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The ForexTrading CourseA Self-Study Guide to BecomingA Successful Currency Trader
ABE COFNAS
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The ForexTrading Course
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Founded in 1807, John Wiley & Sons is the oldest independent publishing company in theUnited States. With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and servicesfor our customers’ professional and personal knowledge and understanding.The Wiley Trading series features books by traders who have survived the market’sever-changing temperament and have prospered—some by reinventing systems, othersby getting back to basics. Whether a novice trader, professional, or somewhere in between, these books will provide the advice and strategies needed to prosper today andwell into the future.For a list of available titles, visit our Web site at www.WileyFinance.com.
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The ForexTrading CourseA Self-Study Guide to BecomingA Successful Currency Trader
ABE COFNAS
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C 2008 by Abe Cofnas. All rights reserved.Copyright 
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.Wiley Bicentennial Logo: Richard J. PacificoNo part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or byany means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted underSection 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of thePublisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center,Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the web atwww.copyright.com. Requests to the Publisher for permission should be addressed to the PermissionsDepartment, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008,or online at www.wiley.com/go/permissions.Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts inpreparing this book, they make no representations or warranties with respect to the accuracy or completenessof the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for aparticular purpose. No warranty may be created or extended by sales representatives or written sales materials.The advice and strategies contained herein may not be suitable for your situation. You should consult with aprofessional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or anyother commercial damages, including but not limited to special, incidental, consequential, or other damages.For general information on our other products and services or for technical support, please contact ourCustomer Care Department within the United States at (800) 762-2974, outside the United States at (317)572-3993 or fax (317) 572-4002.Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not beavailable in electronic books. For more information about Wiley products, visit our web site at www.wiley.com.C 2006 All rights reserved worldwide.Figures 1.1, 3.1, and 5.5 are reprinted with permission of CQG, Inc. 
Library of Congress Cataloging-in-Publication Data:Cofnas, Abe, 1950–The Forex trading course : a self-study guide to becoming a successfulcurrency trader / Abe Cofnas.p. cm. — (Wiley trading series)Includes index.ISBN 978-0-470-13764-2 (pbk.)1. Foreign exchange futures. 2. Foreign exchange market. 3. Speculation.I. Title.HG3853.C64 20082007019251332.4 5–dc22Printed in the United States of America10 9 8 7 6 5 4 3 2 1
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This book is dedicated to my students throughout the world, who have thecourage to take on the challenge of forex trading. I have learned much fromthem about trading and about the human condition.
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Contents
Foreword
ix
Preface
xi
Acknowledgments
xiii
About the Author
xv
PART I
What Drives the Forex Market?
1
CHAPTER 1
The Fundamentals of Forex
3
CHAPTER 2
The Role of Inflation
15
CHAPTER 3
Exploiting Information About Economic Growth
19
CHAPTER 4
The China Factor
27
CHAPTER 5
The Commodities Connection
33
CHAPTER 6
How Business Confidence and Consumer SentimentAffect the Market
41
CHAPTER 7
Fundamental Personalities of Currencies
43
CHAPTER 8
The Personality and Performance of the U.S. Dollar
69
CHAPTER 9
Conducting Your Own Fundamental Analysis
75
PART II
Timing the Trade with Technical Analysis
79
CHAPTER 10 Mapping Price Action
81
CHAPTER 11 Finding Significant Support and Resistance
91vii
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viii
CONTENTS
CHAPTER 12 Volatility in Forex and Its Dimensions
105
CHAPTER 13 Chart Formations and Price Patterns YouShould Know
131
CHAPTER 14 Trading Styles and Setups
143
CHAPTER 15 Alternative Setups and Trading Strategies
161
PART III
171
Putting It Together
CHAPTER 16 The Right Way To Use Simulation Accounts
173
CHAPTER 17 Strategies and Challenges for DifferentAccount Sizes
177
CHAPTER 18 The Path to Success in Forex Trading
189
CHAPTER 19 Test Your Forex IQ
195
APPENDIXIndex
Selected Futures Columns
201207
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Foreword
ver 30 years ago, Abe Cofnas was a student of mine at the University of Californiaat Berkeley. At the time, I am certain to have delivered a long-held admonition:95 percent of what you read in economics will be either wrong or irrelevant. Iam pleased to report that The Forex Trading Course falls into the 5 percent residualcategory of materials that are worth reading.In addition to satisfying those with a healthy obsession to work on improving theirprofessional skills, The Forex Trading Course will force readers to think outside the boxand to develop an appetite for the pursuit of knowledge about trading. This, of course,is the most important aspect of the book and reminds me of an observation made by SirHugh Rigby, surgeon to King George V. Sir Hugh was once asked, “What makes a greatsurgeon?” He replied, “There isn’t much to choose between surgeons in manual dexterity.What distinguishes a great surgeon is who knows more than other surgeons.” The samecan be said for traders.In the interest of putting the reader a leg up, an understanding of the structureof exchange-rate regimes is essential. There are three distinct types of exchange-rateregimes—floating, fixed, and pegged—each with different characteristics and differentresults.
