CurrencyTrader0305.pdf

• CATCHING CURRENCYBOTTOMS by the numbers

• BARBARA ROCKEFELLER’S technical FX outlook

• WHAT’S NEXTfor the Euro/Swiss franc?

• JOHN BOLLINGERinterview

• THE U.S.DOLLAR/YEN RATE:Will 100.00 give way?

• THE SCOOP ONFX options

• CATCHING CURRENCYBOTTOMS by the numbers

• BARBARA ROCKEFELLER’S technical FX outlook

• WHAT’S NEXTfor the Euro/Swiss franc?

• JOHN BOLLINGERinterview

• THE U.S.DOLLAR/YEN RATE:Will 100.00 give way?

• THE SCOOP ONFX options

HAS THE EURO TOPPED?HAS THE EURO TOPPED?

2 March 2005 • CURRENCY TRADER

Editor’s Note . . . . . . . . . . . . . . . . . . . . .6

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

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

Global EconomyHas the Euro topped? . . . . . . . . . . . .12The bear trend in the U.S. dollar vs. theEuro took a turn in 2005. Find out what analysts say might be in store in the coming months.By Currency Trader Staff

Will this be the year 100.00-yen gives way? . . . . . . . . . . .14The dollar/yen rate is flirting with a historiclevel, and traders are busy staking theirclaim to both sides of the market. Find out if the long-term trend is likely to prevail.By Currency Trader Staff

Industry NewsBy Carlise Peterson

Tower Group comments on BIS survey . . . . . . . . . . . . . . . . . .16Research firm Tower Group gives its takeon the Bank for International Settlements’survey on the foreign exchange industry.

NYC Traders expo spotlights currency trading . . . . . . . . . . . . . . . .16The Currency Trader panel at the New York Traders Expo focused on thefuture of the dollar.

Intershow announces 2005 forex conference . . . . . . . . . . . . . . . .17Intershow, which heads the Traders Exposheld in New York, Las Vegas, and Chicago,will add a forex conference to its roster thisyear.

The Big PictureThe technicals rule . . . . . . . . . . . . . .18Are deficits or interests rates controlling theforex market? Or are the technicals reallyrunning the show?By Barbara Rockefeller

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

Currency Calendar . . . . . . . . . . . . . .29

Currency CharacteristicsThe international trade report and the U.S. dollar . . . . . . . . . . . . . . .30Analysis of price patterns in the U.S. dollararound the monthly trade balance report.By David Bukey

Currency Trader InterviewJohn Bollinger on consolidations . .36By Currency Trader Staff

continued on p. 4

CONTENTS

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CONTENTS

Have a question about something you’ve seen in Currency Trader?

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Looking for an advertiser?Consult the list below and click on the company name for a direct link to the ad in this month’s

issue of Currency Trader.

FXCM Refco Gain Capital

InvestorflixParis ExpoEFX

Index of Advertisers

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

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

Indicator BasicsPrice oscillator . . . . . . . . . . . . . . . . .46By Currency Trader Staff

New Products . . . . . . . . . . . . . . . . . .49

Currency MoversEuro/Swiss franc . . . . . . . . . . . . . . . .50European cross rates: Where’s theEuro/Swiss franc rate headed?By Currency Trader Staff

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

Currency System AnalysisParabolic FX . . . . . . . . . . . . . . . . . . .56

Global News Briefs . . . . . . . . . . . . .59

International Market Summary . . .60

Currency Futures . . . . . . . . . . . . . . .62

Trade Diary . . . . . . . . . . . . . . . . . . . .63

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http://www.forex.com/linkc.html?src=ccytradermagMAR05

B arely out of its toddling clothes, the

Euro has quickly vaulted to prominence

among world currencies and has been

one of the main beneficiaries of the dol-

lar’s malaise over the past few years.

The Euro’s ascendancy has been so

strong that many pundits began to

talk of the Euro replacing the dollar as

the globe’s primary reserve currency.

The latest stats (see Global News

Briefs) don’t indicate that’s going to

happen any time soon, but there’s lit-

tle doubt the Euro has a strong hold

on the No. 2 spot on the Currency

Countdown.

“Has the Euro topped?” looks at the

Euro/U.S. dollar relationship as the

first quarter of 2005 enters its final

weeks. The FX world has been waiting

for two months for the dollar situation

to clarify, which of course will simplify the Euro picture: Is

the current down swing a genuine reversal, or just a

breather in what is destined to be an even larger uptrend?

The Euro is also featured in this month’s Currency

Movers analysis, which does a spot check on the

Euro/Swiss franc rate (that holdover from the Continent’s

not-so-distant currency-fragmented past). Judging by the

charts, EUR/CHF looks like it might

be poised to do one thing, but based

on historical patterns, could be setting

up to do the opposite — at least in the

near-term.

For shorter-term ideas, this issue

features a trading strategy and Forex

Diary that illustrate a pattern-based

trading approach executed in the

Aussie dollar/U.S. dollar rate, which

— like the Currency Movers piece —

highlights the differences between

appearances and reality in the

markets.


Is the current down swing

a genuine reversal, or

just a breather in what is

destined to be an even

larger uptrend?

Holding out for a Euro

Mark Etzkorn, Editor-in-chief

EDITOR’S NOTE

www.investorflix.com/at

Editor-in-chief: Mark [email protected]

Managing editor: Molly [email protected]

Associate editor: Carlise Peterson [email protected]

Associate editor: David Bukey [email protected]

Contributing editor: Jeff [email protected]

Editorial and Web assistant: Kesha [email protected]

Art director: Laura [email protected]

President: Phil [email protected]

Publisher,Ad sales East Coast and Midwest:

Bob [email protected]

Ad sales West Coast and Southwest only:

Allison [email protected]

Classified ad sales: Mark [email protected]

Volume 2, Issue 3. Currency Trader is published monthly by TechInfo, Inc., 150 S. Wacker Drive, Suite 880, Chicago, IL 60606. Copyright © 2005TechInfo, Inc. All rights reserved. Information in this publication may not bestored or reproduced in any form without written permission from the publisher.

The information in Currency Trader magazine is intended for educational pur-poses only. It is not meant to recommend, promote or in any way imply theeffectiveness of any trading system, strategy or approach. Traders are advisedto do their own research and testing to determine the validity of a trading idea.Trading and investing carry a high level of risk. Past performance does notguarantee future results.

For all subscriber services:www.currencytradermag.com

A publication of Active Trader®

CONTRIBUTORS


CONTRIBUTORS

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

� Hannah M. Terhune, JD, LLM is chief attorney andmember manager of GreenTraderLaw PLLC, an internation-al law firm. Terhune specializes in hedge funds, internation-al and domestic tax, shareholder litigation, and business law.In addition to practicing law, Terhune lectures about tax,accounting, and business law for two universities inWashington, D.C. She writes, edits, and publishes the “U.S.International Tax Analyst,” a newsletter dedicated to analy-sis of U.S. international tax planning trends. She also con-tributes articles to other prominent publications.

�Michael Schneider has been involved in trading since1982 when he was head of the special interest group invest-ments of the German Apple user group and operated one ofthe first low-cost quote vendors in Germany. He later incor-porated a small trading company that served clients inEurope (primarily Monaco). Currently he is head of thesupervisory board of a German stock firm and director of asecond company that manages international projects. Inaddition, he manages the office of the German VereinigungTechnischer Analysten e.v., which is the German member ofthe International Federation of Technical Analysts.

� Noble DraKoln is the author of the books Forex forSmall Speculators and Futures for Small Speculators, availableat Amazon.com and www.smallspeculators.com. He hasbeen an investor, broker, and analyst since 1994. He is a well-known Southern California educator through his SmallSpeculators investing seminars. You can subscribe to his freemonthly newsletter at www.liverpoolgroup.com or pur-chase his futures and forex seminars on CD at www.small-speculators.com.

� Roger D. Lorence, JD LLM ([email protected]),is a senior securities and tax attorney with GreenTraderLawPLLC, an international law firm (www.greentraderlaw.com).Lorence covers tax and accounting issues affecting the hedgefund industry for Derivatives Financial Products Report, amonthly publication for financial services professionals.













www.rts-forex.com

www.greentraderlaw.com

www.salonat.com

LETTERS

10 CURRENCY TRADER • March 2005

Forex trading systems

Can you refer me to some reviews on[currency trading system], which iscurrency trading software being pro-moted throughout the country at sem-inars?

Are any professional traders usingthis software? I need professionalopinions on this product.

— Michael M.

We don’t have any information about thesoftware. As a rule, we don’t review“canned” trading systems or strategies.Our magazines are designed to helptraders educate themselves and develop theskills to objectively analyze markets anddesign their own trading ideas.

Some retail trading systems have value;others do not. Unfortunately, there is noway to know the true value of a given sys-tem without risking real money in themarket. The next best thing is to havedetailed, valid, historical test results thatcan give some indication of a system’spotential. However, system results can befudged, so it takes some experience to knowwhether or not performance statistics aremeaningful.

Anyone who wants to experiment withthird-party trading systems should askthemselves a few questions:

1. Are the system’s rules/logic fully dis-closed? (If they’re not, you have no idea

what you’re buying.)2. Do those rules makes sense to me —that is, do I understand how and whythe system is supposed to make (andpotentially lose) money? Do thoserules match my trading style and risk-tolerance level?3. Does the company have audited bro-kerage statements or trade results thatverify the system’s performance?4. If they don’t, do they have valid his-torical test results for the system?

In general, if you’re new to trading,it‘s difficult to make an informed deci-sion about a trading strategy or system.

•

Paper trail

We really enjoy Currency Trader. It’sgood to see the high quality of ActiveTrader repeated here.

We are of the generation that grewup with pen and paper and have usedcomputers since the 70s onward bothfor employment and enjoyment.However, we trade intraday Forex andtherefore spend enough time staring atcomputer screens, without having toconsider doing it for leisure. There’sstill nothing better than relaxing in aneasy chair with a cup of coffee and ourfavorite Forex magazine.

Thought you might be interested in

what we do when we receive youremail stating that the latest edition isavailable:

1. Download the .PDF file.2. Set up our laser printer and ourinkjet printer.3. Print pages in groups — to thelaser if color is not important and tothe inkjet for pages we want in color.4. Collate the two sets of printouts.5. Bind the magazine into either spi-ral binding or heated covers.

We would be more than happy topay for a printed version, be it inglossy format or whatever, eventhough it would arrive after we receivenotice of the online versions beingavailable.

— Vanessa and David ChampionBrisbane, Australia

We appreciate your dedication! It’s con-venient at times to have a printed maga-zine, but because of the global nature of itscontent, Currency Trader is best distrib-uted in electronic format. Although noteveryone likes printing (and other peopledon’t mind reading on screen), this formatoffers instantaneous access to the articles(much of which provides easy access torelated Internet content) as well as person-al control over what to print.

LETTERS

That’s dollars, as in taxes – not Dallas, Texas

I have been reading some articles and literature about Forex and I would liketo open an account in any of the several brokerage companies that offer theirservices on the web. However, I have not found any information about “taxesin forex.” I would like to know if you have any information regarding thissubject. If so, please send it to me.

— Jose Del Solar

The October 2004 issue of Currency Trader contains the article “Different market,different tax rules,” by Robert A. Green, which covers this topic. Back issues ofCurrency Trader are free to subscribers and can be downloaded through the Web site.

Options Trader is a monthly, full-feature electronic magazine covering trading strategies, systems, market analysis, news and commentary for options traders.

Be one of the first 5,000 people to register at www.optionstradermag.com and receive a free subscription. All you need to register is an email address.

Each month you can download the current issue from the Internet using technology that combines the high-quality look and feel of a print magazine with the interactive features of Web content.

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GLOBAL ECONOMY

BY CURRENCY TRADER STAFF

H eading into late 2004,many currency marketstrategists were fore-casting doom and

gloom for the U.S. dollar. Faced withthe evils of the twin deficits, some sawthe potential for global financial catas-trophe.

Dollar bears subsequently drove theEuro/U.S. dollar rate (EUR/USD) to apeak of $1.36 and change just ahead ofthe new year. But 2005 has ushered ina dramatically different picture.

From the opening bell of 2005, theU.S. dollar began to strengthen againstthe Euro and has posted steadyimprovement through the middle ofFebruary. Many currency watchersnow believe the late-December highmarked a significant multi-month topfor the Euro.

Although momentum-based trendtraders might be disappointed by fore-casts of range-bound price action overthe next month or so, the dramaticmulti-year bear trend in the U.S. dollarvs. the Euro appears to have found aresting point for now.

The view from the top In mid-February, Robert Sinche, headof global currency strategy at the Bankof America, called the Euro “absolute-ly overvalued” even at the $1.27 area.

“At $1.30 and higher it is seriouslyout of line with its reasonable valua-tion range,” Sinche says.

Pointing to the Euro’s peak in lateDecember at $1.36, he says, “I think itis a distinct possibility we are unlikely

to test that $1.36 high. Depending onthe direction of U.S. policy, there ispotential for that to be the high formany years.”

Jamie Coleman, managing analyst atIFR-Forex Watch, agrees.

“I do think [$1.36] was a medium-term top,” he says, pointing to a“brand-new focus on the deficit fromthe Bush Administration” as a factorbehind the dollar’s strength againstthe Euro early in 2005.

“The market anticipated the fiscaland trade deficits would be complete-ly ignored,” Coleman adds. “The con-cerns of an imminent current accountdollar crisis have [diminished] since

the beginning of the year.” Sinche echoes this line of thinking. “The frenzy of concern over the U.S.

twin deficits reached its zenith in thelatter part of last year,” he says. “Butthere have been some signs of spendingrestraint. The markets have gone fromsignificant concern about the U.S. struc-tural position regarding the trade andbudget deficit to a scenario that lookslike structural factors are stabilizing.”

The market’s perception of U.S. gov-ernment attention to budget cuts,lower oil prices, and the relative cur-rency values between the U.S. andEurope have played into Fed expecta-tions that improvement could be seen

Euro/U.S. dollar (EUR/USD), daily

November December 2005 February

1.36

1.34

1.32

1.30

1.28

1.26

1.24

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

FIGURE 1 — TOP IN 2005?

Source: TradeStation

Has the Euro topped?Has the dollar’s day come vs. the Euro? Take a look at some of the reasons

behind the recent Euro weakness, and whether the trend is likely to continue.

CURRENCY TRADER • March 2005 13

in the deficit arena. “The trade deficit probably peaked

in the fourth quarter of last year,” saysSinche.

U.S. trade deficit figures came in at$56.4 billion for December, $59.3 bil-lion for November, and $56.1 billionfor October.

At the end of the fourth quarter, “themarket had really begun to price in aworst-case scenario in terms of the cur-rent account deficit. When the skydoesn’t fall you’ve got to take thattrade back off,” says Coleman.

Some of the dollar strength in early2005 may have been bearish dollarpositions simply being unwound, headds.

Dollar positives aheadLooking ahead, some analysts point tothe potential for positive interest rateand positive growth rate differentialsas factors in favor of the U.S. dollar vs.the Euro. In early February, the FederalOpen Market Committee (FOMC)hiked interest rates for a sixth consecu-tive time, boosting the federal fundsrate to 2.5 percent. (The next meeting is

March 22, where a .25-percent hike isexpected.) This compares to the similarEuropean rate at 2.00 percent. At thispoint, most analysts believe theEuropean Central Bank won’t likelyraise rates until the second half of 2005.

“The markets expect the Fed to con-tinue on its tightening path, whichwould bring the funds rate to 3.00 per-cent by mid-year,” Sinche notes. “Thatwould be 100 basis points above theEuro area repo rate. The last time therepo rate was 100 basis points in favorof the U.S. was in January 2001.”

The bottom line is that improvementin short-term interest rate differentialswill also impact short-term currencyflows. The capital flow situation has

shifted in favor of the U.S. and that islikely to persist, Sinche says.

The U.S. wins out from a growthrate perspective as well. Lookingahead, Brian Dolan, director ofresearch at Gain Capital, noted econo-mists are forecasting nominal GDPgrowth in the 3.5 to 4.0 percent area for

the U.S, versus expectations of 1.5 per-cent growth for Europe and 2.0 percentfor Japan. Dolan pointed to this factoras one of the key supports for the U.S.buck in early 2005.

“The market all of a sudden focusedon growth rate differentials,” he says.

Longer term, however, Dolanbelieves the fundamentals for the dol-lar will remain weak.

“The dollar will be weak for the nextyear or two,” he says. “That amount oftime needs to pass for the global tradeadjustment to take place.”

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

mid-February (see Figure 1), most ana-lysts believe that countertrend movehas run its course. Through the end ofMarch, many currency analysts see theEuro moving into range-bound envi-ronment between $1.27-28 on thedownside and $1.34-35 on the upside.

“The $1.36-37 area is [not likely to bereached] over the next few months,”says IFR-Forex Watch’s Coleman.

Currency traders need to adjusttheir views once again from a trendingtype of environment to a more range-bound situation, Dolan advises.

“Traders should defer to more of asideways-type environment,” he says.“It will be a broad and volatile range— but be prepared for reversalsaround the highs and lows of therange.”

Looking back to 2004, Sinche notesthat Euro action was confined to atrading range until a breakout at theend of the year (see Figure 2).Similarly, he currently expects a trad-ing-range environment.

“Resist the temptation to playbreakouts,” he says.

The bottom line for traders: “Don’tget all bulled up and expect a move to$1.50 or a drop to $1.15,” says Dolan.“Be prepared for it to move sidewaysin the $1.28-$1.35 area.”�

Euro/U.S. dollar (EUR/USD), weekly

2002 2003 2004 2005

1.30

1.20

1.10

1.00

0.90

The most recent top (after a lengthy consolidation in 2004) was just the latestpeak in a series of Euro surges dating back to 2002. However, favorable inter-est-rate differentials might favor the buck over the Euro in the future.

FIGURE 2 — THE EURO’S LONG RISE


Some market watchers now believe the late-December high marked a significant

multi-month top for the Euro.


GLOBAL ECONOMY continued


A fter a strong sell-off inthe U.S. dollar/Japan-ese yen (USD/JPY)from January 2002

through January 2005, bulls once againtried to seize control of the marketearly this year, pushing it up from alow of 101.67 on Jan. 17 to a high of106.86 on Feb. 10.

The move might look somewhatbullish on a daily chart (see Figure 1),but from a longer-term perspective therally appears less significant — andseveral market watchers believe 2005could be the year 100.00 yen finallycracks.

While day traders may be glued totheir one- and five-minute charts, itcan be worthwhile to step back andtake a look at the monthly dollar/yenchart for a longer-term outlook (seeFigure 2). The USD/JPY rate has nottraded below 100.00 since late 1995,but given the dominant downwardtrend in recent years, a serious test ofthat floor could be in the cards laterthis year, according to some analysts.

However, just above the psycholog-ically significant 100.00 floor, strongchart support is evident in the101.25/101.60 area, which are the lowsfrom late 1999 and January 2005.

The early rallyAfter touching the 101.60 area in midJanuary, dollar/yen bulls propelledthe market to near the 107.00 area as ofmid-February (after which it fell toaround 104.00 by March 1). Some ana-lysts called the rally a “U.S. dollarstory” rather than a “yen story,” as the

U.S. dollar managed to gain groundagainst many currencies in early 2005.

Heading into late 2004, speculationwas rampant among currency marketparticipants that an imminent revalua-tion by the Chinese government oftheir currency was possible, whichmay have fueled position adjustmentsin the dollar/yen.

“There was a clean-out of positionsearly in the year as traders had beenshort dollar/yen — short dollar-every-thing, really — in late 2004,” says SeanCallow, currency strategist atIdeaGlobal. “Everyone thought the[bearish dollar] momentum would con-

tinue from last year. They expected thedollar to continue to fall week afterweek.

“There was an expectation that arevaluation would also make the dol-lar/yen fall sharply,” he adds. “Thefact that China brushed off speculationand talked down that possibility was asupportive factor for the dollar/yenearly in the year.”

Looking ahead, Andy Busch, globalforeign exchange strategist atHarris/Nesbitt warns traders, “theChina story is not going to change.”He suggests those trading the dol-lar/yen should “not trade it with the

U.S. dollar/Japanese yen (USD/JPY), daily

November December 2005 February

110

109

108

107

106

105

104

103

102

After making a new low in December 2004, the dollar/yen briefly rallied beforefalling to a slightly lower low in mid January. The market then rallied again,making a three-month high on Feb. 10. Some chartists might be tempted tobelieve the currency pair is in the early stages of forming a double-bottomreversal, but there are reasons to believe the dollar/yen will move to new lows.

FIGURE 1 — BULLS MAKING THEIR RUN?


Will this be the year100.00-yen gives way?

It’s been nearly 10 years since the dollar/yen rate has traded below 100.

Is that barrier due to be shattered in 2005?


idea China will revalue any time soon.Make your decisions based on the eco-nomic fundamentals, such as interestrate differentials.”

Others simply think the early 2005rally is a correction in the longer-termdowntrend.

“The rally to the 107 area was only acorrection in an otherwise slow driftlower in the dollar/yen,” says BrianDolan, director of research at GainCapital. “It was precipitated by osten-sibly dollar-positive comments fromGreenspan in his London speech onFeb. 4.”

Several currency watchers speculat-ed that the early February rally in dol-lar/yen to near the 107.00 area couldbe a strong top for the market.

“It will be very hard to get above the107.00 cap,” says Tom Rogers, seniorcurrency analyst at Thomson Financial.“I think we made a really big top at106.86. It could be the cap for the year.”

The bearish caseDolan believes the dollar/yen will fallbelow 100.00 in 2005, most likely in thelatter half of the year. However, “it willmostly be a case of U.S. dollar weak-ness rather than Japanese yenstrength,” he adds.

Callow agreed with a longer-termnegative view of dollar/yen, notingIdeaglobal has a year-end target at the96.00 area. One “yen positive” factorCallow points to is the net inflow offoreign investment into Japan: Almost$30 billion (JPY 3.1 trillion) in net secu-rities inflows occurred in Japan duringJanuary.

That, combined with Japan’s tradesurplus, adds up to a bullish support forthe yen — and bearish pressure on thedollar/yen rate. For December, Japan’strade surplus stood at 1.6 trillion yen, orroughly 15 billion U.S. dollars. That fig-

ure was 35 percent higher than a yearearlier.

“That is very bullish for the curren-cy,” says Rogers.

