicators is a study unto itself and goes beyond the scope of this forex tutorial. If you wish to learn more about this subject, we suggest you read our technical analysis tutorial.

A few indicators that we feel we should mention, due to their popularity, are: Bollinger bands, Fibonacci retracement, moving averages, moving average convergence divergence (MACD) and stochastics. These technical tools are rarely used by themselves to generate signals, but rather in conjunction with other indicators and chart patterns.

Fundamental Analysis & Fundamentals Trading Strategies

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In the equities market, fundamental analysis looks to measure a company's true value and to base investments upon this type of calculation. To some extent, the same is done in the retail forex market, where forex fundamental traders evaluate currencies, and their countries, like companies and use economic announcements to gain an idea of the currency’s true value.

All of the news reports, economic data and political events that come out about a country are similar to news that comes out about a stock in that it is used by investors to gain an idea of value. This value changes over time due to many factors, including economic growth and financial strength. Fundamental traders look at all of this information to evaluate a country's currency.

Given that there are practically unlimited forex fundamentals trading strategies based on fundamental data, one could write a book on this subject. To give you a better idea of a tangible trading opportunity, let’s go over one of the most well-known situations, the forex carry trade. (To read some frequently asked questions about currency trading, see Common Questions About Currency Trading.)

A Breakdown of the Forex Carry Trade

The currency carry trade is a strategy in which a trader sells a currency that is offering lower interest rates and purchases a currency that offers a higher interest rate. In other words, you borrow at a low rate, and then lend at a higher rate. The trader using the strategy captures the difference between the two rates. When highly leveraging the trade, even a small difference between two rates can make the trade highly profitable. Along with capturing the rate difference, investors also will often see the value of the higher currency rise as money flows into the higher-yielding currency, which bids up its value.

Real-life examples of a yen carry trade can be found starting in 1999, when Japan decreased its interest rates to almost zero. Investors would capitalize upon these lower interest rates and borrow a large sum of Japanese yen. The borrowed yen is then converted into U.S. dollars, which are used to buy U.S. Treasury bonds with yields and coupons at around 4.5-5%. Since the Japanese interest rate was essentially zero, the investor would be paying next to nothing to borrow the Japanese yen and earn almost all the yield on his or her U.S. Treasury bonds. But with leverage, you can greatly increase the return.

For example, 10 times leverage would create a return of 30% on a 3% yield. If you have $1,000 in your account and have access to 10 times leverage, you will control $10,000. If you implement the currency carry trade from the example above, you will earn 3% per year. At the end of the year, your $10,000 investment would equal $10,300, or a $300 gain. Because you only invested $1,000 of your own money, your real return would be 30% ($300/$1,000). However this strategy only works if the currency pair’s value remains unchanged or appreciates. Therefore, most forex carry traders look not only to earn the interest rate differential, but also capital appreciation. While we’ve greatly simplified this transaction, the key thing to remember here is that a small difference in interest rates can result in huge gains when leverage is applied. Most currency brokers require a minimum margin to earn interest for carry trades.

However, this transaction is complicated by changes to the exchange rate between the two countries. If the lower-yielding currency appreciates against the higher-yielding currency, the gain earned between the two yields could be eliminated. The major reason that this can happen is that the risks of the higher-yielding currency are too much for investors, so they choose to invest in the lower-yielding, safer currency. Because carry trades are longer term in nature, they are susceptible to a variety of changes over time, such as rising rates in the lower-yielding currency, which attracts more investors and can lead to currency appreciation, diminishing the returns of the carry trade. This makes the future direction of the currency pair just as important as the interest rate differential itself. (To read more about currency pairs, see Using Currency Correlations To Your Advantage, Making Sense Of The Euro/Swiss Franc Relationship and Forces Behind Exchange Rates.)

To clarify this further, imagine that the interest rate in the U.S. was 5%, while the same interest rate in Russia was 10%, providing a carry trade opportunity for traders to short the U.S. dollar and to long the Russian ruble. Assume the trader borrows $1,000 US at 5% for a year and converts it into Russian rubles at a rate of 25 USD/RUB (25,000 rubles), investing the proceeds for a year. Assuming no currency changes, the 25,000 rubles grows to 27,500 and, if converted back to U.S. dollars, will be worth $1,100 US. But because the trader borrowed $1,000 US at 5%, he or she owes $1,050 US, making the net proceeds of the trade only $50.

However, imagine that there was another crisis in Russia, such as the one that was seen in 1998 when the Russian government defaulted on its debt and there was large currency devaluation in Russia as market participants sold off their Russian currency positions. If, at the end of the year the exchange rate was 50 USD/RUB, your 27,500 rubles would now convert into only $550 US (27,500 RUB x 0.02 RUB/USD). Because the trader owes $1,050 US, he or she will have lost a significant percentage of the original investment on this carry trade because of the currency’s fluctuation - even though the interest rates in Russia were higher than the U.S.

Another good example of forex fundamental analysis is based on commodity prices. (To read more about this, see Commodity Prices And Currency Movements.)

You should now have an idea of some of the basic economic and fundamental ideas that underlie the forex and impact the movement of currencies. The most important thing that should be taken away from this section is that currencies and countries, like companies, are constantly changing in value based on fundamental factors such as economic growth and interest rates. You should also, based on the economic theories mentioned above, have an idea how certain economic factors impact a country's currency. We will now move on to technical analysis, the other school of analysis that can be used to pick trades in the forex market.

