X ismuch more important. Although it is important to watch fundamentalswhen trading in the stock market, it is much easier to manipulate the data.After all, where does the fundamental data come from that traders use tomake their trading decisions?29Copyright © 2004 by The McGraw-Hill Companies, Inc. Click here for terms of use.
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Every publicly traded company has to produce 10q’s and 10k’s. Theseare their quarterly and annual reports, respectively. These reports have to besubmitted to the Securities and Exchange Commission (SEC) on time andcorrect or the companies face fines and penalties. These reports have to gothrough the SEC for review before they are released to the general public ofshareholders.Does this ring any bells? How about the big problems of Enron, GlobalCrossing, and all the rest? If companies submit financial reports to the SECthat are not 100 percent accurate, how are you, the investor, supposed toknow?It is pretty hard, and this is exactly what happened at Enron. Investorswere trading Enron stock thinking that it was one of the largest companieson the exchange, when, in fact, some of the fundamental data on the company were incorrect. In fact the company was much smaller than investorsperceived.In the FOREX, fundamental analysis has a much bigger emphasis. Thefundamental data that I am talking about are usually key economic indicators. When these numbers are released, the various currencies will react.If the numbers are different from expected, huge moves can take place.These huge moves can make or lose a trader a lot of money, depending onwhether the trader is on the right side of the trade and/or the trader has usedgood money management.This is an example of what traders look for in economic FOREX calendars (see Figure 3-1).You can see that the forecast is what traders are building into themomentum of the currency. If the actual number comes in higher or lowerthan that predicted, the currency will react. These reports are used in allcountries. The consumer price index (CPI) is calculated in all countries,some with different names but nonetheless the same type of measurement,and thus it would affect that country’s currency.When you are trading, be sure to know when the news is coming out.Ultimately, the trend in the currency will prevail, but unexpected news canaffect the trend even if only for a very short time. The effect, however, canbe enough to stop you out of your trade.Don’t worry, though; you do not have to know about these forecasts ifyou don’t want to because there are numerous FOREX alert services outthere. These alert services usually charge a monthly fee and will keep youapprised of news and what is anticipated, as well as what to expect if something unanticipated happens.
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FIGURE 3-1 Schedule in the FOREX Market
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I wanted something very specific, so I founded PremiereTradefx, acompany that FOREX traders can use to open a demo trading account or abrokerage account to trade the FOREX. In addition, I have created FOREXAlerts, a software/service for which you can get a preview trial at www.premieretrade.com. My professional traders make trades and alert you to thoseopportunities as well as provide daily and weekly updates, and they willkeep you informed of upcoming world and economic news.
TECHNICAL ANALYSISThe second method is technical analysis. This is one of the oldest toolswith which to trade. Technical analysis has been around for roughly 30years. There are more than 150 different types of technical analyses that atrader can use. It is really up to the trader.The common description of technical analysis is that you take past performance of a position, equity, currency, future, or whatever and tie ittogether with mathematical calculations to try to predict the future outcomeof the position.Technical analysis is based on three assumptions:1.2.3.
All available information and its impact on traders and the marketare already reflected in a currency’s price.Prices move in trends or patterns.History repeats itself.These assumptions lead to the following conclusions:
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As a direct consequence of the first assumption, technicians believethat there is little to be gained by researching economic fundamentals.
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Technicians believe that fundamental research will lead to an explanation of the current price rather than an accurate forecast of futureprice.
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Fundamental analysts can only follow a limited number of aspects atone time.
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Price activity reflects most of the relevant fundamental events andtheir impact on most traders most of the time, so a technician enjoysa more complete perspective of all the activity unfolding than a “fundamentalist.”
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The power of technical analysis is that it can be applied effectively tovirtually any market.
