Frequently Asked Questions
What is the difference between trading foreign exchange and trading equities or other securities?
Answer: There is no real difference between trading equities and trading FX. You use the open-high-low-close of the bar to get a grasp of market sentiment. You use all the same indicators, although they behave differently in each market (see Curtis Arnold’s book, The PPS Trading System, in which he asserts that commodities are more susceptible to support-and-resistance analysis than equities—and we agree.) You still seek to buy low and sell high, or buy high and sell higher, as Larry Williams puts it. You need a stop and a target no matter what you are trading. FX is just another security…
EXCEPT it differs in three ways, although they are not always in play.
Shorting in equities has a negative connotation that shorting in FX does not have. In FX, if you are selling one currency, you are buying another.
We do not get volume information in FX as in equities. The spot trades done by professionals at banks and brokers are private contracts and not disclosed. The information we have on spot volume comes in the form of occasional Fed surveys and the biennial survey conducted by the BIS (Bank for International Settlements). Volume information every two years is hardly useful for day-to-day trading. In FX futures, we get live tick volume but not true trading volume until the day session has ended. Volume data can be very useful in trading equities and it is a drawback of trading FX that we do not have it. Note that the CFTC Commitments of Traders Report, issued every Friday on positions held by major futures market participants for the previous Tuesday, is information that is similar to volume information.
Central bank intervention is extremely rare in other securities but more common in FX. During 2003-2004, the Bank of Japan intervened to the tune of hundreds of millions of dollars. In 2009 and 2010, the Swiss National Bank intervened in undisclosed amounts in both EUR/CHF and USD/CHF. The last time the US intervened was during the Clinton Administration (Asian crisis, 1997-98). Emerging market central banks such as the Bank of Korea, the People’s Bank of China, the Bank of Mexico, and others, often intervene. This may not have an immediate effect of the major traded currencies like the EUR/USD, but central bank intervention is always a serious sign of perceived financial distress, and that’s useful information.
Why do I have to read all this material about central banks, economies and politics? All I want to do is trade.
Answer: You don’t have to read all this stuff. You can trade on technical signals alone. After all, technical analysts say that all the information you need is already in the price.
But to have no understanding of the fundamentals means you are always rushing to catch up with price action. The fundamentals we report in the Morning Forex Briefing are what professional traders use to fashion the price. When you know what they are looking at, you have an advantage—you can anticipate how they will respond to expected news and developments. To be ignorant of events is to limit yourself and make you vulnerable to unhappy surprises.
Professional traders are out to trick you and take your money away from you. The short squeeze game, for example, presses a price downward on some piece of news or rumor, either real or bogus, to get you to go short. The pros know where your stops are and at what price you can be induced to go short. When the price is low enough, the pros come in and bid it back up and your stops get hit a second time. The same thing happens on the upside. The pros create a spike up that sometimes features the highest high of the series. They engineer a widely used candlestick pattern (like an engulfing bull candlestick). But they just want to trick you into going long.
When you know what story inspired the spike, you can judge whether it’s true and useful, but only if you have the background and context. You can’t use a BS detector unless you know what is not BS in the first place. This, by the way, is why forex chat rooms are a colossal waste of time. Nearly all of the people in chat rooms don’t know what they are talking about. They may know something about the big picture macro outlook but if you don’t also know how traders think and operate, the information is not useful.
Keynes compared trading to judging a beauty contest. It doesn’t matter which girl you think is the prettiest. It only matters that you can discern which girl the other judges will think is the prettiest.
Why do the prices my spot broker shows for high and low differ from what Rockefeller Treasury is reporting?
Answer: Here is an actual letter from a subscriber: “Your 3/19/2010 afternoon report claims that our profit target of 1.0068 on USD/CAD was hit . Actually it never happened. My Oanda account shows the lowest it got was about 1.00728, so the trade is still in play.”
There is no central clearinghouse in spot fx (as there is in FX futures). eSignal has the Friday low at 1.0055 as of 8 am and Reuters has the low at 1.0063. Oanda, a well-respected name, quotes a third low. The issue is that the spot market is not an exchange-traded market and so there is no central authority to say what is the exact high or low (let alone open and close). This gives the broker an opportunity to cheat you if the broker chooses. We get a dozen letters every year asking whether we think the broker has cheated. But we can’t answer the question. It’s entirely possible that a particular broker didn’t do any trades at those other levels, so as far as it is concerned, its version of the low is the low. In other words, none of these quotes is “wrong.” This is a perpetual problem in spot retail. We choose to use data from eSignal and Reuters because they each have multiple brokers feeding their quote collection.
Q: Why do I have to read all this material? The morning report is 4-5 pages long. Do I really need to know all this stuff? How does it help me trade?
A: Yes, you really should read all this material because it helps prevent your getting blindsided by an unpleasant surprise. If bond yields are rising in the US, that’s a dollar-friendly event, and vice versa. Bonds are far more important than equities to the FX market, and most retail traders have to learn to follow bond yields. The supposed correlation of the dollar to various commodities (oil, gold) is an important theme for the past few years, too. Why would you want to place your money in a market without knowing anything about the market? You wouldn’t buy a stock without knowing what the company sells, would you?
You may want to skip over some of the dry economic data, for example (and we do not claim to do thorough coverage of all the economic data, which would take all day), but then you can’t complain if a central bank suddenly raises interest rates because of inflation. When we see inflation making an unusual appearance, we try to note it. We always joke that if you read every morning report for a year and go look up things you don’t understand, you will have the equivalent of a master’s degree in international finance by the end of the year.
