ely, when an oscillator readingis below a certain oversold threshold during a trading range, it hintsthat downward momentum may soon be exhausted, and that animpending upward turn may occur.As will be seen in Chapter 5, oscillators also excel at providingdivergence signals, among other functions. Divergence can provideimportant clues as to the possible direction of future momentum.The Moving Average Convergence Divergence (MACD) isamong the most popular indicators/oscillators ever invented. Manytraders use MACD as their sole confirming oscillator. Some traders
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Indicators of Change
EXHIBIT 3.20
MACD
Source: FX Solutions -– FX AccuCharts
also take trading signals exclusively from MACD. This multifacetedindicator acts as a sign of trend momentum by representing the relationship between two moving averages. MACD can be traded by taking signals from crossovers of the two lines, crosses above and belowthe zero line, and price-oscillator divergence, among other uses. SeeExhibit 3.20.Relative Strength Index (RSI) is another popular oscillator thatprovides a measure of price momentum. RSI is a classic oscillatorthat excels at giving overbought and oversold signals in rangingmarkets. Its usefulness, like most other oscillators, tends to diminish considerably during trending markets. RSI may also be used for
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divergence purposes. One of its primary usages is as a trade confirmation tool that identifies overbought/oversold markets. The mathematical formula for RSI compares the magnitude of a currencypair’s recent gains to the magnitude of its recent losses.The Stochastics oscillators come in several different flavors—fast,slow, and full. Whichever variety is chosen, the purpose is similar toother oscillators—identify overbought/oversold and provide divergence signals. The mathematical formula for Stochastics comparesthe currency pair’s closing price to its price range over a set periodof time. Because Stochastics has two lines as opposed to RSI’s oneline, Stochastics can give off an additional signal that results whenthe %K line crosses the %D line. Slow Stochastics is a smoothed version of Fast Stochastics.Rate of Change (ROC) is a very simple and classic oscillatorthat provides a basic momentum measure. The mathematical calculation for this oscillator measures the percent change from the pricea given number of periods ago to the current price. Besides showingdivergence and overbought/oversold, ROC can also provide signalswhen the oscillator goes above and below the zero line.The Commodity Channel Index (CCI) is an important butmisnamed oscillator. Just as comfortable in the equities and foreign exchange worlds as it is in the futures/commodities arena,CCI has proven itself to be a popular oscillator for currency trading. Originally intended to identify cycles in the commodities markets, CCI has grown to become a highly valued tool in foreignexchange trading. Although CCI adherents have invented many different methods of analyzing this oscillator, its popular usage remainssimilar to the other oscillators—to identify divergences, as well as
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Po i n t i n g t h e Way w i t h P i v o t Po i n t s
to point out overbought/oversold areas in the attempts to forecastprice reversals at extremes.The indicators and oscillators described in this section makeup just a fraction of the technical studies available on most chartingplatforms. Some of these platforms offer hundreds of different studies. But the ones just mentioned comprise some of the most essential and useful indicators/oscillators available, and therefore merit themost extensive consideration.
P ointing the Way with Pivot PointsThe pivot point method of trading has made its way to the foreignexchange markets from its use in futures and equities trading. Pivotpoints are support and resistance levels derived mathematically fromthe previous day’s key data points. To calculate the main pivot point,for example, a trader would take the average of the previous day’shigh, low, and close. Then, four additional pivot points (named S1,S2, R1, and R2, where S=Support and R=Resistance) are calculatedbased on the central pivot point. Traders often add even more pivotpoints beyond the basic four plus the central pivot, but these are considered the most common and essential levels. See Exhibit 3.21.The idea behind pivot points is that they can act as key support and resistance levels, where price may turn as in a retracementor correction. Many analysts believe that like some other technical tools, pivot points are a self-fulfilling prophecy. In other words,they work only because enough traders believe in them and tradeoff of them that there is bound to be some significant price activity at those levels. This self-fulfilling prophecy concept can also be
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EXHIBIT 3.21
Pivot Points
Source: FX Solutions – FX AccuCharts
extended to trendlines, horizontal support/resistance lines, Fibonacciretracements, and other technical tools. The basics of trading withpivot points will be touched upon in Chapter 5.
