10.576% OF TOTAL2239.7181.41135.4
TotalT billsT bonds and notesSource: www.treas.gov/tic/mfh.txt.
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Economists are in agreement that the effect of foreign purchasers of U.S. Treasurysecurities is to lower interest rates. Without such purchases, U.S. rates might be nearly1 percent more. Here is how analysts at the U.S. Treasury Department portrayed risks tothe United States related to foreign ownership of U.S. Treasury securities:
r Treasury ownership by itself does not present a risk, but the “special” role of thedollar in private and official dealings has meant that:r The dollar has been stronger.r The trade balance has been weaker.r Econometric evidence suggests that recent heavy central bank buying has helpedkeep interest rates low.r If the dollar’s role were to fade, interest rates would be pushed up and the dollardown:r Central banks would diversify reserve currencies away from dollars.r U.S. investors would increase exposure to foreign securities.r A decline in the role of the dollar, were it to occur, would likely be gradual . . .r Central banks are very conservative by nature.r The institutional structure of global trade payment system would change gradually.r . . . and thus does not present a risk of a sharp or destabilizing financialmarket event (www.treas.gov/offices/domestic-finance/debt-management/adv-com/minutes/mm-2005-q1.pdf).In the long run, evidence exists that there is a trend toward diversification of foreignholders away from dollar assets. As other economies grow, the incentives to reallocatereserves away from U.S. dollar assets to more local assets will rise. Even rumors of suchdiversification lead to selling U.S. dollars in the market by traders who do not want torisk holding dollars. This has an effect of weakening support for the dollar.
ASSIGNMENTFind the Top 10 Holders of U.S. Treasury SecuritiesGo towww.treas.gov/tic/mfh.txt and answer these questions:
r Has there been a change in the trend of foreign holders of U.S. Treasury securities?r When is the next Treasury International Capital System report coming out?
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CHAPTER 9
Conducting Your OwnFundamental Analysis
he forex trader today is very lucky. The Internet provides unprecedented accessto information and data—perhaps too much information. A good technique to usethat provides an efficient way to pull information out of the World Wide Web isto use the search engines and input the right terms. For example, as the trader preparesto evaluate a currency to trade, he or she should also scan the latest news. Here is how todo it:
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1. Go to Google, click on the News link and then click on Sort by Date.2. Input search terms (U.S. dollar, Australian economy, etc.).
For example, if you input the term Australian interest rates, the results will quicklypoint to the latest article on it.Using Google or any other search engine effectively will depend on which terms areentered. The trader should enter a variety of terms to maximize the items retrieved. Hereare some useful terms to start with:U.S. dollarU.S. economyU.S. interest ratesBloomberg on U.S. DollarEuropean economyEuropean interest ratesGerman economy75
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German interest ratesBernankeTrichetZhou XiaochuanBank of ChinaFukuiAustralian interest ratesAustralian economyCanadian economyCanadian interest ratesGovernor DodgeBank of JapanThe idea is to search for the latest analysis while you are scanning the charts,which will help you gain an understanding of what forces are moving the charts whileyou trading.
DEVELOPING A FUNDAMENTAL OUTLOOKDeveloping a fundamental outlook is part of the evolution of a forex trader. When youfirst begin trading, the focus tends to be on technique and tactics because learning howto put on the trades and how to read the charts is the most important task at hand. But asa forex trader develops an understanding of the fundamentals, he or she will eventuallyask the following two questions:1. What currency pairs should I be trading?2. What direction is my next trade?
It is helpful to be able to group currencies by their fundamental personalities. Wecan see that some currencies are stronger than others and that some currencies are fundamentally at extremes; those groups become more interesting to trade. A fundamentalview leads to the understanding that the major causes of change in the relative value ofcurrencies are real or perceived changes in interest rates, inflation, or economic growthbetween their economies.The relationship between fundamentals and forex prices is not a direct relationship;rather, it is more akin to fuzzy logic or a chemistry of forex. Fundamentals remain in thebackground and provide important conditions conducive to a currency’s strengthening
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or weakening. By forming a fundamental view of currencies, the trader is able to get inline with the powerful economic forces that currencies ultimately reflect.To guide traders in conducting their own fundamental analysis, they need to havetheir own fundamental forex checklist and action plan. The purpose of the fundamentalforex checklist is to make sure you have the information to make some trade strategydecisions.Fundamental Forex Checklist and Action Plan1. Scan and list current global data on gross domestic product (GDP), interest rates,and inflation levels.2. Scan price patterns in commodities such as oil, gold, copper.3. Review the Trade-Weighted Index (TWI) of each currency to determine if any are
probing key support or resistance.4. Check the U.S. Dollar Index (USDX) at www.ino.com and compare it to the TWI of
the U.S. dollar.5. Scan global interest rates and try to group currencies by:a. Countries expected to raise ratesb. Countries expected to keep rates the samec. Countries expected to lower rates6. Choose which currency pairs to trade.7. Choose the preferred direction of your next trade. If you do not have a preferred
direction, that means you are choosing to trade in either direction.8. Watch the calendar for economic releases.
