so why don’t you? Probably because diversification is aword that has been around for so long that we just forget what it means.I like to say diversification is “common sense,” just not “commonknowledge.” Well, it is now, because this is what I am going to teach you,as well as how to do it.The foreign exchange market, FOREX for short, is the spot market forcurrency. Don’t get this market confused with the futures market, whereyou buy a contract to purchase currency at a future price in time. The spotmarket does not have time value associated with it; therefore, there are nodeltas, thetas, or intrinsic value to worry about. Don’t stop reading, becauseit gets real easy. In fact, in my opinion, this market is easier to trade than thestock market. I will explain.The spot foreign currency market is where traders come to trade theU.S. dollar. Have you ever heard of Bank of America? Certainly it is one ofthe largest, if not the largest, bank in the United States. Well, it uses theFOREX to diversify its portfolio, and so do numerous other banks.If you go on the Internet, you can go to the Bank of America Web siteand look under “Investor Relations.” There you will find Bank of America’sannual reports. This is public information and free. In the annual reports,which, by the way, are very long and detailed, you will find a category classified as “Global investment income” (see Figure 1-6).On page 41 of the 2001 annual report (Figure 1-7) you will see where theBank of America had $541 million in foreign exchange revenue, up $5 million.If this market is good enough for the big banks, it’s good enough foryou. This market was made available to the average investor in 1998, and itis one of the fastest growing markets in the world.With daily volume of nearly 100 times that of the stock market andavailable to almost anyone in the world, it is almost mandatory for you toinvest in this market to properly diversify your portfolio.The FOREX allows you to practice money management to its fullest,and because it is open 24 hours a day 6 days a week it doesn’t see the samegap ups/downs, you never have to worry about your stop limit beingskipped. Equally, the worry of companies posting false information andmoney managers or experts offering biased opinions will not have a largeimpact on a country’s currency.The FOREX trades currency pairs, which offers equal risk for shortand long positions due to one of the currencies always having a bull
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FIGURE 1-6 Bank of America 2001 Annual Report
FIGURE 1-7 Bank of America 2001 Annual Report
side. For example, entering a long position on EUR/USD means thatyou are going long on the euro (EUR) and short on the U.S. dollar(USD), and it works the same way when you enter a short position onEUR/USD, in which you are actually going short on the euro and longon the U.S. dollar.
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The FOREX has had a large impact on all the major banks, which areposting larger profits each year. Bank of America reported in its 2002 annualreport a $530 million profit from foreign exchange revenue. Meanwhile, itreported only $384 million from equities and $86 million from commodities.The 2002 revenues grew to $530 million from only $5 million in 2000.
FOREX DEFINEDFOREX is the acronym for the foreign exchange market, where one country’s currency is exchanged for that of another through a floatingexchange-rate system. It is the world’s largest financial market, with anestimated daily average turnover of upwards of $2.5 trillion.FOREX trading is not bound to any one trading floor and is not a market in the traditional sense because there is no central exchange. Instead,the entire market is run electronically, within a network of banks, continuously over a 24-hour period. The market opens Sunday at 5 P.M. (EST) andgoes thru Friday afternoon at 4:30 P.M. (EST).Banks have a natural flow of foreign exchange business from theircustomers, who buy and sell currency according to their individual needs.The banks must manage their own currency deposits in the changing lightof their customers’ transactions. To hedge or not to hedge? This is a wayto basically minimize their potential for loss, often referred to as a hedge.Investment managers also now deal globally, and they also must takepositions in the different currencies, as well as in more traditional instruments, such as bonds and equities. For example, if a mutual fund is investedin U.S. bonds, the manager must decide if the fund should be invested inU.S. dollars or in a different currency. Again it is a question of hedging,another layer of risk to manage.Conversely, because currencies have become an asset class, managersalso must decide if the creation of a foreign currency exposure is desirablefor speculative purposes. For example, it is possible to be long (to havebought) on the Nikkei Dow and short of (to have sold) the Japanese yen. Inthis case, the manager is using his or her knowledge of currency fluctuations to hedge in equity index position.Companies and institutions of all kinds that have foreign customers orsuppliers must decide if they should hedge the foreign exchange exposurethat this creates. Exporters have the risk of a rise in the value of their localcurrency, and importers have the risk of a fall in theirs. If there is a change
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in currency value before the goods are exchanged, one of the parties couldlose all their expected profits. This uncertainty in expected profits can beeliminated by offsetting the risk in the currency exchange.As a result of these types of transactions, noninterbank turnover in the FOREXnow accounts for about 25 percent of all transactions (21 percent in 1992).
