10-pip spread instantly, wiping out seven pips ofhard-earned profit. Always check the broker’s hours of operation and atwhat time the increased spread goes into effect.• Trading very obscure cross rates. Trading non-USD cross currencypairs like HUF (the Hungarian forint) or SAR (the Saudi riyal) is notadvisable. The bid/ask spread is abnormally high and volatility may beunusually low. Without volatility, your open trade could lapse into arollover position (usually two days). This is best left to the professionals who may be using an obscure cross rate as a leg in triangulararbitrage trade.• Overconfidence. “Pride goeth before destruction, and a haughty spiritbefore a fall.” Try to keep everything in the proper perspective.• False expectations. Currency trading offers no guarantees. Do notbecome discouraged over losses. After all, you are not risking moniesearmarked as your survival fund.
What to Do If Things Go Wrong
137
• Trading without a plan. Never enter a trade without first examiningthe big picture. Most trading platforms allow the trader to view multiple time intervals of the same currency pair. Scrutinizing the 5-secondchart alone is usually not sufficient. Also check the 1-minute chart, the1-hour chart, and the 1-day chart, or whatever multiples the platformprovides. A long-term trend may be in motion, which is not clearly visible in a short time interval chart. Also, any available technical and/orfundamental analysis on the targeted currency pair is also beneficial.• Never add to a losing position. Exit the losing position, take a break,and start over. Compounding your loss will not force a price reversal.• Don’t exit because of whipsawing. When a market begins whipsawing near your market entry price, there is no urgency to liquidate theposition. A fellow trader once commented, “Monitoring extended periods of whipsawing is like watching paint dry.” We explained that themarket is simply building up energy to make a significant breakout. Infact, most technicians feel that whatever price direction was in motionprior to whipsawing will resume in that same direction after the whipsawing period. Patience is a trading quality that must be learned.• Lack of focus. Pay very close attention when initiating a new order.The two most common mistakes are entering the wrong action (buy orsell) and mistyping the number of units to trade. Neither can be corrected once the entry order is executed except by liquidation.• Clouded judgment. Never let the results of a sour trade affect yourjudgment criteria for the subsequent trade. Each trade is a separateentity. Simply reversing the market action (buy to sell or sell to buy)after a loss does not guarantee that the current trend will continue.• If in doubt, don’t trade. This speaks for itself. It is always better tomake no trades than a series of costly trades. Take the day off or at leastwait an hour or two.
Correcting ErrorsThe following guidelines should be reviewed even when things are movingsmoothly:• First, take a break. The markets will be there an hour from now.• Review your performance log in detail. Pinpoint your strengths andyour weaknesses.• Reread Chapter 12, “Trading Tactics.” It may be time to adjust yourapproach to the market.
138
THE BUSINESS OF TRADING
• You may need to increase or decrease the number of pips that you areusing to set the stop-loss and take-profit limit orders.• Determine if you are entering the market too early or too late. Propermarket timing is the key to profitable trading.• You may want to lower the number of units traded (temporarily) simply to rebolster trading confidence.• Try trading at different times in the day even if it means getting upearly. Also, there is no reason that you cannot trade any of the sevenmajor USD currencies pairs or even the cross rates with the EUR, JPY,and GBP currencies once you gain some trading experience.• Nearly all FOREX trading platforms will provide an Activity Log thatitemizes the details of each trade. Display the log on the screen (or evenprint a hard copy) to scrutinize any shortcomings on your part.
When to Say “Uncle”It may be wise to set a threshold percentage of the original equity that youdeposited with your broker. If your current balance drops below this thresholdlevel, you may need to reevaluate your priorities. A change in attitude or greaterflexibility may be indicated. As we mentioned earlier, currency trading may notsuit everyone’s disposition.
14Chapter
Record Keeping
e find it useful to keep daily and weekly records of our trading plans,thoughts, and activities. It’s important to come to the markets wellprepared for many contingencies. The records will also help you diagnose problems and find solutions.
W
Daily Trade Plan and EvaluationIn the previous chapter, we recommended that novice traders maintain a simplehandwritten daily performance sheet and an account balance sheet. By scrutinizing this data at the end of the trading session, traders will be able to identifytheir strengths and weaknesses and develop a “feel” for market characteristics fordifferent currency pairs, trading times, and chart patterns.