F ibonacci ’s Magic NumbersThere is a long and interesting story behind Fibonacci numbersthat is beyond the scope of this book. It should suffice to say thatLeonardo Fibonacci was a 13th century Italian mathematician whocalculated a sequence of numbers that ultimately led to the discovery of the golden ratio—1.618. This ratio, and its inverse of 0.618,
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Fibonacci's Magic Numbers
EXHIBIT 3.22
Fibonacci Retracements
Source: FX Solutions – FX AccuCharts
are purported to occur throughout science, nature, and art. Even asnail’s shell is said to follow the laws of the golden ratio.Because of the seemingly universal significance of this ratio,traders long ago began applying it to trading the financial markets.Today, technical analysts have many tools that are derived from theGolden Ratio and Fibonacci’s work. The most important and popular of these is the Fibonacci Retracement tool. See Exhibit 3.22.Drawn on a chart from a low price extreme to a high one, or viceversa, Fibonacci retracements help outline key support and resistancelevels on retracements from the primary price move. For example, itshould be expected that within an uptrend, price will retrace at some
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point. When it does, Fibonacci theory suggests that price will likelyretrace a magnitude of 38.2%, 50%, or 61.8% of the original move.These are the most significant levels according to Fibonacci tradingtheory. Other important retracement levels include 23.6%, 76.4%, and100%. Knowing where all of these levels occur on a given price chartcan be instrumental in finding out where traders may be paying particular attention. As such, Fibonacci levels can be considered, to someextent, a self-fulfilling prophecy much like the pivot points.The various Fibonacci tools, especially retracements, are extremelypopular with foreign exchange traders. More information on howtraders use Fibonacci principles to trade currencies will be touchedupon in Chapter 5.
R iding the Elliott WaveRelated to Fibonacci methodology, Elliott Wave Theory is namedafter Ralph Nelson Elliott, who asserted that price movement ispredictable and can be classified into a series of identifiable waves.The basic wave structure is a series of five waves comprising theprimary trend movement with three waves comprising the corrective movement. Several rules and guidelines accompany this basicstructure that makes Elliott Wave Theory a complete philosophy oftrading. See Exhibit 3.23.This trading philosophy is immensely popular with countless global adherents. Included among these adherents are some of the mostcompetent traders and analysts in the world. Although some detractors may deem Elliott Wave analysis as too subjective to be consistently effective, the fact that scores of successful traders have long
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Getting to the Point & Figure
EXHIBIT 3.23
Elliott WaveElliott Wave TheoryA54
B
C
321
abided by the tenets of this theory makes this a trading methodologythat should not be ignored by foreign exchange traders. The ElliottWave trading methodology will be described further in Chapter 5.
G etting to the Point & FigurePoint & figure (p&f ) charting is an older, but still popular, form oftechnical analysis that constitutes an entire trading methodologyunto itself. Some may characterize p&f charting as trading basedupon pure price action. This is because only price, which is undeniably the most important aspect of technical analysis, is customarilyincluded on this type of chart (in the form of Xs and Os). Otherdata that can readily be found on bar and candlestick charts, liketime and period opens/closes, are generally excluded on p&f charts.This leaves only the uncluttered purity of price action. See Exhibit3.24 for a typical forex point & figure chart.The primary advantage of using p&f charting methodology overother types of charts (like bars and candlesticks) lies in the clearer
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EXHIBIT 3.24
Point & Figure Chart
Source: FX Solutions – FX AccuCharts
and more simplified representation of trend, support/resistance, andbreakouts. Generally, much of the up-and-down price “noise” that isso common in the foreign exchange markets is filtered out by p&fcharts, leaving just the clarity of trend movement and direction. Aswill be described in Chapter 5, point & figure charting consists primarily of watching for price level breakouts.
C hapter Summar yMost foreign exchange traders use at least some form of technical analysis in their currency trading.The many tools of technical analysis beginwith the basic chart, of which there are a couple of primary types.
