INTRODUCTION TO THE FOREIGN EXCHANGE MARKET

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Fundamental Analysis and Technical Analysis- forex trading
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Although the foreign exchange market is the largest traded market in the world, its reach to the retail sector pales in comparison to the Equity and Fixed Income markets. This is in large part due to a general lack of awareness of FX in the investor community, along with a lack of understanding of how and why currencies move. Adding to the mystique of this market is the lack of a physical central exchange akin to the NYSE or the CME. It is this very lack of structure that enables the FX markets to operate on a 24-hour basis, beginning the trading day in New Zealand and continuing through the time zones.

Traditionally, access to the FX market was limited to the bank community that traded large blocks of currencies for commercial, hedging, or speculative purposes. The creation of firms like Trade Orbitz has opened the door of Forex trading to such institutions as funds and money managers, as well as to the individual retail trader. This sector of the market has grown exponentially over the past several years.

WHAT IS FOREIGN EXCHANGE (FX)?

For active traders and investors, foreign exchange should be no different than other investment products such as equities, commodities or fixed-income. Because of globalization in the economic world and consolidation of whole economic regions (i.e., the European Union), including currencies in a portfolio helps to diversify assets and can reduce risk.

Just like other investment alternatives, foreign exchange offers traders/investors a market where they can buy or sell an investment product. In this case it is a specific Currency Pair. The currency pair may be the Euro versus the US Dollar, the US Dollar versus the Japanese Yen, the British Pound versus the US Dollar, the Euro versus British Pound, or a number of other currency combinations.

The different currency combinations represent nothing more than the value of one currency versus the value of another. That relationship is represented by a single price. In foreign exchange, the price of a currency pair is the market’s expectations (at that time) of the value of that currency measured against another currency given the current and expected economic and political situation in the two economies. In equity terms, it is the price of the stock.

If, for example, an economy’s inflation/interest rates are low and stable, if its output is growing strongly, or if its politics are stable and expectations are for more of the same, then one can expect (in general) for that country’s currency to remain strong versus a less fundamentally favorable currency.

Contrasting that with an equity, if the domestic and global economy is strong, if inflation is not rampant, if competition is not taking away market share or eating into margins, if product demand and growth are strong, of if the companies internal “politics” are such that the workers are happy and productive, and expectations are for more of the same, then you can expect that company’s stock to remain strong versus a company with less favorable fundamentals.

Similar to equities there are other factors that determine the short term value of a product including technical analysis, short term supply and demand, seasonal capital flow patterns, the current price of the instrument, etc. It is these universal dynamics that will move a currency’s value up or down.

Forex vs. Equities

If you are interested in trading currencies online, you will find that the Forex market is significantly different from the equities market.

24-HOUR TRADING

Forex is a true 24-hour market. Whether it’s 6pm or 6am, somewhere in the world there are always buyers and sellers actively trading foreign currencies. Traders can always respond to breaking news immediately, and P&L is not affected by after hours earning reports or analyst conference calls.

After hours trading for U.S. equities brings with it several limitations. ECN’s (Electronic Communication Networks), also called matching systems, exist to bring together buyers and sellers – when possible. However, there is no guarantee that every trade will be executed, nor at a fair market price. Quite frequently, traders must wait until the market opens the following day in order to receive a tighter spread. OTC cash foreign exchange is not traded on an organized exchange like the New York Stock Exchange or other instutionalized stock exchanges. The OTC market and its inherent liquidity moves around the world on a continuous basis and is not “closed” during the week to allow for different day sessions and overnight sessions. The OTC market is based on the global market pricing for currencies made by banks and foreign exchange dealers.

The majority of global foreign currency dealers and banks are compensated on the difference between the bid/ask spread in the currency price offered to participating traders and/or the ability to accumulate positions on a proprietary basis and assume the risk of the net open positions they carry. Trading in the foreign exchange markets involves the very significant risk of loss and individual traders should only use true discretionary capital for trading. The leverage offered in foreign exchange, which is typically much greater than that offered in the equities market, can work in the trader’s favor if the trader is right and can work significantly against the trader if the trader is wrong. Traders should be aware of all the risks associated with trading in the foreign exchange market before trading and should take the time to educate themselves on the risks associated with such trading. Since the foreign exchange market is a global dynamic market place traders must realize that there is no way to eliminate risk and learning how to take and manage risk is an essential part of trading.

SUPERIOR LIQUIDITY

With a daily trading volume that is 50x larger than the New York Stock Exchange, there are always broker/dealers willing to buy or sell currencies in the FX markets. The liquidity of this market, especially that of the major currencies, helps ensure price stability. Traders can almost always open or close a position at a fair market price.

Because of the lower trade volume, investors in the stock market are more vulnerable to liquidity risk, which results in a wider dealing spread or larger price movements in response to any relatively large transactions.

LEVERAGE

100:1 leverage is commonly available from online FX dealers, which substantially exceeds the common 2:1 margin offered by equity brokers. At 100:1, traders post $1000 margin for a $100,000 position, or 1%. While certainly not for everyone, the substantial leverage available from online currency trading firms is a powerful, moneymaking tool. Rather than merely loading up on risk as many people incorrectly assume, leverage is essential in the Forex market. This is because the average daily percentage move of a major currency is less than 1%, whereas a stock can easily have a 10% price move on any given day. The most effective way to manage the risk associated with margined trading is to diligently follow a disciplined trading style that consistently utilizes stop and limit orders. Devise and adhere to a system where your controls kick in when emotion might otherwise take over.

