CATCHING CURRENCY BOTTOMS by the numbers BARBARA ROCKEFELLERS technical FX outlook WHATS NEXT for the Euro/Swiss franc?

JOHN BOLLINGER interview THE U.S. DOLLAR/YEN RATE: Will 100.00 give way? THE SCOOP ON FX options

HAS THE EURO TOPPED?

CONTENTS

Editors Note . . . . . . . . . . . . . . . . . . . . .6

Contributors . . . . . . . . . . . . . . . . . . . . .8

Letters . . . . . . . . . . . . . . . . . . . . . . . . .10

Global Economy Has the Euro topped? . . . . . . . . . . . .12 The bear trend in the U.S. dollar vs. the Euro took a turn in 2005. Find out what analysts say might be in store in the coming months. By Currency Trader Staff Will this be the year 100.00-yen gives way? . . . . . . . . . . .14 The dollar/yen rate is flirting with a historic level, and traders are busy staking their claim to both sides of the market. Find out if the long-term trend is likely to prevail. By Currency Trader Staff Industry News
By Carlise Peterson

The Big Picture The technicals rule . . . . . . . . . . . . . .18 Are deficits or interests rates controlling the forex market? Or are the technicals really running the show?
By Barbara Rockefeller

Tower Group comments on BIS survey . . . . . . . . . . . . . . . . . .16 Research firm Tower Group gives its take on the Bank for International Settlements survey on the foreign exchange industry. NYC Traders expo spotlights currency trading . . . . . . . . . . . . . . . .16 The Currency Trader panel at the New York Traders Expo focused on the future of the dollar. Intershow announces 2005 forex conference . . . . . . . . . . . . . . . .17 Intershow, which heads the Traders Expos held in New York, Las Vegas, and Chicago, will add a forex conference to its roster this year.

Currency Strategies Spike-low bottoms . . . . . . . . . . . . . .24 This pattern analysis shows the difference between a trade that looks good on a chart and one that actually has favorable probabilities for future trading.
By Currency Trader Staff

Currency Calendar . . . . . . . . . . . . . .29 Currency Characteristics The international trade report and the U.S. dollar . . . . . . . . . . . . . . .30 Analysis of price patterns in the U.S. dollar around the monthly trade balance report.
By David Bukey

Currency Trader Interview John Bollinger on consolidations . .36

By Currency Trader Staff
continued on p. 4

March 2005 CURRENCY TRADER

CONTENTS

Currency Basics Forex options . . . . . . . . . . . . . . . . . . 40 A look at option trading in the forex market.
By Carlise Peterson

Money management fundamentals: How much should you risk? . . . . . . .42 Find out how to balance your trading approach with your account equity.
By Noble DraKoln

Indicator Basics Price oscillator . . . . . . . . . . . . . . . . .46

By Currency Trader Staff

Currency System Analysis Parabolic FX . . . . . . . . . . . . . . . . . . .56 Global News Briefs . . . . . . . . . . . . .59

New Products . . . . . . . . . . . . . . . . . .49 International Market Summary . . .60 Currency Movers Euro/Swiss franc . . . . . . . . . . . . . . . .50 European cross rates: Wheres the Euro/Swiss franc rate headed?
By Currency Trader Staff

Currency Futures . . . . . . . . . . . . . . .62 Trade Diary . . . . . . . . . . . . . . . . . . . .63

Business of Trading Forex hedge fund management . . . .52 We look at the details involved in setting up a forex hedge fund.
By Hannah Terhune

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March 2005 CURRENCY TRADER

EDITORS NOTE

Holding out for a Euro

B
Countdown.

arely out of its toddling clothes, the Euro has quickly vaulted to prominence among world currencies and has been one of the main beneficiaries of the dolEuro/Swiss franc rate (that holdover from the Continents not-so-distant currency-fragmented past). Judging by the charts, EUR/CHF looks like it might be poised to do one thing, but based on historical patterns, could be setting up to do the opposite at least in the near-term. For shorter-term ideas, this issue features a trading strategy and Forex Diary that illustrate a pattern-based trading approach executed in the Aussie dollar/U.S. dollar rate, which like the Currency Movers piece highlights the differences between appearances markets. and reality in the

lars malaise over the past few years. The Euros ascendancy has been so strong that many pundits began to talk of the Euro replacing the dollar as the globes primary reserve currency. The latest stats (see Global News

Is the current down swing a genuine reversal, or just a breather in what is destined to be an even larger uptrend?

Briefs) dont indicate thats going to happen any time soon, but theres little doubt the Euro has a strong hold on the No. 2 spot on the Currency Has the Euro topped? looks at the Euro/U.S. dollar relationship as the first quarter of 2005 enters its final weeks. The FX world has been waiting for two months for the dollar situation to clarify, which of course will simplify the Euro picture: Is the current down swing a genuine reversal, or just a breather in what is destined to be an even larger uptrend? The Euro is also featured in this months Currency Movers analysis, which does a spot check on the

Mark Etzkorn, Editor-in-chief

March 2005 CURRENCY TRADER

CONTRIBUTORS CONTRIBUTORS
Barbara Rockefeller (www.rts-forex.com) is an international economist with a focus on foreign exchange. She has worked as a forecaster, trader, and consultant at Citibank and other financial institutions, and currently publishes two daily reports on foreign exchange. Rockefeller is the author of Technical Analysis for Dummies (2004), 24/7 Trading Around the Clock, Around the World (John Wiley & Sons, 2000), The Global Trader (John Wiley & Sons, 2001), and How to Invest Internationally, published in Japan in 1999. A book tentatively titled How to Trade FX is in the works.

A publication of Active Trader

For all subscriber services:

www.currencytradermag.com
Editor-in-chief: Mark Etzkorn metzkorn@currencytradermag.com Managing editor: Molly Flynn mflynn@currencytradermag.com Associate editor: Carlise Peterson cpeterson@currencytradermag.com Associate editor: David Bukey dbukey@currencytradermag.com Contributing editor: Jeff Ponczak jponczak@currencytradermag.com Editorial and Web assistant: Kesha Green kgreen@currencytradermag.com Art director: Laura Coyle lcoyle@currencytradermag.com President: Phil Dorman pdorman@currencytradermag.com Publisher, Ad sales East Coast and Midwest: Bob Dorman bdorman@currencytradermag.com Ad sales West Coast and Southwest only: Allison Ellis aellis@currencytradermag.com Classified ad sales: Mark Seger mseger@currencytradermag.com

Hannah M. Terhune, JD, LLM is chief attorney and member manager of GreenTraderLaw PLLC, an international law firm. Terhune specializes in hedge funds, international and domestic tax, shareholder litigation, and business law. In addition to practicing law, Terhune lectures about tax, accounting, and business law for two universities in Washington, D.C. She writes, edits, and publishes the U.S. International Tax Analyst, a newsletter dedicated to analysis of U.S. international tax planning trends. She also contributes articles to other prominent publications. Michael Schneider has been involved in trading since 1982 when he was head of the special interest group investments of the German Apple user group and operated one of the first low-cost quote vendors in Germany. He later incorporated a small trading company that served clients in Europe (primarily Monaco). Currently he is head of the supervisory board of a German stock firm and director of a second company that manages international projects. In addition, he manages the office of the German Vereinigung Technischer Analysten e.v., which is the German member of the International Federation of Technical Analysts. Noble DraKoln is the author of the books Forex for Small Speculators and Futures for Small Speculators, available at Amazon.com and www.smallspeculators.com. He has been an investor, broker, and analyst since 1994. He is a wellknown Southern California educator through his Small Speculators investing seminars. You can subscribe to his free monthly newsletter at www.liverpoolgroup.com or purchase his futures and forex seminars on CD at www.smallspeculators.com.

Volume 2, Issue 3. Currency Trader is published monthly by TechInfo, Inc., 150 S. Wacker Drive, Suite 880, Chicago, IL 60606. Copyright 2005 TechInfo, Inc. All rights reserved. Information in this publication may not be stored or reproduced in any form without written permission from the publisher. The information in Currency Trader magazine is intended for educational purposes 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 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 guarantee future results.

Roger D. Lorence, JD LLM (legal@greencompany.com), is a senior securities and tax attorney with GreenTraderLaw PLLC, an international law firm (www.greentraderlaw.com). Lorence covers tax and accounting issues affecting the hedge fund industry for Derivatives Financial Products Report, a monthly publication for financial services professionals.

March 2005 CURRENCY TRADER

LETTERS

Thats dollars, as in taxes not Dallas, Texas

I have been reading some articles and literature about Forex and I would like to open an account in any of the several brokerage companies that offer their services on the web. However, I have not found any information about taxes in forex. I would like to know if you have any information regarding this subject. If so, please send it to me. Jose Del Solar The October 2004 issue of Currency Trader contains the article Different market, different tax rules, by Robert A. Green, which covers this topic. Back issues of Currency Trader are free to subscribers and can be downloaded through the Web site.

Forex trading systems

Can you refer me to some reviews on [currency trading system], which is currency trading software being promoted throughout the country at seminars? Are any professional traders using this software? I need professional opinions on this product. Michael M. We dont have any information about the software. As a rule, we dont review canned trading systems or strategies. Our magazines are designed to help traders educate themselves and develop the skills to objectively analyze markets and design their own trading ideas. Some retail trading systems have value; others do not. Unfortunately, there is no way to know the true value of a given system without risking real money in the market. The next best thing is to have detailed, valid, historical test results that can give some indication of a systems potential. However, system results can be fudged, so it takes some experience to know whether or not performance statistics are meaningful. Anyone who wants to experiment with third-party trading systems should ask themselves a few questions: 1. Are the systems rules/logic fully disclosed? (If theyre not, you have no idea
10

what youre buying.) 2. Do those rules makes sense to me that is, do I understand how and why the system is supposed to make (and potentially lose) money? Do those rules match my trading style and risktolerance level? 3. Does the company have audited brokerage statements or trade results that verify the systems performance? 4. If they dont, do they have valid historical test results for the system? In general, if youre new to trading, its difficult to make an informed decision about a trading strategy or system.

what we do when we receive your email stating that the latest edition is available: 1. Download the .PDF file. 2. Set up our laser printer and our inkjet printer. 3. Print pages in groups to the laser if color is not important and to the inkjet for pages we want in color. 4. Collate the two sets of printouts. 5. Bind the magazine into either spiral binding or heated covers. We would be more than happy to pay for a printed version, be it in glossy format or whatever, even though it would arrive after we receive notice of the online versions being available. Vanessa and David Champion Brisbane, Australia We appreciate your dedication! Its convenient at times to have a printed magazine, but because of the global nature of its content, Currency Trader is best distributed in electronic format. Although not everyone likes printing (and other people dont mind reading on screen), this format offers instantaneous access to the articles (much of which provides easy access to related Internet content) as well as personal control over what to print.

Paper trail
We really enjoy Currency Trader. Its good to see the high quality of Active Trader repeated here. We are of the generation that grew up with pen and paper and have used computers since the 70s onward both for employment and enjoyment. However, we trade intraday Forex and therefore spend enough time staring at computer screens, without having to consider doing it for leisure. Theres still nothing better than relaxing in an easy chair with a cup of coffee and our favorite Forex magazine. Thought you might be interested in

CURRENCY TRADER March 2005

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GLOBAL ECONOMY

Has the Euro topped?

Has the dollars day come vs. the Euro? Take a look at some of the reasons behind the recent Euro weakness, and whether the trend is likely to continue.

BY CURRENCY TRADER STAFF

eading into late 2004, many currency market strategists were forecasting doom and gloom for the U.S. dollar. Faced with the evils of the twin deficits, some saw the potential for global financial catastrophe. Dollar bears subsequently drove the Euro/U.S. dollar rate (EUR/USD) to a peak of $1.36 and change just ahead of the new year. But 2005 has ushered in a dramatically different picture. From the opening bell of 2005, the U.S. dollar began to strengthen against the Euro and has posted steady improvement through the middle of February. Many currency watchers now believe the late-December high marked a significant multi-month top for the Euro. Although momentum-based trend traders might be disappointed by forecasts of range-bound price action over the next month or so, the dramatic multi-year bear trend in the U.S. dollar vs. the Euro appears to have found a resting point for now.

to test that $1.36 high. Depending on the direction of U.S. policy, there is potential for that to be the high for many years. Jamie Coleman, managing analyst at IFR-Forex Watch, agrees. I do think [$1.36] was a mediumterm top, he says, pointing to a brand-new focus on the deficit from the Bush Administration as a factor behind the dollars strength against the Euro early in 2005. The market anticipated the fiscal and trade deficits would be completely ignored, Coleman adds. The concerns of an imminent current account dollar crisis have [diminished] since
FIGURE 1 TOP IN 2005?

the beginning of the year. Sinche echoes this line of thinking. The frenzy of concern over the U.S. twin deficits reached its zenith in the latter part of last year, he says. But there have been some signs of spending restraint. The markets have gone from significant concern about the U.S. structural position regarding the trade and budget deficit to a scenario that looks like structural factors are stabilizing. The markets perception of U.S. government attention to budget cuts, lower oil prices, and the relative currency values between the U.S. and Europe have played into Fed expectations that improvement could be seen

The Euro/U.S. dollar rate peaked intraday at 1.3666 on Dec. 30, 2004 and dropped to a low of 1.2871 in early February. Some analysts believe the earlyFebruary rally was simply a correction, and the Euro might not match its end-of2004 top for some time.
Euro/U.S. dollar (EUR/USD), daily 1.36

1.34

1.32

1.30

The view from the top

In mid-February, Robert Sinche, head of global currency strategy at the Bank of America, called the Euro absolutely overvalued even at the $1.27 area. At $1.30 and higher it is seriously out of line with its reasonable valuation range, Sinche says. Pointing to the Euros peak in late December at $1.36, he says, I think it is a distinct possibility we are unlikely
12

1.28

1.26

1.24

November Source: TradeStation

December

2005

February

March 2005 CURRENCY TRADER

FIGURE 2 THE EUROS LONG RISE The most recent top (after a lengthy consolidation in 2004) was just the latest peak in a series of Euro surges dating back to 2002. However, favorable interest-rate differentials might favor the buck over the Euro in the future.
Euro/U.S. dollar (EUR/USD), weekly 1.30

in the deficit arena. The trade deficit probably peaked in the fourth quarter of last year, says Sinche. U.S. trade deficit figures came in at $56.4 billion for December, $59.3 billion for November, and $56.1 billion for October. At the end of the fourth quarter, the market had really begun to price in a worst-case scenario in terms of the current account deficit. When the sky doesnt fall youve got to take that trade back off, says Coleman. Some of the dollar strength in early 2005 may have been bearish dollar positions simply being unwound, he adds.

1.20

1.10

1.00

0.90 2002 2003 2004 2005

Dollar positives ahead

Looking ahead, some analysts point to the potential for positive interest rate and positive growth rate differentials as factors in favor of the U.S. dollar vs. the Euro. In early February, the Federal Open Market Committee (FOMC) hiked interest rates for a sixth consecutive time, boosting the federal funds rate to 2.5 percent. (The next meeting is

Source: TradeStation

shifted in favor of the U.S. and that is likely to persist, Sinche says. The U.S. wins out from a growth rate perspective as well. Looking ahead, Brian Dolan, director of research at Gain Capital, noted economists are forecasting nominal GDP growth in the 3.5 to 4.0 percent area for

Some market watchers now believe the late-December high marked a significant multi-month top for the Euro.
March 22, where a .25-percent hike is expected.) This compares to the similar European rate at 2.00 percent. At this point, most analysts believe the European Central Bank wont likely raise rates until the second half of 2005. The markets expect the Fed to continue on its tightening path, which would bring the funds rate to 3.00 percent by mid-year, Sinche notes. That would be 100 basis points above the Euro area repo rate. The last time the repo rate was 100 basis points in favor of the U.S. was in January 2001. The bottom line is that improvement in short-term interest rate differentials will also impact short-term currency flows. The capital flow situation has
CURRENCY TRADER March 2005

the U.S, versus expectations of 1.5 percent growth for Europe and 2.0 percent for Japan. Dolan pointed to this factor as one of the key supports for the U.S. buck in early 2005. The market all of a sudden focused on growth rate differentials, he says. Longer term, however, Dolan believes the fundamentals for the dollar will remain weak. The dollar will be weak for the next year or two, he says. That amount of time needs to pass for the global trade adjustment to take place.

Range-bound action?
Despite the improvement seen in the U.S. dollar versus the Euro in early- to

mid-February (see Figure 1), most analysts believe that countertrend move has run its course. Through the end of March, many currency analysts see the Euro moving into range-bound environment between $1.27-28 on the downside and $1.34-35 on the upside. The $1.36-37 area is [not likely to be reached] over the next few months, says IFR-Forex Watchs Coleman. Currency traders need to adjust their views once again from a trending type of environment to a more rangebound situation, Dolan advises. Traders should defer to more of a sideways-type environment, he says. It will be a broad and volatile range but be prepared for reversals around the highs and lows of the range. Looking back to 2004, Sinche notes that Euro action was confined to a trading range until a breakout at the end of the year (see Figure 2). Similarly, he currently expects a trading-range environment. Resist the temptation to play breakouts, he says. The bottom line for traders: Dont get all bulled up and expect a move to $1.50 or a drop to $1.15, says Dolan. Be prepared for it to move sideways in the $1.28-$1.35 area.
13

GLOBAL ECONOMY continued

Will this be the year 100.00-yen gives way?

Its been nearly 10 years since the dollar/yen rate has traded below 100. Is that barrier due to be shattered in 2005?
BY CURRENCY TRADER STAFF
fter a strong sell-off in the U.S. dollar/Japanese yen (USD/JPY) from January 2002 through January 2005, bulls once again tried to seize control of the market early this year, pushing it up from a low of 101.67 on Jan. 17 to a high of 106.86 on Feb. 10. The move might look somewhat bullish on a daily chart (see Figure 1), but from a longer-term perspective the rally appears less significant and several market watchers believe 2005 could be the year 100.00 yen finally cracks. While day traders may be glued to their one- and five-minute charts, it can be worthwhile to step back and take a look at the monthly dollar/yen chart for a longer-term outlook (see Figure 2). The USD/JPY rate has not traded below 100.00 since late 1995, but given the dominant downward trend in recent years, a serious test of that floor could be in the cards later this year, according to some analysts. However, just above the psychologically significant 100.00 floor, strong chart support is evident in the 101.25/101.60 area, which are the lows from late 1999 and January 2005. U.S. dollar managed to gain ground against many currencies in early 2005. Heading into late 2004, speculation was rampant among currency market participants that an imminent revaluation by the Chinese government of their currency was possible, which may have fueled position adjustments in the dollar/yen. There was a clean-out of positions early in the year as traders had been short dollar/yen short dollar-everything, really in late 2004, says Sean Callow, currency strategist at IdeaGlobal. Everyone thought the [bearish dollar] momentum would continue from last year. They expected the dollar to continue to fall week after week. There was an expectation that a revaluation would also make the dollar/yen fall sharply, he adds. The fact that China brushed off speculation and talked down that possibility was a supportive factor for the dollar/yen early in the year. Looking ahead, Andy Busch, global foreign exchange strategist at Harris/Nesbitt warns traders, the China story is not going to change. He suggests those trading the dollar/yen should not trade it with the

FIGURE 1 BULLS MAKING THEIR RUN? After making a new low in December 2004, the dollar/yen briefly rallied before falling to a slightly lower low in mid January. The market then rallied again, making a three-month high on Feb. 10. Some chartists might be tempted to believe the currency pair is in the early stages of forming a double-bottom reversal, but there are reasons to believe the dollar/yen will move to new lows.
U.S. dollar/Japanese yen (USD/JPY), daily 110 109 108 107 106 105 104 103 102 November Source: TradeStation December 2005 February

The early rally

After touching the 101.60 area in mid January, dollar/yen bulls propelled the market to near the 107.00 area as of mid-February (after which it fell to around 104.00 by March 1). Some analysts called the rally a U.S. dollar story rather than a yen story, as the
14

March 2005 CURRENCY TRADER

FIGURE 2 LONG-TERM DOWNTREND

idea China will revalue any time soon. Make your decisions based on the economic fundamentals, such as interest rate differentials. Others simply think the early 2005 rally is a correction in the longer-term downtrend. The rally to the 107 area was only a correction in an otherwise slow drift lower in the dollar/yen, says Brian Dolan, director of research at Gain Capital. It was precipitated by ostensibly dollar-positive comments from Greenspan in his London speech on Feb. 4. Several currency watchers speculated that the early February rally in dollar/yen to near the 107.00 area could be a strong top for the market. It will be very hard to get above the 107.00 cap, says Tom Rogers, senior currency analyst at Thomson Financial. I think we made a really big top at 106.86. It could be the cap for the year.

