missed, but in general all traders should try to trade the London—-NY overlap,since that is where the market is at its deepest and the moves offer the best opportu-nities for day traders. If seen on a graph, the daily currency trading turnover wouldfeature spikes of activity during the major money center hours and flatline nearsome predictable times of illiquidity and abnormal moves. San Francisco neverblossomed into the bridge between NY and Tokyo, leaving a liquidity gap between3 and 7 pm (NY time), making for thin markets and abnormal spikes caused bystop-hunting.
You want to make it a point to trade no more than two of the three tradingsessions, and learn to manage your time so that you above all avoid the boring andilliquid hours between openings. Since the body is pre-wired to seek out stimulationat all times there is possibly nothing worse for a trader’s mind than boredom, and82 Beat the Forex Dealer
instead of sitting on your hands you will find yourself needlessly entering themarket in search of some action. For this reason, low-interest times should beavoided at all costs, and even if you have open positions you should simply setyour stops/limits and go away. More likely than not you will find the price exactlywhere you left it.14Trading Thin Markets
 
Thin markets are the FX equivalent of shark-infested waters. When markets arereferred to as being “thin” or “light”, it means that there is simply not enoughliquidity (buyers and sellers) to create a deep and balanced market. In these situa-tions, transactions that would normally be absorbed by an active market can haveunusually large and usually unpleasant ramifications on price. Thin markets areoften used to run stops by dealers and specs alike, since this is when they get mostbang for their buck. Thus liquidity-challenged hours (late NY, Sydney) are proneto see jumps, gaps, and generally unaccounted for moves.
How to identify thin markets
e Prices have not moved more than 10 pips in two hours.
° Prices are jumping back and forth 50 pips at a time.
Hours
e Once the Europeans go home and the New Yorkers settle in for their after-
noon nap, you can actually hear the liquidity dry up if you stand closeenough to your monitor.
° The late Asian session also tends to be a lot less liquid than the London orNY hours, especially outside the majors.
Events
° Before/after major news releases. It makes sense that markets would be thinright before a major economic release, since most people do not want totake a position (gamble) right before the numbers. Prices become jumpy,spreads widen, and stops get killed.84 Beat the Forex Dealer
Seasonal. Bank holidays, month of August, the week between Christmas and NewYear.
How to trade thin marketse The easiest thing to do is to avoid them.
e If holding a position, take some exposure off the table or place your stopsout of the reach of stop hunters. You can also hedge your position witha highly correlated pair (i.e. EURUSD and USDCHF). The last thing youwant is to have your position taken out by a single blip.
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Typical price action on US data-heavy Fridays.
TAKING ADVANTAGE OF THIN MARKETS
On a Friday when important news has been released (deficit, NFP, etc.), pricestend to move one way, then the other, then the other, until finally deciding on onedirection. After the big move the pair becomes O/S (or O/B) on an intra-day basis,and some sort of support has been established that will presumably hold until theweekend. This is the kind of setup that dealers love to exploit, and if you recognizeit so can you.Trading Thin Markets 85
 
Looking for a quick trade before the weekend, Joe Trader will buy near thebottom (see above) hoping to catch a quick over-sold bounce. He places his stopsbelow the day’s support and is in the trade more because he is bored than becauseof his convictions. Smart traders will recognize this level and know that beforeeveryone heads home for the day one final stop-hunting move is probably on thecards.
After London goes home for the weekend, and about the time New Yorkers startchecking their clocks, the dealers will pounce. If there are enough stops gatherednearby to garner their attention, they will quickly set up a coordinated attack andtake them out in the blink of an eye. All that you have to do is identify the setup andgo short with the dealers as soon as the rate approaches the support level, knowingthat the support is artificial and the move should give you a quick 10-20 pip move(just enough to run Joe’s stops). Since the buildup to these moves tends to be ratherslow (although the actual stop run in instantaneous), it is best to simply set ordersin the market and wait for the price to come to you. The first sell order would beplaced at/near the support level, with a take profit some pips below (exactly theopposite of Joe’s orders). Having them as limit/stop orders will ensure that theyget executed since some brokers like to shift to “manual execution” when they areabout to run stops.
Once the stops are filled, the price goes back to where it was, and the marketproceeds to die for the rest of the day. Your profit take order is done and you arefree to enjoy the rest of your Friday afternoon.
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Towards the end of the day dealers easily take out Joe’s attempt to pick a bottom.15Using the Crosses
 
