Day Trading the Currency Market by Kathy Lien

Contents  ˅

Preface 1) Foreign Exchange: The Fastest-Growing Market of Our Time 2) Historical Events in the FX Market 3) What Moves the Currency Market in the Long Term? 4) What Moves the Currency Market in the Short Term? 5) What Are the Best Times to Trade for Individual Currency Pairs? 6) What Are Currency Correlations and How Do Traders Use Them? 7) Trade Parameters for Different Market Conditions 8) Technical Trading Strategies 9) Fundamental Trading Strategies 10) Profiles and Unique Characteristics of Major Currency Pairs

Based on her experience teaching others how to trade, Kathy Lien has two objectives for this book. She wants to explain the fundamentals of the foreign exchange (FX) market, and provide actionable trading strategies.

The foreign exchange market (forex or FX), was once only available to central banks and large institutions. Now that individuals have access, forex offers a new trading opportunity along with insights to the effects of currencies on stocks and bonds.

Currencies are assets. And like any asset, a currency only has value in relation to another asset. Or simply, what can a currency buy? In the foreign exchange market, currencies are always traded as a pair. A trader sells one currency to pay for another. An example of a popular pair is the U.S. dollar against the Japanese yen (symbol USD/JPY). This pair buys dollars with yen or sells dollars for yen.

As major trading partners, Japan and the United States are affected by changes in the USD/JPY value. Significant changes in the USD/JPY value, impacts the prices of imports, exports, corporate profits, and stock prices. The same effect occurs with other U.S. trading partners like Canada and the European Union.

In an effort to maintain strong exports, China has been notorious in keeping its currency, the yuan, artificially weak. It does this by selling yuans and buying dollars. China then uses those dollars to buy U.S. bonds. This strong demand creates high bond prices which results in low interest rates.

China could decide to let the yuan's value rise by reversing this process. It would sell bonds for dollars, and use those dollars to buy yuans. As the largest foreign holder of U.S. bonds, China's currency decisions can have a large impact on bond holders and the United States.

Foreign exchange takes place on two networks, the interbank market and the online market. Trading in the interbank market is only available to the largest banks. Smaller banks and other organizations, such as hedge funds, must either trade with one of these large banks or use the online market.

The majority of currency trading happens through the interbank market. But the online market volume has grown significantly. The ease and efficiency of online FX, gives individual traders prices and trade execution which are similar to those of the largest banks.

Despite its dependence on technology, today's foreign exchange market wasn't born in a high-tech lab. FX is the result of a series of events dating back to 1944. It has been said, "Man plans, and God laughs." In the planning and operation of currency trading, God has laughed a lot.

Major Currency Trading Events

Bretton Woods Agreement
Forty-four nations met in 1944 at Bretton Woods, New Hampshire, to create a global economic plan. The plan's goal was to provide world economic stability, and maintain fair trade. Stability measures focused on fixed currency exchange rates, and making the U.S. dollar convertible with gold.

The two stability measures are no longer in effect, but three trade organizations formed at the time still remain. Two of these trade organizations are the International Monetary Fund (IMF) and the World Bank. Their mutual goal is to lend money to developing nations, for economic growth and increased trade. The third organization, the General Agreement on Tariffs and Trade (GATT), works for fair trade by promoting the elimination of tariffs and quotas.

Smithsonian Agreement
By 1971, it was clear Bretton Woods was no longer workable. The Smithsonian Agreement was its replacement. This agreement eliminated a fixed U.S. dollar gold price, but still kept currency rates fixed. Currencies were allowed to fluctuate within a 2.25 percent range instead of the previous 1 percent set by Bretton Woods. At the time, President Nixon called the plan the "greatest monetary agreement in the history of the world." This greatest monetary agreement…was dead in six months.

Free Market Currencies
In February 1972, foreign exchange markets closed and remained closed until the following year. Then in March 1973, foreign exchange became a free market. A currency's value was no longer bound by any fixed limit, but could fluctuate in response to supply and demand.

European Monetary System
Despite the benefits of a free market system, it's not a plan. And unfortunately, France and Germany were unhappy with a "no plan" currency plan. They felt what the world really needed, was another can't-miss plan and still more acronyms.

