The Currency Cash Machine

FOREX, THE CURRENCY CASH MACHINE     

Foreign exchange currency trading, otherwise known as the forex market, offers an investment asset class that is completely different from stocks of futures and offers leverage and virtually unrestricted access 24 hours a day. Forex trades virtually around the clock, from when the Asian market opens on Sunday night until the U.S. markets close on Friday afternoon. One of the attractions from an individual trader’s perspective is that there is this constant access to make a trade.

Forex is the simultaneous buying of one currency and selling of another. In other words, currencies are always traded in pairs; in every transaction, a trader is long one currency and short the other. A position is expressed in terms of the first currency in the pair. For example, if you have purchased euro and sold U.S. dollars, it would be stated as a euro/dollar pair.

The foreign exchange market (forex, or FX) is the largest and most liquid financial market in the world, with a volume of over $1.5 trillion daily— more than three times the aggregate amount of the U.S. Equity and Treasury markets combined. This means that a trader can enter or exit the market at will in almost any market condition with minimal execution risk. The forex market is so vast and has so many participants that no single entity, not even a central bank, can control the market price for an extended period of time. Unlike other financial markets, the forex market has no physical location, no central exchange. It operates through an electronic network of banks, corporations, and individuals trading one currency for another. The lack of a physical exchange enables the forex market to operate on a 24-hour basis, spanning from one zone to another, across the major financial centers.

Margin and Leverage

The forex market allows traders to control massive amounts of leverage with minimal margin requirements; some firms offer as much as 100-to-1 leverage. For example, traders can control a $100,000 position with $1,000, or 1 percent. Obviously, leverage can be a powerful tool for currency traders. While it does contribute to the risk of a given position, leverage is necessary in the forex market because the average daily move of a major currency is about 1 percent, while a stock typically sees much more substantial moves.

Leverage can be seen as a free short-term credit allowance, just as it is in the futures markets, allowing traders to purchase an amount of currency exceeding that of their account balance. As a result, traders are exposed to an increased level of both risk and opportunity. Due to the nature of the leverage in the forex markets, positions are normally short-lived. For this reason, entry and exit points are crucial for success and must be based on various technical analysis tools. While fundamental analysis focuses on what should happen, technical analysis is based on what has or is happening at the current time.

Identifying the overall trend, whether it is short-term or long-term, is the most fundamental element of trading with technical analysis. A weekly or monthly chart should be used to identify a longer-term trend, while a daily or intraday chart must be used for examining the shorter-term trend. After determining the direction of the market, it is important to identify the time horizon of potential trades and to apply those strategies to the appropriate trend. Therefore, the techniques covered in this book are highly effective in trading the forex markets.

Technical analysis is the study of historical prices in an attempt to predict future price movements. There are two basic components on which technical analysis is based: prices and volume. By having the proper understanding of how these two components exploit the impact of supply and demand in the marketplace, with a stronger understanding of how indicators work, especially when combining candle charts and pivot analysis, you will soon discover a powerful trading method to incorporate in the forex market.

Long or Short

One of the advantages that the forex market has over equity markets is that there is no uptick rule, as exists in the stock market, if one wants to take advantage of a price decline. Short selling in forex is similar to that in the futures market. By definition, when a trader goes short, he is selling a currency with the expectation that the price will drop, allowing for a profitable offset. If the market moves against the trader’s position, he will be forced to buy back the contract at a higher price. The result is a loss on the trade. There is no limit to how high a currency can go, giving short sellers an unlimited loss scenario. Theoretically, a short seller is exposed to more risk than a trader with a long position; however, through the use of stop loss orders, traders can mitigate their risk regardless of long or short positions. It is imperative that traders are well-disciplined and execute previously planned trades, as opposed to spontaneous trading based on a “feeling that the price will decline.”

