The Forex Nitty Gritty

If a beginning trader wishes to profit from fluctuations in the US Dollar, Swiss franc or Euro versus other currencies he will need to develop a Forex trading system. Although it is possible to let a team of traders and programmers develop a Forex trading system for you it is important that any foreign currency trader understands the ins and outs of the system. Even if you plan to purchase a trading system it is an excellent exercise to think through the various aspects of foreign currency trading in order to put things in perspective. So, if you are going to develop a Forex trading system or purchase one “off the shelf” what are the important parts?

Which Currency Pair and When

People trade foreign currencies for two basic reasons. Companies doing business internationally need to exchange currencies in order to make and receive payment for goods and services. These folks follow fundamentals and use Forex technical strategies in order to hedge the risk of currency fluctuation between the signing of a contract and final payment. Currency speculators simply seek to profit from price changes between any given pair of currencies. To a degree it is easier to develop a Forex trading system for hedging currency risk because the trader is only interested in one pair of currencies and one specific time frame. On the other hand a currency speculator will commonly keep his eye on a number of currency pairs in order to trade the most profitable pair at the most profitable time. Thus a speculator will need to allot time to seeking the most profitable pairs to trade and may subscribe to an alert service in order to trade when price action is potentially most profitable.

Which Market to Trade and What Time of Day

The major Forex exchanges are London, New York, and Tokyo. The sum total of their business hours allows a trader, in theory, to trade around the clock. However, humans need sleep. Traders also need prep time to scout out trading opportunities, learn more about trading strategies, review results, and modify their trading system. In order to develop a Forex trading system that works for people, time of day, available hours and organization of work flow are crucial. Folks wishing to trade the post tsunami Yen versus other currencies may wish to work during Tokyo business hours while those trading the British Pound may wish to work London business hours. For a trader living in Miami, Chicago, Denver, or San Francisco this will require other arrangements in order for the trader to have a personal, social, or family life.

How Much Do You Want To Risk and How Do You Protect Your Money?

Success is never guaranteed in Forex trading. Traders typically trade using a margin account. Then they leverage their trades which can greatly magnify profits but can also magnify losses. Smart traders also use trailing stops in order to lock in gains and avoid disastrous losses. Smart day traders get out of all of their trades at the end of the trading session to avoid getting caught in a big gap when the market opens the next day. Smart traders never put all of their money into one trade and smart traders never look upon what they are doing as gambling. And good traders review their results whether they are trading the Euro and the Greek debt crisis or are knowledgeable about commodities and trading the AUD, and if their system does not work they develop a Forex trading system that does.

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An interesting new problem may have arisen for currency traders, how to trade a declining Yuan. The assertion regarding the Chinese currency for many years has been that the People’s Bank of China buys dollars in order to reduce the value of the Yuan and keep Chinese exports flowing. The continuing balance of payments deficits that the US, especially, runs with China, has led US and other lawmakers to demand that China allow its currency to float without any intervention. The theory is that by allowing the Yuan to float Chinese exports will become more expensive and less competitive. Now it appears that the Yuan is falling in value, and not because of currency manipulation. Today’s currency traders trade a declining Yuan as the global economic recovery weakens and the twin financial crises in North America and Europe threaten a second dip to the recession and substantially reduced imports from China. In addition an increase in Chinese imports may well erase the Chinese trade surplus, according to Chinese sources.

Those who currently trade a declining Yuan, have watched as Yuan forwards declined. Forwards are derivative contracts used to hedge currency risk or engage in currency speculation for profit. Unlike trading options on currencies no money changes hands when a forward contract is agreed upon. Also, unlike options contracts, both the seller and the buyer are obligated to fulfill their portion of the forward contract on the delivery date. As currency traders anticipate a falling Yuan, forwards decline. The early result of the debt crisis in Europe and the USA has been the appreciation of other currencies, including the Yuan. However, the threat of a substantial economic downturn in both economies threatens Chinese exports and threatens to drive down the Yuan. Chinese exports did, in fact, fall last month. While talk of internationalization of the Yuan persists its value seems to be driving today by the market and much less so by currency manipulation.

