<s> Sy) Wiley Trading
Agustin Silvani
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An insider's look into tradingtoday’s foreign exchange market
 The foreign-exchange market is often referred to as the Slaughterhouse wherenovice traders go to get ‘chopped up’. It is one of egos and money, wheremillions of dollars are won and lost every day and phones are routinely thrownacross hectic trading desks. This palpable excitement has led to the explosionof the retail FX market, which has unfortunately spawned a new breed ofauthors and gurus more than happy to provide misleading and oftendownright fraudulent information by promising traders riches while makingforex trading ‘easy’.
Well I'll let you in on a little secret: there is nothing easy about tradingcurrencies. If you don’t believe me then stop by Warren Buffet's office and askhim how he could lose $850m betting on the dollar or ask George Soros whyhis short yen bets cost him $600m not once but twice in 1994. What's wrongwith these guys, don’t they read FX books?
In reality, the average client's trading approach combined with theunscrupulous practices of some brokers make spot FX trading more akin
to the games found on the Vegas strip than to anything seen on Wall Street.The FX market is littered with the remains of day traders and genius ‘systems,’and to survive in the long-run traders have to realize that they are playing
a game where the cards are clearly stacked against them.
Have you ever had your stop hit at a price that turned out to be the low/highfor the day? Bad luck perhaps? Maybe. What if it happens more than once?Do you ever feel like the market is out to get you? Well guess what, in thisZero Sum game it absolutely is.
Covering the day-to-day mechanics of the FX market and the unsavourydealings going on, Beat the Forex Dealer offers traders the market-proventrading techniques needed to side-step dealer traps and develop winningtrading methods. Learn from an industry insider the truth behind dirty dealerpractices including: stop-hunting, price shading, trading against clients and‘no dealing desk’ realities.
Detailing the dealer-inspired trading techniques developed by MIGFX Inc,
~ consistently ranked among the world’s leading currency trading firms, thebook helps turn average traders into winning traders; and in a market with
a 90% loss rate winning traders are in fact quite rare! More than just a simplemanual, Beat the Forex Dealer brings to life the excitement of the FX market bydelivering insights into some of the greatest trading triumphs and highlightinglegendary disasters; all written in an easy to read style. By stripping away thetheory and getting down to the core of trading, you too will find yourself onthe way to beating the forex dealer!
WILEY PUBLISHING
ISBN 9788470722084IMalleta 7ee47Gl P22ue4
56000
 One of the pioneers in foreign-exchangetrading, Agustin Silvani developed one ofthe first retail-oriented currency programsand currently leads the team of professionalsat MIGFX Inc, consistently rated among thetop-ten currency traders as ranked byBarron’s, Futures, and Currency TraderMagazine. Mr Silvani's experience in FXranges from the interbank to the retail sector,helping manage portfolios ranging from $1million to more than $10 billion in size, andis a regular contributor to the financial press.
To receive the latest news and updates(ole UA M-TUL Cate] eUY 1 OxT1 Cc)www.beattheforexdealer.com
Original jacket design by Ania Potocki,jacket layout by Design DeluxeBeat the Forex DealerFor other titles in the Wiley Trading Seriesplease see www.wiley.com/financeBEAT THE FOREXDEALER
An insider’s look into trading today’sforeign exchange market
Agustin Silvani
A John Wiley & Sons, Ltd., PublicationCopyright © 2008 John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester,West Sussex PO19 8SQ, England
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Typeset in 10/12 Times by Laserwords Private Limited, Chennai, IndiaPrinted and bound in Great Britain by TJ International, Padstow, Cornwall, UKContents
 
Acknowledgments
Introduction
PART I THROUGH THE EYES OF A TRADER
1
23456
On Markets
The Currency MarketA Rare Breed
FX Dealers
Today’s FX MarketThe Players
PART II THE RETAIL SIDE OF THINGS
78910
Card Stacking
Don’t Trust Your FCMThird-Party ServicesFighting Back
PART III JOINING THE 10%
11
Becoming a Great Trader
12 Picking the Right Approach
13192327
3335434751
555763vi
Contents
 