Weekly Trade Plan and EvaluationHere is a suggested weekly trade plan and evaluation:• Plans should include decision contingencies for various market actionsfor that trading session; this is very similar to football coaches’ “scripting” the first few plays of a game.
139
THE BUSINESS OF TRADING
140
• Evaluations should include what went right and what went wrong, aswell as a brief text summary of the session.You may add more to your daily and weekly summaries based on your specific trading program.Novice traders may review their daily performance and account balancesheets collectively to ascertain any weaknesses in the trading system. Scanningthe daily sheets for wins and losses helps put the entire endeavor in proper perspective. Adding comments and ideas to the weekly plan provides insight whenreviewed later and assists traders in recognizing the direction of their marketacumen and development.
The Tax ManRegrettably, profits and losses from FOREX trades in the United States are subject to short-term (one year or less) capital gains tax as dictated by the InternalRevenue Service. The governments of other civilized countries will also behappy to share in any good fortune that might come your way in the markets.The basic U.S. reporting instrument is Form 1040 Schedule D, thoughsupplementary forms may also be required. Forms and instructions can bedownloaded in portable document format (PDF) at http://www.irs.gov/pub/.Consult your accountant for full details on taxes and the expensing ofwrite-offs that you might be able to take for your trading activities.
5Part
Advanced Topics
15Chapter
Advanced Topics
T
his chapter is optional for the novice trader though investors with sometrading experience will find it informative.
RolloversA rollover is the process whereby the settlement of an open trade is rolled forward to another value date. The cost of this process is based on the interest ratedifferential of the two currencies.In the spot FOREX market, trades must be settled within two businessdays. For example, if a trader sells a certain number of currency units onWednesday, he or she must deliver an equivalent number of units on Friday. Yetcurrency trading systems may allow for a rollover, with which open positionscan be swapped forward to the next settlement date (giving an extension of twoadditional business day). The interest rate for such a swap is predetermined,and, in fact, these swaps are actually financial instruments that can also betraded on the currency market.In any spot rollover transaction the difference between the interest rates ofthe base and quote currencies is reflected as an overnight loan. If the traderholds a long position in the currency with the higher interest rate, he or shewould gain on the spot rollover. The amount of such a gain would fluctuate day
143
144
ADVANCED TOPICS
to day according to the precise interest rate differential between the base andthe quote currency. Such rollover rates are quoted in dollars and are shownin the interest column of the FOREX trading system. Rollovers, however, willnot affect traders who never hold a position overnight, since the rollover isexclusively a day-to-day phenomenon.Some brokers will automatically roll over open trades while others may liquidate orders that exceed the two-day limitation. Also, some dealers may appenda rollover charge in addition to the interest differential. Rollover credits or debitsare reflected in the unrealized profit and loss column of the open position.If you intend to maintain open positions longer than two days, carefullyread your dealer’s policy agreement or consult their customer service department. Also note that rollover costs may affect margin requirements.
HedgingA hedge is a position or combination of positions in one security that reducesthe risk of your primary position in the same security.An example of hedging in commodity futures is the Midwest farmer whogrows #1 Soft Red Wheat and intends to physically take his harvest to market forSeptember delivery. After tilling the soil and planting the seeds in late spring, thefarmer initiates a short (sell) commodity futures contract for September wheat atthe Chicago Board of Trade at what he feels is a fair price. If the price of wheatdeclines dramatically in September, the farmer will suffer losses on his physicaldelivery but will make profits on his futures contract. If the price of wheat risessubstantially in the fall, the farmer will make profits on his physical delivery butwill suffer losses on his futures contract. Thus, hedging not only reduces risk butcan also be used to lock in predetermined profits in some situations.Normally when you have an open position to buy or sell at your FOREXdealer and you open a new position in the opposite direction, the two positionswill close each other out. If you had a position for USD/CHF to buy, for example, and you opened a new position USD/CHF to sell, both positions wouldclose, since you cannot buy and sell currencies at the same time. The feature ofhedging, however, allows you to do exactly that if your FOREX dealer offers thistrading feature.When you open a hedge position, both positions (the original and thenewly hedged one) will remain opened. You will have two positions, going inthe opposite direction of each other in the same currency pair. This is used tolock your current loss or win, until you have a better understanding of wherethe market is moving. Theoretically, profit is to be gained by skillful timing ofthe liquidation orders. If liquidated at the same time, the trader will automati-
Advanced Topics
145
cally lose only the transaction cost since the gain in one trade will be canceledexactly by the loss in the other trade.Brokers who offer hedging do not normally require additional margin forthe second hedged position. Consult your broker for details before attemptingto apply this rather esoteric trading strategy.
