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Volume 3, No. 5

MEXICAN PESO:
TRADING THE SOUTH OF THE BORDER CURRENCY
INTERVIEW WITH MONEY MANAGER
PETER PANHOLZER
FOREX
MONEY MANAGEMENT STRATEGIES
THE EURO INDEX – NEW HEDGING
AND TRADING TOOL

JAPAN AND THE YEN:

NEW ERA OR MORE OF THE SAME?
 CONTENTS

Contributors . . . . . . . . . . . . . . . . . . . .6 The return of reserve

diversification . . . . . . . . . . . . . . . . .20
What do recent central bank reserve
Global Markets diversification moves mean for the
Yen still in holding pattern . . . . . . . . .8 dollar and the euro?
The outlook for the yen in the aftermath By Barbara Rockefeller
of the Bank of Japan’s decision to
raise interest rates.
By Currency Trader Staff Trading Strategies
FX money management . . . . . . . . . .24
Mexican peso: Settling down Cracking open the “myth” of 2-to-1
prior to summer elections? . . . . . . .10 money management and exploring
Taking a look at the peso’s future for practical money-management techniques.
the remainder of the year. By Boris Schlossberg
By Currency Trader Staff

Advanced Concepts
Big Picture The euro index: The dollar index
Japan: Rising Sun meets its match . . . . . . . . . . . . . . . .26
or just another day? . . . . . . . . . . . .14 A look at the development of a viable —
Analyzing what Japan’s apparent and tradable — euro index.
economic rebound means for the yen. Howard L. Simons
By Marc Chandler

Currency System Analysis . . . . . .30

Channel Midpoint indicator

continued on p. 4

2 May 2006 • CURRENCY TRADER

 CONTENTS

Currency Trader Interview . . . . . .34

Peter Panholzer on market sentiment
How a top currency trader uses contrarian Global News Briefs . . . . . . . . . . . . .42
opinion.
By Mark Etzkorn
Events . . . . . . . . . . . . . . . . . . . . . . . .43
Conferences, seminars, and
International other events.
Market Summary . . . . . . . . . . . . . . .38

New Products and Services . . . . .43

Industry News . . . . . . . . . . . . . . . . .40
RefcoFX customers left in limbo
Refco and its creditors refused to accept Global Economic Calendar . . . . . .44
FXCM’s bid for RefcoFX.com. Key dates for currency traders.

Key Concepts . . . . . . . . . . . . . . . . . .40

References and definitions. Forex Trade Journal . . . . . . . . . . . .46
Buying a pullback in the U.S.-Canadian
dollar rate.
Currency Futures . . . . . . . . . . . . . .41
News and data from the currency
futures world.

Have a question about something you’ve seen in

Currency Trader?
Submit your editorial queries or comments to
webmaster@currencytradermag.com.

Looking for an advertiser?

Consult the list below and click on the company name for a direct link to the ad in this month’s
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Index of advertisers

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International Trader’s Expo Expo Trader Brazil

4 May 2006 • CURRENCY TRADER

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individuals of all levels of skill and experience.

This is neither a solicitation to buy or sell any type of financial instruments, nor intended as investment recommendations. All investment trading involves multiple substantial risks of mon-
etary loss. Don’t trade with money you can’t afford to lose. Trading is not suitable for everyone. Past performance, whether indicated by actual or hypothetical results or testimonials are no
guarantee of future performance or success. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT,
THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS OR TESTIMONIALS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR
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 CONTRIBUTORS
CONTRIBUTORS

 Marc Chandler is the head of global for-

eign exchange strategies at Brown Brothers
Harriman and an associate professor at New
A publication of Active Trader ®
York’s School of Continuing and Professional

For all subscriber services: Studies. From May 2001 through Oct. 1, 2004, he
www.currencytradermag.com was chief currency strategist at HSBC Bank
USA. Prior to HSBC, he was the chief currency
Editor-in-chief: Mark Etzkorn
metzkorn@currencytradermag.com strategist at Mellon Financial, a senior currency strategist at
Deutsche Bank, and the director of research at EZA Associates.
Managing editor: Molly Flynn
mflynn@currencytradermag.com

 Howard Simons is president of Rosewood Trading, Inc.,

Associate editor: David Bukey
dbukey@currencytradermag.com and a strategist for Bianco Research. He writes and speaks
frequently on a wide range of economic and financial
Contributing editor: Jeff Ponczak
jponczak@currencytradermag.com
market issues.

Editorial assistant and

 Barbara Rockefeller (www.rts-forex.com) is an interna-
Webmaster: Kesha Green
kgreen@currencytradermag.com tional economist with a focus on foreign exchange. She has
worked as a forecaster, trader, and consultant at Citibank and
Art director: Laura Coyle
lcoyle@currencytradermag.com
other financial institutions, and currently publishes two daily
reports on foreign exchange. Rockefeller is the author of
President: Phil Dorman
Technical Analysis for Dummies (2004), 24/7 Trading Around the
pdorman@currencytradermag.com
Clock, Around the World (John Wiley & Sons, 2000), The Global
Publisher, Trader (John Wiley & Sons, 2001), and How to Invest
Ad sales East Coast and Midwest:
Internationally, published in Japan in 1999. A book tentatively
Bob Dorman
bdorman@currencytradermag.com titled How to Trade FX is in the works.

Ad sales
 Boris Schlossberg is a senior currency
West Coast and Southwest only:
Allison Ellis strategist at Forex Capital Markets in New York
aellis@currencytradermag.com
and author of Technical Analysis of the Currency

Classified ad sales: Mark Seger Market (John Wiley & Sons, 2006). He is also a
mseger@currencytradermag.com guest lecturer at www.fxstreet.com, covering
proper risk management, trader psychology,
and true market structure. Schlossberg is a frequent commen-
tator for Reuters and Dow Jones/CBS Marketwatch currency
and bond market sections. He has been an independent trader
Volume 3, Issue 5. Currency Trader is published monthly by TechInfo, Inc.,
150 S. Wacker Drive, Suite 880, Chicago, IL 60606. Copyright © 2006
since 1999, trading a variety of instruments including stocks,
TechInfo, Inc. All rights reserved. Information in this publication may not be
stored or reproduced in any form without written permission from the publisher. options, futures, and currencies.
The information in Currency Trader magazine is intended for educational pur-
poses only. It is not meant to recommend, promote or in any way imply the
effectiveness of any trading system, strategy or approach. Traders are advised  José Cruset (jose@wealth-lab.com) is a private trader,
to do their own research and testing to determine the validity of a trading idea.
Trading and investing carry a high level of risk. Past performance does not software engineer, and trading system researcher. He holds an
guarantee future results.
MBA and a NASD-Series 3 certificate and has worked many
years in the banking industry.

6 May 2006 • CURRENCY TRADER

 GLOBAL MARKETS

Yen still in Japan has sent out signals it is finally ready

to begin raising interest rates this year,
holding pattern but the yen’s response so far has been muted.

BY CURRENCY TRADER STAFF

I n the wake of the “big news” — the Bank of Japan’s

(BOJ) March 9 decision to end its easy monetary pol-
icy — the dollar/yen rate (USD/JPY) has gone
absolutely nowhere. The pair has remained locked
within the same narrow range — roughly 115.00 to 119.00 —
that has confined action since early February (Figure 1), and
which is itself well within the boundaries of the December
“They increased their reserves so banks could lend out
more cash,” says David Powell, currency analyst at
Ideaglobal.
The BOJ’s quantitative easing target stood at 30 trillion
yen. Now, the BOJ has shifted down its target to 6 trillion
yen, which it aims to achieve by June 9.
“They are well on their way,” Powell says. “It has been
2005 high of 121.39 and January 2006 low 113.40 (Figure 2). reduced significantly.”
Is a breakout on the horizon? Will an actual shift from the Once the BOJ has finished withdrawing all the excess liq-
zero interest-rate policy (ZIRP) strengthen the yen later this uidity from the banking system, the policymakers can begin
year? When will the BOJ actually bump rates up and what considering an actual hike to the overnight rate, which cur-
will this mean for the popular yen carry-trade? rently stands at zero percent.
Before diving into these questions, let’s first take a look at At the BOJ’s April 11 meeting, monetary policy was held
what the BOJ has actually done in the aftermath of its early steady and no timing was offered for the actual end to ZIRP.
March bias shift.
Is the carry trade dead?
Quantitative easing Many analysts have warned the end of the BOJ’s easy mon-
The BOJ has indeed already begun a monetary policy tight- etary policy could wreak havoc on the world financial mar-
ening of sorts. During its long battle with deflation, the kets, as global portfolio managers and large hedge funds
bank had effectively dropped interest rates to zero. Looking unwind their so-called yen-carry trades. But that has yet to
for another tool, the bank also flooded the banking system happen. With Japanese rates at zero, it had become a popu-
with extra cash. lar strategy in recent years to borrow money in Japan and
invest it in other assets around the world. However,
FIGURE 1 — SHORT-TERM BREAKDOWN because official Japanese rates are still at zero, analysts
The USD/JPY just recently broke down out of a narrow range - say the carry trade is still in play.
roughly 115.00 to 119.00 - that has confined action since early “It is a bit premature to forecast the end of the carry
February. trade,” Powell says. “Even when they do hike rates, it
will be at a moderate pace and it will still be far below
anything else in the G-10.”
However, Charmaine Buskas, economist at Moody’s
Economy.com, has noticed a change in the trend in the
Commodity Futures Trading Commission’s (CFTC)
Commitment of Traders (COT) data, which tracks the
positions of different types of traders (large speculators,
hedgers, small traders, etc.).
“The data has shown yen short positions are unwind-
ing,” she says. “But for a wholesale reversal of short
positions, you are going to see further action by the
BOJ.”

Timing and size of a rate hike

The third quarter of this year is the earliest market
watchers say an actual bump up in the Japanese
overnight rate would occur, and some point to the
Source: TradeStation
fourth quarter or even early 2007.

8 May 2006 • CURRENCY TRADER

 FIGURE 2 — BIGGER PICTURE CONSOLIDATION

Most economists expect a 25 basis-point hike, but Even after the breakdown shown in Figure 2, the dollar-yen still
remains within the boundaries of a larger consolidation between
Buskas offers a more gradual hiking scenario. She
the Dec. 2005 high of 121.39 and Jan. 2006 low 113.40.
thinks the third quarter is the likely time for a rate
increase, but says the BOJ may choose to hike by less
than 25 basis points.
“I think they are really going to treat the tightening
cycle with kid gloves,” she says. “They’ll start off with
10 basis points and see how that goes.”
That forecast compares with JP Morgan’s view the
BOJ will hike rates by 25 basis points at both its
August and December meetings, which will leave
rates at .50 percent at year-end.

A look at the economic numbers

Most economists agree the overall growth picture
looks positive for Japan.
“It looks more like a real recovery,” says Robert
Mellman, senior economist at JP Morgan. “For a long
time, it had just been export-led, but now it seems
more balanced. Profit margins have been high, profit Source: TradeStation
growth has been good and they’ve gone from defla-
tion to inflation.” side break from recent ranges in the dollar/yen pair later
JP Morgan expects Japan to post a respectable 3.2-percent this year, with the key trigger being an actual rate hike by
gross domestic product (GDP) growth in 2006. Ideaglobal the BOJ.
analysts forecast a 3.0-percent GDP reading in 2006, while Buskas expects to see a global shift in forex dynamics
Moody’s Economy.com projects a 2.0-percent figure. ahead.
Inflation, of course, is the critical factor in the wake of the “Instead of going short the yen, players are going to be
long fight against deflation. Core CPI data posted a 0.5-per- more interested in going long the yen,” she says. “By the
cent month-over month reading in February, following a middle to the latter half of the year, the market will be
0.5-percent rise in January, according to Ideaglobal’s forced to take a bigger-picture look at the U.S. and its
Powell. unsustainable external deficits.”
“The core measure does not exclude oil,” Powell notes. “It She points to a rate hike as the catalyst to spark a down-
excludes only fresh food. When you factor in the huge rally in side breakout in the dollar/yen with an initial target at the
oil and energy costs, you have to wonder how much inflation 110.00 area.
is really there.” Once a rate hike sets the trend toward a stronger yen into
Even within Japan there is some debate regarding the motion, gains toward the 108.00 area could be seen by the
level of inflation. end of first quarter 2007, Ideaglobal analysts say.
“The BOJ has been saying inflation has been on a sus- Tim Mazanec, senior FX strategist at Investor’s Bank &
tainable upward trend, but not everyone in Japan agrees Trust, offers another view.
with that,” Powell says. “The Ministry of Finance is more “This quarter I think we will see a breakout,” he says.
cautious.” continued on p. 12
Buskas believes core prices are the big
question mark. U.S. DOLLAR/JAPANESE YEN AT A GLANCE
“They have been slow to rise,” she
says. “The BOJ will look for another cou- Daily range (past 40 days): Average: .99 Median .98
ple of months of steady increases in core Weekly range (past 26 weeks): Average: 2.35 Median: 2.16
prices.” 52-week high/low: 121.39/104.19
U.S. Japan
Yen strength ahead? Prevailing interest rates (%) 4.75 0.00
“The outlook for the yen is quite posi- Next central bank meetings May 10 May 19
tive,” Buskas says. “We have solid funda- GDP Q4 2005* Q3 2005 Q2 2005
mentals for the first time in a decade and US JPN US JPN US JPN
this paves the way for interest-rate 1.7 0.8 4.1 -0.1 3.3 1.2
hikes.” *Estimate All data as of April 28
Many analysts are forecasting a down-

CURRENCY TRADER • May 2006 9

 GLOBAL MARKETS continued

Mexican peso:
Settling down prior to summer elections?
The peso has been gaining strength vs. the dollar since February. But upcoming events may keep
a lid on the currency’s movements in the near future.
BY CURRENCY TRADER STAFF

W
ith the peso hovering around roughly 11 vs. have sparked some volatility and “defensiveness” in the
the U.S. dollar (see Figure 1), some analysts peso market, explains Enrique Alvarez, head of Latin
say the currency may have settled into a American Research at Ideaglobal. Given the manufacturing
sideways consolidation as the interest-rate ties between the U.S. and Mexico, concerns that higher U.S.
differential between the U.S. and Mexico has narrowed, and rates could ultimately slow the economy were seen as even-
with the Mexican presidential and congressional elections tually triggering a slowdown in the Mexican economy.
looming in July. “We’ve been in a very wide range of about 10.40-11.00,”
The peso had been on a clear uptrend vs. the dollar, mov- Alvarez says. “My sense is that it wants to flatten out and
ing from 11.70 in mid-2004 to 10.40 in late 2005-early 2006. hover around 11.”
Higher oil prices and tighter Mexican monetary policy Guillermo Estebanez, currency strategist at Bank of
through mid-2005 helped support the peso. But after top- America, adds, “We think the outlook for the peso is not
ping out at 9.75 percent in August 2005, the Banco de quite as bullish as in previous years.”
Mexico shifted course and began cutting rates in an effort to He points to tightening monetary conditions in the U.S.
spur economic growth. as a factor.
After several rate cuts, the Banco de Mexico again “The peso is part of a class of assets — emerging markets,
slashed the overnight rate by .25 basis points on April 21, which tend to be bid up in conditions of loose liquidity,” he
dropping the official rate to 7 percent. At the same time, the says. “We think liquidity conditions will become less favor-
bank indicated that the cut was the end of the nine-month able for emerging markets.”
easing cycle.
U.S. rate action will be key to watch
Peso action Because of the close correlation between U.S. and Mexican
Heading into April, the higher U.S. Treasury market rates growth, some in the market say the pace and timing of
future rate increases by the U.S. Fed will
FIGURE 1 — PESO PAUSE be key for peso market action. The U.S.
After rallying vs. the dollar during the first quarter of the year, the peso has Federal funds rate currently stands at
stalled, perhaps because of uncertainty regarding presidential elections in July 4.75 percent.
and the narrowing of U.S.-Mexican interest rates. “If U.S. rates stagnate around 5.00
percent, we should see a new range from
11.10-10.90 short to medium term,”
Alvarez says.
However, Alvarez adds, if the U.S.
Fed hikes short-term rates to 5.25 per-
cent or beyond, it could spark a new
peso range in the 11.15-11.30 region.
“We expect peso weakness largely as
a function of the narrowing of interest-
rate differentials between the U.S. and
Mexico,” says Alonso Cervera, senior
economist at Credit Suisse.

