Currency Forecasts Q2, 2008

U.S. Dollar and Euro 2008 Q2 Outlook

By Kathy Lien and Boris Schlossberg

Dollar weakness hit a new extreme in the first quarter of 2008 as the greenback fell within an arm’s reach of 1.60 against the euro and 95 against the Japanese yen. Interest rate cuts by the Federal Reserve have turned the U.S. dollar into the second-lowest yielding currency in the developed world. Since then, the dollar has recovered from its March lows, leaving many traders wondering whether the greenback has hit a bottom. Interestingly enough, the outlook for the U.S. economy has actually worsened, with U.S. non-farm payrolls falling for the third consecutive month. Given this deterioration, how can the U.S. dollar strengthen; and furthermore, can this rally turn into a more significant recovery?

Unprecedented Developments Trigger Unprecedented Responses

Over the past three months, the Federal Reserve has taken unprecedented measures to restore stability to the U.S. financial system. The collapse of Bear Stearns, which was once the nation’s fifth-largest investment bank, put the 2007 – 2008 financial crisis into the history books. This was the first time since the Great Depression that a major U.S. bank has failed. In response to this groundbreaking crisis, the Federal Reserve invoked an emergency provision allowing the central bank to loan directly to investment banks. This provision was added to the Federal Reserve Act during the Great Depression and has not been used since then. However, the collapse of a major U.S. bank and tight credit markets are making the Federal Reserve’s job exceptionally difficult. Cutting interest rates alone has not worked, and as a result, the U.S. Central Bank has introduced an alphabet soup of new measures, including the Term Auction Facility and the Term Securities Lending Facility, to inject liquidity into the financial system. They are even willing to accept less liquid and dubious mortgage-backed securities for the Fed’s highly liquid and rock solid U.S. Treasuries.

Although these efforts have prevented a collapse in the equity markets, it has not prevented a continual deterioration of the U.S. economy. With foreclosures on the rise and the median price of existing homes falling by the largest amount on record in February, the housing market shows no signs of stabilization. Layoffs are on the rise and consumer spending is contracting, which has forced the Federal Reserve to cut interest rates by 200bp in the first quarter, the most that the central bank has cut in one quarter since 1984. The combination of a deteriorating outlook for the U.S. economy, lower interest rates, and desperate measures by the Federal Reserve are the main reasons why the U.S. dollar hit a record low in March.

A continual recovery of the dollar will depend on one of two things (or both):

1) The degree of interest rate cuts from the Federal Reserve
2) Slowdown in the euro zone economy

How Low Will the Fed Go?

We expect the Federal Reserve to continue cutting interest rates because the U.S. economy will deteriorate further. The labor market alone is enough reason for the Fed to bring rates down to 1.50 percent. Dell and Motorola joined ATA and Aloha Airlines in announcing more layoffs. These four companies alone will shave 14k from the U.S. workforce. Over the past three decades, the U.S. economy has gone through three recessions. During those times, a string of job losses lasted for a minimum of 10 months, and we are already beginning to see the same trend unfold. It will be months before the U.S. economy once again begins creating jobs. The largest single- month job loss in each of the prior three recessions was more than 300k, so why should it be any different this time around? We would not be surprised to see the same severity of job losses in this business cycle. If NFPs print -100k, the markets will be rushing to price in 1.50 percent rates. As for retail sales, they should continue to suffer as well. Linens ‘n Things has just joined Domain, Fortunoff, and Sharper Image in filing for bankruptcy protection. Other companies, such as Foot Locker, have closed many of their stores and are expected to shut down even more in the coming year.

What about Inflation?

Another 75bp is probably the best that we will get from the U.S. Central Bank because at some point, they will no longer be able to turn a blind eye to inflation. According to the March 18 FOMC minutes, two of the Fed Presidents expressed strong concern about heightened inflation risks and favored easing policy less aggressively than the 75bp that the Fed actually delivered. They believe that it takes time for rate cuts to be felt in the economy and that they cannot wait for evidence of inflation sticking, as by then it would be too late to prevent a further increase.