As for how it helps you trade, each theme is selected for its potential effect on the FX market. This changes over time and so the main categories change over time, too. As of May 2010, for example, we will probably move from “Greek Debt Drama” to “EMU Debt Contamination Story” or something like that. In the past we had had “Japanese Intervention Saga” and other sub-heads.
Q: How do you know when a trend will end?
A: We never know when a trend will end. Anyone who tells you there is a magic formula is barking mad. But in our upcoming book on foreign exchange, we will have a little primer on reversals. These are some of the indicators that we use on a day-to-day basis to help guide us choosing what direction to trade and where to place stops and targets. Here is part of it:
Reversals in FX can be gradual and gentle, or abrupt and dramatic. The key point to remember about reversals is that you will consistently make the biggest trading gains by trading them as soon as you see them, because a new move often degenerates into a confusing choppiness.
Reversal Rule 1, Crossover of 20-Period Moving Average: A closing price that breaks the 20-period moving average in the opposite direction of the existing trend has a high probability of continuing in the new direction. A big-bar drop that crosses the 20-day moving average to the downside reliably indicates another 2-5 periods of lower lows. Notice that it doesn’t necessarily mean lower closes.
Reversal Rule 2, Failure to Match and Surpass Previous High/Low: A move that fails to match and surpass a previous intermediate high or low will stop and reverse. We often mark a previous low or high with a horizontal line. Here every point counts. An effort to touch a previous high or low that fails by one point is still a failure. After the failure, expect a move in the opposite direction.
If that move is weak, prices now enter “The Box,” with choppy price action and even a bar or two violating the old low or high but failing to hold it and build on the breakout. “The Box” is a region on the chart where the price thrashes around making no lasting directional move either way. You may have a series of higher high s and higher lows, one definition of “trend,” but the ability to trade with the trend is severely compromised by the choppiness.
Reversal Rule 3: Island or Near-Island Reversal Bar: An island reversal is a bar separated by the preceding and succeeding bars by a gap. In the FX market, island reversals are extremely rare because the market hardly ever closes, and so the opportunity for gaps is limited. But we often get an outlier bar that marks a low or a high surrounded by bars going in opposite direction, so we call it a near-island reversal. It’s one of the most reliable indicators around. A stand-alone high or low bar indicated exhaustion. What, exactly, is exhausted? The population of traders still willing to put on fresh positions in the starting trend direction.
Reversal Rule 4: Support/Resistance Line Break: A breakout of support or resistance in the same direction is a warning sign of a reversal. You might think that breaking support constitutes confirmation of the downward trend. Sometimes this is true but as a general rule, it’s another symptom of exhaustion. After an upside breakout of resistance, we expect a series of lower lows and lower closes.
Reversal Rule 5: Congestion periods are always followed by a breakout and sometimes the breakout is a reversal. Congestion is defined as a series of prices within a narrow high-low range that show no consistency of placement on the bar of the open and close or high and low. Congestive periods are usually fairly brief, 5-10 days. We will sometimes get a series of higher highs in which each new higher high is a smaller amount than the one before—deceleration, so to speak. This is illustrated by a drop in momentum, calculated as today’s close divided by the close x number of days ago. Again, we deduce exhaustion—everyone who was going to buy has already bought and some are already taking profit. Many traders and technical analysts disdain momentum as an indicator. We say it’s a valuable indicator to warn of an impending reversal if the price series becomes congestive.
We have many more reversal rules. This is just a starter for helping you to understand why sometimes we take a counter-trend position in what seems like a perfectly good trend.
Q: If you do not intend to carry a position from one day to another day, do you close your futures trades with the CME pit close? I gather that this would be 3 PM Eastern.
A: No, Globex (electronic market) is open 23 hours per day and assuming you are using an electronic platform, you can easily carry positions for as long as you want, including after the CME close. We generally try to open and close each position every day starting with the CME close, but sometimes carry over to the next day or two. If you are trading the old-fashioned way and your broker goes home after the close, you need to re-consider which broker you want to use!
Q: I understand most of the concepts of the contingency rules. A scenario that is not specifically covered by these contingency rules is that we already have an executed profit target (hooray!) and the price now returns to the same level as the entry. I would like to understand your thought process on this – would you recommend entering the same trade again or does your experience say otherwise?
A: You are absolutely correct that if you were willing to enter at one price, you should be willing to enter it again at the same price—with a warning. We tend to enter at the CME close, which in practice means the Globex open since obviously you can’t enter at a price that is already gone. The CME close is not exactly random and in fact it’s the most important price on the bar, summing up the sentiment of the day. Still, it would be nice to know that a return to the previous close is just a profit-taking correction and not a reversal! We set the profit target at a big chunk of the average daily range, so a return to yesterday;s close, assuming that is our entry, is a big move against us. So, if you re-enter at the same price a second time, be sure you have checked the chart carefully. This one is a judgment call.
Q: Back to the contingency rules: I want to make sure that I understand how to properly apply the following from Contingency Rule #3: “We also re-enter after a stop at the previous day’s close if that is higher than the stop just hit.” Can you give me an example of this, please?
A: Let’s say you were long sterling at 1.4950 but hit the stop at 1.4875 for a loss of 75 points. Now the price has risen back to 1.4950, i.e., a 100% retracement of the loss just taken. If you were willing to buy at 1.4950 once, you should be willing to do it again especially now that the worst case event has already occurred, i.e, the 75- point loss. What are the odds of a second loss of exactly the same size happening again? Almost zero, although double bottoms do occur. So re-enter and restore the same stop and target.