Economic Theories, Models, Feeds & Data

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There is a great deal of academic theory revolving around currencies. While often not applicable directly to day-to-day trading, it is helpful to understand the overarching ideas behind the academic research.

The main economic theories found in the foreign exchange deal with parity conditions. A parity condition is an economic explanation of the price at which two currencies should be exchanged, based on factors such as inflation and interest rates. The economic theories suggest that when the parity condition does not hold, an arbitrage opportunity exists for market participants. However, arbitrage opportunities, as in many other markets, are quickly discovered and eliminated before even giving the individual investor an opportunity to capitalize on them. Other theories are based on economic factors such as trade, capital flows and the way a country runs its operations. We review each of them briefly below.

Major Theories: Purchasing Power Parity

Purchasing Power Parity (PPP) is the economic theory that price levels between two countries should be equivalent to one another after exchange-rate adjustment. The basis of this theory is the law of one price, where the cost of an identical good should be the same around the world. Based on the theory, if there is a large difference in price between two countries for the same product after exchange rate adjustment, an arbitrage opportunity is created, because the product can be obtained from the country that sells it for the lowest price.

The relative version of PPP is as follows:

Where 'e' represents the rate of change in the exchange rate and 'π1' and 'π2'represent the rates of inflation for country 1 and country 2, respectively.

For example, if the inflation rate for country XYZ is 10% and the inflation for country ABC is 5%, then ABC's currency should appreciate 4.76% against that of XYZ.

Interest Rate Parity

The concept of Interest Rate Parity (IRP) is similar to PPP, in that it suggests that for there to be no arbitrage opportunities, two assets in two different countries should have similar interest rates, as long as the risk for each is the same. The basis for this parity is also the law of one price, in that the purchase of one investment asset in one country should yield the same return as the exact same asset in another country; otherwise exchange rates would have to adjust to make up for the difference.

The formula for determining IRP can be found by:

Where 'F' represents the forward exchange rate; 'S' represents the spot exchange rate; 'i1' represents the interest rate in country 1; and 'i2' represents the interest rate in country 2.

International Fisher Effect

The International Fisher Effect (IFE) theory suggests that the exchange rate between two countries should change by an amount similar to the difference between their nominal interest rates. If the nominal rate in one country is lower than another, the currency of the country with the lower nominal rate should appreciate against the higher rate country by the same amount.

The formula for IFE is as follows:

Where 'e' represents the rate of change in the exchange rate and 'i1' and 'i2'represent the rates of inflation for country 1 and country 2, respectively.

Balance of Payments Theory

A country's balance of payments is comprised of two segments - the current account and the capital account - which measure the inflows and outflows of goods and capital for a country. The balance of payments theory looks at the current account, which is the account dealing with trade of tangible goods, to get an idea of exchange-rate directions.

If a country is running a large current account surplus or deficit, it is a sign that a country's exchange rate is out of equilibrium. To bring the current account back into equilibrium, the exchange rate will need to adjust over time. If a country is running a large deficit (more imports than exports), the domestic currency will depreciate. On the other hand, a surplus would lead to currency appreciation.

The balance of payments identity is found by:

Where BCA represents the current account balance; BKA represents the capital account balance; and BRA represents the reserves account balance.

Real Interest Rate Differentiation Model

The Real Interest Rate Differential Model simply suggests that countries with higher real interest rates will see their currencies appreciate against countries with lower interest rates. The reason for this is that investors around the world will move their money to countries with higher real rates to earn higher returns, which bids up the price of the higher real rate currency.

Asset Market Model

The Asset Market Model looks at the inflow of money into a country by foreign investors for the purpose of purchasing assets such as stocks, bonds and other financial instruments. If a country is seeing large inflows by foreign investors, the price of its currency is expected to increase, as the domestic currency needs to be purchased by these foreign investors. This theory considers the capital account of the balance of trade compared to the current account in the prior theory. This model has gained more acceptance as the capital accounts of countries are starting to greatly outpace the current account as international money flow increases.

Monetary Model

The Monetary Model focuses on a country's monetary policy to help determine the exchange rate. A country's monetary policy deals with the money supply of that country, which is determined by both the interest rate set by central banks and the amount of money printed by the treasury. Countries that adopt a monetary policy that rapidly grows its monetary supply will see inflationary pressure due to the increased amount of money in circulation. This leads to a devaluation of the currency.

These economic theories, which are based on assumptions and perfect situations, help to illustrate the basic fundamentals of currencies and how they are impacted by economic factors. However, the fact that there are so many conflicting theories indicates the difficulty in any one of them being 100% accurate in predicting currency fluctuations. Their importance will likely vary by the different market environment, but it is still important to know the fundamental basis behind each of the theories.

Economic Data

Economic theories may move currencies in the long term, but on a shorter-term, day-to-day or week-to-week basis, economic data has a more significant impact. It is often said the biggest companies in the world are actually countries and that their currency is essentially shares in that country. Economic data, such as the latest gross domestic product (GDP) numbers, are often considered to be like a company's latest earnings data. In the same way that financial news and current events can affect a company's stock price, news and information about a country can have a major impact on the direction of that country's currency. Changes in interest rates, inflation, unemployment, consumer confidence, GDP, political stability etc. can all lead to extremely large gains/losses depending on the nature of the announcement and the current state of the country.