Interest rate cuts alone will not do the trick; and for this reason, the Federal Reserve needs to focus on other measures targeted at relieving liquidity strains. Slowing down or putting an end to rate cuts may be exactly what the U.S. dollar needs to recover. Going forward, we expect more creativity from the Federal Reserve because, short of printing money, the size of the Federal Reserve’s balance sheet will limit what they can do. In the middle of March, the Fed committed to swap 60% ($420 billion) of its $700 billion balance sheet of U.S. Treasuries for mortgage-backed securities. Recently, there have been reports that the Fed is eyeing the Nordic-style nationalization of U.S. banks as a temporary solution to the U.S. financial crisis. Printing money in the current market environment is not a likely option because it would foster even stronger inflationary pressures.

The second factor that could turn the dollar around would be a sharp slowdown in the euro zone economy. This is discussed further in the Q2 outlook for the euro zone, but recoupling in the fourth quarter of 2008 could play a big role in the dollar’s recovery. The ripple effects of the U.S. subprime crisis have affected many countries, and chinks in the armor are beginning to show in the euro zone despite the European Central Bank's persistently hawkish monetary policy stance. Eventually, the ECB will be forced to cut interest rates, and at that time, they will most likely find themselves behind the curve. This will result in an interesting twist of fate where the ECB begins to cut interest rates at a time when the Federal Reserve is done.

U.S.: How Deep of a Recession?

Debating whether or not the U.S. economy has fallen into a recession is now a moot point because most Americans already feel as if the U.S. economy is in a recession. Growth in the fourth quarter was a mere 0.4 percent, and growth in the first quarter could be even worse. Two weeks ago (for the first time in this business cycle), Fed Chairman Ben Bernanke, while testifying before the Joint Economic Committee, said that the U.S. economy could fall into a recession. Until now, every member of the Bush Administration has avoided the word like the plague; but the question remains: How deep of a recession will we see? The Central Bank is throwing everything but the kitchen sink at the markets, and we believe that they will begin to see the fruits of their labor in the fourth quarter. A lot of money is still parked on the sidelines waiting for a buying opportunity, although foreigners have come into the U.S. to buy relatively cheap real estate, providing a buffer for the ailing housing market. The same thing is happening in U.S. stocks, and we believe that this could exacerbate on the first signs of stabilization in the U.S. economy. Therefore, even though Q2 could mean more dollar weakness, the dollar should begin to recover in the second half of the year.


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Currency Forecasts Q2, 2008

Euro, the Invincible

One of the more amazing feats of the euro zone economy in Q1 of 2008 was its ability to compete and grow despite the twin obstacles of a slowing North American market and the ever-rising exchange rate, which created massive cost disadvantages for the export-driven region. One key piece of evidence supporting this point of view was the latest reading of the IFO survey of business sentiment, which printed a much stronger 104.8 versus expectations of 103.5. The report suggested that, at least for the moment, the economy in the 17- nation union continues to operate at a healthy pace, irrespective of the troubles in the U.S.

The boom in the euro zone was led by the export sector, most notably in Germany, as gains in efficiency coupled with strong demand from emerging markets have helped producers in metal, electronics, and car industries to create more jobs at the start of the year than at any time in the past four decades.

ECB Remained Hawkish as Employment Growth Continued

Little wonder then that the ECB has remained hawkish throughout the first quarter of 2008, feeling no particular pressure to ease rates any time soon. The net result was that euro zone rates have remained steady at 4% while the Fed funds rate declined to 2.25%, creating a 175 basis point interest-rate differential in favor of the single currency.

One of the key reasons for the ECB’s staunch hawkishness has been the relatively buoyant labor picture. German unemployment continued to decline each month during the quarter and French unemployment reached a 20-year low. We have long contended that the ECB will not change its hawkish posture until and unless demand for labor in the region begins to contract. The strong IFO results, which were supportive of continued expansion in employment, indicate that Mr. Trichet and company will not be in any hurry to change their policy course anytime soon.

