Currency Trader Magazine 2006.06 by FXCM

VIEWS: 320 PAGES: 51

									                                June 2006 • Strategy, News, and Analysis for Forex Traders

Volume 3, No.6

                     TRADING SYSTEM ANALYSIS:
                  Correlated currencies trend strategy
                      FX MONEY MANAGEMENT:
                       The “10-percent solution”
                 THE YEN, THE YUAN...AND U.S. BONDS?
                          TRADE JOURNAL:
                       Knocked out by the news
                      MERC AND REUTERS SEEK
                      to bridge spot-futures gap

DOLLAR                                                      DAZE:
                     Will the buck’s
                   hard luck persist?

                                                               Playing with fire . . . . . . . . . . . . . . . .16
                                                               It’s a risky game when politicians and
                                                               bureaucrats try to use the currency
                                                               market to address perceived economic
                                                               problems. Find out why the recent
                                                               dollar-depreciation strategy is likely to be
                                                               a disruptive force in the international
                                                               economy and what lies in store for key
                                                               By Marc Chandler

     Contributors . . . . . . . . . . . . . . . . . . . .6
                                                             Advanced Strategies
                                                              The yen carry trade,
     Global Markets . . . . . . . . . . . . . . . . . .8      currencies, and U.S. bonds . . . . . . .22
       Beyond rate hikes:                                      The latest source of anxiety for bond
       What’s next for the dollar                              traders has some surprising connections
       The dollar’s spring collapse has many                   to the currency market. Find out what the
       market watchers on the edge of their                    story is behind U.S. Treasuries, the
       seats. What triggered the sell-off, and                 Japanese yen, and the Chinese yuan.
       what is likely to happen in the second                  By Howard L. Simons
       half of 2006?
       By Currency Trader Staff                                Trade management: Risk, reward,
                                                               and the 10-percent solution . . . . . . .27
                                                               Just as there are different catalysts for
     Big Picture                                               trades, there are different risk- and
       The dollar “crisis” and                                 trade-management techniques. This
       the New World Order . . . . . . . . . . . .12           excerpt from a new book on forex trading
       The dollar has had a brutal spring.                     explores different methods for getting
       Is this a temporary setback, or a sign of               in and out of positions based on your
       worse things to come?                                   approach to risk.
       By Barbara Rockefeller                                  By Boris Schlossberg

                                                                                                   continued on p. 4

2                                                                                     June 2006 • CURRENCY TRADER

                                                            Currency Futures . . . . . . . . . . . . . .45
                                                              News and data from the currency
                                                              futures world.
      Trading Strategies
        The inside market:                                  Industry News . . . . . . . . . . . . . . . . .46
        Hitting bids, lifting offers . . . . . . . . .32      CME deal opens new doors
        For intraday traders, knowing whether                 The Chicago Mercantile Exchange
        buyers are taking out offers or sellers               and Reuters have teamed up in an
        are taking out bids can provide insight               agreement that will give Reuters’
        about who’s driving the market and                    customers access to CME products.
        which direction it is likely to move.                 By Currency Trader Staff
        By Currency Trader Staff
                                                            Key Concepts . . . . . . . . . . . . . . . . . .46
                                                              References and definitions.
      Currency System Analysis . . . . . .38
       Correlated currencies breakout                       Events . . . . . . . . . . . . . . . . . . . . . . . .47
       system                                                 Conferences, seminars, and other events.

      International                                         Global Economic Calendar . . . . . .48
      Market Summary . . . . . . . . . . . . . . .42          Key dates for currency traders.
        Global currency, stock market, and
        interest-rate performance.                          New Products and Services . . . . .49

      Global News Briefs . . . . . . . . . . . . .44        Forex Trade Journal . . . . . . . . . . . .50
        Market and economic news.                             Anticipating a reversal of dollar weakness.

                Have a question about something you’ve seen in
                               Currency Trader?
                                     Submit your editorial queries or comments to

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

                                               Index of advertisers

                              FXCM                            Currency Trader Bookstore
                              MetaStock                       International Trader’s Expo
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4                                                                                   June 2006 • CURRENCY TRADER
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                                                                                       Marc Chandler is the head of global foreign
                                                                                    exchange strategies at Brown Brothers Harriman
                                                                                    and an associate professor at New York’s School
                                                                                    of Continuing and Professional Studies. From
                   A publication of Active Trader ®                                 May 2001 through Oct. 1, 2004, he was chief cur-
                                                                                    rency strategist at HSBC Bank USA. Prior to
            For all subscriber services:                                            HSBC, he was the chief currency strategist at
                                                 Mellon Financial, a senior currency strategist at Deutsche Bank,
                                                                                    and the director of research at EZA Associates.
               Editor-in-chief: Mark Etzkorn
                                                                                        Barbara Rockefeller ( is an interna-
                Managing editor: Molly Flynn                                        tional economist with a focus on foreign exchange. She has
                                              worked as a forecaster, trader, and consultant at Citibank and
                                                                                    other financial institutions, and currently publishes two daily
             Contributing editor: David Bukey                                       reports on foreign exchange. Rockefeller is the author of
                                                                                    Technical Analysis for Dummies (2004), 24/7 Trading Around the
                                                                                    Clock, Around the World (John Wiley & Sons, 2000), The Global
             Contributing editor: Jeff Ponczak
                                            Trader (John Wiley & Sons, 2001), and How to Invest
                                                                                    Internationally, published in Japan in 1999. A book tentatively
                  Contributing Writers:                                             titled How to Trade FX is in the works.
              Marc Chandler, Barbara Rockefeller

                  Editorial assistant and
                                                                                                        Thom Hartle ( is
                  Webmaster: Kesha Green                                                            director of marketing for CQG and a contribut-
                                                              ing editor to Active Trader magazine. In a career
                                                                                                    spanning more than 20 years, Hartle has been a
                   Art director: Laura Coyle                                                        commodity account executive for Merrill Lynch,
                                                                                                    vice president of financial futures for Drexel
                   President: Phil Dorman                                                           Burnham Lambert, trader for the Federal Home
                                             Loan Bank of Seattle, and editor for nine years of Technical
                                                                                    Analysis of Stocks & Commodities magazine.
          Ad sales East Coast and Midwest:
                     Bob Dorman                                                         Boris Schlossberg is a senior currency
                                             strategist at Forex Capital Markets in New York.
                                                                                    He is also a guest lecturer at,
                        Ad sales                                                    covering proper risk management, trader psy-
           West Coast and Southwest only:                                           chology, and true market structure. Schlossberg is
                       Allison Ellis
                                                                                    a frequent commentator for Reuters and Dow
                                                                                    Jones/CBS Marketwatch currency and bond market sections. He
             Classified ad sales: Mark Seger                                        has been an independent trader since 1999, trading a variety of
                                              instruments including stocks, options, futures, and currencies.

                                                                                        José Cruset ( is a private trader,
Volume 3, Issue 6. Currency Trader is published monthly by TechInfo, Inc.,          software engineer, and trading system researcher. He holds an
150 S. Wacker Drive, Suite 880, Chicago, IL 60606. Copyright © 2006
TechInfo, Inc. All rights reserved. Information in this publication may not be      MBA and a NASD-Series 3 certificate and has worked many
stored or reproduced in any form without written permission from the publisher.
                                                                                    years in the banking industry.
The information in Currency Trader magazine is intended for educational pur-
poses only. It is not meant to recommend, promote or in any way imply the
effectiveness of any trading system, strategy or approach. Traders are advised
to do their own research and testing to determine the validity of a trading idea.      Howard Simons is president of Rosewood Trading, Inc.,
Trading and investing carry a high level of risk. Past performance does not
guarantee future results.                                                           and a strategist for Bianco Research. He writes and speaks fre-
                                                                                    quently on a wide range of economic and financial market

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            GLOBAL MARKETS

                 Beyond rate hikes:
                 What’s next for the dollar
                                        What has sparked the dollar’s plunge?
                Is the trend likely to reverse, or has a long-overdue tab finally being settled?

                                             BY CURRENCY TRADER STAFF

A              renewed wave of U.S.-dollar bearishness
               swept into the forex arena in mid-April, tak-
               ing the greenback sharply lower vs. the yen
               and the euro into mid-May. Heading into the
second half of 2006, it’s important to take a look at the major
factors driving the U.S. dollar to determine which
will likely grab the reins into the latter portion
                                                                  cent jump in April to a 3.5-percent year-over-year reading.
                                                                    “The premise that there will be a clear end to the tighten-
                                                                  ing cycle is not entirely accurate — it depends on the data,”
                                                                  says Brian Dolan, director of research at Gain Capital
                                                                            This uncertainty has also spilled over immediate-
                                                                               ly to currencies.
of this year.                                                                        “Near-term moves are harder to forecast
   Interest-rate differentials and Fed rate                                          now,” says David Powell, currency analyst at
hikes have been a dominating market                                                   Ideaglobal. “The FX markets will react to
factor for those trading the U.S. dollar                                                data in a much more exacerbated way.”
over the past year or so. The U.S. Fed                                                      Many analysts expect a pause at the
hiked rates 16 consecutive times as of                                                    June meeting, assuming inflation
the May 10 meeting, which pushed                                                          pressures moderate. Analysts specu-
up the funds rate to 5.00 percent.                                                         late that one or two more 25 basis
   With the next Federal Open Market                                                       point hikes are in the pipeline for
Committee (FOMC) meeting looming                                                          later this summer or early fall, if the
on June 28-29, many analysts believe                                                      data warrants it. However, Powell
the Fed could pause the hike cycle.                                                      thinks once the Fed stops hiking rates,
However, the wording of the latest pol-                                                 the market focus will return to the
icy statement has left the door open for                                              growing U.S. deficits.
either a pause or a hike, depending on
growth and inflation data.                                                       The story that won’t die
   According to the Fed’s May 10 statement,                                    The trade imbalance remains the issue that sim-
“The Committee judges that some further policy                            ply won’t go away. The U.S. can’t continue wracking
firming may yet be needed to address inflation risks but          up increasingly higher trade and current account deficits,
emphasizes that the extent and timing of any such firming         some people argue. At various times over the past several
will depend importantly on the evolution of the economic          years, market analysts and economists have warned that at
outlook as implied by incoming information.”                      some point the U.S. will have to pay the tab. Many analysts
                                                                  argue that will come in the form of a dramatically weaker
The new data dependency                                           U.S. dollar.
Unlike 2005, when the Fed clearly signaled to the financial          China remains the main culprit in this story, especially
markets the hiking mode was intact, traders are now adjust-       according to some of the folks in Washington D.C. The U.S.
ing to a more data-dependent atmosphere.                          trade deficit with China is larger than with any other coun-
   Some analysts previously forecasted an end to the tighten-     try, eclipsing the $200 billion mark in 2005.
ing cycle as early as this summer. But thoughts have shifted         “By all estimates, it seems the currency pair in most need
in the wake of recent inflation data. Looking at some current     of adjustment is dollar/yuan,” says Charmaine Buskas of
(as of June 1) inflation measures, the core rate of consumer      Moody’s “The dollar is still very overvalued
inflation rose 0.3 percent to 2.3 percent on a year-over-year     compared to the yuan. The U.S. sees China as having an
basis in April. Meanwhile, the overall CPI posted a 0.6-per-      unfair advantage due to a weak yuan.”

8                                                                                                June 2006 • CURRENCY TRADER
   The Chinese authorities did revalue the yuan last year, reaffirm that exchange rates should reflect economic funda-
bolstering its currency by 2.1 percent in July 2005. Since mentals. Excess volatility and disorderly movements in
then, however, only modest appreciation in the neighbor- exchange rates are undesirable for economic growth. We
hood of 1.2 percent has occurred. The yuan continues to continue to monitor exchange rates closely and cooperate as
hover around eight per U.S. dollar ($0.125).                appropriate. Greater exchange rate flexibility is desirable in
   In 2005, the U.S. trade deficit screamed to a new record emerging economies with large current account surpluses,
high at $723 billion, up from 2004’s $617.6 billion. Powell especially China, for necessary adjustments to occur.”
sees that expansion continuing. According to his data, the    Analysts say this latest communiqué is significant in that
first three months of 2006 totaled $196.2
billion, vs. $172.1 billion for the same peri-  FIGURE 1 — EURO/U.S. DOLLAR (EUR/USD)
od in 2005.
                                                  The euro/dollar pair consolidated for much of May, but some analysts see the
Foreign buyers:                                   potential for a move up to 1.33 if dollar weakness persists.
Holding up a house of cards?
For now, large monthly foreign capital
inflows, primarily into the U.S. Treasury
market, have been cushioning a potential
   “[Foreign purchases of U.S. assets] large-
ly come from intervening central banks in
Asia who buy dollars to hold down the
value of their currencies,” Powell says.
   Powell also points to oil-producing
countries that reinvest “petro-dollars” into
the U.S. as another large buyer of U.S.
assets, helping to offset the trade gap.
   One way to monitor those inflows is to
watch the monthly Treasury International
Capital (TIC) report. In March, TIC data,
which measures foreign net inflows,
totaled $69.8 billion, just covering the trade
gap of $62 billion for that month.
   “The biggest worry is that a depreciating
dollar would mean losses on these invest-
ments, which would just create a downward
spiral,” Powell says.
                                                   Source: TradeStation
   FX traders will want to monitor the
monthly TIC report to make sure portfolio
flows continue to cover the monthly trade gap.                    it is a departure from typical verbiage.
   “If it doesn’t cover [the gap], that would be the catalyst         “In the last several years of communiqués, there has been
for a major dollar sell-off,” Buskas predicts.                    very little substance,” Buskas says. “They have tended to
   For another perspective on U.S. and foreign investment, issue a pat statement on how currency valuations should
see “Playing with fire.”                                          reflect fundamentals.”
                                                                      The G7 statement also outlined specific recommenda-
The spark: April’s G7 communiqué                                  tions for several countries: in the U.S., further action to
Some analysts point to the April 21 Group of Seven (G7) encourage and bolster the national savings rate; in Europe,
communiqué as a trigger for the May and April U.S. dollar structural reforms for labor markets, which in turn could
weakness. That trend could be the start of a new focus into spark domestic demand-led growth; in China, greater flexi-
the second half of 2006.                                          bility in exchange rates is critical and would help lessen its
   In broad terms, the announcement from the G7 nations current export-led growth mode.
(the U.S., Canada, Great Britain, Italy, France, Germany, and         “The G7 focused not only on currency-rate adjustment,
Japan) stated the strong global economic expansion contin- but on stimulating domestic demand in the countries with
ues into its fourth year and the outlook remains “favorable.” trade surpluses,” Dolan says. “Japan, China — most of the
   However, the key segment of the communiqué that sent Asian economies are heavily export-led.”
the forex market flying was a note on exchange rates: “We                                                      continued on p. 10

CURRENCY TRADER • June 2006                                                                                                    9
       GLOBAL ECONOMY continued

   If the Chinese authorities were to allow the yuan to           system, and Western expectations are a little unrealistic.”
strengthen against the dollar, the appetite for Chinese goods
could slow, which could help ease the U.S. trade deficit.         Looking ahead
                                                                  “We are looking for a dollar sell-off into the second half of
The market’s reaction                                             the year,” says Ideaglobal’s Powell, who sees the potential
“The G7 comments were such a divergence from the norm             for the euro to strengthen toward the $1.33 area vs. the dol-
that the markets just jumped on it,” Buskas says. “It was the     lar by year-end. “The fear is that the Bush Administration
primary catalyst to sell the dollar, which has been the theme     has opted out for a weak dollar instead of trying to increase
for the past month. The market is awakening to the idea it        the savings rate [to help solve the trade imbalance]. Once
can no longer wear these rose colored glasses.”                   we move beyond the end of the hiking cycle, we will likely
   Buskas says the end of Fed rate hikes will leave an unsus-     see a sustained downtrend for the dollar.”
tainable U.S. structure as the focal
point.                                       FIGURE 2 — U.S. DOLLAR/JAPANESE YEN (USD/JPY)
   “The global imbalance issue will be
the driving theme for the U.S. dollar         In the second half of May the dollar regained some of its decline vs. the
into the second half and 2007,” she says.     yen, but the overall bias remains down.
   The U.S. dollar weakened vs. the
euro from a low at $1.21 on April 17 to
the $1.29 region as of May 15 (Figure 1).
A huge down gap is evident on the
daily dollar/yen chart on April 21,
which started the latest wave of bear-
ishness (Figure 2). Gap top resistance
lies at 116.55, but the pair had slumped
as low as 108.98 as of May 17.

