133 Trading tips

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Here we have a collection of tips for the average forex trader


133 TRADING TIPS by (Ak forex)


1. Learn the basics of forex trading. It's amazing how many people simply don't know
what they're doing. In order to compete at the highest level in the trading business and
be one of the few truly successful participants you must be well-educated about what
you are doing. This does not mean having a degree from a well-respected university –
the market doesn’t care where you were educated.
2. Forex trading is a zero sum game. For every long there is also a short. If 80% of
the traders are on the long side ,then the remaining 20% are on the short side. This
means further that the shorts must be well capitalized and are considered to be strong
hands. The 80%, who are holding much smaller positions per trader, are considered to
be weaker hands who will be forced to liquidate those longs on any sudden turn in
prices.
3. Nobody is bigger than the market.
4. The challenge is not to be the market, but to read the market. Riding the wave is
much more rewarding than being hit by it.
5. Trade with the trends, rather than trying to pick tops and bottoms.
6. Trying to pick tops and bottoms is another common fx trading mistake. If you're
going to trade tops and bottoms, at least wait until the price action actually confirms
that a top or a bottom has been formed before you take a position in the market.
Trying to pin-point tops and bottoms in the foreign exchange market is very risky, but
exercising a little patience and waiting for a proven top or bottom to form can
increase your odds of profiting and somewhat reduce your risk.
7. There are at least three types of markets: up trending, range bound, and down. Have
different trading strategies for each.
8. Standing aside is a position.
9. In uptrends, buy the dips ;in downtrends, sell bounces.
10. In a Bull market, never sell a dull market, in Bear market, never buy a dull market.

11. Up market and down market patterns are ALWAYS present, merely one is more
dominant. In an up market, for example, it is very easy to take sell signal after sell
signal, only to be stopped out time and again. Select trades with the trend.
12. A buy signal that fails is a sell signal. A sell signal that fails is a buy signal.
13. Let profits run, cut losses short.
14. Let your profits run, but don't let greed get in the way. Once you've already made
a nice profit on a trade, consider taking either some or all of the money off the table
and move on to the next trade. It's natural to hope that one trade will end up as your
"winning lottery ticket" and make you rich, but that is simply not realistic. Don't hold
the position too long and end up giving all your well-deserved profits back to the
market.
15. Use protective stops to limit losses.
16. Use appropriate stop-loss orders at all times to cut your losses and never, ever sit
back and let your losses run. Almost every trader at some point makes the mistake of
letting his or her losses run in hopes that the market will eventually turn around in his
or her favor but, more often than not, it simply leads to an even greater loss. You win
some, you lose some. Simply learn to cut your losses, take your occasional lumps and
move on to the next trade. And if you made a mistake, learn from it and don't do it
again. To avoid letting your losses run, get into the habit of determining an
acceptable profit target as well as an acceptable risk tolerance level for each and every
forex trade before entering the market. Then simply place a stop-loss order at the
appropriate price - but not so tight (close to the market) that the stop could quickly
take you out of the position before the market has a chance to move in your favor.
Using a stop is always the smart move.
17. Avoid placing protective stops at obvious round numbers. Protective stops on long
positions should be placed below round numbers (10, 20, 25, 50,75, 100) and on short
positions ,above such numbers.
18. Placing stop loss is an art. The trader must combine technical factors on the price
chart with money management considerations.
19. Analyze your losses. Learn from your losses. They're expensive lessons; you paid
for them. Most traders don't learn from their mistakes because they don't like to think
about them.
20. Stay out of trouble, your first loss is your smallest loss.

21. Survive! In forex trading, the ones who stay around long enough to be there when
those "big moves" come along are often successful.
22. If you are a new trader, be a small trader (mini account) for at least a year, then
analyze your good trades and your bad ones. You can really learn more from your bad
ones.
23. Don't trade unless you're well financed...so that market action, not financial
condition, dictates your entry and exit from the market. If you don't start with enough
money, you may not be able to hang in there if the market temporarily turns against
you.
24. Be more objective and less emotional.
25. Use money management principles.
26. Money management increases the odds that the trader will survive to reach the
long run.
27. Diversify, but don’t overdo it.
28. Employ at least a 3 to 1 reward-to-risk ratio.
29. Calculate the risk/reward ratio before putting a trade on, then
guard against holding it too long.
30. Don’t trade impulsively ; have a plan
31. Have specific goals and objectives.
32. Five steps to build a trading system:
a) Start with a concept b)Turn it into a set of objective rules.
c) Visually check it out on the charts d) Formally test it with a demo
e) Evaluate the results.
33. Plan your work and work your plan.
34. Trade with a plan - not with hope, greed, or fear. Plan where you will get in the
market, how much you will risk on the trade, and where you will take your profits.

35. Follow your plan. Once a position is established and stops are selected, do not get
out unless the stop is reached or the fundamental reason for taking the position
changes.
36. Any successful trading system must take into account three important factors:
price forecasting , timing , and money management. Price forecasting indicates
which way a market is expected to trend. Timing determines specific entry and exit
points. Money management determines how much to commit to the trade.
37. Don't cherry-pick your system's set-ups. Trade every signal.
38.Trading systems that work in an up market may not work in a down market.
39. Establish your trading plans before the market opening to eliminate emotional
reactions. Decide on entry points, exit points, and objectives. Subject your decisions
to only minor changes during the session. Profits are for those who act, not react.Don't
change during the session unless you have a very good reason.
40. Double-check everything.
41. Always think in terms of probabilities. Trading is all about thinking in
probabilities NOT certainties. You can make all the “right” decisions and the trade
still goes against you. This does not make it a “wrong” trade, just one of the many
trades you will take which, through probability, are on the “loosing” side of your
trading plan. Don’t expect not to have negative trades - they are a necessary part of
the plan and cannot be avoided.
42. The place to start your market analysis is always by determining the general trend
of the market.
43. Trade only with a strategy that you've proven to yourself.
44. When pyramiding (adding positions), follow these guidelines.
a. Each successive layer should be smaller than before.
b. Add only to winning positions.
c. Never add to a losing position. One of the few trade management rules
that we can state we never break is ‘Never add to a losing trade’.
Trades are split into winners and losers, and if a trade is a loser, the
chances of it turning right around and becoming a winner are too small
to risk more money on. If indeed it is a winner disguised as a loser,
why not wait until it shows it’s true colors (and becomes a

d. winner)before you add to it. If you do this you will notice that nearly
always the trade ends up hitting your stop loss and does not look back.
Sometimes the trade turns around before it hits your stop and becomes
a winner and you can count yourself very fortunate. Sometimes the
trade hits your stop loss and then turns around and becomes a winner
and you can count yourself unlucky. Whatever the result, it is never
worth adding to a loser, hoping that it will become a winner. The odds
of success are just too low to risk more capital in addition to the initial
risk.
e. Adjust protective stops to the breakeven point.
45. Risk Control
A)Never risk more than 3-4 percent of your capital on any trade
B)Predetermine your exit point before you get into a trade
c)If you lose a certain predetermined amount of your starting capital, stop trading,
analyze what went wrong, and wait until you feel confident before you begin trading
46. Don’t trade scared money.
No one ever made any money trading when they had to do it to pay the mortgage at
the end of the month. Having a requirement to make X dollars per month or you will
be financially in trouble is the best way I know to completely mess up all trading
discipline, rules, objectives, and leads quickly to disaster.
Trading is about taking a reasonable risk in order to achieve a good reward. The
markets and how and when they give up their profits is not under your control. Do not
trade if you need the money to pay bills. Do not trade if your business and personal
expenses are not covered by another income stream or cash reserve. This will only
lead to additional unmanageable stress and be very detrimental to your trading
performance.
47. Know why you are in the markets. To relieve boredom? To hit it big? When you
can honestly answer this question, you may be on your way to successful forex
trading
.
48. Never meet a margin call; don’t throw good money after bad.
49. Close out losing positions before the winning ones,

50. Except for very short term trading, make decisions away from the market,
preferably when the markets are closed.
51. Work from the long term to the short term.
52. Use intraday charts to fine-tune entry and exit.
53. Master interday trading before trying intraday trading.
54. Don't trade the time frame. Trade the pattern. Reversal patterns, hesitation patterns
and breakout patterns appear often. Learn to look for the pattern in any time frame.
55. Try to ignore conventional wisdom; don’t take anything said in the financial
media too seriously.
56. Always do your homework and stay current on global events. You never know
what's going to set off a particular currency on any given day.
57. Learn to be comfortable being in the minority. If you are right on the market, most
people will disagree with you. (90% losers,10% winners).
58. Technical analysis is a skill that improves with experience and study. Always be a
student and keep learning.
59. Beware of all tips and inside information. Wait for the market's action to tell you
if the information you've obtained is accurate, then take a position with the
developing trend.
60. Buy the rumor, sell the news.
61. K.I.S.S – Keep It Simple Stupid, more complicated isn’t always better.
62. Timing is especially crucial in forex trading.
63. Timing is everything in forex trading. Determining the correct direction of the
market only solves a portion of the trading problem. If the timing of the entry point is
off by a day ,or sometimes even minutes ,it can mean the difference between a winner
or a loser.
64. A “buy and hold” strategy doesn’t apply in forex trading

65. When you open an account with a broker, don't just decide on the amount of
money, decide on the length of time you should trade. This approach helps you
conserve your equity, and helps avoid the Las Vegas approach of "Well, I'll trade till
my stake runs out." Experience shows that many who have been at it over a long
period of time end up making money.
66. Carry a notebook with you, and jot down interesting market information. Write
down the market openings, price ranges, your fills, stop orders, and your own
personal observations. Re-read your notes from time to time; use them to help analyze
your performance.
67. Don't count profits in your first 20 trades. Keep track of the percentage of wins.
Once you know you can pick direction, profits can be increased with multi-plot
trading and variations in using your stops. In other words, now is the time to get
serious about money management.
68."Rome was not built in a day," and no real movement of importance takes place in
one day.
69. Do not overtrade.
70. Have two accounts. One real account and the other a demo account. Learning
doesn't stop when trading real dollars begins. Keep the demo account and use it to test
alternative trades, alternative stops, etc.
71. Patience is important not only in waiting for the right trades,but also in staying
with trades that are working.
72. You are superstitious; don't trade if something bothers you.
73. Technical analysis is the study of market action through the use of charts,for the
purpose of forecasting future price trends.
74. The charts reflect the bullish or bearish psychology of the marketplace.
75. The whole purpose of charting the price action of a market is to identify trends in
early stages of their development for the purpose of trading in the direction of those
trends
76. The fundamentalist studies the cause of market movement, while the technician
studies the effect.

77. Rising commodity prices generally hint at a stronger economy and rising
inflationary pressure. Falling commodity prices usually warn that the economy is
slowing along with inflation.
78. The longer the period of time that priced trade in a support or resistance area,the
more significant that area becomes.
79. There are three decisions confronting the trader –whether- to go long, go short or
do nothing. When a market is rising ,the best strategy is preferable. When the market
is falling, the second approach would be correct. However ,when the market is
moving sideways ,the third choise –to stay out of the market- is usually the wisest.
80. Channel lines have measuring implications. Once a breakout occurs from an
existing price channel ,prices usually travel a distance equal to the width of the
channel .Therefore, the trader has to simply measure the width of the channel and then
project that amount from the point at which either trendline is broken.
81. The larger the Pattern ,the Great the potential. When we use the term “larger” ,we
are referring to the the height and the width of the price pattern. The height measures
the volatility of the pattern. The width is the amount of time required to build and
complete the pattern. The greater the size of the pattern-that is ,the wider the price
swings within the pattern (the volatility ) and the longer it takes to build –the more
important the pattern becomes and the greater the potential for the ensuing price
move.
82. The breaking of important trendlines . The first sign of an impending trend
reversal is often the breaking of an important trendline. Remember however ,that the
violation of a major trendline does not necessarily signal a trend reversal.The
breaking of a major up trendline might signal the beginning of a sideways price
pattern ,which later would be intedified as either the reversal or consolidation
type.Sometimes the breaking of the major trendline coincides with the completion of
the price pattern.
83. The minimum requirement for a triangle is four reversal points. Remember that it
always takes two points to draw a trendline.
84. The moving average is a follower , not a leader. It never anticipates;it only reacts.
The moving average follows a market and tells us that a trend has begun, but only
after the fact.

85. Shorter term averages are more sensitive to the price action ,whereas longer range
averages are less sensitive.In certain types of markets ,it is more advantageous to use
a shorter average and ,at other times , a longer and less sensitive average proves more
useful.
86. When the closing price moves above the moving average , a buy signal is
generated. A sell signal is given when prices move below the moving average.
87. A buying signal on a two-moving average combination occurs when the shorter
term of two consecutive averages intersects the longer one upward. A selling signal
occurs when the reverse happens, and the longer of two consecutive averages
intersects the shorter one downward.
89. Shorter average generates more false signals ,it has the advantage of giving trend
signals earlier in the move .The trick is to find the average that is sensitive enough to
generate early signals, but insensitive enough to avoid most of the random “noise”.
90. Cutting losses is painful for every trader.The ability to cut one’s losses in time is
the sign of a seasoned trader.
91.A channel breakout suggests a target for the currency price equal to the width of
the channel.
92. Long term charts provide important information regarding long-terms or cycles.
The trader can get a correct perspective regarding the real direction of the market in
the long run, the strength or direction of the current trend occurring within that trend,
or the possibility of a breakout from the long-term trend.
93. Common Points All Of Reversal Patterms
A)The first signal of an impending trend reversal is often the breaking of an important
trendline.
B)The larger the pattern,the greater the subsequent move
C)Topping patterns are usually shorter in duration and more volatile than bottoms.
D)Bottoms usually have smaller price ranges and take longer to build
94. The head-and-shoulders formation is confirmed only when the completion of the
three rallies and their reversals is followed by a breach of the neckline. The failure of
the price to break through the neckline on closing prices basis puts on hold or negates
the validity of the formation.
95. The double-top formation is confirmed only when the full completion of the two
rallies and their respective reversals is followed by a breach of the neckline (the

closing price is outside the neckline ).The failure of the price to break through the
neckline puts on hold or negates the validity of the formation.
96. The flag formation is a reliable chart pattern that provides two vital signals:
direction and price objective. This formation consists of a brief consolidation period
within a solid and steep upward trend or downward trend. The consolidation itself
tends to be sloped in the opposite direction from the slope of the original trend, or
simply flat.
97. A Breakaway gap provides the direction of the market.
98. The runaway or measurement gap provides the direction of the market. This gap
confirms the health and velocity of the trend.
99. The runaway or measurement gap is the only type of gap that provides a price
objective. The price objective is the previous length of the trend, measured from the
runaway gap, in the same direction as the original trend.
100. The exhaustion gap provides the direction of the market.
101. Near the beginning of important moves, oscillator analysis isn’t that helpful and
can be misleading. Toward the end of market moves ,however ,oscillators become
extremely valuable.
102. When the oscillator reaches an extreme value in either the upper or lower end of
the band, this suggest that the current price move have gone too far too fast and is due
for a correction of some type.
103. The oscillator is most useful when its value reaches an extreme reading near the
upper or lower end of its boundaries. The market is said to be overbought when it is
near the upper extreme and oversold when it is near the lower extreme. This warns
that the price trend is overextended and vulnerable.
104. A divergence between the oscillator and the price action when the oscillator is in
an extreme position is usually an important warning.
105.-Oscillator-The crossing of the zero line can give important trading signals in the
direction of the price trend.
106.Because of the way it is constructed, the momentum line is always a step ahead of
the price movement. It leads the advance or decline in prices , then levels off while
the current price trend is still in effect. It then begins to move in the opposite direction
as prices begin to level off.

107. RSI is plotted on a vertical scale of 0 to 100. Movements above 70 are
considered overbought, while an oversold condition would be a move under 30
.Because of shifting that takes place in bull and bear markets, the 80 level usually
becomes the overbought level in bull markets and the 20 level the oversold level in
bear markets.
108. The first move of RSI into the overbought or oversold region is usually just a
warning. The signal to pay close attention to is the second move by the oscillator into
the danger zone. If the second move fails to confirm the price move into new highs or
new lows, a possible divergence exists. At that point ,some defensive action can be
taken to protect existing positions. If the oscillator moves in the opposite direction,
breaking a previous high or low, then a divergence or failure swing is confirmed.
109. Stochastics simply measures , on a percentage basis of 0 to 100, where the
closing price is in relation to the total price range for a selected time period. A very
high reading (over 80) would put the closing price near the top of the range ,while a
low reading (under 20) near the bottom of the range.
110. One way to combine daily and weekly stochastics is to use weekly signals to
determine market direction and daily signals for timing(it depends from the type of
the trader). It’s also a good idea to combine stochastics with RSI.
111. Most oscillator buy signals work best in uptrends and oscillator sell signals are
most profitables in downtrends. The place to start your market analysis is always by
determining the general trend of the market. Oscillators can then be used to help time
market entry.
112. Give less attention to the oscillators in the early stages of an important move, but
pay close attention to its signals as the move reaches maturity.
113.The best way to combine technical indicators is use weekly signals to determine
market direction and the daily signals to fine-tune entry and exit points. A daily signal
is followed only when it agrees with the weekly signal. (daily-weekly, 4 hour-daily,4
hour-1 hour).
114. The failure of prices to react to bullish news in an overbought area is a clear
warning that a turn may be near. The failure of prices in an oversold area to react to
bearish news can be taken as a warning that all the bad news has been fully
discounted in the current low price. Any bullish news will push prices higher.
115. -Elliot Wave Theory- A complete bull market cycle is made up of eight waves,
five up waves followed by three down waves.

116 -Elliot Wave Theory- A trend divides into five waves in the direction of the
longer trend.
117-Elliot Wave Theory- Corrections always take place in three waves.
118-Elliot Wave Theory- Waves can be expanded into longer waves and subdivided
into shorter waves.
119-Elliot Wave Theory- Sometimes one of the impulse waves extends. The other
two should then be equal in time and magnitude.
120-Elliot Wave Theory- The Finobacci sequence is the mathematical basis of the
Elliot Wave Theory.
121-Elliot Wave Theory- The number of waves follows the Finobacci sequence.
122-Elliot Wave Theory- Finobacci ratios and retracements are used to determine
price objectives. The most common retracements are 62%, 50% and 38%.
123 -Elliot Wave Theory- Bear markets should not fall below the bottom of the
previous fourth wave.
124 -Elliot Wave Theory- Wave 4 should not overlap wave 1.
125 .Support and resistance are the most effective chart tools to use for entry and exit
points. For purposes of placing stop loss, support and resistance levels are most
valuable.
126. One of the commodities most effected by the dollar is the gold market. The
prices of gold and the U.S. dollar usually trend in opposite directions.
127. The Yen is sensitive to changes in the price or structure of the raw material
markets.
128. The commodity-producing countries (Canada, Australia, N. Zealand ) are more
dependent on Japan than the other way around.
129. The Yen is sensitive to the fortunes of the Nikkei index, the Japanese stock
market and the real estate market.
130. The majority of the pound transactions take place in London with a volume
decreasing significantly in the U.S. market, and slowing down to a trickle in Asia.
Therefore, in the New York market, many banks have to stop quoting the pound at
noon.

131. Swiss Franc has a very close economic relationship with Germany, and thus to
the euro zone.
132. The major markets are London, with 32 percent of the market,New York with 18
percent and Tokyo with 8 percent. Singapore follows with 7 percent, Germany has 5
percent and Switzerland, France and Hong Kong have 4 percent each.
133. Don't use the markets to feed your need for excitement.


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Getting Started in Currency Trading

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Contents
Acknowledgments xi
Introduction xiii
About This Book xiii
How This Book Is Organized xiii
Disclaimer xv
PART 1
THEN AND NOW
Chapter 1
Getting Started 3
What Is FOREX? 3
What Is a Spot Market? 3
Which Currencies Are Traded? 4
Who Trades on the Foreign Exchange? 4
How Are Currency Prices Determined? 5
Why Trade Foreign Currencies? 5
What Tools Do I Need to Trade Currencies? 7
What Does It Cost to Trade Currencies? 8
FOREX versus Stocks 8
FOREX versus Futures 8
Chapter 2
History of Currency Trading 11
Ancient Times 11
The Gold Standard, 1816–1933 11
The “Fed” 12
Securities and Exchange Commission, 1933–1934 13
The Bretton Woods System, 1944–1973 14
The End of BrettonWoods and Floating Exchange Rates 15
International Monetary Market 15
Commodity Futures Trading Commission 15
National Futures Association 16
vi CONTENTS
Commodity Futures Modernization Act of 2000 16
Regulation in Other Countries 17
The Arrival of the Euro 17
Chapter 3
Currency Futures and the IMM 21
Futures Contracts 21
Currency Futures 21
Contract Specifications 22
Currencies Trading Volume 23
U.S. Dollar Index 24
PART 2
WHAT EVERY TRADER MUST KNOW
Chapter 4
FOREX Terms 27
Currency Pairs 27
Major and Minor Currencies 27
Cross Currency 28
Base Currency 28
Quote Currency 28
Pips 28
Ticks 29
Margin 29
Leverage 30
Bid Price 30
Ask Price 30
Bid/Ask Spread 30
Quote Convention 31
Transaction Cost 31
Rollover 31
Putting It All Together 31
The Trader’s Nemesis 32
Chapter 5
Selecting a FOREX Broker 33
Caveat Emptor 33
Broker Services 34
Contents
Broker Policies 36
Avoiding Fraudulent Operations 39
Chapter 6
Opening an Online Trading Account 41
Account Types 41
Registration 42
Account Activation 42
Identification Confirmation 42
Chapter 7
Mechanics of FOREX Trading 45
Order Types 45
Order Execution 47
Order Confirmation 48
Transaction Exposure 49
Chapter 8
The Calculating Trader 51
Leverage and Margin Percent 51
Pip Values 52
Calculating Profit and Loss 53
Calculating Units Available 60
Calculating Margin Requirements 62
Calculating Transaction Cost 63
Calculating Account Summary Balance 66
For Futures Traders 68
In Review 69
PART 3
HOW TO BEAT THE MARKET (MAYBE)
Chapter 9
Fundamental Analysis 73
Supply and Demand 73
Interest Rates 74
Balance of Trade 74
Purchasing Power Parity 77
Gross Domestic Product 78
vii
viii CONTENTS
Intervention 80
Other Economic Indicators 80
Forecasting 82
Chapter 10
Technical Analysis 87
Overview 87
Bar Charts 88
Trend Lines 90
Support and Resistance 91
Recognizing Chart Patterns 91
Reversal Patterns 92
Continuation Patterns 93
Gaps 95
Candlestick Charts 96
Point and Figure Charts 98
Indicators and Oscillators 101
Relative Strength Indicator 101
Momentum Analysis 102
Moving Averages 104
Bollinger Bands 104
Swing Analysis 107
Advanced Studies 108
Into the Future 109
The Technician’s Creed 109
PART 4
THE BUSINESS OF TRADING
Chapter 11
Money Management and Psychology 113
The Trading Triangle 113
Money Management Factors 114
Risk/Reward Ratio 114
Ad Hoc Adjustment of Limit Orders 115
Early Liquidation 115
More Ideas on Setting Stops 116
Trade Capital Allocation 116
Trading Psychology 117
Contents ix
Fear and Greed,Greed and Fear! 117
Characteristics of Successful Traders 118
Chapter 12
Trading Tactics 121
Trading Strategy 121
Trading Tactics 126
Eclectic Approach 128
Selecting Markets to Trade 128
Selecting Trading Parameters 130
Trading Matrices 130
Dagger Entry Rule 132
Market Timing 132
Chapter 13
What to Do If Things Go Wrong 135
Evaluating Your Performance 135
Common Trading Mistakes 136
Correcting Errors 137
When to Say “Uncle” 138
Chapter 14
Record Keeping 139
Daily Trade Plan and Evaluation 139
Weekly Trade Plan and Evaluation 139
The Tax Man 140
PART 5
ADVANCED TOPICS
Chapter 15
Advanced Topics 143
Rollovers 143
Hedging 144
Options Trading 145
Arbitrage 146
Adding Complexity 150
Pros and Cons of Arbitrage 151
Further Studies 151
x CONTENTS
Appendix A
List of World Currencies and Symbols 153
Appendix B
Exchange Rates 159
Appendix C
Euro Currency Unit 163
Appendix D
Time Zones and Global Banking Hours 165
Appendix E
Central Banks and Regulatory Agencies 167
Appendix F
Resources 171
Glossary 175
Index 183
About the Authors 191
Acknowledgments
We would like to thank our personal friends Susan L. Cress and Gregory R. Morris
for their meticulous assistance in design layout, organization, and editing. It is not
surprising to find out that both have become avid small-cap FOREX traders since
their involvement in editing this book.
xi

Introduction
About This Book
This book is intended to introduce the novice investor to the exciting, complex,
and sometimes profitable realm of trading world currencies on the foreign
exchange markets (FOREX). It also serves as a reference guide for stocks and
futures traders who wish to branch out into new securities opportunities. Our
primary focus is on the rapidly expanding and evolving online trading marketplace
for spot currencies.
From the very beginning we must emphasize that currency trading may
not be to everyone’s disposition. The neophyte investor must be keenly aware of
all the risks involved and should never trade on funds he or she deems necessary
for survival. If you have some experience with leveraged markets such as futures
or options, you owe yourself a look at FOREX. Those who have never traded
will find it the “purest” of all speculative adventures.
How This Book Is Organized
There are six main parts to this book:
1. Part 1—Then and Now
Getting Started; History of Currency Trading; Currency Futures and
the IMM
We open the book with a questions-and-answer overview of the
currency market in which we hope to dispel any myths the reader may
have. We then proceed to a brief history and the current regulations
surrounding the currencies market.
2. Part 2—What Every Trader Must Know
FOREX Terms; Selecting a FOREX Broker; Opening an Online
Trading Account; Mechanics of FOREX Trading; The Calculating
Trader
xiii
xiv INTRODUCTION
Every lucrative industry has its own gamut of highly specialized
terms, and currency trading is no exception. You must thoroughly
comprehend these terms before attempting to initiate any trades. With
a little familiarization, the jargon of currency trading will become second
nature.
We will assist the new trader in selecting a reputable online currency
dealer and explain the steps involved in opening a trading
account. The actual step-by-step processes of initiating and liquidating
a live market order are examined in detail with a lengthy explanation of
each order type.
Currency trading requires some minimal record keeping. The
novice investor will be pleased to know that the mathematics of trading
and calculating profit or loss involves nothing more than simple, fourfunction
arithmetic—addition, subtraction, multiplication and division—
and that we have kept division examples to a minimum.
This section must be understood before the reader proceeds to
the later sections.
3. Part 3—How to Beat the Market (Maybe)
Fundamental Analysis; Technical Analysis
Once the trader understands the mechanics of trading, he or she
must develop a trading strategy. In Part 3, we assist the trader in formulating
his own personalized trading schemes and tactics. Historically,
there have been two major schools of thought in this endeavor: fundamental
analysis and technical analysis. We explore the advantages and
disadvantages of both schools in the chapters in this section.
4. Part 4—The Business of Trading
Money Management and Psychology; Trading Tactics; What to Do If
Things Go Wrong; Record Keeping.
In this section, we expose the trader to the psychology of trading
and the stresses that may accompany same. We place much emphasis
on money management and psychology—two key topics that are vital
to success but are often neglected in the search for the holy grail of trading
methods.
5. Part 5—Advanced Topics
A single chapter covers Rollovers, Hedging, Options Trading, Arbitrage,
Adding Complexity, and Pros and Cons of Arbitrage.
Introduction
This section is optional for the novice trader though investors
with some trading experience will find it informative.
6. Appendices
Our appendices section is very much a ready reference of FOREXspecific
information.
We attempted to make Getting Started in Currency Trading an all-in-one
introduction as well as a handy computer-side reference guide. Only you, the
reader, may judge the level of our success therein.
Disclaimer
Neither the publisher nor the authors are liable for any financial losses incurred
while trading currencies.
xv