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Chapter Summary
Bar charts and candlestick charts are, by far, the most prevalent typesof charts. From there, we move onto charting timeframes, of whichthere are many. Extremely short-term traders may use minute charts(where each bar/candlestick is worth a minute of price action), whilelonger-term traders may use hourly, daily, or weekly charts, among amyriad of other timeframes.The real essentials of technical analysis lie partly in the twinphenomena of support and resistance, where price seems to beattracted to and repelled by these oft-visited levels. These levels areusually denoted with horizontal lines across the chart. Going a stepfurther, trend lines and trend channels are sloped lines that point outdynamic support and resistance with respect to a directional trend.Moving averages also excel at outlining the general trend, as well asshowing dynamic support and resistance levels.Patterns are very common on currency charts. There are severaldifferent types of patterns that are prevalent. Japanese candlestickpatterns that consist of single or multiple candles are, by definition,found only on candlestick charts. These include dojis, hammers,engulfing patterns, and so on. Larger, Western-style patterns liketriangles, head-and-shoulders, flags, and pennants can be found onboth bar and candlestick charts. All of these patterns paint a revealing picture to the experienced technical analyst.Chart indicators also reveal information to technical traders. Thisinformation is primarily in the form of momentum readings andoverbought/oversold levels. Mostly used to confirm trading signalsfrom other technical analysis tools, indicators and oscillators are usually either overlaid right on top of the price bars/candlesticks, orseparated in an area vertically above or below price.
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Some other specialized technical analysis methods have alsogained many adherents in the trading world. Often, comprehensive trading strategies have evolved around these techniques. Theseinclude pivot points, Fibonacci, and Elliott Wave, among others.Entire books can and have been written about each of these topics. It is in the best interests of every well-rounded foreign exchangetrader to have at least a passing familiarity with these useful analytical methods.Finally, although point & figure charts will perhaps never be ableto surpass the widespread use of bar and candlestick charts, all serious technical analysts should be familiar with this granddaddy ofcharting types. Analysis on point & figure charts is significantly different from analysis performed on bar or candlestick charts. But theunique insights provided by point & figure charts, especially withrespect to trend, support/resistance, and breakouts, can be extremelyvaluable to technical traders in the foreign exchange markets.
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CHAPTER 4
FundamentalAnalysis—WhatDrives the ForeignExchange MarketsAfter reading this chapter, you will beable to:●
Recognize what really makes the foreign exchangemarkets move, and how best to take advantage of thisknowledge.
●
Appreciate how interest rates, inflation, economicgrowth, and other fundamental factors contribute tocurrency valuation.
●
Identify the economic indicators that are essential for successful foreign exchange traders to know and understand.
●
Apply the fundamental concepts of carry trading andnews trading to your own market strategies.
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Fundamental Analysis
I ntroduction to Fundamental Analysis — BasicEconomicsLike technical analysis, fundamental analysis is another major aspect offinancial analysis used for trading the foreign exchange markets.Whereastechnical analysis is concerned primarily with interpreting price action,fundamental analysis concentrates on such topics as economic data, government policy, sociopolitical conditions, global news, and the businesscycle. These topics include an array of different variables, most notableof which include macroeconomic factors like interest rates, inflation,central bank policy, economic growth, housing, employment, industrialand commercial production, and the list goes on and on.Whereas technical analysis excels at providing logical trade entriesand exits, fundamental analysis can provide a framework for formulating a longer-term opinion on the global currency markets. Becauseof this, with the notable exception of news trading and carry trading(which will both be discussed later in this chapter and in Chapter 5),there is a lack of practical and concrete trading methodologies forretail forex traders that utilize fundamental analysis exclusively. Inother words, an individual foreign exchange trader could certainlytry to place trades based solely on a fundamental understandingof economic and political factors. But in doing so, the placement oftrade entries and exits could be considered essentially an arbitrary actwithout the precise entry/exit methods of technical analysis.That being said, however, fundamental analysis is an extremelyvital and indispensable aspect of successful foreign exchange trading.Fundamental factors, or the market’s perceptions of these factors, areessentially what make the currency markets move.
