= JPY 1,000 / USDJPY spot (105.50) = USD 9.47
= JPY 1,000 / USDJPY spot (105.50) = USD 9.47
Calculating Profit and LossMany FOREX trading platforms offer their clients a variety of online utilitiesthat assist the investor in his or her trading calculations. The utility to computethe profit or loss on each trade should resemble what is shown in Figure 8.1.Because all profits are expressed in U.S. dollars, a key factor in the calculation of profit and loss is the currency pair and whether the USD is the base currency or the quote currency, or if the currency pair is a non-USD cross rate.Therefore, we will present several examples involving all cases.Remember that the first currency in a currency pair is called the base currency (determines the number of units traded) and the second is called thequote currency (determines the pip values of each price change).Scenario 1USD Is the Quote Currency (Profit)Currency pair. Select the corresponding currency pair from the dropdown list.The default is the EUR/USD pair.Position. Choose either “buy” or “sell.” The default is “buy.”
54
FIGURE 8.1
WHAT EVERY TRADER MUST KNOW
Online profit calculator.
Number of units. This is the individual number of units and not the number oflots or mini-lots. A full lot should be entered as “100000” and a mini-lot as“10000.”Entry price. This is the entry price regardless if the trade was a market order ora limit order. Include the decimal point.Exit price. This is the liquidation price regardless if the trade was manuallyexited or a limit order was triggered.Conversion rate. This entry is necessary to convert any profit or loss to U.S. dollars if the quote currency (the second one in the pair) is not USD. In this example, USD is the quote currency. Enter the single digit “1” since we already haveconversion parity. Other possibilities are explained later.Click the “Calculate” button as shown in Figure 8.2.In this example we bought a mini-lot (10,000 units) of the EUR/USDpair at 1.2563 and sold at 1.2588, netting a clear profit of 25 pips (price changetimes pip factor, or 0.0025 × 10,000). The price change is simply:Price Change = Exit Price − Entry Price
The Calculating Trader
FIGURE 8.2
55
A 25-pip profit in EUR/USD.
The pip factor is the number of pips in the monetary unit of quotecurrency. There are 10,000 pips in one U.S. dollar and, conversely a single pipequals $0.0001. The pip factor is therefore 10,000.Profit in Pips = Price Change × Pip FactorWhen the quote currency is the USD, profit or loss is calculated verysimply as:Profit in USD = Price Change × Units TradedIn our scenario, this equates to:$ 25.00 = 0.0025 × 10,000Many of you have just exclaimed “Wow! That was painlessly simple. Showme one more!”Scenario 2USD Is the Quote Currency (Loss) For those of you who exclaimed nothing orare staring blankly at this page, we will do it again, this time with the GBP/USDcurrency pair. See Figure 8.3.
56
FIGURE 8.3
WHAT EVERY TRADER MUST KNOW
A 20-pip loss in GBP/USD.
In this instance, we initiated a 30,000-unit short (sell) trade in theGBP/USD pair at 1.8863 and, sadly, it advanced against our hopes. We exitedat 1.8883, losing 20 pips. Since the quote currency (the second currency) isUSD, we know the conversion rate is 1. Thus using the profit formulaProfit in USD = Price Change × Units Tradedwe find that our profit is actually a loss:−$60.00 = −0.0020 × 30000If the above calculations are still causing some confusion, we recommendthat you take a break, then reread Chapter 4, “FOREX Terms.” As promisedbefore, these calculations only require the four simple arithmetic functions:addition, subtraction, multiplication, and division. No exponents, logs, or trigfunctions. But this information must be completely clear before proceeding.Keep in mind that it is your money at stake.Scenario 3USD Is the Base Currency (Profit) If the quote (second) currency is not theU.S. dollar, then profit or loss must be converted to U.S. dollars. For example, a
The Calculating Trader
FIGURE 8.4
57
A 35-pip profit in USD/JPY.