ASSIGNMENTPrepare your own Fundamental Outlook ReportTry to write a paragraph describing in your own words the fundamental outlook for a currency.Send it to learn4x@earthlink.net will be reviewed, and you will receive advice on how to improveit. Here is a sample:Fundamental Outlook Report on the Currency Pair (−−−−−−−−)The CURRENCY PAIR is in a strong position fundamentally because its economy is experiencinggrowth at a GDP rate of (−−−−−−−−) per year. Its inﬂation rate is now at (−−−−−−−−). The centralbank has indicated (1) a bias toward increasing interest rates; (2) a neutral stance on interestrates; (3) concern on slowdown of the economy. The Trade-Weighted Index has shown a trend(up) or (down).
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The biggest risk factor for this currency pair is:
1. Unexpected rise in inﬂation2. Further slowdown in housing3. Direction of oil prices, etc.In other words, put in your own words a summary of what’s going on with the fundamentalsaﬀecting the currency that you are looking to trade.
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P A R T II
Timing the Tradewith TechnicalAnalysis
he question in every trader’s mind is: Just when and where should I pull the trigger? Technical analysis supplies the tools for answering that question, but thereis no single answer. There is no single technical indicator that can be exclusivelyrelied on to produce winning outcomes, because the markets are too complex. No one,to date, has produced a consistently reliable technical trading system for any market,let alone forex. This is because technical indicators can never capture all of the variables that influence price movements. Financial mathematicians, known as “quants,” tryto come up with algorithms (equations) that improve predictive ability, and they get millions of dollars to try. They’ve tried every conceivable methodology, such as Fourieranalysis, wavelets, and neural networks, to try to gain even the smallest increment of predictive value. Yet none can replace the seasoned experienced trader. The reason shouldbe obvious—technical analysis provides a snapshot of market moves that have alreadyoccurred. The resulting snapshot is a picture that is always lagging and limited in resolution. In contrast, the smart trader has evolved a successful mixture of analytical toolsthat sense repeatable patterns in the market.
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Yet technical analysis is not without its value. Technical analysis of chart movements, when used correctly, can improve trading, not by predicting but by providinga “map” revealing important aspects of what the price has been doing and how it gotthere. Technical analysis can help sort out the “noise” of price movements and revealpatterns that can be traded with a high probability of success. The forex trader’s mainchallenge is to use technical analysis of charts to achieve actionable “knowledge” ofmarket conditions.Whatever analysis techniques are used, the single most important question that theforex trader has to ask and answer is: Where is my next trade? By asking this question,the trader prioritizes information and analysis and separates what is useful from whatis not. For example, the forex industry is filled with a great deal of information flow.We might even call it information overload. Traders have numerous chat rooms to visit;there are a number of news feeds pushing the latest headlines to the trader. Blogs haveadded to the noise as well. Every forex firm seeks to gain a competitive edge by providingthe latest “analysis” of market conditions. The challenge is to pull the information thathelps shape your next trade. How to shape your next trade is the goal of Part II ofthis book.Becoming a forex trader is not an instant process—it’s an evolution. Beginners toforex do not even know what they need to know. Trades are put on without a plan, andbeginning trades are really trial-and-error experiments. Winning trades occur but don’tseem repeatable. The beginning forex trader experiences the market but doesn’t leveragehis knowledge. At this early stage, the exposure to quick and large losses usually wipesout the trader within the first month of trading.The second stage of the evolution of a forex trader is the discovery of indicators andtechnical analysis. At this stage, the trader tends to use too many indicators. The tradingresults are not much better, but this stage is characterized by hunting trades. The traderovertrades due to a desire to put on trades as often as possible.The final stage in the evolution of a forex trader occurs when the trader has sharpened his tools and has acquired an ability to let the market come to him. This is achievedwhen knowledge and experience combine. While the biblical adage that there is no wisdom without pain still rings true, much of the pain that new traders experience in unnecessary losses can be avoided. The best traders in the world lose perhaps 40 percent ofthe time but are still able to become profitable.How does one evolve to his or her level of maximum forex competence? While everyone cannot become a master trader, everyone has the capability of raising their levelof competence. Competence is the ability to apply forex knowledge with consistentlyprofitable results. Therefore, the purpose of technical analysis is to help the trader shapea trade that offers a high probable profit within acceptable levels of risk. The processof becoming competent in forex trading started with understanding what forces moveforex prices. It continues with understanding how to map the market. Let’s start.