Options TradingAn option is an agreement that gives the holder the option to buy or sell a specific security at a certain price within a certain time. Two types of options exist:call and put. A call is the right to buy while a put is the right to sell. One canwrite or buy call and put options.Options on the foreign exchange are really no different from options onstock shares, commodity futures, or real estate. The basic premise is that thebuyer of an option has the right but not the obligation to enter into a contractwith the seller. Naturally the option owner exercises this right when it is to his orher advantage. Currency options specify a foreign exchange contract and givethe owner the right to enter into the specified contract during a pre-agreedperiod of time.FOREX options have gained acceptance as invaluable tools in managingforeign exchange risk. They are used extensively and make up between 5 and 10percent of total volume of trading. Currency options bring a much wider rangeof hedging alternatives to portfolio managers and corporate treasuries.An American option may be exercised at any valid business date throughout the life of the option, while a European option can only be exercised on theexpiration date.An option is said to have intrinsic value when the strike price of the optionis more favorable than the current market forward rate. As a general rule, thegreater the intrinsic value of an option, the higher its premium:• An option with some intrinsic value is described as being “in-themoney.”• An option with no intrinsic value is said to be “out-of-the-money.”• Where the strike price of the option is equal to the current forward ratethe option is said to be “at-the-money.”Consult your broker for details and margin requirements. Be particularlyaware when dealing with options—it’s an area that has attracted a substantialportion of the FOREX fraud.
ADVANCED TOPICS
146
ArbitrageIn general, arbitrage is the purchase or sale of any financial instrument andsimultaneous taking of an equal and opposite position in a related market, inorder to take advantage of small price differentials between markets. Essentially,arbitrage opportunities arise when currency prices go out of sync with eachother. There are numerous forms of arbitrage involving multiple markets, futuredeliveries, options, and other complex derivatives. A less sophisticated exampleof a two-currency, two-location arbitrage transaction follows:Bank ABC offers 170 Japanese yen for one U.S. dollar and BankXYZ offers only 150 yen for one dollar. Go to Bank ABC and purchase 170 yen. Next go to Bank XYZ and sell the yen for $1.13. In alittle more than the time it took to cross the street that separates thetwo banks, you earned a 13 percent return on your original investment. If the anomaly between the two banks’ exchange rates persists,repeat the transactions. After exchanging currencies at both bankssix times, you will have more than doubled your investment.Within the FOREX market, triangular arbitrage is a specific trading strategy that involves three currencies, their correlation, and any discrepancy in theirparity rates. Thus, there are no arbitrage opportunities when dealing with justtwo currencies in a single market. Their fluctuations are simply the tradingrange of their exchange rate.In the subsequent examples, we refer to the following tables of currencypairs consisting of the five most frequently traded pairs (USD, EUR, JPY, GBP,and CHF) with recent bid/ask rates. See Table 15.1.We omitted the other two majors, CAD and AUD, for the sake ofsimplicity and not because there is a lack of arbitrage opportunities in thesetwo majors.Example 1Two USD pairs and one cross pair (multiply) First we must identify certaincharacteristics and distinguish the following categories:• USD is the base currency (leftmost currency in the pair):USD/CHF1.2402/05USD/JPY105.61/64• USD is the quote currency (rightmost currency in the pair):EUR/USD1.2638/40GBP/USD1.8275/78
Advanced Topics
147
TABLE 15.1 Combinations of the Five MostFrequently Traded CurrenciesCurrency
Bid
Ask
Pip Spread
CHF/JPY
0.8514
0.8519
4
EUR/CHF
1.5676
1.5678
2
EUR/GBP
0.6915
0.6917
2
EUR/JPY
133.51
133.54
3
EUR/USD
1.2638
1.2640
2
GBP/CHF
2.2666
2.6674
8
GBP/JPY
193.02
193.10
8
GBP/USD
1.8275
1.8278
3
USD/CHF
1.2402
1.2405
3
USD/JPY
105.61
105.64
3
• Cross rates (non-USD currency pairs):CHF/JPY85.14/19EUR/CHF1.5676/78EUR/GBP0.6915/17EUR/JPY133.51/54GBP/CHF2.2666/74GBP/JPY193.02/10The fact that the USD is the base currency in two of the pairs (USD/CHFand USD/JPY) and is the quote currency in two other pairs (EUR/USD andGBP/USD) plays an important role in the arithmetic of arbitrage. We begin ourinvestigation with just the bid prices (see Table 15.2).