Finding the right pair to trade should be of utmost importance to all individualtraders. Opportunity cost is a real cost for most traders and funds committed toany one position are funds that cannot be used in other (possibly more profitable?)trades. Since in FX every pair is in one way or another connected to the others,traders who adopt a dollar-centric view risk missing promising trades and notunderstanding the real potential some opportunities offer. Although most of thedealing is done through direct dollar buying/selling, one should constantly keep aneye on the crosses in order to gauge a currency’s true strength/weakness,! whichin the end will tell you which pair is best to trade.
A very reasonable way to trade equities is to trade from big to small. For example,through your analysis you determine that the stock market in general should rise,but knowing that you have limited funds, you need to choose your stocks carefully.It would therefore be advisable to look at sector-specific indices and find the mostpromising of the bunch. From there, you would look within the index and find themost attractive company(s) in which to invest directly. This “big-to-small” thinkingis very solid and should be applied to FX.
Even if not trading them directly, cross movements should never be overlooked,since the movements of the crosses can often hide the footsteps of large playerschoosing to position themselves in a stealthy manner rather than through one of themajors. If someone is looking to load up on euros, for example, they may try to flyunder the radar by buying euros against Swiss francs, sterling, yen, or other moreobscure crosses. These are bets on broad-based euro strength (for fundamentalreasons) spread out over a number of currencies (a basket) rather than taking adirect dollar negative position.
The crosses can also prove incredibly important to swing or momentum traders,since they can be used as forecasting tools and show you which currency is leading
'T personally do not like to use the USD Index (USDX) to gage the USD’s broad strength/weakness,since the basket is heavily euro-weighted and essentially makes the index a mirror of the EURUSD.88 Beat the Forex Dealer
 
the pack. Traders that overlook the importance of the crosses are often stuck withpositions that do not move, while the rest of the market takes off in their desireddirection.
PRESSURE VALVES
If the dollar is rallying against everything, but cable does not seem to be movingmuch, then one look at its crosses will show you where the selling pressure isbeing absorbed. Maybe sterling is rallying strongly against the euro or against theyen; in the end it does not matter. All that matters is that your cable short is barelyin the black, and probably poised to bounce back strongly when the demand fordollars is exhausted.
With limited funds you always want to pick the pair that will move the most, buthow exactly do you come to a reasonable conclusion? That is where the crossescome in.
Cross movements either work to amplify the move or minimize the effects.If the euro is dropping against the dollar, for example, but rising against thepound, the net effect will be to limit the size of the EURUSD fall. When thiscross is rising, it is telling us that the euro is outperforming the pound, and viceversa.
Look at an example below of using the crosses. You are certain that the nextfew days will be a period of dollar strength (for whatever reason), but faced with
 
 
 
 
 
 
  
 
 