The economy
Looking at the economic fundamentals,
Mexico appears to be in good shape.
“The outlook for the Mexican econo-
Source: ADVFN (www.advfn.com)
continued on p. 12

10 May 2006 • CURRENCY TRADER

 GLOBAL ECONOMY continued

MEXICAN PESO FUTURES (MP) AT A GLANCE

my continues to be quite positive,”
Cervera says. “The economy is growing at Daily range (past 40 days): Average: 000817 Median: 000775
a pace between three and four percent, Weekly range (past 26 weeks): Average: 0.001722 Median: 0.001450
with a low inflation rate.” 52-week high/low: 0.097900/0.088875
Cervera pegged recent headline infla- U.S. Mexico
tion at 3.4 percent, with the core rate at 3.0 Prevailing interest rates (%) 4.75 7.00
percent. Next central bank meetings May 10 May 26
In the April edition of Emerging Markets GDP Q4 2005* Q3 2005 Q2 2005
FX Roadmap issued by HSBC Global US MEX US MEX US MEX
Research, HSBC analysts forecast a 3.4- 1.7 3.3 4.1 3.25 3.3 4.1
*Estimate All data as of April 28
percent Mexican GDP growth in 2006, fol-
lowing 2005’s 3.0-percent reading.
Mexico, a large oil exporter, has benefited from the Obrador, from the PRD, Felipe Calderon, from the center-
worldwide rally in crude oil prices in recent months. right PAN, and Roberto Madrazo, from the PRI.
Cervera points to the $31 billion in Mexican oil exports in “Uncertain scenarios could make investors nervous
2005, or 4.1 percent of Mexican GDP, as an overall bullish about Mexico,” Cervera says. “This is a tighter race than we
factor for the economy. had originally thought.”
Analysts seem to agree the “favorite” candidate for the
The politics markets is the current ruling PAN party; most feared is from
With the Presidential election looming on July 2, market the PRD party.
watchers say the uncertainty up until that time could spark But despite the presidential win, analysts add that
less foreign appetite for the Mexican arena. Congress will likely be split and no candidate will have a
“In general, elections tend to be problematic,” says Bank clear majority, which could keep overall macro policies
of America’s Estebanez. “They tend to cause volatility.” moving in the same direction.
On July 2, the entire Congress will also be up for reelection. Overall, most analysts see risk for additional peso weak-
Currently, there are three top contenders for the ness between now and year-end, with forecasts ranging
Presidency and recent polls show them nearly tied in terms from 11.20 to 11.70, depending on the outcome of the presi-
of popularity. The three main candidates are Andre Lopez dential election. 

JAPANESE YEN continued from p. 9

“I’ve been a believer of a strong dollar and continue to “All ranges eventually break out,” Mazanec notes.
expect that.” He sees a break above 119.00 leading to a quick If he is wrong and the market instead breaks down, he
rally toward the 122.00-123.00 zone. sees a target at the 112.00-111.00 area. 

Related reading
“Getting a lift from the carry trade,” by Kathy Lien “All traders, big and small:
Currency Trader, October 2004. The Commitment of Traders report”
Correctly assessing the risk environment paves the way to Active Trader, March 2003.
capitalizing on the interest-rate differentials between In futures, as in stocks, the “institutional” money usually dic-
currencies. tates price action. The Commitment of Traders report gives
you a glimpse of what the big money is doing in the markets
“Dollar-yen: The year’s hottest carry trade,” by Kathy Lien you trade. An article for beginners.
Currency Trader, August 2005.
The buck was on the short side of many carry trades last “Larry Williams looks inside futures”
year, but the current interest-rate hike cycle offers the opportu- Active Trader, January 2006.
nity to go long the dollar and short the yen. An interview with Larry Williams in which he discusses the
twists he puts on the commitment of traders report.
“The short-term British pound/Japanese yen carry trade”
Currency Trader, December 2004. “Floyd Upperman: Digging into COT data”
It pays to have a currency pair’s rollover charges on your side. Active Trader, February 2006.
Find out how the daily rollover has affected GBP/JPY — a Its not just a matter of hedgers vs. speculators. In this inter-
popular carry trade — in recent years. view, an engineer turned trader discusses ways to make
sense of the futures Commitment of Traders report.
You can purchase and download past articles at www.activetradermag.com/purchase_articles.htm.

12 May 2006 • CURRENCY TRADER

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 THE BIG PICTURE

Japan:
Rising Sun or just another day?
Things seems to be picking up for Japan after a long malaise,
but the country’s economy and currency aren’t necessarily out of the woods yet.

BY MARC CHANDLER

J apan is emerging from an economic period

comparable to the U.S. Great Depression. The
gradual adjustment to monetary and fiscal
policies has already begun: Tax increases and a
reduction of bond issuance are already in the works, and
the Bank of Japan (BOJ) signaled an end to its “quantitative
easing strategy,” under which it provided something on the
companies). Some studies indicate cross shareholdings fell
from 46 percent of the total outstanding shares in the early
90s to 27 percent in 2002. They are now are believed to be
closer to 20 percent.
At the same time, significant industry consolidation has
occurred. In the 80s, there were 14 large oil producers and
about the same number of paper companies. Now there are
magnitude of five to six times the amount of liquidity four main oil producers and three large paper companies.
Japanese banks required. Overnight interest rates continue Numerous steel companies have been reduced to a field of
to be near zero, although there are widespread expectations four and they are producing roughly the same amount of
the BOJ will deliver a first rate hike this summer. steel the industry did almost a decade ago, with a work
This assumes the normalization of the Japanese business force reduced by a third, according to a recent report in
cycle. The economy is enjoying sustained growth and is Financial Times.
expected to be among the fastest growing of the major These changes highlight the transformation of the
industrialized countries this year. Corporate profits are near employer-employee relationship in Japan. Although life-
record levels and the stock market is at 14-year highs. time employment still is offered by some firms, reports sug-
Commercial land prices in Japan’s three largest metropoli- gest it is not as widely practiced in the past. There has also
tan areas are rising for the first time in 15 years. The been a significant increase in the use of contract workers.
improved macro-economic performance has given rise to Industry estimates suggest contract workers now account
the belief that “Japan is back.” for almost one-third of the Japanese work force, compared
The real situation is more complicated and, in many to only one-fifth previously.

Today’s Japanese economy is not the same one that entered into
a period of malaise more than 15 years ago.
ways, rather than heralding the return of the Rising Sun, The relationship between Japanese companies and their
suggests it is just another day in Japan. main banks has also changed. This seems especially true for
manufacturing companies. Many, though clearly not all,
Changing relationships have reduced their dependence on banks. The process econ-
In fairness, though, one must acknowledge the Japanese omists call “disintermediation” has taken root in Japan.
economy today is not the same one that entered into a peri- Many large manufacturing companies use their own cash
od of malaise more than 15 years ago. Several key relation- flow and their profits to finance investment rather than rely
ships that underpin the domestic economy have fundamen- on bank loans. More than before, Japanese companies are
tally changed. going directly to the capital markets to raise funds by issu-
First, the relationship between Japanese companies has ing stocks and bonds.
generally weakened, as evidenced by the reduction of cross The loosening of the relationship between industrial cap-
shareholdings (when companies have equity stake in other ital and finance capital was largely predicated on the pro-

14 May 2006 • CURRENCY TRADER

longed banking crisis that played such a critical role in hob- three legs: exports, government spending, and investment,
bling the Japanese economy. But as in industry, so too in with only a modest role for consumption. Second, Japan
finance: The government encouraged intensive consolida- continues to generate surplus savings and struggles to use
tion among Japanese banks. In the 80s there were a little it efficiently.
more than a dozen large banks. Today there are four. From the last deep trough in GDP in Q4 2001 through Q4
This consolidation was integral to the resolution of the 2005, the Japanese economy expanded by about 10 percent
non-performing loan problem that paralyzed the banking in real terms. Financial Times economics columnist Martin
system for a decade. There were many false starts, but in the Wolf recently noted that exports accounted for almost a
spring of 2002 the efforts became earnest. The goal of cut- third of that growth. The strong exports are a function of a
ting the non-performing loans in half in three years was significant decline in the Japanese yen. In real trade-weight-
achieved. Currently, non-performing loans at the top four ed terms, the yen depreciated by 30 percent between
banks average around 2.5 percent. December 1999 and February 2006. On the demand side, the
Japan’s bad loan problem was partly resolved by the booming Chinese economy accounts for a third of Japan’s
transformation of another important relationship — that of total export increase from 2001 to 2005.
foreign investors. Drawing on their experience in their own The second leg of the economy is government spending.
countries, U.S. and European financial institutions were sig- Between Q4 2001 and Q4 2005, government spending
nificant buyers of bad loans from Japanese banks. Some for- accounted for almost 15 percent of Japan’s growth, and per-
eign financial firms, for example, reportedly garnered sistent budget deficits have accumulated into a significant
returns nearly twice the recovery rate of the U.S. S&L crisis level of debt. Even this year, when there is widespread
of the early 90s. recognition that the Japanese economic recovery has broad-
The role of foreign investors in the Japanese equity mar- ened and deepened, the budget deficit this year will likely

Contrary to the impression one would make from U.S. industry captains
who claim Japan is manipulating the currency market, Japan has not
intervened in the foreign exchange market for nearly two years.

ket has also increased markedly. Prior to Japan’s depres- be in excess of six percent of GDP.
sion, foreign investors owned less than five percent of out- An Organization for Economic Cooperation and
standing Japanese shares. According to the Tokyo Stock Development (OECD) estimate from the end of last year
Exchange, foreign ownership is currently closer to 25 per- puts Japan’s national debt at more than 160 percent of GDP,
cent. more than any other member (Italy stands second, near 128
In many respects these changes are giving the markets percent). Because of a various intra-government loans, the
greater influence. Just as strong fences make for good measure of net debt may be closer to 82 percent (the com-
neighbors, so can a robust regulatory regime make for parable figure for Italy is 103.5 percent).
stronger markets. Japan belatedly has introduced mark-to- Investment accounted for almost a fifth of the Japanese
market accounting, and consolidated reporting makes for growth during this period. Japanese investment exceeds
more transparent corporate activity. Also, Japanese compa- other major industrialized countries — roughly 40-percent
nies must more rigorously account for pension liabilities, higher than in the U.S. and Germany. What befuddles many
which is particularly important given the country’s aging observers is that such high investment has not generated
population. strong growth, nor will it likely in the future. The
International Monetary Fund (IMF) estimates potential
Cursed by too much money growth for Japan at around 1.5 percent. By comparison, it
In two critical ways, however, Japan 2006 is the same as the estimates potential U.S. growth near 3 percent.
Japan of old. First, the main economic drivers haven’t Private consumption accounts for less than 40 percent of
changed. The Japanese economy continues to stand on continued on p. 16

CURRENCY TRADER • May 2006 15

 THE BIG PICTURE continued

Japan’s growth. (In the U.S., by contrast, consumption wash Japan’s 20th-century history, much to the chagrin of
drives nearly 70 percent of the world’s largest economy.) neighbors such as South Korea and China. Although this
Nor is the outlook particularly favorable, despite the cycli- problem obviously did not begin with Koizumi, it has con-
cal expansion underway, the tightness in the labor market, tinued unabated during Koizumi’s tenure. Koizumi’s
and the upward pressure on wages. A combination of high- nationalism also lies behind his insistence of visiting the
er sales taxes and the elimination of a previous income tax Yasukuni Shrine that includes some of Japan’s war heroes
cut may reduce disposable income. and criminals.
While there are arguably cultural impediments to con- Sometimes national interests are at stake, but the way
spicuous consumption, the “lack land” reform may exacer- they are expressed is often in nationalistic terms. For exam-
bate the problem. The inefficient use of land leads to high ple, there is a simmering territorial dispute between China
land prices in Japan, even after a decline over the past and Japan (both of which are major energy importers) over
decade, and small dwellings also curtail consumption. the East China Sea, which is thought to have vast oil and
Trans-generational mortgages have been reported. A low natural gas deposits.
level of consumption, under-developed capital markets, a Another expression of Japanese nationalism is the steps
relatively small service sector, and a political system domi- toward remilitarization, which requires a reinterpretation, if
nated by one party are often characteristics of a developing not a constitutional change. Japan is located in a dangerous
country. neighborhood. Its most proximate threat comes from North
Simply, Japan does not enjoy excess savings — it suffers Korea, which has demonstrated the capability to launch a
from it. Surplus often is wasted; Japan has proven to be a missile attack on Japan. Longer-term, the most obvious

Provided the economic recovery remains intact and core inflation continues to
rise, it’s possible the Bank of Japan will raise interest rates twice this year.

terribly inefficient user of capital. It still requires roughly 70 change in the status quo comes from its regional rival
percent more capital to produce a given unit of GDP com- China, which is pursuing an ambitious arms program.
pared to the U.S. At the end of the Cold War, many wondered whether the
Japan’s private sector saves between 25 and 30 percent of U.S. still required Japan to act as a large “aircraft carrier” in
GDP. Although household savings have slipped a bit lately, the Pacific. However, the rise of global terrorism and the
the increase in corporate savings offset this. On top of that, arms race in Asia, amid concerns that the U.S. may be over-
Japan has been running a current account surplus of 3 per- stretched, obviously underscores the opportunity to re-
cent of GDP. examine Japan’s defense strategy. The recent U.S.-Japan
This co-existence of high private savings and investment agreement on the mutual defense of Taiwan and the first
with a slow growth runs counter to economic orthodoxy, use of Japanese forces outside of Japan point to a somewhat
which teaches national savings are the pool from which more assertive foreign policy that is perfectly consistent
investment capital is provided. In turn, investment is the with the rise of nationalism. Efforts to secure a seat on the
key to long-term growth. United Nation’s Security Council are another example of
this recent tendency.
Nationalism and socialism The socialist component is similar to the West’s after the
The U.S. and Western Europe emerged from the Great Great Depression. For example, as lifetime employment
Depression through a combination of socialism (the cre- became less common and unemployment rose as the econ-
ation of the modern welfare state) and nationalism, includ- omy stumbled through its trough, the Japanese government
ing but not limited to its military expressions. Japan also expanded the services it provided, including the beginnings
has practiced a mixture of socialism and nationalism in of unemployment compensation and job banks.
emerging from its Great Depression — something that High unemployment (by Japanese standards) and
speaks to a changed relationship between the citizenry and increased contract work have contributed to the number of
the state. Japanese without savings reportedly doubling in the past
Japan’s Prime Minister Junichiro Koizumi appears to five years to 24 percent — the highest level since the 60s.
have purposefully reinvigorated the country’s nationalism. Welfare payments and education assistance tied to income
This can be seen in the controversial textbooks that white- levels have risen markedly. The New York Times recently

