a useful life of at least three years,and generally include higher-priced products such as automobiles, appliances, industrial machinery, computers, and the like.The Durable Goods Report is one of the economic indicatorsthat paint a picture of the U.S. manufacturing sector, which isa vital aspect of the economy. Therefore, the report also reflectsgeneral business demand and confidence within the entireeconomy. For these reasons, this indicator can certainly movethe currency markets, especially if the numbers deviate significantly from the expected consensus numbers (more on consensus will be discussed later in this chapter).
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• Industrial production—The Industrial Production Report isa monthly measure of the percentage change in manufacturing and factory production. Like the Durable Goods Report,the Industrial Production Report is important because it provides information on the vital manufacturing sector. Significantchanges in this sector can signal changes in the entire economy,including economic growth, inflation, and recession. Therefore,this economic indicator contains useful data for the foreignexchange trader.• Purchasing Managers Index (PMI)—The Institute for SupplyManagement (ISM), a nonprofit group, maintains the PMI andissues monthly releases based upon this index. The PMI is acomposite index of the manufacturing situation that includes:new orders, production level, employment, supplier deliverytimes, and inventories. Data for this index, which is essentiallya sentiment indicator for the national manufacturing sector,are obtained through surveys of purchasing managers. Like theDurable Goods Report and the Industrial Production Report,PMI releases are important to the foreign exchange market because they provide a good measure of the manufacturing sector, which is an integral component of U.S. economichealth.• Employment Cost Index (ECI)—The ECI is a quarterly reportreleased by the Bureau of Labor Statistics (BLS).This report measures changes in payroll compensation costs for nonfarm industries, as well as state and local governments (but excludes federalgovernment). Like the CPI, the ECI is used mainly for its role asan inflation indicator. Because of this, and the fact that the Fed
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uses it to help decide monetary policy, the ECI is a useful economic indicator for foreign exchange traders to watch.• Housing starts/existing home sales—Together, Housing Starts(New Residential Construction Report) and the ExistingHome Sales Report provide a solid picture of the U.S. housing situation. Housing starts is issued monthly by the U.S.Census Bureau. Through surveys of homebuilders, it collectsdata primarily with regard to the percentage change in housingstarts (new homes on which construction of the foundationhas begun) and building permits. Housing starts is often usedas an indicator of where the economy falls within the current business cycle. The Existing Home Sales Report, on theother hand, is a monthly release by the National Associationof Realtors that measures the number of existing homes thatwere closed on (sold) in the previous month, along with average sales prices. Like Housing Starts, the Existing Home SalesReport also provides business cycle indications. When taken asa whole, these two reports accurately reflect the state of theU.S. housing market. This, in turn, can provide strong guidancefor the U.S. dollar during times when the housing situation isnegatively affecting the entire economy.• Trade balance—The monthly Trade Balance Report is important to foreign exchange traders because it has become anindicator of U.S. economic health, as well as U.S. economicstanding in relation to foreign economies. The nominal tradedeficit data, which represents the difference in monetary valuebetween exports and imports, is probably the most watchedand anticipated aspect of the Trade Balance Report. Data from116
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this report can have an impact on the foreign exchange markets in several ways. One of these ways has to do with changing supply and demand for a currency (in this case, the U.S.dollar). If there is a decreasing U.S. trade deficit, countriesimporting more U.S. products must convert their funds to U.S.dollars, thereby increasing the general demand for dollars andmaking the dollar appreciate. If, on the other hand, there is anincreasing U.S. trade deficit, with the U.S. buying more foreigngoods, this will necessitate the selling of dollars and buying ofmore foreign currencies to pay for those foreign goods. Thisgenerally results in a greater supply of dollars, and thereforepotential dollar depreciation. The Trade Balance Report cancertainly move the foreign exchange markets when released,but especially if the numbers show a large change from theprevious period, or if they deviate considerably from consensusestimates.• Personal income and outlays—The Personal Income and Outlays Report is a monthly release by the Bureau of EconomicAnalysis (BEA). Personal income is the amount of incomereceived by individuals from all sources, especially wages andsalaries. Personal outlays consist primarily of consumer purchases of goods and services. Components of this report includeReal Personal Income (income per capita adjusted for inflation),Disposable Personal Income (income less tax payments), PersonalSavings Rate (Disposable Personal Income less personal outlays), and Personal Consumption Expenditures (PCE). This lastcomponent, the PCE Index, provides a measure of how muchindividuals are spending, including on consumer goods and