O
Hanke’s FX Trichotomy
Type ofRegime
ExchangeRate Policy
MonetaryPolicy
FloatingFixedPegged
NoYesYes
YesNoYes
Source ofMonetaryBaseDomesticForeignDomesticand Foreign
Conflicts betweenExchange-RateBalance-ofand MonetaryPaymentsPolicyCrisis
ExchangeControls
NoNoYes
NoNoMaybe
NoNoYes
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FOREWORD
Although floating and fixed rates appear dissimilar, they are members of the samefree-market family. Both operate without exchange controls and are free-market mechanisms for balance-of-payments adjustments. With a floating rate, a central bank sets amonetary policy but has no exchange-rate policy—the exchange rate is on autopilot. Inconsequence, the monetary base is determined domestically by a central bank. With afixed rate, there are two possibilities: either a currency board sets the exchange rate buthas no monetary policy—the money supply is on autopilot—or a country is “dollarized”and uses a foreign currency as its own. In consequence, under a fixed-rate regime, acountry’s monetary base is determined by the balance of payments, moving in a one-toone correspondence with changes in its foreign reserves. With both of these free-market,exchange-rate mechanisms, there cannot be conflicts between monetary and exchangerate policies, and balance-of-payments crises cannot rear their ugly heads. Indeed, underfloating- and fixed-rate regimes, market forces act to automatically rebalance financialflows and avert balance-of-payments crises.Fixed and pegged rates appear to be the same. However, they are fundamentallydifferent: pegged-rate systems often employ exchange controls and are not free-marketmechanisms for international balance-of-payments adjustments. Pegged rates require acentral bank to manage both the exchange rate and monetary policy. With a pegged rate,the monetary base contains both domestic and foreign components. Unlike floating andfixed rates, pegged rates invariably result in conflicts between monetary and exchangerate policies. For example, when capital inflows become “excessive” under a peggedsystem, a central bank often attempts to sterilize the ensuing increase in the foreigncomponent of the monetary base by selling bonds, reducing the domestic componentof the base. And when outflows become “excessive,” a central bank attempts to offsetthe decrease in the foreign component of the base by buying bonds, increasing the domestic component of the monetary base. Balance-of-payments crises erupt as a centralbank begins to offset more and more of the reduction in the foreign component of themonetary base with domestically created base money. When this occurs, it is only a matter of time before currency speculators spot the contradictions between exchange-rateand monetary policies (as they did in the Asian financial crisis of 1997–1998) and force adevaluation or the imposition of exchange controls.Steve H. HankeProfessor of Applied EconomicsJohns Hopkins UniversityBaltimoreJuly 2007
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Preface
s forex’s popularity increases to unprecedented levels, people around the worldare considering its potential. There are many reasons for its popularity. First, weare truly in an online revolution, powered by the globalization of the Internet.From your desktop—whether at home, an airport, or at an Internet café—you can actually trade any of the world’s currencies. The implications are profound. People can beliberated from the confines of one’s economy and engage in a new profession—forextrading. Additionally, globalization of the world’s economies has created great uncertainty regarding individual career paths. Individuals can no longer expect to work forone employer. Baby Boomers are facing the opportunity and challenge of post-retirementcareers.In response to forex’s popularity, many new trading firms and training firms havearisen to supply services to this new group of aspiring forex traders. The result hasbeen a cacophony of information overload, instant gurus, and instant trading solutions that appeal to those looking for shortcuts to success. These programs essentially confuse people and divert them from a realistic approach to training in forextrading.This book is written for the purpose of providing a getting started guide in forextrading. It, however, is not only for the person new to forex, but for those who have triedto trade forex but received mixed results through trial and error. It is also for those whohave experience in trading other markets and seek to apply that experience to forex.They will be able to build upon their experience and gain new insights into how to approach forex. Those who have achieved a level of initial success but seek to optimizetheir performance will find training strategies and tactics particularly useful.The underlying premise of this book is that traders are not born—they evolve. Ourgoal is to sharpen the insights and the skills of the reader by providing both fundamentaland technical knowledge that are common to successful traders. An underlying philosophy of this book is that successful forex trading requires a total approach that integratesfundamentals, technical analysis, and psychology.