In 1979, France and Germany initiated the European Monetary System (EMS). To carry out the goal of more stable exchange rates, the EMS established the Exchange Rate Mechanism (ERM). Member countries of the ERM agreed to keep their exchange rates within 2.25 percent of a basket of currencies, the European Currency Unit (ECU).

The original ERM countries were Belgium, Denmark, France, Germany, Ireland, Italy, Luxembourg, and the Netherlands. The United Kingdom joined the ERM in 1990 and agreed to keep the pound within 6 percent of 2.95 deutsche marks.

Plaza Accord
Representatives from France, Germany, Japan, the United Kingdom, and the United States, got together at the New York Plaza Hotel in 1985. At this meeting, the countries decided the U.S. dollar's value should be lowered, in order to fix trade imbalances.

The primary way to affect the dollar's decline, was for the U.S. to cut its interest rates, while other countries increased theirs. This agreement had the intended effect, as the weakened dollar led to greater U.S. exports. With their power to set interest rates, the Plaza Accord established the central banks as the prime movers of currency values.

George Soros and the Bank of England Smackdown
In 1992, George Soros made a bet the British pound was overvalued. His Quantum hedge fund sold pounds and bought deutsche marks. The fund used options, futures, and outright positions with a total value of $10 billion.

At the same time, the Bank of England bought pounds to try to keep their value within the fixed range. When that wasn't enough, the bank said it would raise interest rates to 15 percent. Usually a higher interest rate boosts a currency due to greater demand. But the announcement failed to have an effect on the pound's value. At that point, the Bank of England gave up. Britain left the ERM and let the pound float. The resulting pound depreciation against the deutsche mark, gave the Quantum Fund a $2 billion profit.

Southeast Asian Financial Crisis
During the 1980s, the economies of Asian countries were booming and attracting large foreign investments. This led to both higher currency values and greater trade deficits. In a slow motion crash from 1994 through 1998, the economies of Japan, South Korea, and Thailand, began to slow down and then collapse.

With their economies interconnected, as one country fell, it created problems in the others. Nonperforming loans ($400 billion in Japan alone), poor lending practices, and insufficient currency reserves, were a major part of the countries' downfall.

The Euro is Created
A group of 11 European countries got together to form the European Monetary Union (EMU) in 1992. The EMU was created to maintain stable currency values and make trade easier between its members. To that end, a common currency, the euro, was created in 1999. Each of the initial countries, and those which joined later, agreed to fix their currency to a set rate against the euro. Each country also agreed to let the European Central Bank (ECB) set the monetary policy for the EMU members.

In order to join the EMU, a country has to follow the terms of the 1993 Maastricht Treaty. A country's budget deficit must not exceed 3 percent of GDP or its debt be no larger than 60 percent of GDP.

A prospective member country must have limited inflation and interest rates. Inflation can't be more than 1.5 percent or interest more than 2 percent above the rates of the average of the three EU countries with the lowest inflation.

Finally, a country had to maintain its exchange rate within the ERM limits without realignment for two years before it could join.

Fundamental analysis and technical analysis are the peanut butter and jelly of trading. Both work better together, than on their own. Neither is perfect, but in a free market, a currency's fundamentals must eventually prevail. However, with a lot of variables to rate, fundamental analysis is hard to effectively apply.

Unlike fundamental analysis, the value of technical analysis has been debated for years. But what technical analysis can do, is find good entry and exit points for a fundamentally sound trade. Choosing those entry and exit points is the subject of chapter 8.

Fundamental Analysis
It's the balance between supply and demand which sets the value of a currency. However, unlike other products, the value of a currency is not in the paper or metal contents. The value is what the paper or metal will buy. In general, the more in demand a country's goods and services are, the stronger its currency.

When the U.S. stock or real estate markets are booming, they attract foreign investors. If the Japanese want to buy U.S. stocks, they exchange their yen for dollars. This increases the demand for dollars without an increase in supply. Because of what it will buy, the dollar's value increases compared to the yen.

Of course this example is a simplified version of reality. The demand for a country's goods, is just one of the many fundamental factors affecting currency prices. Yet the net amount of a currency bought and sold, is a major component of a currency's value.

Capital Flows
"Follow the money", is good advice to analyze criminal activity and currency prices. The capital flow of a country is the difference between the amount of currency bought and sold, when used for capital investments. A positive capital flow shows foreign investment money coming into a country, exceeds the domestic investment going out. A negative flow means more investment money is leaving the country, than is coming in.