Clouds on the Horizon

However, as the quarter came to an end, evidence of a slowdown in the region began to appear in the data, and the vaunted decoupling scenario that supported euro bulls throughout the Q1 rally was starting to come apart at the seams. Most notable was the very steep decline in euro zone retail sales, which, for the month of February, declined by -0.5% versus consensus calls of 0.2% gain. The sharp fall-off was led by the region’s most important economy—Germany, which saw retail sales contract -1.7% on a month-over- month basis. Given the strength in employment and the high value of the euro, such a large decrease caught many market participants by surprise, suggesting that the euro-zone economy may be weaker than it seemed. Indeed, with the consumer unwilling to spend, the region's growth is likely to depend even more on the growth of its producers, and because global expansion is beginning to slow, such dependence on the export sector may prove to be highly problematic.

North – South Decoupling?

Furthermore, growth in the euro zone is not uniform, but rather highly divided between northern and southern parts of the region. The latest Retail PMI report showed deterioration across the board, but the reading from Italy was particularly bad, printing at 36.4—the worst level since the survey began. Italy remains the weakest link amongst the top three euro-zone economies, and if the situation there deteriorates further, political tensions in the region could begin to undermine the euro’s seemingly relentless rise as the interests of Italy, Spain, and other southern European members could come in conflict with those of France and Germany, where growth continues at a reasonable pace. Decoupling may continue to be the theme in Q2, but this time decoupling will refer to the story of divergence within euro zone itself rather than the more common notion of growth-rate differentials between U.S. and euro zone economies.

Euro Strength will only come from the Dollar’s Weakness

In Q1, euro strength was driven by surprisingly strong fundamentals as the region continued to grow and expand despite having to battle higher exchange rates, higher interest rates, and the effects of a slowdown in North America caused by the credit crisis in asset- backed securities. However, as the quarter came to a close, the slowdown in demand was becoming evident in the euro zone as well. Therefore, going forward, the data from the region is unlikely to prove as fundamentally supportive as it did during Q1 of 2008. As global demand cools and the after effects of the financial crisis begin to afflict euro-zone economies, the euro will no longer benefit from diverging interest-rate trends. At best, euro-zone interest rates will remain stationary at 4% and may even begin to ease as the year progresses. Under such a scenario, much of the momentum for euro-long positions will be gone, and the unit will only rise on anti-dollar sentiment alone. To that end, the upside in the pair will be determined by further deterioration of U.S. data, most particularly the contraction in U.S. jobs. With consumer credit at record highs, the U.S. could experience a serious recession if unemployment skyrockets and incomes drop, which will severely handicap the ability of the U.S. consumer to service their debts. U.S. rates will likely fall further, widening the interest-rate differential in the pair and propelling the euro higher.

Intervention Beyond 1.60?

However, even if the EUR/USD rises, how much further can it go before attracting the interest of monetary authorities? At 1.60, the Europeans, especially the French, are likely to become quite concerned about the strength of the currency. France's Finance Minister, Christine Lagarde, has already noted that, “'We have acknowledged that we are suffering together from the excessive volatility of exchange rates among all currencies,” adding that there is a “need to obtain adjustments, if possible.” While any talk of central-bank intervention is clearly premature, it is important to note that the last time the EUR/USD appreciated approximately 12% in a near uninterrupted fashion in 2004, ECB chief Jean-Claude Trichet noted that the moves were “brutal,” and the EUR/USD immediately declined 600 points as a result. So far, ECB officials have stayed away from such dramatic rhetoric; however, should the EUR/USD catapult to approximately 1.6200, it will have appreciated about 12% in the most recent rally. At that time, the laissez-faire attitude of ECB officials may change, and their rhetoric is likely to become much more aggressive as they try to contain any further appreciation in the currency.