The word from the Hill
The U.S. Treasury stopped shy of nam-
ing China as a currency manipulator
(as many had expected it would) in its
early May semi-annual report on glob-
al currencies. Instead, in the report
Treasury Secretary John Snow stated it
is “a matter of extreme urgency” that
Chinese authorities allow the yuan to
rise faster vs. the U.S. dollar.
   “The Treasury tried to walk a fine
line, with the intention of diffusing
protectionist sentiment in Congress,”
says Jim Glassman, senior economist             Source: TradeStation
at JP Morgan Chase.
   Prior to the report’s release, there was talk in the market          Most analysts stress, however, that most of the likely
about China not doing enough, and many economists downward adjustment will occur primarily in the U.S. dol-
thought the Treasury was going to come down hard on lar vs. Asian currencies, not European currencies. Japan in
China. However, Buskas views the Treasury’s actions with particular has kept its currency artificially low in order to
a unique perspective.                                                compete with China.
   “[The Treasury] used reverse psychology by not naming                Gain Capital’s Dolan says these market factors make dol-
China,” she says. “It might give China time to revalue lar/yen a sale in the 112.00 to 114.00 area, with the potential
because they are not being pressured. They save face in for a move to the 108.00 to 105.00 region in the second half
international markets.                                               of 2006.
   “While U.S. officials might see the slow pace of apprecia-           Additional revaluations by the Chinese will also be key
tion as foot dragging, the Chinese still have a lot of work to factors in the dollar’s second-half performance. Moody’s
do on their financial markets.”                             projects as much as a 5-percent yuan adjust-
   Glassman notes, “Frankly, what China does with its cur- ment over the next year, which could allow USD/JPY to
rency is not our call. It takes decades to transform a financial move toward 100.00 into 2007.

10                                                                                               June 2006 • CURRENCY TRADER
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            THE BIG PICTURE

                The dollar “crisis”
               and the New World Order
                            Just when you thought it was safe to back into the dollar…
                                             BY BARBARA ROCKEFELLER

T               he concept of a New World Order is one of
                those compelling political ideas designed to
                scare some people and inspire others, even if
                it has little or no basis in reality. There’s no
New World Order, of course — but lately, plenty of people
wish we did have one.
   It looks like the U.S. has run off the rails and is deliber-
                                                                   Three strikes and you’re out
                                                                   The first strike was the reserve diversification story, which
                                                                   gained credibility on the Swedish Riksbank action in April
                                                                   (see “The return of reserve diversification,” Currency Trader,
                                                                   May 2006).
                                                                      The second strike is Europe making every effort to get the
                                                                   euro accepted as the new reserve currency. The ECB had
ately provoking a dollar crisis. Usually we pooh-pooh any-         good timing, just as the Fed is perceived to be on the verge
thing that involves the word “crisis” — the word pops up           of pausing its rate-hike cycle. It’s impossible to know with
dozens of times for every time there’s a real one. But this        certainty the Fed will pause in June, but by the time the Fed
time, we are worried. Very worried.                                meets, a lot of water will have gone over the dam, including
   The long-suspected idea the U.S. actively seeks a weaker        the ECB rate hike earlier in the month and additional com-
dollar was confirmed in a Wall Street Journal story on May         ments from top officials.
13 (see also “Playing with fire”), which asserted the U.S. is         The ECB seems hell-bent on raising rates no matter what,
“acquiescing” in the willful misinterpretation of the G7           or at least on giving the impression that it is the top infla-
communiqué, which read, “In emerging Asia, particularly            tion-fighter on the planet. This image contributes to its
China, greater flexibility in exchange rates is critical to        long-term goal of having the euro supplant the dollar as the
allow necessary appreciations, as is strengthening domestic        world’s reserve currency. Historically, the issuer of a reserve
demand, easing reliance on export-led growth strategies,           currency is an actual country and the top military power in
and actions to strengthen financial sectors.”                      the world of its day. The European Union does not qualify,
   This was interpreted as a call for the dollar to depreciate     but never mind. Maybe the rules are different today.
across the board, even though the G7 clearly did not say that.        The third strike against the dollar: The U.S. is picking a
Fed Chairman Ben Bernanke, Treasury Secretary John Snow,           fight with Japan it cannot win. It all starts with the refusal
European Central Bank (ECB) President Jean-Claude Trichet,         to name China as a currency manipulator in the semi-annu-
and Japanese Finance Minister Sadakazu Tanigaki each com-          al Treasury report. Evidently a lot of horse trading was
plained the market was misinterpreting the G7 statement, to        going on in the background. The G7 communiqué was
no effect at all. This means their protests and denials came       strong or even harsh, in return for the U.S. pulling its

     The market thinks that somehow there is something wrong with a finance
             ministry that acquiesces to the downfall of its currency.
across as weak and unconvincing to the market.                     punches. (We have yet to hear the response of the congress-
   The market thinks that somehow there is something               men to whom the report is technically addressed.)
wrong with a finance ministry that acquiesces to the down-            During the first week of June, Treasury Secretary Snow
fall of its currency — and former Fed Chairman Paul Volcker        gives testimony about the report and answers questions,
would agree. It’s also arrogant. Both the Fed and the              which ought to be fun. Meanwhile, China allowed the yuan
Treasury have recently said that any diversification out of        to get past the purportedly psychologically important 8.1
dollars is not a danger to incoming capital flows (which are       level vs. the dollar, which was perhaps a “reward” to the
mostly private and not official) or the interest-rate structure.   Treasury for letting it off the hook. A state-sponsored think
   It looks like we are about to find out if this is true.         tank trotted out an economist to offer that an additional

12                                                                                                June 2006 • CURRENCY TRADER
five-percent revaluation would be a good thing for the              The new new world order
banking sector and domestic economy without causing too             Ahead of G7, we heard vague mutterings that we need a
much harm. This is a trial balloon wafting over                     new world order in currencies. Some mentioned a new
Washington.                                                         Plaza Accord. Heaven forbid!
   While the developments in U.S.-China relations are fasci-           For those not around at the time, the Plaza Accord in 1985
nating, they are not the main event. That honor belongs to          was a decision among what is now G7 to “manage” the dol-
the U.S. telling Japan it should not intervene in the dollar-yen    lar downward. Volcker wrote about it at length in his book,
rate, or even talk about the dollar-yen in public. The U.S. atti-   Changing Fortunes (still the best forex read around). The
tude is that if the market chooses to buy yen as a proxy for        Plaza Accord forced Japan to change interest rates solely to
the Chinese yuan, the Japanese should grin and bear it. They        get a currency effect (while Europe did nothing much), but
should not repeat the extraordinary intervention in 2003-           on the whole, the Plaza Accord was the “Plaza Statement”
2004, during which time the Bank of Japan (BOJ) was active          — simply saying the top ministers wanted a weaker dollar
in the market over 100 times, to the tune of ¥30 trillion.          was sufficient to get traders selling dollars in force. The
   Japanese Finance Minister Tanigaki protested that the G7         problem was, they had no mechanism to stop it. A few

    There is no one to tell the U.S. that it is foolish to be so openly hypocritical.
       You can get people to sell the dollar but you can’t make them stop.
principle is that currency movements should reflect econom-         years later, when the dollar had weakened “too far,” the
ic fundamentals, and sudden and speculative movements are           Louvre Accord was not a success — it would have required
undesirable. This has been Japan’s hitherto unassailable            changes in interest rates that no one was willing to make
rationale when it intervened — currency movements are too           just for the sake of the U.S. and its currency. Germany, in
abrupt and result in levels that do not reflect fundamentals.       particular, said that it set rates according to its money sup-
How can the U.S. sign the G7 agreement and then turn                ply and inflation outlook, and wasn’t about to risk inflation
around and deny the right to intervention to another signato-       by cutting rates just to suit Washington.
ry? Tanigaki didn’t say so out loud, but it’s the old “beggar          We learned a number of lessons from the Plaza Accord.
thy neighbor” policy from the days of fixed exchange rates,         First is the power of the “announcement effect” and second
when one country would over-devalue to grab export mar-             is that announcement effects can be asymmetrical. Ask
kets from its neighbors. Today such a policy is relevant main-      traders to sell dollars and they are happy to oblige. Ask
ly in autos, where Tokyo is eating Detroit’s lunch.                 them to buy the dollar, and they refuse. This lopsidedness is
   Tanigaki also said the Ministry of Finance “will make            nothing new. But the real lesson of the Plaza Accord is that
cautious judgments on how to manage the composition of              countries seldom act outside their self-interest. Japan was a
the reserves…We don’t believe the reserves should expand            good Boy Scout — and got suckered, as Volcker mourns.
unrestrained...but our foreign reserves are massive and we             So here we are, more than 20 years later, and the market
should be very careful about making comments on how we              is crying out for some grown-ups to come along and be in
would like to manage our reserves.”                                 charge. Actually, what they really seek is an enforcement
   A little later the same day, the ministry came out with          mechanism at the IMF to shepherd countries like China
modifications, clarifications, and general softening — but          through the currency adjustment process. But even if the
how can this be interpreted as anything other than a direct         IMF were a better-run organization, there is no agreement
threat? Some say G7 would have to be consulted before               on what the rules ought to be. The IMF wants entirely free
Japan could engage in reserve diversification. Well, if the         markets. But we would argue, for example, that capital con-
U.S. is not going to abide by a G7 agreement that gives             trols are appropriate for emerging economies (and Malaysia
implied authority to Japan to intervene, why should Japan           proved it after the Asian crisis in 1997-98), contrary to theo-
abide by any other part of the G7 agreement?                        ry and conventional wisdom. Who is to say that complete
   This contretemps will probably blow over without esca-           relaxation of capital controls in China would not result in a
lating to the point of crisis — and Japan will win. It can win      wholesale exodus of money out of the country?
by actually intervening and somehow getting the U.S. to                For the U.S. to have a “secret” weak-dollar policy while
concede its sovereign right to intervene, or by getting the         professing a strong dollar policy is political hell. It makes
U.S. to remain silent, which is the same thing. Either way,         the U.S. government look unprincipled, or indecisive, or
the U.S. loses face.                                                incompetent, and certainly vulnerable to ridicule. Everyone
                                                                                                                  continued on p. 14

CURRENCY TRADER • June 2006                                                                                                      13
     THE BIG PICTURE continued

                                              FIGURE 1 — 1.3850 AND BEYOND?
and his economist brother has been
saying for years that the dollar must         If the apparent bottom pattern shown here follows through, the EUR/USD pair
devalue to fix the global imbalance,          could easily rally to the previous high of 1.3850 and beyond.
and yet it’s fairly easy to demonstrate
that a weaker dollar will not achieve
that goal — fixing the imbalance really
is a shared responsibility. But in a
world where G7 deals with lots of
things beyond currencies and the IMF
is in a state of confusion and disarray,
there is no one to tell the U.S. that it is
foolish to be so openly hypocritical.
The hypocrisy means you can get peo-
ple to sell the dollar but you can’t make
them stop.

When does it stop?
We don’t see where the end lies. The
longest-running lame duck, Treasury
Secretary Snow, was asked to leave (as
long rumored) and someone new will
be brought in to deliver a different
message. But there’s no evidence a new        Source: TradeStation
team can reverse the damage — and
who has the stature to pull it off?
   When Merrill Lynch issued a fore-         FIGURE 2 — DOLLAR INDEX PERSPECTIVE
cast that 1.5000 in the euro-U.S. dollar     In the U.S. dollar index, the bottoming pattern in Figure 1 appears as a
rate was a real possibility, the market      topping pattern. The index is now closer to its 2004 low than its 2005 high.
initially poked fun at the idea. But the
U.S. embrace of a weaker dollar is seri-
ous business, and consider that curren-
cies always overshoot. Figure 1 indi-
cates a possible inverted head-and-
shoulders bottom, which is a usually
reliable pattern. There is often a bounce
back to the line marking the highest
point of the formation, in this case
1.2570, but then a resumption of the
bullish euro/bearish dollar move
could easily take the pair to the previ-
ous high of 1.3850 and beyond. Figure
2 shows the current condition in terms
of the dollar index, which shows a
head-and-shoulders top.
   Possibly nothing much will come of
all this. International investors will
continue to prefer the U.S. markets for
their size, variety, transparency, etc.,
and we will not see much additional           Source: TradeStation
reserve diversification, if any.
   It’s too soon to call it a crisis. It                           modity and gold prices will look sensible instead of the
becomes a crisis when the Treasury has to add another one bubble it appears to be today.
to two percent to sell its T-bills and notes at auction. That
day may be closer than we think. Then the run-up in com- For information on the author see p. 6.

14                                                                                            June 2006 • CURRENCY TRADER
           THE BIG PICTURE

                                         Playing with fire
                                          The U.S. is apparently attempting to drive the dollar lower, but such
                                          actions suggest policymakers don’t necessarily understand how
                                          nations compete in the world economy.

                                                 BY MARC CHANDLER

O                ld men should know better than to play A cure worse than the disease
                 with fire. But that is precisely what the old Although a number of officials, including European Central
                 men of the G7 and International Monetary Bank (ECB) President Jean-Claude Trichet, Federal Reserve
                 Fund (IMF) are doing.                            Chairman Benjamin Bernanke, and Japan Finance Minister
   Many private observers and public officials have long Sadakazu Tanigaki, indicated the G7 and IMF statement did
maintained the large U.S. external imbalance was a major not signal a desire for a general dollar decline, the market
risk to the world economy. The solution that appeared to suspects otherwise. It understands those comments as half-
have been embraced was a multi-prong approach: The U.S. hearted attempts to maintain an orderly market.
would boost domestic savings and Europe and
Japan would boost domestic demand, while             FIGURE 1 — THE DANGER OF A DECLINING DOLLAR
Asia needed to adopt more flexible capital
                                                      A weak-dollar policy might have been a politically expedient way to
markets. However, the lack of political will to
                                                      address the perceived risk of U.S. deficits, but the question remains
implement this strategy led to the more expe-
                                                      whether this cure will end up being worse than the disease.
dient course of signaling the currency market
should bear a greater burden of the adjust-
ment, which in turn has sparked a dramatic
decline in the U.S. dollar (Figure 1).
   Officials have warned the U.S. trade deficit is
not sustainable and that it injects unnecessary
volatility into the capital markets, which dis-
torts investment and economic decision mak-
ing. But the real disruption to the capital mar-
kets in April and May — and one with the
potential to negatively affect world growth —
was not the U.S. trade deficit (which has, in fact,
in recent months been smaller than the consen-
sus forecasts), but rather the clumsy attempt by
the G7 and IMF to fix the “problem.” Global
equity markets sold off and the rise of global
interest rates accelerated.
   The sharply falling dollar makes the ability
to smoothly finance the U.S. current account
deficit more difficult, as reflected in the luke-
warm reception to the mid-May Treasury auc-
tions.                                               Source: TradeStation

16                                                                                          June 2006 • CURRENCY TRADER
                                                    FIGURE 2 — RESURGENT EURO
           OF THE DOLLAR INDEX                       The dollar’s loss has been the euro’s gain, and ECB comments seem
                                                     to reflect a lack of concern about the euro’s appreciation.

      Currency               Percentage
      Euro                      57.6%
      Japanese yen              13.6%
      British pound             11.9%
      Canadian dollar           9.1%
      Swedish krona             4.2%
      Swiss franc               3.6%

   The absence of clear, strongly-worded
protests about the pace or magnitude of moves
in the forex market is understood by many par-
ticipants as acquiescence at the very least, and
even possibly an endorsement. While the euro
was motoring ahead (Figure 2), at least two
ECB officials indicated (without, apparently,
much prompting) that more aggressive rate
hikes might be needed. The comments seemed
                                                    Source: TradeStation
to reflect the lack of concern about the euro’s
                                                                rates to adjust global imbalances. The U.S. has abandoned
Deja vu all over again                                          the strong-dollar policy first articulated by former Treasury
Political considerations seemed to argue against a new G7       Secretary Robert Rubin to signal a break from the devalua-
policy initiative. The governments in Germany, Italy, and       tionist thrust of his predecessor, Lloyd Bentsen.
Canada are new. Japanese Prime Minister Junichiro                  Many observers have portrayed the G7 and IMF stance
Koizumi is expected to step down in the fall and there will     as multilateral. This is deceiving. There were two other sig-
likely be a new finance minister as well. Many people sus-      nificant meetings of international monetary officials this
pect UK Prime Minister Tony Blair may also step down            spring (ASEAN+3 got together in early May, while the
before the end of the year. The French                                              Asian and European finance ministers
government is unpopular and there is
talk President Jacques Chirac may reshuf-
                                                      The dollar’s                  met in late April), and their resulting
                                                                                    statements did not reflect the sense of
fle his government to bolster the party’s                                           urgency of the G7-IMF meeting commu-
chances for next year’s election.
                                                     depreciation                   niqué. The key difference was the
   In the U.S., there continued to be spec-                                         absence of the U.S.
ulation that Treasury Secretary Snow               is tantamount to                    Remember, too, that after the 1997-
may be replaced shortly. One rumored                                                1998 Asian financial crisis, insofar as it
potential successor is Harvard’s Martin            a partial default.               essentially pushed for the implementa-
Feldstein, who incidentally has pub-                                                tions of the Washington consensus, the
lished at least two essays calling for a substantial dollar     IMF is hardly perceived as an independent actor. U.S. for-
decline. Even though Feldstein is unlikely to get the           eign economic policy is a subset of U.S. foreign policy, and
appointment, his comments did not do the dollar any             in this sense the IMF is another “coalition of the willing.”
favors.                                                            In addition, while there is official recognition that the
   Rather than prevent a new initiative, the political weak-    IMF’s voting system no longer reflects economic reality and
ness of the individual G7 countries led to the acceptance of    reforms are likely to be announced in September, it did not
the U.S. offensive, which was a reversion to an earlier and     prevent the old IMF (in which developing countries such as
politically-expedient strategy: the reliance on exchange                                                     continued on p. 18

CURRENCY TRADER • June 2006                                                                                                 17
     THE BIG PICTURE continued

FIGURE 3 — DOLLAR/YEN                                                   China, India, South Korea, Brazil, and Russia
                                                                        were not fairly represented) from taking on a
 The dollar/yen rate’s recent slide below 110.00 is just another        new foreign-exchange mandate.
 manifestation of the greenback’s 2006 swoon.
                                                                           We have been down this road before. The
                                                                        pattern is for European and Japanese officials to
                                                                        “cry uncle” before the U.S. and long before the
                                                                        dollar has fallen to a level the conventional
                                                                        view says is required to correct global imbal-
                                                                           In mid-May, with the U.S. Congress approv-
                                                                        ing the renewal of some the Bush
                                                                        Administration tax cuts, the signal being sent
                                                                        is the U.S. is not serious about boosting sav-
                                                                        ings and will rely on currency depreciation. As
                                                                        the euro approaches its historical highs, the
                                                                        dollar sags below 110 yen (Figure 3), and glob-
                                                                        al equity and bond markets become more
                                                                        volatile, it will not take long for domestic pres-
                                                                        sure to build in Europe and Japan and resist-
                                                                        ance to dollar depreciation to grow.

