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Autore: High Probability Systems and Strategies for Active Traders

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Page i

Forex
Conquered

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Forex
Conquered
High Probability Systems
and Strategies for
Active Traders

JOHN L. PERSON

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Page v

To Mary, my partner, best friend, and wife of twenty years;
time has gone by, but it seems like it has been a short
yet not so strange trip with you at my side.

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Contents

Preface

ix

Acknowledgments

xi

Disclaimer

xii

CHAPTER 1

The Business of Trading Money

CHAPTER 2

Pivot Point Analysis, Filtering Methods,
and Moving Averages

1

65

CHAPTER 3

Candlestick Charting

107

CHAPTER 4

Traditional Chart Patterns

133

CHAPTER 5

Indicators and Oscillators:
Stochastics and MACD

151

CHAPTER 6

Fibonacci Combined with Pivot Points

169

CHAPTER 7

Elliott Wave Theory

181

CHAPTER 8

Trading Systems: Combining
Pivots with Indicators

199
vii

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viii

CONTENTS

CHAPTER 9

Selecting Your Trading Window Frames

225

CHAPTER 10

Risk and Trade Management:
Stop Selection, Scaling Out, and
Setting Profit Targets

233

Game Psychology: Techniques
to Master Your Emotions

249

CHAPTER 11

Postscript

257

Glossary

258

About the CD-ROM

275

Index

279

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Preface

or the most part, day and swing traders use all forms of market analysis to identify opportunities from specific chart patterns that demonstrate frequent reoccurring results. They need to trade in active time
periods, using trend lines and moving averages, both of which are a form of
trend line analysis; these will help in certain market conditions. We will go
over a different set of moving averages than what is normally written about;
this will help identify conditional changes in the market, thereby giving
forex traders a better edge. We will also incorporate and show you how to
calculate support and resistance levels from such mathematically based
models as pivot point analysis and other means, such as Fibonacci corrections and extensions, to identify opportunities and drive trading decisions.
These are the methods I will be covering in this book to help you form
a trading plan based on specific rules and conditions for trading the forex
market. This trading book should help you learn the methodology of the
best and most effective trading techniques to harness and capture consistent results in the forex market. Consider this like market analysis on
steroids. This book combined with the compact disc (CD) should help you
learn in the most effective fashion. By rereading and continually studying
this material, these study tools will help you change the way you trade and
leave you with a specific set of rules on when to enter a position; how to
identify a trade setup, a trigger, or entry execution order; and how to effectively place a stop and know when to exit a trade without hesitation. Most
successful traders live by the adage, Buy low and sell high; really great
traders also know when to buy high and sell even higher.
The best traders in the world also take advantage of short selling,
which is one aspect that draws so many skilled traders to the forex market;
they can sell short at extreme price highs and buy back at lower prices.
Whatever your method is, the results need to be profitable or your career as a trader will be cut short. Whether you are a position trader, a swing
trader, or the more popular day trader, the key to profits is to try to capture
a portion of a price move in order to generate a positive cash flow (make
money). A trader’s search for discovering a method that generates con-

F

ix

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PREFACE

sistency in positive results is the primary goal and should be a continuous
learning event. There is one common feature among successful traders,
and that is that many of them are prepared before trading and have a
formulated game plan.
The techniques in this book can be applied to other markets, but this
specifically targets the forex market. I will teach you a trading system so
that you develop your own personal program and then follow that plan.
Using these techniques should help you to effectively anticipate a potential
resistance or support level that will give you an edge in the market for both
entering and exiting positions. Blending the strengths and characteristics of
candlestick chart pattern recognition with pivot point analysis is what I
have been teaching private investors, professional traders, and other leading educators. Many new methods have been introduced to traders, but the
one constant is human emotional behavior. In order to master trading, people need to control their emotions. After all, the markets are simply a reflection of these emotions. Fear of losing money causes market prices to
head lower as people sell; and fear of missing an opportunity causes market prices to move up as greedy people buy, trying to catch a free ride. As a
forex trader, you are looking at technical analysis to help capture profits
from a movement in price. Therefore, it is imperative that you understand
how and when a market moves and what signals or patterns give you a clue
for a directional price move. There are consistently recurring patterns and
these are what I plan to share with you in this book. I will also discuss
methodologies on trade management and risk management to help you
when an inevitable trading loss occurs.
I will disclose how to use time-tested tools such as the Elliott wave theory to help you determine where prices are in a given cycle. We will go over
a system based on pivot point analysis and disclose how to effectively use
Fibonacci analysis, which is a system based on the theory that prices rise or
fall by specific percentages after reaching a high or a low. I will also discuss
two very popular indicators, stochastics and the moving average convergence/divergence (MACD), to demonstrate which one interacts best with
pivot point support and resistance levels that can produce maximized returns for an automated trading system. I will not only teach the system and
include the code but also share the results with you. I believe that a trader
who possesses knowledge of the key concepts in technical analysis will
have superior advantage over a trader who is simply depending on computer- or software-driven trading signals. My goal in writing this book is to
give you an edge from the most powerful trading tools I have come across
in my 26 years as a trader.
JOHN L. PERSON

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Acknowledgments

want to thank Pamela van Giessen and Jennifer MacDonald of John
Wiley & Sons, who helped me get this book project off the ground and
published. Another individual who deserves a big round of applause is
Mary Daniello, also from John Wiley & Sons. Thank you for going over the
top in making sure the production schedule was pushed back so I could get
this book completed in time.
I would also like to thank Glen Larson and Pete Kilman from Genesis
Software for testing my theories and helping me develop my trading library
on their software; a big thumbs up to TradeStation and, in particular, Stanley Dash. With these two charting software companies, traders will be set
in the best possible direction for seeking success in their trading careers.
And many thanks to my wife Mary who worked hard on programming the
pivot point and Fibonacci calculators—your work did not go unnoticed.

I

J. L. P.

xi

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Disclaimer

he information contained herein is believed to be reliable but cannot
be guaranteed as to reliability, accuracy, or completeness. John Person, Inc., John L. Person, will not be responsible for anything that
may result from one’s reliance on this material or the opinions expressed
herein. There is significant risk of loss trading forex, stocks, futures, and
options. Trading may not be suitable for everyone, and you should carefully
consider the risks in light of your financial condition in deciding whether to
trade futures, options, and forex. Further, you assume the entire cost, loss,
and/or risk of any trading you choose to undertake; therefore, only genuine
risk funds should be used. Past performance is not necessarily an indication of future performance. You may sustain a total loss of the initial margin funds and any additional funds that you deposit in your account to
establish or maintain a position in the forex market. No representation is
being made that any person will, or is likely to, achieve profits or losses
similar to those shown in this book. In fact, there are frequently sharp differences between hypothetical performance results and the actual results
subsequently achieved by any particular trading method. Hypothetical performance results have many real limitations; one of which is that limitations of hypothetical performance results are generally prepared with the
benefit of hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for
the impact of financial risk in actual trading. There are numerous other factors related to the markets, in general, or to the implementation of any specific trading program that cannot be fully accounted for in the preparation
of hypothetical performance results and that can all adversely affect actual
trading results.

T

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CHAPTER 1

The Business of
Trading Money

WHAT IS FOREX?
Foreign currency is simply money valued against one currency or another,
in most cases the U.S. dollar. Simply put, a forex trader is simultaneously
buying one currency and selling off another. Money, after all, is what makes
the world go ’round. There will always be demand and activity in this product. How to successfully trade this market or any market requires proper
education of the vehicle in which you are trading and knowledge of the
basic fundamentals and technical analysis tools. One also has to be fairly
savvy in technology, as forex trading is virtually all done online through the
Internet. Conquering the forex market and mastering success in trading absolutely requires identifying and learning how to avoid a multitude of pitfalls more than it does identifying trading opportunities. In fact, most
professional traders will tell you that it is not any specific trading methodology or trading system that makes successful trades; rather it is the discipline and patience needed to master and to stick to their trading rules and
to remain controlled in their overall trading methods. In order to win at
trading, you must manage risks and understand that there will be lots of losing trades. Remember that success takes time, but mostly it requires consistency in how you seek, execute, and exit positions. If you want to
conquer the forex market and wish to learn which technical tools will serve
you best, then this is the right book for you.
My goal in this book is to present an easy yet comprehensible set of
trading techniques and reliable trading tactics that you can apply in every1

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FOREX CONQUERED

day trading circumstances. These techniques should help you identify frequently reoccurring trading opportunities. Yet to better enhance these techniques, I will cover why it is important to develop and maintain a systematic
approach based on historical data that is back-tested either visually or by
the aid of a computer or trading software program. The signals and methods can be applied for long and short positions. Forex has no restrictions
on selling short, so these trading methods will improve and increase your
trading opportunities because you can trade both long and short strategies.
Imagine a trading product that allows you 24-hour access so you can apply
techniques that will set your stop-loss levels, profit objectives, and various
order types (such as contingency orders and trailing stops) to maximize
your performance. This is what the forex market offers, including flexible
leverage and commission-free trading.