A BRIEF HISTORY OF THE FOREXIn theory, foreign exchange dates back to ancient times, when traders firstbegan exchanging coins from different countries and groups. However, theforeign exchange industry itself is the newest of the financial markets.In the last hundred years, the foreign exchange market has undergonesome dramatic transformations. In 1944, the postwar foreign exchange system was established as a result of a multination conference held at BrettonWoods, New Hampshire. That system remained intact until the early 1970s.At this conference, representatives from 45 nations met together to discuss the future exchange system. The conference resulted in the formationof the International Monetary Fund (IMF). It also produced an agreementthat fixed currencies in an exchange-rate system would tolerate 1 percentcurrency fluctuations to gold values, or to the U.S. dollar, which was established previously as the “gold standard.” The system of connecting the currency’s value to gold or the U.S. dollar was called pegging.In 1971, the Bretton Woods Accord was first tested because of dramatically uncontrollable currency rate fluctuations. This started a chain reaction,and by 1973, the gold standard was abandoned by President Richard M.Nixon. The fixed-rate system collapsed under heavy market pressures, andcurrencies finally were allowed to float freely. Thereafter, the FOREX quicklyestablished itself as the financial market, the world’s largest financial market.
FREE-FLOATING FOREX MARKETThe foreign exchange markets officially switched to a free-floating marketafter the double demise of the Smithsonian Agreement and the EuropeanJoint Float. This switch occurred more due to lack of any other availableoptions, but it is important to understand that the free floating of currencywas not by any means imposed. This means that countries were free to peg,semipeg, or free-float their currencies.
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FREE-FLOATING CURRENCIESWhen the major currencies are free floating, such as the U.S. dollar, theymove independently of other currencies. The value of the currency is determined by supply and demand, which has no specific intervention point thathas to be observed, and can be traded by anybody so inclined. Free-floatingcurrencies are in the heaviest trading demand.
SEMIPEGGED CURRENCIESSemipegged currencies have disappeared since 1993. A perfect example ofsemipegging would be the currencies of the European Monetary System(EMS). Those currencies would be allowed to fluctuate only within 2.25 percent or, exceptionally, within 6 percent intervention bands. Following the foreign exchange crisis of 1993, the new EMS intervention rates were expandedto 15 percent. Semipegging would have a slowing-down effect on currencieswhen they were reaching the extreme values allowed within the range.Since 1999, the semipegged currencies of the EMS were switched tofully pegged values that form the Euro.
PEGGED CURRENCIESSome smaller economies have attached their currencies to largereconomies with which they hold close economic liaisons. For instance,many Caribbean nations, such as Jamaica, have pegged their currencies tothe U.S. dollar.
MAJOR FOREX PARTICIPANTSMajor FOREX participants include commercial and investment banks andcentral banks. Other participants include corporations, hedge funds, and millions of traders worldwide. The top seven banks that provide liquidity in thismarket include Bank of America, Credit Suisse, First Boston, Goldman Sachs,HSBC, J.P. Morgan, Morgan Stanley, Dean Whitter, and UBS Warburg.As times change and many individual investors begin looking for an alternative to the stock market, the FOREX is growing every day, with averagedaily volumes reaching upwards from $1.5 trillion to $3.5 trillion. Now morethan ever, the FOREX will play a key role in the wealth transfer of tomorrow.