                                                                        Be wary of
                                                                        snake oil salesmen
                                                                        If dollar depreciation would work to reduce
 Source: TradeStation                                                   the global imbalances, it would arguably be
                                                                        acceptable. However, the problem is the actual
                                                                        empirical record, rather than sophomoric eco-
                                                                        nomic theory, indicates there is little evidence
The U.S. dollar has been in a downtrend vs. the Canadian dollar since   a decline in the dollar will achieve this goal.
2002, and the USD/CAD rate dropped as low as 1.1014 in May.                The U.S. dollar peaked against the Canadian
                                                                        dollar in 2002 (Figure 4). The Canadian dollar
                                                                        has appreciated by about 50 percent in the past
                                                                        four years, which is what some of the more
                                                                        extreme estimates suggest the Chinese curren-
                                                                        cy (yuan, or renminbi) is undervalued by. The
                                                                        average monthly U.S. trade deficit with
                                                                        Canada has risen from about $4 billion in 2002
                                                                        to approximately $6.7 billion. The four years
                                                                        that have passed should be enough to offset
                                                                        the “J-curve” effect economists use to account
                                                                        for a lag between changes in the price of finan-
                                                                        cial variables and changes in the prices of
                                                                           This experience is not limited to Canada, the
                                                                        U.S.’s biggest trading partner. Consider
                                                                        Europe. In 2000 the euro recorded its historic
                                                                        low against the dollar near $0.8230. It, too, has
                                                                        appreciated by more than 50 percent against
                                                                        the U.S. dollar. The U.S. recorded an average
                                                                        monthly trade deficit with Europe of roughly
                                                                        $5 billion in 2000 and 2001. It stands near $10.5
 Source: TradeStation
                                                                        billion now.

18                                                                                       June 2006 • CURRENCY TRADER
   Japan is not an exception to this general pattern. The dol-     service foreign markets. It is not simply by exporting, even
lar has been recording lower highs vs. the yen for nearly 20       though the U.S. is the world’s biggest exporter. Rather
years. The last major high was in 1998 near 147.50 yen. The        America’s contribution to commercial empire is “build
peak in 2002 was near 135 yen. In 1998, the average U.S.           locally, sell locally,” so the sales of affiliates of U.S. multina-
monthly bilateral trade deficit was less than $5.5 billion.        tional companies outstrips exports by a ratio of three to one.
Now the monthly average is closer to $7.0 billion.                    There are many ways China competes in the world econ-
                                                                   omy. The relatively cheap currency may help, but policy
Eyes on the prize                                                  makers are mistaken if they think it is the only way, or even
First we argued that the cure of the global imbalances by the      a critical competitive element. China competes in the world
G7-IMF’s dollar depreciation was more disruptive to the            economy through its cheap and docile work force. The
capital markets than the anticipated disease of imbalances         Asian Development Bank estimates that Chinese manufac-
themselves.                                                        turing wages are 1/33 of U.S. levels. Workers in this “work-
   Second we argued the dollar-depreciation has a poor             ers paradise” are not allowed to unionize and do not have
track record of reducing the U.S. trade deficit. Third, we         social security or unemployment insurance. Universal

    In a world of fiat currencies, confidence in officials is a critical factor. At the
    moment, confidence in the U.S. administration is on shaky ground, at best.
would also argue that not only is the dollar-depreciation          health care has been scrapped.
strategy unlikely to significantly reduce the global imbal-           The Chinese government has also purposely engaged
ances, it inflicts actual harm.                                    multinational companies to assist in its development. Special
   Given that policy makers cannot be sure the U.S.-China          economic zones have been established and the Chinese gov-
imbalance will improve even if the Chinese yuan appreci-           ernment provides various financial incentives to foreign
ates against the U.S. dollar, the risks of the current strategy    investors. Indeed, such incentives are so lucrative that some
seem greater than likely rewards.                                  mainland Chinese entrepreneurs reportedly set-up offshore
   Nearly every one agrees the U.S. external imbalance is          companies to qualify. Companies with foreign links account
not sustainable, but the sense of urgency articulated by           for around half of China’s manufacturing exports.
some U.S. officials does not seem justified. There are more           To the extent China is told a strong currency is in its inter-
pressing issues — including Iran, North Korea, Taiwan, the         est, there seems to be some tacit recognition an appreciation
regional arms race, and environmental issues — for which           in the yuan would be beneficial to China — unless we are to
Chinese cooperation is critical, and which appear to have a        believe the officials are cynical and engaged in deception.
higher probability of success.                                        If history and experience are our guides, rather than eco-
   Emphasizing foreign exchange may misunderstand how              nomic conjecture, an appreciation of the Chinese yuan would
nations compete in the modern global economy. U.S.-head-           see exporters move up the value-added chain. Low-cost pro-
quartered companies in a number of industries have organ-          ducers who use China as an export platform may migrate
ized their activity in terms of the North American continent.      elsewhere in the region, leaving the U.S. trade deficit largely
Although outsourcing tends to grab headlines, multination-         unaffected, even if the geographic origin shifts.
al companies have in-sourced trade — that is, the move-
ment of goods and services within the same company                 Feel mush, push
counts for more than a third of global trade and half of the       In sword fighting, it is said, when you feel mush, push;
U.S. trade deficit. For example, a component that is made in       when you feel steel, retreat. The dollar feels like mush and
the U.S. is exported to Canada, where it gets incorporated         the market is pushing. While technical indicators and short-
into a larger product that gets sent back to the parent com-       term speculative positioning are at extreme levels (warning
pany, which then distributes the final product. This typifies      that a technical correction may be in the offing) the dollar
the economy ushered in by NAFTA.                                   bears will remain in control until the official pain threshold
   Our 19th-century way of accounting tells us this is a trade     is reached.
deficit, but it is not. It is moving a good from one side of the      Support for the euro is seen ahead of $1.2750. Many
factory floor to the other, and the 49th parallel just happens     investment banks have revised down their dollar forecasts
to weave in and out of the factory.                                based on the recent price action; many are now looking for
   In addition, many policy makers and economists seem to          a test of the $1.30 level in the euro. As more observers rec-
have an outmoded understanding of how U.S. companies                                                                continued on p. 20

CURRENCY TRADER • June 2006                                                                                                        19
   THE BIG PICTURE continued

                                                                                   Related reading
                                                                                   Other Marc Chandler articles:
                                                                     “U.S. investment abroad”
ognize the U.S. has abandoned the strong-dollar policy in            Active Trader, July 2006.
everything but the exact words, the risk is the euro will test       Is being the largest debtor nation in the world as bad as
its record high near $1.3660 this year.                              everyone seems to think it is?
   The dollar also faces important resistance near 112.00 yen
and while 109.00 may now offer support, the real downside            “Japan: Rising Sun or just another day?”
objective is closer to 105-106.                                      Currency Trader, May 2006.
   The dollar’s depreciation is tantamount to a partial              Analyzing what Japan’s apparent economic rebound
default. The risk is officials will find it increasingly difficult   means for the yen.
to arrest the greenback’s decline as this becomes more evi-
dent. In a world of fiat currencies, confidence in officials is      “Surplus savings revisited”
a critical factor. Confidence in the U.S. Administration is on       Active Trader, April 2006.
shaky ground at best at the moment and it does not seem to           Can excess capital really be a bad thing? The ideas of
realize it.                                                          Charles Conant from more than a century ago offer some
   The combination of low volatility, low interest rates in          clues about this “conundrum” facing the new Fed chief.
advanced industrial countries, plenty of global liquidity, and
rising commodity markets has fueled a multi-year rally in            “The dollar super cycle”
many emerging markets. These conditions have changed.                Currency Trader, March 2006.
The risk is for a larger unwinding of emerging market invest-        Where’s the buck going? Perhaps long-term cyclical
ments. Investors in the emerging markets could be among              analysis offers a clue.
those burned when old men play with fire.
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               The yen carry trade,
                 currencies, and U.S. bonds
     What does the future hold for the yen, the yuan, and U.S. debt markets in light of Japan’s changing
            interest-rate stance and continued pressures on China to allow its currency to float?

                                                BY HOWARD L. SIMONS

B               ond traders are congenitally anxious people. country’s portfolio of U.S. Treasuries, who would be hurt
                This derives from the very nature of bond more, them or the U.S.?
                investing: Once you lend someone money,             But answering irrational fears with rational arguments is
                the only acceptable outcome is you will get a losing proposition. For more than 30 years, bond traders
paid in full on both the coupons and the principal. have searched the skies for an incoming wave of Japanese
Anything else is bad.
   In addition to outright default in the
                                                                 bond sellers attacking out of the rising sun. How foolish:

corporate and municipal markets, you         FIGURE 1 — JAPANESE SHARE OF FOREIGN U.S. TREASURY PURCHASES
have to worry about currency risks for
international bonds, inflation risk          The Japanese have been sellers of U.S. Treasuries several times — including
everywhere, interest rate risk, and the      early 2006 — without consequence. With minor exceptions in late 2001 and
                                             early 2002, other foreign investors have been net buyers each time this
gnawing sense that someone, some-
where, is going to wake up in the
morning and say, “Sell!”
   Never mind the old joke that if you
owe someone $10 and cannot pay, you
have a problem, but if you owe $10 mil-
lion and cannot pay, they have a prob-
lem. A rational person understands
some simple verities of international
finance. These include the equivalence
between the U.S. current account
deficit and the U.S. capital account sur-
plus. The dollars being paid by
Americans to overseas suppliers are
claims on U.S. goods and services and
therefore eventually have to be rein-
vested in the U.S. And they include the
role of the U.S. capital surplus in main-
taining the export industries of our
suppliers. Bluntly, if someone in Tokyo
or Beijing or Taipei woke up one morn-
ing and decided to liquidate their

22                                                                                            June 2006 • CURRENCY TRADER
                                            FIGURE 2 — COMPARATIVE CURRENCY STRENGTH
                                                       AFTER YUAN PEG LOOSENING

                                              The Chinese yuan (CNY) has strengthened against the U.S. dollar since
                                              July 2005, but the Japanese yen (JPY) has weakened. Prior to Feb. 3,
Even if the Japanese sell, other holders      2006,the yuan's rise was gradual, but it accelerated after this date.
of dollars are forced to buy because of
the current account-capital account sit-
uation. The Japanese have actually
been net sellers of U.S. Treasuries sev-
eral times, including in early 2006,
without consequence (see Figure 1).
With some minor exceptions in late
2001 and early 2002, other foreign
investors have been net buyers each
time this happened.

The yen carry trade
The latest source of anxiety for bond
traders has some surprising currency
linkages. The yen carry trade, wherein
the cheap-to-borrow yen (created by
Japan’s post-2002 program of “quanti-
tative easing” of its money supply) are
lent elsewhere in risky assets, may be
coming to an end. (See “The yen
stands alone,” Currency Trader, March      FIGURE 3 — WHEN WERE SPECULATORS TRAPPED SHORT IN THE YEN?
2006.) Carry essentially is the spread     On Nov. 23, 2005 volatility in three-month JPY forwards jumped higher
between the cost of borrowing and the      and continued moving strongly higher into mid-January 2006. The spot JPY
returns on lending. Certainly the Bank     bottomed on Dec. 7. Both measures continued to firm on Dec. 15 when
of Japan has signaled this to be the       the Bank of Japan first warned it might end its quantitative easing program.
case; Governor Toshihiko Fukui first
indicated quantitative easing would
end in December 2005 and then sig-
naled Japan’s zero-percent short-term
interest rates would end on Feb. 3,
2006 (these dates are highlighted in
Figures 2-5).
   Before we continue, let’s debunk the
notion that the health of the bond mar-
ket depends on high carry. The Federal
Reserve has been raising the federal
funds rate like clockwork since June
2004, and the 10-year note’s yield has
barely budged. Long-term interest
rates are set by the supply and
demand for credit, by inflation expec-
tations, and, as we shall see, by the
volatility of the currency market. If the
idea that long-term rates and the price
of risky assets such as stocks were                           irrational fears with facts — a losing trade.
determined by carry was true, the yield curve would have
a constant shape and stock prices would be discounted off The yen and the yuan
the federal funds rate, not the long-term capital markets Japanese purchases of Treasuries can be viewed as an
rate. Neither is true, but once again we are responding to                                                    continued on p. 24

CURRENCY TRADER • June 2006                                                                                                  23


  As the JPY six-to-nine month yield curve steepened (indicating expectations            (protests of American protectionists
  for short-term rate hikes in Japan), the yen carry curve flattened even as U.S.        notwithstanding) until July 20, 2005,
  rates rose.                                                                            at which point a confused and confus-
                                                                                         ing statement was issued about letting
                                                                                         the CNY appreciate against an undes-
                                                                                         ignated basket of currencies. As
                                                                                         shown in Figure 2, the CNY has
                                                                                         strengthened against the USD since
                                                                                         last July, but the JPY has weakened.
                                                                                         (The chart truncates the 100-percent
                                                                                         index base date of July 20, 2005 to
                                                                                         emphasize the yuan’s path.) While the
                                                                                         yuan’s rise prior to Feb. 3 was grad-
                                                                                         ual, it accelerated after this critical
                                                                                         date, which is highlighted on Figure 2.

                                                                                         Carry-trade risk
                                                                                          The risk of the yen carry trade is a
                                                                                          stronger JPY when the loan needs to
                                                                                          be repaid. Fortunately for carry
                                                                                          traders after the CNY began to float in
                                                                                          July 2005, the JPY weakened against
                                                                                          the USD into late 2005 as the interest-
                                                                                          rate differential between the U.S. and
   Before Feb. 3, FRR and 10-year note yields were correlated positively.                 Japan expanded.
   Between Feb. 3 and March 24 the correlation became negative. The period
                                                                                             This changed suddenly on Nov. 23,
   after Feb. 3 is associated with both an acceleration in the CNY’s strength and a
   rapidly declining yen carry. As the CNY strengthened, Japanese short-term
                                                                                          2005. Volatility on three-month JPY
   rates rose faster than did U.S. long-term rates.                                       forwards jumped higher and contin-
                                                                                          ued moving strongly higher into mid-
                                                                                          January (Figure 3). The spot JPY bot-
                                                                                          tomed on Dec. 7. Both measures con-
                                                                                          tinued to firm on Dec. 15 when the
                                                                                          Bank of Japan first warned it might
                                                                                          have to end its quantitative easing
                                                                                             The timing of the respective market
                                                                                          bottoms (see the dotted vertical lines
                                                                                          in Figure 3) well prior to the news
                                                                                          might seem a little suspicious, but that
                                                                                          is a story for another time and place.
                                                                                          (It is called Japan, Inc., for a reason.)
                                                                                             If the market was short the JPY, as it
                                                                                          must have been given the obvious
                                                                                          trend, then the rise in option volatility
                                                                                          should be interpreted as currency
                                                                                          traders buying insurance against a
                                                                                          stronger JPY.
instrument of national policy. Not only is Japan financing           Option volatilities in February and March fell below their
its customers with these purchases, it is suppressing the January highs but surged in April as the market began to
value of the yen (JPY) relative to both the U.S. dollar (USD) speculate the Chinese would move to revalue the CNY at a
and the Chinese yuan (CNY).                                       faster rate. Volatilities surged in the aftermath of Chinese
   The CNY had remained in a tight peg against the USD Premier Hu Jintao’s visit to the U.S. This suggests those