LOWER TRANSACTION COSTS

It is much more cost-efficient to trade Forex. Most Forex Brokers offer traders access to all relevant market information and trading tools as part of their free services. In contrast, commissions for stock trades range from $7.95-$29.95 per trade with online discount brokers up to $100 or more per trade with full service brokers.

Another important point to consider is the width of the bid/ask spread. Regardless of deal size, forex dealing spreads are normally 5 pips or less (a pip is .0005 US cents). In general, the width of the spread in a forex transaction is less than 1/10 that of a stock transaction, which could include a .125 (1/8) wide spread.

PROFIT AND LOSS POTENTIAL IN BOTH RISING AND FALLING MARKETS

Profit and Loss Potential In Both Rising And Falling Markets In every open FX position, an investor is long in one currency and short the other. A short position is one in which the trader sells a currency in anticipation that it will depreciate. This means that potential exists for both profits and losses in a rising as well as a falling market.

Forex vs. Futures

OTC cash foreign exchange is not traded on an organized exchange like the Chicago Board of Trade or other instutionalized futures exchanges. The OTC market and its inherent liquidity moves around the world on a continuous basis and is not “closed” at the end of the day to allow for different day sessions and overnight sessions. The OTC market is based on the global market pricing for currencies made by banks and foreign exchange dealers rather than just one exchange. The majority of global foreign currency dealers and banks are compensated on the difference between the bid/ask spread in the currency price offered to participating traders and/or the ability to accumulate positions on a proprietary basis and assume the risk of the net open positions they carry.

Futures exchanges and their clearing members and introducers are compensated by exchange, clearing, brokerage fees, electronic access fees, commissions, and quote fees. Like futures trading, trading in the foreign exchange markets involves the very significant risk of loss and individual traders should only use true discretionary capital for trading. The leverage offered in foreign exchange, which is typically much greater than that offered in the futures market, can work in the trader’s favor if the trader is right and can work significantly against the trader if the trader is wrong. Traders should be aware of all the risks associated with trading in the foreign exchange market before trading and should take the time to educate themselves on the risks associated with such trading. Since the foreign exchange market is a global dynamic market place traders must realize that there is no way to eliminate risk and learning how to take and manage risk is an essential part of trading.

The global foreign exchange market is the largest, most active market in the world. Trading in the forex markets takes place nearly round the clock with over $1 trillion changing hands every day.

The benefits of forex over currency futures trading are considerable. The dissimilarities between the two instruments range from philosophical realities such as the history of each, their target audience, and their relevance in the modern forex markets, to more tangible issues such as transactions fees, margin requirements, access to liquidity, ease of use and the technical and educational support offered by providers of each service. These differences are outlined below:

  • * More Volume = Better Liquidity. Daily currency futures volume on the CME is just 1% of the volume seen every day in the forex markets. Incomparable liquidity is one of many characteristics that differentiate the cash forex markets from currency futures. Truth be told, this is old news. Any currency professional can tell you that cash has been king since the dawn of the modern currency markets in the early 1970′s. The real news is that individual traders from every risk profile now have full access to the opportunities available in the forex markets.
  • Forex markets offer tighter bid to offer spreads than currency futures markets. By inverting the futures price to compare it to cash, you can readily see that in the USD/CHF example above, inverting the futures dealing price of .5894 – .5897 results in a cash price of 1.6958 – 1.6966, 8 pips vs. the 5-pip spread available in the cash markets.
  • Forex markets offer higher leverage and lower margin rates than those found in currency futures trading. When trading currency futures, traders have one margin rate for “day” trades and another for “overnight” positions. These margin rates can vary depending on transaction size. Currency trading gives the customer one rate all the time, day and night.
  • Forex markets utilize easily understood and universally used terms and price quotes. Currency futures quotes are inversions of the cash price. For example, if the cash price for USD/CHF is 1.2600/1.2605, the futures equivalent is .7933/ .7937; a methodology followed only in the confines of futures trading.

Currency futures prices have the added complication of including a forward forex component that takes into account a time factor, interest rates and the interest differentials between various currencies. The forex markets require no such adjustments, mathematical manipulation or consideration for the interest rate component of futures contracts.

  • Currency futures have the added baggage of trading commissions, exchange fees and clearing fees. These fees can add up quickly and seriously eat into a trader’s earnings. In contrast, currency futures are a small part of a much larger market; one that has undergone historical changes over the last decade.
  • Currency futures contracts (called IMM contracts or international monetary market futures) were created at the Chicago Mercantile Exchange in 1972.
  • These contracts were created for the market professionals, who at that time, accounted for 99% of the volume generated in the currency markets.
  • While some intrepid individuals did speculate in currency futures, highly trained specialists dominated the pits.
  • Rather than becoming a hub for global currency transactions, currency futures became more of a sideshow (relative to the cash markets) for hedgers and arbitragers on the prowl for small, momentary anomalies between cash and futures currency prices.
  • In what appears to be a permanent rather than cyclical change, fewer and fewer of these arbitrage windows are opening these days. And, when they do, they are immediately slammed shut by a swarm of professional dealers.