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even credit card interest. Personal income data are important toforeign exchange traders because it is a strong indicator of futuredemand, and it acts as a barometer for the consumer sector. Interms of personal outlays, or consumption, the PCE Index hasbecome one of the key indicators of inflation, as well as a majorcomponent of GDP. For these reasons, foreign exchange traders would be remiss to ignore the information contained in thePersonal Income and Outlays Report.• Federal Open Market Committee (FOMC) rate decisions—As is evident from earlier in this chapter, interest rates are amajor determinant of currency value. An FOMC rate decision is not as much of an economic data indicator as the others described in this section. Rather, it is a market-movingannouncement resulting from an all-important meeting oninterest rates, inflation, and the economy by the top Fed boardmembers and bank presidents in the country. The FOMC,which currently has eight regularly scheduled meetings peryear, is a major element of the Federal Reserve System, andit serves as the primary director of U.S. monetary policy. Thecentral component of this policy is the setting of target levels for the Fed Funds rate, which is the interest rate that bankscharge each other on overnight loans. Needless to say, becauseof the FOMC’s influence on interest rates, its decisions canhave an enormous impact on the foreign exchange markets.Especially when there is a large change or unexpected departure from consensus, FOMC rate decisions can immediatelymove the currency markets in an extreme manner.
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EXECUTIVE INSIGHT
Joseph TrevisaniWith all of the media news and noise that may affect the foreignexchange markets, it can be extremely tricky to decipher whichpieces of information actually drive currency prices in a majorway. An expert in fundamental analysis, Joseph Trevisani—ChiefMarket Analyst at FX Solutions (FXSolutions.com)—serves as aninvaluable guide for separating the truly important informationfrom the not-so-important. With around two decades of experienceas an institutional currency trader and trading desk manager atlarge global banks, Trevisani appears regularly on financial newschannels and is quoted frequently by the major financial press.In an interview with the author, Trevisani states:“Central bank interest rates have a higher positive correlation with the value of a country’s currency than anyother factor. The country with the higher rate will generally have the more valuable currency. If British rates arehigher than American rates they will support the valueof the pound against the dollar, and vice versa. Banks incountries with a rate advantage both pay more on deposits and attract more funds to earn the higher rate. Butfor the currency markets the composition of the centralbank rate cycle is just as important as the comparisonbetween current rates. Central banks rarely make onerate adjustment. Rates tend to move in cycles, a seriesof rate cuts or increases over time, as the central bankresponds to changing economic conditions and attemptsto anticipate future conditions. It is the change in thesecycles, or the advent of a new cycle, that drives currency markets. When a central bank recalibrates its economic view, the currency markets tend to build-in a large
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EXECUTIVE INSIGHT (CONTINUED)portion of the prospective rate cycle almost immediately.Trading rates will adjust quickly to the new view. Centralbanks play different roles within their respective economies, determined both by conception and tradition. TheEuropean Central Bank has a specific mandate to protect against inflation—economic growth is secondary.The American Federal Reserve’s role is to promote economic growth and jobs, as well as to watch against inflation. Almost all central banks have responsibility for thefunctioning of the national financial system, thoughthe degree varies. A central bank’s rate policy is primarilydetermined by domestic economic circumstance and notby a desire or a need to affect the value of its currencyon the international stage.The value of a nation’s currency is also directlyaffected by the comparative strength and weakness ofa country’s economy in relation to those of its tradingpartners. The stronger economy, that with the higher GDPgrowth, lower inflation, greater productivity, political stability and a host of other factors will, over time, have thestronger currency. It is these fundamental factors, in conjunction with central bank interest rate cycles, which produce the long-lasting price trends typical of the currencymarkets. Some factors that affect a country’s economicstatus reflect the choices of the political system. The balance between social welfare and individual competitionis one example—the openness of an economy to foreigntrade and capital is another. Other economic factors suchas labor mobility, entrepreneurship, and savings ratesare part of the social and cultural makeup of the nation.And yet others, like oil or mineral deposits, stem from anation’s geographic or resource endowment. All of these