24                                                                                                June 2006 • CURRENCY TRADER
short the JPY suddenly became more fearful of greater               strengthened, Japanese short-term rates rose faster than
strength in the currency. The purchase of option protection         U.S. long-term rates.
on the JPY rather than exiting the carry trade outright                Fundamental economic relationships do not reverse on a
makes sense, as the yen carry trades are still highly prof-         whim. Which side of Feb. 3 is the correct one? The answer,
itable.                                                             as we shall see shortly, depends on the outlook for the
                                                                    JPY/CNY exchange rate.
Divergent yield curves                                                 Before we delve off into this important cross rate, let’s
We can compare the movements of different yield curves              take one final parting shot at the yen carry trade’s impor-
across different maturity segments via the forward rate             tance to U.S. Treasury yields. In the long-term, connections
ratio (FRR) between six and nine months. This is the rate at        between the yen carry trade and 10-year note yields col-
which we can borrow for three months starting six months            lapse altogether. We can extend the analysis back to 1989
from now, divided by the nine-month rate.                           and observe how very low levels of carry in the late 80s and
   Any threat to end quantitative easing in Japan should            early 90s corresponded with rapidly falling U.S. yields and
affect the FRR along the money-market curve, especially the         how very high levels of carry did not prevent a general
six-to-nine month segment. This, indeed, occurred in                increase in yields after September 2003 (Figure 6). The two
November at the time yen option volatility began to rise            series are virtually unrelated.
(Figure 4).
   This FRR began a climb that accelerated on Feb. 3, the The Chinese connection revisited
same date at which the yuan’s climb against the dollar If we overlay the JPY/CNY exchange rate on U.S. 10-year
began to accelerate. This steepening
was accompanied by a flattening of the
                                              FIGURE 6 — DID THE CARRY TRADE MATTER IN THE LONG-TERM?
FRR between the three-month yen
LIBOR rate and 10-year U.S. Treasury          In the long-term, connections between the yen carry trade and 10-year note
yields. As the JPY six-to-nine month          yields collapse altogether. Very low levels of carry in the late 80s and early 90s
yield curve steepened, indicating             corresponded with rapidly falling U.S. yields and very high levels of carry did
expectations for short-term rate hikes        not prevent a general increase in yields after September 2003.
in Japan, the yen carry curve flattened
even as U.S. rates rose. The carry curve
between the three-month yen LIBOR
and 10-year U.S. Treasuries is still
greater than 1.00, confirming this trade
is still profitable. The high JPY option
volatility confirms traders are buying
insurance against the trade’s principal
risk, future JPY strength.
   It is critical to note just how little the
yen carry trade affects the course of
U.S. 10-year notes (Figure 5). The yen
carry trade’s FRR flattened rapidly
after Feb. 3, and while 10-year note
yields rose after that point, it is impor-
tant to note they had been rising irreg-
ularly for some time. It would be diffi-
cult to ascribe causality to the yen
carry trade in the short-term.
   More important, however, is a corre-
lation reversal around Feb. 3. Prior to this date a wider FRR note rates, we see a fairly strong directional correlation
and 10-year note yields were correlated positively. Between between the beginning of the CNY’s controlled float in July
Feb. 3 and March 24, also marked on the chart, the correla- 2005 and Feb. 3 (Figure 7). The more the JPY weakened
tion became negative. The period after Feb. 3, as we have against the CNY, the higher U.S. note rates rose. A cynic
seen, is associated with both an acceleration in the CNY’s might assume the Japanese were content with this compet-
strength and with a rapidly declining yen carry. As the CNY                                                        continued on p. 26

CURRENCY TRADER • June 2006                                                                                                       25

                                                                                        in allowing the CNY to appreciate fur-
  There’s a fairly strong directional correlation between the JPY-CNY exchange
  rate and U.S. 10-year note rates between the beginning of the CNY’s controlled
                                                                                        Traders in general, and Treasury
  float in July 2005 and Feb. 3. The more the JPY weakened against the CNY,
  the higher U.S. note rates rose.                                                      traders in particular, find simple
                                                                                        explanations and bilateral relation-
                                                                                        ships comfortable. They focus on sim-
                                                                                        ple things such as the Bank of Japan
                                                                                        raising short-term rates by a meaning-
                                                                                        less handful of basis points or on the
                                                                                        JPY-USD rate. Currencies and bonds
                                                                                        form a unified and multilateral sys-
                                                                                        tem across all segments of the yield
                                                                                        curve. We need to focus on as many
                                                                                        relationships simultaneously as we
                                                                                        can and consider how the bilateral
                                                                                        relationship between China and Japan
                                                                                        affects the U.S. Treasury market. As
                                                                                        China and surely India increase their
                                                                                        role in international trade and finance,
                                                                                        this need will grow, not shrink.
                                                                                        A simple focus has led many toward
                                                                                        the knee-jerk trade of selling U.S.
                                                                                        Treasuries on the yen carry story. We
itive devaluation and therefore felt less need to intervene in   suggest the yen carry trade will remain and unless Japan is
the currency market by buying U.S. Treasuries. And if the        willing to accept a stronger JPY vis-à-vis the CNY, Japanese
JPY firmed, as it did after Dec. 7, the interventions resumed.   purchases of U.S. Treasuries will accelerate.
The JPY is no longer weakening against the CNY. With the           Currency traders, in turn, can focus on the JPY/CNY
USD cheaper in JPY terms and with the yen carry trade still      cross rate and its relationship to the U.S. Treasury market.
profitable, why would the Bank of Japan not start buying         The more this arbitrage relationship is understood, the
U.S. Treasuries again? It serves the interests of all three      greater the potential to profit.
countries. Japan finances its and China’s customer, the U.S.
gets lower interest rates, and the Chinese can take their time   For information on the author see p. 6.

                                               Related reading
                                               Other Howard Simons articles:
 “The euro index: The dollar index meets its match”              Here’s a look at the factors impacting Canadian
 Currency Trader, May 2006.                                      dollar movements.
 A look at the development of a viable — and tradable —          “What drives the dollar index?”
 euro index.                                                     Currency Trader, January 2006.
 “The index approach to currency risk management”                Market watchers often point to deficits and interest-
 Currency Trader, April 2006.                                    rate differentials to explain the dollar’s behavior, but
 Using dollar index futures to hedge non-dollar                  analysis shows these factors might not be in the
 investments.                                                    driver’s seat after all.
 “The yen stands alone”                                          “The dollar index and ‘firm’ exchange rates”
 Currency Trader, March 2006.                                    Currency Trader, December 2005.
 The usual rules of the currency world haven’t necessarily       The majority of currency traders are familiar only with the
 applied to the Japanese yen. Will that continue to be           current floating-rate system. Are we about to enter a
 the case?                                                       new “firm exchange rate” era dominated by the dollar
 “Remember the forgotten currency”                               and euro?
 Currency Trader, February 2006.
                                                                 You can purchase and download past articles at
 It’s often labeled a “commodity currency,” but the Canadian
 dollar tends to be ruled by other factors.

26                                                                                                 June 2006 • CURRENCY TRADER

                  Trade management:
 Risk, reward, and the 10-percent solution
In the second of two articles adapted from his new book, Technical Analysis of the Currency Market,
Boris Schlossberg looks at aggressive money management, scale-in techniques, and a
trade-management approach designed to balance high-risk and conservative approaches.

                                                   BY BORIS SCHLOSSBERG

Editor’s note: In last month’s article, “FX money management,” the   itor price action carefully. The price has now reached 1.2000
author addressed the “myth” of 2-to-1 money management and           and you sell another unit at that price. You now have sold a
looked at practical ways to manage risk in the forex market. This    total of three units at an average price of 1.2230. As long as
installment focuses on three different approaches to managing        the price remains below this level, you stay in the trade.
positions.                                                              Your patience pays off and the price collapses to 1.1700,
                                                                     at which point you finally cover the whole position. Let’s
                                                                     review the total profits from the trade:

D             o you have the killer instinct? Can you press
              the trade? Then the following trade-manage-
              ment technique may be for you. If you ever
              want to hit home runs, if you ever want to
make a huge score in trading, then this is the only way for
you to trade and FX is the single best market to effect this
                                                                         •1 unit at 1.2500 covered at 1.1700 results in a profit
                                                                          of +800 points.
                                                                         •1 unit at 1.2200 covered at 1.1700: +500 points.
                                                                         •1 unit at 1.2000 covered at 1.1700: +300 points.
                                                                         •Total profit: 1,600 points.
                                                                         •Total risk: 50 points.
   Let’s review the EUR/USD trade discussed in last
month’s article. Again, assume you get short at 1.2500 but              For those traders who can implement this strategy, this is
this time your strategy is different. If the pair trades up to       clearly the best way to trade. Dennis Gartman (the famous
1.2550, you cut your loss quickly and await the next oppor-          investment newsletter writer), an old pit trader himself,
tunity.                                                              calls this method “doing more of what is working and less

     For traders who are more than willing to suffer a long series of losses
   and empty trades for a chance to score big, FX offers the best opportunity
                  to do so of any financial market in the world.
   If, however, the trade moves your way, you do not auto-           of what is not.” It is no doubt deceptively simple and seduc-
matically take half the position out of the market. Rather,          tive.
you wait patiently and watch the price action. Imagine the              In fact, here is a description (taken from the Elite Trader
price has now moved to 1.2200, fully 300 points in the               bulletin board) of another famous pit trader, Richard
money. Instead of taking profits, you add another unit to            Dennis, employing just such a strategy in the bonds.
the trade. If the price begins to retrace all the way back to
1.2350, you cover the whole position for a scratch. You                  As someone who has seen the likes of Rich Dennis and
haven’t lost anything on the trade, but you haven’t made a             Tudor Jones operate, those “5 percent” winning trades
profit, either.                                                        involve add-on after add-on. Case in point is Dennis in the
   However, if the price retraces only slightly but then               1985-86 bull market in bond futures. He would start with
resumes direction, you stay in the position and again mon-                                                         continued on p. 28

CURRENCY TRADER • June 2006                                                                                                          27

     his normal unit of 500 contracts and get chopped for days.     are more than willing to suffer a long series of losses and
     Buy the day’s high, put ’em back out on a new swing low,       empty trades for a chance to score big, FX offers the best
     etc. Every once in awhile he’d wind up with 500 that           opportunity to do so of any financial market in the world.
     worked. Then he’d start the process higher, all over again.    Why? Leverage and liquidity.
     Work ’em in, work ’em out.
        After maybe a couple of months the market has rallied 10    Using leverage and liquidity
     points from where he started and he has 2,000 on (meaning      Here is how this strategy would work. Assume that you
     2 million a point). Now the market is short and ready to pop   have $10,000 of trading capital. Deposit only $2,000 of capi-
     on any size buying and he’s there supplying the noose.         tal with your FX dealer. Keep the rest in your bank account.
     Bidding for 500 on every uptick, he finally gets to a point    With 100:1 leverage, which is standard in the FX market,
     where for the last month of the move he has 5,000 on. T-       you will have 100 points of leeway before you get a margin
     bonds rally 20 points in just over a month and he’s up         call in EUR/USD. (Trading other pairs the margin require-
     $100,000,000 on a trade that started out with him just test-   ments might be different, so consult with your dealer before
     ing the waters, losing $100,000 a few times before he could    attempting this idea on other currencies.)
     establish a position worth doubling up on.                        If the trade moves against you, an automatic margin call
                                                                    will instantly take you out of the market. Dealers will not
  Wouldn’t we all want to own that trade? One trade, $100           call you in advance and warn you of an impending margin
million in profit. But let’s remember what’s required to get        call like they may do in exchange-based futures markets.
there:                                                              Rather, the dealer’s software program will automatically
                                                                    liquidate your position. This may seem a bit brusque, but
       • Accurate directional entry into trend.                     the upside of such an arrangement is that your account
       • An intense, multi-hundred-point trend with little          should never experience negative equity and your total risk
         or virtually no retracement along the way.                 should be limited to the amount you’ve deposited. The
                                                                    margin call will then act as a de facto stop on your account.
  What are the chances this type of strategy succeeds?                 If a margin call is triggered, your account should have
Minimal at best. Note that the writer described these as “5         approximately $1,000 of equity left: $2,000 initial deposit –
percent” trades, meaning they occurred only 5 percent of            $1,000 loss on trade ($10 * 100 points at 100:1 leverage) =
the time. In fact, the perfect confluence of events to gener-       $1,000.

     What most books never tell you is that almost all trades start out as losers.
      It is extremely difficult to time the entry so well that it immediately begins
                          to move in the direction of your trade.
ate such profits probably happens less than that.                      Deposit another $1,000 from your bank and trade again
   Far more than the fortuitous market conditions necessary         once your setup is triggered. You can repeat this process up
to produce such windfall profits is the unbelievable psycho-        to nine times before you run out of your trading capital.
logical pressure such trading will generate. The term “press-       Will you lose most of your money? Perhaps. Remember, this
ing the trade” is most apropos to describe this dynamic. Not        is a very low-probability trade. But at least by subdividing
only is the trader pressing the market by adding more and           your capital into 10 equal pieces you’ve given yourself the
more units as they go deep into the money, but he is also           best opportunity to succeed. This strategy is basically a
pressed by the market as his profits pile up.                       more intelligent variation on the old trader saying, “Have a
   Put yourself in Richard Dennis’ place. Would you be able         hunch, bet a bunch.”
to stay in the trade once it hit $1 million? How about $10             Let‘s imagine, however, that on one of the trades you
million? $50 million? At each level the intensity is enor-          were successful and caught the large directional move. If
mous, and for most people the pressure of winning can be            that’s the case, you could employ the trade management
far worse than the fear of losing.                                  strategy discussed before and continuously add to your
   Forget Richard Dennis and just think how you would               position as prices move your way. In the best of all possible
have felt if after selling the third unit at 1.2000 you had to      scenarios the trader could eventually build up a large posi-
cover at 1.2233 as prices retraced, and you had to watch a          tion, perhaps 10 lots or more (with notional value of $1 mil-
certain profit of 700 points evaporate.                             lion), that could be 1,000 points in the money. In that case
   For those unconcerned with such issues, for traders who          the profit on the trade would grow to $100,000. Not bad for

28                                                                                                June 2006 • CURRENCY TRADER
$1,000 of initial risk.                                                 2. Trade in very small increments.
  As I’ve already noted, this strategy is not for the faint of
heart. This is a very high-risk, (potential) high-reward strat-        To understand just how destructive this strategy can be,
egy that requires a unique mindset and proper trade man-            let’s examine what happens if the trader uses this method
agement techniques to succeed. For those inclined toward a          employing the standard allocation of 2 percent of capital
more steady approach, here is a completely different trade          per trade. Imagine that the trader with a trading account of
methodology and one that I employ myself.                           $10,000 initiates the first trade in the EUR/USD currency
                                                                    using two mini lots (worth $1,000 each). Prices move
Take a nibble, not a bite: Scaling into trades                      against his entry by 100 points and he now doubles his allo-
Never add to a loser. Never double down. These old trad-            cation to four mini lots. Again prices continue to move
ing maxims are treated as sacrosanct truths by most traders.        against him by another 100 points and he doubles his posi-
   What a bunch of nonsense. I add to losers all the time,          tion yet again to eight mini lots.
and so do some of the most successful traders I know. Why?             Prices continue to follow this adverse pattern and move
Because what most books never tell you is that almost all           against him by 100 points more. Finally, the trader gives up
trades start out as losers. It is extremely difficult to time the   and covers his position in dismay. What is his total loss? A
entry so well that it immediately begins to move in the             whopping 22 percent of his total capital!
direction of your trade. Sometimes trades will move only a
few points against the position but occasionally prices may             •$600 on two mini lots (prices moved 300 points
retrace several hundred points away from initial entry only              away from entry).
to eventually turn around and become profitable.                        •$800 on four mini lots (prices moved 200 points
   Trading is the art of accurately forecasting direction and            away from entry).
timing. Between the two, timing is far harder to handicap,              •$800 on eight mini lots (prices moved 100 points
especially if prices seesaw back and forth for a while before            away from entry).
ultimately moving in the right direction. Traders who trade

    Like a mother who feeds her baby medicine in tiny little portions in order
    to make it more palatable, this technique forces the trader to do what is
            best for his account with minimal psychological damage.
highly leveraged positions with tight stops will be eviscer-           The irony of the matter is that after an uninterrupted 300-
ated in such an environment, as they will continuously get          point move against the position, chances are quite high that
stopped out. Far worse than the hit to equity is the psycho-        the trade may turn around and could quickly become prof-
logical pain of “death by a thousand stops.”                        itable. But by overleveraging the position the trader is
   That is why traders who do not like frequent stop-outs           unable to withstand the drawdown.
prefer the scale-in approach to price entry. This strategy is          Imagine the same scenario but instead of using mini lots
almost diametrically opposite to the strategy discussed in          with the value of $1 per point, the trader uses micro lots
the preceding section. Using the scale-in approach assumes          with each point having a value of only 1 dime ($1,000). In
that the first entry will almost never be the best entry; as a      FX, where many dealers offer such small lot sizes, this strat-
result, the approach requires very low leverage in order for        egy is eminently possible. In that case the drawdown would
the strategy to withstand the adverse price moves.                  be a far more manageable 2.2 percent of capital and the
   In this strategy, the trader continuously adds more units        price would need to move back only 150 points instead of
as prices move against him, trying to achieve a blended             the full 300 points in order for the trade to become prof-
price that remains near the current price. If prices do even-       itable.
tually turn, the constant averaging of price levels will make          This type of scaling where the trader doubles the size of
the position profitable much faster than if he expended all         the position at every interval is called “geometric scaling.”
of his trading capital on the first price entry. While this can     Unlike regular average-in scaling that cuts the break-even
be a successful trading strategy, it can also be highly dan-        point by 50 percent, geometric scaling requires that prices
gerous if the trader does not follow two key rules:                 retrace by only 33 percent to reach the break-even point.
                                                                       While this can be a very effective way to quickly make a
     1. Set a hard stop for the whole position.                                                                  continued on p. 30

CURRENCY TRADER • June 2006                                                                                                      29

