Make The Currency Cross Your Boss

In the stock market, a trader has the opportunity to choose from more than 5,000 companies - hundreds of which will rally in the most vicious of bear markets and thousands of which will crash during the strongest of bull runs. But in the currency market, such divergent possibilities do not seem to exist. In this article, we'll look at how forex traders can use currency crosses to make a wide variety of trades that are unaffected by the day-to-day fluctuations of the greenback.

All Currency Bets Are the Same
When dealing in the major currency pairs, most traders are presented with only one choice: dollar bull or dollar bear? Regardless of whether a trader is long the GBP/USD (British pound-U.S. dollar) or the EUR/USD (euro-dollar), or short the USD/CHF (dollar-Swiss franc) or USD/JPY (dollar-Japanese yen), the unifying theme in all of these positions is that the trader is bearish on the greenback. Therefore, the question of which of the four trades should be taken is immaterial, since all of them will likely be profitable if the dollar is weak and all will lose money if the dollar is strong.

Granted, this may sound like a gross oversimplification of the forex market. We'll be the first to acknowledge that some currencies can and do challenge this paradigm - the Canadian dollar is one good recent example of such a dynamic. Buoyed by skyrocketing oil prices, the loonie has turned into a petrocurrency as Canada has become the United States' No.1 supplier of crude. As a result, while other major currencies like the euro, the yen and the pound have recently declined against the U.S. dollar, the Canadian dollar has gained in value. However, this is an exception that proves the rule.

To better understand how this works, let's take a look at the two charts below. Figure 1 looks at the performance of the seven most liquid currency pairs in forex, composed of the four majors:

• EUR/USD
• USD/JPY
• GBP/USD
• USD/CHF

and the three commodity pairs:

• USD/CAD
• AUD/USD
• NZD/USD

Figure 1 looks at activity on a single trading day - October 12, 2005. To normalize the data, we converted every pair so that its performance could be analyzed accurately. Typically, if the dollar were weak, the EUR/USD would rise and the USD/CHF would decline; however, in Figure 1 we have made the adjustment so that the returns are consistent vis a vis the dollar.

Figure 1: In forex, some currency pairs are quoted in terms of the U.S. dollar (e.g. EUR/USD), while others are not (e.g. USD/CHF). By inverting the pairs that are not expressed in terms of the dollar, we can compare the strength/weakness of each pair relative to the dollar.

Source: DailyFX.com

Figure 2 looks at activity on the same trading day - October 12, 2005 - for the Dow Jones Industrial Average.

Figure 2: In FX, most traders (those trading the seven most liquid currency pairs) are presented with only one choice - dollar bull or dollar bear - but the stock market is less straightforward. As this chart shows, even when an index like the DJIA is down overall, many of its stocks can be up, making it harder to take a purely bearish or bullish outlook.

Source: DowJones.com

Both of these charts clearly illustrate that while the stock market is truly a market of stocks, the currency market is really a market of dollars and anti-dollars. The central reason why this is so is that the dollar serves as the reserve currency for the world's central banks. Therefore, when speculators are bullish on the dollar, capital will flow from all the major currencies into the greenback and vice versa when the sentiment reverses.

Crosses Offer More Possibilities
If you look closely at Figure 1, however, you'll notice that the capital flows are far from uniform. Some currencies appreciate substantially against the dollar, while others gain barely a few basis points. This difference in performance against the greenback creates profit opportunities for market players who choose to trade in currency crosses. Crosses are simply a measure of the relative strength of an individual currency against the dollar. Crosses are distinguished by the fact that they do not include the dollar as either the numerator or the denominator of the pair. As such, they offer traders a tremendous opportunity to make far more nuanced bets in the currency market than the simple pro- or anti-dollar trade.

What makes crosses especially interesting to currency traders is the fact that they can provide much cleaner trend or range signals which will be unaffected by the day-to-day oscillations of the greenback.

To better understand how crosses work, let's examine the following two charts, which look at data over the same period of time (from July 1, 2005 to October 14, 2005). While the most liquid financial instrument in the world - the EUR/USD - has done nothing but range aimlessly during the period in question, frustrating both bulls and bears (see Fig. 3), the CAD/JPY has displayed one of the purest trends in recent memory, gaining almost 1,000 points without any material retracement (see Fig. 4).

Figure 3: The EUR/USD has traveled between support and resistance, making it very frustrating for bulls and bears alike.

Source: FXTrek

Figure 4: Traders of currency crosses were able to profit from the prolonged uptrend of the CAD/JPY.

Source: FXTrek

Why did the CAD/JPY rally? As we mentioned earlier, the Canadian dollar is a petrocurrency that has received a tremendous boost from the stratospheric rise in the price of crude. The yen, on the other hand, is the principal victim of high oil prices because it is the only highly industrialized country in the world that must rely on imports for 99.5% of its petroleum needs. The CAD/JPY, therefore has an 89% correlation with the price of oil.

Canny traders who bet on an oil rally could have expressed that opinion very effectively in the currency market through a long CAD/JPY position. Even better, they would have harnessed a positive yield differential in the process. With the loonie currently yielding 2.75%, while the yen rates remain at 0%, the interest rate differential alone was 275 basis points or 27.5% annualized using a standard 10:1 leverage factor. (This essentially means that since FX traders can use $1 of capital to control $10 worth of currency, the gain from the 275 basis point differential will be 10 times larger than if traders did not use leverage.)

Carry or Capital Gains
Crosses can be as volatile as the most heavily-traded stocks during the heyday of the Nasdaq bubble or as sedate as a 'AAA'-rated dividend-yielding utility share on the NYSE. Trading in crosses can focus on carry strategies that try to profit from interest rate differentials between the currencies or it can be focused on pure capital gains speculation. Trades can also be based on economic analysis or political news. Some crosses can trend for months, while others will be highly range-bound. In short, the possibilities with currency crosses are endless. Let's look at the charts below to see some examples of recent trades in the crosses that demonstrate these ideas.

The Carry Trade
One of the most popular trades in foreign exchange is the carry trade, which involves going long a high-yielding currency against a low-yielding one. Looking at the seven most liquid crosses in the world, no pair has shown a greater interest rate differential than the NZD/JPY pair. In mid-October 2005, the New Zealand dollar, nicknamed the "kiwi", yielded 6.75% (the Reserve Bank of New Zealand subsequently increased that rate to 7% at the end of October). The Japanese yen., on the other hand, yielded 0% (as of October 2005), and the Bank of Japan's zero interest rate monetary policy is expected to remain in effect until all vestiges of deflation are gone from the Japanese economy. The spread between the currencies was a whopping 675 basis points, and as a result, carry trade speculators plowed into the cross, increasing its value by 400 pips between July and October 2005.

