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Forex Trading Using Intermarket Analysis .pdf

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Autore: Discovering Hidden Market Relationships that Provide Early Clues for Price Direction

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Forex Trading

Discovering Hidden Market Relationships
That Provide Early Clues for Price Direction

Louis B. Mendelsohn
Foreword by Darrell R. Jobman

Trading Using

Trading Using
n ermarke
Market e ationships
hat rovide ar y
ues or rice

Louis B. Mende sohn



. Jo










Chapter 1

If you have traveled internationally, you may already know something about the forex market, today’s hottest marketplace. Discover
why you might want to trade forex.

Chapter 2

The forex market is the world’s largest marketplace, dwarfing all
other markets combined. See how forex grew so large and how you
can participate.

Chapter 3

Forex traders can get plenty of information, sometimes so much that
it can be hard to sift through it all. Here are some reports a forex
trader needs to consider.

Chapter 4

With fundamental information overwhelming, many forex traders
analyze price action in charts. Chart patterns and indicators have
shortcomings, but see how predictive moving averages can help with
market forecasting.


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Chapter 5

What happens in one market is influenced by what happens in a
number of related markets. Discover why single-market analysis
should give way to intermarket analysis in today’s global marketplace, especially in forex markets, which are ideally suited for this
type of analysis.

Chapter 6

With so many fundamentals and so much influence from related markets, it’s hard to see all the patterns and relationships in the forex
market. Find out how neural networks can uncover hidden patterns
in data and select the best to make short-term market forecasts.

Chapter 7

Once you understand how the forex market works and the basics of
technical analysis, you are ready to put theory into practice. Here
are a few more practical tips and chart examples to help you apply
your knowledge to actual trading.

Chapter 8

Using only one approach to trade no longer works in today’s global
markets. Successful trading requires the synthesis of technical,
intermarket and fundamental approaches.




F o rex Tra di ng Usi ng Inte rmar ket Analysis

In the early 1980s, as the editor-in-chief of Commodities magazine, I was privy to a number of different trading ideas and techniques—so many, in fact, it was difficult to determine which was
best or sometimes which had merit. This was during the heyday of
innovations in the futures markets with the introduction of the cashsettlement concept in eurodollar futures, futures on broad-based stock
indexes, crude oil futures, the pilot program for options on futures, and
a number of other new contracts in areas where futures and options
did not exist before. It also was the period when the personal computer
was introduced and trading software was a new market analysis tool.
Inevitably, the developments in futures trading and in computerized
market analysis using trading software began to come together, and it
became obvious that the magazine needed to devote a lot more space
to this subject. The problem was finding authors with actual trading
experience who could explain the value of using this new computer
technology for market analysis to readers without an academic background in computer science.
In early 1983 I received an article from Lou Mendelsohn. Lou and
I did not know each other. He had a message about trading software
that he was willing to share, and he knew that Commodities was the
best way to reach a broad audience of futures traders. I just happened
to be looking for good articles on that subject. What Lou submitted
contained solid information on this new technology, and as a bonus,
his article was well written. No one on the magazine’s staff could have
written such an article at that point because no one had the trading
experience nor the knowledge of computers and trading software that
Lou provided.
His first article entitled, “Picking Software Programs: Know Their
Limitations,” appeared in the May 1983 issue of Commodities. This
article compared analysis software and system software in a logical,


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sensible way. At that time Lou recommended at least a 48-kilobyte
computer—not the megabytes or gigabytes that are common today—
evidence that this was a time when many traders were just learning
how to use personal computers.
A second article, entitled “History Tester Important Factor in Software
Selection,” appeared in the July 1983 issue of Commodities. Lou
emphasized the need for a history tester to compare the performance
of different trading strategies and to have standardized performance
reports so traders could make accurate comparisons of the results.
Today we know about net return per trade, drawdowns, and all the
other aspects of performance provided by software programs, but Lou’s
implementation of strategy back-testing in software for the personal
computer was the first in the financial industry, long before TradeStation
and other competing software programs appeared on the scene.
A third article, entitled “Execution Timing Critical Factor in System
Performance,” appeared in December 1983. By then, Commodities
was called Futures as the move toward financial products had begun.
In this article Lou analyzed the results of various entry and exit
points in Treasury bill futures, one of the first articles featuring this
type of research.
All of these articles illustrated Lou’s thorough understanding of
the markets and how traders could use their personal computers to
analyze data and develop successful trading systems and strategies.
This was new information to traders, and Lou’s pioneering work was
instrumental in incorporating the personal computer into the trading
mainstream, particularly with the release in 1983 of his ProfitTaker
software program. This was the first trading software program available for personal computers that performed strategy back-testing.
ProfitTaker laid the foundation for much of the technical analysis software development that has evolved over the past twenty-five years.