                                                                                          trade moves against us by 10 points we
                                                 Notional         Notional
                                                                                          would sell one mini lot, leaving us
                                       Arithmetic value Geometric value
                                                                                          with nine mini lots (90,000 units) in the
  Long every 50 pips down 1.2500           100     $125      100     $125
                          1.2450           200     $249      200     $249
                                                                                             If the trade moves 20 points counter
  Starting account $5,000 1.2400           300     $372      400     $496
                                                                                          to our entry we would sell one more
  Unit — 100              1.2350           400     $494      800     $988
                                                                                          mini lot, leaving us with 80,000 units
  Pip value — 1 cent      1.2300           500     $615     1,600   $1,968
                                                                                          — and so on, until the price reached
                          1.2250           600     $735     3,200   $3,920
                                                                                          our ultimate stop-out value of 1.2600,
                          1.2200           700     $854     6,400   $7,808
                                                                                          at which point we would only have to
                          1.2150           800     $972    12,800  $15,552
                                                                                          liquidate one mini lot left in our inven-
                          1.2100           900    $1,089   25,600  $30,976
                                                                                          tory. On the opposite side we would
                          1.2050         1,000    $1,205   51,200  $61,696
                                                                                          maintain our target of 100-point profit
                          1.2000         1,100    $1,320  102,400 $122,880
                                                                                          regardless of how many lots we had
                                         6,600    $8,030  204,800 $246,658
                                                                                          left, so if we got stopped out on three
  Hard stop               1.1950
                                                                                          mini lots but prices then turned in our
  Break-even value                       1.2166                              1.2049
                                                                                          favor we would harvest a 100-point
  Maximum loss in pips                    -143                              -2,041.5
                                                                                          profit on the remaining seven lots.
  Maximum loss in dollars                 -143                              -2,041.5
                                                                                             Think about the implications of this
                                                                                          strategy for a moment. In the original
losing trade profitable, the strategy can also spiral out of       trade we risked 100 points on 10 mini lots or a total of 1,000
control. A better compromise between the straight average-         points (100 * 10 = 1,000). Using this compromise stop-out
in method and the geometric scale-in is the arithmetic scale       approach we were able to winnow down the total loss from
strategy. Instead of doubling up the position at every inter-      1,000 points to only 550 points if the trade became a com-
val, the arithmetic scale calls for an increase of the position    plete bust.
by a fixed amount. Table 1 shows the key differences                  However, if the trade turned in our favor at any time
between the geometric and arithmetic approaches using a            before reaching the eighth stop-out, we would still have
hypothetical scale-in strategy in EUR/USD starting with            been able to bank a gain. The attractiveness of this approach
entry at 1.2500 and a hard stop at 1.1950.                         is twofold. It automatically reduces risk if the trade moves
   Note that in the worst-case scenario the geometric strate-      against you, but it allows the trader to partially remain in
gy loses more than $2,000 on a $5,000 account while the            the trade up to the very last moment. Not only is this a good
arithmetic strategy loses only $143. At the same time the          practice of risk management but it is also a very clever way
break-even point on the arithmetic strategy is 1.2166, only        to get the trader to actually accept his stops. Just like a
slightly higher than the 1.2049 break-even on the geometric        mother who feeds her baby medicine in tiny little portions
approach. The data clearly shows that for multiple-interval        in order to make it more palatable, this technique forces the
scale-in approaches the arithmetic strategy is the best bet.       trader to do what is best for his account with minimal psy-
                                                                   chological damage.
The 10 percent solution                                               Steve Cohen, probably the greatest trader in the world
An interesting trade-management compromise between the             today — so good that he is able to charge 50 percent of gross
low-probability, (potential) high-reward method of scaling         profits in his multibillion-dollar hedge fund STC Capital —
up into a position and the high-probability, low-reward            once said in an interview with Jack Schwager in Stock Market
technique of scaling down into a trade is something I call         Wizards (Harper-Collins, 2001), “What happens when you
the 10-percent solution, which I picked up from a trader on        are short a stock that is moving against you, and there is no
one of the FX trading bulletin boards.                             imminent catalyst? I always tell my traders, ‘If you think
   Let’s suppose once again we would like to short the             you’re wrong, or if the market is moving against you and
EUR/USD pair at 1.2500. For simplicity’s sake, we are will-        you don’t know why, take in half. You can always put it on
ing to risk 100 points and seek a 100-point target on the          again.’”
trade. In other words, our stop is at 1.2600 and our target is        When I first read that comment it went in one ear and out
at 1.2400.                                                         the other. But upon further reflection, I realized Steve
   Let’s further imagine we will trade 10 mini-lot contracts       Cohen was practicing just this type of risk control method-
with total notional value of 100,000 units. We place our           ology for all of his trading.
short at 1.2500. However, here is the rub. Instead of stop-           The 10-percent solution strategy is only a template. We
ping out at 1.2600 with the whole position, we place stops         need not scale out at every 10 percent of the distance to the
at 10-point intervals for 10 percent of the position. So, if the   ultimate stop. We could use 20 percent, 25 percent, 33 per-

30                                                                                                June 2006 • CURRENCY TRADER
                                                               Related reading
                                                               Technical Analysis of the Currency Market: Classic
cent, or any other type of ratio that makes sense. The         Techniques for Profiting from Market Swings and Trader
strategy can also be refined further to enhance the            Sentiment by Boris Schlossberg (2006, John Wiley & Sons).
probability of success, though at a cost to profitability.
   For example, instead of keeping the profit target at a      Other articles by Boris Schlossberg:
static 100 points from original entry, we could adjust the     “FX money management,” Currency Trader, May 2006.
target in response to price action. If the price moved 10      Cracking open the “myth” of 2-to-1 money management
points against our position we could reduce the profit         and exploring practical money-management techniques.
target by 10 points, so that instead of 1.2400, we would
                                                               “Progressive entry technique,” Currency Trader, July 2005.
decrease the profit target for our short to 1.2410; if the
                                                               A staggered trade-entry approach allows you to be more flexi-
price moved 20 points we would decrease the profit tar-
                                                               ble and structure your trade depending on market develop-
get to 1.2420. Table 2 shows what happens when the
system is adjusted in such manner.
   Note that while the profitability of each trade is          “Forex options,” Currency Trader, June 2005.
somewhat reduced, the probability of the success for           Forex options are a breed apart. Traders accustomed to stan-
each trade is likely to be better as it needs to travel less   dard calls and puts need to familiarize themselves with some
and less distance in order to reach the profit target.         new concepts and terminology before trading these “exotic”
Conclusion                                                        You can purchase and download past articles at
Whenever I teach new sales traders at my firm about     
proper trade management in the currency market, I
often start out with the example of Richard Dennis and
the method of pressing the trade. Before I even have a customize the size of their positions without incurring any
chance to finish, some overeager rookie will inevitably marginal costs. Whether the trader wants to deal 1 million
jump up and confidently proclaim, “Yes! That’s the only units of EUR/USD contract or only 100 units, the transac-
way to trade!” However, in trading there is no “only” way tion cost among most of the reputable dealers will almost
of doing anything, especially money management.                     never exceed 0.03 percent. This allows even the smallest
   One of the great strengths of trading is that it is an art, not traders to implement any of these sophisticated risk-man-
a science — and there is a highly flexible discipline that agement techniques on the exact same terms as the biggest
allows for numerous individual modifications.                       interbank FX traders.
   Are you comfortable with the classic 1:2 risk-reward                However, the one inviolable truth that no trader, big or
approach? If so, it can be quite profitable, especially if you small, should ever forget is this: Everybody loses in trading
modify it as most traders do by scaling out of half of the at some time in their career. The difference between those
position at profit distance equal to risk and trail the rest who survive and those who do not is that winners honor
with a break-even stop.                                             their stops while losers make excuses.
   Do you have a killer instinct? Can you easily give up
small to medium-sized gains in quest of one huge win? For information on the author see p. 6.
Then pressing the trade by constantly
adding to a winning position may be           TABLE 2 — TEN PERCENT SOLUTION STRATEGY
the best strategy for you.
   What if you like taking small, fre-        Number of profitable lots         Total points      Total points at 10 percent
quent gains and can accept an occa-               (out of 10 total)            at 10 percent       with adjustable targets
sional large loss? Then arithmetic scal-                  10                       1,000                    1,000
ing may be just the right approach for                     9                        890                      810
you to succeed.                                            8                        770                      610
   Finally, what if you are a true mod-                    7                        640                      430
erate, neither seeking remarkable                          6                        500                      260
gains nor afraid to absorb a series of
                                                           5                        350                      100
small losses? Then the 10-percent solu-
                                                           4                        190                       -50
tion may be just the “solution” for you.
   As you can see, risk-management                         3                         20                      -170
trading is truly contingent on the trad-                   2                        -160                     -300
er’s personal preferences. The curren-                     1                        -350                     -420
cy market makes the task immeasur-                         0                        -550                     -550
ably easier by allowing retail traders to

CURRENCY TRADER • June 2006                                                                                                  31

                  The inside market:
                  Hitting bids, lifting offers
         Knowing whether trading is occurring on the bid or ask — and the size of the trades —
                              provides a fresh perspective on intraday price action.

                                                    BY THOM HARTLE

W                   hen an economic number hits the mar- 1.2712 to the high of 1.2730. Also, this bar closed at its low.
                    kets, traders take action and the “inside
                    market” — that is, the current bid-ask bers, the next bar jumped immediately to 1.2730 and rallied
                    spread — jumps
around rapidly. The problem is, the
inside market can move so quickly it is
difficult to decipher what is happening
                                                                      Then, when traders finally saw the employment num-

                                             FIGURE 1 — EMPLOYMENT NUMBER REACTION
                                             Just before the jobs report was released, the euro dropped — then rallied
                                             sharply for a little more than two minutes, peaking above 1.2800 before pulling
in the market until well after price has     back a bit. However, even this very short-term (one-minute) bar chart leaves out
made its move.                               valuable information about the market’s dynamics.
   Price bars don’t provide information
about the inside market; they simply
plot the last price that occurred. For
example, Figure 1 shows a one-minute
chart (with volume) of the June 2006
euro currency futures (ECM06) before
and after the release of the U.S.
employment numbers on May 5.
   Although most people think of the
impact of the employment report in
terms of the stock and bonds markets,
the forex market also anticipates these
numbers and can be rocked by unex-
pected developments. Figure 1 shows
the euro’s dramatic reaction to the 7:30
a.m. CT announcement that the non-
farm payrolls number came in lower
than expected and the previous
month’s number was revised down.
U.S. interest rates fell and the dollar
weakened, resulting in a spike in the
   Prior to the release of the payroll
number, the typical one-minute bar for
the euro had ranged from three to five
ticks (the tick move in this market
being .0001). The range of the one-
minute bar immediately preceding the
                                             Source: CQGNet (
release was 18 ticks, from the low of

32                                                                                            June 2006 • CURRENCY TRADER
to 1.2784. Clearly, traders were aggres-   FIGURE 2 — MONITORING BID-ASK ACTIVITY
sively lifting offers over the next two     Knowing whether trades are occurring on the bid or ask side of the market (and
minutes, but what was really happen-        how much volume there is) provides much more insight about market dynamics
ing in terms of available opportunities     than simply knowing whether price is moving higher or lower. On this TradeFlow
to execute trades? The one-minute bars      chart, the high and low of each bar represent the best bid and ask price, and the
don’t provide a very good indication of     width and color of each bar reflects the volume of trades. The bars are color
the changes occurring to the bid-ask        coded based on the percentage of the volume of trades at the bid (red) vs. the
spread.                                     ask (green). The volume study shows the actual number of contracts traded at
   Other tools can be used to help shed     the ask (green histogram bar) and at the bid (red histogram bar).
light on whether buyers or sellers are
controlling the market on an intraday
basis. In addition to whether price is
moving higher or lower at a given
time, it is useful to know whether
trades are occurring at the ask price
(which reflects buying pressure) or the
bid price (which reflects selling pres-
sure), as well as the relative volume of
those trades. For example, more trades
occurring on the ask than the bid might
seem bullish, but if those trades are
occurring on very low volume, the
market’s strength is more suspect than
it would be if volume were higher than
   The following section uses this kind
of information to analyze the market’s
behavior after the release of the
employment report.

The inside scoop
Something you could not know by
looking at a standard bar chart is that
during the first minute following the
release of the employment number, the
inside bid-ask prices changed more
than 280 times — almost five times per      Source: CQGNet (
second. Being able to see the action of
the inside market immediately after                           (red) portion.
this release is valuable as an example of market conditions      For example, if the market was 1.2789 bid for 300 con-
traders might face when trying to execute a trade, either to tracts, and 400 contracts were offered at 1.2790, the low of
enter a new position or exit an old one after employment the bar would be 1.2789 and the high would be 1.2790. If a
data is released.                                             total of 100 contracts traded hands and traders bought 60
   Figure 2 shows a “TradeFlow” chart in which the indi- contracts at the offer price of 1.2790 and sold 40 contracts at
vidual bars display price action in terms of the bid-ask the bid price of 1.2789, the bar would be 60 percent green
spread. The lower panel shows the TradeFlow volume and 40 percent red.
study, which shows the actual number of contracts traded         The width and brightness of each bar shows it relation-
at the bid or ask. In effect, a TradeFlow chart tracks the ship to typical volume. If the volume is high relative to typ-
inside market rather than last price. The low of each ical volume, the bar will be wide and the colors will be
TradeFlow bar is the best bid and the high is the best ask. bright; low-volume bars will be thin and darker. Thus, the
The bars are colored based on the percentage of volume of bars highlight low and active periods along with empha-
trades executed at the ask price (green) vs. the bid price                                                continued on p. 34

CURRENCY TRADER • June 2006                                                                                                     33

sizing whether buyers or sellers are the aggressors.           reading and the red histogram bar would have a -40 read-
   The volume study lets you see the actual trading volume     ing.
that occurred at the ask price (green histogram bars) vs. at      Figure 2 shows typical trending action — the inside mar-
the bid (red histogram bars). Using the preceding trade        ket is zigzagging upward, and for the most part the spread
example, the green volume histogram bar would have a +60       between the high and low of each bar is one tick. Notice
                                                               during the period of sideways price action the bars tended
                                                               to be a little wider and colored a higher percentage of green
                                                               than red. This indicates that during the sideways move-
                                                               ment traders were buying at support more than they were
                                                               selling; the market subsequently pushed higher. If sellers
                                                               had been more aggressive about hitting bids during this
                                                               period, it would have cast doubt on the potential for anoth-
                                                               er up swing.
                                                                  Also, notice the solid red bars in Figure 2, which indicate
                                                               that traders were only hitting bids. These bars tended to be
                                                               narrow, and therefore indicated the volume was light —
                                                               not much selling pressure was hitting the market at these
                                                                  Finally, with one exception, the volume study was dom-
                                                               inated by tall green histogram bars rather than deep nega-
                                                               tive red histogram bars, confirming that throughout this
                                                               trend, traders were more aggressively lifting offers than hit-
                                                               ting bids.

                                                               Release of the jobs data
                                                               Figures 3 through 11 show the movement of the inside mar-
                                                               ket for the first minute of trading following the release of
                                                               the payroll data. The fact it takes eight charts to detail the
 Source: CQGNet (                                  action of the inside market for a one-minute price bar

 FIGURE 4                                                       FIGURE 5

 Source: CQGNet (                                   Source: CQGNet (

34                                                                                           June 2006 • CURRENCY TRADER
shows just how active the market becomes when an impor-             market is still a bit from the high.
tant economic report is released.                                     In Figure 5, the bars on the left side of the chart are nar-
   Figure 3 shows the immediate and dramatic reaction to            row, indicating the trade volume is lower than what was
the employment data. First, the inside market greatly               occurring in Figure 4 (which, again, can be confirmed by
expanded as traders rushed to lift offers. The solid green                                                       continued on p. 36
bars with the rising ask prices reflect a market being swept
by buyers. Offers are being aggressively lifted; there is no
                                                                     FIGURE 7
selling into the bid.
   The reaction to the numbers was met by overwhelming
buying, as traders only lifted offers from 1.2730 to the ini-
tial run to 1.2747 (the bars are all green). In the last ten bars
on the chart traders started to hit bids, but only single con-
tracts were executed at the bid at 1.2744 and 1.2737; then
traders lifted offers again. At this point, the bid-ask pair
was jumping around with bids as low as 1.2736 and offers
as high as 1.2749.
   In Figure 4 the bid levels are flat and the ask prices keep
climbing. Most of the bars are nearly all green, which
means there was trading at the ask price rather than the bid
price. The volume study’s green histogram bars are much
higher than the red histogram bars, reflecting the greater
volume occurring at the ask prices.
   The right corner of Figure 4 shows offers were being lift-
ed as high as 1.2765 while the bars started to narrow (com-
pare them to those in the middle of the chart); volume is
starting to subside. Keep in mind that this inside market
action is occurring in the first minute following the release
of the employment report. Referring again to Figure 1, the
high of the 7:30 a.m. one-minute bar is 1.2784, so the inside        Source: CQGNet (

FIGURE 6                                                             FIGURE 8

 Source: CQGNet (                                        Source: CQGNet (

CURRENCY TRADER • June 2006                                                                                                     35
     THE BIG PICTURE continued

looking at the volume study). As volume trailed off, the        balanced between selling (red) and buying (green). Then, at
market stalled out, making the 1.2772 offer price the high.     bar A, traders hit the bid for more than 50 contracts, which
Temporary support was established at the 1.2764 bid.            was the heaviest selling so far. However, traders only hit
   At this point, traders are starting to back away from pay-   bids on two of the next four bars, and this selling was very
ing the ask price and are starting to hit bids. To the right    light. This set the stage for buyers to step in again.
side of the chart the volume histogram bars become more            With support holding at 1.2764 from the two tests of the
                                                                bid at this level, the inside market climbed to a bid-ask
                                                                range of 1.2774-1.2777 (Figure 6). The bars were wide dur-
 FIGURE 9                                                       ing this advance, indicating expanding volume, but at bar
                                                                A, traders sold more than 120 contracts at the bid, at which
                                                                point the market went into another trading range.
                                                                   But as the inside market slipped lower, the number of
                                                                contracts sold into the bid declined as indicated by the pro-
                                                                gressively smaller red volume histogram bars.
                                                                   In Figure 7, the inside market moved sideways after
                                                                traders hit bids from bar A in Figure 6. During the first half
                                                                of the chart the volume histogram bars were balanced until
                                                                bar A, at which point traders lifted a little more than 75 con-
                                                                tracts at the ask price of 1.2776. However, other traders
                                                                started hitting bids, as reflected in the progressively larger
                                                                red volume histogram bars B, C, D, and E.
                                                                   However, this selling did not lead to a breakdown, as
                                                                shown in Figure 8. The initial hitting of bids led to a side-
                                                                ways market, during which traders once again lifted offers
                                                                more than they hit bids. (At bars A and B traders twice hit
                                                                bids of nearly 50 contracts, but this selling was readily
                                                                absorbed and the market advanced again.)
                                                                   In Figure 9, buyers continued to be the aggressors, paying
                                                                up until the inside market was offered at 1.2784. This level,
                                                                which was tested twice, turned out to be the high for the 7:30
 Source: CQGNet (
                                                                a.m. one-minute bar. However, this bar had not closed yet.