Figure 5: The NZD/JPY pair gained momentum in the three months shown here in response to widespread speculation that the NZD rate would increase to 7% in Nov 2005. Carry trade speculators plowed into the cross in order to gain exposure to this higher rate differential, causing the NZD/JPY to increase in value

Source: FXTrek

The Political Trade
In mid-September 2005, both Japan and Germany had elections. In Japan, Prime Minister Junichiro Koizumi ran on a reform agenda that called for the privatization of the Japanese postal service, a quasi-banking institution with $3 trillion in deposits and 25,000 branches. In Germany, the reform-minded candidate Angela Merkel ran against the standing Chancellor Gerhard Schroeder. While Koizumi's message resonated well with the Japanese voters as he headed to an overwhelming win, Merkel's victory over Schroeder was hard-fought - the two contenders were locked in a struggle for leadership for more than a month after the German elections were initially held. In September 2005, therefore, the EUR/JPY cross presented a tremendous profit opportunity as a de facto "Koizumi/Schroeder spread". Indeed, from September 9 to September 12, the cross tumbled nearly 200 points as traders bid up the yen and shorted the euro as a response to the election results.

Figure 6: The chart above shows the weakness in the euro which could be attributed in part to the uncertainty over the outcome of the German elections. FX traders were more inclined to place their money in the Japanese yen, because the political situation in Japan was more certain

Source: FXTrek

The Economic Trade
Consistent disparities in economic performance can sometimes offer very profitable trades in the crosses. A case in point is the price action in the second half of 2005 in the EUR/CHF currency cross. The massive declines in the two currencies during the first half of 2005 were beneficial for both the euro zone and Switzerland since both regions are heavy exporters and both generate substantial trade surpluses. However, the smaller and more nimble Switzerland did not suffer from the political and institutional disarray that pervaded the euro zone after the rejection of the EU Constitution in the summer of 2005. With much better unemployment numbers (3.8% in Switzerland vs. 9.9% in EU) and faster growing retail sales (4.7% vs. 0.9%), Switzerland was clearly outperforming its much larger neighbor next door. As the realization of this fact began to permeate the market, the EUR/CHF cross (one of the least volatile crosses in the market) declined by over 100 points in the period between late September and early October 2005 shown in Figure 7.

Figure 7: The cross shown here illustrates Switzerland's resilience to the economic and political hardships that were happening in the euro zone

Source: FXTrek

The Volatility Trade
If you are a trader who likes volatility and lots of it, nothing provides more action than the GBP/JPY cross. Trading this cross is akin to trading a volatile technology stock; it often moves several hundred points in a day. One of the key reasons for such wild price action is that GBP/JPY is also a very popular carry trade. With U.K. rates at 4.50% in October 2005 and Japan's rates at 0%, the interest rate differential was 450 basis points.

A slowdown in the U.K. economy caused the Bank of England to lower rates by 25 basis points in September 2005, and with the market highly uncertain of whether this was a one-off move or a hint of more rate cuts to come, trading in the GBP/JPY looked set to be especially turbulent, thus providing volatility-seeking traders with plenty of opportunities.

Figure 8: There are currency crosses to suit all types of traders. This chart shows the GBP/JPY, which is one of the most volatile crosses.

Source: FXTrek

Conclusion
The examples discussed here should give you a sense of the variety of trades that are possible using cross currencies in the FX market. Typically, 90% of all trading by volume in forex takes place across the four major currency pairs. However, for traders willing to step out of the crowd and explore a different path, trading in currency crosses can provide a multitude of profitable opportunities and should become a standard part of any FX trader's arsenal of ideas.

Using Currency Correlations To Your Advantage

To be an effective trader, understanding your entire portfolio's sensitivity to market volatility is important. This is particularly so when trading forex. Because currencies are priced in pairs, no single pair trades completely independent of the others. Once you are aware of these correlations and how they change, you can use them control your overall portfolio's exposure. (For a guide to all things forex, check out our Investopedia Special Feature: Forex.)

Defining Correlation
The reason for the interdependence of currency pairs is easy to see: if you were trading the British pound against the Japanese yen (GBP/JPY pair), for example, you are actually trading a derivative of the GBP/USD and USD/JPY pairs; therefore, GBP/JPY must be somewhat correlated to one if not both of these other currency pairs. However, the interdependence among currencies stems from more than the simple fact that they are in pairs. While some currency pairs will move in tandem, other currency pairs may move in opposite directions, which is in essence the result of more complex forces.

Correlation, in the financial world, is the statistical measure of the relationship between two securities. The correlation coefficient ranges between -1 and +1. A correlation of +1 implies that the two currency pairs will move in the same direction 100% of the time. A correlation of -1 implies the two currency pairs will move in the opposite direction 100% of the time. A correlation of zero implies that the relationship between the currency pairs is completely random.

Reading The Correlation Table
With this knowledge of correlations in mind, let's look at the following tables, each showing correlations between the major currency pairs during the month of February 2010.


The upper table above shows that over the month of February (one month) EUR/USD and GBP/USD had a very strong positive correlation of 0.95. This implies that when the EUR/USD rallies, the GBP/USD has also rallied 95% of the time. Over the past 6 months though, the correlation was weaker (0.66) but in the long run (1 year) the two currency pairs still have a strong correlation.

By contrast, the EUR/USD and USD/CHF had a near-perfect negative correlation of -1.00. This implies that 100% of the time, when the EUR/USD rallied, USD/CHF sold off. This relationship even holds true over longer periods as the correlation figures remain relatively stable.

Yet correlations do not always remain stable. Take USD/CAD and USD/CHF, for example. With a coefficient of 0.95, they had a strong positive correlation over the past year, but the relationship deteriorated significantly in February 2010 for a number of reasons, including the rally in oil prices and the hawkishness of the Bank of Canada. (For more, see Using Interest Rate Parity To Trade Forex.)

