The Foreign Exchange Interbank Market
by: rameshwor
The Ichimoku Kinko Hyo or equilibrium chart isolates higher probability trades in the forex market. It is new to the mainstream, but has been rising incrementally in popularity among novice and experienced traders. More known for its applications in the futures and equities forums, the Ichimoku displays a clearer picture because it shows more data points, which provide a more reliable price action. The application offers multiple tests and combines three indicators into one chart, allowing the trader to make the most informed decision. Learn how the Ichimoku works and how to add it to your own trading routine.Getting to Know IchimokuBefore a trader can trade effectively on the chart, a basic understanding of the components that make up the equilibrium chart need to be established. Created and revealed in 1968, the Ichimoku was developed in a manner unlike most other technical indicators and chart applications. Usually formulated by statisticians or mathematicians in the industry, the indicator was constructed by a Tokyo newspaper writer named Goichi Hosoda and a handful of assistants running multiple calculations.What they came up with is now used by many Japanese trading rooms because it offers multiple tests on the price action, creating higher probability trades. Although many traders are intimidated by the abundance of lines drawn when the chart is actually applied, the components can be easily translated into more commonly accepted indicators. Essentially made up of four major components, the application offers the trader key insight into FX market price action.
First, we'll take a look at both the Tenkan and Kijun Sens. Used as a moving average crossover, both lines are simple translations of the 20- and 50-day moving averages, although with slightly different time frames.1. The Tenkan Sen - Calculated as the sum of the highest high and the lowest low divided by two. The Tenkan is calculated over the previous seven to eight time periods.2. The Kijun Sen - Calculated as the sum of the highest high and the lowest low divided by two. Although the calculation is similar, the Kijun takes the past 22 time periods into account.What the trader will want to do here is use the crossover to initiate the position - this is similar to a moving average crossover. Looking at our example in Figure 1, we see a clear crossover of the Tenkan Sen (black line) and the Kijun Sen (red line) at point X. This decline simply means that near-term prices are dipping below the longer term price trend, signaling a downtrending move lower.
Figure 1 - A crossover in similar Western branded fashionNow let's take a look at the most important component, the Ichimoku "cloud”, which represents current and historical price action. It behaves in much the same way as simple support and resistance by creating formative barriers. The last two components of the Ichimoku application are:3. Senkou Span A - The sum of the Tenkan Sen and the Kijun Sen divided by two. The calculation is then plotted 26 time periods ahead of the current price action.4. Senkou Span B - The sum of the highest high and the lowest low divided by two. This calculation is taken over the past 44 time periods and is plotted 22 periods ahead.Once plotted on the chart, the area between the two lines is referred to as the Kumo, or cloud. Comparatively thicker than your run-of-the-mill support and resistance lines, the cloud offers the trader a thorough filter. Instead of giving the trader a visually thin price level for support and resistance, the thicker cloud will tend to take the volatility of the currency markets into account. A break through the cloud and a subsequent move above or below it will suggest a better and more probable trade.
Let's take a look Figure 2's comparison.Taking our USD/CAD example, we see a comparable difference between the two. Although we see a clear support at 1.1522 in our more standard chart (Figure 2), we subsequently see a retest of the level. At this point, some trades probably will be stopped out as the price action comes back against the level, which is somewhat concerning for even the most advanced trader.
However, in our Ichimoku example (Figure 3), the cloud serves as an excellent filter. Taking the volatility and apparent take back into account, the cloud suggests a better trade opportunity on a break of the 1.1450 figure. Here, the price action does not trade back, keeping the trade in the overall downtrend momentum.Last is the Chikou Span. Seen as simple market sentiment, the Chikou is calculated using the most recent closing price and is plotted 22 periods behind the price action. This feature suggests the market's sentiment by showing the prevailing trend as it relates to current price momentum. The interpretation is simple: as sellers dominate the market, the Chikou span will hover below the price trend while the opposite occurs on the buy side. When a pair remains bid in the market or is bought up, the span will rise and hover above the price action.Putting It All TogetherLike everything else, there's no better substitute for learning but through application. Let's break down the best method of trading the Ichimoku cloud technique.
Trading The Cloud…Taking our U.S. dollar/Japanese yen example in Figure 4, we'll zoom in on a more recent scenario in Figure 5. With the currency pair fluctuating in a range between 116 and 119 figures for the beginning of the year, traders were anxious to see a breakout of the persistent range. Here, the cloud is a product of the range-bound scenario over the first four months and stands as a significant support/resistance barrier. With that established, we look to the Tenkan and Kijun Sen. As mentioned before, these two act as a moving average crossover with the Tenkan representing a more short-term moving average and the Kijun acting as the base line. As a result, the Tenkan dips below the Kijun, signaling a decline in price action. However, with the crossover occurring within the cloud at Point A in Figure 5, the signal remains unclear and will need to be clear of the cloud before an entry can be considered. We can also confirm the bearish sentiment through the Chikou Span, which at this point remains below the price action. Conversely, if the Chikou was above the price action, it would confirm bullish sentiment. Putting it all together, we are now looking for a short position in our U.S.dollar/Japanese yen currency pair.Because we are equating the cloud to a support/resistance barrier, we will want to see a close of the session below the cloud before initiating any type of short sell position. As a result, we will be entering at Point B on our chart. Here, we have a confirmed break of the cloud as the price action stalls on a support level at 114.56. The trader, at this point, can opt to place the entry at the support figure of 114.56 or place the order one point below the low of the session. Placing the order one point below would act as confirmation that the momentum is still in place for another move lower. Subsequently, we place the stop just above the high of the candle within the cloud formation. In this example, it would be at Point C or 116.65. The price action should not trade above this price if the momentum remains. Therefore, we have an entry at 114.22 and a corresponding stop at 116.65, leaving our risk out at 243 pips. In keeping with sound money management, the trade will have to have a minimum of a 1:1 risk/reward ratio with a preferable 2:1 risk/reward for legitimate opportunities. In our example, we will maintain a 2:1 risk/reward ratio as the price moves lower to hit a low of 108.96 before pulling back. This equates to roughly 500 pips and a 2:1 risk to reward - a profitable opportunity. One key note to remember: notice how the Ichimoku is applied to longer time frames, in this instance the daily. With the volatility in shorter time frames, the application will tend not to work as well as with many technical indicators.7 Things Every Investor Must Know!To Recap:1. Refer To The Kijun / Tenkan Cross - The potential crossover in both lines will act in similar fashion to the more recognized moving average crossover. This technical occurrence is great for isolating moves in the price action.2. Confirm Down / Uptrend With Chikou - Confirming that the market sentiment is in line with the crossover will increase the probability of the trade as it acts in similar fashion with a momentum oscillator.3. Price Action Should Break Through The Cloud - The impending down/uptrend should make a clear break through of the cloud of resistance/support. This decision will increase the probability of the trade working in the trader's favor.4. Follow Money Management When Placing Entries - By adhering to strict money management rules, the trader will be able to balance risk/reward ratios and control the position. The Round UpIntimidating at first, once the Ichimoku chart is broken down, every trader from novice to advanced will find the application helpful. Not only does it mesh three indicators into one, but it also offers a more filtered approach to the price action for the currency trader. Additionally, this approach will not only increase the probability of the trade in the FX markets, but will assist in isolating only the true momentum plays. This is opposed to riskier trades where the position has a chance of trading back former profits.The Foreign Exchange Interbank Market According to an April 2004 report by the Bank for International Settlements, the foreign exchange market has an average daily volume of close to $2,000 billion, making it the largest market in the world. Unlike most other exchanges such as the New York Stock Exchange or the Chicago Board of Trade, the FX market is not a centralized market. In a centralized market, each transaction is recorded by price dealt and volume traded. There is usually one central place back to which all trades can be traced and there is often one specialist or market maker. The currency market, however, is a decentralized market. There isn't one "exchange" where every trade is recorded. Instead, each market maker records his or her own transactions and keeps it as proprietary information. The primary market makers who make bid and ask spreads in the currency market are the largest banks in the world. They deal with each other constantly either on behalf of themselves or their customers. This is why the market on which banks conduct transactions is called the interbank market. The competition between banks ensures tight spreads and fair pricing. For individual investors, this is the source of price quotes and is where forex brokers offset their positions. Most individuals are unable to access the pricing available on the interbank market because the customers at the interbank desks tend to include the largest mutual and hedge funds in the world as well as large multinational corporations who have millions (if not billions) of dollars.
Despite this, it is important for individual investors to understand how the interbank market works because it is one the best ways to understand how retail spreads are priced, and to decide whether you are getting fair pricing from your broker. Read on to find out how this market works and how its inner workings can affect your investments.Who makes the prices?Trading in a decentralized market has its advantages and disadvantages. In a centralized market, you have the benefit of seeing volume in the market as a whole but at the same time, prices can easily be skewed to accommodate the interests of the specialist and not the trader. The international nature of the interbank market can make it difficult to regulate, however, with such important players in the market, self-regulation is sometimes even more effective than government regulations. For the individual investor, a forex broker must be registered with the Commodity Futures Trading Commission as a futures commission merchant and be a member of the National Futures Association (NFA). The CFTC regulates the broker and ensures that he or she meets strict financial standards.According to the "Wall Street Journal Europe" (February 2006), 73% of total forex volume is done through 10 banks. These banks are the brand names that we all know well, including Deutsche Bank, UBS, Citigroup and HSBC. Each bank is structured differently but most banks will have a separate group known as the Foreign Exchange Sales and Trading Department. This group is responsible for making prices for the bank's clients and for offsetting that risk with other banks. Within the Foreign Exchange group, there is a sales and a trading desk. The sales desk is generally responsible for taking the orders from the client, getting a quote from the spot trader and relaying the quote to the client to see if they want to deal on it. This three-step process is quite common because even though online foreign exchange trading is available, many of the large clients who deal anywhere from $10 million to $100 million at a time (cash on cash), believe that they can get better pricing dealing over the phone than over the trading platform. This is because most platforms offered by banks will have a trading size limit because the dealer wants to make sure that it is able to offset the risk.On a foreign exchange spot trading desk, there are generally one or two market makers responsible for each currency pair. That is, for the EUR/USD, there is only one primary dealer that will give quotes on the currency. He or she may have a secondary dealer that gives quotes on a smaller transaction size. This setup is mostly true for the four majors where the dealers see a lot of activity. For the commodity currencies, there may be one dealer responsible for all three commodity currencies or, depending upon how much volume the bank sees, there may be two dealers. This is important because the bank wants to make sure that each dealer knows its currency well and understands the behavior of the other players in the market.