16 May 2006 • CURRENCY TRADER

 FIGURE 1 — USD/JPY RATE, WEEKLY
Over the past three years, the dollar/yen rate has made significant moves up and
reported the number of Japanese down, but it has also spent a great deal of time — including most of this year — in
households receiving welfare pay- trading ranges (horizontal bars).
ments has risen by more than 37 per-
cent since 2000, to more than one mil-
lion.
Although elementary and junior
high school are mandatory and free in
Japan, the number of these students
receiving aid based on household
income rose by more than a third to
almost 13 percent between 2000 and
2004. Of the major cities, Osaka and
Tokyo have the highest assistance rates
— 28 and 25 percent of school children,
respectively.
In addition to economic considera-
tions, demographic changes will influ-
ence the development of Japan’s wel-
fare state. In the past Japan relied on the
substitution of welfare by family. For
numerous reasons this was recognized
as unsustainable, and the result was the Source: TradeStation
implementation of the Long-Term Care
services Insurance Act in 2000. The challenge posed by the monetizing the government’s debt — and providing incred-
aging population is going to intensify in the next couple of ibly excessive reserves to the banks — the BOJ in essence
years as the baby boom generation begins retiring. At the took the advice of some economists that to end deflation,
same time, the population as a whole has begun to decline. Japan ought to “drop yen from a helicopter.”
Social security benefits are growing as a percentage of GDP Contrary to the impression one would get by listening to
and now stand at nearly 25 percent. Nearly three quarters of U.S. industry captains who claim Japan is manipulating the
the social security benefits go to the elderly. currency market, Japan has not intervened in the foreign
Japan has implemented (to varying degrees) the kind of exchange market for nearly two years. The BOJ appears to
Keynesian demand-management, income-distribution proj- have successfully mastered the preferred practices of the
ects practiced in the West, but it may find a new use for its U.S.: Rather than manipulate the currency market, manipu-
previous asset demand management efforts. The country’s late interest rates and other financial variables, such as
total national assets are 20 times larger than national reserves. Although the BOJ continues to monetize its debt,
income and 26 times larger than worker compensation. The it has begun mopping up the excess reserves. By the middle
capital gain from a one-percent increase in asset prices is of June this operation should be complete and reserves will
equivalent to a 26-percent wage increase. Rising asset prices likely be near the required amount of approximately six tril-
are in the nation’s interest in a very real way. lion yen.
The distribution of that gain is a different story. The This sets the stage for a rate hike in July or August.
growth of the welfare state in Japan is in part a response to Provided the economic recovery remains intact and core
the growing disparity that has been a consequence of both inflation continues to rise, as the BOJ forecasts, it is possible
the economic malaise and the economic policies pursued in the BOJ will raise rates twice this year. The overnight call
recovery. The state is assuming some of the functions of the rate could be near 0.50 percent by the late 2006 or early
more traditional family-centric model of welfare (non-mar- 2007, which would match the expected rate of inflation. The
ket relationships) and the corporate-centric model (lifetime real rate then will remain close to zero and, therefore, mon-
employment, pension programs) previously provided. The etary policy will remain accommodative.
growth and shape of Japan’s welfare state is an expression
of the nation’s changing social contract. The yen picture
The outlook for the yen is not clear cut. Against the dollar,
Now what? The interest-rate picture the yen often trades in identifiable ranges — appearing to
Japan’s cyclical economic recovery has sufficient momen- trend largely as it moves from one trading range to another
tum to allow the Bank of Japan to begin to normalize mon- (Figure 1).
etary policy. Through intervention, purchasing, and thereby continued on p. 18

CURRENCY TRADER • May 2006 17

 THE BIG PICTURE continued

With the Chinese yuan expected to continue to appreciate in the coming

months, and with rate hikes by other East Asian countries, it is possible
the yen will remain weak in the region, even if it rebounds against
the U.S. dollar later in the year.
The rise of long-term interest rates in Japan and the yen’s may still be attractive for some investors and speculators.
relative weakness is encouraging institutional investors in The yen has depreciated markedly over the past couple
Japan, such as life insurance companies, to keep more of their of years against other Asian currencies, which, given the
funds in Japan. Foreign investors continue to scoop up significance of intra-regional trade, translates into a decline
Japanese equities. These portfolio flows can be expected to in the yen on a trade-weighted basis. On an inflation adjust-
exert upward pressure on the yen. However, such pressure is ed trade-weighted basis, the BOJ calculates that the yen is
likely to be mitigated by the fact that with interest rates in near a 15 year-low. As the Japanese economic recovery con-
Japan remaining low in absolute terms and relative to other tinues and monetary policy is gradually normalized, the
countries, the yen will still be seen as a “financing currency” — yen might recover some of that lost ground.
that is, the yen carry trade (short the yen vs. another currency) However, the rise of China is changing the Asian eco-
nomic landscape. The South Korean won and the Taiwanese
dollar, for example, have become more correlated with the
movement of the Chinese yuan vs. the dollar and less cor-
related to the yen’s movement vs. the dollar since China
Related reading changed its currency regime in July 2005 by instituting a
“managed float.” With the Chinese yuan expected to con-
Other Marc Chandler articles:
tinue to appreciate in the coming months, and with rate
hikes by other countries in East Asia, including South
“Surplus savings revisited”
Korea, Thailand, and Taiwan, it is possible the yen will
Active Trader, April 2006.
remain weak in the region, even if it rebounds against the
Can excess capital really be a bad thing? The ideas of
U.S. dollar later in the year.
Charles Conant from more than a century ago offer
Prime Minister Koizumi is expected to step down in the
some clues about this “conundrum” facing the new Fed
fall. His most likely successor is the chief cabinet secretary
chief.
Shinzo Abe. Abe is part of Koizumi’s reform wing of the
Liberal Democrat Party. That, coupled with the relative
“3-D economics: Debt, deficits, and the dollar”
independence of the BOJ, means there will likely be a high
Active Trader, December 2005.
degree of continuity in macro-economic policy. Kozumi’s
While the U.S. undoubtedly has a significant amount of
reforms and altered economic relationships will make Japan
foreign debt, those numbers don’t tell the entire story.
Inc. work a bit better, and the improved balance sheets of
In fact, a closer look shows how the U.S. deficit actual-
Japanese banks will allow for the conduct of more effective
ly reveals the strength of the U.S. and its economy.
monetary policy.
Japan is enjoying an export and investment-led econom-
“Who’s afraid of the big, bad deficit?”
ic recovery, with a budget deficit almost double other G7
Currency Trader, April 2005.
members. Corporate Japan is posting record profits. The
Contrary to conventional wisdom, the current account
stock market looks like it has legs. But do not confuse this
deficit does not drive the dollar, according to one
cyclical recovery with a resolution of Japan’s excess savings
strategist.
problem. Without addressing this surplus capital problem,
You can purchase and download past articles at Japan’s penchant for wasting capital will persist and the
www.activetradermag.com/purchase_articles.htm. resulting global imbalances will remain a potential source
of global instability. 

For information on the author see p. 6.

18 May 2006 • CURRENCY TRADER

 THE BIG PICTURE

The return
of reserve diversification
“Reserve diversification” is again on the lips of forex traders and analysts. The last time this topic was
hot, it turned out to be a red herring. But although you’re never supposed to say it in trading, this time
things might be different.

BY BARBARA ROCKEFELLER

F or two months this spring, new significant

higher highs in the euro were interrupted by
downward corrections lasting four or five days
(Figure 1). So, when a corrective down move
started on April 20, as shown by a lower low and a lower
close than the day before, technical analysts could reason-
ably expect that this retracement also would last four or five
Instead, it lasted only two days after the significant high.
The end of the move occurred on a Friday, and while the
euro had already made a new low (as expected), it closed
up on the day and then rocketed upward when the market
opened Sunday night. The following Monday, the euro sur-
passed the previous significant high, and the corrective
down move was decisively over.
days. What happened? This was a really good instance of fun-
damentals trumping the technicals.
The Swedish central bank — the
FIGURE 1 — FUNDAMENTAL MOVE Riksbank — announced on Friday,
April 21 that it was increasing the pro-
The Swedish Central Bank’s decision to tilt its currency reserves toward the
portion of euros in reserves from 37
euro and away from the dollar cut short a correction in the EUR/USD and
resulted in a swift move to new 2006 highs. percent to a total of 50 percent, and
reducing the dollar to 20 percent from
37 percent. The announcement carried
weight as hard evidence of a trend the
market had been fearing for over a
year — reserve diversification. Over
the past few years, other countries had
raised the proportion of euros in
reserves, including Russia and China,
but this was the first time the euro was
given such a high weight (50 percent),
and the dollar such a low weight —
just 20 percent.
Just one week earlier, the United
Arab Emirates and Kuwait had each
said they were considering reallocat-
ing currency reserves, committing a
bigger share to the euro.
In addition, an organization named
the Gulf Cooperation Council, made
up of six oil-producing states in the
Source: chart by Metastock; data courtesy of Reuters DataLink.
Middle East, confirmed it was consult-
ing the European Central Bank (ECB)

20 May 2006 • CURRENCY TRADER

on a possible monetary union of their own. A “memoran- the Riksbank reduced the share of the Japanese yen in
dum of understanding” is being prepared and is likely to be reserves to improve the rate of return on the combined port-
signed within a few weeks by Bahrain, Kuwait, Oman, folio). This is financial rationality.
Qatar, Saudi Arabia, and the United Arab Emirates, who Moreover, Sweden is politically neutral, so the decision
may aim for a single currency by 2010. A lot of work would cannot be seen as having anything to do with the U.S. role
have to done in a short while, such as determining mone- in world affairs. For conferring respectability on reserve
tary and fiscal convergence criteria and the location of a diversification, Sweden is at the top of the list — only
new central bank, but these are trivial considerations in Switzerland would carry more weight, and Switzerland is
light of the euro becoming a reserve currency in its own not an International Monetary Fund (IMF) member and
right. It’s not assuming too much to suppose the ECB will doesn’t share information about its reserves.
propose a big role for the euro as a reserve currency in the The six Middle East oil producers combined hold nearly
new union. $1 trillion, and are adding to it to the tune of $300 billion per
Until now, I have pooh-poohed reserve diversification as year with oil at current prices near $70. While Swedish
a key factor determining forex rates, and judged that dollar- reserves are not big (only about $21 billion), the Middle East
selling on an announcement of some minor reallocation was not only has bigger reserves but a bigger potential to add to
an inappropriate and exaggerated response. After all, the reserves. During previous oil crises in 1973 and 1979,
amounts are small, usually only a few billion dollars — a experts were quick to point out that financial markets were

If traders are saying that reserve diversification is on their minds and they are
impressed by the Swedish Central Bank’s diversification move — and the price
action bears it out — then the story is credible.
mere blip in the daily forex volume of almost $2 trillion. In not developed in the region and that markets outside the
the autumn 2005, reserve diversification was cited as a U.S. were not free. Constraints on capital flows pretty much
major factor in the dollar’s decline at the time — but then made it inevitable that petrodollars would be recycled back
we got hard data from the Bank for International to the U.S.
Settlements indicating that dollar-based reserves didn’t fall, And recycling is exactly what happened. Although today
but actually rose. So, diversification was a false story and Middle Eastern financial markets are still in their infancy,
only an excuse for traders to do what they wanted to do — they nonetheless exist, and some of the windfall profits
sell dollars. from higher oil prices are being recycled within the Middle
The dollar did not rise specifically on the news the diver- East in new investment projects. Construction in Abu Dhabi
sification story was false; it was rising at the time, anyway, alone is growing by over 350 percent annually. Financial
so it’s hard to be sure. But traders are like a dog that does- markets in Europe are also freer — and bigger and more liq-
n’t remember it ate your sock, puzzled when you yell at it uid. From the point of view of global capital flows, the exis-
with ruined sock in hand. They live in the moment, and the tence of a single currency is a vast improvement over earli-
sock-eating moment has passed. In trading, this phenome- er conditions. As advertised, it’s efficient. But more impor-
non is called“Don’t bother me with the facts.” The diversi- tantly, European leaders are determined to attract Middle
fication story seemed logical and compelling, and maybe East capital flows and are actively promoting the euro.
would be logical and compelling someday, even if it wasn’t Then there’s China, which said at the April IMF meeting
at that moment. that it is “subsidizing” the U.S. consumer with its purchas-
es of U.S. paper for its reserves. This is an incorrect usage of
It’s different this time the word “subsidize,” and not a little insulting. The U.S.
And they were right. The story is back, it’s not false this buys Chinese goods and China uses the export proceeds to
time, and the deduction is logical and compelling that the buy dollar investments. This is a pure, commercial quid-
dollar has a big, fat negative hanging over its head. In short, pro-quo, not a subsidy, which implies a gift or “something
it’s different this time. for nothing.”
Sweden is a modern and successful European country, The implication is malicious — that China can choose to
not some tin-pot dictatorship or banana republic. Its central take its investments elsewhere. China has over $800 billion
bank is highly regarded as thoroughly competent (note that continued on p. 22

CURRENCY TRADER • May 2006 21

 THE BIG PICTURE continued

FIGURE 2 — WHEN THE MARKET IGNORES THE FUNDAMENTALS

The failure of good economic news to significantly lift the dollar vs. the euro (i.e., push down the EUR/USD rate) was
another indication of the dollar’s weak position.