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A Healthy Interest in Global Bank Rates
Technicals without the fundamentals makes for just as incomplete a trader as fundamentals alone. These two aspects of foreignexchange market analysis complement each other extremely well,and are two of the key ingredients to approaching foreign exchangetrading in an intelligent, well-rounded manner. Even those technicalpurists who refuse to heed fundamental information, insisting thatall of this information is already reflected in the price charts, wouldbe well served to pay attention at least to how central bank policy,economic data announcements, and major sociopolitical events mayaffect price.While all of these concepts are integral elements of the fundamental approach, the main crux of fundamental analysis clearly liesin the framework of basic economics. Currencies appreciate anddepreciate in value because of simple economic supply and demandfactors. If there is a progressively higher demand for and/or lowersupply of a certain country’s currency, its value should increase.Conversely, if there is a progressively lower demand for and/orhigher supply of a currency, its value should decrease. It is the foreign exchange speculator’s job to determine in which direction theshifting of supply and demand is most likely to occur.There are many factors that can contribute to this shifting ofsupply/demand for the world’s currencies. One of the most important of these factors is interest rates, which will be discussed next.
A Healthy Interest in Global Bank RatesGlobal interest rates are one of the primary drivers of currencyexchange rates. Generally speaking, when all other variables are
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kept equal, rising interest rates (central bank tightening) have a tendency to contribute to an appreciation in a currency. This is becausehigher-yielding currencies attract more demand from large institutional investors, who are consistently in search of ways to earn moreon their money. If, on the other hand, there is a lowering of interestrates (central bank easing), the tendency is towards a depreciationof the currency. This is due to decreasing demand by the institutional investors, who generally tend to move their money awayfrom lower-yielding assets. Although this may constitute a simplisticassumption regarding international capital flows, as so many otherfactors contribute to exchange rate movement, interest rates generally tend to exert their influence in this manner.It should be kept in mind, from a foreign exchange trading perspective, that the appreciation or depreciation in an exchange rateis less a product of the absolute value of the interest rate than thedirection of change in the interest rate. In other words, althoughthe current interest rate for a country’s currency is important inhelping the market to determine its exchange value, the directionof interest rate change is even more important. Just because a currency carries a high-yield does not ensure an appreciation in theexchange rate. But if the currency’s central bank continues to raiseinterest rates and indicates an intention to keep doing so, this canhave a considerable impact on appreciation in the currency.Changes in interest rates are initiated by central bank policy. Inthe United States, this central bank is the Federal Reserve (informallycalled the “Fed”). Other major central banks include the EuropeanCentral Bank (ECB), the Bank of England (BOE), the Bank ofJapan (BOJ), the Bank of Canada (BOC), and the Reserve Bank
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of Australia (RBA). These institutions make decisions that help determine the direction of interest rates.In adjusting interest rates, central banks seek to achieve a delicate balance between attaining a significant level of economic growthwhile staving off excessive inflation. A certain controlled level of inflation is necessary for economic growth, as a country without inflationis a sign of a stagnant economy. At the same time, however, excessiveinflation can be enormously disadvantageous to an economy and itsconsumers. Therefore, each central bank must take both goals of economic growth and inflation control into serious consideration whensetting monetary policy.In view of these goals, there are a couple of primary reasonswhy a central bank would seek to change interest rates. These areby no means the only reasons, but they are usually among the mostcompelling ones for central banks. Generally speaking, central bankswill look to increase interest rates (tighten) in order to help stave offexcessive inflation. Conversely, central banks will look to decreaseinterest rates (ease) in order to help stimulate economic growth.Either way, central banks have the power to impact the foreignexchange markets enormously by making changes in interest ratepolicy.Often, an actual change in rate policy is not even needed to affecta currency’s value. Merely a comment hinting at potential policyintention within a speech by the Fed chairman, for example, is oftensufficient to trigger drastic price moves. This highlights the fact that itis not as much the actual fundamentals that move currency exchangerates. Rather, it is more the traders’ collective perceptions and expectations of the fundamentals that truly drive these markets.