Usually, the Australian dollar dealer is also responsible for the New Zealand dollar and there is often a separate dealer making quotes for the Canadian dollar. There usually isn't a "crosses" dealer - the primary dealer responsible for the more liquid currency will make the quote. For example, the Japanese yen trader will make quotes on all yen crosses. Finally, there is one additional dealer that is responsible for the exotic currencies such as the Mexican peso and the South African rand. This setup is mimicked usually across three trading centers - London, New York and Tokyo. Each center passes the client orders and positions to another trading center at the end of the day to ensure that client orders are watched 24 hours a day. How do banks determine the price?Bank dealers will determine their prices based upon a variety of factors including, the current market rate, how much volume is available at the current price level, their views on where the currency pair is headed and their inventory positions. If they think that the euro is headed higher, they may be willing to offer a more competitive rate for clients that want to sell euros because they believe that once they are given the euros, they can hold onto them for a few pips and offset at a better price. On the flip side, if they think that the euro is headed lower and the client is giving them euros, they may offer a lower price because they are not sure if they can sell the euro back to the market at the same level at which it was given to them. This is something that is unique to market makers that do not offer a fixed spread.How does a bank offset risk?Similar to the way we see prices on an electronic forex broker's platform, there are two primary platforms that interbank traders use: one is offered by Reuters Dealing and the other is offered by the Electronic Brokerage Service (EBS). The interbank market is a credit-approved system in which banks trade based solely on the credit relationships they have established with one another. All of the banks can see the best market rates currently available; however, each bank must have a specific credit relationship with another bank in order to trade at the rates being offered. The bigger the banks, the more credit relationships they can have and the better pricing they will be able access. The same is true for clients such as retail forex brokers. The larger the retail forex broker in terms of capital available, the more favorable pricing it can get from the interbank market. If a client or even a bank is small, it is restricted to dealing with only a select number of larger banks and tends to get less favorable pricing.Both the EBS and Reuters Dealing systems offer trading in the major currency pairs, but certain currency pairs are more liquid and are traded more frequently over either EBS or Reuters Dealing. These two companies are continually trying to capture each other's market shares, but as a guide, the following is the breakdown where each currency pair is primarily traded:EBS ReutersEUR/USD GBP/USDUSD/JPY EUR/GBPEUR/JPY USD/CADEUR/CHF AUD/USDUSD/CHF NZD/USDCross currency pairs are generally not quoted on either platform, but are calculated based on the rates of the major currency pairs and then offset through the legs. For example, if an interbank trader had a client who wanted to go long EUR/CAD, the trader would most likely buy EUR/USD over the EBS system and buy USD/CAD over the Reuters platform. The trader then would multiply these rates and provide the client with the respective EUR/CAD rate. The two-currency-pair transaction is the reason why the spread for currency crosses, such as the EUR/CAD, tends to be wider than the spread for the EUR/USD. The minimum transaction size of each unit that can be dealt on either platforms tends to one million of the base currency. The average one-ticket transaction size tends to five million of the base currency. This is why individual investors can't access the interbank market - what would be an extremely large trading amount (remember this is unleveraged) is the bare minimum quote that banks are willing to give - and this is only for clients that trade usually between $10 million and $100 million and just need to clear up some loose change on their books. ConclusionIndividual clients then rely on online market makers for pricing. The forex brokers use their own capital to gain credit with the banks that trade on the interbank market. The more well capitalized the market makers, the more credit relationships they can establish and the more competitive pricing they can access for themselves as well as their clients. This also means that when markets are volatile, the banks are more obligated to give their good clients continuously competitive pricing. Therefore, if a forex retail broker is not well capitalized, how they can access more competitive pricing than a well capitalized market maker remains questionable. The structure of the market makes it extremely difficult for this to be the case. As a result, it is extremely important for individual investors to do extensive due diligence on the forex broker with which they choose to trade.Stop Hunting With The Big PlayersThe forex market is the most leveraged financial market in the world. In equities, standard margin is set at 2:1, which means that a trader must put up at least $50 cash to control $100 worth of stock. In options, the leverage increases to 10:1, with $10 controlling $100. In the futures markets, the leverage factor is increased to 20:1. For example, in a Dow Jones futures e-mini contract, a trader only needs $2,500 to control $50,000 worth of stock. However, none of these markets approaches the intensity of the forex market, where the default leverage at most dealers is set at 100:1 and can rise up to 200:1. That means that a mere $50 can control up to $10,000 worth of currency. Why is this important? First and foremost, the high degree of leverage can make FX either extremely lucrative or extraordinarily dangerous, depending on which side of the trade you are on. In FX, retail traders can literally double their accounts overnight or lose it all in a matter of hours if they employ the full margin at their disposal, although most professional traders limit their leverage to no more than 10:1 and never assume such enormous risk. But regardless of whether they trade on 200:1 leverage or 2:1 leverage, almost everyone in FX trades with stops. In this article, you'll learn how to use stops to set up the "stop hunting with the big specs" strategy. Stops are KeyPrecisely because the forex market is so leveraged, most market players understand that stops are critical to long-term survival. The notion of "waiting it out", as some equity investors might do, simply does not exist for most forex traders. Trading without stops in the currency market means that the trader will inevitably face forced liquidation in the form of a margin call. With the exception of a few long-term investors who may trade on a cash basis, a large portion of forex market participants are believed to be speculators, therefore, they simply do not have the luxury of nursing a losing trade for too long because their positions are highly leveraged.
Because of this unusual duality of the FX market (high leverage and almost universal use of stops), stop hunting is a very common practice. Although it may have negative connotations to some readers, stop hunting is a legitimate form of trading. It is nothing more than the art of flushing the losing players out of the market. In forex-speak they are known as weak longs or weak shorts. Much like a strong poker player may take out less capable opponents by raising stakes and "buying the pot", large speculative players (like investment banks, hedge funds and money center banks) like to gun stops in the hope of generating further directional momentum. In fact, the practice is so common in FX that any trader unaware of these price dynamics will probably suffer unnecessary losses. Because the human mind naturally seeks order, most stops are clustered around round numbers ending in "00". For example, if the EUR/USD pair was trading at 1.2470 and rising in value, most stops would reside within one or two points of the 1.2500 price point rather than, say, 1.2517. This fact alone is valuable knowledge, as it clearly indicates that most retail traders should place their stops at less crowded and more unusual locations.More interesting, however, is the possibility of profit from this unique dynamic of the currency market. The fact that the FX market is so stop driven gives scope to several opportunistic setups for short-term traders. In her book "Day Trading The Currency Market" (2005), Kathy Lien describes one such setup based on fading the "00" level. The approach discussed here is based on the opposite notion of joining the short-term momentum. Taking Advantage of the HuntThe "stop hunting with the big specs" is an exceedingly simple setup, requiring nothing more than a price chart and one indicator. Here is the setup in a nutshell: On a one-hour chart, mark lines 15 points of either side of the round number. For example, if the EUR/USD is approaching the 1.2500 figure, the trader would mark off 1.2485 and 1.2515 on the chart. This 30-point area is known as the "trade zone", much like the 20-yard line on the football field is known as the "redzone". Both names communicate the same idea - namely that the participants have a high probability of scoring once they enter that area. The idea behind this setup is straightforward. Once prices approach the round-number level, speculators will try to target the stops clustered in that region. Because FX is a decentralized market, no one knows the exact amount of stops at any particular "00" level, but traders hope that the size is large enough to trigger further liquidation of positions - a cascade of stop orders that will push price farther in that direction than it would move under normal conditions. Therefore, in the case of long setup, if the price in the EUR/USD was climbing toward the 1.2500 level, the trader would go long the pair with two units as soon as it crossed the 1.2485 threshold. The stop on the trade would be 15 points back of the entry because this is a strict momentum trade. If prices do not immediately follow through, chances are the setup failed. The profit target on the first unit would be the amount of initial risk or approximately 1.2500, at which point the trader would move the stop on the second unit to breakeven to lock in profit. The target on the second unit would be two times initial risk or 1.2515, allowing the trader to exit on a momentum burst. Aside from watching these key chart levels, there is only one other rule that a trader must follow in order to optimize the probability of success. Because this setup is basically a derivative of momentum trading, it should be traded only in the direction of the larger trend. There are numerous ways to ascertain direction using technical analysis, but the 200-period simple moving average (SMA) on the hourly charts may be particularly effective in this case. By using a longer term average on the short-term charts, you can stay on the right side of the price action without being subject to near-term whipsaw moves. ConclusionThe "stop hunt with the big specs" is one of the simplest and most efficient FX setups available to short-term traders. It requires nothing more than focus and a basic understanding of currency market dynamics. Instead of being victims of stop hunting expeditions, retail traders can finally turn the tables and join the move with the big players, banking short-term profits in the process.Inside Day Bollinger Band Turn TradeWe have long been taught that to be a successful trader, your objective should be to buy low and sell high or buy high and sell higher (and vice versa for shorts). Different strategies approach this most basic definition of speculation in various ways. Trend traders look to buy strength on the breakout and sell weakness on the breakdown. Good trend traders can make great sums of money in the long term with just a few big winners. However, most find applying trend trading far more difficult than the theory behind it. Simply stated, the human brain is not wired to trade trends. For example, buying the breakout in GBP/USD at 1.8000 (after it had bottomed at 1.7229 34 weeks earlier) and holding until 1.9000 sounds great, but human tendency makes it difficult