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EXECUTIVE INSIGHT (CONTINUED)factors, and many more, are monitored, assessed andjudged for their effect on economic growth and development. A change in one factor or several can affect theproductivity capacity of an economy, alter its competitiveness against its trading partners, and change the relativevalue of its currency.Exchange rates tend to focus on one aspect of acurrency—its use as a medium of exchange. The U.S.economy is currently 22% of world GDP; it was once 50%.Modern industrial capitalism is spreading to new and everlarger sections of the world. Since World War II the U.S.percentage of the world economy has steadily diminishedas other national economies have grown at faster rates.Over time that reduction has decreased the demand forthe dollar as an agent of exchange. But currencies alsoact as a long term store of value. Any foreign investor ina country is also an investor in that country’s currency.When a central bank or private entity buys United StatesTreasury Bonds or American stocks, it does so with dollars, creating demand for the U.S. currency. Until the creation of the euro there was no alternative to the dollaras a store of value. No other country could match theeconomic, technological and political power of the UnitedStates, and these qualities made it a favorite investmentdestination. The demand for the dollar as a store of valuecreated by investment flow added greatly to its demandin the currency markets.”
N o News Is Bad News for News TradersWith economic news and data coming out of the United States andother countries on an ongoing basis, foreign exchange traders who
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truly strive to be successful, regardless of whether they are primarilytechnical or fundamental strategists, must necessarily be vigilant ofscheduled economic releases and current events. Fundamental forcesaffect currency prices too thoroughly to ignore. But when tradersconcentrate all of their attention on news and economic data to theexclusion of other factors, this is called news trading.As mentioned earlier in this chapter, news trading can be difficult for a number of reasons. One notable difficulty is the speed thatis required to place trades at the right time in order to take advantage of the best price moves on a data release. These moves can takeplace during or only milliseconds after the release, and traders needto compete with countless other individuals and institutions that areplacing trades at the same time.In addition, obtaining the news earlier than others is virtuallyimpossible for the average individual trader. Most traders do nothave access to the almost instantaneous news feeds that are necessary for trading the news effectively. Any lag time in receiving datareleases translates into potentially lost profits.Furthermore, during and immediately after news releases areamong the most volatile times for the currency markets. This meansthat it may be harder for trades to be filled by the broker as accurately as during quieter markets. This is due to the sheer speed ofprice movement as well as the price gaps that can occur in fastmarkets.Besides the speed factor, another underlying difficulty with newstrading involves the proper interpretation of the news. Economicdata releases and other news announcements hold many nuancesthat can be difficult for the average foreign exchange trader to
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comprehend fully. Often, a new economic number comes outthat should obviously make the dollar go up, but instead, the dollar plummets, or vice versa. This is where the concept of consensuscomes in.When a piece of news or data release comes out and the marketdoes something intuitively different or opposite of what it shoulddo, traders will say that the information was already “priced in”to the market. For example, if bad news for the dollar comes outbut the dollar goes up anyway, it should mean that the market wasalready expecting bad news. Maybe the news that ultimately cameout, though bad, was not as bad as traders had been expecting. Whena market expecting horrible news receives only bad news, the relatively positive nature of the bad news will often make the market goup. In this example, the expectation of horrible news is called theconsensus.Foreign exchange traders who trade the news must pay attention not only to the actual numbers that are released, but also tothe consensus, or what the economists and other experts are expecting. Then, trading can take place based on how far the actual numbers deviate from the consensus numbers. In this way, news tradingis based almost entirely on relative values rather than absolute values.Often, news traders will determine their own trading threshold forthe difference between actual data and consensus data, placing longor short trades only if the respective threshold is met or exceeded bythe actual data.One final point regarding economic indicators and trading thenews lies in the economic data issuer’s common practice of releasing revisions. For example, if Non-Farm Payrolls data are released
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on the first Friday in February describing employment figures forthe month of January, what will sometimes happen is that thoseJanuary numbers will be significantly revised when the new NonFarm-Payrolls report comes out in March. If substantial enough,this March revision has the potential to move the foreign exchangemarkets even more than the original report released in February.Therefore, the prudent news trader must necessarily pay close attention not only to consensus and actual data figures, but also to thepossibility of unexpected revisions.As many fundamental news traders will attest, because of all thedifficulties involved in trading the news, including those describedhere, it is definitely a very challenging style of trading. Those whotake the time and trouble to overcome the obstacles, though, oftenfind it a very rewarding one.