The number of economic announcements made each day from around the world can be intimidating, but as one spends more time learning about the forex market it becomes clear which announcements have the greatest influence. Listed below are a number of economic indicators that are generally considered to have the greatest influence - regardless of which country the announcement comes from.

Employment Data

Most countries release data about the number of people that currently are employed within that economy. In the U.S., this data is known as non-farm payrolls and is released the first Friday of the month by the Bureau of Labor Statistics. In most cases, strong increases in employment signal that a country enjoys a prosperous economy, while decreases are a sign of potential contraction. If a country has gone recently through economic troubles, strong employment data could send the currency higher because it is a sign of economic health and recovery. On the other hand, high employment can also lead to inflation, so this data could send the currency downward. In other words, economic data and the movement of currency will often depend on the circumstances that exist when the data is released.

Interest Rates

As was seen with some of the economic theories, interest rates are a major focus in the forex market. The most focus by market participants, in terms of interest rates, is placed on the country's central bank changes of its bank rate, which is used to adjust monetary supply and institute the country's monetary policy. In the U.S., the Federal Open Market Committee (FOMC) determines the bank rate, or the rate at which commercial banks can borrow and lend to the U.S. Treasury. The FOMC meets eight times a year to make decisions on whether to raise, lower or leave the bank rate the same; and each meeting, along with the minutes, is a point of focus. (For more on central banks read Get to Know the Major Central Banks.)

Inflation

Inflation data measures the increases and decreases of price levels over a period of time. Due to the sheer amount of goods and services within an economy, a basket of goods and services is used to measure changes in prices. Price increases are a sign of inflation, which suggests that the country will see its currency depreciate. In the U.S., inflation data is shown in the Consumer Price Index, which is released on a monthly basis by the Bureau of Labor Statistics.

Gross Domestic Product

The gross domestic product of a country is a measure of all of the finished goods and services that a country generated during a given period. The GDP calculation is split into four categories: private consumption, government spending, business spending and total net exports. GDP is considered the best overall measure of the health of a country's economy, with GDP increases signaling economic growth. The healthier a country's economy is, the more attractive it is to foreign investors, which in turn can often lead to increases in the value of its currency, as money moves into the country. In the U.S., this data is released by the Bureau of Economic Analysis once a month in the third or fourth quarter of the month.

Retail Sales

Retail sales data measures the amount of sales that retailers make during the period, reflecting consumer spending. The measure itself doesn't look at all stores, but, similar to GDP, uses a group of stores of varying types to get an idea of consumer spending. This measure also gives market participants an idea of the strength of the economy, where increased spending signals a strong economy. In the U.S., the Department of Commerce releases data on retail sales around the middle of the month.

Durable Goods

The data for durable goods (those with a lifespan of more than three years) measures the amount of manufactured goods that are ordered, shipped and unfilled for the time period. These goods include such things as cars and appliances, giving economists an idea of the amount of individual spending on these longer-term goods, along with an idea of the health of the factory sector. This measure again gives market participants insight into the health of the economy, with data being released around the 26th of the month by the Department of Commerce.

Trade and Capital Flows

Interactions between countries create huge monetary flows that can have a substantial impact on the value of currencies. As was mentioned before, a country that imports far more than it exports could see its currency decline due to its need to sell its own currency to purchase the currency of the exporting nation. Furthermore, increased investments in a country can lead to substantial increases in the value of its currency.

Trade flow data looks at the difference between a country's imports and exports, with a trade deficit occurring when imports are greater than exports. In the U.S., the Commerce Department releases balance of trade data on a monthly basis, which shows the amount of goods and services that the U.S. exported and imported during the past month. Capital flow data looks at the difference in the amount of currency being brought in through investment and/or exports to currency being sold for foreign investments and/or imports. A country that is seeing a lot of foreign investment, where outsiders are purchasing domestic assets such as stocks or real estate, will generally have a capital flow surplus.

Balance of payments data is the combined total of a country's trade and capital flow over a period of time. The balance of payments is split into three categories: the current account, the capital account and the financial account. The current account looks at the flow of goods and services between countries. The capital account looks at the exchange of money between countries for the purpose of purchasing capital assets. The financial account looks at the monetary flow between countries for investment purposes.

Macroeconomic and Geopolitical Events
The biggest changes in the forex often come from macroeconomic and geopolitical events such as wars, elections, monetary policy changes and financial crises. These events have the ability to change or reshape the country, including its fundamentals. For example, wars can put a huge economic strain on a country and greatly increase the volatility in a region, which could impact the value of its currency. It is important to keep up to date on these macroeconomic and geopolitical events.

There is so much data that is released in the forex market that it can be very difficult for the average individual to know which data to follow. Despite this, it is important to know what news releases will affect the currencies you trade. (For more insight, check out Trading On News Releases and Economic Indicators To Know.)

Now that you know a little more about what drives the market, we will look next at the two main trading strategies used by traders in the forex market – fundamental and technical analysis.

Forex History and Market Participants

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Given the global nature of the forex exchange market, it is important to first examine and learn some of the important historical events relating to currencies and currency exchange before entering any trades. In this section we’ll review the international monetary system and how it has evolved to its current state. We will then take a look at the major players that occupy the forex market - something that is important for all potential forex traders to understand.

The History of the Forex

Gold Standard System

The creation of the gold standard monetary system in 1875 marks one of the most important events in the history of the forex market. Before the gold standard was implemented, countries would commonly use gold and silver as means of international payment. The main issue with using gold and silver for payment is that their value is affected by external supply and demand. For example, the discovery of a new gold mine would drive gold prices down.