to buy something at what is perceived as a high price (such as 1.8000). Furthermore, false breakouts will whipsaw a trader out of many trades - it simply isn't an efficient way to trade. On the other hand, traders that attempt to pick bottoms and tops usually get blown out of the water because they either do not have a method or they fail to follow their method - the end result is akin to attempting to stop a freight train by standing in front of it. Traditional trend trading (buying and selling breakouts) seems far too challenging from a psychological point of view, but for a novice trader, picking tops and bottoms at the same time is simply dangerous. What we need is a relative definition of high and low and a filter to help identify proper top and bottom trades. In this article we'll take a look at the inside day Bollinger band, which can help objectively measure what is high and low. Combining Inside Days with Bollinger BandsPrices at the upper Bollinger band are considered high and prices at the lower Bollinger band are considered low. However, just because prices have hit the upper Bollinger does not necessarily mean that it is a good time to sell. Strong trends will 'ride' these bands and wipe out any trader attempting to buy the 'low' prices in a downtrend or sell the 'high' prices in an uptrend. Therefore, just buying at the lower band and selling at the upper band is out of the question. By definition, price makes new highs in an uptrend and new lows in a downtrend, which means that they will naturally be hitting the bands. With this information in mind, our filter will require that buy signals occur only if the candle following the one that hits the Bollinger band does not make a new high or low. This type of candle is commonly known as an inside day. The best time frames to look for the inside days are daily charts, but this strategy can also be used on hourly, weekly and monthly charts. Combining inside days with Bollinger bands increases the likelihood that we are only picking a top or bottom after prices have hit extreme levels. As a rule of thumb, the longer the time frame, the rarer the trade will be, but the signal will also be more significant. Candlesticks and their respective patterns illustrate the psychology of the market at a particular point in time. Specifically, the inside candle represents a period of contracted volatility. If, in an uptrend, volatility begins to slow and the market fails to make a new high (as illustrated by the inside candle), then we can deduce that strength is waning and that the chance for a reversal exists. When combined with a Bollinger band, we ensure that we are trading a reversal only by either selling high prices (higher Bollinger band) are buying low prices (lower Bollinger band). In this way, we trade for the big move; not necessarily selling the low tick or buying the bottom tick but definitely buying near the relative bottom and selling near the relative top. The key is confirmation.Since Bollinger bands typically use a length of 20, we can employ a 20-period simple moving average (SMA) as a target to take profit. The 20 period SMA will trade equidistant from the upper and lower Bollinger bands. To catch large moves, allow the pair to trade through the 20-period SMA and then trail your stop with the moving average, only closing trades on the close after the pair crosses the SMA again. The examples below will shed light on this process. We have four guidelines. We'll call these guidelines (rather than rules) because this is a strategy that involves discretion. The guidelines present a trade setup that may or may not result in a trade.For longs: 1. Look for the currency pair to hit or come very close to hitting the lower Bollinger. 2. Wait for next candle and make sure that the next candle's low is greater than or equal to the previous candle's low and that the high is also less than or equal to the previous period's high. If so, go long at the open of the third candle.3. The initial stop is placed a few pips below the previous candle's low.4. Trail stop on a closing basis with the 20-period SMA.For shorts:1. Look for the currency pair to hit or come very close to hitting the upper Bollinger. 2. Wait for next candle and make sure that the next candle's high is less than or equal to the previous candle's high and that the low is also greater than or equal to the previous period's low. If so, go short at the open of the third candle.3. The initial stop is placed a few pips above the previous candle's high.4. Trail stop on a closing basis with the 20-period SMA.Longer Term ChartsThe inside day Bollinger band setup can also be used to identify major turns on weekly or even monthly charts for the longer-term position trader. The following examples show signals of our setup at major tops in GBP/USD (weekly chart) in Figure 4, a major bottom in EUR/GBP (weekly chart) in Figure 5 as well as well as a buy signal that indicated an all-time low in EUR/USD back in late 2000 on the monthly chart shown in Figure 6, and finally a USD/JPY sell signal in Figure 7 that was triggered in February 2002 at 133.36 on a monthly chart. In the last example, the pair closed at 119.49 just four months later! BenefitsThere are many benefits to the inside day Bollinger band strategy. The most obvious is its simplicity. Creating a trading strategy is not rocket science, but those that treat it as such usually end up frustrated and confused and - worse still - with a losing trading record. We can easily measure risk with this strategy and place stops appropriately. In other words, we have distinct points of reference (the inside day's high and low) from which to enter the trade and place stops. The setup is dynamic, meaning that it works on all time frames. Even a short-term day trader could use it on an hourly chart. However, the shorter the time frame, the less reliable the signal. Remember that candlesticks and their patterns shine light on the psychology of the market. An hourly chart encompasses a smaller amount of market data than a daily chart. As a result, an hourly chart is not as true an indication of mass psychology as a daily chart. ConclusionThis setup is just that - a setup. The trade should be managed according to your risk parameters and your trading style. Some may prefer to sell on a retrace after a short signal occurs, while others may prefer to sell a break of a daily low after a short signal. As we mentioned above, alter the size of the trade and the exit strategy. For example, trade multiple lots (if account size permits) and take profit on one lot at the 20 SMA, take profit on another lot at the opposite Bollinger band, and trail another lot(s) with the 20 SMA. Regardless of how you choose to implement this strategy, keep in mind that the FX market is an extremely trending market, which makes it even more important for range traders to get confirmation before trying to pick tops and bottoms. Combining inside days with Bollinger bands is a simple way of waiting for confirmation before taking the trade.Is Pressing The Trade Just Pressing Your Luck?Almost everyone who has ever traded has scaled down into a trade at least once in his or her career. This very common mistake stems from the need to be proved right. The thinking usually goes like this: if you liked the EUR/USD long at 1.2000, you'll love it even better at 1.1900 - it's a better bargain! Of course, the market eventually teaches all traders the folly of such thinking. There are situations in which markets simply do not turn around, and profits accumulated through years of trading can disappear within days. Follow the scale down strategy long enough, and you will eventually go broke. Scaling down can be a valid strategy, but only when it is practiced with inviolable discipline - which, unfortunately, most traders do not possess. Far rarer than the scaling down strategy, yet potentially far more lucrative, is its exact opposite - scaling up. Among traders, scaling up is also known as "pressing the trade". In this article, we'll explain the strategy of scaling up, show you an example of how it's done and discuss the risks that come with this approach.What Is Scaling Up?The idea of scaling up into a trade is relatively straightforward. Instead of adding to a position as it moves against him or her, the trader would only add as the position becomes increasingly profitable. For example, if a trader went long EUR/USD at 1.2000, he would only add to his trade if the currency pair moved to 1.2200. On the surface, this appears to be an eminently reasonable course of action. It is what Dennis Gartman - investing guru and writer of the famous daily stock market newsletter "The Gartman Letter" - refers to as "doing more of what is working and less of what is not".In fact, this strategy is as old as trading itself. Dickson G. Watts (who was President of the New York Cotton Exchange between 1878 and 1880) wrote about it as early as the 1880s, in the book "Speculation As A Fine Art And Thoughts On Life": "It is better to 'average up' than to 'average down'. This opinion is contrary to the one commonly held and acted upon; it being the practice to buy, and on a decline to buy more. This reduces the average. Probably four times out of five this method will result in striking a reaction in the market that will prevent loss, but the fifth time, meeting with a permanently declining market, the operator loses his head and closes out, making a heavy loss - a loss so great as to bring complete demoralization, often ruin."But buying at first moderately, and, as the market advances, adding slowly and cautiously to the 'line' - this is a way of speculating that requires great care and watchfulness, for the market will often (probably four times out of five) react to the point of 'average'. Here lies the danger. Failure to close out at the point of the average destroys the safety of the whole operation. Occasionally a permanently advancing market is met with and a big profit secured."In such an operation the original risk is small, the danger at no time great, and when successful, the profit is large. The method should only be employed when an important advance or decline is expected, and with a moderate capital can be undertaken with comparative safety."Why Isn't It More Popular?So, why do so many traders employ scaling down strategies, while so few traders engage in scaling up trades? The key reason may be our innate predilection for bargain hunting. It is said that real New Yorkers never pay retail. And it is indeed true that many denizens of Wall Street will ruthlessly search out the best deals for anything from a cup of street vendor's coffee to a designer suit. However, this trait is as common among farmers in Happy, Texas as it is among investment bankers in Manhattan. Most people hate to "pay up", and that's the reason why they won't "scale up" into trades. Nevertheless, scaling up can be an extremely profitable endeavor. Here is a description taken from the Elite Trader bulletin board about how a very famous pit trader, Richard Dennis, employed just such a strategy with bond futures. "As someone who has seen the likes of Rich Dennis and Tudor Jones operate, those '5%' winning trades involve add-on after add-on. Case in point is Dennis in the 1985-1986 bull market in bond futures. He would start with his normal unit of 500 contracts and get chopped for days. Buy the day's high, put 'em back out on a new swing low, etc. Every once in a while he'd wind up with 500 that worked. Then he'd start the process higher, all over again. Work 'em in, work 'em out. After maybe a couple of months the market has rallied 10 pts. from where he started, and he has 2,000 on (meaning 2 million a point). Now the market is short and ready to pop on any size buying, and he's there supplying the noose. Bidding for 500 on every uptick, he finally gets to a point where for the last month of the move he has 5,000 on. T-bonds rally 20 pts. In just over a month he's up $100 million on a trade that started out with him just testing the waters, losing $100,000 a few times before he could establish a position worth doubling up on."One trade, $100 million dollars in profit. While most of us can never aspire to success on such an enormous scale, the profit opportunities for scale up trades present themselves to retail FX traders on a regular basis. Let's take a look at the recent price action in the USD/JPY pair for a good example of this strategy in action.Putting