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Volume in the FOREX
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How Profits Are Made
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The FOREX as a Two-Way Market
CURRENCY PAIRSCurrencies are traded in pairs, for example, U.S. dollar/Japanese yen orU.S. dollar/Swiss franc. Every position involves the buying of one currencyand the selling of another.Have you traveled abroad? If so, then you are probably familiar withcurrency exchange rates. Most people living in the United States are notsubjected to daily needs of currency exchange, but let’s say that you decideto take a trip to Canada. As soon as you cross the border, you will start tofind a need to exchange your U.S. dollars for Canadian dollars.You will receive slightly more than 1.25 times your U.S. dollars inCanadian dollars. Not a bad day’s worth of work. In fact, with the currencyexchange rates, most people take extra cash and go shopping. Just don’t15Copyright © 2004 by The McGraw-Hill Companies, Inc. Click here for terms of use.
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have any left over when you return home because it will have the oppositeeffect on your wallet.Let’s look at another example. You are a chief executive officer (CEO)of a big international construction company. Your company specializes inbuilding roads, and you just got a contract to build roads in Saudi Arabia. Itis going to take about 5 years to build the roads, and you are going to bepaid $20 million over the next 5 years. What do you do?Do you take the job and start building the roads? No! The first thingyou have to do is hedge the dollar value of your project. If it takes 5 yearsto complete your road-building project, there will be considerable fluctuation between the dollar and the reale, the local currency of Saudi Arabia.What if there was a war or economic unrest in the area? Do you think thatsuch an event can cause fluctuations in the currency exchange rates? If so, thething to do is hedge. Most large corporations will hedge, which means theyoffset or opposite their position. In the case of building roads in Saudi Arabia,the CEO would buy or sell the U.S. dollar against the future value of the reale.If the hedge is correct, then the road-building company will not lose anymoney if the reale goes up or down against the U.S. dollar over the 5 years.Multinational corporations and big banks do these types of investment everyday, thus creating the daily tremendous volumes in the marketplace.Take a look at some of the biggest banks mentioned in this book. Lookat their annual financial statements, published every year and available toindividual investors via their 10k’s (annual reports). Most of these reportsare listed on the banks’ Web sites under “Investor Relations.”As you start to read through these very extensive reports, some hundredsof pages, you can see where these banks make all their money. Look for a heading that says, “Global Investment Income.” When you do, you will see that millions and millions of dollars are made just on the exchange of currency.
RECOMMENDED CURRENCY PAIRSWhile there are scores of currency pairs to choose from, the following currency pairs in Figure 2-1, due to their volume and liquidity in the market,are the most widely traded. It is important to keep in mind that you will bea much more successful trader if you concentrate on only a few currenciesto trade rather than all the available ones.Just like the stock market, when you start worrying about 40,000-plusstocks, it is hard to find the right currency pair to trade. Limit yourself andbecome an expert on just a few currencies you want to trade.
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Currency that trades against the U.S. dollar is the most popular. It is themost liquid and volatile, which allows you as a trader to have a betteropportunity to make a profit.In addition to the currency pairs, there are also cross-currency pairs.Instead of trading against the U.S. dollar, one foreign currency tradesagainst another non-U.S. currency, for example:(EUR/CHF)(CHF/JPY)There are many different ones, but again, stay focused and concentrated onthe U.S. cross-currency pairs.As you may have noticed, currencies are displayed, for example, asEUR/USD. The base currency is the currency that is displayed in Figure 2-1.An easy way to remember which currency is the base currency is to look athow they are displayed.The currency in front, such as the EUR above, willbe the one that is going up in value if the currency pair is going up, and ifthe currency pair is going down, then the EUR would be getting weaker.FIGURE 2-1 Currency pairs.
Australian dollarBritish poundCanadian dollar
(AUD/USD)(GBP/USD)(USD/CAD)
Euro dollarJapanese yenSwiss franc
(EUR/USD)(USD/JPY)(USD/CHF)
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FIGURE 2-2 Dollar Volume by Market
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Thus, if the EUR/USD goes up in price, then the EUR is getting strongeragainst the dollar, and it takes more U.S. dollars to equal a euro. The samething is true in reverse if the EUR/USD goes down. Whenever you have acurrency pair that is at 1.00 even, then it is considered to be in parity. Thisis when one U.S. dollar would equal one euro.
WHY TRADE THE FOREX?There are many benefits in trading the foreign exchange market (theFOREX). A few of them are●
It has continuous liquidity.
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It has very low dealing costs; 4 to 5 price interest point (pip;discussed later in this chapter) spreads.