Benefits for Selling Short

There are obvious benefits to short selling. This aspect of the forex market allows traders to profit from declining markets. The ease of selling con-tracts before buying them first is in contrast to typical stock trading. Market prices have a tendency to drop faster than they rise, giving short sellers an opportunity to capitalize on this phenomenon. Similarly, prices will often rally gradually with increasing volume. As prices trend toward a peak, trading volume will typically taper off. This is a signal that many short sellers look for to initiate a trade. When a reversal does occur, there will typically be more momentum than there was with the corresponding up move. Volume will increase throughout the sell-off until the prices reach a point at which sellers begin to back off.

Famous Short Plays

There have been quite a few milestone memories from famous currency trades, with both short positions and long. For example, famed financier George Soros “broke” the Bank of England by winning an estimated $10 billion bet that the British pound would lose value! How about Daimler Chrysler, the parent company of Chrysler and Mercedes Benz—reportedly it made more money in the forex markets than it did selling cars! On the negative side, in early 2005, Warren Buffett announced the U.S. dollar was in trouble and stated he was heavily short the U.S. currency. That did not turn out well for him, as the dollar rallied for the most part during all of 2005. What turned the market around? There were many issues mainly political, geopolitical, and economic developments that influenced the dollar’s value. For starters, many U.S.-based multi conflomerate corporations were prompted to bring money back into the United States due to the Homeland Investment Act (HIA). The HIA is part of 2004 American Jobs Creation Act and was intended to encourage U.S.-based companies to bring money back home.

The window of opportunity afforded by the HIA prompted companies to increase the pace at which funds are repatriated to the United States. Since companies had only until the end of 2005, many analysts suspected that companies would rush to repatriate foreign profits by year’s end and that there would be a high dollar demand to convert foreign currencies. Don’t forget, during the middle of 2005, there were riots in France. That contributed to poor market sentiment toward the euro zone, thus giving ground for a flight to safety, and helped foreign investors switch to buying U.S. dollars. The tone was essentially dollar-positive and euro-negative, which is indicative of politics having a negative effect on the euro. Meanwhile, the broader market was also most likely influenced by the high profile move by Berkshire Hathaway, Inc.’s, Warren Buffett to cut back speculative positions against the U.S. dollar after losing big on it due to surprising dollar strength.

Mr. Buffett had bet that the dollar would continue losing ground, as it did in 2004, as he felt the massive U.S. current-account deficit would be dollar negative. But instead, monetary policy dictated otherwise as the Federal Reserve continued to raise interest rates. That was helping to drive demand as the interest rate differentials widened. In its third-quarter report in 2005, Berkshire Hathaway said it had cut its foreign-currency exposure to $16.5 billion, down from $21.5 billion in June 2005.

As you can see from the dollar Index weekly chart in Figure 1.34, on a year-to-year basis, the dollar did make an outstanding run. However, keep in mind that the dollar was at a high of 120.80 back in 2002; so depending on where Buffett was shorting the dollar, he could still be in a lucrative position. The focus of this story is how shifts in monetary and fiscal policies can and do dictate price swings in the market, as happened in 2005.

Forex trading is considered the juggernaut in the investment world, with more than 3.5 trillion in currency trading taking place per day, according to the Bank for International Settlements. There is more daily volume in the forex market than in all of the U.S. stock markets combined. There is no doubt that that is one reason why foreign currency has become so popular.

          Other reasons why forex attracts so many individual investors are that the market has liquidity and favorable trading applications, such as the ability to go long or short a position, and that it trends and trades well, based off technical analysis studies.

In the past, currency trading was accessible for speculators through the futures industry when the central marketplace in the banking arena was for the privileged few. This has all changed now, and the competition is fierce. The industry has expanded from what was an exclusive club of proprietary traders and banks to a location where any and all individual traders who want to participate have access in this 24-hour market from their home or office computers or laptops.

The forex markets offer traders free commissions, no exchange fees, on-line access, and plenty of liquidity. Unlike the futures products, the markets are standardized contract values, meaning a full-size position is 100,000 value across the board. The one main element that attracted investors is the commission-free trading. Plus, most forex firms require less capital to initiate a start-up account than a futures account does. In fact, investors can open accounts on their debit and/or credit cards, and the practice of accepting payments online through PayPal exists.