F o rex Tra di ng Usi ng Inte rmar ket Analysis

Lou has continued to write extensively on the application of computer and software technologies to trading and has pursued various
areas of research for the benefit of traders performing market analysis
with their computers. Intuitively, traders know that a target market is
influenced by developments in related markets and, in turn, the target
market affects what happens in other markets. The difficulty is in
quantifying those relationships. In the late 1980s Lou discovered that,
by applying computerized “artificial intelligence” concepts, involving
a mathematical technology known as neural networks, to market analysis he could ferret out intermarket patterns and connections between
markets that could never be seen through chart analysis. He then used
that information to forecast moving averages, making them a leading
rather than a lagging technical indicator.
His research into intermarket relationships and predicted moving
averages led to the development of VantagePoint Intermarket Analysis
Software™, first released in 1991. The research has not ended there,
however, as newly updated versions are released, all of which benefit
from his ongoing research into the application of neural networks to
intermarket analysis and incorporate new “learning” by the software
through periodic retraining of the neural networks.
This book is a result of Lou’s ongoing research, focusing specifically on
the foreign exchange market, the largest trading market in the world. If
there is a market that is perfectly matched to Lou’s analytical approach
of applying computerized trading software technology, such as neural
networks, to intermarket analysis, it is the forex market because of the
relationships of various currencies to each other and to other financial
influences (i.e., interest rates, stock indexes in a global marketplace).
As icing on the cake, forex is typically a trending market that makes it
an excellent candidate for his forecasted moving average analysis.


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As with those articles in Commodities and Futures nearly twenty-five
years ago, this book presents sound, practical information about forex
trading, focusing on the benefit of analytic trading software that can
make highly accurate short-term forecasts of the market direction of
this exciting and potentially highly lucrative trading arena.
Darrell Jobman is an acknowledged authority on the financial markets and has been writing
about them for over 35 years. After spending nearly 20 years as editor of Futures Magazine
Mr. Jobman is now Editor-in-Chief for Mr. Jobman has authored
and/or edited six books including The Handbook of Technical Analysis as well as trading
materials for both the Chicago Mercantile Exchange and the Chicago Board of Trade.



F o rex Tra di ng Usi ng Inte rmar ket Analysis

THIS BOOK EXPLORES the application of intermarket analysis to the foreign exchange market, the world’s largest and most
widely traded financial market. Intermarket analysis helps traders
identify and anticipate changes in trend direction and prices due
to influences of other related markets as financial markets have
become interconnected and interdependent in today’s global economy.
These markets include forex futures and options as well as major cash
forex pairs, which are affected not only by other currencies but by
related markets such the S&P 500 Index, gold, crude oil, and interest
rates. As the world economy of the twenty-first century continues to
grow and as new advances in information technologies continue to be
introduced, financial markets will become even more globalized and
sophisticated than they are today, increasing the central role that the
forex markets play in the global economy.
Since its introduction in the 1980s, intermarket analysis has become
a critical facet of the overall field of technical analysis because it
empowers individual traders to make more effective trading decisions
based upon the linkages between related financial markets. By incorporating intermarket analysis into trading plans and strategies instead
of limiting the scope of analysis to each individual market, traders can
make these relationships and interconnections between markets work
for instead of against them.
Forex markets are especially good candidates for intermarket analysis
because of the key role of the U. S. dollar in most major currency
pairs while other currencies tend to move in concert against the dollar.
What influences one currency often influences many other currencies,
usually not in lockstep but to a greater or lesser degree, depending on
the circumstance. Knowing what is occurring in various currencies
and other related markets can provide traders with both a broader
perspective and greater insight into forex market dynamics. It can


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thereby provide an early warning of impending changes in trend direction in the target market. This allows traders to make more effective
and decisive trading decisions than would be possible by relying on
traditional single-market technical analysis indicators that too often
lag the market.
This book is addressed primarily to traders and investors who use personal computers and the Internet to analyze forex markets and make
their own trading decisions. The book also offers insights into how
day traders and position traders in both the cash and futures markets
can improve their trading performance and achieve a serious competitive advantage in today’s globally interdependent financial markets. It
will interest both experienced traders and newcomers to forex markets
who are inclined toward technical analysis and recognize the potential
financial benefits of incorporating intermarket analysis into their trading strategies.

Louis B. Mendelsohn



F o rex Tra di ng Usi ng Inte rmar ket Analysis

I RECOUNTED HOW I GOT INVOLVED in commodity futures trading
and computerized technical analysis in my 2000 book, Trend Forecasting
with Technical Analysis: Unleashing the Hidden Power of Intermarket
Analysis to Beat the Market. However, I believe that it is worth repeating the highlights here because they address the convergence of the
development of futures trading and trading software technology during
the 1980s and 1990s that is now applied in today’s hot forex markets.
I traded stocks and options for nearly a decade, using various technical
analysis methods before I began day trading and position trading commodities in the late 1970s while employed as a hospital administrator
for Humana, one of the largest for-profit hospital management companies in the United States at that time. A physician friend who traded
gold futures provided the encouragement that moved me from equities
into this new trading area. This was during the inflationary period when
gold prices were building to a peak above $800 an ounce, so there was
incredible market excitement surrounding commodities trading.
At first I subscribed to weekly chart services, which had to be updated
by hand during the week and required a very sharp pencil to draw
my support and resistance lines, which in turn determined where I
placed my stops. It was very annoying to anticipate the trend direction correctly, only to miss out on a big move after being stopped out
prematurely at a loss due to an ill-placed stop.
With only a handheld calculator available to compute numbers in the
years before microcomputers, I learned the underlying theories and
mathematical equations for numerous technical indicators, such as
moving averages, and devised mathematical shortcuts to expedite my
daily calculations.
I was quite excited when I brought home my first personal computer
in the late 1970s. Soon I was teaching myself programming and writing simple software programs to automate many of these calculations.