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It has 100:1 leverage for margin trading.
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It has a very volatile, trending market.
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It has a two-way market; that is, traders participate in bull or bearmarkets.
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It is open 24 hours a day from Sunday night to Friday afternoon.
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There are no separate commissions.
VOLUME IN THE FOREXThe Central Bank Survey of Foreign Exchange and Derivatives MarketActivity, coordinated by the Bank for International Settlements in March1995 and published in May 1996, stated that turnover in the FOREX grew by45 percent to $1.2 trillion between 1992 and 1995 (comparable figures forApril 1989 and April 1992 were $590 billion and $820 billion, respectively).The NASDAQ’s dollar volume in 2001 reached $10.9 trillion, anincrease of $10.2 trillion since 1991. This is a 1557 percent increase in thelast 10 years (see Figures 2-2 and 2-3).Official figures show the U.S. dollar on one side of 83 percent of spotforeign exchange transactions and in 95 percent of all deals in the swapsmarket. The euro remains the second most important currency in the foreignexchange market, with 37 percent (40 percent in 1992). The Japanese yen(24 percent) and the British pound sterling (10 percent) are ranked third and
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FIGURE 2-3 Dollar Volume by Market
fourth. The Swiss franc’s share was 7 percent, and both the Australian andCanadian dollars accounted for 3 percent. Perhaps the most interesting statistic is “Other Currencies,” which now account for 8 percent and rising.As a result of the consolidation of currencies with the development of theeuro, nearly 90 percent of the daily volume in the FOREX passes throughthese six major currency cross rates even though the bulk of all exchangetranspires through the United Kingdom, the United States, and Japan.Unlike the stock market, where there are more than 40,000 stocks tochoose from, a foreign currency trader needs to follow only the six majorcurrencies and their relative pairings. To take this a step further, most of theprofessional currency traders around the world concentrate only on threecurrency pairs (see Figure 2-4). The EUR/USD and the USD/JPY are probably the two most heavily traded currency pairs.
LONDON: CAPITAL OF THE WORLDLondon remains the world’s largest foreign exchange center, with dailyturnover during April 1995 of $464 billion (60 percent higher than the $290billion recorded in April 1992), or 35 percent of the world’s total daily volume.
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FIGURE 2-4 Volume by Country 2001
In the same period, both the Federal Reserve Bank of New York and theBank of Japan reported smaller percentage increases of 46 and 34 percent,to $244 billion and $161 billion, respectively (compared with $167 and$120 billion in 1992).The next four most important centers are Singapore, Hong Kong,Switzerland, and Germany, with daily turnovers ranging from $105 billionto $76 billion. France was ranked eighth, with a turnover of $58 billion.In London, U.S. dollar/euro and U.S. dollar/Japanese yen tradingaccount for 22 and 17 percent, respectively, of all transactions. Turnover inBritish pound sterling/U.S. dollar accounts for about 11 percent, and overall, the proportion of trades that involve British pounds sterling has fallenfrom 24 percent in 1992 to 16 percent at present.A larger share of business in both the U.S. dollar (30 percent) and theeuro (28 percent) takes place in London rather than in either the UnitedStates (16 percent) or Germany (10 percent). London is also the mostimportant site, after its own domestic markets, for the trading of Japaneseyen, Swiss francs, and Canadian and Australian dollars.In addition, London remains the most diversified foreign exchange market. In New York, 64 percent is between the U.S. dollar and the four major currencies (euro, Japanese yen, British pounds sterling, and the Swiss franc; 74percent in 1992), compared with 55 percent in London (59 percent in 1992). InTokyo, the range of currencies traded is even more limited; the U.S. dollar/Japanese yen accounts for 76 percent of turnover, up from 67 percent in 1992.