Some firms offer smaller-size flexi accounts, allowing traders to start applying their skills at technical analysis with as little as $500 and trading ultra mini-accounts with leverage. This feature of what is known as mini-accounts allows individual investors to adjust their positions by not having too big a contract value per position; they can add or scale into greater or lesser positions to adjust the level of leverage according to their account size. Smaller-size investors are not excluded from trading; they can participate with mini-contracts. What is great about this feature is that a new trader or an experienced trader who is testing a new system can trade the market with real money, rather than simply paper trading, and benefit from the actual experience of working out execution issues and, more important, of seeing how they handle the mental or emotional side of trading. Having real money on the line certainly helps teach people to learn about their emotional makeup. This is one great way to overcome the fear-and-greed syndrome that many traders seem to battle. Another excellent quality that forex mini-accounts have is that traders with low-equity accounts can afford to trade multiple positions without being exposed to excessive risks like full-sized positions for scaling out of positions in order to let a portion of the position ride a profitable position, while capturing profits on a partial exit. We will go over more on that style of trading later.

What Benefits Do Forex Firms Offer?

Besides offering leverage accounts, other benefits that most forex companies offer are free real-time news, charts, and quotes with state-of-the-art order-entry platforms; and some even have automated order-entry features such as one cancels the other and trailing stops. All of these tools and order-entry platforms come at no additional charge to the trader.

These features may sound too good to be true. With all the benefits that the forex market offers, most newcomers want to know what the catch is. There are some slight cost factors that relate to execution; you pay a premium or a higher spread to buy and a higher spread to sell. Also, most forex companies take the other side of your trade; you do not have direct access to the interbank market, as it is called. Since the forex market is decentralized, it is possible that five different companies are showing five different prices all at the same time within a few points (PIPs—percentage in points). Since most forex traders are short term in nature, meaning they are quick in-and-out players, day trading in the forex markets is beneficial for these traders due to the fact that there are no commissions; but the PIP spreads can and do add up. There lies the catch.

Buy and Sell the Spread

Forex prices, or quotes, include a “bid” and an “ask” similar to other financial products. The bid is the price at which a dealer is willing to buy and a trader can sell a currency; and the ask is the price at which a dealer is willing to sell and a trader can buy a currency. In forex trading, unlike futures or equities, you have to pay a percentage in price (PIP) spread on entering a trade. The PIP spread is the point difference between the bid and the asking price of the spot currency price. This can vary between two and four PIPs on a euro versus U.S. dollar spread. The spread varies on other currency pairs and is usually wider on more exotic cross markets, such as the Canadian dollar versus the Swiss franc.

If you want to hold a position for several days, a rollover process is necessary. In the spot forex market, all trades must be settled within two business days at the close of business at 5 p.m. (EST). The only fee involved here is the interest payment on the position of currency held. At times, depending on the position, a trader can receive an interest payment as well. This is where the term tomorrow/next (Tom/Next) applies. It refers to the simultaneous buying and selling of a currency for delivery the following day.

As with futures, forex markets are now regulated to an extent and come under the scrutiny of the self-imposed regulators, such as the National Futures Association after the CFTC Modernization Act passed in 2002; but since there is no centralized marketplace, many forex dealers can and do make their own markets, as discussed earlier.

Why Trade Spot Forex Markets?