TABLE 15.2CHFJPY
= USDJPY / USDCHF
Formulas for Cross Currencies85.14
= 105.61 / 1.2402
85.1556
EURCHF = EURUSD × USDCHF
1.5676 = 1.2638 × 1.2402
1.567365
EURGBP = EURUSD / GBPUSD
0.6915 = 1.2638 / 1.8275
0.691546
EURJPY
= EURUSD × USDJPY
133.51 = 1.2638 × 105.61
133.4699
GBPCHF = GBPUSD × USDCHF
2.2666 = 1.8275 × 1.2402
2.266466
GBPJPY
193.02 = 1.8275 × 105.61
193.0023
= GBPUSD × USDJPY
ADVANCED TOPICS
148TABLE 15.3
Calculations for Cross Currencies
Pair
Rate
Calculation
Deviation
Pip Values
CHFJPY
85.1556
−85.14
= +0.0156
+1.56 pips
EURCHF
1.567365
−1.5676
= −0.000235
−2.35 pips
EURGBP
0.691546
−0.6915
= +0.000046
+0.46 pips
EURJPY
133.4699
−133.51
= −0.0401
−4.01 pips
GBPCHF
2.266466
−2.2666
= +0.000134
+1.34 pips
GBPJPY
193.0023
−193.02
= −0.0177
−1.77 pips
The criterion whether to multiply or divide the USD pairs in order to calculate the cross rate is simple:• If the USD is the base currency in both pairs then divide the USD pairs.• If the USD is the quote currency in both pairs then divide the USD pairs.• Otherwise multiply the USD pairs.To determine the deviation from parity for each cross pair, subtract theexchange rate from the calculated rate and convert the floating point decimalsto pip values (see Table 15.3).From the information in Table 15.3, we can see that the EUR/JPY is outof parity by four pips. To determine if an arbitrage opportunity is profitable, wemust first calculate the total transaction cost by adding the three bid/ask spreadsof the corresponding pairs:EUR/USDUSD/JPYEUR/JPY
2+3+38
An eight-pip transaction cost to earn a four-pip profit is counterproductive—it amounts to a four-pip loss. If the parity deviation (the number of pipsby which the three currency pairs are out of alignment) were greater—say, 30pips—then a definite arbitrage opportunity exists.The trading mechanism to take advantage of this anomaly requires someconsideration. First, determine what market actions are necessary to correct thisanomaly. Assume that the EUR/JPY rate is currently trading at 133.51 and thecalculated rate using the current EUR/USD and USD/JPY pairs is 133.81 (a30-pip deviation). Parity between the three currencies will be restored if the following price action occurs:
Advanced Topics
149
(A) The EUR/JPY pair rises to 133.81, or(B) The product of the EUR/USD and USD/JPY pairs drops to 133.51.Therefore the following trades are required to “lock in” the 30-pip profit:••••
Buy one lot of the EUR/JPY pair.Sell one lot of the EUR/USD pair.Sell one lot of the USD/JPY pair.Liquidate all three trades simultaneously when parity is reestablished.
Note: Executing only one or two “legs” of the three trades required in anarbitrage package does not guarantee a profit and may be quite dangerous. Allthree trades must be executed simultaneously before the “locked-in” profit canbe realized.Example 2Two USD pairs and one cross pair (divide) Example 1 used the product ofthe two USD currencies to calculate the cross rate. Now let’s take an exampleof the ratio of the two USD currencies. Assume the EUR/GBP cross pair iscurrently trading at 0.6992 and that the ratio between the EUR/USD andGBP/USD pairs is calculated as 0.6952, a 40-pip deviation. Parity will be restoredwhen the following price actions occur:(A) The EUR/GBP pair drops to 0.6952, or(B) The ratio of the EUR/USD and GBP/USD pairs rises to 0.6992.In order for the second action to rise, either the EUR/USD pair must alsorise or the GBP/USD pair must decline (this differs from the previous example).Therefore the following trades are required to realize a 40-pip profit:••••
Sell one lot of the EUR/GBP pair.Buy one lot of the EUR/USD pair.Sell one lot of the GBP/USD pair.Liquidate all three trades the moment that parity is reestablished.