These changes have significantly reduced the number of currency futures professionals, closed the window further on forex vs. futures arbitrage opportunities and so far, have paved the way to more orderly markets. And while a more level playing field is poison to the P&L of a currency futures trader, it’s been the pathway out of the maze for individuals trading in the forex markets.

Leverage in Currency Trading

Leverage financed with credit, such as that purchased on a margin account is very common in Forex. A margined account is a leverageable account in which Forex can be purchased for a combination of cash or collateral depending what your brokers will accept. We cautions traders that leverage can significantly work against traders by compounding loses.

The loan (leverage) in the margined account is collateralized by your initial margin (deposit), if the value of the trade (position) drops sufficiently, the broker will ask you to either put in more cash, or sell a portion of your position or even close your position.

Margin rules may be regulated in some countries, but margin requirements and interest vary among broker/dealers so always check with the company you are dealing with to ensure you understand their policy.

Up until this point you are probably wondering how a small investor can trade such large amounts of money (positions). The amount of leverage you use will depend on your broker and what you feel comfortable with. There was a time when it was difficult to find companies prepared to offer margined accounts but nowadays you can get leverage from a high as 1% with some brokers. This means you could control $100,000 with only $1,000.

Typically the broker will have a minimum account size also known as account margin or initial margin e.g. $10,000. Once you have deposited your money you will then be able to trade. The broker will also stipulate how much they require per position (lot) traded.

In the example above for every $1,000 you have you can take a lot of $100,000 so if you have $5,000 they may allow you to trade up to $500,00 of forex.

Margin call is also something that you will have to be aware of. If for any reason the broker thinks that your position is in danger e.g. you have a position of $100,000 with a margin of one percent ($1,000) and your losses are approaching your margin ($1,000). He will call you and either ask you to deposit more money, or close your position to limit your risk and his risk.

If you are going to trade on a margin account it is imperative that you talk with your broker first to find out what their polices are on this type of accounts.

Variation Margin is also very important. Variation margin is the amount of profit or loss your account is showing on open positions.

Let’s say you have just deposited $10,000 with your broker. You take 5 lots of USD/JPY, which is $500,000. To secure this the broker needs $5,000 (1%).

The trade goes bad and your losses equal $5001, your broker may do a margin call. The reason he may do a margin call is that even though you still have $4,999 in your account the broker needs that as security and allowing you to use it could endanger yourself and him.

Another way to look at it is this, if you have an account of $10,000 and you have a 1 lot ($100,000) position. That’s $1,000 assuming a (1% margin) is no longer available for you to trade. The money still belongs to you but for the time you are margined the broker needs that as security.

Another point of note is that some brokers may require a higher margin during the weekends. This may take the form of 1% margin during the week and if you intend to hold the position over the weekend it may rise to 2% or higher. Also in the example we have used a 1% margin. This is by no means standard. I have seen as high as 0.5% and many between 3%-5% margin. It all depends on your broker.

There have been many discussions on the topic of margin and some argue that too much margin is dangerous. Again, we cautions traders that leverage can significantly work against traders by compounding loses. This is a point for the individual concerned. The important thing to remember as with all trading is that you thoroughly understand your broker’s policies on the subject and you are comfortable with and understand your risk.

The minimum security (Margin) for each lot will very from broker to broker. In the example above the broker required a one percent margin. This means that for every $100,000 traded the broker wanted $1,000 as security on the position.

Forex Trading Basics – Part 1

EXCHANGE RATES AND SPREADS

All currencies are assigned an International Standards Organization (ISO) code abbreviation. In currency trading, these codes are often used to express which specific currencies make up a currency pair. For example, EUR/USD refers to two currencies: the Euro Dollar and the US Dollar.

EXCHANGE RATE

An exchange rate is simply the ratio of one currency valued against another. The first currency is referred to as the base currency and the second as the counter or quote currency. If buying, an exchange rate specifies how much you have to pay in the counter or quote currency to obtain one unit of the base currency. If selling, the exchange rate specifies how much you get in the counter or quote currency when selling one unit of the base currency.

EUR/USD
base currency/quote currency

BID/ASK PRICE

A currency exchange rate is typically given as a bid price and an ask price. The bid price is always lower than the ask price. The bid price represents what will be obtained in the quote currency when selling one unit of the base currency. The ask price represents what has to be paid in the quote currency to obtain one unit of the base currency. The following EUR/USD price quote is an example of bid/ask notation:

 

EUR/USD: .9726 / .9731

EXAMPLE
The first component (before the slash) refers to the BID price (what you obtain in USD when you sell EUR). In this example, the BID price is .9726. The second component (after the slash) is used to obtain the ASK price (what you have to pay in EUR if you buy USD). In this example, the ASK price is .9731.

SPREAD

The difference between the bid and the ask price is referred to as the spread. In the example above, the spread is .0005 or 5 pips. Unlike the EUR/USD, some currency pair quotes are carried out to the 2nd decimal place (i.e. USD/JPY may be quoted at 119.45/50), in which case 5 pips represents a difference of .05. Although a pip may seem small, a movement of one pip in either direction can translate into thousands of dollars in gains or losses in the inter-bank market.

When trading amounts of $1M or higher, the spread obtained in a quote is typically 5 pips. When trading smaller amounts, the spread is typically larger. For example, when trading less than $100,000, spreads of 50-200 pips are common. Credit card companies typically apply a spread of 200-300 pips. Banks and exchange bureaus typically use a spread in the range of 200-1000 pips (in addition to charging a commission).