To trade a declining Yuan will require a change of mindset for many traders. The Yuan rose to a seventeen year high against the dollar in mid-November, after a nearly four percent run up this year. Some may merely view this as a correction. However, the debt issues in Europe and North America are terribly real. Thus the Asian exporters who have profited from keeping their currencies weak and have built up huge dollar and Euro currency reserves are likely to pay a price in terms of reduced exports. A silver lining to the clouds may be that as the Yuan depreciates the value of China’s reserves will go up. For those set to trade a declining Yuan two general issues come to mind. One is that the continued appreciation of the Yuan is not guaranteed, especially if China ceases to manipulate its currency. The other is that China has its own set of internal issues and problems. The nation has had steady economic growth for years and many Chinese would consider it political suicide to drastically reduce exports and cash flow into the country. China states that it intends to increase development of internal infrastructure projects in order to maintain high employment and its internal economy. With time, to trade a declining Yuan or a rising Yuan traders may spend less time concerning themselves with currency manipulation and will watch the same sorts of employment numbers and statistics as they watch in the USA when trading the US dollar. With time the Yuan could join the dollar as a safe haven currency.

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The recently announced French austerity plan reminds us that it is not only the so called PIIGS nations in the European Union that need to cut expenses. In announcing the French austerity plan Prime Minister Francois Fillon forecasted that the French austerity plan needs to save 100 billion euros. President Nicolas Sarkozy and his government would like to avoid a downgrade of their credit rating (as seen in the USA) and is thus cutting budgets and looking to raise taxes. With the Greek debt crisis ever so painfully in the news Italy is seen as the next, and worse, problem confronting the EU. The news the other day carried a telling item. The very Catholic nation of Ireland will no longer have an ambassador to the Vatican. It appears that everyone is cutting something in their budget.

French growth forecasts have been cut in half. Analysts say the French austerity plan will certainly reduce debts but may not be sufficient to avoid a cut in the nation’s credit rating. This issue is a little like looking at Illinois or California within the USA. It has to do with a member of the EU and not the EU itself. But, maybe not. In order for the bailout plans of the various nations in the EU to work the two largest economies must grow. Italy, the third largest EU economy is in trouble. France is looking to reduce debt which will likely reduce economic growth. That leaves Germany whose economy is recovering from the recession more slowly than desired. How does all of this affect the seemingly continuous downward direction of the Euro? Europe, for all of its current problems, is either the first or second largest economy in the world, depending upon whether they or the USA are in the lead for the year. However, the value of the Euro versus other currencies will adjust based upon the economic strength of the EU in relation to other economies.

French officials are cautioning the nation that sacrifices may be required as the idea of a European nation going bankrupt is no longer an abstraction. With Greece, Spain, and now Italy in danger of debt default it is altogether possible that one or more nations might leave the EU. How this new reality will affect the Euro versus the dollar is uncertain. A national bankruptcy could cause a cascade of defaults in weaker European economies. This could lead to nations leaving the EU. On the other hand it could end up with a stronger and more economically viable union. As with all Forex trading the issue of the French austerity plan requires continual fundamental and technical analysis of the currency involved, the Euro. Obviously a true global economic recovery would speed the recovery of the major nations of Europe and help stave off the wave of defaults that trouble world markets. As always traders need to watch two economies and two sets of data at once in Forex trading as traders trade one currency against the other.

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Currency traders concerned about the uncertainty of the markets have stayed home in large numbers during the last month resulting in low foreign currency trading volume. Figures released by US banks that trade foreign currencies show a distinct reduction in revenue due to decreased Forex trading. What does generally reduced foreign currency trading volume mean for the individual Forex trader? Does reduced foreign currency trading volume change how to trade Forex? First of all remember that traders are not staying out of the market because volume is low. They are staying out of the market because they think that the market too volatile, especially in trading the EUR/USD, EUR/YEN, EUR/CHF and other currency pairs that include the Euro. Nevertheless, Forex technical strategies work best in high trading volume and high liquidity. So, to a degree we might be seeing a domino effect. Traders watching the fundamentals leave the market because of confusing reports about resolution of the European debt crisis. Then technical traders leave the market because trading volume is low. This sort of thing could become a vicious circle of cause and effect leading to ever lower foreign currency trading volume.