1
Then and Now
Part

1
Getting Started
Chapter
What Is FOREX?
Foreign exchange is the simultaneous buying of one currency and selling of
another. Currencies are traded through a broker or dealer and are executed in
currency pairs; for example, the Euro dollar and the US dollar (EUR/USD) or
the British pound and the Japanese yen (GBP/JPY).
The Foreign Exchange Market (FOREX) is the largest financial market in
the world, with a volume of over $1.95 trillion daily. This is more than three
times the total amount of the stocks and futures markets combined.
Unlike other financial markets, the FOREX spot market has neither a
physical location nor a central exchange. It operates through an electronic network
of banks, corporations, and individuals trading one currency for another.
The lack of a physical exchange enables the FOREX market to operate on a 24-
hour basis, spanning from one time zone to another across the major financial
centers. This fact—that there is no centralized exchange—is important to keep
in mind as it permeates all aspects of the FOREX experience.
What Is a Spot Market?
A spot market is any market that deals in the current price of a financial instrument.
Futures markets, such as the Chicago Board of Trade, offer commodity
contracts whose delivery date may span several months into the future.
3
4 THEN AND NOW
Settlement of FOREX spot transactions usually occurs within two business
days. There are also futures and forwards in FOREX, but the overwhelming
majority of traders use the spot market. We will discuss the opportunities to
trade FOREX futures on the International Monetary Market.
Which Currencies Are Traded?
Any currency backed by an existing nation can be traded at the larger brokers.
The trading volume of the major currencies (along with their symbols) is given
in descending order: the U.S. dollar (USD), the Euro dollar (EUR), the
Japanese yen (JPY), the British pound sterling (GBP), the Swiss franc (CHF),
the Canadian dollar (CAD), and the Australian dollar (AUD). All other currencies
are referred to as minors.
FOREX currency symbols are always three letters, where the first two
letters identify the name of the country and the third letter identifies the name
of that country’s currency. (The “CH” in the Swiss franc acronym stands for
Confederation Helvetica). See Table 1.1.
Who Trades on the Foreign Exchange?
There are two main groups that trade currencies. About five percent of daily volume
is from companies and governments that buy or sell products and services
in a foreign country and must subsequently convert profits made in foreign currencies
into their own domestic currency in the course of doing business. This is
primarily hedging activity. The other 95 percent consists of investors trading for
profit, or speculation. Speculators range from large banks trading 10,000,000
TABLE 1.1 Major FOREX Currencies
Symbol Country Currency
USD United States dollar
EUR Euro members Euro
JPY Japan yen
GBP Great Britain pound
CHF Switzerland franc
CAD Canada dollar
AUD Australia dollar
Getting Started
million currency units or more and the home-based operator trading perhaps
10,000 units or less.
Today, importers and exporters, international portfolio managers, multinational
corporations, speculators, day traders, long-term holders, and hedge
funds all use the FOREX market to pay for goods and services, to transact in
financial assets, or to reduce the risk of currency movements by hedging their
exposure in other markets.
A producer of Widgets in the United Kingdom is intrinsically long the
British pound (GBP). If they sign a long-term sales contract with a company in
the United States, they may wish to buy some quantity of the USD and sell an
equal quantity of the GBP to hedge their margins from a fall in the GBP.
The speculator trades to make a profit by purchasing one currency and
simultaneously selling another. The hedger trades to protect his or her margin
on an international sale (for example) from adverse currency fluctuations. The
hedger has an intrinsic interest in one side of the market or the other. The speculator
does not.
How Are Currency Prices Determined?
Currency prices are affected by a variety of economic and political conditions,
but probably the most important are interest rates, international trade, inflation,
and political stability. Sometimes governments actually participate in the
foreign exchange market to influence the value of their currencies. They do this
either by flooding the market with their domestic currency in an attempt to
lower the price or, conversely, buying in order to raise the price. This is known
as central bank intervention. Any of these factors, as well as large market orders,
can cause high volatility in currency prices. However, the size and volume of the
FOREX market make it impossible for any one entity to drive the market for
any length of time.
Why Trade Foreign Currencies?
In today’s marketplace, the dollar constantly fluctuates against the other currencies
of the world. Several factors, such as the decline of global equity markets
and declining world interest rates, have forced investors to pursue new opportunities.
The global increase in trade and foreign investments has led to many
national economies becoming interconnected with one another. This interconnection,
and the resulting fluctuations in exchange rates, has created a huge
international market: FOREX. For many investors, this has created exciting
opportunities and new profit potentials. The FOREX market offers unmatched
5
6 THEN AND NOW
potential for profitable trading in any market condition or any stage of the business
cycle. These factors equate to the following advantages:
• No commissions. No clearing fees, no exchange fees, no government
fees, no brokerage fees.
• No middlemen. Spot currency trading does away with the middlemen
and allows clients to interact directly with the market maker responsible
for the pricing on a particular currency pair.
• No fixed lot size. In the futures markets, lot or contract sizes are determined
by the exchanges. A standard-sized contract for silver futures is
5000 ounces. Even a “mini-contract” of silver, 1000 ounces, represents
a value of approximately $6,000.00. In spot FOREX, you determine
the lot size appropriate for your grubstake. This allows traders to effectively
participate with accounts of well under $1,000.00.
• Low transaction cost. The retail transaction cost (the bid/ask spread)
is typically less than 0.1 percent under normal market conditions. At
larger dealers, the spread could be as low as 0.07 percent. This will be
described in detail later.
• High liquidity. With an average trading volume of over $1.95 trillion
per day, FOREX is the most liquid market in the world. It means that
a trader can enter or exit the market at will in almost any market condition.
• Almost instantaneous transactions. This is a very advantageous byproduct
of high liquidity.
• Low margin, high leverage. These factors increase the potential for
higher profits (and losses) and are discussed later.
• A 24-hour market. A trader may take advantage of all profitable market
conditions at any time. There is no waiting for the opening bell.
• Online access. The big boom in FOREX came with the advent of
online (Internet) trading platforms.
• Not related to the stock market. A trader in the FOREX market
involves selling or buying one currency against another. Thus, there is
no correlation between the foreign currency market and the stock market.
A bull market or a bear market for a currency is defined in terms of
the outlook for its relative value against other currencies. If the outlook
is positive, we have a bull market in which a trader profits by buying
the currency against other currencies. Conversely, if the outlook is pessimistic,
we have a bull market for other currencies and traders take
profits by selling the currency against other currencies. In either case,
there is always a good market trading opportunity for a trader.
Getting Started 7
• Interbank market. The backbone of the FOREX market consists of a
global network of dealers. They are mainly major commercial banks
that communicate and trade with one another and with their clients
through electronic networks and by telephone. There are no organized
exchanges to serve as a central location to facilitate transactions the way
the New York Stock Exchange serves the equity markets. The FOREX
market operates in a manner similar to that of the NASDAQ market in
the United States; thus it is also referred to as an over-the-counter
(OTC) market.
• No one can corner the market. The FOREX market is so vast and
has so many participants that no single entity, not even a central bank,
can control the market price for an extended period of time. Even
interventions by mighty central banks are becoming increasingly ineffectual
and short-lived. Thus central banks are becoming less and less
inclined to intervene to manipulate market prices. (You may remember
the attempt to corner the silver futures market in the late 1970s. Such
disruptive excess is not possible in the FOREX markets.)
• No insider trading. Because of the FOREX market’s size and noncentralized
nature, there is virtually no chance for ill effects caused by
insider trading. Fraud possibilities, at least against the system as a
whole, are significantly less than in any other financial instruments.
• Limited regulation. There is but limited governmental influence via
regulation in the FOREX markets, primarily because there is no centralized
location or exchange. Of course, this is a sword that may cut
both ways, but the authors believe—with a hardy caveat emptor—that
less regulation is, on balance, an advantage. Nevertheless, most countries
do have some regulatory say and more seems on the way.
Regardless, fraud is always fraud wherever it is found and subject to
criminal penalties in all countries.
Traditionally, investors’ only means of gaining access to the foreign exchange
market was through banks that transacted large amounts of currencies
for commercial and investment purposes. Trading volume has increased rapidly
over time, especially after exchange rates were allowed to float freely in 1971.
What Tools Do I Need to
Trade Currencies?
A computer with reliable (and preferably fast) Internet access and the information
in this book are all that is needed to begin trading currencies.
8 THEN AND NOW
What Does It Cost to Trade Currencies?
An online currency trading account (a “mini-account”) may be opened for as little
as $100. Do not laugh—mini-accounts are a good way to get your feet wet
without taking a bath. Unlike futures, where the size of a contract is set by the
exchanges, in FOREX you select how much of any particular currency you wish
to buy or sell. Thus, a $3,000.00 grubstake is not unreasonable as long as the
trader engages in appropriately sized trades. FOREX mini-accounts also do not
suffer the illiquidity of many futures mini-contracts, as everyone feeds from the
same currency “pool.”
FOREX Versus Stocks
Historically, the securities markets have been considered, at least by the majority
of the public, as an investment vehicle. In the last ten years, securities have taken
on a more speculative nature. This was perhaps due to the downfall of the overall
stock market as many security issues experienced extreme volatility because
of the “irrational exuberance” displayed in the marketplace. The implied return
associated with an investment was no longer true. Many traders engaged in the
day trader rush of the late 1990s only to discover that from a leverage standpoint
it took quite a bit of capital to day trade, and the return—while potentially
higher than long-term investing—was not exponential, to say the least.
After the onset of the day trader rush, many traders moved into the futures
stock index markets where they found they could better leverage their capital and
not have their capital tied up when it could be earning interest or making money
somewhere else. Like the futures markets, spot currency trading is an excellent
vehicle for the pattern day trader that desires to leverage his or her current capital
to trade. Spot currency trading provides more options and greater volatility while at
the same time stronger trends than are currently available in stock futures indexes.
Former securities day traders have an excellent home in the FOREX market.
There are approximately 4,000 stocks listed on the New York Stock Exchange.
Another 2,800 are listed on the NASDAQ. Which one will you trade?
Trading just the seven major USD currency pairs instead of 7,800 stocks
simplifies matters significantly for the FOREX trader. Fewer decisions, fewer
headaches.
FOREX Versus Futures
The futures contract is precisely that—a legally binding agreement to deliver or
accept delivery of a specified grade and quantity of a given commodity in a distant
month. FOREX, however, is a spot (cash) market in which trades rarely
Getting Started
exceed two days. Many FOREX brokers allow their investors to “roll over” open
trades after two days. There exist FOREX futures or forward contracts, but
almost all activity is in the spot market facilitated by rollovers.
In addition to the advantages listed, FOREX trades are almost always executed
at the time and price asked by the speculator. There are numerous horror
stories about futures traders being locked into an open position even after placing
the liquidation order. The high liquidity of the foreign exchange market
(roughly three times the trading volume of all the futures markets combined)
ensures the prompt execution of all orders (entry, exit, limit, etc.) at the desired
price and time.
The caveat here is something called a requote which we will discuss in a
later chapter.
The Commodity Futures Trading Commission (CFTC) authorizes futures
exchanges to place daily limits on contracts that significantly hamper the ability
to enter and exit the market at a selected price and time. No such limits exist in
the FOREX market.
Stock and futures traders are used to thinking in terms of the U.S. dollar
versus something else, such as the price of a stock or the price of wheat. This
is like comparing apples to oranges. In currency trading, however, it’s always a
comparison of one currency to another currency—someone’s apples to someone
else’s apples. This paradigm shift can take a little getting used to, but we will give
you plenty of examples to help smooth the transition.
We must reiterate: There is always some risk in speculation regardless of
which financial instruments are traded and where they are traded, regulated or
unregulated.
9
Summary
• FOREX means “Foreign Exchange.”
• The FOREX market is a $1.95 trillion-a-day financial market, dwarfing
everything else including stocks and futures.
• There is no centralized exchange or clearing house for currency trading.
• The FOREX market is less regulated than other financial markets.
• The top four traded currencies are: the U.S. dollar (USD), the European
dollar (EUR), the Japanese yen (JPY), and the British pound
(GBP).
• Access to the FOREX markets via the Internet has resulted in a great
deal of interest by small traders previously locked out of this enormous
marketplace.

2
History of
Currency Trading
Chapter
This material may not seem very relevant to trading currencies today, but a
little perspective never hurts.
Ancient Times
Foreign exchange dealing may be traced back to the early stages of history, possibly
beginning with the introduction of coinage by the ancient Egyptians, and
the use of paper notes by the Babylonians. Certainly by biblical times, the
Middle East saw a rudimentary international monetary system when the Roman
gold coin aureus gained worldwide acceptance followed by the silver denarius,
both a common stock among money changers of the period.
By the Middle Ages, foreign exchange became a function of international
banking with the growth in the use of bills of exchange by the merchant princes
and international debt papers by the budding European powers in the course of
their underwriting the period’s wars.
The Gold Standard, 1816–1933
The gold standard was a fixed commodity standard: participating countries
fixed a physical weight of gold for the currency in circulation, making it directly
11
12 THEN AND NOW
redeemable in the form of the precious metal. In 1816 for instance, the pound
sterling was defined as 123.27 grains of gold, which was on its way to becoming
the foremost reserve currency and was at the time the principal component of
the international capital market. This led to the expression “as good as gold”
when applied to Sterling—the Bank of England at the time gained stability and
prestige as the premier monetary authority.
Of the major currencies, the U.S. dollar adopted the gold standard late in
1879 and became the standard-bearer, replacing the British pound when Britain
and other European countries came off the system with the outbreak of World
War I in 1914. Eventually, though, the worsening international depression led
even the dollar off the gold standard by 1933; this marked the period of collapse
in international trade and financial flows prior to World War II.
The “Fed”
As an investor, it is essential to acquire a basic knowledge of the Federal Reserve
System (the Fed). The Federal Reserve was created by the U.S. Congress in
1913. Before that, the U.S. government lacked any formal organization for
studying and implementing monetary policy. Consequently, markets were often
unstable and the public had very little faith in the banking system. The Fed is an
independent entity, but is subject to oversight from Congress. This means that
decisions do not have to be ratified by the president or anyone else in the government,
but Congress periodically reviews the Fed’s activities.
The Fed is headed by a government agency in Washington known as the
Board of Governors of the Federal Reserve. The Board of Governors consists of
seven presidential appointees, who each serve 14-year terms. All members must
be confirmed by the Senate, and they can be reappointed. The board is led by a
chairman and a vice chairman, each appointed by the president and approved
by the Senate for four year terms. The current chair is Alan Greenspan, who has
been chairman since 1987. His latest term expires in 2006.
There are 12 regional Federal Reserve Banks located in major cities around
the country that operate under the supervision of the Board of Governors.
Reserve Banks act as the operating arm of the central bank and do most of the
work of the Fed. The banks generate their own income from four main sources:
1. Services provided to banks
2. Interest earned on government securities
3. Income from foreign currency held
4. Interest on loans to depository institutions
The income generated from these activities is used to finance day-to-day
operations, including information gathering and economic research. Any excess
income is funneled back into the U.S. Treasury.
History of Currency Trading
The system also includes the Federal Open Market Committee, better
known as the FOMC. This is the policy-creating branch of the Federal Reserve.
Traditionally the chair of the board is also selected as the chair of the FOMC.
The voting members of the FOMC are the seven members of the Board of
Governors, the president of the Federal Reserve Bank of New York, and presidents
of four other Reserve Banks who serve on a one-year rotating basis. All
Reserve Bank presidents participate in FOMC policy discussions whether or
not they are voting members. The FOMC makes the important decisions on
interest rates and other monetary policies. This is the reason they get most of the
attention in the media.
The primary responsibility of the Fed is “to promote sustainable growth,
high levels of employment, stability of prices to help preserve the purchasing
power of the dollar, and moderate long-term interest rates.”
In other words, the Fed’s job is to foster a sound banking system and a
healthy economy. To accomplish its mission the Fed serves as the banker’s bank,
the government’s bank, the regulator of financial institutions, and as the nation’s
money manager.
The Fed also issues all coin and paper currency. The U.S. Treasury actually
produces the cash, but the Fed Banks then distributes it to financial institutions.
It is also the Fed’s responsibility to check bills for wear and tear, taking damaged
currency out of circulation.
The Federal Reserve Board (FRB) has regulation and supervision responsibilities
over banks. This includes monitoring banks that are members of the
system, international banking facilities in the United States, foreign activities of
member banks, and the U.S. activities of foreign-owned banks. The Fed also
helps to ensure that banks act in the public’s interest by helping in the development
of federal laws governing consumer credit. Examples are the Truth in
Lending Act, the Equal Credit Opportunity Act, the Home Mortgage Disclosure
Act, and the Truth in Savings Act. In short, the FED is the policeman for banking
activities within the United States and abroad.
The FRB also sets margin requirements for investors. This limits the
amount of money you can borrow to purchase securities. Currently, the requirement
is set at 50 percent, meaning that with $500 you have the opportunity to
purchase up to $1000 worth of securities.
Securities and Exchange Commission,
1933–1934
When the stock market crashed in October 1929, countless investors lost their
fortunes. Banks also lost great sums of money in the Crash because they had
invested heavily in the markets. When people feared their banks might not be
13
14 THEN AND NOW
able to pay back the money that depositors had in their accounts, a “run” on the
banking system caused many bank failures.
With the Crash and ensuing depression, public confidence in the markets
plummeted. There was a consensus that for the economy to recover, the public’s
faith in the capital markets needed to be restored. Congress held hearings to
identify the problems and search for solutions.
Based on the findings in these hearings, Congress passed the Securities Act
of 1933 and the Securities Exchange Act of 1934. These laws were designed to
restore investor confidence in capital markets by providing more structure and
government oversight. The main purposes of these laws can be reduced to two
common-sense notions:
1. Companies that publicly offer securities for investment dollars must
tell the public the truth about their businesses, the securities they are
selling, and the risks involved in investing.
2. People who sell and trade securities—brokers, dealers, and exchanges—
must treat investors fairly and honestly, putting investors’ interests first.
The Bretton Woods System,
1944–1973
The post-World War II period saw Great Britain’s economy in ruins, its infrastructure
having been bombed. The country’s confidence with its currency was
at a low. By contrast, the United States, thanks to its physical isolation, was left
relatively unscathed by the war. Its industrial might was ready to be turned to
civilian purposes. This then has led to the dollar’s rise to prominence, becoming
the reserve currency of choice and staple to the international financial markets.
Bretton Woods came about in July 1944 when 45 countries attended, at
the behest of the United States, a conference to formulate a new international
financial framework. This framework was designed to ensure prosperity in the
post-war period and prevent the recurrence of the 1930s global depression.
Named after a resort hotel in New Hampshire, the Bretton Woods system formalized
the role of the U.S. dollar as the new global reserve currency, with its
value fixed into gold. The United States assumed the responsibility of ensuring
convertibility while other currencies were pegged to the dollar.
Among the key features of the new framework were:
• Fixed but adjustable exchange rates
• The International Monetary Fund
• The World Bank
History of Currency Trading 15
The End of Bretton Woods
and Floating Exchange Rates
After close to three decades of running the international financial system,
Bretton Woods finally went the way of history due to growing structural imbalances
among the economies, leading to mounting volatility and speculation in
a one-year period from June 1972 to June 1973. At the time the United
Kingdom, facing deficit problems, initially floated the sterling. Then it was
devaluated further in February of 1973 losing 11 percent of its value along with
the Swiss franc and the Japanese yen. This eventually led to the European
Economic Community floating their currencies as well.
At the core of Bretton Woods’ problems were deteriorating confidence in
the dollars’ ability to maintain full convertibility and the unwillingness of surplus
countries to revalue for its adverse impact in external trade. Despite a last-ditch
effort by the Group of Ten finance ministers through the Smithsonian Agreement
in December 1971, the international financial system from 1973 onwards saw
market-driven floating exchange rates taking hold. Several times efforts for
reestablishing controlled systems were undertaken with varying levels of success.
The most well known of these was Europe’s Exchange Rate Mechanism of the
1990s which eventually led to the European Monetary Union.
International Monetary Market
In December 1972, the International Monetary Market (IMM) was incorporated
as a division of the Chicago Mercantile Exchange (CME) that specialized
in currency futures, interest-rate futures, and stock index futures, as well as
futures options.
Commodity Futures Trading Commission
In 1974 Congress created the Commodity Futures Trading Commission
(CFTC) as an independent agency with the mandate to regulate commodity
futures and options markets in the United States. The agency is chartered to protect
market participants against manipulation, abusive trade practices, and fraud.
Through effective oversight and regulation, the CFTC enables the markets
to better serve their important functions in the nation’s economy, providing
a mechanism for price discovery and a means of offsetting price risk. The CFTC
also seeks to protect customers by requiring three things: that registrants disclose
market risks and past performance information to prospective customers,
that customer funds be kept in accounts separate from those maintained by the
16 THEN AND NOW
firm for its own use, and that customer accounts be adjusted to reflect the current
market value at the close of trading each day.
National Futures Association
The National Futures Association (NFA), created in 1982, is a quasi-private,
self-regulatory agency established by the CFTC and participants in the futures
markets. The NFA sets standards for the registration of professionals with the
authority to impose limited fines for breach of conduct. NFA is the premier
independent provider of efficient and innovative regulatory programs that safeguard
the integrity of the derivatives markets and directs the regulatory actions
of the CFTC into the marketplace.
Commodity Futures Modernization Act
of 2000
The Commodity Futures Trading Commission (CFTC) proposed rules relating
to trading facilities to implement the Commodity Futures Modernization Act of
2000 (CFMA). On December 15, 2000, Congress passed, and on December
21, 2000, the president signed into law, the CFMA, which substantially altered
the Commodity Exchange Act. The CFMA amended the law to establish three
categories of markets: designated contract markets, derivative transaction execution
facilities, and markets exempt from CFTC regulation. The three categories
match the degree of regulation to the varying nature of the products and the
nature of the participant having access to the market.
Beginning in the 1980s, cross-border capital movements accelerated with
the advent of computers and technology, extending market continuum through
Asian, European, and American time zones. Transactions in foreign exchange
rocketed from about $70 billion a day in the 1980s to more than $1.85 trillion
a day two decades later.
Keep in mind that the Modernization Act pertains mostly to futures and
forwards, not cash/spot markets. However, the CFTC seems to be gaining more
and more momentum for some form of FOREX cash regulation within the
boundaries of the United States.
The NFA stipulates that members cannot transact with non-members. So,
for example, if your FOREX broker/dealer is an NFA member, he or she must
consent to being regulated and is not allowed to do business with non-NFA
money managers. We would not accept a broker simply because he or she is an
NFA member; nor would we condemn one who is not a member. It is still a
“buyer beware” marketplace.
Currency trading remains much less regulated than either the stock or
futures markets. This means the prospective trader must be especially knowledgeHistory
of Currency Trading
able, alert, and realistic. As the market has opened up to the small speculator, it
has also opened up the market for less-than-scrupulous companies and individuals.
Remember: If it’s too good to be true—it probably is! The non-centralized
nature of FOREX makes the level of regulation seen in the futures market
unlikely to be attained.
Check in on the CFTC and NFA Web sites from time to time for actions
against broker/dealers and for updates on any pending regulation that might
affect U.S.–based FOREX traders.
Refer to the Appendix entitled “Regulatory Agencies and Central Banks”
for information on obtaining the complete text of the Modernization Act.
Regulation in Other Countries
Nearly every major country around the globe has created a government agency
responsible for overseeing the conduct of trading securities and protecting
investors from fraudulent dealers and scam artists. In the United Kingdom, this
agency is called the Financial Services Authority (FSA) and in Australia it is called
the Australian Securities and Investment Commission (ASIC). Refer to the
Appendix entitled “Regulatory Agencies and Central Banks” for further details.
The Arrival of the Euro
On January 1, 2002, the Euro became the official currency of twelve European
nations that agreed to remove their previous currencies from circulation prior to
February 28, 2002. See Table 2.1.
17
TABLE 2.1 European Monetary Union
Austria schilling
Belgium franc
Finland markka
France franc
Germany mark
Greece drachma
Ireland punt
Italy lira
Luxembourg franc
Netherlands guilder
Portugal escudo
Spain peseta
18 THEN AND NOW
The Euro was considered an immediate success and is now the second
most frequently traded currency in FOREX markets. More details on the Euro
can be found in the Appendix of this book.
Table 2.2 depicts the major events in FOREX history and regulation.
TABLE 2.2 Timeline of Foreign Exchange
1913—U.S. Congress creates the Federal Reserve System.
1933—Congress passes the Securities Act of 1933 to counter the effects of the
Great Crash of 1929.
1934—The Securities Exchange Act of 1934 creates the beginnings of the
Securities and Exchange Commission.
1936—The Commodity Exchange Act is enacted in direct response to manipulating
grain and futures markets.
1944—The Bretton Woods Accord is established to help stabilize the global
economy after World War II.
1971—The Smithsonian Agreement is established to allow for a greater fluctuation
band for currencies.
1972—The European Joint Float is established as the European community tries
to move away from their dependency on the U.S. dollar.
1972—The International Monetary Market is created as a division of the Chicago
Mercantile Exchange.
1973—The Smithsonian Agreement and European Joint Float fail, signifying the
official switch to a free-floating system.
1974—Congress creates the Commodity Futures Trading Commission to regulate
the futures and options markets.
1978—The European Monetary System is introduced to again try to gain
independence from the U.S. dollar.
1978—The Free-floating system is officially mandated by the International
Monetary Fund.
1993—The European Monetary System fails to make way for a worldwide,
free-floating system.
1994—Online currency trading makes its debut.
2000—Commodity Modernization Act establishes new regulations for
securities derivatives, including currencies in futures or forwards
form.
2002—The Euro becomes the official currency of twelve European nations on
January 1.
History of Currency Trading 19
Summary
• Until the late 1960s the currency markets were extremely stable and
very much a closed club. Things were about to change rapidly!
• Currency trading is probably the world’s second-oldest profession!
• The Euro, introduced in 2002, is the official currency of twelve
European countries: Austria, Belgium, Finland, France, Germany,
Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and
Spain.
• Key dates and events—1973, 1978, 1994, 2002
• The trend is towards more regulation of cash/spot currency markets.
Traders should watch the actions of the Commodity Futures Trading
Commission (CFTC) and its quasi-independent administration arm,
the National Futures Associations (NFA). Do not take regulation as an
excuse for not doing your own homework!

3
Currency Futures
and the IMM
Chapter
Futures Contracts
A futures contract is an agreement between two parties: a short position, the
party who agrees to deliver a commodity, and a long position, the party who
agrees to receive a commodity. For example, a grain farmer would be the holder
of the short position (agreeing to sell the grain) while the bakery would be the
holder of the long (agreeing to buy the grain).
In a futures contract, everything is precisely specified: the quantity and
quality of the underlying commodity, the specific price per unit, and the date
and method of delivery. The price of a futures contract is represented by the
agreed-upon price of the underlying commodity or financial instrument that will
be delivered in the future. For example, in the grain scenario, the price of the
contract might be 5,000 bushels of grain at a price of four dollars per bushel and
the delivery date may be the third Wednesday in September of the current year.
Currency Futures
The FOREX market is essentially a cash or spot market in which over 90 percent
of the trades are liquidated within 48 hours. Currency trades held longer than
this are normally routed through an authorized commodity futures exchange
such as the International Monetary Market. IMM was founded in 1972 and is a
division of the Chicago Mercantile Exchange (CME) that specializes in currency
futures, interest-rate futures, and stock index futures, as well as options on
21
22 THEN AND NOW
futures. Clearing houses (the futures exchange) and introducing brokers are subject
to more stringent regulations from the SEC, CFTC, and NFA agencies than
the FOREX spot market (see www.cme.com for more details).
It should also be noted that FOREX traders are charged only a transaction
cost per trade, which is simply the difference between the current bid and ask
prices. Currency futures traders are charged a round-turn commission that
varies from broker house to broker house. In addition, margin requirements for
futures contracts are usually slightly higher than the requirements for the
FOREX spot market.
Contract Specifications
Table 3.1 is a list of currencies traded through IMM at the Chicago Mercantile
Exchange and their contract specifications.
Size represents one contract requirement though some brokers offer minicontracts,
usually one-tenth the size of the standard contract. Months identify
the month of contract delivery. The tick symbols H, M, U, Z are abbreviations
for March, June, September, and December respectively. Hours indicate the
TABLE 3.1 Currency Contract Specifications
Minimum
Commodity Contract Size Months Hours Fluctuation
Australian
dollar 100,000 AUD H, M, U, Z 7:20–14:00 0.0001 AUD= $10.00
British pound 62,500 GBP H, M, U, Z 7:20–14:15 0.0002 GBP = $12.50
Canadian
dollar 100,000 CAD H, M, U, Z 7:20–14:00 0.0001 CAD= $10.00
Eurocurrency 62,500 EUR H, M, U, Z 7:20–14:15 0.0001 EUR = $ 6.25
Japanese
yen 12,500,000 JPY H, M, U, Z 7:00–14:00 0.0001 JPY = $12.50
Mexican
peso 500,000 MXN All months 7:00–14:00 0.0025 MXN= $12.50
New Zealand
dollar 100,000 NZD H, M, U, Z 7:00–14:00 0.0001 NZD= $10.00
Russian
ruble 2,500,00 RUR H, M, U, Z 7:20–14:00 0.0001 RUR = $25.00
South African
rand 5,000,000 ZAR All months 7:20–14:00 0.0025 ZAR = $12.50
Swiss franc 62,500 CHF H, M, U, Z 7:20–14:15 0.0001 CHF = $12.50
Currency Futures and the IMM
local trading hours in Chicago. The minimum fluctuation represents the
smallest monetary unit that is registered as one pip in price movement at
the exchange and is usually one-ten thousandth of the base currency.
Currencies Trading Volume
Table 3.2 summarizes the trading activity of selected futures contracts in currencies,
precious metals, and some financial instruments. The volume and open interest
readings are not trade signals. They are intended only to provide a brief synopsis
of each market’s liquidity and volatility based on the average of 30 trading days.
23
TABLE 3.2 Futures Volume and Open Interest
Market Sym Exch Vol OI
S&P 500 e-mini ES CME 489.1 377.9
Nasdaq 100 e-mini NQ CME 237.6 158.4
Eurodollar ED CME 93.9 772.5
S&P 500 SP CME 59.3 531.4
Eurocurrency EC CME 49.5 112.9
Mini Dow YM CBOT 48.1 30.2
10-year T-note TY CBOT 43.1 676.4
Gold GC NYMEX 33.7 163.0
5-year T-note FV CBOT 29.6 582.8
30-year T-bond US CBOT 25.9 324.1
Japanese yen JY CME 18.6 132.1
Canadian dollar CD CME 18.0 64.2
Nasdaq 100 ND CME 13.3 65.4
British pound BP CME 12.2 58.3
Silver SI NYMEX 10.0 84.2
Swiss franc SF CME 9.3 45.6
Mexican peso ME CME 8.8 30.5
Dow Jones DJ CBOT 8.7 29.5
Aussie dollar AD CME 7.8 55.7
2-year T-note TU CME 7.0 108.6
Copper HG NYMEX 4.2 32.8
Legend: Sym: Ticker symbol, Exch: Futures exchange on which contract is traded,
Vol: 30-day average daily volume, in thousands, OI: Open interest, in thousands.
Source: Active Trader Magazine, January 16, 2004 (www.activetradermag.com).
24 THEN AND NOW
U.S. Dollar Index
The U.S. Dollar Index (ticker symbol = DX) is an openly traded futures contract
offered by the New York Board of Trade. It is computed using a tradeweighted
geometric average of six currencies. See Table 3.3.
IMM currency futures traders monitor the U.S. Dollar Index to gauge the
dollar’s overall performance in world currency markets. If the Dollar Index is
trending lower, then it is very likely that a major currency that is a component
of the Dollar Index is trading higher. When a currency trader takes a quick
glance at the price of the U.S. Dollar Index, it gives the trader a good feel for
what is going on in the FOREX market worldwide.
For traders who are interested in more details on commodity futures, we
recommend Todd Lofton’s paperbound book, Getting Started in Futures (2001:
John Wiley & Sons, Inc.).
TABLE 3.3 U.S. Dollar Index
Currency Weight %
Eurocurrency 57.6
Japanese yen 13.6
British pound 11.9
Canadian dollar 9.1
Swedish krona 4.2
Swiss franc 3.6
2
What
Every Trader
Must Know
Part