There are two types of capital flows, physical and portfolio. Physical capital flows cover investments in tangible properties, like real estate and manufacturing plants. Countries with low labor costs, make them popular for investments by foreign companies. Like the stock market example, foreign companies must exchange their currency for the domestic currency. This outside investment, can produce a positive physical capital flow for such countries.

Portfolio flows, are the net currency amount from intangible investments, such as stocks and bonds. Just as cheap labor can attract foreign investment, so too does a soaring stock market or high interest bonds. The demand for a country's bonds, is also related to how investors view the stability of the country and its government. In times of crisis, money flows to the strong and stable government bonds and currencies. FX traders are advised to compare the major stock and bond markets, as a directional indicator of portfolio flows.

Trade Flows
Capital flows measure the value of investment money, moving in and out of a country. Trade flows measure the value of a country's imports and exports. The currency movement for trade flows has a similar effect as with capital flows. When domestic exports are bought by a foreign country, it must pay for the purchase by buying the domestic currency. The countries with exports greater than their imports, adds value to their currency because of this positive trade balance.

Economic Surprises
It's relatively simple to understand the influence of capital and trade flows on currency prices. But what is the net effect of a dozen other fundamental factors? The hedge fund manager Michael Steinhardt, created the variant perception chart, to answer that question.

A variant perception chart shows the daily prices of a currency pair for one month. The price scale is recorded on the right vertical axis and the days numbered on the top horizontal axis. On the left vertical axis are the labels for numerous important economic reports. For the U.S., the reports would include such things as industrial production, personal income, and the Consumer Price Index.

Trading markets tend to anticipate the impact of news events and economic reports. If a report is accurately anticipated, prices often remain unchanged when the report is released. The lack of market reaction to the report, shows the information had already been priced into the market. So the report's release had no effect.

The purpose of the variant perception chart is to record economic report surprises. Each report is noted as more positive, negative, or the same as what was expected. The bottom horizontal chart axis is labeled with a scale from large negative to large positive percentages. Then for each of the economic reports on the left axis, plot the percentage difference between the projected results and the actual results. The variant perception chart provides a framework to see the effect these surprises, especially large ones, have on future prices.

Seven Currency Forecasting Models

Balance of Payments Theory (BOP)
A country's balance of payments is the current account and the capital account. The current account is the net of exports minus imports. The capital account is the net of money going to domestic or foreign investments. Positive account balances mean more money is coming into the country than going out. This positive inflow strengthens the currency.

Ideally, both accounts should be in balance. But a positive balance of one account can offset a negative balance in the other. The closer in balance the two accounts are, the more stable the currency is.

Despite the BOP's name, only the current account balance is considered in making forecasts. However, since the 1990s, capital flows and their effect on the balance of payments have increased to become a major part of the balance of payments. Understanding and using the complete BOP information is probably the most important fundamental FX tool.

Purchasing Power Parity (PPP)
A currency only has value for what it can buy. The PPP theory holds that the cost of the same basket of goods for different currencies, should determine the exchange rate. If the same group of products cost 110 dollars or 100 euros, then 1.10 dollars ought to equal 1 euro.

The Organization for Economic Cooperation and Development (OECD), publishes a weekly PPP chart which compares a currency's purchasing power against the actual exchange rate. In an ideal world, PPP would be very accurate. But the model doesn't account for trade quotas, tariffs, and taxes. PPP forecasts can take 5 to 10 years to be realized.

Interest Rate Parity
Interest rate parity states, interest rate differences between countries, should be reflected in their future exchange rate. If U.S. interest rates are 2 percent and Canadian rates are 1 percent, then the U.S. dollar ought to depreciate 1 percent against the Canadian dollar.

The IRP theory is based on preventing riskless arbitrage. But since many interest rate changes have nothing to do with preventing arbitrage, this model has little validity.

Monetary Model
According to this model, the country with the best monetary policy wins. The monetary model looks at a country's current growth rate and money supply, along with their expected future levels. With the advent of floating currencies, the monetary approach has become much less effective. The model doesn't take into account how trade and capital flows can offset monetary policy.