Key Points

As currency markets look ahead to Q2 of 2008, the picture for the EUR/USD looks far more precarious than it did at the start of the year. For the time being, the unit remains in a strong uptrend against the greenback, enjoying a substantial interest-rate differential in its favor. However, clear signs of slowing economic growth in the region and the vast disparity in performance between northern and southern nations of the European Union are likely to create more tensions as we move ahead. So far, the region has been able to absorb the brunt of the exchange-rate adjustments and continues to grow despite the headwinds of unfavorable exchange rates. However, should the unit appreciate much beyond the 1.6000 level, ECB monetary officials are unlikely to remain so nonchalant about the strength of the currency as the combination of slowing global economic growth along with persistently high exchange rate will cause an inevitable decline in labor demand, putting enormous political pressure on the ECB to ease monetary policy. Further upside in the euro, therefore, is likely to come only from additional anti-dollar sentiment rather than from any organic strength of its own, and that upside is likely to be curbed by actions of euro-zone monetary officials who will become quite concerned if the unit trades much above the 1.60 level.


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The World of Currency Crosses

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 will crash during the strongest of bull markets. In the currency market, however, such divergent possibilities do not tend to occur, and finding trading opportunities are simplified due to the narrower investment selection. In this article, we'll look at how FX 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 Trades are Not the Same

When dealing with the major currency pairs, most traders are presented with only two choices: buy the dollar or sell the dollar. Regardless of whether a trader decides to long the GBP/USD (British pound-US dollar) or EUR/USD (Euro-US dollar), or short the USD/CHF (US dollar-Swiss franc) or USD/JPY (US dollar-Japanese yen), the unifying theme in all of these positions is that the trader is bearish on the greenback. Therefore, the remaining question of which of the four trades should be taken is somewhat immaterial, since all of them are linked to the dollar's movement. Granted, this is a gross oversimplification of the FX market. We'll be the first to acknowledge that not all currency movements will be tailored to this paradigm—the New Zealand dollar is one good, recent example of such a dynamic. The New Zealand dollar is considered a high-yielding currency, as the Reserve Bank of New Zealand has set their official cash rate at a record high of 8.25 percent. Furthermore, given the country’s reliance on exports for economic growth and geographical proximity to Australia, the New Zealand dollar’s exchange rate has a correlation with both commodity prices and the Australian dollar, which itself has a strong correlation with gold. As a result, while major currencies like the Euro have held strong against the US dollar, a drop in commodity prices has weighed heavily on the New Zealand dollar. On the other hand, when the markets are willing to take on risk and carry trades thrive, the New Zealand dollar tends to crush the US dollar while other currencies, like the Japanese yen and Swiss franc, may suffer.

Currency Crosses Offer More Possibilities

Trading simply on your own bias of the US dollar versus other currencies will rarely yield uniform capital flows. Some currencies appreciate substantially greater against the dollar, while others barely gain even a few basis points. This disparity in performance against the greenback creates many trading opportunities for market players who opt to choose from the wide array of currency crosses. When simplified, currency crosses merely measure the relative strength of one individual currency against another, and are distinguished by the fact that they do not include the US dollar as either the base (first) or counter (second) currency of the pair. As such, they offer traders tremendous opportunities to go beyond the simple trading strategy of buying or selling the dollar.

Different Crosses for Different Types of Trading

For traders that appreciate taking on risk, currency crosses—such as the Japanese yen pairs—may be attractive because they can be just as volatile as the DJIA, but allow for easier short-selling during bearish times. Meanwhile, when the financial market sentiment remains broadly risk seeking, trading crosses can focus on carry-trading strategies that look to profit from the interest-rate differentials between the currencies or can focus on pure capital gains speculation (link to carry trade article). Alternatively, some crosses can trend for months, such as EUR/GBP. Indeed, this pair has rallied almost non-stop since September 2007, and traders who have chosen to trade with the trend could have profited significantly. Meanwhile, others will be highly range-bound for weeks or months at a time, such as the EUR/AUD between late November 2007 and late January 2008, before breaking out. In short, the possibilities with currency crosses are endless.

The Economic Trade

Consistent disparities in economic performance can often bring about many trading opportunities in currency crosses. A case in point is the price action in the second half of 2005 for 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 they are heavy exporters, and were able to generate substantial trade surpluses from the depreciation. 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 next-door neighbor. As the realization of this fact began to permeate the market, the EUR/CHF cross (one of the least volatile crosses in the market at the time) declined by over 100 points in the period between late September and early October 2005.