Current Organization of EconomicCooperation and Development (OECD)forecasts expect 1.4-percent GDPgrowth in Japan for 2005 and 1.5 per-cent in 2006.

“We look for a modest pick-up ingrowth beginning in the April-Junequarter on the back of strongerexports,” says Peter Morgan, econo-mist at HSBC Securities in Japan. “Thiswould be positive for the yen, but italso depends on what the U.S. econo-my is doing at that stage.”

Trading dollar/yen“The 108.00-106.00 range should be agood level to become short dollar/yen,”

Callow says. He points to the 101.80/101.60 level

(the December 2004 and January 2005lows on the daily dollar/yen chart) as a“big, attractive multi-week target.”Short-term consolidation is possible,however, ahead of Japan’s fiscal year-endon March 31. Callow believes this couldprove to be a quiet consolidative period.

Gain Capital’s Dolan suggests traders“actively manage their long yen posi-tions as opposed to buying and holding.The normal volatility of the pair, coupledwith unknown intervention intentions ofthe Ministry of Finance, will make forwide swings in the months ahead.”

Finally, traders should remembermarkets don’t often break major sup-port levels on the first try; they mustbe cautious on tests of strong supportaround the 101.60 area.

“Traders should be willing to takeprofits when the dollar/yen declinesto recent lows and resist the urge topile in as the market is making newlows,” Dolan says. “They will be muchbetter served by having the ability tosell into rallies that follow what is like-ly to be several failed attempts to breakdefinitively below 101.50.” �


101.60

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

145.00

140.00

135.00

130.00

125.00

120.00

115.00

110.00

105.00

100.00

95.00

90.00

85.00

The dollar/yen has been in a prolonged downtrend dating back to 2002, and ithas not traded at 100.00 since 1995.

FIGURE 2 — LONG-TERM DOWNTREND


The USD/JPY rate hasn’t traded below 100.00

since late 1995, but given the dominant downward

trend, a serious test of that floor could be in the

cards later this year.


D ot-coms no longerdominate the electronicforeign exchange land-scape, and the market

is maturing, according to a recentreport by Tower Group, a Boston-based research firm.

After years of investment by banksand brokerages, the FX industry’stechnology has grown enough toattract a more diversified clientele,including buy-side institutions (fundmanagers, hedge funds, etc.) that arebecoming increasingly influential inthe marketplace.

Yet “as competition intensifies, banksand brokers have determined that onlythe largest dealers will succeed; thusmany seek unprecedented growth,

which places great importance on tech-nology to manage their distributionand volumes,” writes Robert Hegarty,vice-president of TowerGroup’s Secur-ities and Investments division, in hisNovember 2004 report “Foreign

Exchange Trading: Evolving into aMature Electronic Marketplace.”

Statistics from the latest BIS survey onforeign exchange and derivative marketactivity verified the expanding marketand the impact of technological invest-

INDUSTRY NEWS

T he sixth annualOnline Traders Expoin New York Cityattracted 5,987 atten-

dees in February, 17 percent more than2004, with over 115 companies partici-pating.

Although the conference encom-passed all markets, forex was the focusof many presentations and seminars.On Feb. 15, Currency Trader hosted apanel consisting of Jes Black, CorneliusLuca, and Kathy Lien, who debatedthe dollar’s predicament, the forexmarket outlook for 2005, and currencytrading approaches, among other top-ics.

Black, partner and hedge fund man-ager at Black Flag Capital Partners, felt2005 could be a banner year for cur-rencies. The U.S. dollar, he believed —despite the market’s current bearish-ness — is poised to surge, with its

gains coming at the expense of Asiancurrencies rather than the Euro andother European currencies.

Lien and Luca were less bullish onthe dollar, although Luca, author ofTechnical Analysis Applications in theGlobal Currency Markets and Trading inthe Global Currency Markets, and a reg-ular columnist for Global ForexTrading (GFT), said a near-term rallyin the dollar was likely before itresumed its downtrend.

Both Lien and Luca pointed to thetightening cycle of the Federal Reservebank as a boon to the dollar, statingthat the Fed is the only central bank inthe midst of a tightening cycle at thispoint. (Luca’s analysis can be found inthe Currency Movers section of theFebruary 2005 issue of CurrencyTrader).

One aspect of the forex market thisyear raised by Lien, chief currency ana-lyst at FXCM (www.fxcm.com), was

that money would continue to moveout of so-called “commodity” curren-cies such as the Australian dollar, NewZealand dollar, and Canadian dollar,and into growth currencies, such as theBrazilian real and Russian ruble. Luca,however, cautioned that strong handsare now playing in these currencies,making them a bit riskier for the newinvestor. �

Tower Group comments on BIS survey

Single-dealer [forex] sites offer a richer experiencethan multi-dealer systems because dealers canmore effectively control the environment from end toend and offer more services and access to all assetclasses.

—Robert Hegarty, TowerGroup

NYC Traders expo spotlights currency trading

http://www.currencytradermag.com/backissues.htm



www.fxcm.com


ment. Hedge funds stepped up their FXparticipation, taking more aggressivelyspeculative positions, contributing to a58-percent growth in aggregate dollarvolume from 2001 to 2004.

“Technology too played a major rolein this growth, the ease with whichinvestors can now transact via elec-tronic platforms having drawnincreased volumes,” the report states.“The customer is wielding a biggerstick and the brokers must respond.”

The customer is always rightSingle-dealer forex portals servicehigh-end traders, such as hedge funds,as well as retail traders. Multi-banksites, known for their dependabilityand liquidity, attract money managerswho are required to obtain several

quotes before a single execution.While both types of portals have

seen increased business in recentyears, the report identifies a shift tosingle-dealer systems. The dealers’drive for growth has translated intoimproved customer service capabili-ties and more complex marketingstrategies, according to the report.

“Single-dealer sites offer a richerexperience in this manner than domulti-dealer systems because dealerscan more effectively control the envi-ronment from end to end and offermore services and access to all assetclasses,” Hegarty says in the report.“The dealers’ proprietary sites offerthem two services, post-trade process-ing and prime brokerage, that are ofgreat value to them and are not avail-

able through other venues.”Multi-dealer portals focused on

overall improvements by adding prod-ucts related to their basic quote andexecution services. Even as institution-al investor business picks up, the so-called “improved” technology willslow growth.

“They will need to get over theproblem of ‘lowest common denomi-nator’ technology,” Hegarty says inthe report. “That is, multi-dealer plat-forms can offer a quality of serviceequal only to that of the worst of themultibank participants. As a result,they cannot offer new and valuableservices and technology as rapidly andeffectively as the single-dealer sys-tems.”

Maturity shows volume gapsIncreased electronic trading volumehas further differentiated multi-dealersystems. Electronic trade volume inthe FX market is at 44 percent and ispredicted to increase to a peak rate of74 percent in 2007, according toTowerGroup.

The top four multi-dealer portals interms of market share — FX Connect,FXall, Currenex and HotspotFXi —have not enjoyed comparable slices ofvolume. FXConnect and FXall share 86percent of the multi-dealer tradingvolume, as both HotspotFXi andCurrenex cater to smaller clients.

Yet as a stand-alone system andwith reduced dealer-owner invest-ment, FXall’s dominating position isnot at all assured, according to thereport. TowerGroup predictsCurrenex’s niche position will encour-age a takeover, while FXall may lose allof its institutional and dealer support.

While the FX market matures, “thereliance on electronic platforms willgrow deeper. Because clients gain littlevalue from ‘additional’ non-executionservices offered by these systems, theywill experience great difficulty in sus-taining their profitable models,”according to the report.�

Intershow announces 2005 forex conference

Intershow, the group that organizes the various Money Shows(www.moneyshow.com) and International Trader Expos (www.trader-sexpo.com), announced it would hold a conference dedicated to forextrading later this year in Las Vegas.

“Over the past two years, we’ve really seen the demand for Forex educa-tional conference sessions at Traders Expo increase,” says Tim Bourquin,

cofounder of the Expo shows.“Attendees are looking for addition-al markets to trade when the stockmarket volatility is flat. Also, global-ization of trade has brought curren-cy fluctuations into mainstreambusiness news, so I think traders are

more in tune with the opportunities foreign exchange trading brings.”There were more Forex-related exhibitors at the February TradersExpo

show in New York than ever before, Bourquin says. “Forex trading has grown to the point that a conference just focusing on

that topic is warranted,” he says.The Forex Trading Expo will be held Nov. 19-20, 2005 at the Mandalay Bay

Hotel in Las Vegas. At this point, the show is expected to include approxi-mately 30 exhibitors and 1,500 attendees. Intershow will launch a Web sitewith more information in the near future.�

T he market has been hav-ing trouble decidingwhether the currentaccount deficit is more

powerfully dollar-negative than therising interest rate environment is dol-lar-positive.

The European-led current accountgang believes the structural deficit is afar weightier issue than interest-ratedifferentials. In contrast, Japanese andother Asian traders are more con-cerned with higher rates, especiallybecause Japan is in a technical reces-sion and any monetary policy tighten-ing there is postponed.

So while traders slug it out over the

fundamentals, the technical factorsrule, or seem to.

First there were a few big tradinghouses (such as UBS) saying justbefore year-end that the dollar wouldsoon start to correct from the steepdowntrend of the fourth quarter. Loand behold, the retracement of the dol-

lar downtrend started on the first trad-ing day of the year.

To cap that off, the Euro/U.S. dollar(EUR/USD) retracement ended only

20 points (.0020) from the precise “the-oretical” Fibonacci 50-percent retrace-ment level. (Technically, 50 percent isnot a Fibonacci number, but nevermind.) A 50-percent retracement of themove from the May 2004 low of 1.1760to the December high of 1.3667 is0.0954 points, which translates to a tar-get of 1.2713 (see Figure 1). The dollarretracement stopped in early Februaryat 1.2733 — which was the low on bothFeb. 7 and 8 — or 0.15 percent from the50-percent retracement level. That’sdownright spooky, and almost certain-ly evidence of the grip technical ideashave on the FX market.

Unsolvable mysteriesWhat’s ruling the market — the cur-rent account deficit or interest rate dif-ferentials? This question is unanswer-able in practice — or in theory, for thatmatter. Currencies can fall despite aninterest-rate advantage, and currencies

can rise despite a current-account dis-advantage. These are both big “envi-ronmental” background factors thatbecome immediate, tradable factors on


THE BIG PICTURE

The technicals ruleWhen the fundamentals

are foggy, technical factors can

drive the market.

BY BARBARA ROCKEFELLER

Greenspan expressed a wish for the dollar to rise,

and the market was willing to oblige.




the whim of the trading community. “Whim” sounds like a disparaging

term, but it’s not meant to be. WhenFederal Reserve Chairman AlanGreenspan told a conference inLondon (the same day the G7 meetingstarted in February) the currentaccount might soon improve becauseof “market forces” and new budgetconstraints, the market was willing tobuy dollars. (G7 is the "Group of 7"countries, including the U.S., UK,Japan, Germany, France, Italy, andCanada, which meet twice a year totalk about the global economy andinternational financial system.Recently Russia has been invited soG7 is sometimes called G8.) ButGreenspan didn’t go into detail aboutthose “market forces” except to sayexporters to the U.S. had to be feelinga profit pinch, which is a weak argu-ment. As for the connection betweenthe current account deficit and thebudget deficit, it doesn’t really exist,as a study by the Fed itself had justshown the month before.

The only reason for Greenspanto make these remarks was togoose the dollar upward.Greenspan expressed a wish forthe dollar to rise, and the marketwas willing to oblige. It’s impor-tant to note the dollar was alreadyrising when he made the com-ments; he was talking “with thewind,” as the Japanese say. It’s notclear if Greenspan’s remarks couldhave stopped the dollar from slid-ing further had it already beenfalling.

Productivity, the buck, andcrudeLater in February Greenspan toldCongress future monetary policydepends on three things: the trendin labor productivity, the level ofthe dollar, and the price of oil.

All three are really proxies forfuture inflation. Rising productivi-ty inhibits inflation, so when itdecelerates, as it is now (produc-tivity is up 4.1 percent at an annu-al rate as of Q4 2004, compared to

continued on p. 20

Euro (EUR), 1.3055, 1.3055, 1.3055, 1.3055

38.2%

50.0%

May June July Aug. Sept. Oct. Nov. Dec. 2005 Feb. Mar.

1.37

1.36

1.35

1.34

1.33

1.32

1.31

1.30

1.29

1.28

1.27

1.26

1.25

1.24

1.23

1.22

1.21

1.20

1.19

1.18

1.17

The Euro/U.S. dollar retracement stopped in early February just 20 pips shy ofa precise 50-percent retracement of the May-December rally.

FIGURE 1 – EURO RETRACEMENT

Source: eSignal

Light Crude Oil (CL), 47.60, 48.50, 47.52, 48.35

2003 M J J A S O N D 2004 M A M J J A S O N D 2005

55

50

45

40

35

30

25

Some analysts contend $8-12 of the recent price of oil is a premium for the inherentrisks in the major producing countries. However, oil has been on a serious uptrendfor several years and there is no reason to expect these risks will disappear soon,or the price of oil will stabilize or fall.

FIGURE 2 – THE OIL FACTOR

Source: eSignal


4.4 percent in both 2003 and 2002),Greenspan worries about inflation.

A falling dollar automatically raisesthe prices of imported goods (at leastfrom countries whose currencies floatagainst the dollar), which is inflation-ary.

The price of oil, of course, is a coin-toss. Oil experts say $8-12 of the recentprice of approximately $48 is a premi-um for the risks inherent in the majoroil-producing countries, from Nigeriaand Venezuela to Saudi Arabia andIraq. It’s unrealistic to expect thoserisks to subside, although on thedemand side, the coming of spring isan ameliorating factor. But the impor-tant point is oil has been in a seriousuptrend for several years now andthere’s no reason to think it will stabi-lize or fall (see Figure 2).

The bond market conundrumAs it has been since last summer, thebig issue of the day is still the mysteri-ous refusal of the bond market to takethe yield on the 10-year bond higher inlockstep with short-term interest rates.

Since June 2004 the Fed has raisedthe Fed funds rate six times, from 2percent to 3.5 percent, while the yieldon the 10-year bond has fallen from4.70 percent to about 4.2 percent (and

even briefly lower). This has narrowedthe spread between the two-year noteand the 10-year note to only 70 pointsor so, which is a historical aberration

— what Greenspan calls a “conun-drum.”

We know Greenspan likes the per-sonal consumption expenditure priceindex, which is really a GDP deflator.

Figure 2 shows what it looks like, cour-tesy of the St. Louis Fed. The index hasbeen on a steady upward path. Shouldwe deduce the Fed is scared, at least a

little, about inflation? Well, that’s itsjob. But if so, why does the bond mar-ket not share that concern?

Commentators say the Fed has doneits job too well, and the bond marketbelieves the Bank will succeed in hold-ing inflation down, so there is no needfor long-term rates to rise. Otherspoint out that when supply is relative-ly fixed and demand rises, prices rise— which in the case of bonds meansthe yield falls. Because foreigners aswell as domestic buyers have notshown any loss of appetite for U.S.paper, the drop in the 10-year yields isno surprise.

In fact, it’s a desirable outcome,because last November Greenspanfretted about foreigners losing theirappetite. This concern came in theaftermath of a comment from SanFrancisco Fed president Janet Yellenthat so much foreign demand for U.S.paper was hindering the Fed’s desireto get longer rates up, too. FX traderstook each comment to mean the Fedwanted the dollar to fall, although sub-

THE BIG PICTURE continued

Personal Consumption Expenditures: Chain-type Price Index(Index 2000=100)

2000 2001 2002 2003 2004 2005

2005 Federal Reserve Bank of St. Louis (research.stlouisfed.org)

110

108

106

104

102

100

98

The personal expenditures index has been on a steady upward path, whichmight make the Fed nervous about inflation. But right now, the bond marketdoesn’t show that concern.

FIGURE 3 – SHOP TILL YOU DROP

Source: U.S. Department of Commerce, Bureau of Economic Analysis

Kaufman speaks about dollarIn an interview with The New York Times, economist Henry Kaufman ("Dr. Doom")

had some important things to say about the dollar.

He thinks China and Japan will not diversify away from the dollar because it’s self-

defeating — if the dollar drops a lot, their "export drive" to the U.S. suffers.

Meanwhile, the falling dollar has very little effect on exports because the U.S. can’t

compete with low labor-cost countries. It would take a huge dollar drop to get the

desired effect, and that’s not going to happen.

"Today, there is an enormous international disequilibrium,” Kaufman said. “For the

near term, it is in the best interest of all the participants to maintain it."

This is the Golden Goose theory I wrote about in last month's article. As for a fore-

cast, Kaufman sees "relative stability with occasionally a little bit of give in the value

of the dollar." In other words, flat to down — but not up.

—Barbara Rockefeller

Click here for The New York Times article: “The Alpha Currency? It's Still the Dollar,”

by William J. Holstein, Feb. 27, 2005.

http://www.nytimes.com/auth/login?URI=http://www.nytimes.com/2005/02/27/business/yourmoney/27advi.html&OP=934ac8f/dWVQ3FdQ3Eumf~uuQ276d6Q20Q20vdQ206d61dQ3FpfQ5EhVffdBup~iuhVBd61Q3CQ3EjQ5ExQ5DQ27iY



sequent reports from the U.S.Treasury did not validate anysuch loss of appetite.

In November — the monthin which the dollar lost almost5 cents against the Euro — for-eigners bought a net $89.3 bil-lion in U.S. securities of alltypes; in December, theybought an additional $61.3 bil-lion. Net portfolio flows intothe U.S. averaged $68.5 billionper month in 2004, comparedto $57.0 billion in 2003 and$47.9 billion in 2002. For theyear 2004, the inflow of portfo-lio investment into the U.S. wasa total of $821.8 billion, or a 20percent increase from $683.6billion in 2003 and a 43 percentrise over $574.6 billion in 2002.

The 2004 inflow of $821.8billion is plenty to “cover” thecurrent account deficit, whichwas running at an annual rateof $658.8 billion as of the endof Q3.

In fact, the only worrisome thingabout the Treasury flow report was theoutflow of capital from the U.S., pre-sumably from U.S. citizens whoexpected better returns abroad(including a currency effect). U.S.investors bought a net $15.4 billion inforeign equities in December, almostdouble the amount in November ($8.5billion), and the most since 2000. Theyalso went long foreign bonds. To a cer-tain extent, this reveals U.S. investorsare free to choose foreign securities butat least some foreign investors in theU.S. are here involuntarily becausemanagement rules dictate a certainpercentage of money must be investedaccording to market size.

Kinks in the roadIt’s only logical to assume if foreigninvestors are willing to place a largeamount of their capital in the U.S. in alow-rate environment, they will allo-cate even more to the U.S. when theyield curve finally catches up and the10-year bond delivers more than 50-70points over the equivalent German

Bund, as is the case today. Therefore,we probably don’t have to worrymuch about capital flows in the com-ing months, which should be dollar-favorable. But now we run into twokinks in the forecast, the first from theFed and the second from the technical-ly-driven FX market.

Much of what drives the U.S. econo-my is the consumer, and a lot of whathas been driving consumers over thepast few years is the ability to refinancetheir main asset — their home — to getmore money for consumption.

While it is no doubt true manyhouseholds have cleaned up their bal-

ance sheets and used the proceeds ofmortgage refinancing to pay downhigh-cost credit card debt, at somepoint rising rates at the long end of theyield curve will reduce the number ofrefinancings. Surely the Fed considersthis dynamic in its plans, and someeconomists think that instead of get-

ting a bigger rate increase in comingmonths (which would be signaled bythe FOMC dropping the “measuredmove” phrasing), we will get a pausein rate hikes. In fact, some members ofthe bond fraternity may be countingon it.

continued on p. 22

The dollar could move sideways if many traders

think the interest-rate buffer is only a finger

in the dike; for them to accept a lasting dollar

improvement, the current account does, indeed,

have to fall.

Euro (EUR), 1.3055, 1.3055, 1.3055, 1.3055

Sept. Oct. Nov. Dec. 2005 Feb. Mar. Apr. May June

1.38

1.37

1.36

1.35

1.34

1.33

1.32

1.31

1.30

1.29

1.28

1.27

1.26

1.25

1.24

1.23

1.22

1.21

One of several possible outcomes in the Euro is a double-top, which would mark the dollarrising/Euro falling if the interest-rate differential between them were to get big enough.

FIGURE 4 – DOUBLE-TOP SCENARIO

Source: eSignal


THE BIG PICTURE continued

A pause is bad for the dollar,because now the market has built inFed rate hikes every period. If the dol-lar is falling and the Fed stops raisingrates, it’s a dollar negative, so the dol-lar will fall more. If the dollar is risingand the Fed pauses in raising rates, thedollar will stop rising and could evenfall. If the dollar is rising and the Fedpauses in hiking rates, the dollar stopsrising.

What does Mr. Greenspanwant?The Fed chairman is resolutely anti-inflation and his credentials are ashigh as anyone’s have ever been.

While the high-falutin talk about “nor-malizing” rates is quite convincing,Greenspan is also a pragmatist, and hisjob is to prevent inflation from gettinga toehold rather than satisfying someacademic market model. The Fed can’tdo anything about productivity or theprice of oil, but it can do somethingabout the dollar. Greenspan can’t pos-sibly want the dollar to fall, whichmakes his “loss of appetite” remarkslast fall all the more curious.

However, it looks like traders arebuying the 50-percent trading rule,and the Euro will now return to thelevel of last December (above 1.3600),and perhaps beyond. But this is prob-ably not what the Fed wants. It’s likelywe’ll hear more inflation warningsfrom the Fed, which will be aimed atcontrolling inflation but also atprompting the bond market to raisethe yield on the 10-year note to get itmore in line with the recent rate hikesin the Fed funds rate. The U.S. isalready attracting enough capital, buta more substantial differential ensuresa bigger buffer against a dollar crash.(It needs to be a hefty buffer, too,

because European traders still believethe structural deficit is some kind ofabsolute no other factor can override.This is not true. There are very fewabsolutes in economics and almostnone in trading.)

Will this approach work? Yes, prob-ably. There is likely some interest-ratelevel that will halt the Euro’s rise. It’spossible to imagine a double-top, forexample, that would mark the dollarrising/Euro falling when the interestrate differential gets big enough (seeFigure 4). This is only one of severalpossible outcomes, and it assumes theFed gets its way. Alternately, therecould be sideways movement if a large

number of traders think the interest-rate buffer is only a finger in the dike;for them to accept a lasting dollarimprovement, the current accountdoes, indeed, have to fall.