However, the fundamentals in Europe will eventually change. The situation is driven by the fact that debt instruments in various nations of the PIIGS group (Portugal, Italy, Ireland, Greece, and Spain) are coming due. In Greece, especially, the problem is acute as creditors are demanding severe austerity measures in return for debt forgiveness and debt extension. The value of Greek government notes has fallen drastically. The concern of the Forex markets is that if the Greek government defaults on its debts there will be a ripple effect throughout the EU and even the world. Greece could be forced to withdraw from the EU. The situation will resolve itself for good or for ill. At some point the fundamentals will become less chaotic and less vague and trading of the Euro will pick up again. The downward direction of the Euro will probably stop. Because the majority of trading in Forex markets involves the US dollar an increase in foreign currency trading volume will include the USD. The US dollar could fall versus the Euro in an EU recovery. Traders bullish on the Euro could prosper in such a situation.

There is a sort of fatigue that sets in when markets are constantly chaotic, hard to predict, and unprofitable. Lack of profit and perceived potential for profit is often more important in driving down foreign currency trading volume than the specifics of trading themselves. Forex traders work with a trading strategy. Successful traders back test their results. When they are not making profits and do not understand why, the better choice is to sit on the sidelines until things become more clear. Many traders who stay in the market in such situations use options. For example in trading options on the falling Euro a trader might buy calls on the Euro with dollars. If the debt crisis resolves itself well the Euro will rise and the trader will profit. If the situation worsens the trader has limited his risk to the cost of the options contract.

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Some Forex traders made money trading the Euro rally that followed positive news about the rescue of banks and remedies for the sovereign debt crisis plaguing the European Union. Others lost as the Euro staged an impressive rally in the EUR/USD pair and in virtually all Euro currency pairs on the news that Germany and France will intervene with sufficient effort to fix the debt crises of its Southern tier states, Greece, Italy, Spain, and Portugal, and Ireland, to so call PIIGS debt crisis. Now that the Euro has turned around and headed up again traders must ask themselves if this is just a brief rally in a generally dismal market for the Euro of if the currency will stabilize. In trading the Euro rally that just occurred traders must think of both fundamentals and technical pricing. The fundamentals are that there is a lot of debt to cover and that continual bailouts of weaker governments by Germany and France, the economic kingpins of the continent, will over serve to weaken the general economic picture and the Euro in the long run. However, traders, and the world in general, are looking for some good news. Those trading options on the falling Euro did well if they were buying calls.

While some were making money trading the Euro rally others profited from rising stock markets throughout the world. Traders are looking for stability. We see this in the flight to the dollar of late. Not only have traders been buying dollars and sending the greenback higher but US Treasuries have been selling like hotcakes as well, driving down interest rates and making currently held Treasuries more valuable. In fact the best investments in the last month or so have been secondary market US Treasuries and the US dollar itself. Now, in trading the Euro rally, bearish traders will likely short the Euro while those expecting a European debt solution will likely jump in with both feet and either buy Euros or buy calls on the Euro. Until the Greek debt crisis and possibility of Italian debt default resolve themselves the market will likely remain chaotic.

An advantage of buying options in a chaotic market is that one need never purchase the currencies involved. A trader can buy calls or puts on the Euro with US dollars, Yen, or Swiss francs. If the EUR/USD, EUR/CHF, or EUR/YEN perform as expected the trader can simply execute the opposite trade and exit his position with a profit. He will, of course, have to hold his assets in one currency or the other but need not buy Euros if he trading them versus another currency. Many expect the current rally of the Euro to be short lived. These traders will typically day trade the Euro and get out before the market closes, fearing that breaking news when their market is closed or when they are asleep will be devastating to an established trading position. In trading the Euro rally traders will likely watch technical pricing data more closely than the fundamentals, which are still somewhat unclear. Although both German and French leaders have promised help for banks and the governments of the PIIGS nations there is dissent, especially in Germany, at the suggestion of using German assets to bail out those governments seen as profligate by German voters. In the meantime trading the Euro rally could result in profits, or losses, for those trading in either direction. A successful Forex trading system in this instance could involve use of a strategy such as a long straddle which would allow traders to profit from either upward or downward movement of the Euro against other currencies.