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C H A P T E R 10
Mapping Price ActionFinding the Geometry of the Market
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he purpose of this chatper is to explain the first steps in conducting technical analysis of forex prices. These steps involve finding support and resistance, trend lines,and assessing where the price is in relationship to these geometric points.
PROJECTING HORIZONTAL SUPPORT ANDRESISTANCE POINTSWhere is the currency pair price and what is it doing? This question is quite basic butit involves many levels of analysis. Understanding the location of the currency pair is afoundational beginning of technical analysis and will reveal a great deal of informationthat a trader can use in formulating trading strategy.But how do we know where to look? The basic technical measurement of horizontalsupport and resistance provides the ground floor of technical analysis. Whenever youlook at a currency pair, you have to ask where support is and where resistance is. Theanswers provide the first mapping of the market.Support is where the price stops falling, and resistance is where it stops rising. Theprocess for locating support and resistance is fairly straightforward. Figure 10.1 includesseveral support and resistance lines. Those lines that form floors and ceilings are outersupport and resistance containing the price action within a range. Those lines that areinside these larger lines are inner support and resistance.What is most significant about horizontal support and resistance lines is that they arenot lagging. In contrast to indicators, they are projections and form psychological hurdle81
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FIGURE 10.1 Horizontal Support and Resistance Lines for Monthly EURUSD.Source: www.tradesignal.com.
zones. When price establishes support or resistance, the market recognizes that locationas a zone or hurdle that has to be overcome. The immediate future price movementsneed to probe and penetrate a support or resistance line. One of the first principles oftrading forex is to locate a trade near support or resistance.Once we know where horizontal support and resistance are, we need to also determine the strength of that support and resistance. There are different ways of forming anopinion about the level of strength in the S/R lines. In Figure 10.1, we can see that the1.2500 level offers strong support because over six months that price point was unableto be broken down and the euro–U.S. dollar (EURUSD) held above it. In contrast, theresistance levels show only one test of the previous high. The trader can conclude thatthere is greater strength on the support side at 1.25. If the price moved toward the previous high (1.3367 on December 31) and failed to go through it, confidence that resistancewas stronger at that level would increase. The time interval on a chart also can be usedto weight one’s confidence about how strong the S/R levels are. The longer time frames
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FIGURE 10.2 Price Is Probing Support and Resistance.Source: www.tradesignal.com.
such as monthly and weekly resistance and support are more robust. After all, a greatdeal of money has had the chance to go through those levels but did not.In constructing support and resistance lines, the trader needs to realize that there isa degree of judgment. In Figure 10.2, the support and resistance lines are drawn wherethere appears to be a set of highs and lows. Some of the candlewicks are penetrating thelines. Those penetrations would be viewed as creating temporary levels of new supportand resistance, with the stronger levels being those connecting more points. Drawingsupport and resistance lines need to be done with the perspective that these are zonesand not exact lines.
TREND LINESThe trend is your friend—until it is at an end.After finding the geometry of support and resistance, we come to the most classical toolused by chartists—trend lines. Trend lines provide a projection of support and resistancethat links past behavior into the future. A trend line is used to map whether there is
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consistency in highs and lows. While simple in its construction, knowing the trend is abasic foundation for trading forex. Once a trend is identified, detecting a potential changein the trend becomes a focus for the trader because trading at the break of a trend or thefailure to break a trend line is a high probable point of success. Figure 10.3 shows adowntrend in place and the price twice coming to the trend line, and then failing to stayabove. Although the price actually created a high above it (where the arrow points), itfailed to follow with another candle at that high point. Thereafter, the return of the priceunder the trend line and the resumption of the downtrend would be recognized by anexperienced trader as a sell condition.The main benefit of trading with a trend is one of probabilities. An upward trendpresents a greater number of buying opportunities to the trader. It doesn’t mean thereare no good selling or contratrend opportunities. We can see in the charts that therewere countertrend moves, but much fewer than trend-aligned moves. A prudent traderwill seek opportunities that provide a higher probability of success. Trading with a trend
FIGURE 10.3 Price Tests Trends and Fails.Source: www.tradesignal.com.