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It is reasonable to assume that EURGBP will bounce from the area of strong support.
limited resources you cannot take a broad-based USD bet. You only have enoughammunition to trade one pair, and decide to either short the euro or cable. Thequestion then becomes, which one?
By looking at the EURGBP chart above, we notice that its sharp fall has ittesting the area of strong support near .6720. Chart patterns and oversold technicalreadings means that we can reasonably assume that this area of support will holdand that the cross may stage a brief rebound. Of course we can either anticipatethis move or wait for the price action to confirm our thoughts. Either way, a risingEURGBP means that sterling is likely to be the weaker of the two.
Any EURUSD selling pressure (euro sells) is likely to be offset somewhat bythe rebounding cross (euro buys), while GBPUSD sales (sterling sales) will onlybe amplified by the cross sales (sterling sales). Since EURGBP is likely to bounce,it would therefore make sense to short cable instead of euro.
In the aftermath, we can see that EURGBP did indeed bounce as expected (seebelow), and the added selling pressure on sterling caused GBPUSD to drop nearly200 pips more than EURUSD! If at the very beginning we had instead chosen torandomly pick one of the two pairs to short, we may have missed out on a greattrade.Beat the Forex Dealer
 
 
 
 
 
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The difference in picking the right pair can prove significant!Using the Crosses
1
 
Every trader should have currency pages set up within their charting software
that focus on these key crosses:
 
 
EURO STERLING YEN SWISSYEURUSD GBPUSD USDJPY USDCHFEURCHF GBPCHF EURJPY EURCHFEURJPY GBPJPY GBPJPY GBPCHFEURGBP EURGBP CHFJPY CHFJPY
 
Looking at the cross charts in a daily and 4 hour time frame will instantly giveyou an idea of the relative strength of a currency and show you who is leading the
pack in the near term.
 
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Looking at a yen page, we can instantly see that the yen strengthened across the board,confirming the yen as the primary driver. If some of the charts were dropping and somewere rising, on the other hand, this would indicate that the market was concentrating on
another currency.16All About Stops
 
Does active stop hunting really take place? Of course it does! Dealers are as muchinformation peddlers as they are price quoters, and every dealing desk has theirpartners in crime: either important clients or other friendly desks to whom theycommunicate their client’s positions and stops. Stop hunting takes place all day,every day, and there are some prop desks that actually specialize in hunting forstops for short-term gains. Sometimes no communication is needed, since dealersknow that Joe Trader places his stops at such obvious levels that they becomeperfect targets.
It is amusing to see that most brokers actively preach to their clients the value ofplacing tight stops as a way to control risk, but in reality they are just looking forstop levels to shoot for. Tight stops more often hurt the trader than they help him,since the intra-day FX market is filled with random moves (noise) that routinelywipe out the retail crowd’s 10 pip stops.
Like all players in the market, stop hunters have limited ammunition and areprone to act during certain market hours in order to achieve the maximum effect.Illiquid or extremely volatile times enable operators to easily manipulate prices inthe short run, either by quoting off-market prices or by moving the market withlarge orders. Thin market hours are especially vulnerable to manipulation, and earlySydney and late NY should be avoided by traders. The rollover hour! is also partic-ularly prone to manipulation as inexperienced spec traders place short-term tradeshoping to take advantage of the rollover interest, only to see them get blown awayby the dealers. Only pigs waiting to get slaughtered place intra-day carry trades.
STOP LEVELS
The intra-day FX market is so full of market noise that knowing where to placestops (or not place them) has become increasingly important. Prices tend to jump 10
‘Usually 5 pm NY time, when overnight positions are “rolled over” and interest is credited/debited.94 Beat the Forex Dealer
 
or 20 pips for no apparent reason (most likely because of flows) and retail tradersoften find their stops being constantly taken out even though the market may bemoving in their desired direction. Ideally, you should aim not to leave any fixedstops in the market. Although professional money managers often trade with stops,they leave the orders on their computers instead of with their brokers (makingthem invisible), and more often than not trade with no stops at all. Trading in thisway involves viewing your positions not as one-off trades that either go right orwrong, but rather as continuous views that are to be constantly traded around untilthe preferred outcome materializes (see the Appendix for tips on trading out of alosing position).
 