It into PracticeProceed with CautionIf you are a trader, you may be thinking at this point that scaling up sounds like a pretty good way to make a tidy profit. But before you rush to initiate scale up trade strategies, it is critical that you understand the drawbacks. While the scale up trade may indeed be very lucrative, it is also extremely rare. There is a reason why, in the quote about Richard Dennis, the person posting refers to the trade as a "5 percenter". Scale up trades are in fact successful only 5% of the time, if not less. In order to work, scale up trades require two key ingredients: a propitious entry that becomes profitable almost from the start of the trade and a strong uninterrupted trend with virtually no retraces along the way. The description of the scale up strategy as "pressing the trade" is actually very apropos, because the trader is in fact pushing the position further and further as price action moves his or her way. Imagine a situation in which the USD/JPY trade did not go as smoothly as shown, but instead retraced back to 113.50 after the third unit was sold short at 111.50. The trader would then have to cover the position at breakeven, faced with the knowledge that a guaranteed profit of 600 points disappeared instantly as the scale up trade went awry. Unfortunately, this type of price action happens more often than not, as the strategy of "pressing the trade" often presses back on the trader.ConclusionFor traders capable of withstanding the psychological pressure of losing massive open profits to the vagaries of the market, the scale up trade can be an invaluable strategy. Clearly, it has produced some of the greatest trading successes in the history of financial markets, but anyone who attempts this approach must prepare for many moments of failure and frustration. Imagine that you have worked on a complex jigsaw puzzle for several weeks and are within a few pieces of finishing it, when someone intentionally comes by and scrambles all the pieces. If you can accept such turns of events with quietude and calmly begin the assembly process once again, then the scale up trade may be right for you.Making Sense Of The Euro/Swiss Franc RelationshipIf you're interested in getting into the forex market, there is one relationship of which you must be aware before you even start trading. This is the relationship between the euro and the Swiss franc currency pairs - a correlation too strong to be ignored. In the article Using Currency Correlations To Your Advantage, we see that the correlation between these two currency pairs can be upwards of negative 95%. This is known as an inverse relationship, which means that - generally speaking - when the EUR/USD (euro/U.S. dollar) rallies, the USD/CHF (U.S. dollar/Swiss franc) sells off the majority of the time and vice versa. When you're dealing with two separate and distinct financial instruments, a 95% correlation is as close to perfection as you can hope for. In this article we explain what causes this relationship, what it means for trading, how the correlation differs on an intraday basis and when such a strong relationship can decouple. Read on and you'll also find out why, contrary to popular belief, arbitraging the two currencies to earn the interest rate differential does not work.Where Does This Relationship Come from? In the article Using Currency Correlations To Your Advantage, we see that over the long term (one year) most currencies that trade against the U.S. dollar have an above 50% correlation. This is the case because the U.S. dollar is a dominant currency that is involved in 90% of all currency transactions. Furthermore, the U.S. economy is the largest in the world, which means that its health has an impact on the health of many other nations. Although the strong relationship between the EUR/USD and USD/CHF is partially due to the common dollar factor in the two currency pairs, the fact that the relationship is far stronger than that of other currency pairs stems from the close ties between the eurozone and Switzerland. As a country surrounded by other members of the eurozone, Switzerland has very close political and economic ties with its larger neighbors. The close economic relationship began with the free trade agreement established back in 1972 and was then followed by more than 100 bilateral agreements. These agreements have allowed the free flow of Swiss citizens into the workforce of the European Union (EU) and the gradual opening of the Swiss labor market to citizens of the EU. In fact, 20% of the Swiss workforce now comes from EU member states. But the ties do not end there. Sixty percent of Swiss exports are destined for the EU, while 80% of imports come from the EU. The two economies are very intimately linked, especially since exports account for over 40% of Swiss GDP. Therefore, if the eurozone contracts, Switzerland will feel the ripple effects. What Does This Mean for Trading?Why Arbitrage Does Not WorkNevertheless, with such strong correlation, you will often hear novice traders say that they can hedge one currency pair with the other and capture the pure interest spread. What they are talking about is the interest rate differential between the two currency pairs. At the time of writing (May 2006), the EUR/USD had an interest rate spread of negative 2.50%, with the eurozone yielding 2.50% and the U.S. yielding 5%. This meant that if you were long the EUR, you would earn 2.50% interest per year, while paying 5% interest on the U.S. dollar short. By contrast, the interest rate spread between the U.S. dollar and the Swiss franc, which yields 1.25%, is positive 3.75%. As a result, many new traders will ask why they cannot just go long the EUR/USD and pay 2.50% interest and long USD/CHF to earn 3.75% interest - netting a neat 1.25% interest with zero risk. This may seem like a lot of work to you for a mere 1.25%, but bear in mind that extreme leverage in the FX market can in some cases be upwards of 100 times capital - therefore, even a conservative 10 times capital turns the 1.25% to 12.5% per year. The general assumption is that leverage is risky, but in this case, novices will argue that it is not because you are perfectly hedged! Unfortunately, there is no free lunch in any market, so although it may seem like this may work out, it doesn't.
The key lies in the differing pip values between the two currency pairs and the fact that just because the EUR/USD moves one point, that does not mean that USD/CHF will move one point too.Differing Pip ValuesThe EUR/USD and USD/CHF have different point or pip values, which means that each tick in each currency is worth different dollar amounts. The EUR/USD has a point value of US$10 [((.0001/1.2795) x 100,000) x 1.2795], while USD/CHF has a pip value of $8.20 [(.0001/1.2195) x 100,000]. Therefore, when these two pairs move in opposite directions, they are not necessarily doing so to the same degree. The best way to get rid of the misconceptions that some traders may have about possible arbitrage opportunities is to look at examples of monthly returns for the 12 months of 2005. Some may argue that you need to neutralize the U.S. dollar exposure in order to properly hedge. So we run the same scenario and hedge the USD/CHF by the dollar equivalent amount for a euro each month. We do this by multiplying the USD/CHF return by the EUR/USD rate at the beginning of each month, which means that if one euro is equal to US$1.14 at the beginning of the month, we hedge by buying US$1.14 against the Swiss franc.When Does the Relationship Decouple?The relationship between the EUR/USD and USD/CHF decouples when there are divergent political or monetary policies. For example, if elections bring on uncertainty in Europe while Switzerland chugs merrily along, the EUR/USD might slide further in value than the USD/CHF rallies. Conversely, if the eurozone raises interest rates aggressively and Switzerland does not, the EUR/USD might appreciate more in value than the USD/CHF slides. Basically, the fact that ranges of the two currencies can vary more or less than the point difference, as shown in Figure 8, is the primary reason why interest rate arbitrage in the FX market using these two currency pairs does not work. The ratio of the range is calculated by dividing the USD/CHF range by the EUR/USD range.While technical analysis is critical to currency trading - especially for pinpointing entries and exits - it is insufficient on its own for creating a comprehensive trading game plan. Market sentiment in FX is driven primarily by the economic and geopolitical news of the day. The key players in the currency market - Fortune 500 multinationals, the world's central banks, multibillion-dollar hedge funds and the top tier investment banks that service them - do not care if there is a double top in the EUR/JPY on the hourly candles. Instead, they formulate their trades by analyzing the most recent economic news and geopolitical developments, as well as the latest pronouncements from G-7 monetary authorities. Therefore, the proper approach to FX trading can be summarized as follows: trigger fundamentally, enter and exit technically.Popular wisdom in the market states that traders who want to trade fundamentally should choose a longer time frame involving daily, or even weekly, charts. Those traders who want to trade more short term (hourly charts, for example) should focus strictly on technical setups. As with so much conventional wisdom in FX, this bit of advice couldn't be more wrong. For the purposes of this article, we define scalping in FX as using short-term time frames (usually hourly charts or smaller) to make trades with targets and stops approximately 20-30 points in length. Not only is it possible to scalp FX fundamentally, but retail traders actually have a significant advantage over larger market players when it comes to executing their trades. Macroeconomic News Moves the MarketOne of the great aspects of the currency market is that it trades off macroeconomic news that is transparent, impossible to fabricate and readily available to all market participants at the same time. (To learn more, see Trading On News Releases.) The key news that drives the FX market is governmental economic data such as the latest employment statistics, GDP growth rates, trade balance reports, inflation readings and interest rate announcements. These reports are typically released every month and can been previewed on economic calendars such as the ones published on Daily FX and FXStreet.com. Not only is the release of this data planned well in advance, but it is also reported instantaneously through a variety of news outlets including Bloomberg, Reuters, Dow Jones and CNBC, making it universally accessible. There's no need for traders to know about a secret contract that Intel may have negotiated, or the super-cool new product that a company like Apple just prototyped at its labs in Cupertino, California. In FX, headline economic data really does move markets, and currency traders can take advantage of that fact. More importantly, individual traders often have a decided advantage in reacting to the news faster than the larger corporate and hedge fund players. Retail Traders Can React Quickly As the most liquid financial market in the world, forex trades almost US$2 trillion each day in volume (in April 2004, the Bank for International Settlements (BIS) reported that the forex market traded US$1.9 trillion a day). Most retail brokers will provide liquidity up to $20 million, meaning that they will allow any trader to buy up to $20 million worth of a currency pair at the current ask or to sell the same amount at the present bid. This trade size can accommodate 99% of all retail orders, making it easy for traders to open a position quickly without affecting the market. However, larger players that are looking to place trades worth hundreds of millions or even billions of dollars at a time will move markets.
Therefore, by reacting quickly, retail traders in FX have a chance to front-run the big players and benefit from any momentum generated by that order flow. Economic news, whether favorable or unfavorable, can take up to several hours to fully filter through the market as traders adjust to the new information. This type of time frame offers astute retail traders a great opportunity to take advantage of the situation and scalp short-term profits as the pressure from the big players moves prices in the direction of the news.