Correlations Do Change
It is clear then that correlations do change, which makes following the shift in correlations even more important. Sentiment and global economic factors are very dynamic and can even change on a daily basis. Strong correlations today might not be in line with the longer-term correlation between two currency pairs. That is why taking a look at the six-month trailing correlation is also very important. This provides a clearer perspective on the average six-month relationship between the two currency pairs, which tends to be more accurate. Correlations change for a variety of reasons, the most common of which include diverging monetary policies, a certain currency pair’s sensitivity to commodity prices, as well as unique economic and political factors.

Here is a table showing the six-month trailing correlations that EUR/USD shares with other pairs:

Calculating Correlations Yourself
The best way to keep current on the direction and strength of your correlation pairings is to calculate them yourself. This may sound difficult, but it's actually quite simple.

To calculate a simple correlation, just use a spreadsheet, like Microsoft Excel. Many charting packages (even some free ones) allow you to download historical daily currency prices, which you can then transport into Excel. In Excel, just use the correlation function, which is =CORREL(range 1, range 2). The one-year, six-, three- and one-month trailing readings give the most comprehensive view of the similarities and differences in correlation over time; however, you can decide for yourself which or how many of these readings you want to analyze.

Here is the correlation-calculation process reviewed step by step: 1. Get the pricing data for your two currency pairs; say they are GBP/USD and USD/JPY
2. Make two individual columns, each labeled with one of these pairs. Then fill in the columns with the past daily prices that occurred for each pair over the time period you are analyzing
3. At the bottom of the one of the columns, in an empty slot, type in =CORREL(
4. Highlight all of the data in one of the pricing columns; you should get a range of cells in the formula box.
5. Type in comma
6. Repeat steps 3-5 for the other currency
7. Close the formula so that it looks like =CORREL(A1:A50,B1:B50)
8. The number that is produced represents the correlation between the two currency pairs

Even though correlations change, it is not necessary to update your numbers every day, updating once every few weeks or at the very least once a month is generally a good idea.

How To Use It To Manage Exposure
Now that you know how to calculate correlations, it is time to go over how to use them to your advantage.

First, they can help you avoid entering two positions that cancel each other out, For instance, by knowing that EUR/USD and USD/CHF move in opposite directions nearly 100% of time, you would see that having a portfolio of long EUR/USD and long USD/CHF is the same as having virtually no position - this is true because, as the correlation indicates, when the EUR/USD rallies, USD/CHF will undergo a selloff. On the other hand, holding long EUR/USD and long AUD/USD or NZD/USD is similar to doubling up on the same position since the correlations are so strong. (Learn more in Forex: Wading Into The Currency Market.)

Diversification is another factor to consider. Since the EUR/USD and AUD/USD correlation is traditionally not 100% positive, traders can use these two pairs to diversify their risk somewhat while still maintaining a core directional view. For example, to express a bearish outlook on the USD, the trader, instead of buying two lots of the EUR/USD, may buy one lot of the EUR/USD and one lot of the AUD/USD. The imperfect correlation between the two different currency pairs allows for more diversification and marginally lower risk. Furthermore, the central banks of Australia and Europe have different monetary policy biases, so in the event of a dollar rally, the Australian dollar may be less affected than the Euro, or vice versa.

A trader can use also different pip or point values for his or her advantage. Lets consider the EUR/USD and USD/CHF once again. They have a near-perfect negative correlation, but the value of a pip move in the EUR/USD is $10 for a lot of 100,000 units while the value of a pip move in USD/CHF is $9.24 for the same number of units. This implies traders can use USD/CHF to hedge EUR/USD exposure.

Here's how the hedge would work: say a trader had a portfolio of one short EUR/USD lot of 100,000 units and one short USD/CHF lot of 100,000 units. When the EUR/USD increases by ten pips or points, the trader would be down $100 on the position. However, since USDCHF moves opposite to the EUR/USD, the short USD/CHF position would be profitable, likely moving close to ten pips higher, up $92.40. This would turn the net loss of the portfolio into -$7.60 instead of -$100. Of course, this hedge also means smaller profits in the event of a strong EUR/USD sell-off, but in the worst-case scenario, losses become relatively lower.

Regardless of whether you are looking to diversify your positions or find alternate pairs to leverage your view, it is very important to be aware of the correlation between various currency pairs and their shifting trends. This is powerful knowledge for all professional traders holding more than one currency pair in their trading accounts. Such knowledge helps traders, diversify, hedge or double up on profits.

The Bottom Line
To be an effective trader, it is important to understand how different currency pairs move in relation to each other so traders can better understand their exposure. Some currency pairs move in tandem with each other, while others may be polar opposites. Learning about currency correlation helps traders manage their portfolios more appropriately. Regardless of your trading strategy and whether you are looking to diversify your positions or find alternate pairs to leverage your view, it is very important to keep in mind the correlation between various currency pairs and their shifting trends

Forex Trading: Using The Big Picture

While the majority of individual investors and traders focus on traditional investments such as stocks and bonds, the fact remains that the forex market is by far the most active and liquid market in the world. As more and more individuals become aware of the forex market and learn not only about how to trade currency pairs but also about the mechanics and capital requirements involved, their level of participation continues to grow. And while the interest is genuine and the opportunities are real, traders new to this market must still decide just exactly how they will go about determining when to enter and/or exit individual trades. (For a primer on the currency markets, take a look at our Forex Walkthrough.)

Finding the Trend

Most of the trading in the forex markets takes place on a short-term basis. Large traders and institutions with high-powered computers and highly sophisticated trading algorithms account for much of the trading in forex pairs. And even for the small trader the lure of short-term trading is strong as it involves limiting the amount of time that capital is at risk. In fact, there is nothing wrong with trading on a short-term time frame. Nevertheless, one still has to decide whether to be bullish or bearish on a given pair before entering a trade. It is here where a longer-term, big picture snapshot can provide a useful roadmap.

Perhaps the oldest adage in all of trading is "the trend is your friend." And this adage has stood the test of time. While any number of short-term trading methods can be profitable, in most cases, it is easier to make money by trading in the direction of the major trend than it is to trade against it. As such, before considering a trade in any forex pair, attempt to objectively identify the current major trend of the market. From there, you can attempt to fine tune your actual entries and exits. The primary objective is to focus on long trades when the major trend is bullish and on short trades when the major trend is bearish. Let's take a look at an example of one way to do this. (Trade 10 of the most popular currency pairs on our NEW forex trading simulator, FXtrader.)