Because of these overwhelming factors, I encourage technical tradingrather than trading on fundamental analysis alone, but not traditional technical analysis. With the advancements in computer technology, we are nowable to analyze the market technically using computer programming tomeasure supply and demand as well as many other factors, therefore eliminating the emotional and human discretionary aspects of trading.There is so much interpretation when using technical analysis thattraders looking at the same thing may see different things altogether. Thisis one reason that you will want to find a trader who is willing to share hisor her perspective. Whether you use managed accounts or alerts or a mentor or a coach, it is imperative to your success as a trader to get as muchtraining as you can to increase your potential for success.Recent history in the stock market only proves my point. When stockswere going down—and I mean way down—many individual traders werebuying more—that’s right, more stock—even though the trends in both thestock and general markets were going down.Investors were saying such things as, “It can’t go any lower,” “It is a goodcompany,” “It will come back,” and so on.” How about, “It’s a good time tocost average down,” “I can’t sell it right now,” and “It is only a loss on paper”?These are all things that have contributed to the demise of most traders’ portfolios—simply because they failed to follow the basic trend reversals.
FUNDAMENTAL VERSUS TECHNICAL ANALYSISA “fundamentalist” studies the cause of market movement, whereas a technician studies the effect. Most traders would classify themselves as bothtechnicians and fundamentalists. In reality, there is a lot of overlap in information and how each factor ends up moving the market one way or another.Most fundamentalists will have knowledge of charts, indicators, andchart analysis. Similarly, most technicians will have knowledge and awareness of the fundamentals. The problem is that the charts and fundamentalsare often in conflict with each other, because one tries to predict the futurewith present events and the other uses history to predict the future.I myself have always been a technician. I think that some of the mathematical calculations are extremely good at showing you where a potentialtrade can go in the future. Although technical analysis cannot predict thefuture, it can give valuable insight into where a trade is going.
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As I will begin to tie all the strategies together in this book, you can seehow the next-generation software that is out there can help investors of alltypes with an easier approach to investing. With more than 150 differenttypes of technical analyses, it is hard to determine which one is right foryou. I cover some of my favorites.In the end, the approach to trading that is best for you is the one thatfeels the most comfortable and the one that you feel you can duplicate thebest. To be successful in trading, you have to be able to duplicate your success every time.
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CURRENCYOPTIONS●
Currency Options Introduction
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Option Pricing
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Advantages of Trading Options
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European and American Options
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Exotic Options
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Lock in Profits
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Accelerate Your Profits
CURRENCY OPTIONS INTRODUCTIONOptions are used within many companies as a risk-management tool and areimportant in that process. Risk managers must have a good understanding ofcurrency options as they apply to their unique position in the marketplace.What is an option? Simply stated, an option is a choice. The buyer of anoption acquires the right but not the obligation to buy or sell an underlyingasset under specific conditions in exchange for the payment of a premium.It is entirely up to the buyer whether or not to exercise that right; only theseller of the option is obligated to perform.
35Copyright © 2004 by The McGraw-Hill Companies, Inc. Click here for terms of use.
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In every foreign exchange transaction, one currency is purchased andanother currency is sold. Consequently, every currency option is both a calland a put. A call option conveys the right to buy the underlying asset, anda put option gives the buyer the right to sell.An option to buy Australian dollars against U.S. dollars is both an Australian dollar call and a U.S. dollar put. Conversely, an option to sell Australiandollars against U.S. dollars is an Australian dollar put and U.S. dollar call.Let’s take the example of an Australian importer who has the obligationin 3 months’ time to pay US$1 million for a commodity such as soymilk.The importer has a number of alternatives:●
Remain unhedged and purchase the U.S. dollars at the prevailingspot rate in 3 months’ time
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Hedge by buying U.S. dollars forward
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Hedge by using an options strategy
One of the many strategies available to an importer is to buy an Australian dollar put/U.S. dollar call option. The effect of buying an Australiandollar put is to place a ceiling on the cost of imports without limiting thepotential benefit if the spot rate rises. The importer limits the cost to a maximum while not limiting the minimum.