C hapter Summar yFundamental analysis is essentially the study of why markets move,or, more specifically, what drives them to move. The primary drivers in foreign exchange, like that of other financial markets, are thebasic economic concepts of supply and demand. If there is highdemand for and/or low supply of a currency, its value should go up.Conversely, if there is low demand for and/or high supply of a currency, its value should go down.In turn, supply and demand are driven primarily by traders’ collective perceptions of fundamental factors. These factors includeinterest rates, central bank policy, economic growth, and inflation,
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among others. Changes in these factors can have profound effectson the currency markets.In terms of interest rates and central bank policy, which areinstrumental determinants of currency value, central banks willtend to increase rates (tighten) with the goal of controlling inflation.On the other hand, these banks will seek to decrease rates (ease) inorder to help stimulate the economy. Generally speaking, the immediate effect of tightening tends toward an appreciation of the currency,while the immediate effect of easing tends toward a depreciation ofthe currency. These are only general tendencies—not rules—as manydifferent factors combine to dictate currency exchange rates.Also in the realm of interest rates, carry traders can earn interest income on the interest rate differential for the currency pair theyare trading, provided the trade is in the direction of positive interest.For example, for a carry-traded pair like AUD/JPY (where AUD hasa high interest rate and JPY has a low interest rate) a trader wouldearn a positive differential for holding a long AUD/JPY position,and would be charged as a result of a negative differential for holding a short AUD/JPY position.Also important to the value of a currency, and what many shortterm foreign exchange traders gravitate towards, are economic dataindicators. These indicators are usually released on a monthly orquarterly basis by government agencies or private organizations, andthey each provide a barometer reading for a certain sector or aspectof the economy. For example, GDP is used for assessing economicgrowth, CPI for providing indications of inflation, and the NonFarm Payrolls report for evaluating the employment situation.
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News traders in the foreign exchange markets seek to exploitthese economic data releases by trading currencies based on how theactual data figures may deviate from the predetermined consensusfigures. In this way, these traders are using the twin concepts of market expectation and surprise to dictate their trading. There are manydifficulties involved in this type of trading, but those who are ableto overcome the significant obstacles often find news trading to be aworthwhile pursuit.Regardless of whether one is classified primarily as a technical analyst or a fundamental analyst, it is absolutely essential for anyforeign exchange trader who wishes to have a reasonable chanceat success to pay at least some attention to the fundamentals. Themore a trader learns about fundamental market drivers, the betterthat trader will be prepared for the often unpredictable nature of theforeign exchange markets.
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CHAPTER 5
Foreign ExchangeTrading Methodsand StrategiesAfter reading this chapter, you will beable to:●
Appreciate the many methods and strategies commonlyused by experienced foreign exchange traders.
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Comprehend the logic and reasoning behind the mostpopular forex trading styles.
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Execute specific, high-probability strategies in a foreignexchange trading account.
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Understand the basics of backtesting and autotrading.