WHY TRADE FOREX?
As I stated one moment ago, there will always be demand and supply for
money. Democracy, capitalism, and the American dream have led people to
seek fortunes. The problem is that many folks who rushed into a venture or
an investment saw these dreams diminish as they got in either too late or
too early or were just poorly informed. Looking back in recent history, manias such as the “tech wreck” and the stock market bubble financially ruined many people. And there were the innocent victims who invested in
Enron, AT&T, and other such companies. I am not talking about speculators; I am referring to employees of those companies who had their retirement savings invested with their employers. Lately, we see weakness and a
potential for a bubble to burst in the real estate market. Perhaps you are invested in a second home or know someone who made a killing buying and
selling fixer-uppers. The term “flippers” was popular as FSBO (for sale by
owner) signs were planted in the front lawn of houses across the United
States as eager investors were enticed to flip the property and make a fast
buck. If you were in the game early on, you did well. If you got in the game
late and are holding onto excess inventory, then you are at risk.
In late June 2006, many investors were left holding the bag on excess
inventory—they bought a housing unit (condo, town home, or home) to
turn around and sell for a profit but, due to such market conditions as an
excess supply of homes for sale, cannot sell the property. Most of their
cash or past profits may be tied up in the investment. Even worse, they may
be overextended in credit from their bank. These are the folks who will be
exposed to major financial disaster. To make matters worse, the Federal
Reserve (the Fed) raised interest rates once more, for a record-breaking 17

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The Business of Trading Money

3

consecutive hikes. That brought the Fed Funds interest rate to 5.25 percent.
The prime lending rate shot up to 8.25 percent. That put the fixed rate for a
30-year mortgage up to 6.62 percent (actual mortgage rates depend on your
credit score, down payment, etc.). What this did in effect was to bring on
higher borrowing costs, which slowed the housing market even more.
As of October 2006, both new and existing home sales have continued
to slow. Higher mortgage rates had been expected to slow the housing market, and they finally started showing their effects. Just to show you, mortgage rates went up roughly 125 basis points since the same period starting
from 2005. So when the reports came in from June 2006, new home sales
edged down 3.0 percent to an annual rate of 1.131 million. New home sales
were down 11.1 percent on a year-over-year basis. The graph in Figure 1.1
shows the rise in mortgage rates and the decline in new home sales.
It did not stop there either; existing home sales slowed with supplies
rising. Existing home sales edged down 1.3 percent in June 2005. Existing
home sales at that time were down 8.9 percent on a year-over-year basis.
Supply became even more of an issue for existing homes than for new
homes as inventory of unsold existing homes rose in June 2006 to 6.8
months from 6.4 in May 2006. That set a supply figure at a nine-year high.
Figure 1.2 shows the same trend: As rates moved up, sales declined.

FIGURE 1.1
Rates

New Home Sales versus Nationwide Average Mortgage

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FOREX CONQUERED

Existing home sales (millions)
Mortgage rates (percent)

FIGURE 1.2

Existing Home Sales versus Mortgage Rates

This slowdown has many investors looking to maintain a means to generate an income, which is what is attracting so many people into trading the
forex market. Some of the benefits of forex trading are that there is no traveling involved, you trade from the comfort of your home or office through
the Internet, and you have virtually 24-hour access to the market. Yes, there
are risks to trading; but as we have seen in the past, most investments come
with risk. You just need to be properly informed and educated, and that is
what I want you to achieve through reading and studying the material presented in this book.

FOREX OR FUTURES: WHICH IS RIGHT FOR YOU?
The Foreign Exchange (FX) is one of the fastest-growing investment arenas
today. Large institutional investors and hedge funds are big players in the
forex market; and in the past three years, the Foreign Exchange market had
an estimated 50 percent increase in volume. Some had credited this increase to the large activity created by the online currency trading for the retail investor. The forex market is an over-the-counter market, which means
that there is no main exchange or clearinghouse. This is contrary to the futures markets which offer futures trading in “open outcry” and electronic
access; which is transparent pricing through a trading platform. This en-

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ables one to see the bids/asks and size, otherwise known as the “depth of
market” (dome).
In this book, we will be looking at the different aspects of trading the
currency markets, including the advantages and disadvantages of trading
the forex market. In addition, you will learn how to use other resources to
make better decisions on when to enter or exit your forex positions. Trading the forex offers leverage, leverage that the individual controls. Through
the use of margin, an individual investor has the choice to increase or decrease leverage through various means. Most currency firms offer 100 times
leverage on a regular size account; compare this leverage to the leverage offered to the average equity investor, and you can see why many traders are
more attracted to trading the forex. As mentioned previously, leverage in
the forex market can also be customized to the individual trader, which
means that a trader can choose to lower or eliminate leverage while trading
foreign currencies.

FOREX: THE ATM OF THE INVESTMENT WORLD
Foreign Exchange currency trading, otherwise known as the forex market,
offers a completely different investment asset class that offers leverage and
virtually unrestricted access 24 hours a day. Forex trades virtually around
the clock from the Asian market open on Sunday night until the U.S. market close on Friday afternoon. One of the attractions from an individual
trader’s perspective is that there is this constant access to make a trade. In
other words, in every transaction, a trader is long one currency and short
the other. A position is expressed in terms of the first currency in the pair.
For this reason, currencies are always traded in pairs; for example, if you
have purchased euro and sold U.S. dollars, it would be stated as a euro/dollar pair. With a volume of over $1.5 trillion daily, the Foreign Exchange
market is the largest and most liquid financial market in the world—more
than three times the aggregate amount of the U.S. equity and Treasury markets combined. This means that a trader can enter or exit the market at will
in almost any market condition with minimal execution risk. Due to the
sheer size of liquidity, a continuous supply-and-demand driven product (we
all use and need money), and the accessibility of trading make many professional traders consider the forex market like a bank’s automatic teller
machine (ATM).
The forex market is so vast and has so many participants that no single
entity, not even a central bank, can control the market price for an extended period of time. Unlike other financial markets, the forex market has
no physical location, no central exchange. It operates through an electronic
network of banks, corporations, and individuals, trading one currency for

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FOREX CONQUERED

another. The lack of a physical exchange enables the forex market to operate on a 24-hour basis, spanning from one zone to another across the major
financial centers.

HARNESS THE POWER OF LEVERAGE
The forex market allows traders to control massive amounts of leverage
with minimal margin requirements; some firms offer as much as 100-to-1
leverage. For example, traders can control a $100,000 position with $1,000,
or 1 percent.
Obviously, leverage can be a powerful tool for currency traders. While
it does contribute to the risk of a given position, leverage is necessary in the
forex market because the average daily move of a major currency is about
1 percent, while a stock typically sees much more substantial moves in excess of 10 percent. When trading in the forex arena, the use of leverage is
pretty much considered similar to an interest-free loan from your broker. It
enables a trader to use as much as 200-to-1 leverage. This translates to having $500 in margin while controlling a $100,000 position in the market, or
0.5 percent of the position value. This is considerable leverage that can
work in favor of as well as against an online forex trader. Once again, leverage can be seen as a free short-term credit allowance, just as it is in the futures markets, allowing traders to purchase an amount of currency
exceeding that of their account balance. As a result, traders are exposed to
an increased level of both risk and opportunity. Due to the nature of the
leverage in the forex markets, positions are normally short-lived. For this
reason, entry and exit points are crucial for success and must be based on
various technical analysis tools. While fundamental analysis focuses on
what should happen, technical analysis is based on what has or is happening at the current time.
Identifying the overall trend, whether it is short term or long term, is
the most elementary element of trading with technical analysis. A weekly
or monthly chart should be used to identify a longer-term trend, while a
daily or intraday chart must be used for examining the shorter-term trend.
After determining the direction of the market, it is important to identify the
time horizon of potential trades and to apply those strategies to the appropriate trend. Therefore, the techniques covered in this book are highly effective in trading the FX markets. Technical analysis techniques will be
your “bread and butter”; they will help you master and generate profits in
the forex market.
Technical analysis is the study of historical prices in an attempt to predict future price movements. There are two basic components on which
technical analysis is based: (1) prices and (2) volume. With the proper un-

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derstanding of how these two components exploit the impact of supply
and demand in the marketplace, combined with a stronger understanding
of how indicators work, especially when combining candle charts and pivot
analysis, you will soon discover a powerful trading method to incorporate
in the forex market.

PLAY BOTH SIDES: LONG OR SHORT
If one wants to take advantage of a price decline, one of the advantages that
the forex market has over equity markets is that there is no uptick rule as
exists in the stock market; short selling in forex is similar to that in the futures market. By definition, when a trader goes short, he is selling a currency with the expectation that the price will drop, allowing for a profitable
offset. If the market moves against the trader’s position, he will be forced to
buy back the contract at a higher price, resulting in a loss on the trade.
There is no limit to how high a currency can go, giving short sellers an unlimited loss scenario. Theoretically, a short seller is exposed to more risk
than a trader with a long position; however, through use of stop orders,
traders can mitigate their risk, regardless if long or short. It is imperative
that traders are well disciplined and that they execute previously planned
trades, as opposed to spontaneous, spur-of-the-moment, emotionally driven
trades. There are obvious benefits to short selling. This aspect of the forex
market allows traders to profit from declining markets. The ease of selling
contracts before buying them first is in contrast to typical stock trades.
Market prices have a tendency to drop faster than they rise, giving short
sellers an opportunity to capitalize on this phenomenon. Similarly, prices
will often rally gradually with increasing volume.
As prices begin to reach a peak, trading volume will typically taper
off—a signal to short sellers to initiate a trade. When a reversal does occur,
there will typically be more momentum than for the corresponding up
move. Volume will increase throughout the sell-off until the prices reach a
point at which sellers begin to back off. The concept here is represented in
detail in this book and is a powerful tool for swing and position traders.
Even day traders will benefit from knowing volume analysis. It is important
to know where to get the daily volume information and how to apply this information to foreign currency trading. I will share this with you shortly.