The Ichimoku Kinko Hyo or equilibrium chart isolates higher probability trades in the forex market. It is new to the mainstream, but has been rising incrementally in popularity among novice and experienced traders. More known for its applications in the futures and equities forums, the Ichimoku displays a clearer picture because it shows more data points, which provide a more reliable price action. The application offers multiple tests and combines three indicators into one chart, allowing the trader to make the most informed decision. Learn how the Ichimoku works and how to add it to your own trading routine.Getting to Know IchimokuBefore a trader can trade effectively on the chart, a basic understanding of the components that make up the equilibrium chart need to be established. Created and revealed in 1968, the Ichimoku was developed in a manner unlike most other technical indicators and chart applications. Usually formulated by statisticians or mathematicians in the industry, the indicator was constructed by a Tokyo newspaper writer named Goichi Hosoda and a handful of assistants running multiple calculations.What they came up with is now used by many Japanese trading rooms because it offers multiple tests on the price action, creating higher probability trades. Although many traders are intimidated by the abundance of lines drawn when the chart is actually applied, the components can be easily translated into more commonly accepted indicators. Essentially made up of four major components, the application offers the trader key insight into FX market price action.
First, we'll take a look at both the Tenkan and Kijun Sens. Used as a moving average crossover, both lines are simple translations of the 20- and 50-day moving averages, although with slightly different time frames.1. The Tenkan Sen - Calculated as the sum of the highest high and the lowest low divided by two. The Tenkan is calculated over the previous seven to eight time periods.2. The Kijun Sen - Calculated as the sum of the highest high and the lowest low divided by two. Although the calculation is similar, the Kijun takes the past 22 time periods into account.What the trader will want to do here is use the crossover to initiate the position - this is similar to a moving average crossover. Looking at our example in Figure 1, we see a clear crossover of the Tenkan Sen (black line) and the Kijun Sen (red line) at point X. This decline simply means that near-term prices are dipping below the longer term price trend, signaling a downtrending move lower.
Figure 1 - A crossover in similar Western branded fashionNow let's take a look at the most important component, the Ichimoku "cloud”, which represents current and historical price action. It behaves in much the same way as simple support and resistance by creating formative barriers. The last two components of the Ichimoku application are:3. Senkou Span A - The sum of the Tenkan Sen and the Kijun Sen divided by two. The calculation is then plotted 26 time periods ahead of the current price action.4. Senkou Span B - The sum of the highest high and the lowest low divided by two. This calculation is taken over the past 44 time periods and is plotted 22 periods ahead.Once plotted on the chart, the area between the two lines is referred to as the Kumo, or cloud. Comparatively thicker than your run-of-the-mill support and resistance lines, the cloud offers the trader a thorough filter. Instead of giving the trader a visually thin price level for support and resistance, the thicker cloud will tend to take the volatility of the currency markets into account. A break through the cloud and a subsequent move above or below it will suggest a better and more probable trade.
Let's take a look Figure 2's comparison.Taking our USD/CAD example, we see a comparable difference between the two. Although we see a clear support at 1.1522 in our more standard chart (Figure 2), we subsequently see a retest of the level. At this point, some trades probably will be stopped out as the price action comes back against the level, which is somewhat concerning for even the most advanced trader.
However, in our Ichimoku example (Figure 3), the cloud serves as an excellent filter. Taking the volatility and apparent take back into account, the cloud suggests a better trade opportunity on a break of the 1.1450 figure. Here, the price action does not trade back, keeping the trade in the overall downtrend momentum.Last is the Chikou Span. Seen as simple market sentiment, the Chikou is calculated using the most recent closing price and is plotted 22 periods behind the price action. This feature suggests the market's sentiment by showing the prevailing trend as it relates to current price momentum. The interpretation is simple: as sellers dominate the market, the Chikou span will hover below the price trend while the opposite occurs on the buy side. When a pair remains bid in the market or is bought up, the span will rise and hover above the price action.Putting It All TogetherLike everything else, there's no better substitute for learning but through application. Let's break down the best method of trading the Ichimoku cloud technique.
Trading The Cloud…Taking our U.S. dollar/Japanese yen example in Figure 4, we'll zoom in on a more recent scenario in Figure 5. With the currency pair fluctuating in a range between 116 and 119 figures for the beginning of the year, traders were anxious to see a breakout of the persistent range. Here, the cloud is a product of the range-bound scenario over the first four months and stands as a significant support/resistance barrier. With that established, we look to the Tenkan and Kijun Sen. As mentioned before, these two act as a moving average crossover with the Tenkan representing a more short-term moving average and the Kijun acting as the base line. As a result, the Tenkan dips below the Kijun, signaling a decline in price action. However, with the crossover occurring within the cloud at Point A in Figure 5, the signal remains unclear and will need to be clear of the cloud before an entry can be considered. We can also confirm the bearish sentiment through the Chikou Span, which at this point remains below the price action. Conversely, if the Chikou was above the price action, it would confirm bullish sentiment. Putting it all together, we are now looking for a short position in our U.S.dollar/Japanese yen currency pair.Because we are equating the cloud to a support/resistance barrier, we will want to see a close of the session below the cloud before initiating any type of short sell position. As a result, we will be entering at Point B on our chart. Here, we have a confirmed break of the cloud as the price action stalls on a support level at 114.56. The trader, at this point, can opt to place the entry at the support figure of 114.56 or place the order one point below the low of the session. Placing the order one point below would act as confirmation that the momentum is still in place for another move lower. Subsequently, we place the stop just above the high of the candle within the cloud formation. In this example, it would be at Point C or 116.65. The price action should not trade above this price if the momentum remains. Therefore, we have an entry at 114.22 and a corresponding stop at 116.65, leaving our risk out at 243 pips. In keeping with sound money management, the trade will have to have a minimum of a 1:1 risk/reward ratio with a preferable 2:1 risk/reward for legitimate opportunities. In our example, we will maintain a 2:1 risk/reward ratio as the price moves lower to hit a low of 108.96 before pulling back. This equates to roughly 500 pips and a 2:1 risk to reward - a profitable opportunity. One key note to remember: notice how the Ichimoku is applied to longer time frames, in this instance the daily. With the volatility in shorter time frames, the application will tend not to work as well as with many technical indicators.7 Things Every Investor Must Know!To Recap:1. Refer To The Kijun / Tenkan Cross - The potential crossover in both lines will act in similar fashion to the more recognized moving average crossover. This technical occurrence is great for isolating moves in the price action.2. Confirm Down / Uptrend With Chikou - Confirming that the market sentiment is in line with the crossover will increase the probability of the trade as it acts in similar fashion with a momentum oscillator.3. Price Action Should Break Through The Cloud - The impending down/uptrend should make a clear break through of the cloud of resistance/support. This decision will increase the probability of the trade working in the trader's favor.4. Follow Money Management When Placing Entries - By adhering to strict money management rules, the trader will be able to balance risk/reward ratios and control the position. The Round UpIntimidating at first, once the Ichimoku chart is broken down, every trader from novice to advanced will find the application helpful. Not only does it mesh three indicators into one, but it also offers a more filtered approach to the price action for the currency trader. Additionally, this approach will not only increase the probability of the trade in the FX markets, but will assist in isolating only the true momentum plays. This is opposed to riskier trades where the position has a chance of trading back former profits.The Foreign Exchange Interbank Market According to an April 2004 report by the Bank for International Settlements, the foreign exchange market has an average daily volume of close to $2,000 billion, making it the largest market in the world. Unlike most other exchanges such as the New York Stock Exchange or the Chicago Board of Trade, the FX market is not a centralized market. In a centralized market, each transaction is recorded by price dealt and volume traded. There is usually one central place back to which all trades can be traced and there is often one specialist or market maker. The currency market, however, is a decentralized market. There isn't one "exchange" where every trade is recorded. Instead, each market maker records his or her own transactions and keeps it as proprietary information. The primary market makers who make bid and ask spreads in the currency market are the largest banks in the world. They deal with each other constantly either on behalf of themselves or their customers. This is why the market on which banks conduct transactions is called the interbank market. The competition between banks ensures tight spreads and fair pricing. For individual investors, this is the source of price quotes and is where forex brokers offset their positions. Most individuals are unable to access the pricing available on the interbank market because the customers at the interbank desks tend to include the largest mutual and hedge funds in the world as well as large multinational corporations who have millions (if not billions) of dollars.
Despite this, it is important for individual investors to understand how the interbank market works because it is one the best ways to understand how retail spreads are priced, and to decide whether you are getting fair pricing from your broker. Read on to find out how this market works and how its inner workings can affect your investments.Who makes the prices?Trading in a decentralized market has its advantages and disadvantages. In a centralized market, you have the benefit of seeing volume in the market as a whole but at the same time, prices can easily be skewed to accommodate the interests of the specialist and not the trader. The international nature of the interbank market can make it difficult to regulate, however, with such important players in the market, self-regulation is sometimes even more effective than government regulations. For the individual investor, a forex broker must be registered with the Commodity Futures Trading Commission as a futures commission merchant and be a member of the National Futures Association (NFA). The CFTC regulates the broker and ensures that he or she meets strict financial standards.According to the "Wall Street Journal Europe" (February 2006), 73% of total forex volume is done through 10 banks. These banks are the brand names that we all know well, including Deutsche Bank, UBS, Citigroup and HSBC. Each bank is structured differently but most banks will have a separate group known as the Foreign Exchange Sales and Trading Department. This group is responsible for making prices for the bank's clients and for offsetting that risk with other banks. Within the Foreign Exchange group, there is a sales and a trading desk. The sales desk is generally responsible for taking the orders from the client, getting a quote from the spot trader and relaying the quote to the client to see if they want to deal on it. This three-step process is quite common because even though online foreign exchange trading is available, many of the large clients who deal anywhere from $10 million to $100 million at a time (cash on cash), believe that they can get better pricing dealing over the phone than over the trading platform. This is because most platforms offered by banks will have a trading size limit because the dealer wants to make sure that it is able to offset the risk.On a foreign exchange spot trading desk, there are generally one or two market makers responsible for each currency pair. That is, for the EUR/USD, there is only one primary dealer that will give quotes on the currency. He or she may have a secondary dealer that gives quotes on a smaller transaction size. This setup is mostly true for the four majors where the dealers see a lot of activity. For the commodity currencies, there may be one dealer responsible for all three commodity currencies or, depending upon how much volume the bank sees, there may be two dealers. This is important because the bank wants to make sure that each dealer knows its currency well and understands the behavior of the other players in the market.