BUYING AND SELLING

All trades result in the buying of one currency and the selling of another, simultaneously.

Buying (“going long”) the currency pair implies buying the first, base currency and selling an equivalent amount of the second, quote currency (to pay for the base currency). It is not necessary to own the quote currency prior to selling, as it is sold short. A trader buys a currency pair if he/she believes the base currency will go up relative to the quote currency, or equivalently that the corresponding exchange rate will go up.

Selling (“going short”) the currency pair implies selling the first, base currency, and buying the second, quote currency. A trader sells a currency pair if he/she believes the base currency will go down relative to the quote currency, or equivalently, that the quote currency will go up relative to the base currency.

An open trade or position is one in which a trader has either bought or sold one currency pair and has not sold or bought back an adequate amount of that currency pair to effectively close the trade. When a trader has an open trade or position, he/she stands to profit or lose from fluctuations in the price of that currency pair.

Forex Trading Basics – Part 2

BUYING/SELLING CURRENCY

Cardinal Rule: All trades result in the buying of one currency and the selling of another, simultaneously.

The objective of currency trading is to exchange one currency for another with the expectation that the market rate or price will change such that the currency pair you have bought has appreciated in value relative to the currency you have sold. If the currency you have bought appreciates in value and you close your open position by selling this currency, or effectively buying the currency that you originally sold, then you are locking in a profit. If the currency depreciates in value and you close your open position by selling this currency, or effectively buying the currency you have sold, then you are realizing a loss.

BASIC ENTRY & EXIT RULES

  1. Buying a currency is equivalent with taking a long position in that currency.
  2. Selling a currency is equivalent with selling short that currency.

    OPEN TRADE

    An open trade or position is one in which a trader has either bought or sold one currency pair and has not sold or bought back an adequate amount of that currency pair to effectively close the trade. When a trader has an open trade or position, he/she stands to profit or lose from fluctuations in the price of that currency pair.

    CURENCY SPREAD AND DEALING RATES

    A currency exchange rate is always quoted for a currency pair. For example, EUR/USD refers to two currencies: the Euro Dollar and the US Dollar.

    EXCHANGE RATES

    An exchange rate is simply the ratio of one currency valued against another. The first currency is referred to as the base currency and the second as the counter or quote currency. If buying, an exchange rate specifies how much you have to pay in the counter or quote currency to obtain one unit of the base currency. If selling, the exchange rate specifies how much you get in the counter or quote currency when selling one unit of the base currency.

    A currency exchange rate is typically given as a bid price and an ask price. The bid price is always lower than the ask price. The bid price represents what will be obtained in the quote currency when selling one unit of the base currency. The ask price represents what has to be paid in the quote currency to obtain one unit of the base currency. The following EUR/USD price quote is an example of bid/ask notation:

     

    EUR/USD: .9726 / .9731

     

    The first component (before the slash) refers to the BID price (what you obtain in USD when you sell EUR). In this example, the BID price is .9726. The second component (after the slash) is used to obtain the ASK price (what you have to pay in EUR if you buy USD). In this example, the ASK price is .9731.

    SPREAD

    The difference between the bid and the ask price is referred to as the spread. In the example above, the spread is .05 or 5 pips. Unlike the EUR/USD, some currency pair quotes are carried out to the 2nd decimal place (i.e. USD/JPY may be quoted at 119.45/50), in which case 5 pips represents a difference of .05. Although a pip may seem small, a movement of one pip in either direction can translate into thousands of dollars in gains or losses in the inter-bank market.

    DIRECT RATES

    Most currencies are traded directly against the US Dollar. The market rates that are expressed for such currency pairs are called direct rates. In most cases, the US Dollar is the base currency pair whereby the quote currency is expressed as a certain number of units per 1 US Dollar. For example, the following rate USD/CAD=1.4500 indicates that 1 USD (US Dollars)= 1.4500 CAD (Canadian Dollars).

    INDIRECT RATES

    For some currency pairs, the US Dollar is not the base currency but the counter or quote currency. The market rates that are expressed for such currency pairs are called indirect rates. This is the case with GBP (British Pound or “Cable”), NZD (New Zealand Dollar), EUR (Eurodollar), and AUD (Australian Dollar). For example, the following rate GBP/USD=1.5800 indicates that 1 GBP (British Pound)= 1.5800 USD (US Dollars).

    CROSS RATES

    When one currency is traded against any currency other than the USD, the market rate for this currency pair is called a cross rate. Cross rate is the exchange rate between two currencies not involving the US Dollar. Although the US dollar rates do not appear in the final cross rate, they are usually used in the calculation and so must be known. Trading between two non-US Dollar currencies usually occurs by first trading one against the US Dollar and then trading the US Dollar against the second non-US Dollar currency. There are a few non-US Dollar currencies that are traded directly, such as GBP/EUR or EUR/CHF.

Calculating Profit & Loss

For ease of use, our online trading platforms automatically calculate the P&L of a traders’ open positions. However, it is useful to understand how this calculation is derived.

To illustrate a typical FX trade, consider the following example.

The current bid/ask price for USD/CHF is 1.2622/1.2627, meaning you can buy $1 US for 1.2627 Swiss Francs or sell $1 US for 1.2622.