In a technically-driven market,traders interpret the news whateverway is most convenient for their posi-tions. When they are feeling a nega-tive-dollar bias, news that is truly dol-lar negative, such as foreign centralbanks diversifying out of dollars, isexaggerated. In practice, diversifica-tion is a minor factor — only a few bil-lion dollars against a market thattrades more than $1.3 trillion per day.But the public relations effect is huge,and the technicals set up a random fac-tor such as that to have a big effect.

And the winner is…This month, bet on the technicals, eventhough the current trend being formedis contrary to what the institutionalpicture seems to be — a Fed deter-mined not to have the dollar fall, or nothaving it fall too much.

We used to have to watch theunforecastable payrolls report, with an

obscure meaning for the economic out-look we all got wrong, anyway. Thejobless recovery was supposed todeliver a recession, but the canny Fedkept rates low and fueled a consumerboom via home refinancings instead.

Now we have to watch the unfor-castable Greenspan, who makesambiguous comments in the name ofcentral bank transparency and dancesevery noun around the room six timesbefore he gets to the end of the sentence.

This is just another example of theperversity of the FX market. Of thethousand variables that can effectexchange rates, it chooses the strangestand most difficult — payrolls. As far asthe upcoming month goes, it’s the sillyseason. We often get a sea-change inFebruary-March, including vast confu-sion over whether the yen always risesbecause of repatriation of foreign prof-its (answer: sometimes it does, but notreliably enough to trade on). This time,it looks like the technicals are ruling, atleast until a compelling event relatedto the current account or interest ratescomes along.�

For information on the author see p. 8.

Related readingOther Currency Trader articles by Barbara Rockefeller:

“Combining fundamentals and technicals in FX trading,” October 2004.

“The obscure key to successfulFX trading,” November 2004.

“The great global imbalancehoax,” December 2004.

“Trends, retracements and newsin foreign exchange,” January 2005.

“The Golden Goose Rule,”February 2005.

In a technically-driven market, traders interpret

the news whatever way is most convenient

for their positions.

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N owhere is the adage“If it looks too good tobe true, it probably is”more applicable than

in trading. Promises of 90-percent winrates and easy millions are marketinghype aimed at the unwary masses.Any trader who has spent enoughtime in the markets to develop suc-cessful trading techniques knows howrare viable ideas are — for every usefulmethodology, 10 (or 20, etc.) othershave likely been consigned to the dust-bin of history.

Price chart analysis can be particu-larly deceptive. The human eye ishardwired to see what it wants tosee — namely, profitable tradeopportunities that are usuallyobvious only in retrospect — andoverlook pitfalls. It’s only when aprice pattern is quantified and test-ed that its warts become apparent.

For example, looking at Figure 1might lead you to believe that sell-ing on the close of bars with highsnoticeably higher than the immedi-ately preceding highs and buyingon the close of bars with lowsnoticeably lower than the immedi-ately preceding lows would be agood entry technique.

Actually defining “noticeablyhigher/lower” casts an unfavor-able light on this trade premise.Figure 2 shows what happens if wedefine noticeably higher or loweras a high 32 pips above the previ-ous high or a low 33 pips below theprevious low — which are thesmallest respective differences ofthe selected bars from Figure 1.

Yes, several worthwhile entry pointsare identified, but so are many moreuseless “signals.”

However, this doesn’t mean theoriginal pattern concept cannot identi-fy useful trade points or be used as thebasis of a trading strategy. Perhaps itsimply means there’s more work to bedone.

What are we trying to exploit?Analysis software makes it easy (tooeasy, some might argue) to crunchnumbers a million different ways —optimize trade signals, find very spe-

cific patterns and market conditions,etc. Unfortunately, this often results indeveloping trade ideas that have nobasis in logic or reality — they are sim-ply coincidences that computingpower has tricked us into thinkinghave significance. This is what money-manager Nassim Taleb referred to asbeing “fooled by randomness.”

To avoid this problem, it’s helpful tofirst define the type of price behavioryou’re trying to capture and determinewhether the trade premise it impliesmakes sense. In this case, what initial-ly grabbed our attention were the price

CURRENCY STRATEGIES

Australian dollar/U.S. dollar (AUD/USD), daily

March April May

0.80

0.79

0.78

0.77

0.76

0.75

0.74

0.73

0.72

0.71

0.70

0.69

0.68

Visual chart analysis is risky because our eyes are drawn to retrospective trade "opportunities" and tend to overlook risks and other flaws.

FIGURE 1 — FIRST IMPRESSIONS


Spike-low bottomsHistorical testing of a one-bar price pattern reveals a useful confirmation signal the day

after the pattern. Find out the probabilities of catching a reversal.



reversals, which we noticed wereoften preceded by bars that had“spiked” significantly higher or lowerthan their preceding bars.

It’s not difficult to understand whatthis behavior represents and whetherit’s a logical trade idea. It makes sensethat a price move might be capped bya strong thrust that would overextendor “exhaust” the market just before itchanged direction. This means whatwe are trying to exploit is priceexhaustion. What we need to do isdefine and test price spikes to deter-mine if they are advantageous rever-sal signals.

Defining the patternThe strategy outlined here attempts toidentify bottoms (and buying points)using a specific definition of a spike-low bar. Figure 3 shows an examplethe Australian dollar/U.S. dollar rate(AUD/USD). After making lowerhighs, lower lows and lower closes forseveral days, AUD/USD fell sharplyduring the Feb. 8 trading session, onlyto rally intraday and close very nearthe high of the day (using 5 p.m. as theclose of the session).

Let’s first consider the broader mar-ket conditions: AUD/USD had beenconsolidating since late-November2004 after a huge rally that started inSeptember. The market had madehigher lows on Dec. 10, 2004 and Jan.8, 2005 and lower highs on Dec. 21and Jan. 28, as price kept swinging inan increasingly tight range. Chartists— noticing this price behavior —would likely be inclined to speculatewhether the Feb. 8 low was going tomark another higher low in this con-solidation. (See the Forex Diary in theFebruary issue of Currency Trader toread about a trade related to this con-solidation.)

Now let’s look at the price spikeitself. We compared it to similar barsto see if there were any common char-acteristics that separated bars that

continued on p. 26


March April May

0.80

0.79

0.78

0.77

0.76

0.75

0.74

0.73

0.72

0.71

0.70

0.69

0.68

Using specific criteria to define bars with highs and lows that are "noticeably"higher than the preceding bars identifies a few useful trade opportunities but farmore meaningless signals.

FIGURE 2 — THE TRUTH OF THE MATTER



July Aug. Sept. Oct. Nov. Dec. 2005 Feb.

0.79

0.78

0.77

0.76

0.75

0.74

0.73

0.72

0.71

0.70

0.69

0.68

The marked bars met specific criteria for declining a certain amount below the previous bar but reversing intraday to close high within the daily range. These"spike-low" bars will form the basis of a trading strategy that attempts to catch bottoms in the AUD/USD rate.

FIGURE 3 — SPIKE-LOW DAYS





preceded reversals or corrections fromthose that did not. We used the follow-ing definition for the pattern:

1. Today’s low must be at least 25pips lower than the previous low.2. Today’s low must be lower thanthe previous 10 lows.3. Today’s close must be in the top25 percent of the bar’s range.

This definition attempts to capturespecific price behavior. First, the bar’slow must not only be lower than thepreceding bar by a certain amount, itmust also be lower than the previous10 lows. This ensures the market hasbeen declining before the spike-lowbar, which increases the potential for abottom to form. If we used only thefirst criterion, the bar could simply bea one-day aberration in a series ofuptrending bars. Second, the highclose indicates buyers came in anddominated trading in a bearish envi-ronment — not necessarily a guarantee

of a reversal, but a sign conditions forone could be developing.

We initially used more rigid patterncriteria, but found too few past exam-ples in the analysis period of January1998 to February 2005. If you can onlyfind a handful of similar patterns, youhave two strikes against you: You can’tbe as confident in the conclusions youdraw from the pattern than you couldif you had many examples, and even ifthe pattern was reliable, it doesn’t pro-vide many trade opportunities.

Table 1 shows the average and medi-an returns based on entering on theclose of the bars that satisfied these cri-teria (25 bars total) and exiting on thecloses of each of the following 20 days.Also shown are the largest intraday upmoves and down moves (LUM andLDM, respectively) that occurred ateach interval, which show how muchpotential profit and risk existed. Finally,the percentage of positive returns (% >0) are shown for days 1 through 10.

For example, the average move from

the close of the spike-low bar to thesubsequent close (day 1) was .20 per-cent; the median move was .03 per-cent. The maximum positive close-to-close move was 3.19 percent and themaximum negative close-to-closemove was -1.13 percent. The averagelargest up move from the close of thespike-low bar to day 1’s high was .74percent, while the average largestdown move from the close to day 1’slow was -.53 percent. The single largestclose-to-high move was 4.5 percentand the largest close-to-low move was-1.76 percent. Day 1’s close was higher52 percent of the time.

One of the most obvious aspects ofTable 1 is the general tendency forgains in days 1 through 4 (both theaverage and median returns for eachday are positive, and the winning per-centages climb from a low of 52 to 64percent) followed by losses in days 5through 8.

Although the probable gains impliedby the average and median figures are

CURRENCY STRATEGIES continued

Days 1 through 4 showed the most potential for positive moves; days 5 through 8 had a mildly negative bias.

TABLE 1 — SPIKE-LOW BAR STATISTICS

Day 1 LUM LDM D2 LUM LDM D3 LUM LDM D4 LUM LDM D5 LUM LDMAvg. 0.20% 0.74% -0.51% 0.14% 1.04% -0.73% 0.32% 1.17% -0.88% 0.24% 1.42% -1.03% -0.03% 1.55% -1.26%Med. 0.03% 0.53% -0.34% 0.04% 0.78% -0.65% 0.19% 0.99% -0.88% 0.22% 1.21% -0.88% -0.14% 1.21% -0.88%Max. 3.19% 4.50% 0.00% 2.70% 4.50% 0.00% 3.49% 5.99% 0.00% 2.92% 5.99% 0.00% 3.25% 5.99% -0.14%Min. -1.13% 0.00% -1.76% -2.19% 0.01% -2.29% -1.38% 0.01% -2.88% -2.86% 0.01% -3.04% -3.88% 0.01% -4.48%%>0 52.00% 52.00% 56.00% 64.00% 44.00%

D6 LUM LDM D7 LUM LDM D8 LUM LDM D9 LUM LDM D10 LUM LDMAvg. -0.25% 1.61% -1.48% -0.33% 1.73% -1.79% -0.15% 1.76% -1.82% 0.05% 1.83% -1.94% 0.16% 2.09% -2.35%Med. -0.50% 1.21% -1.21% -0.07% 1.35% -1.73% -0.29% 1.38% -1.73% 0.17% 1.39% -1.73% -0.44% 1.54% -1.96%Max. 3.26% 5.99% -0.14% 4.34% 5.99% -0.14% 3.94% 5.99% -0.14% 4.03% 5.99% -0.14% 6.71% 7.30% -0.67%Min. -2.72% 0.01% -4.48% -3.54% 0.19% -4.48% -3.33% 0.19% -4.48% -5.33% 0.19% -5.83% -6.60% 0.19% -7.96%

D11 LUM LDM D12 LUM LDM D13 LUM LDM D14 LUM LDM D15 LUM LDMAvg. 0.25% 2.20% -2.23% 0.09% 2.32% -2.32% 0.54% 2.47% -2.39% 0.67% 2.57% -2.44% 0.78% 2.73% -2.50%Med. 0.47% 1.54% -1.84% 0.04% 1.64% -1.84% 0.73% 1.84% -1.96% 1.09% 1.88% -1.96% 1.09% 1.88% -1.96%Max. 6.45% 7.54% -0.14% 5.64% 7.54% -0.14% 7.85% 8.17% -0.14% 7.79% 8.31% -0.14% 9.19% 9.69% -0.14%Min. -5.11% 0.20% -7.96% -5.32% 0.30% -7.96% -5.12% 0.30% -7.96% -4.87% 0.30% -7.96% -6.28% 0.30% -7.96%

D16 LUM LDM D17 LUM LDM D18 LUM LDM D19 LUM LDM D20 LUM LDMAvg. 0.88% 2.93% -2.54% 0.70% 2.98% -2.63% 0.70% 3.02% -2.72% 0.73% 3.08% -2.79% 1.02% 3.26% -2.86%Med. 0.58% 1.88% -1.96% 0.50% 1.88% -2.16% 0.83% 1.88% -2.35% 1.52% 2.11% -2.35% 1.46% 2.58% -2.35%Max. 9.91% 10.32% -0.14% 9.17% 10.46% -0.14% 8.57% 10.46% -0.14% 8.62% 10.46% -0.14% 7.93% 10.46% -0.14%Min. -5.85% 0.30% -7.96% -6.68% 0.30% -7.96% -6.44% 0.30% -7.96% -5.32% 0.30% -7.96% -5.23% 0.30% -7.96%


not particularly large (assuming wewould not be lucky enough to sell atthe absolute highs), they still point tothe potential for the market to movehigher after spike-low bars.

Following up on followthroughOne way to approach this informationwould be to simply construct a tradingstrategy that went long on the close ofqualifying spike-low bars. The statis-tics regarding the close-to-close movesand intraday maximum up and downmoves could be used to set logicalstop-loss and exit levels.

For example, from days 1 through 4,the average largest up move was 1.42percent and the average largest downmove was -1.03 percent. The LUMnumber could be used as a profit targetand the LDM number could be used asthe initial stop-loss. (A more conserva-tive approach would be to use thesmaller median LUM of 1.21 percent.)

However, a closer look at the per-formance statistics suggests a way toisolate better trade opportunities anddesign an improved trade strategy.When day 1 closed higher than theentry day, the gains were more likelyto persist over subsequent days. When

day 1 closed lower, AUD/USD tendedto continue to lose ground. This simpleobservation — that the direction of theclose on day 1 provides an indicationof the continued success of the pattern— can be used a simple filter.

Table 2 shows the statistics for days1 through 10 when day 1 closed higherthan the entry day. Days 2 through 6had larger gains — and higher proba-bilities of gains — than the same daysin Table 1. Also, the typical largestdown moves are smaller, which meansin these instances the potential rewardis greater and the potential risk isreduced. As a result, a lower close on

day 1 can be used as an initial stop:Hold only those positions that closehigher on day 1.

The table also shows both the typi-cal gain and the odds of a gaindecrease on day 5. Also, day 6 has anegative median close-to-close move(-.06 percent), even though the averagegain is positive (.51 percent) — a signof instability. It still seems as if the bestcombination of largest typical moveand odds of success are greatest indays 2 through 4. On day 4, the aver-age LUM was 2.04 percent and themedian LUM was 1.73 percent. Theaverage LDM was -.49 percent and the

median value was -.29 percent. Thefollowing rules incorporate this newinformation to establish appropriatestop-loss and profit-target levels:

1. Go long on the close of a spike-low day.

2. Exit with a loss if day 1 closesbelow the entry price.

3. Exit with a profit if price rallies by1.7 percent. (This number is just below the more conservative median figure, which is used to improve the odds of success.)

4. Exit any trade that is still open bythe close of day 4.

Applying these rules to the 25 origi-nal spike-low pattern examples result-ed in 12 trades being stopped out onday 1 for a total loss of 486 pips($4,860.00). Of the 13 remaining trades,seven hit the 1.7 percent profit target,four were exited on the close of dayfour with smaller profits, and twowere exited on the close of day 4 withlosses. The total profit was 1303 pips($13,030.00), for a net profit of$13,030.00 - $4,860.00 = $8,150.

The rules obviously leave room formodification. Figure 4 sorts the day 4LUMs and shows that 7 of 13, or 54

Of the 25 trades included in Table 1, 13 closed higher the day after entry (Day 1). The upside tendency through day four shownin Table 1 is even more pronounced here.

TABLE 2 — WHEN DAY 2 CLOSES HIGHER

Day 1 LUM LDM D2 LUM LDM D3 LUM LDM D4 LUM LDM D5 LUM LDM

Avg. 0.76% 1.16% -0.21% 0.69% 1.58% -0.34% 0.79% 1.72% -0.46% 1.03% 2.04% -0.49% 0.82% 2.21% -0.61%

Med. 0.53% 0.71% -0.20% 0.68% 1.44% -0.20% 0.69% 1.44% -0.28% 1.13% 1.73% -0.29% 1.07% 1.73% -0.59%

Max. 3.19% 4.50% 0.00% 2.70% 4.50% 0.00% 3.49% 5.99% 0.00% 2.92% 5.99% 0.00% 3.25% 5.99% -0.14%

Min. 0.03% 0.32% -0.59% -0.55% 0.46% -0.99% -0.94% 0.48% -1.29% -0.60% 0.73% -1.29% -1.37% 0.73% -1.77%

%>0 100.00% 84.62% 76.92% 84.62% 53.85%

D6 LUM LDM D7 LUM LDM D8 LUM LDM D9 LUM LDM D10 LUM LDM

Avg. 0.51% 2.29% -0.77% 0.58% 2.42% -0.99% 0.58% 2.45% -1.00% 0.88% 2.50% -1.06% 1.48% 2.93% -1.56%

Med. -0.06% 1.73% -0.65% 0.20% 1.73% -0.65% 0.35% 1.73% -0.65% 0.43% 1.73% -0.65% 0.84% 1.73% -1.38%

Max. 3.26% 5.99% -0.14% 4.34% 5.99% -0.14% 3.94% 5.99% -0.14% 4.03% 5.99% -0.14% 6.71% 7.30% -0.67%

Min. -1.64% 0.73% -1.96% -2.67% 0.73% -3.28% -1.61% 0.73% -3.28% -1.32% 0.73% -3.28% -2.18% 0.85% -3.28%

continued on p. 28


CURRENCY STRATEGIES continued

percent, were 1.73 percent or larger.However, 9 of 13, or 69 percent, were1.54 percent or larger, which means thestrategy’s winning percentage couldbe increased by accepting a more mod-est profit target. (Notice also that onlyfour of the signals produced LUMsabove 2.04 percent, which was theaverage LUM by day 4.) This type ofanalysis can be used to gauge the like-lihood the strategy will reach differentprofit targets on different days andadjusting a position as necessary.

Finally, another worthwhile idea toexplore is whether the profit targetactually helps the system, or whetheran alternate approach — say, a trailingstop — would give the strategy moreof an opportunity to capitalize on thelarge moves that can occur from timeto time.�

This month’s Forex Trade Diary describesa trade based on this strategy.

Largest up moves (LUM) by day 4

.73% .85%1.19% 1.21%

1.54% 1.64% 1.73% 1.89% 2.02% 2.12%2.34%

3.25%

5.99%

1 2 3 4 5 6 7 8 9 10 11 12 13Largest up moves

7%

6%

5%

4%

3%

2%

1%

0.00

Of the 13 trades that satisfied the criterion of closing higher the day after entry,nine produced up moves larger than 1.5 percent by day 4. There was oneexceptionally large trade (5.99 percent).

FIGURE 4 — LARGEST UP MOVES BY DAY 4


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Monday Tuesday Wednesday Thursday Friday Saturday

GLOBAL ECONOMIC CALENDAR MONTH

March 2005 • CURRENCY TRADER 29

1U.S.: ISM report onbusinessAustralia: Index of commodity pricesJapan: Account balancesGermany: Employment

2Japan: Monetarybase

Germany: Retailturnover

3ECB: Governingcouncil meeting

Germany:Production index

5

7Australia: Officialreserve assets

8 9Great Britain:Monetary PolicyCommitteemeeting

10U.S.: Wholesale inventoriesGreat Britain: MonetaryPolicy Committee meeting Japan: Corporate goodsprice indexGermany: Foreign trade

11U.S.: Trade balance

12

14Great Britain: PPI

Japan: Balance of pay-ments; Monetary survey

Italy: Balance of payments

15U.S.: Retail sales

Canada:Manufacturingsurvey

Germany: CPI

16Great Britain:Employment

17U.S.: Leading indicators

ECB: Governingcouncil and general councilmeeting

18Great Britain:Capital issues

Germany: PPI;Bankruptcies

22U.S.: PPI forMarch; FOMCmeetingGreat Britain: CPICanada: Retailtrade

23U.S.: CPI Great Britain:GDP; Balance ofpaymentsCanada: CPI;Leading indicators

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

CPI: Consumer Price Index

ECB: European Central Bank

FOMC: Federal Open MarketCommittee

GDP: Gross Domestic Product

ISM: Institute for Supply Management

PPI: Producer Price Index

Legend

Monday Tuesday Wednesday Thursday Friday Saturday

GLOBAL ECONOMIC CALENDAR MARCH

24U.S.: Durablegoods

Great Britain:Productivity

31Canada: GDPGermany: EmploymentAustralia: International reservesand foreign currency liquidityItaly: International reserves andforeign currency liquidity

25Japan:Corporate serv-ice price index

21Canada:Wholesale trade

26

4U.S.: Employmentreport

Germany: Ordersreceived andmanufacturingturnover

29Canada:Employment

30U.S.: GDP

19

27 28


M any economists arguethe U.S. current ac-count balance andbudget shortfalls —

the “twin” deficits — are the main cul-prits behind the U.S. dollar’s three-year decline. The U.S. tradeimbalance, or the gap betweenthe country’s imports andexports, is a critical compo-nent of the broader currentaccount balance and has bal-looned to historic levels since1998.

There’s virtually no doubtthat the U.S. can’t continue toimport hundreds of billions ofdollars more than it exportseach year without furtherweakening the buck. How-ever, solutions are trickybecause the dollar’s value ispart of the problem: Astronger dollar can fuel thetrade deficit because importsbecome cheaper for U.S. con-sumers while exports becomemore expensive. Similarly, aweaker dollar can potentiallyreduce the trade gap byincreasing the cost of importsand slashing U.S. exportprices.

The following study focus-

es on the dollar’s short-term patternssurrounding the monthly Inter-national Trade in Goods and Servicesreport. We measured the dollar’s per-formance before and after 100 releasesof the report from Oct. 18, 1996 to Jan.

12, 2005, examining the differencesbetween increasing and droppingtrade deficits as well as the reaction tolarger- and smaller-than-expectedtrade gaps.