OPTION PRICINGThe premium quoted for a particular option at a particular time representsa consensus of the option’s current value, which consists of two elements:intrinsic value and time value. Intrinsic value is simply the differencebetween the spot price and the strike price. A put option will have intrinsicvalue only when the spot price is below the strike price. A call option willhave intrinsic value only when the spot price is above the strike price.Options that have intrinsic value are said to be “in the money.”Time value is more complex. When the price of a call or put option isgreater than its intrinsic value, this is so because the option has time value. Timevalue is determined by five variables: the spot or underlying price, the expectedvolatility of the underlying currency, the exercise price, the time to expiration,and the difference in the “risk free” rate of interest that can be earned by the twocurrencies. Time value falls toward zero as the expiration date approaches.An option is said to be “out of the money” if its price consists only oftime value. A number of complex option pricing models such as the Black-
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Scholes and Cox-Rubinstein models have been developed to determineoption pricing. Another commonly used model for currency option valuation is the Garmen-Kohlhagen model.Many texts cover the specifics of option pricing models in detail. Interest-rate differentials between nations and temporary supply/demand imbalances also can have an effect on option premiums. In the final analysis,however, option prices (premiums) must be low enough to induce potentialbuyers to buy and high enough to induce potential option writers to sell.
ADVANTAGES OF TRADING OPTIONSOptions offer a low-cost method of hedging or speculative spot trading withthe ability to minimize risk for potentially high profit returns. The amountof capital risk is always known in advance. With the ability to fully customize your options, including payout amounts, barrier prices, and expiration dates, options have greater flexibility for different styles of trading.
EUROPEAN AND AMERICAN OPTIONSThe two parties to a currency option contract are the option buyer and theoption seller/writer. The option buyer may, for an agreed-on price called thepremium, purchase from the option writer a commitment that the optionwriter will sell (or purchase) a specified amount of a foreign currency ondemand.The option extends only until the expiration date. The rate at which onecurrency can be purchased or sold is one of the terms of the option and iscalled the exercise price or strike price. The details described in a currencyoption include the underlying currencies, the contract size, the expirationdate, the exercise price, and another important detail—whether the optionis an option to purchase the underlying currency—a call—or an option tosell the underlying currency—a put.There are two types of option expirations—American-style and European-style. American-style options can be exercised on any business dayprior to the expiration date. European-style options can be exercised atexpiration only.Currency options may be quoted in one of two ways—American terms,in which a currency is quoted in terms of the U.S. dollar per unit of foreigncurrency, and European terms (inverse terms), in which the dollar is quoted
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in terms of units of foreign currency per dollar. The same logic can beapplied to currency pairs in which the U.S. dollar is not one of the currencies. Either currency can be expressed in terms of the other.
EXOTIC OPTIONSThere are five exotic options that are most popular:1.2.3.4.5.
DigitalNo-touchOne-touchDouble no-touchDouble-touch
DIGITALDigital options are simple and inexpensive. If you believe that the EUR/USDwill be above 1.0700 at the end of 2 months, but you are not exactly surewhen this decline will occur, a digital option is perfect for you. You wouldsimply buy a 2-month EUR call/USD put digital option with a 1.0700 strike.If after 2 months the EUR/USD rate is equal to or greater than 1.0700 at expiration, you would automatically earn your predetermined payoff. If not, youroption simply would expire worthless. With low option premiums, your predetermined return can be in excess of 100 percent (see Figure 4-1).
ONE-TOUCH OPTIONSThis type of option is perfect for traders who anticipate a retracement andbelieve that the price of a given currency will test a support/resistance level.The one-touch option pays a fixed amount if the market touches the predetermined barrier level.All you need to do is to determine the desired payoff, the currency pair,the barrier price, and the expiration date. As long as the spot level hits thebarrier level at least once prior to expiration, you receive the payoffamount. If the barrier is not reached during the option period, the optionexpires worthless. The payoffs of the options are credited to the clients’account as soon as the market touches the barrier level.
NO-TOUCH OPTIONSA no-touch option is a great way to profit from a trending market. The notouch option pays a fixed amount if the market never touches the barrierlevel that you choose.
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FIGURE 4-1 Good market calls, bad market timing
You trade 15-minute movements but also have a 2-month view.EUR/USD now: 1.0300I think: EUR/USD will be above 1.0700 in 2 monthsSample option: Buy 2-month EUR call/USD put digital option with$5000 payoff for $800.Two months from now:EUR/USD > 1.0700 = earn $5000 (minus the premium paid)EUR/USD < 1.0700 = option expires worthless, lose $800
All you need to do is to determine the desired payoff, the currency pair,the barrier price, and the expiration date. As long as the spot level never hitsthe barrier price before expiration, you receive the payoff amount. If thebarrier is reached during the option period, the option expires worthless.