HEADLINE TRADES
The BBC commonly refers to the British Broadcasting Corporation; but in
the forex market, it is trader’s nomenclature or slang for the Big Boys Club:

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FOREX CONQUERED

banks, brokers, and corporations. And there is a fourth group: large hedge
funds. Each one has made its mark in history using foreign currencies. Two
milestone trades made headline news. These are the famous curency
trades, both of which took advantage of taking short and long positions.
Let’s look at the hedge fund world when famed financier George Soros
“broke” the Bank of England. He placed an estimated $10 billion bet that
the British pound would lose value, and he won the bet! How about DaimlerChrysler, the parent company of Chrysler and Mercedes Benz; it reportedly made more money in the forex market that it did selling cars! Imagine
explaining to your boss that you made more money hedging and trading foreign currencies than doing what you do best, building cars.
Another milestone event is as recent as early 2005. This involved Warren Buffett the founder of Berkshire Hathaway (the fourteenth-largest
U.S. company, according to the July 4, 2006, issue of Fortune magazine).
When the financial media was pounding out news stories that the dollar
was in trouble, Warren made a statement that he was heavily short the U.S.
dollar. Unfortunately, once he made that announcement, the dollar gained
value and rallied for most of 2005. If you did not do your own research or
homework and blindly followed his advice, things did not turn out so well
for you.
In the remainder of 2005, the dollar moved higher against most major
currency pairs. What turned the market around? Some of the events that
drove the dollar higher were dictated by monetary policy as the Federal Reserve continued to raise interest rates. Then there were economic, geopolitical, and political developments on the domestic front that influenced
the dollar’s value. For starters, the Homeland Investment Act (HIA) was
passed. The HIA is part of the 2004 American Jobs Creation Act and was intended to entice U.S.–based multiconglomerate corporations to bring
money back into the United States. The window of opportunity for companies to take advantage of the HIA benefits prompted companies to increase
the pace at which funds are repatriated to the United States. Since companies had only until the end of 2005, many analysts suspected that companies would rush to repatriate foreign profits by year’s end and that there
would then be a high dollar demand to convert foreign currencies. Geopolitical issues arose during the summer of 2005 when there were riots in
France as a result of less support for the euro currency. That contributed to
a very poor market sentiment and a lack of confidence in the euro. This was
grounds for foreign investors to make a flight to financial safety, selling
their currency to buy U.S. dollars. The tone was essentially dollar positive
and euro negative, which is a result of a change in political views and shows
how consumer sentiment can have a negative effect on a currency. I said
earlier that technical analysis will be your “bread and butter” for profiting
in the forex market; but you still need to be aware of fundamental develop-

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9

ments, economic reports, and the times when these reports hit the
newswires. As this section shows, fiscal policy changes can drive markets
in new directions.
What may have contributed to the dollar rally in 2005 and hurt Mr. Buffett’s position was the fact that other players may have been preying on his
position. Berkshire Hathaway, Inc., is without a doubt a high-profile player.
So when Warren Buffett announced he was going to cut back speculative
positions against the U.S. dollar after losing profits due to surprising dollar
strength, the buying to cover his shorts boosted the dollar. Keep in mind
that Mr. Buffett had bet that the dollar would continue losing ground, as it
did in 2004; he felt the massive U.S. current account deficit would be dollar
negative. But instead, monetary policy dictated otherwise, as the Federal
Reserve continued to raise interest rates. That was helping to drive demand
as the interest rate differentials widened. In its third-quarter report in 2005,
Berkshire Hathaway said it had cut its foreign-currency exposure from
$21.5 billion to $16.5 billion. That was a significant amount of selling foreign
currencies and buying U.S. dollars.
As you can see from the Dollar Index weekly chart in Figure 1.3, on a

FIGURE 1.3

U.S. Dollar Index Contract (monthly bars)
Used with permission of GenesisFT.com.

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year-to-year basis, the dollar did make an outstanding run. However, that
rally fizzled out in 2006. Also, keep in mind the dollar was at a high of 120.80
back in 2002; so depending on where Mr. Buffett was shorting the dollar, he
could still be in a lucrative or profitable position. When I was wrapping
things up for this book, the Dollar Index had managed to decline near the
multidecade lows, and investor sentiment remained longer-term negative
on the dollar. In addition, if you look at the longer-term price direction dating back since the inception of the Dollar Index contract, the Dollar Index
is in a descending or declining channel.
The focus of this example is how shifts in monetary and fiscal policies
can and do dictate price swings in the market, as happened in 2005 and
2006. Furthermore, foreign currency trading has become an acceptable
asset class and valuable trading vehicle for the large multinational corporations. Just for your knowledge, the July 4, 2006, issue of Fortune magazine listed the top-10 largest U.S. corporations as ExxonMobil, Wal-Mart,
General Motors, Chevron, Ford Motor, Conoco Philips, General Electric,
Citigroup, American International Group, and International Business Machines. Funny that 30 percent of the top-10 businesses consisted of energy
companies. I found this intriguing; Microsoft was ranked number 50 and
Intel number 51. Who was number 100, you ask? John Deere. I think you
can see the trends of investment flows and which sector is the leader as
represented by the amount of a company’s revenue growth. In 2006, the
leader was British Petroleum!
Back in late 1999, money poured into technology stocks. In late 2003
and 2004, money poured into home builders. Then in 2005 and 2006, money
poured into energy stocks, and not just for short-term trading but also for
long-term investment opportunities in exploration and research and development for new oil fields and infrastructure repairs of pipelines and refineries. The most important terms to remember here are money flow and
sector leaders. Following money flows, sector leadership among corporations can help you to determine where we are in a business cycle. We will
talk about how these two concepts are important factors to monitor when
trading foreign currencies. The relationships between how and where
money is being made and which industry it is being made in directly impact
foreign currency values and can help you in your trading decisions.
Money flows into one sector and out of another. If consumer demand
is in technology, as was the case in the middle to late 1990s, then the U.S.
dollar is strong. If demand changes to commodity-based products, such as
crude oil, gold, and construction materials, the Aussie and Canadian dollars
will appreciate. Australia and Canada are both producers of such commodity products as gold and lumber; and since Canada has vast reserves of
tar sands, its currency benefits from higher crude oil prices.

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THE PRIVATE BANKERS’ CLUB
HAS NOW TURNED PUBLIC
In the past, currency trading was exclusively accessible for individual speculators through the futures industry, whereas the spot marketplace in the
banking arena was for the private bankers’ club, the privileged few. This
has all changed now, and the competition is fierce. The industry has expanded from what was an exclusive club of proprietary hedge fund traders,
corporations, banks, and large institutions. Just to give you an idea of who
the competition is that takes part in the forex arena, here is the list of the
top five banks in the United States as of July 4, 2006, according to Fortune
magazine. This is in order of capitalization: Bank of America, JP Morgan,
Citigroup, Wachovia, and Wells Fargo. This does not include foreign banks
or pension funds who participate in trading. Forex is no longer exclusive to
the major trading firms, such as Goldman Sachs, Mitsubishi, Merrill Lynch,
and Morgan Stanley. Now it is available to any and all individual traders
who want to participate. You have 24-hour access in this market from your
home or office right off your desktop or laptop computer.
Forex trading is considered the behemoth of the investment world,
with more than $3.5 trillion in currency trading taking place per day, according to the Bank for International Settlements. There is more daily volume in the forex market than in all of the U.S. stock markets combined.
There is no doubt that that is one reason why foreign currency has become
so popular. Also, the market has liquidity; has favorable trading applications, such as the ability to go long or short a position; and has a tendency
to trend well. Chart watchers love the currency market because it trades
well based off technical analysis studies.

FOREX TRADES EASILY
The forex market offers traders free commissions, no exchange fees, online
access, and plenty of liquidity. Unlike the futures products, the forex market uses standardized contract values, meaning that full-size positions are
valued at 100,000. The one main element that has attracted investors was
and is the commission-free trading. Plus, most forex firms require less capital to initiate a start-up account than a futures account. In fact, investors
can open accounts on their debit and/or credit cards; and the practice still
exists of online payments through PayPal.
Some firms offer smaller-size flexi-accounts that allow traders to start
applying their skills at technical analysis with as little as $500. And there is
also the mini-account, which allows individual investors to adjust their

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positions by not having too big a contract value per position, as they can
add or scale into more or fewer positions to adjust the level of leverage according to their account size. This means that smaller-size investors are not
excluded from trading because they can participate with mini-contracts.
What is great about this feature is that a new trader or an experienced
trader who is testing a system can trade the market with real money, rather
than simply paper trading; the new traders can benefit from the actual experience of working with money and will be able to see how they handle
the mental or emotional side of trading. People are emotionally driven.
Fear, greed, and anxiety can wreak havoc on people’s psyches. Therefore,
practice trading with smaller leverage will not make you rich immediately;
but it will help you hone your trading skills and help you develop confidence in your methods and execution skills.
Having real money on the line certainly helps people to learn about
their emotional makeup. This is one great way to overcome the fear and
greed syndrome that many traders seem to battle. Another excellent quality that forex mini-accounts have is that smaller-size traders can afford to
trade multiple lots for scaling out of trades in order to let a portion of their
contracts ride for a longer, more-profitable trade and still capture profits on
a partial exit.
Another attraction is that most forex companies offer free real-time
news, charts, and quotes with state-of-the-art order-entry platforms; some
even have automated order-entry features, such as “one cancels the other”
and “trailing stops.” All of these tools and order entry platforms come at no
additional charge to the trader. This market is a pay-as-you-go concept because there are no commissions—you simply pay a premium, or a higher
spread, to buy and a higher spread to sell. Most forex dealers take the other
side of your trade. You do not have direct access to the interbank market,
as it is called. Because the forex market is decentralized, it is possible that
five different companies are showing five different prices all at the same
time within a few points (or PIPs, as they are called). Most forex traders are
short term in nature, meaning they are quick-in-and-out players. Day trading in the forex market is beneficial for these traders due to the fact that
there are no commissions, but the PIP spreads can and do add up.
IMPORTANT FEATURE
Flexi or mini forex accounts can be set up by an individual. The main benefit is
that you can control the leverage and use smaller lot sizes, which enable you
to trade multiple contracts that will allow you to scale into and out of a trade at
various price points.