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Stop hunting near an obvious support point. Dealers know the size and location of the stopssitting below the support zone and decide to go after them.
Unless trading long-term, placing a trailing stop is also not advisable since youeffectively give up control of your position and simply choose to exit at a randomnumber, which may or may not have anything to do with the price action. Place ittoo close and you will get hit too early; place it too far and you will forego someprofits if the rate quickly retraces. A static 10-20 pip stop is also arbitrary and canactually turn a winner into a loser very quickly.
Your stop points should therefore be based on dynamic levels rather than arbitrarystatic numbers. Dynamic stop levels such as moving averages, Bollinger bands,All About Stops 95
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As you can see, dealers quickly trip stops, after which the price is then free to move accordingto regular market flows.
SARs, etc.,” are all good ways to manage risk while letting the market do whatit does. The more experienced a trader you become, the more you will come torealize that trading with fixed stops in the market may actually hurt you more thanhelp, both psychologically and profit-wise.
Don't Feed the Stop Hunters!
Avoid placing stops in these situations:
- close to/at round numbers- before/after news releases- times of thin liquidity
 
2All indicators are readily available in most charting packages. Use default settings or tweak themaccording to your timeframe.96 Beat the Forex Dealer
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Stop hunting before news releases. In this sequence the dealers see their client base goinglong sterling into the news release, so they decide to take out their stops just before thenumber is published. If a dealer thinks that the economic data are not likely to have a bigimpact on prices, their tactic is to sell aggressively right before the news (using an illiquidmarket), trip the stops, and then take back their positions. This is why it is prudent never toenter a trade right before news releases!17Characteristics of FX Trends
 
When properly formed, FX trends tend to be particularly vicious and one-way,and routinely wipe out speculators who commit the trading sin of trend fading. Itis important, therefore, to learn to identify trends early in their development anddistinguish them from short-term price moves.
FX trends usually start slowly. FX trends are special because they often emergeas the unintended consequence of another action in the world’s capital markets.Since foreign exchange is merely a facilitator and still not used extensively to placeoutright speculative bets, an indirect event such as a booming local stock marketcan also leave behind a massive FX trend in its wake. If Japanese stock marketsare strong and global equity funds want to buy into the bull market, they willbe forced to exchange their local currency for yen in order to purchase Japanesestocks. Although they are not intentionally betting on yen strength, if strong enoughthese flows will come to dominate the FX market. Since the initial moves of an FXtrend are usually underpinned by steady real-money buying such as yield hunters,hedgers, or value investors, you have to keep one eye on the macro situation bylooking for signs that the “smart money” is moving in to take advantage of asituation.
The longer the trend, the longer the correction/consolidation. Most funda-mentally driven trends do not simply make U-turns. Before taking the next leghigher/lower, the market needs time to digest the initial move and draw in morebuyers/sellers, or remove the fundamental reason (yield difference) in order toreverse the direction.
If the public realizes that a trend has developed, it is too late. As they say, aNewsweek cover is the kiss of death for any trend. By the time the general publiccomes to realize what a great opportunity something is, professionals have longbeen in the trade and are waiting to cash in by unloading on to the retail crowd.98 Beat the Forex Dealer
It's all connected!Usual market correlations to keep in mind when trading
aC (C ee Yields UP / USD UPet ares Gold UP / USD DOWN / AUD UP / CAD UP
Or eken aires Crude UP / USD DOWN / CAD UP (USDCAD DOWN)ced CRM Index UP / USD DOWN / AUD UP / CAD UPEOC LtcHe Emerging Mkts DOWN, USD UP
All traders should include bond and gold prices in their market monitors.
In times of slow growth (yield hungry), the currency market typically waitsfor the bond market reaction before committing positions. In this way,
bond yields can be used as leading indicators in economic data-heavy days.
‘AUDIUSD RATE* INTEREST RATE DIFFERENTIAL“ ‘AUD FX TURNOVER™*
1998 2000 2002 2004 1998 2000 2002 2004 1998 2000 2002 2004
* An increasing rate indicates a depreciating dollar** Three-month Australian dollar Libor minus US dollar Libor.*** indexed to first quarter of 1998 = 100 in Australian dollars.
Sources. BIS Quarterly Review, Dec 2004 Gala, Melvin. Bloomberg, Australian FMA
 