Suppose you decide that the US Dollar (USD) is undervalued against the Swiss Franc (CHF). To execute this strategy, you would buy Dollars (simultaneously selling Francs), and then wait for the exchange rate to rise.

So you make the trade: purchasing US$100,000 and selling 126,270 Francs. (Remember, at 1% margin, your initial margin deposit would be $1,000.)

Unexpectantly, the USDCHF rate drops to 1.2602/07. You decide now to take this trade as a realized loss, close this order, and sell $1 US for 1.2602 francs.

Since you’re long dollars (and are short francs), you must now sell dollars and buy back the francs.

You sell US$100,000 at the current USDCHF rate of 1.2602, and receive 126,020 CHF. Since you originally sold (paid) 126,270, your net loss is 250 CHF.

To calculate your realized loss in terms of US dollars, simply divide 250 by the current USD/CHF rate of 1.2602

Total loss = $198.38 (or 25 pip loss on this transaction)

Technical Analysis

The two primary approaches of analyzing currency markets are fundamental analysis and technical analysis. Fundamentals focus on financial and economic theories, as well as political developments to determine forces of supply and demand. One clear point of distinction between fundamentals and technicals is that fundamental analysis studies the causes of market movements, while technical analysis studies the effects of market movements.

Technical analysis examines past price and volume data to forecast future price movements. This type of analysis focuses on the formation of charts and formulae to capture major and minor trends, identify buying/selling opportunities, and assessing the extent of market turnarounds. Depending upon your time horizon, you could use technical analysis on an intraday basis (5-minute, 15 minute, hourly), weekly or monthly basis.

THE BASIC THEORIES

Dow Theory

The oldest theory in technical analysis states that prices fully reflect all existing information. Knowledge available to participants (traders, analysts, portfolio managers, market strategists and investors) is already discounted in the price action. Movements caused by unpredictable events such as acts of god will be contained within the overall trend. Technical analysis aims at studying price action to draw conclusions on future moves.

Developed primarily around stock market averages, the Dow Theory holds that prices progressed into wave patterns, which consisted of three types of magnitude—primary, secondary and minor. The time involved ranged from less than three weeks to over a year. The theory also identified retracement patterns, which are common levels by which trends pare their moves. Such retracements are 33%, 50% and 66%.

Fibonacci Retracement

This is a popular retracement series based on mathematical ratios arising from natural and man-made phenomena. It is used to determine how far a price has rebounded or backtracked from its underlying trend. The most important retracement levels are: 38.2%, 50% and 61.8%.

Elliott Wave

Ellioticians classify price movements in patterned waves that can indicate future targets and reversals. Waves moving with the trend are called impulse waves, whereas waves moving against the trend are called corrective waves. Elliott Wave Theory breaks down impulse waves and corrective waves into five primary and three secondary movement respectively. The eight movements comprise a complete wave cycle. Time frames can range from 15 minutes to decades.

The challenging part of Elliott Wave Theory is figuring out the relativity of the wave structure. A corrective wave, for instance, could be composed of sub impulsive and corrective waves. It is therefore crucial to determine the role of a wave in relation to the greater wave structure. Thus, the key to Elliot Waves is to be able to identify the wave context in question. Ellioticians also use Fibonacci retracements to predict the tops and bottoms of future waves.

WHAT TO LOOK FOR IN TECHNICALS?

Find the Trend

One of the first things you’ll ever hear in technical analysis is the following motto: “the trend is your friend.” Finding the prevailing trend will help you become aware of the overall market direction and offer you better visibility—especially when shorter-term movements tend to clutter the picture. Weekly and monthly charts are more ideally suited for identifying longer-term trends. Once you have found the overall trend, you could select the trend of the time horizon in which you wish to trade. Thus, you could effectively buy on the dips during rising trends, and sell the rallies during downward trends.

Support & Resistance

Support and resistance levels are points where a chart experiences recurring upward or downward pressure. A support level is usually the low point in any chart pattern (hourly, weekly or annually), whereas a resistance level is the high or the peak point of the pattern. These points are identified as support and resistance when they show a tendency to reappear. It is best to buy/sell near support/resistance levels that are unlikely to be broken.

Once these levels are broken, they tend to become the opposite obstacle. Thus, in a rising market, a resistance level that is broken, could serve as a support for the upward trend; whereas in a falling market, once a support level is broken, it could turn into a resistance.

Lines & Channels

Trend lines are simple, yet helpful tools in confirming the direction of market trends. An upward straight line is drawn by connecting at least two successive lows. Naturally, the second point must be higher than the first. The continuation of the line helps determine the path along which the market will move. An upward trend is a concrete method to identify support lines/levels. Conversely, downward lines are charted by connecting two points or more. The validity of a trading line is partly related to the number of connection points. Yet it’s worth mentioning that points must not be too close together. A channel is defined as the price path drawn by two parallel trend lines. The lines serve as an upward, downward or straight corridor for the price. A familiar property of a channel for a connecting point of a trend line is to lie between the two connecting point of its opposite line.

Averages

If you believe in the “trend-is-your-friend” tenet of technical analysis, moving averages are very helpful. Moving averages tell the average price in a given point of time over a defined period of time. They are called moving because they reflect the latest average, while adhering to the same time measure.