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PAY THE SPREAD
Forex prices, or quotes, include a bid and an ask, similar to other financial
products. The bid is the price at which a dealer is willing to buy and traders
can sell a currency. The ask is the price at which a dealer is willing to sell
and traders can buy a currency. In forex trading, unlike futures or equities,
one has to pay a PIP (percentage in points) spread on entering and on exiting a trade. The PIP spread is the point difference between the bid and the
asking price of the spot currency price. This can vary between two and six
PIPs, depending on the volume and the popularity of the cross currency.
A typical example is the euro (EUR) versus the U.S. dollar (USD). We
will see a bid price on the EUR/USD of 1.2630 and an asking price of 1.2633,
which means you are paying a three-PIP spread. The spread essentially
works like this. You place a buy on the EUR/USD at 1.2633, but you won’t
see breakeven on the trade until the price moves to 1.2633 bid. If you are
trading a mini-account, you will see a $3.00 deduction for your trade profit
on entry. Once the price moves to 1.2633 bid, then your account comes out
of the red and into the black. In an exotic cross such as the euro versus
against the Japanese yen or the New Zealand dollar versus the Japanese
yen, you might pay a higher bid-ask spread of 6 to 12 PIPs. You need to
check with your forex dealer for the listing of PIP spreads per preset
crosses and pairs trades.

WHAT ABOUT INTEREST?
If you want to hold a position for several days, a rollover process is necessary. In the spot forex market, all trades must be settled within two business days at the close of business at 5 P.M. (Eastern Standard Time, EST).
The only fee involved here is the interest payment on the position of currency held. At times, depending on the position, you can receive an interest
payment as well. This is where the term tomorrow/next (Tom/Next) applies. It refers to the simultaneous buying and selling of a currency for delivery the following day. As with futures, the forex market is now regulated
to an extent and comes under the scrutiny of the self-imposed regulators,
such as the National Futures Association after the Commodity Futures
Trading Commission (CFTC) Modernization Act passed in 2002; but since
there is no centralized marketplace, many forex dealers can and do make
their own rules and policies. Because forex dealers are in the business to
make money and to provide a service for traders, some firms will charge interest on your account but not make an interest payment to your account

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unless you meet certain financial requirements. Again, because these dealers are in the business to make money, I have heard stories that some
will even increase the interest charge by more than double the going rate;
and if they do give a credit offer, the rate will be below what the market is
really at.
Since most traders in forex are short term in nature, by settling up or
closing out their positions by 5 P.M. (EST), they are not generally concerned
with the interest rate charge aspect. Also, unless they have serious positions on (over $1,000,000 value), the interest charge will be minimal anyway
and not something that should distract from the job at hand, which is trading. My advice is this: Do your homework when looking for the right dealer
to trade through and ask questions regarding interest charge policies when
holding positions for several days.

IS THERE GOING TO BE A NEW KID IN TOWN?
Yes, there is going to be a new kid; and by the time this book is published,
the name and place will be FXMarketSpace. This entity represents a collaborative effort between two foreign currency industry leaders: Reuters
and the Chicago Mercantile Exchange (CME).
This venture is expected to launch in 2007. What it will do is facilitate
spot trading transactions on six major currencies against the U.S. dollar:
the euro, the Japanese yen, the British pound, the Australian dollar, the
Swiss franc, and the Canadian dollar. Four cross-currency pairs will also be
supported. FXMarketSpace intends to add more products in forwards and
options at a later date. Since the forex market has changed dramatically
over the past few years, many players, such as hedge funds and commodity
trading advisors who manage money, have entered the market with a new
set of needs, one of which is order anonymity.
This concept will be the first over-the-counter FX trading platform to
offer central counterparty clearing and full trade anonymity. FXMarketSpace will also be accessible through multiple portals, giving its users
unprecedented breadth of access to its trading platform. These characteristics are expected to increase participation and to enhance liquidity in
the forex market. FXMarketSpace combines the central counterparty
model and clearing function of the Chicago Mercantile Exchange with the
global distribution network and direct processing capability of Reuters. It
is supported by one of the best matching and clearing technology programs and offers industry-leading matching-engine capabilities provided
by the CME.

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Who Is Reuters?
Reuters is the leading provider of news, financial information, and technology solutions to institutions, businesses, and media worldwide. Founded in
1850, Reuters has always been committed to delivering information using
the best available technology. In 1992, Reuters pioneered electronic trading
services and established its presence with the launch of Reuters Dealing
(originally D-2001, now Dealing Direct), an electronic peer-to-peer trading
platform. Since then, the Reuters platform, in its formative and subsequent
versions, has provided a catalyst for forex trade-volume growth by significantly reducing both execution speed and transaction costs.

FXMarketSpace
This venture will offer participants unprecedented choice of access to its
platform through a variety of means including CME’s i-Link API, Reuters
Dealing 3000 and Reuters 3000 X-tra desktops, Reuters standard transactions, API Select Independent Software Vendors (ISVs), and portals of participating clearing member firms. FXMarketSpace is targeted to meet the
explosive growth in demand for currency transactions by banks and other
financial institutions, including traditional asset managers, proprietary
trading firms, leveraged funds, currency managers, hedge funds, and commodity trading advisers (CTAs). It is designed to provide increased price
transparency, to introduce trading anonymity, and to heighten forex market
accessibility. These three features will attract more players, which in turn
will increase market liquidity and market efficiency for the next generation
of forex traders. All market participants will be able to trade against the
same set of firm, executable prices. The central counterparty clearing
model provides for full anonymity and eliminates the need for bilateral
credit lines to support trading activities. The company’s matching host provides increased transparency through both a five-level depth of book display with bid/offer quantities and detailed “time and sales” information.
Firms may utilize the existing CME telecommunications hubs to facilitate
their connections to FXMarketSpace, providing improved speed of access
while reducing costs. Hubs are currently located in London, Amsterdam,
Dublin, Paris, Milan, Gibraltar, and Singapore. Customers may utilize either
their existing Reuters infrastructure or secure Internet connections to access the market.
FXMarketSpace will reduce counterparty risk by being the buyer to
every seller and the seller to every buyer by employing CME clearinghouse
functionalities. If you bought this book to learn about the trading opportunities in the forex arena or even if you are a seasoned trading pro, look to

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learn some of my techniques. Keep your eyes and interest open on this new
venture for currency trading; it promises to revolutionize the way we trade.
It is like combining the best of futures and the spot forex market. Perhaps
as it develops the centralized marketplace, we will have access to spot
forex volume and will not need to worry about capturing that data from the
futures market.

WHY TRADE THE SPOT FOREX MARKET?
From all the financial instruments traded, forex is believed for a number of
reasons by many professional traders and analysts to be one of the bestsuited markets to trade using technical analysis methods. First, it is wellsuited because of its sheer size in trading volume; according to the Bank for
International Settlements, average daily turnover in traditional Foreign Exchange markets amounted to $1.9 trillion in the cash exchange market and
another $1.2 trillion per day in the over-the-counter (OTC) Foreign Exchange and interest-rate derivatives market as of April 2005. Second, the
rate of growth and market participants in forex trading has increased some
2000 percent over the past three decades, rising from barely $1 billion per
day in 1974 to an estimated $2 trillion per day by 2005. Third, since the market does not have an official closing time, there is never a backlog or “pool”
of client orders parked overnight that may cause a severe reaction to news
stories hitting the market at the U.S. bank opening. This generally reduces
the chance for price gaps. Currencies tend to experience longer-lasting,
trending market conditions than do other markets.
These trends can last for months, or even years, as most central banks
do not switch interest rate policies every other day. This makes them ideal
markets for trend trading and even breakout systems traders. This might
explain why chart pattern analysis works so well in forex trading. With
such widespread groups playing the game around the world, crowd behavior plays a large part in currency moves; and it is this crowd behavior that
is the foundation for the myriad of technical analysis tools and techniques.
Due in part to its size, forex is less volatile than other markets. Lower
volatility equals lower risk. For example, the Standard & Poor’s (S&P) 500
Index trading range is between 4 percent and 5 percent daily, whereas the
daily volatility range in the euro is around 1 percent. Trading veterans know
that markets are interdependent, with some markets more heavily influenced by certain markets than others. We covered some of these relationships looking at futures and certain stocks and how interest rates move
equity markets and currencies. We will learn in coming sections how to detect hidden yet repeating patterns that occur between these related mar-

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kets. Forex is the ideal market for the experienced trader who has paid his
or her “trading tuition” in other markets. Forex is by far the largest market
in dollar volume. At times it can be less volatile; experiences longer, more
accentuated price trends; and does not have trading commissions as we discussed. However, there are no free lunches. Traders must use all the trading tools at their disposal; the better these fundamental and technical tools,
the greater their chance for trading success.
While intermarket and other relationships are often complex and difficult to apply effectively, with a little high-tech help, traders and investors
can enjoy the benefits of using them without having to scrap their existing
trading methods.