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C arried Away with TradingWithin the context of trading foreign exchange based on fundamental factors, one of the primary trading/investment modelsutilized both by institutional and retail traders is the carry trade.Further information on carry trading will be discussed in Chapter 5,but the general concept will be described here.The carry trade is primarily a longer-term fundamental investment strategy used by foreign exchange participants to exploit interest rate differentials between currencies. Used in conjunction withthe high leverage ratios commonly offered in foreign exchange trading, this strategy can produce exceptionally magnified returns whilealso carrying a significant degree of risk.The basic idea behind carry trading is to buy a currency witha high interest rate while simultaneously selling another currencywith a low interest rate. The net effect is that the trader earns a positive yield based on the differential between the two interest rates.For example, suppose a foreign exchange trader buys AUD/JPY, which is a frequently carry-traded pair due to the traditionally wide interest rate differential between the Australian dollarand the Japanese yen. Buying, or being long, the AUD/JPY is thesame as buying AUD while simultaneously selling JPY. Anotherway to look at a long position in AUD/JPY is the concept of borrowing the yen (low interest rate) in order to buy the aussie (highinterest rate). Either way it is viewed, the result is the same—thetrader earns the high rate while paying the low rate, or the traderearns the differential between the rates (minus the inevitable interestrate spread).
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C a r r i e d A w a y w i t h Tr a d i n g
If trading with one of the major retail foreign exchange brokers, the carry trader earns daily interest profits for all open positions whose interest rate differential is positive, as in the case of along position in AUD/JPY. Based on the size of the trader’s openposition and the amount of leverage used, this positive yield is converted into a monetary amount that is actually paid directly into thetrader’s account each day when the foreign exchange broker “rollsover” open positions.As mentioned earlier, because of the highly leveraged natureof foreign exchange trading, this amount can be substantial. But itshould be kept in mind that interest rates can also work against traders in an equally substantial manner if positions that carry a negativedifferential are kept open. To use AUD/JPY once again as an example, it could get very expensive from an interest rate perspective tohold a short position open in this pair. Short AUD/JPY is the sameas being short aussie (high interest rate) while simultaneously beinglong yen (low interest rate), or borrowing at the high interest rate tobuy at the low interest rate. The net result in terms of the rate differential is negative, which means the trader is required to pay a dailyinterest amount for the open position based on the negative differential, the size of the trade, and the amount of leverage used.It is therefore imperative that foreign exchange traders pay closeattention to interest rate differentials on all trades initiated, especially those that will likely remain as open positions for more than aday. Whether positive or negative, interest rate differentials can havean extremely significant impact on the daily balance in a foreignexchange trading account. More on how traders may take advantageof the positive interest rate differentials so eagerly sought-after by
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carry traders (while mitigating the inherent exchange rate risks) willbe discussed in Chapter 5.
I ndication of Things to Come — EconomicIndicatorsAside from interest rates and central bank policy, one of the mostvitally important fundamental factors to foreign exchange traders iseconomic data. Even technical traders who eschew the use of fundamental analysis should at least know when data are being released (byreferring to any online economic data calendar), but should preferably go even a step further by understanding the ramifications of eachrelease. Economic data and news announcements help drive bothshort-term and long-term movements in currency exchange rates, soit behooves all foreign exchange traders to know at least what everymajor data point means, if not the underlying nuances of each.On the opposite extreme from the technical-trading purists, awhole legion of short-term foreign exchange traders actually liveand die by fundamental data and news announcements. Duringnews time, many of these traders simply sit at their computers—trigger finger on the buy/sell button and live news feed blasting—waiting for economic data to be released publicly so a trade can beentered. In order to profit with a few pips, news traders who tradeforeign exchange in this manner must be quick to make a splitsecond assessment of the news or data, and then place a corresponding trade within milliseconds. The trade must then be closed foreither a profit or a loss, often only seconds after the trade was entered.This is not an easy method of trading, and it most certainly is not for