Last month, we analyzed the dol-

CURRENCY CHARACTERISTICS

Annual U.S. trade balance vs. U.S. dollar major currencies index

(1973-2004)

Annual U.S. trade balance (in billions, left scale)Nominal U.S. dollar major currencies index (right scale)

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

*

140

130

120

110

100

90

80

$0

-$100

-$200

-$300

-$400

-$500

-$600

The U.S. has run a trade deficit since 1976, but the gap didn't widen beyond $200 billionuntil 1999. Although there is no solid link between the trade balance and the dollar, thegreenback's two steep declines have occurred as this gap hit historical levels (1984 to1987 and 2001 to 2004).

FIGURE 1 — TRADE BALANCE VS. DOLLAR

Source: Bureau of Economic Analysis, Federal Reserve *January through November only

Ann

ual U

.S.

trad

e ba

lanc

e (in

bill

ions

)

Nom

inal U.S

. dollar major currencies index

The international trade reportand the U.S. dollar

Many economists point to a connection between the widening U.S. trade deficit

and the U.S. dollar’s three-year slump. This short-term view analyzes

how the greenback performs around the monthly trade balance report.

BY DAVID BUKEY

The lower three sections break out trade reports into categories: increasing deficits, decreasing deficits, and no change. Althoughthe dollar lacked a clear pattern prior to these announcements, it welcomed news of a narrowing trade gap.

TABLE 1 — TRADE BALANCE REPORT ANALYSIS

Source: Bureau of Economic Analysis and NYBOT


lar’s historical reaction to the currentaccount balance report and discov-ered that it tended to fall after theseannouncements — regardless of theircontent (see Related reading).

Although both reports have similarcontent, the Commerce Departmentreleases trade balance data eachmonth, while the current accountreport is published only once eachquarter. Traders generally view thetrade balance report as more relevant,which may explain why we found thedollar behaved much differentlyaround its release than around currentaccount reports. For a detailed expla-nation of the international tradereport and how it differs from the cur-rent account report, see “Measuringthe U.S. trade deficit.”

continued on p. 32

U.S. dollar index performance around trade balance reports (1996 to 2005)

Ave

rag

e g

ain

/loss

(%

)

Day Day Day Day Day Day Day Day Day Day Day Day Day Day Day Day Day-8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8

Days before and after announcement (Day 0)

0.15

0.10

0.05

0.00

-0.05

-0.10

NYBOT U.S. dollar index futures contract

Fed nominal U.S. dollar major currencies

Both indices have moved roughly in line with each other, although there aresome notable differences. Overall, the dollar lacks a clear pattern before or aftertrade balance reports, but it tends to head higher in the second and third daysafter the number is released.

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

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

Close Day Day Day Day Day Day Day Day Day Day Day Day Day Day Day Day Day location -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8

Overall (100 instances)Avg: 51.18 0.00%* 0.03% -0.01% -0.07% 0.01% 0.06% -0.04% 0.01% 0.01% -0.04% 0.11% 0.08% -0.04% 0.01% 0.07% -0.08% -0.03%Med: 53.54 0.03% 0.00% -0.01% -0.03% 0.04% 0.06% 0.00%* 0.06% 0.07% -0.03% 0.07% 0.06% -0.06% 0.00% 0.12% -0.08% -0.03%Pct. > 0: 50.51% 49.49% 48.00% 46.00% 55.00% 56.00% 50.00% 59.00% 53.00% 47.00% 53.00% 58.00% 42.00% 49.00% 60.00% 42.42% 44.44%

Standard deviation: 0.53% 0.53% 0.50% 0.57% 0.47% 0.52% 0.49% 0.44% 0.50% 0.49% 0.56% 0.51% 0.53% 0.49% 0.50% 0.52% 0.49%U.S. trade deficit increases (58 instances)

Avg: 50.15 -0.03% 0.05% 0.03% -0.06% 0.03% 0.06% -0.01% -0.04% -0.03% -0.04% 0.12% 0.01% -0.02% -0.06% 0.10% -0.03% -0.01%Med: 52.23 -0.02% 0.01% 0.07% 0.01% 0.07% 0.07% 0.01% 0.02% 0.05% -0.03% 0.05% 0.04% -0.09% -0.05% 0.15% -0.02% -0.02%Pct. > 0: 49.12% 52.63% 53.45% 50.00% 58.62% 58.62% 51.72% 53.45% 51.72% 48.28% 51.72% 53.45% 43.10% 44.83% 60.34% 44.83% 48.28%Standard deviation: 0.53% 0.45% 0.52% 0.57% 0.49% 0.49% 0.46% 0.40% 0.51% 0.47% 0.56% 0.53% 0.55% 0.47% 0.52% 0.51% 0.45%

U.S. trade deficit decreases (41 instances)Avg: 53.68 0.04% 0.03% -0.06% -0.07% -0.01% 0.04% -0.08% 0.06% 0.08% -0.04% 0.07% 0.17% -0.07% 0.13% 0.04% -0.16% -0.07%Med: 55.88 0.11% -0.01% -0.08% -0.08% 0.03% 0.03% -0.08% 0.07% 0.12% -0.03% 0.07% 0.16% -0.06% 0.03% 0.11% -0.23% -0.05%Pct. > 0: 51.22% 46.34% 41.46% 41.46% 51.22% 51.22% 46.34% 65.85% 56.10% 46.34% 53.66% 63.41% 39.02% 56.10% 60.98% 37.50% 37.50%Standard deviation: 0.54% 0.60% 0.47% 0.59% 0.44% 0.54% 0.54% 0.50% 0.48% 0.53% 0.56% 0.47% 0.52% 0.49% 0.46% 0.53% 0.56%

Same as prior month (1 instance)8.51 0.45% -1.31% 0.00% -0.18% -0.57% 1.10% 0.10% 0.63% -0.32% -0.15% 0.52% 0.10% 0.04% -0.51% -0.22% 0.56% 0.19%

*Greater than zero, but less than 0.01 percent


The long-term viewFigure 1 compares the annual tradebalance to the Federal Reserve’s nomi-nal U.S. dollar major currencies index

over the past 32 years (1973 through2004). The current trade-gap era beganall the way back in 1976, but it hit all-time highs during two periods — 1983

to 1987 and 1998 to 2004.Although it is obvious the dollar

suffered its worst declines after thetrade deficit had widened to historiclevels (i.e., 1984 to 1987 and 2002 to2004), the connection between thetrade gap and the dollar isn’t cut anddried. For example, the dollar rallied13.83 percent from 1999 to 2001 despitean increasing deficit, which rose near-ly $100 billion during that period.

Short-term patterns:Oct. 1996 to Jan. 2005We analyzed the S&P 500’s reaction to100 trade balance reports from October1996 to January 2005, using the actualreported trade deficit and ignoring theCommerce Department’s subsequentrevisions. However, we used the prior-month’s revised value to measure themonth-to-month trade changes in thedeficit. The trade gap increased 58times, dropped 41 times and wasunchanged once during the analysisperiod.

To discover how the dollar faredbefore the announcements, we calcu-lated its gain or loss on each of theeight days prior to each release. Wethen measured the dollar’s perform-ance on report day (Day 0) and theeight days following.

Our study used both the Fed’s nom-inal U.S. dollar major currencies indexand the New York Board of Trade’s(NYBOT) U.S. dollar continuousfutures contract (DX) to measure thedollar’s daily performance surround-ing monthly trade reports. Althoughthese instruments didn’t move exactlyin line with each other because of dif-ferent weighting methods, the differ-ences were fairly small. Figure 2 com-pares the Fed index’s average dailyperformance to that of the NYBOTfutures on the 17 days surroundingtrade deficit announcements. Theindices gained or lost ground togetheron all but two of those days.

Both indices’ average daily gainsand losses are quite small (0.12 percent

CURRENCY CHARACTERISTICS continued

U.S. dollar index futures performance surrounding U.S. trade balance reports(1996 to 2005)

Increasing trade deficit

Dropping trade deficit

Aver

age

gain

/loss

(%)

.20

.15

.10

.05

.00

-.05

-.10

-.15

-.20

The dollar performed better on four of the six days following smaller deficits(including announcement day) than after larger ones.

FIGURE 3 — TRADE DEFICIT INCREASES VS. DECREASES

Source: Bureau of Economic Analysis and NYBOT

U.S. dollar index performance around U.S. trade balance reports (1996 to 2005)

Day 0 Day 1 Day 2 Day 3 Day 4 Day 5 Day 6 Day 7 Day 8

Days after announcement (Day 0)

.6

.4

.2

.0

-.2

-.4

-.6

The dollar tended to reverse direction after closing within the upper or lower 20percent of its daily range on announcement day. The greenback fell an average0.13 percent on the day following a strong close before climbing 0.06 percentthe next day. Similarly, the dollar rose 0.23 percent in the first two days after aweak close and then gained ground during four of the six following days.

FIGURE 4 — STRONG VS. WEAK CLOSES

Source: Bureau of Economic Analysis, NYBOT and Federal Reserve

Day Day Day Day Day Day Day Day Day Day Day Day Day Day Day Day Day-8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8

Days before and after announcement (Day 0)

Strong close

Weak close

Aver

age

gain

/loss

(%)


or less), and they lack a clear pattern.The buck traded sideways before andafter trade balance announcementsand didn’t move in one direction formore than two consecutive days.However, the dollar edged at least0.11 percent higher on the second dayafter trade reports — a small gain, butworth mentioning since the dollar’sdaily benchmark, or typical one-daymove over the past nine years, wasflat.

Trade deficit changesTable 1 shows the dollar futures con-tract’s daily behavior before and aftertrade balance reports in more detail.In addition to the dollar’s averagegains and losses, the table also listseach day’s median value, percentageof gains, and standard deviation. Thetable’s bottom three sections break outthe dollar’s performance byannouncement type — increasingdeficits, declining deficits, andunchanged.

Table 1’s first column indicateswhere the dollar closed relative to itsrange on announcement day. Forexample, if the index closed at itsdaily high, the “Close location” is 100,but if it ended the day at its low, thenumber is zero.

Overall, the average values werewithin .10 percent of the median val-ues, which suggests the dollar’s per-formance in Figure 2 is accurate. (See“Average and median” and “Varianceand standard deviation” for detailedexplanations of Table 1’s statistics.)

Although there’s not much differ-ence between the dollar’s perform-ance before increasing and decreasingdeficits, the dollar seemed to antici-pate trade reports by rising an averageof 0.06 percent the day before theannouncement of smaller tradedeficits. Similarly, the dollar fell 0.04percent that day as news of a largergap approached.

On announcement day, the dollarcontinued on p. 34

Measuring the U.S. trade deficit

The U.S. Commerce Department’s Census Bureau and its Bureau ofEconomic Analysis (BEA) jointly release the International Trade inGoods and Services report each month, which is a snapshot of the

U.S.’s trade balance, or the gap between its imports and exports.The trade balance report is one of two releases that focus on foreign trade,

but unlike the current account balance report, which also includes foreigninvestment, the trade release only tracks the goods and services imported toand exported from the U.S.

The report isn’t as relevant as other economic indicators because its sta-tistics are delayed by two months (i.e., January’s report contains November’sdata), but its monthly release is more popular than the quarterly currentaccount balance report. It hits the Street at 8:30 a.m. ET the second week ofthe month.

Traders tend to concentrate on the overall figures for each month (totalimports and exports as well as the trade gap, or difference between them),but the report contains 18 detailed tables that break down U.S. trade in a vari-ety of ways.

First, the announcement divides both imports and exports into either goodsor services, and provides three-month moving averages of all four categories.The report then divides these groups further into smaller categories includingsix types of services, petroleum or non-petroleum goods, and dozens ofindustrial supplies and consumer products that range from nuclear materialsto fruit. Finally, the trade balance report breaks out U.S. imports and exportsby nearly 40 countries.

The Commerce Department directly tracks monthly changes in importedand exported goods, but it uses business surveys to compile its servicesdata. The release provides both seasonally adjusted and raw data as well asnominal and real, or inflation-adjusted, statistics. Each report contains reviseddata from previous months, and annual revisions are released each June.

Source: Bernard Baumohl, The Secrets of Economic Indicators: HiddenClues to Futures Economic Trends and Investment Opportunities (WhartonSchool Publishing, 2005).

Average and median

The mean (or average) of a set of values is the sum of the values divid-ed by the number of values in the set. If a set consists of 10 numbers,add them and divide by 10 to get the mean.

A statistical weakness of the mean is that it can be distorted by exception-ally large or small values. For example, the mean of 1, 2, 3, 4, 5, 6, 7, and200 is 28.5 (228/8). Take away 200, and the mean of the remaining sevennumbers is 4, which is much more representative of the numbers in this setthan 28.5.

The median can help gauge how representative a mean really is. Themedian of a data set is its middle value (when the set has an odd number ofelements) or the mean of the middle two elements (when the set has an evennumber of elements). The median is less susceptible than the mean to dis-tortion from extreme, non-representative values. The median of 1, 2, 3, 4, 5,6, 7, and 200 is 4.5 ((4+5)/2), which is much more in line with the majority ofnumbers in the set.


gained 0.08 percent in reaction tosmaller deficits, but fell 0.03 percent inresponse to expanding gaps.Although the dollar didn’t consistent-ly rally the week following tradedeficit declines, it rose 0.39 percent bythe sixth day after such announce-ments. In contrast, the dollar gainedjust 0.08 percent by that point afterdeficit increases.

Figure 3 compares the dollar indexfutures’ average gains and lossesaround increasing trade deficits to itsbehavior around declining gaps andreinforces Table 1’s patterns. The fig-ure clearly shows the dollar’s tenden-cy to rally once the CommerceDepartment reported a narrowingtrade gap. However, this bullishbehavior was short-lived — the dollar

CURRENCY CHARACTERISTICS continued

U.S. dollar index futures following U.S. trade balance reports (1999-2005)

Overall

Larger-than-expected trade deficits

Smaller-than-expected trade deficits

Ave

rag

e g

ain

/loss

(%

)

Day 0 Day 1 Day 2 Day 3 Day 4 Day 5 Day 6 Day 7 Day 8

Days after announcement (Day 0)

0.30

0.25

0.20

0.15

0.10

0.05

0.00

-0.05

-0.10

-0.15

The dollar has clearly preferred smaller-than-expected trade deficits to larger-than-expected gaps. The greenback rose an average 0.38 percent in the firstweek after surprisingly smaller deficits, while it fell 0.13 percent after unexpect-edly wider ones.

FIGURE 5 — LARGER- VS. SMALLER-THAN-EXPECTED TRADE DEFICITS

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

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

TABLE 2 — TRADE DEFICIT ESTIMATES

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

Close Day Day Day Day Day Day Day Day Daylocation 0 1 2 3 4 5 6 7 8

Overall (73 instances)Avg: 47.85 -0.04% -0.02% 0.17% 0.03% -0.05% 0.03% 0.01% -0.09% -0.03%Med: 41.03 0.00% 0.02% 0.07% 0.00% -0.08% 0.01% 0.09% -0.08% -0.02%Pct. >0: 49.32% 52.05% 53.42% 49.32% 42.47% 52.05% 54.79% 41.67% 44.44%Standard deviation: 0.51% 0.53% 0.57% 0.54% 0.55% 0.52% 0.53% 0.53% 0.49%

Larger-than-expected (41 instances)Avg: 47.51 -0.11% -0.02% 0.12% -0.06% -0.06% -0.01% 0.03% -0.09% -0.03%Med: 39.73 0.00% 0.09% -0.03% -0.01% -0.08% -0.02% 0.07% -0.14% -0.03%Pct. > 0: 48.78% 56.10% 46.34% 46.34% 43.90% 43.90% 53.66% 39.02% 43.90%Standard deviation: 0.50% 0.55% 0.64% 0.56% 0.53% 0.54% 0.56% 0.53% 0.51%

Smaller-than-expected (29 instances)Avg: 49.30 0.09% -0.02% 0.24% 0.09% -0.03% 0.05% -0.03% -0.08% 0.01%Med: 55.56 0.06% -0.03% 0.24% 0.02% -0.06% 0.07% 0.10% -0.07% 0.04%Pct. > 0: 51.72% 48.28% 62.07% 51.72% 44.83% 58.62% 55.17% 46.43% 50.00%Standard deviation: 0.49% 0.54% 0.48% 0.46% 0.60% 0.47% 0.53% 0.55% 0.47%

Inline (3 instances)Avg: 38.40 -0.18% -0.11% 0.08% 0.51% -0.16% 0.42% 0.11% -0.16% -0.48%Med: 16.67 -0.44% -0.03% 0.18% 0.60% -0.10% 0.30% 0.04% 0.00% -0.51%Pct. > 0: 33.33% 33.33% 66.67% 66.67% 0.00% 100.00% 66.67% 33.33% 0.00%Standard deviation: 0.71% 0.34% 0.22% 0.88% 0.18% 0.47% 0.29% 0.59% 0.18%


gave up most of its prior gains in thefinal two days of the analysis window.

Watch for reversalsWe tracked the dollar futures con-tract’s close locations on announce-ment day to find out if predictableprice patterns emerged once the dollarclosed near the top or bottom of itsdaily range.

Figure 4 compares the dollar’s aver-age gains and losses on announcementday and the eight days followingstrong closes to its behavior after weakcloses (i.e., within the upper and lower20 percent of its report-day range,respectively).

The dollar tended to reverse direc-tion following extreme closes. Forexample, the dollar gained 0.42 per-cent on strong-closing report days, butsank 0.13 percent on the day afterthese events. Similarly, the dollar lost0.58 percent on weak-closingannouncement days, but it thenrebounded 0.23 percent in the follow-ing two days.

Overall, the dollar slipped 0.18 per-cent during the eight days after strongcloses, and it rose 0.47 percent in thesame period succeeding weak closes.

Hitting or missing economists estimatesThe next part of the analysis consistedof comparing the actual trade deficitfigures to Briefing.com’s consensusestimates, from Jan. 21, 1999 to Jan. 12,2005 (73 reports). The trade deficitcame in above forecasts 41 times,below them 29 times, and was in linethree times.

Table 2 compares the dollar indexfutures contract’s overall response toits price moves following larger-than-expected, smaller-than-expected, andin-line trade balance reports. On sevenof the table’s nine days the dollar post-ed either larger gains or smaller lossesafter surprisingly smaller deficits thanafter larger-than-expected ones. Onannouncement day, the dollar jumped0.09 percent in response to smaller-

than-expected trade gaps, yet itdropped 0.11 percent when the deficitwas wider than expected.

Although the dollar rallied 0.32 per-cent in the nine days following small-er-than-expected deficits, most of itsgains occurred on the second day aftertrade reports as the greenback soared0.24 percent. In contrast, despite its0.12-percent climb on the second dayafter disappointing trade news, thedollar tumbled 0.23 percent by the endof our analysis window.

Figure 5 shows the dollar’s averagedaily performance following the samescenarios as in Table 2, and confirms

that its bullish reaction to smaller-than-expected trade gaps was fairlyshort: The dollar had surged 0.40 per-cent by the third day, but it then head-ed lower in the final week, regardlessof whether the trade report was a pos-itive surprise or not.

Bottom lineThe dollar’s tendency to rally inresponse to either a narrowing orsmaller-than-expected trade deficitmakes sense. However, the greenbackclearly preferred unexpected trade-gap reductions to mere drops in actualmonthly values.�

Related reading“The dollar and the deficit,” Currency Trader, November 2004.An overview of how the current account and trade deficits affect the U.S.dollar.

“Elections and the U.S. dollar,” Currency Trader, November 2004.An analysis of how the dollar fared surrounding U.S. elections since 1973.

“U.S. dollar: Q1 recovery should precede further downtrend,” Currency Trader,February 2005. A look at recent U.S. dollar price moves.

“The current account deficit’s impact on the U.S. dollar,” Currency Trader,February 2005. A study of historical tendencies surrounding the quarterly cur-rent account balance report over the past 10 years.

Variance and standard deviation

V ariance measures how spread out a group of values are — in otherwords, how much they vary. Mathematically, variance is the averagesquared “deviation” (or difference) of each number in the group from

the group’s mean value, divided by the number of elements in the group. Forexample, for the numbers 8, 9, and 10, the mean is 9 and the variance is:

{(8-9)2 + (9-9)2 + (10-9)2}/3 = (1 + 0 + 1)/3 = .667

Now look at the variance of a more widely distributed set of numbers, 2, 9, 16:

{(2-9)2 + (9-9)2 + (16-9)2 }/3 = (49 + 0 + 49)/3 = 32.67

The more varied a system’s returns, the higher their variance or standarddeviation, and the riskier the system will likely be to trade. The more varied amarket’s price changes from day to day (or week to week, etc.), the morevolatile that market is.

A common application of variance in trading is standard deviation, which isthe square root of variance. The standard deviation of 8, 9, and 10 is: .667 =.82; the standard deviation of 2, 9, and 16 is: 32.67 = 5.72.








MONEY TALKS

John Bollinger on consolidations

John Bollinger on market cycles, overlooked

opportunities and why a “consolidating” market

may be just what the doctor ordered for a new

breed of swing trader.


The following discussion is taken from an interview with John

Bollinger in the April 2003 issue of Active Trader magazine

(“Relatively speaking: John Bollinger”), in which he touched

upon using Bollinger Bands and how to understand and trade

range-bound (rather than trending) markets. Although he was

addressing the stock market, the principles he describes are appli-

cable to all instruments, including currencies – especially consid-

ering the current speculation about diminishing trend moves and

potential consolidation in the forex market this year.


CT: Where do you suggest traders conditioned to trade inlong-term trends get started in terms of operating in range-type markets?JB: The tools that work the best are relative tools — thosethat let you get a grip on what’s happening in relation toimmediately prior history.

Of course, different traders will have different ideasabout what “immediately prior” means. For some it willmean what’s happened this morning, for others it will meanthe past 20 days or the past six months or year. But theadvantage of relative tools is that you can adapt them toyour purposes.

Bollinger Bands, for instance, provide a definitionwhether prices are high or low on a relative basis (see“Indicator reference”). At the upper band, prices are high,and at the lower band, prices are low. If price tags the upperband, you know prices are high, so you can consult anoth-er tool to determine whether you believe that “highness” issustainable or whether it’s a potential reversal to be sold.

One of the problems I’ve seen is that people treatBollinger Bands in the simplest way possible. They auto-matically think a tag of the upper band is a sell and a tag ofthe lower band is a buy. Nothing could be further from thetruth. Some tags of the upper and lower bands are sells andbuys, respectively, but not all tags are action points. Pricecan, and does, walk up the upper band or walk down thelower band, and often when this happens you get some ofthe most profitable trades.