The underlying idea behind the gold standard was that governments guaranteed the conversion of currency into a specific amount of gold, and vice versa. In other words, a currency would be backed by gold. Obviously, governments needed a fairly substantial gold reserve in order to meet the demand for currency exchanges. During the late nineteenth century, all of the major economic countries had defined an amount of currency to an ounce of gold. Over time, the difference in price of an ounce of gold between two currencies became the exchange rate for those two currencies. This represented the first standardized means of currency exchange in history.

The gold standard eventually broke down during the beginning of World War I. Due to the political tension with Germany, the major European powers felt a need to complete large military projects. The financial burden of these projects was so substantial that there was not enough gold at the time to exchange for all the excess currency that the governments were printing off.

Although the gold standard would make a small comeback during the inter-war years, most countries had dropped it again by the onset of World War II. However, gold never ceased being the ultimate form of monetary value. (For more on this, read The Gold Standard Revisited, What Is Wrong With Gold? and Using Technical Analysis In The Gold Markets.)

Bretton Woods System
Before the end of World War II, the Allied nations believed that there would be a need to set up a monetary system in order to fill the void that was left behind when the gold standard system was abandoned. In July 1944, more than 700 representatives from the Allies convened at Bretton Woods, New Hampshire, to deliberate over what would be called the Bretton Woods system of international monetary management.

To simplify, Bretton Woods led to the formation of the following:

1. A method of fixed exchange rates;
2. The U.S. dollar replacing the gold standard to become a primary reserve currency; and
3. The creation of three international agencies to oversee economic activity: the International Monetary Fund (IMF), International Bank for Reconstruction and Development, and the General Agreement on Tariffs and Trade (GATT).

One of the main features of Bretton Woods is that the U.S. dollar replaced gold as the main standard of convertibility for the world’s currencies; and furthermore, the U.S. dollar became the only currency that would be backed by gold. (This turned out to be the primary reason that Bretton Woods eventually failed.)

Over the next 25 or so years, the U.S. had to run a series of balance of payment deficits in order to be the world’s reserved currency. By the early 1970s, U.S. gold reserves were so depleted that the U.S. treasury did not have enough gold to cover all the U.S. dollars that foreign central banks had in reserve.

Finally, on August 15, 1971, U.S. President Richard Nixon closed the gold window, and the U.S. announced to the world that it would no longer exchange gold for the U.S. dollars that were held in foreign reserves. This event marked the end of Bretton Woods.

Even though Bretton Woods didn’t last, it left an important legacy that still has a significant effect on today’s international economic climate. This legacy exists in the form of the three international agencies created in the 1940s: the IMF, the International Bank for Reconstruction and Development (now part of the World Bank) and GATT, the precursor to the World Trade Organization. (To learn more about Bretton Wood, read What Is The International Monetary Fund? and Floating And Fixed Exchange Rates.)

Current Exchange Rates
After the Bretton Woods system broke down, the world finally accepted the use of floating foreign exchange rates during the Jamaica agreement of 1976. This meant that the use of the gold standard would be permanently abolished. However, this is not to say that governments adopted a pure free-floating exchange rate system. Most governments employ one of the following three exchange rate systems that are still used today:

1. Dollarization;
2. Pegged rate; and
3. Managed floating rate.

Dollarization

This event occurs when a country decides not to issue its own currency and adopts a foreign currency as its national currency. Although dollarization usually enables a country to be seen as a more stable place for investment, the drawback is that the country’s central bank can no longer print money or make any sort of monetary policy. An example of dollarization is El Salvador's use of the U.S. dollar. (To read more, see Dollarization Explained.)

Pegged Rates

Pegging occurs when one country directly fixes its exchange rate to a foreign currency so that the country will have somewhat more stability than a normal float. More specifically, pegging allows a country’s currency to be exchanged at a fixed rate with a single or a specific basket of foreign currencies. The currency will only fluctuate when the pegged currencies change.

For example, China pegged its yuan to the U.S. dollar at a rate of 8.28 yuan to US$1, between 1997 and July 21, 2005. The downside to pegging would be that a currency’s value is at the mercy of the pegged currency’s economic situation. For example, if the U.S. dollar appreciates substantially against all other currencies, the yuan would also appreciate, which may not be what the Chinese central bank wants.

Managed Floating Rates

This type of system is created when a currency’s exchange rate is allowed to freely change in value subject to the market forces of supply and demand. However, the government or central bank may intervene to stabilize extreme fluctuations in exchange rates. For example, if a country’s currency is depreciating far beyond an acceptable level, the government can raise short-term interest rates. Raising rates should cause the currency to appreciate slightly; but understand that this is a very simplified example. Central banks typically employ a number of tools to manage currency.

Market Participants

Unlike the equity market - where investors often only trade with institutional investors (such as mutual funds) or other individual investors - there are additional participants that trade on the forex market for entirely different reasons than those on the equity market. Therefore, it is important to identify and understand the functions and motivations of the main players of the forex market.

Governments and Central Banks

Arguably, some of the most influential participants involved with currency exchange are the central banks and federal governments. In most countries, the central bank is an extension of the government and conducts its policy in tandem with the government. However, some governments feel that a more independent central bank would be more effective in balancing the goals of curbing inflation and keeping interest rates low, which tends to increase economic growth. Regardless of the degree of independence that a central bank possesses, government representatives typically have regular consultations with central bank representatives to discuss monetary policy. Thus, central banks and governments are usually on the same page when it comes to monetary policy.