FOREX VERSUS FUTURES MARKET
The futures market through the International Monetary Market (IMM) of
the Chicago Mercantile Exchange has many benefits as well. Founded in
1898, CME is the leader in the FX futures arena, accounting for 96 percent
of all currency futures contracts traded on a worldwide basis. The Chicago
Mercantile Exchange pioneered this segment by offering the world’s first financial futures contracts on seven foreign currencies in May 1972. Since
that time, it has continued to expand its reach in FX by introducing new
products, expanding its customer base and leveraging the market leading
technology found in CME Globex®, its proprietary electronic trading platform. The exchange handles over a billion contracts valued at more than
$638 trillion on an annual basis. It is a public company; and as of August 18,
2006, the stock (CME) was trading at 461.35. Amazing, considering that
when this stock was first released in its initial public offering (IPO) in December 2002, it was trading at under 40 per share! The history of the exchange and the innovator of the IMM, Leo Melamed, who brought foreign
currency trading to life, is legendary. It has allowed investors, large and
small, to trade foreign currencies exclusively for nearly 25 years before the
explosive growth of spot forex was available. As with any product, there
are strengths and weaknesses. I wish to share with you the facts so you can
determine which investment vehicle suits your taste and trading style.
First, you should know the symbols for the individual futures currencies as quoted against the U.S. dollar. There are just minor differences between spot forex and futures symbols, as shown in Table 1.1.
Note that futures trade in quarterly cycles; and to differentiate between
the various contract months, futures have universal symbols for each of the
different contract months. December is “Z,” March is “H,” June is “M,” and
September is “U.” Here is what you would use with a charting or quote ven-

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TABLE 1.1

FOREX CONQUERED

Symbols for Futures and Forex Quoted against the U.S. Dollar

Currency

Euro currency
British pound
Japanese yen
Australian dollar
Canadian dollar
Swiss franc

Futures Symbol

Forex Symbol—Nickname

EC
BP
JY
AD
CD
SF

EUR/USD—Euro
GBP/USD—Cable
USD/JPY—Yen
AUD/USD—Aussie
USD/CAS—Loonie
USD/CHF—Swissy

dor to get a futures contract quote on a June 2007 euro currency—ECM7.
On some quote and charting services, the current year or the next contract
month going forward would be assumed and understood. The quotes symbols for the different expiration months and various contract sizes of the futures markets are confusing, but you can quickly learn these variables.
At times, the futures arguably have tighter “spreads” between the bid
and the asking prices; plus there is no interest charge or rollover fee every
other day. In addition, the futures markets offer options for longer-term
traders. There are transactions costs that apply per round turn; but if the
brokerage commission exchange, regulatory, and transaction charges are
less than the PIP spread in forex, an active speculator would be given a better cost advantage using the futures markets instead of the forex spot market. For example, let’s compare a trade in forex on a contract value similar
in size to one on the futures exchange. Use the example of a euro futures
contract on the CME with a contract size of USD125,000 worth of euros,
where each tick or PIP would be 12.50 in value. If the commissions and related fees are $10, which is the average charge by most brokerage firms,
that is your transaction cost per round turn. That is $5 to buy and $5 to sell
out of the position. Keep in mind that the contract value is 25 percent
higher than a full-size forex position, too. If a day trader in forex trading in
a 100,000 full-lot-size contract pays two PIPs on every transaction of a position, this trader would be charged $20 per round turn transaction. The futures arena also has other interesting features and products; one is the U.S.
Dollar Index® contract traded on the New York Board of Trade. It is computed using a trade-weighted geometric average of six currencies. It trades
virtually around the clock; the trading hours are from 7:00 P.M. to 10:00 P.M.,
then from 3:00 A.M. to 8:05 A.M., and then from 8:05 A.M. to 3:00 P.M. Unlike
the forex, there are daily limits on the price movement, with 200 ticks above
and below the prior day’s settlement, except during the last 30 minutes of
any trading session, when no limit applies. Should the price reach the limit
and remain within 100 ticks of the limit for 15 minutes, new limits will be
established 200 ticks above and below the previous price limit. The chart in
Figure 1.4 shows a breakdown of the six currencies and their respective

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FIGURE 1.4

Currencies and Their
Respective Average Weights

weights on the average. The top four include the euro, which is the heaviest weight with 57.6 percent; then the Japanese yen with 13.6 percent; then
the British pound with 11.9 percent; and the Canadian dollar with 9.1 percent. The Swedish krona is only 4.2 percent and the Swiss franc 3.6 percent.

FOREX ANALYSIS IS SIMPLER
From an analytical point of view, tracking the forex market is a much simplified trading vehicle when compared to the futures products. One reason
is due to the uniform contract sizes. In the forex market, the standard lot
size is $100,000. The tick, or PIP, value varies in the futures products based
on the contract, and the contract size varies on the different currencies. For
example, the euro is $125,000, and the tick value is $12.50 per point; the
Canadian dollar is $100,000, and the tick value is $10 dollars per point. The
British pound futures have a contract value of $62,500, which makes each
tick worth $6.25. The yen is worth $125,000, so every point is valued at
$12.50; but it is quoted inversely to the cash market. For instance, the futures is quoted at 0.8610, and at the same time the spot forex would be bid
at 116.50 and offered at 116.54. Forex traders do not have to deal with what
is known as rollover. Every quarter in the futures markets, there is an expiration of the contracts. The rollover period takes place in the second

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week of every June, September, December, and March. It is at that time that
you need to convert or roll out of the old contract month and then into the
new month or next expiration contract going forward. Commodity markets
can cause confusion and can create errors during a rollover period. Often
times, when I was a frequent guest on CNBC, Joe Kernan hated the crude
oil market because it rolled every month. Generally there was a $2 premium from one month to the next; so in early November 2006, crude fell to
just $55.00. But when the front contract month expired and the next rolled
over, prices were quoted $2 a barrel higher. The same scenario exists for
currencies; however, the rollover is every three months.
The first notice day and last trading day combined with the options expirations can hinder trading and cause confusion; there are situations
where traders place orders for the wrong contract months during this
“switching period.” This rollover period gets confusing even for an old pro
like me; but if you know what to expect, then you can prepare for the event.
We have not covered this topic yet (which will be covered in depth in the
next few chapters), but the greatest technical tool for forex trading is pivot
point analysis. It is based on a mathematical formula to predict future support and resistance target levels. If you are calculating pivot points for the
futures markets, you already know that you need to constantly switch your
analysis from the expiring contract to the new contract month. This can
cause “gaps” in your analysis. Take, for example, the rollover that occurred
in March 2006. On March 7, the March futures contract was still trading and
was quoted at 0.8485. The June futures contract had become the lead
month and was quoted at 0.8597. That would mean that there was a gap of
over 100 PIPs due to what is called the basis—the difference between the
cash market today and the futures contract for delivery in June. The basis
includes what is known as the carrying costs.
As a trader, I would need to adjust my numbers and analysis for this
gap or start backtracking prior sessions to accommodate for the price differences. It is done every quarter; and, believe me, it is a royal pain. So not
only do you have to be careful placing the right contract, but you need to
know the various margin requirements, the right expiration dates, the contract values, and the value of each tick (point). I am not going to give you
the “let’s turn lemons to lemonade” line here; futures rollover is a pain in
the neck.
To summarize, the benefits of trading the spot forex market outweigh
trading the futures markets from many perspectives. If you acknowledge
that paying the PIP or spread for your trades is not cutting into your profits, especially since you do get free charts, news, and order execution privileges, then trading in the spot forex market is better than the futures
markets. Granted, most forex dealers trade platforms and charting capa-

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bilities are not high-powered systems but they do allow a beginner to execute trades without additional software expenses. The analytical tools such
as volume analysis and open interest studies combined with the CFTC
Commitment of Traders (COT) report data can and should be integrated
for spot forex trading. If you can learn to merge the benefits of both worlds,
then perhaps one of the best short-term trading vehicles is the spot currency market known as forex.

GEM OF A BENEFIT IN FUTURES
One of the best features of the futures markets is that they have listed options; and because these are futures products, they also have the access of
the transparency on how many options on the futures contracts are available to buy and how many options on the futures contracts are offered to
sell. This book, Forex Conquered, is designed to give you specific trading
plans on all aspects of foreign currency trading opportunities. I feel that
there are many, many choices; and yet so few people are aware of them.
Options are just one futures trading vehicle, and many forex traders have
had only limited exposure to options. Therefore, I want to introduce you to
what they are and how you can benefit from them in your trading career.
To start with, there are two types of options: a call and a put. And there are
two kinds of positions for each call and put: a buyer and a seller, or an option writer.
A buyer or long option holder of a call has the right but not the obligation to be long a futures position at a specific price level, for a specific period of time and for a specific price called the premium. A buyer or long
option holder of a put has the right but not the obligation to be short a futures position for a specific price that is paid by the buyer at a specific price
level and for a specific period of time. For option buyers, the premium is a
nonrefundable payment, unlike a margin requirement for a futures contract
where it is a good-faith deposit. Premium values are subject to constant
changes as dictated by market conditions and other variables, such as time
decay and the distance between the underlying value of the market and the
strike price of the option. One more factor that determines an options value
is the volatility rate, which is based on price fluctuations in the activity on
the underlying futures market. The wider and faster the price movements
are, the higher the volatility level is; and a higher volatility rate will help increase the options value.
There are other variables that are used to calculate an options value,
such as interest rates and demand for the options itself. For instance, if you
bought a call option and if the underlying futures market is moving up toward your strike price, then the option’s premium value may increase, be-

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cause option writers or sellers will want more money and buyers will have
to pay more for the premium of the option. This is an example of an increase in demand for the option as a direct result of the market’s expectation of the movement in the price direction.
One of the first things to know about buying options in futures is that
you do not need to hold them until expiration. Option buyers may sell their
position at any time during market hours when the contracts are trading on
the exchange. Options may be exercised at any time before the expiration
date during regular market hours by notifying the broker. Usually one exercises in-the-money options; this is called the American style of option exercising. It is called the European style of option exercising when the
option can only be exercised on the day the option expires.
A seller or option writer of a call or put grants the option buyer
the rights conveyed from that option. The seller receives a price that is paid
by the buyer, that is, the premium. Sellers have no rights to that specific option except that they receive the premium for the transaction and are obligated to deliver the futures position as assigned according to the terms of
the option.
A seller can cover his or her position by buying back the option or by
spreading off the risk in other options or in the underlying futures market
if market conditions permit. A buyer of an option has the right to either offset the long option or exercise his option at any time during the life of the
option. When a trader exercises his option, it gives the buyer the specific
position (long for calls and short for puts) in the underlying futures contract at the specific price level as determined by the strike price. Options
are generally exercised when they are in the money (ITM)—the strike price
is below the futures price for a call option and above the futures price for a
put option.
HOT TIP
The Chicago Mercantile Exchange, as of July 31, 2006, started trading European-style options on the British pound, the Canadian dollar, and the Swiss
franc; futures contracts; and euro and Japanese yen contracts. These options,
if in the money, are automatically exercised at expiration. European-style
options are used by most options traders in the OTC FX markets. Because there
is no risk of early exercise, they are often priced lower than American-style
options. European-style options on CME FX futures are traded electronically,
virtually around the clock, from Sunday afternoon to Friday afternoon on the
CME trading platform and Monday morning through Friday afternoon on the
trading floor.