35-pip profit in the USD/JPY pair means that the 35 pips are expressed inJapanese yen (see Figure 8.4). Therefore, one extra step is required to convert yento dollars:Conversion Rate. If USD is the base currency of the currency pair being calculated, then divide the profit or loss by the exit price. This simply converts thepip profit expressed as yens to a profit expressed as dollars.Thus, when calculating currency pairs where the base (first) currency isthe U.S. dollar, the profit formula must be adjusted as follows:Profit in USD = Price Change × Units Traded / Exit Priceor, specifically:$33.09 = 0.35 × 10000 / 105.77Obviously, all U.S. brokers perform this simple conversion to U.S. dollarsbefore adding profits to your margin account.Scenario 4USD Is the Base Currency (Loss) This example is arithmetically identical tothe previous example, except that a small loss was incurred. We purchased 5,000
WHAT EVERY TRADER MUST KNOW
58
FIGURE 8.5
A 10-pip loss in USD/CAD.
units of the USD/CAD pair at 1.3152 and set a stop-loss limit order at 1.3142,which, unfortunately, was triggered (see Figure 8.5).Using the same adjusted profit formula as in the previous example,Profit in USD = Price Change × Units Traded / Exit Pricewe find:−$3.80 = −0.0010 × 5000 / 1.3142Note: Always keep your losses small.Scenario 5Non-USD Cross Rates (USD/Quote) Most experienced traders can mentallyperform the arithmetic in the above examples. It just takes practice. However, wemust now tackle cross rates, currency pairs where neither currency is the U.S. dollar. Obviously the profit in pips will be initially expressed in terms of the quote(second) currency of the cross rate pair. The solution is simple: Look up the current price of the currency pair containing USD and the quote currency of thecross rate pair, as shown in Figure 8.6.The Conversion Rate entry of 105.32 in Figure 8.6 is actually the currentprice of the USD/JPY pair. The adjusted profit formula for this cross rate trade is:
The Calculating Trader
FIGURE 8.6
59
A 40-pip profit in CHF/JPY.
Profit in USD = Price Change × Units Traded / Conversion Rateor$37.98 = 0.40 × 10000 / 105.43A pattern is developing here . . .Scenario 6Non-USD Cross Rates (Base/USD) In the previous example, the USD was thebase currency in the conversion pair (USD/JPY). In Figure 8.7 USD is the quotecurrency of the conversion pair (GBP/USD).The Conversion Rate entry in Figure 8.7 is the current price of theGBP/USD pair. The reversal of the role of the U.S. dollar in the conversion pair(GBP/USD) requires another change in the profit formula:Profit in USD = Price Change × Units Traded × Rateor$19.05 = 0.0018 × 20000 × 1.8902
WHAT EVERY TRADER MUST KNOW
60
FIGURE 8.7
An 18-pip profit in EUR/GBP.
Remember that when USD is the quote currency of the conversion pair, youmust multiply the rate. If USD is the base currency of the conversion pair, thendivide the rate. Give yourself an A+ if you understood the previous examples onthe first reading. You are destined for great things.You may have noticed there was no mention of transaction costs in thesix scenarios given. The broker always subtracts the transaction cost at the moment the trade is initiated; therefore transaction costs do not affect the abovecalculations.
Calculating Units AvailableBefore initiating a new trade, it is always advantageous to know the maximumnumber of units that you can safely trade without risking a margin call basedupon your current account balance. Most trading platforms provide an onlineutility that calculates this information, usually resembling what is shown inFigure 8.8.Enter the following data fields to calculate the maximum number of unitsto buy or sell:• Margin available. This is the amount in your margin account youwant to earmark for the current trade.
The Calculating Trader
FIGURE 8.8
61
Units available calculator.
• Margin percent. This is your broker’s margin percentage for leveragingtrades.• Currency pair. Select the corresponding currency pair. In this example,select EUR/USD.• Current price. Enter the current ask price in the currency pair.• Conversion rate. If the quote currency in the selected currency pair isUSD, then enter “1”.Click “Calculate.” (See Figure 8.9.)
FIGURE 8.9
15,944 units available.
WHAT EVERY TRADER MUST KNOW
62
FIGURE 8.10
500,000 units available.