4
FOREX Terms
Chapter
As in any worthwhile endeavor, each industry tends to create its own
unique lingo. The FOREX market is no different. You, the novice
trader, must thoroughly comprehend certain terms before making
your first trade.
Currency Pairs
Every FOREX trade involves the simultaneous buying of one currency and the
selling of another currency. These two currencies are always referred to as the
currency pair in a trade.
Major and Minor Currencies
The seven most frequently traded currencies (USD, EUR, JPY, GBP, CHF,
CAD, and AUD) are called the major currencies. All other currencies are
referred to as minor currencies. The most frequently traded minors are the New
Zealand dollar (NZD), the South African rand (ZAR), and the Singapore dollar
(SGD). After that, the frequency is difficult to ascertain because of perpetually
changing trade agreements in the international arena.
27
28 WHAT EVERY TRADER MUST KNOW
Cross Currency
A cross currency is any pair in which neither currency is the U.S. dollar. These
pairs may exhibit erratic price behavior since the trader has, in effect, initiated
two USD trades. For example, initiating a long (buy) EUR/GBP trade is equivalent
to buying a EUR/USD currency pair and selling a GBP/USD. Cross currency
pairs frequently carry a higher transaction cost. The three most frequently
traded cross rates are EUR/JPY, GBP/EUR, and GBP/JPY.
Base Currency
The base currency is the first currency in any currency pair. It shows how much
the base currency is worth as measured against the second currency. For example,
if the USD/CHF rate equals 1.6215, then one USD is worth CHF 1.6215.
In the FOREX markets, the U.S. dollar is normally considered the “base” currency
for quotes, meaning that quotes are expressed as a unit of $1 USD per the
other currency quoted in the pair. The primary exceptions to this rule are the
British pound, the Euro, and the Australian dollar.
Quote Currency
The quote currency is the second currency in any currency pair. This is frequently
called the pip currency and any unrealized profit or loss is expressed in
this currency.
Pips
A pip is the smallest unit of price for any foreign currency. Nearly all currency
pairs consist of five significant digits and most pairs have the decimal point
immediately after the first digit, that is, EUR/USD equals 1.2812. In this
instance, a single pip equals the smallest change in the fourth decimal place, that
is, 0.0001. Therefore, if the quote currency in any pair is USD, then one pip
always equals 1⁄100 of a cent.
One notable exception is the USD/JPY pair where a pip equals $ 0.01
(one U.S. dollar equals approximately 107.19 Japanese yen). Pips are sometimes
called points.
FOREX Terms
Ticks
Just as a pip is the smallest price movement (the y-axis), a tick is the smallest
interval of time (the x-axis) that occurs between two trades. When trading the
most active currency pairs (such as EUR/USD or USD/JPY) during peak trading
periods, multiple ticks may (and will) occur within the span of one second.
When trading a low-activity minor cross pair (such as the Mexican peso and the
Singapore dollar), a tick may only occur once every two or three hours.
Ticks, therefore, do not occur at uniform intervals of time. Fortunately,
most historical data vendors will “group” sequences of streaming data and
calculate the open, high, low, and close over regular time intervals (1-minute,
5-minute, 30-minute, 1-hour, daily, and so forth.). See Figure 4.1.
Margin
When an investor opens a new margin account with a FOREX broker, he or
she must deposit a minimum amount of monies with that broker. This minimum
varies from broker to broker and can be as low as $100.00 to as high as
$100,000.00.
Each time the trader executes a new trade, a certain percentage of the
account balance in the margin account will be earmarked as the initial margin
requirement for the new trade based upon the underlying currency pair, its
current price, and the number of units traded, (called a lot). The lot size
29
Ticks
Pips
FIGURE 4.1 Pip-tick relationship.
30 WHAT EVERY TRADER MUST KNOW
always refers to the base currency. An even lot is usually a quantity of 100,000
units, but most brokers permit investors to trade in odd lots (fractions of
100,000 units).
Leverage
Leverage is the ratio of the amount used in a transaction to the required security
deposit (margin). It is the ability to control large dollar amounts of a security
with a comparatively small amount of capital. Leveraging varies dramatically with
different brokers, ranging from 10:1 to 100:1. Leverage is frequently referred to
as gearing. The formula for calculating leverage is:
Leverage = 100/Margin Percent
Bid Price
The bid is the price at which the market is prepared to buy a specific currency
pair in the FOREX market. At this price, the trader can sell the base currency. It
is shown on the left side of the quotation. For example, in the quote USD/CHF
1.4527/32, the bid price is 1.4527; meaning you can sell one U.S. dollar for
1.4527 Swiss francs.
Ask Price
The ask is the price at which the market is prepared to sell a specific currency
pair in the FOREX market. At this price, the trader can buy the base currency.
It is shown on the right side of the quotation. For example, in the quote
USD/CHF 1.4527/32, the ask price is 1.4532; meaning you can buy one U.S.
dollar for 1.4532 Swiss francs. The ask price is also called the offer price.
Bid/Ask Spread
The spread is the difference between the bid and ask price. The “big figure
quote” is the dealer expression referring to the first few digits of an exchange
rate. These digits are often omitted in dealer quotes. For example, a USD/JPY
rate might be 117.30/117.35, but would be quoted verbally without the first
three digits as “30/35.”
FOREX Terms 31
Quote Convention
Exchange rates in the FOREX market are expressed using the following format:
Base Currency /Quote Currency Bid/Ask
Examples can be found in Table 4.1.
Normally only the final two digits of the bid price are shown. If the ask
price is more than 100 pips above the bid price, then three digits will be displayed
to the right of the slash mark (that is, EUR/CZK 32.5420/780). This
only occurs when the quote currency is a very weak monetary unit.
Transaction Cost
The critical characteristic of the bid/ask spread is that it is also the transaction
cost for a round-turn trade. Round-turn means both a buy (or sell) trade and an
offsetting sell (or buy) trade of the same size in the same currency pair. In the
case of the EUR/USD rate in Table 4.1, the transaction cost is three pips. The
formula for calculating the transaction cost is:
Transaction Cost = Ask Price − Bid Price
Rollover
Rollover is the process whereby the settlement of an open trade is rolled forward
to another value date. The cost of this process is based on the interest rate differential
of the two currencies.
Putting It All Together
Trading currencies on margin lets you increase your buying power. If you have
$2,000 cash in a margin account that allows 100:1 leverage, you could purchase
TABLE 4.1 Examples of Quote Convention
EUR/USD 1.2604/07
GBP/USD 1.5089/94
CHF/JPY 84.40/45
32 WHAT EVERY TRADER MUST KNOW
up to $200,000 worth of currency because you only have to post one percent of
the purchase price as collateral. Another way of saying this is that you have
$200,000 in buying power.
With more buying power, you can increase your total return on investment
with less cash outlay. To be sure, trading on margin magnifies your profits
and your losses.
A detailed description on how to calculate profit and loss of leveraged
trades occurs in Chapter 8: The Calculating Trader.
The Trader’s Nemesis
All traders fear the dreaded margin call. This occurs when the broker notifies the
trader that his or her margin deposits have fallen below the required minimum
level because an open position has moved against the trader.
Trading on margin can be a profitable investment strategy, but it is important
that you take the time to understand the risks. You should make sure you
fully understand how your margin account works. Be sure to read the margin
agreement between you and your clearing firm. Talk to your account representative
if you have any questions.
The positions in your account could be partially or totally liquidated
should the available margin in your account fall below a predetermined threshold.
You may not receive a margin call before your positions are liquidated.
Margin calls can be effectively avoided by monitoring your account balance
on a very regular basis and by utilizing stop-loss orders (discussed later) on
every open position to limit risk. For ease of use, most online trading platforms
automatically calculate the profit and loss of a trader’s open positions.
Margin Calls
Nearly all FOREX brokers monitor your account balance continuously. If
your balance falls below four percent of the open margin requirement,
they will issue the first margin call warning, usually by an online popup
message on the screen and/or an email notification. If your account
balance drops below three percent of the margin requirement for your
open positions, they will issue a second margin warning. At two percent,
they will liquidate all your open trades and notify you of your
current account balance. These percentages may vary from broker to
broker.
5
Selecting
a FOREX Broker
Chapter
Caveat Emptor
Before selecting an Internet or online FOREX broker, the new investor should
closely examine the services that each candidate dealer offers and the policies
that it mandates.
Since the passage of the Commodity Futures Modernization Act of 2000,
the CFTC’s Division of Enforcement has filed 41 FOREX cases in eleven states:
14 in Florida; 10 in California; 6 in New York; 3 in Georgia; 2 in Utah; and one
each in Michigan, North Carolina, Ohio, Oregon, Texas, and Washington. The
defendants in these actions defrauded approximately 3,400 retail investors.
These scam artists advertised continually on radio and television. They promised
unrealistic profits on very modest investments. They offered bid/ask spreads
in excess of 30 pips while charging a $200 commission per trade.
The novice trader must be aware of Off-Exchange Currency Dealers
(derogatorily called “bucket shops”). When selecting a prospective FOREX
broker, find out with which regulatory agencies each dealer is registered, if
any. The FOREX market is billed as an “unregulated” market, and essentially
it is. Regulation is typically reactive, occurring only after the damage
has been done.
There are numerous safe and reputable FOREX brokers from which to
choose; consider your specific needs and likes/dislikes before making a
selection.
33
34 WHAT EVERY TRADER MUST KNOW
Broker Services
Online Trading Platform
Nearly all FOREX brokers allow their clients to conduct trading over the
Internet in a clear and comprehensible fashion. The backbone of any trading
platform is, of course, the order entry process.
Examine the dealer’s screen layout: It should include a bar chart of the currency
pair being monitored, an account summary showing the trader’s current
account balance with realized and unrealized profit and loss, margin available,
and any margin locked in active positions. A list of currently held positions
should also be displayed on the same Web page, or at least be readily accessible.
Most trading platforms are either in Windows or Java format; some dealers
offer both versions. A few trading platforms are appearing with Flash.
Some investors may prefer to use voice brokers to execute their trades as
in the pre-Internet era. This service must be specifically mentioned in the broker’s
list of services since telephone trading is a waning method of trading in
the new millennium.
While the authors much prefer the online format, we highly recommend
finding a dealer who offers a voice backup—the Internet can do strange things,
often at the wrong time.
Charting Packages
Some dealers are now offering integrated charting and technical analysis packages
with their dealing platform, or partnerships with charting services. These
are definitely worth exploring if the charts or technical tools offered are of value
to your method of trading. The level of integration with the dealing platform
also varies and is worth understanding carefully.
Here are a few to consider (there are more):
• www.gaincapital.com
• www.gftforex.com
• www.refcofx.com
Some of the charting services offering robust FOREX are:
• www.tradestation.com
• www.esignal.com
• www.aspenres.com
We are told Trade Station will soon integrate with the dealing platform of
www.rjobrien.com.
Selecting a FOREX Broker
Paper Trading
Numerous dealers provide a “paper trading” service that allows the beginning
trader to become acclimated to the real market and “test” a given trading strategy
without risk. These brokers provide a free demo account in which the
investor places orders in a real-time environment but no money exchanges
hands. These trades exist only on paper and are not executed by the broker.
After a week or two of paper trading, the new trader can then assess his or her
potential for profit or loss in the “real” market and proceed accordingly.
Micro-Accounts
Some dealers offer very small “mini-accounts” for as little as $100, although we
feel even a mini-account should have at least a $1000 balance. Micro-accounts
are a great way to get started and test your basic trading expertise and acumen.
Even trading with very small amounts is much more telling than paper trading.
But the broker you use for a micro-account may not be the one you want to use
for “real” trading.
Online Assistance
Though not a requisite, some brokers offer education services and training
courses for the first-time trader. Also the trading platform should have a robust
Help directory on its main menu Web page. Additionally, each candidate broker
should list an email address for customer service queries.
News Services
Before beginning a new trading session, the experienced trader will normally peruse
the news articles that his or her broker has posted to a news articles Web page.
Though this service is not requisite, it is very informative and may affect the trader’s
choices for which currency pairs and which positions to take for that session.
Chat Rooms
Many dealers sponsor open chat rooms for their member clients that focus on
currency trading. Many of the questions that a new trader has are frequently
answered in chat rooms. Be cautious of unsolicited trade tips in these chat
rooms and on the discussion boards—or from anywhere, for that matter.
Other Services
Other services are up to the whim of the individual trader, such as multilingual
platforms, advanced charting, technical and fundamental analysis add-ins, and
35
36 WHAT EVERY TRADER MUST KNOW
various accounting system options. It is also wise to see with which regulatory
agencies the candidate broker is registered (CFTC, NFA, and so on). In addition,
examining a broker’s FAQ Web page will guide the new trader through the
services and options available.
Broker Policies
Available Currency Pairs
The new trader should confirm that the prospective broker offers the seven
major currencies (AUD, CAD, CHF, EUR, GBP, JPY, and USD). Certain cross
currency pairs (a pair in which neither currency is USD) may not be available,
since this entails extra risk.
Transaction Costs
As described earlier, transaction costs are calculated in terms of pips. The lower
the number of pips required per trade by the broker, the greater the profit that
the trader makes. Comparing pip spreads of a half dozen brokers or so
will reveal different transaction costs. One arbitrary rule of thumb is that
the bid/ask spread for EUR/USD (the most frequently traded currency pair)
should never exceed three or four pips, and a two-pip transaction cost is
highly preferable.
Margin Requirement
The lower the margin requirement (and hence the higher the leverage), the
greater the potential for higher profits and losses. Margin percentages can vary
from 1 percent to 10 percent.
Low margin requirements are great when your trades are good, but not so
great when you are wrong. Be realistic about margins and remember that they
swing both ways. In general, low margins are nice to have available, although
you may not normally want to take full advantage of them.
Minimum Trading Size Requirement
The size of one lot may vary from broker to broker, spanning 1,000, 10,000,
and 100,000 units. These brokers usually offer a mini-lot, which is one-tenth of
a lot. Ideally, a broker offers fractional unit sizes (called odd lots) to allow the
trader to select any unit size that he or she wants.
Selecting a FOREX Broker 37
Rollover Charges
Rollover charges are determined by the difference between U.S. interest rates
and the interest rates in the corresponding country. The greater the interest rate
differential between the two currencies in the currency pair, the greater the
rollover charge will be. For example, if the British pound has the greatest differential
with the U.S. dollar, then the rollover charge for holding British
pound positions would be the most expensive. Conversely, if the Swiss franc
were to have the smallest interest rate differential to the U.S. dollar, then
overnight charges for USD/CHF would be the least expensive of the currency
pairs. The whole rollover mechanism is discussed in detail in Chapter 8, on
advanced topics.
Margin Account Interest Rate
Most brokers pay interest on a trader’s margin account. The interest rates normally
fluctuate with the prevailing national rates. At least the equity in your
margin account will be accruing interest if you decide to take an extended break
from trading.
Trading Hours
Nearly all brokers align their hours of operation to coincide with the hours of
operation of the global FOREX market: 5:00 PM EST Sunday through 4:00
PM EST Friday. Confirm this when selecting a dealer.
Other Policies
Be certain to scrutinize a prospective broker’s “fine print” section to be fully
aware of all the nuances that a specific broker may impose on a new trader.
There are several active forums and discussion groups on currency trading
on the Internet. Spend a little time in these forums reviewing what others
have experienced with certain brokers. Feel free to ask questions, too. Do not
get addicted to the discussion groups and forums, however. Although they are
a great way to occasionally find information and share information, they are,
for the most part, a distraction to the serious trader. The authors check in
with the top two or three boards about once a week for perhaps ten minutes
each, maximum.
The premier board at this time is www.moneytec.com, but also worthy of
mention is www.global-view.com. Both of these boards accept paid advertising.
Check in with these forums while doing your initial due diligence, thereafter on
a periodic basis. Again, do not become addicted to them.
38 WHAT EVERY TRADER MUST KNOW
Broker Selection Process
• No broker/dealer is perfect. Having no centralized exchange makes the
selection process very important; the total number of distinct platforms
is now well over 100!
• Start with at least three prospects so you may do comparables and perhaps
negotiate if you are opening a larger account (typically over
$25,000).
• Ask for references with whom you can speak on the telephone.
• Check the regulatory agencies in the country in which the broker
resides if the broker/dealer is regulated.
• Go to the various FOREX discussion groups on the Internet. Look for
information on that broker. Ask questions, too. But be careful—the
person answering you may be the broker or one of the broker’s “representatives.”
• Requoting. This is the major complaint against online brokers. It
occurs when the trading platform does not give you the quote you
select on the screen, but something else, not as good—perhaps as
much as 10 pips difference. You’re not likely to find an online broker
who doesn’t requote occasionally, but beware brokers who requote
often, especially when you are winning!
Requoting is a very much discussed topic today in the FOREX community.
Because there is no centralized exchange it is going to happen
from time to time. When reviewing the requoting of a broker/dealer it
is important to ask 1) How often does it occur? and 2) When does it occur?
If requoting happens in fast-moving markets, it’s probably the nature of
the beast. If it happens whenever you have a big winning trade, beware.
• Review all of the broker’s paperwork (typically downloadable from the
broker’s site). Compare it to others for wording, terms, and so on.
• Send a list of email questions to each of your initial prospects—this is
to get answers and to test for responsiveness.
• Call the broker’s telephone number to see if voice contact is reliable.
The authors would not personally deal with a broker who does not
offer a voice backup or customer service support line.
• Compare especially: account minimums, costs (pip spreads), the handling
of account withdrawals (time period), and margin. Pips vary from currency
pair to currency pair, the most popular having the lowest spread;
two pips for the EUR/USD pair is not uncommon. Some dealers may
charge a small “lot fee” that can add up quickly, so be sure to ask if a dealer
has such a fee and what it is. Get hard copy printouts of everything.
Selecting a FOREX Broker
Finding the right broker/dealer is a critical part of the process. It is not
easy and requires some real work on your part. Do not pick the first one that
looks good to you. Keep looking. Do not be necessarily put off by persistent
sales representatives but be sure to shun high-pressure sales tactics.
Avoiding Fraudulent Operations
There are several levels of FOREX dealers with online access:
Bucket shops. These have essentially no connection to the real-world FOREX
market. The identifying characteristic on most of these is that they heavily tout
currency futures and options over spot FOREX.
Book makers. These are perfectly legitimate in some countries and fine if you
want to simply place a “bet” on a currency. One Web site to explore is
www.deltaindex.com.
39
Broker Selection Process (continued)
• Finally, you will want to spend some time with the broker’s online
Dealing or Trading Platform paper trade, and then trade a miniaccount
for 30 days. Most trading platforms are not bug-free—it’s
extremely complicated software and real-time delivery over the
Internet is not a small task.
• Check the discussion boards for other traders’ experiences.
Top on your list should be:
1. Does the broker have a good recommendation?
2. How did it score on the broker selection process?
3. Do you feel comfortable with the trading platform? Is it reliable?
4. Does the broker offer telephone and email means of communication
and trade back-up?
5. Are costs in line with the market? Especially pip spreads and margins?
6. What are the requoting experiences of other traders?
40 WHAT EVERY TRADER MUST KNOW
Retail market makers (RMMs). These represent the vast majority of online dealers.
There is a wide spectrum amongst them with respect to their organizational
form and how much they actually connect directly to the FOREX market. One
such dealer is actually a U.S.–domiciled bank: www.cbfx.com.
A few other RMMs are:
• www.refcofx.com
• www.gftforex.com
• www.saxobank.com
• www.sbfx.net
• www.gaincapital.com
Institutional market makers. These are very closely aligned with the FOREX
interbank market, and are great if you have enough for their minimum account
requirement.Two examples are www.hotspot.com and www.fxall.com.
Institutional FOREX. At the top of the heap is the Intranet-based trading system,
EBS. This is actually a consortium of close to 200 banks and represents
well over 50 percent of bank FOREX trading. You must be a bank to participate.
For more, see www.ebs.com.
It is still critical that traders investigate the integrity of prospective brokers
as well as their services, costs, and trading platforms. Some traders jump from
one dealer to another in the blink of an eye. Don’t do it; rather, investigate thoroughly
beforehand.
6
Opening an Online
Trading Account
Chapter
Opening a new account with an Internet FOREX broker usually consists
of four simple steps: selecting an account type, registration, account activation,
and confirmation. Consider opening micro or mini-accounts
with two or three broker/dealers and ultimately consolidating your money to the
one that seems to work best for you. Take time making a decision you can live
with: Don’t be rushed and don’t be afraid to ask lots and lots of questions! But
once you decide on a dealer, try to stick with it unless you realize you’ve made a
very big mistake.
Account Types
FOREX brokers offer individual and corporate accounts. There may also be different
account types based on the size of the initial equities that a trader deposits
with the broker. Read the fine print first.
Many brokers offer managed accounts in which the dealer makes all the
decisions on which currency pairs to buy and sell and which trade sizes to transact.
This is equivalent to depositing equities into some form of investment
instrument (such as mutual funds) but with a higher risk factor. It also removes
the intrigue and emotional aspect of trading your private account.
Make sure you are opening a FOREX spot account and not a FOREX forwards
or futures account. Almost everyone uses the spot market, as it is easy to
41
42 WHAT EVERY TRADER MUST KNOW
rollover your position should you wish to hold it for more than a single session
of trading. Also, most of the fraud in the FOREX game has been seen in the forwards
and futures arena.
Registration
The required paperwork to register a new account varies from broker to broker
but always includes the items shown in Table 6.1.
These are usually provided in PDF (portable document format) format
and can be printed using your Adobe Acrobat program. A free download of this
great program is available at: http://www.adobe.com/products/acrobat/ readstep2.html.
Discuss any questions on the telephone whenever possible and get answers,
clarifications, changes, and promises in writing.
Account Activation
The broker will email you the necessary steps to activate your new trading
account after receipt of your initial deposit and the required application forms.
Identification Confirmation
Upon account activation, you will have to confirm your identification by email.
You will be assigned a user name and password that you use each time you enter
a trading session.
Before signing and returning the broker’s application forms, be certain
that you feel comfortable with the following broker policies since you are entering
a binding contractual agreement:
TABLE 6.1 Account Registration Forms
Application form
Risk disclosure statement
Consent to conduct business electronically
Customer agreement
W-9 tax form
Opening an Online Trading Account
• The broker’s hours of operation.
• The bid/ask pip spread on major currency pairs.
• The amount of margin that the broker requires per trade.
• The minimum trading unit size.
• There are no hidden commission costs or other trading fees.
• The reliability of the trading platform.
• Charting and technical analysis services. These are either add-on or
integrated into the trading platform.
• Requoting policy. Be sure to get this in writing.
Last, never send the broker money that you consider non-disposable. If
you are too anxious about your money, you will not make good trading decisions.
If this happens, trade down to a sleeping level.
43

7
Mechanics of
FOREX Trading
Chapter
In this chapter, we discuss the variety of orders that may be placed into the
market. The basic rule of thumb, especially for novice traders, is to keep it
simple. Make certain you know which types of orders your broker/dealer
accepts and build your trading system accordingly. Conversely, if your trading
system requires complex order methodologies (we hope it does not), be sure the
broker you select can comfortably handle them.
Different broker/dealers accept (and do not accept) different types of
orders. Once you have developed your trading plan you will be able to determine
which types of orders are “must haves” for you.
Order Types
Basic Order Types
There are some basic order types that all brokers provide and some others that
are more esoteric. The basic ones are:
• Market orders. A market order is an order to buy or sell at the current
market price. Remember in currency trading, you are buying or selling
one currency against another currency.
• Limit orders. A limit order is an order placed to buy or sell at a certain
price. The order essentially contains two variables, price and duration.
45
46 WHAT EVERY TRADER MUST KNOW
The trader specifies the price at which he or she wishes to buy/sell a certain
currency pair and also specifies the duration that the order should
remain active.
• Limit entry orders. Limit entry orders are executed when the exchange
rate touches (but does not break) a specific level. The client placing a
limit entry order believes that after touching a specific level, the rate
will bounce in the opposite direction of its previous momentum.
• Stop-loss orders. A stop-loss is a limit order linked to a specific position
for the purpose of stopping the position from accruing additional
losses. A stop-loss order placed on a buy position is a stop entry order to
sell linked to that position. A stop-loss order remains in effect until the
position is liquidated or the client cancels the stop-loss order.
• Take profit orders. A take profit order is a limit order linked to a specific
position for the purpose of capturing accrued profits and liquidating
the position. A take profit order remains in effect until the position
is liquidated or the client cancels the take profit order.
Esoteric Order Types
The following more esoteric orders may not be available at all dealers and are
usually just variations of other order types or involve a specified duration of time:
• GTC (Good ’til canceled). A GTC order remains active in the market
until the trader decides to cancel it. The dealer will not cancel the order
at any time, therefore it is the customer’s responsibility to remember
that he or she possesses the order.
• GFD (Good for the day). A GFD order remains active in the market
until the end of the trading day. Because foreign exchange is an ongoing
market, the end of day must be a set hour.
• OCO (Order cancels other). An OCO order is a mixture of two limit
and/or stop-loss orders. Two orders with price and duration variables
are placed above and below the current price. When one of the orders is
executed the other order is canceled. Example: The price of EUR/USD
is 0.9340. The trader wants to either buy 10,000 at 0.9395 over the
resistance level in anticipation of a breakout or initiate a selling position
if the price falls to 0.9300. The understanding is that if 0.9395 is
reached, the trader will buy 10,000 and the 0.9300 order will be automatically
canceled.
Mechanics of FOREX Trading
Always read your broker’s documentation for specific order information
and to see if any rollover fees will be applied if a position is held longer than one
day. Keeping your ordering rules simple is the best strategy.
Most online broker/dealers are not among the small pool of institutional
FOREX market makers. They can give instantaneous orders primarily because
they are “throwing off ” bulk orders to larger dealers—sometimes market makers.
The bid-ask spread is not only part of their profit picture, but protects them
against fluctuations in the market.
Once you decide which order types you need for trading (generally speaking,
fewer is best), check out the brokers on your list to see which ones will best
accommodate you.
Order Execution
Traders using an online trading platform click on the “buy” or “sell” button after
having specified the underlying currency pair and the desired number of units to
trade. The execution of the order is instantaneous. This means that the price seen
at the exact time of the click will be given to the customer. See Figures 7.1 and 7.2.
Placing a market order by phone is quite similar but usually takes a few
seconds more. The exact process is as shown in Table 7.1.
47
FIGURE 7.1 Market order request.
48 WHAT EVERY TRADER MUST KNOW
Order Confirmation
Online traders receive a screen message indicating confirmation of an order
within seconds after the trade has been executed, as shown in Figure 7.3.
Traders can also cancel any limit order that has not been executed at any
time. Most brokers respond with a message similar to the one seen in Figure 7.4.
Voice traders usually receive a verbal confirmation within 5 to 15 seconds
after placing the order.
FIGURE 7.2 Limit order request.
TABLE 7.1 Order Sequence
1. A customer specifies the currency pair and the deal size to the dealer.
2. The dealer gives a two-way price (bid and ask price).
3. The customer takes one of the two prices (he or she may ask for a requote).
4. The dealer confirms the trade. Under normal market conditions, dealers usually
respond to market orders in about 5 to 10 seconds at most. Assuming the
customer deals immediately on the offered prices, the average phone deal can
be made in 10 to 15 seconds.
Mechanics of FOREX Trading 49
Transaction Exposure
All online trading platforms are obligated to inform the investor of his or her
current status in the FOREX market. Most will display this critical information
in a window similar to the one seen in Figure 7.5.
The abbreviation GTC in the Expiry (expiration date) column in Figure
7.5 stands for “Good ’Til Canceled.”
FIGURE 7.3 Order confirmation message.
FIGURE 7.4 Limit order cancellation.
50 WHAT EVERY TRADER MUST KNOW
FIGURE 7.5 Transaction exposure.
Summary
The basic order types (market, stop loss, and take profit) are usually all
that most traders ever need. Unless you are a veteran trader, do not design
a system of trading requiring a large number of orders sandwiched in the
market at all times—stick with the basic stuff first.
If you are using an online trading platform: before submitting an
order, close your eyes for a moment, then check all aspects of your order
before clicking “submit.” The two most common errors here are selecting
“buy” (the default) when “sell” was intended and entering an incorrect
number of units.
Make certain you fully understand and are comfortable with your
broker’s order entry system before executing a trade. Do not make a trade
with real money until you have an extremely high comfort level with the
trading platform and order entry system.
8
The Calculating Trader
Chapter
Here is where the rubber meets the road. Take your time with this information,
as it is necessary knowledge for all FOREX traders. We recommend
that you do not even paper trade until you are completely
comfortable with pip values and calculating profit and loss for any pairs or
crosses you intend to trade.
Profit and Loss (P&L) for every open position is calculated in real-time on
most brokers’ trading platforms. The information in this chapter enables traders
to track their own P&L tick by tick as the market fluctuates.
Leverage and Margin Percent
Some brokers describe their gearing in terms of a leverage ratio and others in terms
of a margin percentage. The simple relationships between the two terms are:
Leverage = 100 / Margin Percent
Margin Percent = 100 / Leverage
Leverage is conventionally displayed as a ratio, such as 20:1 or 50:1. In
the examples that follow which require leverage, we use only the number on
the left side of the ratio—that is, 20 or 50—since the number on the right side
is always 1.
51
52 WHAT EVERY TRADER MUST KNOW
Pip Values
A pip is the smallest price increment that any currency pair can move in either
direction. In the FOREX markets, profits are calculated in terms of pips first,
then dollars second. See Table 8.1.
Approximate USD values for a one-pip move per contract in the major
currency pairs are shown in Table 8.2, per 100,000 units of the base currency.
On a typical day, actively traded currency pairs like EUR/USD and
USD/JPY can fluctuate 100 pips or more. The above table is based upon a margin
requirement of 100 percent (leverage = 1:1). To calculate actual profit (or
loss) in leveraged positions, multiply the pip value per 100k times the leverage
ratio (margin percentage divided by 100).
Note that the EUR/GBP cross rate pair in Table 8.2 uses multiplication
with the USD spot price instead of division. This is because the USD is the
quote (second) currency in the spot conversion pair.
TABLE 8.1 Single Pip Values
USD = Quote Currency
EUR/USD .0001 USD
GBP/USD .0001 USD
AUD/USD .0001 USD
USD = Base Currency
USD/JPY .01 JPY
USD/CHF .0001 CHF
USD/CAD .0001 CAD
Non-USD Cross Rates
EUR/JPY .01 JPY
EUR/CHF .0001 CHF
EUR/GBP .0001 GBP
GBP/JPY .01 JPY
GBP/CHF .0001 CHF
CHF/JPY .01 JPY
The Calculating Trader
Calculating Profit and Loss
Many FOREX trading platforms offer their clients a variety of online utilities
that assist the investor in his or her trading calculations. The utility to compute
the profit or loss on each trade should resemble what is shown in Figure 8.1.
Because all profits are expressed in U.S. dollars, a key factor in the calculation
of profit and loss is the currency pair and whether the USD is the base currency
or the quote currency, or if the currency pair is a non-USD cross rate.
Therefore, we will present several examples involving all cases.
Remember that the first currency in a currency pair is called the base currency
(determines the number of units traded) and the second is called the
quote currency (determines the pip values of each price change).
Scenario 1
USD Is the Quote Currency (Profit)
Currency pair. Select the corresponding currency pair from the dropdown list.
The default is the EUR/USD pair.
Position. Choose either “buy” or “sell.” The default is “buy.”
53
TABLE 8.2 Full Lot Pip Values
Currencies 1 Pip Value Per Full Lot (100,000 units)
EUR/USD EUR 100,000 × .0001= USD 10.00
GBP/USD GBP 100,000 × .0001= USD 10.00
AUD/USD AUD100,000 × .0001= USD 10.00
USD/JPY USD 100,000 × .01 = JPY 1,000 / USDJPY spot (105.50) = USD 9.47
USD/CHF USD 100,000 × .0001= CHF 10.00 / USDCHF spot (1.2335) = USD 8.11
USD/CAD USD 100,000 × .0001= CAD 10.00 / USDCAD spot (1.3148) = USD 7.61
EUR/JPY EUR 100,000 × .01 = JPY 1,000 / USDJPY spot (105.50) = USD 9.47
EUR/CHF EUR 100,000 × .0001= CHF 10.00 / USDCHF spot (1.2335) = USD 8.11
EUR/GBP EUR 100,000 × .0001= CHF 10.00 × GBPUSD spot (1.8890) = USD 5.2
GBP/JPY GBP 100,000 × .01 = JPY 1,000 / USDJPY spot (105.50) = USD 9.47
GBP/CHF GBP 100,000 × .0001= CHF 10.00 / USDCHF spot (1.2335) = USD 8.11
CHF/JPY CHF 100,000 × .01 = JPY 1,000 / USDJPY spot (105.50) = USD 9.47
54 WHAT EVERY TRADER MUST KNOW
Number of units. This is the individual number of units and not the number of
lots or mini-lots. A full lot should be entered as “100000” and a mini-lot as
“10000.”
Entry price. This is the entry price regardless if the trade was a market order or
a limit order. Include the decimal point.
Exit price. This is the liquidation price regardless if the trade was manually
exited or a limit order was triggered.
Conversion rate. This entry is necessary to convert any profit or loss to U.S. dollars
if the quote currency (the second one in the pair) is not USD. In this example,
USD is the quote currency. Enter the single digit “1” since we already have
conversion parity. Other possibilities are explained later.
Click the “Calculate” button as shown in Figure 8.2.
In this example we bought a mini-lot (10,000 units) of the EUR/USD
pair at 1.2563 and sold at 1.2588, netting a clear profit of 25 pips (price change
times pip factor, or 0.0025 × 10,000). The price change is simply:
Price Change = Exit Price − Entry Price
FIGURE 8.1 Online profit calculator.
The Calculating Trader 55
The pip factor is the number of pips in the monetary unit of quote
currency. There are 10,000 pips in one U.S. dollar and, conversely a single pip
equals $0.0001. The pip factor is therefore 10,000.
Profit in Pips = Price Change × Pip Factor
When the quote currency is the USD, profit or loss is calculated very
simply as:
Profit in USD = Price Change × Units Traded
In our scenario, this equates to:
$ 25.00 = 0.0025 × 10,000
Many of you have just exclaimed “Wow! That was painlessly simple. Show
me one more!”
Scenario 2
USD Is the Quote Currency (Loss) For those of you who exclaimed nothing or
are staring blankly at this page, we will do it again, this time with the GBP/USD
currency pair. See Figure 8.3.
FIGURE 8.2 A 25-pip profit in EUR/USD.
56 WHAT EVERY TRADER MUST KNOW
In this instance, we initiated a 30,000-unit short (sell) trade in the
GBP/USD pair at 1.8863 and, sadly, it advanced against our hopes. We exited
at 1.8883, losing 20 pips. Since the quote currency (the second currency) is
USD, we know the conversion rate is 1. Thus using the profit formula
Profit in USD = Price Change × Units Traded
we find that our profit is actually a loss:
−$60.00 = −0.0020 × 30000
If the above calculations are still causing some confusion, we recommend
that you take a break, then reread Chapter 4, “FOREX Terms.” As promised
before, these calculations only require the four simple arithmetic functions:
addition, subtraction, multiplication, and division. No exponents, logs, or trig
functions. But this information must be completely clear before proceeding.
Keep in mind that it is your money at stake.
Scenario 3
USD Is the Base Currency (Profit) If the quote (second) currency is not the
U.S. dollar, then profit or loss must be converted to U.S. dollars. For example, a
FIGURE 8.3 A 20-pip loss in GBP/USD.
The Calculating Trader
35-pip profit in the USD/JPY pair means that the 35 pips are expressed in
Japanese yen (see Figure 8.4). Therefore, one extra step is required to convert yen
to dollars:
Conversion Rate. If USD is the base currency of the currency pair being calculated,
then divide the profit or loss by the exit price. This simply converts the
pip profit expressed as yens to a profit expressed as dollars.
Thus, when calculating currency pairs where the base (first) currency is
the U.S. dollar, the profit formula must be adjusted as follows:
Profit in USD = Price Change × Units Traded / Exit Price
or, specifically:
$33.09 = 0.35 × 10000 / 105.77
Obviously, all U.S. brokers perform this simple conversion to U.S. dollars
before adding profits to your margin account.
Scenario 4
USD Is the Base Currency (Loss) This example is arithmetically identical to
the previous example, except that a small loss was incurred. We purchased 5,000
57
FIGURE 8.4 A 35-pip profit in USD/JPY.
58 WHAT EVERY TRADER MUST KNOW
units of the USD/CAD pair at 1.3152 and set a stop-loss limit order at 1.3142,
which, unfortunately, was triggered (see Figure 8.5).
Using the same adjusted profit formula as in the previous example,
Profit in USD = Price Change × Units Traded / Exit Price
we find:
−$3.80 = −0.0010 × 5000 / 1.3142
Note: Always keep your losses small.
Scenario 5
Non-USD Cross Rates (USD/Quote) Most experienced traders can mentally
perform the arithmetic in the above examples. It just takes practice. However, we
must now tackle cross rates, currency pairs where neither currency is the U.S. dollar.
Obviously the profit in pips will be initially expressed in terms of the quote
(second) currency of the cross rate pair. The solution is simple: Look up the current
price of the currency pair containing USD and the quote currency of the
cross rate pair, as shown in Figure 8.6.
The Conversion Rate entry of 105.32 in Figure 8.6 is actually the current
price of the USD/JPY pair. The adjusted profit formula for this cross rate trade is:
FIGURE 8.5 A 10-pip loss in USD/CAD.
The Calculating Trader
Profit in USD = Price Change × Units Traded / Conversion Rate
or
$37.98 = 0.40 × 10000 / 105.43
A pattern is developing here . . .
Scenario 6
Non-USD Cross Rates (Base/USD) In the previous example, the USD was the
base currency in the conversion pair (USD/JPY). In Figure 8.7 USD is the quote
currency of the conversion pair (GBP/USD).
The Conversion Rate entry in Figure 8.7 is the current price of the
GBP/USD pair. The reversal of the role of the U.S. dollar in the conversion pair
(GBP/USD) requires another change in the profit formula:
Profit in USD = Price Change × Units Traded × Rate
or
$19.05 = 0.0018 × 20000 × 1.8902
59
FIGURE 8.6 A 40-pip profit in CHF/JPY.
60 WHAT EVERY TRADER MUST KNOW
Remember that when USD is the quote currency of the conversion pair, you
must multiply the rate. If USD is the base currency of the conversion pair, then
divide the rate. Give yourself an A+ if you understood the previous examples on
the first reading. You are destined for great things.
You may have noticed there was no mention of transaction costs in the
six scenarios given. The broker always subtracts the transaction cost at the moment
the trade is initiated; therefore transaction costs do not affect the above
calculations.
Calculating Units Available
Before initiating a new trade, it is always advantageous to know the maximum
number of units that you can safely trade without risking a margin call based
upon your current account balance. Most trading platforms provide an online
utility that calculates this information, usually resembling what is shown in
Figure 8.8.
Enter the following data fields to calculate the maximum number of units
to buy or sell:
• Margin available. This is the amount in your margin account you
want to earmark for the current trade.
FIGURE 8.7 An 18-pip profit in EUR/GBP.
The Calculating Trader
• Margin percent. This is your broker’s margin percentage for leveraging
trades.
• Currency pair. Select the corresponding currency pair. In this example,
select EUR/USD.
• Current price. Enter the current ask price in the currency pair.
• Conversion rate. If the quote currency in the selected currency pair is
USD, then enter “1”.
Click “Calculate.” (See Figure 8.9.)
61
FIGURE 8.8 Units available calculator.
FIGURE 8.9 15,944 units available.
62 WHAT EVERY TRADER MUST KNOW
You can safely trade 15,000 units of EUR/USD in this example. In the
next example (Figure 8.10), we calculate the units available for a currency pair
in which the base currency is USD. Enter the first four fields as in the previous
example. Since USD is the base currency in the USD/JPY pair, we must enter
the current price as the conversion rate.
The formula to calculate the maximum units that can be traded is:
Units Available =
100 × Margin Available × Rate / (Current Price × Margin Percent)
If USD is the base currency, then this reduces to:
Units Available = 100 × Margin Available / Margin Percent
Cross rates can be handled in the same fashion by simply manipulating
the conversion rate. Note: Always decrease the unites available slightly to avoid a
margin call. We recommend 10 percent.
Calculating Margin Requirements
Before executing any trade, you should always have a rough idea of how much
of your account balance will be used as the margin requirement. Any trade
FIGURE 8.10 500,000 units available.
The Calculating Trader
whose margin requirement exceeds your existing account balance will not be
executed. Trades whose margin requirements deplete nearly all the equity in
your account are very risky and may incur the dreaded margin call. The formula
to calculate the margin requirement for a trade is very simple:
Margin Requirement =
Current Price × Units Traded × Margin Percent / 100
Assume your broker mandates a 5percent margin percentage. You want to
buy a full lot (100,000 units) of the EUR/USD currency pair, which is trading
at 1.2538. Thus:
$6,269.00 = 1.2538 × 100,000 × 5 / 100
This trade requires $6,269.00 for margin. Proceed accordingly.
Calculating Transaction Cost
Your broker will always calculate the transaction cost because that cost is automatically
subtracted from your account balance the instant you initiate a new
trade. Nonetheless, it is useful to know just how the broker computes this debit.
See Figure 8.11.
63
FIGURE 8.11 Calculate transaction cost.
64 WHAT EVERY TRADER MUST KNOW
Remember that the bid price is used when the trader initiates a new buy
(long) trade and the ask price is used when the trader initiates a new sell (short)
trade. When the USD is the quote currency in the currency pair, the conversion
rate equals 1, as seen in Figure 8.12.
The basic formulas for the transaction cost in this instance are:
Spread = Ask Price − Bid Price
Transaction Cost = Spread × Units Traded
$3.00 = (1.2569 − 1.2566) × 10,000
Figure 8.13 shows an example in which we calculate the transaction cost
when the base currency is USD.
In this case, the formula becomes:
Spread = Ask Price − Bid Price
Transaction Cost = Spread × Units Traded / Ask Price
$3.24 = (1.2359 − 1.2355) × 10,000 / 1.2359
In our final example, we calculate the transaction cost in U.S. dollars
for a non-USD cross rate. We need to look up the current price of the currency
pair containing USD and the quote currency of the cross rate pair (see
Figure 8.14).
FIGURE 8.12 A 3-pip spread in EUR/USD.
The Calculating Trader
In this case of non-USD cross rates, the formula becomes:
Transaction Cost = Spread × Units Traded / Conversion Rate
or
$5.69 = (85.52 − 85.46) × 10000 / 105.43
65
FIGURE 8.13 A 4-pip spread in USD/CHF.
FIGURE 8.14 A 6-pip spread in CHF/JPY.
66 WHAT EVERY TRADER MUST KNOW
Calculating Account Summary Balance
In this section, we make the following assumptions before walking you through
the accounting system of your first trade:
• You have read and thoroughly understand the FOREX trading terms
described in Chapter 4.
• You have researched a half dozen or so reputable FOREX brokers and
selected one that satisfies your financial needs and goals.
• You have used the broker’s paper trading feature and/or the demo program
that he or she provides and now feel comfortable with the screen
layout of the trading platform and its mouse/keyboard navigation
system.
• You have opened a new margin account, signed and returned the necessary
application forms, and deposited 5,000 USD with the broker.
You are now ready to make your first trade in the FOREX currency markets.
The Account Summary section of your broker’s trading platform should
look similar to what is shown in Figure 8.15.
Let us say that your new broker offers 20:1 leverage, which means that you
must “risk” five percent of the total value of any trade that you execute, long or
short. Assume that you have analyzed, both technically and fundamentally, several
major currency pairs and feel that the USD/JPY pair is overpriced and it
will decline in the immediate future. You now execute a very conservative entry
order to sell 5,000 units of USD/JPY at a market price of 105.64. The transaction
cost (the difference between the bid and the ask price) is three pips for
the USD/JPY pair.
FIGURE 8.15 Account summary before first trade.
The Calculating Trader
In Figure 8.16 we see that the Balance and the Realized P&L entries are
unchanged. Unrealized P&L show a negative 1.42 USD. This is the round-turn
transaction cost, which is subtracted the moment a new trade is executed. Each
pip in the USD/JPY trade is worth 0.4733 USD. Therefore:
1 pip = .1/105.64 × 50
1 pip = 0.4733 USD
3 pips = 1.4199 USD
The Margin Used entry shows 250.00 USD, calculated as follows:
Margin Used = Total Cost of Trade × Margin Percentage
250.00 = 5,000.00 × 5%
The Margin Available entry has also changed:
Margin Available = Balance − Margin Used
4,750.00 = 5,000.00 − 250.00
After ten minutes or so, we notice that your “feeling”—that the USD/JPY
pair was oversold and would decline—has paid off. The USD/JPY has dropped
to 105.51. Not only have you recouped the transaction cost (minus three pips)
but you gained a plus 10 pips in profit, as shown in Figure 8.17.
At this point, market activity slows down and the price direction starts
moving laterally. You decide that a plus 10 pips on your first trade is satisfactory
67
FIGURE 8.16 Account summary after market entry.
68 WHAT EVERY TRADER MUST KNOW
and you close the trade. Essentially, this means purchasing 5,000 units of
USD/JPY to offset your previous sale. Once your trade liquidation is logged at
the broker’s firm, your new Account Summary should resemble what is shown
in Figure 8.18.
The example, of course, is merely an illustration. Your first trade may be
greater or smaller than the example.
For Futures Traders
Futures traders tend to think in dollars versus a commodity asset (silver, soybeans,
pork bellies, etc.). The switch to corelational values—one currency against
another—can be a bit trying at first. The trick is to practice calculating profit and
loss for fictitious trades. Most broker dealing platforms provide such a calculator.
FIGURE 8.17 A 10-pip profit.
FIGURE 8.18 After liquidating first trade.
The Calculating Trader
In Review
The math in this chapter is not nearly as complex as it may appear at first. In
fact we can reduce it all to the following cheat sheet:
Price Change = Exit Price − Entry Price
Leverage = 100 / Margin Percent
Margin Percent = 100 / Leverage
Profit in Pips = Price Change × Pip Factor
If the Quote Currency in a trade = USD, then
Profit in USD = Price Change × Units Traded
If the Base Currency in a trade = USD, then
Profit in USD = Price Change × Units Traded / Exit Price
When the profit for non-USD cross rates is being calculated, the following
applies:
The conversion rate is the currency pair with the USD
and the quote currency of the cross rate pair.
If the quote currency of the conversion rate = USD, then
Profit in USD = Price Change × Units Traded / Conversion Rate
If the base currency of the conversion rate = USD, then
Profit in USD = Price Change × Units Traded × Conversion Rate
You can now calculate profit and loss during open positions.
69