Usually, the Australian dollar dealer is also responsible for the New Zealand dollar and there is often a separate dealer making quotes for the Canadian dollar. There usually isn't a "crosses" dealer - the primary dealer responsible for the more liquid currency will make the quote. For example, the Japanese yen trader will make quotes on all yen crosses. Finally, there is one additional dealer that is responsible for the exotic currencies such as the Mexican peso and the South African rand. This setup is mimicked usually across three trading centers - London, New York and Tokyo. Each center passes the client orders and positions to another trading center at the end of the day to ensure that client orders are watched 24 hours a day. How do banks determine the price?Bank dealers will determine their prices based upon a variety of factors including, the current market rate, how much volume is available at the current price level, their views on where the currency pair is headed and their inventory positions. If they think that the euro is headed higher, they may be willing to offer a more competitive rate for clients that want to sell euros because they believe that once they are given the euros, they can hold onto them for a few pips and offset at a better price. On the flip side, if they think that the euro is headed lower and the client is giving them euros, they may offer a lower price because they are not sure if they can sell the euro back to the market at the same level at which it was given to them. This is something that is unique to market makers that do not offer a fixed spread.How does a bank offset risk?Similar to the way we see prices on an electronic forex broker's platform, there are two primary platforms that interbank traders use: one is offered by Reuters Dealing and the other is offered by the Electronic Brokerage Service (EBS). The interbank market is a credit-approved system in which banks trade based solely on the credit relationships they have established with one another. All of the banks can see the best market rates currently available; however, each bank must have a specific credit relationship with another bank in order to trade at the rates being offered. The bigger the banks, the more credit relationships they can have and the better pricing they will be able access. The same is true for clients such as retail forex brokers. The larger the retail forex broker in terms of capital available, the more favorable pricing it can get from the interbank market. If a client or even a bank is small, it is restricted to dealing with only a select number of larger banks and tends to get less favorable pricing.Both the EBS and Reuters Dealing systems offer trading in the major currency pairs, but certain currency pairs are more liquid and are traded more frequently over either EBS or Reuters Dealing. These two companies are continually trying to capture each other's market shares, but as a guide, the following is the breakdown where each currency pair is primarily traded:EBS ReutersEUR/USD GBP/USDUSD/JPY EUR/GBPEUR/JPY USD/CADEUR/CHF AUD/USDUSD/CHF NZD/USDCross currency pairs are generally not quoted on either platform, but are calculated based on the rates of the major currency pairs and then offset through the legs. For example, if an interbank trader had a client who wanted to go long EUR/CAD, the trader would most likely buy EUR/USD over the EBS system and buy USD/CAD over the Reuters platform. The trader then would multiply these rates and provide the client with the respective EUR/CAD rate. The two-currency-pair transaction is the reason why the spread for currency crosses, such as the EUR/CAD, tends to be wider than the spread for the EUR/USD. The minimum transaction size of each unit that can be dealt on either platforms tends to one million of the base currency. The average one-ticket transaction size tends to five million of the base currency. This is why individual investors can't access the interbank market - what would be an extremely large trading amount (remember this is unleveraged) is the bare minimum quote that banks are willing to give - and this is only for clients that trade usually between $10 million and $100 million and just need to clear up some loose change on their books. ConclusionIndividual clients then rely on online market makers for pricing. The forex brokers use their own capital to gain credit with the banks that trade on the interbank market. The more well capitalized the market makers, the more credit relationships they can establish and the more competitive pricing they can access for themselves as well as their clients. This also means that when markets are volatile, the banks are more obligated to give their good clients continuously competitive pricing. Therefore, if a forex retail broker is not well capitalized, how they can access more competitive pricing than a well capitalized market maker remains questionable. The structure of the market makes it extremely difficult for this to be the case. As a result, it is extremely important for individual investors to do extensive due diligence on the forex broker with which they choose to trade.Stop Hunting With The Big PlayersThe forex market is the most leveraged financial market in the world. In equities, standard margin is set at 2:1, which means that a trader must put up at least $50 cash to control $100 worth of stock. In options, the leverage increases to 10:1, with $10 controlling $100. In the futures markets, the leverage factor is increased to 20:1. For example, in a Dow Jones futures e-mini contract, a trader only needs $2,500 to control $50,000 worth of stock. However, none of these markets approaches the intensity of the forex market, where the default leverage at most dealers is set at 100:1 and can rise up to 200:1. That means that a mere $50 can control up to $10,000 worth of currency. Why is this important? First and foremost, the high degree of leverage can make FX either extremely lucrative or extraordinarily dangerous, depending on which side of the trade you are on. In FX, retail traders can literally double their accounts overnight or lose it all in a matter of hours if they employ the full margin at their disposal, although most professional traders limit their leverage to no more than 10:1 and never assume such enormous risk. But regardless of whether they trade on 200:1 leverage or 2:1 leverage, almost everyone in FX trades with stops. In this article, you'll learn how to use stops to set up the "stop hunting with the big specs" strategy. Stops are KeyPrecisely because the forex market is so leveraged, most market players understand that stops are critical to long-term survival. The notion of "waiting it out", as some equity investors might do, simply does not exist for most forex traders. Trading without stops in the currency market means that the trader will inevitably face forced liquidation in the form of a margin call. With the exception of a few long-term investors who may trade on a cash basis, a large portion of forex market participants are believed to be speculators, therefore, they simply do not have the luxury of nursing a losing trade for too long because their positions are highly leveraged.
Because of this unusual duality of the FX market (high leverage and almost universal use of stops), stop hunting is a very common practice. Although it may have negative connotations to some readers, stop hunting is a legitimate form of trading. It is nothing more than the art of flushing the losing players out of the market. In forex-speak they are known as weak longs or weak shorts. Much like a strong poker player may take out less capable opponents by raising stakes and "buying the pot", large speculative players (like investment banks, hedge funds and money center banks) like to gun stops in the hope of generating further directional momentum. In fact, the practice is so common in FX that any trader unaware of these price dynamics will probably suffer unnecessary losses. Because the human mind naturally seeks order, most stops are clustered around round numbers ending in "00". For example, if the EUR/USD pair was trading at 1.2470 and rising in value, most stops would reside within one or two points of the 1.2500 price point rather than, say, 1.2517. This fact alone is valuable knowledge, as it clearly indicates that most retail traders should place their stops at less crowded and more unusual locations.More interesting, however, is the possibility of profit from this unique dynamic of the currency market. The fact that the FX market is so stop driven gives scope to several opportunistic setups for short-term traders. In her book "Day Trading The Currency Market" (2005), Kathy Lien describes one such setup based on fading the "00" level. The approach discussed here is based on the opposite notion of joining the short-term momentum. Taking Advantage of the HuntThe "stop hunting with the big specs" is an exceedingly simple setup, requiring nothing more than a price chart and one indicator. Here is the setup in a nutshell: On a one-hour chart, mark lines 15 points of either side of the round number. For example, if the EUR/USD is approaching the 1.2500 figure, the trader would mark off 1.2485 and 1.2515 on the chart. This 30-point area is known as the "trade zone", much like the 20-yard line on the football field is known as the "redzone". Both names communicate the same idea - namely that the participants have a high probability of scoring once they enter that area. The idea behind this setup is straightforward. Once prices approach the round-number level, speculators will try to target the stops clustered in that region. Because FX is a decentralized market, no one knows the exact amount of stops at any particular "00" level, but traders hope that the size is large enough to trigger further liquidation of positions - a cascade of stop orders that will push price farther in that direction than it would move under normal conditions. Therefore, in the case of long setup, if the price in the EUR/USD was climbing toward the 1.2500 level, the trader would go long the pair with two units as soon as it crossed the 1.2485 threshold. The stop on the trade would be 15 points back of the entry because this is a strict momentum trade. If prices do not immediately follow through, chances are the setup failed. The profit target on the first unit would be the amount of initial risk or approximately 1.2500, at which point the trader would move the stop on the second unit to breakeven to lock in profit. The target on the second unit would be two times initial risk or 1.2515, allowing the trader to exit on a momentum burst. Aside from watching these key chart levels, there is only one other rule that a trader must follow in order to optimize the probability of success. Because this setup is basically a derivative of momentum trading, it should be traded only in the direction of the larger trend. There are numerous ways to ascertain direction using technical analysis, but the 200-period simple moving average (SMA) on the hourly charts may be particularly effective in this case. By using a longer term average on the short-term charts, you can stay on the right side of the price action without being subject to near-term whipsaw moves. ConclusionThe "stop hunt with the big specs" is one of the simplest and most efficient FX setups available to short-term traders. It requires nothing more than focus and a basic understanding of currency market dynamics. Instead of being victims of stop hunting expeditions, retail traders can finally turn the tables and join the move with the big players, banking short-term profits in the process.Inside Day Bollinger Band Turn TradeWe have long been taught that to be a successful trader, your objective should be to buy low and sell high or buy high and sell higher (and vice versa for shorts). Different strategies approach this most basic definition of speculation in various ways. Trend traders look to buy strength on the breakout and sell weakness on the breakdown. Good trend traders can make great sums of money in the long term with just a few big winners. However, most find applying trend trading far more difficult than the theory behind it. Simply stated, the human brain is not wired to trade trends. For example, buying the breakout in GBP/USD at 1.8000 (after it had bottomed at 1.7229 34 weeks earlier) and holding until 1.9000 sounds great, but human tendency makes it difficult to buy something