You can safely trade 15,000 units of EUR/USD in this example. In thenext example (Figure 8.10), we calculate the units available for a currency pairin which the base currency is USD. Enter the first four fields as in the previousexample. Since USD is the base currency in the USD/JPY pair, we must enterthe current price as the conversion rate.The formula to calculate the maximum units that can be traded is:Units Available =100 × Margin Available × Rate / (Current Price × Margin Percent)If USD is the base currency, then this reduces to:Units Available = 100 × Margin Available / Margin PercentCross rates can be handled in the same fashion by simply manipulatingthe conversion rate. Note: Always decrease the unites available slightly to avoid amargin call. We recommend 10 percent.
Calculating Margin RequirementsBefore executing any trade, you should always have a rough idea of how muchof your account balance will be used as the margin requirement. Any trade
The Calculating Trader
63
whose margin requirement exceeds your existing account balance will not beexecuted. Trades whose margin requirements deplete nearly all the equity inyour account are very risky and may incur the dreaded margin call. The formulato calculate the margin requirement for a trade is very simple:Margin Requirement =Current Price × Units Traded × Margin Percent / 100Assume your broker mandates a 5percent margin percentage. You want tobuy a full lot (100,000 units) of the EUR/USD currency pair, which is tradingat 1.2538. Thus:$6,269.00 = 1.2538 × 100,000 × 5 / 100This trade requires $6,269.00 for margin. Proceed accordingly.
Calculating Transaction CostYour broker will always calculate the transaction cost because that cost is automatically subtracted from your account balance the instant you initiate a newtrade. Nonetheless, it is useful to know just how the broker computes this debit.See Figure 8.11.
FIGURE 8.11
Calculate transaction cost.
WHAT EVERY TRADER MUST KNOW
64
FIGURE 8.12
A 3-pip spread in EUR/USD.
Remember that the bid price is used when the trader initiates a new buy(long) trade and the ask price is used when the trader initiates a new sell (short)trade. When the USD is the quote currency in the currency pair, the conversionrate equals 1, as seen in Figure 8.12.The basic formulas for the transaction cost in this instance are:Spread = Ask Price − Bid PriceTransaction Cost = Spread × Units Traded$3.00 = (1.2569 − 1.2566) × 10,000Figure 8.13 shows an example in which we calculate the transaction costwhen the base currency is USD.In this case, the formula becomes:Spread = Ask Price − Bid PriceTransaction Cost = Spread × Units Traded / Ask Price$3.24 = (1.2359 − 1.2355) × 10,000 / 1.2359In our final example, we calculate the transaction cost in U.S. dollarsfor a non-USD cross rate. We need to look up the current price of the currency pair containing USD and the quote currency of the cross rate pair (seeFigure 8.14).
The Calculating Trader
FIGURE 8.13
A 4-pip spread in USD/CHF.
In this case of non-USD cross rates, the formula becomes:Transaction Cost = Spread × Units Traded / Conversion Rateor$5.69 = (85.52 − 85.46) × 10000 / 105.43
FIGURE 8.14
A 6-pip spread in CHF/JPY.
65
WHAT EVERY TRADER MUST KNOW
66
Calculating Account Summary BalanceIn this section, we make the following assumptions before walking you throughthe accounting system of your first trade:• You have read and thoroughly understand the FOREX trading termsdescribed in Chapter 4.• You have researched a half dozen or so reputable FOREX brokers andselected one that satisfies your financial needs and goals.• You have used the broker’s paper trading feature and/or the demo program that he or she provides and now feel comfortable with the screenlayout of the trading platform and its mouse/keyboard navigationsystem.• You have opened a new margin account, signed and returned the necessary application forms, and deposited 5,000 USD with the broker.You are now ready to make your first trade in the FOREX currency markets. The Account Summary section of your broker’s trading platform shouldlook similar to what is shown in Figure 8.15.Let us say that your new broker offers 20:1 leverage, which means that youmust “risk” five percent of the total value of any trade that you execute, long orshort. Assume that you have analyzed, both technically and fundamentally, several major currency pairs and feel that the USD/JPY pair is overpriced and itwill decline in the immediate future. You now execute a very conservative entryorder to sell 5,000 units of USD/JPY at a market price of 105.64. The transaction cost (the difference between the bid and the ask price) is three pips forthe USD/JPY pair.
FIGURE 8.15
Account summary before first trade.
The Calculating Trader
FIGURE 8.16
67
Account summary after market entry.