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While London remains the world’s foreign exchange capital, the NorthAmerican principals continue to be the most active, with a 42 percent marketshare. As you know, there is only one way to make money trading anything—buy lower and sell higher (or sell higher and buy back lower for short sales).To buy lower and sell higher, prices must trend higher from where youbought (or lower from where you sold). If prices never trended, therewould never be an opportunity to make a profit. Furthermore, without upand down price trends, institutional traders (hedgers) would have no needto insure themselves from price changes, and trading volume would disappear. What this means is that price trends are the essence of all profitable trading.The realization that trends are the essence of profitable trading makesthe idea of trading currencies very exciting because currencies are theworld’s best trending markets. Countless studies of trend-following systemsprove invariably that currency trends are the most consistent and profitable.Regardless of the type of trend-following system used—long term, intermediate term, or short term—currencies invariably outperform all other markets, including stocks, bonds, and other commodities. It should come as nosurprise that some of the world’s most successful traders are currency traders.One reason that currencies trend better than every other market isbecause of their macroeconomic nature. Unlike many commodities whosesupply and demand fundamentals literally can change with the weather,currency fundamentals are much less random and far more predictable.For example, let’s consider interest-rate differentials. Assume that U.S.interest rates are 4 percent and German interest rates are 6 percent. If youcould borrow $1 million at 4 percent from one bank and invest it at 6 percent at another bank, would you? Of course you would! (With interbankcurrency trading, you can.)The difference between 4 and 6 percent will attract internationalinvestors to borrow billions of U.S. dollars at 4 percent and invest them inGerman marks at 6 percent. Remember, such interest-rate differentialsbetween countries are likely to last for some time. The United States wouldnever change interest rates from 4 to 6 percent overnight, nor would Germany change interest rates from 6 to 4 percent overnight.Large changes in interest rates over a short time could cause economicchaos. Therefore, as long as investors can buy German marks with U.S.dollars and receive sizable profits, billions of dollars will continue to buythose German marks, pushing prices for them ever higher (a classic trend).This is just one of several important reasons why currency trends tend to beso long and pronounced.
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The FOREX has experienced spectacular growth in volume ever sincecurrencies were allowed to float freely against each other. While the dailyvolume in 1977 was US$5 billion, it increased to US$600 billion in 1987and reached the US$1.5 to 2.5 trillion mark since 2000.In summary, currencies are one of the best all-around markets. Interbank currencies represent the world’s largest marketplace and have themost powerful and persistent price trends. Propensities for strong and sustained price trends give interbank currency traders a profit-making edgethat is unavailable in any other market.
ANALYZING THE FOREXThe forces of supply and demand determine the values of currencies. Speculation in the FOREX must be based on sound analytical principles. Thereare two radically different methods of forecasting where the forces of supply and demand are heading.The first method, known as fundamental analysis, focuses on the actualevents that are believed to have caused market movement in the past.The second method, technical analysis, makes judgments based on the patterns and behavior of price data and indicators as they are displayed on charts.There are several ways to trade the FOREX, such as charts and graphs andnext-generation software. I found a piece of next-generation software called4X Made Easy, which takes numerous different technical analyses and combines them with an algorithm that gives you buy and sell opportunities.The important thing to note about this is that because the computerdoes the calculations for you, it does it the same way every time, with nodeviations and no emotions. To be successful at trading, you must be ableto duplicate success every time—trade the same way each and every trade.Together with good money management, you only need to be right 50percent of the time to make money. As long as your wins are greater thanyour losses, you can be a profitable trader. Good money management willbridge the gap.
HOW PROFITS ARE MADEI make profits by using margin trading, where a relatively small deposit isrequired to control much larger positions in the market. My recommendedbrokers require a 1 percent margin deposit. Therefore, $1000 controls$100,000 of trade currency.