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meets this condition. The question arises: Which trend should the trader align himselfwith—the week trend, day trend, 4-hour trend, and so on?Each choice has advantages and disadvantages. The basic trade-off is the increasein price volatility and range when a larger trend time frame is selected. Trading in thedirection of the weekly trend means that a trader will see periods of time and maybedays when the price is moving the other way, threatening losses. But in this case, ifthe day trends are also moving in the same direction as the weekly trends, it representsmore confidence that the trend is stable. For intraday traders trading off a 15-minutechart, when the 15-minute trend direction is aligned with the 4-hour trend direction andalso confirmed by the 5-minute trend direction, there is a high level of robustness tothe trend. The concept of three time zones confirming trading decisions will apply inmany areas.
CONFIRMING AND DETECTING TREND CHANGES:THREE-LINE BREAK CHARTSThree-line break charts are useful for detecting and confirming trend changes. Threeline break charts are increasingly available to retail traders through their forex firmsand through charting companies. They are worth using because there is little ambiguity whether a trend is in place and also at what point it would be considered reversed.Therefore, three-line break charts provide the ability to confirm trend direction in anytime interval and project where the trend would be considered reversed! Three-line breakcharts are excellent charting tools to help answer the question: In which direction shoulda trade be taken, and where should I enter the trade?Let’s explore this chart tool and how it shows trend strength, trend stability, andtrend direction. The chart looks like a candlestick chart, but it is not. Each block represents the completion of a new high or new low. The chart therefore shows only consecutive highs or consecutive lows. This provides a snapshot of the sentiment. What thetrader is looking for is the predominant direction of the sentiment, whether the sentimentis weakening, and (most importantly) whether it has reversed.In the example in Figure 10.4, there are 10 blocks (or lines) down and then a reversal.At the point where the reversal block went past the previous three down blocks, we geta reversal signal. The trader can look to buy at that point since the market showed theability to reverse the sentiment. This is why it is called three-line reversal. Similarly, moveto the right of the chart and we can see that after 17 consecutive new highs, there wasa reversal down. If the trader is looking to confirm a decision to buy or sell, then thethree-line break pattern is used to support that decision. If there is an intention to buy,then the three-line break blocks should, at a minimum, show that the market is in a buy
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FIGURE 10.4 Three-Line Break Reversal Points.Source: www.tradesignal.com.
trend by showing that it is producing consecutive closes of newer highs. The timing of theentry may be based on other setups, but it is even better if the entry to buy occurred onthe three-line break reversal from a previous series of down sequences. The decision tosell a currency pair would be confirmed by having the three-line blocks showing a downsequence, and preferably the entry would occur upon the reversal. The trader has thechallenge to select the right time frame for the three-line break charts. Using a day chartconverted to three-line break chart will show consecutive day closes of highs or lows.This does not mean that there will not be intraday reversals of important magnitude. Itwon’t show up. As the trader selects shorter time frames, such as the 4-hour, 30-minute,and 5-minute three-line break charts, the trader will recognize the strength of the trendsentiment from a multiple time perspective.The first important use of three-line break charts is to decide to trade with the threeline break direction. But it can be with the day, 4-hour, 30-minute, or 5-minute directions.If they are all aligned, it is the best of all worlds. Using the 5-minute three-line breakcharts provides a short time frame but still enables the trader to detect trend directionand reversals that lead to magnitudes of 20 and more pip moves that can be captured.Take a look at the U.S. dollar–Japanese yen (USDJPY) 30-minute three-line breakchart right before and after the February 27 sell-off that affected the world’s equity andcurrency markets. We can see that by using three-line break charts, the trader would havehad a first reversal at 121.4 for a sell signal. Then the pair proceeded to close 16 new30-minute lows consecutively before it reversed up briefly; a new reversal at 120.4 occurred, followed by 18 new lows; and then it reversed back to 118.2. The dramatic fall ofthe USDJPY is seen by the three-line charts as very strong, with long sequences of sellingcreating new lows consistently (Figure 10.5). There were very few buying opportunities.An alert trader would be to use the three-line chart to join the sentiment ride down, butwould know when to get out (when it reversed up) and when to get in again (when it
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FIGURE 10.5 USDJPY Three-Line Break Reversals on February 27.Source: www.tradesignal.com.
reversed back down). One of the biggest mistakes traders make is to be caught on thewrong side of the market. Three-line break charts reduce this kind of error by definingthe trend in an unambiguous way. Trading with the trend can be rephrased as tradingwith the three-line break trend.Using what you have just learned, take a look at a chart of the New Zealand dollarU.S. dollar (NZDUSD) (Figure 10.6). It is a day chart with a three-line break in it. We cansee this pair had very nice alternative sequences of up and down trends. The trader who
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FIGURE 10.6 NZDUSD Day Chart with Three-Line Break.Source: www.tradesignal.com.
wants to buy would see that the pair is in a downtrend and that the NZDUSD has justreversed an uptrend. The trader would want to wait for a reversal again at point B.