3
How to Beat
the Market
(Maybe)
Part

9
Fundamental Analysis
Chapter
It is commonly accepted that there are two major schools when formulating a
trading strategy for any market, be it securities, futures, or currencies. These
two disciplines are called fundamental analysis and technical analysis. The
former is based on economic factors while the latter is concerned with price
actions. Of course, the trader may opt to include elements of both disciplines
while honing his or her personal trading strategy.
Supply and Demand
Fundamental analysis is a study of the economy and is based on the assumption
that the supply and demand for currencies is a result of economic processes that
can be observed in practice and that can be predicted. Fundamental analysis
studies the relationship between the evolution of exchange rates and economic
indicators, a relationship which it verifies and uses to make predictions.
For currencies, a fundamental trading strategy consists of strategic assessments
in which a certain currency is traded based on virtually any criteria excluding
the price action. These criteria include, but are not limited to, the economic
condition of the country that the currency represents, monetary policy, and other
elements that are fundamental to economies.
The focus of fundamental analysis lies in the economic, social, and political
forces that drive supply and demand. There is no single set of beliefs that guides
fundamental analysis, yet most fundamental analysts look at various macro-
73
74 HOW TO BEAT THE MARKET (MAYBE)
economic indicators, such as economic growth rates, interest rates, inflation, and
unemployment. Several theories prevail as to how currencies should be valued.
Done alone, fundamental analysis can be stressful for traders who deal with
commodities, currencies, and other “margined” products. The reason for this is
that fundamental analysis often does not provide specific entry and exit points,
and therefore it can be difficult for traders to control risk when utilizing leverage
techniques.
Currency prices are a reflection of the balance between supply and demand
for currencies. Interest rates and the overall strength of the economy are the two
primary factors that affect supply and demand. Economic indicators (for example,
gross domestic product, foreign investment, and the trade balance) reflect
the overall health of an economy. Therefore, they are responsible for the underlying
changes in supply and demand for a particular currency. A tremendous
amount of data relating to these indicators is released at regular intervals, and
some of this data is significant. Data that is related to interest rates and international
trade is analyzed very closely.
Interest Rates
If there is an uncertainty in the market in terms of interest rates, then any developments
regarding interest rates can have a direct effect on the currency markets.
Generally, when a country raises its interest rates, the country’s currency
strengthens in relation to other currencies as assets are shifted away from it to
gain a higher return elsewhere. Interest rates hikes, however, are usually not
good news for stock markets. This is due to the fact that many investors withdraw
money from a country’s stock market when there is an increase in interest
rates, causing the country’s currency to weaken. See Figure 9.1.
Knowing which effect prevails can be tricky, but usually there is an agreement
among practitioners in the field as to what the interest rate move will do.
The producer price index, the consumer price index, and the gross domestic
product have proven to be the indicators with the biggest impact. The timing of
interest rate moves is usually known in advance. It is generally known that these
moves take place after regular meetings of the BOE (Bank of England), FED
(U.S. Federal Reserve), ECB (European Central Bank), BOJ (Bank of Japan),
and other central banks.
Balance of Trade
The trade balance portrays the net difference (over a period of time) between
the imports and exports of a nation. When the value of imports becomes more
than that of exports, the trade balance shows a deficit (this is, for the most part,
Fundamental Analysis
considered unfavorable). For example, if Euros are sold for other domestic
national currencies, such as U.S. dollars, to pay for imports, the value of the currency
will depreciate due to the flow of dollars outside the country. By contrast,
if trade figures show an increase in exports, money will flow into the country and
increase the value of the currency. In some ways, however, a deficit is not necessarily
a bad thing. A deficit is only negative if the deficit is greater than market
expectations and therefore will trigger a negative price movement. See Table 9.1
75
FIGURE 9.1 U.S. interest rates.
TABLE 9.1 U.S. Balance of Trade, 2003
(in thousands of U.S. dollars)
Country Exports Imports Balance
China 28,418.5 152,379.1 −123,960.6
Japan 52,063.7 118,029.0 −65,965.3
Canada 169,768.8 224,165.3 −54,396.5
Mexico 97,457.3 138,073.5 −40,616.2
Germany 28,847.9 68,047.1 −39,199.2
Italy 10,569.9 25,436.6 −14,866.7
Taiwan 17,487.9 31,599.9 −14,112.0
(continued on next page)
76 HOW TO BEAT THE MARKET (MAYBE)
TABLE 9.1 (continued)
Country Exports Imports Balance
Saudi Arabia 4,595.9 18,069.1 −13,473.2
South Korea 24,098.6 36,963.3 −12,864.7
France 17,068.2 29,221.2 −12,153.0
Thailand 5,841.8 15,180.8 −9,339.0
United Kingdom 33,895.7 42,666.9 −8,771.2
India 4,986.4 13,052.7 −8,066.3
Sweden 3,225.5 11,124.7 −7,899.2
Indonesia 2,520.1 9,520.0 −6,999.9
Russia 2,450.0 8,598.4 −6,148.4
Israel 6,878.4 12,770.3 −5,891.9
Norway 1,467.5 5,212.2 −3,744.7
Austria 1,792.6 4,489.3 −2,696.7
Denmark 1,548.3 3,718.5 −2,170.2
Philippines 7,992.1 10,061.0 −2,068.9
Switzerland 8,660.0 10,667.8 −2,007.8
Finland 1,713.8 3,597.9 −1,884.1
South Africa 2,821.3 4,637.6 −1,816.3
Hungary 934.1 2,699.2 −1,765.1
Portugal 863.0 1,967.3 −1,104.3
Turkey 2,904.3 3,788.0 −883.7
Kuwait 1,509.0 2,276.8 −767.8
Spain 5,935.3 6,708.1 −772.8
Czech Republic 672.3 1,394.4 −722.1
Poland 758.7 1,325.8 −567.1
Lichtenstein 15.9 261.9 −246.0
Iceland 242.2 283.0 −40.8
Albania 9.8 4.4 5.4
North Korea 7.9 0.1 7.8
Luxembourg 279.0 265.0 14.0
Greece 1,191.3 616.2 575.1
Singapore 16,575.8 15,158.0 1,417.8
Hong Kong 13,542.1 8,850.2 4,691.9
Belgium 15,217.9 10,140.6 5,077.3
Australia 13,103.8 6,413.9 6,689.9
Netherlands 20,703.0 10,971.8 9,731.2
Source: FTDWebMaster, Foreign Trade Division, U.S. Census Bureau, Washington, D.C.
Fundamental Analysis 77
Purchasing Power Parity
Purchasing power parity (PPP) is a theory that states that exchange rates between
currencies are in equilibrium when their purchasing power is the same in each
of the two countries. This means that the exchange rate between two countries
should equal the ratio of the two countries’ price level of a fixed basket of goods
and services. When a country’s domestic price level is increasing (i.e., a country
experiences inflation), that country’s exchange rate must depreciate in order to
return to PPP.
The basis for PPP is the “law of one price.” In the absence of transportation
and other transaction costs, competitive markets will equalize the price of
an identical good in two countries when the prices are expressed in the same
currency. For example, a particular TV set that sells for 500 U.S. dollars (USD)
in Seattle should cost 750 Canadian dollars (CAD) in Vancouver when the
exchange rate between Canada and the United States is 1.50 USD/CAD. If the
price of the TV in Vancouver cost only 700 CAD, however, consumers in
Seattle would prefer buying the TV set in Vancouver. If this process (called arbitrage)
is carried out on a large scale, the American consumers buying Canadian
goods will bid up the value of the Canadian dollar, thus making Canadian goods
more costly to them. This process continues until the goods again have the same
price. There are three caveats with this law of one price: (1) As mentioned above,
transportation costs, barriers to trade, and other transaction costs can be significant.
(2) There must be competitive markets for the goods and services in both
countries. (3) The law of one price only applies to tradeable goods; immobile
goods such as houses and many services that are local are, of course, not traded
between countries.
Economists use two versions of purchasing power parity: absolute PPP
and relative PPP. Absolute PPP was described in the previous paragraph; it refers
to the equalization of price levels across countries. Put formally, the exchange
rate between Canada and the United States ECAD/USD is equal to the price
level in Canada PCAN divided by the price level in the United States PUSA.
Assume that the price level ratio PCAD/PUSD implies a PPP exchange rate
of 1.3 CAD per 1 USD. If today’s exchange rate ECAD/USD is 1.5 CAD per 1
USD, PPP theory implies that the CAD will appreciate (get stronger) against
the USD, and the USD will in turn depreciate (get weaker) against the CAD.
Relative PPP refers to rates of changes of price levels, that is, inflation
rates. This proposition states that the rate of appreciation of a currency is equal
to the difference in inflation rates between the foreign and the home country.
For example, if Canada has an inflation rate of one percent and the United
States has an inflation rate of three percent, the U.S. dollar will depreciate
against the Canadian dollar by two percent per year. This proposition holds well
empirically, especially when the inflation differences are large.
78 HOW TO BEAT THE MARKET (MAYBE)
The simplest way to calculate purchasing power parity between two countries
is to compare the price of a “standard” good that is, in fact, identical across
countries. Every year The Economist magazine publishes a light-hearted version
of PPP: Its “Hamburger Index” lists the price of a McDonald’s hamburger in
various countries around the world. More sophisticated versions of PPP look at
a large number of goods and services. One of the key problems in computing a
comprehensive PPP is that people in different countries consume very different
sets of goods and services, making it difficult to compare the purchasing power
between countries. See Figure 9.2.
Gross Domestic Product
The gross domestic product (GDP) is the total market value of all goods and services
produced either by domestic or foreign companies within a country’s borders.
GDP indicates the pace at which a country’s economy is growing (or shrinking)
and is considered the broadest indicator of economic output and growth.
GDPs of different countries may be compared (see Table 9.2) by converting
their value in national currency according to either (a) exchange rates prevailing
on international currency markets, or (b) the purchasing power parity
(PPP) of each currency relative to a selected standard (usually the U.S. dollar).
FIGURE 9.2 Purchasing power parity.
Source: Office for Economic Cooperation and Development
Fundamental Analysis
The relative ranking of countries may differ dramatically depending upon
which approach is used: Using official exchange rates can routinely understate
the relative effective domestic purchasing power of the average producer or consumer
within a less-developed economy by 50 to 60 percent, owing to the weakness
of local currencies on world markets.
79
TABLE 9.2 Gross Domestic Product, PPP Basis
PPP total USD PPP/capita Population
Rank Entity (billions) USD 2003 est.
1. European Union 10,840 28,600 379,000,000
2. USA 10,400 37,600 290,343,000
3. China 5,700 4,400 1,287,000,000
4. Japan 3,550 28,000 127,215,000
5. India 2,660 2,540 1,049,701,000
6. Germany 2,180 26,600 82,399,000
7. France 1,540 25,700 60,181,000
8. United Kingdom 1,520 25,300 60,095,000
9. Italy 1,440 25,000 57,998,000
10. Russia 1,350 9,300 144,526,000
11. Brazil 1,340 7,600 182,032,000
12. South Korea 931 19,400 48,249,000
13. Canada 923 29,400 32,207,000
14. Mexico 900 9,000 104,908,000
15. Spain 828 20,700 40,218,000
16. Indonesia 663 3,100 234,894,000
17. Australia 528 27,000 19,732,000
18. Turkey 468 7,000 68,110,000
19.Iran 456 7,000 68,279,000
20. Netherlands 434 26,900 16,151,000
21. South Africa 432 10,000 42,769,000
22. Thailand 429 6,900 70,000,000
23. Taiwan 406 18,000 22,116,000
24. Argentina 391 10,200 38,000,000
25. Poland 368 9,500 38,000,000
Source: CIA World Factbook: PPP, PPP/Capita, Population
80 HOW TO BEAT THE MARKET (MAYBE)
However, comparison based on official exchange rates can offer a better
indication of a country’s purchasing power on the international market for
goods and services.
Intervention
Another important fundamental influence on FOREX currency prices is called
intervention. This occurs when an official regulatory agency or a financial institution
with one government directly coerces the exchange rate of its currency,
usually by reevaluation, devaluation, or by the manipulation of imports and
exports in some way.
Such actions may cause broad and erratic changes in the exchange rate
with foreign currencies. However, it is from such anomalies that the FOREX
trader may profit, if the proper stop-loss safeguards are in place.
Other Economic Indicators
Industrial Production
Industrial production (IP) is a chain-weighted measure of the change in the production
of the nation’s factories, mines, and utilities, as well as a measure of their
industrial capacity and how many available resources among factories, utilities,
and mines are being used (commonly known as capacity utilization). The manufacturing
sector accounts for one-quarter of the economy. The capacity utilization
rate provides an estimate of how much factory capacity is in use.
Purchasing Managers Index
The National Association of Purchasing Managers (NAPM), now called the
Institute for Supply Management, releases a monthly composite index of
national manufacturing conditions, constructed from data on new orders,
production, supplier delivery times, backlogs, inventories, prices, employment,
export orders, and import orders. It is divided into manufacturing and nonmanufacturing
subindices.
Producer Price Index
The producer price index (PPI) is a measure of price changes in the manufacturing
sector. It measures average changes in selling prices received by domestic
producers in the manufacturing, mining, agriculture, and electric utility industries
for their output. The PPIs most often used for economic analysis are those
for finished goods, intermediate goods, and crude goods.
Fundamental Analysis
Consumer Price Index
The consumer price index (CPI) is a measure of the average price level paid by
urban consumers (80 percent of the population) for a fixed basket of goods and
services. It reports price changes in over 200 categories. The CPI also includes
various user fees and taxes directly associated with the prices of specific goods
and services.
Durable Goods
The durable goods orders indicator measures new orders placed with domestic
manufacturers for immediate and future delivery of factory hard goods. A
durable good is defined as a good that lasts an extended period of time (over
three years) during which its services are extended.
Employment Cost Index
Payroll employment is a measure of the number of jobs in more than 500
industries in all 50 states and 255 metropolitan areas. The employment estimates
are based on a survey of larger businesses and count the number of paid
employees working part-time or full-time in the nation’s business and government
establishments.
Retail Sales
The retail sales report is a measure of the total receipts of retail stores from samples
representing all sizes and kinds of business in retail trade throughout the
nation. It is the timeliest indicator of broad consumer spending patterns and is
adjusted for normal seasonal variation, holidays, and trading-day differences.
Retail sales include durable and nondurable merchandise sold, and services and
excise taxes incidental to the sale of merchandise. Excluded are sales taxes collected
directly from the customer.
Housing Starts
The housing starts report measures the number of residential units on which
construction is begun each month. A start in construction is defined as the
beginning of excavation of the foundation for the building and is comprised primarily
of residential housing. Housing is very interest rate–sensitive and is one
of the first sectors to react to changes in interest rates. Significant reaction of
starts/permits to changing interest rates signals that interest rates are nearing a
trough or a peak. To analyze the data, focus on the percentage change in levels
from the previous month. The report is released around the middle of the following
month.
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82 HOW TO BEAT THE MARKET (MAYBE)
Forecasting
Fundamental analysis refers to the study of the core underlying elements that
influence the economy of a particular entity. It is a method of study that attempts
to predict price action and market trends by analyzing economic indicators, government
policy, and societal factors (to name just a few elements) within a business
cycle framework. If you think of the financial markets as a big clock, the
fundamentals are the gears and springs that move the hands around the face.
Anyone walking down the street can look at this clock and tell you what time it
is now, but the fundamentalist can tell you how it came to be this time and more
importantly, what time (or more precisely, what price) it will be in the future.
There is a tendency to pigeonhole traders into two distinct schools of market
analysis—fundamental and technical. Indeed, the first question posed to
you after you tell someone that you are a trader is generally “Are you a technician
or a fundamentalist?” The reality is that it has become increasingly difficult
to be a purist of either persuasion. Fundamentalists need to keep an eye on the
various signals derived from the price action on charts, while few technicians
can afford to completely ignore impending economic data, critical political
decisions, or the myriad of societal issues that influence prices.
Bearing in mind that the financial underpinnings of any country, trading
bloc, or multinational industry take into account many factors, including social,
political, and economic influences, staying on top of an extremely fluid fundamental
picture can be challenging. At the same time, you’ll find that your
knowledge and understanding of a dynamic global market will increase immeasurably
as you delve further and further into the complexities and subtleties of
the fundamentals of the markets.
Fundamental analysis is a very effective way to forecast economic conditions,
but not necessarily exact market prices. For example, when analyzing an
economist’s forecast of the upcoming GDP or employment report, you begin to
get a fairly clear picture of the general health of the economy and the forces at
work behind it. However, you’ll need to come up with a precise method as to
how best to translate this information into entry and exit points for a particular
trading strategy.
A trader who studies the markets using fundamental analysis generally creates
models to formulate a trading strategy. These models typically utilize a host
of empirical data and attempt to forecast market behavior and estimate future
values or prices by using past values of core economic indicators. These forecasts
are then used to derive specific trades that best exploit this information.
Forecasting models are as numerous and varied as the traders and market
buffs that create them. Two people can look at the same data and come up with
two completely different conclusions about how the market will be influenced
by it. Therefore it is important that before casting yourself into a particular
Fundamental Analysis
mold regarding any aspect of market analysis, you study the fundamentals and
see how they best fit your trading style and expectations.
Do not succumb to “paralysis by analysis.” Given the multitude of factors
that fall under the heading of “The Fundamentals,” there is a distinct danger of
information overload. Sometimes traders fall into this trap and are unable to pull
the trigger on a trade. This is one of the reasons why many traders turn to technical
analysis. To some, technical analysis is seen as a way to transform all of the
fundamental factors that influence the markets into one simple tool: prices. However,
trading a particular market without knowing a great deal about the exact
nature of its underlying elements is like fishing without bait. You might get lucky
and snare a few on occasion, but it’s not the best approach over the long haul.
For FOREX traders, the fundamentals are everything that makes a country
tick. From interest rates and central bank policy to natural disasters, the
fundamentals are a dynamic mix of distinct plans, erratic behaviors, and unforeseen
events. Therefore, it is easier to get a handle on the most influential
contributors to this diverse mix than it is to formulate a comprehensive list of
all the fundamentals.
Economic indicators are snippets of financial and economic data published
by various agencies of the government or private sector. These statistics,
which are made public on a regularly scheduled basis, help market observers
monitor the pulse of the economy. Therefore, they are religiously followed by
almost everyone in the financial markets. With so many people poised to react
to the same information, economic indicators in general have tremendous
potential to generate volume and to move prices in the markets. While on the
surface it might seem that an advanced degree in economics would come in
handy to analyze and then trade on the glut of information contained in these
economic indicators, a few simple guidelines are all that is necessary to track,
organize, and make trading decisions based on the data.
Know exactly when each economic indicator is due to be released. Keep a
calendar on your desk or trading station that contains the date and time when
each statistic will be made public. You can find these calendars on the N.Y.
Federal Reserve Bank Web site using this link: http://www.ny.frb.org/. Then search
for “economic indicators.” The same information is also available from many
other sources on the Web or from the company you use to execute your trades.
Keeping track of the calendar of economic indicators will also help you
make sense out of otherwise unanticipated price action in the market. Consider
this scenario: It’s Monday morning and the U.S. dollar has been in a tailspin for
three weeks. As such, it is safe to assume that many traders are holding large
short USD positions. However, the employment data for the United States is
due to be released on Friday. It is very likely that with this key piece of economic
information soon to be made public, the USD could experience a short-term
rally leading up to the data on Friday as traders pare down their short positions.
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84 HOW TO BEAT THE MARKET (MAYBE)
The point here is that economic indicators can affect prices directly (following
their release to the public) or indirectly (as traders massage their positions in
anticipation of the data).
Understand which particular aspect of the economy is being revealed in
the data. For example, you should know which indicators measure the growth
of the economy (GDP) versus those that measure inflation (PPI, CPI) or
employment (non-farm payrolls). After you follow the data for a while, you will
become very familiar with the nuances of each economic indicator and which
part of the economy it measures.
Not all economic indicators are created equal. Well, they might have
been created with equal importance but along the way, some have acquired
much greater potential to move the markets than others. Market participants
will place higher regard on one statistic versus another depending on the state
of the economy.
Know which indicators the markets are keying on. For example, if prices
(inflation) are not a crucial issue for a particular country, the markets will probably
not as keenly anticipate or react to inflation data. However, if economic
growth is a vexing problem, changes in employment data or GDP will be eagerly
anticipated and could precipitate tremendous volatility following its release.
The data itself is not as important as whether or not it falls within market
expectations. Besides knowing when all the data will hit the wires, it is vitally
important that you know what economists and other market pundits are forecasting
for each indicator. For example, knowing the economic consequences
of an unexpected monthly rise of 0.3 percent in the producer price index (PPI)
is not nearly as vital to your short-term trading decisions as it is to know that
this month the market was looking for PPI to fall by 0.1 percent. As mentioned,
you should know that PPI measures prices and that an unexpected rise
could be a sign of inflation. But analyzing the longer-term ramifications of this
unexpected monthly rise in prices can wait until after you have taken advantage
of the trading opportunities presented by the data. Once again, market
expectations for all economic releases are published on various sources on the
Web and you should post these expectations on your calendar along with
the release date of the indicator.
Do not get caught up in the headlines, however. Part of getting a handle
on what the market is forecasting for various economic indicators is knowing
the key aspects of each indicator. While your macroeconomics professor might
have drilled the significance of the unemployment rate into your head, even
junior traders can tell you that the headline figure is for amateurs and that the
most closely watched detail in the payroll data is the non-farm payrolls figure.
Other economic indicators are similar in that the headline figure is not nearly as
closely watched as the finer points of the data. PPI, for example, measures
changes in producer prices. But the statistic most closely watched by the marFundamental
Analysis
kets is PPI, minus food and energy price changes. Traders know that the food
and energy component of the data is much too volatile and subject to revisions
on a month-to-month basis to provide an accurate reading on the changes in
producer prices.
Speaking of revisions, do not be too quick to pull that trigger should a particular
economic indicator fall outside of market expectations. Contained in
each new economic indicator released to the public are revisions to previously
released data. For example, if durable goods should rise by 0.5 percent in the
current month, while the market is anticipating them to fall, the unexpected rise
could be the result of a downward revision to the prior month. Look at revisions
to older data because in this case, the previous month’s durable goods figure
might have been originally reported as a rise of 0.5 percent but now, along with
the new figures, it is being revised to indicate a rise of only 0.1 percent.
Therefore, the unexpected rise in the current month is likely the result of a
downward revision to the previous month’s data.
Do not forget that there are two sides to a trade in the foreign exchange
market. So, while you might have a handle on the complete package of economic
indicators published in the United States or Europe, most other countries
also publish similar economic data. The important thing to remember here
is that not all countries are as efficient as the G8 in releasing this information.
Once again, if you are going to trade the currency of a particular country, you
need to find out the particulars about that country’s economic indicators. As
mentioned earlier, not all of these indicators carry the same weight in the markets
and not all of them are as accurate as others. Do your homework so you
won’t be caught off guard.
When it comes to focusing exclusively on the impact that economic indicators
have on price action in a particular market, the foreign exchange markets
are the most challenging. Therefore, they have the greatest potential for profits
of any market. Obviously, factors other than economic indicators move prices
and as such make other markets more or less potentially profitable. But since a
currency is a proxy for the country it represents, the economic health of that
country is priced into the currency. One very important way to measure the
health of an economy is through economic indicators. The challenge comes in
diligently keeping track of the nuts and bolts of each country’s particular economic
information package. Here are a few general comments about economic
indicators and some of the more closely watched data.
Most economic indicators can be divided into leading and lagging indicators.
Leading indicators are economic factors that change before the economy
starts to follow a particular pattern or trend. Leading indicators are used
to predict changes in the economy. Lagging indicators are economic factors
that change after the economy has already begun to follow a particular pattern
or trend.
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86 HOW TO BEAT THE MARKET (MAYBE)
The problem with fundamental analysis is that it is difficult to convert the
“qualitative” information into a specific price prediction. With FOREX leverage
being what it is, it is seldom enough to know that a report is “bullish” for a currency
without being able to attach specific values.
Even if you opt for a technical analysis trading approach, as most traders
do, do not completely ignore the fundamentals. Use a new service to do a daily
take on what’s happening. Remember: Be aware of pending reports, statistical
releases, and so on, as they often will cause a violent market reaction one way or
the other.
The authors consulted numerous sources while compiling the current chapter.
We wish to acknowledge specifically http://www.sbfx.net/fundamental_analysis.
aspx for their informative Web site. Fundamental analysis is a very deep well. It
is important to understand the basic fundamentals that drive currency prices,
even though most traders use technical analysis to make specific day-to-day
trading decisions.
10
Technical Analysis
Chapter
Overview
Probably the most successful and most utilized means of making decisions and
analyzing FOREX markets is technical analysis. The difference between technical
and fundamental analyses is that technical analysis ignores fundamental
factors and is applied only to the price action of the market. While fundamental
data can often provide only a long-term forecast of exchange rate movements,
technical analysis has become the primary tool to successfully analyze
and trade shorter-term price movements, as well as to set profit targets and
stop-loss safeguards because of its ability to generate price-specific information
and forecasts.
Historically, technical analysis in the futures markets has focused on the
six price fields available during any given period of time: open, high, low, close,
volume, and open interest. Since the FOREX market has no central exchange, it
is very difficult to estimate the latter two fields, volume and open interest. In
this chapter, we therefore limit our analysis to the first four price fields.
Technical analysis consists primarily of a variety of technical studies,
each of which can be interpreted to predict market direction or to generate
buy and sell signals. Many technical studies share one common important
tool: a price-time chart that emphasizes selected characteristics in the price
motion of the underlying security. One great advantage of technical analysis
is its “visualness.”
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88 HOW TO BEAT THE MARKET (MAYBE)
Bar Charts
Bar charts are the most widely used type of chart in security market technical
analysis and date back to the last decade of the nineteenth century. They are
popular because they are easy to construct and understand. These charts are constructed
by representing intra-day, daily, weekly, or monthly activity as a vertical
bar. Opening and closing prices are represented by horizontal marks to the left
and right of the vertical bar respectively. Spotting both patterns and the trend of
a market, two of the essentials of chart reading, is often easiest using bar charts.
Bar charts present the data individually, without linking prices to neighboring
prices. Each set of price fields is a single “island.”
Each vertical bar has the components shown in Figure 10.1.
Figure 10.2 shows a daily bar chart for the EUR/USD currency pair for
the month of June 2003. The vertical scale on the right represents the cost of
one Euro in terms of U.S. dollars. The horizontal legend at the bottom of the
chart represents the day of week.
A common method of classifying the vertical bars is to show the relationships
between the opening and closing prices within a single time interval, as
seen in Figure 10.3.
Graphically, an open/high/low/close (OHLC) bar chart is defined using
the following algorithm:
High
Open
Close
Low
FIGURE 10.1 Anatomy of single vertical bar.
OHLC Bar Chart Algorithm
• Step 1—One vertical rectangle whose upper boundary represents the
high for the day and whose lower boundary represents the low for the
given time period.
• Step 2—One horizontal rectangle to the left of the high-low rectangle
whose central value represents the opening price for the given period.
• Step 3—One horizontal rectangle to the right of the high-low rectangle
whose central value represents the closing price for the given period.
Technical Analysis
One interesting variation to the standard OHLC bar chart was developed
by author/trader Burton Pugh is the 1930s. His model involved connecting the
previous set of quotes to the current set of quotes, which generates a continuous
line representation of price movements. There are four basic formations
between two adjacent vertical bars in Burton’s system. (see Figure 10.4)
Bar chart interpretation is one of the most fascinating and well-studied topics
in the realm of technical analysis. Recurring bar chart formations have been
labeled, categorized, and analyzed in detail. Common formations like tops, bottoms,
head-and-shoulders, inverted head-and-shoulders, lines of support and
resistance, reversals, and so forth, are examined in the following sections.
89
FIGURE 10.2 Vertical bar chart.
Close Open
Open Close
Bull Bar Bear Bar
FIGURE 10.3 Anatomy of bull and bear bars.
90 HOW TO BEAT THE MARKET (MAYBE)
Trend Lines
A trend can be up, down, or lateral and is represented by drawing a straight line
above the daily highs in a downward trend and a straight line below the daily
lows in an upward trend. See Figure 10.5
A common trading technique involves the intersection of the trend line
with the most recent prices. If the trend line for a downward trend crosses
A B A B
A B A B
Bull
Higher Highs, Higher Lows
Outside
Higher Highs, Lower Lows
Bear
Lower Highs, Lower Lows
Inside
Lower Highs, Higher Lows
FIGURE 10.4 Continuous line bar chart.
Trend line
Trend line
Trend line
FIGURE 10.5 Bar chart with trend lines.
Technical Analysis 91
through the most recent prices, a buy signal is generated. Conversely, if the
trend line for an upward trend passes through the most recent prices, then a sell
signal is generated.
Support and Resistance
Support levels indicate the price at which most traders feel that prices will move
higher. There is sufficient demand for a security to cause a halt in a downward
trend and turn the trend up. You can spot support levels on the bar charts by
looking for a sequence of daily lows that fluctuate only slightly along a horizontal
line. When a support level is penetrated (the price drops below the support
level) it often becomes a resistance level; this is because traders want to limit
their losses and will sell later, when prices approach the former level.
Like support levels, resistance levels are horizontal lines on the bar chart.
They mark the upper level for trading, or a price at which sellers typically outnumber
buyers. When resistance levels are broken, the price moves above the
resistance level, and often does so decisively. See Figure 10.6.
Many traders find lines of support and resistance useful in determining
the placement of stop-loss and take-profit limit orders.
Recognizing Chart Patterns
Proper identification of an ongoing trend can be a tremendous asset to the trader.
However, the trader must also learn to recognize recurring chart patterns that
disrupt the continuity of trend lines. Broadly speaking, these chart patterns can
be categorized as reversal patterns and continuation patterns.
Resistance
Support
FIGURE 10.6 Bar chart with support and resistance lines.
92 HOW TO BEAT THE MARKET (MAYBE)
Reversal Patterns
Reversal patterns are important because they inform the trader that a market
entry point is unfolding or that it may be time to liquidate an open position.
Figures 10.7 through 10.10 illustrate the most common reversal patterns.
FIGURE 10.7 Double top.
FIGURE 10.8 Double bottom.
Left Shoulder
Head
Right Shoulder
Neckline
FIGURE 10.9 Head-and-shoulders top.
Technical Analysis
Continuation Patterns
A continuation pattern implies that while a visible trend was in progress, it was
temporarily interrupted, and then continued in the direction of the original
trend. The most common continuation patterns are shown in Figure 10.11
through 10.15.
The proper identification of a continuation pattern may prevent the trader
from prematurely liquidating an open position that still has profit potential.
93
FIGURE 10.10 Head-and-shoulders bottom.
FIGURE 10.11 Flag or pennant.
FIGURE 10.12 Symmetrical triangle.
94 HOW TO BEAT THE MARKET (MAYBE)
FIGURE 10.13 Ascending triangle.
FIGURE 10.14 Descending triangle.
FIGURE 10.15 Rectangle.
Technical Analysis
Gaps
A gap occurs when the trading range on a given day lies outside the trading range
of the previous day. Often the result of an emotional response to overnight news,
a gap can be an indication of a new price trend. See Figures 10.16.through 10.19.
The authors’ research indicates that gaps are of special importance in
FOREX.
95
FIGURE 10.16 Breakaway gap.
FIGURE 10.17 Runaway gap.
FIGURE 10.18 Exhaustion gap.
96 HOW TO BEAT THE MARKET (MAYBE)
Candlestick Charts
Candlestick charting is usually credited to the Japanese rice trader Munehisa
Homma in the early eighteenth century, though many references indicate that
this method of technical analysis probably existed as early as the 1600s. Steven
Nison of Merrill Lynch is credited with popularizing candlestick charting in
Western markets and has become recognized as the leading expert on their interpretation.
See Figure 10.20.
FIGURE 10.19 Island reversal gap.
FIGURE 10.20 Candlestick chart.
Technical Analysis
The candlestick is the graphic representation of the price bar: the open,
high, low, and closing price of the period. The algorithm to construct a candlestick
chart follows:
97
Candlestick Chart Algorithm
• Step 1—The candlestick is made up of a body and two shadows.
• Step 2—The body is depicted as a vertical column bounded by the
opening price and the closing price.
• Step 3—The shadows are just vertical lines—a line above the body to
the high of the day (the upper shadow) and a line below the body to
the low of the day (the lower shadow).
• Step 4—It is customary for the body to be empty if the close was
higher than the open (a bull day) and filled if the close was lower than
the open (a bear day).
The elements of a candlestick bar are shown in Figure 10.21.
The nomenclature used to identify individual or consecutive combinations
of candlesticks is rich in imagery: Hammer, hanging man, dark cloud
cover, morning star, three black crows, three mountains, three advanced white
soldiers, and spinning tops are only a few of the candlestick patterns that have
been categorized and used in technical analysis.
High
Upper shadow
Real body
Close
Open
Close
Open
Lower shadow
Low
FIGURE 10.21 Anatomy of candlestick bar.
98 HOW TO BEAT THE MARKET (MAYBE)
A thorough description of how to interpret candlestick charts is given in
Steven Nison’s books: Japanese Candlestick Charting Techniques, Hall, 1991, and
Beyond Candlesticks: More Japanese Charting Techniques Revealed, Wiley, 1994. A
summary of the different candlestick patterns can also be found at www.hotcandle.
com/candle.htm.
Point and Figure Charts
The modern point and figure (P&F) chart was created in the late nineteenth
century and is roughly 15 years older than the standard OHLC bar chart. This
technique, also called the three-box reversal method, is probably the oldest
Western method of charting prices still around today.
Its roots date back into trading lore, as it has been intimated that this
method was successfully used by the legendary trader James R. Keene during the
merger of U.S. Steel in 1901. Mr. Keene was employed by Andrew Carnegie to
distribute the company shares, as Carnegie refused to take stock as payment for
his equity interest in the company. Keene, using point and figure charting and
tape readings, managed to promote the stock and get rid of Carnegie’s sizeable
stake without causing the price to crash. This simple method of charting has
stood the test of time and requires less time to construct and maintain than the
traditional bar chart. See Figure 10.22.
The point and figure method derives its name from the fact that price is
recorded using figures (Xs and Os) to represent a point, hence the name “Point
FIGURE 10.22 Point and figure chart.
Technical Analysis
and Figure.” Charles Dow, the original founder of the Wall Street Journal and
the inventor of stock indexes, was rumored to be a point and figure user. Indeed,
the practice of point and figure charting is alive and well today on the floor of all
futures exchanges. The method’s simplicity in identifying price trends and support
and resistance levels, as well as its ease of upkeep, has allowed it to endure
the test of time, even in the age of Web pages, personal computers, and the
information explosion.
The elements of the point and figure anatomy are shown on Figure 10.23.
Two user-defined variables are required to plot a point and figure chart,
the first of which is called the box size. This is the minimum grid increment that
the price must move in order to satisfy the plotting of a new X and O. The selection
of the box size variable is usually based upon a multiple of the minimum
tick size determined by the commodity exchange. If the box size is too small,
then the point and figure chart will not filter out white noise, while too large a
filter will not present enough detail in the chart to make it useful. We recommend
initializing the box size for a FOREX P&F chart with the value of one or
two pips in the underlying currency pair.
The second user-defined parameter necessary to plot a point and figure
chart is called the reversal amount. If the price moves in the same direction as
the existing trend, then only one box size is required to plot the continuation of
the trend. However, in order to filter out small fluctuations in price movements
(or lateral congestion), a reversal in trend cannot be plotted until it satisfies the
reversal amount constraint. Typically, this value is set at three box sizes, though
any value between one and seven is a plausible candidate. The daily limit
imposed by most commodity exchanges can also influence the trader’s selection
of the reversal amount variable.
The algorithm to construct a point and figure chart follows:
99
X
X
X
X
X
X
X
X
X
O
O
O
O
O
O
One Box Size
Downward Trends
Upward Trends
Starting Point
FIGURE 10.23 Anatomy of point and figure columns.
100 HOW TO BEAT THE MARKET (MAYBE)
Point and Figure Algorithm
• Upward trends are represented as a vertical column of Xs, while downward
trends are displayed as an adjacent column of Os.
• New figures (Xs or Os) cannot be added to the current column unless
the increase (or decrease) in price satisfies the minimum box size
requirement.
• A reversal cannot be plotted in the subsequent column until the price
has changed by the reversal amount times the box size.
Advantages of P&F Charts
• Eliminate the insignificant price movements that often make bar
charts appear “noisy.”
• Remove the often misleading effects of time from the analysis process
(whipsawing).
• Make trend line recognition a “no-brainer.”
• Make recognizing support/resistance levels much easier.
Nearly all of the pattern formations discussed above have analogous
patterns that appear when using a standard OHLC bar chart.
Adjusting the two variables, box size and reversal amount, may cause
these patterns to become more recognizable. P&F charts also:
• Are a viable online analytical tool in real time. They require only a
sheet of paper and pencil.
• Help you stay focused on the important long-term price developments.
Point and figure charts display the underlying supply and demand of
prices. A column of Xs shows that demand is exceeding supply (a rally); a column
of Os shows that supply is exceeding demand (a decline); and a series of
short columns shows that supply and demand are relatively equal. There are several
advantages to using P&F charts instead of the more traditional bar or candlestick
charts.
P&F charts automatically:
For a more detailed examination of this charting technique, we recommend
Point & Figure Charting by Thomas J. Dorsey (2001: John Wiley & Sons, Inc.).
Technical Analysis
Indicators and Oscillators
Beyond charting are various market indicators—calculations using the primary
information of open, high, low, or close. Indicators may also be charted or
graphed. Buy and sell signals and complete systems may be generated from a
battery of indicators. The most popular indicators are: relative strength, moving
averages, oscillators or momentum analysis (actually a superset of relative
strength), and Bollinger bands.
Relative Strength Indicator
The relative strength indicator (RSI) shows whether a currency is overbought or
oversold. Overbought indicates an upward market trend, since the financial
operators are buying a currency in the hope of further rate increases. Sooner or
later saturation will occur because the financial operators have already created a
long position. They show restraint in making additional purchases and try to
make a profit. The profits made can very quickly lead to a change in the trend or
at least a consolidation.
Oversold indicates that the market is showing downward trend conditions,
since the operators are selling a currency in the hope of further rate falls.
Over time saturation will occur because the financial operators have created
short positions. They then limit their sales and try to compensate for the short
positions with profits. This can rapidly lead to a change in the trend.
You cannot determine directly whether the market is overbought or oversold.
This would suppose that you knew all of the foreign exchange positions of
all the financial operators. However, experience shows that only speculative buying,
which leads to an overbought situation, makes very rapid rate rallies possible.
The RSI is a numerical indication of price fluctuations over a given
period; it is expressed as a percentage.
RSI = sum of price rises / sum of all price fluctuations
To illustrate this, we have selected the daily closes (multiplied by 10,000)
for the EUR/USD currency pair when it first appeared on the FOREX market
in January of 2002. The running time frame in this example is nine days. See
Table 10.1.
An RSI between 30 and 70 percent is considered neutral. Below 25 percent
indicates an oversold market, over 75 percent indicates an overbought market.
The RSI should never be considered alone but in conjunction with other indicators
and charts. Moreover, its interpretation depends largely on the period studied.
The example in Table 10.1 is nine days. An RSI over 25 days would show,
101
102 HOW TO BEAT THE MARKET (MAYBE)
given a steady evolution of rates, fewer fluctuations. The advantage of obtaining
more rapid signals for selling and buying (by using a smaller number of days) is
counterbalanced by a greater risk of receiving the unconfirmed signals.
Momentum Analysis
Like the RSI, momentum measures the rate of change in trends over a given
period. Unlike the RSI, which measures all the rate changes and fluctuations
within a given period, momentum allows you to analyze only the rate variations
between the start and end of the period studied.
TABLE 10.1 Calculating RSI
Date Close Daily Chg Ups Downs Total Percent
1/01/02 8894
1/02/02 9037 +43
1/03/02 8985 −51
1/04/02 8944 −41
1/07/02 8935 −9
1/08/02 8935 0
1/09/02 8914 −21
1/10/02 8914 0
1/11/02 8925 +11 54 122 176 30.7
1/14/02 8943 +18 72 122 194 37.1
1/15/02 8828 −15 29 137 166 17.5
1/16/02 8821 −7 29 93 122 23.8
1/17/02 8814 −7 29 59 88 33.0
1/18/02 8846 +32 61 50 111 55.0
1/21/02 8836 −10 61 60 121 50.4
1/22/02 8860 +24 85 39 124 68.5
1/23/02 8783 +23 108 39 147 73.5
1/24/02 8782 −1 97 40 137 70.8
1/25/02 8650 –132 79 171 250 31.6
1/28/02 8623 −27 79 183 262 30.2
1/29/02 8656 +33 112 176 288 39.0
1/30/02 8610 −46 112 215 327 34.3
1/31/02 8584 −26 80 232 312 25.6
Technical Analysis
The larger n is, the more the daily fluctuations tend to disappear. When
momentum is above zero or its curve is rising, it indicates an uptrend. A signal
to buy is given as soon as the momentum exceeds zero, and when it drops below
zero, triggers the signal to sell.
Momentum = price on day (X ) − price on day (X − n)
where n = number of days in the period studied.
The following example in Table 10.2 of momentum analysis uses the
EUR/USD currency pair as the underlying security.
103
TABLE 10.2 Calculating Momentum
9-Day
Date Close Momentum
1/01/02 8894
1/02/02 9037
1/03/02 8985
1/04/02 8944
1/07/02 8935
1/08/02 8935
1/09/02 8914
1/10/02 8914
1/11/02 8925
1/14/02 8943 +49
1/15/02 8828 −209
1/16/02 8821 −164
1/17/02 8814 −130
1/18/02 8846 −99
1/21/02 8836 −99
1/22/02 8860 −54
1/23/02 8783 −131
1/24/02 8782 −143
1/25/02 8650 −293
1/28/02 8623 −205
1/29/02 8656 −165
1/30/02 8610 −204
1/31/02 8584 −262
104 HOW TO BEAT THE MARKET (MAYBE)
Examination of the nine-day momentum shows a clear downward trend.
Momentum analysis should not be used as the sole criterion for market entry
and exit timing, but in conjunction with other indicators and chart signals.
Moving Averages
The moving average (MA) is another instrument used to study trends and generate
market entry and exit signals. It is the arithmetic average of closing prices
over a given period. The longer the period studied, the weaker the magnitude of
the moving average curve. The number of closes in the given period is called the
moving average index.
Market signals are generated by calculating the residual value:
Residual = Price(X) −MA(X)
When the residual crosses into the positive area, a buy signal is generated.
When the residual drops below zero, a sell signal is generated.
A significant refinement to this residual method (also called moving average
convergence divergence, or MACD for short) is the use of two moving
averages. When the MA with the shorter MA index (called the oscillating
MA index) crosses above the MA with the longer MA index (called the basis MA
index), a sell signal is generated.
Residual = Basis MA(X) − Oscillating MA(X)
Again we use the EUR/USD currency pair to illustrate the moving average
method (see Table 10.3).
The reliability of the moving average residual method depends heavily on
the MA indices chosen. Depending on market conditions, it is the shorter periods
or longer periods that give the best results. When an ideal combination of
moving averages is used, the results are comparatively good. The disadvantage is
that the signals to buy and sell are indicated relatively late, after the maximum
and minimum rates have been reached.
The residual method can be optimized by simple experimentation or by a
software program. Keep in mind that when a large sample of daily closes is used,
the indices will need to be adjusted as market conditions change.
Bollinger Bands
This indicator was developed by John Bollinger and is explained in detail in his
opus called Bollinger on Bollinger Bands. The technique involves overlaying three
Technical Analysis
bands (lines) on top of an OHLC bar chart (or a candlestick chart) of the
underlying security.
The central band is a simple arithmetic moving average of the daily closes
using a trader-selected moving average index. The upper and lower bands are
the running standard deviation above and below the central moving average.
Since the standard deviation is a measure of volatility, the bands are selfadjusting,
widening during volatile markets and contracting during calmer
periods. Bollinger recommends 10 days for short-term trading, 20 days for
105
TABLE 10.3 Calculating Moving Average Residuals
Date Close 3-Day MA 5-Day MA Residual
1/01/02 8894
1/02/02 9037
1/03/02 8985 8972
1/04/02 8944 8989
1/07/02 8935 8955 8959 4
1/08/02 8935 8938 8967 29
1/09/02 8914 8928 8943 15
1/10/02 8914 8921 8928 7
1/11/02 8925 8918 8925 7
1/14/02 8943 8927 8926 −1
1/15/02 8828 8899 8905 6
1/16/02 8821 8864 8886 22
1/17/02 8814 8821 8866 45
1/18/02 8846 8827 8850 23
1/21/02 8836 8832 8829 −3
1/22/02 8860 8847 8835 −12
1/23/02 8783 8826 8828 2
1/24/02 8782 8808 8821 13
1/25/02 8650 8738 8782 44
1/28/02 8623 8685 8740 55
1/29/02 8656 8643 8699 56
1/30/02 8610 8630 8664 34
1/31/02 8584 8617 8625 8
106 HOW TO BEAT THE MARKET (MAYBE)
intermediate-term trading, and 50 days for longer-term trading. These values
typically apply to stocks and bonds, thus shorter time periods will be preferred
by commodity traders. See Figure 10.24.
Bollinger bands require two trader-selected input variables: the number of
days in the moving average index and the number of standard deviations to plot
above and below the moving average. Over 95 percent of all the daily closes fall
within three standard deviations from the mean of the time series. Typical values
for the second parameter range from 1.5 to 2.5 standard deviations.
As with moving average envelopes, the basic interpretation of Bollinger
bands is that prices tend to stay within the upper and lower band. The distinctive
characteristic of Bollinger bands is that the spacing between the bands
varies based on the volatility of the prices. During periods of extreme price
changes (that is, high volatility), the bands widen to become more forgiving.
During periods of stagnant pricing (that is, low volatility), the bands narrow to
contain prices.
Bollinger notes the following characteristics of Bollinger bands:
• Sharp price changes tend to occur after the bands tighten, as volatility
lessens.
• When prices move outside the bands, a continuation of the current
trend is implied.
• Bottoms and tops made outside the bands followed by bottoms and
tops made inside the bands call for reversals in the trend.
8707.00
8584.50
8462.00
8339.50
8217.00
FIGURE 10.24 Bollinger bands.
Technical Analysis
• A move that originates at one band tends to go all the way to the other
band. This observation is useful when projecting price targets.
Bollinger bands do not generate buy and sell signals alone. They should be
used with another indicator, usually the relative strength index. This is because
when price touches one of the bands, it could indicate one of two things: a continuation
of the trend or it could indicate a reaction the other way. So Bollinger
bands used by themselves do not provide all of what technicians need to know,
which is when to buy and sell. MACD can be used in conjunction with
Bollinger bands and RSI.
Swing Analysis
Swing analysis is one of those nebulous terms that means different things to different
people. It is often associated with swing trading, which also harbors a
variety of connotations (the swing trader usually keeps a trade open longer than
the typical session or day trader).
Within the framework of this book, we will define swing analysis as the
study of the distance between local peaks and troughs in the closing prices for
the purpose of identifying recurring patterns and correlations. The swing chart,
like its older sibling the point and figure chart, requires the use of a massaging
algorithm that filters out lateral congestion (whipsawing) during periods of low
volatility. For this purpose, a minimum box size must be selected. Within currency
trading, this is almost always a single pip in the quote (second) currency of
the currency pair. Additionally, a minimum reversal quantity must be selected.
This is simply the number of pips (box sizes) required before a retracement can
be drawn in the opposite direction (the continuation of an existing trend
requires only one box size to plot the next point).
Unlike the P&F chart, the swing chart does not distort the time element.
That is, swing charts are frequently overlaid directly on top of a vertical bar
chart since both use the same numerical scaling for the x- and the y-axis. See
Figure 10.25.
In Figure 10.25, it is clear that a swing chart is a sequence of alternating
straight lines, called waves, which connect each peak with its succeeding trough
and vice versa.
The swing analyst is particularly interested in retracement percentages.
Market behavior is such that when a major trend does break out, there is a
sequence of impulse waves in the direction of the trend with interceding retracement
waves (also called corrective waves). The ratio of the corrective wave
divided by the preceding impulse wave is referred to as the percentage of retrace-
107
108 HOW TO BEAT THE MARKET (MAYBE)
ment. Famous analysts such as William D. Gann and Ralph N. Elliott have dedicated
their lives to interpreting these ratios and estimating the length of the
next wave in the time series.
Gann believed that market waves moved in patterns based upon, among
other things, the Fibonacci number series, which emphasizes the use of so-called
magic numbers such as 38.2 percent, 50 percent, and 61.8 percent. Actually,
there is no magic involved at all; they are simply proportions derived from the
Golden Mean or Divine Ratio. This is a complete study unto itself and has
many fascinating possibilities. Visit http://www-groups.dcs.st-and.ac.uk/~history/
Mathematicians/Fibonacci.html for more details on Fibonacci and his work.
In his analysis of stocks in the 1920s and 1930s, Elliott was able to identify
and categorize nine levels of cycles (that is, a sequence of successive waves) over the
same time period for a single bar chart. This entailed increasing the minimum
reversal threshold in the filtering algorithm, which creates fewer but longer waves
with each new iteration. He believed each major impulse wave was composed of
five smaller waves while major corrective waves were composed of only three
smaller waves. We refer interested readers to the Web site www.elliottwave.com for
more details on Elliott and his theories.
Advanced Studies
This chapter serves as a stepping stone into the realm of technical analysis. Time
series analysis is a complex and ever-changing discipline. Advanced studies include
deviation analysis, retracement studies, statistical regressions, Fibonacci progressions,
Fourier transforms, and the Box-Jenkins method, to name just a few.
FIGURE 10.25 Bar chart with swing analysis overlay.
Technical Analysis
Into the Future
There are also those using techniques from other disciplines to analyze the markets.
Michael Duane Archer, coauthor of this book, has deeply explored the use
of Cellular Automata to forecast FOREX prices.
Your analysis of the markets is only one component of your trading system.
In fact, two other components are more important, in the opinion of the
authors: money management and psychology (discussed in detail in later chapters).
Most traders who fail (and most traders do fail) tend to spend all their
energies on developing a trading system at the expense of money management
and trading psychology. Don’t be like them!
The Technician’s Creed
All market fundamentals are depicted in the actual market data. So the actual
market fundamentals need not be studied in detail.
History repeats itself and therefore markets move in fairly predictable, or
at least quantifiable, patterns. These patterns, generated by price movement, are
called signals. The goal in technical analysis is to uncover the signals exhibited in
a current market by examining past market signals.
Prices move in trends. Technicians typically do not believe that price fluctuations
are random and unpredictable. Prices can move in one of three directions:
up, down, or sideways. Once a trend in any of these directions is established, it
usually will continue for some period. Trends occur at all price levels: tick, 5-
minute, 1-hour, 1-day, weekly. What is a trend at the 1-minute level is obviously
just a small blip on the radar on a weekly chart. Curiously, the various prices levels
are interconnected.
Never make a trading decision based solely on a single indicator. The
eclectic approach of comparing several indicators and charts at the same time is
the best strategy.
As in all other aspects of trading, be very disciplined when using technical
analysis. Too often, a trader fails to sell or buy into a market even after it has
reached a price that his technical studies have identified as an entry or exit
point. This is money management and psychology, not technical analysis, and
both are very important!
Do you understand the differences between fundamental analysis and
technical analysis?
The basic types of technical analysis tools are charts, moving averages,
oscillators, and momentum analysis. In Chapter 12: Trading Tactics we will put
forth a suggested program for developing your own technical analysis arsenal.
Your analysis of the markets is only one of three components to successful trading—
money management and psychology are the others.
109