at what is perceived as a high price (such as 1.8000). Furthermore, false breakouts will whipsaw a trader out of many trades - it simply isn't an efficient way to trade. On the other hand, traders that attempt to pick bottoms and tops usually get blown out of the water because they either do not have a method or they fail to follow their method - the end result is akin to attempting to stop a freight train by standing in front of it. Traditional trend trading (buying and selling breakouts) seems far too challenging from a psychological point of view, but for a novice trader, picking tops and bottoms at the same time is simply dangerous. What we need is a relative definition of high and low and a filter to help identify proper top and bottom trades. In this article we'll take a look at the inside day Bollinger band, which can help objectively measure what is high and low. Combining Inside Days with Bollinger BandsPrices at the upper Bollinger band are considered high and prices at the lower Bollinger band are considered low. However, just because prices have hit the upper Bollinger does not necessarily mean that it is a good time to sell. Strong trends will 'ride' these bands and wipe out any trader attempting to buy the 'low' prices in a downtrend or sell the 'high' prices in an uptrend. Therefore, just buying at the lower band and selling at the upper band is out of the question. By definition, price makes new highs in an uptrend and new lows in a downtrend, which means that they will naturally be hitting the bands. With this information in mind, our filter will require that buy signals occur only if the candle following the one that hits the Bollinger band does not make a new high or low. This type of candle is commonly known as an inside day. The best time frames to look for the inside days are daily charts, but this strategy can also be used on hourly, weekly and monthly charts. Combining inside days with Bollinger bands increases the likelihood that we are only picking a top or bottom after prices have hit extreme levels. As a rule of thumb, the longer the time frame, the rarer the trade will be, but the signal will also be more significant. Candlesticks and their respective patterns illustrate the psychology of the market at a particular point in time. Specifically, the inside candle represents a period of contracted volatility. If, in an uptrend, volatility begins to slow and the market fails to make a new high (as illustrated by the inside candle), then we can deduce that strength is waning and that the chance for a reversal exists. When combined with a Bollinger band, we ensure that we are trading a reversal only by either selling high prices (higher Bollinger band) are buying low prices (lower Bollinger band). In this way, we trade for the big move; not necessarily selling the low tick or buying the bottom tick but definitely buying near the relative bottom and selling near the relative top. The key is confirmation.Since Bollinger bands typically use a length of 20, we can employ a 20-period simple moving average (SMA) as a target to take profit. The 20 period SMA will trade equidistant from the upper and lower Bollinger bands. To catch large moves, allow the pair to trade through the 20-period SMA and then trail your stop with the moving average, only closing trades on the close after the pair crosses the SMA again. The examples below will shed light on this process. We have four guidelines. We'll call these guidelines (rather than rules) because this is a strategy that involves discretion. The guidelines present a trade setup that may or may not result in a trade.For longs: 1. Look for the currency pair to hit or come very close to hitting the lower Bollinger. 2. Wait for next candle and make sure that the next candle's low is greater than or equal to the previous candle's low and that the high is also less than or equal to the previous period's high. If so, go long at the open of the third candle.3. The initial stop is placed a few pips below the previous candle's low.4. Trail stop on a closing basis with the 20-period SMA.For shorts:1. Look for the currency pair to hit or come very close to hitting the upper Bollinger. 2. Wait for next candle and make sure that the next candle's high is less than or equal to the previous candle's high and that the low is also greater than or equal to the previous period's low. If so, go short at the open of the third candle.3. The initial stop is placed a few pips above the previous candle's high.4. Trail stop on a closing basis with the 20-period SMA.Longer Term ChartsThe inside day Bollinger band setup can also be used to identify major turns on weekly or even monthly charts for the longer-term position trader. The following examples show signals of our setup at major tops in GBP/USD (weekly chart) in Figure 4, a major bottom in EUR/GBP (weekly chart) in Figure 5 as well as well as a buy signal that indicated an all-time low in EUR/USD back in late 2000 on the monthly chart shown in Figure 6, and finally a USD/JPY sell signal in Figure 7 that was triggered in February 2002 at 133.36 on a monthly chart. In the last example, the pair closed at 119.49 just four months later! BenefitsThere are many benefits to the inside day Bollinger band strategy. The most obvious is its simplicity. Creating a trading strategy is not rocket science, but those that treat it as such usually end up frustrated and confused and - worse still - with a losing trading record. We can easily measure risk with this strategy and place stops appropriately. In other words, we have distinct points of reference (the inside day's high and low) from which to enter the trade and place stops. The setup is dynamic, meaning that it works on all time frames. Even a short-term day trader could use it on an hourly chart. However, the shorter the time frame, the less reliable the signal. Remember that candlesticks and their patterns shine light on the psychology of the market. An hourly chart encompasses a smaller amount of market data than a daily chart. As a result, an hourly chart is not as true an indication of mass psychology as a daily chart. ConclusionThis setup is just that - a setup. The trade should be managed according to your risk parameters and your trading style. Some may prefer to sell on a retrace after a short signal occurs, while others may prefer to sell a break of a daily low after a short signal. As we mentioned above, alter the size of the trade and the exit strategy. For example, trade multiple lots (if account size permits) and take profit on one lot at the 20 SMA, take profit on another lot at the opposite Bollinger band, and trail another lot(s) with the 20 SMA. Regardless of how you choose to implement this strategy, keep in mind that the FX market is an extremely trending market, which makes it even more important for range traders to get confirmation before trying to pick tops and bottoms. Combining inside days with Bollinger bands is a simple way of waiting for confirmation before taking the trade.Is Pressing The Trade Just Pressing Your Luck?Almost everyone who has ever traded has scaled down into a trade at least once in his or her career. This very common mistake stems from the need to be proved right. The thinking usually goes like this: if you liked the EUR/USD long at 1.2000, you'll love it even better at 1.1900 - it's a better bargain! Of course, the market eventually teaches all traders the folly of such thinking. There are situations in which markets simply do not turn around, and profits accumulated through years of trading can disappear within days. Follow the scale down strategy long enough, and you will eventually go broke. Scaling down can be a valid strategy, but only when it is practiced with inviolable discipline - which, unfortunately, most traders do not possess. Far rarer than the scaling down strategy, yet potentially far more lucrative, is its exact opposite - scaling up. Among traders, scaling up is also known as "pressing the trade". In this article, we'll explain the strategy of scaling up, show you an example of how it's done and discuss the risks that come with this approach.What Is Scaling Up?The idea of scaling up into a trade is relatively straightforward. Instead of adding to a position as it moves against him or her, the trader would only add as the position becomes increasingly profitable. For example, if a trader went long EUR/USD at 1.2000, he would only add to his trade if the currency pair moved to 1.2200. On the surface, this appears to be an eminently reasonable course of action. It is what Dennis Gartman - investing guru and writer of the famous daily stock market newsletter "The Gartman Letter" - refers to as "doing more of what is working and less of what is not".In fact, this strategy is as old as trading itself. Dickson G. Watts (who was President of the New York Cotton Exchange between 1878 and 1880) wrote about it as early as the 1880s, in the book "Speculation As A Fine Art And Thoughts On Life": "It is better to 'average up' than to 'average down'. This opinion is contrary to the one commonly held and acted upon; it being the practice to buy, and on a decline to buy more. This reduces the average. Probably four times out of five this method will result in striking a reaction in the market that will prevent loss, but the fifth time, meeting with a permanently declining market, the operator loses his head and closes out, making a heavy loss - a loss so great as to bring complete demoralization, often ruin."But buying at first moderately, and, as the market advances, adding slowly and cautiously to the 'line' - this is a way of speculating that requires great care and watchfulness, for the market will often (probably four times out of five) react to the point of 'average'. Here lies the danger. Failure to close out at the point of the average destroys the safety of the whole operation. Occasionally a permanently advancing market is met with and a big profit secured."In such an operation the original risk is small, the danger at no time great, and when successful, the profit is large. The method should only be employed when an important advance or decline is expected, and with a moderate capital can be undertaken with comparative safety."Why Isn't It More Popular?So, why do so many traders employ scaling down strategies, while so few traders engage in scaling up trades? The key reason may be our innate predilection for bargain hunting. It is said that real New Yorkers never pay retail. And it is indeed true that many denizens of Wall Street will ruthlessly search out the best deals for anything from a cup of street vendor's coffee to a designer suit. However, this trait is as common among farmers in Happy, Texas as it is among investment bankers in Manhattan. Most people hate to "pay up", and that's the reason why they won't "scale up" into trades. Nevertheless, scaling up can be an extremely profitable endeavor. Here is a description taken from the Elite Trader bulletin board about how a very famous pit trader, Richard Dennis, employed just such a strategy with bond futures. "As someone who has seen the likes of Rich Dennis and Tudor Jones operate, those '5%' winning trades involve add-on after add-on. Case in point is Dennis in the 1985-1986 bull market in bond futures. He would start with his normal unit of 500 contracts and get chopped for days. Buy the day's high, put 'em back out on a new swing low, etc. Every once in a while he'd wind up with 500 that worked. Then he'd start the process higher, all over again. Work 'em in, work 'em out. After maybe a couple of months the market has rallied 10 pts. from where he started, and he has 2,000 on (meaning 2 million a point). Now the market is short and ready to pop on any size buying, and he's there supplying the noose. Bidding for 500 on every uptick, he finally gets to a point where for the last month of the move he has 5,000 on. T-bonds rally 20 pts. In just over a month he's up $100 million on a trade that started out with him just testing the waters, losing $100,000 a few times before he could establish a position worth doubling up on."One trade, $100 million dollars in profit. While most of us can never aspire to success on such an enormous scale, the profit opportunities for scale up trades present themselves to retail FX traders on a regular basis. Let's take a look at the recent price action in the USD/JPY pair for a good example of this strategy in action.Putting It into PracticeProceed with