SPOTTING MICRO CHANGES IN TREND SENTIMENT:RENKO CHARTSFinding the trend direction and points where the trend would be considered being reversed is valuable for entering trades, but one of the largest challenges facing the forextrader is to know when sentiment has changed and turned against the trader and then getout of the way. When it comes to detecting the earliest form of change in trend direction,the trader should consider renko charts. Renko means brick in Japanese and provides a
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way of smoothing out the noise of the market. A renko chart provides an ability to represent a predefined move in the price. While each candlestick or bar provides the low,high, open, and close of a sample period, renko charts provide an additional renko blockonly if the price has moved and closed at the predetermined setting. In other words, ifthe trader wants to know only if there is persistence in the sentiment, seeing consecutive renko blocks would confirm that the market is showing the ability to push furtherbrick by brick. This is very useful, and we will show you how to use renko blocks incombination with other indicators to enable precision exiting.Figure 10.7 compares renko visualization of price action and with the standard candlestick variation. Each renko block is set here at one pip move. This means that if theprice closes one pip higher or lower, a new block is added. The time interval is oneminute. The trader can choose any time frame and setting appropriate to his or her goals.However, the value of renko blocks is mostly at the smallest setting generating information to the trader about the patterns in the sentiment that are difficult to detect with othercharts.
FIGURE 10.7 Bear and Bull Sentiment Patterns In 1-Minute Renko Charts.Source: www.tradesignal.com.
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In effect, we can see that the currency pair exhibits varying degrees of patterns ofsentiment. The ability to generate a consecutive series of new up blocks or new downblocks reveals clearly whether a strong micro trend is in place. At points A and B, wesee a reversal of the pattern. There will always be some reversals. In this case, one ortwo renko blocks should not be perceived as the end of the previous pattern. In mostrecent series of blocks, at the right end we see a downtrend. The trader seeing this chartwho was already in a sell position would interpret this last formation as permission tocontinue to stay in that position. We will demonstrate how to use renko in combinationwith several setups and strategies later on.By mapping the price action along key support and resistance lines and finding trendlines, the trader creates a foundation for shaping the trade. We can see that one cango even further by examining intraday, intrahour, and even micro-trend directions usingthree-line break and renko charts to show patterns of bull or bear bias. The key advantageof using three-line break or renko charts is to reveal whether the sentiment of the markethas changed either at the large time frames or the smallest time frames. It is a tool worthexploring.
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C H A P T E R 11
Finding SignificantSupport andResistance
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his chapter provides a guide to detecting when support and resistance levels areexhibiting Fibonacci characteristics and their importance. Resistance and supportat pivot points are also explored.
FIBONACCI LEVELS OF SUPPORT AND RESISTANCEBeyond basic geometric measures of support and resistance, there are hidden factors involving psychological forces and patterns in the market that enable the trader to projectfuture levels of support and resistance. Most famous among these forces are Fibonaccilevels.Fibonacci ratios are mathematical patterns of sequences that are expressed in manyways. There are innumerable references to the universality of Fibonacci numbers—aquick Google search reveals over 1,230,000 citations. The Fibonacci sequence describeskey ratios from growth in plants, human anatomy, and so on. The forex application is toprice movements, which appears to realize Fibonacci ratios. This is particularly obviouson larger time frames such as weekly, daily, and 4-hour time charts. A large move froma low to a high is often followed by an attempt of the price to move back or “retrace”the original move. The profit taking will cause the price to give back a proportion of themove and then rest at support or resistance. These areas of rest are Fibonacci points. Forexample, let’s look at a chart showing a price move on the euro–U.S. dollar (EURUSD)weekly chart (see Figure 11.1).
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FIGURE 11.1 EURUSD Weekly Chart with Fibonacci Patterns.Source: www.tradesignal.com.
We can see that the EURUSD made a low at 1.2478 and then proceeded to form a highat 1.3374. Once this move was completed, the trader can use a Fibonacci (Fib) graphictool, which is available on all platforms to draw a Fib line. Since the price started fromthe low, the Fib tool assigns the 100 percent level to this origin point. The best way tointerpret this is to think of the price going all the way back home to where it started.It would achieve a 100 percent retracement. Once the low and the high are connected,the Fib graphic tool draws the lines and projects it out. Notice that these Fib lines