Focusing on the Long Term
Figure 1 displays a simple monthly bar chart of the British pound/Japanese yen cross (GBP/JPY). As is the case with any tradable security, there are times when this pair advances, times when it declines and times when it trades in a range. Our primary function here is to establish a few simple methods for objectively deeming the major trend as "bullish", "bearish", or "neutral" at any given point in time. No method can be expected to be always right, but our primary purpose here is simply to determine the direction in which to trade - if any - not to identify specific entry and exit points.

Figure 1: The British pound/Japanese yen currency cross (GBP/JPY)

Source: ProfitSource by HUBB

Adding Trend Filter No.1
One of the simplest methods for trend-filtering is to apply a moving average to a data set. In Figure 2 you see the same bar chart, however, this time the 12-month exponential moving average has been added. There are advantages and disadvantages to using moving averages. The good news is that they allow a trader to quickly visualize the current trend by simply observing whether price action is above or below the moving average. The primary disadvantage to using moving averages is that a strict use of these to trigger entries and exits almost invariably involves whipsaw signals.

Figure 2 - GBP/JPY with a 26-month exponential moving average

Source - ProfitSource by HUBB

A rough interpretation of Figure 2 allows us to identify essentially five primary "trending periods" in the pair since 1992.

• From 1992 into late 1995 - primary trend DOWN
  
• From late 1995 until late 1998 - primary trend UP
  
• From late 1998 into early 2001 - primary trend DOWN
  
• From early 2001 until late 2007 (with a brief whipsaw in late 2003) - primary trend UP
  
• Since late 2007 - primary trend DOWN
  

As you can see, simply by adhering to the primary trend identified using this simple interpretation could have helped a trader to focus on the best opportunities.

Adding Trend Filter No.2
In an attempt to further refine our identification of the primary trend - and also to afford the opportunity to identify good times to make no trade at all (i.e., when two indicators disagree on the trend) - lets add another indicator into the mix. Figure 3 displays the same chart as that in Figure 2, however, now the MACD indicator is plotted below the bar chart.

The points in time when MACD changed from bearish to bullish are marked with upward green arrows. Conversely, points in time when MACD changed from bullish to bearish are marked with downward red arrows. Note that we have applied relatively long-term parameter values of 18, 37 and 9 for the MACD (the most common defaults are 12, 26 and 9). There are no "correct" values, and some experimentation might be needed market to market. Still, this setting fits in well with our desire to focus on the longer-term trend.

Figure 3: GBP/JPY with 26-month exponential moving average and long-term MACD

Source: ProfitSource by HUBB

At this point we would designate the "major trend" as "bullish", and would consider only long trades if:

a. GBP/JPY is above its 26-month exponential moving average, AND;

b. The latest signal from MACD was an "Up" green arrow.

Conversely, we would designate the "major trend" as "bearish", and would consider only short trades if:

c. GBP/JPY is below its 26-month exponential moving average, AND;

d. The latest signal from MACD was a "Down" red arrow.

Under any other circumstance, we would designate the "major trend" as "neutral" and would not trade the GBP/JPY pair. Namely, if:

e. GBP/JPY is above its 26-month exponential moving average but the attest MACD signal is a down red arrow, OR;

f. GBP/JPY is below its 26-month exponential moving average but the attest MACD signal is an up green arrow.

In case e or f above, we would sit out this particular currency pair.

Summary
One of the keys to trading success is developing the ability to spot opportunities and identify ways to take advantage of them. Clearly a great many opportunities are likely available at any given point in time among the various currency pairs traded on the forex. Trading in the direction of the major trend has long been one of the best methods for improving one's odds in the financial markets.

The specific methods described in this piece should be no means be considered the "be all, end all" of trend identification tools - far from it. In fact, they are presented merely as examples of ways to objectively identify and categorize the longer-term trend. Individual investors may find different and better ways to achieve this task across a cross-section of tradable markets. From there the next piece of the puzzle remains: deciding specifically when to enter of exit trades. Whatever method or methods one ultimately settles on, they will at least enjoy some peace of mind in knowing that they are trading with the primary trend of that particular market.

Forex Minis Shrink Risk Exposure

Trading currencies means buying one country's currency while simultaneously selling another country's currency. Every currency trade therefore involves two currencies. The usual size of a currency pair is 100,000 units, known as a "standard lot."

In most cases, beginner traders do not want to stomach the risk that comes with the exposure of a standard lot. As a result, most online forex brokers offer the ability to trade mini lots, which are 10,000 units of the currency rather than 100,000. For a new trader, these mini lots can be an especially effective tool for learning to trade forex. (For background reading, see Getting Started In Forex.)

What is a Pip?
Before one can fully understand the benefits of a mini lot, it is important to review the concept of a pip. A pip is the smallest increment that a currency pair can move. For most currency pairs, a pip is a change in the fourth decimal place of the currency quote. For example, if EUR/USD is quoted at 1.5567 and it moves to 1.5568, it has increased by 1 pip. The value of 1 pip is calculated by the size of the lot that is traded. So, if you buy a standard lot of 100,000 EUR/USD at 1.5567 and it goes to 1.5568, a 1-pip move, then the value of your trade has increased by $10 (or 100,000 x 0.0001). (For more on this, see What is the value of one pip and why are they different between currency pairs?)

If we did the exact same calculation using a mini lot, then we would multiply the 1 pip by the size of a 10,000 mini lot instead of the usual 100,000 lot. So 10,000 x 0.0001 = $1. When you trade a standard lot, the value of the pip is $10, but when trading a mini lot the value of a pip is $1. This is true when the U.S. dollar is the second, or quoted, currency in the pair. (For more, see Common Questions About Currency Trading.)

Base Currency Vs. Quote Currency
One other piece of information to remember is that a currency pair is comprised of a base currency, which is the first currency listed in the pair, and the quote currency, which is the second currency listed in the pair. In the case of the EUR/USD, the euro is the base currency and the dollar is the quote currency.

The profit or loss is always expressed in terms of the quote currency. If the currency pair is the GBP/USD, then the base currency is the British pound and the quote currency is the U.S. dollar. For the USD/CAD, the base currency is the U.S. dollar and the quote currency is the Canadian dollar. Why the dollar is listed first in some instances but second in others is just a matter of convention. (For more insight, see the Forex Tutorial: Reading a Quote and Understanding The Jargon.)