Real Interest Rate Differential Model
Higher interest rates should lead to lower currency values according to the interest rate parity model. But the Real Interest Rate Differential model takes the opposite view. The model expects higher interest rates should lead to higher currency values. If the higher rates are expected to last a long time, the appreciation amount will be greater than if the rates are only temporary.

Although this model has a sound basis, it produces mixed results. It doesn't take into account factors which affect the quality of interest rates, such as political and economic stability. It also doesn't account for trade flows.

Asset Market Model
The BOP model has traditionally relied on using only the current account for making projections. The asset market model uses only a country's capital account, the investment funds flow, for its forecasts. Since most investment money goes into the stock and bond markets, this theory implies the stronger the markets, the stronger the currency. This is one of the newer models and it's long-term value is uncertain.

Currency Substitution Model
Currency substitution is more of a game plan, than a forecasting model. It takes action based on what the monetary policy model predicts. If the United States decided to stimulate the economy by increasing the money supply, two things would happen. The inflation rate would increase, and the dollar's exchange rate value would fall.

The currency substitution model would short the dollar in anticipation of its decline. As with the other models, this model considers only a limited number of factors. For instance, a high current account surplus, can offset the effect of negative capital flows.

The real value of these models is the perspective they give. No single factor or model perfectly correlates with predicting exchange rates. But a trader can look at the various model indications, to get an overall sense for expected currency strength or weakness.

If analysts could perfectly predict economic report data, a report's release would have no effect on currency prices. But since the forecasts are imperfect, a report's effect can be significant.

U.S. economic reports are the most important releases to watch, because 90 percent of currency trading is against the dollar. Kathy Lien did a study of the impact on the EUR/USD by various reports. Of the nine reports she looked at, the nonfarm payrolls report had the most effect.

The average daily range for the EUR/USD in the study was 111 pips (100 pips equals 1 percent). But on the day the nonfarm payrolls report was released, the average range expanded to 193 pips. The second most influential report was the Federal Open Market Committee (FOMC) decisions on interest rates. This report's release expanded the average day's range to 140 pips. The gross domestic report (GDP) impact, was actually less than the average range, at only 110 pips.

These findings were significant at the time, but don't expect them to last. The reports with the most impact have changed over time. As the importance of an economic factor for a country rises and falls, so does the corresponding report's influence.

Due to a report's shifting importance, it's best for traders to conduct their own studies. Traders can use the daily range information to anticipate breakouts or range-bound days.

In addition to measuring the daily range of report release days, it's helpful to record the range of the first 20 minutes. Lien's study showed some report days had over 50 percent of the daily range occurring in the first 20 minutes. Yet other report releases, had the first 20 minutes accounting for only about a third of the daily range.

Trading currencies 24 hours a day is possible, but even with insomnia, not recommended. The activity in different time zones and currencies, varies from hour to hour. So a trader needs to devise a workable schedule, for when it's best to trade the different currencies.

Major Currency Trading Sessions

Asia (Tokyo) 7 P.M.—4 A.M. EST
Among the most commonly traded currency pairs, the GBP/JPY shows the widest average daily range of 112 pips according to Lien's chart. She lists the EUR/GBP pair as having the smallest range of only 25 pips.

Traders can use the daily range information to choose pairs which best suit their trading goals and risk preference. Because trading can be thin during this session, some large traders are known to try to run stops. It's wise to update daily range records since they will change over time.

Europe (London) 2 A.M.—12 P.M. EST
This session has the most activity and is the most volatile. The daily price ranges can be 10 to 20 percent greater than the other sessions. Lien's chart has GBP/CHF with a daily range of 150 pips and GBP/JPY at 145 pips.

The European session overlaps both the Asian and U.S. sessions. Banks are active during these overlap periods. The banks convert Asian currencies to European currencies, and then convert those to American dollars. This conversion process is a major reason for the extra volatility. In fact, most of a currency pair's daily range, happens during the overlap with the U.S. session.

U.S. (New York) 8 A.M.—5 P.M. EST
The U.S. dollar is the base for most FX quotes. At the time this book was written, the two largest daily ranges involved the British pound. The GBP/CHF was 129 pips and GBP/JPY was 119. Pairs without the U.S. dollar require the combination of two pairs which include the dollar.