A weakness of moving averages is that they lag the market, so they do not necessarily signal a change in trends. To address this issue, using a shorter period, such as 5 or 10 day moving average, would be more reflective of the recent price action than the 40 or 200-day moving averages.

Alternatively, moving averages may be used by combining two averages of distinct time-frames. Whether using 5 and 20-day MA, or 40 and 200-day MA, buy signals are usually detected when the shorter-term average crosses above the longer-term average. Conversely, sell signals are suggested when the shorter average falls below the longer one.

There are three kinds of mathematically distinct moving averages: Simple MA; Linearly Weighted MA; and Exponentially Smoothed. The latter choice is the preferred one because it assigns greater weight for the most recent data, and considers data in the entire life of the instrument.

Fundamental Analysis

The two primary approaches of analyzing currency markets are fundamental analysis and technical analysis. Fundamentals focus on financial and economic theories, as well as political developments to determine forces of supply and demand. One clear point of distinction between fundamentals and technicals is that fundamental analysis studies the causes of market movements, while technical analysis studies the effects of market movements.

Fundamental analysis comprises the examination of macroeconomic indicators, asset markets, and political considerations when evaluating one nation’s currency relative to another. Macroeconomic indicators include figures such as growth rates; as measured by Gross Domestic Product, interest rates, inflation, unemployment, money supply, foreign exchange reserves and productivity. Asset markets comprise stocks, bonds, and real estate. Political considerations impact the level of confidence in a nation’s government, the climate of stability and level of certainty.

Sometimes governments stand in the way of market forces impacting their currencies, and hence, intervene to keep currencies from deviating markedly from undesired levels. Currency interventions are conducted by central banks and usually have a notable, albeit a temporary, impact on FX markets. A central bank could undertake unilateral purchases/sales of its currency against another currency; or engage in a concerted intervention in which it collaborates with other central banks for a much more pronounced effect. Alternatively, some countries can manage to move their currencies, merely by hinting, or threatening to intervene.

THE BASIC THEORIES OF FUNDAMENTAL ANALYSIS

Purchasing Power Parity

The PPP theory states that exchange rates are determined by the relative prices of similar baskets of goods. Changes in inflation rates are expected to be offset by equal but opposite changes in the exchange rate. Take the classic example of hamburgers. If the burger costs $2.00 in the US and £1.00 in the UK, then according to PPP, the £-$ exchange rate must be 2 dollars per one British pound. If the prevailing market exchange rate is $1.7 per British pound, then the pound is said to be undervalued and the dollar overvalued. The theory then postulates that the two currencies will eventually move towards the 2:1 relation.

PPP’s major weakness is that it assumes goods are easily tradable, with no costs to trade such as tariffs, quotas or taxes. Another weakness is that it applies only for goods and ignores services, where room for differences in value is significant. Furthermore, there are several factors besides inflation and interest rate differentials impacting exchange rates, such as economic releases/reports, asset markets and political developments. There was little empirical evidence of the effectiveness of PPP prior to the 1990s. Thereafter, PPP was seen to have worked only in the long term (3-5 years) when prices eventually correct towards parity.

Interest Rate Parity

IRP states that an appreciation (depreciation) of one currency against another currency must be neutralized by a change in the interest rate differential. If US interest rates exceed Japanese interest rates, then the US dollar should depreciate against the Japanese yen by an amount that prevents riskless arbitrage. The future exchange rate is reflected into the forward exchange rate stated today. In our example, the forward exchange rate of the dollar is said to be at discount because it buys fewer Japanese yen in the forward rate than it does in the spot rate. The yen is said to be at a premium.

IRP showed no proof of working after the 1990s. Contrary to the theory, currencies with higher interest rates characteristically appreciated rather than depreciated on the reward of future containment of inflation and a higher yielding currency.

Balance of Payments Model

This model holds that a foreign exchange rate must be at its equilibrium level—the rate that produces a stable current account balance. A nation with a trade deficit will experience a reduction in its foreign exchange reserves, which ultimately lowers (depreciates) the value of its currency. The cheaper currency renders the nation’ goods (exports) more affordable in the global market place while making imports more expensive. After an intermediate period, imports are forced down and exports rise, thus stabilizing the trade balance and the currency towards equilibrium.

Like PPP, the balance of payments model focuses largely on tradable goods and services, while ignoring the increasing role of global capital flows. In other words, money is not only chasing goods and services, but to a larger extent, financial assets such as stocks and bonds. Such flows go into the capital account item of the balance of payments, thus, balancing the deficit in the current account. The increase in capital flows has given rise to the Asset Market Model.

Asset Market Model

The explosion in trading of financial assets (stocks and bonds) has reshaped the way analysts and traders look at currencies. Economic variables such as growth, inflation, and productivity are no longer the only drivers of currency movements. The proportion of foreign exchange transactions stemming from cross border-trading of financial assets has dwarfed the extent of currency transactions generated from trading in goods and services. The asset market approach views currencies as asset prices traded in an efficient financial market. Consequently, currencies are increasingly demonstrating a strong correlation with asset markets, particularly equities.

Fundamentals Affecting the US Dollar

INTEREST RATES

Fed Funds Rate: Clearly the most important interest rate. It is the rate that depositary institutions charge each other for overnight loans. The Fed announces changes in the Fed Funds rate when it wishes to send clear monetary policy signals. These announcements normally have large impact on all stock, bond and currency markets.