The Value of a Pip
The last important point that should be noted before we talk about mini lots specifically is the value of a pip. Suppose you are trading the GBP/JPY; the British pound is the base currency and the Japanese yen is the quote currency. Now in this instance, we have an exception to the fourth decimal place rule for the size of a pip. In the case of the yen, 1 pip is measured in the second decimal place. The yen is the only exception. To calculate the value of the move, if we buy dollars against the yen and the dollar goes up from 103.45 to 103.46, then we have a 1-pip move. Multiplying by the standard lot of 100,000 x 0.01 = 1,000 yen. To bring this back to dollars, you would then divide the 1,000 yen by the dollar rate, let's say it's 103.46, which equals $9.66.

Why Trade Minis?
The real value of trading minis is in the versatility it provides in matching the trade size to an acceptable level of risk. For example, suppose you decide to take a long position in the USD/JPY. Let's assume that your entry point is 103.55 and that you've set your stop-loss order 15 pips away at 103.40. If you have $1,000 in your trading account, the maximum risk you should take in any trade is 3% of your trading capital. Because your capital is $1,000, 3% of your capital is $30. If you are stopped out of this trade and you are trading a mini lot, you will lose $15. But if you are prepared to risk $30, you can actually trade two mini lots and get the power and benefit of some leverage. If you were only trading standard lots, this trade would not be possible because a 15-pip loss, as per this example, would be $150, which is 15% of your $1,000 trading capital. Given a risk tolerance of 3% of the portfolio, this is too much risk for one trade. (For related reading, see Forex Leverage: A Double-Edged Sword.)

Mini lots allow a trader to adjust the amount of effective leverage used in each trade. With mini contracts, you can trade the equivalent of one standard lot by simply trading 10 minis. If you only want to trade a half of a standard lot, you can do so by buying five mini lots.

The Bottom Line
Mini lots provide flexibility that standard lots cannot offer. A mini lot is simply 10% of a standard lot and therefore, by trading in minis you can trade in fractions of a standard lot, anywhere from 1 mini to 10 minis. Mini lots are useful if the natural stop loss for your trade is farther away than the maximum risk you feel comfortable taking. You can simply reduce the risk by decreasing the number of minis until that number would equate to the stop-loss risk. Of course, if your market maker offers you 100:1 leverage, then for an account of $1,000, you can trade up to 10 minis at a time. The number of minis traded should be governed by how much you can lose if your trade goes wrong, which should not exceed 2-3% per trade.

Forex: Identifying Trending And Range-Bound Currencies

The overall forex market generally trends more than the overall stock market. Why? The equity market, which is really a market of many individual stocks, is governed by the micro dynamics of particular companies. The forex market, on the other hand, is driven by macroeconomic trends that can sometimes take years to play out. These trends best manifest themselves through the major pairs and the commodity block currencies. Here we take a look at these trends, examining where and why they occur. Then we also look at what types of pairs offer the best opportunities for range-bound trading. (Trade 10 of the most popular currency pairs on our NEW forex trading simulator, FXtrader.)

The Majors
There are only four major currency pairs in forex, which makes it a quite easy to follow the market. They are:

• EUR/USD - euro / U.S. dollar
• USD/JPY - U.S. dollar / Japanese yen
• GBP/USD - British pound / U.S. dollar
• USD/CHF - U.S. dollar / Swiss franc

It is understandable why the United States, the European Union and Japan would have the most active and liquid currencies in the world, but why the United Kingdom? After all, as of 2005, India has a larger GDP ($3.3 trillion vs. $1.7 trillion for the U.K.), while Russia's GDP ($1.4 trillion) and Brazil's GDP ($1.5 trillion) almost match U.K.'s total economic production. The explanation, which applies to much of the forex market, is tradition. The U.K. was the first economy in the world to develop sophisticated capital markets and at one time it was the British pound, not the U.S. dollar, that served as the world's reserve currency. Because of this legacy and because of London's primacy as the center of global forex dealing, the pound is still considered one of the major currencies of the world.

The Swiss franc, on the other hand, takes its place amongst the four majors because of Switzerland's famed neutrality and fiscal prudence. At one time the Swiss franc was 40% backed by gold, but to many traders in the forex market it is still known as "liquid gold". In times of turmoil or economic stagflation, traders turn to the Swiss franc as a safe-haven currency.

The largest major pair - in fact the single most liquid financial instrument in the world - is the EUR/USD. This pair trades almost $1 trillion per day of notional value from Tokyo to London to New York 24 hours a day, five days a week. The two currencies represent the two largest economic entities in the world: the U.S. with an annual GDP of $11 trillion and the Eurozone with a GDP of about $10.5 trillion.

Although U.S. economic growth has been far better than that of the Eurozone (3.1% vs.1.6%), the Eurozone economy generates net trade surpluses while the U.S. runs chronic trade deficits. The superior balance-sheet position of the Eurozone and the sheer size of the Eurozone economy has made the euro an attractive alternative reserve currency to the dollar. As such, many central banks including Russia, Brazil and South Korea have diversified some of their reserves into euro. Clearly this diversification process has taken time as do many of the events or shifts that affect the forex market. That is why one of the key attributes of successful trend trading in forex is a longer-term outlook.

Observing the Significance of the Long Term
To see the importance of this longer-term outlook, take a look at Figure 1 and Figure 2, which both use a three-simple-moving-average (three-SMA) filter.

Figure 1: Charts the EUR/USD exchange rate from Mar 1 to May 15, 2005. Note recent price action suggests choppiness and a possible start of a downtrend as all three simple moving averages line up under one another.

Figure 2: Charts the EUR/USD exchange rate from Aug 2002 to Jun 2005. Every bar corresponds to one week rather than one day (as in Figure 1). And in this longer-term chart, a completely different view emerges - the uptrend remains intact with every down move doing nothing more than providing the starting point for new highs.

The three-SMA filter is a good way to gauge the strength of trend. The basic premise of this filter is that if the short-term trend (seven-day SMA) and the intermediate-term trend (20-day SMA) and the long-term trend (65-day SMA) are all aligned in one direction, then the trend is strong.

Some traders may wonder why we use the 65 SMA. The truthful answer is that we picked up this idea from John Carter, a futures trader and educator, as these were the values he used. But the importance of the three-SMA filter not does lie in the specific SMA values, but rather in the interplay of the short-, intermediate- and long-term price trends provided by the SMAs. As long you use reasonable proxies for each of these trends, the three-SMA filter will provide valuable analysis.