Central banks are often involved in manipulating reserve volumes in order to meet certain economic goals. For example, ever since pegging its currency (the yuan) to the U.S. dollar, China has been buying up millions of dollars worth of U.S. treasury bills in order to keep the yuan at its target exchange rate. Central banks use the foreign exchange market to adjust their reserve volumes. With extremely deep pockets, they yield significant influence on the currency markets.

Banks and Other Financial Institutions

In addition to central banks and governments, some of the largest participants involved with forex transactions are banks. Most individuals who need foreign currency for small-scale transactions deal with neighborhood banks. However, individual transactions pale in comparison to the volumes that are traded in the interbank market.

The interbank market is the market through which large banks transact with each other and determine the currency price that individual traders see on their trading platforms. These banks transact with each other on electronic brokering systems that are based upon credit. Only banks that have credit relationships with each other can engage in transactions. The larger the bank, the more credit relationships it has and the better the pricing it can access for its customers. The smaller the bank, the less credit relationships it has and the lower the priority it has on the pricing scale.

Banks, in general, act as dealers in the sense that they are willing to buy/sell a currency at the bid/ask price. One way that banks make money on the forex market is by exchanging currency at a premium to the price they paid to obtain it. Since the forex market is a decentralized market, it is common to see different banks with slightly different exchange rates for the same currency.

Hedgers

Some of the biggest clients of these banks are businesses that deal with international transactions. Whether a business is selling to an international client or buying from an international supplier, it will need to deal with the volatility of fluctuating currencies.

If there is one thing that management (and shareholders) detest, it is uncertainty. Having to deal with foreign-exchange risk is a big problem for many multinationals. For example, suppose that a German company orders some equipment from a Japanese manufacturer to be paid in yen one year from now. Since the exchange rate can fluctuate wildly over an entire year, the German company has no way of knowing whether it will end up paying more euros at the time of delivery.

One choice that a business can make to reduce the uncertainty of foreign-exchange risk is to go into the spot market and make an immediate transaction for the foreign currency that they need.

Unfortunately, businesses may not have enough cash on hand to make spot transactions or may not want to hold massive amounts of foreign currency for long periods of time. Therefore, businesses quite frequently employ hedging strategies in order to lock in a specific exchange rate for the future or to remove all sources of exchange-rate risk for that transaction.

For example, if a European company wants to import steel from the U.S., it would have to pay in U.S. dollars. If the price of the euro falls against the dollar before payment is made, the European company will realize a financial loss. As such, it could enter into a contract that locked in the current exchange rate to eliminate the risk of dealing in U.S. dollars. These contracts could be either forwards or futures contracts.

Speculators

Another class of market participants involved with foreign exchange-related transactions is speculators. Rather than hedging against movement in exchange rates or exchanging currency to fund international transactions, speculators attempt to make money by taking advantage of fluctuating exchange-rate levels.

The most famous of all currency speculators is probably George Soros. The billionaire hedge fund manager is most famous for speculating on the decline of the British pound, a move that earned $1.1 billion in less than a month. On the other hand, Nick Leeson, a derivatives trader with England’s Barings Bank, took speculative positions on futures contracts in yen that resulted in losses amounting to more than $1.4 billion, which led to the collapse of the company.

Some of the largest and most controversial speculators on the forex market are hedge funds, which are essentially unregulated funds that employ unconventional investment strategies in order to reap large returns. Think of them as mutual funds on steroids. Hedge funds are the favorite whipping boys of many a central banker. Given that they can place such massive bets, they can have a major effect on a country’s currency and economy. Some critics blamed hedge funds for the Asian currency crisis of the late 1990s, but others have pointed out that the real problem was the ineptness of Asian central bankers. (For more on hedge funds, see Introduction To Hedge Funds - Part One and Part Two.)Either way, speculators can have a big sway on the currency markets, particularly big ones.

Now that you have a basic understanding of the forex market, its participants and its history, we can move on to some of the more advanced concepts that will bring you closer to being able to trade within this massive market. The next section will look at the main economic theories that underlie the forex market.

Foreign Exchange Risk and Benefits

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The Good and the Bad

We already have mentioned that factors such as the size, volatility and global structure of the foreign exchange market have all contributed to its rapid success. Given the highly liquid nature of this market, investors are able to place extremely large trades without affecting any given exchange rate. These large positions are made available to forex traders because of the low margin requirements used by the majority of the industry's brokers. For example, it is possible for a trader to control a position of US$100,000 by putting down as little as US$1,000 up front and borrowing the remainder from his or her forex broker. This amount of leverage acts as a double-edged sword because investors can realize large gains when rates make a small favorable change, but they also run the risk of a massive loss when the rates move against them. Despite the foreign exchange risks, the amount of leverage available in the forex market is what makes it attractive for many speculators.

The currency market is also the only market that is truly open 24 hours a day with decent liquidity throughout the day. For traders who may have a day job or just a busy schedule, it is an optimal market to trade in. As you can see from the chart below, the major trading hubs are spread throughout many different time zones, eliminating the need to wait for an opening or closing bell. As the U.S. trading closes, other markets in the East are opening, making it possible to trade at any time during the day.