Source: eSignal

in reserves today, probably reaching $1 trillion by the end of whether it’s “one and done,” meaning the May hike in the
the year. Again, a reallocation would have more of an Fed funds rate to 5 percent is the last, or if the economy has
announcement effect than an actual market effect. The forex enough steam to justify another hike at the June meeting.
market can easily swallow a few hundred million at a time, On Wednesday, April 26, the stock market and dollar both
but most of the $1.9 trillion traded every day is speculative rallied on good housing market data and a higher consumer
in the first place, not transaction-driven, and traders need confidence indicator (when drops were forecast in both
incentives and a story. Reserve diversification fits the bill. instances). The yield on the 10-year Treasury note rose to
Whether it’s a small, respectable country like Sweden, or 5.081 percent from under 5 percent the Friday before, and
a big, controversial country like China, the next announce- Fed funds interest rate futures raised the odds of a June move
ment of reserve diversification to the euro is highly likely to to 52 percent from 38 percent the week before. The dollar
have the same effect as the Swedish announcement in April. gained from 1.2418 at the close the night before to 1.2388.
Reserve diversification is a theme on the rise, and although Uh-oh. This is only 30 points when the average daily
we should be getting used to it, traders love an Event to range is 80 to 100 points. The dollar “should” have rallied
trade on, and the announcement of another country choos- more. The small move was a failure of good fundamentals
ing the euro as a secondary reserve currency is a fine excuse. to overcome the euro’s uptrend. Overnight, the dollar ral-
Would it be safe to automatically sell the dollar the lied again and for the same reason — favorable data — but
instant you hear such news? Yes, until reserve diversifica- again it failed to break out of the hourly range or even to
tion becomes old hat. Here the analysis becomes a bit circu- surpass the good-news move from the day before (Figure
lar. You know the topic is old hat when it stops working, 2). Experienced traders started to get very worried. If good
and you know it has stopped working on the first occasion news was failing to lift the dollar, any bad news was likely
when it does stop working. But that’s months, if not years, to trash it.
away. Then Fed Chairman Ben Bernanke spoke to a
Congressional committee on the economic outlook. Unlike
When fundamentals fail to trump his predecessor, who delighted in declining to say anything
Going into the Fed’s May meeting, controversy reigns over clear and substantive, Bernanke came right out and said

22 May 2006 • CURRENCY TRADER

that it’s “reasonable” to expect the economy to moderate, is critical is to read what traders say they care about.
instead of keeping up the sizzling 5-percent pace of the first Traders are not disinterested parties, of course. Many
quarter, and “At some point in the future, the committee times they have an agenda, which is their own existing
may decide to take no action at one or more meetings in the position, or they want to mislead others in order to build a
interest of allowing more time to receive information rele- new position. Reporters at the major financial newspapers
vant to the outlook.” and wire services are often misled, too. You have to read
With the usual exaggeration, the market started to question everything with a dose of salt.
whether even the May rate hike is the dead certainty it expect- But if traders are saying that reserve diversification is on
ed only the hour before Bernanke started speaking. The euro their minds and they are impressed by the Swedish move —
broke out of its “normal” standard error channel to make a and the price action bears it out — then the story is credible.
new high over 1.2500, a level not seen since the Hurricane In April, the Riksbank story trumped what should have
Katrina-inspired spike in September 2005. The Katrina spike been a bigger correction in the dollar’s favor. The Bernanke
wasn’t a true fundamental change, and it didn’t hold. story was pre-figured by the failure of the dollar to rally
This rise to the 1.2500 level seems real — i.e., having real beyond a normal range on good news, meaning the market
fundamentals behind it. (It doesn’t get more real than the was already expecting an unfavorable outcome. Now that
chairman of the Federal Reserve.) We can expect the stock the euro has broken out to the upside, many technical ana-
market to rally and the bond market to take yields lower. lysts will expect the usual profit-taking pullback to a range
Gold could rise because the dollar is weaker or fall because inside the old channel.
the Fed doesn’t see inflation — probably the former, But the new fundamental landscape argues against the
because that’s more fun. usual technical interpretation — it will almost certainly
How do you know when a fundamental factor is going to trump the channel, and it will be necessary to draw a new,
be decisive? Because we lack a hierarchy of factors and can’t steeper, one. 
put weights on the many variables that affect traders, the
only way to know in advance whether some development For information on the author see p. 6.

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 TRADING STRATEGIES

FX money management
In the first of two articles adapted from his new book, Technical Analysis of the Currency Market,
Boris Schlossberg addresses money-management myths and looks at ways to manage trades
and capture profits in the real world.

BY BORIS SCHLOSSBERG

J ust as in trading there are really only two deci-

sions to make — trend or fade — so, too, in
money management there are only two strate-
gies to follow: You can either suffer numerous
small losses and hope that an occasional large win will
more than offset the drawdowns in your account, or you
can harvest many small profits and suffer an occasional
The notion that technical analysis doesn’t matter — it’s
just money management that matters — is, like so many
trading myths, complete nonsense. Money management
alone will not make you a successful trader. It is, however,
a vital complement to any intelligent technical setup.
Money-management strategies are as unique as each
trader, and one of the most pernicious myths perpetrated
large loss that you hope doesn’t overwhelm the profit cush- on the gullible public is that money-management strategies
ion you have built. are sacrosanct and thus all traders must follow the same
Of course, novice traders rarely face these two choices; money-management rules in order to achieve success.
they simply lose money. Some lose money in small incre- That is utter nonsense. In fact, the longer the traders
ments over a long period of time, while others lose money trade, the more flexible, the more complex, the more cre-
in shockingly huge chunks and are out of the game before ative their money-management skills become. Because FX
they even have a chance to learn how to properly use their offers retail traders unprecedented liquidity and limitless
trading software. customization, money-management strategies in FX are
Why do novices inevitably lose? Because they trade in a truly variable.
random fashion. They rarely practice consistency in their
setups. They rarely understand the dynamics of price flow, The myth of 2:1
and even when they learn it, they frequently misunder- Let’s start the most classic money-management technique
stand the nature of technical analysis. preached by every trading book ever printed: In every trade
Trading randomly is one of the quickest ways to lose your reward-risk ratio must be at least 2 to 1 — that is, you
money in FX. Many threads on many Internet bulletin must try to obtain 2 points of gains for 1 point of risk. This
boards have been started using the random entry “coin flip” way the trader needs be correct only 40 percent of the time
approach and some basic form of money management, such and will still have a positive expectancy to his trades.
as risking $1 for every $2 of profit; within a matter of weeks On the surface this idea sounds eminently logical and

One of the most pernicious myths perpetrated on the trading public

is that money-management strategies are sacrosanct and all traders
must follow the same money-management rules to achieve success.
or months, the originators of those threads have found practical. In real life, however, it’s quite difficult to squeeze
themselves either in deep drawdown or completely broke. out 2 points of profit for 1 point of risk. Try it and see. First
Ironically enough, the practitioners of the random entry look at the price action on the smallest time frame and see
method inadvertently prove that market action is not ran- how hard it is to risk 1 point in order to capture 2 points.
dom. If it were random, then they presumably should per- On the smallest level the FX trader faces the overwhelm-
form no worse than skilled traders. But alas, like a lucky ing barriers of the spread. Even in the most liquid financial
idiot who sinks a half-court shot during a contest but could instrument in the world, the EUR/USD, the spread is 3
never win a one-on-one game against a professional basket- points wide, so in effect the trader must make 5 points in
ball player, so, too, these novice traders will fall by the way- order to earn 2, thus forcing him to generate an improbable
side when competing against professional technical traders ratio of 5:1 in order to simply meet this goal.
over any reasonable length of time. Moving on to a 10-point increment, a 10-point risk for a

24 May 2006 • CURRENCY TRADER

 Related reading
20-point profit still requires a 23-point gain and allows for
Technical Analysis of the Currency Market: Classic
only a 7-point risk of loss in the tightest spread pairs like
Techniques for Profiting from Market Swings and Trader
EUR/USD and USD/JPY; in effect, this means a trader
Sentiment by Boris Schlossberg (2006, John Wiley & Sons).
must generate 3 points of profit for 1 point of risk just to
meet the 2:1 reward/risk ratio. Other articles by Boris Schlossberg:
Expanding the time line to longer time frames, a 100-
“Progressive entry technique,” Currency Trader, July 2005.
point risk with a 200-point profit target provides much
A staggered trade-entry approach allows you to be more flexi-
better odds. Here the spread plays a minuscule part as it
ble and structure your trade depending on market develop-
requires only 203 points of profit and allows for 97 points
ments.
of risk, generating very close to a 2:1 ratio.
But let’s step back a second. What if you were simply not “Forex options,” Currency Trader, June 2005.
predisposed to patiently stay in the trade for the time nec- Forex options are a breed apart. Traders accustomed to stan-
essary to see it to fruition? If you were impatient, wouldn’t dard calls and puts need to familiarize themselves with some
it be much more probable that you would try to take your new concepts and terminology before trading these “exotic”
profits far sooner, perhaps at 100 points in the money or instruments.
even 50 points in the money, turning what in effect was You can purchase and download past articles at
supposed to be a 2:1 trade into a 1:1 or 1:2 reward-to-risk www.activetradermag.com/purchase_articles.htm.
setup? You will do what every trading book preaches not
to — you will cut your profits short by not letting them
run. But given your personality, can you really be expected to their stop-loss to the breakeven point to assure themselves
do it any differently? that a winning trade will not become a losing trade. So in
But let’s suppose you are different. You possess the patience the case of our EUR/USD trade the trader would move the
of a saint, you have the discipline to follow this rule inviolably. stop to 1.2500 once the price breached the 1.2400 level.
Imagine the following scenario: You place a trade in This, however, still presents a dilemma for most traders.
EUR/USD. Let’s say you decide to short the pair at 1.2500 with Suppose the price retraced all the way back to 1.2500, stop-
a 1.2600 stop and a target of 1.2300. The trade is going well. ping the trader out. There would be no losses, but also no
The price moves your way. EUR/USD first drops to 1.2400, gains. The trade would be a scratch. In trading there is noth-
then to 1.2350, and slowly makes its way toward 1.2300. ing more frustrating and psychologically unnerving than to
At 1.2335 the price action pauses and the pair starts to be right on direction and walk away with no profit. It’s the
inch back up, first trading through 1.2350, then 1.2375. You, equivalent of working very hard all day long at your job and
however, are patient. You have nerves of steel. You hold on, then losing that day’s pay through a hole in your pocket.
looking for your 2:1 reward-to-risk. The price starts to move For this reason many traders practice a scale-out
back down and you are starting to feel vindicated. Back to approach. Typically traders will let go of half of their posi-
1.2350, 1.2325; slowly but surely you see the target in sight. tion once the gains match their risk value. In our EUR/USD
1.2320, 1.2310, 1.2305. Your take-profit order sits on the plat- example the trader would sell half at 1.2400 and then move
form waiting to be filled. The price ticks a few more pips the stop to the break-even point, assuring himself of har-
down, reaching all the way to 1.2301 — but then it bounces vesting at least some profit out of the trade.
back, first slightly, then violently, until in a matter of seconds This approach allows the trader to remain in the trade for
it’s at 1.2350, then 1.2370. as long as necessary because it satisfies the most basic desire
You remain calm. The price nearly touched your target. It’s of trading — the need to get paid. By selling half of the posi-
bound to test that level again. You won’t make the same mis- tion at 1.2400 and half at 1.2300, the trader is able to harvest
take others make of cutting your profits short. You will stay only a 1.5:1 reward-to-risk ratio, which of course is mathe-
in the trade and follow the classic money-management rules. matically inferior to 2:1. However, trading is not a game of
Of course, the price never does see 1.2300. Instead the mathematics but one of psychology, and frequently what is
pair “verticalizes” and soon reaches 1.2600, easily taking mathematically optimal is psychologically disastrous.
out your stop. You are now faced with the idea that you had Professional traders recognize this fact. They also under-
a 199-point profit and allowed it to become a 100-point loss. stand that market dynamics are fluid and will rarely con-
Welcome to real trading. form to rigid reward/risk ratios. By constantly monitoring
their positions and adjusting their risk parameters to the
Modifying the approach reality of the markets, professional traders are able to not
How many episodes like that do you think a novice trader only generate positive reward/risk ratios, but also produce
can experience before abandoning all sense of discipline and more profitable trades.
proper money management? This is the reason why the 2:1
reward-to-risk strategy is mostly a fantasy, an ideal. In prac- For information on the author see p. 6.
tice most traders will modify the strategy in one of two ways.
First, once price moves in the direction of the trade by the Next month: More money-management strategies from the book
amount of points risked, professional traders will move Technical Analysis of the Currency Market.

CURRENCY TRADER • May 2006 25

 ADVANCED CONCEPTS

The euro index:

The dollar index meets its match
The launch of tradable euro index futures and options may be the next step in the ascendancy
of a new dollar-euro currency regime.

BY HOWARD L. SIMONS

T here are a few ways to answer the seemingly

simple question, “What’s the euro worth?”
The first and most reflexive response would
be to run over to your nearest quote screen
and punch in the exchange rate between the euro (EUR) and
the U.S. dollar (USD). This is the standard answer, but it is
very incomplete.
would provide a more complete answer, it confuses data
with information: All those cross-rates — without some
measure of their relative importance — just muddle the
issue. Also, the relative importance of these cross-rates
changes constantly.
A third way would be to quote the EUR in terms of an
absolute standard. Both gold and the International
A second way, and an attempt at greater completeness, Monetary Fund’s Special Drawing Rights (SDR) have been
would be to reference several cross-rates between the EUR posited as such standards, with gold by far having the
and the currencies of its major trading partners, such as the greatest number of adherents and cultists.
British pound (GBP) and the Swiss franc (CHF). While this But if 2004-2006 has shown us anything, it is that gold is
really nothing more than just another
FIGURE 1 — CURRENCY-ADJUSTED LONDON AM GOLD commodity whose price may or may
not reflect absolute currency stability
The currency-adjusted movements of London gold in USD, EUR, and GBP (or inflation expectations). If the long-
turned parallel even though the currencies themselves did not. The lesson is only commodity indexers start buying
that gold is simply another commodity — one whose price may or may not gold in large quantities, or if one or
reflect absolute currency stability or inflation expectations.
two major central banks decide to
place a greater portion of their reserves
into gold (as opposed to, say, the USD)
gold ceases to be an absolute standard.
This certainly appears to have
occurred in late 2005, when the curren-
cy-adjusted movements of London
gold in USD, EUR, and GBP turned
parallel even though the currencies
themselves did not (Figure 1).
With gold no longer an absolute
standard and SDRs unavailable to
investors, we must seek a fourth way
of quoting the EUR: a fixed basket.

The basket case

For more than three decades, the dollar
index (DXY) has demonstrated the util-
ity of a fixed-weight basket approach
to answering the question, “What’s the

26 May 2006 • CURRENCY TRADER

 FIGURE 2 — THREE EURO INDICES: ARE THEY EQUIVALENT?

Three euro indices are shown: the original 12-currency Euro Effective
dollar worth?” For more than two exchange rate index (left); the five-currency Euro index (ECX) discussed
decades it has functioned as the basis here (middle); and the 23-currency index (right).
for exchange-traded futures and
options. As we move ever-closer to
what was described in the December
2005 Currency Trader as a “firm”
exchange-rate environment (see “The
dollar index and ‘firm’ exchange rates,”
in “Related reading”) organized into
USD and EUR blocs, it would be useful
to have a euro parallel to the DXY.
Once we agree on an indexing
approach, we run into the problem of
how to assemble the index, how to
weight the index, what to include in the
index, etc. Think of all the indices you
know about; each claims to be the best
for a given purpose, but you have no
single way to make that determination.
The European Central Bank (ECB) FIGURE 3 — THE EUR/USD RATE AND EURO INDICES
created a 12-currency Euro Effective
Exchange Rate index, but stopped The ECX and the 23-currency index had more moderate histories compared to
the EUR/USD rate, both during the euro’s 2001-2002 weakness and later
during its 2004 strength.