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everyone. But many of those who can make it work claim to reapconsistent success with this method. Further details on news tradingwill be discussed later in this chapter and in Chapter 5.When economic data are released, currency pairs relatingto the specific release often react in extreme ways. For news traders,the best possible reaction is for price to initiate a one-way run without looking back. Often, however, extreme nondirectional volatilityis the order of the day, where price just seems to jump up and down,whipsawing every position in sight. This is every foreign exchangetrader’s nightmare. In any event, the major, market-moving economic data indicators need to be identified and studied in order fora trader to have any chance of trading currencies successfully duringand after data releases.Following are the key economic indicators relevant to the U.S.dollar. These indicators constitute the major economic data reportsreleased periodically to the public by government agencies and private entities. Of course, there are many other indicators that comeout every day affecting the many non-U.S. currencies. But since thevast majority of trading volume in the foreign exchange markets iscentered primarily on U.S. dollar-based currency pairs (more than90%), the following is an excellent representative sampling of thefundamental indicators that help drive the global currency markets.Within this list, the relative importance and market-moving potential of each indicator may change from month-to-month and yearto-year, so the indicators are listed in no particular order:• Gross Domestic Product (GDP)—GDP is perhaps the most consistently followed and studied economic indicator for foreign
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exchange traders. This is because it is virtually an all-encompassingmeasure of economic growth and output. Released quarterlyand quoted on an annualized basis, the GDP is the total marketvalue of all goods and services produced by the economy withina given period of time. Real GDP, which is GDP adjusted forinflation, takes into account price level changes, and so is considered a more accurate reflection of production than the original GDP percentage. When the real GDP report is released on aquarterly basis, foreign exchange markets often move in a substantial manner. This is due to the fact that real GDP is perhaps thebest single assessment of an economy’s health available to marketparticipants. Therefore, if there is one economic indicator that allforeign exchange traders should be aware of, it is the real GDPstatistic.• Employment situation—The Employment Situation Report isput out monthly by the Bureau of Labor Statistics, and includestwo vitally important surveys that summarize the nation’s laborsituation: the Household Survey, and the Establishment Survey.Within these surveys are some figures that have been knownin the past several years to move the foreign exchange marketssignificantly. Most notable of these figures is the Non-FarmPayrolls (NFP) data (within the Establishment Survey), whichhas been one of the most anticipated and traded benchmark statistics by foreign exchange traders in recent years. At the heightof its popularity, legions of foreign exchange traders have beenknown to sit eagerly at their trading stations on the first Fridayof every month, waiting nervously for the NFP numbers to bereleased. Like these NFP numbers, the unemployment rate data
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Indication of Things to Come—Economic Indicators
(within the Household Survey) also constitutes a major, marketmoving statistic.• Retail sales—Another very important economic indicator, themonthly Retail sales report releases data for the previous monthon the value of merchandise sold to end consumers by a representative sampling of retailers. Retail sales data includes the totalretail sales in dollars, with the percentage change from the priormonth. It also includes the total retail sales excluding automobile sales (“ex-autos”). This is because auto sales tend to skewthe total sales figure in a way that would render it somewhatmisleading. Retail sales data provides traders with a broad measure of sales activity, and therefore, an accurate reflection of theeconomy’s health as a whole. It can also give strong indicationsof potential inflation, interest rate change, and possibly evenrecession. Therefore, this economic indicator is one that foreignexchange traders should pay special attention to.• Consumer Price Index (CPI)—Because the monthly CPI is abenchmark inflation indicator, it is one of the most anticipatedreleases by the foreign exchange trading community. The CPItakes a basket of common, daily-use consumer products andcompares price levels from previous years. Two metrics comprise the CPI statistics—Core CPI (minus food and energy)and chain-weighted CPI. Core CPI is more anticipated bytraders than chain-weighted CPI. Because CPI is probably thebest set of statistics for indicating inflation, it can be effective ingiving hints as to future potential interest rate changes by theFed. For this reason alone, CPI is extremely worth watching byforeign exchange traders.113
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• Producer Price Index (PPI)—From a foreign exchange trading perspective, the primary role of the monthly PPI, whichis released before the CPI every month, is essentially as a predictor of the all-important CPI inflation-indicator. Whereasthe CPI is an index of consumer prices, the PPI is an index ofproducer, or wholesale, prices. Since consumer prices and producer prices are closely interrelated, the PPI and CPI are generally close reflections of each other. Within the PPI, core PPI(minus food and energy) is the most followed statistic. Becauseinflation and interest rates are so important to the value of theU.S. dollar—and the CPI is perhaps the most accurate indicator of inflation available—the PPI is also an important economic indicator because it is, in turn, an accurate predictor ofthe CPI.• Durable goods—The Durable Goods Report is a monthlyreport that provides data on new orders placed with domesticmanufacturers for delivery of durable goods. These are definedas factory hard goods with