With rare exceptions, it’s not enough to use BollingerBands alone. You have to combine them with somethingelse that tells you about sustainability. For me, that some-thing else is volume indicators.

CT: Just indicators? Do you ever look at raw volume num-bers?JB: Both can work. Some people are able to look at volume,relate it to the price bars and intuitively understand thesupply-demand relationship. Other people need to parsevolume into an indicator to clarify the picture.

Older traders who grew up keeping charts by handwould probably be more comfortable with raw volumenumbers. Traders who grew up with technology that couldeasily calculate and plot complex indicators will likely behappier with volume indicators. [It helps to] use a volume“clip” — normalized volume, or at least a moving averageof volume so you have some idea of whether volume is highor low on a relative basis.

CT: Can’t volume be misleading, though? High volume canaccompany reversal points or support trends, but it seemsas if many volume-watching traders conveniently overlookthe frequent occasions when volume gives “classic” signalsand price does the opposite of what it’s supposed to. Andyou can also find plenty of turning points where volume

continued on p. 38

Indicator reference:Bollinger Bands

Bollinger Bands are a type of trading “envelope”consisting of lines plotted above and below amoving average, which are designed to cap-

ture a market’s typical price fluctuations. BollingerBands were created by John Bollinger, CFA, CMT, thepresident and founder of Bollinger Capital Management.

The indicator is similar in concept to the moving aver-age envelope (see Indicator Insight, Active TraderSeptember 2002), with an important difference: Whilemoving average envelopes plot lines a fixed percentageabove and below the average (typically three percentabove and below a 21-day simple moving average),Bollinger Bands use a statistical calculation called stan-dard deviation to determine how far above and belowthe moving average the lines are placed. As a result,while the upper and lower lines of a moving averageenvelope always move in tandem, Bollinger Bandsexpand during periods of rising market volatility andcontract during periods of decreasing market volatility.

By default, the upper and lower Bollinger Bands areplaced two standard deviations above and below a 20-period simple moving average.

Upper band = 20-period simple moving average +2 standard deviations

Middle line = 20-period simple moving average ofclosing prices

Lower band = 20-period simple moving average -2 standard deviations

Standard deviation is a statistical calculation thatmeasures how far values range from an average value— in this case, how far prices stray from a 20-day mov-ing average. Statistically, 95 percent of values will fallwithin two standard deviations of the average value,which means 95 percent of price action should occurwithin the upper and lower Bollinger Bands.

Bollinger Bands highlights when price has becomehigh or low on a relative basis, which is signaled throughthe touch (or minor penetration) of the upper or lowerline. Put another way, price is seen as relatively high(overbought) on a touch of the upper band and relative-ly low (oversold) on a touch of the lower band.

However, Bollinger stresses that price touching thelower or upper band does not constitute an automaticbuy or sell signal. For example, a close (or multiple clos-es) above the upper band or below the lower bandreflects stronger upside or downside momentum that ismore likely to be a breakout (or trend) signal, rather thana reversal signal. Accordingly, Bollinger suggests usingthe bands in conjunction with other trading tools that cansupply context and signal confirmation.


wasn’t unusual one way or the other.JB: Well, first of all, I’m working with the relative defini-tion of high and low price levels, so that lets me know whento consult volume.

For example, if price has just tagged the upper band, Iknow this is a point to see if volume is adding anything tothe picture. I don’t scan volume continuously, trying tomake an ongoing stream of decisions based on the relation-ship between it and price. I only look at critical junctures.

What I’ve found, in this regard, is that it pays to wait. Inother words, after I get a buy or sell signal, I wait for price

action to confirm that signal. If price tags the upper bandand a volume indicator — say, 20-day on balance volume(OBV) — is in negative territory, you can treat that as awarning or alert because the combination suggests this is apotentially unsustainable situation. Then, if there’s evi-dence of a decline, you can act, because you know a propersetup was in place.

The other thing you have going for you in this kind oftrade situation is knowing whether there’s a good risk-reward relationship. If price tags the upper band and turnsdown, you can place a stop just above the entry point,knowing if price goes back up and violates the stop, yoursetup is broken. And that stop will be fairly close by, so the

amount you’re risking is relatively small, whereas theimmediate target for the move is for price to get back to thelower band, which is much farther away.

CT: What kind of risk-reward numbers do you operate with?JB: Here’s one way to look at it: There are only two waysto improve your trading performance. First, you canincrease your number of winning trades vs. losing trades. Ifyou’re batting around .500, you can try to add different tim-ing information and indicators, and so on, and maybe getyour batting average up to around .600 or .650. I think

you’re doing pretty well if you have 65percent winners.

Second, you can increase the size ofyour winners vs. the size of your los-ers. Say your winners are twice thesize of your losers — that’s prettygood. If you get up to three times thesize, I think you’ll find the mathemat-ics work very much in your favor. Ifyou have 60 to 65 percent winningtrades and your winners are two tothree times the size of your losers,you’ll find you’re making money pret-ty quickly.

By using this relative tradingapproach, you can address both thoserisk-reward dimensions. You addressthe size of the winners vs. losers byhaving entry points with logical [stop]points nearby that let you know yourtrade was wrong. You address thenumber of winners by finding theright volume indicators to assess thetype of trade and the vehicles you’reusing.

CT: What about a trend componentthat’s independent from what you’rediscussing now — independent in thatit would probably be on a longer timeframe?

JB: I think the idea of biasing your trading in the directionof the greatest probability of success is very important. In asideways market, you’ll get fairly important intermediate-term buy signals near the bottom of the range and sell sig-nals near the top. Those should absolutely dictate the direc-tion of your trading. Clearly, if you can bias your trading infavor of the intermediate swing direction of the market,you’ll go a long way toward improving the two key com-ponents of success.

In terms of time frame, if you’re using Bollinger Bands,for example, rather than trying to adjust the time frame bychanging the periods and width of the bands — 20 and 2seem to work very well for most applications and are cer-

MONEY TALKS continued


Sept. Oct. Nov. Dec. 2005 Feb.

112

111

110

109

108

107

106

105

104

103

102

Notice the many touches and minor penetrations of the lower band during theOctober-November downtrend; price never approaches the upper band duringthis period an only penetrates the moving average (middle line) once. TheDecember-January trading range is characterized by much more even swingsbetween the two bands. Finally, notice the contraction of the bands during thelow-volatility September consolidation vs. the expansion of the bands as volatili-ty increases in October.

FIGURE 1 — BOLLINGER BANDS: USD/JPY



tainly a good place to start — try usinga different bar length. If you’re usingdaily bars and you want a shorter-termview, you might switch to hourly bars.If you want a longer-term view, tryswitching to weekly bars. That’s agood way to get an idea of what’s hap-pening in different time frames.

CT: Working on the assumption that amarket may be in a consolidation envi-ronment for an extended period, whattime frame would you begin youranalysis on? JB: It depends on what you’re tryingto do. If you’re trying to get a handleon the market’s intermediate-termactivity as background information, Ithink you can estimate the swings willbe three to six months at a minimumand six months to a year maximum —that’s a typical pattern that’s occurredin the past. Weekly bars seem to be theappropriate way to visualize that information.

When you get down to the shorter-term — actually exe-cuting trades in individual stocks or indices — I recom-mend daily bars. That’s my bias. I’ve looked at charts foryears and I’m comfortable in that time frame. For evenshorter-term trades, hourly bars are quite useful.

There’s obviously that subset of traders who are going totrade within much tighter parameters — people who areusing five-minute bars and tick charts. But the conceptsreally remain the same, regardless of the time frame: know-ing what’s happening on the longer-term time frame so youcan correctly bias your operations in the shorter time frame.

If you get a nice entry signal for a long trade and the mar-ket is in an upswing, you probably want to take that a littlemore seriously than you would a nice entry signal for ashort. The principles we’re talking about are fractal innature — they exhibit the same kinds of patterns and char-acteristics at different levels of magnification, whether it’s10 minutes and hourly, hourly and daily or daily and week-ly. The same types of setups and trading patterns are evi-dent.

CT: It’s surprising how many people don’t buy into that,because it seems pretty apparent if you just look at chartsfor a while. JB: I remember there was a fellow by the name of SamKachigan who designed a trading system called the Lennoxsystem. One of the basic elements of the system was thattrades had to be confirmed in three time frames. There wasthe long-term setup, then you looked for a similar setup onthe intermediate time frame and, finally, the same thing onthe shorter time frame, which is where you executed the

trade. It’s the same old idea — having all the parts andpieces pulling in the same direction.�

Related reading

“John Bollinger: Focus on the markets” (Active Trader, January-February 2001).John Bollinger talks about developing Bollinger Bandsand what his career has taught him about markets and traders.

“Relatively speaking: John Bollinger” (Active Trader, April 2003).In this interview, Bollinger discusses market cycles,trading consolidations rather than trends, and othertopics.

“Volume indicators revisited” by John Bollinger (Active Trader, March 2002).John Bollinger reviews the origins of volume indicatorsand explains how traders can benefit from understanding these tools.

“Indicator Insight: Bollinger Bands” (Active Trader, July 2003).A primer for understanding and using Bollinger Bands.

You can purchase and download past Active Traderarticles at www.activetradermag.com/purchase_arti-cles.htm

Euro/U.S. dollar (EUR/USD), 180-minute

12/29 12/30 1/2 1/4 1/6 1/9 1/11 1/13 1/14 1/18 1/19 1/21 1/25 1/26 1/28

.

1.36

1.35

1.34

1.33

1.32

1.31

1.30

This 180-minute chart actually shares many characteristics with the daily chartin Figure 1, including the transition from a trend period (which is preceded by anotable contraction in the bands) to a trading range.

FIGURE 2 — BOLLINGER BANDS: INTRADAY PERSPECTIVE


www.activetradermag.com/purchase_articles.htm



A s forex trading continues to expand in theretail trading space, one aspect of the marketmany traders have wondered about is optiontrading.

Although they are not yet a common part of retail spotforex trading, individual market players do have access tooption trading — depending on their broker. Options in thespot forex market are not standardized the way optionscontracts are for exchange-traded stocks and futures — thatis, there are no predefined strike prices or expiration datesall brokers and traders use. If your brokerage offers optiontrading, they likely have their own relatively set menu ofoption contracts, as well as the ability to create a cus-tomized instrument of your choosing.

Forex option characteristicsUnlike option trading in the equity and futures markets,where options expire at regular intervals (e.g., every 30days or three months) and can be traded online, in the forexworld customers typically must trade options over thephone — but they can also create customized option con-tracts with just about any strike price and expiration.

This customization gives traders flexibility, but it alsomakes FX options more complicated because of the difficultyof determining if a particular option is fairly priced. Mostforex firms, including Gain Capital and HotSpotFX, say theyare not yet seeing much interest from customers. As a result,forex option trading is best suited for experienced traders,according to Gain, which offers FX option trading within itstraditional FX platform.

Most platforms do not charge commissions for options; theyare compensated through the bid/ask spread. Forex options

are typically constructed to expire in one or two weeks, butagain, that is up to the brokerage and the customer.

For more information on basic option characteristics andtrading approaches, see "Related reading."

Option types and strategiesForex options come in two flavors: vanilla and exotic.Vanilla options are simple calls and puts familiar to stockand futures option traders. Exotic options refer to eithercombinations of options (spreads) or variations on the pay-off profiles of vanilla options — completely different kindsof products with option-like characteristics.

One type of forex option trade that falls into the last cat-egory is a "fixed-rate" option, which is a unique transactionthat enables a trader to profit by a predetermined "payout"

amount if the trader's selected price or price range isreached during a specific trading period.

Generally, a brokerage will divide each 24-hour trad-ing day into multiple trading sessions. Prior to the startof a trading session, the firm will typically indicateprice limits for certain currency pairs within whichfixed-rate option orders may be entered for that tradingsession. The firm will then quote the premium the trad-er must pay to buy the fixed-rate option trade. Once anorder is entered, the premium for the trade is automat-ically deducted from your trading account.

If the selected price or price range of the underlyingcurrency pair is reached during the trading session, a pre-set payout (which the firm and customer decide upon asterms of the option "contract") will automatically be credit-ed to the trader's account at the end of the trading session.In the event the price of the underlying currency pair is notreached during the trading session, the fixed-rate optionwill expire, worthless.

For example, if the Euro/U.S. dollar rate (EUR/USD)was at 1.3028 before a particular trading period, a fixed-rateoption contract could be constructed whereby the traderwould receive a payout amount of $X if EUR/USD tradedabove 1.3070 during the trading period.

Barrier options are based on a pre-selected price level (thebarrier) in a currency, which if reached will either create a vanil-la option (call or put) or eliminate the existence of a vanillaoption. These are referred to as "knock-in/knock-out" options.

There are two kinds of knock-in options: up and in and

CURRENCY BASICS

Forex options Most stock and futures traders are at least familiar with basic option-trading concepts,

but options are a much different beast in the forex world.

BY CARLISE PETERSON


down and in. In the case of an up-and-in option, the buyerselects an upper price barrier above the market. If the curren-cy hits that level, a vanilla option position is triggered with amaturity date and strike price agreed upon at the outset.

For example, if EUR/USD is at 1.3028, an up-and-inoption might consist of a long call option position with astrike price of 1.3055 being triggered if EUR/USD tradesabove 1.3050.

A down-and-in option is the same, except the currencymust reach a lower barrier to trigger the option position.Upon hitting the chosen lower price level, it creates a call orput option position.

Knock-out options are the reverse of knock-ins. Withknock-outs, the buyer begins with a vanilla option; howev-er, if the predetermined price barrier is hit, the vanillaoption position is cancelled. As with the knock-in option,there are two kinds: up and out and down and out. With anup-and-out strategy, if the option hits the upper barrier, theoption is cancelled and you lose your premium. With adown and out, if the option hits the lower price barrier, theoption is cancelled.

Risks in trading spot forex optionsForex options contracts are vastly different from options onstocks or futures contracts. There are no standardized contractspecifications or centralized, exchange-traded markets, which

means there is little or no price transparency; this makes it dif-ficult to determine if the price you pay for an option is closeto the "fair" theoretical value. Essentially, a forex option is acustomized, private transaction between a trader and a bro-kerage. Only traders with significant experience in both forextrading and option-pricing techniques should attempt tomake use of option strategies in the forex market.�

American style: An option that can be exercised at any time until expi-ration.

At the money (ATM): An option whose strike price is identical (or veryclose) to the current underlying stock (or futures) price.

Call option: An option that gives the owner the right, but not the obliga-tion, to buy a stock (or futures contract) at a fixed price.

Deep (e.g., deep in-the-money option or deep out-of-the money option):call options with strike prices that are far above the current price of theunderlying asset and put options with strike prices that are far below thecurrent price of the underlying asset.

European style: An option that can only be exercised at expiration, notbefore.

Exercise: To exchange an option for the underlying instrument.

Expiration: The last day on which an option can be exercised andexchanged for the underlying instrument (usually the last trading day orone day after).

In the money (ITM): A call option with a strike price below the price ofthe underlying instrument or a put option with a strike price above theunderlying instrument’s price.

Intrinsic value: The difference between the strike price of an in-the-money option and the underlying asset price. A call option with a strikeprice of 22 has 2 points of intrinsic value if the underlying market is trad-ing at 24.

Out of the money (OTM): A call option with a strike price above the priceof the underlying instrument or a put option with a strike price below theunderlying instrument’s price.

Premium: The price of an option.

Put option: An option that gives the owner the right, but not the obliga-tion, to sell a stock (or futures contract) at a fixed price.

Strike ("exercise") price: The price at which an underlying stock isexchanged upon exercise of an option.

Time value: The amount of an option’s value that is a function of the timeremaining until expiration. As expiration approaches, time value decreas-es at an accelerated rate, a phenomenon known as "time decay."

Volatility: The level of price movement in a market. Historical volatilitymeasures the price fluctuations (usually calculated as the standarddeviation of closing prices) over a certain time period — e.g., the past20 days. Implied volatility is the current market estimate of future volatil-ity as reflected in the level of option premiums. The higher the impliedvolatility, the higher the option premium.

Related reading"Getting started in options," Options Trader magazine, April, 2005.Get a handle on how options work and how to takeadvantage of them as trading and hedging tools.

"Spreading your charting options," Active Trader, April 2001. A handy guide to understanding which strategies goeswith which market conditions.

"Stepping into options," Active Trader, April 2001. When trading options, you have to walk first and runlater. Learn how to take things one step at a time so youcan use these tools more effectively.

Special notice: For a limited time you can sign up forfree subscription to Options Trader magazine atwww.optionstradermag.com.

You can purchase and download past Active Trader arti-cles at www.activetradermag.com/purchase_articles.htm.

Options glossary




BY NOBLE DRAKOLN

T here has always been debate among tradersregarding the value of technical analysis vs.fundamental analysis. Unfortunately, thisdebate ignores the most important element of

overall trading success — money management. While thereare many books about optimizing trading rules or handlinga trade once you’re in it, it is difficult to find hard-and-fast money-management rules for individual traders.

There are three money-management areas individualtraders must address: what markets to trade, how manyshares or contracts to trade (position sizing), and howmuch to risk once you’re in a trade. Here, we’ll focusmostly on the last of these three money-managementcomponents — how much to risk on a given trade, andhow that relates to your trading approach and accountsize.

Capital preservationOn Jan. 12, 2005, a record U.S. trade deficit of $60.3 bil-lion dollars was reported — a $20.3 billion dollarincrease from the November 2003 report — and the U.S.dollar declined sharply (Figure 1). Currency traders whohad been bearish the U.S. dollar found their long foreigncurrency trades significantly in the black.

The next day, Jan. 13, 2005, there was an immediatereversal in the perceived value of the U.S. dollar. Longpositions in many foreign currencies fell, giving backmost (and in some cases, more) of the gains they hadmade against the dollar the prior day. While differenttechnical indicators suggested the dollar’s rebound wassimply a short-covering rally, the fact remains those holdingshort dollar positions lost money. How do you exit a tradesuccessfully in such whipsaw conditions?

The goal of all traders is to be profitable, but before thatis possible you must focus on capital preservation. The onlyway to succeed at trading in the long run is to have as manyopportunities to profit as possible, and the best way to putyourself in that position is to preserve your initial capital.Therefore, you must understand the relationship between

the analytical tools you use to define a trade and the capitalyou have at your disposal.

The following examples focus mostly on the ChicagoMercantile Exchange (CME) currency futures contracts, but

CURRENCY BASICS

U.S. dollar index (DXY), daily

Dollar plunges onJan. 12…

…but reverses the next day

2005 10

84.0

83.5

83.0

82.5

82.0

81.5

81.0

A sharp down move by the U.S. dollar is quickly reversed thefollowing day.

FIGURE 1 — DOLLAR DAYS

Source: FutureSource Workstation

Money management fundamentals:How much should you risk?

Most traders only think about potential profits, but capital preservation should be foremost

in their thoughts. Knowing your stop points and keeping per-trade risk at a conservative level

will keep you in the game.


the same money-managementprincipals apply to the spotforex market.

Setting basic money-managementboundariesThe key to successful moneymanagement is to identify howfar a market can go against you— that is, a trade’s deepestpotential drawdown — andreconcile that potential losswith the amount of equity inyour account you are willingto risk. This is a consistentapproach used by many pro-fessional money managers.

The primary way such pro-fessionals reconcile drawdown against overall equity is toset a maximum loss based on a total percentage assetsunder management. On any given trade, such traders arerarely willing to risk more than 2 percent of total equity. Forexample, if a manager has $1 million under management,the maximum risk per trade would be $20,000.

Individual traders should use a similar hard money-management rule. However, because the majority of indi-vidual traders have significantly less equity than most pro-fessional money managers, a higher maximum risk loss —perhaps as much as 7 to 10 percent — is more realistic, atleast for experienced traders. Other traders should simplyuse smaller position sizes or trade “micro” forex lots($10,000 vs. the usual $100,000) or “mini” futures contracts,if available. But regardless of the size of your position, it isimportant to have a set stop loss.

Market examplesWe’ll walk through a few examples of establishing moneymanagement boundaries. You can use whatever tools youfeel comfortable with to set such targets. A systematic trad-er, for example, might have historical test results that indi-cate appropriate levels for taking losses or exiting tradesprofitably.

The Commitment of Traders Report (COT) released bythe Commodities Futures Trading Commission (CFTC)tracks the positions of different kinds of traders (i.e., smalland large speculators and commercial hedgers) in thefutures markets. It is often used to gauge which side of themarket the “smart money” (usually the large commercial

traders) is on. In mid-January, the majority of small specu-lators held open foreign currency positions that wereweighted heavily to the long side — that is, against the dol-lar.

The chart examples help illustrate the various accountsizes needed to handle different percentage losses. We willlook at the size of the losses hypothetical long trades wouldincur and determine how much account equity would benecessary to stay within 2-percent, 7-percent, and 10-per-cent risk levels. All you need to do is divide the expectedloss by the appropriate percentage amount.

Figure 2 shows a daily chart of the Australian dollarfutures (AD). If you went long when the contract droppedsharply from .7663 to .7539, you would have had a loss of.0124, or $1,240 per contract (each tick is worth $10.00). As aresult, you would need the following account sizes:

1. For this to be a 2-percent loss you would need $62,000($1,240/.02) of account equity per contract.



So, for example, if you had less than $62,000 in youraccount, you would have to risk more than 2 percent ofequity per trade.

continued on p. 44

March 2005 Australian dollar futures (ADH05), daily

Longs have a total loss of .0124

0.7663

0.7539

0.7663

0.7539

13 Sept. Oct. Nov. Dec. 2005 Feb

0.8100

0.8000

0.7900

0.7800

0.7700

0.7600

0.7500

0.7400

0.7300

0.7200

0.7100

0.7000

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

FIGURE 2 — AUSSIE DOLLAR



Figure 3 shows the Canadian dollar futures (CD) had con-solidated between approximately .8385 and .8276 inNovember 2004 before a final up leg created a new high. The

contract then sold off in December, passing below the supportarea defined by the congestion, which then became resistancethe market would have to surpass to make a new high.