Situations like these are important for the individual investor to understand since trends arehard to stop overnight. Once the yield difference shifts in the AUD’s direction in 2002, allkinds of buyers plow into the market.
In this case of the Aussie dollar uptrend, we can see a couple of interesting thingshappen in 2002 when the yield advantage between the USD and the AUD shiftedin the Aussie’s favor and set a chain of events in motion that are sometimesimpossible to stop. The initial buyers of the AUDUSD are mainly yield-hungry butconservative real-money managers (i.e. pension funds), who decide to switch someof their US dollars into the higher-yielding Australian dollar. Theirs is a bet thatthe money they make from the yield difference will more than make up for anyexchange rate losses suffered. This sudden demand for Aussie dollars momentarilypumps up the AUDUSD rate, which attracts more active managers such as hedgefunds that like to play short-term trends. Of course, their buying further inflatesthe AUDUSD rate, which is now in a full-fledged up trend, and finally forces thehand of Australian exporters who were hedged at lower levels and must now enterthe market to cover future cash flows (buying AUD). This chain of events can beclearly seen in the rapid increase in turnover and the rising AUDUSD rate, whichat some point becomes self-sustaining and far from the original “yield play” thatsome were after. All types of players are now long AUDUSD for various reasons,Characteristics of FX Trends 99
 
and these kinds of trends stop only when the fundamental backdrop is taken away(yield difference) either in a real or perceived manner, and more often than notthey end in tears.
TREND EXAMPLE
Let us take a look at a real-world example of a USDJPY move seen during thelast quarter of 2005.
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An extended move in USDJPY exhibits all the typical signs of FX trends.
1. Accumulation Stage (USDJPY 109-115)
From September to November, institutional and real money buyers begin to sellyen across the board. Two things fueled this “insider” move, Japan’s zero interestrate policy and the rally in commodities. An oversimplified view of the eventswould go something like this: with their zero interest rate policy, Japan is basicallygiving away money and everyone and their grandmother is using the yen to financetheir carry trades. Wanting to pad their P/L before the year end (remember it is100 Beat the Forex Dealer
 
Q4), fund managers take out yen-denominated loans and convert them into USD(driving USDJPY higher) in order to buy dollar-denominated commodities suchas oil, gold, and copper for their portfolios. When the price reaches the top ofthe range near 114, the usual range-capping suspects (Japanese exporters) are notpresent, meaning that they are either fully hedged or that they expect the yen tocontinue depreciating.
2. Hot Money Stage (USDJPY 115-116)
Speculators enter the fray. Momentum funds pile into the long side of the tradeand continue to do so until the market tells them otherwise. Retail specs, on theother hand, take notice of the overbought readings and think that the rate is ripefor a correction since it has already gone up “too much”. Those that fade the movehere are faced with two outcomes: death by a thousand stops or death by averagingdown. Either way, those that do not swallow their pride and recognize that theywere wrong are soon forced into an all-or-nothing trade.
3. Throwing in the towel (USDJPY 120-121)
A last gasp higher takes whatever stops were left in the market. Notice all ofthe shooting star candles near the top, a sign that after three months and ten bigfigures those holding long positions are beginning to cash out on any blips higher.Everybody seems to be long now, and the trend will seemingly go on “forever”.
4. Reversal (USDJPY 120)
In December, the market makes a sudden 180 degree turn and drops nearly 500pips in two days. The long-awaited reversal finally came (although several hundredpips above what the retail crowd thought) as the result of some kind of catalystthat changed the underlying equation supporting USDJPY. More often than notthis is a shift in government policy or some other external factor that forces thereal money crowd’s hand (such as a big coupon payment/redemption). In thiscase, the catalyst was the seemingly uneventful fact that the Bank of Japan raisedthe minimum margin requirements for the Tokyo metals market in order to limitspeculation. Although it is nothing huge like a surprise rate hike, the slight changeforced hedge funds to cash in on some of their long gold positions in order to meetthe new margin requirements of the exchange.
Since the change was announced during the weekend, when Monday morningcame around the market was flooded with a sudden, massive sell interest that soonsnowballed into outright pandemonium in the gold market. The market headedtowards free-fall and traders rushed to unwind their positions before it was tooCharacteristics of FX Trends 101
late, with the end result being that gold dropped 20% that day! When the goldpositions were unwound, the dollars received were converted back into yen in orderto pay back the JPY-denominated loans that were taken out in the first place, andthis massive yen buying caused the USDJPY to take a steep tumble. Although themargin requirement change may have been responsible for only the first 150-200pips of the move, it was enough to get the ball rolling and shift the trend dynamics.This should bring home the fact that little things can have big implications, so be onthe lookout for abnormal price moves in other markets that could have an eventualimpact on FX prices.
Not surprisingly, I did not hear any comments about this gold story from anyanalysts, either before or after the fact ...they probably blamed it on some technicalpattern, economic fundamentals, or growth rates.18Trading the FED
 