PART IV FX TRADING TIPS13 Adapting to the FX Market14 Trading Thin Markets15 Using the Crosses16 All About Stops17. Characteristics of FX Trends18 Trading the FED19 Fading News20 FX Analysts: Who Cares?
PART V DEALER TRADES21 Trading Against Dealers22 The Big Figure Trade23 The Friday to Sunday Extension
24 Sticking it to Your Dealer
PART VI THE FUTURE25 The End of the Beginning
APPENDIX TRADING “HOW TO’S”How to Set Up Your TradingHow to Trade Price ActionHow to Build a Position
How to Trade Out of a Losing Position
737583879397103109113
117119123131137
143145
149151157163169Contents
NOTESSpeaking Like a DealerFX GlossaryTrading MaximsBibliography
CFTC Minimum Finance Requirement
Index
vii177179181189191193
209Acknowledgements
 
This book required the expert help and contributions of a wide range of friendsand colleagues. Special thanks go out to all of the great people at MIGFX, whosehard work and dedication to trading gave rise to this project. I would also like togive special thanks to Richard Hoffman for his help and dedicated research, andto the many industry contacts whose insights proved invaluable. Without you thisbook would not have been possible.
I would also like to thank the great people at ProRealTime.com for granting mepermission to use their fabulous charts. Every trader should visit their website andcheck out their charting packages, for they are truly top-notch in the industry.Introduction
 
Over the years, I have tried to get my hands on every currency trading book thatI could find, but as you may well know the pickings are slim when it comes toFX literature. Apart from a few notable exceptions, most of the available materialseems to fall into one of two categories: unabashedly theoretical or completelymisguided. The dry, outdated, and sometimes esoteric academic works tend toleave the reader with the perception that currency trading is as gentlemanly andordered as the world of stamp collecting, when in reality nothing could be furtherfrom the truth in a market referred to as a “slaughterhouse” where traders routinelyget “chopped up”. The FX market I know is one of egos and money, where millionsof dollars are won and lost every day, and phones are routinely thrown across hectictrading desks. This palpable excitement has led to the emergence of a second classof literature, often misleading and downright fraudulent, where authors promise thereader riches by offering to make forex trading “easy”.
Well, I'll let you in on a little secret: there is nothing easy about trading cur-rencies. If you don’t believe me, then stop by Warren Buffet’s office and ask himhow he could lose $850 million betting on the dollar or ask “King” George Soroswhy his short bets lost him $600 million not once but twice in 1994. Don’t theseguys read FX trading books? If these investment legends can lose billions in theFX market, what makes anyone think there is anything easy about it?
The average retail trader must feel a terrible disconnect between what is describedby famous “experts” and their actual trading experiences. Theory very rarely trans-lates into fact when it comes to trading, and real-life FX trading is much morecomplicated and tricky than any guru would have you believe. In this jungle it isa kill-or-be-killed attitude that marks survival, and the minute you step on to theplaying field a target has been placed next to your account number.
Realizing that most FX books in print are either written by scam artists or aca-demics with little real-world trading experience, I decided to put my own thoughtsto paper. While I certainly do not proclaim to be any sort of market wizard, themarket insights I have gained while managing a successful currency fund shouldprove valuable to readers, even if they are just starting their trading careers. Beinga firm believer in the “small is beautiful” mantra, I have therefore tried to keepthis book short, and to the point.xii Introduction
 