In January the market twiceattempted to reach the .8385level, but both attempts failedand the market collapsed. Ifyou were unfortunate enoughto buy at the highest high ofthis second move (.8369) andwere using the .8276 level for astop point, you would havelost .0093, or $930, per contract.You would need the followingaccount sizes to trade one con-tract:

1. For this to be a 2-percentloss you would need $46,500($930/.02) of account equityper contract.



In Figure 4, the Euro FX con-tract (EC) fell from a high of1.33, breaching support at1.3239. This support level wasestablished by the congestionin December and January —the market repeatedly touchedthe level and bounced upwardbefore finally collapsing it to alower support at 1.3074. Hadyou hoped this to be a minorcorrection and held on to yourlong position, you would havebeen disappointed. With a tickvalue of $12.50, the total pointloss for the move betweenthese two levels was .0164, or$2,050. You would need thefollowing account sizes:

CURRENCY BASICS continued

March 2005 Euro FX futures (ECH05), daily

1.32390

1.30746

1.32390

1.30746

Nov. 15 Dec. 15 2005 20 Feb

1.40000

1.39000

1.38000

1.37000

1.36000

1.35000

1.34000

1.33000

1.32000

1.31000

1.30000

1.29000

If you allowed yourself to risk 10 percent of account equity per trade, you could take thisloss if you had a $20,500 account. Limiting risk to 2 percent of account equity wouldrequire $102,500.

FIGURE 4 — EURO FX


Longs have a total loss of .01644

March 2005 Canadian dollar futures (CDH05), daily

13 Sept. Oct. Nov. Dec. 2005 Feb

0.8500

0.8400

0.8300

0.8200

0.8100

0.8000

0.7900

0.7800

0.7700

0.7600

0.7500

The $1090 loss on this trade would be 2 percent of a $54,500 account, and 7 percent ofa $15,570 account.

FIGURE 3 — CANADIAN DOLLAR


0.8385

0.8276

0.8385

0.8276




3. For this to be a 10-percent loss youwould need $20,500 ($2,050/.10) ofaccount equity per contract.

A note on margin: The Euro FX con-tract has a minimum margin rate of$3,240, which means the exchangerequires you (your broker, actually) tohave this much money in your accountper contract. However, notice howmuch lower this amount is than thefigures quoted above. If you tradedwith minimum margin, the $2,050 losswould represent a 63-percent draw-down ($2,050/$3,240) in account equi-ty. Your trading approach and a con-servative equity percentage riskthreshold should determine howmuch money you need to trade — notthe minimum margin rate.

Finally, the following summarypresents a scenario for the NewZealand dollar/U.S. dollar spot forexrate (NZD/USD). Figure 5 showsNZD/USD consolidating after bouncing off its mid-Januarylow. If a trader took a short position on a breakdown movebelow the support level of the recent consolidation (at.7080) and the stop-loss was played above the recent high at.7215, the potential loss of .0135 (135 pips) is $1,350 usingthe standard $100,000 trade lot size and a pip (tick) value of$10. You would need the following account sizes to tradeone lot:

1. For this to be a 2-percent loss you would need $67,500($1,350/.02) of account equity per lot.



Each chart example had a technical support point thatextended $1,000 or more from the resistance point. If that

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

Integrating money management and trade strategy According to a recent survey, 65 percent of subscribers to afutures newsletter had less than $25,000 of equity in theirtrading accounts. The reality is that in order to enjoy long-term success, traders must give money management prior-ity over whatever trading approach they are using. Theymust assess their own maximum risk according to theiraccount value and stick to it.

Being able to accurately determine a stop-loss pointbased on a percentage of your account value is simply onepart money management process, but it will put you aheadof the majority of traders who are over-extending theiraccounts on a trade-by-trade basis.

As always, the goal is not to be “right” about a market’sdirection, but to be profitable. This can only be accom-plished by preserving the capital you start with and jeal-ously protecting the profits you accumulate.�


New Zealand dollar/U.S. dollar (NZD/USD), daily

Stop-loss

Support

Go short ifprice breaks

support

Consolidation

December 2005 February

0.725

0.720

0.715

0.710

0.705

0.700

0.695

0.690

0.685

The money-management principles used in the currency futures examples arealso applicable to the spot forex market. Here, a consolidation in the NZD/USDrate lets you establish a stop point and risk threshold.

FIGURE 5 — KIWI DOLLAR



T he price oscillator (PO)is a simple momentumindicator used mostly tohighlight shorter-term

market turning points and over-bought-oversold levels. It is some-times referred to as a “moving averageoscillator,” because it is constructedfrom two moving averages, similar tothe well-known moving average con-vergence-divergence (MACD) indica-tor.

It is an instructive indicator to studybecause it provides the groundworkfor other frequently used trading toolsand concepts.

CalculationThe price oscillator is calculated bysubtracting a longer-term movingaverage from a shorter-term movingaverage.

PO = MAS - MAL

where

MAS is a shorter-term moving aver-age (e.g., five bars), and

MAL is a longer-term moving aver-age (e.g., 20 bars).

Alternately, the shorter-term aver-age can be divided by the longer-term

average. A variation on this secondapproach is to divide the differencebetween the two moving averages bythe shorter moving average and multi-ply the result by 100. This expressesthe difference as a percentage of theshorter moving average:

PO = [( MAS - MAL)/ MAS ]*100

The resulting indicators are thesame as the original calculation exceptfor their scale.

The PO can be further modified byusing a different kind of moving aver-age — i.e., substituting an exponentialmoving average (EMA) for the more

commonly used simple mov-ing average (SMA).

The PO simply measures thedistance between the two mov-ing averages; the greater thedistance, the more momentum(up or down) the market isshowing — relative to thelength of the moving averages.In general, the shorter-termaverage essentially functionsas a substitute for price. Thesecond average represents alonger-term mean price valueor trend. The farther the short-er average moves above orbelow the longer average(resulting in higher or lowerPO values), the faster the mar-ket is moving.

Figure 1 is a daily chart witha “5-20” price oscillator — thatis, a PO using five- and 20-daySMAs. The PO exhibits thesame characteristics regardlessof time frame. Figure 2 shows a

CURRENCY BASICS

Euro/U.S. dollar (EUR/USD), daily

20-bar moving average


5-20 Price Oscillator

May June July Aug. Sept. Oct. Nov. Dec.

1.34

1.32

1.30

1.28

1.26

1.24

1.22

1.20

1.18

0.02

0.005

-0.01

The price oscillator (PO) is created by subtracting a longer-term moving average from ashorter-term average. When the market is moving sideways, the indicator swings fairlyregularly above and below the zero line. During the trend period, the indicator wasalmost exclusively in positive territory.

FIGURE 1 — THE PRICE OSCILLATOR


Indicator Basics:Price oscillator



10-40 PO (i.e., using 10- and40-bar moving averages) on a10-minute chart.

Interpretation and useThe PO is mostly used as amomentum indicator to high-light swing points and (rela-tive) overbought and oversoldlevels. When the indicatorreaches a high level, this sup-posedly reflects a potentiallyoverbought condition in themarket and warns of a poten-tial correction. The opposite istrue for low indicator read-ings.

Notice in Figure 1 the POoscillates above and below thezero line during the first half ofthe chart when the market ismoving sideways, then staysabove the zero line as the mar-ket trends upward. While themarket is moving sideways,the indicator’s relative highs and lowscorrespond to most of the price highsand lows — although there are noobjective, fixed levels to define “over-bought” or “oversold.”

Like other momentum indicators,divergence between price and the POsometimes accompanies marketexhaustion and correction. A diver-gence occurs when price moves in onedirection and the momentum indica-tor does not. The classic example iswhen price makes a higher high butthe indicator makes a lower high,which means price has pushed to anew level on weaker momentum. Insuch situations, a correction or rever-sal is possible.

In Figure 2, between 2:20 a.m and6:40 a.m. ET, price made a new low forthe day, rallied slightly, then made alower low. Meanwhile, the POmatched the first price low with a newlow of its own. However, the PO madea higher low when price made its newlow — a so-called “bullish diver-

continued on p. 48

Euro/Japanese yen (EUR/JPY), daily

September October November December 2005

140

138

136

134

132

1

-0.5

-2

2

1

0

The upper PO, which is composed of short-term moving averages, capturesshorter-term moves. The lower PO, which is composed of longer-term aver-ages, follows broader turns of the market.

FIGURE 3 — THE TIME-FRAME DIFFERENCE


Australian dollar/U.S. dollar (AUD/USD), 10-minute



Moving averagecrossovers

(above) are thesame as zero-line crossings(below)

Divergence

6:50 9:00 11:10 13:20 15:30 17:40 19:50 22:00 2/1 2:20 4:30 6:40 8:50 11:00

0.776

0.775

0.774

0.773

0.772

0.771

0.770

0.002

0.001

0.000

-0.001

Notice the crossovers of the 10- and 40-bar moving averages in the top part of the chart cor-respond to the PO crossing above and below its zero line. A “bullish divergence” occurred onthis chart when the price made a lower low but the indicator made a higher low.

FIGURE 2 — INTRADAY CHART WITH DIVERGENCE


10-40 price oscillator




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

Key pointsThe price oscillator is essentially a dif-ferent way of displaying a moving-average crossover, which is usuallyused as a basic trend-following tool:Directional (trend) changes are sig-naled when the shorter-term movingaverage crosses above or below thelonger-term average.

In the PO, the longer-term averagebecomes the horizontal “zero line.” Asa result, PO crosses above and belowthe zero line correspond to moving

average crossovers, which is evident inboth Figures 1 and 2.

The degree to which the PO reflectslonger- or shorter-term price swingsdepends on the length of the movingaverages used. Shorter averages will

reflect shorter price swings. Figure 3compares two POs: The top one iscomposed of short-term moving aver-ages (4 and 15 bars), and the bottom iscomposed of longer-term averages (20and 60 bars). The former capturesmore of the short-term, intratrendprice moves while the latter followsthe broader turns of the market.

The PO is an “unbounded” indica-

tor, meaning it does not fluctuate in afixed range (say, -100 to +100), as domost indicators referred to as oscilla-tors. As a result, determining whatconstitutes overbought or oversold isquite subjective, and is mostly a matter

of consulting the indicator readingsthat accompanied past highs and lowsand putting that information in thecontext of the current price action. Forexample, if the recent PO reading ishigher than the last three indicatorreadings that were followed by down-side reversals, traders might want tobe on the lookout for another reversal.

As is the case with any momentum,PO overbought and oversold signals,as well as divergences, can be verymisleading. They do not guaranteecorrections or reversals, or that thesewill be significant enough to tradeprofitably if they do, in fact, occur;they merely give cause to look for suchevents.

A market can remain overbought fora very long time if the uptrend isstrong enough; vice versa in a strongdowntrend. Similarly, a market maypost divergence after divergence in astrong trend, indicating a reversalwhen none is forthcoming.

Another look at Figure 1 shows howthe PO remained above the zero line,and was often at very high levelsthroughout much of the uptrend. Itnever produced a negative reading —let alone anything remotely close to anoversold signal (which would havetriggered long positions) — afterSeptember. Someone who sold inOctober because of the PO had pro-duced its highest reading in six monthswould have been quickly blown out bythe continuing trend. One way sometraders try to adjust to the influence ofa trend is to look for higher PO highsand lows in uptrends (vice versa indowntrends) than they normallywould in a sideways market. However,this is obviously a subjective process.

One aspect of oscillators that manytraders seek to exploit is the so-called“leading characteristic” — i.e., oscilla-

CURRENCY BASICS continued

Euro/Japanese yen (EUR/JPY), daily

September October November December 2005

142

140

138

136

134

132

1.5

0.0

-1.5

1

0.4

-0.2

-0.8

The minor differences in the two indicators are because the PO (middle) is usu-ally calculated using simple moving averages and the MACD (bottom) is calcu-lated using exponential moving averages. If the PO had been calculated usingEMAs, it would have been identical to the MACD, except for the absence of thesecond “signal” line.

FIGURE 4 — PO VS. MACD



12-26-9 MACD

The price oscillator measures the distance

between the two moving averages.


tors sometimes top or bottom andreverse before price. Prices must con-tinue to increase or decrease at anaccelerating rate for a momentumindicator to persistently rise or fall. Forexample, as an uptrend reaches its con-clusion, it may continue to gainground each day, but the gains may besmaller and smaller. This will bereflected by a declining oscillator,which is highlighting the loss ofupward momentum.

However, because it is based onmoving averages, which smooth pricesand therefore lag turning points, thePO exhibits less of a leading character-istic than other similar indicators. As aresult, it might be better suited to iden-tifying more intermediate-term turningpoints (using longer-term averages,say 10-bar and 40-bar, or 20-bar and 60-bar, etc.), similar to the MACD indica-tor it resembles so closely.

Figure 4 shows a PO consisting of12- and 26-day simple moving aver-ages, and below it an MACD lineusing the standard 12- and 26-dayexponential moving averages. The dif-ferences between the two indicators(aside from the MACD’s second line)are a result of the difference in themoving average calculations.

Bottom lineThe price oscillator is a basic technicalanalysis tool that takes a trend-follow-ing concept (the moving averagecrossover) and uses it as the basis of anoverbought-oversold indicator. It isessentially the same indicator as themoving average convergence-diver-gence (MACD) indicator, except that itdoes not use specific lengths for themoving averages.

It can provide a succinct summary ofthe current trend direction, as well as

indicate if a market is at a potentialexhaustion point. However, like all oscil-lators, it is prone to false signals in trend-ing markets, and it does not provide anybenchmarks for what constitutes excep-tionally high or low readings. �

Related reading

“Indicator Basics: Simple moving average,” Currency Trader, November 2004.

“Indicator Basics: Weighted andexponential moving averages,”Currency Trader, October 2004.

“Indicator Insight: Moving averageconvergence-divergence (MACD),”Active Trader, September 2001.

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�The Active Trader magazine group is launching its third monthly magazine, Options Trader, in April 2005.Like Currency Trader, Options Trader is an electronic magazine that readers can download each month. Each issue willcontain trading strategies, analysis, and news specifically for options investors and traders, as well as interviews withtop traders and insights from industry professionals. The magazine is delivered directly to your desktop each monthas an Adobe Acrobat PDF file that combines the look and feel of a high-quality print magazine with interactive elec-tronic features, such as Internet links and zoom capabilities. The first issue of Options Trader will be available in April2005. The first 5,000 subscriptions are free. For more information, visit www.optionstradermag.com.

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T he Euro/Swiss franc(EUR/CHF) ratespent much of 2003pushing higher,

while 2004 consisted of an initialsell-off followed by a period ofwide-ranging price swings (seeFigure 1).

In late-November 2004, the paircame close to matching its June2004 low before rallying into year-end, and then stalled out in January2005 before eclipsing the October2004 and January 2005 highs in Feb.2005 (see Figure 2).

This move turned out to besomething of a "bull trap," howev-er, as price quickly made a new2005 low in late February. The cli-max of this sell-off occurred on Feb.22, when EUR/USD plunged loweron a 112-pip wide-range bar andclosed near its low.

The next two days of price actionwere interesting: Feb. 23 was aninside day and Feb. 24 was a strongup-closing day that regained nearlyall of the Feb. 22 loss. Was this thebeginning of a turnaround to theupside?

In an attempt to find out what hadhappened in similar past situations,we created the following pattern def-inition: The bar two days ago had tohave a range of at least 75 pips; theclose of the bar two days ago had tobe at least 50 pips lower than theclose three days ago; today’s rangehad to be at least 50 pips; and today’slow had to be above the lows of theprevious two bars.

There were 10 other times thisthree-bar pattern appeared over thepast two years in this currency pair,and a few of the more recent onesare highlighted in Figure 2. In these

CURRENCY MOVERS

Euro/Swiss franc (EUR/CHF), weekly

Stochastic

July Oct. 2003 April July Oct. 2004 April July Oct. 2005

1.58

1.56

1.54

1.52

1.50

1.48

1.46

90

60

30

Although a technician might be inclined to think the currency pair is poised to dropfurther based on the chart and indicator conditions, testing of the three-bar patternhighlighted at various points on the chart has a slight upside bias.

FIGURE 1 — WEEKLY EURO/SWISS FRANC


Euro/Swiss franc (EUR/CHF), daily

August September October November December 2005 February

1.565

1.555

1.545

1.535

1.525

1.515

90

60

30

The highlighted pattern on the daily chart had very high odds of being followed byupside movement (albeit modest) starting the second day after the pattern com-pletes.

FIGURE 2 — DAILY EURO/SWISS FRANC


Euro/Swiss francThe current scenario for the Euro/Swiss franc rate is a tale of two time frames.

Stochastic


TABLE 1 — DAILY THREE-BAR REVERSAL PATTERN

Day 1 Day 2 Day 3 Day 4 Day 5 Day 6 Day 7 Day 8 Day 9 Day 10

Avg 0.10% 0.16% 0.26% 0.27% 0.27% 0.25% 0.33% 0.37% 0.40% 0.43%

Med 0.01% 0.07% 0.26% 0.36% 0.39% 0.31% 0.25% 0.24% 0.34% 0.41%

Max up 0.42% 0.62% 0.72% 0.89% 0.87% 1.00% 1.15% 1.18% 1.22% 1.33%

Max down -0.12% -0.27% -0.44% -1.32% -1.04% -0.97% -0.60% -0.36% -0.43% -0.42%

STD 0.21% 0.27% 0.32% 0.63% 0.52% 0.55% 0.50% 0.48% 0.48% 0.62%

%>0 50.00% 80.00% 80.00% 80.00% 90.00% 70.00% 80.00% 80.00% 90.00% 70.00%

Day 11 Day 12 Day 13 Day 14 Day 15 Day 16 Day 17 Day 18 Day 19 Day 20

Avg 0.52% 0.57% 0.63% 0.63% 0.65% 0.60% 0.82% 0.76% 0.87% 0.98%

Med 0.32% 0.57% 0.62% 0.53% 0.51% 0.56% 0.75% 0.52% 0.66% 0.75%

Max up 1.74% 1.57% 1.91% 2.26% 1.96% 1.73% 1.94% 2.02% 2.11% 2.46%

Max down -0.30% -0.30% -0.21% -0.84% -0.88% -1.39% -1.17% -1.14% -0.99% -0.88%

STD 0.70% 0.63% 0.66% 0.88% 0.85% 0.91% 0.92% 0.96% 0.95% 1.02%

%>0 70.00% 70.00% 70.00% 80.00% 80.00% 80.00% 90.00% 90.00% 90.00% 90.00%

instances, the pattern was followed byup moves, although the size andnature of these moves — and the con-text in which they developed — weredifferent.

Table 1 summarizes the average,median, maximum up, and maximumdown moves for the 20 days (on aclose-to-close basis) following thesepatterns. There’s an upside bias, butit’s not a particularly forceful one, onaverage. However, other than the 50-50 odds of an up move on day 1, theodds of a higher close (than the entryprice) on each of the other days isnever lower than 70 percent.

Returning to the weekly perspec-tive, Figure 1 highlights the three mostrecent bars as of Feb. 24, 2005, whichmarked a rather sharp decline from themulti-month high. To see if this patternhad any significance, we looked forsimilar events in the past, using thefollowing conditions: The high twoweeks ago minus this week’s low mustbe at least 150 pips; the high twoweeks ago must be higher than the 10highest high of the preceding weeks;this week’s high and low must belower than last week’s high and low,and last week’s high and low must belower than the high and low twoweeks ago.

There were nine previous instances ofthis pattern since May 2001, and as therepresentative ones in Figure 1 suggest,the price action following them was a

mixed bag.Table 2 shows the

performance forthis pattern. Theprobability of gainsand the size of thosegains are lower thanthose indicated forthe daily pattern inTable 2, but there isstill a slight bias tothe upside (but themost recent exam-ple in Oct. 2004 wasfollowed by moreselling).

Figures 1 and 2also show the sto-chastic oscillator,which many techni-cal traders mightconsult to deter-mine whether amarket is temporar-ily overbought oroversold. As onemight expect, thesharp drop on thedaily chart registersas oversold, while the weekly chart isjust turning below the stochastic over-bought threshold.

Pure chartists might be inclined tointerpret the current down thrust onthe weekly chart as a retreat from thetop on the current range, which wouldimply a move to the lower boundary

of the range. However, the Feb. 24daily high eclipsed the previous high;if the slightly bullish pattern statisticshave any significance, they suggest thecurrency pair could “buck the charts”and make for an up move in the nearfuture, with the potential for longer-term gains. �

TABLE 2 — WEEKLY THREE-BAR DECLINE PATTERN

Week 1 Week 2 Week 3 Week 4

Avg 0.06% 0.12% -0.10% 0.00%

Med 0.10% 0.16% 0.05% 0.37%

Max up 0.66% 0.73% 0.63% 0.99%

Max down -0.46% -0.60% -0.99% -1.54%

STD 0.35% 0.47% 0.56% 0.97%

%>0 55.56% 66.67% 55.56% 55.56%


Avg 0.13% 0.17% 0.14% 0.16%

Med 0.45% 0.13% -0.03% 0.12%

Max up 1.51% 1.28% 1.38% 1.38%

Max down -1.38% -0.91% -0.76% -1.22%

STD 1.06% 0.86% 0.77% 0.98%

%>0 55.56% 55.56% 44.44% 66.67%


Avg 0.06% -0.07% 0.07% 0.13%

Med 0.22% 0.24% 0.49% 0.72%

Max up 1.30% 1.23% 1.85% 2.02%

Max down -1.76% -1.83% -2.34% -2.98%

STD 1.09% 1.09% 1.30% 1.55%

%>0 66.67% 55.56% 55.56% 55.56%


It’s understandable why hedgefunds have become so popularin recent years — from a trad-er’s perspective. A talented

hedge-fund manager can accrue sub-stantial income, and while starting ahedge-fund obviously isn’t for thenovice forex trader, it’s not as compli-cated as it seems.

Let’s assume a trader has a modest$3 million under management and hisforex hedge fund has a 1-percent man-agement fee and a 20-percent perform-ance allocation fee (i.e., a share of theprofits). Assume the fund was startedon the first day of the year andreturned 15 percent.

In this case, the trader would havegross income of $120,000, consisting ofa $30,000 management fee ($3 million *1% = $30,000) and a $90,000 perform-ance allocation ($3 million * 15%return = $450,000 * 20% = $90,000).Using all the same assumptions, ahedge-fund manager with $10 millionunder management would make$400,000.

Also, because prospective investorslike to see fund managers’ risk theirpersonal capital, assume the fundmanager has a significant portion ofhis own money invested in the fund.Because there are no fees assessed (itwould just increase taxes), the traderearns an additional 30 percent on hisown investment in the fund.