4
The Business
of Trading
Part

11
Money Management
and Psychology
Chapter
The Trading Triangle
There are three components to a trading program: trading method, money
management, and psychology or attitude. The vast majority of traders spend
almost all of their efforts on a trading method. Yet most successful traders will
tell you of the three, the trading method is the least important.
You do well by allocating significant thought and effort to the other two
components. How much you weigh them determines your trading triangle. See
Figure 11.1.
113
Trading
Method
Money
Management Psychology
FIGURE 11.1 The trading triangle.
114 THE BUSINESS OF TRADING
Money Management Factors
Money management is obviously about how you manage the money you trade;
it includes both your trading capital and how you determine your exit from a
trade, as in taking profits or setting stop-losses.
Most trading methods determine when you enter a trade, but not when
you exit. If your trading method does automatically determine such factors, be
careful the rules are not too restrictive. Most traders prefer something of a separate
ad hoc method of determining trade exits.
Allocating your capital is a function of how large a percentage of trades
you expect to be winners versus losers and the ratio between amount won and
amount lost. The higher your percentage of winners and the greater the ratio
between winners and losers, the less winning trades you need to make.
Be realistic. Do not expect to hit 80 percent winning trades with a 10:1
ratio between gains and losses. Position traders are happy to hit 30 percent of
their trades, but expect a ratio of perhaps 5:1 on wins/losses. By contrast, guerilla
scalpers figure a 1:1 ratio between winning dollars and losing dollars, so they
need perhaps 60 percent winners to stay in the game. Consider your trading
method and what type of trader you are, then construct trading triangles for 25
percent, 50 percent, and 100 percent annual returns.
Risk/Reward Ratio
One of the most crucial aspects of trading any security is the trader’s propensity
toward the ever-present risk factor. The risk/reward ratio is a nebulous, frequently
underestimated component of trading that makes the trade possible.
Without risk, there would be no profit or loss, just transaction costs.
Paradoxically, in the risk/reward ratio, the reward part is traditionally
listed first. So a 4:1 ratio indicates that the reward is 4 times greater than the
risk. Attempting to quantify the risk/reward ratio is a tricky endeavor. Let us
assume that the trader has decided upon a 3:1 ratio and wants to initiate a long
(buy) position in the EUR/USD currency pair based upon some recently
acquired fundamental studies.
The current price is 1.2500 and the “fundamentals” indicate that there will
be an upward rally to a price of 1.2800 within the next 36 hours (no rollover
required). To “enforce” a risk/reward ratio of 3:1, our trader must set a take-profit
limit order at 1.2800 and a stop-loss limit order at 1.2400. It is assumed that the
trader has entered the market at a price of exactly 1.2500.
The math looks like this.
Take-profit spread: 1.2800 − 1.2500 = 300 pips
Stop-loss spread: 1.2500 − 1.2400 = 100 pips
Money Management and Psychology
Thus, the risk/reward ratio can be quantified as the quotient of the takeprofit
spread divided by the stop-loss spread.
Let us also assume our trader had sufficient equity in a margin account to
execute the trade with a unit size of one lot (100k of Euros). The broker offers
two percent margin trading (50:1 leverage). Each pip in a lot of the EUR/USD
pair is worth USD 10.00. Thus, if the targeted price of 1.2800 is triggered first,
the trader makes a profit of:
USD 10.00 × 50:1 leverage × 300 pips = USD 60,000
However, if the stop-loss limit is triggered first, the trader will lose:
USD 10.00 × 50:1 leverage × 100 pips = USD 20,000
The selection of a risk/reward ratio is highly subjective and is something
that the trader must decide carefully after considering many factors including
his or her trading style and trading methodology.
Ad Hoc Adjustment of Limit Orders
The notion of losing 20,000 dollars on one trade (as in the previous example)
should make all traders cringe. However, the trader can limit his or her potential
losses by “tightening the reins” of the trade, that is, moving both the take-profit
and the stop-loss limit orders closer to the market entry price.
The trader can cut the loss potential to one-fourth the loss potential in the
example by raising the stop-loss to 1.2475 and lowering the take-profit to 1.2600.
If the price direction begins to react adversely, the trader may even elect to exit
early by manually liquidating the trade.
However, if the price direction moves favorably, then the trader should
raise both limit orders accordingly. At some point, he or she may even move the
stop-loss limit order above the market entry price, thus “locking in” guaranteed
profits. At the time, the trader still has the potential to hit the originally targeted
price of 1.2800.
Early Liquidation
When dealing with long (buy) positions, the trader should hesitate lowering a
stop-loss limit order. Accept the small loss and examine a different currency pair
for market entry possibilities. A take-profit limit in a long position should
only be lowered if the trader is fairly certain a period of lateral congestion or a
115
116 THE BUSINESS OF TRADING
reversal is about to occur. It may even be better to simply liquidate. The converse
is true for short (sell) positions. But the road to large losses usually starts
with moving or removing a stop-loss order!
If at any point the trader becomes overrun with uncertainty (a polite word
for fear), doubt, and confusion, it is better to manually liquidate the trade with
a small profit or loss than to hang on dismally waiting for a large loss.
More Ideas on Setting Stops
Don’t put stops where everyone else does!
Stop-losses are typically placed below or above a previous low or high. We prefer
to set stops as a function of market volatility. Look at some recent charts for the
pairs you trade and the data and time frame you will use to actually execute a
trade. Average the subtrends in the major trend direction and average the subtrends
in the minor trend direction. Redo these averages occasionally to also get
an idea of how volatility is shifting. Use the information to set price objectives
and also stops. The technique may also be utilized for entry point purposes.
Trade Capital Allocation
Never allocate more than 10 percent of your trading capital to a single trade,
either as margin or risk. Never start trading until you have funds for at least 30,
and preferably 50 or more, trades.
Suppose your starting capital or grubstake is $3,000.00. Break it into three
portions of $1,000.00 each. Then, break each of those down into 10 trades of
$100 each. If you lose the first $1,000.00, take a deep breath and maybe a few
days off. If you lose the second $1,000.00, spend some time analyzing your
approach to the markets and making minor adjustments—resist the temptation
to completely retool every time you have a bad trade or a losing streak.
Obviously you must consider your trading method and your trading type.
You can be a scalper on small lots risking $50 a trade, but you cannot be a position
trader on large lots with the same risk. Consider all factors in proportion.
Trade logical transaction sizes. Margin trading allows the FOREX trader a
very large amount of leverage; trading at full margin capacity can make for some
very large profits or losses on an account. Scaling your trades so that you may
reenter the market or make transactions on other currencies is generally wiser.
In short, do not trade amounts that can potentially wipe you out and do not put
all your eggs in one basket. See Figure 11.2.
Money Management and Psychology 117
Stick with your trading method long enough to give it a chance to work.
Don’t even make your first trade until you have studied it under different market
environments. This applies to your money management plan too: Give it an
opportunity to work.
Trading Psychology
Trading psychology is what separates the men from the boys, the women from
the girls. You might have made a small mint through paper-trading, but when
real money is on the line “things” happen. Know thyself !
Fear and Greed, Greed and Fear!
By nature all people are emotionally attached to their money. Since the you will be
trading with funds that you have already defined as nonessential to your well
being, you must cultivate an attitude of emotional detachment from your
FOREX trading account. This is emotional detachment—not indifference or
nonchalance. Otherwise, each sour trade will infest you with stress, worry, and
fear. Currency trading is not worth an ulcer.
On the other side of the coin is overconfidence. One very profitable trade
can induce the novice trader to go “gung-ho” and trade more currency pairs than
he or she can track efficiently in one trading session. Overconfidence tends
to breed avarice and avarice can lead to financial shakiness. Moderation, levelheadedness,
experience, and intuition all play key roles in the formula to successful
currency trading. Knowing when to take a calculated risk definitely helps, too.
1 × $3,000 3 × $1,000 3 × 10 × $100
FIGURE 11.2 Sample allocation program.
118 THE BUSINESS OF TRADING
To paraphrase pioneer technical analyst J. Welles Wilder in his book The
Adam Theory of Markets: The first idea is one of emotion and attitude, namely
that in order to be successful one must “surrender” to the market. If one ceases to
worry about what might happen or what should happen, then one is free to concentrate
on what the market is doing, which is where the profit will be made.
Characteristics of Successful Traders
There are some very basic characteristics attributed to most successful traders
whether they are in stocks, bonds, futures, or currencies:
• Successful traders tend to have absolute control over their emotions—
they never get too elated over a win or too depressed over a loss.
• Successful traders seldom think of prices as “too high” or “too low.”
• Successful traders do not panic—they make evolutionary adjustments
rather than revolutionary changes to their trading style.
• Successful traders do not flinch at making the decision to take a loss,
never let losses ride, and never add to losing trades.
One old trader told me he thought of his positions as stock in a retail
store. If something sells and is making you money, you add to that line.
If something is not selling and costing you money, you discount it and
unload it as quickly as possible.
• Successful traders treat trading as business and not a hobby.
• Successful traders stay physically fit.
• Successful traders are prepared for all eventualities on any given trading
day. They come to work with a plan that includes many contingencies
and not just what they hope will happen.
In your own trading program you should have predetermined
answers to the following questions: What happens if . . .
• prices open sharply higher or lower?
• the market is very quiet?
• the market is very volatile?
• the market makes new highs?
• the market makes new lows?
• the market goes up early and reverses later?
• the market goes down early and reverses later?
Money Management and Psychology
• The successful trader trades only with money he or she can afford
to lose.
Trading FOREX is speculative and can result in substantial losses. It
is also exciting, exhilarating, and can be addictive. The more you are
emotionally involved with your money, the harder it is to make objective,
clear-headed decisions about market entry and exit.
• Successful traders spend at least as much time focusing on money management
as they do on a trading method.
You don’t have the profile of a successful trader if at least some of the
above traits don’t sound like you. We will offer a few additional money
management and psychology guidelines in later chapters.
• Successful traders keep a low profile.
• Successful traders “listen” to the markets. Unsuccessful traders attempt
to impose their will on the market.
119