Compared to
a single-currency rate,
a trade-weighted index
is less volatile and
reduces the overall
risks involved in timing
and placing a hedge.
publishing it in October 2005 in favor
of a 23-currency index. This latter
index looks like European political
correctness run amok. In includes the
small-weight currencies of countries on the European (LTL), Maltese lira (MTL), Polish zloty (PLN), Slovakian
periphery, such as Latvia, Lithuania, Estonia, Malta, koruna (SKK), Slovenian tolar (SIT), and the Hungarian
Cyprus, the non-Euro Scandinavian currencies, and non- forint (HUF) — to the mix and designate their 17.35-percent
European trading partners such as Hong Kong, Singapore, collective weight as “Other” (OTH), we arrive at the new
and Korea. 23-currency index depicted on the right. The middle stack
Figure 2 depicts three index approaches. The original 12- of five currencies comprises the Euro index (ECX).
currency Euro Effective exchange rate index is on the left; its The 23-currency index has several problems. First, some
components are highlighted in the legend box on the right. of its components are currencies destined to become part of
If we add nine additional currencies — the Chinese yuan the euro. Second, several of its larger component currencies
(CNY), Czech koruna (CZK), Cypriot pound (CYP), are not freely floating at all. These include the managed
Estonian kroon (EEK), Latvian lat (LVL), Lithuanian litas continued on p. 28

CURRENCY TRADER • May 2006 27

 ADVANCED CONCEPTS continued

FIGURE 4 — COMPARATIVE INDEX PERFORMANCE, HEDGED & UNHEDGED

Swedish krona, and Norwegian krone
The EUR’s burst of strength in 2003-2004 propelled its results higher, but may be of deep and lasting importance
the opposite would have been true in 2001 and the first half of 2002. to our Scandinavian friends, but these
are not lynchpins of global finance.
Fourth, and most important for cur-
rency traders, the cumulative bid-ask
spreads on 23 different currencies (not
all of them deep and liquid) make
trading this index too expensive.
The New York Board of Trade
(NYBOT) got around this problem in
the time-honored tradition of equity
basket traders: It constructed a repre-
sentative sample out of five different
currencies — the U.S. dollar, Japanese
yen, British pound, Swiss franc, and
Swedish krona. The exchange’s new
Euro Index (ECX) is a geometric weight-
ed average of these five designed to
match the original 12-currency index.
This it did between its January 2001
inception and mid-July 2005, at which
point the 23-currency index weakened
FIGURE 5 — HEDGING A NON-EURO BOND PORTFOLIO on a relative basis to reflect the USD’s
fourth-quarter 2005 rally (Figure 3).
The unhedged portfolio underperformed over the entire period, but it Both the ECX and the 23-currency
outperformed both hedged portfolios from January 2001-May 2002. Also, after index had more moderate histories
the start of 2003, the EUR-only hedged portfolio outperformed the ECX-hedged
compared to the EUR/USD rate, both
portfolio. However, such a hedge presumes the bond manager is willing to act
during the euro’s 2001-2002 weakness
like a position trader in currencies over an extended time period.
and later during its 2004 strength. This
may be the cleanest example of the
advantage a trade-weighted index has
relative to a single-currency rate: It is
less volatile and therefore reduces the
overall risks involved in timing and
placing a hedge.
Of course, having a less-volatile
hedge instrument does not necessarily
translate into having a higher return on
your hedge. If, for example, we were to
compare the euro-denominated Morgan
Stanley Capital International Euro index
(MSER) with the dollar-denominated
Russell 3000 and hedge the MSER into
USD using the euro, the ECX, and the
23-currency index, we would get widely
differing results (Figure 4). It just so hap-
pens the EUR’s burst of strength in 2003-
2004 propelled its results higher; the
opposite would have been true in 2001
float of the HUF against both the USD and EUR, and the and the first half of 2002.
essentially fixed CNY. European investors might see the world quite differently,
Third, this index has too many members whose curren- however. They would want the benefits of a diverse index
cies are too closely correlated to make the distinctions such as the ECX to hedge their multi-currency portfolios. As
meaningful. The cross-rates between the Danish krone, many European global investors have portfolios denominat-

28 May 2006 • CURRENCY TRADER

 FIGURE 6 — EURO INDEX FUTURES BASIS
If the average yield on the ECX is less than that of the euro (and money
rates for the Japanese yen, Swiss franc, and Swedish krona are less than the
euro rates) the futures should trade above the index, as was the case in the
ed in a wide array of currencies, the ECX futures first month of trading.
value of an index-based hedge as
opposed to a single-currency hedge is
rather apparent. We can illustrate this
by comparing the returns on a portfolio
of non-EUR global government bonds,
seven to 10 years maturity, hedged back
into EUR using both the ECX and the
EUR itself (Figure 5).
Although the unhedged portfolio
underperformed over the entire period,
it outperformed both hedged portfolios
between January 2001 and May 2002.
Also, after the start of 2003 the EUR-
only hedged portfolio outperformed the
ECX-hedged portfolio. However, such a
hedge presumes the bond manager is
willing to act like a position trader in
currencies over an extended period of
time and willing to tolerate the greater
variance of a single-currency hedge in
converting the portfolio back to a euro-denominated basis. Related reading
The standard deviation of returns for the EUR-hedged port- Other Howard Simons articles:
folio is .00685, as opposed to .004562 for the ECX-hedged
portfolio. “The index approach to currency risk management”
Currency Trader, April 2006.
Trading the index Using dollar index futures to hedge non-dollar
Futures and options on the ECX now trade on the familiar investments.
quarterly expiration cycle (March, June, September, and “The yen stands alone”
December) at the NYBOT (see “NYBOT begins trading Euro Currency Trader, March 2006.
Currency Index futures, options,” Currency Trader, February The usual rules of the currency world haven’t necessarily
2006). The pricing of these futures contracts reflects the applied to the Japanese yen. Will that continue to be
interest-rate differential between the cash index and the the case?
interest-bearing short-term deposits in each currency. If the “Remember the forgotten currency”
average yield on the ECX is less than that of the euro itself Currency Trader, February 2006.
— and money rates for the Japanese yen, Swiss franc, and It’s often labeled a “commodity currency,” but the
Swedish krona are less than the euro rates — we should Canadian dollar tends to be ruled by other factors.
expect the future to trade above the index. Here’s a look at the factors impacting Canadian
Why? Because a long futures position here is equivalent dollar movements.
to borrowing at the higher euro rate and lending at the
“What drives the dollar index?”
lower ECX rate. You “pay” this net interest rate differential
Currency Trader, January 2006.
by purchasing the future for more than the index and then
Market watchers often point to deficits and interest-
suffering basis deterioration along the way. This was appar-
rate differentials to explain the dollar’s behavior, but
ent over the first month of the March 2006 contract’s trading
analysis shows these factors might not be in the
history (Figure 6).
driver’s seat after all.
While dollar-domiciled investors are likely to focus on
the bilateral euro-dollar exchange rate, we should expect to “The dollar index and ‘firm’ exchange rates”
see a move toward the ECX as an analytic and eventually a Currency Trader, December 2005.
liquid trading tool for global investors with euro-denomi- The majority of currency traders are familiar only with the
nated assets or for euro-domiciled investors looking to current floating-rate system. Are we about to enter a
hedge their own currency as so many Americans were look- new “firm exchange rate” era dominated by the dollar
ing to hedge the dollar in 2004. This completes the stage-set- and euro?
ting for the two-currency world. 
You can purchase and download past articles at
www.activetradermag.com/purchase_articles.htm.
For information on the author see p. 6.

CURRENCY TRADER • May 2006 29

 CURRENCY SYSTEM ANALYSIS

FIGURE 1 — SAMPLE TRADES

Channel The system caught a major downtrend in the Japanese yen.

Midpoint
indicator
Market: Currencies.

System concept: The Chan-

nel Midpoint indicator is the
middle line between the two
boundaries of a Donchian
Channel — that is, the midpoint
between the highest and lowest
prices of the past n bars.
The indicator follows the trend
like a moving average but it has
the benefit of remaining static
(i.e., its value does not change)
during consolidation phases.
This behavior makes the indica-
tor useful for distinguishing Source for all figures: Wealth-Lab Inc. (www.wealth-lab.com)
between trending and non-
trending periods with the FIGURE 2 — EQUITY CURVE
goal of producing “clean-
er” trade signals (fewer The majority of the system’s profit occurred in the final four years of the test period.
whipsaws).
Trend-following sys-
tems typically make most
of their profits from a
small number of large
trades; most trades are
small gains or losses. This
test will determine if the
Channel Midpoint indica-
tor can provide the basis of
a higher-probability trend
system.
The system uses two
Channel Midpoint indica-
tors based on different
time frames. The rules are
similar to a standard mov-
ing-average crossover sys-
tem: the system goes long
when the shorter-term
Channel Midpoint indicator crosses above the longer-term periods (150 and 250 days), the system is geared toward
Channel Midpoint indicator and goes short when the oppo- detecting major trends.
site occurs. The system went short on July 31, 2000 when the short-
Figure 1 shows a trade example in Japanese yen futures. term indicator crossed below the long-term indicator. The
The longer-term (250 bars) Channel Midpoint indicator is downtrend persisted until early March 2002, at which point
green and the shorter-term indicator (150 bars) is red. Both an extended consolidation developed and both indicators
indicators follow the long-term trend, but during consoli- remained flat. The next crossover occurred on Oct. 2, 2002
dation periods they go flat. With its long-term look-back when the system exited the short position and reversed to the

30 May 2006 • CURRENCY TRADER

long side. The system made 19 points of profit in this trade. the 150-day Channel Midpoint indicator crosses below
the 250-day Channel Midpoint indicator.
Rules:
1. Go long and exit short the next day at the market if Test period: January 1991 to December 2005.
the 150-day Channel Midpoint indicator crosses above
the 250-day Channel Midpoint indicator. Test data: The system was tested on the following cur-
2. Go short and exit long the next day at the market if continued on p. 32

STRATEGY SUMMARY LEGEND: Starting capital — Equity at the beginning of the

simulation period • Ending capital — Equity at the end of the
Long + Short Long Only Short Only simulation period • Net profit — Profit at end of test period,
less commission • Net profit % — Profit at end of test period in
Starting capital ($) 1,000,000.00 1,000,000.00 1,000,000.00 percent of starting equity • Annualized gain % —
Ending capital ($) 5,483,610.46 4,230,375.91 2,253,234.55 Compounded annual growth rate • Exposure — The area of the
equity curve exposed to long or short positions, as opposed to
Net profit ($) 4,483,610.46 3,230,375.91 1,253,234.55 cash • Number of trades — The total number of round-trip
Net profit (%) 448.36 323.04 125.32 trades plus open positions • Avg profit/loss — The average
Annualized gain (%) 12.01 10.09 5.56 profit/loss per trade in dollars • Avg profit/loss % —The aver-
age percentage profit/loss per trade • Avg bars held — The
Exposure (%) 6.38 4.41 4.14 average number of bars held per trade • Winning trades — The
total number of winning trades • Winning % — The percentage
of winning trades • Gross profit — The total profit generated
Number of trades 46 21 25 by the winning trades, minus commissions and slippage • Avg
Avg profit/loss ($) 97,469.79 153,827.42 50,129.38 profit — The average profit per winning trade • Avg profit %
— The average percentage profit per winning trade • Avg bars
Avg profit/loss (%) 4.62 6.12 3.36 held — The average number of bars held per winning trade •
Avg bars held 266.39 320.48 220.96 Max consecutive — The maximum number of consecutive win-
ners • Losing trades — The total number of losing trades •
Losing % — The percentage of losing trades • Gross loss —
Winning trades 24 11 13 The total loss generated by the losing trades, minus commissions
Winning % 52.17 52.38 52.00 and slippage • Avg loss — The average loss per losing trade •
Avg loss % — The average percentage loss per losing trade •
Gross profit ($) 6,174,365.41 3,987,952.67 2,186,412.73 Avg bars held — The average number of bars held per losing
Avg profit ($) 257,265.23 362,541.15 168,185.59 trade • Max consecutive — The maximum number of consecu-
Avg profit (%) 12.00 15.08 9.39 tive losers • Max drawdown — Largest decline in equity in
dollars • Max drawdown % — Largest percentage decline in
Avg bars held 387.54 443.82 339.92 equity • Max drawdown date — Date on which the max draw-
Max consecutive 5 7 5 down was realized • Wealth-Lab score — An overall measure
of profitability, exposure (efficiency), and risk • Profit factor —
Gross profit divided by gross loss • Recovery factor — Net
Losing trades 22 10 12 profit divided by max. drawdown • Payoff ratio — Average
Losing % 47.83 47.62 48.00 profit of winning trades divided by average loss of losing trades
• Sharpe ratio — Annualized average return divided by the
Gross loss ($) -1,690,754.94 -757,576.76 -933,178.18 annualized standard deviation of returns • Ulcer index — A
Avg loss ($) -76,852.50 -75,757.68 -77,764.85 measure of the portfolio’s overall volatility • Wealth-Lab error
term — The average of the absolute values of all percentage dis-
Avg loss (%) -3.43 -3.74 -3.16 tances along the equity curve from its linear regression line •
Avg bars held 134.23 184.80 92.08 Wealth-Lab reward ratio — Annual percentage return divided
by the Wealth-Lab error term • Luck coefficient — The per-
Max consecutive 5 7 4 centage profit of the largest winning trade divided by the average
percentage profit of all winning trades • Pessimistic rate of
Max drawdown ($) -2,543,364.00 -2,031,644.00 -1,343,600.25 return — A statistical adjustment of the wins to losses ratio that
estimates the worst-expected return from previous results •
Max drawdown (%) -39.14 -36.85 -64.96 Equity drop ratio — The standard deviation of all drops in the
Max drawdown date 9/2/2005 7/8/2005 11/3/2005 equity curve — measured from each equity low to the previous
equity high — divided into the annualized return.

Wealth-Lab score 114.52 144.44 47.04

Currency System Analysis strategies are tested on a
Profit factor 3.65 5.26 2.34 portfolio basis (unless otherwise noted) using Wealth-
Recovery factor 1.76 1.59 0.93 Lab Inc.’s testing platform. If you have a system you’d
like to see tested, please send the trading and money-
Payoff ratio 3.50 4.03 2.97 management rules to
Sharpe ratio 0.60 0.56 0.29 editorial@currencytradermag.com.
Ulcer index 11.82 19.41 17.96 Disclaimer: Currency System Analysis is intended for
educational purposes only to provide a perspective
Wealth-Lab error term 12.35 18.66 8.36 on different market concepts. It is not meant to rec-
Wealth-Lab reward ratio 0.97 0.54 0.67 ommend or promote any trading system or
approach. Traders are advised to do their own
Luck coefficient 3.81 3.03 2.92 research and testing to determine the validity of a
Pessimistic rate of return 2.51 2.35 1.80 trading idea. Past performance does not guarantee
future results; historical testing may not reflect a sys-
Equity drop ratio 0.41 0.40 1.34
tem’s behavior in real-time trading.