The dollar/yen has been in a prolonged downtrend dating back to 2002, and it has not traded at 100.00 since 1995.
U.S. dollar/Japanese yen (USD/JPY), daily 145.00 140.00 135.00 130.00 125.00 120.00 115.00 110.00 105.00 101.60 100.00 95.00 90.00 85.00 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Source: TradeStation

The bearish case

Dolan believes the dollar/yen will fall below 100.00 in 2005, most likely in the latter half of the year. However, it will mostly be a case of U.S. dollar weakness rather than Japanese yen strength, he adds. Callow agreed with a longer-term negative view of dollar/yen, noting Ideaglobal has a year-end target at the 96.00 area. One yen positive factor Callow points to is the net inflow of foreign investment into Japan: Almost $30 billion (JPY 3.1 trillion) in net securities inflows occurred in Japan during January. That, combined with Japans trade surplus, adds up to a bullish support for the yen and bearish pressure on the dollar/yen rate. For December, Japans trade surplus stood at 1.6 trillion yen, or roughly 15 billion U.S. dollars. That figure was 35 percent higher than a year earlier. That is very bullish for the currency, says Rogers. Current Organization of Economic Cooperation and Development (OECD) forecasts expect 1.4-percent GDP growth in Japan for 2005 and 1.5 percent in 2006. We look for a modest pick-up in growth beginning in the April-June quarter on the back of stronger exports, says Peter Morgan, economist at HSBC Securities in Japan. This would be positive for the yen, but it also depends on what the U.S. economy is doing at that stage. Callow says. He points to the 101.80/101.60 level (the December 2004 and January 2005 lows on the daily dollar/yen chart) as a big, attractive multi-week target. Short-term consolidation is possible, however, ahead of Japans fiscal year-end on March 31. Callow believes this could prove to be a quiet consolidative period. Gain Capitals Dolan suggests traders actively manage their long yen positions as opposed to buying and holding. The normal volatility of the pair, coupled with unknown intervention intentions of the Ministry of Finance, will make for wide swings in the months ahead. Finally, traders should remember markets dont often break major support levels on the first try; they must be cautious on tests of strong support around the 101.60 area. Traders should be willing to take profits when the dollar/yen declines to recent lows and resist the urge to pile in as the market is making new lows, Dolan says. They will be much better served by having the ability to sell into rallies that follow what is likely to be several failed attempts to break definitively below 101.50.
15

Trading dollar/yen
The 108.00-106.00 range should be a good level to become short dollar/yen,

The USD/JPY rate hasnt traded below 100.00 since late 1995, but given the dominant downward trend, a serious test of that floor could be in the cards later this year.
CURRENCY TRADER March 2005

INDUSTRY NEWS

Tower Group comments on BIS survey

ot-coms no longer dominate the electronic foreign exchange landscape, and the market is maturing, according to a recent report by Tower Group, a Bostonbased research firm. After years of investment by banks and brokerages, the FX industrys technology has grown enough to attract a more diversified clientele, including buy-side institutions (fund managers, hedge funds, etc.) that are becoming increasingly influential in the marketplace. Yet as competition intensifies, banks and brokers have determined that only the largest dealers will succeed; thus many seek unprecedented growth,

which places great importance on technology to manage their distribution and volumes, writes Robert Hegarty, vice-president of TowerGroups Securities and Investments division, in his November 2004 report Foreign

Exchange Trading: Evolving into a Mature Electronic Marketplace. Statistics from the latest BIS survey on foreign exchange and derivative market activity verified the expanding market and the impact of technological invest-

Single-dealer [forex] sites offer a richer experience than multi-dealer systems because dealers can more effectively control the environment from end to end and offer more services and access to all asset classes.
Robert Hegarty, TowerGroup

NYC Traders expo spotlights currency trading

he sixth annual Online Traders Expo in New York City attracted 5,987 attendees in February, 17 percent more than 2004, with over 115 companies participating. Although the conference encompassed all markets, forex was the focus of many presentations and seminars. On Feb. 15, Currency Trader hosted a panel consisting of Jes Black, Cornelius Luca, and Kathy Lien, who debated the dollars predicament, the forex market outlook for 2005, and currency trading approaches, among other topics. Black, partner and hedge fund manager at Black Flag Capital Partners, felt 2005 could be a banner year for currencies. The U.S. dollar, he believed despite the markets current bearishness is poised to surge, with its
16

gains coming at the expense of Asian currencies rather than the Euro and other European currencies. Lien and Luca were less bullish on the dollar, although Luca, author of Technical Analysis Applications in the Global Currency Markets and Trading in the Global Currency Markets, and a regular columnist for Global Forex Trading (GFT), said a near-term rally in the dollar was likely before it resumed its downtrend. Both Lien and Luca pointed to the tightening cycle of the Federal Reserve bank as a boon to the dollar, stating that the Fed is the only central bank in the midst of a tightening cycle at this point. (Lucas analysis can be found in the Currency Movers section of the February 2005 issue of Currency Trader). One aspect of the forex market this year raised by Lien, chief currency analyst at FXCM (www.fxcm.com), was

that money would continue to move out of so-called commodity currencies such as the Australian dollar, New Zealand dollar, and Canadian dollar, and into growth currencies, such as the Brazilian real and Russian ruble. Luca, however, cautioned that strong hands are now playing in these currencies, making them a bit riskier for the new investor.
March 2005 CURRENCY TRADER

ment. Hedge funds stepped up their FX participation, taking more aggressively speculative positions, contributing to a 58-percent growth in aggregate dollar volume from 2001 to 2004. Technology too played a major role in this growth, the ease with which investors can now transact via electronic platforms having drawn increased volumes, the report states. The customer is wielding a bigger stick and the brokers must respond.

The customer is always right

Single-dealer forex portals service high-end traders, such as hedge funds, as well as retail traders. Multi-bank sites, known for their dependability and liquidity, attract money managers who are required to obtain several

quotes before a single execution. While both types of portals have seen increased business in recent years, the report identifies a shift to single-dealer systems. The dealers drive for growth has translated into improved customer service capabilities and more complex marketing strategies, according to the report. Single-dealer sites offer a richer experience in this manner than do multi-dealer systems because dealers can more effectively control the environment from end to end and offer more services and access to all asset classes, Hegarty says in the report. The dealers proprietary sites offer them two services, post-trade processing and prime brokerage, that are of great value to them and are not avail-

able through other venues. Multi-dealer portals focused on overall improvements by adding products related to their basic quote and execution services. Even as institutional investor business picks up, the socalled improved technology will slow growth. They will need to get over the problem of lowest common denominator technology, Hegarty says in the report. That is, multi-dealer platforms can offer a quality of service equal only to that of the worst of the multibank participants. As a result, they cannot offer new and valuable services and technology as rapidly and effectively as the single-dealer systems.

Maturity shows volume gaps

Intershow announces 2005 forex conference

ntershow, the group that organizes the various Money Shows (www.moneyshow.com) and International Trader Expos (www.tradersexpo.com), announced it would hold a conference dedicated to forex trading later this year in Las Vegas. Over the past two years, weve really seen the demand for Forex educational conference sessions at Traders Expo increase, says Tim Bourquin, cofounder of the Expo shows. Attendees are looking for additional markets to trade when the stock market volatility is flat. Also, globalization of trade has brought currency fluctuations into mainstream business news, so I think traders are more in tune with the opportunities foreign exchange trading brings. There were more Forex-related exhibitors at the February TradersExpo show in New York than ever before, Bourquin says. Forex trading has grown to the point that a conference just focusing on that topic is warranted, he says. The Forex Trading Expo will be held Nov. 19-20, 2005 at the Mandalay Bay Hotel in Las Vegas. At this point, the show is expected to include approximately 30 exhibitors and 1,500 attendees. Intershow will launch a Web site with more information in the near future.

Increased electronic trading volume has further differentiated multi-dealer systems. Electronic trade volume in the FX market is at 44 percent and is predicted to increase to a peak rate of 74 percent in 2007, according to TowerGroup. The top four multi-dealer portals in terms of market share FX Connect, FXall, Currenex and HotspotFXi have not enjoyed comparable slices of volume. FXConnect and FXall share 86 percent of the multi-dealer trading volume, as both HotspotFXi and Currenex cater to smaller clients. Yet as a stand-alone system and with reduced dealer-owner investment, FXalls dominating position is not at all assured, according to the report. TowerGroup predicts Currenexs niche position will encourage a takeover, while FXall may lose all of its institutional and dealer support. While the FX market matures, the reliance on electronic platforms will grow deeper. Because clients gain little value from additional non-execution services offered by these systems, they will experience great difficulty in sustaining their profitable models, according to the report.
17

CURRENCY TRADER March 2005

THE BIG PICTURE

The technicals rule

When the fundamentals are foggy, technical factors can drive the market.

BY BARBARA ROCKEFELLER

T
18

20 points (.0020) from the precise theoretical Fibonacci 50-percent retracement level. (Technically, 50 percent is not a Fibonacci number, but never mind.) A 50-percent retracement of the move from the May 2004 low of 1.1760 to the December high of 1.3667 is 0.0954 points, which translates to a target of 1.2713 (see Figure 1). The dollar retracement stopped in early February at 1.2733 which was the low on both Feb. 7 and 8 or 0.15 percent from the 50-percent retracement level. Thats downright spooky, and almost certainly evidence of the grip technical ideas have on the FX market. fundamentals, the technical factors rule, or seem to. First there were a few big trading houses (such as UBS) saying just before year-end that the dollar would soon start to correct from the steep downtrend of the fourth quarter. Lo and behold, the retracement of the dol-

he market has been having trouble deciding whether the current account deficit is more powerfully dollar-negative than the rising interest rate environment is dollar-positive. The European-led current account gang believes the structural deficit is a far weightier issue than interest-rate differentials. In contrast, Japanese and other Asian traders are more concerned with higher rates, especially because Japan is in a technical recession and any monetary policy tightening there is postponed. So while traders slug it out over the

Unsolvable mysteries
Whats ruling the market the current account deficit or interest rate differentials? This question is unanswerable in practice or in theory, for that matter. Currencies can fall despite an interest-rate advantage, and currencies

Greenspan expressed a wish for the dollar to rise, and the market was willing to oblige.
lar downtrend started on the first trading day of the year. To cap that off, the Euro/U.S. dollar (EUR/USD) retracement ended only can rise despite a current-account disadvantage. These are both big environmental background factors that become immediate, tradable factors on
March 2005 CURRENCY TRADER

FIGURE 1 EURO RETRACEMENT

the whim of the trading community. The Euro/U.S. dollar retracement stopped in early February just 20 pips shy of a precise 50-percent retracement of the May-December rally. Whim sounds like a disparaging term, but its not meant to be. When Euro (EUR), 1.3055, 1.3055, 1.3055, 1.3055 1.37 Federal Reserve Chairman Alan 1.36 Greenspan told a conference in 1.35 London (the same day the G7 meeting 1.34 started in February) the current 1.33 account might soon improve because 1.32 of market forces and new budget 1.31 constraints, the market was willing to 1.30 38.2% buy dollars. (G7 is the "Group of 7" 1.29 countries, including the U.S., UK, 1.28 50.0% Japan, Germany, France, Italy, and 1.27 Canada, which meet twice a year to 1.26 talk about the global economy and 1.25 international financial system. 1.24 Recently Russia has been invited so 1.23 G7 is sometimes called G8.) But 1.22 Greenspan didnt go into detail about 1.21 those market forces except to say 1.20 1.19 exporters to the U.S. had to be feeling 1.18 a profit pinch, which is a weak argu1.17 ment. As for the connection between the current account deficit and the May June July Aug. Sept. Oct. Nov. Dec. 2005 Feb. Mar. budget deficit, it doesnt really exist, Source: eSignal as a study by the Fed itself had just shown the month before. FIGURE 2 THE OIL FACTOR The only reason for Greenspan Some analysts contend $8-12 of the recent price of oil is a premium for the inherent to make these remarks was to risks in the major producing countries. However, oil has been on a serious uptrend goose the dollar upward. for several years and there is no reason to expect these risks will disappear soon, Greenspan expressed a wish for or the price of oil will stabilize or fall. the dollar to rise, and the market was willing to oblige. Its imporLight Crude Oil (CL), 47.60, 48.50, 47.52, 48.35 tant to note the dollar was already 55 rising when he made the comments; he was talking with the wind, as the Japanese say. Its not 50 clear if Greenspans remarks could have stopped the dollar from sliding further had it already been 45 falling.

Productivity, the buck, and crude

Later in February Greenspan told Congress future monetary policy depends on three things: the trend in labor productivity, the level of the dollar, and the price of oil. All three are really proxies for future inflation. Rising productivity inhibits inflation, so when it decelerates, as it is now (productivity is up 4.1 percent at an annual rate as of Q4 2004, compared to
continued on p. 20

40

35

30

25 2003 M J J A S Source: eSignal O N D 2004 M A M J J A S O N D 2005

CURRENCY TRADER March 2005

19

THE BIG PICTURE continued

4.4 percent in both 2003 and 2002), Greenspan worries about inflation. A falling dollar automatically raises the prices of imported goods (at least from countries whose currencies float against the dollar), which is inflationary. The price of oil, of course, is a cointoss. Oil experts say $8-12 of the recent price of approximately $48 is a premium for the risks inherent in the major oil-producing countries, from Nigeria and Venezuela to Saudi Arabia and Iraq. Its unrealistic to expect those risks to subside, although on the demand side, the coming of spring is an ameliorating factor. But the important point is oil has been in a serious uptrend for several years now and theres no reason to think it will stabilize or fall (see Figure 2).

even briefly lower). This has narrowed the spread between the two-year note and the 10-year note to only 70 points or so, which is a historical aberration
FIGURE 3 SHOP TILL YOU DROP

Figure 2 shows what it looks like, courtesy of the St. Louis Fed. The index has been on a steady upward path. Should we deduce the Fed is scared, at least a

The personal expenditures index has been on a steady upward path, which might make the Fed nervous about inflation. But right now, the bond market doesnt show that concern.
Personal Consumption Expenditures: Chain-type Price Index (Index 2000=100) 110 108 106 104 102 100

The bond market conundrum

As it has been since last summer, the big issue of the day is still the mysterious refusal of the bond market to take the yield on the 10-year bond higher in lockstep with short-term interest rates. Since June 2004 the Fed has raised the Fed funds rate six times, from 2 percent to 3.5 percent, while the yield on the 10-year bond has fallen from 4.70 percent to about 4.2 percent (and

98 2000

2001

2002

2003

2004

2005

2005 Federal Reserve Bank of St. Louis (research.stlouisfed.org) Source: U.S. Department of Commerce, Bureau of Economic Analysis

what Greenspan calls a conundrum. We know Greenspan likes the personal consumption expenditure price index, which is really a GDP deflator.

Kaufman speaks about dollar

In an interview with The New York Times, economist Henry Kaufman ("Dr. Doom") had some important things to say about the dollar. He thinks China and Japan will not diversify away from the dollar because its selfdefeating if the dollar drops a lot, their "export drive" to the U.S. suffers. Meanwhile, the falling dollar has very little effect on exports because the U.S. cant compete with low labor-cost countries. It would take a huge dollar drop to get the desired effect, and thats not going to happen. "Today, there is an enormous international disequilibrium, Kaufman said. For the near term, it is in the best interest of all the participants to maintain it." This is the Golden Goose theory I wrote about in last month's article. As for a forecast, Kaufman sees "relative stability with occasionally a little bit of give in the value of the dollar." In other words, flat to down but not up. Barbara Rockefeller Click here for The New York Times article: The Alpha Currency? It's Still the Dollar, by William J. Holstein, Feb. 27, 2005.

little, about inflation? Well, thats its job. But if so, why does the bond market not share that concern? Commentators say the Fed has done its job too well, and the bond market believes the Bank will succeed in holding inflation down, so there is no need for long-term rates to rise. Others point out that when supply is relatively fixed and demand rises, prices rise which in the case of bonds means the yield falls. Because foreigners as well as domestic buyers have not shown any loss of appetite for U.S. paper, the drop in the 10-year yields is no surprise. In fact, its a desirable outcome, because last November Greenspan fretted about foreigners losing their appetite. This concern came in the aftermath of a comment from San Francisco Fed president Janet Yellen that so much foreign demand for U.S. paper was hindering the Feds desire to get longer rates up, too. FX traders took each comment to mean the Fed wanted the dollar to fall, although subMarch 2005 CURRENCY TRADER

20

FIGURE 4 DOUBLE-TOP SCENARIO

sequent reports from the U.S. One of several possible outcomes in the Euro is a double-top, which would mark the dollar Treasury did not validate any rising/Euro falling if the interest-rate differential between them were to get big enough. such loss of appetite. Euro (EUR), 1.3055, 1.3055, 1.3055, 1.3055 In November the month 1.38 in which the dollar lost almost 1.37 5 cents against the Euro for1.36 eigners bought a net $89.3 bil1.35 lion in U.S. securities of all 1.34 types; in December, they 1.33 bought an additional $61.3 bil1.32 lion. Net portfolio flows into 1.31 the U.S. averaged $68.5 billion 1.30 per month in 2004, compared 1.29 to $57.0 billion in 2003 and 1.28 $47.9 billion in 2002. For the year 2004, the inflow of portfo1.27 lio investment into the U.S. was 1.26 a total of $821.8 billion, or a 20 1.25 percent increase from $683.6 1.24 billion in 2003 and a 43 percent 1.23 rise over $574.6 billion in 2002. 1.22 The 2004 inflow of $821.8 1.21 billion is plenty to cover the current account deficit, which Sept. Oct. Nov. Dec. 2005 Feb. Mar. Apr. May June Source: eSignal was running at an annual rate of $658.8 billion as of the end Bund, as is the case today. Therefore, ance sheets and used the proceeds of of Q3. In fact, the only worrisome thing we probably dont have to worry mortgage refinancing to pay down about the Treasury flow report was the much about capital flows in the com- high-cost credit card debt, at some outflow of capital from the U.S., pre- ing months, which should be dollar- point rising rates at the long end of the sumably from U.S. citizens who favorable. But now we run into two yield curve will reduce the number of expected better returns abroad kinks in the forecast, the first from the refinancings. Surely the Fed considers (including a currency effect). U.S. Fed and the second from the technical- this dynamic in its plans, and some economists think that instead of getinvestors bought a net $15.4 billion in ly-driven FX market. foreign equities in December, almost double the amount in November ($8.5 billion), and the most since 2000. They also went long foreign bonds. To a certain extent, this reveals U.S. investors are free to choose foreign securities but at least some foreign investors in the U.S. are here involuntarily because management rules dictate a certain percentage of money must be invested according to market size.

The dollar could move sideways if many traders think the interest-rate buffer is only a finger in the dike; for them to accept a lasting dollar improvement, the current account does, indeed, have to fall.

Kinks in the road

Its only logical to assume if foreign investors are willing to place a large amount of their capital in the U.S. in a low-rate environment, they will allocate even more to the U.S. when the yield curve finally catches up and the 10-year bond delivers more than 50-70 points over the equivalent German
CURRENCY TRADER March 2005

Much of what drives the U.S. economy is the consumer, and a lot of what has been driving consumers over the past few years is the ability to refinance their main asset their home to get more money for consumption. While it is no doubt true many households have cleaned up their bal-

ting a bigger rate increase in coming months (which would be signaled by the FOMC dropping the measured move phrasing), we will get a pause in rate hikes. In fact, some members of the bond fraternity may be counting on it.
continued on p. 22

21

THE BIG PICTURE continued

A pause is bad for the dollar, because now the market has built in Fed rate hikes every period. If the dollar is falling and the Fed stops raising rates, its a dollar negative, so the dollar will fall more. If the dollar is rising and the Fed pauses in raising rates, the dollar will stop rising and could even fall. If the dollar is rising and the Fed pauses in hiking rates, the dollar stops rising.

What does Mr. Greenspan want?

The Fed chairman is resolutely antiinflation and his credentials are as high as anyones have ever been.

because European traders still believe the structural deficit is some kind of absolute no other factor can override. This is not true. There are very few absolutes in economics and almost none in trading.) Will this approach work? Yes, probably. There is likely some interest-rate level that will halt the Euros rise. Its possible to imagine a double-top, for example, that would mark the dollar rising/Euro falling when the interest rate differential gets big enough (see Figure 4). This is only one of several possible outcomes, and it assumes the Fed gets its way. Alternately, there could be sideways movement if a large

In a technically-driven market, traders interpret the news whatever way is most convenient for their positions.
While the high-falutin talk about normalizing rates is quite convincing, Greenspan is also a pragmatist, and his job is to prevent inflation from getting a toehold rather than satisfying some academic market model. The Fed cant do anything about productivity or the price of oil, but it can do something about the dollar. Greenspan cant possibly want the dollar to fall, which makes his loss of appetite remarks last fall all the more curious. However, it looks like traders are buying the 50-percent trading rule, and the Euro will now return to the level of last December (above 1.3600), and perhaps beyond. But this is probably not what the Fed wants. Its likely well hear more inflation warnings from the Fed, which will be aimed at controlling inflation but also at prompting the bond market to raise the yield on the 10-year note to get it more in line with the recent rate hikes in the Fed funds rate. The U.S. is already attracting enough capital, but a more substantial differential ensures a bigger buffer against a dollar crash. (It needs to be a hefty buffer, too,
22

number of traders think the interestrate buffer is only a finger in the dike; for them to accept a lasting dollar improvement, the current account does, indeed, have to fall. In a technically-driven market, traders interpret the news whatever way is most convenient for their positions. When they are feeling a negative-dollar bias, news that is truly dollar negative, such as foreign central banks diversifying out of dollars, is exaggerated. In practice, diversification is a minor factor only a few billion dollars against a market that trades more than $1.3 trillion per day. But the public relations effect is huge, and the technicals set up a random factor such as that to have a big effect.

obscure meaning for the economic outlook we all got wrong, anyway. The jobless recovery was supposed to deliver a recession, but the canny Fed kept rates low and fueled a consumer boom via home refinancings instead. Now we have to watch the unforcastable Greenspan, who makes ambiguous comments in the name of central bank transparency and dances every noun around the room six times before he gets to the end of the sentence. This is just another example of the perversity of the FX market. Of the thousand variables that can effect exchange rates, it chooses the strangest and most difficult payrolls. As far as the upcoming month goes, its the silly season. We often get a sea-change in February-March, including vast confusion over whether the yen always rises because of repatriation of foreign profits (answer: sometimes it does, but not reliably enough to trade on). This time, it looks like the technicals are ruling, at least until a compelling event related to the current account or interest rates comes along.
For information on the author see p. 8.

Related reading
Other Currency Trader articles by Barbara Rockefeller: Combining fundamentals and technicals in FX trading, October 2004. The obscure key to successful FX trading, November 2004. The great global imbalance hoax, December 2004. Trends, retracements and news in foreign exchange, January 2005. The Golden Goose Rule, February 2005.