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The Most Active Market Hours and Currency Pairs in the FX Market

Although the FX market is open 24 hours, there are still periods during each day when price action is more volatile than others. When trading currencies, it is essential to know when these time frames are, as it can define an intraday trade or prevent it. In this lesson, we will break the trading day down into the three major trading sessions, cover the most active times, and give some insight as to why we should expect this relationship to hold into the future.

FX Trading Sessions

There are three major financial centers around the world; and it isn’t a coincidence that activity in the currency market as a whole rises and falls when the markets in these regions are online. In fact, given the major financial institutions’ deals, speculators’ trades, and day-to-day business transactions are performed when each of these markets is open, it makes sense that there should be a greater level of price action in currency markets around the same time. The three major sessions for the global financial markets covers activity in the Asian, European, and North American markets to span most of the world’s time zones. The Asian session is centered on the active Tokyo trading hours. Officially, this encompasses the times that the Tokyo Stock Exchange is open, between 8:00 PM and 5:00 AM (EST), but it stands to reason that the currency market is in fact drawing traders an hour or two before and after the equity markets are active. As a financial center, the Tokyo session includes liquidity from not only Japan, but also China, Australia, New Zealand, India, Hong Kong, and many other nations.

Europe is a very dense continent in terms of population and accumulated wealth. Although the euro zone is centered on its largest economy (Germany), the de facto capital for the European session is the world’s financial capital: London. Exchanges in the U.K. are officially open between 4:00 AM and 12:30 PM (EST); but once again, the presence of traders in European countries that are further east and the after-hours nature of the FX market expands this range in both directions by a few hours. When the London session is online, liquidity from Germany, France, Italy, Spain, the Netherlands, and African nations, among others, are contributing to liquidity in the foreign exchange market.

Finally, the North American session ends the calendar day with a concentration of activity around the open hours for the New York exchanges. New York’s exchanges are active between 9:00 AM and 4:30 PM (EST), but many currency traders in this time zone will logon a few hours early to see how price action is developing before the official open of markets in the U.S. When following this time zone, liquidity from the U.S., Canada, Mexico, Brazil, and other South American countries is represented.



The Average Hourly Reaction of the EUR/USD

Running through the last three years of price action, we have found that volatility across the majors rises and falls during certain periods. Since the fluctuations are pretty consistent across the dollar-based majors, we have used the EUR/USD as a benchmark for the seven majors. The graph below shows the average range for each hour in a 24-hour day. The results clearly reveal periods of heightened and reduced activity. In fact, the most active time (9:00 AM (EST) or 1:00 PM (GMT)) for the markets experiences more than three times the average range than the slowest period (5:00 PM (EST) or 9:00 PM (GMT)) does. Beyond this, we can make the observation that price action generally rises through the opening hours of each of the three major sessions. In fact, over the opening hour of the Asian session, the EURUSD averages a 13-point range; at the beginning of the European session, the EUR/USD moves 23 points; and at the start of the North American session, price action tops 31 points.



The Top Market Moving Periods for Forex

Considering price action increases when there are more traders in the market, it isn’t surprising that the currency market is most active when the major sessions overlap, drawing the greatest level of global participation. It is easy to see in the chart of hourly EUR/USD ranges above that the greatest level of price action occurs when the US and European sessions overlap between 9:00 AM and 12:00 PM (EST). The reaction over the next two hours is comparable, but slightly more reserved. However, the mere presence of traders isn’t the only component to activity around this time. Another element behind the high volatility during this period is the frequency with which major US economic indicators are released. Major market-moving indicators such as Non-farm payrolls, the Consumer Price Index, and retail sales, among others, are released during this time. The same considerations no doubt apply to the increase in activity around 4:00 AM (EST)—as the opening of the European session meets the close of the Asian session and German and Eurozone data is released. The sharp spike at 4:00 PM on the other hand is unique to EUR/USD. The jump in volatility during one the least liquid periods of the day is due to the closing of the US markets. This reaction is reflected in this pair specifically because it is the most heavily traded.