CURRENCY TRADER • May 2006 31

 CURRENCY SYSTEM ANALYSIS continued

rency futures portfolio: British pound (BP), euro (EC), contract’s dollar risk is $2,500. The system can risk $40,000
Japanese yen (JY), and Swiss franc (SF). Data source: for this trade, so it buys 16 contracts ($40,000/$2,500).
Pinnacle Data Corp. (www.pinnacledata.com).
Test results: Figure 2 shows the system’s equity
Starting equity: $1,000,000. Deduct $20 commission per increased slowly from 1991 to 2002, but exploded (to more
round-trip trade per contract. Apply two ticks of slippage than $6 million) after that. Figure 3 shows large drawdowns
per stop order. occurred at the beginning of the test period, but the system
was able to recover relative-
FIGURE 3 — DRAWDOWN CURVE ly quickly from them.
Drawdowns were mostly
Drawdowns diminished in size and duration in the middle of the test period, but the deep- moderate after the 1996-97
est drawdown occurred toward the end of the test.
give-back, until the largest
drawdown (39 percent)
occurred in 2005.
The ratio of winners to los-
ers was 52 percent to 48 per-
cent — more balanced than
the typical trend-following
system. Further-more, the
4.62-percent average profit
per trade is very high, which
will provide a cushion
against higher-than-expected
slippage or commissions.
The annual results (Figure 4) show only three years out of
Risk control and money management: Risk a max- 15 had negative returns and six years had profits larger than
imum of four percent of account equity per trade and use 20 percent. However, since the system’s total number of
four times the 10-day average true range (ATR) as a stop- trades is only 46, more trades are necessary to determine the
loss level. The number of contracts is calculated using the system’s robustness in various market conditions (as well
entry price, the stop-loss level, and the dollar value of a one- as across various look-back periods). Because the system’s
point move. exposure is quite low (6.38 percent), you could consider
increasing the position size
to boost profits (which
FIGURE 4 — ANNUAL PERFORMANCE
would, of course, increase
The system resulted in 12 of 15 profitable years, and six years with returns above 20 percent. risk), or investing part of
your equity in another,
uncorrelated system.

Bottom line: The trend-

following system based on
the Channel Midpoint indi-
cator produced respectable
profits, and was character-
ized by a high winning per-
centage — something unusu-
al among trend strategies.
The system’s volatility is
For example, assume the system goes long at 100 in a con- high but its exposure is low, which means investing the
tract in which a one-point move has a value of $1,250. The remaining equity in a different, uncorrelated strategy could
stop-loss is $98. To determine the trade’s dollar risk, multi- help produce a flatter overall equity curve.
ply the point value ($1,250) by the difference between the
entry price and the stop-loss level ($100 - $98 = $2). A single —José Cruset of Wealth-Lab

32 May 2006 • CURRENCY TRADER

 Gain insight with
online weekly commentary
from Thom Hartle on trading,
Weekend Market Review and
Weekly HOLDR Review.

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 CURRENCY TRADER INTERVIEW

Peter Panholzer
on market sentiment
This top manager has been trading currencies professionally
for nearly three decades, using systematic, statistical approaches
as well as subjective, sentiment-driven techniques.
Find out how he uses contrary opinion in the forex market.

BY MARK ETZKORN

W
ith its 52.96-percent return last year, fect trade signals — in reverse.
DynexCorp’s Percival Market Sentiment “We consistently used his entry price to go in the oppo-
program topped the Barclay Group’s rank- site direction, and used his stop-loss as a profit target,”
ings of top currency managers ($1 million to Panholzer says. “There was virtually no need to use a stop-
$50 million under management) in 2005 (see “Top currency loss of our own because the win rate was so high, but we
traders of 2005,” Currency Trader, April 2006). would generally use his profit target as our stop-loss. If that
The last time Currency Trader spoke with DynexCorp was too far away, we used a one-percent equity protection
(www.dynexcorp.com) head Peter Panholzer (“Peter stop.”

Most people don’t realize that in a bull market you normally do have
bullish consensus, so you can’t simply go against it.

Panholzer: Currency system architect,” November 2004), The trading program ran its course when the analyst got
much of the discussion revolved around his firm’s TETRA a different job and suddenly became less drastically wrong.
strategy, which is systematically oriented and executed Why this was the case can be explained in terms of at least
without discretion. (In addition to TETRA and Percival, one of the characteristics Panholzer says should be present
DynexCorp trades three other programs — Ranger, Halley, in useful contrarian information:
and Interbanker — to diversify across different time hori-
zons, currency portfolios, and approaches.) 1. It is provided gratuitously, which excludes paid
By contrast, the Percival Market Sentiment program is a advisories. This can include a volunteered
discretionary trading strategy that incorporates principles opinion or a forecast in the press.
laid out in currency trader John Percival’s book The Way of
the Dollar, as well as many of the contrarian ideas and sen- 2. It is “unpunished” — for example, immune to the
timent analysis tools Panholzer has used in one way or negative feedback of clients. Typically, this kind of
another for decades. information is provided by salaried employees of
In fact, one of Panholzer’s previous discretionary brokerage houses who are not involved in trading or
approaches — the Dynex Market Sentiment Strategy, which managing client funds.
he traded from 1994 to 1998 — was based on a very specif-
ic type of contrarian market interpretation. It relied on the 3. It is a buy or sell recommendation arrived at by a
daily trade recommendations of a single analyst (“Mr. X”) committee — for example, within the boardroom of a
who worked at a large Chicago-based futures brokerage. bank or brokerage house.
Panholzer found the analyst was the source of nearly per-

34 May 2006 • CURRENCY TRADER

 Ideally, Panholzer says, the contrarian input should come interpreting and acting on sentiment data is challenging
from participants who are unaware of the final use of their and subjective; it requires experience to understand it in the
input. context of other market information.
Mr. X was one of several sources Panholzer monitored at
the time. CT: Can you explain the basics of using bullish con-
“We had what we called a stable of contrarian horses, and sensus and other sentiment indicators?
he was the lead horse — the best,” Panholzer says. “He did- PP: We measure the extremes in the consensus — the his-
n’t care if he was right or wrong, and people liked to read torical extremes over the past five years — so we’re moni-
his little blurbs. We found him to be so persistently wrong toring readings between zero percent and 100 percent. Most
we could make money off him. An advisory service that of the time consensus hovers between historic extremes and
gets paid couldn’t afford to lose on every trade — they typ- thus indicates — at best — the market is not yet overheated.
ically break even.” Twenty percent is a very low reading, but we’ve seen fig-
When Mr. X left his position at the brokerage, Panholzer ures as low as seven percent when the market is moving
“begged him” to continue his service for a fee, which he only one way. And 80 percent is very high, but you might
did. But — per the preceding rules — Mr. X was no longer see figures go as high as 95 percent.
a reliable contrarian source: Most importantly, he was no
longer providing free advice; he was a paid advisor. CT: Is a market’s reaction to specific news events a
Also, Panholzer notes, Mr. X was very excited about his useful sentiment gauge?

“Baby” markets are trendy, but as they grow older they become
more random and less trendy.
new job, so his possible dissatisfaction at his former posi- PP: It’s not good when the market does not maintain a pos-
tion had impacted his performance. Once his situation itive reaction to a positive news item. For example, just
changed, he stopped losing, and Panholzer was forced to recently there was a very bullish Consumer Price Index
evict this “horse” from the contrarian stable. reading. The dollar rallied for a while and then faded.
Panholzer consults several well-known contrarian indi-
cators, including Market Vane’s Bullish Consensus report CT: Do you also use Commitment of Traders (COT) data?
(www.marketvane.net), which measures the bullish or PP: Yes, it’s a standard tool, but you have to be careful with
bearishness of market newsletters, and Consensus magazine it. We only look at small traders. It might give you a clue
(www.consensus-inc.com). However, he stresses, such data only once or twice a year, but when it does, it’s powerful.
is just part of the contrarian market puzzle, and it must be But you cannot always rely on a particular indicator to
interpreted judiciously. provide a signal. When [many] indicators fall in line, you
“It might be a bad sign if too many market letters turn get a very strong tool, of course.
bullish, for example,” he explains. “But it’s not as simple as
that. Most people don’t realize that in a bull market you CT: So when you say the COT provides a useful signal
normally do have bullish consensus, so you can’t simply go once or twice a year, does that mean the small-trader
against it.” reading is reaching a certain level in conjunction with
Another factor is the price level accompanying a senti- other sentiment inputs? For example, the specific COT
ment reading, although Panholzer notes this applies to small-trader reading might occur frequently, but it only
commodities, which have “real” prices attached to them. occurs in conjunction with the other signals at certain
“We always interpret bullish consensus percentages in times.
context to relative historic price levels,” he says. “If the bull- PP: Exactly. Another indicator is provided by Oanda. On
ish consensus was high when a market peaked at, say, $2, their site (http://fxtrade.oanda.com) they show the open
and it reached the same level when the market was subse- positions of their own traders, which are typically small
quently at $2.50, it would be a meaningless signal because traders. Through this, you get a perfect sample of small-
it was occurring at a higher price. But if the bullish consen- trader opinion — which by the way, happened to be short
sus reading was as high with price now at $1.50, that would the euro all along the recent up move. Oanda also shows,
be very bearish, because price was lower.” for example, how many short positions have been put on
As the rest of our conversation with Panholzer illustrates, continued on p. 36

CURRENCY TRADER • May 2006 35

 CURRENCY TRADER INTERVIEW continued

FIGURE 1 — SMALL TRADERS SHORT THE UPTREND

Open trade data from Oanda Corporation (top) shows the greater number of
200 or 300 points below the market
shorts vs. longs in the EUR/USD rate despite the recent uptrend (bottom).
and long positions 200 or 300 points
above the market (Figure 1).

CT: With the currency market

becoming more mature and effi-
cient, has it changed the way you
trade?
PP: Yes and no. With regard to market
sentiment and contrarian opinion,
nothing has changed. With regard to
trendiness, things are different. “Baby”
markets are trendy, but as they grow
older they become more random and
less trendy.

CT: But if that’s the case, it would

seem as if there’s less directional
movement to capture regardless of
the approach you use — which
would impact profits.
PP: I would agree. If you took any
trend-following program and meas-
ured it over the past 30 years, you
would find continuous deterioration.
Pierre Lequeux (www.cibef.com) creat-
ed his own trend-following index
because he believes peer-group bench-
mark indices tend to be inappropriate
for comparison of single-advisor per-
formance, since there have been some
embedded covariance effects that make
them underestimate the risk of the sin-
gle advisor. So, why not create a stan-
dard trend-following system and make Source: TradeStation
it an index? Currently he is disappoint-
ed by this project because the index is deteriorating so much. PP: You would use, obviously, some kind of a trend indi-
cator to gauge price — for example the statistical tools we
CT: How useful do you think “media signals” are? currently use in the TETRA program. The time frame might
PP: I remember waiting in the train station in Zurich in differ. I’ve used a four-hour interval since 1994 for all our
1995 and seeing the cover of Time magazine, which had a price signals.
headline about how high the yen might go. Next to it was Also, contrarian or sentiment indicators don’t really
Newsweek, which had a cartoon picture of Superman on it work with stops. Of course, there must be an equity stop of
with the headline, “Superman Yen.” some kind, typically placed far enough away to be comfort-
I shivered, but it wasn’t because of the cold March wind. able. Or — and this might be easier — you use an option.
Both of the magazines appearing on the newsstand at the Coincidentally, a good trading system seems to have a
same time gave me an incredibly strong signal to sell the yen. lifespan of four or five years before it falls to the wayside.
It had been rising to 80 yen per dollar, and it subsequently fell That was the case with my Magnum trading program,
very quickly to 100 cents per dollar by Labor Day 1995. which ran from 1979 to 1984 and was the first instance of
currencies offered as an asset class of their own — it offered
CT: Timing those kinds of signals can be very difficult, trading in nothing but currencies, which was a kind of a
though, can’t it? Do you have to be willing to take a lot sacrilege in the diversified trend-following world that had
of heat if you enter the market on something like that? emerged in the highly inflationary 1970s.
The market can keep going in the same direction quite In 1991 I had the good luck to be invited for a chat with
a while before it reverses. (macro trader) Bruce Kovner in his Park Avenue flat. He was

36 May 2006 • CURRENCY TRADER

interested in systems, but he didn’t trade them himself. He but it seems like it might — eventually — go through
pointed out that systems tend to drop off every four or five another profitable phase. Did you ever check to see if a
years. particular system might have a new life if applied to a
different time frame?
CT: Have you ever found systems to come back into PP: We haven’t found any good results. Also, every so often
phase? Or when something dies, is it dead forever? a single trading strategy may become out of sync with price
PP: I would think yes. The Magnum program, for example, behavior and sustain losses that are heavier than previously
never came back. It’s amazing. experienced. Basically, single strategies are subject to per-
formance cycles whose depth and length are difficult to pre-
CT: That’s interesting, because I can understand that a dict. Diversification into three or more strategies at the same
system would never perform as good as it initially did, time tends to reduce single-strategy portfolio risk.

Currency price scaling: Unique characteristics

any years ago, Panholzer conducted a FIGURE 2 — PRICE SCALING: CURRENCIES VS. COMMODITIES

M study and discovered that currencies

are fundamentally different from other
markets in that their price moves don’t markedly
As the price of silver (top) increased, the average daily ranges
also increased, which is typical behavior in most markets.
However, as the British pound (bottom) increased in price, its
change as they move from high prices to low daily ranges remained relatively stable.
price — they are “scale linear.”
He analyzed the daily price moves in various
commodities and currencies, measuring the shifts
that occurred as prices moved higher and lower.
“During a huge bull market in anything — cof-
fee, sugar, soybeans, gold — as you go higher,
the daily price changes increase and become
more volatile, which is normal,” Panholzer
explains. “When you go to extremely low prices,
the opposite occurs.
“Those price moves had kind of a parabolic,
logarithmic behavior, which made it more difficult
for a commodity portfolio manager to balance,
say, very low sugar prices with very high copper
prices. How do you allocate the trade sizes?”
Panholzer discovered currencies didn’t behave
the same way — their daily price moves essen-
tially stayed constant regardless of high or low
price levels (Figure 2).
“You could use the same amount in each cur-
rency and it didn’t matter if a currency was high or
low,” he says.
Why is this? Panholzer points out that because
currencies are by definition “reciprocal” — if
you’re long one currency you’re automatically
short another. You can, legitimately, price the dol-
lar in British pounds as well as price the British
pound in dollars.
“They are both valid markets,” he says. “If the
pound was very high, you would expect larger
price changes relative to the level. But that would
mean the opposite would have to be occurring for
the dollar — which simply wouldn’t work.” Source: Peter Panholzer/DynexCorp.