The purpose of this book is two-fold. First, by explaining the day-to-day mechan-ics of the FX market and pointing out some of the more unsavory dealings goingon in the retail side, I hope to make evident for the reader the risks and rewardsinvolved in currency trading. The second objective of the book is to help turnaverage traders into winning traders. “Average” traders are losing traders; winningtraders are in fact quite rare. However, by highlighting some market-proven tradingtricks and techniques, I hope to give traders an initial leg-up.
As you may have guessed, this book takes its name from Edward O. Thorp’slandmark work on blackjack, Beat the Dealer. In 1962, the MIT mathematicsprofessor revealed to the public the gambling industry’s tricks and traps, while atthe same time managing to teach a successful method for playing the game oftwenty-one. Likewise, you will find this book roughly split into two parts: the firsthalf is dedicated to revealing the foreign exchange market’s unfair practices andthe second half is designed to help the retail FX trader implement an effective andwinning game plan by providing trading tips and detailed examples.
FROM VEGAS TO WALL STREET
The past five years has seen the FX market open its arms to nontraditional par-ticipants, and now everyone from dotcom investors to cash-strapped grandmas arejumping in hoping to strike it rich.
What most of these new participants fail to realize is that they are stepping onto a battlefield littered with the remains of day traders and genius “systems”. It isfrequently noted that over 90 % of FX traders do not survive in the long run, yetyou won’t find that statistic in any of the publicity dished out by the FX brokers.To be profitable, retail traders must realize that the foreign exchange market wasfundamentally developed as a professional’s market, and its outdated conventionsand procedures mean that it still is very much geared toward the professional. Ina market where the retail trader exerts little (though growing) influence, most canhave little hope of success.
The retail brokers who have sprung up recently would like you to believe thatcurrency trading is a high form of financial speculation. In reality, the averageclient’s trading approach combined with the unscrupulous practices of some brokersmake spot FX trading more akin to the games found on the Vegas strip than toanything seen on Wall Street. The new breed of on-line FX brokers simply share toomany of the traits employed by casinos to stack the odds in their favor, includingthese:
e The “house” always has the advantage (the spread).
e The “house” feeds off the player’s greed and actively promotes it (by offer-ing trading signals, excessive leverage, and fancy platforms resembling slotmachines!).Introduction xiii
 