 FIGURE 10                                                       FIGURE 11

 Source: CQGNet (                                    Source: CQGNet (

36                                                                                             June 2006 • CURRENCY TRADER
                                                                                   Related reading
   Figure 10 shows that after the inside market peaked at
                                                                   “Forex trading: Understanding the currency market”
1.2784, the bid-ask pair moved down and found good sup-
                                                                   Active Trader, July 2004.
port at the 1.2777 bid. Some good buying showed up, with
                                                                   What makes currencies tick? Find out which economic
nearly 100 contacts lifted 1.2779 (bar A) and again at 1.2781
                                                                   factors help shape the short-term and long-term forex
(bar B), which led to another test of 1.2784 where traders
paid the offered price. However, only a few contracts actu-
ally changed hands at the offer price; sellers hit bids and the
                                                                   “Economic reports in the Forex market”
inside market dropped to a bid of 1.2779 (bar C) on light
                                                                   Currency Trader, December 2004.
                                                                   A look at top economic indicators and when they are
   The 7:30 a.m. one-minute bar closed in Figure 11. The
                                                                   most likely to influence forex market sentiment.
inside market challenged the 1.2784 level one more time
before pulling back to 1.2779-1.2781. However, buyers were         You can purchase and download past articles at
still more aggressive: The volume study continued to dis-
play taller green histogram bars (trades at the ask price)
compared to the red histogram bars (trades at the bid
price). Figure 1 shows how price continued to move higher         the majority of traders started lifting offers, the implication
(to above 1.2800) in the next minute.                             is support will hold.
                                                                     The charts shown here illustrate that when an important
Looking inside price action                                       economic number is released, the inside market can change
Traders often make decisions based on traditional price           at a dramatic rate and become chaotic, with wide bid-ask
charts, which simply show the last price, not whether             pairs and little volume or size. Traders should understand
traders are lifting offers or hitting bids.                       how the market conditions (the inside market) can change
   If the inside market is dropping and the last price is test-   in reaction to an economic release, as that affects fills.
ing support on a standard price chart, it is beneficial to
know precisely what other traders are doing. For example,         For information on the author see p. 6.
if fewer bids were being hit as the bid dropped (indicating       Click here for more information about analysis platforms
traders were doing less selling on the way down), and then        with bid-ask analysis capability.

Correlated                             FIGURE 1 — SAMPLE TRADES
                                       The system caught the downtrend in the euro with a sell signal from the British pound.
Market: Currencies.

System concept: Various
currencies are highly correlat-
ed, especially those that trade
against the U.S. dollar. This
system uses one currency as an
“indicator” to trade a second,
highly correlated currency —
i.e., it takes buy and sell sig-
nals from one currency and
applies them to the other. The         Source for all figures: Wealth-Lab Inc. (
analysis        also   compares
whether these signals create better trades if they’re based               2. Exit long and go short the next day at the market if the
on the original currency or the correlated currency.                         indicator currency drops to a new 120-day low.
   The first step is to calculate the correlation between dif-
ferent currencies. The following table lists the correlation Money management: Risk a maximum of four percent
between different currencies during the test period (Jan. 1, of account equity per trade and use four times the 10-day
1999 to Dec. 31, 2005):                                                average true range (ATR) as stop-loss level. The number of
                                                                       contracts is calculated using the entry price, the stop-loss
       Analyzed currencies              Correlation
          British pound/Euro               0.96
                                                                      FIGURE 2 — EQUITY CURVE
          Swiss franc/Euro                 0.98
          Swiss franc/British pound        0.92                        The system’s performance was uneven in the first half of the
          Japanese yen/Euro                0.06                        test period before taking off in the second half.
          Japanese yen/Swiss franc         0.04
          Japanese yen/British pound       0.00

With exception of the Japanese yen, the currencies have a
strong correlation to at least one other currency. The sys-
tem uses these currencies as indicators:

     Traded currency               Indicator currency
       British pound                  Euro
       Euro                           British pound
       Japanese yen                   Japanese yen
       Swiss franc                    Euro

The system trades each currency (except the yen) using
120-day breakout signals from its correlated counterpart:
long trades are triggered when the correlated currency
makes a new 120-day high, and short trades are signaled
when that currency makes a new 120-day low.

 1. Go long the next day at the market if the indicator
    currency climbs to a new 120-day high.

38                                                                                                  June 2006 • CURRENCY TRADER
level, and the dollar value of a one-point move.                  Test data: The system was tested on the following cur-
   For example, assume the system goes long at 100 in a con-      rency futures portfolio: British pound (BP), euro (EC),
tract in which a one-point move has a value of $1,250. The        Japanese yen (JY), Swiss franc (SF). Data source: Pinnacle
stop-loss is $98. To determine the trade’s dollar risk, multi-    Data Corp. (
ply the point value ($1,250) by the difference between the
basis price and the stop-loss level ($100 - $98 = $2). A single   Test period: January 1999 to December 2005.
contract’s dollar risk is $2,500. The system can risk $40,000
for this trade, so it buys 16 contracts ($40,000/$2,500).         Starting equity: $1,000,000. Deduct $20 commission per
                                                                                                                            continued on p. 40

 STRATEGY SUMMARY                                                                   LEGEND: Starting capital — Equity at the beginning of the
                                                                                    simulation period • Ending capital — Equity at the end of the
                              Long + Short       Long Only        Short Only        simulation period • Net profit — Profit at end of test period,
                                                                                    less commission • Net profit % — Profit at end of test period in
 Starting capital ($)         1,000,000.00       1,000,000.00     1,000,000.00      percent of starting equity • Annualized gain % —
 Ending capital ($)           2,852,380.94       1,976,554.41     1,875,826.53      Compounded annual growth rate • Exposure — The area of the
                                                                                    equity curve exposed to long or short positions, as opposed to
 Net profit ($)               1,852,380.94       976,554.41       875,826.53        cash • Number of trades — The total number of round-trip
 Net profit (%)               185.24             97.66            87.58             trades plus open positions • Avg profit/loss — The average
 Annualized gain (%)          16.17              10.24            9.41              profit/loss per trade in dollars • Avg profit/loss % —The aver-
                                                                                    age percentage profit/loss per trade • Avg bars held — The
 Exposure (%)                 7.78               4.68             4.44              average number of bars held per trade • Winning trades — The
                                                                                    total number of winning trades • Winning % — The percentage
                                                                                    of winning trades • Gross profit — The total profit generated
 Number of trades             30                 13               17                by the winning trades, minus commissions and slippage • Avg
 Avg profit/loss ($)          61,746.03          75,119.57        51,519.21         profit — The average profit per winning trade • Avg profit %
                                                                                    — The average percentage profit per winning trade • Avg bars
 Avg profit/loss (%)          3.50               5.11             2.27              held — The average number of bars held per winning trade •
 Avg bars held                226.23             278.85           186.00            Max consecutive — The maximum number of consecutive win-
                                                                                    ners • Losing trades — The total number of losing trades •
                                                                                    Losing % — The percentage of losing trades • Gross loss —
 Winning trades               12                 4                8                 The total loss generated by the losing trades, minus commissions
 Winning %                    40.00              30.77            47.06             and slippage • Avg loss — The average loss per losing trade •
                                                                                    Avg loss % — The average percentage loss per losing trade •
 Gross profit ($)             2,853,112.39       1,457,311.85     1,395,800.54      Avg bars held — The average number of bars held per losing
 Avg profit ($)               237,759.37         364,327.96       174,475.07        trade • Max consecutive — The maximum number of consecu-
 Avg profit (%)               16.35              28.25            10.40             tive losers • Max drawdown — Largest decline in equity in
                                                                                    dollars • Max drawdown % — Largest percentage decline in
 Avg bars held                431.83             689.25           303.13            equity • Max drawdown date — Date on which the max draw-
 Max consecutive              4                  2                4                 down was realized • Wealth-Lab score — An overall measure
                                                                                    of profitability, exposure (efficiency), and risk • Profit factor —
                                                                                    Gross profit divided by gross loss • Recovery factor — Net
 Losing trades                18                 9                9                 profit divided by max. drawdown • Payoff ratio — Average
 Losing %                     60.00              69.23            52.94             profit of winning trades divided by average loss of losing trades
                                                                                    • Sharpe ratio — Annualized average return divided by the
 Gross loss ($)               -1,000,731.45      -480,757.44      -519,974.01       annualized standard deviation of returns • Ulcer index — A
 Avg loss ($)                 -55,596.19         -53,417.49       -57,774.89        measure of the portfolio’s overall volatility • Wealth-Lab error
                                                                                    term — The average of the absolute values of all percentage dis-
 Avg loss (%)                 -5.07              -5.18            -4.96             tances along the equity curve from its linear regression line •
 Avg bars held                89.17              96.44            81.89             Wealth-Lab reward ratio — Annual percentage return divided
                                                                                    by the Wealth-Lab error term • Luck coefficient — The per-
 Max consecutive              6                  4                7                 centage profit of the largest winning trade divided by the average
                                                                                    percentage profit of all winning trades • Pessimistic rate of
 Max drawdown ($)             -692,391.94        -522,232.31      -673,449.25       return — A statistical adjustment of the wins to losses ratio that
                                                                                    estimates the worst-expected return from previous results •
 Max drawdown (%)             -47.82             -47.66           -43.46            Equity drop ratio — The standard deviation of all drops in the
 Max drawdown date            5/14/2002          1/31/2002        5/5/2005          equity curve — measured from each equity low to the previous
                                                                                    equity high — divided into the annualized return.

 Wealth-Lab score             108.45             114.56           119.98
                                                                                      Currency System Analysis strategies are tested on a
 Profit factor                2.85               3.03             2.68                portfolio basis (unless otherwise noted) using Wealth-
 Recovery factor              2.68               1.87             1.30                Lab Inc.’s testing platform. If you have a system you’d
                                                                                      like to see tested, please send the trading and money-
 Payoff ratio                 3.22               5.45             2.10                management rules to
 Sharpe ratio                 0.65               0.49             0.45      
 Ulcer index                  19.45              20.54            24.49               Disclaimer: Currency System Analysis is intended for
                                                                                      educational purposes only to provide a perspective
 Wealth-Lab error term        11.97              15.64            9.33                on different market concepts. It is not meant to rec-
 Wealth-Lab reward ratio      1.35               0.65             1.01                ommend or promote any trading system or
                                                                                      approach. Traders are advised to do their own
 Luck coefficient             2.71               1.57             1.71                research and testing to determine the validity of a
 Pessimistic rate of return   1.24               0.91             0.90                trading idea. Past performance does not guarantee
                                                                                      future results; historical testing may not reflect a sys-
 Equity drop ratio            0.28               0.44             0.64
                                                                                      tem’s behavior in real-time trading.

CURRENCY TRADER • June 2006                                                                                                                        39

 FIGURE 3 — DRAWDOWN CURVE                                             FIGURE 4 — ANNUAL PERFORMANCE
  The system suffered a 45-percent drawdown in 2002 — a                 The system had only one losing year (2001) while gaining
  challenging hurdle.                                                   more than 20 percent in four of the test’s seven years.

                                                                      the currency that was traded in the first test to see whether
                                                                      the results were better or worse than using signals from the
   round-trip trade per contract. Apply two ticks of slippage         indicator currency. It compared both approaches across dif-
   per stop order.                                                    ferent breakout periods (20 days, 30 days, 40 days, and so
                                                                      on) to ensure the results weren’t coincidental.
   Test results: Figure 2’s equity curve shows uneven                    Applying the signals directly to the currency was only
   results in the first half of the test period. However, equity      better in four of the 19 look-back periods. In all other cases,
   increased strongly in the second half, which tripled the cap-      it was more profitable to use the correlated currency to
   ital within only four years.                                       detect trends.
      Overall, the system gained 16 percent per year on aver-            Because of the strategy’s large number of look-back days
   age. The annual results (Figure 4) show only one losing            (120), only 30 trades occurred in seven years. To get more
   year, and four of the seven years had annual profits of more       reliable results, you should test the system on a larger port-
   than 20 percent. The average per-trade profit was 3.5 per-         folio or longer time frame. Also, the system’s exposure is
   cent, which means it can handle higher commissions and             quite low (7.78 percent), so you could consider increasing
   slippage.                                                          the position size to improve profits. Or you could invest
      However, Figure 3’s drawdown curve shows the system             some equity in a different, uncorrelated, system.
   experienced a 45-percent drawdown in 2002 before the
   large gains began.                                                  Bottom line: These tests suggest there may be some ben-
      A second test applied the same breakout rules directly to        efit to generating trade signals in one currency and trading
                                                                                                 them in a second, highly correlated
FIGURE 5 — PERFORMANCE COMPARISON                                                                currency. However, before trading
                                                                                                 this system, you should analyze
It was more profitable to generate trade signals in an “indicator” currency and trade            how correlated these currencies are
them in a second, correlated currency in 15 of 19 look-back periods.
                                                                                                 and test this strategy on different
                                                                                                    One thing to keep in mind is that
                                                                                                 the degree of correlation between
                                                                                                 two currencies may change over
                                                                                                 time, although dollar-traded cur-
                                                                                                 rencies will always have some
                                                                                                 degree of commonality. For sim-
                                                                                                 plicity, in this test the correlations
                                                                                                 were calculated using the same
                                                                                                 time window that would produce
                                                                                                 the trade signals. In real trading,
                                                                                                 calculate correlations between cur-
                                                                                                 rencies on past data and assume
                                                                                                 the same degree of connectedness
                                                                                                 will persist in the future.