Looking at the EUR/USD from two time perspectives, we can see how different the trend signals can be. Figure 1 displays the daily price action for the months of March, April and May 2005, which shows choppy movement with a clear bearish bias. Figure 2, however, charts the weekly data for all of 2003, 2004 and 2005, and paints a very different picture. According to Figure 2, EUR/USD remains in a clear uptrend despite some very sharp corrections along the way.

Warren Buffett, the famous investor who is well known for making long-term trend trades, has been heavily criticized for holding onto his massive long EUR/USD position which has suffered some losses along the way. By looking at the formation on Figure 2, however, it becomes much clearer why Buffet may have the last laugh.

Commodity Block Currencies
The three most liquid commodity currencies in forex markets are USD/CAD, AUD/USD and NZD/USD. The Canadian dollar is affectionately known as the "loonie", the Australian dollar as the "Aussie" and the New Zealand Dollar as the "kiwi". These three nations are tremendous exporters of commodities and often trend very strongly in concert with the demand for each their primary export commodity.

For instance, take a look at Figure 3, which shows the relationship between the Canadian dollar and prices of crude oil. Canada is the largest exporter of oil to U.S. and almost 10% of Canada's GDP comprises the energy exploration sector. The USD/CAD trades inversely, so Canadian dollar strength creates a downtrend in the pair.

Figure 3: This chart displaysthe relationship between the loonie and price of crude oil. The Canadian economy is a very rich source of oil reserves. The chart shows that as the price of oil increases, it becomes less expensive for a person holding the Canadian dollar to purchase U.S.dollars.

Although Australia does not have many oil reserves, the country is a very rich source of precious metals and is the second-largest exporter of gold in the world. In Figure 4 we can see the relationship between the Australian dollar and gold.

Figure 4: This chart looks at the relationship between the Aussie and gold prices (in U.S. dollars). Note how a rally in gold from Dec 2002 to Nov 2004 coincided with a very strong uptrend in the Australian dollar.

Crosses Are Best for Range
In contrast to the majors and commodity block currencies, both of which offer traders the strongest and longest trending opportunities, currency crosses present the best range-bound trades. In forex, crosses are defined as currency pairs that do not have the USD as part of the pairing. The EUR/CHF is one such cross, and it has been known to be perhaps the best range-bound pair to trade. One of the reasons is of course that there is very little difference between the growth rates of Switzerland and the European Union. Both regions run current-account surpluses and adhere to fiscally conservative policies.

One strategy for range traders is to determine the parameters of the range for the pair, divide these parameters by a median line and simply buy below the median and sell above it. The parameters of the range is determined by the high and low between which the prices fluctuate over a give period. For example in EUR/CHF, range traders could, for the period between May 2004 to Apr 2005, establish 1.5550 as the top and 1.5050 as the bottom of the range with 1.5300 median line demarcating the buy and sell zones. (See Figure 5 below).

Figure 5: This charts the EUR/CHF (from May 2004 to Apr 2005), with 1.5550 as the top and 1.5050 as the bottom of the range, and 1.5300 as the median line. One range-trading strategy involves selling above the median and buying below the median.

Remember range traders are agnostic about direction (for more on this, see Trading Trend or Range?). They simply want to sell relatively overbought conditions and buy relatively oversold conditions.

Cross currencies are so attractive for the range-bound strategy because they represent currency pairs from culturally and economically similar countries; imbalances between these currencies therefore often return to equilibrium. It is hard to fathom, for instance, that Switzerland would go into a depression while the rest of Europe merrily expands. The same sort of tendency toward equilibrium, however, cannot be said for stocks of similar nature. It is quite easy to imagine how, say, General Motors could file for bankruptcy even while Ford and Chrysler continue to do business. Because currencies represent macroeconomic forces they are not as susceptible to risks that occur on the micro level - as individual company stocks are. Currencies are therefore much safer to range trade.

Nevertheless, risk is present in all speculation, and traders should never range trade any pair without a stop loss. A reasonable strategy is to employ a stop at half the amplitude of the total range. In the case of the EUR/CHF range we defined in Figure 5, the stop would be at 250 pips above the high and 250 below the low. In other words if this pair reached 1.5800 or 1.4800, the trader should stop him- or herself out of the trade because the range would most likely have been broken.

Interest Rates - the Final Piece of the Puzzle
While EUR/CHF has a relatively tight range of 500 pips over the year shown in Figure 5, a pair like GBP/JPY has a far larger range at 1800 pips, which is shown in Figure 6. Interest rates are the reason there's a difference.

The interest rate differential between two countries affects the trading range of their currency pairs. For the period represented in Figure 5, Switzerland has an interest rate of 75 basis points (bps) and Eurozone rates are 200 bps, creating a differential of only 125 bps. However, for the period represented in Figure 6, however, the interest rates in the U.K are at 475 bps while in Japan - which is gripped by deflation - rates are 0 bps, making a whopping 475 bps differential between the two countries. The rule of thumb in forex is the larger the interest rate differential, the more volatile the pair.

Figure 6: This charts the GBP/JPY (from Dec 2003 to Nov 2004). Notice the range in this pair is almost 1800 pips!

To further demonstrate the relationship between trading ranges and interest rates, the following is a table of various crosses, their interest rate differentials and the maximum pip movement from high to low over the period from May 2004 to May 2005.

Currency Pair	Central Bank Rates (in basis points)	Interest Rate Spread (in basis points)	12-Month TradingRange (in pips)
AUD/JPY	AUD - 550 / JPY - 0	550	1000
GBP/JPY	GBP - 475 / JPY - 0	475	1600
GBP/CHF	GBP - 475 / CHF - 75	400	1950
EUR/GBP	EUR - 200 / GBP - 475	275	550
EUR/JPY	EUR - 200 / JPY - 0	200	1150
EUR/CHF	EUR - 200 / CHF - 75	125	603
CHF/JPY	CHF - 75 / JPY - 0	75	650

While the relationship is not perfect, it is certainly substantial. Note how pairs with wider interest rate spreads typically trade in larger ranges. Therefore, when contemplating range trading strategies in forex, traders must be keenly aware of rate differentials and adjust for volatility accordingly. Failure to take interest rate differential into account could turn potentially profitable range ideas into losing propositions.

The forex market is incredibly flexible, accommodating both trend and range traders, but as with success in any enterprise, proper knowledge is key

Is Pressing The Trade Just Pressing Your Luck?