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Profit Mantras
1. Knowledge is must: good knowledge is very essential before trading. Understanding of subject, terminology, financial market behavior, current trends, foreign news are must for the trader.
2. Knowing currencies well: currencies are traded in pairs. So it is very important to understand the impact and relationship among both the currencies.
3. Risk Management: take risk only when you are prepared. Risk and return are the two sides of coins. Better management of risk will fetch better results.
4. Read, learn and trust trend charts: gaining information and following trend charts can help the trader to earn huge profit. It is always advisable to stick with the trends as the currencies mostly follow a similar pattern with minor fluctuations.
5. Deal in common pairs of currency: for a beginner it is always safe to trade in common currencies as the proper information is available. Uncommon currencies are very volatile and sometimes do not follow the past trends.
6. Learn from the past experiences: always try not to repeat the same mistake and remember the mistakes done in past. Experience will make trader confident and will help him to understand market well.
7. Avoid unknown Forex trading strategies: trader should not involve in these strategies which he does not understand.

Candlesticks: Do they Really Work?

One of the most popular trading strategies in the FX markets involves the use of Japanese Candlestick charts. Given a specific pattern in candlestick formations, traders look to buy and sell currencies in anticipation of reversal or continuations in price. Here we’ll discuss four of the most popular candlestick formations and how you can use them to trade in the FX markets:



A Morning Star formation is a bullish reversal signal for an overall downtrend. The first candle should be strongly negative and full-bodied, reflecting heavy losses. The second candle opens at or below the previous close, trading within a relatively narrow range with the high staying below the midpoint of the first candle. The third candle is strongly positive and closes above the midpoint of the first candle. This tells us that bearish sentiment is unable to push price below previous lows, and risks remain for a reversal in price trends.

The Evening Star is effectively the opposite of a Morning Star, as price starts in an uptrend and the first candle is strongly positive. The second candle opens above or at the previous close, trading within a fairly narrow range and with its low above the previous bar’s midpoint. The third candle is strongly negative and closes below the first candle’s midpoint. This gives a warning that bulls are unable to push price to new highs, and a strong, bearish candle hints at further downside potential through subsequent trading.



A Hammer forms when price is in a downtrend and price trades sharply lower from the open, but a subsequent reversal leaves price marginally unchanged through the close. The candlestick formation is distinct for its long wick to the downside, small candle body, and little or no wick to the topside—signaling that price finished near the top of its intra-candle range. It is a decidedly bullish formation, as it tells us that bulls have overpowered an initial bearish tumble.

A Shooting Star formation is effectively the exact opposite of the Hammer. Price remains in an uptrend when it opens and trades sharply higher within a given candle, but a subsequent reversal leaves it near or below its candle open. The Shooting Star is distinctive for its very long, upward wick, small candle body, and little to no wick to the downside. The formation signals that a bullish run was initially enough to push price to new highs, but exhaustion has allowed bears to push price significantly lower before the candle's close.

How to Trade FX Using Candlesticks

The key to using candlesticks when trading in the FX markets is to keep technical levels in mind, particularly with the four candlestick patterns we’ve discussed. Indeed, the likelihood of accurately interpreting the candlestick signals increases dramatically when you take into account key support and resistance levels. For example, if a trader is watching the EUR/USD pair and anticipates a potential change in trend, chances are they will be waiting for price to approach a significant trendline or Fibonacci level. By watching the candlestick patterns, the trader simply has an additional tool by which to more confidently call for a turn.

When employing candlestick patterns, it is important to utilize the rules of money management. A trader can do this by using fairly tight stop-loss orders. If the currency pair that is being traded does not follow the direction that the candlestick pattern signals it should, chances are it won’t at all. As a result of placing a stop-loss order, the trader can avoid being caught on the wrong side of the position if the pair breaks out and thus, can limit their losses.

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thanks for the information. i hve got all the basics of forex here. nice work. very interesting and hard work.

You're welcome and good luck with your trading.