Time Zone Time (ET)
Tokyo Open 7:00 pm
Tokyo Close 4:00 am
London Open 3:00 am
London Close 12:00 pm
New York Open 8:00 am
New York Close 5:00 pm

While the forex market may offer more excitement to the investor, the risks are also higher in comparison to trading equities. The ultra-high leverage of the forex market means that huge gains can quickly turn to damaging losses and can wipe out the majority of your account in a matter of minutes. This is important for all new traders to understand, because in the forex market - due to the large amount of money involved and the number of players - traders will react quickly to information released into the market, leading to sharp moves in the price of the currency pair.

Though currencies don't tend to move as sharply as equities on a percentage basis (where a company's stock can lose a large portion of its value in a matter of minutes after a bad announcement), it is the leverage in the spot market that creates the volatility. For example, if you are using 100:1 leverage on $1,000 invested, you control $100,000 in capital. If you put $100,000 into a currency and the currency's price moves 1% against you, the value of the capital will have decreased to $99,000 - a loss of $1,000, or all of your invested capital, representing a 100% loss. In the equities market, most traders do not use leverage, therefore a 1% loss in the stock's value on a $1,000 investment, would only mean a loss of $10. Therefore, it is important to take into account the risks involved in the forex market before diving in.

Differences Between Forex and Equities
A major difference between the forex and equities markets is the number of traded instruments: the forex market has very few compared to the thousands found in the equities market. The majority of forex traders focus their efforts on seven different currency pairs: the four majors, which include (EUR/USD, USD/JPY, GBP/USD, USD/CHF); and the three commodity pairs (USD/CAD, AUD/USD, NZD/USD). All other pairs are just different combinations of the same currencies, otherwise known as cross currencies. This makes currency trading easier to follow because rather than having to cherry-pick between 10,000 stocks to find the best value, all that FX traders need to do is “keep up” on the economic and political news of eight countries.

The equity markets often can hit a lull, resulting in shrinking volumes and activity. As a result, it may be hard to open and close positions when desired. Furthermore, in a declining market, it is only with extreme ingenuity that an equities investor can make a profit. It is difficult to short-sell in the U.S. equities market because of strict rules and regulations regarding the process. On the other hand, forex offers the opportunity to profit in both rising and declining markets because with each trade, you are buying and selling simultaneously, and short-selling is, therefore, inherent in every transaction. In addition, since the forex market is so liquid, traders are not required to wait for an uptick before they are allowed to enter into a short position - as they are in the equities market.

Due to the extreme liquidity of the forex market, margins are low and leverage is high. It just is not possible to find such low margin rates in the equities markets; most margin traders in the equities markets need at least 50% of the value of the investment available as margin, whereas forex traders need as little as 1%. Furthermore, commissions in the equities market are much higher than in the forex market. Traditional brokers ask for commission fees on top of the spread, plus the fees that have to be paid to the exchange. Spot forex brokers take only the spread as their fee for the transaction. (For a more in-depth introduction to currency trading, see Getting Started in Forex and A Primer On The Forex Market.)

By now you should have a basic understanding of what the forex market is and how it works. In the next section, we'll examine the evolution of the current foreign exchange system.

Reading a Forex Quote and Understanding the Jargon

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One of the biggest sources of confusion for those new to the currency market is the standard for quoting currencies. In this section, we'll go over currency quotations and how they work in currency pair trades.

Reading a Quote

When a currency is quoted, it is done in relation to another currency, so that the value of one is reflected through the value of another. Therefore, if you are trying to determine the exchange rate between the U.S. dollar (USD) and the Japanese yen (JPY), the forex quote would look like this:

USD/JPY = 119.50

This is referred to as a currency pair. The currency to the left of the slash is the base currency, while the currency on the right is called the quote or counter currency. The base currency (in this case, the U.S. dollar) is always equal to one unit (in this case, US$1), and the quoted currency (in this case, the Japanese yen) is what that one base unit is equivalent to in the other currency. The quote means that US$1 = 119.50 Japanese yen. In other words, US$1 can buy 119.50 Japanese yen. The forex quote includes the currency abbreviations for the currencies in question.

Direct Currency Quote vs. Indirect Currency Quote

There are two ways to quote a currency pair, either directly or indirectly. A direct currencyquote is simply a currency pair in which the domestic currency is the base currency; while an indirect quote, is a currency pair where the domestic currency is the quoted currency. So if you were looking at the Canadian dollar as the domestic currency and U.S. dollar as the foreign currency, a direct quote would be CAD/USD, while an indirect quote would be USD/CAD. The direct quote varies the foreign currency, and the quoted, or domestic currency, remains fixed at one unit. In the indirect quote, on the other hand, the domestic currency is variable and the foreign currency is fixed at one unit.

For example, if Canada is the domestic currency, a direct quote would be 0.85 CAD/USD, which means with C$1, you can purchase US$0.85. The indirect quote for this would be the inverse (1/0.85), which is 1.18 USD/CAD and means that USD$1 will purchase C$1.18.

In the forex spot market, most currencies are traded against the U.S. dollar, and the U.S. dollar is frequently the base currency in the currency pair. In these cases, it is called a direct quote. This would apply to the above USD/JPY currency pair, which indicates that US$1 is equal to 119.50 Japanese yen.