Of all financial instruments traded, forex is believed by many professional traders and analysts to be one of the best-suited markets to trade based off technical analysis methods, for a number of reasons. First is its sheer size in trading volume: According to the Bank for International Settlements, average daily turnover in traditional foreign exchange markets amounted to $1.9 trillion in the cash exchange market and another $1.2 trillion per day in the over-the-counter (OTC) foreign exchange and interest rate derivatives market as of April 2005. Second, the rate of growth and the number of market participants in forex trading have grown some 2,000 percent over the past three decades, rising from barely $1 billion per day in 1974 to an estimated $2 trillion by 2005. Third, since the market does not have an official closing time, there is never a backlog or “pool” of client orders parked overnight that may cause a severe reaction to news stories hitting the market at the U.S. Bank opening. This generally reduces the chance for price gaps. Currencies tend to experience longer-lasting trending market conditions than other markets. These trends can last for months or even years, as most central banks do not switch interest rate policies every other day. This makes them ideal markets for trend trading and even breakout systems traders. This might explain why chart pattern analysis works so well in forex trading. With such widespread groups playing the game around the world, crowd behavior plays a large part in currency moves; and it is this crowd behavior that is the foundation for the myriad of technical analysis tools and techniques.

Due in part to its size, forex is less volatile than other markets. Lower volatility equals lower risk. For example, the S&P 500 Index trading range is between 4 percent and 5 percent daily, while the daily volatility range in the euro is around 1 percent.

Trading veterans know that markets are interdependent, with some markets more heavily influenced by certain markets than others. We covered some of these relationships looking at futures and certain stocks and how changes in interest rates can move equity markets as well as the currencies markets. We will learn in coming chapters how to detect hidden yet repeating patterns that occur between these related markets and how forex traders can profit from these patterns.

Which Is Bigger—Stocks or Forex?

Forex is by far the largest market in dollar volume, is less volatile, experiences longer and more accentuated price trends, and does not have trading commissions. Forex is the ideal market for the experienced trader who has paid his or her “trading tuition” in other markets. However, there are no free lunches. Traders must use all the trading tools at their disposal. The better these fundamental and technical tools, the greater is their chance for trading success. While inter-market and other relationships are often complex and difficult to apply effectively, with a little high-tech help, traders and investors can enjoy the benefits of using them without having to scrap their existing trading methods.

Forex versus Futures

The futures market through the International Monetary Market (IMM) of the Chicago Mercantile Exchange has many benefits as well. Some believe there are tighter spreads between the bid and the asking price, plus there is no interest charge or rollover fee every other day. In addition, the futures markets offer options for longer-term traders. There are transactions costs that apply per round turn; but if the brokerage commission exchange, regulatory, and transaction charges are less than the PIP spread in forex, an active speculator would be given a better cost advantage by using the futures markets instead of the forex spot markets.

Let’s compare a trade in forex to a trade with a similar-size contract value on the futures exchange, using the example of a euro futures contract on the CME, where it has a contract size of USD 125,000 worth of euros, where each PIP would be 12.50 in value. If the commissions and related fees are on a par with most discount brokerage firms, $20 is your transaction cost per round turn, that is, $10 to buy and $10 to sell out the position. Keep in mind that the contract value is 25 percent higher than a full- size forex position, too. If a day trader in forex does a $100,000 full-lot-size contract and pays three PIPS on every transaction for both the entry and the exit of each position, this trader would be charged $30 per round-turn transaction.

The futures arena also has other interesting features and products; one is the U.S. dollar Index® contract traded on the New York Board of Trade, as was shown in Figure 1.34. That index is computed using a trade- weighted geometric average of six currencies. It virtually trades around the clock—the trading hours are from 7 p.m. to 10 p.m., then from 3 a.m. to 8:05 A.M., and then from 8:05 a.m. to 3 p.m. Unlike the forex, there are daily limits on the price movement with 200 ticks above and below the prior day’s settlement, except during the last 30 minutes of any trading session, when no limit applies. Should the price reach the limit and remain within 100 ticks of the limit for 15 minutes, then new limits will be established 200 ticks above and below the previous price limit. Figure 1.35 shows a breakdown of the various currencies and their respective weights on the average. 

The top four include the euro, which is the heaviest weight at 57.6 percent, followed by the Japanese yen at 13.6 percent, then the British pound at 11.90 percent, and the Canadian dollar at 9.10 percent.