And the winner is

This month, bet on the technicals, even though the current trend being formed is contrary to what the institutional picture seems to be a Fed determined not to have the dollar fall, or not having it fall too much. We used to have to watch the unforecastable payrolls report, with an

March 2005 CURRENCY TRADER

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CURRENCY STRATEGIES

Spike-low bottoms
Historical testing of a one-bar price pattern reveals a useful confirmation signal the day after the pattern. Find out the probabilities of catching a reversal.
BY CURRENCY TRADER STAFF

owhere is the adage Yes, several worthwhile entry points cific patterns and market conditions, If it looks too good to are identified, but so are many more etc. Unfortunately, this often results in be true, it probably is useless signals. developing trade ideas that have no more applicable than However, this doesnt mean the basis in logic or reality they are simin trading. Promises of 90-percent win original pattern concept cannot identi- ply coincidences that computing rates and easy millions are marketing fy useful trade points or be used as the power has tricked us into thinking hype aimed at the unwary masses. basis of a trading strategy. Perhaps it have significance. This is what moneyAny trader who has spent enough simply means theres more work to be manager Nassim Taleb referred to as time in the markets to develop suc- done. being fooled by randomness. cessful trading techniques knows how To avoid this problem, its helpful to rare viable ideas are for every useful What are we trying to exploit? first define the type of price behavior methodology, 10 (or 20, etc.) others Analysis software makes it easy (too youre trying to capture and determine have likely been consigned to the dust- easy, some might argue) to crunch whether the trade premise it implies bin of history. numbers a million different ways makes sense. In this case, what initialPrice chart analysis can be particu- optimize trade signals, find very spe- ly grabbed our attention were the price larly deceptive. The human eye is hardwired to see what it wants to FIGURE 1 FIRST IMPRESSIONS see namely, profitable trade Visual chart analysis is risky because our eyes are drawn to retrospective opportunities that are usually trade "opportunities" and tend to overlook risks and other flaws. obvious only in retrospect and overlook pitfalls. Its only when a 0.80 Australian dollar/U.S. dollar (AUD/USD), daily price pattern is quantified and tested that its warts become apparent. 0.79 For example, looking at Figure 1 0.78 might lead you to believe that selling on the close of bars with highs 0.77 noticeably higher than the immedi0.76 ately preceding highs and buying 0.75 on the close of bars with lows noticeably lower than the immedi0.74 ately preceding lows would be a 0.73 good entry technique. Actually defining noticeably 0.72 higher/lower casts an unfavor0.71 able light on this trade premise. Figure 2 shows what happens if we 0.70 define noticeably higher or lower 0.69 as a high 32 pips above the previ0.68 ous high or a low 33 pips below the previous low which are the March April May smallest respective differences of Source: TradeStation the selected bars from Figure 1.
24 March 2005 CURRENCY TRADER

reversals, which we noticed were often preceded by bars that had spiked significantly higher or lower than their preceding bars. Its not difficult to understand what this behavior represents and whether its a logical trade idea. It makes sense that a price move might be capped by a strong thrust that would overextend or exhaust the market just before it changed direction. This means what we are trying to exploit is price exhaustion. What we need to do is define and test price spikes to determine if they are advantageous reversal signals.

FIGURE 2 THE TRUTH OF THE MATTER Using specific criteria to define bars with highs and lows that are "noticeably" higher than the preceding bars identifies a few useful trade opportunities but far more meaningless signals.
Australian dollar/U.S. dollar (AUD/USD), daily 0.80 0.79 0.78 0.77 0.76 0.75 0.74 0.73 0.72 0.71 0.70 0.69 0.68 March Source: TradeStation April May

Defining the pattern

The strategy outlined here attempts to identify bottoms (and buying points) using a specific definition of a spikelow bar. Figure 3 shows an example the Australian dollar/U.S. dollar rate (AUD/USD). After making lower highs, lower lows and lower closes for several days, AUD/USD fell sharply during the Feb. 8 trading session, only to rally intraday and close very near the high of the day (using 5 p.m. as the close of the session). Lets first consider the broader market conditions: AUD/USD had been consolidating since late-November 2004 after a huge rally that started in September. The market had made higher lows on Dec. 10, 2004 and Jan. 8, 2005 and lower highs on Dec. 21 and Jan. 28, as price kept swinging in an increasingly tight range. Chartists noticing this price behavior would likely be inclined to speculate whether the Feb. 8 low was going to mark another higher low in this consolidation. (See the Forex Diary in the February issue of Currency Trader to read about a trade related to this consolidation.) Now lets look at the price spike itself. We compared it to similar bars to see if there were any common characteristics that separated bars that
continued on p. 26

FIGURE 3 SPIKE-LOW DAYS The marked bars met specific criteria for declining a certain amount below the previous bar but reversing intraday to close high within the daily range. These "spike-low" bars will form the basis of a trading strategy that attempts to catch bottoms in the AUD/USD rate.
Australian dollar/U.S. dollar (AUD/USD), daily 0.79 0.78 0.77 0.76 0.75 0.74 0.73 0.72 0.71 0.70 0.69 0.68
July Aug. Sept. Oct. Nov. Dec. 2005 Feb.

Source: TradeStation

CURRENCY TRADER March 2005

25

CURRENCY STRATEGIES continued

TABLE 1 SPIKE-LOW BAR STATISTICS Days 1 through 4 showed the most potential for positive moves; days 5 through 8 had a mildly negative bias.

Avg. Med. Max. Min. %>0 Avg. Med. Max. Min. Avg. Med. Max. Min. Avg. Med. Max. Min.

Day 1 0.20% 0.03% 3.19% -1.13% 52.00% D6 -0.25% -0.50% 3.26% -2.72% D11 0.25% 0.47% 6.45% -5.11% D16 0.88% 0.58% 9.91% -5.85%

LUM 0.74% 0.53% 4.50% 0.00% LUM 1.61% 1.21% 5.99% 0.01% LUM 2.20% 1.54% 7.54% 0.20% LUM 2.93% 1.88% 10.32% 0.30%

LDM D2 -0.51% 0.14% -0.34% 0.04% 0.00% 2.70% -1.76% -2.19% 52.00%

LUM 1.04% 0.78% 4.50% 0.01%

LDM -0.73% -0.65% 0.00% -2.29% LDM -1.79% -1.73% -0.14% -4.48% LDM -2.32% -1.84% -0.14% -7.96% LDM -2.63% -2.16% -0.14% -7.96%

D3 0.32% 0.19% 3.49% -1.38% 56.00% D8 -0.15% -0.29% 3.94% -3.33% D13 0.54% 0.73% 7.85% -5.12% D18 0.70% 0.83% 8.57% -6.44%

LUM 1.17% 0.99% 5.99% 0.01% LUM 1.76% 1.38% 5.99% 0.19% LUM 2.47% 1.84% 8.17% 0.30% LUM 3.02% 1.88% 10.46% 0.30%

LDM -0.88% -0.88% 0.00% -2.88% LDM -1.82% -1.73% -0.14% -4.48% LDM -2.39% -1.96% -0.14% -7.96% LDM -2.72% -2.35% -0.14% -7.96%

D4 0.24% 0.22% 2.92% -2.86% 64.00% D9 0.05% 0.17% 4.03% -5.33% D14 0.67% 1.09% 7.79% -4.87% D19 0.73% 1.52% 8.62% -5.32%

LUM 1.42% 1.21% 5.99% 0.01% LUM 1.83% 1.39% 5.99% 0.19% LUM 2.57% 1.88% 8.31% 0.30% LUM 3.08% 2.11% 10.46% 0.30%

LDM D5 LUM LDM -1.03% -0.03% 1.55% -1.26% -0.88% -0.14% 1.21% -0.88% 0.00% 3.25% 5.99% -0.14% -3.04% -3.88% 0.01% -4.48% 44.00% LDM D10 LUM LDM -1.94% 0.16% 2.09% -2.35% -1.73% -0.44% 1.54% -1.96% -0.14% 6.71% 7.30% -0.67% -5.83% -6.60% 0.19% -7.96% LDM D15 -2.44% 0.78% -1.96% 1.09% -0.14% 9.19% -7.96% -6.28% LDM D20 -2.79% 1.02% -2.35% 1.46% -0.14% 7.93% -7.96% -5.23% LUM 2.73% 1.88% 9.69% 0.30% LUM 3.26% 2.58% 10.46% 0.30% LDM -2.50% -1.96% -0.14% -7.96% LDM -2.86% -2.35% -0.14% -7.96%

LDM D7 LUM -1.48% -0.33% 1.73% -1.21% -0.07% 1.35% -0.14% 4.34% 5.99% -4.48% -3.54% 0.19% LDM D12 -2.23% 0.09% -1.84% 0.04% -0.14% 5.64% -7.96% -5.32% LDM D17 -2.54% 0.70% -1.96% 0.50% -0.14% 9.17% -7.96% -6.68% LUM 2.32% 1.64% 7.54% 0.30% LUM 2.98% 1.88% 10.46% 0.30%

preceded reversals or corrections from those that did not. We used the following definition for the pattern: 1. Todays low must be at least 25 pips lower than the previous low. 2. Todays low must be lower than the previous 10 lows. 3. Todays close must be in the top 25 percent of the bars range. This definition attempts to capture specific price behavior. First, the bars low must not only be lower than the preceding bar by a certain amount, it must also be lower than the previous 10 lows. This ensures the market has been declining before the spike-low bar, which increases the potential for a bottom to form. If we used only the first criterion, the bar could simply be a one-day aberration in a series of uptrending bars. Second, the high close indicates buyers came in and dominated trading in a bearish environment not necessarily a guarantee
26

of a reversal, but a sign conditions for one could be developing. We initially used more rigid pattern criteria, but found too few past examples in the analysis period of January 1998 to February 2005. If you can only find a handful of similar patterns, you have two strikes against you: You cant be as confident in the conclusions you draw from the pattern than you could if you had many examples, and even if the pattern was reliable, it doesnt provide many trade opportunities. Table 1 shows the average and median returns based on entering on the close of the bars that satisfied these criteria (25 bars total) and exiting on the closes of each of the following 20 days. Also shown are the largest intraday up moves and down moves (LUM and LDM, respectively) that occurred at each interval, which show how much potential profit and risk existed. Finally, the percentage of positive returns (% > 0) are shown for days 1 through 10. For example, the average move from

the close of the spike-low bar to the subsequent close (day 1) was .20 percent; the median move was .03 percent. The maximum positive close-toclose move was 3.19 percent and the maximum negative close-to-close move was -1.13 percent. The average largest up move from the close of the spike-low bar to day 1s high was .74 percent, while the average largest down move from the close to day 1s low was -.53 percent. The single largest close-to-high move was 4.5 percent and the largest close-to-low move was -1.76 percent. Day 1s close was higher 52 percent of the time. One of the most obvious aspects of Table 1 is the general tendency for gains in days 1 through 4 (both the average and median returns for each day are positive, and the winning percentages climb from a low of 52 to 64 percent) followed by losses in days 5 through 8. Although the probable gains implied by the average and median figures are
March 2005 CURRENCY TRADER

not particularly large (assuming we would not be lucky enough to sell at the absolute highs), they still point to the potential for the market to move higher after spike-low bars.

Following up on follow through

One way to approach this information would be to simply construct a trading strategy that went long on the close of qualifying spike-low bars. The statistics regarding the close-to-close moves and intraday maximum up and down moves could be used to set logical stop-loss and exit levels.

day 1 closed lower, AUD/USD tended to continue to lose ground. This simple observation that the direction of the close on day 1 provides an indication of the continued success of the pattern can be used a simple filter. Table 2 shows the statistics for days 1 through 10 when day 1 closed higher than the entry day. Days 2 through 6 had larger gains and higher probabilities of gains than the same days in Table 1. Also, the typical largest down moves are smaller, which means in these instances the potential reward is greater and the potential risk is reduced. As a result, a lower close on

median value was -.29 percent. The following rules incorporate this new information to establish appropriate stop-loss and profit-target levels: 1. Go long on the close of a spikelow day. 2. Exit with a loss if day 1 closes below the entry price. 3. Exit with a profit if price rallies by 1.7 percent. (This number is just below the more conservative median figure, which is used to improve the odds of success.) 4. Exit any trade that is still open by the close of day 4.

TABLE 2 WHEN DAY 2 CLOSES HIGHER Of the 25 trades included in Table 1, 13 closed higher the day after entry (Day 1). The upside tendency through day four shown in Table 1 is even more pronounced here.

Avg. Med. Max. Min. %>0

Day 1 0.76% 0.53% 3.19% 0.03% 100.00% D6 0.51% -0.06% 3.26% -1.64%

LUM 1.16% 0.71% 4.50% 0.32%

LDM D2 -0.21% 0.69% -0.20% 0.68% 0.00% 2.70% -0.59% -0.55% 84.62% LDM D7 -0.77% 0.58% -0.65% 0.20% -0.14% 4.34% -1.96% -2.67%

LUM 1.58% 1.44% 4.50% 0.46%

LDM -0.34% -0.20% 0.00% -0.99%

D3 0.79% 0.69% 3.49% -0.94% 76.92% D8 0.58% 0.35% 3.94% -1.61%

LUM 1.72% 1.44% 5.99% 0.48%

LDM -0.46% -0.28% 0.00% -1.29%

D4 1.03% 1.13% 2.92% -0.60% 84.62% D9 0.88% 0.43% 4.03% -1.32%

LUM 2.04% 1.73% 5.99% 0.73%

LDM D5 -0.49% 0.82% -0.29% 1.07% 0.00% 3.25% -1.29% -1.37% 53.85% LDM D10 -1.06% 1.48% -0.65% 0.84% -0.14% 6.71% -3.28% -2.18%

LUM 2.21% 1.73% 5.99% 0.73%

LDM -0.61% -0.59% -0.14% -1.77%

Avg. Med. Max. Min.

LUM 2.29% 1.73% 5.99% 0.73%

LUM 2.42% 1.73% 5.99% 0.73%

LDM -0.99% -0.65% -0.14% -3.28%

LUM 2.45% 1.73% 5.99% 0.73%

LDM -1.00% -0.65% -0.14% -3.28%

LUM 2.50% 1.73% 5.99% 0.73%

LUM 2.93% 1.73% 7.30% 0.85%

LDM -1.56% -1.38% -0.67% -3.28%

For example, from days 1 through 4, the average largest up move was 1.42 percent and the average largest down move was -1.03 percent. The LUM number could be used as a profit target and the LDM number could be used as the initial stop-loss. (A more conservative approach would be to use the smaller median LUM of 1.21 percent.) However, a closer look at the performance statistics suggests a way to isolate better trade opportunities and design an improved trade strategy. When day 1 closed higher than the entry day, the gains were more likely to persist over subsequent days. When
CURRENCY TRADER March 2005

day 1 can be used as an initial stop: Hold only those positions that close higher on day 1. The table also shows both the typical gain and the odds of a gain decrease on day 5. Also, day 6 has a negative median close-to-close move (-.06 percent), even though the average gain is positive (.51 percent) a sign of instability. It still seems as if the best combination of largest typical move and odds of success are greatest in days 2 through 4. On day 4, the average LUM was 2.04 percent and the median LUM was 1.73 percent. The average LDM was -.49 percent and the

Applying these rules to the 25 original spike-low pattern examples resulted in 12 trades being stopped out on day 1 for a total loss of 486 pips ($4,860.00). Of the 13 remaining trades, seven hit the 1.7 percent profit target, four were exited on the close of day four with smaller profits, and two were exited on the close of day 4 with losses. The total profit was 1303 pips ($13,030.00), for a net profit of $13,030.00 - $4,860.00 = $8,150. The rules obviously leave room for modification. Figure 4 sorts the day 4 LUMs and shows that 7 of 13, or 54
continued on p. 28

27

CURRENCY STRATEGIES continued

percent, were 1.73 percent or larger. However, 9 of 13, or 69 percent, were 1.54 percent or larger, which means the strategys winning percentage could be increased by accepting a more modest profit target. (Notice also that only four of the signals produced LUMs above 2.04 percent, which was the average LUM by day 4.) This type of analysis can be used to gauge the likelihood the strategy will reach different profit targets on different days and adjusting a position as necessary. Finally, another worthwhile idea to explore is whether the profit target actually helps the system, or whether an alternate approach say, a trailing stop would give the strategy more of an opportunity to capitalize on the large moves that can occur from time to time. This months Forex Trade Diary describes a trade based on this strategy.

FIGURE 4 LARGEST UP MOVES BY DAY 4 Of the 13 trades that satisfied the criterion of closing higher the day after entry, nine produced up moves larger than 1.5 percent by day 4. There was one exceptionally large trade (5.99 percent).
Largest up moves (LUM) by day 4 7% 6% 5% 4% 3.25% 3% 2% 1% 0.00 1 2 3 4 5 6 7 8 Largest up moves 9 10 11 12 13 .73% .85% 1.19% 1.21% 1.89% 1.54% 1.64% 1.73% 2.02% 2.12% 2.34% 5.99%

Source: TradeStation

HIT YOUR MARK!

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28

March 2005 CURRENCY TRADER

GLOBAL GLOBAL ECONOMIC ECONOMIC CALENDAR CALENDAR

Monday Monday Tuesday Tuesday Wednesday Wednesday Thursday Thursday Friday Friday

MARCH MONTH
Saturday Saturday

1
U.S.: ISM report on business Australia: Index of commodity prices Japan: Account balances Germany: Employment

2
Japan: Monetary base Germany: Retail turnover

3
ECB: Governing council meeting Germany: Production index

4
U.S.: Employment report Germany: Orders received and manufacturing turnover

7
Australia: Official reserve assets

9
Great Britain: Monetary Policy Committee meeting

10
U.S.: Wholesale inventories Great Britain: Monetary Policy Committee meeting Japan: Corporate goods price index Germany: Foreign trade

11
U.S.: Trade balance

12

14
Great Britain: PPI Japan: Balance of payments; Monetary survey Italy: Balance of payments

15
U.S.: Retail sales Canada: Manufacturing survey Germany: CPI

16
Great Britain: Employment

17
U.S.: Leading indicators ECB: Governing council and general council meeting

18
Great Britain: Capital issues Germany: PPI; Bankruptcies

19

21
Canada: Wholesale trade

22
U.S.: PPI for March; FOMC meeting Great Britain: CPI Canada: Retail trade

23
U.S.: CPI Great Britain: GDP; Balance of payments Canada: CPI; Leading indicators

24
U.S.: Durable goods Great Britain: Productivity

25
Japan: Corporate service price index

26

27

28

29
Canada: Employment

30
U.S.: GDP

31
Canada: GDP Germany: Employment Australia: International reserves and foreign currency liquidity Italy: International reserves and foreign currency liquidity

Legend
CPI: Consumer Price Index ECB: European Central Bank FOMC: Federal Open Market Committee GDP: Gross Domestic Product ISM: Institute for Supply Management PPI: Producer Price Index

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

March 2005 CURRENCY TRADER

29

CURRENCY CHARACTERISTICS

The international trade report and the U.S. dollar

Many economists point to a connection between the widening U.S. trade deficit and the U.S. dollars three-year slump. This short-term view analyzes how the greenback performs around the monthly trade balance report.
BY DAVID BUKEY

any economists argue es on the dollars short-term patterns 12, 2005, examining the differences the U.S. current ac- surrounding the monthly Inter- between increasing and dropping count balance and national Trade in Goods and Services trade deficits as well as the reaction to budget shortfalls report. We measured the dollars per- larger- and smaller-than-expected the twin deficits are the main cul- formance before and after 100 releases trade gaps. prits behind the U.S. dollars three- of the report from Oct. 18, 1996 to Jan. Last month, we analyzed the dolyear decline. The U.S. trade imbalance, or the gap between FIGURE 1 TRADE BALANCE VS. DOLLAR the countrys imports and The U.S. has run a trade deficit since 1976, but the gap didn't widen beyond $200 billion exports, is a critical compountil 1999. Although there is no solid link between the trade balance and the dollar, the nent of the broader current greenback's two steep declines have occurred as this gap hit historical levels (1984 to account balance and has bal1987 and 2001 to 2004). looned to historic levels since 1998. Annual U.S. trade balance Annual U.S. trade balance (in billions, left scale) vs. U.S. dollar major currencies index Theres virtually no doubt Nominal U.S. dollar major currencies index (1973-2004) (right scale) that the U.S. cant continue to import hundreds of billions of 140 dollars more than it exports $0 each year without further 130 weakening the buck. How-$100 ever, solutions are tricky 120 because the dollars value is -$200 part of the problem: A stronger dollar can fuel the 110 -$300 trade deficit because imports become cheaper for U.S. con100 -$400 sumers while exports become more expensive. Similarly, a 90 -$500 weaker dollar can potentially reduce the trade gap by 80 -$600 increasing the cost of imports and slashing U.S. export prices. Source: Bureau of Economic Analysis, Federal Reserve *January through November only The following study focusNominal U.S. dollar major currencies index Annual U.S. trade balance (in billions) 30 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004* March 2005 CURRENCY TRADER

FIGURE 2 DOLLAR INDEX PERFORMANCE: NYBOT FUTURES VS. FED INDEX

lars historical reaction to the current account balance report and discovered that it tended to fall after these announcements regardless of their content (see Related reading). Although both reports have similar content, the Commerce Department releases trade balance data each month, while the current account report is published only once each quarter. Traders generally view the trade balance report as more relevant, which may explain why we found the dollar behaved much differently around its release than around current account reports. For a detailed explanation of the international trade report and how it differs from the current account report, see Measuring the U.S. trade deficit.
continued on p. 32

Both indices have moved roughly in line with each other, although there are some notable differences. Overall, the dollar lacks a clear pattern before or after trade balance reports, but it tends to head higher in the second and third days after the number is released.
U.S. dollar index performance around trade balance reports (1996 to 2005) 0.15 NYBOT U.S. dollar index futures contract Average gain/loss (%) 0.10 Fed nominal U.S. dollar major currencies

0.05

0.00

-0.05

-0.10

Day Day Day Day Day Day Day Day Day Day Day Day Day Day Day Day Day -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 Days before and after announcement (Day 0)

Source: Bureau of Economic Analysis, NYBOT, and Federal Reserve

TABLE 1 TRADE BALANCE REPORT ANALYSIS The lower three sections break out trade reports into categories: increasing deficits, decreasing deficits, and no change. Although the dollar lacked a clear pattern prior to these announcements, it welcomed news of a narrowing trade gap.