However, not all currencies have the U.S. dollar as the base. The Queen's currencies - those currencies that historically have had a tie with Britain, such as the British pound, Australian Dollar and New Zealand dollar - are all quoted as the base currency against the U.S. dollar. The euro, which is relatively new, is quoted the same way as well. In these cases, the U.S. dollar is the counter currency, and the exchange rate is referred to as an indirect quote. This is why the EUR/USD quote is given as 1.25, for example, because it means that one euro is the equivalent of 1.25 U.S. dollars.

Most currency exchange rates are quoted out to four digits after the decimal place, with the exception of the Japanese yen (JPY), which is quoted out to two decimal places.

Cross Currency

When a currency quote is given without the U.S. dollar as one of its components, this is called a cross currency. The most common cross currency pairs are the EUR/GBP, EUR/CHF and EUR/JPY. These currency pairs expand the trading possibilities in the forex market, but it is important to note that they do not have as much of a following (for example, not as actively traded) as pairs that include the U.S. dollar, which also are called the majors. (For more on cross currency, see Make The Currency Cross Your Boss.)

Bid and Ask

As with most trading in the financial markets, when you are trading a currency pair there is a bid price (buy) and an ask price (sell). Again, these are in relation to the base currency. When buying a currency pair (going long), the ask price refers to the amount of quoted currency that has to be paid in order to buy one unit of the base currency, or how much the market will sell one unit of the base currency for in relation to the quoted currency.

The bid price is used when selling a currency pair (going short) and reflects how much of the quoted currency will be obtained when selling one unit of the base currency, or how much the market will pay for the quoted currency in relation to the base currency.

The quote before the slash is the bid price, and the two digits after the slash represent the ask price (only the last two digits of the full price are typically quoted). Note that the bid price is always smaller than the ask price. Let's look at an example:

USD/CAD = 1.2000/05
Bid = 1.2000
Ask= 1.2005

If you want to buy this currency pair, this means that you intend to buy the base currency and are therefore looking at the ask price to see how much (in Canadian dollars) the market will charge for U.S. dollars. According to the ask price, you can buy one U.S. dollar with 1.2005 Canadian dollars.

However, in order to sell this currency pair, or sell the base currency in exchange for the quoted currency, you would look at the bid price. It tells you that the market will buy US$1 base currency (you will be selling the market the base currency) for a price equivalent to 1.2000 Canadian dollars, which is the quoted currency.

Whichever currency is quoted first (the base currency) is always the one in which the transaction is being conducted. You either buy or sell the base currency. Depending on what currency you want to use to buy or sell the base with, you refer to the corresponding currency pair spot exchange rate to determine the price.

Spreads and Pips

The difference between the bid price and the ask price is called a spread. If we were to look at the following quote: EUR/USD = 1.2500/03, the spread would be 0.0003 or 3 pips, also known as points. Although these movements may seem insignificant, even the smallest point change can result in thousands of dollars being made or lost due to leverage. Again, this is one of the reasons that speculators are so attracted to the forex market; even the tiniest price movement can result in huge profit.

The pip is the smallest amount a price can move in any currency quote. In the case of the U.S. dollar, euro, British pound or Swiss franc, one pip would be 0.0001. With the Japanese yen, one pip would be 0.01, because this currency is quoted to two decimal places. So, in a forex quote of USD/CHF, the pip would be 0.0001 Swiss francs. Most currencies trade within a range of 100 to 150 pips a day.

Currency Quote Overview

USD/CAD = 1.2232/37
Base Currency Currency to the left (USD)
Quote/Counter Currency Currency to the right (CAD)
Bid Price 1.2232 Price for which the market maker will buy the base currency. Bid is always smaller than ask.
Ask Price 1.2237 Price for which the market maker will sell the base currency.
Pip One point move, in USD/CAD it is .0001 and 1 point change would be from 1.2231 to 1.2232 The pip/point is the smallest movement a price can make.
Spread Spread in this case is 5 pips/points; difference between bid and ask price (1.2237-1.2232).

Currency Pairs in the Forwards and Futures Markets

One of the key technical differences between the forex markets is the way currencies are quoted. In the forwards or futures markets, foreign exchange always is quoted against the U.S. dollar. This means that pricing is done in terms of how many U.S. dollars are needed to buy one unit of the other currency. Remember that in the spot market some currencies are quoted against the U.S. dollar, while for others, the U.S. dollar is being quoted against them. As such, the forwards/futures market and the spot market quotes will not always be parallel one another.

For example, in the spot market, the British pound is quoted against the U.S. dollar as GBP/USD. This is the same way it would be quoted in the forwards and futures markets. Thus, when the British pound strengthens against the U.S. dollar in the spot market, it will also rise in the forwards and futures markets.

On the other hand, when looking at the exchange rate for the U.S. dollar and the Japanese yen, the former is quoted against the latter. In the spot market, the quote would be 115 for example, which means that one U.S. dollar would buy 115 Japanese yen. In the futures market, it would be quoted as (1/115) or .0087, which means that 1 Japanese yen would buy .0087 U.S. dollars. As such, a rise in the USD/JPY spot rate would equate to a decline in the JPY futures rate because the U.S. dollar would have strengthened against the Japanese yen and therefore one Japanese yen would buy less U.S. dollars.

Now that you know a little bit about how currencies are quoted, let's move on to the benefits and risks involved with trading forex.

What is Forex Trading?