Example 3Three non-USD cross pairs Technically the arbitrage strategy can be performedon three non-USD currency pairs. In this example, we examine a straddle between
ADVANCED TOPICS
150
the three European majors (EUR, GBP, CHF) while focusing on the EUR/CHFpair in respect to the two GBP currency pairs (GBP/CHF and EUR/GBP).Assume the current rates of exchange are:EUR/CHF = 1.5676/78EUR/GBP = 0.6915/17GBP/CHF = 2.2604/12and their relationship is:EUR/CHF = EUR/GBP × GBP/CHFThus the calculated value for the EUR/CHF rate is 0.6915 × 2.2604 or1.5631. The deviation from parity is −.0045 (1.5631 − 1.5676), or 45 CHF pips,since CHF is the pip currency in the EUR/CHF pair. The trading strategy is:••••
Sell one lot of EUR/CHF.Buy one lot of EUR/GBP.Buy one lot of GBP/CHF.Liquidate all three when parity is reestablished.
If all three trades are executed successfully, a profit of 45 CHF pips is realized. Subtract the three bid/ask spreads for the transaction costs (2 + 2 + 8 = 12)to see a net profit of 33 CHF pips. Now convert CHF pips to dollars (33divided by the USD/CHF rate, 1.2402) to obtain 27 USD pips.
Adding ComplexityIt should be noted that in all the examples presented here that only threecurrencies are analyzed simultaneously. It is possible to add a fourth or even fifthcurrency to the mix, though this is normally left to the very serious arbitragestrategists.The methodology for examining four (or even five) currencies at one timeis to calculate every possible three-currency combination among the currenciesselected. Rearrange them in order of magnitude of deviation from parity.Examine the deviations closely to see if there is a single anomaly or possibly evena double anomaly among the four currencies. This type of scrutiny will thendetermine if a four-currency arbitrage opportunity exists.Specialized software is definitely required when dealing with four or morecurrencies in a single arbitrage package.
Advanced Topics
151
Pros and Cons of ArbitrageUsing triangular arbitrage strategies on the FOREX market has one very salientadvantage: predetermined profits can be realized if the trades execute smoothly.Unfortunately, the disadvantages of this strategy are numerous:• Higher transaction costs. The trader must pay the bid/ask spreads onthree separate trades.• Higher margin requirements. Roughly three times the margin is necessary to execute the arbitrage strategy and odd-lot trading may berequired for the small-capital investor.• Precision timing is required. Arbitrage opportunities are usuallyshort-lived.• Complexity. The trader must thoroughly understand the arbitragemechanism in order to determine which currency pairs to buy andwhich to sell. Each arbitrage “package” consists of two buys and one sellor one buy and two sells. Miscalculating any one of the three trades cancause disaster.• Advanced monitoring techniques are usually required. This meanscalculating the above analysis on several pairs simultaneously in realtime. You will need a software program that analyzes streaming quotescontinually. It is possible to perform these tasks manually but the tradermust have a high tolerance for tedium.We must also mention that in the examples in this chapter, we intentionally simplified calculations by using only the bid price throughout. When executing an actual arbitrage trade, the investor must supply both bid and ask ratewhere applicable.
Further StudiesIf you are interested in delving deeper into the topics above for the purpose ofincluding them in your personalized trading strategy, we recommend that (a)you contact your FOREX broker for detailed information and (b) review thetexts and Web sites listed in Appendix F.
Appendix A
List of World Currenciesand Symbols
able A.1 is a list of global currencies and the three-character currencycodes that we have found are generally used to represent them. Often, butnot always, this code is the same as the ISO 4217 standard. (The ISO, orInternational Organization for Standardization, is a worldwide federation ofnational standards.)In most cases, the currency code is composed of the country’s two-characterInternet country code plus an extra character to denote the currency unit. Forexample, the code for Canadian dollars is simply Canada’s two-characterInternet code (“CA”) plus a one-character currency designator (“D”).We have endeavored to list the codes that, in our experience, are actuallyin general industry use to represent the currencies. Currency names are given inthe plural form. This list does not contain obsolete Euro-zone currencies.