e The “house” adopts various dubious risk-management controls, whichinclude cheating and cutting off winning players.
All of these benefits ensure that, in the long run, the house (broker) will end upwith virtually all of the player’s (trader’s) money. The odds are simply stacked intheir favor.
Thorp’s original Beat the Dealer was brilliant in that he focused his energy on aniche game (blackjack) which featured changing odds. In a game with fixed odds(such as the lottery) a player is virtually assured ruin, while a game with shiftingodds allows the smart player to effectively control his risk while maximizing hisgains. Although the long-run odds may not favor the player, a set of rules can beadopted that allow the gambler to “play” only when the odds are in his favor, thusgreatly improving his chance for success. Playing in this way enables you to refrainfrom gambling (betting on luck) and concentrate on playing the probabilities. FXtraders need to take a cue from their card-playing counterparts and learn to tradeonly when the odds are shifted in their favor. In this spirit, the last part of this bookis dedicated to exposing high-probability trades commonly seen in the intra-dayFX market, which can effectively be used to “double up” when they are seen.
BEAT THE DEALER
In my experience, most retail FX traders seem to have a decent system or genuine“feel” for the market, yet more often than not they still find themselves postingsteady losses. They see the possibility for greatness, yet they are unable to graspit. Something must be missing ...but what? Although they may spend hours duti-fully studying technical analysis, candle charting, and the history of the market,seldom do they take a moment to concentrate on their number one killer: the forexdealer. By preying on the small speculator, these shadowy characters are oftensingle-handedly responsible for turning winning trades into losers.
Both casinos and FX brokers have an ace up their sleeve which ensures that theodds are always shifted aggressively against a player, and not surprisingly thesevillains share a common name. Dealers are much more than simple order-processors(do you want to buy/sell, hit/stay?); they are in fact the house’s fail-safe devicesent out to take down any player who is deemed to be winning “too much”. Theirdirect and purposeful interference can ruin even the most advanced or eleganttrading system.
Have you ever had your stop hit at a price that turned out to be the low/high forthe day? Bad luck perhaps? Maybe. What if it happens more than once? Do youever feel like the market is “out to get you?” Well, guess what...in this zero-sumgame it absolutely is.
Dealers make particularly tough opponents for traders because they act on betterinformation. Although it is hard to bluff when the other party knows your cards,you can however profit by betting on their actions, and a dealer’s actions are, afterxiv Introduction
all, very predictable. You know what they want (your money) and you have a roughidea of how they will come after it (running stops, shading prices, fading moves,etc.); all that you now need is a way to exploit these actions. Throughout this bookyou will find information meant to help you identify and counteract typical dealertraps, which if implemented correctly can instantly improve your trading profits.Many of these are exactly the same techniques used by hedge funds and CTAs toexploit loopholes left by their dealers, which can also be used successfully by theretail trader.
Make no mistake about it. There is a lot of money to be made in currency trading;you just have to know where to look. Sidestepping dealer traps is one simple wayof improving your daily P/L, but it is surely not the only one. Successful tradingcomes down to taking care of the details, and for me the only way to do this is byproviding concrete, up-to-date, real-life examples, and sharing the FX trading tipsthat have proved so profitable over the years.
In the end, it is my hope that by stripping away the theory and getting downto the core of trading you too may find yourself well on your way to beating theforex dealer!
Some Terms Commonly Used In This Book
Individual (Retail) Trader Nonprofessional trader; i.e. speculates for his ownaccount as opposed to trading for a bank or hedge fund. Normally trades smallsizes (under $1 million), usually either for speculation or fun.
Interbank Market Loose term used to describe the FX trading done by banksdirectly with each other, as opposed to trading with clients. Can essentially bethought of as the “wholesale” FX market, where entry is restricted to professionals.Not a physical market or exchange, the interbank market is a web of credit facilitiesbuilt over time and used by banks to trade with each other directly or throughelectronic matching platforms such as Reuters and EBS.
Retail FX Broker Also called Futures Commission Merchant (FCM), these arecompanies created to “open up” the spot currency market to the retail trader throughtheir small minimum account sizes (as low as $300). In theory, they should simplybe the middlemen between the FX wholesalers and their retail client base, charginga small fee (the spread) for their service. Much like on-line stock brokers (E-trade,etc.), they promise to “connect” the retail trader to the market at reduced costs, yetoften fall well short of this promise.
FX Dealer If the interbank is the wholesale market and the brokers are the middle-men, then the dealers are the salesmen. Dealers typically work for FCMs or banks,and their primary responsibility is to process client transactions (buy/sell orders). IfIntroduction xv
wanting to trade, clients have the option of phoning their dealer or trading electron-ically. The dealer then goes to the wholesale market, executes the order, and keepsthe price difference (in theory at least). Retail dealers concern themselves mostlywith providing accurate prices (through their on-line trading platforms), handlingclient flows, and running stops of course!
Simplistic view of a retail FX transaction
 
Trader: “1 want to buy EURUSD, what's your price?”Dealer : “Moment please”
 
Dealers(work for the brokers)
   
Dealer : “Price is 1.25”Trader: “Ok. | buy”
iC a 1k CLE)
Dealer asks aroundfora price
 
NL
Dealer gets a market Interbank Marketprice to buy of 1.24
 
BANK BANK BANK
Note. If you are not at all familiar with the foreign exchange market or tradingin general, then you may well benefit from reading up on the subject beforeproceeding. There are many valuable books that teach technical analysis, can-dlestick reading, history of the markets, economic theory, etc. Most of those
books give the beginning trader a basic grounding in the financial theory thatunderpins successful trading, and should be dutifully studied by all traders; thisbook is not meant to replace any of them. The material covered in this bookis strictly centered on sharing professional “buy-side” insights for trading thespot foreign exchange market.
  