DOUBLE NO-TOUCHIf you have a successful track record of identifying and profiting from breakouts but always lose money or do not make money in range markets, a doubleno-touch option is perfect for you. Breakouts are simply a currency pair suchas the EUR/USD that has been trading around the same price for instancemaybe it is 1.12-1.13. If the currency pair goes above the 1.13 or below the1.12 it has now broken out of that range. That example wll also work as arange bound example. Lets say that the same EUR/USD is trading between1.12 and 1.13. If the currency pair stays within that range of 1.12-1.13 it srange bound. Now lets look at a example of a double no-touch option;. If youare waiting for breakout levels in AUD/USD at 0.5400 or 0.5800 and expectthis to happen within the next month, you can profit from the range tradingmarket by buying a low-cost double no-touch AUD/USD option with 0.5400and 0.5800 barrier levels and a payoff of $20,000 for $7000. In this way, if theAUD/USD does not break out within the next month, you will still earn$20,000. If it does break out, you will lose the $7000 premium paid for theoption, but you will earn from your breakout strategy (see Figure 4-2).
DOUBLE ONE-TOUCHIf you are successful at picking tops and bottoms in a range market butcan’t sustain your losses in a breakout market, then a double one-touchoption is perfect for you. For example, if you are range trading NZD/USD
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FIGURE 4-2 Double no-touch option strategy
Breakouts, but you can’t make money in range markets (to hedge againstrange markets).AUD/USD now: 0.5600I think: AUD/USD will break out of 0.5400 or 0.5800 in the nextmonth, and I will make $20,000 in a breakout scenarioSample option to hedge against no profits in range market: Buy 1-monthAUD/USD double no-touch option with 0.5400 and 0.5800 barrier levels and a $20,000 payoff for $7000.One month from now:AUD/USD does not break out and does not touch 0.5400 or 0.5800= earn $20,000 (minus the premium paid)AUD/USD breaks out and touches either 0.5400 or 0.5800 =option expires worthless, lose premium of $7000, but makeexpected breakout profits of $20,000
between 0.5100 and 0.5400 with good success but know that it may break0.5100 or 0.5400 within the next 3 months, your losses could large. However, you can profit or reduce losses from a breakout by buying a doubleone-touch NZD/USD option with 0.5100 and 0.5400 barrier levels and apayoff of $15,000 for $1800.In this way, if NZD/USD breaks out of those levels within the next 3months, you will receive a payoff and reduce losses by $13,200. If it doesnot break out, you will lose the $1800 premium paid for the option, but youwill earn from your range-trading strategy (see Figure 4-3).
LOCK IN PROFITSIf your option appreciates significantly in value, you can improve youroption-trading returns by locking in profits. This is a very simple process;you simply sell the current option, and purchase a cheaper option with adifferent strike price or maturity.By purchasing the cheaper option, you would be putting less money at risk,or taking profits. In addition, you would still be able to earn from further optionappreciation if the currency market rate continues to move in your favor.
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FIGURE 4-3 Double one-touch option strategy
You are great at picking tops and bottoms in a range market, but as soonas there is a breakout, you lose money (to hedge against breakout markets). Range trading works great for you, but market volatility or excessive movements are your pitfalls (to hedge against breakout markets)NZD/USD now: 0.5250I think: NZD/USD will range trade at 0.5100 or 0.5400 in the next3 months, and I will make $8000Sample option to hedge against losses: If NZD/USD breaks out ofrange, buy 3-month NZD/USD double one-touch option with 0.5100and 0.5400 barrier levels and a $15,000 payoff for $1800.Three months from now:NZD/USD breaks out and touches either 0.5100 or 0.5400 = earn$15,000 (minus the premium paid)NZD/USD continues to range trade and does not touch either0.5100 or 0.5400 = option expires worthless, lose $1800, butmake expected breakout profits of $8000For example, suppose that you bought a 3-month EUR call/USD putoption with a 1.0000 strike price when the current EUR/USD market ratewas 0.9900. Now, EUR/USD is 1.0500, and you have made significantprofits. You still believe that the EUR/USD will appreciate, but you want tolock in some profits.What you do is to sell your original option and purchase a cheaperoption, such as a 3-month EUR call/USD put with a 1.0300 strike price.The difference between what you earned when selling the original optionand the new option premium is the amount of profits that you have “lockedin.” Given that you still own a EUR call/USD put option, you will continueto benefit from further EUR/USD appreciation.