Whenever the Federal Market Open Committee (FOMC) meets to set interest ratesin the US, trading proves tricky, to say the least. These days the FED goes out ofits way to telegraph the moves well in advance, so the market has switched fromthe nail-biting hike or no hike scenario to looking and analyzing every single wordin the accompanying statement. This evaluation and re-evaluation of what the Fedactually “means” translates into a free-for-all immediately following the release,and dealers are hard at work chopping up players on both sides of the marketwhile the FX heavy-hitters sit and deliberate whether the statement was “hawkish”or “dovish”.
What should one do in a situation like this, when the price jumps 50 pips oneminute and then dives 50 the next? Simple: wait for the dust to settle and let theprice action guide your moves. Since traders like to limit their exposure before anyFED release, the market will tend to trade a reasonably tight range the day(s) beforeany announcement, and these range extremes can be used effectively to trade withthe dealers, and against the general public.
This is how Joe Trader would trade this FOMC release. When the FOMCannounces its quarter-point rate hike (the market bought on the rumour and is nowselling the fact) Joe goes long at the next tradable price (1, 2). Stops are placedat a “safe” distance and the EURUSD spends the next five minutes whipping backand forth, wiping clean any stops in an 80-point range.
After ten minutes, the pair moves higher again and Joe is convinced that thistime the move is for real, so he sets his stops below the previous low, away fromthe noise (3, 4). Dealers see the spec market go long EURUSD so they are happyto fade the move higher and target the downside stops (5). Intra-day stops aresuccessfully tripped, and dealers take back their shorts for a nice profit and callit a day (6). Frustrated, Joe Trader throws in the towel, and the market is free tomove back within the range again.104 Beat the Forex Dealer
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Dealers gun for the obvious stop levels before returning to pre-FOMC levels.
This typical scenario plays out almost every time the FOMC meets to set rates,with the rate chopping around for a while after the decision until the market finallymakes up its mind as to the statement. Since the statement came in with the market’sexpectations, the euro eventually finds itself at the same price it was prior to theannouncement (even though it moved more than 200 pips round-trip!). In situationslike these, when the market gets what they are expecting, then the usual scenarioTrading the FED 105,
 
is for dealers to hit the intra-day stops on both sides of the intra-day range andthen settle on the pre-FOMC equilibrium point. After all, if nothing changed thenthere is no reason for players to aggressively push the market one way or another.
THE TRADE
Trading like a dealer in this case would mean recognizing the stop-hunting push30 min after the release and going short around 1.2820 or so, knowing that dealersare going for Joe’s obvious stops sitting below the previous low of 1.2807 (seebelow). Take-profit orders for the shorts would be placed under the figure, for anice 30 pip gain, which surely beats getting stopped out two or three