CautionIf you are a trader, you may be thinking at this point that scaling up sounds like a pretty good way to make a tidy profit. But before you rush to initiate scale up trade strategies, it is critical that you understand the drawbacks. While the scale up trade may indeed be very lucrative, it is also extremely rare. There is a reason why, in the quote about Richard Dennis, the person posting refers to the trade as a "5 percenter". Scale up trades are in fact successful only 5% of the time, if not less. In order to work, scale up trades require two key ingredients: a propitious entry that becomes profitable almost from the start of the trade and a strong uninterrupted trend with virtually no retraces along the way. The description of the scale up strategy as "pressing the trade" is actually very apropos, because the trader is in fact pushing the position further and further as price action moves his or her way. Imagine a situation in which the USD/JPY trade did not go as smoothly as shown, but instead retraced back to 113.50 after the third unit was sold short at 111.50. The trader would then have to cover the position at breakeven, faced with the knowledge that a guaranteed profit of 600 points disappeared instantly as the scale up trade went awry. Unfortunately, this type of price action happens more often than not, as the strategy of "pressing the trade" often presses back on the trader.ConclusionFor traders capable of withstanding the psychological pressure of losing massive open profits to the vagaries of the market, the scale up trade can be an invaluable strategy. Clearly, it has produced some of the greatest trading successes in the history of financial markets, but anyone who attempts this approach must prepare for many moments of failure and frustration. Imagine that you have worked on a complex jigsaw puzzle for several weeks and are within a few pieces of finishing it, when someone intentionally comes by and scrambles all the pieces. If you can accept such turns of events with quietude and calmly begin the assembly process once again, then the scale up trade may be right for you.Making Sense Of The Euro/Swiss Franc RelationshipIf you're interested in getting into the forex market, there is one relationship of which you must be aware before you even start trading. This is the relationship between the euro and the Swiss franc currency pairs - a correlation too strong to be ignored. In the article Using Currency Correlations To Your Advantage, we see that the correlation between these two currency pairs can be upwards of negative 95%. This is known as an inverse relationship, which means that - generally speaking - when the EUR/USD (euro/U.S. dollar) rallies, the USD/CHF (U.S. dollar/Swiss franc) sells off the majority of the time and vice versa. When you're dealing with two separate and distinct financial instruments, a 95% correlation is as close to perfection as you can hope for. In this article we explain what causes this relationship, what it means for trading, how the correlation differs on an intraday basis and when such a strong relationship can decouple. Read on and you'll also find out why, contrary to popular belief, arbitraging the two currencies to earn the interest rate differential does not work.Where Does This Relationship Come from? In the article Using Currency Correlations To Your Advantage, we see that over the long term (one year) most currencies that trade against the U.S. dollar have an above 50% correlation. This is the case because the U.S. dollar is a dominant currency that is involved in 90% of all currency transactions. Furthermore, the U.S. economy is the largest in the world, which means that its health has an impact on the health of many other nations. Although the strong relationship between the EUR/USD and USD/CHF is partially due to the common dollar factor in the two currency pairs, the fact that the relationship is far stronger than that of other currency pairs stems from the close ties between the eurozone and Switzerland. As a country surrounded by other members of the eurozone, Switzerland has very close political and economic ties with its larger neighbors. The close economic relationship began with the free trade agreement established back in 1972 and was then followed by more than 100 bilateral agreements. These agreements have allowed the free flow of Swiss citizens into the workforce of the European Union (EU) and the gradual opening of the Swiss labor market to citizens of the EU. In fact, 20% of the Swiss workforce now comes from EU member states. But the ties do not end there. Sixty percent of Swiss exports are destined for the EU, while 80% of imports come from the EU. The two economies are very intimately linked, especially since exports account for over 40% of Swiss GDP. Therefore, if the eurozone contracts, Switzerland will feel the ripple effects. What Does This Mean for Trading?Why Arbitrage Does Not WorkNevertheless, with such strong correlation, you will often hear novice traders say that they can hedge one currency pair with the other and capture the pure interest spread. What they are talking about is the interest rate differential between the two currency pairs. At the time of writing (May 2006), the EUR/USD had an interest rate spread of negative 2.50%, with the eurozone yielding 2.50% and the U.S. yielding 5%. This meant that if you were long the EUR, you would earn 2.50% interest per year, while paying 5% interest on the U.S. dollar short. By contrast, the interest rate spread between the U.S. dollar and the Swiss franc, which yields 1.25%, is positive 3.75%. As a result, many new traders will ask why they cannot just go long the EUR/USD and pay 2.50% interest and long USD/CHF to earn 3.75% interest - netting a neat 1.25% interest with zero risk. This may seem like a lot of work to you for a mere 1.25%, but bear in mind that extreme leverage in the FX market can in some cases be upwards of 100 times capital - therefore, even a conservative 10 times capital turns the 1.25% to 12.5% per year. The general assumption is that leverage is risky, but in this case, novices will argue that it is not because you are perfectly hedged! Unfortunately, there is no free lunch in any market, so although it may seem like this may work out, it doesn't.
The key lies in the differing pip values between the two currency pairs and the fact that just because the EUR/USD moves one point, that does not mean that USD/CHF will move one point too.Differing Pip ValuesThe EUR/USD and USD/CHF have different point or pip values, which means that each tick in each currency is worth different dollar amounts. The EUR/USD has a point value of US$10 [((.0001/1.2795) x 100,000) x 1.2795], while USD/CHF has a pip value of $8.20 [(.0001/1.2195) x 100,000]. Therefore, when these two pairs move in opposite directions, they are not necessarily doing so to the same degree. The best way to get rid of the misconceptions that some traders may have about possible arbitrage opportunities is to look at examples of monthly returns for the 12 months of 2005. Some may argue that you need to neutralize the U.S. dollar exposure in order to properly hedge. So we run the same scenario and hedge the USD/CHF by the dollar equivalent amount for a euro each month. We do this by multiplying the USD/CHF return by the EUR/USD rate at the beginning of each month, which means that if one euro is equal to US$1.14 at the beginning of the month, we hedge by buying US$1.14 against the Swiss franc.When Does the Relationship Decouple?The relationship between the EUR/USD and USD/CHF decouples when there are divergent political or monetary policies. For example, if elections bring on uncertainty in Europe while Switzerland chugs merrily along, the EUR/USD might slide further in value than the USD/CHF rallies. Conversely, if the eurozone raises interest rates aggressively and Switzerland does not, the EUR/USD might appreciate more in value than the USD/CHF slides. Basically, the fact that ranges of the two currencies can vary more or less than the point difference, as shown in Figure 8, is the primary reason why interest rate arbitrage in the FX market using these two currency pairs does not work. The ratio of the range is calculated by dividing the USD/CHF range by the EUR/USD range.While technical analysis is critical to currency trading - especially for pinpointing entries and exits - it is insufficient on its own for creating a comprehensive trading game plan. Market sentiment in FX is driven primarily by the economic and geopolitical news of the day. The key players in the currency market - Fortune 500 multinationals, the world's central banks, multibillion-dollar hedge funds and the top tier investment banks that service them - do not care if there is a double top in the EUR/JPY on the hourly candles. Instead, they formulate their trades by analyzing the most recent economic news and geopolitical developments, as well as the latest pronouncements from G-7 monetary authorities. Therefore, the proper approach to FX trading can be summarized as follows: trigger fundamentally, enter and exit technically.Popular wisdom in the market states that traders who want to trade fundamentally should choose a longer time frame involving daily, or even weekly, charts. Those traders who want to trade more short term (hourly charts, for example) should focus strictly on technical setups. As with so much conventional wisdom in FX, this bit of advice couldn't be more wrong. For the purposes of this article, we define scalping in FX as using short-term time frames (usually hourly charts or smaller) to make trades with targets and stops approximately 20-30 points in length. Not only is it possible to scalp FX fundamentally, but retail traders actually have a significant advantage over larger market players when it comes to executing their trades. Macroeconomic News Moves the MarketOne of the great aspects of the currency market is that it trades off macroeconomic news that is transparent, impossible to fabricate and readily available to all market participants at the same time. (To learn more, see Trading On News Releases.) The key news that drives the FX market is governmental economic data such as the latest employment statistics, GDP growth rates, trade balance reports, inflation readings and interest rate announcements. These reports are typically released every month and can been previewed on economic calendars such as the ones published on Daily FX and FXStreet.com. Not only is the release of this data planned well in advance, but it is also reported instantaneously through a variety of news outlets including Bloomberg, Reuters, Dow Jones and CNBC, making it universally accessible. There's no need for traders to know about a secret contract that Intel may have negotiated, or the super-cool new product that a company like Apple just prototyped at its labs in Cupertino, California. In FX, headline economic data really does move markets, and currency traders can take advantage of that fact. More importantly, individual traders often have a decided advantage in reacting to the news faster than the larger corporate and hedge fund players. Retail Traders Can React Quickly As the most liquid financial market in the world, forex trades almost US$2 trillion each day in volume (in April 2004, the Bank for International Settlements (BIS) reported that the forex market traded US$1.9 trillion a day). Most retail brokers will provide liquidity up to $20 million, meaning that they will allow any trader to buy up to $20 million worth of a currency pair at the current ask or to sell the same amount at the present bid. This trade size can accommodate 99% of all retail orders, making it easy for traders to open a position quickly without affecting the market. However, larger players that are looking to place trades worth hundreds of millions or even billions of dollars at a time will move markets.
Therefore, by reacting quickly, retail traders in FX have a chance to front-run the big players and benefit from any momentum generated by that order flow. Economic news, whether favorable or unfavorable, can take up to several hours to fully filter through the market as traders adjust to the new information. This type of time frame offers astute retail traders a great opportunity to take advantage of the situation and scalp short-term profits as the pressure from the big players moves prices in the direction of the news.
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