In Figure 8.16 we see that the Balance and the Realized P&L entries areunchanged. Unrealized P&L show a negative 1.42 USD. This is the round-turntransaction cost, which is subtracted the moment a new trade is executed. Eachpip in the USD/JPY trade is worth 0.4733 USD. Therefore:1 pip = .1/105.64 × 501 pip = 0.4733 USD3 pips = 1.4199 USDThe Margin Used entry shows 250.00 USD, calculated as follows:Margin Used = Total Cost of Trade × Margin Percentage250.00 = 5,000.00 × 5%The Margin Available entry has also changed:Margin Available = Balance − Margin Used4,750.00 = 5,000.00 − 250.00After ten minutes or so, we notice that your “feeling”—that the USD/JPYpair was oversold and would decline—has paid off. The USD/JPY has droppedto 105.51. Not only have you recouped the transaction cost (minus three pips)but you gained a plus 10 pips in profit, as shown in Figure 8.17.At this point, market activity slows down and the price direction startsmoving laterally. You decide that a plus 10 pips on your first trade is satisfactory
68
FIGURE 8.17
WHAT EVERY TRADER MUST KNOW
A 10-pip profit.
and you close the trade. Essentially, this means purchasing 5,000 units ofUSD/JPY to offset your previous sale. Once your trade liquidation is logged atthe broker’s firm, your new Account Summary should resemble what is shownin Figure 8.18.The example, of course, is merely an illustration. Your first trade may begreater or smaller than the example.
For Futures TradersFutures traders tend to think in dollars versus a commodity asset (silver, soybeans, pork bellies, etc.). The switch to corelational values—one currency againstanother—can be a bit trying at first. The trick is to practice calculating profit andloss for fictitious trades. Most broker dealing platforms provide such a calculator.
FIGURE 8.18
After liquidating first trade.
The Calculating Trader
69
In ReviewThe math in this chapter is not nearly as complex as it may appear at first. Infact we can reduce it all to the following cheat sheet:Price Change = Exit Price − Entry PriceLeverage = 100 / Margin PercentMargin Percent = 100 / LeverageProfit in Pips = Price Change × Pip FactorIf the Quote Currency in a trade = USD, thenProfit in USD = Price Change × Units TradedIf the Base Currency in a trade = USD, thenProfit in USD = Price Change × Units Traded / Exit PriceWhen the profit for non-USD cross rates is being calculated, the followingapplies:The conversion rate is the currency pair with the USDand the quote currency of the cross rate pair.If the quote currency of the conversion rate = USD, thenProfit in USD = Price Change × Units Traded / Conversion RateIf the base currency of the conversion rate = USD, thenProfit in USD = Price Change × Units Traded × Conversion RateYou can now calculate profit and loss during open positions.
3Part
How to Beatthe Market(Maybe)
9Chapter
Fundamental Analysis
t is commonly accepted that there are two major schools when formulating atrading strategy for any market, be it securities, futures, or currencies. Thesetwo disciplines are called fundamental analysis and technical analysis. Theformer is based on economic factors while the latter is concerned with priceactions. Of course, the trader may opt to include elements of both disciplineswhile honing his or her personal trading strategy.
I
Supply and DemandFundamental analysis is a study of the economy and is based on the assumptionthat the supply and demand for currencies is a result of economic processes thatcan be observed in practice and that can be predicted. Fundamental analysisstudies the relationship between the evolution of exchange rates and economicindicators, a relationship which it verifies and uses to make predictions.For currencies, a fundamental trading strategy consists of strategic assessments in which a certain currency is traded based on virtually any criteria excluding the price action. These criteria include, but are not limited to, the economiccondition of the country that the currency represents, monetary policy, and otherelements that are fundamental to economies.The focus of fundamental analysis lies in the economic, social, and politicalforces that drive supply and demand. There is no single set of beliefs that guidesfundamental analysis, yet most fundamental analysts look at various macro73
74
HOW TO BEAT THE MARKET (MAYBE)
economic indicators, such as economic growth rates, interest rates, inflation, andunemployment. Several theories prevail as to how currencies should be valued.Done alone, fundamental analysis can be stressful for traders who deal withcommodities, currencies, and other “margined” products. The reason for this isthat fundamental analysis often does not provide specific entry and exit points,and therefore it can be difficult for traders to control risk when utilizing leveragetechniques.Currency prices are a reflection of the balance between supply and demandfor currencies. Interest rates and the overall strength of the economy are the twoprimary factors that affect supply and demand. Economic indicators (for example, gross domestic product, foreign investment, and the trade balance) reflectthe overall health of an economy. Therefore, they are responsible for the underlying changes in supply and demand for a particular currency. A tremendousamount of data relating to these indicators is released at regular intervals, andsome of this data is significant. Data that is related to interest rates and international trade is analyzed very closely.