The pairs combination is basic math. GBP/CHF = GBP/USD x USD/CHF. The volatility of pairs like GBP/CHF depends on the correlation of the two derived pairs. Since these two are negatively correlated, it increase the GBP/CHF's volatility.

The most active part of the U.S. trading day happens from 8 a.m. until noon. During this period, the European markets are still active. As the second largest FX market, liquidity is always good. Currency trading activity typically slows when this session ends, and doesn't pick up until Asian markets open.

When trading currencies, everything is relative. The price of a currency pair is based on the value difference between the two currencies. How much the pair's price will change, depends on how correlated the two currencies are.

Currencies which tend to move the same amount up or down at the same time, are positively correlated. When a pair of currencies are positively correlated, their relative price changes will be small.

Currencies which tend to move in opposite directions are negatively correlated. The result for a negatively correlated pair is greater than average volatility.

The degree of correlation ranges from a maximum negative correlation of -1, to a maximum positive correlation of 1. Two currencies with a -1 correlation would move the same amount in opposite direction, and if paired, produce large price swings. But a 1 correlated pair's price would never change, since each currency would move exactly the same as the other.

Correlation also applies to the relationship between different currency pairs. When pairs have the same base, such as AUD/USD and EUR/USD, their correlation is usually strongly positive. This means trading one position of each pair at the same time, is about the same as trading two positions of either one.

Recognizing when two pairs are positively correlated is important for managing risk. Trading two uncorrelated pairs is diversification, which is a good way to reduce risk. But a trader who attempts to diversify with two positively correlated pairs, is actually increasing risk.

Negatively correlated pairs can also cause problems. Most likely, pairs with a different base such as GBP/USD and USD/CHF have a negative correlation. If a trader holds the same position in two negatively correlated pairs, the result is almost the same as a long and short position in either pair. Since negative correlated pairs move in opposite directions, the two pairs will offset each to some extent. The amount of offset depends on the strength of their negative correlation.

It's important for a trader to monitor correlations since they will change. Not only is the amount of correlation fluid, but sometimes even the type of correlation, positive or negative, will switch. To calculate correlations, you need weekly price data and a spreadsheet program like Excel or an alternative. It's recommended to update the figures at least once a month.

A business wouldn't survive if it didn't keep records. It needs to know which parts of the business are doing well and which parts are not. Successful traders also keep records for the same reason.

Which trades are working well and which trades are not? Which entries and exits are working well and which are not? Which fundamental or technical tools are working well and which ones are not? Good records show what needs to be improved, and how the improvement progresses.

Kathy Lien suggests using a trading journal for record keeping, and dividing it into the following three sections:

Currency Pair Checklist
The checklist is a daily record meant to give an overview of the currency pairs traded. Using a spreadsheet, list the pairs down the left column. In each row, include the daily high, low, and last price. You might include other reference prices such as the 10-day high and low.

The next two parts of the checklist are for technical indicator readings. One part is for trend indicators, and the other part is for range-bound trading indicators. For each indicator column, select and label what would be a positive or negative reading.

An example trend indicator column could record when the price is above the 25-day moving average. If the pair's price was above the moving average, put a checkmark in the column. The overbought/oversold indicators section is treated in the same way. The more boxes checked, the stronger the trend or more range bound the pair is.

Trades I Am Waiting For
This journal section is a trade plan outline, for trades which may set up on the current day. The plan would include the pair, the price and type of order, the stop, and the exit point. The plan should also include the reason for the trade. The trade reason is included as a reminder to note if anything has happened which voids the trade.

Existing or Completed Trades
What's working and what's not working is the object of this section. For executed trades, record the planned entry and exit points, along with the actual result. Include thoughts about why the trade won or lost.

The reason for the trade plan of the previous section, is to eliminate emotions and spur of the moment decisions. Be objective when analyzing trades. Did you follow the plan or alter it? If the plan was altered, was a profit taken too soon, or was a losing trade held too long?

The trade journal checklist requires defining the indicator parameters which signal a trend, or an overbought/oversold condition in a sideways market. Lien makes the following indicator and parameter suggestions:

The trading journal indicator checklist only signals the type of trade, not how to plan entries. To do that, create a set of rules for each trade type and the expected duration. The following are example guidelines:

Risk Management
The essence of successful trading is simple. Make more money than you lose. But to do that, takes more than a profitable trading method. Even a method with a high win rate can be a net loser, if the average loss is greater than the average profit. To be a successful trader requires an understanding of risk management, and a disciplined approach to its use.