CURRENCY TRADER • May 2006 37

 INTERNATIONAL MARKET SUMMARY
FOREX (vs. U.S. DOLLAR)
Current
price vs. 1-month 3-month 6-month 52-week 52-week Previous
Rank* Country Currency U.S. dollar gain/loss gain/loss gain/loss high low rank

1 South African 0.1687 6.10% 0.66% 11.35% 0.1685 0.1427 14

rand

2 Australian 0.7446 3.76% -1.04% -0.57% 0.784 0.7014 15

dollar

3 Thai 0.02655 3.55% 3.79% 8.54% 0.02653 0.02362 4

baht

4 Swedish 0.1325 2.95% 0.08% 5.66% 0.145 0.1206 1

krona

5 Swiss 0.7844 2.63% -0.76% 1.45% 0.8477 0.7525 5

franc

6 Canadian 0.8793 2.55% 1.24% 4.43% 0.885 0.7851 13

dollar

7 Euro 1.2348 2.49% 0.88% 3.39% 1.3078 1.1638 2

8 British 1.783 2.31% 0.15% 0.91% 1.9172 1.7048 8

pound

9 Brazilian 0.472 1.53% 7.01% 6.74% 0.4763 0.3914 10

real

10 Singapore 0.6271 1.41% 1.75% 6.29% 0.6284 0.5858 6

dollar

11 New Zealand 0.6335 1.15% -7.32% -9.47% 0.7376 0.599 16

dollar

12 Russian 0.03639 1.08% 2.02% 4.27% 0.03644 0.03447 3

rouble

13 Taiwanese 0.03098 0.85% -1.05% 4.20% 0.03225 0.02955 12

dollar

14 Japanese 0.008583 0.52% -1.55% -0.50% 0.00959 0.00824 11

yen

15 Hong Kong 0.129 0.08% 0.00% 0.00% 0.1291 0.128 7

dollar

16 Indian 0.02222 -1.24% -2.07% -0.09% 0.02317 0.02152 9

rupee
As of April 24 *based on one-month gain/loss

GLOBAL BOND RATES

Rank Country Rate April 24 1-month 3-month 6-month Previous
1 UK Short sterling 95.35 -0.02% -0.08% -0.15% 1
2 Australia 10-year bonds 94.365 -0.30% -0.28% -0.22% 3
3 Japan Government Bond 132.84 -0.67% -2.96% -2.88% 4
4 U.S. 10-year T-note 105.280 -1.75% -3.54% -3.46% 2
5 Germany BUND 115.74 -2.11% -3.91% -4.58% 5

38 May 2006 • CURRENCY TRADER

 NON-U.S. DOLLAR FOREX CROSS RATES
Currency 1-month 3-month 6-month 52-week 52-week
Rank pair Symbol April 24 gain/loss gain/loss gain/loss high low Previous
1 Aussie $/ Yen AUD/JPY 86.8033 3.27% 0.55% -0.03% 91.34 80.63 17
2 Franc / Yen CHF/JPY 91.4695 2.18% 0.85% 2.02% 93.14 85.1568 5
3 Canada $ / Yen CAD/JPY 102.536 2.11% 2.90% 5.02% 104.635 83.2354 11
4 Euro / Yen EUR/JPY 143.913 1.99% 2.49% 3.94% 145.488 130.6 3
5 Pound / Yen GBP/JPY 207.839 1.82% 1.75% 1.44% 213.03 192.62 7
6 Aussie $ / Pound AUD/GBP 0.4178 1.46% -1.16% -1.46% 0.4398 0.405 18
7 Aussie $ / Euro AUD/EUR 0.6035 1.29% -1.85% -3.79% 0.6424 0.5839 20
8 Aussie $ / Canada $ AUD/CAD 0.8476 1.23% -2.22% -4.76% 0.9837 0.8254 15
9 Aussie $ / Franc AUD/CHF 0.9501 1.17% -0.23% -1.95% 0.9945 0.9226 19
10 Real / Yen BRL/JPY 55.0443 1.09% 8.77% 7.35% 55.8704 41.4728 8
11 Franc / Pound CHF/GBP 0.4401 0.34% -0.90% 0.57% 0.4474 0.4289 6
12 Canada $ / Pound CAD/GBP 0.4934 0.28% 1.11% 3.52% 0.5041 0.4162 12
13 Franc / Euro CHF/EUR 0.6355 0.19% -1.59% -1.90% 0.6542 0.6306 10
14 Canada $ / Euro CAD/EUR 0.7127 0.14% 0.42% 1.05% 0.739 0.6169 16
15 Franc / Canada $ CHF/CAD 0.8929 0.13% -1.93% -2.81% 1.0543 0.8646 2
16 Pound / Euro GBP/EUR 1.4447 -0.14% -0.71% -2.40% 1.5124 1.4102 13
17 Real / Pound BRL/GBP 0.2649 -0.71% 6.90% 5.83% 0.2721 0.2058 9
18 Real / Euro BRL/EUR 0.3826 -0.86% 6.16% 3.29% 0.3976 0.3016 14
19 Real / Canada $ BRL/CAD 0.5373 -0.94% 5.75% 2.26% 0.5517 0.4859 4
20 Real / Aussie $ BRL/AUD 0.6347 -2.05% 8.22% 7.43% 0.6573 0.5043 1

GLOBAL STOCK INDICES

1-month 3-month 6-month 52-week 52-week
Rank Country Index April 24 gain/loss gain/loss gain/loss high low Previous
1 India BSE 30 11,915.24 8.81% 24.77% 50.43% 12,102.00 6,138.47 1
2 Hong Kong Hang Seng 16,705.67 6.29% 6.29% 7.57% 16,991.52 13,541.77 13
3 Brazil Bovespa 39,751.00 5.79% 6.29% 33.24% 40,278.00 23,680.00 14
4 Mexico IPC 20,198.71 4.44% 7.01% 31.53% 20,287.55 11,995.26 9
5 Australia All ordinaries 5,217.70 4.32% 9.16% 20.86% 5,250.10 3,886.00 2
6 Singapore Straits Times 2,592.50 3.81% 9.47% 16.63% 2,605.12 2,125.25 6
7 Canada S&P/TSX composite 12,342.23 3.30% 5.56% 19.12% 12,494.72 9,261.45 10
8 Japan Nikkei 225 16,914.40 2.13% 8.09% 29.06% 17,563.37 10,788.59 5
9 Germany Xetra Dax 6,079.09 1.77% 13.96% 24.02% 6,108.69 4,157.51 7
10 UK FTSE 100 6,098.70 1.03% 8.25% 17.11% 6,137.10 4,820.70 3
11 Italy MIBTel 29,673 0.58% 9.13% 18.03% 29,942.00 23,484.00 8
12 U.S. S&P 500 1,309.62 0.51% 3.38% 9.19% 1,318.16 1,139.19 12
13 Switzerland Swiss Market 8,076.30 0.39% 7.72% 4.99% 8,133.40 5,820.00 11
14 France CAC 40 5,221.44 0.05% 9.96% 18.08% 5,258.51 3,882.42 4
15 Egypt CMA 2,178.94 -0.84% -12.15% 8.01% 2,653.25 1,603.22 15

ACCOUNT BALANCE
Rank Country 2005* Ratio 2004 2006+ Rank Country 2005* Ratio 2004 2006+
1 Hong Kong 17.808 10.3 16.119 18.678 9 UK -40.981 -1.9 -42.086 -40.118
2 Taiwan 14.369 4.3 18.606 16.26 10 Spain -69.382 -6.2 -55.266 -80.067
3 Japan 153.101 3.3 172.07 140.484 11 U.S. -759.018 -6.1 -668.082 -805.179
4 Germany 121.064 4.3 103.828 121.937 12 New Zealand -7.946 -7.4 -6.141 -8.34
5 Canada 16.689 1.5 22.159 19.529 13 Australia -38.765 -5.7 -39.797 -35.419
6 Denmark 4.797 1.9 6.001 5.468 Totals in billions of U.S. dollars
+
7 France -27.253 -1.3 -8.396 -31.022 *Account balance in percent of GDP Estimate
Source: International Monetary Fund, World Economic Outlook
8 Italy -29.877 -1.7 -14.963 -24.394 Database, September 2005

CURRENCY TRADER • May 2006 39

 INDUSTRY NEWS

It’s not enough

RefcoFX customers left in limbo

BY CURRENCY TRADER STAFF

T
he status of RefcoFX.com remains up in the air after “We can understand how difficult Refco’s bankruptcy
Forex Capital Markets (FXCM) ended its negotia- and the resulting losses and dislocation have been for its
tions with the bankrupt futures firm’s currency many customers, especially individual customers,”
arm. RefcoFX.com said on its Web site. “From the very beginning
FXCM was the only bidder for RefcoFX.com, and its $110 of the Refco Chapter 11 case, we have worked diligently to
million offer was approved by a federal bankruptcy judge protect the RefcoFX clients and the value in their accounts.
in February. However, Refco and its creditors refused to We very quickly reached an agreement with FXCM that not
accept the offer, saying it was not enough money, and con- only provided for the sale of the RefcoFX client accounts
vinced the bankruptcy court to extend the period for but also allowed clients to continue trading in their
prospective buyers. accounts with only limited disruption pending the sale and
During that time, no other offers came forward, although transfer of the accounts. We still hope that a transaction can
FXCM raised its offer to $130 million. However, the group be restored and that we will be able to conclude this phase
responsible for settling Refco’s debts refused that offer as of Refco’s bankruptcy to the benefit of all parties.”
well, leaving RefcoFX.com without a buyer. An April 11 bankruptcy court date was postponed indef-
“We have done everything in our power to rescue the initely to give other potential bidders a chance to make an
clients of RefcoFX,” says Drew Niv, CEO of FXCM. “From offer, but as of late April, nobody else had stepped forward.
the very beginning our purpose has been to make their That gives Niv hope FXCM will still be able to make a deal,
17,000 clients whole. If successful, our efforts would have although he’s not all that optimistic.
meant that every one of the 17,000 RefcoFX customers “While our hope remains to effect a transaction, the cred-
would have been paid back in full.” itors’ demands remain unreasonable and their position
For its part, RefcoFX.com had hoped the FXCM offer inflexible,” Niv says. “They leave us no choice but to aban-
would be accepted. don negotiations at this time.”

KEY CONCEPTS

Special Drawing Rights (SDR): A special reserve calculation provides a more accurate reflection of the size of
asset used by the International Monetary Fund (IMF) as its a price move over a given period than the standard range
internal “unit of account” and designed to facilitate inter- calculation, which is simply the high of a price bar minus
national liquidity among member nations. The SDR, which the low of a price bar. The true range calculation was devel-
is valued using a basket of currencies (euro, Japanese yen, oped by Welles Wilder and discussed in his book New
pound sterling, and U.S. dollar), is allocated to member Concepts in Technical Trading Systems (Trend Research, 1978).
countries based on their relative economic standing. The True range can be calculated on any time frame or price
U.S. dollar value of the SDR (which was $1.47 on April 28, bar — five-minute, hourly, daily, weekly, etc. The following
2006) is posted daily on the IMF Web site. discussion uses daily price bars for simplicity.
According to the IMF Web site (www.imf.org): “[The True range is the greatest (absolute) distance of the fol-
SDR] is a potential claim on the freely usable currencies of lowing:
IMF members. Holders of SDRs can obtain these currencies
in exchange for their SDRs in two ways: first, through the 1. Today’s high and today’s low.
arrangement of voluntary exchanges between members; 2. Today’s high and yesterday’s close.
and second, by the IMF designating members with strong 3. Today’s low and yesterday’s close.
external positions to purchase SDRs from members with
weak external positions.” Average true range (ATR) is simply a moving average of
the true range over a certain time period. For example, the
True range (TR): A measure of price movement that five-day ATR would be the average of the true range calcu-
accounts for the gaps that occur between price bars. This lations over the last five days.

40 May 2006 • CURRENCY TRADER

 CURRENCY FUTURES
Managed Money
The Barclay Group’s (www.barclaygrp.com) Currency Trader's Index
Israeli shekel latest addition was down 1.41 percent for the year through March. Barclay's BTOP
FX index, which tracks the 50 largest currency commodity trading
to Merc’s forex lineup advisors (CTAs) was down 2.85 percent on the year through April 27.

I
n April, the Chicago Mercantile Exchange (CME) The following table shows the top currency managers for the month
announced it will begin trading Israeli shekel of March, organized in two groups: those who manage $1 million to
futures and futures options beginning at 5:00 $10 million and those who manage more.
p.m. on Sunday, May 7, 2006.
Manager/ March 2006 YTD Funds
A CME press release cited Israel’s five-percent real Fund Return Return
gross domestic product (GDP) growth in 2005 as one > $10 million
reason for listing contracts on the currency (the U.S. is 1. Allied Irish Capital (Pembroke FX) 5.65 5.80 15.2M
also Israel’s No. 1 trade partner), which will trade exclu- 2. 24FX Management Ltd 5.30 7.10 12.1M
sively on the Merc’s Globex electronic trading platform. 3. IKOS Partners (Currency) 4.51 5.62 663.4M
Shekel futures will trade in the standard quarterly 4. Spot Forex Mgmt. (Zurich) 4.50 5.81 24.0M
cycle (March, June, September, and December), with 5. Monarch Capital Mgmt. 4.42 0.90 13.0M
six contract months listed at any given time. The con- 6. Algorithmic Trading (Currency) 4.16 23.86 11.1M
tract is priced in U.S. dollars and will be sized at 7. Dominion Capital Mgmt. (FX) 3.42 6.16 12.0M
1,000,000 shekels. The tick size will be US$0.00001 per 8. Solaris Capital Advisors (Currency) 3.35 1.48 26.0M
Shekel (i.e., $10.00). For more information on the con- 9. Bank Sal. Oppenheim (Figaro Currency) 3.21 1.22 24.7M
tracts, go to www.cme.com/shekel. 10. Wallwood Consultants (Forex) 3.17 2.49 22.0M
> $1 million, < $10 million
1. Shark Fisher (4X-PROplus) 10.68 10.29 5.4M
NYBOT currency volume 2. Shark Fisher (ProFund 4X) 2.91 2.90 7.7M
robust in Q1 3. Lambay Capital Limited (Intraday) 1.42 -1.51 2.8M
4. Perreard Partners Investments 0.69 -0.84 4.3M

F
irst-quarter volume in currency futures at 5. C-View Limited (1X) 0.53 1.72 5.5M
the New York Board of Trade (NYBOT) 6. Coral Rock Investments (Institutional) 0.52 0.27 5.0M
were up 38-percent over Q1 volume in 7. Trident Asset Mgmt. (Gl. Currency) 0.31 0.91 8.0M
2005. Last year was a record-volume year for the 8. SSgA Absolute Return Currency Fund 0.02 -1.78 7.4M
exchange, which also trades several “soft” com- 9. MIGFX Inc (Managed) 0.00 -1.27 3.5M
modity contracts, including sugar, coffee, cocoa, 10. IFX Capital Management (IFX) -0.40 0.44 2.6M
and cotton. Source: The Barclay Group (www.barclaygrp.com)

CURRENCY FUTURES SNAPSHOT The information does NOT constitute trade signals. It is intended only to provide a brief synopsis of each market’s
as of 4/27/06 liquidity, direction, and levels of momentum and volatility. See the legend for explanations of the different fields.