DISCOUNT RATE

The interest rate at which the Fed charges commercial banks for emergency liquidity purposes. Although this is more of a symbolic rate, changes in it imply clear policy signals. The Discount Rate is almost always less than the Fed Funds Rate.

30-YEAR TREASURY BOND

The 30-year US Treasury Bond, also known as the long bond, or bellwether treasury. It is the most important indicator of markets’ expectations on inflation. Markets most commonly use the yield (rather than price) when referring to the level of the bond. As in all bonds, the yield on the 30-year treasury is inversely related to the price. There is no clear-cut relation between the long bond and the US dollar. But the following relation usually holds: A fall in the value of the bond (rise in the yield) due to inflationary concerns may pressure the dollar. These concerns could arise from strong economic data.

Depending on the stage of the economic cycle, strong economic data could have varying impacts on the dollar. In an environment where inflation is not a threat, strong economic data may boost the dollar. But at times when the threat of inflation (higher interest rates) is most urgent, strong data normally hurt the dollar, by means of the resulting sell-off in bonds.

Nonetheless, as the supply of 30-year bonds began to shrink following the US Treasury’s refunding operations (buy back its debt), the 30-year bond’s role as a benchmark had gradually given way to its 10-year counterpart.

Being a benchmark asset-class, the long bond is normally impacted by shifting capital flows triggered by global considerations. Financial/political turmoil in emerging markets could be a possible booster for US treasuries due to their safe nature, thereby, helping the dollar.

3-MONTH EURODOLLAR DEPOSITS

The interest rate on 3-month dollar-denominated deposits held in banks outside the US. It serves as a valuable benchmark for determining interest rate differentials to help estimate exchange rates. To illustrate USD/JPY as a theoretical example, the greater the interest rate differential in favor of the eurodollar against the euroyen deposit, the more likely USD/JPY will receive a boost. Sometimes, this relation does not hold due to the confluence of other factors.

10-YEAR TREASURY NOTE

FX markets usually refer to the 10-year note when comparing its yield with that on similar bonds overseas, namely the Euro (German 10-year bund), Japan (10-year JGB) and the UK (10-year gilt). The spread differential (difference in yields) between the yield on 10-year US Treasury note and that on non US bonds, impacts the exchange rate. A higher US yield usually benefits the US dollar against foreign currencies.

FEDERAL RESERVE BANK (FED)

The U.S Central Bank has full independence in setting monetary policy to achieve maximum non-inflationary growth. The Fed’s chief policy signals are: open market operations, the Discount Rate and the Fed Funds rate.

FEDERAL OPEN MARKET COMMITTEE (FOMC)

The FOMC is responsible for making decisions on monetary policy, including the crucial interest rate announcements it makes 8 times a year. The 12-member committee is made up of 7 members of the Board of Governors; the president of the Federal Reserve Bank of New York; while the remaining four seats carry one-year term each, in a rotating selection of the presidents of the 11 other Reserve Banks.

TREASURY

The US Treasury is responsible for issuing government debt and for making decisions on the fiscal budget. The Treasury has no say in monetary policy, but its statements on the dollar have an major influence on the currency.

ECONOMIC DATA

The most important economic data items released in the US are: labor report (payrolls, unemployment rate and average hourly earnings), CPI, PPI, GDP, international trade, ECI, NAPM, productivity, industrial production, housing starts, housing permits and consumer confidence.

STOCK MARKET

The three major stock indices are the Dow Jones Industrials Index (Dow), S&P 500, and NASDAQ. The Dow is the most influential index on the dollar. Since the mid-1990s, the index has shown a strong positive correlation with the greenback as foreign investors purchased US equities. Three major forces affect the Dow: 1) Corporate earnings, forecast and actual; 2) Interest rate expectations and; 3) Global considerations. Consequently, these factors channel their way through the dollar

CROSS RATE EFFECT

The dollar’s value against one currency is sometimes impacted by another currency pair (exchange rate) that may not involve the dollar. To illustrate, a sharp rise in the yen against the euro (falling EUR/JPY) could cause a general decline in the euro, including a fall in EUR/USD.

Economic Indicators – The Basics

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 stat will be made public.

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 USD has been in a tailspin for three weeks. As such, it’s safe to assume that many traders are holding large short USD positions. However, on Friday the employment data for the U.S. is due to be released. 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. The point here is that economic indicators can effect prices directly (following their release to the public) or indirectly (as traders massage their positions in anticipation of the data.)

Understand what 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) vs. those that measure inflation (PPI, CPI) or employment (non-farm payrolls). After you follow the data for a while, you’ll become very familiar with the nuances of each economic indicator and what part of the economy they are measuring.

Not all economic indicators are created equal. Well, they might’ve 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 stat vs. 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, inflation data will probably not be as keenly anticipated or reacted to by the markets. On the other hand, if economic growth is a vexing problem, changes in employment data or GDP will be eagerly anticipated and could precipitate tremendous volatility following their 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% 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%. 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’ve 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.

Don’t get caught up in the headlines. 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 stat most closely watched by the markets is PPI, ex-food and energy. 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, don’t 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% 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’ve been originally reported as a rise of 0.5% but now, along with the new figures, is being revised lower to say a rise of only 0.1% Therefore, the unexpected rise in the current month is likely the result of a downward revision to the previous month’s data.