A risk management plan starts with a risk versus reward decision. What's the projected gain amount divided by the maximum acceptable loss. It's recommended the gain should be at least twice the loss amount, for a ratio of 2:1 or better.

The maximum amount at risk in a trade is controlled by stop-loss orders. Once a projected profit is determined, the risk-reward ratio automatically determines the initial stop. But during a trade, every dollar of profit, is another dollar at risk. It's the job of the trailing stop to manage this increasing amount at risk.

The first trailing stop can be placed at a price which creates a risk-free trade. When a trade is in profit the same amount as the initial stop, move the stop to break even.

Two other recommended trailing stops are based on volatility. The two-day stop places a stop 10 pips below a currency pair's lowest low of the previous two days. The parabolic stop and reversal (SAR) also adjusts for volatility. This stop uses Welles Wilder's parabolic formula to determine the trailing stop level.

Risk management is part probability and part trader personality. The use of trailing stops is about finding a balance between the two. There's no best trailing stop method, only what works best for you. The simplest trailing stop keeps the amount risked constant throughout the trade. The trailing stop is the initial stop moved up the same amount as every increase in profit.

When planning a trade, it's best to have the fundamental and technical outlooks support each other. Be aware of important economic reports which might change the situation. Lien looks for fundamentally and technically sound pairs which have retraced within a medium-term trend. She also checks the FXCM Speculative Sentiment index to see if it's in line with her trade plan.

The existence or direction of a trend depends on the chosen time frame. An hourly chart might show a strong up or down trend. But a daily chart might show this price move as merely a reaction in a more dominant trend. So when planning an intraday trade, first check the trend for the daily chart. Only take intraday trades in line with the daily trend.

When trading intraday, higher time frame analysis is also applied to other intraday charts. If trading with 15 minute bars, both the hourly and daily charts should be scanned to check for their trends, along with areas of support and resistance.

Double Zero Trade Strategy
A common area of support and resistance occurs at price levels with double zeros, such as 114.00. The public sees the double zero levels as important and the banks like to take out stops placed there. The following strategy attempts to enter the market on the same side as the banks. Reverse the buying rules for a short trade.

The best situation for this trade is a generally quiet market which is not reacting to a news event. The results are also improved if the double zero number is also at a significant technical level. This could be a previous high or low or a trend line. If the number is a triple zero, such as 140.00, this also makes the trade stronger.

Waiting for the Real Deal Strategy
Although the FX market trades 24 hours a day, some hours are more important to watch than others. The London open is one such hour. Following the relatively quiet Asian market, the London open often signals currency directions. This is especially so for the EUR/USD and GBP/USD pairs.

However, with the London open, what you see is not always what you get. European dealers are the biggest traders of the GBP/USD and are most active during London market hours. These dealers have a habit of taking out any close stops on the London open, before they begin their real trading. The Real Deal strategy is designed to take advantage of this situation. Reverse the buying rules for a short trade.

Inside Day Breakout Strategy
When market volatility changes, the direction of the market often does too. The Inside Day Breakout strategy uses the breakout from two or more inside days to enter the trade. An inside day has its range within the previous day's range. The inside day's high is less than the previous day's high and its low is greater than the previous day's low.

Although hourly charts can be used for this trade, daily and longer time frames work better. If hourly charts are used, it's best when the inside bars occur before the London or U.S. market opens. The pairs with the tightest ranges, EUR/GBP, USD/CAD, EUR/CHF, EUR/CAD, and AUD/CAD, are the most reliable.

To allow for false breakouts, this strategy uses a stop and reverse order (SAR). If technical indicators show a breakout direction bias, it's optional to ignore a breakout in the opposite direction. Reverse the buying rules for a short trade.

Fader Strategy
Breakout trades can result in good profits, but also quick losses. Avoiding false breakouts is what the Fader strategy attempts to do. A range-bound currency pair is selected using a daily chart. An hourly chart determines the entry.

This strategy should not be used for a range formed before an important economic report. A breakout following a report is more likely to be genuine. Less volatile currency pairs with narrow ranges are the best choice for this strategy. For a short trade, keep the same ADX rule and reverse the other rules.