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PREFACE
The book is organized as a self-paced sourcebook. Each chapter topic is in essencea module of knowledge, which can be read individually or sequentially.
r Part I (Chapters 1–9) focuses on the forces that move prices, also known as fundamentals. The topics included in the fundamentals show the reader how to use fundamental knowledge to arrive at trading decisions. The chapters provide insight onhow currency price movements are affected by things like interest rates, interest ratedifferentials, trade-weighted indexes, commodities, housing data, China, and more.r Part II (Chapters 10–15) focus on technical knowledge—how to read and analyzecharts. The reader will build specific knowledge about the components of technicalanalysis and how to evaluate price action in terms of classical and advanced tools including: support and resistance, retracement concepts, trend analysis, and volatilityand momentum indicators. Nontraditional charting using renko and three-line breakare featured.r Part III (Chapters 16–19) provides strategies for testing one’s knowledge and skillsin the real world of trading. The final chapter includes 100 questions that the readershould be able to answer at that point.Learning about trading must be interactive, so throughout the book you will find“assignments” that test your skills. They are designed to help you assess how well youunderstand the material and guide you in finding and using valuable information for scanning currency conditions.Ultimately, all knowledge needs to be actionable. It is my hope that experience oftrying forex trading is enhanced by this book and that forex trading becomes a journeywhich is enjoyable for its enormous challenges and more profitable than it otherwisewould be.
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Acknowledgments
his book is dedicated to the students I have encountered and had the privilegeof mentoring throughout the years. I applaud them for their courage to pursuethe challenges of forex trading and I have learned much from them about how toteach forex with improved effectiveness. I must acknowledge the late Professor AaronWildavsky, at the Graduate School of Public Policy, who shaped my thinking skills morethan 30 years ago into the tools of inquiry that allowed this book to emerge.
T
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About the Author
be Cofnas has been the forex trading columnist of Futures magazine since 2001and has been a leader in designing and delivering forex training courses. He hasconducted seminars in the United States, London, and Dubai as well as onlinetraining in all time zones. Mr. Cofnas founded www.learn4x.com in 2001 as the desktop forex trading industry started to provide education and training in this field. He
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ABOUT THE AUTHOR
recently founded www.currencygames.com, a company providing forex education andglobal forex competitions. He has been in the financial service industry as an equity broker, futures, and forex trader since 1990.Mr. Cofnas holds two master’s degrees, in political science from the Graduate Schoolof Political Science, University of California, and in public policy from the University ofCalifornia, Graduate School of Public Policy. He currently lives in Longwood, Florida,with his wife, Paula, where he conducts research on artificial intelligence programs usingcellular automata and enjoys digital photography. He has a daughter Paige, 25, and a sonPaul, 22.
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The ForexTrading Course
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PART I
What Drives theForex Market?
art I of this book offers a look at the “big picture” in foreign exchange (forex)trading, that is, what forces influence currency price movements. These forces areaccepted by economists around the world as responsible for changes in the valueof currencies. The person learning to trade forex or trying to improve his or her tradingwill benefit from a gain of knowledge of these fundamentals. In fact, as you will see,fundamental forces act as leading indicators of currency movement.U.S. and global interest rates, economic growth, and market sentiment toward thedollar are the key ingredients that shape trading opportunities. Part I provides basicknowledge on how these factors impact forex prices and how they can be used in selecting trading opportunities.