THROUGH THE EYESOF A TRADER1On Markets
 
If one believes in a random universe, a strong case can be made for the fact thatany sort of technical analysis and trading tactics are in fact quite useless. Under thisscenario, random and unpredictable price movements makes research, analysis, andmarket timing an exercise in futility, and relegates any kind of strategy (other thanbuy-and-hold) to a game of chance, not skill. As Burton Malkiel famously noted,“A blindfolded monkey throwing darts at the financial pages of a newspaper canselect a portfolio that will do just as well as one carefully selected by the experts”.This market view is supported by the fact that the vast majority of mutual fundsfail to beat the broader market year after year, and history shows us that the tenbest-performing funds in any one year will drop to the bottom of the pack in thefollowing two to four years, meaning that a manager’s outperformance is largelythe product of luck, like a gambler’s short-term winning streak. Simply put, thereis no way to consistently beat the market.
Needless to say, this view of things does not sit well with Wall Street, whichpreaches that research, analysis, and relying on expertise are the keys to investing(and their business model!). Assuming that we can draw a similar parallel to othermarkets, then why bother trading? Why spend so much time researching the marketand analyzing prices when we could just as simply close our eyes and buy or sell?
Thankfully for traders, although the random walk theory paints a strong caseagainst mutual funds, it is not entirely bullet-proof. Investors consistently fall preyto fear, envy, overconfidence, faddism, and other recognizably human imperfectionsthat make markets not only inefficient but predictably inefficient. In the short run,recognizable patterns are indeed visible in the stock market. Bubbles are created,and then burst. If the DOW goes up one week, it is more likely to go up thenext week. In the long run all of these moves smooth themselves out, but in theshort run, predicting and trading these constant adjustments can actually makefor quite a profitable proposition. Through research and analysis we can visuallyidentify these inefficiencies and market anomalies in charts, and then trade their4 Beat the Forex Dealer
 
   
PAST AND PRESENT BUBBLES
NASDAQ 40074 300%1995-2002
    
DOW JONES1927-1932
ox 0%tem ae er we ve oh waeSHANGHAI aeNIKKEI Al !1985-1992 a 2005 - 7al 0% | rn a
me i lm i re ne te
‘SOURCE: YAHOO.COM. LOWRISK CoM
 
Stock market bubbles tend to be of similar length, duration, and size. The chart patternsare similar since the impetus behind them is the same (low borrowing costs, greed, andoverconfidence). “This time it’s different... .”
expected outcomes. The point in trading is therefore not to forecast the futureevents themselves, but rather to predict and profit from their consequences instead.
The day the financial community realized exactly how imperfect a science itpractices was 19 October 1987. On this “Black Monday” US stock markets man-aged to drop an incredible 22.6 % for no apparent reason, which proved especiallyshocking to the brilliant mathematical minds that had spent their academic careerssolving most of the puzzles surrounding proper pricing and valuation. By the late1980s it seemed that markets had finally been “figured out” and trading was nolonger the realm of risk-hungry cowboys as technology quickly came to replace thegut in pricing (and trading) decisions. Yet in light of all this, the world’s biggestand most sophisticated market still managed to shed nearly one-quarter of its valuein one day and on no news, putting into question even the most basic financialassumptions. By noon of that day, IBM’s stock stopped trading in the face of onlysell orders; literally no one wanted to buy. If a stock is only worth as much assomeone is willing to pay for it, did this mean that IBM’s stock was, at least forthe time being, worthless? What exactly was going on? How could we call themarket rational and efficient, let alone figured out?On Markets 5
 