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I quickly realized that the marriage of technical analysis with microcomputers would revolutionize financial market analysis and trading. Although I had been hooked on financial markets and technical
analysis for nearly a decade by then, it was the prospect of applying
computing technology to technical analysis that crystallized the intellectual passion that I had long sought.
In 1979 at the age of 31 and intent on pursuing this goal, I started a
trading software company that was the predecessor to my current company, Market Technologies, LLC. A year later, with my wife Illyce’s
support and, more importantly, with her income, I left Humana to trade
commodities full-time while continuing to develop trading software. My
goal was to design technical analysis software that would do more than
just speed up the analysis calculations that I had been doing by hand
each evening with a calculator. I wanted to test and compare various
trading strategies that I had created to identify the best ones and forecast the trend directions of the commodities markets that I traded.
Working alone and at a feverish pace, I spent day and night for the next
few years focused intently on my daily trading activities, researching
more about the commodities markets, studying books and articles on
technical analysis, examining every one of my winning and losing
trades for patterns to incorporate into my trading strategies, and developing trading software for the microcomputers that were just becoming
fashionable among commodities traders.
In 1983, after three years of full-time research and development in
which I was basically operating as a one-man think tank, I released
ProfitTaker Futures Trading software, which offered both automated
strategy back-testing capabilities and optimization. It was hot! It
even did back-testing on actual commodity contracts with a built-in
“rollover” function that moved from an expiring contract into the next
actively traded contract. This same year, I authored a series of articles


F o rex Tra di ng Usi ng Inte rmar ket Analysis

on technical analysis software for Commodities magazine (now known
as Futures) in which I introduced the concept of strategy back-testing
and optimization for microcomputers and outlined the impact that this
innovation would have on technical analysis and trading.
I was encouraged in those early years by several prominent technicians and traders. Foremost among them was Darrell Jobman at
Commodities magazine. Had he not seen the potential of applying
computer technology and trading software to the markets when this
new technology was in its infancy and had he not supported these
efforts by publishing articles on the subject in his magazine, there is
no telling what route the application of computer software technology
to technical analysis might have taken.
For the next few years, I continued my software development efforts
with ProfitTaker, wrote many more articles, collaborated on books on
trading, and spoke at trading conferences at which I warned about the
dangers of curve-fitting and over-optimization. Now that strategy backtesting is an integral part of today’s single-market technical analysis
software, I actually find it somewhat amusing (whereas as recently as
the late 1990s I often found it annoying) when I hear new traders, who
are just learning the ABCs of technical analysis, say that strategy testing has always been in trading software—as if airplanes have always
taken off and landed. Little do they realize how much effort it took to
implement rollover back-testing on commodity contracts on an Apple
II+ computer with just two floppy disk drives.
By the mid-1980s, through my observations of changes in how the
markets interact, it had become apparent that the prevailing singlemarket approach to trading software was already becoming obsolete.
I concluded that technical analysis that looked internally at only
one market at a time, such as ProfitTaker did, would no longer be
sufficient, even with its strategy testing and optimization features.


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Changes that were starting to occur in the global financial markets
due to advances in both computing and telecommunications technologies, coupled with the emerging “global economy,” made multimarket
analysis absolutely necessary.
I realized that the globalization of the world’s financial markets would
mean that the scope of technical analysis and its application through
the use of trading software to the financial markets would need to
change drastically. As a result, I embarked on my next maniacal mission, which would result in the development of intermarket analysis
In that pursuit, the scope of technical analysis had to expand to include
not just a single-market analysis approach, where I had focused my
attention previously, but also an analysis of how related markets actually affect each other and, more importantly, how this information can
be applied by traders to their advantage. My goal was to examine the
linkages between related global financial markets so that they could be
quantified and used to forecast market trends and make more effective
and timely trading decisions.
In 1986 I developed my second trading software program, which
focused on these market interdependencies. The program, simply
named “Trader,” used a spreadsheet format to correlate the likely trend
direction of a target market with those of related markets, as well as
with expectations regarding fundamental economic indicators affecting
the target market. This trading software program, albeit quite primitive by today’s standards, was the first commercial program available to
traders in the financial industry to implement intermarket analysis.
When the stock market crashed in October 1987, my convictions about
the interdependencies of the world’s equities, futures, and derivatives
markets were starkly affirmed. By then, I was sure that technical analysis would have to broaden its scope to include intermarket analysis,