12
Trading Tactics
Chapter
This chapter is a potpourri of topics that collectively will determine your
trading style. Style is what criteria you use to make selections in various
areas of trading. A trading style does not develop out of the blue but will
emerge as you make your first trades. But now is a good time to begin thinking
about these intangibles. Once you start trading, continue to think about your
trading style from time to time. Giving yourself feedback on an ongoing basis is
the best way to stay fresh and avoid getting in a rut or just plain going nuts from
watching the markets.
Trading Strategy
Trading successfully is by no means a simple matter. It requires time, market
knowledge, market understanding, and a large amount of self-restraint. Anyone
who says you can consistently make money in foreign exchange markets is being
untruthful. Foreign exchange is by nature a volatile market. The practice of
trading it by way of margin increases that volatility geometrically.
We are therefore talking about a very fast market that is naturally inconsistent.
Following that precept, it is logical to say that in order to make a successful
trade, a trader has to take into account technical and fundamental data
and make an informed decision based on his or her perception of market sentiment
and market expectation. Timing a trade correctly is probably the most
121
122 THE BUSINESS OF TRADING
important aspect of trading successfully, but invariably there will be cases where
a trader’s timing is off. A successful trader does not expect to generate returns on
every trade.
Let’s examine what a trader needs to do in order to increase his or her
chances for profitable trades.
Trade with Money You Can Afford to Lose
Trading FOREX markets is speculative and can result in losses. It is also exciting,
exhilarating, and can be addictive. The more you are involved with your
money, the harder it is to make a clear-headed decision. Money you have earned
is precious, but money you need for survival should never be traded.
Identify the State of the Market
What is the market doing? Is it trending upwards or downwards? Is it in a trading
range? Is the trend strong or weak? Did it begin long ago or does it look like
a new trend is forming? Getting a clear picture of the market situation is laying
the groundwork for a successful trade. No matter how complex and leadingedge
your trading system might be, it never hurts to sit back and eyeball the
charts. Markets often have a remarkable rhythm. Look for the following:
• The length of the primary trend versus the secondary trend.
• The average time between tops and bottoms.
• The average range of a bar, whether you are watching 1-minute,
5-minute, hourly, or daily data.
You will see different rhythms for the same market when viewing charts at
different scales—for example, 1-minute, 1-hour, and daily. Put these rhythms
together for a true perspective on things.
Identify the Market Environment
Every market may be defined on a continuum of price movement, or trend
slope, and volatility. Volatility measures how much prices move in the aggregate
over some fixed period of time. Figure 12.1 indicates an arbitrary scale of
1 to 8 for purposes of example only. This can also be studied on different
chart-time matrices.
All markets may be measured as an index of where they reside on both
these lines. For example, a market with a very high trend slope and low volatility
could be represented as a “7-2” market.
Trading Tactics 123
Price movement is the defined slope of a trend from beginning to end
point. See Figure 12.2.
Volatility is the total amount of price movement over a specified time. See
Figure 12.3.
In technical analysis we discussed the concept of trading environment—
that all market activity can be defined by where it sits on two scales of volatility
and price movement. Keep the market environment in mind and watch for
both evolutionary and revolutionary shifts. The elements of the trading environment
are the time frame and the three-chart system.
Time Frame Many traders get in the market without thinking when they
would like to get out—after all, the goal is to make money. When trading, the
trader must extrapolate the movement that he or she expects to happen. Within
this extrapolation resides a price evolution during a certain period of time.
1 2 3 4 5 6 7 8
1 2 3 4 5 6 7 8
Price Movement
Volatility
FIGURE 12.1 Price movement and volatility.
FIGURE 12.2 Price movement.
124 THE BUSINESS OF TRADING
Attached to this is the idea of exit price. The importance of this is to mentally
put your trade in perspective. Although it is clearly impossible to know
exactly when you will exit the market, it is important to define from the outset
if you will be “scalping” (trying to get a few points off the market), trading intraday,
or trading over a longer term.
This will also determine what chart period you are examining. If you trade
many times a day, there is no point basing your technical analysis on a daily
graph: You will instead want to analyze 30-minute or hourly graphs. It is also
important to know the different time periods when various financial centers
enter and exit the market, as this creates more or less volatility and liquidity and
can influence market movements.
The Three-Chart System Determine your desired trading time frame. If, for
example, you use hourly charts to determine entry and exit, then use 5-minute
charts for detail and daily charts for a long view of things. If you use
5-minute charts to trade, use 1-minute charts for detail and hourly ones for
the long view. See also Table 12.1 for more on timing matrices.
TABLE 12.1 Timing Matrices for Different Traders
Trader Timing Home Trend
Scalper Tick 1 to 5 Minutes 1 Hour
Day Trader 1 Minute 5 to 10 Minutes 1 Day
Position Trader 10 Minutes 1 to 24 Hours 2 Days
FIGURE 12.3 Volatility.
Trading Tactics 125
Time Your Trade
You can be right about a potential market movement but be too early or too late
when you enter the trade. Timing considerations are twofold: An expected market
figure like the consumer price index, retail sales, or a federal reserve decision
can consolidate a movement that is already underway. Timing your move means
knowing what is expected and taking into account all considerations before
trading. Technical analysis can help you identify when and at what price a move
may occur. We will look at technical analysis in more detail later.
If In Doubt, Stay Out
The conservative Belgian dentist strategy is “Sit on your hands, sit on your
hands.” The bulls make money, the bears make money, but the pigs just get
slaughtered! (The bulls prefer advancing markets, the bears trade in declining
markets, while the pigs expect quick killings in any market.)
Trade Logical Transaction Sizes
Margin trading allows the FOREX trader a very large amount of leverage, but
trading at full margin capacity can make for some very large profits or losses
on an account. Scaling your trades so that you may reenter the market or make
transactions on other currencies is generally wiser. In short, do not trade
amounts that can potentially wipe you out and do not put all your eggs in
one basket.
Gauge Market Sentiment
Market sentiment is what most of the market is perceived to be feeling about the
market and therefore what it is doing or will do. This is essentially about trend.
You may have heard the phrase “the trend is your friend,” which means that if
you are in the right direction with a strong trend you will make successful
trades. This of course is very simplistic; a trend is capable of reversal at any time.
Technical and fundamental data can indicate, however, if the trend began long
ago and if it is strong or weak.
Exercise Contrary Opinion
Never be afraid to go against the crowd—the crowd is almost always wrong.
Follow the old Wall Street adage “Buy the rumor, sell the news.”
126 THE BUSINESS OF TRADING
Know the Market Expectation
Market expectation relates to what most people are expecting as far as upcoming
news is concerned. If people are expecting an interest rate to rise and it does,
then there usually will not be much of a movement because the information will
already have been “discounted” by the market; alternatively, if the adverse happens,
markets will usually react violently.
Watch what other traders are doing but don’t follow them!
In a perfect world, every trader would be looking at a 14-day RSI (Relative
Strength Indicator) and making trading decisions based on that. If that were the
case, when RSI would go under the 30 percent level, everyone would buy and
by consequence the price would rise. Needless to say, the world is not perfect
and not all market participants follow the same technical indicators, draw the
same trend lines, or identify the same support and resistance levels.
The great diversity of opinions and techniques used translates directly into
price diversity. Traders, however, have a tendency to use a limited variety of
technical tools. The most common are 9- and 14-day RSI, obvious trend lines
and support levels, Fibonacci retracement, MACD, and 9-, 20- and 40-day
exponential moving averages. The closer you get to what most traders are looking
at, the more precise your estimations will be. The reason for this is simple
arithmetic: Larger numbers of buyers than sellers at a certain price will move the
market up from that price and vice versa.
Check the various FOREX discussion groups once a week to see how the
majority of traders perceive the market. Just don’t be a slave to the news.
Trading Tactics
This section concerns the actual details on trade execution, tracking, and exiting.
It also assumes that every trading session is attended (that is, that the trader
is monitoring the price action while in motion and does not walk away from his
or her trading platform).
Once the trader has selected the currency pair, the position to take (buy or
sell), and the number of units to trade, he or she will initiate the trade.
The trader has two options for entering into a new trade. The simplest is
either a market order in which the trade is executed at the current market price
or a limit order in which the order is delayed until the market price hits the limit
order price that the trader specified.
At the same time that the trader enters the market, he or she must also set
both of the stop-loss and take-profit limit moves. As mentioned earlier, by tradTrading
Tactics
ing without a stop-loss safeguard, you are unnecessarily exposing yourself to
tremendous risk that can clear out part or all of your margin.
Setting a reasonable take-profit limit is also important in the event there
is a power glitch or some other disrupting anomaly. Modern computers are taking
longer to reboot, after which you must log into your broker’s trading platform.
In the four to eight minutes that the restarting process requires, an open
trade may have hit a respectable level of profit return, but the realization did not
occur because you did not place a take-profit limit order or you set it too far
from the entry price.
The placement of the stop-loss and take-profit limits is highly subjective
and is based on the trader’s sensitivity to risk. Several trading platforms automatically
calculate these values (stop-loss and take-profit) when you click on a
check box. Their calculation algorithm may be a simple linear distance from the
entry price (say, 15, 20, or 25 pips in both directions) or it may involve some
percentage of the current range of trading. Either way, you are at liberty to
adjust the stop-loss and take-profit limit orders in an open position.
In a position that moves against you, it is recommended that the trader let
the price action trigger the liquidation of the order and simply absorb the loss.
Or, if you believe that the price direction will not reverse itself in your favor, you
may liquidate the position manually before the stop-loss is triggered. It is not
recommended that you lower the stop-loss in a long position with the hopes
that the price will reverse shortly and move in the opposite direction. The odds
are against it. Take the loss, stand up, walk around, clear your head, and start
over, preferably by examining a different currency pair.
This is the disappointing part to trading. However, when prices move in
your favor, you have more options based on price volatility. If the price moves
significantly in your favor (say, 15 to 20 pips in a buy position), then move the
stop-loss above the entry price (say, three to five pips) and raise the take-profit
limit order by 20 pips or so. As the trade continues to advance favorably, continue
raising both the stop-loss and the take-profit orders.
In this manner, you can successfully “lock in” guaranteed profits while letting
the market run its course. Large profits can be realized using this mechanism.
The exit mechanism should not be triggered by hitting the take-profit
limit but by a reversal, triggering the favorably adjusted stop-loss limit order.
The exception is when you “feel” it is time and exit manually.
However, the subjective part is how closely the two limit orders should be
set in relation to the current price. When setting the initial values for both the
stop-loss and take-profit orders, look for support and resistance lines in the prices
immediately preceding the current price. This will give you some idea of the
range of trading in the immediate past.
Lastly, we should discuss pyramiding. This trading tactic involves adding
to a favorable open position. This is done very simply by initiating new orders in
127
128 THE BUSINESS OF TRADING
the same currency pair and in the same position (buy or sell). This tactic may be
handled profitably by veteran traders but is not recommended for the novice
trader. The trader must be ever-conscious of margin requirements and the amount
remaining in his or her account. Using unrealized profits as the margin for new
trades has landed many a trader in deep trouble. Sharp market reversals in pyramid
trading have a devastating effect on the trader’s margin account. Be forewarned!
Eclectic Approach
Should you use fundamental analysis or technical analysis to determine the
details of my trades? The veteran technician will adamantly respond “technical
analysis” while the fundamentalist will confidently reply “fundamental analysis.”
The correct answer is both. Any current market data deemed valid,
whether fundamental or technical, should never be ignored. It is, however, a
very subjective decision on the part of the trader; how much “weight” to put on
either discipline is learned from experience. Do not be afraid to change your
trading methodology from time to time. But keep changes evolutionary, not
revolutionary. Do not make changes just because a single trade went sour.
Selecting Markets to Trade
We recommend that the novice trader begin by trading the major USD currency
pairs only. These pairs usually require a lower bid/ask pip spread, which
increases your profit potential while reducing your transaction costs.
In addition to the transaction costs, you must also examine the current
volatility of each candidate currency pair. Statistically, volatility is usually defined
as the standard deviation of a data sample. However, this is a somewhat
laborious process since it entails summing all the elements in the data sample. In
Table 12.2 we use the lazy man’s method for calculating two relatives of volatility,
called the absolute range and the relative range of the data sample.
Absolute range is converted from a decimal value to number of pips by
multiplying by 1,000 (or 10 in some cases) and expressed as pips in the quote
(second) currency.
TABLE 12.2 Calculating Absolute and Relative Range
midrange = (high + low) /2
absolute range = high − low
relative range = 100 × range / midrange
Trading Tactics
The time period used in Table 12.3 is July 1, 2003, through December 31,
2003. The table is divided into three groups: USD major currency pairs, USD
minors, and non-USD cross pairs.
Currency pairs with a relative range value less than 1.50 should probably
be avoided due to lack of volatility, unless the trader knows how to profit from
horizontal markets (this involves scalping small profits from numerous trades
and accrues a very large transaction cost in the account summary). Even though
Table 12.3 required several thousand ticks to compile, it is in no way conclusive.
Absolute range is a statistic that characterizes an important property of a
single currency pair. Relative range is used to compare multiple currency pairs
with each other.
129
TABLE 12.3 Selecting Currency Pair Criteria
Currency 6-Month 6-Month Adjusted Relative Bid/Ask
Pair High Low Range Range Spread
EUR/USD 1.2542 1.0796 1746 3.74 3
USD/JPY 120.36 106.92 1344 3.05 3
GBP/USD 1.8106 1.5663 2443 3.62 3
USD/CHF 1.4217 1.2434 1783 3.35 3
USD/CAD 1.4079 1.2834 1245 2.31 4
AUD/USD 0.7662 0.6355 1307 4.66 4
NZD/USD 0.6839 0.5643 1196 4.79 5
USD/SGD 1.7645 1.7008 637 0.92 8
USD/HKD 7.8104 7.7089 1015 0.33 10
USD/DKK 6.8898 5.9401 9497 3.70 35
USD/MXN 11.4319 10.7456 6863 1.55 50
USD/ZAR 3.7942 3.7513 429 0.28 90
EUR/JPY 137.31 124.84 1247 2.38 3
EUR/GBP 0.7113 0.6812 301 1.08 3
EUR/CHF 1.5749 1.5322 427 0.69 3
CHF/JPY 89.24 79.29 995 2.95 6
GBP/JPY 194.76 180.15 1461 1.95 9
EUR/AUD 1.7567 1.6048 1519 2.26 12
EUR/CZK 32.9606 31.4485 15121 1.17 60
130 THE BUSINESS OF TRADING
Selecting Trading Parameters
Once you have selected the trading currency pair and determined a market entry
price, you must decide the remaining parameters:
Trade Unit Size
This only applies if the broker allows the trader to deal in odd-lot sizes. One recommendation
for small-capital traders is that no single trade should ever exceed
10 percent of the trader’s margin account.
Stop-Loss Order Differential
This differential defines the number of pips below the entry price that the stoploss
limit order is placed in a buy (long) trade and vice versa in a sell (short) trade.
Take-Profit Order Differential
This differential defines the number of pips above the entry price that the
take-profit limit order is placed in a buy (long) trade and vice versa in a sell
(short) trade.
You need to be realistic about these numbers and willing to make adjustments
along the way. It is not reasonable to have a 10-pip stop-loss order and a
500-pip take-profit order. Scale your differentials to the type of trading you are
doing and the ratio you reasonably expect between winning trades and losing
trades. For example, when trading the EUR/USD pair, you might initialize the
market entry trade with a 15-pip stop-loss and a 30-pip take-profit order.
Duration
Duration, or expiry, is used on limit orders only and denotes the length of time
that you want the broker to keep an untriggered limit order active. We recommend
keeping all limit orders to less than a day (or even a few hours). The logic
here is that while trading in a different currency pair, the limit order on the first
currency pair may trigger, thereby reducing the amount of available margin.
Trading Matrices
Market action is constantly occurring at different levels, or price matrices, concurrently.
A price matrix consists of three consecutive “legs” in a price action: an
initial trend either up or down, a retracement movement in the opposite direction,
and a final leg in the same direction as the first leg (see Figure 12.4).
Trading Tactics
We typically measure these based on the time interval involved: streaming
tick data, 1-minute data, 5-minute data, hourly data, daily data, and weekly
data. Specifically, parameters must be set to determine when to draw the retracement
leg. Typically, either a minimum percentage of the preceding leg must
occur or a minimum number of pips in the opposite direction will “trigger” a
new leg as shown in Figure 12.5.
An important decision to make early on is: At what level am I trading,
primarily? Types of traders are related to the matrix level they call “home.”
Scalpers are most associated with tick data, day traders with 1-minute and 5-
minute data, and position traders with hourly data. Because of the volatility and
leverage in the FOREX markets, few traders call daily data home.
While you want to call one or two neighboring levels home, it is a mistake
to avoid giving attention to the levels below and above your home. Typically you
131
Primary
Impulse
Wave
Continuation
Wave
50% Retracement
Wave
FIGURE 12.4 Basic upward price matrix.
FIGURE 12.5 Trading matrices with different minimum triggering
mechanisms.
132 THE BUSINESS OF TRADING
want to follow the market with your home levels; get ideas about the overall
trend from the matrix just above, and use the matrix below for timing your
entry, exit, and stop-loss orders.
Dagger Entry Rule
The Dagger Entry Rule was first published by Mike Archer in Denver Magazine
in June 1978. It is used to determine the price level for an efficient market entry
point and consists of three steps:
Step 1: We wait for a major trend to form. Call it (A). Step 2: We
watch for a price correction in the opposite direction; call it (B). The
third step is to complete the dagger: Wait for a sign of an end to
the down trend (B) and buy as soon as prices start up again. The
dagger, of which I have given only the basics, guarantees that you
buy at bargain levels and also that you do not attempt to pick the
bottom of the market.
See Figure 12.6.
Market Timing
Here are some tips for getting the most of market timing. When developing
your own personalized FOREX trading strategy, there are many factors you can
Entry Point
(A)
(B)
(C)
FIGURE 12.6 The dagger entry rule.
Trading Tactics
research that can turn to your advantage. Four of these involve timing: market
opening, market closing, time of day, and day of week.
Market Opening
Officially the FOREX market opens at 5:30 PM ET, though different brokers
react differently in different time zones. Keep in mind that over the weekend
all currency pairs carry an extra premium in transaction costs. A normal 3-pip
bid/ask spread during normal trading hours may increase to a 10-pip spread on
weekends.
Once the weekend transaction costs return to normal, many pairs exhibit
high volatility due to economic influences that occurred over the weekend.
Analyzing a set number of currency pairs enhances your profit opportunities.
Frequently a trend emerges in one direction or the other and continues until the
weekend influences have been satisfied. This may entail tracking several pairs
until the early hours of Monday morning. When opportunity knocks . . .
Market Closing
Many corporations like to clear out last-minute orders Friday afternoon to avoid
possible rollover charges and to reduce the risk of any adverse anomalies that
may occur over the weekend. This equates to increased volatility right before the
market closes at 4:30 PM Friday afternoon.
If you trade during this peak period of volatility, always be certain to
liquidate your trades before the bid/ask spread jumps to its increased weekend
range.
Time of Day
For the most past, the highest volatility periods revolve around banking hours in
New York City. This overlaps only slightly with banking hours in London and
Frankfurt. Another factor is the time zone in which your broker is located.
Taking these three factors into consideration plus your own time zone, you
should be able to determine periods of high volatility that increase profit potential.
See Appendix C for details on time zones and world banking hours.
Day of Week
The days on which the market opens and closes have already been discussed.
Other days of the week may also have special significance. For instance, new
interest rates are normally published on Thursdays, which causes immediate
changes in USD currency pairs.
133
134 THE BUSINESS OF TRADING
Summary
• The decisions you make about specific trading options—both strategy
and tactics—determine your trading style. Be aware of your style,
monitor it, and make changes wisely.
• Stop-loss and take-profit levels should be realistic and complementary
to the type of trading you do.
• The market operates at many different levels or matrices concurrently.
Identify your home levels early on in your career.
• Use matrices above and below your home for clues to the long-term
trend and entry/exit points.
• When in doubt, stay out!
• The markets will always be around. Missing a potential opportunity is
infinitely better than taking an actual loss.
13
What to Do
If Things Go Wrong
Chapter
Evaluating Your Performance
We recommend that the novice trader start the trading experience with a simple
handwritten log of his or her trades. This does not mean logging every single
trade, which would be too cumbersome. Instead, record a simple synopsis of
each day’s performance similar to the format shown in Figure 13.1.
135
Trading Beginning No. of Pairs Strategies Ending
Date Balance Trades Traded Used Balance Comment
7/1/2004
7/2/2004
7/3/2004
7/4/2004
7/5/2004
FIGURE 13.1 Daily performance log.
136 THE BUSINESS OF TRADING
Common Trading Mistakes
Throughout this book, we have mentioned several trading caveats and wish to
resummarize them here (with others):
• Trading without a stop-loss limit order. Neglecting to set a stop loss
is asking for financial disaster. In the event of a power outage, you may
receive a margin call in the time it takes to reboot your computer.
• Trading without a take-profit limit order. Always set a reasonable
take-profit limit order. Again, in the event of a power outage, the market
may hit your expectations and reverse to the market entry price (or further)
in the time it takes to reboot the computer. Always remember:
When a trade is beginning to move favorably, you can adjust your takeprofit
farther from the market entry price.
• Using too much of your margin. Your margin requirement is recalculated
with each price change. This is especially noticeable when you
have sold a position and the price is advancing. For small-capital
traders, we recommend never using more than one-third of the total
account balance on any single trade.
• Trading too many pairs at one time. First, this could cause a margin
call. Many dealers will liquidate all open trades if any single trade generates
a margin call, which could potentially eradicate any profit.
Second, it clutters up the screen (and the trader’s attention) when five
or more bar charts are displayed simultaneously on the screen.
• Trading at the broker’s closing time. At closing time, most dealers
increase the bid/ask spread to cover low volatility and liquidity. A 3-pip
spread may jump to a 10-pip spread instantly, wiping out seven pips of
hard-earned profit. Always check the broker’s hours of operation and at
what time the increased spread goes into effect.
• Trading very obscure cross rates. Trading non-USD cross currency
pairs like HUF (the Hungarian forint) or SAR (the Saudi riyal) is not
advisable. The bid/ask spread is abnormally high and volatility may be
unusually low. Without volatility, your open trade could lapse into a
rollover position (usually two days). This is best left to the professionals
who may be using an obscure cross rate as a leg in triangular
arbitrage trade.
• Overconfidence. “Pride goeth before destruction, and a haughty spirit
before a fall.” Try to keep everything in the proper perspective.
• False expectations. Currency trading offers no guarantees. Do not
become discouraged over losses. After all, you are not risking monies
earmarked as your survival fund.
What to Do If Things Go Wrong
• Trading without a plan. Never enter a trade without first examining
the big picture. Most trading platforms allow the trader to view multiple
time intervals of the same currency pair. Scrutinizing the 5-second
chart alone is usually not sufficient. Also check the 1-minute chart, the
1-hour chart, and the 1-day chart, or whatever multiples the platform
provides. A long-term trend may be in motion, which is not clearly visible
in a short time interval chart. Also, any available technical and/or
fundamental analysis on the targeted currency pair is also beneficial.
• Never add to a losing position. Exit the losing position, take a break,
and start over. Compounding your loss will not force a price reversal.
• Don’t exit because of whipsawing. When a market begins whipsawing
near your market entry price, there is no urgency to liquidate the
position. A fellow trader once commented, “Monitoring extended periods
of whipsawing is like watching paint dry.” We explained that the
market is simply building up energy to make a significant breakout. In
fact, most technicians feel that whatever price direction was in motion
prior to whipsawing will resume in that same direction after the whipsawing
period. Patience is a trading quality that must be learned.
• Lack of focus. Pay very close attention when initiating a new order.
The two most common mistakes are entering the wrong action (buy or
sell) and mistyping the number of units to trade. Neither can be corrected
once the entry order is executed except by liquidation.
• Clouded judgment. Never let the results of a sour trade affect your
judgment criteria for the subsequent trade. Each trade is a separate
entity. Simply reversing the market action (buy to sell or sell to buy)
after a loss does not guarantee that the current trend will continue.
• If in doubt, don’t trade. This speaks for itself. It is always better to
make no trades than a series of costly trades. Take the day off or at least
wait an hour or two.
Correcting Errors
The following guidelines should be reviewed even when things are moving
smoothly:
• First, take a break. The markets will be there an hour from now.
• Review your performance log in detail. Pinpoint your strengths and
your weaknesses.
• Reread Chapter 12, “Trading Tactics.” It may be time to adjust your
approach to the market.
137
138 THE BUSINESS OF TRADING
• You may need to increase or decrease the number of pips that you are
using to set the stop-loss and take-profit limit orders.
• Determine if you are entering the market too early or too late. Proper
market timing is the key to profitable trading.
• You may want to lower the number of units traded (temporarily) simply
to rebolster trading confidence.
• Try trading at different times in the day even if it means getting up
early. Also, there is no reason that you cannot trade any of the seven
major USD currencies pairs or even the cross rates with the EUR, JPY,
and GBP currencies once you gain some trading experience.
• Nearly all FOREX trading platforms will provide an Activity Log that
itemizes the details of each trade. Display the log on the screen (or even
print a hard copy) to scrutinize any shortcomings on your part.
When to Say “Uncle”
It may be wise to set a threshold percentage of the original equity that you
deposited with your broker. If your current balance drops below this threshold
level, you may need to reevaluate your priorities. A change in attitude or greater
flexibility may be indicated. As we mentioned earlier, currency trading may not
suit everyone’s disposition.
14
Record Keeping
Chapter
We find it useful to keep daily and weekly records of our trading plans,
thoughts, and activities. It’s important to come to the markets well
prepared for many contingencies. The records will also help you diagnose
problems and find solutions.
Daily Trade Plan and Evaluation
In the previous chapter, we recommended that novice traders maintain a simple
handwritten daily performance sheet and an account balance sheet. By scrutinizing
this data at the end of the trading session, traders will be able to identify
their strengths and weaknesses and develop a “feel” for market characteristics for
different currency pairs, trading times, and chart patterns.
Weekly Trade Plan and Evaluation
Here is a suggested weekly trade plan and evaluation:
• Plans should include decision contingencies for various market actions
for that trading session; this is very similar to football coaches’ “scripting”
the first few plays of a game.
139
140 THE BUSINESS OF TRADING
• Evaluations should include what went right and what went wrong, as
well as a brief text summary of the session.
You may add more to your daily and weekly summaries based on your specific
trading program.
Novice traders may review their daily performance and account balance
sheets collectively to ascertain any weaknesses in the trading system. Scanning
the daily sheets for wins and losses helps put the entire endeavor in proper perspective.
Adding comments and ideas to the weekly plan provides insight when
reviewed later and assists traders in recognizing the direction of their market
acumen and development.
The Tax Man
Regrettably, profits and losses from FOREX trades in the United States are subject
to short-term (one year or less) capital gains tax as dictated by the Internal
Revenue Service. The governments of other civilized countries will also be
happy to share in any good fortune that might come your way in the markets.
The basic U.S. reporting instrument is Form 1040 Schedule D, though
supplementary forms may also be required. Forms and instructions can be
downloaded in portable document format (PDF) at http://www.irs.gov/pub/.
Consult your accountant for full details on taxes and the expensing of
write-offs that you might be able to take for your trading activities.
5
Advanced Topics
Part