Interest RatesIf there is an uncertainty in the market in terms of interest rates, then any developments regarding interest rates can have a direct effect on the currency markets. Generally, when a country raises its interest rates, the country’s currencystrengthens in relation to other currencies as assets are shifted away from it togain a higher return elsewhere. Interest rates hikes, however, are usually notgood news for stock markets. This is due to the fact that many investors withdraw money from a country’s stock market when there is an increase in interestrates, causing the country’s currency to weaken. See Figure 9.1.Knowing which effect prevails can be tricky, but usually there is an agreement among practitioners in the field as to what the interest rate move will do.The producer price index, the consumer price index, and the gross domesticproduct have proven to be the indicators with the biggest impact. The timing ofinterest rate moves is usually known in advance. It is generally known that thesemoves take place after regular meetings of the BOE (Bank of England), FED(U.S. Federal Reserve), ECB (European Central Bank), BOJ (Bank of Japan),and other central banks.
Balance of TradeThe trade balance portrays the net difference (over a period of time) betweenthe imports and exports of a nation. When the value of imports becomes morethan that of exports, the trade balance shows a deficit (this is, for the most part,
Fundamental Analysis
FIGURE 9.1
75
U.S. interest rates.
considered unfavorable). For example, if Euros are sold for other domesticnational currencies, such as U.S. dollars, to pay for imports, the value of the currency will depreciate due to the flow of dollars outside the country. By contrast,if trade figures show an increase in exports, money will flow into the country andincrease the value of the currency. In some ways, however, a deficit is not necessarily a bad thing. A deficit is only negative if the deficit is greater than marketexpectations and therefore will trigger a negative price movement. See Table 9.1TABLE 9.1 U.S. Balance of Trade, 2003(in thousands of U.S. dollars)Country
Exports
Imports
Balance
China
28,418.5
152,379.1
−123,960.6
Japan
52,063.7
118,029.0
−65,965.3
Canada
169,768.8
224,165.3
−54,396.5
Mexico
97,457.3
138,073.5
−40,616.2
Germany
28,847.9
68,047.1
−39,199.2
Italy
10,569.9
25,436.6
−14,866.7
Taiwan
17,487.9
31,599.9
−14,112.0(continued on next page)
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HOW TO BEAT THE MARKET (MAYBE)
TABLE 9.1
(continued)
Country
Exports
Imports
Balance
Saudi Arabia
4,595.9
18,069.1
−13,473.2
South Korea
24,098.6
36,963.3
−12,864.7
France
17,068.2
29,221.2
−12,153.0
Thailand
5,841.8
15,180.8
−9,339.0
United Kingdom
33,895.7
42,666.9
−8,771.2
India
4,986.4
13,052.7
−8,066.3
Sweden
3,225.5
11,124.7
−7,899.2
Indonesia
2,520.1
9,520.0
−6,999.9
Russia
2,450.0
8,598.4
−6,148.4
Israel
6,878.4
12,770.3
−5,891.9
Norway
1,467.5
5,212.2
−3,744.7
Austria
1,792.6
4,489.3
−2,696.7
Denmark
1,548.3
3,718.5
−2,170.2
Philippines
7,992.1
10,061.0
−2,068.9
Switzerland
8,660.0
10,667.8
−2,007.8
Finland
1,713.8
3,597.9
−1,884.1
South Africa
2,821.3
4,637.6
−1,816.3
Hungary
934.1
2,699.2
−1,765.1
Portugal
863.0
1,967.3
−1,104.3
Turkey
2,904.3
3,788.0
−883.7
Kuwait
1,509.0
2,276.8
−767.8
Spain
5,935.3
6,708.1
−772.8
Czech Republic
672.3
1,394.4
−722.1
Poland
758.7
1,325.8
−567.1
Lichtenstein
15.9
261.9
−246.0
Iceland
242.2
283.0
−40.8
Albania
9.8
4.4
5.4
North Korea
7.9
0.1
7.8
Luxembourg
279.0
265.0
14.0
1,191.3
616.2
575.1
Singapore
16,575.8
15,158.0
1,417.8
Hong Kong
13,542.1
8,850.2
4,691.9
Belgium
15,217.9
10,140.6
5,077.3
Australia
13,103.8
6,413.9
6,689.9
Netherlands
20,703.0
10,971.8
9,731.2
Greece
Source: FTDWebMaster, Foreign Trade Division, U.S. Census Bureau, Washington, D.C.