Close Day location -8

Day -7

Day -6

Day -5
-0.07% -0.03% 46.00% 0.57% -0.06% 0.01% 50.00% 0.57% -0.07% -0.08% 41.46% 0.59%

Day -4
0.01% 0.04% 55.00% 0.47% 0.03% 0.07% 58.62% 0.49% -0.01% 0.03% 51.22% 0.44%

Day -3

Day -2

Day -1
0.01% 0.06% 59.00% 0.44% -0.04% 0.02% 53.45% 0.40% 0.06% 0.07% 65.85% 0.50%

Day 0
0.01% 0.07% 53.00% 0.50% -0.03% 0.05% 51.72% 0.51% 0.08% 0.12% 56.10% 0.48%

Day 1

Day 2

Day 3

Day 4

Day 5
0.01% 0.00% 49.00% 0.49% -0.06% -0.05% 44.83% 0.47% 0.13% 0.03% 56.10% 0.49%

Day 6

Day 7

Day 8

Overall (100 instances) Avg: 51.18 0.00%* 0.03% -0.01% Med: 53.54 0.03% 0.00% -0.01% Pct. > 0: 50.51% 49.49% 48.00% Standard deviation: 0.53% 0.53% 0.50% U.S. trade deficit increases (58 instances) Avg: 50.15 -0.03% 0.05% 0.03% Med: 52.23 -0.02% 0.01% 0.07% Pct. > 0: 49.12% 52.63% 53.45% Standard deviation: 0.53% 0.45% 0.52% U.S. trade deficit decreases (41 instances) Avg: 53.68 0.04% 0.03% -0.06% Med: 55.88 0.11% -0.01% -0.08% Pct. > 0: 51.22% 46.34% 41.46% Standard deviation: 0.54% 0.60% 0.47% Same as prior month (1 instance)
8.51

0.06% -0.04% 0.06% 0.00%* 56.00% 50.00% 0.52% 0.49% 0.06% -0.01% 0.07% 0.01% 58.62% 51.72% 0.49% 0.46% 0.04% -0.08% 0.03% -0.08% 51.22% 46.34% 0.54% 0.54%

-0.04% 0.11% -0.03% 0.07% 47.00% 53.00% 0.49% 0.56% -0.04% 0.12% -0.03% 0.05% 48.28% 51.72% 0.47% 0.56% -0.04% 0.07% -0.03% 0.07% 46.34% 53.66% 0.53% 0.56%

0.08% -0.04% 0.06% -0.06% 58.00% 42.00% 0.51% 0.53% 0.01% -0.02% 0.04% -0.09% 53.45% 43.10% 0.53% 0.55% 0.17% -0.07% 0.16% -0.06% 63.41% 39.02% 0.47% 0.52%

0.07% -0.08% -0.03% 0.12% -0.08% -0.03% 60.00% 42.42% 44.44% 0.50% 0.52% 0.49% 0.10% -0.03% -0.01% 0.15% -0.02% -0.02% 60.34% 44.83% 48.28% 0.52% 0.51% 0.45% 0.04% -0.16% -0.07% 0.11% -0.23% -0.05% 60.98% 37.50% 37.50% 0.46% 0.53% 0.56% 0.56% 0.19%

0.45% -1.31% 0.00% -0.18% -0.57% 1.10% 0.10% 0.63% -0.32% -0.15% 0.52% 0.10% 0.04% -0.51% -0.22%

*Greater than zero, but less than 0.01 percent Source: Bureau of Economic Analysis and NYBOT

CURRENCY TRADER March 2005

31

CURRENCY CHARACTERISTICS continued

FIGURE 3 TRADE DEFICIT INCREASES VS. DECREASES The dollar performed better on four of the six days following smaller deficits (including announcement day) than after larger ones.
U.S. dollar index futures performance surrounding U.S. trade balance reports (1996 to 2005) .20 .15 .10 Average gain/loss (%) .05 .00 -.05 -.10 Increasing trade deficit -.15 -.20 Dropping trade deficit Day Day Day Day Day Day Day Day Day Day Day Day Day Day Day Day Day -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 Days before and after announcement (Day 0)

to 1987 and 1998 to 2004. Although it is obvious the dollar suffered its worst declines after the trade deficit had widened to historic levels (i.e., 1984 to 1987 and 2002 to 2004), the connection between the trade gap and the dollar isnt cut and dried. For example, the dollar rallied 13.83 percent from 1999 to 2001 despite an increasing deficit, which rose nearly $100 billion during that period.

Short-term patterns: Oct. 1996 to Jan. 2005

We analyzed the S&P 500s reaction to 100 trade balance reports from October 1996 to January 2005, using the actual reported trade deficit and ignoring the Commerce Departments subsequent revisions. However, we used the priormonths revised value to measure the month-to-month trade changes in the deficit. The trade gap increased 58 times, dropped 41 times and was unchanged once during the analysis period. To discover how the dollar fared before the announcements, we calculated its gain or loss on each of the eight days prior to each release. We then measured the dollars performance on report day (Day 0) and the eight days following. Our study used both the Feds nominal U.S. dollar major currencies index and the New York Board of Trades (NYBOT) U.S. dollar continuous futures contract (DX) to measure the dollars daily performance surrounding monthly trade reports. Although these instruments didnt move exactly in line with each other because of different weighting methods, the differences were fairly small. Figure 2 compares the Fed indexs average daily performance to that of the NYBOT futures on the 17 days surrounding trade deficit announcements. The indices gained or lost ground together on all but two of those days. Both indices average daily gains and losses are quite small (0.12 percent
March 2005 CURRENCY TRADER

Source: Bureau of Economic Analysis and NYBOT

The long-term view

Figure 1 compares the annual trade balance to the Federal Reserves nominal U.S. dollar major currencies index

over the past 32 years (1973 through 2004). The current trade-gap era began all the way back in 1976, but it hit alltime highs during two periods 1983

FIGURE 4 STRONG VS. WEAK CLOSES The dollar tended to reverse direction after closing within the upper or lower 20 percent of its daily range on announcement day. The greenback fell an average 0.13 percent on the day following a strong close before climbing 0.06 percent the next day. Similarly, the dollar rose 0.23 percent in the first two days after a weak close and then gained ground during four of the six following days.
.6 .4 Average gain/loss (%) .2 .0 -.2 -.4 -.6 U.S. dollar index performance around U.S. trade balance reports (1996 to 2005) Strong close Weak close

Day 0

Day 1

Day 2

Day 3 Day 4 Day 5 Day 6 Days after announcement (Day 0)

Day 7

Day 8

Source: Bureau of Economic Analysis, NYBOT and Federal Reserve

32

Measuring the U.S. trade deficit

or less), and they lack a clear pattern. The buck traded sideways before and after trade balance announcements and didnt move in one direction for more than two consecutive days. However, the dollar edged at least 0.11 percent higher on the second day after trade reports a small gain, but worth mentioning since the dollars daily benchmark, or typical one-day move over the past nine years, was flat. he U.S. Commerce Departments Census Bureau and its Bureau of Economic Analysis (BEA) jointly release the International Trade in Goods and Services report each month, which is a snapshot of the U.S.s trade balance, or the gap between its imports and exports. The trade balance report is one of two releases that focus on foreign trade, but unlike the current account balance report, which also includes foreign investment, the trade release only tracks the goods and services imported to and exported from the U.S. The report isnt as relevant as other economic indicators because its statistics are delayed by two months (i.e., Januarys report contains Novembers data), but its monthly release is more popular than the quarterly current account balance report. It hits the Street at 8:30 a.m. ET the second week of the month. Traders tend to concentrate on the overall figures for each month (total imports and exports as well as the trade gap, or difference between them), but the report contains 18 detailed tables that break down U.S. trade in a variety of ways. First, the announcement divides both imports and exports into either goods or services, and provides three-month moving averages of all four categories. The report then divides these groups further into smaller categories including six types of services, petroleum or non-petroleum goods, and dozens of industrial supplies and consumer products that range from nuclear materials to fruit. Finally, the trade balance report breaks out U.S. imports and exports by nearly 40 countries. The Commerce Department directly tracks monthly changes in imported and exported goods, but it uses business surveys to compile its services data. The release provides both seasonally adjusted and raw data as well as nominal and real, or inflation-adjusted, statistics. Each report contains revised data from previous months, and annual revisions are released each June.

Trade deficit changes

Table 1 shows the dollar futures contracts daily behavior before and after trade balance reports in more detail. In addition to the dollars average gains and losses, the table also lists each days median value, percentage of gains, and standard deviation. The tables bottom three sections break out the dollars performance by announcement type increasing deficits, declining deficits, and unchanged. Table 1s first column indicates where the dollar closed relative to its range on announcement day. For example, if the index closed at its daily high, the Close location is 100, but if it ended the day at its low, the number is zero. Overall, the average values were within .10 percent of the median values, which suggests the dollars performance in Figure 2 is accurate. (See Average and median and Variance and standard deviation for detailed explanations of Table 1s statistics.) Although theres not much difference between the dollars performance before increasing and decreasing deficits, the dollar seemed to anticipate trade reports by rising an average of 0.06 percent the day before the announcement of smaller trade deficits. Similarly, the dollar fell 0.04 percent that day as news of a larger gap approached. On announcement day, the dollar
continued on p. 34

Source: Bernard Baumohl, The Secrets of Economic Indicators: Hidden Clues to Futures Economic Trends and Investment Opportunities (Wharton School Publishing, 2005).

Average and median

he mean (or average) of a set of values is the sum of the values divided by the number of values in the set. If a set consists of 10 numbers, add them and divide by 10 to get the mean. A statistical weakness of the mean is that it can be distorted by exceptionally large or small values. For example, the mean of 1, 2, 3, 4, 5, 6, 7, and 200 is 28.5 (228/8). Take away 200, and the mean of the remaining seven numbers is 4, which is much more representative of the numbers in this set than 28.5. The median can help gauge how representative a mean really is. The median of a data set is its middle value (when the set has an odd number of elements) or the mean of the middle two elements (when the set has an even number of elements). The median is less susceptible than the mean to distortion from extreme, non-representative values. The median of 1, 2, 3, 4, 5, 6, 7, and 200 is 4.5 ((4+5)/2), which is much more in line with the majority of numbers in the set.

CURRENCY TRADER March 2005

33

CURRENCY CHARACTERISTICS continued

FIGURE 5 LARGER- VS. SMALLER-THAN-EXPECTED TRADE DEFICITS The dollar has clearly preferred smaller-than-expected trade deficits to largerthan-expected gaps. The greenback rose an average 0.38 percent in the first week after surprisingly smaller deficits, while it fell 0.13 percent after unexpectedly wider ones.
U.S. dollar index futures following U.S. trade balance reports (1999-2005) 0.30 0.25 Average gain/loss (%) 0.20 0.15 0.10 0.05 0.00 -0.05 -0.10 -0.15 Day 0 Day 1 Day 2 Day 3 Day 4 Day 5 Day 6 Days after announcement (Day 0) Day 7 Day 8 Overall Larger-than-expected trade deficits Smaller-than-expected trade deficits

gained 0.08 percent in reaction to smaller deficits, but fell 0.03 percent in response to expanding gaps. Although the dollar didnt consistently rally the week following trade deficit declines, it rose 0.39 percent by the sixth day after such announcements. In contrast, the dollar gained just 0.08 percent by that point after deficit increases. Figure 3 compares the dollar index futures average gains and losses around increasing trade deficits to its behavior around declining gaps and reinforces Table 1s patterns. The figure clearly shows the dollars tendency to rally once the Commerce Department reported a narrowing trade gap. However, this bullish behavior was short-lived the dollar

Source: Bureau of Economic Analysis, NYBOT, and Briefing.com

TABLE 2 TRADE DEFICIT ESTIMATES Overall, the dollar gained ground in the first week after smaller-than-expected deficits and sank after larger-than-expected gaps.

Close location Overall (73 instances) Avg: 47.85 Med: 41.03 Pct. >0: Standard deviation:

Day 0 -0.04% 0.00% 49.32% 0.51%

Day 1 -0.02% 0.02% 52.05% 0.53% -0.02% 0.09% 56.10% 0.55% -0.02% -0.03% 48.28% 0.54% -0.11% -0.03% 33.33% 0.34%

Day 2 0.17% 0.07% 53.42% 0.57% 0.12% -0.03% 46.34% 0.64% 0.24% 0.24% 62.07% 0.48% 0.08% 0.18% 66.67% 0.22%

Day 3 0.03% 0.00% 49.32% 0.54% -0.06% -0.01% 46.34% 0.56% 0.09% 0.02% 51.72% 0.46% 0.51% 0.60% 66.67% 0.88%

Day 4 -0.05% -0.08% 42.47% 0.55% -0.06% -0.08% 43.90% 0.53% -0.03% -0.06% 44.83% 0.60% -0.16% -0.10% 0.00% 0.18%

Day 5 0.03% 0.01% 52.05% 0.52% -0.01% -0.02% 43.90% 0.54% 0.05% 0.07% 58.62% 0.47% 0.42% 0.30% 100.00% 0.47%

Day 6 0.01% 0.09% 54.79% 0.53% 0.03% 0.07% 53.66% 0.56% -0.03% 0.10% 55.17% 0.53% 0.11% 0.04% 66.67% 0.29%

Day 7 -0.09% -0.08% 41.67% 0.53% -0.09% -0.14% 39.02% 0.53% -0.08% -0.07% 46.43% 0.55% -0.16% 0.00% 33.33% 0.59%

Day 8 -0.03% -0.02% 44.44% 0.49% -0.03% -0.03% 43.90% 0.51% 0.01% 0.04% 50.00% 0.47% -0.48% -0.51% 0.00% 0.18%

Larger-than-expected (41 instances) Avg: 47.51 -0.11% Med: 39.73 0.00% Pct. > 0: 48.78% Standard deviation: 0.50% Smaller-than-expected (29 instances) Avg: 49.30 0.09% Med: 55.56 0.06% Pct. > 0: 51.72% Standard deviation: 0.49% Inline (3 instances) Avg: 38.40 Med: 16.67 Pct. > 0: Standard deviation: -0.18% -0.44% 33.33% 0.71%

Sources: Bureau of Economic Analysis, NYBOT, and Briefing.com.

34

March 2005 CURRENCY TRADER

Variance and standard deviation

gave up most of its prior gains in the final two days of the analysis window.
ariance measures how spread out a group of values are in other words, how much they vary. Mathematically, variance is the average squared deviation (or difference) of each number in the group from the groups mean value, divided by the number of elements in the group. For example, for the numbers 8, 9, and 10, the mean is 9 and the variance is: {(8-9)2 + (9-9)2 + (10-9)2}/3 = (1 + 0 + 1)/3 = .667 Now look at the variance of a more widely distributed set of numbers, 2, 9, 16: {(2-9)2 + (9-9)2 + (16-9)2 }/3 = (49 + 0 + 49)/3 = 32.67 The more varied a systems returns, the higher their variance or standard deviation, and the riskier the system will likely be to trade. The more varied a markets price changes from day to day (or week to week, etc.), the more volatile that market is. A common application of variance in trading is standard deviation, which is the square root of variance. The standard deviation of 8, 9, and 10 is: .667 = .82; the standard deviation of 2, 9, and 16 is: 32.67 = 5.72.

Watch for reversals

We tracked the dollar futures contracts close locations on announcement day to find out if predictable price patterns emerged once the dollar closed near the top or bottom of its daily range. Figure 4 compares the dollars average gains and losses on announcement day and the eight days following strong closes to its behavior after weak closes (i.e., within the upper and lower 20 percent of its report-day range, respectively). The dollar tended to reverse direction following extreme closes. For example, the dollar gained 0.42 percent on strong-closing report days, but sank 0.13 percent on the day after these events. Similarly, the dollar lost 0.58 percent on weak-closing announcement days, but it then rebounded 0.23 percent in the following two days. Overall, the dollar slipped 0.18 percent during the eight days after strong closes, and it rose 0.47 percent in the same period succeeding weak closes.

Hitting or missing economists estimates

The next part of the analysis consisted of comparing the actual trade deficit figures to Briefing.coms consensus estimates, from Jan. 21, 1999 to Jan. 12, 2005 (73 reports). The trade deficit came in above forecasts 41 times, below them 29 times, and was in line three times. Table 2 compares the dollar index futures contracts overall response to its price moves following larger-thanexpected, smaller-than-expected, and in-line trade balance reports. On seven of the tables nine days the dollar posted either larger gains or smaller losses after surprisingly smaller deficits than after larger-than-expected ones. On announcement day, the dollar jumped 0.09 percent in response to smallerCURRENCY TRADER March 2005

than-expected trade gaps, yet it dropped 0.11 percent when the deficit was wider than expected. Although the dollar rallied 0.32 percent in the nine days following smaller-than-expected deficits, most of its gains occurred on the second day after trade reports as the greenback soared 0.24 percent. In contrast, despite its 0.12-percent climb on the second day after disappointing trade news, the dollar tumbled 0.23 percent by the end of our analysis window. Figure 5 shows the dollars average daily performance following the same scenarios as in Table 2, and confirms

that its bullish reaction to smallerthan-expected trade gaps was fairly short: The dollar had surged 0.40 percent by the third day, but it then headed lower in the final week, regardless of whether the trade report was a positive surprise or not.

Bottom line
The dollars tendency to rally in response to either a narrowing or smaller-than-expected trade deficit makes sense. However, the greenback clearly preferred unexpected tradegap reductions to mere drops in actual monthly values.

Related reading
The dollar and the deficit, Currency Trader, November 2004. An overview of how the current account and trade deficits affect the U.S. dollar. Elections and the U.S. dollar, Currency Trader, November 2004. An analysis of how the dollar fared surrounding U.S. elections since 1973. U.S. dollar: Q1 recovery should precede further downtrend, Currency Trader, February 2005. A look at recent U.S. dollar price moves. The current account deficits impact on the U.S. dollar, Currency Trader, February 2005. A study of historical tendencies surrounding the quarterly current account balance report over the past 10 years.

35

MONEY TALKS

John Bollinger on consolidations

John Bollinger on market cycles, overlooked opportunities and why a consolidating market may be just what the doctor ordered for a new breed of swing trader.

BY CURRENCY TRADER STAFF

The following discussion is taken from an interview with John Bollinger in the April 2003 issue of Active Trader magazine (Relatively speaking: John Bollinger), in which he touched upon using Bollinger Bands and how to understand and trade range-bound (rather than trending) markets. Although he was addressing the stock market, the principles he describes are applicable to all instruments, including currencies especially considering the current speculation about diminishing trend moves and potential consolidation in the forex market this year.

36

March 2005 CURRENCY TRADER

CT: Where do you suggest traders conditioned to trade in long-term trends get started in terms of operating in rangetype markets? JB: The tools that work the best are relative tools those that let you get a grip on whats happening in relation to immediately prior history. Of course, different traders will have different ideas about what immediately prior means. For some it will mean whats happened this morning, for others it will mean the past 20 days or the past six months or year. But the advantage of relative tools is that you can adapt them to your purposes. Bollinger Bands, for instance, provide a definition whether prices are high or low on a relative basis (see Indicator reference). At the upper band, prices are high, and at the lower band, prices are low. If price tags the upper band, you know prices are high, so you can consult another tool to determine whether you believe that highness is sustainable or whether its a potential reversal to be sold. One of the problems Ive seen is that people treat Bollinger Bands in the simplest way possible. They automatically think a tag of the upper band is a sell and a tag of the lower band is a buy. Nothing could be further from the truth. Some tags of the upper and lower bands are sells and buys, respectively, but not all tags are action points. Price can, and does, walk up the upper band or walk down the lower band, and often when this happens you get some of the most profitable trades. With rare exceptions, its not enough to use Bollinger Bands alone. You have to combine them with something else that tells you about sustainability. For me, that something else is volume indicators. CT: Just indicators? Do you ever look at raw volume numbers? JB: Both can work. Some people are able to look at volume, relate it to the price bars and intuitively understand the supply-demand relationship. Other people need to parse volume into an indicator to clarify the picture. Older traders who grew up keeping charts by hand would probably be more comfortable with raw volume numbers. Traders who grew up with technology that could easily calculate and plot complex indicators will likely be happier with volume indicators. [It helps to] use a volume clip normalized volume, or at least a moving average of volume so you have some idea of whether volume is high or low on a relative basis. CT: Cant volume be misleading, though? High volume can accompany reversal points or support trends, but it seems as if many volume-watching traders conveniently overlook the frequent occasions when volume gives classic signals and price does the opposite of what its supposed to. And you can also find plenty of turning points where volume
continued on p. 38

Indicator reference: Bollinger Bands

ollinger Bands are a type of trading envelope consisting of lines plotted above and below a moving average, which are designed to capture a markets typical price fluctuations. Bollinger Bands were created by John Bollinger, CFA, CMT, the president and founder of Bollinger Capital Management. The indicator is similar in concept to the moving average envelope (see Indicator Insight, Active Trader September 2002), with an important difference: While moving average envelopes plot lines a fixed percentage above and below the average (typically three percent above and below a 21-day simple moving average), Bollinger Bands use a statistical calculation called standard deviation to determine how far above and below the moving average the lines are placed. As a result, while the upper and lower lines of a moving average envelope always move in tandem, Bollinger Bands expand during periods of rising market volatility and contract during periods of decreasing market volatility. By default, the upper and lower Bollinger Bands are placed two standard deviations above and below a 20period simple moving average. Upper band = 20-period simple moving average + 2 standard deviations Middle line = 20-period simple moving average of closing prices Lower band = 20-period simple moving average 2 standard deviations Standard deviation is a statistical calculation that measures how far values range from an average value in this case, how far prices stray from a 20-day moving average. Statistically, 95 percent of values will fall within two standard deviations of the average value, which means 95 percent of price action should occur within the upper and lower Bollinger Bands. Bollinger Bands highlights when price has become high or low on a relative basis, which is signaled through the touch (or minor penetration) of the upper or lower line. Put another way, price is seen as relatively high (overbought) on a touch of the upper band and relatively low (oversold) on a touch of the lower band. However, Bollinger stresses that price touching the lower or upper band does not constitute an automatic buy or sell signal. For example, a close (or multiple closes) above the upper band or below the lower band reflects stronger upside or downside momentum that is more likely to be a breakout (or trend) signal, rather than a reversal signal. Accordingly, Bollinger suggests using the bands in conjunction with other trading tools that can supply context and signal confirmation.