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It appears as though the best deal last month was investing in the US dollar. Stocks went down, gold plummeted, and interest rates on US Treasuries fell. Meanwhile the US dollar rose in Forex trading in the EUR/USD, USD/YEN, and USD/CHF currencies pairs as well as most others. Investing in the US dollar and US treasuries was an even better deal as progressively lower rates at weekly auctions has raised the value of treasuries in hand. Confidence in the us dollar has risen as confidence in other currencies has fallen. The dollar has traditionally been the safe haven currency of choice although that fact has been called into question in recent years due to the mounting US debt. As the US withdraws from foreign conflicts and uses its military assets more judiciously Europe continues to deal with the debts of its Southern Tier. Greece, Italy, Spain, and Portugal are all dealing with potential debt default as their treasury notes mature. Greece is the constant subject of discussion as severe austerity measures do not appear to be sufficient to meet the requirement of lenders to forgive debt and pay notes coming due.

With the prospect of a second dip to the recession purchases of and futures in industrial raw materials has fallen off roughly ten percent while stocks across the world nearly as badly. The US dollar rose against all major currencies in the last month and several previously stronger minor currencies. That happened for the first time in a number of years. For the quarter the only investment better than investing in the US dollar were US treasuries by 6.4 percent versus 5.7 percent. Part of the rise of the dollar comes from investors seeking the dollar as a safe haven currency. Part is because both Japan and Switzerland have been purchasing other currencies in order to keep the franc and Yen from rising too fast. Forex traders are purchasing dollars because of liquidity as well as the prospect of the currency rising. The Yen and Swiss franc would also be good choices if it were not for the fact that each nation is actively its currency to drive its value down.

Until Europe finds an effective means of dealing with the debt crisis investors and currency traders are going to stay spooked. The flight to quality by investing in the US dollar may be more a flight to liquidity in the face of the Japan and Switzerland driving their currencies down. However, for the time being the dollar is the currency of choice. Fundamentals underlying the dollar include increases in construction and industrial production in the last quarter. The US is not especially dependent upon selling things to Europe – about two percent of exports behind Canada 19 percent Mexico 13 percent, China 7 percent, and Japan 4.7 percent. Also US banks do not have a high degree of exposure to the EU debt crisis. This leaves the USA in a stronger position than others as regards the debt crisis across the Atlantic and Forex risk aversion is driving traders to investing in the US dollar.

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Volatile foreign currency rates are driving Forex traders to the US Dollar – USD. The US congress is back to having problems deciding if it will extend the debt ceiling and Europe is still dallying over a bailout of its struggling members’ debts. Worrying about another dip to the recession the currencies of Asia’s export driven economies are falling among generally volatile foreign currency rates. Versus the US Dollar the British Pound – USD GBP, went down last week as did South Korea’s Won – USD KRW, the India Rupee – USD INR, and the Chinese Yuan – USD CNY. Currency speculators are betting on a continued rise of the US Dollar and the fall of most other currencies. Traders are consulting both fundamentals and Forex technical strategies in order to profit in today’s volatile markets.

There are two roots to this dilemma. One is the sovereign debt crisis in Europe and the other is the continually mounting US debt. Both situations have traders concerned. Traders for companies doing business internationally are especially concerned as currency risk is a major concern during times of volatile foreign currency rates. International businesses will typically buy currency options in order to hedge currency risk. Trading options on the falling Euro has been profitable for those who purchased puts on the Euro in the EUR USD currency pair. Shorting the Euro also worked but entailed a potentially higher risk. The reason is that in options trading the trader’s risk is limited to the price of the options contract. If currency rates move contrary to expectation the trader can exit the contract at a loss or simply let the contract expire at a loss but that is the limit of his losses. A trader who shorts the Euro, for example, could be hurt if the Euro rebounds after a successful resolution of the EU sovereign debt dilemma. The other advantage of options trading is the leverage it offers traders. A trader need never own either currency. He only needs to buy an options contract and then execute the opposite trade in order to gain his profits when dealing with volatile foreign currency rates.