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CHAPTER 1
The Fundamentalsof Forex
e begin in this chapter with an exploration of the forces that move the prices:the fundamentals. The reader will learn why fundamentals are important to foreign exchange (forex) traders as well as what kind of economic activity aremost important in affecting price movements. These include interest rates, interest ratedifferentials, economic growth, and sentiment regarding the U.S. dollar.
W
WHY FUNDAMENTALS ARE IMPORTANTIn many ways, forex trading is similar to playing a game. You have an opponent (themarket). In game of chance the key feature is that everyone faces the same oddsand therefore the same level of information. In these games, no player can changethe odds.Playing forex, however, is not a game of odds. Participants in forex trading do notshare the same amount of information. In forex, this asymmetry of information results inadvantages and disadvantages to trades. Some players have more information than theothers. In forex, information about fundamental aspects of economies does not arrivesimultaneously to all participants. The real important question is what kind of knowledgeand information can improve trading performance. The search for an edge starts with afundamental understanding of the nature of the forex market. Having a foundation ofknowledge in fundamentals is a first step in evolving into a winning trader.In getting acquainted with the forex market, most people start by looking only atprice charts and price patterns. This is called technical analysis. But the study of what3
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WHAT DRIVES THE FOREX MARKET?
moves those charts is called fundamental analysis. The goal of Part I is to identify thecomponents of fundamental analysis in regard to forex and then provide a recipe fordeveloping your own fundamental analysis of a currency pair.Why take time to look at forex fundamentals? Why should fundamentals matter if atrade is done off a short-term time interval such as the 5-minute chart? The short answeris that one cannot separate the fundamentals from the technical analysis without exposing oneself to great distortions in understanding the forex market. Foreign exchange isby its nature both fundamental and technical and reflect the increased globalization ofthe world economy.It is worthwhile to note the comments of the late, great Milton Friedman in a 2005conversation with Dallas Fed president Richard Fisher:The really remarkable thing about the world is how people cooperate together.How somebody in China makes a little bit of your television set. Or somebodyin Malaysia produces some rubber. And that rubber is used by somebody in theUnited States to put on the tip of a pencil, or in some other way. What hashappened has been an enormous expansion in the opportunities for cooperation.(http://dallasfed.org/research/swe/2006/swe0606e.html)Consider the following: every transaction in the world settles in a currency. Whetherit is a consumer purchase, an imported or exported item, an investment in an equity, or even cash under the mattress, the world’s economic activity is essentially aflow of money. What makes forex fascinating as a market and as a trading vehicle isthe fact that currencies provide an intimate linkage to the world economy. The currency trader by putting on a currency trade becomes a participant the world economy.The trader is participating as a speculator looking for a very short-term profit. The forextrader is riding on a global wave. Some will surf the waves, jumping on and off; others will stay in much longer and face the volatility. Forex trading becomes possiblebecause the world is constantly assessing and reassessing the value of one currencyagainst another. The forex currency trader is looking to tap into this stream of changingvalues.The challenge is to find the right combination of tools that can assist the trader infinding high-probability profitable trades. In meeting this challenge, the first step is understanding what moves currencies over time. In putting together a recipe for successfulforex trading, knowing the fundamental chemistry of forex is highly recommended. Anyone who doubts this should simply look at daily headlines that evoke names and placesthat are part of the daily consciousness of a trader. These names should be familiar toall traders: Bernanke, Fukui, Trichet, Xiaochuan. The words and decisions of these central bankers of the United States, the Bank of Japan, the European Central Bank, and
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The Fundamentals of Forex
5
the Bank of China alert the trader to interest rate policy and news that affect sentimentabout the direction of the dollar. Mention the capitals Pyongdong, Baghdad, Tehran, andthey evoke emotions of fear and crises. Detect news about retail giant Wal-Mart’s sales,and one starts anticipating a potential reaction in the currency markets. These and otherfactors mix together and form the chemistry of forex, which results in shifts of sentiment regarding the U.S. dollar. These shifts in sentiment cause price reactions and shiftthe balance between buyers and sellers. Let’s look in more detail at these fundamentalfactors.