T
TABLE A.1
Symbol, Place, Currency Name
AED
United Arab Emirates
Dirhams
AFA
Afghanistan
Afghanis
ALL
Albania
Leke
AMD
Armenia
Drams
ANG
Netherlands Antilles
Guilders
AOA
Angola
Kwanza(continued on next page)
153
APPENDIX A
154
TABLE A.1ARS
Argentina
(continued)Pesos
AUD
Australia
Dollars
AWG
Aruba
Guilders
AZM
Azerbaijan
Manats
BAM
Bosnia, Herzegovina
Convertible Marka
BBD
Barbados
Dollars
BDT
Bangladesh
Taka
BGN
Bulgaria
Leva
BHD
Bahrain
Dinars
BIF
Burundi
Francs
BMD
Bermuda
Dollars
BND
Brunei Darussalam
Dollars
BOB
Bolivia
Bolivianos
BRL
Brazil
Brazil Real
BSD
Bahamas
Dollars
BTN
Bhutan
Ngultrum
BWP
Botswana
Pulas
BYR
Belarus
Rubles
BZD
Belize
Dollars
CAD
Canada
Dollars
CDF
Congo/Kinshasa
Congolese Francs
CHF
Switzerland
Francs
CLP
Chile
Pesos
CNY
China
Renminbi
COP
Colombia
Pesos
CRC
Costa Rica
Colones
CUP
Cuba
Pesos
CVE
Cape Verde
Escudos
CYP
Cyprus
Pounds
CZK
Czech Republic
Koruny
DJF
Djibouti
Francs
DKK
Denmark
Kroner
DOP
Dominican Republic
Pesos
DZD
Algeria
Algeria Dinars
EEK
Estonia
Krooni
Appendix A
TABLE A.1EGP
Egypt
155
(continued)Pounds
ERN
Eritrea
Nakfa
ETB
Ethiopia
Birr
EUR
Euro Member Countries
Euro
FJD
Fiji
Dollars
FKP
Falkland Islands
Pounds
GBP
United Kingdom
Pounds
GEL
Georgia
Lari
GGP
Guernsey
Pounds
GHC
Ghana
Cedis
GIP
Gibraltar
Pounds
GMD
Gambia
Dalasi
GNF
Guinea
Francs
GTQ
Guatemala
Quetzales
GYD
Guyana
Dollars
HKD
Hong Kong
Dollars
HNL
Honduras
Lempiras
HRK
Croatia
Kuna
HTG
Haiti
Gourdes
HUF
Hungary
Forint
IDR
Indonesia
Rupiahs
ILS
Israel
New Shekels
IMP
Isle of Man
Pounds
INR
India
Rupees
IQD
Iraq
Dinars
IRR
Iran
Rials
ISK
Iceland
Kronur
JEP
Jersey
Pounds
JMD
Jamaica
Dollars
JOD
Jordan
Dinars
JPY
Japan
Yen
KES
Kenya
Shillings
KGS
Kyrgyzstan
Soms
KHR
Cambodia
Riels
KMF
Comoros
Francs(continued on next page)
APPENDIX A
156
TABLE A.1
(continued)
KPW
Korea (North)
Won
KRW
Korea (South)
Won
KWD
Kuwait
Dinars
KYD
Cayman Islands
Dollars
KZT
Kazakstan
Tenge
LAK
Laos
Kips
LBP
Lebanon
Pounds
LKR
Sri Lanka
Rupees
LRD
Liberia
Dollars
LSL
Lesotho
Maloti
LTL
Lithuania
Litai
LVL
Latvia
Lati
LYD
Libya
Dinars
MAD
Morocco
Dirhams
MDL
Moldova
Lei
MGA
Madagascar
Ariary
MKD
Macedonia
Denars
MMK
Myanmar (Burma)
Kyats
MNT
Mongolia
Tugriks
MOP
Macau
Patacas
MRO
Mauritania
Ouguiyas
MTL
Malta
Liri
MUR
Mauritius
Rupees
MVR
Maldives
Rufiyaa
MW