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R ules to Trade ByHere is where all that has been learned thus far, especially withregard to basic trading mechanics and technical/fundamental analysis, can be combined to form cohesive trading methods and strategies with definitive rules to trade by. Knowledge of market analysisalone is simply not enough to trade foreign exchange effectively.In order to be successful, each trader must necessarily integrate theprinciples of market analysis into structured, workable trading processes that offer the best chances of consistent profitability. This iswhere trading methods and strategies come in.When reading this chapter, keep in mind that the lines betweeneach trading method/strategy/system/style can often be excessively blurred. For example, swing trading shares many similaritieswith range trading. The same may be said for position trading andlong-term trend trading. Similarly, point & figure trading is sometimes considered breakout trading at its finest. The point is that eachof these ways of tackling the foreign exchange market will have itsown separate heading, but the overlap among them can be substantial. This is due to the fact that there are almost as many ways totrade currencies as there are traders in the financial markets, andeach particular way of trading does not always fit precisely into oneneat bucket. This chapter will provide an overview of some of themain methods of trading forex that have proven themselves overtime, as well as some specifics regarding how to go about applyingthose methods.It should also be noted here that none of these methods can beconsidered the “holy grail” of forex trading. In fact, there is no such
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thing as a holy grail in the trading world. No trading method orstrategy could ever offer any trader a guaranteed promise of successand profitability. The closest thing that comes to anything resemblinga holy grail would be a combination of several factors, including:broad trading experience, extensive market knowledge, sufficient riskcapital, prudent money management, a good trading plan, and a firstrate trading strategy with a positive expectancy. To a degree, this bookcan help with the crucial aspects of knowledge, risk/money management, a trading plan, and a trading strategy. But obviously, experienceand capital are entirely in the hands of each individual trader.What the following trading methods and strategies will provideis a head start into the world of real, hands-on currency trading.Armed with the methods and strategies contained herein, as well asa free practice trading account from any online forex broker, prospective traders can immediately begin to explore the ways in whichexperienced traders approach the foreign exchange markets. It ishighly recommended that traders practice any new method extensively on a demo practice account before attempting to apply it ona real money account. Again, successful trading is not just about agreat trading strategy. If a trader is to be successful, that individualmust necessarily synchronize many positive attributes in conjunction with a good method or strategy.In no particular order, the foreign exchange trading styles, methods, and strategies to be discussed in this book will begin with threegeneral approaches to forex trading in common use: position trading, swing trading, and day trading. Traders generally choose (orevolve into) an approach based on their personality, experience, andrisk appetite, among other factors.
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P osition Trading—Settling in for the Long TermAs its label suggests, position trading is all about taking a directional market position and holding it for as long as the trade makessense from a trend standpoint. This usually means that positions areheld longer-term. In the fast-moving, impatient world of foreignexchange trading, longer-term could mean anywhere from as shortas a week or a month to as long as a year, or possibly more. Mostindividuals trading foreign exchange on a retail basis do not havethe patience to be position traders. This is somewhat unfortunate,as position trading can be one of the most profitable styles of trading due to the fact that many currencies tend to trend exceptionally well on a longer-term basis. Only those position traders whohave the patience to stick with the trend and let their profits run aregenerally able to capitalize substantially on these longer-term pricemoves.Unlike swing trading and day trading, which will both be discussed later in this chapter, position trading usually relies substantially on fundamental analysis, along with longer-term technicalanalysis. Other than in the realm of ultra-short-term news trading,which will also be discussed later in this chapter, fundamental analysis is usually geared toward longer-term price forecasts rather thantoward the short-term swing-to-swing movements that are primarily the domain of technical analysis. As discussed in Chapter 4, fundamental analysis concerns itself with the economic conditions thatdrive the major market movements. These economic conditions,which include interest rates, inflation, and economic growth, helpto determine the value of a national currency over time. The general