                                                                                                        —José Cruset of Wealth-Lab

   40                                                                                                  June 2006 • CURRENCY TRADER
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                                              FOREX (vs. U.S. DOLLAR)
                                          price vs.     1-month     3-month     6-month     52-week         52-week      Previous
Rank*    Country       Currency          U.S. dollar    gain/loss   gain/loss   gain/loss     high            low          rank

     1                British pound        1.8598        2.88%       6.62%       8.44%      1.9025          1.7048           8

     2                Swiss franc          0.8163        2.32%       7.63%       7.62%      0.8383          0.7525           5

     3              Canadian dollar        0.9045        1.53%       3.08%       5.78%       0.911          0.7915           6

     4                    Euro             1.2741        1.47%       7.30%       8.64%      1.2965          1.1638           7

     5               Japanese yen         0.00888        1.36%       3.16%       6.18%      0.00939         0.00824         14

     6               Swedish krona          0.137        1.26%       8.73%      10.31%       0.145          0.1206           4

     7               Russian rouble       0.03697        0.79%       3.76%       6.51%      0.03721         0.03447         12

     8              Australian dollar       0.758        0.21%       2.52%       2.95%       0.781          0.7014           2

     9              Singapore dollar        0.633        0.16%       2.73%       7.07%      0.6408          0.5858          10

 10                 Hong Kong dollar        0.129        0.00%       0.08%       0.00%      0.1291          0.1283          15

 11                New Zealand dollar      0.6343        -0.03%      -4.01%      -9.07%     0.7198           0.599           11

 12                 Taiwanese dollar      0.03122        -0.45%      1.17%       4.77%      0.0321          0.02955         13

 13                    Thai baht          0.02617        -1.91%      2.59%       7.52%      0.0267          0.02362          3

 14                   Indian rupee        0.02186        -1.97%      -3.27%      -1.71%     0.02317         0.02152         16

 15                South African rand      0.1542        -5.69%      -4.81%      -0.39%     0.1678          0.1427           1

 16                   Brazilian real       0.4434        -6.89%      -5.44%      -1.75%     0.4867          0.3999           9

 As of May 29 *based on one-month gain/loss

                                                 GLOBAL INTEREST RATES
 Country                Interest rate                  Rate           Last change              Dec. 2005              June 2005
 U.S.                   Fed Funds Rate                 5              .25 (May 2006)                 4.25               3.25
 Japan                  Overnight call rate            0              —                              0                  0
 Eurozone               Refi rate                      2.5            .25 (March 2006)               2.25               2
 UK                     Repo rate                      4.5            .25 (August 2005)              4.5                4.75
 Canada                 Overnight funding rate         4.25           .25 (May 2006)                 3.25               2.5
 Switzerland            3-month Swiss LIBOR            1.25           .25 (March 2006)               1                  0.75
 Australia              Cash rate                      5.75           .25 (May 2006)                 5.5                5.5
 New Zealand            Cash rate                      7.25           .25 (December 2005)            7.25               6.75
 Brazil                 Selic rate                     15.75          .75 (April 2006)               18                 19.75
 Korea                  Overnight call rate            4              .25 (February 2006)            3.75               3.25
 Taiwan                 Discount rate                  2.375          .125 (March 2006)              2.25               2
 India                  Reverse repo rate              5.5            .25 (January 2005)             5.25               5
 South Africa           Repurchase rate                7              .5 (May 2005)                  7                  7

42                                                                                             June 2006 • CURRENCY TRADER
                                     NON-U.S. DOLLAR FOREX CROSS RATES
            Currency                                     1-month        3-month       6-month      52-week       52-week
   Rank        pair             Symbol       May 29      gain/loss      gain/loss     gain/loss      high           low  Previous
    1      Pound / Yen         GBP/JPY       209.546       1.61%           3.39%        2.11%       213.03        192.62     5
    2     Pound / Euro         GBP/EUR        1.4607       1.46%          -0.57%       -0.20%       1.5124        1.4102    16
    3      Franc / Yen         CHF/JPY       92.0045       1.04%           4.41%        1.34%        93.14       85.1568     2
    4      Franc / Euro        CHF/EUR        0.6408       0.85%           0.33%       -0.96%       0.6542        0.6306    13
    5   Franc / Canada $       CHF/CAD       0.9032        0.83%          4.46%         1.73%       1.0195        0.8646    15
    6    Canada $ / Yen        CAD/JPY       101.951       0.23%           0.00%       -0.38%      104.635       85.5938     3
    7       Euro / Yen         EUR/JPY       143.555       0.19%           4.05%        2.32%      145.488         130.6     4
    8    Canada $ / Euro       CAD/EUR        0.7105       0.13%          -3.86%       -2.63%       0.739         0.6342    14
    9     Franc / Pound        CHF/GBP        0.4391      -0.52%           0.99%       -0.77%       0.4474        0.4289    11
   10     Aussie $ / Yen       AUD/JPY       85.4138      -1.10%          -0.58%       -3.04%       91.34         81.081     1
   11    Aussie $ / Euro       AUD/EUR       0.5952       -1.21%          -4.43%       -5.25%       0.6424        0.5838     7
   12 Aussie $ / Canada $      AUD/CAD       0.8387       -1.25%          -0.51%       -2.68%       0.9651        0.8254     8
   13   Canada $ / Pound       CAD/GBP       0.4866       -1.28%          -3.28%       -2.47%       0.5041        0.4368    12
   14    Aussie $ / Franc      AUD/CHF       0.9294       -1.99%          -4.70%       -4.32%       0.9945        0.9103     9
   15   Aussie $ / Pound       AUD/GBP        0.4078      -2.56%          -3.82%       -5.05%       0.4398        0.4006     6
   16    Real / Aussie $       BRL/AUD       0.5857       -7.00%          -7.68%       -4.56%       0.6573        0.5226    20
   17       Real / Yen         BRL/JPY       49.9711      -8.09%          -8.29%       -7.47%      55.8704       43.1005    10
   18      Real / Euro         BRL/EUR       0.3483       -8.17%         -11.82%       -9.56%       0.3976        0.3281    18
   19    Real / Canada $       BRL/CAD       0.4906       -8.25%          -8.23%       -7.12%       0.5517        0.4746    19
   20     Real / Pound         BRL/GBP       0.2385       -9.49%         -11.31%       -9.42%       0.2721        0.2202    17

                                                GLOBAL STOCK INDICES
                                                         1-month        3-month       6-month      52-week       52-week
  Rank     Country        Index              May 29      gain/loss      gain/loss     gain/loss       high           low   Previous
   1         U.S.       S&P 500              1,280.16      -2.32%         -0.86%         1.80%      1,326.70      1,168.20    12
   2       Australia  All ordinaries        5,069.90       -2.63%         5.32%         10.57%      5,285.50     4,061.40      5
   3       Canada S&P/TSX composite         11,845.48      -2.94%          0.43%         8.25%     12,494.72      9,452.19     7
   4        France       CAC 40              5,015.32      -3.34%         -0.84%         9.30%      5,329.16      4,089.27    14
   5           UK      FTSE 100              5,791.00      -3.85%         -0.91%         5.46%      6,137.10      4,964.00    10
   6      Hong Kong    Hang Seng            15,963.77      -4.19%          0.92%         6.22%     17,328.43     13,684.52     2
   7       Germany     Xetra Dax             5,755.02      -4.24%         -1.90%        10.68%      6,162.37      4,440.36     9
   8      Switzerland Swiss Market           7,688.10      -4.46%         -3.66%         3.32%      8,158.90      6,070.90    13
   9          Italy       MIBTel              28,042       -4.69%         -3.11%         7.77%     30,154.00     23,919.00    11
  10         Brazil     Bovespa             38,145.00      -5.50%         -2.64%        20.51%     42,062.00     24,012.00     3
  11        Mexico         IPC              19,500.54      -5.55%          2.32%        16.81%     21,917.51     12,959.61     4
  12        Japan      Nikkei 225           15,915.68      -5.86%         -0.31%        6.62%      17,563.37     11,148.36     8
  13      Singapore   Straits Times          2,439.91      -6.54%         -1.72%         5.95%      2,666.33      2,156.63     6
  14         India       BSE 30             10,853.14      -8.43%         2.72%         21.52%     12,671.11      6,642.61     1
  15        Egypt          CMA               1,807.61     -16.07%        -24.46%       -12.07%      2,653.25     1,603.22     15

                                                   ACCOUNT BALANCE
   Rank    Country        2006*     Ratio    2005       2007+        Rank     Country        2006*       Ratio      2005       2007+
    1      Hong Kong      18.858    10.1     18.987     20.021        10      Australia      -40.783     -5.6       -42.241    -41.832
    2      Taiwan         18.827    5.4      16.366     20.688        11      U.S.           -864.189    -6.5       -804.951   -899.351
    3      Germany        98.315    3.6      114.828    122.689       12      Spain          -93.668     -8.1       -85.897    -104.255
    4      Japan          140.175   3.2      163.891    133.621       13      New Zealand    -9.471      -8.9       -9.581     -8.365
    5      Canada         39.305    3.1      24.974     38.305
    6      Denmark        6.387     2.4      6.13       7.295        Totals in billions of U.S. dollars
    7      Italy          -18.524   -1.1     -26.645    -11.923      *Account balance in percent of GDP +Estimate
    8      France         -40.647   -1.9     -27.628    -44.796      Source: International Monetary Fund, World Economic Outlook
    9      UK             -61.298    -2.7    -58.053    -66.244      Database, April 2006

                                                  GLOBAL BOND RATES
  Rank        Country          Rate                      May 29             1-month         3-month         6-month       Previous
   1          Germany          BUND                      116.69             0.96%           -2.18%          -2.86%           5
   2          Japan            Government Bond           133.20             0.42%           -1.11%          -3.62%           3
   3          U.S.             10-year T-note            105.195            0.01%           -1.90%          -2.85%           4
   4          Australia        10-year bonds             94.275             -0.02%          -0.49%          -0.39%           2
   5          UK               Short sterling            95.18              -0.06%          -0.24%          -0.30%           1

CURRENCY TRADER • June 2006                                                                                                           43

                                                                    Japan’s economy grew 0.5 percent in Q1 from the pre-
                                                                 vious quarter and increased 3.1 percent compared to the
EUROPE                                                           same quarter a year earlier. The country’s jobless rate for
                                                                 April remained stable at 4.1 percent, which was 0.3 percent
                                                                 lower than April 2005.
    France’s economy grew 0.5 percent in the first quarter
compared to the previous quarter. GDP was boosted pri-              Singapore’s first-quarter GDP increased 10.6 percent
marily by recovery in net foreign trade and acceleration in      compared to the previous quarter. The Ministry of Trade
household consumption expenditure. The country’s March           and Industry raised the GDP growth forecast to between 5
unemployment rate fell 0.1 percent to 9.5 percent, a 0.6-per-    and 7 percent for the year, up from the previous forecast of
cent drop compared to the same month in 2005. This unem-         between 4 and 6 percent.
ployment data doesn’t reflect a recent change in the way
the French government calculates unemployment.                       Singapore’s ruling People’s Action Party dominated
                                                                 May general elections, winning 82 of 84 seats. The opposi-
   Germany’s first quarter GDP increased 0.5 percent from        tion put up its strongest fight in years, but was unable to
the previous quarter and 3.2 percent from Q1 2005. The           gain ground.
unemployment rate for Q1 dropped 0.5 percent to 11.5 per-
cent, the same decrease as the previous quarter and the           AMERICAS
same quarter from a year ago.

   Romano Prodi, a center-left leader and former European           Brazil’s March unemployment rate increased 0.3 per-
Commission president, officially became Italy’s prime            cent from the month prior to 10.4 percent. Although the
minister May 18. Prodi’s coalition held onto mayoral seats       actual rate increased, unemployment grew at a slower rate
in major cities throughout Italy, except Milan, which            than 2005 for the third straight month. As a result, econo-
remained a stronghold for former prime minister Silvio           mists believe labor conditions are stable.
                                                                     Canada’s April jobless rate was 6.4 percent, a 0.1-per-
    The UK’s first-quarter unemployment rate increased           cent increase from March and 0.4 percent lower than April
0.1 percent on the previous quarter to 5.2 percent, a 0.5-per-   2005. In other economic news in the country, the Bank of
cent gain from the same period a year ago.                       Canada raised its key overnight interest rate 0.25 percent to
                                                                 4.25 percent on May 24. The increase was the seventh con-
                                                                 secutive 25 basis points increase since September 2005.
 ASIA & THE SOUTH PACIFIC                                            Colombian President Alvaro Uribe won re-election in
                                                                 late May after gaining a historic 62 percent of the vote. His
    Australia’s jobless rate reached 5.1 percent in              popularity stemmed mostly from policies that cut narcotic
April, a 0.1-percent increase over March and no change           and kidnapping crime rates while spurring economic
from April 2005. Also, the Reserve Bank of Australia raised      growth.
its cash rate 0.25 percent to 5.75 percent on May 3. In a
statement, the RBA cited such factors as above-average              Peru’s National Election Board ended weeks of suspense
growth for the world economy, an increase in domestic            by announcing May 3 that former President Alan Garcia had
spending, and greater credit growth.                             edged past ex-Congresswoman Lourdes Flores by just 64,434
                                                                 votes to earn a spot in the presidential runoff election June 4.
    Preliminary figures showed a 2.4 percent increase in         He will oppose former army officer Ollanta Humala.
Hong Kong’s first-quarter economy compared to the pre-
vious quarter and a 7.8-percent increase compared to a year
earlier. “The economy expanded briskly on a broad front,          AFRICA
driven robust external trade, distinct pick-up in consumer
spending, as well as continued surge in investment in
machinery and equipment,” said K. C. Kwok, Hong Kong                It was a busy few weeks for the Central Bank of Turkey,
government’s economist, in a statement.                          as it lowered the country’s benchmark interest rate 25
                                                                 basis points to 13.25 percent in late April. The decrease
    Hong Kong’s February-through-April unemployment              was the 10th since the rate stood at 18 percent at the end of
rate fell 0.1 percent to 5.1 percent, according to preliminary   2004. At its May meeting, the bank decided to leave inter-
data. The rate is 0.8 percent lower than the same period in      est rates unchanged, although it said the likelihood of
2005.                                                            future reductions has declined.

44                                                                                             June 2006 • CURRENCY TRADER
                 CURRENCY FUTURES
                                                                       Barclay Trading Group’s Currency rankings for April 2006
Currency managers                                                   Top 10 currency traders managing more than $10 million as of 4/30/2006,
continue to lag                                                                           ranked by April 2006 return
                                                                                                          April       2006 YTD     $ Under mgmt.
                                                               Rank Trading advisor                      return        return         (millions)

          lthough commodity trading
                                                                 1 John W. Henry & Co. (Dollar)            9.68         -9.39          244.4M
          advisors (CTAs) had been
          having a good year overall                             2 Richmond Group (Currency)               8.31          2.06           46.7M
through April, those specializing in                             3 John W. Henry & Co. (CSAP)              6.45         -7.66           22.7M
currencies were lagging the pack,                                4 Trigon Investment Adv. (FX Fund)        6.42          3.12           58.9M
according to statistics from Barclay                             5 DynexCorp Ltd. (Currency)               5.91          5.24           44.5M
Trading Group.                                                   6 Absolute Asset Mgmt. (FX)               5.27         11.73           12.4M
   The Barclay CTA Index was up 4.75                             7 24FX Management Ltd                     4.90         12.34           12.6M
percent on the year after a 3.55-per-                            8 Algorithmic Trading (Currency)          4.76         29.76           10.7M
cent gain in April, but the Currency                             9 Currency Insight (Diversified Sys.)     4.67          6.96           84.6M
Traders sub-index was off -0.78 per-                            10 Monarch Capital Mgmt.                   4.52          5.74           14.3M
cent in 2006, despite a .66-percent
                                                                Top 10 currency traders managing less than $10 million and more than $1 million as of
gain in April.                                                                          4/30/06, ranked by April 2006 return
   However, more recent data on the
                                                                  1 Shaffer Asset Mgmt. (FX)                26.59           2.49           1.0M
BTOP FX index, which tracks the 50
                                                                  2 DynexCorp Ltd. (Percival)               15.32          10.06           1.0M
largest currency CTAs, shows some-
                                                                  3 FEM Currency Portfolio Ltd               8.66           3.17           5.5M
thing of a rebound for currency
                                                                  4 Satori Trading (Basic)                   7.58           3.35           1.7M
traders. The BTOP was down only
                                                                  5 Shark Fisher (4X-PROplus)                5.56          16.42           4.8M
-0.28 percent on the year through May
                                                                  6 Coe Capital Advisors (Carry)             5.28           9.05           1.5M
31 after gaining 1.45 percent in May.
   Performance for the top currency                               7 High Desert Currency Mgmt                4.90           3.48           1.5M
managers in the month of April is                                 8 Shark Fisher (ProFund 4X)                4.63           7.66           7.5M
shown in the Managed Money table                                  9 Wooster Asset Mgmt (Portage Fund) 3.46                  0.83           7.9M
(right). John W. Henry’s Dollar fund                             10 John W. Henry & Co. (G-7 Curr.)          2.15         -14.04           1.2M
landed atop the list of managers han-                        Source: The Barclay Group (
dling more than $10 million, but the                         Based on estimates of the composite of all accounts or the fully funded subset method.
                                                             Does not reflect the performance of any single account.
fund was still down on the year as of
                                                             PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE.
April 30.

       CURRENCY FUTURES SNAPSHOT                               The information does NOT constitute trade signals. It is intended only to provide a brief synopsis of each market’s
       as of 5/31/06                                           liquidity, direction, and levels of momentum and volatility. See the legend for explanations of the different fields.