The fact that this event now seems as distant as the stock market crash of 1929is evidence of just how much we have moved forward, yet many of the underlyingreasons behind the crash are still around today and the trading lessons behind theseunderline the major differences from what we may call the “academic” view ofmarkets and the trader’s view.
A LITTLE MARKET THEORY
As we know, professors love formulae, and perfect formulae make for perfectmarkets. The problem with this kind of oversimplified interpretation of the marketis that it tends to marginalize an individual’s contribution, while traders realize thatsometimes individual actions are actually the driving force behind markets. Whydid people sell on Black Monday? It was because everyone else was selling; it isas simple as that.
The problem for the academic world is that while real risks (interest rates, stockprices, etc.) are easy enough to understand, perceived risks are much harder toquantify and are therefore generally ignored. After all, how on earth can we measureJoe Investor’s sensitivity to risk when on the one hand he spends days researchingand analyzing which car to buy and on the other hand he buys Pets.com stock ona friend’s tip?
Over the years traders have learned to get a grasp on this tricky subject, and someinteresting things about the perception of risk have emerged. We know that risktolerance decreases once the market is fully invested, which is why asset bubblesbuild up slowly and deflate violently. We also know that our brain is hard-wiredto shy away from pain and regret, thus making us sell our winning stocks whileholding on to losers hoping that they will turn around. How many dead internetstocks do you still have in your portfolio?
What we now know is that markets are efficient, but they are not perfectlyefficient. The point where buyers and sellers meet does not always reflect “equi-librium”, and the sheer number of arbitrage-hungry hedge funds out there can betaken as an indication of the market’s imperfection. Since prices are man-madecreations that reflect our biases as much as they do economic reality, markets maystay in a state of disequilibrium for a long time when the very reason for buying(prices going up) in turn leads other people to buy.
Those used to doing the day-to-day dirty work in the markets, the traders, deal-ers, and “locals” in the pit, have all come to realize that at least in the short run,markets are often manipulated and highly irrational. Psychology matters, fear mat-ters. Momentum often trumps economic fact, and we can be fairly certain that aslong as there is human involvement in the financial markets they will continueto exhibit the same erratic behavior patterns as human beings. Logic often takesa back seat to greed and fear since at the end of the day it is the trader/moneymanager that has his job and bonus to look after.6 Beat the Forex Dealer
1920's BULL.
 
   
   
 
 
DJIA ae | DJIA4002500300200020015001981-19871000 100va, aad “Black Mondays” eaOt Oct 19th, 1987 : market drops 23%500 ae Oct 28-29th, 1929 : market drops 24%.1923-1929 1 10o 01 122 314 488 620 874 1020 1208 1405 1665 1706
Days into bull market
“A perfect market thinks only of the future, not the past.” The market may not have amemory, but traders certainly do. The eerie similarity between the crash of 1929 and 1987can probably be attributed to traders in 1987 using the past as a way of predicting the future,unwittingly creating a self-fulfilling prophecy with their actions. (Source: Lope Markets)
Traders that overlook these behavioral aspects end up in trouble when confrontedwith tumultuous and emotional markets, even if for a brief period of time; hencethere is the famous saying, “The market can stay irrational longer than you canstay solvent”. This saying is more true that you can imagine, and the Wall Streetgraveyard is littered with traders that made money trading rational markets 99 %of the time, yet got wiped out by that irrational 1 %.
Legendary hedge fund manager Julian Robertson found out just how dangerousit can be to fade! irrational markets when he rationally shorted the tech bubbleof the 1990s and turned his stellar $22 billion dollar fund into a mere $6 billionbasically overnight. His farewell letter to investors pretty much says it all:
The key to Tiger’s success over the years has been a steadycommitment to buying the best stocks and shorting the worst. In arational environment, this strategy functions well. But in an irrationalmarket, where earnings and price considerations take a back seat tomouse clicks and momentum, such logic, as we have learned, does notcount for much.
'To fade a move is to trade against the prevailing direction. Fading a move higher would mean sellingshort into the rally.On Markets a
 
From a trader’s perspective, this means that the market is always right. If irra-tional investors make a bundle on the way up, while rational investors lose theirshirts shorting the move, then who is rational and who is not? Markets are notrational or irrational, they just are, and the only view that traders will ever holdsacred is their need for volatility, because it holds the key to their profits. As longas