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There are three major factors that determine an option’s value, otherwise known as the premium.
1. Time value—the difference between the time you enter the option po-

sition and the life the option holds until expiration. An option that has
more time value is worth more than an option that is soon to expire, all
things being equal. The term wasting asset is applied to an option because the closer the time comes to the option’s expiration, the less the
option is worth.
2. Intrinsic value—the distance between the strike price of the option
and the difference to the underlying derivative contract. If an option’s
strike price is closer to the underlying futures contract, it will be more
expensive than an option that is further away. The term used is a call
option, which gives the buyer the right, not the obligation, to be long
the market. A call option will cost more if the strike price is closer to
the actual futures price. The reverse is true for put options. A put option will be more expensive if it is closer to the derivitive market price.
These two examples are considered to be out of the money (OTM), because neither is worth exericising. (An in-the-money option is referred
to when the strike price is below the futures for a call option and above
the futures for a put option.)
3. Volatility—the measure of historical price changes. Volatility accounts
for the pace of price change. In periods of violent price moves, options
will command high premium values. Volatility is calculated by the magnitude of a market’s past price move and current market condition.
Let’s review some examples and at the same time help review what we
have covered as forex and futures relate to each other. Keep in mind that
the value of a futures contract is $125,000 worth of euros, the initial margin
requirement as of August 29, 2006, is $2,835, and the maintenance margin is
$2,100. These are subject to change without notice and are set by the individual exchanges.

Option Strategy Exercise
On August 29, 2006, at 12:00 P.M. (EST), the forex spot euro currency was at
127.67. At that precise moment, the December futures contract was at
128.49. Reference the basis, which is the price difference between where
the spot market is valued and where the futures price is traded. That difference is 0.82 points. The 130.00 strike price for the December euro currency call option, which expires on December 8, 2006, has a shelf life of 101
days until it expires. The premium was quoted at 1.67 points. Each point is

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worth $12.50, so the value or cost of that option would be $2,087.50. At expiration, the December futures contract price would converge to represent
what the spot forex market price would be.
The basis would narrow as futures becomes the cash market. For
you to just break even, as this was an out-of-the-money call option at expiration, the spot and futures markets would need to be at 131.67. That is the
point value of the premium added to the strike price of the option (130.00
+ 1.67 = 131.67). That’s the bad news. The good news is that if the market
price moved within the first 30 days after you purchase the out-of-themoney call option, then the value would theoretically increase by 0.17 percent, which was determined by the “delta,” one of what is called the
“Greeks.” It is a calculation that helps options traders to determine prices
for option premiums.
By the same token, an out-of-the-money put option with a strike price
of 125.00 was valued at 85 points or $1,062.50 (85 × 12.5 = $1,062.50).
The 125.00 put option was out of the money by 349 points (125.00 – 128.49
= 3.49).

Applying the Strategy
First, if you are outright bullish on the euro and thought the dollar would
decline to new all-time lows, the best strategy for unlimited rewards and
limited risk would simply be to buy a long-term call option, which in the example using the 130 December strike would be less money and defined risk
to the premium you paid, $2,087.50. Second, if you thought the dollar would
rally and the euro would decline with the same risk/reward parameters,
then using the OTM 125 put option would be a good consideration because
your maximum risk would be the premium you paid, $1,062.50.
There are many combinations of option plays with various names, such
as “strangles and straddles.” Using options allows you a whole new world
of opportunities other than long/short outlooks in a specific time frame.
Table 1.2 shows the spread between the strikes and the actual cash or spot
market; they are roughly equal to each other, with the call at a 233-pointspread difference to the spot and the put at a 267-point-spread difference to
the spot. Only the futures markets has the big point spread difference; and
remember, as we get closer to expiration, the futures becomes the cash
market, and the basis narrows with time. Therefore, another strategy called
a strangle would be, if you thought the price of the euro was going to stay
in a range between 125 and 130, to sell (or write) both the call and the put
options. This way you would receive the premium of both the call and the
put. You would have changed your risk parameters because writing options have limited profit potential with unlimited risks and your margin requirements would increase as well.

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TABLE 1.2

Pricing Options

130 Call Option

125 Put Option

167 points, or $2,087.50
233-point spread to spot
151-point spread to futures

85 points, or $1,062.50
267-point spread to spot
349-point spread to futures

However, by writing the call and the put options, you would collect a
combined 252 points (167 for the call and 85 points for the put), or $3,150.00
(252 × $12.50 = $3,150.00). The margin required would be twice the amount
of one position since there are two contracts minus the premium collected,
or $2,520.00. Once again, the margins can change; and if the underlying
market makes an adverse move sharply above 130.0 or well below 125.00,
you have unlimited risk exposure. But let’s check one aspect out: If the market does move above 130.00 at expiration, you have a break-even price of
132.52. If the market declines, your break-even level would be 122.48.
If you had no clue which way the market would move but felt there was
going to be a massive breakout one way or another, particularly in the time
horizon of the three-month shelf life of the December option, then employing what is called a straddle would limit your risks while allowing you to
participate. A straddle occurs when you buy the 130 call and the 125 put. In
this case, you would need to pay out $3,150.00, which is the amount of the
two premiums. Keep in mind that your breakeven at expiration would be
132.52 on the upside and 122.48 on the downside. So at expiration, anything
above or below those levels would start to accrue profits.

In the Money
Using the same variables as in the preceding example, a 125.00 call option
would be considered in the money since the futures market was at 128.49.
This call option has an intrinsic value that is the difference between the
strike price and the underlying market of 349 points (125.00 – 128.49 =
3.49). That leaves a balance of 94 points given for the time premium value.
Notice that the 130 call option was entirely out of the money and has more
time premium value built into the option. Sometimes it pays to buy in-themoney options versus out-of-the-money options.

Collar, Not Choke, the Market
For a dollar bear or a euro bull, here is one of my favorite option strategies.
It is a hedge strategy using both options and the underlying market, which
under the right circumstances can work very effectively as far as risk-to-

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Option Price Comparisons

130 Call Option

125 Put Option

Collect 167 points
82-point credit

Pay 85 points
185-point risk/315-point reward

reward ratios and money management tactics are concerned. The opposite
position can be implemented as well if you are bullish the U.S. dollar and
bearish the euro. Let’s examine a bullish collar strategy for longer-term
traders. This strategy allows you to participate in a limited move with limited risk and still lets you sleep at night. If you trade the spot forex market,
you will need two accounts: a forex account and a futures account. Forex
traders who take a long position in the spot euro currency market with a
full $100,000 lot size position will need to add $25,000 worth of mini lots to
be equal in capitalization size with one futures contract. First, you want to
enter the options side by selling the 130 call option and then buying the 125
put option. Once your order is filled, then enter the long position. You will
collect premium from the short call option, which you will use to finance
the put option. You are collecting more premiums from the call side and
will have a credit, as Table 1.3 shows.
Also keep in mind that this is not an equally weighted position due to
the basis difference between the spot and the futures markets; but as time
passes, remember that the futures will line up with the spot market. If you
are long the spot euro at 127.67, keep in mind that the futures market was
at 128.49. But as you know, on any given day, generally both the cash and
the futures will move in tandem, with a gradual decay in the futures market’s basis. The key here is that you have protection to the downside calculated at expiration of 185 points; your maximum reward is 315 points.
This is close to a one-to-two risk/reward ratio.
In order to make the collar strategy worth executing, you generally
want to collect a premium or get a credit on the strategy or, at the very
least, not pay out-of-pocket money on the options side. Since these are options on a futures contract, you will be charged a commission; therefore,
you will need to check rates and margin requirements with different futures
brokers. Futures brokers cannot lower the margin that the exchange sets,
but they can increase the amount. So you need to do your homework. As far
as options are concerned, they do have great benefits from the aspect of
simple speculating on a directional price move to the use and application as
an insurance vehicle, which is what we refer to as a hedge. As a foreign currency trader, certainly expanding your knowledge of these features and
benefits can enhance your trading opportunities on various time frames, es-

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pecially longer-term horizons. Using options to hedge positions into long
holiday weekends, before government reports (such as the monthly unemployment number), or before Federal Open Market Committee (FOMC)
meetings can help protect your account during violent adverse price moves,
especially when they are short-lived. It is one aspect of trading with which
all traders and investors should become more familiar.

TRADING CURRENCY STOCKS?
Foreign currency trading is not just for gamblers or hungover commodity
traders. It really has become a respected asset classification and is extremely popular with professionally managed trading entities and hedge
funds. Foreign currency is so hot that major players are taking it to the extreme. How so? Well, there is now what is called exchange traded funds
(ETFs) on foreign currencies. The first to be introduced was the Euro Currency Trust (FXE). On the first day of trading, the Euro Currency Trust had
over 600,000 shares trading hands.