However, before a trader can poten-tially enjoy these rewards, he or shemust structure a proper business. Thegood news is forex traders are nowpositioned to quickly launch a forex

fund with minimal regulatory over-sight.

Forex fund basicsRegulation D, Rule 506, of theSecurities Act of 1933 defines a forexfund as an unregistered securityoffered as a private placement.Regulation D provides “safe harbor”provisions which, if complied with,exempt the private offering from com-pliance with the registration andprospectus delivery requirements offederal securities laws. However,Regulation D does not exempt theoffering from compliance with thefraud provisions of the federal andvarious state securities laws.

Forex funds must supply allinvestors with comprehensive infor-mation about the offering in “disclo-sure documents.” The purpose of thesedocuments is to limit the hedge fund’spotential risk by providing full disclo-sure to investors.

A typical set of disclosure docu-ments includes a private placementmemorandum, an investor question-naire and subscription agreement, andan operating agreement for the fund.

Most foreign currency trading is eli-gible for favorable federal income taxtreatment. Regulated futures contracts,regulated commodity option contracts,

forward contracts, and over-the-count-er options in currencies for which thereis also trading in regulated futures, allqualify as “Section 1256 contracts.”Gains in these instruments are taxed ata maximum federal rate of 23 percent(60 percent of the gains and losses arelong-term and 40 percent is short-term). In addition, the fund usuallyqualifies as a “trader in commodities,”so the investors are able to deduct thefund’s expenses more favorably thanexpenses in an investment partner-ship.

Performance-based compensationfor fund advisers is usually structuredas an allocation of profits, but it issometimes structured as fees — in

either event typically between 10 and20 percent of trading profits. In someinstances, the compensation agree-ment specifies that funds be only paidwhen the profits of the fund exceed aminimum rate, or “hurdle rate.”

Exempt forex funds To be exempt from registration underthe Securities Act of 1933, a fund musthave no more than 100 beneficial own-ers (also known as the “100 investortest”) and must not publicly offer itsinterests.

Under the Section 3(c)(7) exemption,a fund must offer its securities to

BUSINESS OF TRADING

Forex hedge fund management

The number of hedge funds and hedge fund investors has soared. Forex traders looking to start a

fund need to understand the rules and regulations before they quit their day jobs.

BY HANNAH TERHUNE AND ROGER LORENCE

Most foreign currency trading is eligible for

favorable federal income tax treatment.


“qualified purchasers.” There are nolimitations on the number of qualifiedpurchasers under the InvestmentCompany Act of 1940.

However, when there are more than500 investors in the limited partner-ship, the entity my be subject to classi-fication as a “publicly traded entity.”If that occurs, the entity could lose itsflow-through tax treatment (i.e., apartnership) which is one of the pri-mary benefits of the hedge fund’sstructure.

Accredited vs. non-accreditedinvestors Generally, “accredited” investorsincludes persons whose net worth (orjoint net worth with spouse) exceeds$1,000,000, or whose income was inexcess of $200,000 in both the two pre-ceding years (or, with a spouse, inexcess of $300,000 in both the two pre-ceding years), and who reasonablyexpect to reach the same level ofincome in the current year.

If you plan to have “non-accreditedinvestors” in your fund, you will notonly need a detailed set of disclosuredocuments, but also audited documen-tation of the source of initial capitalinvested in the fund. This initial auditis referred to as a “launch audit” or asa “seed-capital audit.” Regulation Dlimits the number of non-accreditedinvestors to 35.

Taking on non-accredited investorsis risky because if there are ever anyproblems with the fund’s performanceand investors seek relief in the courts,a judge would probably take the sideof the non-accredited investor.

How do I attract investors?Rule 502(C) of Regulation D prohibitsany form of a general solicitation orgeneral advertising. Generally, inter-ests in your hedge fund may be soldby registered broker dealers, regis-tered investment advisors or officersof the fund’s management to thosepersons with whom they have exist-ing relationships.

Your marketing efforts must be per-continued on p. 54

Steps to launch a forex hedge fund

1. If you need to register as a Commodity Pool Operator (CPO), start theprocess, which you will continue while executing the rest of these steps. Seewww.iard.com to get started.

2. Determine what will make your hedge fund unique. Finalize the fund’sinvestment objective and investment strategies, prepare biographical data onyourself for the offering documents, and make decisions that will affect howoften you accept investors, how you will be compensated, what expensesyour fund (as opposed to the management company) will bear, how you willbe set up regarding trader tax status, etc.

3. If you are forming a commodity hedge fund, start the process of becominga member of the NFA. See this page: http://www.nfa.futures.org/registra-tion/nfa_membership.asp. You will need to register as a Commodity PoolOperator with the NFA. See http://www.nfa.futures.org/registration/cpo.asp.

4. Obtain a first draft of your offering documents (Private PlacementMemorandum, LLC Agreement, and Subscription Materials) from yourprovider (the firm advising you on setting up your hedge fund). Form yourbusiness entities, get tax ID numbers, make the appropriate IRS elections,and prepare resolutions so you can open bank and brokerage accounts.

5. Your provider’s attorney should be actively involved in the review of yourdocuments. This is an important part of the preparation of your fund.

6. If you are registered as an Investment Adviser or registered with the NFAas a Commodity Pool Operator, make sure the regulators have approved anysuch applications.

7. Your provider should give you the SEC Form D and the blue sky filings forthe initial states where you expect to distribute your offering documents.Make sure your provider gives you instructions on how and where to file thevarious documents, and general instructions regarding the distribution ofyour offering documents. You should now have a final set of offering docu-ments.

8. Have your offering documents printed and bound. Consider the image youwish your fund to project when choosing the printing materials and bindingmethod. Remember that you can have no marketing materials other thanyour offering documents.

9. Mail your SEC Form D. You can check here to see that it was processedby the SEC: http://www.sec.gov/edgar/searchedgar/companysearch.html.File your blue sky filings within the appropriate time – either before distribu-tion or within 15 days of the first sale in that state, depending on the state’srules.

10. Start distributing your offering documents and attracting investors. Keepa log of all individuals to whom you distribute your documents. Deposit yourseed capital and start the initial trading of the fund.


sonally directed toward investors whoare known to you. The SEC views non-personal communications as “generalsolicitations,” even when the targetedrecipients of the communicationscould reasonably be expected to bequalified investors.

However, it is possible to complywith the prohibitions against generalsolicitation or advertising by using asecure Web page for which access islimited to accredited investors.

Blue skyWithin 15 days of the first sale of youroffering, you will have to file yourForm D (Notice of Sale) with the SECas well as comply with filing require-ments of the states in which each ofyour investors are located. Then youneed to be sure that your securities aresold with out violating the prohibitionon general advertising.

NFA registration If your forex fund invests in currencyfutures contracts, currency futuresoptions, or forward contracts, it mustbe approved as a commodity pool bythe Commodity Futures TradingCommission (CFTC). In addition, youmust register with the National FuturesAssociation (NFA) and become aCommodity Pool Operator (CPO).

This raises the differences betweenregistration as a CPO and a commodi-ty-trading advisor (CTA). A CTA man-ages individual accounts, while a CPOmanages only the hedge fund, or pool.Many people lose interest in the CTAoption when they realize the adminis-trative hassles associated with manag-ing separate accounts.

Spot forex trading is not regulatedby the CFTC and does not require CPOregistration if the fund trades spot cur-rencies exclusively. Legally, “spot cur-rency” refers to contracts that settle bythe second business day after the datethe trade is entered.

While CFTC registration is notrequired for spot forex traders, it isimportant for fund managers to tradewith firms that are NFA registered, asNFA registered members are subject to

arbitration, capital requirement rules,and customer account regulations.

No sponsor is needed to take the Series3 exam, also known as the NationalCommodity Futures Examination, whichis administered under the auspices of theNASD’s testing program. You can findthe nearest testing location atwww.nasd.com/NASDW_010803.

The CFTC has allowed the NFA tobecome the primary regulator offutures and commodity products (as aself-regulatory organization, similar tothe NASD’s status with the SEC).

The item that will typically take themost time for processing of a CPOapplication is the fingerprint card,which is supplied by the NFA. A CPOwill take it to their local police stationand have their fingerprints taken. Thecard is then mailed to the NFA, whichsends it to the FBI for processing. Thistakes six to eight weeks, and there isno rush service available, so take careof this very early in the applicationprocess.

The NFA must approve all disclo-sure documents before they can beused to solicit clients. If the NFA hascomments, it will usually give them tothe CPO candidate verbally, and inwriting if the CPO candidate requests.

The guide for CPOs and CTAs (see“Web resources”) is an invaluable toolfor creating disclosure documents. TheNFA essentially uses that document asa checklist, and every item must beaddressed to their satisfaction beforethey will approve disclosure docu-ments.

The disclosure document mustinclude information about the CPOand its principals (including perform-ance record), commodity trading advi-sors, futures commission merchants,brokers, details of the commodityinterests, expenses associated with thepool, conflicts of interest, minimuminvestment amounts, transferabilityissues, and any litigation (material,administrative, civil, or criminal)against anyone involved in the man-agement of the fund. Additionally, anyperson who is involved in the com-modity pool must register as an associ-

ate of the CPO.The disclosure document must be

filed with the NFA at least 21 daysprior to the delivery of the documentsto a prospective participant, andupdated periodically. The CPO mustreceive a written confirmation fromeach participant in the pool that theyreceived the Disclosure Documentprior to accepting the participant’sfunds.

CPO registration exemptionsThe CFTC provides for several exemp-tions from CPO regulations. A personis not required to register as a CPO ifthe person did not receive any com-pensation or payment directly or indi-rectly, operated only one commoditypool at a time, or was not otherwiserequired to register with the CFTC.This is referred to as the “closely heldpool exemption.”

Registration as a CPO is also notnecessary from registration when totalgross capital contributions for partici-pation units in all pools that are oper-ated (or intended to be operated) donot in the aggregate exceed $400,000and there are less than 15 participantsin the pool.

Also exempt from registration as aCPO with respect to the pool, wherethe interests have been sold exclusive-ly to participants that the CPO reason-ably believes at the time of their invest-ments were QEPs, and the pool tradescommodities in de minimis amounts.The de minimis limitations are: 1) thepool limits its commodity interestspositions such that the aggregatenotional value of such positions doesnot exceed the liquidation value of thepools portfolio, or 2) the total amountthe pool commits as initial margin andpremiums to establish commoditypositions does not exceed 5 percent ofthe liquidation value of the pool’sportfolio. Another requirement is theinterests in the relevant pool are notmarketed as participants in a vehiclefor trading in commodity interests.

CFTC Rule 4.13(a)(4) establishes aCPO registration exemption for a CPOwith respect to a pool where interests

BUSINESS OF TRADING continued

www.nasd.com/NASDW_010803


are offered and sold without marketingto the public in the United States, andare sold exclusively to participants thatthe CPO reasonably believes are QEPs.

Are you going to trade stocks, too?If you plan to execute more than anoccasional stock trade, you might alsohave to register as an investmentadviser. Beginning in February 2006,hedge fund mangers will be requiredto register with the SEC as investmentadvisers when a fund has assets of $25million or more and has 15 or moreinvestors in the hedge fund.

Until then, the hedge fund itself isconsidered the “client” of the adviser,which affords the adviser an exemp-tion from registration if there are lessthan 15 clients and the adviser doesnot hold itself out to the public as aninvestment adviser.

Funds with less than $25 millionwill not be permitted to register andwill be subject to applicable state law.

State investment adviser registration Each state has its own registrationrequirements which are also interpret-ed in conjunction with the NationalSecurities Market Improvement Act of1996.

In some instances, where the invest-ment adviser has a particular kind ofclient, has fewer than a certain numberof clients within a 12-month consecu-tive period, and does not hold itselfout to the public as an “investmentadviser,” it may be exempt from thatstates’ registration requirement. Ineach instance, it is important that thelaw of the state in question bereviewed for compliance.

More rules and regsIn addition to the registration andsolicitation guidelines summarizedabove, there are also federal and statelaws governing the operation of thefund. These laws govern marketingand advertising, the compensation offund advisers, fund management, per-sonal trading, the use of soft dollars,

reporting requirements, and recordkeeping.

Although the process is involved,experienced forex traders who wish toexpand into professional money man-agement can save themselves a great

deal of trouble later by learning nowabout the forex hedge fund registra-tion process and regulations they willhave to abide by in the future. �


Web resources

http://www.nfa.futures.org/The home page for the National Futures Association (NFA).

http://www.nfa.futures.org/compliance/issues_cpo_cta.asp andhttp://www.nfa.futures.org/compliance/publications/dd2001/DD2004.pdfThe web pages are related to the NFA’s Guidance to Commodity PoolOperators (CPOs) and Commodity Trading Advisers (CTAs). The secondlink is particularly valuable. It essentially defines the sections that need tobe included with a CPO document that is submitted to the NFA. It also dis-cusses some of the various exemptions from registration that are available.Some of these exemptions (particularly the Qualified Eligible Person [QEP]– only pools) are very powerful and should be strongly considered. TheQEP exemption allows you to not have to take the Series 3, not have tobecome a member of the NFA, and not have the NFA or the CFTC as aregulator. Other exemptions, such as those related to small pools, may beof more benefit to certain clients.

http://www.nfa.futures.org/registration/cpo.asp. The NFA’s guidance related to who has to register as a CPO, and how it isaccomplished. It includes a link to a page for an "Easy Reference Guide" toexemptions from registration here: http://www.nfa.futures.org/registration/easyReferenceGuidePart4.pdf.

http://www.nfa.futures.org/registration/cta.asp The equivalent to #3, above, except that it is for CTAs.

http://www.nfa.futures.org/registration/nfa_membership.asp Data related to becoming a member of the NFA. All CPOs and CTAs must bemembers of the NFA, unless they achieve an exemption. Note the reducedfee schedule that became effective on July 1, 2004.

http://www.nfa.futures.org/basicnet/ This is the equivalent of the NASDR’s website, except that it is for the NFA.Through this page, you can access a summary of the status of all NFA mem-bers, including regulatory status and sanctions.

http://www.cftc.gov/cftc/cftclawreg.htm#cea This is an invaluable site to review the underlying federal law related to CFTCissues. Note the various links in the body of the page as well as on the leftnavigation buttons.

Securities Law: http://www.law.uc.edu/CCL/sldtoc.htmlState Securities Administrators: http://nasaa.org/members_only/CFTC Lawand Regulation links: http://www.cftc.gov/cftc/cftclawreg.htm#ceaInvestment Adviser application (for most states): www.iard.com

Our website (tons of additional data):http://www.greencompany.com/HedgeFunds/index.shtml

http://www.nfa.futures.org/

http://www.nfa.futures.org/compliance/issues_cpo_cta.asp

http://www.nfa.futures.org/compliance/publications/dd2001/DD2004.pdf

http://www.nfa.futures.org/registration/cpo.asp

http://www.nfa.futures.org/registration/cta.asp

http://www.nfa.futures.org/registration/nfa_membership.asp

http://www.nfa.futures.org/basicnet/

http://www.cftc.gov/cftc/cftclawreg.htm#cea

http://www.law.uc.edu/CCL/sldtoc.html

http://www.greencompany.com/HedgeFunds/index.shtml

Market(s): All.

System concept: This systemapplies Welles Wilder’s “parabolic”trend-following approach to theforex market. Wilder originallydescribed this system in his 1978book New Concepts in TechnicalTrading Systems.

The parabolic system is a stop-and-reverse (SAR) strategy — thatis, when a long trade is stopped outa short trade is simultaneouslyopened, and vice versa. The basicidea behind the system is the longera trend lasts, the more important it isto protect open profits. On the otherhand, the major drawback of mosttrend-following systems — gettingstopped out too early by small cor-rections or consolidation moveswithin the longer trend — must beavoided for the system to generate thelarge winning trades that will make upmost of its profits.

To balance these needs the parabolicuses a stop that trails well below or abovethe price bar at the beginning of a tradebut moves progressively closer to pricethe longer the trade lasts. This is accom-plished by a multiplier called the “accel-eration factor.” The steadily tighteningstop resembles a parabola, hence the sys-tem’s name (see Figure 1). The calcula-tion for the parabolic is:

SAR price level tomorrow = (SARprice today) + (Acceleration Factor *(Extreme Price - SAR level today))

There are myriad ways to enter andexit the market using the parabolicapproach. We chose the original parame-ters Wilder used in his book. (For moreinformation about the Parabolic system,see “Indicator Insight: Parabolic stop,”Active Trader, February 2005.)

Rules:1. Enter long when price hits today’s

upper parabolic stop value.


CURRENCY SYSTEM ANALYSIS

Equity Cash Linear Reg Long Short

Acc

ount

bal

ance

($)

1,500,0001,450,0001,400,0001,350,0001,300,0001,250,0001,200,0001,150,0001,100,0001,050,0001,000,000

950,000900,000850,000800,000750,000700,000650,000600,000550,000500,000450,000400,000350,000300,000250,000200,000150,000100,00050,000

03/3/95 11/24/95 9/10/96 6/26/97 4/14/98 1/29/99 11/16/99 8/31/00 6/19/01 4/5/02 1/21/02 6/11/03 8/24/04

The system performed terribly on daily data, losing money overalland producing only two profitable currency pairs.

FIGURE 2 — EQUITY CURVE (DAILY)

Parabolic FX Euro/U.S. dollar (EUR/USD), daily

Sell

Sell

SellSell

Sell

Sell

BuyBuy

BuyBuy

Buy

Buy

August 2004 September 2004 October 2004 November 2004 December 2004

1.35001.34501.34001.33501.33001.32501.32001.31501.31001.30501.30001.29501.29001.28501.28001.27501.27001.26501.26001.25501.25001.24501.24001.23501.23001.22501.22001.21501.21001.20501.20001.19501.1900

The parabolic system’s trailing stop moves closer to price as a trend lengthens.

FIGURE 1 — SAMPLE TRADES

Source for all figures: Wealth-Lab Inc. (www.wealth-lab.com)

www.wealth-lab.com


2. Enter short trade when price hits today’s lower parabolic stop

value.3. Exit long trade when price hitstoday’s lower

parabolic stop value.4. Cover short trade when price hitstoday’s upper

parabolic stop value.

Note: We tested the system on bothdaily and weekly timeframes.

Money Management: Risk 2 percent of total capital pertrade.

Test data: The system was tested on the following curren-cy pairs: Australian dollar/U.S. dollar (AUD/USD),Euro/U.S. dollar (EUR/USD), British pound/U.S. dollar(GBP/USD), U.S. dollar/Swiss franc (USD/CHF), U.S. dol-lar/Japanese yen (USD/JPY), and U.S. dollar/Brazilian real(USD/BRL). Note: Currency pairs for which the U.S. dollaris the base currency (e.g., USD/JPY) were inverted (e.g.,JPY/USD) to enable portfolio testing in dollar terms. Datasource: Comstock/FXtrek (www.fxtrek.com).

STRATEGY SUMMARY (WEEKLY)

Profitabilty Trade statistics

Net profit ($): 1,220,638.66 No. trades: 249

Net profit (%): 122.06 Win/loss (%): 42.23

Exposure (%): 10.10 Avg. gain/loss ($): 0.75

Profit factor: 1.31 Avg. hold time (days): 11.45

Payoff ratio: 2.03 Avg. winner (%): 5.23

Recovery factor: 2.26 Avg. hold time (winners): 17.15

Drawdown Avg. loser (%): -2.58

Max. DD (%): -31.41 Avg. hold time (losers): 7.23

Longest flat days: 150 Avg. consec. win/loss: 5/7

STRATEGY SUMMARY (DAILY)

Profitabilty Trade statistics

Net profit ($): -524,481.41 No. trades: 1,328

Net profit (%): -52.45 Win/loss (%): 37.20

Exposure (%): 10.07 Avg. gain/loss ($): -0.04

Profit factor: 0.92 Avg. hold time (days): 10.68

Payoff ratio: 1.60 Avg. winner (%): 2.11

Recovery factor: 0.65 Avg. hold time (winners): 17.19

Drawdown Avg. loser (%): -1.32

Max. DD (%): -65.42 Avg. hold time (losers): 6.82

Longest flat days: 2,048 Avg. consec. win/loss: 10/15

Acc

ount

bal

ance

(%)

0.00-5.00

-10.00-15.00-20.00-25.00-30.00-35.00-40.00-45.00-50.00-55.00-60.00-65.00

3/3/95 11/22/95 9/4/96 6/19/97 4/3/98 1/18/99 11/2/99 8/15/00 5/30/01 3/14/02 12/26/02 10/9/03 7/23/04

The system’s drawdown was huge — and it kept getting bigger.

FIGURE 3 — DRAWDOWN CURVE (DAILY)

continued on p. 58

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

Currency System Analysis strategies are tested on a portfolio basis(unless otherwise noted) using Wealth-Lab Inc.’s testing platform.

If you have a system you’d like to see tested, please send the trading and money-management rules to [email protected].

Disclaimer: Currency System Analysis is intended for educational purposes onlyto provide a perspective on different market concepts. It is not meant to recom-mend or promote any trading system or approach. Traders are advised to do theirown research and testing to determine the validity of a trading idea. Past perform-ance does not guarantee future results; historical testing may not reflect a sys-tem’s behavior in real-time trading.

LEGEND: Avg. return — The average percentage for the period • Sharpe ratio —Average return divided by standard deviation of returns (annualized) • Best return— Best return for the period • Worst return — Worst return for the period •Percentage profitable periods — The percentage of periods that were profitable •Max. consec. profitable — The largest number of consecutive profitable periods •Max. consec. unprofitable — The largest number of consecutive unprofitable periods

PERIODIC RETURNS

% % % Max. Max. Avg. Sharpe Best Worst profitable consec. consec.

return ratio return return periods profitable unprofitable

Weekly -0.08% -0.16 11.32% -13.50% 45.03% 7 8

Monthly -0.37% -0.17 20.22% -17.29% 48.31% 5 6

Quarterly -1.33% -0.26 25.91% 20.95% 42.50% 3 6

Yearly -6.24% -0.46 14.13% 28.04% 40.00% 2 2


www.fxtrek.com


Test period: December 1994 to December 2004 (exceptthe Brazilian Real, which spanned December 1999 toDecember 2004).

Starting equity: $1,000,000 U.S. Interest rate (rollover)fees were not calculated. We included a round-turn com-mission of 4 pips per every 100,000 units traded in the basecurrency and calculated 1 pip for slippage.