F o rex Tra di ng Usi ng Inte rmar ket Analysis

as the forces that would bring about the globalization of the financial
markets continued to gain strength.
Despite my early efforts at developing intermarket analysis software,
I was not satisfied with the underlying mathematical approach that I
had used to correlate intermarket data in the Trader program and felt
compelled to continue my quest for a more robust mathematical tool.
In the late 1980s fortuitously I began working with a mathematical tool
known as neural networks, which is a form of “artificial intelligence.”
I remembered this vaguely from academic material I reviewed while
an undergraduate at Carnegie Mellon University in Pittsburgh in the
late 1960s. A professor there, Herbert A. Simon, was an early pioneer
in the field of artificial intelligence and its application to decisionmaking under conditions of uncertainty. In neural networks I found
the right tool for my job! Neural networks had the ability to quantify
the intermarket relationships and hidden patterns between related
markets that were increasingly responsible for price movements in the
global financial markets of the late 1980s.
In 1991 after considerable research in applying neural networks to
intermarket data, I introduced my third and latest trading software program, VantagePoint Intermarket Analysis Software. I chose that name
because I felt that intermarket analysis gives traders a different vantage point on the markets than is possible looking at just one market
at a time. VantagePoint uses neural networks to analyze price, volume,
and open interest data on a specific target market and between that
market and various other related markets. The software then makes
short-term forecasts of the trend direction and high and low prices of
the target market.
At this same time, other technicians, working independently, began
to explore intermarket relationships, primarily from an intuitive and
descriptive standpoint rather than the quantitative approach that I had
taken. One of these analysts, John Murphy, who at the time was the

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technical analyst for CNBC, lent further credibility among traders to
the newly emerging field of intermarket analysis.
Since the late 1980s, I have continued to refine my trading software
based upon neural networks applied to intermarket analysis and have
succeeded at creating effective trend-forecasting trading strategies
built around forecasted moving averages. VantagePoint, which at first
only made forecasts for thirty-year Treasury bonds in 1991 when it
was first released, now tracks nearly seventy different global markets,
including stock indices, exchange-traded funds, interest rates, energies, agricultural markets, softs, and, of course, foreign exchange spot
and futures markets.
The focus of this book is on how to use intermarket analysis to forecast
moving averages, making them a leading, rather than a lagging, technical indicator for the dynamic forex markets.


Forex Trading Using
Intermarket Analysis


What Is
If you have traveled internationally, you probably are well aware of
the foreign exchange market, often called the forex or FX market.
When you converted U.S. dollars into euros or yen or vice versa at a
bank or currency exchange, you may have noticed big differences in
the buying power of your currency, depending on when and where you
you made the transactions. Although you may have noted the impact
on your pocketbook, you may not have realized that you were also
participating in the largest market in the world.
The forex market trades an estimated $1.5 to $2.5 trillion a day. No
one really knows what the actual figure is because there is no central
marketplace for keeping tabs on all of the forex transactions around
the world. The forex market is massive, dwarfing the $30 billion a day
traded at the New York Stock Exchange. In fact, forex trading exceeds
the combined volume of all the major exchanges trading equities,
futures, and other instruments around the globe.
Although professional traders implementing sophisticated strategies
account for most of the trading in the huge forex market, participation
by individual traders has grown tremendously in recent years with
the proliferation of the Internet, enhancements in personal comput1

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ers and trading software, the launch of dozens of cash forex firms
taking advantage of online trading, and the globalization of markets
in general. The introduction of the euro on January 1, 1999, and the
weakness of the U.S. dollar after peaking in 2001 also contributed to
the surge of interest in forex trading. Increased numbers of individual
traders became aware of the role of forex in global markets with an eye
toward profiting as currency trends unfolded.
More international trade, reduced government regulation, expansion
of democracy worldwide, the increase in private ownership and free
enterprise concepts, and a greater acceptance of free-market trading
principles should keep the forex market at the forefront of traders’
attention for many years to come.

Local Values, International Impact
Every country has its own currency to facilitate its business and trade.
The value of one currency as compared to another depends on the economic health of the nations involved as well as the perception of stability and confidence in the political climate in those countries. As conditions change, currency values fluctuate to reflect the new situation.
These fluctuations create challenges for corporate financial officers and
institutional fund managers but also provide opportunities for traders
who want to speculate on impending changes in currency values.
Changes in currency valuations have a significant impact on governments, corporations, and financial institutions. Currency fluctuations,
particularly when they are abrupt, affect the performance of bottom
lines and the prices for many commodities and other markets. The
forex market probably has a more pervasive influence on worldwide
economic conditions than any other market, including crude oil.
By their very nature, currencies entail strong intermarket relationships. It is obvious that a currency cannot trade in isolation and that

F o rex Tra di ng Usi ng Inte rmar ket Analysis

the mass psychology that drives changes in the value of one currency
is bound to have an influence on what happens to other currencies as
well as other related markets. Because government policies and economic developments that affect currency values tend to evolve over
time, currencies are good trending markets.
The key to successful forex trading is understanding how these currency markets relate to each other and how patterns of past price
action can be expected to occur in the future as markets respond to
ongoing financial, political, and economic forces. However, these patterns and trends are elusive and may not be obvious from the examination of price charts. Nevertheless, traders need to spot these patterns
and trends early, to get into what are potentially highly profitable
trades and to avoid others.
Clearly, intermarket analysis tools that can help traders spot these
recurring patterns and trends in their early stages can give traders
a broad perspective and a competitive edge in today’s fast-paced
forex trading arena. It was this realization more than twenty years ago
that led to my focus on intermarket analysis and the development of
intermarket-based market forecasting tools that could discern likely
short-term trend changes based on the pattern recognition capabilities
of neural networks when applied properly to intermarket data. The
forex market, by its very nature, is an ideal trading vehicle for the
intermarket analysis and trend-forecasting approaches explained in
this book.

Why Trade Forex?
The first question you may have is, “Why trade forex? Is not forex
something that interests only bankers and big money managers?” The
advantages of trading forex are explained in detail in Chapter 2. The


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characteristics of forex trading are described in this chapter, which
should convince traders to include forex in their trading portfolios.