Filtering False Breakouts Strategy
A fault of many new traders is a desire to try to pick market bottoms and tops. But the experienced trader is satisfied with the profit between the market reversal points.

Although this strategy is called a false breakout filter, it's more of a method to enter a strong trend after a minor reaction. Reverse the buying rules for a short trade.

Channel Strategy
When prices move sideways, similar highs and similar lows may be formed. The highs and lows establish two horizontal price levels. This formation is called a channel. A common way to trade this pattern is to buy when prices break above the upper channel line, and go short when prices drop below the lower line. The Channel strategy uses this idea with either daily or intraday price charts. Reverse the buying rules for a short trade.

Perfect Order Strategy
The basis for technical analysis is the belief there's an order to how markets work. The Perfect Order strategy uses a sequence of moving averages to signal the order of a market. The moving averages must be lined up in ascending or descending order according to their periods. In an uptrend, each moving average must be positioned above the next longer period moving average.

A "perfect order" uptrend has the 10-day moving average above the 20-day moving average, which is above the 50-day moving average, and so on. A downtrend reverses this with the periods in descending order from longest to shortest. Except for the ADX rule, all other rules are reversed for a short trade.

The fundamentals of a currency trade involve the economic conditions of both countries. For maximum profit, choose the currency pair which combines the strongest economy with the weakest. This is similar to a negatively correlated pair. The two economies and their currencies should be moving in opposite directions.

The Leveraged Carry Trade
A carry trade is similar to how a bank operates. A bank borrows money at a low interest rate, lends it at a higher interest rate, and profits from the difference.

A carry trade consists of buying a currency with high interest rates, and shorting a currency with low interest rates. The profit comes from the interest rate difference, and any appreciation of the high interest rate currency. If leverage is used, even a small interest difference can be very profitable.

Carry trades are not without risk. The low-interest-rate currency could appreciate due to the country's improving economy. With a stronger economy, the country might start paying higher interest rates to attract more capital.

If these new higher interest rates result in a higher currency price, the combination would reduce or eliminate the carry trade's profit. The extent of profit lost or an outright loss, becomes even greater when leverage is used.

A low-interest-rate currency could also appreciate if the country runs a trade deficit. Since it must finance this imbalance, money will flow into the currency and its price may increase.

Generally, how well a carry trade works depends on the amount of uncertainty in the world. During periods of relative peace, people are willing to assume the risk of a carry trade. But when times are uncertain due to conflicts, unstable governments, or economies, people become more adverse to risk. A desire for high returns is replaced by a need for safety. This is when money flows into the safest currencies, even though their interest rates are low.

One way to check the risk aversion level is to look at the yields for different quality bonds. If the yields for high quality and low quality bonds are similar, it shows people are willing to assume the risk of the lower quality bonds.

A final factor to be aware of with a carry trade, is how long it's held. The minimum expected trade duration is six months. This time frame should be a factor when deciding if leverage will be used. The more leverage used, the greater the chance of getting stopped out by short-term price action.

Macroeconomic Events
Currency relationships change due to short term and long term events. An economic report released today may cause a sharp move in prices. But more important long-term factors may soon cause prices to reverse. Whether the more important factor is a planned meeting or a natural disaster, the effect on currencies can be large and long lasting.

Macroeconomic events don't always cause an immediate economic change, but instead, an anticipation of change. If a country's new leader is expected to grow the economy, its currency will rise before the improvement happens. A significant part of understanding currency fundamentals, is recognizing the current and future impact of world economic events.

Commodity Prices and FX
A currency's price is determined by supply and demand, as with any product or service. And the same economic forces that move commodity prices, can also affect currencies. The two most important global economic commodities are gold and oil. Their price movement can be used to forecast future currency prices.

There are four major currencies which are considered commodity currencies. These currencies are the Australian dollar, the Canadian dollar, the New Zealand dollar, and the Swiss franc. Each of these currencies tends to rise and fall in line with the price of gold.

The Australian and Canadian dollars follow gold prices, because their countries are large gold exporters. New Zealand tends to follow Australia, since the two have strong economic ties. Switzerland doesn't export much gold, but it does back its currency with the precious metal.

There's no question oil is important to the world economy, but its effect on currency prices is complicated. In fact, of the four commodity currencies, only the Canadian dollar is correlated to the price of oil. And even that relationship is weak.