15
Advanced Topics
Chapter
This chapter is optional for the novice trader though investors with some
trading experience will find it informative.
Rollovers
A rollover is the process whereby the settlement of an open trade is rolled forward
to another value date. The cost of this process is based on the interest rate
differential of the two currencies.
In the spot FOREX market, trades must be settled within two business
days. For example, if a trader sells a certain number of currency units on
Wednesday, he or she must deliver an equivalent number of units on Friday. Yet
currency trading systems may allow for a rollover, with which open positions
can be swapped forward to the next settlement date (giving an extension of two
additional business day). The interest rate for such a swap is predetermined,
and, in fact, these swaps are actually financial instruments that can also be
traded on the currency market.
In any spot rollover transaction the difference between the interest rates of
the base and quote currencies is reflected as an overnight loan. If the trader
holds a long position in the currency with the higher interest rate, he or she
would gain on the spot rollover. The amount of such a gain would fluctuate day
143
144 ADVANCED TOPICS
to day according to the precise interest rate differential between the base and
the quote currency. Such rollover rates are quoted in dollars and are shown
in the interest column of the FOREX trading system. Rollovers, however, will
not affect traders who never hold a position overnight, since the rollover is
exclusively a day-to-day phenomenon.
Some brokers will automatically roll over open trades while others may liquidate
orders that exceed the two-day limitation. Also, some dealers may append
a rollover charge in addition to the interest differential. Rollover credits or debits
are reflected in the unrealized profit and loss column of the open position.
If you intend to maintain open positions longer than two days, carefully
read your dealer’s policy agreement or consult their customer service department.
Also note that rollover costs may affect margin requirements.
Hedging
A hedge is a position or combination of positions in one security that reduces
the risk of your primary position in the same security.
An example of hedging in commodity futures is the Midwest farmer who
grows #1 Soft Red Wheat and intends to physically take his harvest to market for
September delivery. After tilling the soil and planting the seeds in late spring, the
farmer initiates a short (sell) commodity futures contract for September wheat at
the Chicago Board of Trade at what he feels is a fair price. If the price of wheat
declines dramatically in September, the farmer will suffer losses on his physical
delivery but will make profits on his futures contract. If the price of wheat rises
substantially in the fall, the farmer will make profits on his physical delivery but
will suffer losses on his futures contract. Thus, hedging not only reduces risk but
can also be used to lock in predetermined profits in some situations.
Normally when you have an open position to buy or sell at your FOREX
dealer and you open a new position in the opposite direction, the two positions
will close each other out. If you had a position for USD/CHF to buy, for example,
and you opened a new position USD/CHF to sell, both positions would
close, since you cannot buy and sell currencies at the same time. The feature of
hedging, however, allows you to do exactly that if your FOREX dealer offers this
trading feature.
When you open a hedge position, both positions (the original and the
newly hedged one) will remain opened. You will have two positions, going in
the opposite direction of each other in the same currency pair. This is used to
lock your current loss or win, until you have a better understanding of where
the market is moving. Theoretically, profit is to be gained by skillful timing of
the liquidation orders. If liquidated at the same time, the trader will automatiAdvanced
Topics
cally lose only the transaction cost since the gain in one trade will be canceled
exactly by the loss in the other trade.
Brokers who offer hedging do not normally require additional margin for
the second hedged position. Consult your broker for details before attempting
to apply this rather esoteric trading strategy.
Options Trading
An option is an agreement that gives the holder the option to buy or sell a specific
security at a certain price within a certain time. Two types of options exist:
call and put. A call is the right to buy while a put is the right to sell. One can
write or buy call and put options.
Options on the foreign exchange are really no different from options on
stock shares, commodity futures, or real estate. The basic premise is that the
buyer of an option has the right but not the obligation to enter into a contract
with the seller. Naturally the option owner exercises this right when it is to his or
her advantage. Currency options specify a foreign exchange contract and give
the owner the right to enter into the specified contract during a pre-agreed
period of time.
FOREX options have gained acceptance as invaluable tools in managing
foreign exchange risk. They are used extensively and make up between 5 and 10
percent of total volume of trading. Currency options bring a much wider range
of hedging alternatives to portfolio managers and corporate treasuries.
An American option may be exercised at any valid business date throughout
the life of the option, while a European option can only be exercised on the
expiration date.
An option is said to have intrinsic value when the strike price of the option
is more favorable than the current market forward rate. As a general rule, the
greater the intrinsic value of an option, the higher its premium:
• An option with some intrinsic value is described as being “in-themoney.”
• An option with no intrinsic value is said to be “out-of-the-money.”
• Where the strike price of the option is equal to the current forward rate
the option is said to be “at-the-money.”
Consult your broker for details and margin requirements. Be particularly
aware when dealing with options—it’s an area that has attracted a substantial
portion of the FOREX fraud.
145
146 ADVANCED TOPICS
Arbitrage
In general, arbitrage is the purchase or sale of any financial instrument and
simultaneous taking of an equal and opposite position in a related market, in
order to take advantage of small price differentials between markets. Essentially,
arbitrage opportunities arise when currency prices go out of sync with each
other. There are numerous forms of arbitrage involving multiple markets, future
deliveries, options, and other complex derivatives. A less sophisticated example
of a two-currency, two-location arbitrage transaction follows:
Bank ABC offers 170 Japanese yen for one U.S. dollar and Bank
XYZ offers only 150 yen for one dollar. Go to Bank ABC and purchase
170 yen. Next go to Bank XYZ and sell the yen for $1.13. In a
little more than the time it took to cross the street that separates the
two banks, you earned a 13 percent return on your original investment.
If the anomaly between the two banks’ exchange rates persists,
repeat the transactions. After exchanging currencies at both banks
six times, you will have more than doubled your investment.
Within the FOREX market, triangular arbitrage is a specific trading strategy
that involves three currencies, their correlation, and any discrepancy in their
parity rates. Thus, there are no arbitrage opportunities when dealing with just
two currencies in a single market. Their fluctuations are simply the trading
range of their exchange rate.
In the subsequent examples, we refer to the following tables of currency
pairs consisting of the five most frequently traded pairs (USD, EUR, JPY, GBP,
and CHF) with recent bid/ask rates. See Table 15.1.
We omitted the other two majors, CAD and AUD, for the sake of
simplicity and not because there is a lack of arbitrage opportunities in these
two majors.
Example 1
Two USD pairs and one cross pair (multiply) First we must identify certain
characteristics and distinguish the following categories:
• USD is the base currency (leftmost currency in the pair):
USD/CHF 1.2402/05
USD/JPY 105.61/64
• USD is the quote currency (rightmost currency in the pair):
EUR/USD 1.2638/40
GBP/USD 1.8275/78
Advanced Topics 147
• Cross rates (non-USD currency pairs):
CHF/JPY 85.14/19
EUR/CHF 1.5676/78
EUR/GBP 0.6915/17
EUR/JPY 133.51/54
GBP/CHF 2.2666/74
GBP/JPY 193.02/10
The fact that the USD is the base currency in two of the pairs (USD/CHF
and USD/JPY) and is the quote currency in two other pairs (EUR/USD and
GBP/USD) plays an important role in the arithmetic of arbitrage. We begin our
investigation with just the bid prices (see Table 15.2).
TABLE 15.1 Combinations of the Five Most
Frequently Traded Currencies
Currency Bid Ask Pip Spread
CHF/JPY 0.8514 0.8519 4
EUR/CHF 1.5676 1.5678 2
EUR/GBP 0.6915 0.6917 2
EUR/JPY 133.51 133.54 3
EUR/USD 1.2638 1.2640 2
GBP/CHF 2.2666 2.6674 8
GBP/JPY 193.02 193.10 8
GBP/USD 1.8275 1.8278 3
USD/CHF 1.2402 1.2405 3
USD/JPY 105.61 105.64 3
TABLE 15.2 Formulas for Cross Currencies
CHFJPY = USDJPY / USDCHF 85.14 = 105.61 / 1.2402 85.1556
EURCHF = EURUSD × USDCHF 1.5676 = 1.2638 × 1.2402 1.567365
EURGBP = EURUSD / GBPUSD 0.6915 = 1.2638 / 1.8275 0.691546
EURJPY = EURUSD × USDJPY 133.51 = 1.2638 × 105.61 133.4699
GBPCHF = GBPUSD × USDCHF 2.2666 = 1.8275 × 1.2402 2.266466
GBPJPY = GBPUSD × USDJPY 193.02 = 1.8275 × 105.61 193.0023
148 ADVANCED TOPICS
The criterion whether to multiply or divide the USD pairs in order to calculate
the cross rate is simple:
• If the USD is the base currency in both pairs then divide the USD pairs.
• If the USD is the quote currency in both pairs then divide the USD pairs.
• Otherwise multiply the USD pairs.
To determine the deviation from parity for each cross pair, subtract the
exchange rate from the calculated rate and convert the floating point decimals
to pip values (see Table 15.3).
From the information in Table 15.3, we can see that the EUR/JPY is out
of parity by four pips. To determine if an arbitrage opportunity is profitable, we
must first calculate the total transaction cost by adding the three bid/ask spreads
of the corresponding pairs:
EUR/USD 2
USD/JPY +3
EUR/JPY +3
8
An eight-pip transaction cost to earn a four-pip profit is counterproductive—
it amounts to a four-pip loss. If the parity deviation (the number of pips
by which the three currency pairs are out of alignment) were greater—say, 30
pips—then a definite arbitrage opportunity exists.
The trading mechanism to take advantage of this anomaly requires some
consideration. First, determine what market actions are necessary to correct this
anomaly. Assume that the EUR/JPY rate is currently trading at 133.51 and the
calculated rate using the current EUR/USD and USD/JPY pairs is 133.81 (a
30-pip deviation). Parity between the three currencies will be restored if the following
price action occurs:
TABLE 15.3 Calculations for Cross Currencies
Pair Rate Calculation Deviation Pip Values
CHFJPY 85.1556 −85.14 = +0.0156 +1.56 pips
EURCHF 1.567365 −1.5676 = −0.000235 −2.35 pips
EURGBP 0.691546 −0.6915 = +0.000046 +0.46 pips
EURJPY 133.4699 −133.51 = −0.0401 −4.01 pips
GBPCHF 2.266466 −2.2666 = +0.000134 +1.34 pips
GBPJPY 193.0023 −193.02 = −0.0177 −1.77 pips
Advanced Topics
(A) The EUR/JPY pair rises to 133.81, or
(B) The product of the EUR/USD and USD/JPY pairs drops to 133.51.
Therefore the following trades are required to “lock in” the 30-pip profit:
• Buy one lot of the EUR/JPY pair.
• Sell one lot of the EUR/USD pair.
• Sell one lot of the USD/JPY pair.
• Liquidate all three trades simultaneously when parity is reestablished.
Note: Executing only one or two “legs” of the three trades required in an
arbitrage package does not guarantee a profit and may be quite dangerous. All
three trades must be executed simultaneously before the “locked-in” profit can
be realized.
Example 2
Two USD pairs and one cross pair (divide) Example 1 used the product of
the two USD currencies to calculate the cross rate. Now let’s take an example
of the ratio of the two USD currencies. Assume the EUR/GBP cross pair is
currently trading at 0.6992 and that the ratio between the EUR/USD and
GBP/USD pairs is calculated as 0.6952, a 40-pip deviation. Parity will be restored
when the following price actions occur:
(A) The EUR/GBP pair drops to 0.6952, or
(B) The ratio of the EUR/USD and GBP/USD pairs rises to 0.6992.
In order for the second action to rise, either the EUR/USD pair must also
rise or the GBP/USD pair must decline (this differs from the previous example).
Therefore the following trades are required to realize a 40-pip profit:
• Sell one lot of the EUR/GBP pair.
• Buy one lot of the EUR/USD pair.
• Sell one lot of the GBP/USD pair.
• Liquidate all three trades the moment that parity is reestablished.
Example 3
Three non-USD cross pairs Technically the arbitrage strategy can be performed
on three non-USD currency pairs. In this example, we examine a straddle between
149
150 ADVANCED TOPICS
the three European majors (EUR, GBP, CHF) while focusing on the EUR/CHF
pair in respect to the two GBP currency pairs (GBP/CHF and EUR/GBP).
Assume the current rates of exchange are:
EUR/CHF = 1.5676/78
EUR/GBP = 0.6915/17
GBP/CHF = 2.2604/12
and their relationship is:
EUR/CHF = EUR/GBP × GBP/CHF
Thus the calculated value for the EUR/CHF rate is 0.6915 × 2.2604 or
1.5631. The deviation from parity is −.0045 (1.5631 − 1.5676), or 45 CHF pips,
since CHF is the pip currency in the EUR/CHF pair. The trading strategy is:
• Sell one lot of EUR/CHF.
• Buy one lot of EUR/GBP.
• Buy one lot of GBP/CHF.
• Liquidate all three when parity is reestablished.
If all three trades are executed successfully, a profit of 45 CHF pips is realized.
Subtract the three bid/ask spreads for the transaction costs (2 + 2 + 8 = 12)
to see a net profit of 33 CHF pips. Now convert CHF pips to dollars (33
divided by the USD/CHF rate, 1.2402) to obtain 27 USD pips.
Adding Complexity
It should be noted that in all the examples presented here that only three
currencies are analyzed simultaneously. It is possible to add a fourth or even fifth
currency to the mix, though this is normally left to the very serious arbitrage
strategists.
The methodology for examining four (or even five) currencies at one time
is to calculate every possible three-currency combination among the currencies
selected. Rearrange them in order of magnitude of deviation from parity.
Examine the deviations closely to see if there is a single anomaly or possibly even
a double anomaly among the four currencies. This type of scrutiny will then
determine if a four-currency arbitrage opportunity exists.
Specialized software is definitely required when dealing with four or more
currencies in a single arbitrage package.
Advanced Topics
Pros and Cons of Arbitrage
Using triangular arbitrage strategies on the FOREX market has one very salient
advantage: predetermined profits can be realized if the trades execute smoothly.
Unfortunately, the disadvantages of this strategy are numerous:
• Higher transaction costs. The trader must pay the bid/ask spreads on
three separate trades.
• Higher margin requirements. Roughly three times the margin is necessary
to execute the arbitrage strategy and odd-lot trading may be
required for the small-capital investor.
• Precision timing is required. Arbitrage opportunities are usually
short-lived.
• Complexity. The trader must thoroughly understand the arbitrage
mechanism in order to determine which currency pairs to buy and
which to sell. Each arbitrage “package” consists of two buys and one sell
or one buy and two sells. Miscalculating any one of the three trades can
cause disaster.
• Advanced monitoring techniques are usually required. This means
calculating the above analysis on several pairs simultaneously in real
time. You will need a software program that analyzes streaming quotes
continually. It is possible to perform these tasks manually but the trader
must have a high tolerance for tedium.
We must also mention that in the examples in this chapter, we intentionally
simplified calculations by using only the bid price throughout. When executing
an actual arbitrage trade, the investor must supply both bid and ask rate
where applicable.
Further Studies
If you are interested in delving deeper into the topics above for the purpose of
including them in your personalized trading strategy, we recommend that (a)
you contact your FOREX broker for detailed information and (b) review the
texts and Web sites listed in Appendix F.
151

List of World Currencies
and Symbols
Appendix A
Table A.1 is a list of global currencies and the three-character currency
codes that we have found are generally used to represent them. Often, but
not always, this code is the same as the ISO 4217 standard. (The ISO, or
International Organization for Standardization, is a worldwide federation of
national standards.)
In most cases, the currency code is composed of the country’s two-character
Internet country code plus an extra character to denote the currency unit. For
example, the code for Canadian dollars is simply Canada’s two-character
Internet code (“CA”) plus a one-character currency designator (“D”).
We have endeavored to list the codes that, in our experience, are actually
in general industry use to represent the currencies. Currency names are given in
the plural form. This list does not contain obsolete Euro-zone currencies.
153
TABLE A.1 Symbol, Place, Currency Name
AED United Arab Emirates Dirhams
AFA Afghanistan Afghanis
ALL Albania Leke
AMD Armenia Drams
ANG Netherlands Antilles Guilders
AOA Angola Kwanza
(continued on next page)
154 APPENDIX A
TABLE A.1 (continued)
ARS Argentina Pesos
AUD Australia Dollars
AWG Aruba Guilders
AZM Azerbaijan Manats
BAM Bosnia, Herzegovina Convertible Marka
BBD Barbados Dollars
BDT Bangladesh Taka
BGN Bulgaria Leva
BHD Bahrain Dinars
BIF Burundi Francs
BMD Bermuda Dollars
BND Brunei Darussalam Dollars
BOB Bolivia Bolivianos
BRL Brazil Brazil Real
BSD Bahamas Dollars
BTN Bhutan Ngultrum
BWP Botswana Pulas
BYR Belarus Rubles
BZD Belize Dollars
CAD Canada Dollars
CDF Congo/Kinshasa Congolese Francs
CHF Switzerland Francs
CLP Chile Pesos
CNY China Renminbi
COP Colombia Pesos
CRC Costa Rica Colones
CUP Cuba Pesos
CVE Cape Verde Escudos
CYP Cyprus Pounds
CZK Czech Republic Koruny
DJF Djibouti Francs
DKK Denmark Kroner
DOP Dominican Republic Pesos
DZD Algeria Algeria Dinars
EEK Estonia Krooni
Appendix A
TABLE A.1 (continued)
EGP Egypt Pounds
ERN Eritrea Nakfa
ETB Ethiopia Birr
EUR Euro Member Countries Euro
FJD Fiji Dollars
FKP Falkland Islands Pounds
GBP United Kingdom Pounds
GEL Georgia Lari
GGP Guernsey Pounds
GHC Ghana Cedis
GIP Gibraltar Pounds
GMD Gambia Dalasi
GNF Guinea Francs
GTQ Guatemala Quetzales
GYD Guyana Dollars
HKD Hong Kong Dollars
HNL Honduras Lempiras
HRK Croatia Kuna
HTG Haiti Gourdes
HUF Hungary Forint
IDR Indonesia Rupiahs
ILS Israel New Shekels
IMP Isle of Man Pounds
INR India Rupees
IQD Iraq Dinars
IRR Iran Rials
ISK Iceland Kronur
JEP Jersey Pounds
JMD Jamaica Dollars
JOD Jordan Dinars
JPY Japan Yen
KES Kenya Shillings
KGS Kyrgyzstan Soms
KHR Cambodia Riels
KMF Comoros Francs
155
(continued on next page)
156 APPENDIX A
TABLE A.1 (continued)
KPW Korea (North) Won
KRW Korea (South) Won
KWD Kuwait Dinars
KYD Cayman Islands Dollars
KZT Kazakstan Tenge
LAK Laos Kips
LBP Lebanon Pounds
LKR Sri Lanka Rupees
LRD Liberia Dollars
LSL Lesotho Maloti
LTL Lithuania Litai
LVL Latvia Lati
LYD Libya Dinars
MAD Morocco Dirhams
MDL Moldova Lei
MGA Madagascar Ariary
MKD Macedonia Denars
MMK Myanmar (Burma) Kyats
MNT Mongolia Tugriks
MOP Macau Patacas
MRO Mauritania Ouguiyas
MTL Malta Liri
MUR Mauritius Rupees
MVR Maldives Rufiyaa
MWK Malawi Kwachas
MXN Mexico Pesos
MYR Malaysia Ringgits
MZM Mozambique Meticais
NAD Namibia Dollars
NGN Nigeria Nairas
NIO Nicaragua Gold Cordobas
NOK Norway Krone
NPR Nepal Nepal Rupees
NZD New Zealand Dollars
OMR Oman Rials
Appendix A 157
TABLE A.1 (continued)
PAB Panama Balboa
PEN Peru Nuevos Soles
PGK Papua New Guinea Kina
PHP Philippines Pesos
PKR Pakistan Rupees
PLN Poland Zlotych
PYG Paraguay Guarani
QAR Qatar Rials
ROL Romania Lei
RUR Russia Rubles
RWF Rwanda Rwanda Francs
SAR Saudi Arabia Riyals
SBD Solomon Islands Dollars
SCR Seychelles Rupees
SDD Sudan Dinars
SEK Sweden Kronor
SGD Singapore Dollars
SHP Saint Helena Pounds
SIT Slovenia Tolars
SKK Slovakia Koruny
SLL Sierra Leone Leones
SOS Somalia Shillings
SPL Seborga Luigini
SRG Suriname Guilders
STD São Tome, Principe Dobras
SVC El Salvador Colones
SYP Syria Pounds
SZL Swaziland Emalangeni
THB Thailand Baht
TJS Tajikistan Somoni
TMM Turkmenistan Manats
TND Tunisia Dinars
TOP Tonga Pa’anga
TRL Turkey Liras
TTD Trinidad, Tobago Dollars
(continued on next page)
158 APPENDIX A
TABLE A.1 (continued)
TVD Tuvalu Tuvalu Dollars
TWD Taiwan New Dollars
TZS Tanzania Shillings
UAH Ukraine Hryvnia
UGX Uganda Shillings
USD United States of America Dollars
UYU Uruguay Pesos
UZS Uzbekistan Sums
VEB Venezuela Bolivares
VND Viet Nam Dong
VUV Vanuatu Vatu
WST Samoa Tala
XAF Communauté Financière
Africaine Francs
XAG Silver Ounces
XAU Gold Ounces
XCD East Caribbean Dollars
XDR International Monetary Fund Special Drawing Rights
XOF Communauté Financière
Africaine Francs
XPD Palladium Ounces
XPF Comptoirs Français du
Pacifique Francs
XPT Platinum Ounces
YER Yemen Rials
YUM Yugoslavia New Dinars
ZAR South Africa Rand
ZMK Zambia Kwacha
ZWD Zimbabwe Zimbabwe Dollars
Exchange Rates
Appendix B
Table B.1 shows the foreign exchange rates on 7/1/2004 compared with
the USD.
159
TABLE B.1 Exchange Rates
ISO Currency USD/Unit Units/USD
TRL Turkish Lira 0.0000 1428571
ROL Romanian Leu 0.0000 33333.3
IDR Indonesian Rupiah 0.0001 8695.65
ZMK Zambian Kwacha 0.0002 4739.33
VEB Venezuelan Bolivar 0.0005 1923.07
LBP Lebanese Pounds 0.0007 1512.85
KRW South Korean Won 0.0009 1155.34
CLP Chilean Pesos 0.0016 623.441
SDD Sudan Dinar 0.0038 263.157
HUF Hungarian Forint 0.0048 210.084
JPY Japanese Yen 0.0092 108.607
ISK Icelandic Krona 0.0136 73.7463
(continued on next page)
160 APPENDIX B
TABLE B.1 (continued)
ISO Currency USD/Unit Units/USD
DZD Algerian Dinars 0.0141 70.9220
JMD Jamaican Dollars 0.0167 60.0601
PKR Pakistani Rupees 0.0175 57.2738
PHP Filipino Pesos 0.0180 55.6793
INR Indian Rupees 0.0223 44.7828
THB Thai Bhat 0.0250 40.0000
SKK Slovakian Koruna 0.0296 33.7838
TWD Taiwanese Dollars 0.0298 33.6022
RUR Russian Rubles 0.0345 29.0189
CZK Czech Koruna 0.0367 27.2480
MXP Mexican Pesos 0.0871 11.4806
CNY Chinese Renminbi 0.1208 8.2781
HKD Hong Kong Dollars 0.1282 7.8004
SEK Swedish Krona 0.1340 7.4623
NOK Norway Kroner 0.1445 6.9208
EGP Egyptian Pounds 0.1618 6.1805
TTD Trinidad/Tobago Dollars 0.1626 6.1501
ZAR South African Rand 0.1637 6.1104
DKK Danish Kroner 0.1650 6.0611
ILS Israeli New Shekels 0.2236 4.4728
PLZ Polish Zloty 0.2510 3.9811
MYR Malaysian Ringgit 0.2632 3.7994
SAR Saudi Arabian Riyal 0.2666 3.7503
BRL Brazilian Real 0.3381 2.9577
ARP Argentinean Pesos 0.3515 2.8450
BBD Barbados Dollars 0.5025 1.9900
FJD Fiji Dollars 0.5670 1.7637
SGD Singapore Dollars 0.5834 1.7141
BGL Bulgarian Lev 0.6133 1.6305
NZD New Zealand Dollars 0.6464 1.5470
AUD Australian Dollars 0.7128 1.4029
CAD Canadian Dollars 0.7543 1.3257
CHF Swiss Francs 0.8097 1.2351
Appendix B 161
TABLE B.1 (continued)
ISO Currency USD/Unit Units/USD
SD Bahamas Dollars 1.0000 1.0000
BMD Bermudan Dollars 1.0000 1.0000
USD United States Dollars 1.0000 1.0000
EUR Eurocurrency 1.2309 0.8124
JOD Jordanian Dinar 1.4129 0.7080
GBP United Kingdom Pounds 1.8031 0.5464
CYP Cyprus Pounds 2.0375 0.4908
Rates quoted from the Bank of Montréal and ExchangeRate.com.