Characteristics of Forex Trading
Diversification. We live in a world where terrorist attacks can occur
at any time and place; where geopolitical tensions over nuclear power,
oil, human rights, and many other issues threaten to disrupt normal
trade and economic relationships; where U.S. companies are investing
heavily in China and elsewhere to reduce their labor costs; and where
China, in turn, is trying to invest in U.S. companies. Economic uncertainty seems to be a way of life. Traders cannot express their investment
concerns about these issues, whether for protection or speculation, in
any individual nation’s stock or interest rate markets. Forex is the
only instrument that incorporates all of these areas of potential concern and serves as a distinct asset class for speculators and investors.

Global Market. Markets such as equities or interest rates tend to
be traded locally during the business day in their own time zone. For
example, Japanese traders focus on Japanese stocks, European traders on European stocks, and U.S. traders on U.S. stocks. All of these
traders certainly should be aware of what is happening elsewhere as
the global integration of financial markets continues. However, an
event in Japan that directly affects Japanese stocks may not have the
same effect in Europe, and traders of European stocks may not pay as
close attention to what happens in the Japanese or U.S. stock markets.
Forex, on the other hand, is an asset class that is truly a global investment reflecting every economic development on earth. Whatever has
an influence on currencies in Japan has an effect on what happens to
currencies in London or Chicago. It is clear that intermarket relationships among currencies are extremely important in today’s world.


F o rex Tra di ng Usi ng Inte rmar ket Analysis

Twenty-four-hour Trading. Forex trading begins Monday morning
in Sydney, Australia (Sunday afternoon in the United States) and
moves around the globe as business days begin in financial centers
from Tokyo to London to New York, ending with the close of trading Friday afternoon in New York. Anything that happens anywhere
in the world at any time of day or night affects the forex market
immediately. It is not necessary for an exchange to open before the
effects can be seen. The forex market is always open for trading.
Electronic Trading. With the advances of technology, specifically,
the Internet and online trading, and electronic trade-matching platforms, most forex trade executions are instantaneous, getting traders
into and out of positions with the click of a mouse once they make a
trading decision. All of the benefits of electronic trading and updates
of positions and current status are available to today’s forex trader.
Liquidity. With the size of the forex market, around-the-clock trading,
and electronic trade execution, illiquidity is not much of an issue in most
venues of forex trading. There is almost always someone to take the other
side of a position a trader may want to establish, no matter when the order
is placed. Forex bids and asks tend to be tight and slippage minimal.

Leverage. Forex markets provide some of the highest leverage of
any investment vehicle. Traders may put up only a few hundred dollars to control a sizable position worth $100,000. As a result, a small
move in a trader’s favor can produce a big return on an investment.
However, traders must remember that leverage works both ways. A
small move that is against a position can eat up the money in traders’ accounts quickly if they are not nimble traders who take quick
action to cut losses. What leverage gives, it can also take away.

Plenty of Information. Governments issue dozens of reports every
month that influence the forex market (see Chapter 3). Information is
widely disseminated by the financial media. With advances in the Internet


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and financial news services, prices and economic data are delivered
within moments of being released and are available to all forex traders
throughout the world. If anything, there may be too much information
for traders to sort through, which has its own negative consequences.

Simplicity. Traders do not have to watch or analyze the reports
and price movements of hundreds of companies or mutual funds,
trying to figure out which to buy or sell. With all of the fundamental information coming from many sources every day, traders
can make trading life easier by concentrating on the forex market
because they can easily limit themselves to monitoring movements
of a half-dozen forex pairs. In addition, traders do not have to worry
about going short or selling on a downtick as they do with equities because it is as easy to sell as it is to buy in the forex market.

Good Technical Market. Once traders understand the basics of
technical analysis and how they can apply a software program to
trading, they can extend that knowledge to all forex markets without having to learn and understand a whole new set of market factors. Because currencies are influenced by government policies
and economic developments that usually stretch over long periods
of time, forex markets have a reputation for being good trending
markets. As a result, if traders keep an eye on economic conditions and charts as they evolve, they may find that forex market
moves are easier to predict than are movements in other markets. A
glance at a currency chart such as the Canadian dollar is enough to
show clear long-term trends (Figure 1.1), which often have enough
movement within them to satisfy the trader looking for short-term
swing moves, as indicated by the bold-face bars in Figure 1.2.

Active Price Movement. Whether looking at price movements within
a day or over a number of days, currencies tend to have trading ranges
that are wide enough to produce attractive trading opportunities.


F o rex Tra di ng Usi ng Inte rmar ket Analysis

Figure 1.1.

Currencies tend to have good long-term trends. The Canadian dollar
chart illustrates the trending nature of currencies.
Source: VantagePoint Intermarket Analysis Software (

Figure 1.2.

Currencies also have good short-term moves. Although currencies
often have extended trends, the same Canadian dollar chart in Figure
1.1 shows they also tend to have tradable counter trends that appeal
to the active trader who moves into and out of positions.
Source: VantagePoint Intermarket Analysis Software (


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Volatility is necessary for a trader to make money in any market, and
the forex market usually provides more than enough volatility because
there are new developments that affect the forex market every day.