Fundamental Analysis
77
Purchasing Power ParityPurchasing power parity (PPP) is a theory that states that exchange rates betweencurrencies are in equilibrium when their purchasing power is the same in eachof the two countries. This means that the exchange rate between two countriesshould equal the ratio of the two countries’ price level of a fixed basket of goodsand services. When a country’s domestic price level is increasing (i.e., a countryexperiences inflation), that country’s exchange rate must depreciate in order toreturn to PPP.The basis for PPP is the “law of one price.” In the absence of transportation and other transaction costs, competitive markets will equalize the price ofan identical good in two countries when the prices are expressed in the samecurrency. For example, a particular TV set that sells for 500 U.S. dollars (USD)in Seattle should cost 750 Canadian dollars (CAD) in Vancouver when theexchange rate between Canada and the United States is 1.50 USD/CAD. If theprice of the TV in Vancouver cost only 700 CAD, however, consumers inSeattle would prefer buying the TV set in Vancouver. If this process (called arbitrage) is carried out on a large scale, the American consumers buying Canadiangoods will bid up the value of the Canadian dollar, thus making Canadian goodsmore costly to them. This process continues until the goods again have the sameprice. There are three caveats with this law of one price: (1) As mentioned above,transportation costs, barriers to trade, and other transaction costs can be significant. (2) There must be competitive markets for the goods and services in bothcountries. (3) The law of one price only applies to tradeable goods; immobilegoods such as houses and many services that are local are, of course, not tradedbetween countries.Economists use two versions of purchasing power parity: absolute PPPand relative PPP. Absolute PPP was described in the previous paragraph; it refersto the equalization of price levels across countries. Put formally, the exchangerate between Canada and the United States ECAD/USD is equal to the pricelevel in Canada PCAN divided by the price level in the United States PUSA.Assume that the price level ratio PCAD/PUSD implies a PPP exchange rateof 1.3 CAD per 1 USD. If today’s exchange rate ECAD/USD is 1.5 CAD per 1USD, PPP theory implies that the CAD will appreciate (get stronger) againstthe USD, and the USD will in turn depreciate (get weaker) against the CAD.Relative PPP refers to rates of changes of price levels, that is, inflationrates. This proposition states that the rate of appreciation of a currency is equalto the difference in inflation rates between the foreign and the home country.For example, if Canada has an inflation rate of one percent and the UnitedStates has an inflation rate of three percent, the U.S. dollar will depreciateagainst the Canadian dollar by two percent per year. This proposition holds wellempirically, especially when the inflation differences are large.
78
FIGURE 9.2
HOW TO BEAT THE MARKET (MAYBE)
Purchasing power parity.
Source: Office for Economic Cooperation and Development
The simplest way to calculate purchasing power parity between two countries is to compare the price of a “standard” good that is, in fact, identical acrosscountries. Every year The Economist magazine publishes a light-hearted versionof PPP: Its “Hamburger Index” lists the price of a McDonald’s hamburger invarious countries around the world. More sophisticated versions of PPP look ata large number of goods and services. One of the key problems in computing acomprehensive PPP is that people in different countries consume very differentsets of goods and services, making it difficult to compare the purchasing powerbetween countries. See Figure 9.2.
Gross Dom