CURRENCY TRADER March 2005

37

MONEY TALKS continued

wasnt unusual one way or the other. JB: Well, first of all, Im working with the relative definition of high and low price levels, so that lets me know when to consult volume. For example, if price has just tagged the upper band, I know this is a point to see if volume is adding anything to the picture. I dont scan volume continuously, trying to make an ongoing stream of decisions based on the relationship between it and price. I only look at critical junctures. What Ive found, in this regard, is that it pays to wait. In other words, after I get a buy or sell signal, I wait for price

amount youre risking is relatively small, whereas the immediate target for the move is for price to get back to the lower band, which is much farther away.

CT: What kind of risk-reward numbers do you operate with? JB: Heres one way to look at it: There are only two ways to improve your trading performance. First, you can increase your number of winning trades vs. losing trades. If youre batting around .500, you can try to add different timing information and indicators, and so on, and maybe get your batting average up to around .600 or .650. I think youre doing pretty well if you have 65 percent winners. FIGURE 1 BOLLINGER BANDS: USD/JPY Second, you can increase the size of your winners vs. the size of your losNotice the many touches and minor penetrations of the lower band during the October-November downtrend; price never approaches the upper band during ers. Say your winners are twice the this period an only penetrates the moving average (middle line) once. The size of your losers thats pretty December-January trading range is characterized by much more even swings good. If you get up to three times the between the two bands. Finally, notice the contraction of the bands during the size, I think youll find the mathematlow-volatility September consolidation vs. the expansion of the bands as volatiliics work very much in your favor. If ty increases in October. you have 60 to 65 percent winning trades and your winners are two to U.S. dollar/Japanese yen (USD/JPY), daily 112 three times the size of your losers, youll find youre making money pret111 ty quickly. 110 By using this relative trading approach, you can address both those 109 risk-reward dimensions. You address 108 the size of the winners vs. losers by 107 having entry points with logical [stop] points nearby that let you know your 106 trade was wrong. You address the 105 number of winners by finding the right volume indicators to assess the 104 type of trade and the vehicles youre 103 using.
102

CT: What about a trend component thats independent from what youre Sept. Oct. Nov. Dec. 2005 Feb. discussing now independent in that Source: TradeStation it would probably be on a longer time frame? action to confirm that signal. If price tags the upper band JB: I think the idea of biasing your trading in the direction and a volume indicator say, 20-day on balance volume of the greatest probability of success is very important. In a (OBV) is in negative territory, you can treat that as a sideways market, youll get fairly important intermediatewarning or alert because the combination suggests this is a term buy signals near the bottom of the range and sell sigpotentially unsustainable situation. Then, if theres evi- nals near the top. Those should absolutely dictate the direcdence of a decline, you can act, because you know a proper tion of your trading. Clearly, if you can bias your trading in setup was in place. favor of the intermediate swing direction of the market, The other thing you have going for you in this kind of youll go a long way toward improving the two key comtrade situation is knowing whether theres a good risk- ponents of success. reward relationship. If price tags the upper band and turns In terms of time frame, if youre using Bollinger Bands, down, you can place a stop just above the entry point, for example, rather than trying to adjust the time frame by knowing if price goes back up and violates the stop, your changing the periods and width of the bands 20 and 2 setup is broken. And that stop will be fairly close by, so the seem to work very well for most applications and are cer38 March 2005 CURRENCY TRADER

FIGURE 2 BOLLINGER BANDS: INTRADAY PERSPECTIVE

tainly a good place to start try using a different bar length. If youre using daily bars and you want a shorter-term view, you might switch to hourly bars. If you want a longer-term view, try switching to weekly bars. Thats a good way to get an idea of whats happening in different time frames.

This 180-minute chart actually shares many characteristics with the daily chart in Figure 1, including the transition from a trend period (which is preceded by a notable contraction in the bands) to a trading range.
Euro/U.S. dollar (EUR/USD), 180-minute . 1.36 1.35

CT: Working on the assumption that a 1.34 market may be in a consolidation environment for an extended period, what 1.33 time frame would you begin your analysis on? 1.32 JB: It depends on what youre trying to do. If youre trying to get a handle 1.31 on the markets intermediate-term activity as background information, I 1.30 think you can estimate the swings will be three to six months at a minimum and six months to a year maximum 12/29 12/30 1/2 1/4 1/6 1/9 1/11 1/13 1/14 1/18 1/19 1/21 1/25 1/26 1/28 thats a typical pattern thats occurred Source: TradeStation in the past. Weekly bars seem to be the trade. Its the same old idea having all the parts and appropriate way to visualize that information. When you get down to the shorter-term actually exe- pieces pulling in the same direction. cuting trades in individual stocks or indices I recommend daily bars. Thats my bias. Ive looked at charts for years and Im comfortable in that time frame. For even shorter-term trades, hourly bars are quite useful. John Bollinger: Focus on the markets Theres obviously that subset of traders who are going to (Active Trader, January-February 2001). trade within much tighter parameters people who are John Bollinger talks about developing Bollinger Bands using five-minute bars and tick charts. But the concepts and what his career has taught him about markets really remain the same, regardless of the time frame: knowand traders. ing whats happening on the longer-term time frame so you can correctly bias your operations in the shorter time frame. Relatively speaking: John Bollinger If you get a nice entry signal for a long trade and the mar(Active Trader, April 2003). ket is in an upswing, you probably want to take that a little In this interview, Bollinger discusses market cycles, more seriously than you would a nice entry signal for a trading consolidations rather than trends, and other short. The principles were talking about are fractal in topics. nature they exhibit the same kinds of patterns and char-

Related reading

acteristics at different levels of magnification, whether its 10 minutes and hourly, hourly and daily or daily and weekly. The same types of setups and trading patterns are evident. CT: Its surprising how many people dont buy into that, because it seems pretty apparent if you just look at charts for a while. JB: I remember there was a fellow by the name of Sam Kachigan who designed a trading system called the Lennox system. One of the basic elements of the system was that trades had to be confirmed in three time frames. There was the long-term setup, then you looked for a similar setup on the intermediate time frame and, finally, the same thing on the shorter time frame, which is where you executed the
CURRENCY TRADER March 2005

Volume indicators revisited by John Bollinger (Active Trader, March 2002). John Bollinger reviews the origins of volume indicators and explains how traders can benefit from understanding these tools. Indicator Insight: Bollinger Bands (Active Trader, July 2003). A primer for understanding and using Bollinger Bands. You can purchase and download past Active Trader articles at www.activetradermag.com/purchase_articles.htm

39

CURRENCY BASICS

Forex options
Most stock and futures traders are at least familiar with basic option-trading concepts, but options are a much different beast in the forex world.
BY CARLISE PETERSON

s forex trading continues to expand in the retail trading space, one aspect of the market many traders have wondered about is option trading. Although they are not yet a common part of retail spot forex trading, individual market players do have access to option trading depending on their broker. Options in the spot forex market are not standardized the way options contracts are for exchange-traded stocks and futures that is, there are no predefined strike prices or expiration dates all brokers and traders use. If your brokerage offers option trading, they likely have their own relatively set menu of option contracts, as well as the ability to create a customized instrument of your choosing.

are typically constructed to expire in one or two weeks, but again, that is up to the brokerage and the customer. For more information on basic option characteristics and trading approaches, see "Related reading."

Option types and strategies

Forex options come in two flavors: vanilla and exotic. Vanilla options are simple calls and puts familiar to stock and futures option traders. Exotic options refer to either combinations of options (spreads) or variations on the payoff profiles of vanilla options completely different kinds of products with option-like characteristics. One type of forex option trade that falls into the last category is a "fixed-rate" option, which is a unique transaction that enables a trader to profit by a predetermined "payout" amount if the trader's selected price or price range is reached during a specific trading period. Generally, a brokerage will divide each 24-hour trading day into multiple trading sessions. Prior to the start of a trading session, the firm will typically indicate price limits for certain currency pairs within which fixed-rate option orders may be entered for that trading session. The firm will then quote the premium the trader must pay to buy the fixed-rate option trade. Once an order is entered, the premium for the trade is automatically deducted from your trading account. If the selected price or price range of the underlying currency pair is reached during the trading session, a preset payout (which the firm and customer decide upon as terms of the option "contract") will automatically be credited to the trader's account at the end of the trading session. In the event the price of the underlying currency pair is not reached during the trading session, the fixed-rate option will expire, worthless. For example, if the Euro/U.S. dollar rate (EUR/USD) was at 1.3028 before a particular trading period, a fixed-rate option contract could be constructed whereby the trader would receive a payout amount of $X if EUR/USD traded above 1.3070 during the trading period. Barrier options are based on a pre-selected price level (the barrier) in a currency, which if reached will either create a vanilla option (call or put) or eliminate the existence of a vanilla option. These are referred to as "knock-in/knock-out" options. There are two kinds of knock-in options: up and in and
March 2005 CURRENCY TRADER

Forex option characteristics

Unlike option trading in the equity and futures markets, where options expire at regular intervals (e.g., every 30 days or three months) and can be traded online, in the forex world customers typically must trade options over the phone but they can also create customized option contracts with just about any strike price and expiration. This customization gives traders flexibility, but it also makes FX options more complicated because of the difficulty of determining if a particular option is fairly priced. Most forex firms, including Gain Capital and HotSpotFX, say they are not yet seeing much interest from customers. As a result, forex option trading is best suited for experienced traders, according to Gain, which offers FX option trading within its traditional FX platform. Most platforms do not charge commissions for options; they are compensated through the bid/ask spread. Forex options
40

Related reading
down and in. In the case of an up-and-in option, the buyer selects an upper price barrier above the market. If the currency hits that level, a vanilla option position is triggered with a maturity date and strike price agreed upon at the outset. For example, if EUR/USD is at 1.3028, an up-and-in option might consist of a long call option position with a strike price of 1.3055 being triggered if EUR/USD trades above 1.3050. A down-and-in option is the same, except the currency must reach a lower barrier to trigger the option position. Upon hitting the chosen lower price level, it creates a call or put option position. Knock-out options are the reverse of knock-ins. With knock-outs, the buyer begins with a vanilla option; however, if the predetermined price barrier is hit, the vanilla option position is cancelled. As with the knock-in option, there are two kinds: up and out and down and out. With an up-and-out strategy, if the option hits the upper barrier, the option is cancelled and you lose your premium. With a down and out, if the option hits the lower price barrier, the option is cancelled. "Getting started in options," Options Trader magazine, April, 2005. Get a handle on how options work and how to take advantage of them as trading and hedging tools. "Spreading your charting options," Active Trader, April 2001. A handy guide to understanding which strategies goes with which market conditions. "Stepping into options," Active Trader, April 2001. When trading options, you have to walk first and run later. Learn how to take things one step at a time so you can use these tools more effectively. Special notice: For a limited time you can sign up for free subscription to Options Trader magazine at www.optionstradermag.com.
You can purchase and download past Active Trader articles at www.activetradermag.com/purchase_articles.htm.

Risks in trading spot forex options

Forex options contracts are vastly different from options on stocks or futures contracts. There are no standardized contract specifications or centralized, exchange-traded markets, which

means there is little or no price transparency; this makes it difficult to determine if the price you pay for an option is close to the "fair" theoretical value. Essentially, a forex option is a customized, private transaction between a trader and a brokerage. Only traders with significant experience in both forex trading and option-pricing techniques should attempt to make use of option strategies in the forex market.

Options glossary
American style: An option that can be exercised at any time until expiration. At the money (ATM): An option whose strike price is identical (or very close) to the current underlying stock (or futures) price. Call option: An option that gives the owner the right, but not the obligation, to buy a stock (or futures contract) at a fixed price. Deep (e.g., deep in-the-money option or deep out-of-the money option): call options with strike prices that are far above the current price of the underlying asset and put options with strike prices that are far below the current price of the underlying asset. European style: An option that can only be exercised at expiration, not before. Exercise: To exchange an option for the underlying instrument. Expiration: The last day on which an option can be exercised and exchanged for the underlying instrument (usually the last trading day or one day after). In the money (ITM): A call option with a strike price below the price of the underlying instrument or a put option with a strike price above the underlying instruments price. Intrinsic value: The difference between the strike price of an in-themoney option and the underlying asset price. A call option with a strike price of 22 has 2 points of intrinsic value if the underlying market is trading at 24. Out of the money (OTM): A call option with a strike price above the price of the underlying instrument or a put option with a strike price below the underlying instruments price. Premium: The price of an option. Put option: An option that gives the owner the right, but not the obligation, to sell a stock (or futures contract) at a fixed price. Strike ("exercise") price: The price at which an underlying stock is exchanged upon exercise of an option. Time value: The amount of an options value that is a function of the time remaining until expiration. As expiration approaches, time value decreases at an accelerated rate, a phenomenon known as "time decay." Volatility: The level of price movement in a market. Historical volatility measures the price fluctuations (usually calculated as the standard deviation of closing prices) over a certain time period e.g., the past 20 days. Implied volatility is the current market estimate of future volatility as reflected in the level of option premiums. The higher the implied volatility, the higher the option premium.
41

CURRENCY TRADER March 2005

CURRENCY BASICS

Money management fundamentals:

How much should you risk?

Most traders only think about potential profits, but capital preservation should be foremost in their thoughts. Knowing your stop points and keeping per-trade risk at a conservative level will keep you in the game.

BY NOBLE DRAKOLN

here has always been debate among traders The goal of all traders is to be profitable, but before that regarding the value of technical analysis vs. is possible you must focus on capital preservation. The only fundamental analysis. Unfortunately, this way to succeed at trading in the long run is to have as many debate ignores the most important element of opportunities to profit as possible, and the best way to put overall trading success money management. While there yourself in that position is to preserve your initial capital. are many books about optimizing trading rules or handling Therefore, you must understand the relationship between a trade once youre in it, it is difficult to find hard-andfast money-management rules for individual traders. FIGURE 1 DOLLAR DAYS There are three money-management areas individual A sharp down move by the U.S. dollar is quickly reversed the traders must address: what markets to trade, how many following day. shares or contracts to trade (position sizing), and how much to risk once youre in a trade. Here, well focus U.S. dollar index (DXY), daily 84.0 mostly on the last of these three money-management components how much to risk on a given trade, and 83.5 how that relates to your trading approach and account size.
83.0 82.5 82.0 81.5 81.0 2005 10

Capital preservation
On Jan. 12, 2005, a record U.S. trade deficit of $60.3 billion dollars was reported a $20.3 billion dollar increase from the November 2003 report and the U.S. dollar declined sharply (Figure 1). Currency traders who had been bearish the U.S. dollar found their long foreign currency trades significantly in the black. The next day, Jan. 13, 2005, there was an immediate reversal in the perceived value of the U.S. dollar. Long positions in many foreign currencies fell, giving back most (and in some cases, more) of the gains they had made against the dollar the prior day. While different technical indicators suggested the dollars rebound was simply a short-covering rally, the fact remains those holding short dollar positions lost money. How do you exit a trade successfully in such whipsaw conditions?
42

Dollar plunges on Jan. 12 but reverses the next day

Source: FutureSource Workstation

the analytical tools you use to define a trade and the capital you have at your disposal. The following examples focus mostly on the Chicago Mercantile Exchange (CME) currency futures contracts, but
March 2005 CURRENCY TRADER

FIGURE 2 AUSSIE DOLLAR To limit your overall equity loss to 2 percent, you would need a $62,000 trading account to handle the $1,240 loss on this trade.

the same money-management principals apply to the spot forex market.

March 2005 Australian dollar futures (ADH05), daily

0.8100 0.8000 0.7900

Setting basic money-management boundaries

Longs have a total loss of .0124 0.7663 0.7539 0.7663 0.7539

0.7800 0.7700 0.7600

The key to successful money 0.7500 management is to identify how 0.7400 far a market can go against you 0.7300 that is, a trades deepest potential drawdown and 0.7200 reconcile that potential loss 0.7100 with the amount of equity in 0.7000 your account you are willing to risk. This is a consistent 13 Sept. Oct. Nov. Dec. 2005 Feb approach used by many professional money managers. Source: FutureSource Workstation The primary way such professionals reconcile drawdown against overall equity is to traders) is on. In mid-January, the majority of small specuset a maximum loss based on a total percentage assets lators held open foreign currency positions that were under management. On any given trade, such traders are weighted heavily to the long side that is, against the dolrarely willing to risk more than 2 percent of total equity. For lar. The chart examples help illustrate the various account example, if a manager has $1 million under management, sizes needed to handle different percentage losses. We will the maximum risk per trade would be $20,000. Individual traders should use a similar hard money- look at the size of the losses hypothetical long trades would management rule. However, because the majority of indi- incur and determine how much account equity would be vidual traders have significantly less equity than most pro- necessary to stay within 2-percent, 7-percent, and 10-perfessional money managers, a higher maximum risk loss cent risk levels. All you need to do is divide the expected perhaps as much as 7 to 10 percent is more realistic, at loss by the appropriate percentage amount. Figure 2 shows a daily chart of the Australian dollar least for experienced traders. Other traders should simply use smaller position sizes or trade micro forex lots futures (AD). If you went long when the contract dropped ($10,000 vs. the usual $100,000) or mini futures contracts, sharply from .7663 to .7539, you would have had a loss of if available. But regardless of the size of your position, it is .0124, or $1,240 per contract (each tick is worth $10.00). As a result, you would need the following account sizes: important to have a set stop loss.

Market examples
Well walk through a few examples of establishing money management boundaries. You can use whatever tools you feel comfortable with to set such targets. A systematic trader, for example, might have historical test results that indicate appropriate levels for taking losses or exiting trades profitably. The Commitment of Traders Report (COT) released by the Commodities Futures Trading Commission (CFTC) tracks the positions of different kinds of traders (i.e., small and large speculators and commercial hedgers) in the futures markets. It is often used to gauge which side of the market the smart money (usually the large commercial
CURRENCY TRADER March 2005

1. For this to be a 2-percent loss you would need $62,000 ($1,240/.02) of account equity per contract. 2. For this to be a 7-percent loss you would need $17,714 ($1,240/.07) of account equity per contract. 3. For this to be a 10-percent loss you would need $12,400 ($1,240/.10) of account equity per contract. So, for example, if you had less than $62,000 in your account, you would have to risk more than 2 percent of equity per trade.
continued on p. 44

43

CURRENCY BASICS continued

Figure 3 shows the Canadian dollar futures (CD) had consolidated between approximately .8385 and .8276 in November 2004 before a final up leg created a new high. The

contract then sold off in December, passing below the support area defined by the congestion, which then became resistance the market would have to surpass to make a new high. In January the market twice attempted to reach the .8385 FIGURE 3 CANADIAN DOLLAR level, but both attempts failed The $1090 loss on this trade would be 2 percent of a $54,500 account, and 7 percent of and the market collapsed. If a $15,570 account. you were unfortunate enough to buy at the highest high of March 2005 Canadian dollar futures 0.8500 this second move (.8369) and (CDH05), daily 0.8385 0.8400 0.8385 were using the .8276 level for a stop point, you would have 0.8276 0.8300 0.8276 lost .0093, or $930, per contract. 0.8200 You would need the following account sizes to trade one con0.8100 tract:
0.8000 0.7900 0.7800 0.7700 0.7600 0.7500 13 Sept. Oct. Nov. Dec. 2005 Feb

1. For this to be a 2-percent loss you would need $46,500 ($930/.02) of account equity per contract. 2. For this to be a 7-percent loss you would need $13,286 ($930/.07) of account equity per contract. 3. For this to be a 10-percent loss you would need $9,300 ($930/.10) of account equity per contract. In Figure 4, the Euro FX contract (EC) fell from a high of 1.33, breaching support at 1.3239. This support level was established by the congestion in December and January the market repeatedly touched the level and bounced upward before finally collapsing it to a lower support at 1.3074. Had you hoped this to be a minor correction and held on to your long position, you would have been disappointed. With a tick value of $12.50, the total point loss for the move between these two levels was .0164, or $2,050. You would need the following account sizes:
March 2005 CURRENCY TRADER

Source: FutureSource Workstation

FIGURE 4 EURO FX If you allowed yourself to risk 10 percent of account equity per trade, you could take this loss if you had a $20,500 account. Limiting risk to 2 percent of account equity would require $102,500.
March 2005 Euro FX futures (ECH05), daily 1.40000 1.39000 1.38000 1.37000 Longs have a total loss of .01644 1.36000 1.35000 1.34000 1.32390 1.30746 1.32390 1.30746 1.33000 1.32000 1.31000 1.30000 1.29000 Nov. 15 Dec. 15 2005 20 Feb

Source: FutureSource Workstation

44

1. For this to be a 2-percent loss you would need $102,500 ($2,050/.02) of account equity per contract. 2. For this to be a 7-percent loss you would need $29,286 ($2,050/.07) of account equity per contract. 3. For this to be a 10-percent loss you would need $20,500 ($2,050/.10) of account equity per contract.

was your typical trade risk and you were attempting to stick to the professional money managers rule of risking 2 percent or less of equity per trade, you would need at least an approximately $50,000 trading account to be able to handle that kind of loss.