Not Too Volatile. Forex markets can have abrupt price movements,
but as a 24-hour market where price changes are always flowing
through the system, forex markets rarely make the type of price move
seen in stocks or futures. Stocks can plunge or soar 10 percent or more
on some overnight earnings report or other announcement, leaving
gaps on price charts when an exchange opens. A $3 change on a $30
stock is not that unusual, but a 10 percent move in a currency—for
example, 12 cents if the euro were at $1.20—is quite unlikely.
In addition, while emerging markets may incur some extreme currency
price movements, the major currencies are not like Enron, Worldcom,
or dotcom stocks that fly all over the chart or even plummet and, like
Refco, declare bankruptcy. If forex trading appears too volatile and
risky, it may be a pleasant surprise for traders to learn that the forex
market is probably more stable than the equities markets.

Pairs, Pips and Points
Forex trading involves the simultaneous buying of one currency and
the selling of another. Unlike markets such as soybeans or Treasury
notes where traders are either long or short the market when they enter
an outright position, forex traders are always trading pairs of currencies—that is, they are always long one currency and short another.
Forex trades are expressed in terms of the first currency of the pair.
For example, a U.S. dollar/Japanese yen position—USD/JPY to the
forex trader—means you are long the dollar and short the yen, believing the value of dollar will gain relative to the value of the yen.


F o rex Tra di ng Usi ng Inte rmar ket Analysis

The U.S. dollar is the key currency in many of these pairs. Together
with the U.S. dollar, six other major currencies account for more than
90 percent of all forex transactions. These are the Japanese yen, euro,
British pound, Swiss franc, Canadian dollar, and Australian dollar.
The Mexican peso, Thailand baht, and dozens of other currencies
are also traded in the forex market, and some have periods of active
trading caused by extraordinary circumstances. For the most part,
however, the forex trader can concentrate on just six major currency
pairs that have the most liquidity:
• Euro/U.S. dollar (EUR/USD)
• U.S. dollar/Japanese yen (USD/JPY)
• British pound/U.S. dollar (GBP/USD)
• U.S. dollar/Swiss franc (USD/CHF)
• U.S. dollar/Canadian dollar (USD/CAD)
• U.S. dollar/Australian dollar (USD/AUD)
When currencies other than the U.S. dollar are traded against each
other—for example, the Japanese yen against the euro (JPY/EUR)—
these positions are known as cross-rates.
The first currency of a pair is the base currency; this is the main
unit that traders buy or sell. The second currency is the secondary
or counter currency against which they trade the base currency. The
base currency has a value of 1.0, and the second currency is quoted
as the number of units against the base currency. In the EUR/USD
pair, you are looking at the number of dollars per one euro, the base
currency—for example, 1.2000 dollars for each euro. In the USD/
JPY pair, you are looking at the number of yen per dollar, the base
currency—for example, 110 yen for each dollar—except in futures,
which are covered in Chapter 2.


trade secrets

Changes in currency values are quoted in terms of “price interest
points” or “pips.” Pips are also called points and are similar to ticks in
stocks or futures markets, the smallest increment of price movement. In
most cases, a pip is a one-point change in the fourth digit to the right
of the decimal—for example, a change from 1.1918 to 1.1919 for the
euro. The value of a pip depends on the size of the contract or lot being
traded, and that depends on where forex is traded (see Chapter 2).



The Forex
Although this book is about trading forex today and not about the fascinating history of currencies since the days of the Babylonians and
Egyptians, it is helpful to have a little historical background to understand how and why today’s currencies developed. The forex market is
actually a relatively new development compared to marketplaces for
equities, bonds, futures, and other financial instruments.
From the 1870s until World War I, gold backing provided stability
for many of the world’s currencies. Despite its long history as a store
of value, however, gold was not without its shortcomings. When a
country’s economy was strong, it could afford to import more goods,
which meant it sent more money overseas. A side effect of this was to
reduce its supply of gold reserves to back its currency. With less gold
to back its currency, money supplies had to be reduced, causing interest rates to rise, which then slowed economic activity until it brought
about a recession.
The lower prices for goods during a recession eventually attracted buyers from overseas. The surge in exports increased the flow of money
into the country, building up gold reserves and the money supply,


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reducing interest rates, and producing an economic expansion and
sometimes a boom.
These boom-and-bust cycles were the norm during the gold standard
days. World War I disrupted trade flow, and forex markets became
very volatile and speculative after the war. The Depression of the
1930s and onset of World War II further disrupted normal economic
and forex activity.

Striving for Stability
Governments, financial institutions, and the public all sought economic and forex stability as volatility and speculation became dirty words.
In an attempt to design a new economic order for a postwar world,
officials from the United States, Great Britain, and France met at
Bretton Woods, New Hampshire, in 1944. With European economies
and their currencies devastated by war, the United States became the
world’s economic engine, and the U.S. dollar emerged as the world’s
benchmark currency.
The Bretton Woods Accord established a plan to peg major currencies
to the U.S. dollar and pegged the dollar to gold at a price of $35 an
ounce. Major currencies were allowed to fluctuate in a band within
1 percent on either side of the standard set for the dollar, and no
devaluations were allowed in an attempt to gain trade advantages. If a
currency deviated too much, central banks had to step into the forex
market to bring the currency back into its acceptable range.
These measures did provide the stability that helped the postwar
recovery. However, as international trade expanded, the amount of
U.S. dollars deposited overseas in the new eurodollar market mounted.
Russia, for one, did not want to place its oil revenues in dollars in U.S.
banks where they might be frozen by the U.S. government during the
Cold War era.