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The foreign exchange market is the "place" where currencies are traded. Currencies are important to most people around the world, whether they realize it or not, because currencies need to be exchanged in order to conduct foreign trade and business. If you are living in the U.S. and want to buy cheese from France, either you or the company that you buy the cheese from has to pay the French for the cheese in euros (EUR). This means that the U.S. importer would have to exchange the equivalent value of U.S. dollars (USD) into euros. The same goes for traveling. A French tourist in Egypt can't pay in euros to see the pyramids because it's not the locally accepted currency. As such, the tourist has to exchange the euros for the local currency, in this case the Egyptian pound, at the current exchange rate.

The need to exchange currencies is the primary reason why the forex market is the largest, most liquid financial market in the world. It dwarfs other markets in size, even the stock market, with an average traded value of around U.S. $2,000 billion per day. (The total volume changes all the time, but as of April 2004, the Bank for International Settlements (BIS) reported that the forex market traded U.S. $1,900 billion per day.)

One unique aspect of this international market is that there is no central marketplace for foreign exchange. Rather, currency trading is conducted electronically over-the-counter (OTC), which means that all transactions occur via computer networks between traders around the world, rather than on one centralized exchange. The market is open 24 hours a day, five and a half days a week, and currencies are traded worldwide in the major financial centers of London, New York, Tokyo, Zurich, Frankfurt, Hong Kong, Singapore, Paris and Sydney - across almost every time zone. This means that when the trading day in the U.S. ends, the forex market begins anew in Tokyo and Hong Kong. As such, the forex market can be extremely active any time of the day, with price quotes changing constantly.

Spot Market and the Forwards and Futures Markets

There are actually three ways that institutions, corporations and individuals trade forex: the spot market, the forwards market and the futures market. The forex trading in the spot market always has been the largest market because it is the "underlying" real asset that the forwards and futures markets are based on. In the past, the futures market was the most popular venue for traders because it was available to individual investors for a longer period of time. However, with the advent of electronic trading, the spot market has witnessed a huge surge in activity and now surpasses the futures market as the preferred trading market for individual investors and speculators. When people refer to the forex market, they usually are referring to the spot market. The forwards and futures markets tend to be more popular with companies that need to hedge their foreign exchange risks out to a specific date in the future.

What is the spot market?

More specifically, the spot market is where currencies are bought and sold according to the current price. That price, determined by supply and demand, is a reflection of many things, including current interest rates, economic performance, sentiment towards ongoing political situations (both locally and internationally), as well as the perception of the future performance of one currency against another. When a deal is finalized, this is known as a "spot deal". It is a bilateral transaction by which one party delivers an agreed-upon currency amount to the counter party and receives a specified amount of another currency at the agreed-upon exchange rate value. After a position is closed, the settlement is in cash. Although the spot market is commonly known as one that deals with transactions in the present (rather than the future), these trades actually take two days for settlement.

What are the forwards and futures markets?

Unlike the spot market, the forwards and futures markets do not trade actual currencies. Instead they deal in contracts that represent claims to a certain currency type, a specific price per unit and a future date for settlement.

In the forwards market, contracts are bought and sold OTC between two parties, who determine the terms of the agreement between themselves.

In the futures market, futures contracts are bought and sold based upon a standard size and settlement date on public commodities markets, such as the Chicago Mercantile Exchange. In the U.S., the National Futures Association regulates the futures market. Futures contracts have specific details, including the number of units being traded, delivery and settlement dates, and minimum price increments that cannot be customized. The exchange acts as a counterpart to the trader, providing clearance and settlement.

Both types of contracts are binding and are typically settled for cash for the exchange in question upon expiry, although contracts can also be bought and sold before they expire. The forwards and futures markets can offer protection against risk when trading currencies. Usually, big international corporations use these markets in order to hedge against future exchange rate fluctuations, but speculators take part in these markets as well. (For a more in-depth introduction to futures, see Futures Fundamentals.)

Note that you'll see the terms: FX, forex, foreign-exchange market and currency market. These terms are synonymous and all refer to the forex market.

Introduction to Currency Trading

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The foreign exchange market (forex or FX for short) is one of the most exciting, fast-paced markets around. Until recently, forex trading in the currency market had been the domain of large financial institutions, corporations, central banks, hedge funds and extremely wealthy individuals. The emergence of the internet has changed all of this, and now it is possible for average investors to buy and sell currencies easily with the click of a mouse through online brokerage accounts.

Daily currency fluctuations are usually very small. Most currency pairs move less than one cent per day, representing a less than 1% change in the value of the currency. This makes foreign exchange one of the least volatile financial markets around. Therefore, many currency speculators rely on the availability of enormous leverage to increase the value of potential movements. In the retail forex market, leverage can be as much as 250:1. Higher leverage can be extremely risky, but because of round-the-clock trading and deep liquidity, foreign exchange brokers have been able to make high leverage an industry standard in order to make the movements meaningful for currency traders.

Extreme liquidity and the availability of high leverage have helped to spur the market's rapid growth and made it the ideal place for many traders. Positions can be opened and closed within minutes or can be held for months. Currency prices are based on objective considerations of supply and demand and cannot be manipulated easily because the size of the market does not allow even the largest players, such as central banks, to move prices at will.

The forex market provides plenty of opportunity for investors. However, in order to be successful, a currency trader has to understand the basics behind currency movements.

The goal of this forex tutorial is to provide a foundation for investors or traders who are new to the foreign currency markets. We'll cover the basics of exchange rates, the market's history and the key concepts you need to understand in order to be able to participate in this market. We'll also venture into how to start trading foreign currencies and the different types of strategies that can be employed.