FIGURE 5 KIWI DOLLAR The money-management principles used in the currency futures examples are also applicable to the spot forex market. Here, a consolidation in the NZD/USD rate lets you establish a stop point and risk threshold.

A note on margin: The Euro FX contract has a minimum margin rate of New Zealand dollar/U.S. dollar (NZD/USD), daily 0.725 $3,240, which means the exchange Stop-loss requires you (your broker, actually) to 0.720 have this much money in your account per contract. However, notice how 0.715 Consolidation much lower this amount is than the 0.710 figures quoted above. If you traded with minimum margin, the $2,050 loss Support 0.705 would represent a 63-percent drawdown ($2,050/$3,240) in account equi0.700 Go short if ty. Your trading approach and a conprice breaks 0.695 servative equity percentage risk support threshold should determine how 0.690 much money you need to trade not 0.685 the minimum margin rate. Finally, the following summary December 2005 February presents a scenario for the New Source: FutureSource Workstation Zealand dollar/U.S. dollar spot forex rate (NZD/USD). Figure 5 shows NZD/USD consolidating after bouncing off its mid-January Integrating money management and trade low. If a trader took a short position on a breakdown move strategy below the support level of the recent consolidation (at According to a recent survey, 65 percent of subscribers to a .7080) and the stop-loss was played above the recent high at futures newsletter had less than $25,000 of equity in their .7215, the potential loss of .0135 (135 pips) is $1,350 using trading accounts. The reality is that in order to enjoy longthe standard $100,000 trade lot size and a pip (tick) value of term success, traders must give money management prior$10. You would need the following account sizes to trade ity over whatever trading approach they are using. They must assess their own maximum risk according to their one lot: account value and stick to it. Being able to accurately determine a stop-loss point 1. For this to be a 2-percent loss you would need $67,500 based on a percentage of your account value is simply one ($1,350/.02) of account equity per lot. part money management process, but it will put you ahead 2. For this to be a 7-percent loss you would need $19,286 of the majority of traders who are over-extending their accounts on a trade-by-trade basis. ($1,350/.07) of account equity per lot. As always, the goal is not to be right about a markets 3. For this to be a 10-percent loss you would need $13,500 direction, but to be profitable. This can only be accomplished by preserving the capital you start with and jeal($1,350/.10) of account equity per lot. ously protecting the profits you accumulate. Each chart example had a technical support point that extended $1,000 or more from the resistance point. If that For information on the author see p. 8.
CURRENCY TRADER March 2005 45

CURRENCY BASICS

Indicator Basics: Price oscillator

BY CURRENCY TRADER STAFF

he price oscillator (PO) is a simple momentum indicator used mostly to highlight shorter-term market turning points and overbought-oversold levels. It is sometimes referred to as a moving average oscillator, because it is constructed from two moving averages, similar to the well-known moving average convergence-divergence (MACD) indicator. It is an instructive indicator to study because it provides the groundwork for other frequently used trading tools and concepts.

Calculation
The price oscillator is calculated by subtracting a longer-term moving average from a shorter-term moving average. PO = MAS - MAL where MAS is a shorter-term moving average (e.g., five bars), and MAL is a longer-term moving average (e.g., 20 bars).

average. A variation on this second approach is to divide the difference between the two moving averages by the shorter moving average and multiply the result by 100. This expresses the difference as a percentage of the shorter moving average: PO = [( MAS - MAL)/ MAS ]*100

The resulting indicators are the same as the original calculation except for their scale. The PO can be further modified by using a different kind of moving averAlternately, the shorter-term aver- age i.e., substituting an exponential age can be divided by the longer-term moving average (EMA) for the more commonly used simple moving average (SMA). FIGURE 1 THE PRICE OSCILLATOR The PO simply measures the The price oscillator (PO) is created by subtracting a longer-term moving average from a distance between the two movshorter-term average. When the market is moving sideways, the indicator swings fairly ing averages; the greater the regularly above and below the zero line. During the trend period, the indicator was distance, the more momentum almost exclusively in positive territory. (up or down) the market is showing relative to the Euro/U.S. dollar (EUR/USD), daily 1.34 length of the moving averages. 1.32 In general, the shorter-term 5-bar moving average average essentially functions 1.30 as a substitute for price. The 1.28 20-bar moving average second average represents a 1.26 longer-term mean price value 1.24 or trend. The farther the shorter average moves above or 1.22 below the longer average 1.20 (resulting in higher or lower 1.18 PO values), the faster the mar5-20 Price Oscillator ket is moving. 0.02 Figure 1 is a daily chart with 0.005 a 5-20 price oscillator that -0.01 is, a PO using five- and 20-day SMAs. The PO exhibits the May June July Aug. Sept. Oct. Nov. Dec. same characteristics regardless Source: TradeStation of time frame. Figure 2 shows a
March 2005 CURRENCY TRADER

46

FIGURE 2 INTRADAY CHART WITH DIVERGENCE

10-40 PO (i.e., using 10- and 40-bar moving averages) on a 10-minute chart.

Notice the crossovers of the 10- and 40-bar moving averages in the top part of the chart correspond to the PO crossing above and below its zero line. A bullish divergence occurred on this chart when the price made a lower low but the indicator made a higher low.
Australian dollar/U.S. dollar (AUD/USD), 10-minute 0.776

Interpretation and use

The PO is mostly used as a 10-bar moving average momentum indicator to high0.775 light swing points and (rela40-bar moving average 0.774 tive) overbought and oversold levels. When the indicator 0.773 reaches a high level, this supMoving average posedly reflects a potentially 0.772 crossovers overbought condition in the (above) are the 0.771 market and warns of a potensame as tial correction. The opposite is zero-line 0.770 true for low indicator readcrossings 10-40 (below) ings. 0.002 price oscillator Divergence Notice in Figure 1 the PO 0.001 oscillates above and below the 0.000 zero line during the first half of -0.001 the chart when the market is moving sideways, then stays 6:50 9:00 11:10 13:20 15:30 17:40 19:50 22:00 2/1 2:20 4:30 6:40 8:50 11:00 above the zero line as the marSource: TradeStation ket trends upward. While the market is moving sideways, FIGURE 3 THE TIME-FRAME DIFFERENCE the indicators relative highs and lows correspond to most of the price highs The upper PO, which is composed of short-term moving averages, captures and lows although there are no shorter-term moves. The lower PO, which is composed of longer-term averobjective, fixed levels to define overages, follows broader turns of the market. bought or oversold. Euro/Japanese yen (EUR/JPY), daily Like other momentum indicators, divergence between price and the PO 140 sometimes accompanies market 138 exhaustion and correction. A divergence occurs when price moves in one 136 direction and the momentum indicator does not. The classic example is 134 when price makes a higher high but the indicator makes a lower high, 132 which means price has pushed to a 4-15 price oscillator new level on weaker momentum. In 1 such situations, a correction or rever-0.5 sal is possible. -2 In Figure 2, between 2:20 a.m and 6:40 a.m. ET, price made a new low for 20-60 price oscillator 2 the day, rallied slightly, then made a lower low. Meanwhile, the PO 1 matched the first price low with a new 0 low of its own. However, the PO made a higher low when price made its new September October November December 2005 low a so-called bullish divercontinued on p. 48 Source: TradeStation

CURRENCY TRADER March 2005

47

CURRENCY BASICS continued

gence, because it is typically interpreted as a sign of a possible up move, which in this case did occur.

The price oscillator measures the distance between the two moving averages.
reflect shorter price swings. Figure 3 compares two POs: The top one is composed of short-term moving averages (4 and 15 bars), and the bottom is composed of longer-term averages (20 and 60 bars). The former captures more of the short-term, intratrend price moves while the latter follows the broader turns of the market. The PO is an unbounded indicaof consulting the indicator readings that accompanied past highs and lows and putting that information in the context of the current price action. For example, if the recent PO reading is higher than the last three indicator readings that were followed by downside reversals, traders might want to be on the lookout for another reversal. As is the case with any momentum, PO overbought and oversold signals, as well as divergences, can be very misleading. They do not guarantee corrections or reversals, or that these will be significant enough to trade profitably if they do, in fact, occur; they merely give cause to look for such events. A market can remain overbought for a very long time if the uptrend is strong enough; vice versa in a strong downtrend. Similarly, a market may post divergence after divergence in a strong trend, indicating a reversal when none is forthcoming. Another look at Figure 1 shows how the PO remained above the zero line, and was often at very high levels throughout much of the uptrend. It never produced a negative reading let alone anything remotely close to an oversold signal (which would have triggered long positions) after September. Someone who sold in October because of the PO had produced its highest reading in six months would have been quickly blown out by the continuing trend. One way some traders try to adjust to the influence of a trend is to look for higher PO highs and lows in uptrends (vice versa in downtrends) than they normally would in a sideways market. However, this is obviously a subjective process. One aspect of oscillators that many traders seek to exploit is the so-called leading characteristic i.e., oscillaMarch 2005 CURRENCY TRADER

Key points
The price oscillator is essentially a different way of displaying a movingaverage crossover, which is usually used as a basic trend-following tool: Directional (trend) changes are signaled when the shorter-term moving average crosses above or below the longer-term average. In the PO, the longer-term average becomes the horizontal zero line. As a result, PO crosses above and below the zero line correspond to moving
FIGURE 4 PO VS. MACD

The minor differences in the two indicators are because the PO (middle) is usually calculated using simple moving averages and the MACD (bottom) is calculated using exponential moving averages. If the PO had been calculated using EMAs, it would have been identical to the MACD, except for the absence of the second signal line.
Euro/Japanese yen (EUR/JPY), daily 142 140 138 136 134 12-26 price oscillator 132 1.5 0.0 -1.5 12-26-9 MACD 1 0.4 -0.2 -0.8 September October November December 2005

Source: TradeStation

average crossovers, which is evident in both Figures 1 and 2. The degree to which the PO reflects longer- or shorter-term price swings depends on the length of the moving averages used. Shorter averages will
48

tor, meaning it does not fluctuate in a fixed range (say, -100 to +100), as do most indicators referred to as oscillators. As a result, determining what constitutes overbought or oversold is quite subjective, and is mostly a matter

tors sometimes top or bottom and reverse before price. Prices must continue to increase or decrease at an accelerating rate for a momentum indicator to persistently rise or fall. For example, as an uptrend reaches its conclusion, it may continue to gain ground each day, but the gains may be smaller and smaller. This will be reflected by a declining oscillator, which is highlighting the loss of upward momentum. However, because it is based on moving averages, which smooth prices and therefore lag turning points, the PO exhibits less of a leading characteristic than other similar indicators. As a result, it might be better suited to identifying more intermediate-term turning points (using longer-term averages, say 10-bar and 40-bar, or 20-bar and 60bar, etc.), similar to the MACD indicator it resembles so closely.

Figure 4 shows a PO consisting of 12- and 26-day simple moving averages, and below it an MACD line using the standard 12- and 26-day exponential moving averages. The differences between the two indicators (aside from the MACDs second line) are a result of the difference in the moving average calculations.

indicate if a market is at a potential exhaustion point. However, like all oscillators, it is prone to false signals in trending markets, and it does not provide any benchmarks for what constitutes exceptionally high or low readings.

Bottom line
The price oscillator is a basic technical analysis tool that takes a trend-following concept (the moving average crossover) and uses it as the basis of an overbought-oversold indicator. It is essentially the same indicator as the moving average convergence-divergence (MACD) indicator, except that it does not use specific lengths for the moving averages. It can provide a succinct summary of the current trend direction, as well as

Related reading
Indicator Basics: Simple moving average, Currency Trader, November 2004. Indicator Basics: Weighted and exponential moving averages, Currency Trader, October 2004. Indicator Insight: Moving average convergence-divergence (MACD), Active Trader, September 2001.

FOREX RESOURCES
Global Forex Trading has partnered with McElhannon Group Inc. to offer a new institutional-quality forex trading signals program called InciteFX. Each trading signal suggests a forex market position or several within a given time period and is delivered directly to traders using GFTs DealBook trading software. InciteFX features buy/sell and stoploss signals that concentrate on three specific currency pairs at two intervals per day. At 8 a.m. or 8 p.m. ET traders can use the analytics feature to enter the information contained in the trading table. The InciteFX program uses a floating three-cross-trade-per-day strategy developed by Commodity Trading Advisor Philip Worley, who has worked in institutional forex research and consulting for more than 30 years. For more information, visit www.gftforex.com. FXCM is again running its mini trading contest again, where more than 10,000 traders compete for $4,000 in cash prizes every month. All live mini accounts with more than $1,000 are automatically entered into the contest, and the five accounts with the greatest percentage returns each month will be ranked winners. Contest participants will be able to view current standings, weekly updates, commentary, interviews with winning traders, and detailed analysis of the winning strategies. The mini account allows clients to experience the FX market with as little as $300 and trade in standard increments of 10,000 units. More information is available at www.fxcm.com/trading-contestexchange.jsp. The Active Trader magazine group is launching its third monthly magazine, Options Trader, in April 2005. Like Currency Trader, Options Trader is an electronic magazine that readers can download each month. Each issue will contain trading strategies, analysis, and news specifically for options investors and traders, as well as interviews with top traders and insights from industry professionals. The magazine is delivered directly to your desktop each month as an Adobe Acrobat PDF file that combines the look and feel of a high-quality print magazine with interactive electronic features, such as Internet links and zoom capabilities. The first issue of Options Trader will be available in April 2005. The first 5,000 subscriptions are free. For more information, visit www.optionstradermag.com.

CURRENCY TRADER March 2005

49

CURRENCY MOVERS

Euro/Swiss franc
The current scenario for the Euro/Swiss franc rate is a tale of two time frames.
FIGURE 1 WEEKLY EURO/SWISS FRANC Although a technician might be inclined to think the currency pair is poised to drop further based on the chart and indicator conditions, testing of the three-bar pattern highlighted at various points on the chart has a slight upside bias.
Euro/Swiss franc (EUR/CHF), weekly 1.58 1.56 1.54 1.52 1.50 1.48 1.46 Stochastic

90 60 30

July

Oct.

2003

April

July

Oct.

2004

April

July

Oct.

2005

Source: TradeStation

FIGURE 2 DAILY EURO/SWISS FRANC The highlighted pattern on the daily chart had very high odds of being followed by upside movement (albeit modest) starting the second day after the pattern completes.
Euro/Swiss franc (EUR/CHF), daily 1.565 1.555 1.545 1.535 1.525 1.515 Stochastic

90 60 30

August

September October

November

December

2005

February

Source: TradeStation

he Euro/Swiss franc (EUR/CHF) rate spent much of 2003 pushing higher, while 2004 consisted of an initial sell-off followed by a period of wide-ranging price swings (see Figure 1). In late-November 2004, the pair came close to matching its June 2004 low before rallying into yearend, and then stalled out in January 2005 before eclipsing the October 2004 and January 2005 highs in Feb. 2005 (see Figure 2). This move turned out to be something of a "bull trap," however, as price quickly made a new 2005 low in late February. The climax of this sell-off occurred on Feb. 22, when EUR/USD plunged lower on a 112-pip wide-range bar and closed near its low. The next two days of price action were interesting: Feb. 23 was an inside day and Feb. 24 was a strong up-closing day that regained nearly all of the Feb. 22 loss. Was this the beginning of a turnaround to the upside? In an attempt to find out what had happened in similar past situations, we created the following pattern definition: The bar two days ago had to have a range of at least 75 pips; the close of the bar two days ago had to be at least 50 pips lower than the close three days ago; todays range had to be at least 50 pips; and todays low had to be above the lows of the previous two bars. There were 10 other times this three-bar pattern appeared over the past two years in this currency pair, and a few of the more recent ones are highlighted in Figure 2. In these
March 2005 CURRENCY TRADER

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TABLE 1 DAILY THREE-BAR REVERSAL PATTERN

Day 1 Avg Med Max up Max down STD %>0 0.10% 0.01% 0.42% -0.12% 0.21% 50.00% Day 11 0.52% 0.32% 1.74% -0.30% 0.70% 70.00%

Day 2 0.16% 0.07% 0.62% -0.27% 0.27% 80.00% Day 12 0.57% 0.57% 1.57% -0.30% 0.63% 70.00%

Day 3 0.26% 0.26% 0.72% -0.44% 0.32% 80.00% Day 13 0.63% 0.62% 1.91% -0.21% 0.66% 70.00%

Day 4

Day 5

Day 6 0.25% 0.31% 1.00% -0.97% 0.55% 70.00% Day 16 0.60% 0.56% 1.73% -1.39% 0.91% 80.00%

Day 7 0.33% 0.25% 1.15% -0.60% 0.50% 80.00% Day 17 0.82% 0.75% 1.94% -1.17% 0.92% 90.00%

Day 8

Day 9

Day 10

0.27% 0.27% 0.36% 0.39% 0.89% 0.87% -1.32% -1.04% 0.63% 0.52% 80.00% 90.00% Day 14 Day 15 0.63% 0.65% 0.53% 0.51% 2.26% 1.96% -0.84% -0.88% 0.88% 0.85% 80.00% 80.00%

0.37% 0.40% 0.43% 0.24% 0.34% 0.41% 1.18% 1.22% 1.33% -0.36% -0.43% -0.42% 0.48% 0.48% 0.62% 80.00% 90.00% 70.00% Day 18 Day 19 Day 20 0.76% 0.87% 0.98% 0.52% 0.66% 0.75% 2.02% 2.11% 2.46% -1.14% -0.99% -0.88% 0.96% 0.95% 1.02% 90.00% 90.00% 90.00%

Avg Med Max up Max down STD %>0

instances, the pattern was followed by up moves, although the size and nature of these moves and the context in which they developed were different. Table 1 summarizes the average, median, maximum up, and maximum down moves for the 20 days (on a close-to-close basis) following these patterns. Theres an upside bias, but its not a particularly forceful one, on average. However, other than the 5050 odds of an up move on day 1, the odds of a higher close (than the entry price) on each of the other days is never lower than 70 percent. Returning to the weekly perspective, Figure 1 highlights the three most recent bars as of Feb. 24, 2005, which marked a rather sharp decline from the multi-month high. To see if this pattern had any significance, we looked for similar events in the past, using the following conditions: The high two weeks ago minus this weeks low must be at least 150 pips; the high two weeks ago must be higher than the 10 highest high of the preceding weeks; this weeks high and low must be lower than last weeks high and low, and last weeks high and low must be lower than the high and low two weeks ago. There were nine previous instances of this pattern since May 2001, and as the representative ones in Figure 1 suggest, the price action following them was a
CURRENCY TRADER March 2005

mixed bag. TABLE 2 WEEKLY THREE-BAR DECLINE PATTERN Table 2 shows the performance for Week 1 Week 2 Week 3 Week 4 this pattern. The Avg 0.06% 0.12% -0.10% 0.00% probability of gains Med 0.10% 0.16% 0.05% 0.37% and the size of those Max up 0.66% 0.73% 0.63% 0.99% gains are lower than Max down -0.46% -0.60% -0.99% -1.54% those indicated for the daily pattern in STD 0.35% 0.47% 0.56% 0.97% Table 2, but there is %>0 55.56% 66.67% 55.56% 55.56% still a slight bias to Week 5 Week 6 Week 7 Week 8 the upside (but the most recent examAvg 0.13% 0.17% 0.14% 0.16% ple in Oct. 2004 was Med 0.45% 0.13% -0.03% 0.12% followed by more Max up 1.51% 1.28% 1.38% 1.38% selling). Max down -1.38% -0.91% -0.76% -1.22% Figures 1 and 2 STD 1.06% 0.86% 0.77% 0.98% also show the sto%>0 55.56% 55.56% 44.44% 66.67% chastic oscillator, which many techniWeek 9 Week 10 Week 11 Week 12 cal traders might Avg 0.06% -0.07% 0.07% 0.13% consult to deterMed 0.22% 0.24% 0.49% 0.72% mine whether a market is temporarMax up 1.30% 1.23% 1.85% 2.02% ily overbought or Max down -1.76% -1.83% -2.34% -2.98% oversold. As one STD 1.09% 1.09% 1.30% 1.55% might expect, the %>0 66.67% 55.56% 55.56% 55.56% sharp drop on the daily chart registers as oversold, while the weekly chart is of the range. However, the Feb. 24 just turning below the stochastic over- daily high eclipsed the previous high; if the slightly bullish pattern statistics bought threshold. Pure chartists might be inclined to have any significance, they suggest the interpret the current down thrust on currency pair could buck the charts the weekly chart as a retreat from the and make for an up move in the near top on the current range, which would future, with the potential for longerimply a move to the lower boundary term gains.
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BUSINESS OF TRADING

Forex hedge fund management

The number of hedge funds and hedge fund investors has soared. Forex traders looking to start a fund need to understand the rules and regulations before they quit their day jobs.
BY HANNAH TERHUNE AND ROGER LORENCE

ts understandable why hedge funds have become so popular in recent years from a traders perspective. A talented hedge-fund manager can accrue substantial income, and while starting a hedge-fund obviously isnt for the novice forex trader, its not as complicated as it seems. Lets assume a trader has a modest $3 million under management and his forex hedge fund has a 1-percent management fee and a 20-percent performance allocation fee (i.e., a share of the profits). Assume the fund was started on the first day of the year and returned 15 percent. In this case, the trader would have gross income of $120,000, consisting of a $30,000 management fee ($3 million * 1% = $30,000) and a $90,000 performance allocation ($3 million * 15% return = $450,000 * 20% = $90,000). Using all the same assumptions, a hedge-fund manager with $10 million under management would make $400,000. Also, because prospective investors like to see fund managers risk their personal capital, assume the fund manager has a significant portion of his own money invested in the fund. Because there are no fees assessed (it would just increase taxes), the trader earns an additional 30 percent on his own investment in the fund. However, before a trader can potentially enjoy these rewards, he or she must structure a proper business. The good news is forex traders are now positioned to quickly launch a forex
52

fund with minimal regulatory oversight.