F o rex Tra di ng Usi ng Inte rmar ket Analysis

With large amounts of U.S. dollars accumulating overseas that could
lead to a massive demand for gold backing those dollars at any time,
President Nixon announced in 1971 that the U.S. dollar would no
longer be convertible to gold. That effectively meant the end of the
Bretton Woods Accord, which was succeeded by the Smithsonian
Agreement in December 1971, providing a wider band within which
currencies would be allowed to fluctuate. Since countries have different resources, different economic growth rates, different political
goals, and other unique circumstances, maintaining a float arrangement was doomed to failure, no matter what the size of the band.
With closer geographic and economic ties, European officials did not
give up on the float concept. However, because they did not want their
economies and currencies to be tied so closely to U.S. developments,
they set up their own arrangement within which their currencies would
float, which also did not last long. In 1978 these European nations then
created the European Monetary System (EMS) to keep their currencies
in alignment. That effort lasted until 1993 when the propped-up value
of the British pound defended by the Bank of England failed to withstand the onslaught of speculators led by George Soros. Great Britain
dropped out of the EMS, spelling the end of that attempt to control
currency values.
The demise of the EMS opened the way for free-floating exchange rates
by default because there was no structure in place to control currency
fluctuations. Most currencies float freely today although the Argentine
peso, Chinese yuan, and other currencies have been pegged to the
U.S. dollar. The various contrived floating arrangements in Europe that
lasted almost a half century finally gave way to the euro, launched on
January 1, 1999. The euro got off to a shaky start but has become one
of the main fixtures in the forex market as it trades freely against the
U.S. dollar, Japanese yen, and other currencies. In fact, the euro has


trade secrets

been mentioned often as a potential successor to the U.S. dollar as a
benchmark currency.

Forex Trading Motives
In this free-floating environment, forex trading volumes have increased
remarkably in recent years as banks, other financial institutions, brokers, hedge funds, multinational corporations, individuals, and even
central banks have become participants, often employing increasingly
sophisticated trading strategies. There are three main reasons to get
involved in the forex market:
• To convert profits in foreign currencies into a domestic currency to bring gains back "home." This applies primarily
to international corporations that do business on a global
basis and whose bottom line may depend to a great extent
on how well they handle their forex transactions.
• To hedge exposure to risk from changes in forex values. If
corporate treasurers are concerned about exchange rate
risk between the time a deal is made, a product is delivered, and payment is made, they may want to lock in a
profit with a forex position at a favorable rate rather than
take the risk of losing money just because currency values might change. A U.S. pension fund may also hedge
its exchange rate risk by using a currency overlay program traded by an outside money manager.
• To speculate on changes in currency values. Although
there is a growing awareness of the usefulness of forex
trading in commercial transactions in global markets,
speculation is probably the primary reason for most
forex trading today. There is no way to quantify how
much of the forex trading volume is for speculation, but

F o rex Tra di ng Usi ng Inte rmar ket Analysis

it has been estimated that more than 95 percent of all
forex trading is for speculative purposes and has nothing
to do with commercial transactions.

Three Main Venues of Forex Trading
Interbank Market for the Big Boys
The greatest share of forex trading takes place in the interbank market
in the form of currency swaps, forwards, and other sophisticated transactions. The interbank market is a global over-the-counter network
that includes, as its name suggests, the world’s largest banks as its
backbone along with other large financial institutions and corporations
that have to be members of the network to participate.
There is no centralized marketplace in the interbank market, no
standardized contracts, and no central regulator. Transactions are
conducted between parties over the phone or electronically. Based on
a call-around tradition, deals may involve billions of dollars as price,
delivery, and other terms are negotiated, sometimes on behalf of customers but often for banks or institutions as they speculate on the price
movement of currencies.
However, unless you are a corporate treasurer, a global money manager, or someone in a similar position, the interbank market is probably not something with which you will be involved. This is a complex
market reserved for sophisticated, professional, and nimble traders.
There are, however, places where traders have easy access to the same
type of forex trading that the big boys have in the interbank market.

Cash Forex Trading
One of the fastest growing segments of trading in recent years has been
in cash forex as dozens of new firms have sprouted up, taking advantage of online trading and less restrictive regulations. Controversy still


trade secrets

surrounds the regulation of cash forex firms, and the National Futures
Association and Commodity Futures Trading Commission have shut
down a number of firms that they perceived to be “bucket shops” or
perpetrators of fraud.
In fact, sometimes the biggest risk in cash forex trading is not the market risk from changing currency values but counter-party risk—that
is, the risk that the cash forex firm will not perform its obligations and
will deal unfairly with customers. Because traders’ accounts depend
on the creditworthiness and integrity of the cash forex firm with which
they are dealing, evaluating a firm carefully is one of the first essential
steps for the cash forex trader.
Nevertheless, cash forex trading offers a number of advantages provided traders are working with a reputable dealer and understand the
risks of high leverage available at some of these firms.