  Contract              Pit       Elec       Exch          Vol          OI        10-day          %       20-day          %          60-day         %         Volatility
                       sym        sym                                              move         rank       move         rank          move         rank ratio/% rank
Eurocurrency             EC        6E        CME          194.8       185.3       -0.51%        67%       1.22%         23%           6.03%       82%         .16 / 2%
Japanese yen             JY        6J        CME          87.1        186.3       -2.80%       100%       0.07%          2%          3.13%        59%        .31 / 30%
British pound            BP        6B        CME          67.9        100.2       -1.06%        50%       1.51%         37%           6.77%       78%         .20 / 7%
Swiss franc              SF        6S        CME          46.5         93.6       -1.14%        75%       1.16%         22%           5.60%       78%         .21 / 7%
Canadian dollar         CD         6C        CME          35.9        105.7        0.51%         9%       0.40%          3%           3.26%       80%        .39 / 37%
Australian dollar        AD        6A        CME          26.4         68.1       -2.15%        89%      -1.30%         53%           1.79%       56%         .23 / 0%
Mexican peso            MP         6M        CME          12.2         61.8       -2.60%        77%      -2.92%         69%          -5.24%       71%         .23 / 0%
U.S. dollar index        DX                NYBOT           4.3         34.3        0.76%        67%      -1.06%         28%          -5.40%       81%         .14 / 2%
Euro / Japanese yen      EJ                NYBOT           1.6         18.6        2.31%       100%       1.19%         50%          2.82%        76%        .51 / 60%
Euro / British pound    GB                 NYBOT           1.1         11.8        0.54%        67%      -0.26%          4%          -0.65%       83%        .44 / 42%
Note: Average volume and open interest data includes both pit and side-by-side electronic contracts (where applicable). Price activity is based on pit-traded contracts.
LEGEND:                                                                                    past sixty 20-day moves; for the 60-day move, the % rank field shows how the most recent
Sym: Ticker symbol.                                                                        60-day move compares to the past one-hundred-twenty 60-day moves. A reading of 100%
                                                                                           means the current reading is larger than all the past readings, while a reading of 0% means
Vol: 30-day average daily volume, in thousands.
                                                                                           the current reading is lower than the previous readings.
OI: 30-day open interest, in thousands.
                                                                                           Volatility ratio/% rank: The ratio is the short-term volatility (10-day standard deviation of
10-day move: The percentage price move from the close 10 days ago to today’s close.        prices) divided by the long-term volatility (100-day standard deviation of prices). The %
20-day move: The percentage price move from the close 20 days ago to today’s close.        rank is the percentile rank of the volatility ratio over the past 60 days.
60-day move: The percentage price move from the close 60 days ago to today’s close.        This information is for educational purposes only. Currency Trader provides this data in
The “% rank” fields for each time window (10-day moves, 20-day moves, etc.) show the       good faith, but assumes no responsibility for the use of this information. Currency
percentile rank of the most recent move to a certain number of the previous moves of the   Trader does not recommend buying or selling any market, nor does it solicit orders to
same size and in the same direction. For example, the % rank for 10-day move shows         buy or sell any market. There is a high level of risk in trading, especially for traders
how the most recent 10-day move compares to the past twenty 10-day moves; for the 20-      who use leverage. The reader assumes all responsibility for his or her actions in the
day move, the % rank field shows how the most recent 20-day move compares to the           market.

CURRENCY TRADER • June 2006                                                                                                                                                            45
             INDUSTRY NEWS

Will Reuters customers have future(s) shock?

CME deal opens new doors

     n May, Reuters and the Chicago Mercantile Exchange               euro/yen, euro/pound, euro/franc, and Aussie dollar/franc.
     (CME) announced the launch of FX MarketSpace, a                     The deal has already gained regulatory approval in the
     centrally cleared, global foreign exchange marketplace.          U.S. but still needs European anti-trust clearance in addi-
Chicago-based CME and London-based Reuters intend to                  tion to approval from the UK Financial Services Authority.
roll out the FX MarketSpace platform late this year and                  Electronically traded foreign exchange futures volume at
early next year.                                                      the CME increased more than 150 percent in the first quar-
   The deal greatly expands the CME’s customer base by                ter of 2006 compared to 2005, and overall volume in forex
allowing it to offer its currency futures markets to Reuters          products averages more than $20 billion in notional value
customers in a spot equivalent format (the CME prices its             per day.
futures so that the prices are easily comparable to spot                 Still, trading of CME’s foreign exchange contracts accounts
forex). Both parties hope this will lead to price efficiencies.       for only about 7 percent of the total foreign exchange market,
   Reuters’ customers, who are located in 123 countries               which is dominated by over-the-counter trades between
around the world, typically trade spot forex through the              banks that don’t involve a central clearing party.
interbank system. The deal will mark the first time CME                  The FX MarketSpace business plan requires each party to
forex futures are directly accessible by a significant portion        contribute capital of up to $45 million to fund the venture
of the spot forex community.                                          through to profitability. The deal is expected to become
   CME will provide clearing services, which will allow               profitable during 2008, according to Rick Redding, the
banks to trade with non-banks.                                        CME’s managing director of products and services.
   FX MarketSpace will “offer market solutions to capitalize             “Frankly, three years ago you would not have seen a
on the growing demand for broader access to the FX mar-               product like this out there,” he says.
ket, the emergence of FX as an asset class, the growth of                The service is scheduled to start in the fourth quarter. It
non-bank financial institutions in global FX markets, and             will initially be available in London, with other markets in
the growth of electronic and algorithmic trading,” the com-           Europe, Asia, and North America to follow.
panies said in a joint press release.                                    “We feel that broader, credit efficient access to forex mar-
   FX MarketSpace will offer six currencies against the U.S.          kets will fuel further growth in the market, to the advantage
dollar (the euro, Japanese yen, British pound, Swiss franc,           of both the futures and spot market,” says a CME
Australian dollar, and Canadian dollar) and four cross rates —        spokesperson.

             KEY CONCEPTS
ASEAN+3: The Association of Southeast Asian Nations, con-             True range (TR): A measure of price movement that
sisting of Brunei Darussalam, Cambodia, Indonesia, Laos,              accounts for the gaps that occur between price bars. This cal-
Malaysia, Myanmar, Philippines, Singapore, Thailand, and              culation provides a more accurate reflection of the size of a
Viet Nam. The “+3” designates China, Japan, and Korea.                price move over a given period than the standard range calcu-
                                                                      lation, which is simply the high of a price bar minus the low of
Correlation coefficient: Sometimes referred to simply as              a price bar. The true range calculation was developed by Welles
correlation, correlation coefficient is the degree of similarity      Wilder and discussed in his book New Concepts in Technical
between two variables. In the markets, correlation is typically       Trading Systems (Trend Research, 1978).
used to measure how close the relationship is between two                True range can be calculated on any time frame or price bar
price series (e.g., two distinct stocks or markets), between an       — five-minute, hourly, daily, weekly, etc. The following discus-
individual stock (or trading fund) and an index, and so on.           sion uses daily price bars for simplicity.
   Correlation coefficients range between -1.00 and +1.00, with          True range is the greatest (absolute) distance of the following:
+1.00 representing perfect positive correlation (two variables
moving precisely in tandem); and -1.00 representing perfect             1. Today’s high and today’s low.
negative correlation (two variables moving exactly opposite to          2. Today’s high and yesterday’s close.
one another). A correlation coefficient of zero means the two           3. Today’s low and yesterday’s close.
variables have no discernible relation.
   The site                   Average true range (ATR) is simply a moving average of the
offers relatively easy-to-digest definitions of this and other sta-   true range over a certain time period. For example, the five-day
tistical terms.                                                       ATR would be the average of the true range calculations over
                                                                      the last five days.

46                                                                                                    June 2006 • CURRENCY TRADER

Event: OpTech 2006                                       Event: The Options Intensive

Date: June 6                                             Dates: Aug. 24-25, Oct. 26-27, Nov. 9-10
Location: The Westin New York at Times Square            Time: 8 a.m. - 5 p.m.
For more information: Visit                              Location: The Options Institute at the CBOE,                Chicago, Ill.

                            •                            For more information: Call (877) THE-CBOE

Event: The Traders Expo Ft. Lauderdale                                              •

Date: June 7-10                                          Event: The Wealth Expo

Location: Broward County Convention Center, Ft.          Date: Sept. 7-9
Lauderdale, Fla.
                                                         Location: Dallas, Texas
For more information: Call (800) 970-4355 or visit
                                                         For more information:
                                                         Event: The Forex Trading Expo
Event: Expo Trader Brazil 2006
                                                         Date: Sept. 8-9
Third Annual International Traders Conference
                                                         Location: Mandalay Bay Hotel & Casino,
Date: June 7-8
                                                         Las Vegas, Nev.
Location: São Paulo, Brazil
                                                         For more information: Visit
For more information: Call +55 21 2232 5133 or visit
                                                         Event: Linda Raschke’s 10th Annual Trading Seminar
Event: London 2006 — FIA / FOA @ the QEII
                                                         Date: Nov. 3-5
Date: June 21-22

Location: Queen Elizabeth II Conference Centre, London   Location: Sheraton Chicago Hotel & Towers

For more information: Visit                              For more information: Visit      
                            •                                                       •
Event: Hedge Fund Trading                                Event: The Traders Expo Las Vegas
Date: July 17-18                                         Date: Nov. 16-19
Location: The Princeton Club, New York, N.Y.             Location: Mandalay Bay Hotel & Casino,
For more information: Call Mary Applegate at             Las Vegas, Nev.
(704) 889-1290 or e-mail           For more information: Visit

CURRENCY TRADER • June 2006                                                                                   47
               GLOBAL ECONOMIC CALENDAR                                                                                                       JUNE/JULY

     Monday                     Tuesday                    Wednesday                     Thursday                      Friday                      Saturday

                                                                                   1                            2                             3
 Legend                                                                            U.S.: ISM                    U.S.:
 CPI: Consumer Price Index              GDP: Gross domestic product                Japan: Account               Unemployment
 ECB: European Central Bank             ISM: Institute for Supply
                                        Management                                 Australia: Index             Japan: Monetary
 FOMC: Federal open market
                                                                                   of commodity                 base
 committee                              PPI: Producer Price Index

5                  6                    7                                            8                                  9                           10
                   Australia:           Great Britain: Monetary policy               U.S.: Wholesale                    U.S.: Trade
                   Reserve              committee meeting                            inventories                        balance
                   bank                 Germany: Orders received and                 ECB: Governing council
                   meeting              manufacturing turnover;                      meeting                            Germany:
                                                                                     Great Britain: Monetary            Production index;
                                        Australia: Official reserve assets
                                        New Zealand: Reserve bank                    policy committee                   Foreign trade
                                        meeting                                      meeting

12                         13                          14                                15                     16                            17
Japan: Balance             U.S.: Retail sales;         U.S.: CPI                         Japan:
of payments;               PPI                         Japan: Monetary                   Monetary
corporate goods                                        survey; monetary                  policy meeting
price index                Germany: CPI                policy meeting
                                                       Manufacturing survey
                                                       Italy: Balance of

19                         20                          21                          22                           23                            24
Canada:                    Great Britain:              Canada: Retail              U.S.: Leading                U.S.: Durable
Wholesale trade            Capital issues              trade; leading              indicators                   goods
                           Canada: CPI                                             ECB: Governing
                                                                                   council and
                           Germany: PPI                                            general council

26                         27                          28                          29                           30
Japan: Corporate                                       U.S.: FOMC                  U.S.: FOMC                   Germany: Retail turnover
service price                                          meeting                     meeting; GDP                 Australia: International
index                                                                              Canada:                      reserves and foreign
                                                                                   Unemployment;                currency liquidity
                                                                                   GDP                          Italy: International reserves
                                                                                   Germany:                     and foreign currency liquidity

3                          4                           5                           6                                    7
U.S.: ISM                  Japan: Monetary             Great Britain:              ECB: Governing council               U.S.: Employment
Japan: Account             base                        Monetary policy             meeting                              Germany:
balances                   Australia:                  committee                   Great Britain: Monetary              Production index;
Australia: Index           Reserve bank                meeting                     policy committee meeting             bankruptcies
of commodity               meeting                                                 Germany: Orders                      Australia: Official
prices                                                                             received and                         reserve assets
                                                                                   manufacturing turnover

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

48                                                                                                                          June 2006 • CURRENCY TRADER

MTPredictor Ltd. has launched
two new add-ons for eSignal and
TradeStation users. Real-time traders
can now find MTPredictor trade set-
ups, assess risk-reward, determine
position size, and manage trades
within their eSignal or TradeStation
application. Specializing in using the
Isolation Approach to Elliott Wave to
find low risk-high reward opportuni-
ties, MTPredictor Real-time 4.0 is now
available in these two certified ver-
sions and an existing standalone
RealTick version. In addition, the firm
released a new position-sizer for real-
time forex traders using MTPredictor
in eSignal. For more information, visit

Alyuda Research Inc. has released a new version of its           COESfx Inc. has formed a partnership with
Tradecision trading software. In Tradecision 2.2, traders        Crosscurrents Investment Advisory Service as part of its
can receive market data from MSN Money, allowing those           ongoing educational efforts. Crosscurrents will now pro-
who use this data provider to integrate free end-of-day          vide daily technical market updates and analysis on a wide
quotes directly into Tradecision. In this version of             spectrum of currencies and currency crosses on the COESfx
Tradecision, users can follow any changes in a symbol’s          trading platform. This service is intended to help traders
price in a variety of time frames. In addition, Tradecision      improve timing and entry into the forex market.
2.2 introduces Custom Bars capability, enabling the trader       Crosscurrents’ charts follow a consistent weekly pattern
to prepare for different, unexpected market scenarios by         ranging from a regular major currency short-term outlook;
visualizing and analyzing in detail various possible market      a 10-year note yield and U.S. equities indices outlook; a
developments. The Tradecision Noise Removal feature has          major currency cross short-term outlook; to major spot cur-
been enhanced with a noise elimination filter (Ingenious         rencies in both medium- and long-term outlooks. For more
Moving Average). For more information, visit                     information about COESfx, visit More                                             information about Crosscurrents Investment Advisory
                                                                 Service is located at
Interactive Brokers recently expanded its IB Universal              In addition, COESfx has partnered with Nostradamus
Account by adding CME floor-traded products, CBOT                Systems Ltd. to offer COMPASS, an intraday tool to help
floor-traded products, Swedish stocks, and Japanese stocks.      predict future levels. Using a neural network approach
IB’s Universal Account allows the trading of multiple prod-      (learning based on pattern recognition), COMPASS offers
ucts worldwide from a single account. Customers can use a        traders 24-hour predictions of intraday future movements
single base currency to trade products in other currencies,      on spot foreign exchange using the bid side of the last
and transactions are executed by either securing a loan          updated market price. Nostradamus Systems also provides
against the base currency or actually converting the curren-     predictions of the highs and lows in a chosen market for the
cy. In either case, the customer’s trading costs are decreased   next two and eight hours.
through professional financing or currency conversion
rates. IB offers access to five interbank currency dealers and   Note: The New Products and Services section is a forum for industry
will route a forex order to the dealer with the best bid or      businesses to announce new products and upgrades. Listings are
offer available at any given moment. Individuals, advisors,      adapted from company press releases and are not endorsements or
institutions, and brokers can open an IB Universal Account       recommendations from the Active Trader Magazine Group. E-mail
by visiting                          press releases to Publication is
                                                                 not guaranteed.

CURRENCY TRADER • June 2006                                                                                                      49

Half a trade better than none at all.

Date: May 15.

Entry: Short the British pound/U.S. dollar
pair (GBP/USD) at 1.8838.

Reason(s) for trade/setup: The dollar has
gotten pummeled in April and early May vs.
most major currencies, setting up the possibili-
ty of a short-term reversal. Statistical analysis of
the dollar index suggested the potential for
short-term gains over an approximately one-
week time window.
   The pound’s recent strength (shown
in terms of the decline in the small                                                                                    Source: TradeStation
euro/pound chart) puts the British cur-
rency in a similar overextended posi-                                             — only to be upended by the dollar’s negative
tion, making a short trade in the                                                 reaction to appointment of Henry M. Paulson as
pound/dollar an attractive play.                                                  U.S. Treasury Secretary on May 30. Luckily, by
   On the entry day, the market was                                               that time half of the trade had been liquidated at
showing weakness — declining after                                                the initial target and the lowered stop order
failing to push above the previous high                                           essentially resulted in a scratch on the second
— after two strong bullish days.                                                  half of the position.
                                                                        It initially looked like the trade might get stopped out
Initial stop: 1.9063, .0065 above the previous day’s high            two days after entry when GBP/USD rallied above 1.900.
(which happened to be the highest high in a year).                   However, the market reversed sharply intraday and then
                                                                     spent several more days moving lower in somewhat
Initial target: 1.8550, which is .0022 above the low of the          volatile trading.
May 11 wide-range up day. Take partial profits at this level            The stop was lowered twice before the market dropped to
and tighten stop.                                                    hit the initial price target, but when the announcement about
                                                                     the new Treasury secretary came out, the dollar plunged and
                                                                     the second half of the trade got knocked out of the box.
RESULT                                                                  As is so often the case, the market’s reaction appeared to
                                                                     be excessive — the GBP/USD rate turned back down
Exit: 1.8550 (first half); 1.8832 (second half).                     immediately, giving back more than half of the previous
                                                                     day’s rally and pushing the market back into what would
Profit/loss: +.0288 (first trade); +.0006 (second trade).            have been profitable territory.

Reason for exit: Initial stop hit (first half); trailing stop        Note: Initial trade targets are typically based on things such as the his-
hit (second half).                                                   torical performance of a price pattern or trading system signal.
                                                                     However, because individual trades are dictated by immediate circum-
Trade executed according to plan? Yes.                               stances, price targets are flexible and are often used as points at which
                                                                     to liquidate a portion of a trade to reduce exposure. As a result, initial
Outcome: After a slow start, this trade progressed nicely            (pre-trade) reward-risk ratios are conjectural by nature.

  Date    Currency      Entry     Initial   Initial   IRR         Exit            Date             P/L            LOP        LOL       Trade
                                   stop     target                                                                                    length

5/15/06 GBP/USD 1.8838           1.9063     1.855     1.28    1.855 (1st half) 5/26/06 +.0288 (1.53%) 0.0309 -0.0185 9 days
                                                             1.8832 (2nd half) 5/30/06 +.0006 (.03%)                11 days

Legend: IRR — initial reward/risk ratio (initial target amount/initial stop amount); LOP — largest open profit (maximum available profit
during lifetime of trade); LOL — largest open loss (maximum potential loss during life of trade).

50                                                                                                       June 2006 • CURRENCY TRADER
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