Almost everyone who has ever traded has scaled down into a trade at least once in his or her career - this is also known as adding to a loser. This very common mistake stems from the need to be proved right. The thinking usually goes like this: if you liked the EUR/USD long at 1.2000, you'll love it even better at 1.1900 - it's a better bargain! Of course, the market eventually teaches all traders the folly of such thinking. There are situations in which markets simply do not turn around, and profits accumulated through years of trading can disappear within days. Follow the scale down strategy long enough, and you will eventually go broke. Scaling down can be a valid strategy, but only when it is practiced with inviolable discipline - which, unfortunately, most traders do not possess. Far rarer than the scaling down strategy, yet potentially far more lucrative, is its exact opposite - scaling up. Among traders, scaling up is also known as "pressing the trade". In this article, we'll explain the strategy of scaling up, show you an example of how it's done and discuss the risks that come with this approach. (These trades rank among the all-time greats, find out who made them in The Greatest Currency Trades Ever Made.)

What Is Scaling Up?
The idea of scaling up into a trade is relatively straightforward. Instead of adding to a position as it moves against him or her, the trader would only add as the position becomes increasingly profitable. For example, if a trader went long EUR/USD at 1.2000, he would only add to his trade if the currency pair moved to 1.2200. On the surface, this appears to be an eminently reasonable course of action. It is what Dennis Gartman - investing guru and writer of the famous daily stock market newsletter "The Gartman Letter" - refers to as "doing more of what is working and less of what is not".

In fact, this strategy is as old as trading itself. Dickson G. Watts (who was President of the New York Cotton Exchange between 1878 and 1880) wrote about it as early as the 1880s, in the book "Speculation As A Fine Art And Thoughts On Life":

"It is better to 'average up' than to 'average down'. This opinion is contrary to the one commonly held and acted upon; it being the practice to buy, and on a decline to buy more. This reduces the average. Probably four times out of five this method will result in striking a reaction in the market that will prevent loss, but the fifth time, meeting with a permanently declining market, the operator loses his head and closes out, making a heavy loss - a loss so great as to bring complete demoralization, often ruin.

"But buying at first moderately, and, as the market advances, adding slowly and cautiously to the 'line' - this is a way of speculating that requires great care and watchfulness, for the market will often (probably four times out of five) react to the point of 'average'. Here lies the danger. Failure to close out at the point of the average destroys the safety of the whole operation. Occasionally a permanently advancing market is met with and a big profit secured.

"In such an operation the original risk is small, the danger at no time great, and when successful, the profit is large. The method should only be employed when an important advance or decline is expected, and with a moderate capital can be undertaken with comparative safety."

Why Isn't It More Popular?
So, why do so many traders employ scaling down strategies, while so few traders engage in scaling up trades? The key reason may be our innate predilection for bargain hunting. It is said that real New Yorkers never pay retail. And it is indeed true that many denizens of Wall Street will ruthlessly search out the best deals for anything from a cup of street vendor's coffee to a designer suit. However, this trait is as common among farmers in Happy, Texas as it is among investment bankers in Manhattan. Most people hate to "pay up", and that's the reason why they won't "scale up" into trades.

Nevertheless, scaling up can be an extremely profitable endeavor. Here is a description taken from the Elite Trader bulletin board about how a very famous pit trader, Richard Dennis, employed just such a strategy with bond futures.

"As someone who has seen the likes of Rich Dennis and Tudor Jones operate, those '5%' winning trades involve add-on after add-on. Case in point is Dennis in the 1985-1986 bull market in bond futures. He would start with his normal unit of 500 contracts and get chopped for days. Buy the day's high, put 'em back out on a new swing low, etc. Every once in a while he'd wind up with 500 that worked. Then he'd start the process higher, all over again. Work 'em in, work 'em out. After maybe a couple of months the market has rallied 10 pts. from where he started, and he has 2,000 on (meaning 2 million a point). Now the market is short and ready to pop on any size buying, and he's there supplying the noose. Bidding for 500 on every uptick, he finally gets to a point where for the last month of the move he has 5,000 on. T-bonds rally 20 pts. In just over a month he's up $100 million on a trade that started out with him just testing the waters, losing $100,000 a few times before he could establish a position worth doubling up on."

One trade, $100 million dollars in profit. While most of us can never aspire to success on such an enormous scale, the profit opportunities for scale up trades present themselves to retail FX traders on a regular basis. Let's take a look at price action in the USD/JPY pair for a good example of this strategy in action.

Putting It into Practice

Figure 1

On April 24, 2006, a scale up trader would have entered a short on USD/JPY at 115.50, after the pair broke the double bottom support at that level, risking 150 points on the trade to 117.00. As the downside momentum accelerated, the trader would have added another unit to his or her position as it breached the 113.50 barrier on May 1. Finally, as USD/JPY careened through the 111.50 level on May 8, the scale up trader would have added yet one more unit, short building the position to three units. At the first sign of loss of downside momentum around the 109.00 figure, the trader would close out the position. At that point, the total profit on the trade would amount to 1350 points on an initial risk of only 150 points, for a whopping 9:1 risk/reward ratio!

Proceed with Caution
If you are a trader, you may be thinking at this point that scaling up sounds like a pretty good way to make a tidy profit. But before you rush to initiate scale up trade strategies, it is critical that you understand the drawbacks. While the scale up trade may indeed be very lucrative, it is also extremely rare. There is a reason why, in the quote about Richard Dennis, the person posting refers to the trade as a "5 percenter". Scale up trades are in fact successful only 5% of the time, if not less.

In order to work, scale up trades require two key ingredients: a propitious entry that becomes profitable almost from the start of the trade and a strong uninterrupted trend with virtually no retraces along the way. The description of the scale up strategy as "pressing the trade" is actually very apropos, because the trader is in fact pushing the position further and further as price action moves his or her way. Imagine a situation in which the USD/JPY trade did not go as smoothly as shown, but instead retraced back to 113.50 after the third unit was sold short at 111.50. The trader would then have to cover the position at breakeven, faced with the knowledge that a guaranteed profit of 600 points disappeared instantly as the scale up trade went awry. Unfortunately, this type of price action happens more often than not, as the strategy of "pressing the trade" often presses back on the trader.