Forex fund basics

Regulation D, Rule 506, of the Securities Act of 1933 defines a forex fund as an unregistered security offered as a private placement. Regulation D provides safe harbor provisions which, if complied with, exempt the private offering from compliance with the registration and prospectus delivery requirements of federal securities laws. However, Regulation D does not exempt the offering from compliance with the fraud provisions of the federal and various state securities laws.

forward contracts, and over-the-counter options in currencies for which there is also trading in regulated futures, all qualify as Section 1256 contracts. Gains in these instruments are taxed at a maximum federal rate of 23 percent (60 percent of the gains and losses are long-term and 40 percent is shortterm). In addition, the fund usually qualifies as a trader in commodities, so the investors are able to deduct the funds expenses more favorably than expenses in an investment partnership. Performance-based compensation for fund advisers is usually structured as an allocation of profits, but it is sometimes structured as fees in

Most foreign currency trading is eligible for favorable federal income tax treatment.
Forex funds must supply all investors with comprehensive information about the offering in disclosure documents. The purpose of these documents is to limit the hedge funds potential risk by providing full disclosure to investors. A typical set of disclosure documents includes a private placement memorandum, an investor questionnaire and subscription agreement, and an operating agreement for the fund. Most foreign currency trading is eligible for favorable federal income tax treatment. Regulated futures contracts, regulated commodity option contracts, either event typically between 10 and 20 percent of trading profits. In some instances, the compensation agreement specifies that funds be only paid when the profits of the fund exceed a minimum rate, or hurdle rate.

Exempt forex funds

To be exempt from registration under the Securities Act of 1933, a fund must have no more than 100 beneficial owners (also known as the 100 investor test) and must not publicly offer its interests. Under the Section 3(c)(7) exemption, a fund must offer its securities to
March 2005 CURRENCY TRADER

qualified purchasers. There are no limitations on the number of qualified purchasers under the Investment Company Act of 1940. However, when there are more than 500 investors in the limited partnership, the entity my be subject to classification as a publicly traded entity. If that occurs, the entity could lose its flow-through tax treatment (i.e., a partnership) which is one of the primary benefits of the hedge funds structure.

Steps to launch a forex hedge fund

1. If you need to register as a Commodity Pool Operator (CPO), start the process, which you will continue while executing the rest of these steps. See www.iard.com to get started. 2. Determine what will make your hedge fund unique. Finalize the funds investment objective and investment strategies, prepare biographical data on yourself for the offering documents, and make decisions that will affect how often you accept investors, how you will be compensated, what expenses your fund (as opposed to the management company) will bear, how you will be set up regarding trader tax status, etc. 3. If you are forming a commodity hedge fund, start the process of becoming a member of the NFA. See this page: http://www.nfa.futures.org/registration/nfa_membership.asp. You will need to register as a Commodity Pool Operator with the NFA. See http://www.nfa.futures.org/registration/cpo.asp. 4. Obtain a first draft of your offering documents (Private Placement Memorandum, LLC Agreement, and Subscription Materials) from your provider (the firm advising you on setting up your hedge fund). Form your business entities, get tax ID numbers, make the appropriate IRS elections, and prepare resolutions so you can open bank and brokerage accounts. 5. Your providers attorney should be actively involved in the review of your documents. This is an important part of the preparation of your fund. 6. If you are registered as an Investment Adviser or registered with the NFA as a Commodity Pool Operator, make sure the regulators have approved any such applications. 7. Your provider should give you the SEC Form D and the blue sky filings for the initial states where you expect to distribute your offering documents. Make sure your provider gives you instructions on how and where to file the various documents, and general instructions regarding the distribution of your offering documents. You should now have a final set of offering documents. 8. Have your offering documents printed and bound. Consider the image you wish your fund to project when choosing the printing materials and binding method. Remember that you can have no marketing materials other than your offering documents. 9. Mail your SEC Form D. You can check here to see that it was processed by the SEC: http://www.sec.gov/edgar/searchedgar/companysearch.html. File your blue sky filings within the appropriate time either before distribution or within 15 days of the first sale in that state, depending on the states rules. 10. Start distributing your offering documents and attracting investors. Keep a log of all individuals to whom you distribute your documents. Deposit your seed capital and start the initial trading of the fund.

Accredited vs. non-accredited investors

Generally, accredited investors includes persons whose net worth (or joint net worth with spouse) exceeds $1,000,000, or whose income was in excess of $200,000 in both the two preceding years (or, with a spouse, in excess of $300,000 in both the two preceding years), and who reasonably expect to reach the same level of income in the current year. If you plan to have non-accredited investors in your fund, you will not only need a detailed set of disclosure documents, but also audited documentation of the source of initial capital invested in the fund. This initial audit is referred to as a launch audit or as a seed-capital audit. Regulation D limits the number of non-accredited investors to 35. Taking on non-accredited investors is risky because if there are ever any problems with the funds performance and investors seek relief in the courts, a judge would probably take the side of the non-accredited investor.

How do I attract investors?

Rule 502(C) of Regulation D prohibits any form of a general solicitation or general advertising. Generally, interests in your hedge fund may be sold by registered broker dealers, registered investment advisors or officers of the funds management to those persons with whom they have existing relationships. Your marketing efforts must be percontinued on p. 54

CURRENCY TRADER March 2005

53

BUSINESS OF TRADING continued

sonally directed toward investors who are known to you. The SEC views nonpersonal communications as general solicitations, even when the targeted recipients of the communications could reasonably be expected to be qualified investors. However, it is possible to comply with the prohibitions against general solicitation or advertising by using a secure Web page for which access is limited to accredited investors.

Blue sky
Within 15 days of the first sale of your offering, you will have to file your Form D (Notice of Sale) with the SEC as well as comply with filing requirements of the states in which each of your investors are located. Then you need to be sure that your securities are sold with out violating the prohibition on general advertising.

NFA registration
If your forex fund invests in currency futures contracts, currency futures options, or forward contracts, it must be approved as a commodity pool by the Commodity Futures Trading Commission (CFTC). In addition, you must register with the National Futures Association (NFA) and become a Commodity Pool Operator (CPO). This raises the differences between registration as a CPO and a commodity-trading advisor (CTA). A CTA manages individual accounts, while a CPO manages only the hedge fund, or pool. Many people lose interest in the CTA option when they realize the administrative hassles associated with managing separate accounts. Spot forex trading is not regulated by the CFTC and does not require CPO registration if the fund trades spot currencies exclusively. Legally, spot currency refers to contracts that settle by the second business day after the date the trade is entered. While CFTC registration is not required for spot forex traders, it is important for fund managers to trade with firms that are NFA registered, as NFA registered members are subject to
54

arbitration, capital requirement rules, and customer account regulations. No sponsor is needed to take the Series 3 exam, also known as the National Commodity Futures Examination, which is administered under the auspices of the NASDs testing program. You can find the nearest testing location at www.nasd.com/NASDW_010803. The CFTC has allowed the NFA to become the primary regulator of futures and commodity products (as a self-regulatory organization, similar to the NASDs status with the SEC). The item that will typically take the most time for processing of a CPO application is the fingerprint card, which is supplied by the NFA. A CPO will take it to their local police station and have their fingerprints taken. The card is then mailed to the NFA, which sends it to the FBI for processing. This takes six to eight weeks, and there is no rush service available, so take care of this very early in the application process. The NFA must approve all disclosure documents before they can be used to solicit clients. If the NFA has comments, it will usually give them to the CPO candidate verbally, and in writing if the CPO candidate requests. The guide for CPOs and CTAs (see Web resources) is an invaluable tool for creating disclosure documents. The NFA essentially uses that document as a checklist, and every item must be addressed to their satisfaction before they will approve disclosure documents. The disclosure document must include information about the CPO and its principals (including performance record), commodity trading advisors, futures commission merchants, brokers, details of the commodity interests, expenses associated with the pool, conflicts of interest, minimum investment amounts, transferability issues, and any litigation (material, administrative, civil, or criminal) against anyone involved in the management of the fund. Additionally, any person who is involved in the commodity pool must register as an associ-

ate of the CPO. The disclosure document must be filed with the NFA at least 21 days prior to the delivery of the documents to a prospective participant, and updated periodically. The CPO must receive a written confirmation from each participant in the pool that they received the Disclosure Document prior to accepting the participants funds.

CPO registration exemptions

The CFTC provides for several exemptions from CPO regulations. A person is not required to register as a CPO if the person did not receive any compensation or payment directly or indirectly, operated only one commodity pool at a time, or was not otherwise required to register with the CFTC. This is referred to as the closely held pool exemption. Registration as a CPO is also not necessary from registration when total gross capital contributions for participation units in all pools that are operated (or intended to be operated) do not in the aggregate exceed $400,000 and there are less than 15 participants in the pool. Also exempt from registration as a CPO with respect to the pool, where the interests have been sold exclusively to participants that the CPO reasonably believes at the time of their investments were QEPs, and the pool trades commodities in de minimis amounts. The de minimis limitations are: 1) the pool limits its commodity interests positions such that the aggregate notional value of such positions does not exceed the liquidation value of the pools portfolio, or 2) the total amount the pool commits as initial margin and premiums to establish commodity positions does not exceed 5 percent of the liquidation value of the pools portfolio. Another requirement is the interests in the relevant pool are not marketed as participants in a vehicle for trading in commodity interests. CFTC Rule 4.13(a)(4) establishes a CPO registration exemption for a CPO with respect to a pool where interests
March 2005 CURRENCY TRADER

Web resources
are offered and sold without marketing to the public in the United States, and are sold exclusively to participants that the CPO reasonably believes are QEPs. http://www.nfa.futures.org/ The home page for the National Futures Association (NFA). http://www.nfa.futures.org/compliance/issues_cpo_cta.asp and http://www.nfa.futures.org/compliance/publications/dd2001/DD2004.pdf The web pages are related to the NFAs Guidance to Commodity Pool Operators (CPOs) and Commodity Trading Advisers (CTAs). The second link is particularly valuable. It essentially defines the sections that need to be included with a CPO document that is submitted to the NFA. It also discusses some of the various exemptions from registration that are available. Some of these exemptions (particularly the Qualified Eligible Person [QEP] only pools) are very powerful and should be strongly considered. The QEP exemption allows you to not have to take the Series 3, not have to become a member of the NFA, and not have the NFA or the CFTC as a regulator. Other exemptions, such as those related to small pools, may be of more benefit to certain clients. http://www.nfa.futures.org/registration/cpo.asp. The NFAs guidance related to who has to register as a CPO, and how it is accomplished. It includes a link to a page for an "Easy Reference Guide" to exemptions from registration here: http://www.nfa.futures.org/registration/ easyReferenceGuidePart4.pdf. http://www.nfa.futures.org/registration/cta.asp The equivalent to #3, above, except that it is for CTAs. http://www.nfa.futures.org/registration/nfa_membership.asp Data related to becoming a member of the NFA. All CPOs and CTAs must be members of the NFA, unless they achieve an exemption. Note the reduced fee schedule that became effective on July 1, 2004. http://www.nfa.futures.org/basicnet/ This is the equivalent of the NASDRs website, except that it is for the NFA. Through this page, you can access a summary of the status of all NFA members, including regulatory status and sanctions. http://www.cftc.gov/cftc/cftclawreg.htm#cea This is an invaluable site to review the underlying federal law related to CFTC issues. Note the various links in the body of the page as well as on the left navigation buttons. Securities Law: http://www.law.uc.edu/CCL/sldtoc.html State Securities Administrators: http://nasaa.org/members_only/CFTC Law and Regulation links: http://www.cftc.gov/cftc/cftclawreg.htm#cea Investment Adviser application (for most states): www.iard.com Our website (tons of additional data): http://www.greencompany.com/HedgeFunds/index.shtml reporting requirements, and record keeping. Although the process is involved, experienced forex traders who wish to expand into professional money management can save themselves a great deal of trouble later by learning now about the forex hedge fund registration process and regulations they will have to abide by in the future.
For information on the author see p. 8.
55

Are you going to trade stocks, too?

If you plan to execute more than an occasional stock trade, you might also have to register as an investment adviser. Beginning in February 2006, hedge fund mangers will be required to register with the SEC as investment advisers when a fund has assets of $25 million or more and has 15 or more investors in the hedge fund. Until then, the hedge fund itself is considered the client of the adviser, which affords the adviser an exemption from registration if there are less than 15 clients and the adviser does not hold itself out to the public as an investment adviser. Funds with less than $25 million will not be permitted to register and will be subject to applicable state law.

State investment adviser registration

Each state has its own registration requirements which are also interpreted in conjunction with the National Securities Market Improvement Act of 1996. In some instances, where the investment adviser has a particular kind of client, has fewer than a certain number of clients within a 12-month consecutive period, and does not hold itself out to the public as an investment adviser, it may be exempt from that states registration requirement. In each instance, it is important that the law of the state in question be reviewed for compliance.

More rules and regs

In addition to the registration and solicitation guidelines summarized above, there are also federal and state laws governing the operation of the fund. These laws govern marketing and advertising, the compensation of fund advisers, fund management, personal trading, the use of soft dollars,
CURRENCY TRADER March 2005

CURRENCY SYSTEM ANALYSIS

FIGURE 1 SAMPLE TRADES

Parabolic FX
Market(s): All.

The parabolic systems trailing stop moves closer to price as a trend lengthens.
Euro/U.S. dollar (EUR/USD), daily Sell 1.3500 1.3450 1.3400 1.3350 1.3300 1.3250 1.3200 1.3150 1.3100 1.3050 1.3000 1.2950 1.2900 1.2850 1.2800 1.2750 1.2700 1.2650 1.2600 1.2550 1.2500 1.2450 1.2400 1.2350 1.2300 1.2250 1.2200 1.2150 1.2100 1.2050 1.2000 1.1950 1.1900

Account balance ($)

Buy System concept: This system applies Welles Wilders parabolic trend-following approach to the Sell forex market. Wilder originally described this system in his 1978 book New Concepts in Technical Trading Systems. Buy The parabolic system is a stopSell and-reverse (SAR) strategy that Sell is, when a long trade is stopped out Sell Sell a short trade is simultaneously opened, and vice versa. The basic Buy idea behind the system is the longer Buy a trend lasts, the more important it is to protect open profits. On the other Buy hand, the major drawback of most Buy trend-following systems getting August 2004 September 2004 October 2004 November 2004 December 2004 stopped out too early by small corSource for all figures: Wealth-Lab Inc. (www.wealth-lab.com) rections or consolidation moves within the longer trend must be avoided for the system to generate the FIGURE 2 EQUITY CURVE (DAILY) large winning trades that will make up most of its profits. The system performed terribly on daily data, losing money overall and producing only two profitable currency pairs. To balance these needs the parabolic uses a stop that trails well below or above 1,500,000 1,450,000 the price bar at the beginning of a trade 1,400,000 but moves progressively closer to price 1,350,000 1,300,000 the longer the trade lasts. This is accom1,250,000 plished by a multiplier called the accel1,200,000 1,150,000 eration factor. The steadily tightening 1,100,000 stop resembles a parabola, hence the sys1,050,000 1,000,000 tems name (see Figure 1). The calcula950,000 tion for the parabolic is: 900,000

SAR price level tomorrow = (SAR price today) + (Acceleration Factor * (Extreme Price - SAR level today)) There are myriad ways to enter and exit the market using the parabolic approach. We chose the original parameters Wilder used in his book. (For more information about the Parabolic system, see Indicator Insight: Parabolic stop, Active Trader, February 2005.) Rules: 1. Enter long when price hits todays upper parabolic stop value.
56

850,000 800,000 750,000 700,000 650,000 600,000 550,000 500,000 450,000 400,000 350,000 300,000 250,000 200,000 150,000 100,000 50,000 0
3/3/95 11/24/95 9/10/96 6/26/97 4/14/98 1/29/99 11/16/99 8/31/00 6/19/01 4/5/02 1/21/02 6/11/03 8/24/04

Equity

Cash

Linear Reg

Long

Short

March 2005 CURRENCY TRADER

Note: We tested the system on both daily and weekly timeframes.

Account balance (%)

2. Enter short trade when price hits todays lower parabolic stop value. 3. Exit long trade when price hits todays lower parabolic stop value. 4. Cover short trade when price hits todays upper parabolic stop value.

FIGURE 3 DRAWDOWN CURVE (DAILY) The systems drawdown was huge and it kept getting bigger.
0.00 -5.00 -10.00 -15.00 -20.00 -25.00 -30.00 -35.00 -40.00 -45.00 -50.00 -55.00 -60.00 -65.00
3/3/95 11/22/95 9/4/96 6/19/97 4/3/98 1/18/99 11/2/99 8/15/00 5/30/01 3/14/02 12/26/02 10/9/03 7/23/04

STRATEGY SUMMARY (DAILY) Profitabilty Net profit ($): Net profit (%): Exposure (%): Profit factor: Payoff ratio: Recovery factor: Drawdown Max. DD (%): Longest flat days: -65.42 2,048 -524,481.41 -52.45 10.07 0.92 1.60 0.65 Trade statistics No. trades: Win/loss (%): Avg. gain/loss ($): Avg. hold time (days): Avg. winner (%): Avg. hold time (winners): Avg. loser (%): Avg. hold time (losers): Avg. consec. win/loss: 1,328 37.20 -0.04 10.68 2.11 17.19 -1.32 6.82 10/15

Money Management: Risk 2 percent of total capital per trade. Test data: The system was tested on the following currency pairs: Australian dollar/U.S. dollar (AUD/USD), Euro/U.S. dollar (EUR/USD), British pound/U.S. dollar (GBP/USD), U.S. dollar/Swiss franc (USD/CHF), U.S. dollar/Japanese yen (USD/JPY), and U.S. dollar/Brazilian real (USD/BRL). Note: Currency pairs for which the U.S. dollar is the base currency (e.g., USD/JPY) were inverted (e.g., JPY/USD) to enable portfolio testing in dollar terms. Data source: Comstock/FXtrek (www.fxtrek.com).
continued on p. 58

STRATEGY SUMMARY (WEEKLY) Profitabilty Net profit ($): Net profit (%): Exposure (%): Profit factor: Payoff ratio: Recovery factor: Drawdown Max. DD (%): Longest flat days: -31.41 150 1,220,638.66 122.06 10.10 1.31 2.03 2.26 Trade statistics No. trades: Win/loss (%): Avg. gain/loss ($): Avg. hold time (days): Avg. winner (%): Avg. hold time (winners): Avg. loser (%): Avg. hold time (losers): Avg. consec. win/loss: 249 42.23 0.75 11.45 5.23 17.15 -2.58 7.23 5/7

PERIODIC RETURNS % Avg. Sharpe Best return ratio return Weekly Monthly % % Max. Max. Worst profitable consec. consec. return periods profitable unprofitable 7 5 3 2 8 6 6 2

-0.08% -0.16 11.32% -13.50% 45.03% -0.37% -0.17 20.22% -17.29% 48.31%

Quarterly -1.33% -0.26 25.91% 20.95% 42.50% Yearly -6.24% -0.46 14.13% 28.04% 40.00%

LEGEND: Net profit Profit at end of test period, less commission Exposure The area of the equity curve exposed to long or short positions, as opposed to cash Profit factor Gross profit divided by gross loss Payoff ratio Average profit of winning trades divided by average loss of losing trades Recovery factor Net profit divided by max. drawdown Max. DD (%) Largest percentage decline in equity Longest flat days Longest period, in days, the system is between two equity highs No. trades Number of trades generated by the system Win/loss (%) the percentage of trades that were profitable Avg. trade The average profit/loss for all trades Avg. winner The average profit for winning trades Avg. loser The average loss for losing trades Avg. hold time The average holding period for all trades Avg. hold time (winners) The average holding time for winning trades Avg. hold time (losers) The average holding time for losing trades Avg. consec. win/loss The maximum number of consecutive winning and losing trades

LEGEND: Avg. return The average percentage for the period Sharpe ratio Average return divided by standard deviation of returns (annualized) Best return Best return for the period Worst return Worst return for the period Percentage profitable periods The percentage of periods that were profitable Max. consec. profitable The largest number of consecutive profitable periods Max. consec. unprofitable The largest number of consecutive unprofitable periods Currency System Analysis strategies are tested on a portfolio basis (unless otherwise noted) using Wealth-Lab Inc.s testing platform. If you have a system youd like to see tested, please send the trading and money-management rules to editorial@currencytradermag.com. Disclaimer: Currency System Analysis is intended for educational purposes only to provide a perspective on different market concepts. It is not meant to recommend or promote any trading system or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Past performance does not guarantee future results; historical testing may not reflect a systems behavior in real-time trading.

CURRENCY TRADER March 2005

57

CURRENCY SYSTEM ANALYSIS continued

Test period: December 1994 to December 2004 (except the Brazilian Real, which spanned December 1999 to December 2004). Starting equity: $1,000,000 U.S. Interest rate (rollover) fees were not calculated. We included a round-turn commission of 4 pips per every 100,000 units traded in the base currency and calculated 1 pip for slippage.

cy pairs AUD/USD (8.89 percent) and JPY/USD (16.96 percent) were profitable. But even this return was too low to offer adequate compensation for the systems risk.