Euro Currency Unit
Appendix C
On January 1, 1999, eleven of the countries in the European Economic
and Monetary Union (EMU) decided to give up their own currencies
and adopt the new Euro (EUR) currency: Austria, Belgium, Finland,
France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and
Spain. Greece followed suit on January 1, 2001. The Vatican City also participated
in the changeover. This changeover is now complete.
It is worth noting that any place that previously used one or more of the
currencies listed below has now also adopted the Euro. This applies to the
Principality of Andorra, the Principality of Monaco, and the Republic of San
Marino. This of course applies automatically to any territories, departments,
possessions, or collectivities of Euro-zone countries, such as the Azores, Balearic
Islands, the Canary Islands, Europa Island, French Guiana, Guadeloupe, Juan
de Nova, the Madeira Islands, Martinique, Mayotte, Réunion, Saint-Martin,
Saint Pierre, and Miquelon, to name just a few.
Euro bank notes and coins began circulating in the above countries on
January 1, 2002. At that time, all transactions in those countries were valued in
Euro, and the “old” notes and coins of these countries were gradually withdrawn
from circulation. The precise dates that each “old” currency ceased being legal
tender are noted in Table C.1.
For convenience, and because their values are now irrevocably set against
the Euro as listed in Table C.1, the XE.com Universal Currency Converter will
continue to support these units even after their withdrawal from circulation. In
163
164 APPENDIX C
addition, most outgoing Euro currencies will still be physically convertible at
special locations for a period of several years. For details, refer to the official
Euro site, www.europa.eu.int/euro.
Also note that the Euro is not just the same thing as the former European
Currency Unit (or “ECU”), which used to be listed as “XEU”. The ECU was a
theoretical “basket” of currencies rather than a currency itself, and no “ECU”
bank notes or coins ever existed. At any rate, the ECU has been replaced by the
Euro, which is a bona fide currency.
A note about spelling and capitalization: the official spelling of the EUR
currency unit in the English language is “euro”, with a lower case “e.” However,
the overwhelmingly prevailing industry practice is to spell it “Euro,” with a capital
“E.” Since other currency names are capitalized in general use, doing so helps
differentiate the noun “Euro,” meaning EUR currency, from the more general
adjective “euro,” meaning anything even remotely having to do with Europe.
TABLE C.1 Official Fixed Euro Rates for Participating Countries
Legacy (Old) Currency Conversion to Euro Conversion from Euro
ATS Austria Schilling ATS / 13.7603 = EUR EUR × 13.7603 = ATS
BEF Belgium Franc BEF / 40.3399 = EUR EUR × 40.3399 = BEF
DEM Germany Mark DEM / 1.95583 = EUR EUR × 1.95583 = DEM
ESP Spain Peseta ESP / 166.386 = EUR EUR × 166.386 = ESP
FIM Finland Markka FIM / 5.94573 = EUR EUR × 5.94573 = FIM
FRF France Franc FRF / 6.55957 = EUR EUR × 6.55957 = FRF
GRD Greece Drachma GRD / 340.750 = EUR EUR × 340.750 = GRD
IEP Ireland Punt IEP / 0.787564 = EUR EUR × 0.787564 = IEP
ITL Italy Lira ITL / 1936.27 = EUR EUR × 1936.27 = ITL
LUF Luxembourg Franc LUF / 40.3399 = EUR EUR × 40.3399 = LUF
NLG Netherlands Guilder NLG / 2.20371 = EUR EUR × 2.20371 = NLG
PTE Portugal Escudo PTE / 200.482 = EUR EUR × 200.482 = PTE
VAL Vatican City Lira VAL / 1936.27 = EUR EUR × 1936.27 = VAL
Time Zones and
Global Banking Hours
Appendix D
The following table emphasizes the importance of the effect of time of
day on FOREX market activity and volatility based on hours of operation
around the globe. The top row is Greenwich Mean Time expressed in
24-hour military format. Banking hours are arbitrarily assumed to be 9:00 AM
to 4:00 PM around the globe. See Figure D.1
165
FIGURE D.1 Global banking hours.
166 APPENDIX D
Examples of chart usage are:
• Locate Denver (row 6, or GMT less 7 hours). The first darkened cell in
this row indicates when Denver banks open relative to other world
banks.
• Move upward to top row to see that the concurrent time in London is
17:00 or 5:00 PM, where British banks are now closed.
• A FOREX trader in New York must trade between 3:00 AM to 11:00 AM
Eastern Standard Time in order to follow the heightened activity
in central European markets (GMT+1: Zurich, Frankfurt, Vienna,
Copenhagen).
• San Francisco banks are closing while Sidney banks are opening, and
so on.
The darkened areas in Figure D.1 accentuate the major banking centers.
FOREX is a 24-hour market. You can trade 24 hours a day.
Central Banks and
Regulatory Agencies
Appendix E
Abrief history of currency regulation is provided in Chapter 2 of this
book. Traders interested in more details may visit the Web sites listed in
Table E.1.
The complete text of the “Commodity Futures Modernization Act 2000”
in Adobe PDF format can be accessed at the following Web site: www. cftc.gov/
files/ogc/ogchr5660.pdf.
Table E.2 is a list of affiliated central banks by country.
167
TABLE E.1 Regulatory Agencies
Federal Reserve System www.federalreserve.gov
Federal Reserve Bank www.ny.frb.org
Securities and Exchange
Commission www.sec.gov
Commodity Futures Trading
Commission www.cftc.gov
National Futures Association www.nfa.futures.org
Financial Services Authority www.fsa.gov.uk
Australian Securities & Investments
Commission www.asic.gov.au/asic/asic.nsf
Bank of International Settlements www.bis.org
Regulation in Canada www.ida.ca/Investors/SecRegulation_en.asp
168 APPENDIX E
TABLE E.2 Central Banks
Argentina Banco Central de la Republica Argentina
Armenia Central Bank of Armenia
Aruba Centrale Bank van Aruba
Australia Reserve Bank of Australia
Austria Oesterreichische Nationalbank
Bahrain Bahrain Monetary Agency
Belgium Banque Nationale de Belgique
Benin Banque Centrale des Etats de l’Afrique de l’Ouest
Bolivia Banco Central de Bolivia
Bosnia Central Bank of Bosnia and Herzegovina
Botswana Bank of Botswana
Brazil Banco Central do Brasil
Bulgaria Bulgarian National Bank
Burkina Faso Banque Centrale des Etats de l’Afrique de l’Ouest
Canada Bank of Canada
Chile Banco Central de Chil
China Peoples Bank of China
Colombia Banco de la Republic
Costa Rica Banco Central de Costa Rica
Côte d’Ivoire Banque Centrale des Etats de l’Afrique de l’Ouest
Croatia Croatian National Bank
Cyprus Central Bank of Cyprus
Czech Republic Ceska Narodni Banka
Denmark Danmarks Nationalbank
East Caribbean The East Caribbean Central Bank
Ecuador Banco Central del Ecuador
Egypt Central Bank of Egypt
El Salvador The Central Reserve Bank of El Salvador
Estonia Eesti Pank
European Union European Central Bank
Finland Suomen Pankki
France Banque de France
Germany Deutsche Bundesbank
Greece Bank of Greece
Appendix E 169
TABLE E.2 (continued)
Guatemala Banco de Guatemala
Guinea Bissau Banque Centrale des Etats de l’Afrique de l’Ouest
Hong Kong Hong Kong Monetary Authority
Hungary National Bank of Hungary
Iceland Central Bank of Iceland
India Reserve Bank of India
Indonesia Bank of Indonesia
Ireland Central Bank of Ireland
Israel Bank of Israel
Italy Banca d’Italia
Jamaica Bank of Jamaica
Japan Bank of Japan
Jordan Central Bank of Jordan
Kenya Central Bank of Kenya
Korea Bank of Korea
Kuwait Central Bank of Kuwait
Latvia Bank of Latvia
Lebanon Banque du Liban
Lithuania Lietuvos Bankas
Luxembourg Banque Centrale du Luxemburg
Macedonia National Bank of the Republic of Macedonia
Malaysia Bank Negara Malaysia
Mali Banque Centrale des Etats de l’Afrique de l’Ouest
Malta Central Bank of Malta
Mauritius Bank of Mauritius
Mexico Banco de Mexico
Moldova The National Bank of Moldova
Mozambique Bank of Mozambique
Namibia Bank of Namibia
Netherlands De Nederlandsche Bank
Netherlands Antilles Bank van de Nederlandse Antillen
New Zealand Reserve Bank of New Zealand
Niger Banque Centrale des Etats de l’Afrique de l’Ouest
Norway Norges Bank
(continued on next page)
170 APPENDIX E
TABLE E.2 (continued)
Paraguay Banco Central del Paraguay
Peru Banco Central de Reserva del Peru
Poland National Bank of Poland
Portugal Banco de Portugal
Qatar Qatar Central Bank
Romania National Bank of Romania
Russia Central Bank of Russia
Saudi Arabia Saudi Arabian Monetary Agency
Senegal Banque Centrale des Etats de l’Afrique de l’Ouest
Singapore Monetary Authority of Singapore
Slovakia National Bank of Slovakia
Slovenia Bank of Slovenia
South Africa The South African Reserve Bank
Spain Banco de España
Sri Lanka Central Bank of Sri Lanka
Sweden Sveriges Riksbank
Switzerland Schweizerische Nationalbank
Tanzania Bank of Tanzania
Thailand Bank of Thailand
Togo Banque Centrale des Etats de l’Afrique de l’Ouest
Trinidad and Tobago Central Bank of Trinidad and Tobago
Tunisia Banque Centrale de Tunisie
Turkey Türkiye Cumhuriyet Merkez Bankasi
Ukraine National Bank of Ukraine
United Kingdom Bank of England
United States Board of Governors of the Federal Reserve System
Zambia Bank of Zambia
Zimbabwe Reserve Bank of Zimbabwe
Central bank Web sites may be found at www.bis.org/cbanks.htm.
Resources
Appendix F
Periodicals
Though the following monthly magazines focus on very specific material, each
frequently prints very informative and timely articles on the FOREX marketplace:
Active Trader (TechInfo, Inc.)—www.activetradermag.com
Futures (Futures Magazine, Inc.)—www.futuresmag.com
Technical Analysis of Stocks & Commodities (Technical Analysis, Inc.)—
www.traders.com
Books
The following list, though in no way complete, provides traders with FOREX
library essentials:
Henderson, Callum, Currency Strategy (Wiley) 2002.
Klopfenstein, Gary, Trading Currency Cross Rates (Wiley) 1993.
Louw, G. N., Begin Forex (FXTrader) 2003.
171
172 APPENDIX F
Luca, Cornelius, Technical Analysis Applications in the Global Currency Markets
(Prentice Hall) 2000.
Luca, Cornelius, Trading in the Global Currency Markets (Prentice Hall) 2000.
Murphy, John, Intermarket Financial Analysis (Wiley) 1999.
Murphy, John, Technical Analysis of the Financial Markets (Prentice Hall) 1999.
Reuters Limited, An Introduction to Foreign Exchange and Money Markets
(Reuters Financial Training) 1999.
Shamah, Shani, A Foreign Exchange Primer (Wiley) 2003.
There are hundreds (if not thousands) of books pertaining specifically to
technical analysis. A few of the most well-known are:
Aby, Carroll D, Jr., PhD, Point and Figure Charting (Traders Press) 1996.
Bickford, Jim, Chart Plotting Algorithms for Technical Analysts (Syzygy) 2002.
McGee, John, Technical Analysis of Stock Trends (American Management
Association) 2001.
Nison, Steve, Japanese Candlestick Charting Techniques (Hall) 2001.
A fine resource for finding more titles is http://www.traderspress.com.
Web Sites
We encourage the trader to visit the following Web sites for additional information
on trading currencies. These sites are provided for research purposes. The
amount of information on currency trading now on the Internet is enormous: A
Google search finds over 2.2 million entries for “forex.” Inclusion herein does
not represent an endorsement of any kind.
Online Brokers and Dealers
www.cbfx.com
www.ac-markets.com
www.refcofx.com
www.saxobank.com
www.gftforex.com
Appendix F
www.hotspotfx.com
www.cmc-forex.com
www.cms-forex.com
www.oanda.com
www.sbfx.com
www.fxall.com
Data
ozforex.tradesecuring.com/misc/ozchart.asp
www.csidata.com
www.forexcapital.com/database.htm
www.olsendata.com
disktrading.is99.com/disktrading
www.cqg.com/products/datafactory.cfm
www.datastream.com/
www.tenfore.com/index.php?T4_Session=9b7d26531b2829babdb317083f8fe994
www.dukascopy.com
www.netdania.com
www.pctrader.com
Charts
www.esignal.com
www.dynexcorp.com/charts/eu1h.shtml
www.forex-markets.com/javacharts.htm
www.fxstreet.com/nou/graph/senseframeschartsnetdania.asp
www.forexcharts.com/
www.fxtrek.com
www.moneytec.com
www.global-view.com/beta/
173
174 APPENDIX F
www.fxstreet.com
www.forexdirectory.net
www.forex-markets.com
www.hantec.com.hk
www.business.com/directory/financial_services/investment_banking_and_ brokerage/
sales_and_trading/foreign_exchange
Portals and Forums
www.moneytec.com
www.investorsresource.info
www.global-view.com/beta
www.fxstreet.com
www.forexdirectory.net
www.forexvision.com
Software Development
www.snapdragon.co.uk
www.commtools.com
Link Pages
www.dynexcorp.com/links.shtml
www.forexdirectory.net
www.forex-brokers-list.com
www.investorsresource.info/portal.htm
Michael Archer’s Web site offers an extensive, categorized “FOREX on the
Internet” report:
www.commtools.com/p-online.html
appreciation a currency is said to appreciate when it strengthens in price in response
to market demand.
arbitrage the purchase or sale of an instrument and simultaneous taking of an equal
and opposite position in a related market, in order to take advantage of small price differentials
between markets.
ask price the price at which the market is prepared to sell a specific currency in a foreign
exchange contract or cross currency contract. At this price, the trader can buy the
base currency. In the quotation, it is shown on the right side of the quotation. For example,
in the quote USD/CHF 1.4527/32, the ask price is 1.4532; meaning you can buy
one U.S. dollar for 1.4532 Swiss francs.
at best an instruction given to a dealer to buy or sell at the best rate that can be
obtained.
at or better an order to deal at a specific rate or better.
balance of trade the value of a country’s exports minus its imports.
bar chart a type of chart that consists of four significant points: the high and the low
prices, which form the vertical bar, the opening price, which is marked with a small horizontal
line to the left of the bar, and the closing price, which is marked with a small
horizontal line to the right of the bar.
base currency the first currency in a currency pair. It shows how much the base currency
is worth as measured against the second currency. For example, if the USD/CHF
rate equals 1.6215, then one USD is worth CHF 1.6215. In the FX markets, the U.S.
dollar is normally considered the base currency for quotes, meaning that quotes are
expressed as a unit of $1 USD per the other currency quoted in the pair. The primary
exceptions to this rule are the British pound, the Euro, and the Australian dollar.
bear market a market distinguished by declining prices.
bid price the bid is the price at which the market is prepared to buy a specific currency
in a foreign exchange contract or cross currency contract. At this price, the trader
can sell the base currency. It is shown on the left side of the quotation. For example, in
the quote USD/CHF 1.4527/32, the bid price is 1.4527, meaning you can sell one U.S.
dollar for 1.4527 Swiss francs.
bid/ask spread the difference between the bid and offer price.
175
Glossary
176 GLOSSARY
big figure quote dealer expression referring to the first few digits of an exchange rate.
These digits are often omitted in dealer quotes. For example, a USD/JPY rate might be
117.30/117.35, but it would be quoted verbally without the first three digits, that is
“30/35.”
book in a professional trading environment, a “book” is the summary of a trader’s or
desk’s total positions.
broker an individual or firm that acts as an intermediary, putting together buyers and
sellers for a fee or commission. In contrast, a dealer commits capital and takes one side
of a position, hoping to earn a spread (profit) by closing out the position in a subsequent
trade with another party.
Bretton Woods agreement of 1944 an agreement that established fixed foreign
exchange rates for major currencies, provided for central bank intervention in the currency
markets, and pegged the price of gold at US $35 per ounce. The agreement lasted
until 1971, when President Nixon overturned the Bretton Woods agreement and established
a floating exchange rate for the major currencies.
bull market a market distinguished by rising prices.
bundesbank germany’s Central Bank.
cable trader jargon referring to the sterling/U.S. dollar exchange rate, so called
because the rate was originally transmitted via a transatlantic cable beginning in the mid
1800s.
candlestick chart a chart that indicates the trading range for the day as well as the
opening and closing price. If the open price is higher than the close price, the rectangle
between the open and close price is shaded. If the close price is higher than the open
price, that area of the chart is not shaded.
cash market the market in the actual financial instrument on which a futures or
options contract is based.
central bank a government or quasi-governmental organization that manages a country’s
monetary policy. For example, the U.S. central bank is the Federal Reserve, and the
German central bank is the Bundesbank.
chartist an individual who uses charts and graphs and interprets historical data to find
trends and predict future movements. Also referred to as technical trader.
cleared funds funds that are freely available, sent in to settle a trade.
closed position exposures in foreign currencies that no longer exist. The process to
close a position is to sell or buy a certain amount of currency to offset an equal amount
of the open position. This will “square” the position.
clearing the process of settling a trade.
collateral something given to secure a loan or as a guarantee of performance.
commission a transaction fee charged by a broker.
confirmation a document exchanged by counterparts to a transaction that states the
terms of said transaction.
Glossary
contagion the tendency of an economic crisis to spread from one market to another.
In 1997, political instability in Indonesia caused high volatility in its domestic currency,
the Rupiah. From there, the contagion spread to other Asian emerging currencies, and
then to Latin America, and is now referred to as the “Asian Contagion.”
contract the standard unit of trading.
counter currency the second listed currency in a currency pair.
counterparty one of the participants in a financial transaction.
country risk risk associated with a cross-border transaction, including, but not limited
to, legal and political conditions.
cross currency pair a foreign exchange transaction in which one foreign currency is
traded against a second foreign currency—for example, EUR/GBP.
cross rate same as cross currency pair.
currency any form of money issued by a government or central bank and used as legal
tender and a basis for trade.
currency pair the two currencies that make up a foreign exchange rate—for example,
EUR/USD.
currency risk the probability of an adverse change in exchange rates.
day trader speculators who take positions in currencies that are then liquidated prior
to the close of the same trading day.
dealer an individual or firm that acts as a principal or counterpart to a transaction.
Principals take one side of a position, hoping to earn a spread (profit) by closing out
the position in a subsequent trade with another party. In contrast, a broker is an individual
or firm that acts as an intermediary, putting together buyers and sellers for a fee
or commission.
deficit a negative balance of trade or payments.
delivery an FX trade where both sides make and take actual delivery of the currencies
traded.
depreciation a fall in the value of a currency due to market forces.
derivative a contract that changes in value in relation to the price movements of a
related or underlying security, future, or other physical instrument. An option is the
most common derivative instrument.
devaluation the deliberate downward adjustment of a currency’s price, normally by
official announcement.
economic indicator a government-issued statistic that indicates current economic
growth and stability. Some common indicators are employment rates, gross domestic
product (GDP), inflation, and retail sales.
end of day order (EOD) an order to buy or sell at a specified price. This order
remains open until the end of the trading day, which is typically 5 PM EST.
177
178 GLOSSARY
European Monetary Union (EMU) the principal goal of the EMU is to establish a
single European currency called the Euro, which will officially replace the national currencies
of the EU member countries in 2002. On Janaury 1, 1999, the transitional
phase to introduce the Euro began. The Euro now exists as a banking currency and
paper financial transactions and foreign exchange are made in Euros. This transition
period will last for three years, at which time Euro notes and coins will enter circulation.
On July 1, 2002, only Euros will be legal tender for EMU participants, the national
currencies of the member countries will cease to exist. The current members of
the EMU are Germany, France, Belgium, Luxembourg, Austria, Finland, Ireland, the
Netherlands, Italy, Spain, and Portugal.
Euro the currency of the European Monetary Union (EMU). A replacement for the
European Currency Unit (ECU).
European Central Bank (ECB) the central bank for the new European Monetary
Union.
Federal Deposit Insurance Corporation (FDIC) the regulatory agency responsible
for administering bank depository insurance in the United States.
Federal Reserve (Fed) the central bank for the United States.
First In First Out (FIFO) open positions are closed according to the FIFO accounting
rule. All positions opened within a particular currency pair are liquidated in the
order in which they were originally opened.
flat/square dealer jargon used to describe a position that has been completely
reversed—for example, you bought $500,000 then sold $500,000, thereby creating a
neutral (flat) position.
foreign exchange (FOREX, FX) the simultaneous buying of one currency and selling
of another.
forward the prespecified exchange rate for a foreign exchange contract settling at
some agreed future date, based upon the interest rate differential between the two currencies
involved.
forward points the pips added to or subtracted from the current exchange rate to calculate
a forward price.
fundamental analysis analysis of economic and political information with the objective
of determining future movements in a financial market.
futures contract an obligation to exchange a good or instrument at a set price at a
future date. The primary difference between a future and a forward is that futures are
typically traded over an exchange (exchange-traded contacts, ETC), whereas forwards
are considered over the counter (OTC) contracts. An OTC is any contract not traded on
an exchange.
FX Foreign exchange.
G8 the eight leading industrial countries that meet annually to evaluate and coordinate
economic policy: the United States, Germany, Japan, France, the United Kingdom,
Canada, Italy, and Russia.
Glossary 179
going long the purchase of a stock, commodity, or currency for investment or
speculation.
going short the selling of a currency or instrument not owned by the seller.
gross domestic product (GDP) total value of a country’s output, income, or expenditure
produced within the country’s physical borders.
gross national product (GNP) gross domestic product plus income earned from
investment or work abroad.
good ’til canceled order (GTC) an order to buy or sell at a specified price. This order
remains open until filled or until the client cancels.
hedge a position or combination of positions that reduces the risk of your primary
position.
“hit the bid” acceptance of purchasing at the offer (ask) price or selling at the bid
price.
inflation an economic condition whereby prices for consumer goods rise, eroding
purchasing power.
initial margin the initial deposit of collateral required to enter into a position as a
guarantee on future performance.
interbank rates the foreign exchange rates at which large international banks quote
other large international banks.
intervention action by a central bank to affect the value of its currency by entering
the market. Concerted intervention refers to action by a number of central banks to
control exchange rates.
kiwi slang for the New Zealand dollar.
leading indicators statistics that are considered to predict future economic activity.
leverage also called margin. The ratio of the amount used in a transaction to the
required security deposit.
LIBOR the London Inter-Bank Offered Rate. Banks use LIBOR when borrowing
from another bank.
limit order an order with restrictions on the maximum price to be paid or the minimum
price to be received.
liquidation the closing of an existing position through the execution of an offsetting
transaction.
liquidity the ability of a market to accept large transactions with minimal to no
impact on price stability; also the ability to enter and exit a market quickly.
long position a position that appreciates in value if market prices increase. When the
base currency in the pair is bought, the position is said to be long.
lot a unit to measure the amount of the deal. The value of the deal always corresponds
to an integer number of lots.
180 GLOSSARY
margin the required equity that an investor must deposit to collateralize a position.
margin call a request from a broker or dealer for additional funds or other collateral
to guarantee performance on a position that has moved against the customer.
market maker a dealer who regularly quotes both bid and ask prices and is ready to
make a two-sided market for any financial instrument.
market risk exposure to changes in market prices.
mark-to-market process of reevaluating all open positions with the current market
prices. These new values then determine margin requirements.
maturity the date for settlement or expiry of a financial instrument.
net position the amount of currency bought or sold that has not yet been offset by
opposite transactions.
offer the rate at which a dealer is willing to sell a currency. See ask price.
offsetting transaction a trade that serves to cancel or offset some or all of the market
risk of an open position.
one cancels the other order (OCO) a designation for two orders whereby when one
part of the two orders is executed the other is automatically canceled.
open order an order that will be executed when a market moves to its designated
price. Normally associated with good ’til canceled orders.
open position an active trade with corresponding unrealized profits and losses, which
have not been offset by an equal and opposite deal.
order an instruction to execute a trade at a specified rate.
over-the-counter (OTC) used to describe any transaction that is not conducted over
an exchange.
overnight position a trade that remains open until the next business day.
pip the smallest unit of price for any foreign currency. Digits added to or subtracted
from the fourth decimal place, that is, 0.0001. Pips are also called points.
political risk exposure to changes in governmental policy that will have an adverse
effect on an investor’s position.
position the netted total holdings of a given currency.
premium in the currency markets, describes the amount by which the forward or
futures price exceed the spot price.
price transparency describes quotes to which every market participant has equal
access.
profit/loss or P/L or gain/loss the actual realized gain or loss resulting from trading
activities on closed positions, plus the theoretical “unrealized” gain or loss on open positions
that have been mark-to-market.
quote an indicative market price, normally used for information purposes only.
Glossary
quote currency the second currency in the currency pair. Price chenges in the currency
pair are expressed in terms of the quote currency.
rally a recovery in price after a period of decline.
range the difference between the highest and lowest price of a future recorded during
a given trading session.
rate the price of one currency in terms of another, typically used for dealing purposes.
resistance a term used in technical analysis indicating a specific price level at which
analysis concludes people will sell.
revaluation an increase in the exchange rate for a currency as a result of central bank
intervention. Opposite of devaluation.
risk exposure to uncertain change, most often used with a negative connotation of
adverse change.
risk management the employment of financial analysis and trading techniques to
reduce and control exposure to various types of risk.
rollover process whereby the settlement of a deal is rolled forward to another value
date. The cost of this process is based on the interest rate differential of the two currencies.
round trip the buying and selling of a specified amount of currency.
settlement the process by which a trade is entered into the books and records of the
counterparts to a transaction. The settlement of currency trades may or may not involve
the actual physical exchange of one currency for another.
short position an investment position that benefits from a decline in market price.
When the base currency in the pair is sold, the position is said to be short.
spot price the current market price. Settlement of spot transactions usually occurs
within two business days.
spread the difference between the bid and offer prices.
square purchase and sales are in balance and thus the dealer has no open position.
sterling slang for British Pound.
stop-loss order order type whereby an open position is automatically liquidated at a
specific price. Often used to minimize exposure to losses if the market moves against an
investor’s position. As an example, if an investor is long USD at 156.27, he or she might
wish to put in a stop-loss order for 155.49, which would limit losses should the dollar
depreciate, possibly below 155.49.
support levels a technique used in technical analysis that indicates a specific price
ceiling and floor at which a given exchange rate will automatically correct itself.
Opposite of resistance.
swap a currency swap is the simultaneous sale and purchase of the same amount of a
given currency at a forward exchange rate.
181
182 GLOSSARY
swissy market slang for Swiss franc.
technical analysis an effort to forecast prices by analyzing market data, that is, historical
price trends and averages, volumes, open interest, and so forth.
tick a minimum change in time required for the price to change, up or down.
transaction cost the cost of buying or selling a financial instrument.
transaction date the date on which a trade occurs.
turnover the total money value of all executed transactions in a given time period;
volume.
two-way price when both a bid and offer rate is quoted for an FX transaction.
unrealized gain/loss the theoretical gain or loss on open positions valued at current
market rates, as determined by the broker at its sole discretion. Unrealized gains/losses
become profits/losses when position is closed.
uptick a new price quote at a price higher than the preceding quote.
uptick rule in the United States, a regulation whereby a security may not be sold
short unless the last trade prior to the short sale was at a price lower than the price at
which the short sale is executed.
U.S. prime rate the interest rate at which United States banks will lend to their prime
corporate customers.
value date the date on which counterparts to a financial transaction agree to settle
their respective obligations, that is, exchanging payments. For spot currency transactions,
the value date is normally two business days forward. Also known as maturity
date.
variation margin funds that a broker must request from the client to have the
required margin deposited. The term usually refers to additional funds that must be
deposited as a result of unfavorable price movements.
volatility a statistical measure of a market’s price movements over time characterized
by deviations from a predetermined central value (usually the arithmetic mean).
whipsaw slang for the condition of when any securities market begins moving laterally
and exhibits very little volatility.
yard slang for a billion.
Index
Account summary balance, calculating,
66–68
Ad hoc adjustment of limit orders,
115
Advanced studies, 108. See also
Technical analysis
Advanced topics in currency trading
arbitrage, 146–151
definition of, 175
examples, 146–150
pros and cons of, 151
further studies, 151
hedging, 144–145
options trading, 145
rollovers, 143–144
Appreciation, definition of, 175
Arbitrage, 146–151
definition of, 175
examples, 146–150
pros and cons of, 151
Ask price, 30
At best, definition of, 175
At or better, definition of, 175
Available currency pairs, 36
Balance of trade, 74–76
definition of, 175
Bank of England (BOE), 74
Bank of Japan (BOJ), 74
Bar charts, 88–90
definition of, 175
Base currency, 28
definition of, 175
Bear market, definition of, 175
Bid/ask spread, 30
definition of, 175
Bid price, 30
definition of, 175
Big figure quote, definition of, 176
BOE (Bank of England), 74
BOJ (Bank of Japan), 74
Bollinger, John, 104–107
Bollinger bands, 104–107
Book, definition of, 176
Book makers, 39
Bretton Woods System (1944–1973),
14–15, 176
Broker, definition of, 176
Broker, selecting
avoiding fraudulent operations, 39–40
broker policies
available currency pairs, 36
margin account interest rate, 37
margin requirement, 36
minimum trading size requirement,
36
miscellaneous policies, 37
rollover charges, 37
trading hours, 37
transaction costs, 36
broker services
charting packages, 34
chat rooms, 35
mini-accounts, 35
news services, 35
online assistance, 35
online trading platform, 34
paper trading, 35
overview and cautions, 33, 38–39
Bucket shops, 39
Bull market, definition of, 176
Bundesbank, definition of, 176
183
184 INDEX
Cable, definition of, 176
Calculations
calculating account summary balance,
66–68
calculating margin requirements,
62–63
calculating profit and loss
non-USD cross rates (base/USD),
59–60
non-USD cross rates (USD/quote),
58–59
USD is the base currency (loss),
57–58
USD is the base currency (profit),
56–57
USD is the quote currency (loss),
55–56
USD is the quote currency (profit),
53–55
calculating transaction cost, 63–65
calculating units available, 60–62
for futures traders, 68
leverage and margin percent, 51
overview, 51
pip values, 52–53
summary, 69
Candlestick charts, 96–98
definition of, 176
Cash market, definition of, 176
Central banks, 168–170
definition of, 176
CFTC (Commodity Futures Trading
Commission), 9
Charting packages, 34
Chartist, definition of, 176
Chat rooms, 35
Cleared funds, definition of, 176
Clearing, definition of, 176
Closed position, definition of, 176
Collateral, definition of, 176
Commission, definition of, 176
Commodity Futures Modernization Act
(2000), 16–17, 33
Commodity Futures Trading
Commission (CFTC), 9,
15–16
Confirmation, definition of, 176
Consumer price index (CPI), 81
Contagion, definition of, 177
Continuation patterns, 93–94
Contract
definition of, 177
specifications, 22–23
Contrary opinion, exercising, 125
Corrective waves, 107
Counter currency, 177
Counterparty, definition of, 177
Country risk, 177
CPI (consumer price index), 81
Cross currency, 28
Cross currency pair, definition of, 177
Cross rate, 177
Currencies
list of, 153–158
major, 4
trading. See Currency trading
Currency, definition of, 177
Currency futures and the IMM
(International Monetary Market)
contract specifications, 22–23
currencies trading volume, 23–24
currency futures, 21–22
futures contracts, 21
U.S. Dollar Index, 24
Currency pairs, 27
definition of, 177
selecting, 128–129
Currency risk, definition of, 177
Currency trading
advanced topics. See Advanced topics
in currency trading
business of trading
money management and
psychology. See Money
management and psychology
record keeping. See Record keeping
trading tactics. See Tactics of
currency trading
what to do if things go wrong.
See What to do if things go wrong
central banks and regulatory agencies,
167–170
Index
characteristics of successful traders,
118–119
common trading mistakes, 136–137
correcting errors, 137–138
currencies and symbols, list of,
153–158
Euro currency unit, 163–164
evaluating your performance, 135
exchange rates, 159–161
introduction to
currency futures and the IMM.
See Currency futures and the IMM
history of. See History of currency
trading
overview of currency market.
See Overview of currency market
resources, 171–174
time zones and global banking hours,
165–166
trying to beat the market
fundamental analysis. See
Fundamental analysis
technical analysis. See Technical
analysis
what every trader must know
calculations. See Calculations
FOREX terms. See Foreign
exchange, terminology
mechanics of FOREX trading.
See Mechanics of FOREX trading
opening an online trading account.
See Opening an online trading
account
selecting a FOREX broker.
See Broker, selecting
when to say “uncle,” 138
Dagger entry rule, 132
Daily trade plan and evaluation, 139
Day trader, definition of, 177
Dealer, definition of, 177
Deficit, definition of, 177
Delivery, definition of, 177
Depreciation, definition of, 177
Derivative, definition of, 177
Devaluation, definition of, 177
Divine Ratio, 108
Dow, Charles, 99
Durable goods, 81
Duration, 130
Early liquidation, 115–116
EBS, 40
ECB (European Central Bank), 74
Eclectic approach to trading, 128
Economic indicator, 177
Elliott, Ralph N., 109
Employment cost index, 81
End of day (EOD) order, 177
Euro currency unit, 163–164
arrival of, 17–18
definition of, 178
European Central Bank (ECB), 74, 178
European Monetary Union (EMU), 17,
163, 178
Exchange rates, 159–161
Fear and greed, 117–118
Federal Deposit Insurance Corporation
(FDIC), 178
Federal Open Market Committee
(FOMC), 13
Federal Reserve, 12–13, 74, 178
Fibonacci number series, 108
First In First Out (FIFO), 178
Flag/square, definition of, 178
Floating exchange rates, 15
Forecasting, 82–86
Foreign exchange (FOREX, FX), 3
definition of, 178
terminology. See also Glossary
ask price, 30
base currency, 28, 175
bid/ask spread, 30, 175
bid price, 30
cross currency, 28, 177
currency pairs, 27, 177
leverage, 30, 179
major and minor currencies, 27
margin, 29–30, 180
margin calls, 32, 180
pips, 28, 180
185
186 INDEX
Foreign exchange (continued)
putting it all together, 31–32
quote convention, 31
quote currency, 28, 181
rollover, 31, 181
ticks, 29, 182
trader’s nemesis, 32
transaction cost, 31, 182
trading. See Currency trading
Forward, definition of, 178
Forward points, definition of, 178
Fraudulent operations, avoiding, 39–40
FRB (Federal Reserve Board), 13
Fundamental analysis
balance of trade, 74–76
definition of, 178
forecasting, 82–86
gross domestic product (GDP), 78–80
interest rates, 74
intervention, 80
miscellaneous economic indicators
consumer price index (CPI), 81
durable goods, 81
employment cost index, 81
housing starts, 81
industrial production (IP), 80
producer price index (PPI), 80
purchasing managers index, 80
retail sales, 81
purchasing power parity (PPP), 77–78
supply and demand, 73–74
Futures
calculations, 68
contract, 21, 178
currency trading versus, 8–9
FX. See Foreign exchange
G8, 178
Gann, William D., 108
Gaps, 95–96
GFD (good for the day) orders, 46
Glossary, 175–182
Going long, definition of, 179
Going short, definition of, 179
Golden Mean, 108
Gold standard (1816–1933), 11–12
Greed and fear, 117–118
Gross domestic product (GDP), 78–80,
179
Gross national product (GNP), 179
GTC (good ‘til canceled) orders, 46, 179
Hedging, 144–145, 179
History of currency trading
ancient times, 11
Bretton Woods System (1944–1973),
14
Commodity Futures Modernization
Act (2000), 16–17
Commodity Futures Trading
Commission (CFTC), 15–16
end of Bretton Woods and floating
exchange rates, 15
Euro, arrival of, 17–18
Federal Reserve System, 12–13
gold standard (1816–1933), 11–12
International Monetary Market
(IMM), 15
National Futures Association (NFA),
16
in other countries, 17
Securities Act (1933) and Securities
Exchange Act (1934), 13–14
summary, 19
timeline, 18
“Hit the bid,” definition of, 179
Housing starts, 81
IMM (International Monetary Market).
See International Monetary
Market (IMM)
Indicators and oscillators
Bollinger bands, 104–107
momentum analysis, 102–104
moving averages, 104
overview, 101
relative strength indicator (RSI),
101–102
swing analysis, 107–108
Industrial production (IP), 80
Inflation, 179
Initial margin, 179
Index
Institute for Supply Management, 80
Institutional FOREX, 40
Institutional market makers, 40
Interbank rates, definition of, 179
Interest rates, 74
International Monetary Market (IMM),
15, 21
currency futures and. See Currency
futures and the IMM
Intervention, 80, 179
IP (industrial production), 80
Keene, James R., 98
Kiwi, definition of, 179
Leading indicators, definition of, 179
Leverage, 30, 51, 179
LIBOR (London inter-bank offered rate),
179
Limit entry orders, 46
Limit orders, 45–46
definition of, 179
Liquidation, definition of, 179
Liquidity, definition of, 179
Long position, definition of, 179
Lot, definition of, 179
Major and minor currencies, 27
Margin, 29–30
definition of, 180
requirements, 36, 62–63
using too much of, 136
Margin account interest rate, 37
Margin calls, 32
definition of, 180
Market closing, 133
Market environment, identifying,
122–124
three-chart system, 124
time frame, 123–124
Market expectation, knowing, 126
Market maker, definition of, 180
Market opening, 133
Market orders, 45
Market risk, 180
Market sentiment, gauging, 125
Market state, identifying, 122
Market timing
day of week, 133
market closing, 133
market opening, 133
overview, 132–133
time of day, 133
Mark-to-market, definition of, 180
Matrices, trading, 130–132
Maturity, definition of, 180
Mechanics of FOREX trading
basic order types
limit entry orders, 46
limit orders, 45–46
market orders, 45
stop-loss orders, 46
take profit orders, 46
esoteric order types
GFD (good for the day), 46
GTC (good ‘til canceled), 46
OCO (one cancels the other), 46
order confirmation, 48–49
order execution, 47–48
overview, 45
summary, 50
transaction exposure, 49–50
Mini-accounts, 35
Minimum trading size requirement, 36
Momentum analysis, 102–104
Money management and psychology
ad hoc adjustment of limit orders, 115
characteristics of successful traders,
118–119
early liquidation, 115–116
fear and greed, 117–118
money management factors, 114
more ideas on setting stops, 116
risk/reward ratio, 114–115
trade capital allocation, 116–117
trading psychology, 117
trading triangle, 113
Moving averages, 104
National Association of Purchasing
Managers (NAPM), 80
National Futures Association (NFA), 16
187
188 INDEX
Net position, 180
News services, 35
OCO (one cancels the other) orders, 46
definition of, 180
Offer, definition of, 180
Offsetting transaction, definition of, 180
OHLC (open/high/low/close) bar chart,
88–89
Online assistance, 35
Online brokers and dealers, 172–173
Online trading platform, 34
Opening an online trading account
account activation, 42
account types, 41–42
identification confirmation, 42–43
overview, 41
registration, 42
Open order, definition of, 180
Open position, definition of, 180
Options trading, 145
Orders
confirmation, 48–49
definition of, 180
execution, 47–48
GFD (good for the day), 46
GTC (good ‘til canceled), 46
limit entry orders, 46
limit orders, 45–46
market orders, 45
OCO (one cancels the other), 46
overview, 45, 50
stop-loss orders, 46
take profit orders, 46
transaction exposure, 49–50
Oscillators and indicators
Bollinger bands, 104–107
momentum analysis, 102–104
moving averages, 104
overview, 101
relative strength indicator (RSI),
101–102
swing analysis, 107–108
Overnight position, definition of, 180
Over-the-counter (OTC), definition of,
180
Overview of currency market
cost of trading currencies, 8
currencies traded, 4
determining currency prices, 5
Foreign Exchange Market (FOREX), 3
futures versus currency trading, 8–9
groups that trade currencies, 4–5
reasons to trade foreign currencies,
5–7
spot market, 3–4
stocks versus currency trading, 8
summary, 9
tools needed to trade currencies, 7
Paper trading, 35
Pips, 28, 52–53
definition of, 180
Point and figure (P&F) charts, 98–100
advantages of, 100
algorithm for, 100
Political risk, 180
Position, definition of, 180
PPP (purchasing power parity), 77–78
Premium, definition of, 180
Price movement, 122–123
Price transparency, definition of, 1890
Prime rate (U.S.), 182
Producer price index (PPI), 80
Profit and loss
calculating
non-USD cross rates (base/USD),
59–60
non-USD cross rates (USD/quote),
58–59
USD is the base currency (loss),
57–58
USD is the base currency (profit),
56–57
USD is the quote currency (loss),
55–56
USD is the quote currency (profit),
53–55
definition of, 180
Psychology. See Money management and
psychology
Pugh, Butron, 89
Index
Purchasing managers index, 80
Purchasing power parity (PPP), 77–78
Quote, definition of, 180
Quote convention, 31
Quote currency, 28, 181
Rally, definition of, 181
Range, definition of, 181
Record keeping
daily trade plan and evaluation, 139
taxes, 140
weekly trade plan and evaluation,
139–140
Regulation, 7, 167
Relative strength indicator (RSI),
101–102
Requoting, 38
Resistance, 181
Resources, 171–174
Retail market makers (RMMs), 40
Retail sales, 81
Retracement waves, 107
Revaluation, 181
Reversal patterns, 92–93
Risk
definition of, 181
management, 181
Risk/reward ratio, 114–115
RMMs (retail market makers), 40
Rollovers, 31, 143–144
charges, 37
definition of, 181
Round trip, definition of, 181
RSI (relative strength indicator),
101–102
Securities Act (1933), 14
Securities Exchange Act (1934), 14
Settlement, definition of, 181
Short position, definition of, 181
Software development, 174
Spot market, 3–4
Spot price, definition of, 181
Spread, definition of, 181
Square, definition of, 181
Sterling, definition of, 181
Stocks versus currency trading, 8
Stop-loss orders, 46, 136
definition of, 181
differential, 130
Stops, setting, 116
Strategy, trading
exercise contrary opinion, 125
gauge market sentiment, 125
identify market environment, 122–124
identify state of market, 122
if in doubt, stay out, 125
know market expectation, 126
overview, 121–122
time your trade, 125
trade logical transaction sizes, 125
trade with money you can afford to
lose, 122
trading tactics, 126–128
Supply and demand, 73–74
Support and resistance, 91
Support levels, 181
Swap, definition of, 181
Swing analysis, 107–108
Swissy, definition of, 182
Symbols and currencies, list of,
153–158
Tactics of currency trading, 126–128
dagger entry rule, 132
eclectic approach, 128
market timing
day of week, 133
market closing, 133
market opening, 133
overview, 132–133
time of day, 133
overview, 121
selecting markets to trade, 128–129
selecting trading parameters
duration, 130
stop-loss order differential, 130
take-profit order differential, 130
trade unit size, 130
summary, 134
trading matrices, 130–132
189
190 INDEX
Tactics of currency trading (continued)
trading strategy
exercise contrary opinion, 125
gauge market sentiment, 125
identify market environment,
122–124
identify state of market, 122
if in doubt, stay out, 125
know market expectation, 126
overview, 121–122
time your trade, 125
trade logical transaction sizes, 125
trade with money you can afford to
lose, 122
trading tactics, 126–128
Take profit orders, 46, 130, 136
Taxes, 140
Technical analysis
advanced studies, 108
bar charts, 88–90
candlestick charts, 96–98
continuation patterns, 93–94
definition of, 182
into the future, 109
gaps, 95–96
indicators and oscillators
Bollinger bands, 104–107
momentum analysis, 102–104
moving averages, 104
overview, 101
relative strength indicator (RSI),
101–102
swing analysis, 107–108
overview, 87
point and figure (P&F) charts,
98–100
recognizing chart patterns, 91
reversal patterns, 92–93
support and resistance, 91
technician’s creed, 109
trend lines, 90–91
Ticks, 29
definition of, 182
Time of day, 133
Time zones and global banking hours,
165–166
Timing your trade, 125
Trade capital allocation, 116–117
Trade unit size, 130
Trading. See Currency trading
Transaction costs, 31, 36, 63–65
definition of, 182
Transaction date, definition of, 182
Transaction exposure, 49–50
Trend lines, 90–91
Triangle, trading, 113
Turnover, definition of, 182
Two-way price, definition of, 182
Units available, calculating, 60–62
Unrealized gain/loss, 182
Uptick
definition of, 182
rule, 182
U.S. Dollar Index, 24
U.S. prime rate, 182
Value date, 182
Variation margin, 182
Volatility, 122–123
definition of, 182
Web sites, 172–174
charts, 173–174
data, 173
link pages, 174
online brokers and dealers, 172–173
Week, day of, 133
Weekly trade plan and evaluation,
139–140
What to do if things go wrong
common trading mistakes, 136–137
correcting errors, 137–138
evaluating your performance, 135
when to say “uncle,” 138
Whipsaw, definition of, 182
Yard, definition of, 182
About the Authors
Michael Duane Archer has been an active commodity futures and FOREX
trader for over 30 years. Mike has also worked in various registered advisory
capacities, notably as a CTA (Commodity Trading Advisor) and as an Investment
Advisor. He is currently CEO of CommTools, Inc., a corporation focusing on
nonlinear solutions to trend forecasting, with a special emphasis on cellular
automata models.
James L. Bickford is a 27-year software engineering veteran, technical analyst,
and a very active FOREX day trader with an academic background in applied
mathematics and statistics. He has numerous books to his credit and recently
published Chart Plotting Algorithms for Technical Analysts.
191