Advantages and Disadvantages
As with any product, there are advantages and disadvantages to ETFs. One
is that this vehicle has an annual expense of 0.4 percent of assets. If that
amount is not enough (the interest rate is below the 0.4 percent expense
ratio), then the sponsor can withdraw deposited euros as needed, which
could diminish the amount of euros each ETF share represents. The currency ETFs are linked to the spot price versus the U.S. dollar. The obvious
strategy to make money in these vehicles is to see the value move in the desired trade direction (you can buy and sell short) and to cover the interest
charge less the trust expenses.
The benefactor or the depository for the ETF is JP Morgan Chase Bank.
This product is structured as a grantor trust, and Bank of New York is the
trustee. Here is how JP Morgan will make money: It will maintain two eurodenominated accounts in London, a primary account that will earn interest
and a secondary account that will not earn interest. JP Morgan will not be
paid a fee for its services to the ETF. It will instead generate an income or
accept the risk of loss based on its ability to earn a spread on the interest it
pays to the trust by using the trust’s euro position to make loans in other
banking situations. To be sure, JP Morgan has an advantage of floating
money, so I would not worry that it will put itself in a position of extreme
risk. As it has control over granting lending rates, I do not think that anyone
will expect that the trust will pay the best available interest rate back to the

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ETF so it will lock in a profit. The bank is in the business of making money.
The best feature for individual investors for using an ETF is that it allows
one to accumulate exposure without excessive leverage in the euro currency for a long-term position play. It can also be used as another means to
hedge forex transactions. Each share of the ETF will represent 100 euros
plus accrued interest. Under the guidelines of an ETF, it is acceptable to
trade the short side without the uptick rule. Also, ETFs are listed on exchanges and trade throughout the day like individual securities. Since it is
a tradable vehicle, unlike the forex market, it does charge a commission,
which needs to be paid to a brokerage firm, to buy or to sell ETF shares.

Downside Risk
One of the downside risks to U.S. shareholders is that these ETFs are not
insured by the Federal Deposit Insurance Corporation (FDIC), according to
documents filed with the Securities and Exchange Commission (SEC).
Also, interest on the primary account accrues daily, with rates based on the
most recent Euro Overnight Index Average (EONIA), minus 0.27 percent
that is paid monthly. The rate can change over time, according to the
prospectus from Rydex; so there is no fixed rate or cost. This is a minor
consideration; but for a large hedge fund, this could make a difference to an
individual investor looking to take advantage of a long-term investment
play. I hardly think this will cause a major change in the value of the investment.
For the record, the ETF’s net asset value (NAV) is based on the Federal
Reserve Bank of New York noon buying rate and expressed in U.S. dollars.
And as you can imagine, the true influence on the value of this product is
the same group of variables that affect the spot currency markets. Therefore, I believe that combining traditional technical analysis with the futures
data, such as the Commitments of Traders Report, Volume and Open Interest studies, can greatly enhance the performance of longer-term investors over time. In June 2006, Rydex released six additional curency
ETFs. So if you want to hedge or speculate that the U.S. dollar is strengthening or weakening against major foreign currencies and like the idea and
concept of ETFs, now there is a pretty good inventory of product to choose
from. The new currency ETFs trade on the New York Stock Exchange
(NYSE) uner the symbols shown in Table 1.4.
To summarize, each unit represents 100 shares. You can sell short without the uptick rule that exists in stocks. ETFs allow a longer-term trader
with limited risk capital to participate in an opportunity against the U.S.
dollar versus major currency markets. Trading hours are during the U.S. equity markets’ session—9:30 A.M. (EST) until 4:00 P.M. (EST). If you want to

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TABLE 1.4

ETF Symbols on the NYSE

Currency

Symbol

Euro currency
British pound
Japanese yen
Australian dollar
Canadian dollar
Swiss franc
Swedish krona

FXE
FXB
FXC
FXM
FXA
FXF
FXS

read more on the subject of currency ETFs, especially about the risks,
charges, and expenses on these products visit www.rydexfunds.com.

DIVERSIFICATION THROUGH TRADING PERIODS
So far, we have introduced you to various products to take advantage of
foreign currency markets through the spot forex and futures and now
through exchange traded funds via the stock market. Many traders and investors need to incorporate diversification into their arsenal of investments. Many believe the best means to diversify is through investments
that have little to no correlation with each other with reserve cash balance,
such as stocks, bonds, real estate, commodities, forex, and cash parked in
a certificate of deposit (CD) or government Treasury bill (T-bill).
If you have a passion for currency trading, then in order to utilize diversification to the extreme, consider your overall allocation of your investment strategies within this sector. Depending on your time constraints,
you may only be able to participate to a limited extent in day trades during
the European session or early morning U.S. hours as economic numbers
are released. As such, you should also have devotion toward holding positions as they go into a strong trend mode and should carry a position for
more than a few days. This is known as a swing trade. Then, if you want to
really capture a longer-term market trend, finding the right vehicle and
strategy will allow you to hold a longer-term position. Let’s define what I
consider the three important time periods and classifications of a trade.
1. Day trade—1 minute up to 24 hours.
2. Swing trade—2 days to 10 days.
3. Position trade—10 days to 1 year or longer.

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Day traders can use the forex or futures markets for small price swings.
Swing traders can also use the forex and futures markets but can also implement an option strategy, such as a long call or a long put. This is a good
consideration if you want to take advantage of establishing a position
ahead of a major economic report, such as the Monthly Jobs number or a
central bank meeting where you expect an interest rate adjustment to create a price shock in the market. For longer-term position trading where you
would want to take advantage of a fundamental policy change or a technical trading program, you have several doors open to you besides just trading spot forex. You can implement an options strategy as an outright trade
or use options as a hedge to reduce your risk exposure, which in turn can
reduce your margin requirements. Also, you can invest in an ETF and gradually add positions without excessive risk exposure; and because ETFs
have no time decay element, such as options on futures, you can really hold
onto a position for a very long time. In a perfect world, I would say that a
trader’s time factor would limit him or her to a percentage breakdown to allocate resources to trading forex as I indicate in Figure 1.5—25 percent to
day trading, 40 percent to swing trading (since a majority of significant
market moves happen over a period of 3 to 10 days and then enter in a consolidation period), and 35 percent to position trading (to account for slow
periods, time off, and vacations).

FIGURE 1.5

Allocation of Resources

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Which Currency Tracks What and Why?
As Figure 1.4 showed, the most popular or heavily weighted currency
against the dollar is the euro. There are several considerations and nuances
that each individual currency tracks, as each not only is affected by the U.S.
dollar but also is manipulated by its own country’s economic and political
influences. From a historic perspective, let’s examine the top-five major
currencies and what influences their values:
The euro was first introduced to world financial markets
as a currency in 1999 and was finally launched with physical coins and
banknotes in 2002. The European Union is composed of these member
countries: Austria, Belgium, Greece, Germany, France, Ireland, Italy,
Luxembourg, the Netherlands, Portugal, and Spain. The largest members are considered socialist countries; and as a result, these countries
tend to run the largest governmental budget deficits. The European
Central Bank (ECB) dictates monetary policy and puts more emphasis
on inflation concerns than it does on economic contraction. We have
seen in the past where the ECB would rather maintain steady interest
rates in periods of slower economic growth than lower rates and risk
igniting inflationary pressure. As a result, the ECB is less likely to frequently adjust rates.

1. The Euro.

The Japanese economy depends on sales of export. For the most part, Japan is a net importer of raw material goods,
especially crude oil. Japan’s economic machine hinges on foreign demand for their manufactured goods. Their main customers are the U.S.
consumer and Europe. One of the biggest concerns that faced the Bank
of Japan (BOJ) in the 1990s was deflationary pressures. This compelled
the BOJ to keep what was known as a zero-interest policy to help
reignite its economy. In turn, it also artificially kept the value of the yen
low as many savvy investment funds made billions of dollars in what is
known as a carry trade—one entity would borrow cheap money at
nearly zero interest, export those funds to another country, and park
them in a higher-interest-bearing account. This transaction prompted
selling of yen to buy the currency in which those funds were to be invested or parked. U.S. Treasury notes and bonds as well as German
bunds were the target of these transactions. As a result, the yen would
trade lower against the U.S. dollar and the euro. Therefore, trading the
yen/euro cross pair is a viable market to trade. One more consideration
when focusing on factors that can influence the yen’s value is that
China is one of Japan’s competitors. Since China also artificially floats
its currency, the yuan, against the U.S. dollar, China’s monetary policy
also weakens or can put downward pressure on the yen’s value.

2. The Japanese Yen.

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The Bank of England (BOE) is in charge of dictating monetary policy in the Unted Kingdom. One of the main influences on Britain’s economy is oil production in the North Sea. Money
may make the world go round, but energy keeps it running. With that
said, you will see in history that as oil prices rise, the British pound
also tends to follow suit. However, oil supplies are dwindling in
the North Sea, and Britain is using more and more natural gas. As of
August 2006, Britain was Europe’s biggest consumer of natural
gas, and it is continuously increasing imports of the fuel to make up
for declines in crude oil production. As a result, natural gas prices in
Britain have risen an average of 60 percent from 2005 through 2006. It
is now reliant on natural gas and susceptible to economic risk exposure if there are outrageous price spikes in the cost of that product. As
of 2004, Britain became a net importer of natural gas. If natural gas
prices spiral out of control, this factor can influence consumer spending or can create a surge in inflationary pressure; and that would justify action by the Bank of England to change monetary policy. This
scenario could influence the value of the British pound. The pound is
also sensitive to economic developments of its European neighbors.
Therefore, trading the cross of the euro against the pound is a very liquid trading relationship.