Volatile foreign currency rates, upward for the dollar, make US assets more valuable. It also makes US products more expensive overseas. In general Asian exporters are interested in a strong dollar but speculators don’t want to get caught in a market of volatile currency rates and falling Asian currencies. In the last week of so several currencies fell versus the dollar. The concern is that a renewed recession in Europe and possibly the USA will dry up the export market for these nations and directly affect their economies. As this situation demonstrates confidence in the dollar is a relative thing. The dollar has generally fallen against many currencies for years. This has led to more successful economies in these export-driven nations. It has also resulted in these nations holding a large amount of US debt. As interest rates fall with successively lower interest rates at Treasury note auctions anyone holding Treasuries has seen an appreciation of about 25% in their investment, a good reason to consider the dollar as a safe haven currency.

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Daily foreign exchange trading volume has more than tripled in the last decade to roughly $4 Trillion US. Much of the increase comes from speculators in currency markets, especially individuals taking advantage of online Forex trading. Online foreign exchange trading allows traders to buy and sell foreign currencies virtually around the clock on all business days. The major currency markets are London, New York, and Tokyo. How to trade Forex starts with opening a trading account and obtaining software compatible with that of a broker. Then any person with sufficient capital can engage in foreign exchange trading. The US dollar is part of over 80% of trades and the vast majority of all trades are between the major currencies which are as follows:

United States Dollar – USD

Euro – EUR

British Pound – GBP

Japanese Yen – JPY

Swiss franc – CHF

Canadian Dollar – CAD

Australian Dollar – AUD

Foreign exchange trading can be lucrative and foreign exchange trading can be financially disastrous. Would be traders need to learn the fundamentals that drive Forex markets and develop Forex technical strategies that lead to profits. Like all business endeavors there is a high rate of failure in the early months and years. The problem for the beginning trader is that he is always trading against professionals with years of experience and substantial research experience. As hedge funds and other new investors enter into foreign exchange trading they bring with them or hire professionals who map market trends and develop increasingly sophisticated computer programs to anticipate market movement and execute split second trades. The backbone of foreign currency trading is comprised of the international companies and banks that exchange currencies as part of their business. These companies often engage in options trading in order to hedge currency risk and have decades of experience in reading the Forex markets.

Professional Forex trading operations typically have a host of professionals at every level of trading, strategic development, and IT in order to develop and execute successfully. While the beginning Forex investor is simply wondering how to trade currency an institutional trader will be using complicated algorithms to profit from the volatility of the Euro in the face of an ever growing debt crisis. Traders will develop dozens of trading models and then test and compare with historic trading data. The beginning investor can do the same but does not have the “horse power” to keep up with the large operations. The flip side is that an individual trader does not need to enter into every possible trade. He does not need a steady income stream to pay the salaries or dozens of support personnel. An individual trader has the option to follow the currency pair or pairs of his choice and execute the occasional, hopefully profitable, trade based upon clear and compelling data and reasoning. A common means of limiting investment risk and also leveraging investment capital is to buy options in foreign exchange trading. A trader buys puts in order to profit from a down turn in a currency he owns and calls to profit from an upturn in a currency he wishes to buy. His investment risk is limited to the premium paid and he has the potential for a multiple return on investment.

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It is said that German companies are bargain hunting in Greece as the Greek debt crisis continues. A year ago Greece required substantial foreign loans to avoid default on its sovereign debt. The member of the European Community was not the only nation in trouble. The so called PIIGS and Forex issue has rocked the stability of the Euro for more than a year. At the current state of the Greek debt crisis central banks in the EU are being asked, pressured is a better term, to roll over their current short term loans to Greece. It is unlikely that the stronger members of the EU will let their financially strapped brothers go down in flames. However, that has not stopped companies from Germany from looking for bargains among distressed Greek companies.