Low Entry Cost. In some cases, traders can control a currency lot for
only a few hundred dollars. A minimal account size of $5,000 is typical,
but in many cases traders can open a cash forex account for less money
than an account to trade forex futures, which have standardized contracts
that are generally larger than the forex lots traded in the cash market.

High Leverage. Traders can control a $100,000 position at a cash
forex firm with $1,000—that is, 100-to-1 leverage. Forex futures may
require 5 to 8 percent of the value of a forex contract in margin as a performance bond, but cash forex requires as little as a 1 percent margin.

Guaranteed Limited Risk. The low initial requirements do not
give traders much leeway for adverse price moves. However, many
cash forex firms will take traders out of their open positions immediately when their equity falls below the required minimum amount.

Real-live Quotes to Trade. The cash forex firm provides traders
with two-way bid and ask prices for a number of forex pairs via a


F o rex Tra di ng Usi ng Inte rmar ket Analysis

free, streaming quote feed on a trading platform that usually also has
some analytical capabilities, depending on the firm and the established arrangements. If traders click on the posted bid or ask price
on the screen, the position is theirs at that price instantly. There is
no slippage or a partial fill as may occur with forex futures where
prices are changing constantly. Real-time quotes for forex futures
usually require the payment of exchange fees, which can mount up.

No Commissions or Fees. Cash forex firms do not charge commissions,
as such. With stocks or futures, traders may have to pay $3.95 or $9.95
or even $100 in commission rates for every trade. Cash forex firms do
not make their money on commissions but on the difference in the bid/
ask spread (the price at which they sell and the price at which they buy).

Forex Futures Trading
Although futures contracts generally came along somewhat later than
well-entrenched cash markets, the opposite is true with forex futures.
Chicago Mercantile Exchange (CME) introduced futures on currencies
in May 1972, not long after President Nixon closed the gold window
and before many currencies had achieved free-floating status. Forex
futures have traded in a floor setting with trading limited to regular
trading hours during the day for more than twenty-five years.
When CME launched its Globex electronic trading platform in 1992,
electronic trading was limited to after-hours or overnight trading
outside of the floor-trading hours. Then CME moved to side-by-side
trading several years ago, allowing electronic trading almost aroundthe-clock, including during those hours when trading was taking place
on the floor.
Volume has been booming since then to make CME’s currency market
the world’s largest regulated marketplace for forex trading (Figure 2.1).
In 2004 CME traded more than 50 million forex contracts, a 50 percent increase from the previous year, with two-thirds of those contracts


trade secrets

traded electronically. With CME making a major push to encourage
trading in options on forex futures, forex volume is likely to get much
larger at CME in the future.
Figure 2.1.

Growing interest in forex trading. Volume in forex futures has
increased sharply in recent years at Chicago Mercantile Exchange, as
has forex trading at cash forex firms
Source: Chicago Mercantile Exchange

In addition to the major forex pairs and a dozen other currencies
offered at CME, Eurex has moved into forex futures trading and the
New York Board of Trade trades U.S. Dollar Index (USDX) futures.
The USDX is not a currency, per se, but it does provide a good gauge
of the value of the dollar against a basket of major currencies although
trading in the USDX contract is not as active as trading in the major
currency pairs.
Forex futures do have a few different quoting conventions than what
traders will find in the interbank and cash forex markets. For example,
the familiar quote for Japanese yen in the cash market is in the number
of yen per dollar so traders will hear a USD/JPY quote of, say, 110 yen.


F o rex Tra di ng Usi ng Inte rmar ket Analysis

In the futures markets at CME, prices are quoted in the value of the
currency as it relates to the U.S. dollar—for example, yen at 110 in
the cash market would be 0.009091 in futures lingo (0.9 of a penny),
often quoted as just 9091.
In addition to the benefits of cash forex trading mentioned earlier,
futures exchanges provide some other advantages that may encourage
trading forex futures.

One Central Market. Instead of having just one source providing bid/ask quotes as in cash forex trading—a source that
incidentally knows your position—there are literally hundreds of
traders, including major banks and financial institutions, making
bids and offers all the time in futures. All of these bids and offers
are channeled into one place, leading to the establishment of one
price that is widely distributed the instant a trade takes place.

Tight Bid/Ask Spreads. With so many traders and so many bids
and asks all coming into one location at one time, futures provide
substantial liquidity and a smooth flow of trading from one price to
another. The spread between bids and asks is small in forex futures,
frequently only a pip or two, in a very competitive environment.
Traders cannot count on that when they deal with only one firm facing no competition when it comes time to close out their position.

Transparent Pricing. The current price determined by these multiple sources is available to all traders of all sizes at the same time.
Electronic futures trading does not play favorites but puts the small
trader on an equal footing with the large trader on a level playing
field. Traders are not limited to one set of bid/ask quotes offered by
one firm and do not have to worry that prices may favor a dealer who
may be factoring hidden spread costs into its quotes. All prices and
all costs associated with forex futures trading are out in the open.


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No Counter-party Risk. Traders do not trade with one firm and do not
have to worry about the creditworthiness of the party that may be on the
other side of the trade. In futures trading, the exchange’s clearing organization is actually the counter-party to every trade, setting rules and
policies to preserve the integrity of futures markets and provide a verified
record of all trading activity that can be audited, if necessary. To date,
no trader has ever lost money in futures due to counter-party default.


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