THE MAIN INGREDIENT: INTEREST RATES ANDINTEREST RATE DIFFERENTIALSInterest rates are the “dough” of the fundamental forex pie. They are one of the most important factors that affect forex prices, as interest rates are the modern tool that centralbanks use as a throttle on their economies. The central banks of the world do not hesitateto use this important tool. In recent years almost all of the central banks increased interest rates. The European Central Bank raised interest rates eight times from December 6,2005, to June 13, 2007, to a level of 4.0 percent to guide a booming European economyto slow down and avoid too high inflation. The United States’ central bank—the FederalReserve—increased interest rates 17 times between June 30, 2004, and August 2006, andthen paused when it decided the economy no longer needed the brake of interest rateincreases.Interest rate increases do much more than slow down an economy; they also act as amagnet to attract capital to bonds and other interest-bearing instruments. This has beencalled an “appetite for yield,” and when applied globally the flow of capital in and out ofa country can be substantially affected by the difference in interest rates between onecountry and another. In recent years the outflow of capital from Japan to New Zealand,Australia, and Great Britain has reflected money chasing more yield and has been a majormultibillion-dollar feature called the “carry trade.” The carry trade was driven by theinterest rate differential that has existed, for example, between Japan (0.50) and NewZealand (8.0), causing low-cost borrowing in yen to invest in higher-yielding kiwis.There can be no doubt of the critical role interest rates play in forex price movements. Some forex traders learned this lesson when the U.S. stock market sold off onFebruary 27, 2007. It was precipitated by traders getting out of their carry trade positions. Since billions of dollars were sold to be converted back into yen, equity marketswere also affected because equity positions had to be sold to buy back the yen positions.In Figure 1.1 we see how the Dow Jones Industrial Index correlated directly with the U.S.dollar–Japanese yen (USDJPY) pair that day.
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FIGURE 1.1 Dollar Yen Slide Causes Dow Sell-Oﬀ.C 2006. All rights reserved worldwide.Source: CQG Inc. Copyright 
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The Fundamentals of Forex
7
THE ROLE OF HOUSING IN FOREX PRICE MOVEMENTSFundamentally, however, one of the most important categories of economic data aroundthe world, which is sensitive to interest rate changes, is housing data. The housing sectorin the United States, as well as other nations, provides a major share of wealth, consumerspending, and job creation. Recent years have seen an international housing boom, withprices growing at more than 10 percent per year in many countries. For example, Irelandgrew at 15 percent in 2006; Spain’s growth actually slowed down to 13 percent. Canada,Norway, and Sweden shared more than 10 percent growth. The United States, in the faceof a slowdown, saw prices up 7 percent. This means that the value of homes around theworld has doubled in the past 10 years, and as a result the increased wealth has fueledeconomic growth and consumer purchase.Closely watched are data releases that relate to housing activity. Some of the maindata releases track:
r The level of unsold homesr Mortgage loan applicationsr New and existing home salesr Single-family housing permitsr Housing pricesForex traders’ expectations of the future direction of interest rates are significantlyaffected by housing data because, for example, weak housing leads to expectations of aslowdown on consumption. The economic reasoning is that consumers start seeing a decline in housing values and restrain their consumer spending. One of the most importantfactors related to housing market strength in recent years has been mortgage equity withdrawals (MEWs). As home prices have increased around the world, consumers take outloans against their mortgages, which stimulates consumption. During periods of housing booms, MEWs rise. MEWs have been, in fact, calculated to contribute to the growthof gross domestic product (GDP). Figure 1.2 shows that MEWs have reached nearly 6percent of U.S. GDP. However, if MEWs slow down, this can portend a decline in consumption and a slowdown in the economy. If and when a slowdown in MEWs occurs,central bankers view it as lessening the likelihood of an interest rate increase. DamonDarlin wrote in the New York Times (“YOUR MONEY; Mortgage Lesson No. 1: Home IsNot a Piggy Bank,” November 4, 2006):Economists argue over what effect the access to money, which mortgage equitywithdrawals allow, has had on consumer spending. Homeowners cash out to payoff more expensive credit card debt, remodel the house to build more equity, or just
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FIGURE 1.2 Home Building Has Slumped.Source: Census Bureau, Bureau of Economic Analysis.
have fun. They may very well have used it to buy another house or not spent it atall, but added it to savings. Economists