Account balance ($)

Weekly: Although there was virtually nothing to recommend the system on the daily timeframe, we then applied the same rules to weekly data and were surprised to find much different results. The system generated a profit of $1,220,639 over 10 years 122.06 percent, or 8.47 percent annualized (Figure 4). The drawFIGURE 4 EQUITY CURVE (WEEKLY) down (Figure 5) shrank to 31.41 percent, which is not ideal but is nonetheThe same rules tested on weekly data produced much more favorable less a great improvement over the daily results. The system turned a profit, despite being in a current slump. results. Also, the analysis of profitable 2,400,000 vs. unprofitable periods improved sub2,300,000 stantially. 2,200,000 Both applications of the parabolic 2,100,000 system showed the same uncomfort2,000,000 1,900,000 able habit of achieving more losing 1,800,000 trades than winning trades, but thats 1,700,000 life for trend followers. 1,600,000
1,500,000 1,400,000 1,300,000 1,200,000 1,100,000 1,000,000 900,000 800,000 700,000 600,000 500,000 400,000 300,000 200,000 100,000 0
3/3/95 11/13/95 8/5/96 5/5/97 3/2/98 1/4/99 10/25/99 8/28/00 6/18/01 3/11/02 1/6/03 11/10/03 9/6/04

Equity

Cash

Linear Reg

Long

Short

Bottom line: The results of the two test runs on daily and weekly data suggest there are much clearer longterm trends than short-term trends in currencies, or the trends that develop on the weekly time frame are more likely to have exploitable differences between exit and entry prices. A typical trend-following system such as this will have a much easier time in the weekly environment, with the added benefit of requiring less day-to-day maintenance. It might be a good idea for trend followers to periodically check their systems on different time frames to determine the friendliest environment.
Michael Schneider of Wealth-Lab

Test results: Daily: On the daily timeframe the system produced disappointing results, even though Figure 1 gives the impression it captures trend moves pretty well. But in fact there are too many sideways periods and shortlived price swings producing losing trades for the systems smaller number of big winners to compensate. The total return was a disappointing 52.45 percent loss with a drawdown of 65.42 percent (Figure 2). The drawdown suggests it is only a matter of time until the maximum loss will become even bigger. Only two curren58

FIGURE 5 DRAWDOWN CURVE (WEEKLY) The weekly drawdown, while hardly unnoticeable, is still a dramatic improvement over the daily version of the system.
0.00 -2.00 -4.00 -6.00 -8.00 -10.00 -12.00 -14.00 -16.00 -18.00 -20.00 -22.00 -24.00 -26.00 -28.00 -30.00
3/3/95 11/13/95 8/5/96 5/5/97 3/2/98 12/28/98 10/18/99 8/14/00 6/4/01 3/1/02 12/16/03 10/13/03 9/8/04

Account balance (%)

March 2005 CURRENCY TRADER

GLOBAL NEWS BRIEFS

EUROPE
Frances economy grew by 0.8 percent, boosted by increased household consumption expenditure and exports. GDP grew 2.3 percent in 2004, 1.8 percent higher than the previous year. The countrys unemployment rate remained stable at 9.9 percent compared to December, and was also unchanged from a year earlier. Germanys GDP fell 0.2 percent from Q3 2004, but grew by 1.8 percent compared to Q4 2004. An 0.8-percent decrease in domestic uses helped cause the quarter-onquarter decrease. The jobless rate in Germany grew 1.3 percent to 12.1 percent and increased 1.1 percent compared to January 2004.

AMERICAS
Brazils unemployment rate fell 1 percent to 9.6 percent in December 2004. The average unemployment rate for 2004 was 11.5 percent, 0.8 percent lower than 2003. The jobless rate for Canada remained stable at 7.0 percent compared to the previous month. Canadas fourth quarter account surplus fell to $6.3 billion Canadian dollars (about $5 billion U.S.) from $8.36 billion Canadian the quarter before. Statistics Canada blamed the decline partly on a falling trade surplus and a stronger Canadian dollar.

AFRICA
South Africas GDP increased at an annualized rate of 4 percent compared to Q3 2004 as most sectors of the economy grew.
* Unemployment rates refer to Q4 2004 or January 2005 numbers, unless otherwise stated. * All GDP is real, at current prices and seasonally adjusted unless otherwise stated. GDP is expressed as a growth/loss percentage and not as an exact rate.

ASIA & THE SOUTH PACIFIC

Chinas National Bureau of Statistics (NBS) announced the countrys economy has stabilized and developed rapidly under new measures. Preliminary estimation indicated the GDP of China in 2004 was 13,651.5 billion yuan, up 9.5 percent over the previous year, without showing big ups and downs, accordong to Li Deshui, commissioner of NBS. Good grain harvests and increased industrial production contributed to the gain. Also, the year showed improvement in the consumer markets, as total retail sales of consumer goods grew 10.2 percent. Retail sales enjoyed major gains in communications products, which increased by 41.7 percent and oil and related products, which increased by 45.9 percent. Australias jobless rate remained unchanged at 5.1 percent compared to the previous month; the rate was 0.6 percent lower than January 2004. Unemployment in Hong Kong fell 0.1 percent to 6.4 percent, its lowest level in three years. The short-term outlook for unemployment will continue to hinge on the rate of job creation in the corporate sector relative to the growth in labor force, said a government spokesperson. Japans preliminary GDP data showed a 0.1 percent decrease in GDP compared to the previous quarter, but a 0.6 percent gain compared to the same quarter a year ago. Japans jobless rate decreased by 0.1 percent to 4.4 percent in December as compared to the previous month and dropped 0.5 percent from December 2003.

Dollar still leads reserves

As of March 2004, the latest data available, total international foreign currency reserves totaled $3.36 trillion, almost double the 1998 year-end total. The foreign currency reserves account for almost 95 percent of the globes non-gold reserve assets. About two-thirds of the reserves were held by developing countries, and around 64 percent were denominated in U.S. dollars. Euros accounted for 20 percent, Japanese yen five percent, British pounds four percent and about half of a percent were denominated in Swiss francs.

Rich nation, poor nation

Rodrigo Rato, head of the International Monetary Fund, said in late February he believes the worlds richest nations need to provide more help to poor nations and urged them to take deliberate steps to fix global economic imbalances. He specifically urged the United States to make every attempt to fix its budget gap, although he said he saw signs of restraint in President Bushs 2006 budget.

March 2005 CURRENCY TRADER

59

INTERNATIONAL MARKET SUMMARY

FOREX (vs. U.S. DOLLAR)
Current price vs. U.S. dollar 0.3858 1-month 3-month 6-month gain/loss gain/loss gain/loss 3.50% 5.47% 12.49% 52-week high 0.3899 52-week low 0.3103 Previous rank 5

Rank*
1

Country

Currency
Brazilian real South African rand Australian dollar Swiss franc British pound New Zealand dollar Euro

0.1728

2.89%

3.01%

13.14%

0.1783

0.1388

16

0.7867

2.22%

0.11%

9.39%

0.7956

0.6773

0.8597

1.86%

-0.38%

8.43%

0.8879

0.7559

14

1.9097

1.64%

2.22%

5.35%

1.955

1.7479

12

0.7225

1.27%

1.44%

8.36%

0.7302

0.591

1.3214

1.25%

1.01%

8.14%

1.3667

1.1758

13

Swedish krona Russian rouble Sinapore dollar Thai baht Hong Kong dollar Indian rupee Taiwanese dollar Canadian dollar

0.1455

1.03%

-0.34%

9.07%

0.152

0.1283

15

0.03598

0.97%

2.45%

4.86%

0.03609

0.03414

11

10

0.6147

0.44%

1.01%

4.91%

0.6158

0.5775

11

0.02607

0.19%

3.68%

7.36%

0.02621

0.0239

12

0.1282

0.00%

-0.31%

0.00%

0.1288

0.1281

10

13

0.02293

-0.04%

3.14%

5.54%

0.02304

0.02145

14

0.031219

-1.00%

1.34%

5.89%

0.03218

0.02801

15

0.808

-1.13%

-4.36%

5.35%

0.8532

0.7138

Japanese 0.009536 -2.03% yen As of Jan. 24, 2005 *based on one-month gain/loss 16

-1.45%

4.50%

0.00983

0.0087

INTEREST RATES
Rank 1 2 3 4 5
60

Country Australia UK Japan U.S. Germany

Rate 3-year bonds Short sterling Government Bond 10-year T-note BUND

Feb. 24 94.52 94.88 138.86 111.1 118.43

1-month -0.16% -0.33% -0.40% -0.91% -1.22%

3-month -0.15% -0.26% 0.53% -0.88% 0.78%

6-month N/A 0.14% 2.21% -0.93% 4.02%

Previous 5 4 3 1 2

March 2005 CURRENCY TRADER

NON-U.S. DOLLAR FOREX CROSS RATES

Rank 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Currency pair Real / Yen Real / Canada $ Aussie $ / Yen Franc / Yen Pound / Yen Aussie $ / Canada $ Euro / Yen Franc / Canada $ Real / Euro Real / Pound Real / Aussie $ Aussie $vEuro Canada $ / Yen Aussie $ / Pound Franc / Euro Pound / Euro Aussie $ / Franc FrancvPound Canada $ / Euro Canada $ / Pound Symbol BRL/JPY BRL/CAD AUD/JPY CHF/JPY GBP/JPY AUD/CAD EUR/JPY CHF/CAD BRL/EUR BRL/GBP BRL/AUD AUD/EUR CAD/JPY AUD/GBP CHF/EUR GBP/EUR AUD/CHF CHF/GBP CAD/EUR CAD/GBP Feb. 24 40.4784 0.4777 82.519 90.1994 200.33 0.974 138.6 1.0644 0.2921 0.2021 0.4907 0.5955 84.7701 0.412 0.6506 1.4459 0.9155 0.4502 0.6116 0.4232 gain/loss 6.84% 4.29% 4.24% 3.84% 3.62% 3.54% 3.25% 3.18% 2.29% 1.88% 1.30% 0.97% 0.64% 0.58% 0.55% 0.41% 0.37% 0.20% -2.70% -3.10% 1-month gain/loss 6.84% 9.42% 1.57% 1.07% 3.63% 4.27% 2.45% 3.80% 4.52% 3.36% 5.38% -0.91% -2.85% -2.16% -1.40% 1.25% 0.50% -2.67% -5.43% -6.71% 3-month gain/loss 8.38% 7.52% 5.16% 4.13% 0.89% 4.23% 3.80% 3.21% 4.76% 7.57% 3.40% 1.38% 0.90% 4.27% 0.32% -2.99% 1.07% 3.24% -3.02% 0.00% 6-month high 41.1739 0.4825 85.559 91.6645 208.03 1.0373 141.59 1.1054 0.301 0.2069 0.5018 0.6358 89.7805 0.4221 0.665 1.5279 0.9894 0.4647 0.6497 0.454 52-week 52-week low Previous 34.3301 0.4212 74.28 80.5368 189.5 0.8863 125.81 0.9952 0.2575 0.1714 0.4337 0.5643 78.0564 0.372 0.6297 1.4057 0.8547 0.4179 0.5916 0.397 12 10 13 19 16 14 18 20 2 6 17 4 9 7 11 8 3 15 1 5

GLOBAL STOCK INDICES

Rank 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Country Index Current 1522.69 28436 6574.21 13684.56 9657.74 14060.91 2152.59 3977.67 4972.1 1200.2 4304.29 5886.02 11531.15 4100.6 24085 1-month gain/loss 15.11% 14.90% 7.12% 6.88% 6.00% 4.79% 3.64% 3.27% 3.21% 3.04% 2.38% 2.30% 2.10% 1.29% 0.80% 3-month gain/loss 22.77% 15.00% 8.19% 12.99% 7.06% 0.45% 5.22% 5.45% 5.08% 1.54% 4.16% 6.54% 5.71% 5.02% 7.05% 6-month gain/loss 36.88% 19.57% 22.92% 25.30% 13.89% 10.06% 11.48% 9.64% 11.36% 8.67% 12.39% 8.59% 4.73% 13.68% 15.96% 52-week high 1522.69 28436 6719.17 13792.86 9729.91 14339.06 2172.93 4042.27 5077.6 1217.9 4409.09 5941.7 12195.66 4188.8 24921 52-week low 829.84 17601 4227.5 9423.99 8098.06 10917.65 1690.35 3452.41 4283 1060.72 3618.58 5264.5 10489.84 3337 19655 Previous 1 15 14 8 11 13 4 6 5 12 10 3 9 7 2

Egypt CMA Brazil Bovespa India BSE 30 Mexico IPC Canada S&P/TSX composite Hong Kong Hang Seng Singapore Straits Times France CAC 40 UK FTSE 100 US S&P 500 Germany Xetra Dax Switzerland Swiss Market Japan Nikkei 225 Australia All ordinaries Italy MIBTel

ACCOUNT BALANCE
Rank Country 1 2 3 4 5 6 7 8 Hong Kong Taiwan Germany Japan Denmark Canada France Italy 2004 16.404 21.3 118.525 159.402 4.289 28.195 -12.761 -18.074 Ratio* 10 6.9 4.4 3.4 1.8 2.9 -0.6 -1.1 2003 16.697 29.202 52.933 136.238 6.327 17 5.474 -21.942 2005+ 16.598 19.378 129.726 148.931 4.543 25.243 -13.246 -13.315 Rank 9 10 11 12 13 Country UK Spain U.S. New Zealand Australia 2004 -43.338 -33.066 -631.268 -4.102 -32.036 Ratio* -2 -3.4 -5.4 -4.4 -5.3 2003 -33.39 -23.549 -530.669 -3.267 -30.212 2005+ -43.098 -36.462 -641.678 -4.151 -30.248

Totals in billions of U.S. dollars + *Ratio: Account balance in percent of GDP; Estimate Source: International Monetary Fund, World Economic Outlook Database, October 2004

CURRENCY TRADER March 2005

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CURRENCY FUTURES

CME to offer Euro and yen options with European-style expiration

he Chicago Mercantile Exchange (CME) will launch new EuroFX and Japanese yen options contracts with Europeanstyle expiration on its electronic Globex platform in April. The CME already offers these contracts with Americanstyle expiration via open outcry and during a limited CME Globex trading period. These electronically traded currency options contracts, which will be available nearly 24 hours a day, will trade side by side with the open outcry markets. In similar fashion to its currency futures, CME will offer connectivity to a select group of automated market makers for these new options. The European-style options on these two futures contracts will be listed on April 3 at 5:00 p.m. on Globex and in the open outcry market on April 4 at 7:20 a.m.

"Last year, our total FX volume grew more than 50 percent, and our electronic volume was up 128 percent from the prior year," said Rick Sears, Managing Director, CME Foreign Exchange. "Now for the first time, investors will be able to trade our futures and options off the same electronic platform nearly 24 hours a day. In addition, offering the choice of

European-style expiration, as well as American-style expiration, allows our investors flexibility in determining investment strategies and also provides alternative tools that are more in line with the OTC market." Average daily volume in CME Euro futures and options was 86,757 in 2004. Volume in CME Japanese yen futures and options was 31,070 in 2004.

Turkish Derivatives Exchange opens Feb. 4

urkDEX, Turkey's first futures and options exchange (VOB), is up and running as of Feb. 4. The exchange, based in the Aegean coastal city of Izmir, will include currency futures contracts previously listed on the Istanbul stock exchange and futures contracts listed on the Istanbul gold bourse. After 11 years of discussion involving details of operation and where it would be based, in March 2004 the exchange was approved by the Capital Markets Board (SPK) and was decided to be established in Izmir.

T
Vol

CURRENCY FUTURES SNAPSHOT The information does NOT constitute trade signals. It is intended only to provide a brief synopsis of each markets
as of 2/28/05

liquidity, direction and levels of momentum and volatility. See the legend for explanations of the different fields.

Contract Eurocurrency* Japanese yen* Canadian dollar* Swiss franc** British pound* Australian dollar* Mexican peso* U.S. dollar index Euro / Japanese yen Euro / Swiss franc

Sym EC JY CD 6S BP AD MP DX EJ RZ

Exch

OI 139.0 140.4 74.7 53.1 67.2 77.4 80.3 16.5 13.7 12.1

CME 122.0 CME 37.6 CME 25.7 CME (Globex) 20.3 CME 19.6 CME 12.7 CME 11.1 NYBOT 2.5 NYBOT 0.8 NYBOT 0.6

10-day move 2.79% 0.42% 0.07% 4.62% 2.75% 0.52% 0.93% -2.27% 2.37% -0.89%

% rank 63% 33% 0% 83% 77% 12% 44% 50% 73% 63%

20-day move 1.53% -2.25% -0.09% 1.67% 1.76% 1.55% 2.45% -0.98% 3.86% -0.16%

% rank 26% 74% 5% 48% 37% 48% 82% 30% 100% 20%

60-day move -0.38% -2.15% -4.40% 2.04% 0.39% 1.77% 1.52% 1.34% 1.84% 1.32%

% rank 7% 72% 86% 68% 7% 29% 38% 83% 48% 37%

Volatility ratio/rank .37 / 85% .23 / 47% .22 / 39% .50 / 95% .34 / 75% .14 / 7% .35 / 25% .36 / 92% .67 / 83% .52 / 81%

Note: Contracts marked with * or ** have both pit-traded and electronic contracts that are traded through the CME's Globex electronic platform. In these cases, we listed the contract with the highest volume * indicates the pit-traded contract had larger volume; ** indicates the electronic contract had larger volume. LEGEND:
Sym: Ticker symbol. Vol: 30-day average daily volume, in thousands. OI: Open interest, in thousands. 10-day move: The percentage price move from the close 10 days ago to todays close. 20-day move: The percentage price move from the close 20 days ago to todays close. 60-day move: The percentage price move from the close 60 days ago to todays close. The % Rank fields for each time window (10-day moves, 20-day moves, etc.) show the percentile rank of the most recent move to a certain number of the previous moves of the same size and in the same direction. For example, the % Rank for 10-day move shows how the most recent 10-day move compares to the past twenty 10-day moves; for the 20-day move, the % Rank field shows how the most recent 20-day move compares to the past sixty 20-day moves; for the 60day move, the % Rank field shows how the most recent 60-day move compares to the past one-hundredtwenty 60-day moves. A reading of 100% means the current reading is larger than all the past readings, while a reading of 0% means the current reading is lower than the previous readings. These figures provide perspective for determining how relatively large or small the most recent price move is compared to past price moves. Volatility ratio/rank: The ratio is the short-term volatility (10-day standard deviation of prices) divided by the long-term volatility (100-day standard deviation of prices). The rank is the percentile rank of the volatility ratio over the past 60 days.

This information is for educational purposes only. Currency Trader provides this data in good faith, but cannot guarantee its accuracy or timeliness. Currency Trader assumes no responsibility for the use of this information. Currency Trader does not recommend buying or selling any market, nor does it solicit orders to buy or sell any market. There is a high level of risk in trading, especially for traders who use leverage. The reader assumes all responsibility for his or her actions in the market. 62 March 2005 CURRENCY TRADER

FOREX DIARY EDITORS NOTE

Australian dollar/U.S. dollar (AUD/USD), daily Potential profit if trailing stop had been used 0.795 0.790 0.785 Initial target 0.780 0.775 Exit at .7797 0.770 0.765 Long at .7667 Initial stop 0.760

Statistics and circumstances point to an up move in the Aussie dollar.

TRADE
Date: Tuesday, Feb. 8, 2005. Entry: Long the Australian dollar/U.S. dollar (AUD/USD) at .7667.

Reason(s) for trade/setup: On Feb. 8, 0.755 AUD/USD traded sharply lower than the previous session, but quickly rallied and 24 31 February 7 14 21 eventually closed in the upper end of the Source: TradeStation trading sessions range. This pattern, 0.80 AUD/USD, weekly described in Spike-low bottoms, has been followed the past few years by up 0.78 moves over the next four days; the average 0.76 largest up move by the fourth day after the RESULT spike-low bar was 1.7 percent, with odds of 0.74 64 percent for a positive move. Exit: .7797. 0.72 Readers of the Forex Diary in the February 2005 Currency Trader will notice Reason for exit: Market hit 0.70 this trade also fits into the consolidation initial profit target. pattern mentioned in the long AUD/USD Aug. Sept. Oct. Nov. Dec. 2005 Feb. trade in that issue. Here, the Feb. 8 low and Profit/loss: +130 pips (1.7 intraday upside reversal occurred at the percent). lower end of the consolidation which means chartwatchers may help the trade by going long at what appears Trade executed according to plan? Yes. to be a likely point for a technical bounce. Lesson(s): Given the way the market exploded through Initial stop: The historical analysis showed the largest the profit target, it seems like it might have been a good average down move in the four days after entry was -1.03 idea to take partial profits at the initial target level and use percent. This translates to 160 pips, which well use to set some kind of trailing stop on the remainder of the position. the initial stop at .7588 (which also happens to be 20 pips The market rallied to .7888 two days after we exited, below the low of the entry bar). expanding the potential profit to 221 pips; even using a simple trailing stop technique that exits below the low of the Initial target: The average largest up move in the first four previous bar would have gotten us out around .7842. The days was 1.7 percent, which we can use to set an initial tar- trades largest up move before pulling back occurred on get of .7797. Because testing also indicated the profit poten- day 4, which was the day identified in testing as the day tial diminishes after day 4, we will exit the trade on the with the highest probability of an up move and the largest close of day 4 if the target has not been hit. average gain.

TRADE SUMMARY
Date 2/8/05 Rate AUD/USD Entry .7667 Initial stop .7588 Initial target .7797 IRR 1.65 Exit .7797 Date 2/10/05 P/L +.0130 (1.7%) LOP .0221 LOL .0038 Trade length 2 days

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).

CURRENCY TRADER March 2005

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