Contract Pit Elec Exch Vol OI 10-day % 20-day % 60-day % Volatility

sym sym move rank move rank move rank ratio/% rank
Eurocurrency EC 6E CME 145.3 152.1 3.49% 100% 4.11% 100% 3.28% 100% .64 / 87%
Japanese yen JY 6J CME 68.0 173.5 3.71% 100% 2.89% 100% 3.09% 83% .90 / 100%
British pound BP 6B CME 59.9 77.4 2.99% 100% 3.93% 100% 1.35% 86% .74 / 85%
Swiss franc SF 6S CME 40.9 82.8 2.95% 100% 3.70% 100% 1.62% 93% .58 / 63%
Canadian dollar CD 6C CME 34.6 84.7 2.15% 73% 4.38% 100% 1.40% 38% .76 / 92%
Australian dollar AD 6A CME 26.8 58.1 3.38% 75% 7.07% 100% -0.07% 4% .63 / 67%
Mexican peso MP 6M CME 11.7 53.8 -0.64% 33% -1.27% 15% -6.13% 95% .28 / 48%
U.S. dollar index DX NYBOT 4.4 26.4 -3.26% 100% -3.89% 100% -2.71% 100% .73 / 93%
Euro / Japanese yen EJ NYBOT 1.5 21.2 -0.29% 0% 1.19% 38% 0.16% 3% .57 / 70%
Note: Average volume and open interest data includes both pit and side-by-side electronic contracts (where applicable). Price activity is based on pit-traded contracts.
LEGEND: past sixty 20-day moves; for the 60-day move, the % rank field shows how the most recent
Sym: Ticker symbol. 60-day move compares to the past one-hundred-twenty 60-day moves. A reading of 100%
means the current reading is larger than all the past readings, while a reading of 0% means
Vol: 30-day average daily volume, in thousands.
the current reading is lower than the previous readings.
OI: 30-day open interest, in thousands.
Volatility ratio/% rank: The ratio is the short-term volatility (10-day standard deviation of
10-day move: The percentage price move from the close 10 days ago to today’s close. prices) divided by the long-term volatility (100-day standard deviation of prices). The %
20-day move: The percentage price move from the close 20 days ago to today’s close. rank is the percentile rank of the volatility ratio over the past 60 days.
60-day move: The percentage price move from the close 60 days ago to today’s close. This information is for educational purposes only. Currency Trader provides this data in
The “% rank” fields for each time window (10-day moves, 20-day moves, etc.) show the good faith, but assumes no responsibility for the use of this information. Currency
percentile rank of the most recent move to a certain number of the previous moves of the Trader does not recommend buying or selling any market, nor does it solicit orders to
same size and in the same direction. For example, the % rank for 10-day move shows buy or sell any market. There is a high level of risk in trading, especially for traders
how the most recent 10-day move compares to the past twenty 10-day moves; for the 20- who use leverage. The reader assumes all responsibility for his or her actions in the
day move, the % rank field shows how the most recent 20-day move compares to the market.

CURRENCY TRADER • May 2006 41

 GLOBAL NEWS BRIEFS
FOREX/INTERNATIONAL
 Peru will hold a runoff election in May or June to decide
its new president, as no candidate held the majority of the vote
EUROPE in April’s first-round election. Former army officer Ollanta
Humala (UP — Union for Peru) led the first round of voting.
 Britain’s Q4 2005 GDP grew 0.6 percent from the Although his run-off opponent had not been decided at press
previous quarter and 1.7 percent compared to the same quar- time, he’ll most likely face a fellow left-leaning candidate, for-
ter in 2004. The UK’s December-February jobless rate inched mer President Alan Garcia (APRA — American Revolutionary
up 0.1 percent to 5.1 percent compared to the previous three- People’s Alliance) based on 99 percent of the votes tallied. The
month period. The rate is 0.4 percent higher than the rate leading conservative contender, Lourdes Flores Nano (PPC —
reported during the same three months a year earlier. Popular Christian Party) held the third-place spot, by a small
fraction, behind Garcia.
 Preliminary estimates show France’s February jobless rate
rose 0.5 percent (to 10.1 percent) compared to the previous  Polls show a switch in Mexican voter opinion for the July
month and to February 2005. 2 presidential election, as leftist and former Indian rights
activist Lopez Obrador saw his lead slip after arguing with
 Germany’s March unemployment rate fell 0.2 percent from current President Vicente Fox and declining to participate in a
January and 0.5 percent from March 2005. televised debate.
 Hungary’s Socialist Party increased its majority parliament
control in a landslide election victory, becoming the country’s first
government to retain power since the fall of communism in 1989.
G7 calls for China to practice greater currency flexibility
 Romano Prodi, a center-left leader and former European The Group of Seven (G7) nations met in late April in Washington,
Commission president, appeared to have claimed Italy’s D.C. to discuss global imbalances and IMF governance reform.
prime minister seat after the country’s April 9-10 elections. He The G7 called for the “adjustment of global imbalances,” pointing
unseated incumbent Prime Minister Silvio Berlusconi, a center- out that China should practice greater flexibility in its exchange
right politician, by a narrow margin. However, Berlusconi had rates to allow for needed appreciations.
not conceded defeat at press time, and was calling for a
recount of votes from abroad. IMF cites economic strength despite high energy prices
In its Spring Economic Outlook report, the International
ASIA & THE SOUTH PACIFIC Monetary Fund (IMF) said global economic growth exceeded
expectations in 2005, as global industrial production increased
 Australia’s March unemployment rate fell 0.2 from mid year, the services sector showed resilience, and con-
percent to 5 percent, 0.1 percent lower than March 2005. sumer confidence, business confidence, and labor market con-
ditions strengthened.
 Hong Kong’s jobless rate remained stable at 5.2 percent from Even so, high and volatile oil prices remained an issue,
the first quarter of 2006. According to an unnamed government increasingly driven to $60-$66 per barrel by concerns over
spokesman in a statement, “The labor market has recovered future supply. Non-fuel commodity prices, while high in 2005,
from the lull in activity after the Lunar New Year holidays.” are expected to moderate in 2006. Interest rate spreads world-
 Japan’s February unemployment rate fell 0.4 percent to 4.1 wide are close to historic lows.
percent. The IMF’s 2006 economic-growth projections were higher for
most countries than in its last report in September 2005. The
world economy forecast jumped 0.6 percent to 4.9 percent. The
AMERICAS IMF estimated 3-percent growth in advanced economies, with
the Eurozone notably getting a 0.2-percent boost in its projec-
 Brazil’s unemployment rate jumped 0.9 percent
tion. Emerging countries received a 0.8-percent boost to their
to 10.1 percent in February, as the number of temporary jobs
forecast, hitting 6.9-percent estimated growth. Other countries
decreased. However, this rate is still 0.5 percent lower than the
with major forecast increases were Japan (up 0.8 percent),
same month a year earlier and the lowest rate for February in
China (up 1.3 percent), and India (up 1 percent).
four years. On April 20, the Central Bank of Brazil cut its
benchmark lending (Selic) rate 0.75 percent to
15.75 percent.
GLOBAL INTEREST RATES
 The Bank of Canada raised its key overnight Country Interest rate Rate Last change Oct. 2005 May 2005
interest rate 0.25 percent to 4 percent on April 25. U.S. Fed Funds Rate 4.75 .25 (March 06) 3.75 3
Japan Overnight call rate 0 — 0 0
 Canada’s March jobless rate decreased 0.1 per- Eurozone Refi rate 2.5 .25 (March 06) 2 2
cent from January, a 32-year low. Job growth was England Repo rate 4.5 .25 (Aug. 05) 4.5 4.75
widespread across many sectors, and there were Canada Overnight funding rate 4 .25 (March 06) 3 2.5
large gains among Ontario youth (ages 18 to 24). Switzerland 3-month Swiss Libor 1.25 .25 (March 06) 0.75 0.75
According to Statistics Canada: “The strike action Australia Cash rate 5.5 .25 (March 05) 5.5 5.5
that temporarily closed Ontario college facilities New Zealand Cash rate 7.25 .25 (Dec. 05) 7 6.75
may have given many youths more time to work at Brazil Selic rate 16.5 0.75 (March 06) 19 19.75
a paid job.” Korea Overnight call rate 4 .25 (Feb. 06) 4.25 3.25
Taiwan Discount rate 2.375 .125 (March 06) 2.125 1.875
 The Central Bank of Chile raised its discount India Reverse repo rate 5.5 .25 (Jan. 05) 5.25 5
rate 0.25 percent to 5 percent on April 19. South Africa Repurchase rate 7 0.5 (May 05) 7 7

42 May 2006 • CURRENCY TRADER

 EVENTS

Event: First Annual FXCM Currency Trading Expo Location: São Paulo, Brazil

Date: June 3-4 For more information: Call +55 21 2232 5133 or visit
www.traderbrasil.com
Location: Hilton Hotel, West 53rd Street and Avenue of
the Americas, New York, N.Y. •

For more information: Event: Hedge Fund Trading

www.fxcm.com/trade-show-page.jsp
Date: July 17-18
•
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Event: The Traders Expo Ft. Lauderdale
For more information: Call Mary Applegate at (704)
Date: June 7-10 889-1290 or e-mail mapplegate@frallc.com

Location: Broward County Convention Center, Ft. •

Lauderdale, Fla.
Event: The Wealth Expo
For more information: Call (800) 970-4355 or visit
Date: Sept. 7-9
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Location: Dallas, Texas
•
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Event: Expo Trader Brazil 2006
Third Annual International Traders Conference

Date: June 7-8

NEW PRODUCTS AND SERVICES

Global Forex Trading (GFT) now offers a cus-
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tion delivered within its proprietary online foreign
exchange trading software, DealBook FX 2. Dow
Jones Newswires provides GFT with a tailored selec-
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have integrated access to Dow Jones coverage of G8
economic indicators, currency market wrap-ups,
columns, and streaming DJ Market Talk forex com-
mentary and analysis. As selected Dow Jones
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systems — all within one program at no extra cost. For more information, visit www.gftforex.com.

Note: The New Products and Services section is a forum for industry business to announce new products and upgrades. Listings are adapt-
ed from company press releases and are not endorsements or recommendations from the Active Trader Magazine Group. E-mail press releas-
es to editorial@currencytradermag.com. Publication is not guaranteed.

CURRENCY TRADER • May 2006 43

 GLOBAL ECONOMIC CALENDAR MAY
MONTH

Monday Tuesday Wednesday Thursday Friday Saturday

Legend
CPI: Consumer Price Index GDP: Gross domestic product
ECB: European Central Bank ISM: Institute for Supply
FOMC: Federal open market Management
committee PPI: Producer Price Index

1 2 3 4 5 6
U.S.: ISM report Australia: Great Britain: ECB: Governing U.S.:
on business Reserve bank Monetary policy council meeting Unemployment
meeting committee meet- Germany:
Japan: Account Germany: Retail ing Great Britain: Bankruptcies
balances turnover Monetary policy Australia:
Venezuela, Peru: committee Statement on
CPI meeting monetary policy

8 9 10 11 12 13
Germany: Orders U.S.: Wholesale U.S.: FOMC U.S.: Retail sales U.S.: Trade
received and inventories meeting balance
manufacturing
turnover Germany: Germany: Foreign Germany: CPI
Production index trade

15 16 17 18 19 20
Japan: Balance of U.S.: PPI U.S.: CPI U.S.: Leading Canada: retail
payments; corporate indicators trade
goods price index Japan: Monetary Japan: Monetary Japan: Monetary
Canada: survey policy meeting policy meeting
Manufacturing survey ECB: Governing Great Britain:
Italy: Balance of Canada: council meeting Capital issues
payments Wholesale trade Canada: CPI Germany: PPI

22 23 24 25 26 27
Germany: U.S.: Durable U.S.: GDP Japan: Corporate
National accounts goods service price index

Canada: Leading
indicators;
Interest rate
announcement

29 30 31
Canada: Canada: Balance Germany: Retail
Unemployment of international turnover;
payments Unemployment
(U.S. markets Italy: International
closed — reserves and Canada: GDP
Memorial Day) foreign currency
liquidity

The information on this page is subject to change. Currency Trader is not responsible for the accuracy of calendar dates beyond press time.

44 May 2006 • CURRENCY TRADER

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 FOREX TRADE JOURNAL

Getting married to a market outlook

ends in a bad divorce.
TRADE

Date: Thurs., April 20 and Tues., April 25.

Entry: Long the U.S. dollar/Canadian dollar

rate (USD/CAD) at 1.1402 and 1.1312.

Reason(s) for trade/setup: The longer-

term analysis in last month’s Spot Check fea-
ture suggested favorable odds of upside move-
ment following March’s outside month with a
close above the February high. The article also
indicated a pullback would proceed another
upside move.
After hitting a high of 1.1771 on April 3, the
Source: TradeStation
USD/CAD rate sold off sharply to below 1.500,
bounced back up for a few days, then dropped
to just below 1.1400 on April 18. Believing the market might Outcome: Overall, these trades exemplify the trap getting
be testing the round-number price of 1.1400 — and with the locked in to a particular stance on the market and refusing
pair approaching the implied support of the March low to accept evidence that stance is just plain wrong.
(1.1298) — we went long on April 20 when price success- We were convinced going long would pay off — sooner
fully rallied back above 1.1400. rather than later — and ignored signs from the market to
the contrary. From the outset, the pair sold off more than it
Initial stop: 1.1291, .0069 below entry day’s low (which should have (before we first entered the market), but once
was also the previous day’s low). This is just below the March the trade idea was entrenched, we overlooked this red flag,
low, a move below which would negate the trade premise. among others.
The second trade (which constituted adding onto a losing
Initial target: 1.1530, just below the April 17 high. We position) was really unforgivable. It could be rationalized
will take partial profits at this level and raise the stop to by the fact that it was executed very near the March support
protect the remainder of the position. The next obvious tar- level, but that is all such analysis is — rationalization. The
get is the April 3 high of 1.1771. market clearly was not performing in a way that pointed
toward success for the trade. The only upside was the fact
Update: On April 25 we bought again at 1.1312 when price that a stop-loss was in place, which limited the damage,
bounced intraday after falling to just above the March low. especially on the second trade.
Interestingly, by penetrating the March low in April, the
RESULT USD/CAD formed a second consecutive outside month,
this time with a lower close.
Exit: 1.1291 (both trades).
Note: Initial trade targets are typically based on things such as the his-
Profit/loss: -.0111 (first trade); -.0021 (second trade). torical performance of a price pattern or trading system signal.
However, because individual trades are dictated by immediate circum-
Reason for exit: Initial stop hit. stances, price targets are flexible and are often used as points at which
to liquidate a portion of a trade to reduce exposure. As a result, initial
Trade executed according to plan? Yes. (pre-trade) reward-risk ratios are conjectural by nature.

TRADE SUMMARY
Date Currency Entry Initial Initial IRR Exit Date P/L LOP LOL Trade
stop target length

4/20/06 USD/CAD 1.1402 1.1291 1.1530 1.15 1.1291 4/26/06 -.0111 (.97%) 0.0020 .0111 4 days
4/25/06 1.1312 1.1291 1.1530 10.3 1.1291 4/26/06 -.0021 (.19%) 0.0012 .0021 1 day

Legend: IRR — initial reward/risk ratio (initial target amount/initial stop amount); LOP — largest open profit (maximum available profit
during lifetime of trade); LOL — largest open loss (maximum potential loss during life of trade).

46 May 2006 • CURRENCY TRADER

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