Canada produces and uses a significant amount of oil. A rise in oil prices results in a higher Canadian dollar only some of the time. As with gold, oil prices act as a lead indicator for the Canadian dollar, and can help confirm other fundamental factors.

Bond Spreads and FX
International institutions always want a good return on their money. Given two countries with similar economies but different bond yields, institutions favor the higher yield currency. Any increase or decrease in bond yields, indicate a corresponding increase or decrease in the affected currency price.

Historical relationships constantly change, which makes it smart for traders to monitor interest rate spreads. For each currency pair, subtract the quoted currency's rate from the base currency's rate.

The quoted currency is on the right side of the currency pair symbol and the base is on the left. The quoted currency for EUR/USD is the U.S. dollar and the base is the euro.

The rates should be from similar 10-year government bonds. Charting the pair along with their rate differential will indicate how well the two are correlated.

Risk Reversals
Risk reversals are a useful indicator of market sentiment. A risk reversal is a pair of options, a call and put on the same currency. The options have the same expiration date and are both out of the money at the same strike price. The implied volatility of the two options should be the same, but usually it's not. The difference is due to market sentiment.

If most traders are bullish towards a currency, they buy more calls than puts. And if most traders are bearish, more puts than calls are bought. If the market is evenly divided between bulls and bears, call and put purchases should also be relatively equal.

A risk reversal table can be constructed for each currency pair to indicate any market sentiment bias. If the demand for calls is greater than the demand for puts, the volatility will also be higher. By tracking the numbers for the different currency pairs, trends and extremes can be seen.

The best use of risk reversal information, is to take trades which are contrary to market sentiment extremes. If a market is in an uptrend and becomes excessively bullish compared to previous highs, a price reversal may be near. Market sentiment usually should not be acted on by itself, but used to confirm other indications.

Option Volatility Strategy
Option volatility can be used to anticipate breakout trades. A market's implied volatility is the expectation of future price changes based on the historical record, usually one year. The market volatility will be different for each time period considered. The difference between the implied volatility of one time period and a longer time period is used to predict a breakout.

To time a trade, use currency options with future expiration dates of 1 month and 3 months. A potential trade is signaled when the implied volatilities are significantly different.

A potential breakout from a range is indicated when the near-term volatility is much below the longer-term volatility. If the near-term volatility is much greater than the longer-term volatility, a price range may soon be created.

Both of these trades are based on the idea that volatility, like prices, swings back and forth around an average. When volatility is relatively high, it's likely to soon decrease and become less directional.

When the current volatility is low, it's likely to soon increase, which indicates a breakout. No direction is indicated, only that a breakout may occur. This information can be used to prepare for a breakout trade, or to avoid taking counter-trend positions in the current range.

Central Bank Interventions
A central bank intervention is an attempt to raise or lower the price of its currency. Sterilized interventions have offsetting government bond transactions. And Unsterilized interventions have no offsetting actions. Both types of interventions can have a short and long term effect on the currency.

Interventions happen infrequently with the major currencies, but are more common with those of emerging markets. Usually the intervention is signaled well in advance by statements from the central bank. The statements will indicate the bank feels the currency is either too strong or too week.

Traders can respond to the intervention warning by either planning a trade or avoiding the currency. On the day the intervention is announced, prices can quickly move 200 pips or more. Prices may continue in the same direction after the announcement day, depending on the central bank's intent.

Traders can either trade for a quick move on the intervention announcement day, or avoid the currency until after the announcement. If trading the announcement day move, look to take a quick profit. The initial price spike sometimes reverses and can wipe out a large part of the potential gain.

This final chapter covers fundamental economic factors for the U.S. dollar, the euro, the British pound, the Swiss franc, the Japanese yen, the Australian dollar, the New Zealand dollar, and the Canadian dollar.

The book briefly describes the significance and potential effect of each of these fundamental factors on the country and its currency.

PJ Nance

Previous	Next
Mechanical Trading Systems by Richard L. Weissman Richard Weissman says the two aims of this book are trading system development and trader development. It's a combined process which leads to not only better…	The Little Book of Market Wizards by Jack D. Schwager "The day you stop learning is the day you begin decaying." Isaac Asimov wasn't the only writer who felt that way. In an apparent attempt to avoid decay…