ACCELERATE YOUR PROFITSIf you have a strong belief in the continued appreciation of your optionvalue, you can increase your option-trading returns by accelerating yourprofits. This is also a very simple process. All you need to do is to sell yourcurrent option and use the funds to purchase cheaper options.
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This would allow you to buy more of the cheaper options than you originally owned. This strategy is different from the strategy for locking inprofits discussed earlier but is also useful.For example, suppose that you purchased five lots of 1-month EURcall/USD put options with a 1.0200 strike price when the EUR/USD market rate was 1.0100 for $3350. Now, EUR/USD is at 1.0400, and youroption is valued at $11,690. You still believe that the EUR/USD will appreciate, and you want to generate higher returns in a shorter period of time.What you can do is sell your original option and purchase a cheaperoption, such as a 1-month EUR call/USD put with a 1.0300 strike price.With the funds generated from your option sale, you potentially could purchase seven lots of the cheaper option. If the EUR/USD rate appreciated to1.0500, the value of your new seven-lot 1.0300 strike option would be$16,425, whereas the value of the five lots of your original option at 1.0500would only be $15,670.Don’t panic if you think what you just read is confusing. It is. You willfind one option strategy that will work for you and then become good at it.Each strategy is designed for a very specific situation. This is why you needto concentrate on one strategy first. Learn that strategy, and then you canuse it when the time is right.If you find the option strategies easy to understand, then you may wantto spend more time trading options rather than currency pairs. Just like thestock market, traders can become professionals at trading only options. Thechoice is yours.
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CREATING AWORKSTATIONFOR TRADING●
Workstation Location
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Trading Computer and Accessories
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Internet Connection
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Trading Software Programs
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Continuing EducationEFORE WE GET TOO far into the nuts and bolts of analyzing
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market data and trading, we first must consider a very important factor in profitable trading. At first glance it may notappear that important, but you will come to appreciate thewisdom of ensuring that you have all the tools necessary tomake your trading experience a positive one.
WORKSTATION LOCATIONChoosing the right place for trading is your first step. Be sure not to rushinto making this decision too quickly. Do you have a spare room? Howabout an existing den or office?43Copyright © 2004 by The McGraw-Hill Companies, Inc. Click here for terms of use.
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The place you choose should be a place where there are few distractions—where you can concentrate and feel comfortable. Trading can bevery stressful at times, so your trading area should be a place where you canrelax. Avoid setting up your trading computer in your bedroom because thiscould disrupt your sleep cycle.Having the right amount of rest and sleep is as important as learningthe trading method itself. Try not to fall into an addictive approach to trading where all you want to do is trade 24 hours a day. Remember, this is nota sprint but a marathon. If there is nothing to trade, then don’t trade.You also may want to consider accessibility to a television at yourworkstation; if you have cable, this is even better. A lot of traders, including myself, have CNBC or CNBCW on while trading.Unlike other financial markets, the foreign exchange market (theFOREX) is driven by real-time news. You will see the FOREX move beforeyour eyes as news is released, especially prior to the commodities marketopening at 8:30 A.M. (EST).Being alerted to breaking news events will quickly cover the cost ofadding cable or satellite television to your workstation, and of course, it istax deductible under Internal Revenue Service (IRS) guidelines. I covermore of this in Chapter 15, “The Business of Trading.”