Test results:Daily: On the daily timeframe the sys-tem produced disappointing results,even though Figure 1 gives theimpression it captures trend movespretty well. But in fact there are toomany sideways periods and short-lived price swings producing losingtrades for the system’s smaller num-ber of big winners to compensate.

The total return was a disappointing52.45 percent loss with a drawdown of65.42 percent (Figure 2). The draw-down suggests it is only a matter oftime until the maximum loss willbecome even bigger. Only two curren-

cy pairs — AUD/USD (8.89 percent) and JPY/USD (16.96percent) — were profitable. But even this return was toolow to offer adequate compensation for the system’s risk.

Weekly:Although there was virtually nothing to recommendthe system on the daily timeframe, we then applied the samerules to weekly data and were surprised to find much differ-ent results. The system generated a profit of $1,220,639 over

10 years — 122.06 percent, or 8.47 per-cent annualized (Figure 4). The draw-down (Figure 5) shrank to 31.41 per-cent, which is not ideal but is nonethe-less a great improvement over the dailyresults. Also, the analysis of profitablevs. unprofitable periods improved sub-stantially.

Both applications of the parabolicsystem showed the same uncomfort-able habit of achieving more losingtrades than winning trades, but that’slife for trend followers.

Bottom line: The results of the twotest runs on daily and weekly datasuggest there are much clearer long-term trends than short-term trends incurrencies, or the trends that developon the weekly time frame are morelikely to have exploitable differencesbetween exit and entry prices. A typi-cal trend-following system such as thiswill have a much easier time in theweekly environment, with the addedbenefit of requiring less day-to-daymaintenance. It might be a good ideafor trend followers to periodicallycheck their systems on different timeframes to determine the friendliestenvironment.

CURRENCY SYSTEM ANALYSIS continued

Equity Cash Linear Reg Long Short

Acc

ount

bal

ance

($)

2,400,0002,300,0002,200,0002,100,0002,000,0001,900,0001,800,0001,700,0001,600,0001,500,0001,400,0001,300,0001,200,0001,100,0001,000,000

900,000800,000700,000600,000500,000400,000300,000200,000100,000

03/3/95 11/13/95 8/5/96 5/5/97 3/2/98 1/4/99 10/25/99 8/28/00 6/18/01 3/11/02 1/6/03 11/10/03 9/6/04

The same rules tested on weekly data produced much more favorableresults. The system turned a profit, despite being in a current slump.

FIGURE 4 — EQUITY CURVE (WEEKLY)

Acc

ount

bal

ance

(%)

0.00-2.00-4.00-6.00-8.00

-10.00-12.00-14.00-16.00-18.00-20.00-22.00-24.00-26.00-28.00-30.00

3/3/95 11/13/95 8/5/96 5/5/97 3/2/98 12/28/98 10/18/99 8/14/00 6/4/01 3/1/02 12/16/03 10/13/03 9/8/04

The weekly drawdown, while hardly unnoticeable, is still a dramatic improvement over the daily version of the system.

FIGURE 5 — DRAWDOWN CURVE (WEEKLY)

––Michael Schneider of Wealth-Lab

March 2005 • CURRENCY TRADER 59

GLOBAL NEWS BRIEFS

� France’s economy grew by 0.8 percent, boosted byincreased household consumption expenditure andexports. GDP grew 2.3 percent in 2004, 1.8 percent higherthan the previous year. The country’s unemployment rateremained stable at 9.9 percent compared to December, andwas also unchanged from a year earlier.

� Germany’s GDP fell 0.2 percent from Q3 2004, but grewby 1.8 percent compared to Q4 2004. An 0.8-percentdecrease in domestic uses helped cause the quarter-on-quarter decrease. The jobless rate in Germany grew 1.3percent to 12.1 percent and increased 1.1 percent comparedto January 2004.

� China’s National Bureau of Statistics (NBS) announcedthe country’s economy has stabilized and developed rapid-ly under new measures. “Preliminary estimation indicatedthe GDP of China in 2004 was 13,651.5 billion yuan, up 9.5percent over the previous year, without showing big upsand downs,” accordong to Li Deshui, commissioner of NBS.Good grain harvests and increased industrial productioncontributed to the gain. Also, the year showed improve-ment in the consumer markets, as total retail sales of con-sumer goods grew 10.2 percent. Retail sales enjoyed majorgains in communications products, which increased by 41.7percent and oil and related products, which increased by45.9 percent.

� Australia’s jobless rate remained unchanged at 5.1 per-cent compared to the previous month; the rate was 0.6 per-cent lower than January 2004.

� Unemployment in Hong Kong fell 0.1 percent to 6.4percent, its lowest level in three years. “The short-term out-look for unemployment will continue to hinge on the rate ofjob creation in the corporate sector relative to the growth inlabor force,” said a government spokesperson.

� Japan’s preliminary GDP data showed a 0.1 percentdecrease in GDP compared to the previous quarter, but a 0.6percent gain compared to the same quarter a year ago.Japan’s jobless rate decreased by 0.1 percent to 4.4 percentin December as compared to the previous month anddropped 0.5 percent from December 2003.

EUROPE

� Brazil’s unemployment rate fell 1 percent to 9.6 percentin December 2004. The average unemployment rate for2004 was 11.5 percent, 0.8 percent lower than 2003.

� The jobless rate for Canada remained stable at 7.0 per-cent compared to the previous month. Canada’s fourthquarter account surplus fell to $6.3 billion Canadian dol-lars (about $5 billion U.S.) from $8.36 billion Canadian thequarter before. Statistics Canada blamed the decline partlyon a falling trade surplus and a stronger Canadian dollar.

ASIA & THE SOUTH PACIFIC

* Unemployment rates refer to Q4 2004 or January 2005 numbers, unlessotherwise stated.

* All GDP is real, at current prices and seasonally adjusted unless other-wise stated. GDP is expressed as a growth/loss percentage and not as anexact rate.

AMERICAS

Rich nation, poor nation� Rodrigo Rato, head of the International MonetaryFund, said in late February he believes the world’s rich-est nations need to provide more help to poor nationsand urged them to take deliberate steps to fix globaleconomic imbalances. He specifically urged the UnitedStates to make every attempt to fix its budget gap,although he said he saw signs of restraint in PresidentBush’s 2006 budget.

Dollar still leads reserves� As of March 2004, the latest data available, totalinternational foreign currency reserves totaled $3.36trillion, almost double the 1998 year-end total. The for-eign currency reserves account for almost 95 percent ofthe globe’s non-gold reserve assets. About two-thirds ofthe reserves were held by developing countries, andaround 64 percent were denominated in U.S. dollars.Euros accounted for 20 percent, Japanese yen five per-cent, British pounds four percent and about half of apercent were denominated in Swiss francs.

� South Africa’s GDP increased at an annualized rate of 4percent compared to Q3 2004 as most sectors of the econo-my grew.

AFRICA

INTERNATIONAL MARKET SUMMARY


Currentprice vs. 1-month 3-month 6-month 52-week 52-week Previous

Rank* Country Currency U.S. dollar gain/loss gain/loss gain/loss high low rank

1 Brazilian 0.3858 3.50% 5.47% 12.49% 0.3899 0.3103 5real

2 South African 0.1728 2.89% 3.01% 13.14% 0.1783 0.1388 16rand

3 Australian 0.7867 2.22% 0.11% 9.39% 0.7956 0.6773 6dollar

4 Swiss 0.8597 1.86% -0.38% 8.43% 0.8879 0.7559 14franc

5 British 1.9097 1.64% 2.22% 5.35% 1.955 1.7479 12pound

6 New Zealand 0.7225 1.27% 1.44% 8.36% 0.7302 0.591 9dollar

7 Euro 1.3214 1.25% 1.01% 8.14% 1.3667 1.1758 13

8 Swedish 0.1455 1.03% -0.34% 9.07% 0.152 0.1283 15krona

9 Russian 0.03598 0.97% 2.45% 4.86% 0.03609 0.03414 11rouble

10 Sinapore 0.6147 0.44% 1.01% 4.91% 0.6158 0.5775 7dollar

11 Thai 0.02607 0.19% 3.68% 7.36% 0.02621 0.0239 2baht

12 Hong Kong 0.1282 0.00% -0.31% 0.00% 0.1288 0.1281 10dollar

13 Indian 0.02293 -0.04% 3.14% 5.54% 0.02304 0.02145 8rupee

14 Taiwanese 0.031219 -1.00% 1.34% 5.89% 0.03218 0.02801 1dollar

15 Canadian 0.808 -1.13% -4.36% 5.35% 0.8532 0.7138 4dollar

16 Japanese 0.009536 -2.03% -1.45% 4.50% 0.00983 0.0087 3yen

As of Jan. 24, 2005 *based on one-month gain/loss

FOREX (vs. U.S. DOLLAR)

INTEREST RATES

Rank Country Rate Feb. 24 1-month 3-month 6-month Previous1 Australia 3-year bonds 94.52 -0.16% -0.15% N/A 52 UK Short sterling 94.88 -0.33% -0.26% 0.14% 43 Japan Government Bond 138.86 -0.40% 0.53% 2.21% 34 U.S. 10-year T-note 111.1 -0.91% -0.88% -0.93% 15 Germany BUND 118.43 -1.22% 0.78% 4.02% 2


Rank Country 2004 Ratio* 2003 2005+

1 Hong Kong 16.404 10 16.697 16.5982 Taiwan 21.3 6.9 29.202 19.3783 Germany 118.525 4.4 52.933 129.7264 Japan 159.402 3.4 136.238 148.9315 Denmark 4.289 1.8 6.327 4.5436 Canada 28.195 2.9 17 25.2437 France -12.761 -0.6 5.474 -13.2468 Italy -18.074 -1.1 -21.942 -13.315

Rank Country 2004 Ratio* 2003 2005+

9 UK -43.338 -2 -33.39 -43.09810 Spain -33.066 -3.4 -23.549 -36.46211 U.S. -631.268 -5.4 -530.669 -641.67812 New Zealand -4.102 -4.4 -3.267 -4.15113 Australia -32.036 -5.3 -30.212 - 3 0 . 2 4 8

Totals in billions of U.S. dollars*Ratio: Account balance in percent of GDP; +Estimate

Source: International Monetary Fund, World Economic OutlookDatabase, October 2004

1-month 3-month 6-month 52-week 52-weekRank Country Index Current gain/loss gain/loss gain/loss high low Previous

1 Egypt CMA 1522.69 15.11% 22.77% 36.88% 1522.69 829.84 12 Brazil Bovespa 28436 14.90% 15.00% 19.57% 28436 17601 153 India BSE 30 6574.21 7.12% 8.19% 22.92% 6719.17 4227.5 144 Mexico IPC 13684.56 6.88% 12.99% 25.30% 13792.86 9423.99 85 Canada S&P/TSX composite 9657.74 6.00% 7.06% 13.89% 9729.91 8098.06 116 Hong Kong Hang Seng 14060.91 4.79% 0.45% 10.06% 14339.06 10917.65 137 Singapore Straits Times 2152.59 3.64% 5.22% 11.48% 2172.93 1690.35 48 France CAC 40 3977.67 3.27% 5.45% 9.64% 4042.27 3452.41 69 UK FTSE 100 4972.1 3.21% 5.08% 11.36% 5077.6 4283 510 US S&P 500 1200.2 3.04% 1.54% 8.67% 1217.9 1060.72 1211 Germany Xetra Dax 4304.29 2.38% 4.16% 12.39% 4409.09 3618.58 1012 Switzerland Swiss Market 5886.02 2.30% 6.54% 8.59% 5941.7 5264.5 313 Japan Nikkei 225 11531.15 2.10% 5.71% 4.73% 12195.66 10489.84 914 Australia All ordinaries 4100.6 1.29% 5.02% 13.68% 4188.8 3337 715 Italy MIBTel 24085 0.80% 7.05% 15.96% 24921 19655 2

Currency 1-month 3-month 6-month 52-week 52-weekRank pair Symbol Feb. 24 gain/loss gain/loss gain/loss high low Previous

1 Real / Yen BRL/JPY 40.4784 6.84% 6.84% 8.38% 41.1739 34.3301 122 Real / Canada $ BRL/CAD 0.4777 4.29% 9.42% 7.52% 0.4825 0.4212 103 Aussie $ / Yen AUD/JPY 82.519 4.24% 1.57% 5.16% 85.559 74.28 134 Franc / Yen CHF/JPY 90.1994 3.84% 1.07% 4.13% 91.6645 80.5368 195 Pound / Yen GBP/JPY 200.33 3.62% 3.63% 0.89% 208.03 189.5 166 Aussie $ / Canada $ AUD/CAD 0.974 3.54% 4.27% 4.23% 1.0373 0.8863 147 Euro / Yen EUR/JPY 138.6 3.25% 2.45% 3.80% 141.59 125.81 188 Franc / Canada $ CHF/CAD 1.0644 3.18% 3.80% 3.21% 1.1054 0.9952 209 Real / Euro BRL/EUR 0.2921 2.29% 4.52% 4.76% 0.301 0.2575 2

10 Real / Pound BRL/GBP 0.2021 1.88% 3.36% 7.57% 0.2069 0.1714 611 Real / Aussie $ BRL/AUD 0.4907 1.30% 5.38% 3.40% 0.5018 0.4337 1712 Aussie $vEuro AUD/EUR 0.5955 0.97% -0.91% 1.38% 0.6358 0.5643 413 Canada $ / Yen CAD/JPY 84.7701 0.64% -2.85% 0.90% 89.7805 78.0564 914 Aussie $ / Pound AUD/GBP 0.412 0.58% -2.16% 4.27% 0.4221 0.372 715 Franc / Euro CHF/EUR 0.6506 0.55% -1.40% 0.32% 0.665 0.6297 1116 Pound / Euro GBP/EUR 1.4459 0.41% 1.25% -2.99% 1.5279 1.4057 817 Aussie $ / Franc AUD/CHF 0.9155 0.37% 0.50% 1.07% 0.9894 0.8547 318 FrancvPound CHF/GBP 0.4502 0.20% -2.67% 3.24% 0.4647 0.4179 1519 Canada $ / Euro CAD/EUR 0.6116 -2.70% -5.43% -3.02% 0.6497 0.5916 1

20 Canada $ / Pound CAD/GBP 0.4232 -3.10% -6.71% 0.00% 0.454 0.397 5

NON-U.S. DOLLAR FOREX CROSS RATES

GLOBAL STOCK INDICES

ACCOUNT BALANCE


CURRENCY FUTURES

The information does NOT constitute trade signals. It is intended only to provide a brief synopsis of each market’sliquidity, direction and levels of momentum and volatility. See the legend for explanations of the different fields.

Contract Sym Exch Vol OI 10-day % 20-day % 60-day % Volatility move rank move rank move rank ratio/rank

Eurocurrency* EC CME 122.0 139.0 2.79% 63% 1.53% 26% -0.38% 7% .37 / 85%Japanese yen* JY CME 37.6 140.4 0.42% 33% -2.25% 74% -2.15% 72% .23 / 47%Canadian dollar* CD CME 25.7 74.7 0.07% 0% -0.09% 5% -4.40% 86% .22 / 39%Swiss franc** 6S CME (Globex) 20.3 53.1 4.62% 83% 1.67% 48% 2.04% 68% .50 / 95%British pound* BP CME 19.6 67.2 2.75% 77% 1.76% 37% 0.39% 7% .34 / 75%Australian dollar* AD CME 12.7 77.4 0.52% 12% 1.55% 48% 1.77% 29% .14 / 7%Mexican peso* MP CME 11.1 80.3 0.93% 44% 2.45% 82% 1.52% 38% .35 / 25%U.S. dollar index DX NYBOT 2.5 16.5 -2.27% 50% -0.98% 30% 1.34% 83% .36 / 92%Euro / Japanese yen EJ NYBOT 0.8 13.7 2.37% 73% 3.86% 100% 1.84% 48% .67 / 83%Euro / Swiss franc RZ NYBOT 0.6 12.1 -0.89% 63% -0.16% 20% 1.32% 37% .52 / 81%Note: Contracts marked with * or ** have both pit-traded and electronic contracts that are traded through the CME's Globex electronic platform. In these cases, welisted the contract with the highest volume — * indicates the pit-traded contract had larger volume; ** indicates the electronic contract had larger volume.

This information is for educational purposes only. Currency Trader provides this data in good faith, but cannot guarantee its accuracy or timeliness. Currency Trader assumesno responsibility for the use of this information. Currency Trader does not recommend buying or selling any market, nor does it solicit orders to buy or sell any market. There isa high level of risk in trading, especially for traders who use leverage. The reader assumes all responsibility for his or her actions in the market.

LEGEND:Sym: Ticker symbol.Vol: 30-day average daily volume, in thousands.OI: Open interest, in thousands.10-day move: The percentage price move from theclose 10 days ago to today’s close.20-day move: The percentage price move from theclose 20 days ago to today’s close.60-day move: The percentage price move from theclose 60 days ago to today’s close.

The “% Rank” fields for each time window (10-daymoves, 20-day moves, etc.) show the percentile rank ofthe most recent move to a certain number of the previ-ous moves of the same size and in the same direction.For example, the “% Rank” for 10-day move shows howthe most recent 10-day move compares to the pasttwenty 10-day moves; for the 20-day move, the “%Rank” field shows how the most recent 20-day movecompares to the past sixty 20-day moves; for the 60-day move, the “% Rank” field shows how the mostrecent 60-day move compares to the past one-hundred-twenty 60-day moves. A reading of 100% means the

current reading is larger than all the past readings, whilea reading of 0% means the current reading is lowerthan the previous readings. These figures provide per-spective for determining how relatively large or small themost recent price move is compared to past pricemoves.Volatility ratio/rank: The ratio is the short-term volatility(10-day standard deviation of prices) divided by thelong-term volatility (100-day standard deviation ofprices). The rank is the percentile rank of the volatilityratio over the past 60 days.

CURRENCY FUTURES SNAPSHOT as of 2/28/05

The Chicago Mercantile Ex-change (CME) will launchnew EuroFX and Japanese

yen options contracts with European-style expiration on its electronic Globexplatform in April. The CME alreadyoffers these contracts with American-style expiration via open outcry andduring a limited CME Globex tradingperiod.

These electronically traded currencyoptions contracts, which will be avail-able nearly 24 hours a day, will tradeside by side with the open outcry mar-kets. In similar fashion to its currencyfutures, CME will offer connectivity toa select group of automated marketmakers for these new options.

The European-style options on thesetwo futures contracts will be listed onApril 3 at 5:00 p.m. on Globex and inthe open outcry market on April 4 at7:20 a.m.

"Last year, our total FX volume grewmore than 50 percent, and our elec-tronic volume was up 128 percentfrom the prior year," said Rick Sears,Managing Director, CME ForeignExchange. "Now for the first time,investors will be able to trade ourfutures and options off the same elec-tronic platform nearly 24 hours a day.In addition, offering the choice of

European-style expiration, as well asAmerican-style expiration, allows ourinvestors flexibility in determininginvestment strategies and also pro-vides alternative tools that are more inline with the OTC market."

Average daily volume in CME Eurofutures and options was 86,757 in 2004.Volume in CME Japanese yen futuresand options was 31,070 in 2004.�

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

Turkish Derivatives Exchange opens Feb. 4

TurkDEX, Turkey's first futures and options exchange (VOB), is upand running as of Feb. 4. The exchange, based in the Aegean coastalcity of Izmir, will include currency futures contracts previously list-

ed on the Istanbul stock exchange and futures contracts listed on the Istanbulgold bourse.

After 11 years of discussion involving details of operation and where itwould be based, in March 2004 the exchange was approved by the CapitalMarkets Board (SPK) and was decided to be established in Izmir.�

EDITOR’S NOTE


Date Rate Entry Initial Initial IRR Exit Date P/L LOP LOL Trade stop target length

2/8/05 AUD/USD .7667 .7588 .7797 1.65 .7797 2/10/05 +.0130 .0221 .0038 2 days(1.7%)

TRADE SUMMARY

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

FOREX DIARY

Statistics and circumstances pointto an up move in the Aussie dollar.

TRADE

Date: Tuesday, Feb. 8, 2005.

Entry: Long the Australian dollar/U.S.dollar (AUD/USD) at .7667.

Reason(s) for trade/setup: On Feb. 8,AUD/USD traded sharply lower than theprevious session, but quickly rallied andeventually closed in the upper end of thetrading session’s range. This pattern,described in “Spike-low bottoms,” hasbeen followed the past few years by upmoves over the next four days; the averagelargest up move by the fourth day after thespike-low bar was 1.7 percent, with odds of64 percent for a positive move.

Readers of the Forex Diary in theFebruary 2005 Currency Trader will noticethis trade also fits into the consolidationpattern mentioned in the long AUD/USDtrade in that issue. Here, the Feb. 8 low andintraday upside reversal occurred at thelower end of the consolidation — which means chart-watchers may help the trade by going long at what appearsto be a likely point for a technical bounce.

Initial stop: The historical analysis showed the largestaverage down move in the four days after entry was -1.03percent. This translates to 160 pips, which we’ll use to setthe initial stop at .7588 (which also happens to be 20 pipsbelow the low of the entry bar).

Initial target: The average largest up move in the first fourdays was 1.7 percent, which we can use to set an initial tar-get of .7797. Because testing also indicated the profit poten-tial diminishes after day 4, we will exit the trade on theclose of day 4 if the target has not been hit.

RESULT

Exit: .7797.

Reason for exit: Market hitinitial profit target.

Profit/loss: +130 pips (1.7percent).

Trade executed according to plan? Yes.

Lesson(s): Given the way the market exploded throughthe profit target, it seems like it might have been a goodidea to take partial profits at the initial target level and usesome kind of trailing stop on the remainder of the position.The market rallied to .7888 two days after we exited,expanding the potential profit to 221 pips; even using a sim-ple trailing stop technique that exits below the low of theprevious bar would have gotten us out around .7842. Thetrade’s largest up move before pulling back occurred onday 4, which was the day identified in testing as the daywith the highest probability of an up move and the largestaverage gain.�


Initial stop

Long at .7667

Exit at .7797

Potential profit if trailingstop had been used

Initial target

0.795

0.790

0.785

0.780

0.775

0.770

0.765

0.760

0.755

24 31 February 7 14 21

Source: TradeStationAUD/USD, weekly

Aug. Sept. Oct. Nov. Dec. 2005 Feb.

0.80

0.78

0.76

0.74

0.72

0.70

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