Don’t forget that there are two sides to a trade in the foreign exchange market. So, while you might have a great 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 G7 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 their economic indicators. As mentioned above, 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 and you won’t be caught off guard.

INDUSTRIAL PRODUCTION

It 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 of 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 (PMI)

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 non-manufacturing sub-indices.

PRODUCER PRICE INDEX (PPI)

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.

CONSUMER PRICE INDEX (CPI)

The Consumer Price Index (CPI) is a measure of the average price level paid by urban consumers (80% of 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

Durable Goods Orders 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 (ECI)

Payroll employment is a measure of the number of jobs in more than 500 industries in all states and 255 metropolitan areas. The employment estimates are based on a survey of larger businesses and counts 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 start/permits to changing interest rates signals interest rates are nearing trough or peak. To analyze, focus on the percentage change in levels from the previous month. Report is released around the middle of the following month.

Fundamental Analysis vs. Technical Analysis

One of the dominant debates in financial market analysis is the relative validity of the two major tiers of analysis: Fundamental and Technical. In Forex, several studies concluded that fundamental analysis was more effective in predicting trends for the long-term (longer than one year), while technical analysis was more appropriate for shorter time horizons (0-90 days). Combining both approaches was suggested to be best suited for periods between 3 months and one year.

Nonetheless, further empirical evidence reveals that technical analysis of long-term trends helps identify longer-term technical “waves,” and that fundamental factors do trigger short-term developments.

Let’s take the declining USD/JPY exchange rate in 1999 as an example. The pair lost 16% in the second half of the year, reaching a year low of 101.90. Both fundamentals and technicals alike could explain the downward move. Fundamentals attributed it to the continuous capital inflows into Japanese assets, which reflect investors increased optimism with the Japanese recovery. Technical analysts were likely to explain the move with the simple argument: the language of the market voiced a clearly downward tone that became more resounding after the breach of key technical landmarks (115 yen and 110 yen).

Thus, both technicals and fundamentals reached the same conclusion. However, fundamental analysts with a technical blind spot risk missing key market turnarounds after the breach of an important support/resistance level.

Conversely, a technically inclined analyst with a disregard for fundamentals and news releases would have missed the rebound in EUR/USD, which was triggered by the release of a stronger than expected German business sentiment survey (IFO) in July 19, 1999. Up to that point, the euro had lost 15% reaching an all time low of $1,010. Most market observers—fundamentals and technicals -were predicting the euro to break below $1.00. Technical analysts stated psychology, momentum, and moving averages as arguments for further downfall. But fundamentally inclined analysts who paid attention to the strong survey would have been able to promptly exit their long dollar positions in favor of the euro. On that day, the euro jumped 200 points against the dollar with an additional 260 points on the following day, and an extra 150 days in the third day. In just two weeks, EUR/USD soared by more than 800 pts.

Obviously, the IFO survey release was not the single reason behind the euro’s 7% rebound. Other factors over the subsequent weeks also helped prop the currency. These included a broadening improvement in economic fundamentals throughout the Eurozone and increasingly hawkish stance (favoring higher interest rates) from the European Central Bank. Nevertheless, the release of the IFO survey was the turning point in shifting expectations of the euro.

It has been often stated that combining fundamentals with technicals was counterproductive. Owing to their contrasting types, technical and fundamental analysis are often said to be mutually exclusive. Yet, a large number of traders combine the two approaches, even instinctively. Thus, technically inclined traders do pay attention to central bank meetings, give consideration to employment reports and heed the latest inflation numbers. Similarly, fundamental traders are often trying to figure out the major and minor levels of support, and determine the percentage of retracement formations. There does not exist a specific formula for figuring out the optimum approach of combining fundamental and technical analysis in the Forex market. Some computer software packages claim to be able to make such decisions, weighing one approach against another depending on economic, technical and quantitative parameters. Yet, these are based on models from past patterns of inter-market dynamics and previous technical and fundamental behavior. The FX market is too dynamic for such pre-formed frameworks.

Different Roles in the FX Market

CENTRAL BANKS AND GOVERNMENTS

Policies that are implemented by governments and central banks can play a major role in the FX market. Central banks can play an important part in controlling the country’s money supply to insure financial stability.

BANKS

A large part of FX turnover is from banks. Large banks can literally trade billions of dollars daily. This can take the form of a service to their customers or they themselves speculate on the FX market.

HEDGE FUNDS

As we know the FX market can be extremely liquid which is why it can be desirable to trade. Hedge Funds have increasingly allocated portions of their portfolios to speculate on the FX market. Another advantage Hedge Funds can utilize is a much higher degree of leverage than would typically be found in the equity markets.

CORPORATE BUSINESSES

The FX market mainstay is that of international trade. Many companies have to import or exports goods to different countries all around the world. Payment for these goods and services may be made and received in different currencies. Many billions of dollars are exchanges daily to facilitate trade. The timing of those transactions can dramatically affect a company’s balance sheet.

THE MAN IN THE STREET

Although you may not think it, the man in the street also plays a part in toady’s FX world. Every time he goes on holiday overseas he normally need to purchase that country’s currency and again change it back into his own currency once he returns. Unwittingly he is in fact trading currencies.

He may also purchase goods and services whilst overseas and his credit card company has to convert those sales back into his base currency in order to charge him.