TRADING COMPUTER AND ACCESSORIESOne of the most frustrating situations for a new trader is attempting to tradewith outdated computer equipment. The following list of requirementsmust not be ignored in acquiring adequate computer equipment, especiallyif you are trading with next-generation software, some of which requiresspecific types of connections and processing speed. Refer to the box thesoftware came in for the requirements.Minimum hardware requirements include●
A Pentium II or greater with a 300-MHz processor
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128 MB of RAM
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A 6-GB hard drive
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A 17-inch monitor or larger (some traders choose to connect two ormore monitors)
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A 56-KBd modem (broadband recommended)
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A color printer
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Whether you chose a desktop or laptop computer, be sure that it meetsthe minimum requirements for the best operating results. You also will wantto have a comfortable chair with adequate lower-back support. You aregoing to be spending lots of stressful time in that chair, so get a good one,and you will thank yourself later.There are numerous trading styles to choose from—long term, shortterm, active, day trading, swing trade, position, and custom trading. Anyone of these can be right for you. You may find that you only trade once aweek.Other useful accessories include a small calculator, a telephone withautodial features to reach your broker fast if you have an online problem, awhite board with dry-erase pens, and a notebook to be used as a trading log.The trading log is helpful daily, but if you make good notes about yourtrades, you will soon discover patterns to success. The more you learn yourown success pattern, the larger your profits will be. Every trader is a littledifferent, and you want to know what you do best.
INTERNET CONNECTIONAlong with an adequate computer, you also will need a stable Internet service provider (ISP). Avoid free Internet services because frequent disconnections are their norm. Dial-up services can range from $5 to $20 permonth. Make sure that you sign up with an ISP that has more than one dialup phone number as well as good customer support services.Recently, Digital Subscriber Line (DSL) and cable services havebecome very popular. Neither DSL nor cable is required to run any of thetrading software programs, but one or the other is recommended for severalreasons. With a dial-up service, you risk a greater chance of being disconnected and much slower download speeds.For those road warriors out there, I have even traded online using mycell phone or modem card. A warning: They are a much slower, and I do notrecommend trading with them short term because the data streaming inmay be delayed as a result of the slow connection speed.
TRADING SOFTWARE PROGRAMSThere are several applications or software programs that can help you tradesuccessfully. A few of the applications to consider are as follows.
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INTERNET BROWSERAn Internet browser, either Internet Explorer 5.0 or higher or Netscape 6.0or higher with Outlook, is required to view information on the numerousWeb sites out there.
DEALING STATIONSIn order to make trades in the FOREX, you will need a trading platform. Itis through a broker that you will execute buy and sell orders that willbecome your trades. In the recent past, buying and selling currency onlyoccurred over the phone and required verbal confirmation from both parties—the trader and the broker.Because of advances in technology, currency buying and selling nowcan occur in seconds with a few clicks of the mouse—through a softwareinterface between trader and broker. This software interface is called adealing station.Of course, the firm I recommend to trade with is the firm that Ifounded and designed from the bottom up to give traders the best tools.PremiereTrade as an introducing broker thru numerous market makersoffers FOREX traders the highest level of price transparency via real-timestreaming quotes and a speed of execution that is unmatched in the marketplace. There are other firms out there, though, and ultimately, the choice isyours. You can go to www.premieretrade.com for more information.So how do brokers make money? They provide liquidity, act as thecounterparts on their clients’ transactions, and assume risk. In return, theyattempt to earn a portion of the difference between the bid and offer (thedealing spread) instead of charging commissions.FOREX electronic communications networks (ECNs) and tradingfirms without market-making desks are basically brokers who must chargecommissions to earn revenue. Yet they offer the same 3- to 5-pip dealingspreads to their customers. So why pay a brokerage if you don’t have to?
REAL-TIME EXCHANGE RATESBid and ask quotations are displayed continuously by the Internet CurrencyTrading System on a 24-hour basis for each currency pair. The quotationsare updated thousands of times per day to reflect in real time the price atwhich a client can buy or sell any given currency pair.
EXECUTABLE QUOTATIONSThe prices displayed on the dealing stations are not indications of where themarket is trading but actual prices at which the broker is offering to buy or
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sell. With two clicks of the mouse, clients can execute a trade at a displayedquotation.There are several systems on the market that make a distinctionbetween indicative quotations and executable prices. Although such systems show prices, the client must request a quotation to find out at whatexchange rate a trade actually can be executed.
EXECUTE ORDERS BY PHONEClients may trade over the telephone with most brokers. The trading desks