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direction of change in this currency value over the long run is whatinterests position traders the most.As mentioned in the beginning of this chapter, position tradingcan be considered very similar to trend trading. One of the differences between these two approaches is the type of analysis that isgenerally emphasized. Whereas position traders may often rely to asignificant extent on long-term fundamentals along with technicals,trend traders (or trend followers) are very often almost exclusivelytechnical in nature. Of course, this generalization is far from a clearcut delineation, but it describes the broad characteristics of thesetwo approaches sufficiently. Similarly, carry trading, where tradershold interest-positive positions in order to benefit from both regularinterest payments and exchange rate profits, can be considered yetanother form of position trading. Both trend trading and carry trading will be discussed later in this chapter.How exactly does a position trader in the foreign exchange market decide which position(s) to take? Although there are countlessfactors and nuances that may enter into the decision-making picture,the basic concept can be relatively simple. Forex position tradersweigh strength and weakness in currencies by looking into a myriadof underlying fundamental and technical factors. They then establishpositions in currency pairs according to these views. Here, the discussion will focus on the fundamental aspects of position trading. Inthe section on trend trading, the technical aspects will be discussed.Let us suppose that a position trader performs ongoing analysis on economic conditions surrounding the major currencies, anddecides that the U.S. dollar is indicating significant fundamental weakness going forward, while the euro is indicating significant
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fundamental strength going forward. This conclusion could havestemmed from any number and combination of information sourcesfrom both countries/regions, including comments on central bankpolicy by a bank president, the state of inflationary pressure in theeconomy, the recent rate of economic growth, the likelihood of animpending recession, and so on.After this fundamental analysis is duly performed, the trader maydecide that there is sufficient evidence supporting overall weaknessin the U.S. dollar combined with overall strength in the euro, andthat this will be the likeliest projected scenario for at least the nextsix months. The next step is for the position trader to seek to establish a long position in the EUR/USD currency pair, which simultaneously provides the trader with a long euro position and a shortdollar position. This combined trade positioning fulfills the trader’sfundamental outlook on both currencies.Pinpointing the most advantageous trade entry timing, as wellas setting risk-managed exit strategies, would then be best accomplished with the use of technical analysis. But the longer-termdirectional basis for the position trade is sufficiently served by fundamental analysis alone.The true strength of position trading using fundamental analysisin this manner lies in the concept of pairing strength with weakness. This concept fits the foreign exchange market extremely wellbecause of the simple fact that all currencies are traded in pairs,unlike in other financial trading markets. Since trading forex requiresa directional commitment on two currencies for each trade, positiontrading with the strength/weakness model is perhaps the most logicalfundamental method for approaching long-term foreign exchange
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trading. Buying one currency because it looks like it will becomestronger is a good way to trade. But buying one currency becauseit looks like it will become stronger while simultaneously selling(or shorting) another currency because it looks like it will becomeweaker is an even better way to trade.The first step in the process of forex position trading is to perform ongoing fundamental research and analysis on all of the majortradable currencies. This can be accomplished through careful scrutiny of central bank policy statements, objective assessments of economic growth factors, and close monitoring of global economicnews. When the currencies with the strongest positive future prospects and the ones with the strongest negative future prospects atany given point in time are identified, the opposite currencies canthen be paired.So, for example, within a pool of well-researched currencies, letus suppose that AUD and JPY happen to be deemed the strongestpotential gainers in the group for the foreseeable future, while theCAD and CHF are deemed to be the strongest potential losers.The opposites could then be paired together for potential positiontrades consisting of long AUD/CAD, short CAD/JPY, long AUD/CHF and/or short CHF/JPY. After these trades are entered with thehelp of technical analysis, the positions would then be held for aslong as they continued to move in the correct general direction, disregarding minor corrective swings and market noise.From the standpoint of disciplined trading, as will be discussed inChapter 6, position trading may perhaps be the most difficult methodfor approaching the foreign exchange markets, especially for beginners. It requires a great deal of patience and faith in one’s own analysis
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to weather the inevitable swings against one’s entrenched positions,not to mention excellent risk and money management. But if mastered properly along with some well-planned entry and exit techniques, this style of trading can be one of the most effective methodsfor extracting long-term profits from the foreign exchange markets.
S wing Trading — Riding the WavesAlso among the most popular methods of trading forex, swingtrading differs considerably from position trading in almost everyway. For the most part, swing traders generally ignore fundamental information and concentrate almost exclusively on the technicals. The only time swing traders will generally pay any attention tothe fundamentals is when they check the schedule for fundamentalnews announcements so that they can avoid trading during marketmoving economic data releases.Much like its label suggests, swing trading is all about tradingswings, or turns, in the market. Any price action that occurs overtime in any financial trading market will