In the Greek debt crisis the basic issue for currency traders is not Greek debt but the strength of the Euro. Portugal is also in line for debt relief. In fact, the acronym, PIIGS, refers to Portugal, Italy, Ireland, Greece, and Spain, all of whom have been dealing with debt worries. As the European Community bails outs its weaker members the Euro tends to suffer. At times the Euro has appeared to be in free fall but then it comes to a stop when fundamentals dictate. Now that the UE is seeing a reduction in manufacturing output, similar to what is now seen in Asia and North America, the mid and longer term strength of the Euro is in question. How to trade the Greek debt crisis and its effects on the Euro has typically been learning the timing of how to short the Euro when the debt crisis worsens and to buy Euros in anticipation of a rebound.

A worrisome factor in the Greek debt crisis and its twin in Portugal is the absence of former International Monetary Fund chief Dominique Strauss-Kahn from last minute negotiations. The even hand and sure council of the former French presidential hopeful is gone as the man defends himself against accusations of sexual misconduct in New York. As the effects of the worst recession in eighty years continue there is always the risk of governments repeating the mistakes of the past. It is not clear, with eighty years of hindsight, that the worst of the Great Depression could have been avoided by an easing of monetary policy instead of the tightening of policy that occurred, especially in the USA. As with the issues relating to the Euro and bailing out Portugal traders will watch the big picture. If IMF officials and other choose to tighten monetary policy or even let one of the EU members default on its sovereign debt it could possibly lead to a succession of defaults and a devaluation of the Euro and other currencies. As such many traders are keeping their positions short in trading the Euro, buying options as insurance against unforeseen movement of the Euro, and looking to either the Swiss franc or the dollar as a safe haven currency in such troubling times.

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Interest rates and Forex are commonly intertwined. Investors will commonly move assets to currencies that pay higher interest rates. Japanese interest rates and Forex trading of the Yen were a case in point for years as many practiced the Yen carry trade. The idea was to borrow money in Japan at extremely low interest rates and use the borrowed Yen to buy dollars, Euros, Swiss francs, British pounds, Australian dollars, or Canadian dollars. Then the investor used his new currency to buy US treasury bills or enter into some other higher interest paying investment. We saw the flip side of the using of interest rates and Forex trading when Japanese companies and individuals began Yen repatriation in order to pay for the costs of dealing with the historic earthquake in that country.

Using interest rates and Forex trading to profit is common and does not require the Yen carry trade or any variation. Countries where government bonds, corporate bonds, and banks pay high interest rates often attract foreign capital. When investors use their currency to buy the currency of the country with higher rates they drive up the price of the other currency. Forex traders can profit from this situation merely by trading Forex. They do not need to make investments in the other country. How to trade Forex and interest rates is simply keeping an eye on the technical and fundamental factors that tend to predict changes in interest rates in order to buy and sell foreign currencies.

A current example of how Forex and interest rates relate is the fact that recently the Euro strengthened on the assumption that the EU will be raising interest rates. Although it is investors buying Euros that drive the price up traders speculating on the price of the Euro in other currencies play their part as well. Investors as well as traders will drive up the price of the Euro so long as buying is likely to lead to profits. For the investor it has to do with whether the rise in the Euro makes buying it prohibitive. For the trader it simply has to do with how the market is likely to react and where prices will turn around. Because central banks are instrumental in setting interest rates the actions of the US Federal Reserve and central banks such as that of Japan are watched carefully by Forex traders. Just as the Federal Reserve buying gold and currency can affect Forex trading so are Forex and interest rates set by the Fed crucial to trading the dollar. An overriding factor now in the Forex markets is the Yen and the draw down of Japanese offshore assets. However, that situation will eventually stabilize and traders will resume their normal routine of watching the pronouncements of the Fed and various central banks to help predict just where interest rates are heading. Interest rates and Forex are always related and those who most accurately predict where rates are going have a distinct advantage in the Forex markets.

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