3. The British Pound.

The Canadian dollar is often referred to as the
“loonie.” The French equivalent of loonie is huard, which is French for
loon, the bird that appears on the face of the Canadian one dollar coin.
The Bank of Canada (BOC) sets monetary policy as it is the central
bank for that country. Back in November 2000, the BOC adopted the
system of eight meetings each year, in which it announces whether it
will change its interest rate policy, just as in the United States. Canada
is rich in natural resources, especially crude oil. The primary source of
Canada’s growing crude oil supplies are vast oil sands reserves. Oil
sands production, which exceeded the 1 million barrels per day (b/d)
plateau late in 2003, is forecast to more than double by 2015 to almost
2.6 million barrels per day. With 175 billion barrels of reserves, it is the
second-largest petroleum deposit in the world. Since the United States
is Canada’s biggest client, as oil prices rise, the value of the Canadian
dollar will be supported in value.
5. The Swiss Franc. The Swissy, as it is called, is considered the safehaven currency, as it is backed by gold. The Swiss National Bank
makes monetary policy decisions based on events that impact the value
of gold as they influence the value of the currency. Factors that influence the Swiss franc are inflation, excessive economic growth or periods of economic contraction, and periods of political instability. The

4. The Canadian Dollar.

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Swiss franc tracks the value of the euro; but during periods of European upheaval, as occurred in 2004 when there existed dissention
among members of the European Union, the Swiss franc will outperform the euro.

Fundamental News Drives the Markets
Traders who are new to forex can take comfort in knowing that analyzing
and forecasting exchange rate movements does not rely solely on macroeconomic factors, the “big picture” issues. These are concepts for which information is readily available but that are not so intuitively grasped by the
masses. Currency traders who are looking to capture big moves in exchange-rate movement definitely should focus on the fundamentals and the
understanding of what drives interest rate differentials between various
countries. The currency pairs are traded especially when attempting to assess the value of currencies.
Traders need to be aware of several key elements and events that can
cause currency values to move. For one, the adjusting of interest rates by
central banks is a major factor that moves markets. These decisions are
based on many concerns, such as international trade flows, investment
flows, the health of individual country’s economies, and inflation worries.
The opposite concern, as has been the case for Japan for over a decade, is
deflation. These are the same factors that can and do influence moves on
the stock and bond markets.
Our civilization has evolved into a very complex international capitalistic environment. Some governments intercede to help benefit their
economies through government support programs, as had been the case in
China. China had artificially supported its currency, the yuan, to move in relationship with the U.S. dollar. Then we have multinational conglomerate
corporations, whose money flow needs can and do influence short-term
price swings in currencies. Throughout these developments, it has become
increasingly difficult to target one single effect on the value of a currency in
the short term, especially one weighted against the U.S. dollar. Take for example what happens in an economic business cycle. Money flow moves
where there are better opportunities either from the perspective of attractiveness on rate of return or from a safety issue in uncertain times. Huge investment funds can move money to higher-yielding interest-earning
instruments, namely bonds, or to foreign stocks. When major hedge funds
see better opportunities from one country to another, they have the resources to move quickly with limited restrictions. These shifts in trading
strategies also cause short-term moves in currency values.
Historically, when we see signs of economic changes taking place,

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money flows in the equity markets move from one sector to another as the
economic business cycle goes into an expansion mode, then into a contraction, and then back into an expansion mode. Foreign investors may
wish to take part in these changes as well, therefore increasing capital
flows to the United States, which will have a short-term supportive boost
for the dollar. As of the middle of October 2006, what we were possibly entering would have been considered an early-stage economic contraction.
There were many factors at play that would lead to that conclusion. For
starters, the Federal reserve had raised interest rates by 0.25 percent 17
consecutive times over a two-year period, bringing the federal funds rate to
5.25 percent. It concluded its interest-rate-hiking campaign based on concerns that it might choke off liquidity, bringing more risks to economic
growth than the risks of inflation. That was a pretty good tip-off that the
economic expansion phase just might moderate. As a result of increased interest rates, even the housing market turned south, as we discussed previously (see Figures 1.1 and 1.2). We had been in a longer-than-normal
economic expansion period, starting from early 2003 through mid-2006.
With this said, it was at the time considered a “long in the tooth” recovery
(lasting more than 40 months), especially after the economic contraction
period that followed 9/11/01.

Treasury Yield Relationship to Currencies
With the Federal Reserve interest-rate hikes and escalating energy prices
taxing the American consumer, it is no wonder we were expecting a contraction. Some argued with the longer-term yields on Treasury bonds inverting in relationship to shorter-term maturities. This gave even more
reasons to suspect a more-than-moderate slowdown might occur. Based on
historical standards, when interest rates on the long end of the yield curve
are below those of shorter-term maturities, we have entered into recessionary periods. The word recession was being tossed about by many leading analysts as a result of this reoccurring. As of August 21, 2006, the yield
on the 10-year note was at 4.84, and the yield on the 2-year note was at 4.87.
Figure 1.6 plots the yield on the various Treasury maturity issues. As you
can see, the yield on the 10-year note dips below that of the 2-year note and
creates the inversion.
An investor or a foreign central bank can park money into a short-term
instrument and receive close to a 5 percent return without risk. That is one
feature that will attract foreign capital flows and help support the dollar.
This effect will occur until better opportunities evolve elsewhere. As a
forex trader, you want to monitor yields on a global scale or events or reports that may impact these rates.

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FIGURE 1.6

35

Yield on Treasury Notes, as of August 21, 2006

ECONOMIC CONDITIONS CLUES TO WATCH FOR
• Inverted yield curve gives warning of an economic slowdown.
• Flat yield curve signals economic recovery.
• Steep yield curve signals economic expansion.

Lessons Learned from Energy Prices
We can benefit with the knowledge from where energy prices are, especially crude oil. As prices rise, oil-producing countries increase their
wealth. However, oil-consuming nations are at a disadvantage, and the increased cost of fuel can contribute to a recession, as occurred in the United
States in the 1970s. If you think about it, higher fossil fuel prices actually act
like a taxing effect on consumers. However, after a prolonged price appreciation, to reflect the higher energy costs, producers eventually need to
raise prices in their finished goods and services to maintain a decent profit
margin and not absorb the burden of higher energy costs. Who pays the
price? You and I, the consumer, and that is inflationary. Crude oil prices hit
an all-time high close at $78.40 per barrel on July 14, 2006 (see Figure 1.7),
due to global demand and fighting in the Middle East. Tensions flared between Israel and Lebanon. Fears arose when many suspected Iran and Syria

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FIGURE 1.7

Crude Oil Prices
Used with permission of GenesisFT.com.

were backing Hezbollah with supplies, fears that Israel would take action to
stop the weapon shipments. The markets were on edge as that region was
deteriorating by the minute. If that was not enough, Iran was threatening to
continue with its nuclear program, despite UN resolutions to have them
stop enriching uranium. Iran’s Supreme Leader Ayatollah Ali Khamenei was
quoted as saying, “Iran would press ahead with its pursuit of nuclear energy,” thus indicating it would not follow requests or directions from the
United Nations. President Bush was quoted as saying we are in “challenging times” in a speech made on August 21, 2006. This was in reference to the
global war on terrorism. This strongly impacted crude oil prices, as did the
geographical location of Iran and the Straits of Hormuz, where oil cargo
vessels sail to the Western world.
Imagine how sensitive the area was with reports that Iran was “testing”
surface-to-sea missiles. There are two points I want to bring to your attention: (1) We want to look at the impact higher energy prices have on the dollar versus the currency of oil-producing countries, such as Canada and
Britain. (2) We can determine from history that with higher energy prices,
the United States is susceptible to recessionary pressures, which put further pressure on the dollar.

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As a trader, I want access to as much relevant information as possible
to give me clues to the overall market conditions so that I can make a
more-educated trading decision. If I know that higher crude prices will
weigh on economic development, I need to ask myself how can I profit
from that situation. Based on a widely accepted business-cycle flow chart,
we see business sectors that perform better under certain market conditions. As we enter a late-stage economic expansion (as I believe we entered in mid-2006), energy markets make a move, as do basic materials, as
building is going like gangbusters. Then as higher interest rates slow consumer spending and credit costs a little more, we see money moving into
safer issues, such as consumer staples and utilities. This occurs as consumer confidence declines in the economy, and people rein in spending.
Technology is weakest during an economic contraction period as capital
spending dries up. Figure 1.8 defines the various stages of the business
cycle. At the top of the pyramid, when we are in the middle to late expansion period, we see energy as one of the top money sectors. As the economy slows, demand for fuel declines; people are more cognizant of their
spending habits and start conserving.
Now to confirm that we were, in fact, in a period of contraction, we
would look to see if these similarities were reflected in the various stock
index performances. If we were entering a period of economic contraction,

FIGURE 1.8

Stages of the Business Cycle

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FIGURE 1.9

Year-to-Date Gain, 12-31-2005 to 8-18-2006

the Dow Jones Industrial Average, which represents 30 of the top blue-chip
stocks, many of which offer dividends, might outperform the other indexes.
We would certainly expect the Dow to outperform the Nasdaq. Let’s examine Figure 1.9. This graph shows the year-to-date gain from December 31,
2005, through August 18, 2006. The Dow outperformed all the major stock
indexes during that seven-and-a-half-month period. Notice the negative return on the Nasdaq? The key word here is negative. That implies that businesses, investors, and consumers are not positive on the economic outlook
here in the United States. That does not bode well for the U.S. dollar. What
we would look for as a clue that the dollar has bottomed would be for a period of economic expansion led by the technology sector. Until we see signs
that the economy reenters a new business cycle, the U.S. dollar might just
as well remain under pressure.
As we look ahead to the 2008 presidential election, this period may redefine an economic expansion. So watch for signs as technology leads the
way. This may attract foreign investment flows, and the dollar may bottom
at that time. Longer-term and short-term position traders can profit by
watching for resurgence in the U.S. economy and confidence in the dollar.
Eventually, it will reign supreme again. If the U.S. economy continues to
grow, and if inflationary pressures build, then the Fed will probably continue to raise rates. This action will help support the dollar’s value.


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