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Currencies are traded in dollar amounts called lots. One lot is equal to$1000, which controls $100,000 in currency. This is margin. A margin callcan occur when your trading account drops below this minimum $1000 perlot traded.Currencies are traded on a price interest point (pip) system. Each currency pair has its own pip value. The goal of a trader is to capture as manyprofitable pips as possible. Values are determined by mathematical formulas and according to the exchange rate of the particular pair. Some pip values are fixed, whereas others can fluctuate slightly as one currency gains orloses strength against the other.Below is a list of the six major currency pairs with their approximateprice and pip values. The currency listed first in the pair is called the basecurrency. The current price of a currency is called the spot rate. (The fluctuating rates are subject to change over time.)Currency
ApproximatePrice
Pip Value
Australian dollar (AUD/USD)
0.4920
$10.00 per pip (fixed)
Canadian dollar (USD/CAD)
1.5705
$6.80 per pip (fluctuating)
Swiss franc (USD/CHF)
1.7310
$7.20 per pip (fluctuating)
Euro (EUR/USD)
0.8810
$10.00 per pip (fixed)
British pound (GBP/USD)
1.4220
$10.00 per pip (fixed)
Japanese yen (USD/JPY)
123.50
$8.40 per pip (fluctuating)
PIP MOVEMENTSAs noted above, each currency price is a little different. For instance, thedecimal point is placed differently for each currency. However, whatremains the same is how we count pips for each currency from one pipmovement to the next. The last digit in the currency price is where one pipmoves to the next.For example, in the Japanese yen (JPY), one pip movement higher is123.50 to 123.51. For the euro (EUR), it is 1.0810 to 1.0811. For theBritish pound (GBP), it is 1.4220 to 1.4221. Therefore, a movement of100 pips for the Japanese yen (JPY) is 123.50 to 124.50; for the euro(EUR), it is 1.0910 to 1.1010; and for the British pound (GBP), it is1.4220 to 1.4320.
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THE FOREX AS A TWO-WAY MARKETIn the FOREX, a trader can enter the market as a buy position (long) or asell position (short). This is a tremendous advantage in the overall tradingstrategy. Since a trader can buy or sell when entering the market, it matterslittle if the currency he or she is trading is trending up or down.Therefore, traders also can take advantage of strong up or down trendsfrom their inception. This can be done because there are two sides to everycurrency cross-rate. Let’s take a closer look at the euro (EUR) currencypair. The EUR is paired first with the U.S. dollar (USD). Since it is pairedfirst, it is the base currency.The FOREX cross-rate transaction involves the buying of one currencyand the selling of the other. In this case, since the EUR is the base currencyin this pair, we will be buying euros and selling U.S. dollars when weexpect prices to rise. If we expect prices to fall, then we will sell euros andbuy U.S. dollars.The wonderful part about this intricate process is that it is nearly seamless through the broker software. The chart software and the broker software are in agreement with all sides of the currencies. Therefore, when welook at a chart and expect prices to rise, we buy. When we expect prices tofall, we sell.When a trader believes that market prices will move higher, the traderwill take a buy position in the market. As long as the trader sells back at ahigher price, then he or she has captured profits. When a trader believesthat prices will move lower, the trader will take a sell position in the market. As long as the trader buys back at a lower price, then he or she has captured profits.Consider the screen shot and examples in Figure 2-5 that explain thistrading process in detail.In this example, a sell signal is indicated by arrow 1, identifying a selling position in British pounds at $1.5832 on July 26. After several days, wesee a buy signal, and the short position is closed out by buying the Britishpound at $1.5211 on August 27. In this scenario, since the trader bought theBritish pound lower than he or she sold it, the trader would have made aprofit of 521 pips.The same holds true from the example entering in the opposite direction. Buying a position, meaning going long in British pounds, as indicatedby arrow 2, results in a price of $1.5211 on August 27. After a few days, wesee a sell signal, and the trader closes out the long position, indicated by
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FIGURE 2-5 GBP/USD Daily Chart 2002–2003
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arrow 3. In this scenario, the price at the sell position is $1.5704 on September 6. This position could have made a 483-pip profit.If a trader has entered a buy position and then must sell back at a lowerprice than the buy position, the trader takes a loss. If a trader who hasentered a sell position and then must buy back at a higher price than the sellposition, the trader takes a loss.These examples are taken from real charts; however, these were onlyexamples of how the market works in both directions. Using proper moneymanagement may have resulted in more or less profit.
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FUNDAMENTAL ANALYSISThe forces of supply and demand determine the value of currencies. Speculation in the foreign exchange market (the FOREX) must be based onsound analytical principles. There are two radically different methods offorecasting where the forces of supply and demand are heading.The first method as mentioned earlier is known as fundamental analysis. While I cannot list all the events that move the market, some of theminclude the forces of currency supply and demand worldwide, fundamentaleconomic data, and political developments.Unlike in the stock market, fundamental analysis in the FORE