Conclusion
For traders capable of withstanding the psychological pressure of losing massive open profits to the vagaries of the market, the scale up trade can be an invaluable strategy. Clearly, it has produced some of the greatest trading successes in the history of financial markets, but anyone who attempts this approach must prepare for many moments of failure and frustration. Imagine that you have worked on a complex jigsaw puzzle for several weeks and are within a few pieces of finishing it, when someone intentionally comes by and scrambles all the pieces. If you can accept such turns of events with quietude and calmly begin the assembly process once again, then the scale up trade may be right for you

Spread-To-Pip Potential: Which Pairs Are Worth Day Trading?

Spreads play a significant factor in profitable forex trading. When we compare to the average spread to the average daily movement many interesting issues arise. Namely, some pairs are more advantageous to trade than others. Secondly, retail spreads are much harder to overcome in short-term trading than some may anticipate. Third, a "larger" spread does not necessarily mean the pair is not as good for day trading when compared to some lower spread alternatives. Same goes for a "smaller" spread - it does not mean it is better to trade than a larger spread alternative. (For a background, see Retail FX Spreads: Do They Even Matter?)

Establishing a Base Line
To understand what we are dealing with, and which pairs are more suited to day trading, a base line is needed. For this the spread is converted to a percentage of the daily range. This allows us to compare spreads versus what the maximum pip potential is for a day trade in that particular pair. While the numbers below reflect the values in existence at a particular period of time, the test can be applied at any time to see which currency pair is offering the best value in terms of its spread to daily pip potential. The test can also be used to cover longer or shorter periods of time.

These are the daily values and approximate spreads (will vary from broker to broker) as of April 7, 2010. As daily average movements change so will the percentage that the spread represents of the daily movement. A change in the spread will also affect the percentage. Please note that in the percentage calculation the spread has been deducted from the daily average range. This is to reflect that retail customers cannot buy at the lowest bid price of the day shown on their charts.

• EUR/USD
  Daily Average Range (12):105
  Spread: 3
  Spread as a percentage of maximum pip potential: 3/102= 2.94%
  
  
• USD/JPY
  Daily Average Range (12):80
  Spread: 3
  Spread as a percentage of maximum pip potential: 3/77= 3.90%
  
  
• GBP/USD
  Daily Average Range (12):128
  Spread: 4
  Spread as a percentage of maximum pip potential: 4/124= 3.23%
  
  
• EUR/JPY
  Daily Average Range (12):121
  Spread: 4
  Spread as a percentage of maximum pip potential: 4/117= 3.42%
  
  
• USD/CAD
  Daily Average Range (12):66
  Spread: 4
  Spread as a percentage of maximum pip potential: 4/62= 6.45%
  
  
• USD/CHF
  Daily Average Range (12):98
  Spread: 4
  Spread as a percentage of maximum pip potential: 4/94= 4.26%
  
  
• GBP/JPY
  Daily Average Range (12):151
  Spread: 6
  Spread as a percentage of maximum pip potential: 6/145= 4.14%

Which Pairs to Trade
When the spread is placed into percentage terms of the daily average move, it can be seen that the spread can be quite significant and have a large impact on day-trading strategies. This is often overlooked by traders who feel they are trading for free since there is no commission.

If a trader is actively day trading and focusing on a certain pair, making trades each day, it is most likely they will trade pairs that have the lowest spread as a percentage of maximum pip potential. The EUR/USD and GBP/USD exhibit the best ratio from the pairs analyzed above. The EUR/JPY also ranks high among the pairs examined. It should be noted that even though the GBP/USD and EUR/JPY have a four-pip spread they out rank the USD/JPY which commonly has a three pip spread.

In the case of the USD/CAD, which also has a four-pip spread, it was one of the worst pairs to day trade with the spread accounting for a significant portion of the daily average range. Pairs such as these are better suited to longer term moves, where the spread becomes less significant the further the pair moves. (For more, check out Investopedia Special Feature: Forex Trading Guide.)

Adding Some Realism
The above calculations assumed that the daily range is capturable, and this is highly unlikely. Based simply on chance and based on the average daily range of the EUR/USD, there is far less than a 1% chance of picking the high and low. Despite what people may think of their trading abilities, even a seasoned day trader won't fair much better in being able to capture an entire day's range - and they don't have to.

Therefore, some realism needs to be added to our calculation, accounting for the fact that picking the exact high and low is extremely unlikely. Assuming that a trader is unlikely to exit/enter in the top 10% of the average daily range, and is unlikely to exit /enter in the bottom 10% of the average daily range, this means that trader has 80% of the available range available to them. Entering and exiting within this area is more realistic than being able to enter right in the area of a daily high or low.

Using 80% of the average daily range in the calculation provides the following values for the currency pairs. These numbers paint a portrait that the spread is very significant.

• EUR/USD
  Spread as a percentage of possible (80%) pip potential: 3/81.6= 3.68%
  
  
• USD/JPY
  Spread as a percentage of maximum pip potential: 3/61.6= 4.87%
  
  
• GBP/USD
  Spread as a percentage of possible (80%) pip potential: 4/99.2= 4.03%
  
  
• EUR/JPY
  Spread as a percentage of possible (80%) pip potential: 4/93.6= 4.27%
  
  
• USD/CAD
  Spread as a percentage of possible (80%) pip potential: 4/49.6= 8.06%
  
  
• USD/CHF
  Spread as a percentage of possible (80%) pip potential: 4/75.2= 5.32%
  
  
• GBP/JPY
  Spread as a percentage of possible (80%) pip potential: 6/116= 5.17%

With the exception of the EUR/USD, which is just under, 4%+ of the daily range is eaten up by the spread. In some pairs the spread is a significant portion of the daily range when factoring for the likely possibly that the trader will not be able to accurately pick entries/exits within 10% of the high and low which establish the daily range. (To learn more, see Forex Currencies: The EUR/USD.)

Final Thoughts
Traders need to be aware that the spread represents a significant portion of the daily average range in many pairs. When factoring likely entry and exit prices the spread becomes even more significant. Traders, especially those trading on short time frames, can monitor daily average movements to verify if trading during low volatility times presents enough profit potential to realistically make active trading (with a spread) worthwhile. Based on the data the EUR/USD and the GBP/USD have the lowest spread-to-movement ratio, although traders must update the figures at regular intervals to see which pairs are worth trading relative to their spread and which ones are not. Statistics will change over time, and during times of great volatility the spread becomes less significant. It is important to track figures and understand when it is worth trading and when it isn't