Like all financial markets, there is a spread in the currency pairs in the FX market. The spread is the difference between the buy price and the sell price. One key point about currency trading though is that most charting packages that specialize in FX will only show the sell side price on their charts. So if the EUR/USD is currently quoted at 1.5763 on your charts, you should realize that this is the bid, which is the price where you can sell the currency pair. If there is a two pip spread in this pair and you buy at the market, you will be filled at the ask, which is the price where you can buy the currency pair. This means that you would be filled at 1.5765 instead of the price on the chart of 1.5763. This is important to know when you are calculating an entry price if you are buying a breakout above resistance or a pullback down to support. You should always add the spread to the sell side price on the chart to get your equivalent buy side price. There are also charting packages available that will offer two charts; one being the sell side price and the other offering buy side prices. But just keep in mind that when you are buying at a price away from where the market is currently selling or placing a protective buy stop, to adjust your actual price to compensate for the spread.

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Risk Management: The Foundation of a Successful Forex Trading Strategy

Even the best trading strategy can falter from time to time; but without good risk management, a small loss could turn into an account-ending margin call. Risk Management simply refers to any effort taken to mitigate uncertainty in a trade. However, this basic description doesn’t do justice to a discipline that has reached a level of complexity that rivals strategy generation itself. In this article, we will boil a broad topic down to the most important rules for any trading style, including: various types of stop losses; position sizing; placing targets; and understanding exposure.

Know Your Exit Even Before You Enter

From the collective wisdom of the market, one rule always seems to top the list of essential money- management commandments: placing stops. A stop loss is merely a level at which a trader will exit a trade that is going against them. This level can be mental or a hard stop—with an order set to automatically exit when spot reaches a certain price. In general, a hard stop will almost always be preferable as it removes the hazard of emotion seeping into a trade and adjusting an otherwise sound trading strategy. However, there are situations where the mental component can be useful. There are two core types of stops in the forex market: a money-based stop and an indicator stop.

Money Stop: The money stop is the most commonly used exit strategy in the investment world. This level is based on a predefined amount of capital a trader is willing to risk on each trade. By deciding how much a trade could potentially lose at the outset, a market participant can survive to trade another day should one position fail. While this stop is primarily calculated as a specific percentage of total capital, or perhaps it is chosen as just a random number, we can also take technicals into consideration when defining the exit level. To show how all of this comes together, we can take as an example a hypothetical trade in EUR/USD. With a bullish outlook on the pair, we could have entered the market when price was testing a rising trendline around 1.5525. With a predetermined level of acceptable risk of 150 pips or $1,500 for a standard account, we would set our stop at 1.5375—well below the rising trendline.



Indicator Stop: Another popular exit strategy is the indicator stop. Unlike the other two stops, which rely predominately on underlying price action, this method uses a technical indicator, alone or in conjunction with spot, to define an exit. This can entail an indicator reaching a certain level, two indicators crossing, or price action interacting with the indicator as a means for gauging an exit point. Theoretically, there are unlimited possibilities for incorporating technicals into a stop policy—ranging from very complicated to extremely simple. One of the most common indicator stops for nearly every market is using a moving average as a self-adjusted stop loss. Here is an example of using the 100-hour SMA as an exit tool for the EUR/USD. Suppose a trader goes long the EUR/USD on a close above the 100-hour SMA. The trader can then proceed to trail the stop using the moving average and only exit the position when price closes back below the SMA. In this example, the long trade is taken at 1.55 and not closed until 1.5750. The only caveat is that this method of a stop does not work well with set orders, so the trader will need to keep an eye on the technical indicator.



Having a stop and sticking with it is the most fundamental rule of trading that separates disciplined traders from undisciplined ones.

Too many new traders spend time developing an approach to trading based on historical data and then when they use it live for the first time and lose, they throw it away thinking that it doesn’t work. The fact may be that the approach is solid, but it is our expectations that are not realistic. We shouldn’t expect to win every trade. Some of the best traders in the world win on less than half of their trades. But they also know that after a series of trades, because of sound money management they can expect to be profitable. This is because they are consistent in their approach, so they expect some consistency in their results. When developing a new strategy, you have to judge it’s effectiveness through different market conditions. This means that you have to see how it works when the market is trending up, trending down, in a range bound situation and also when the market seems confused and directionless. This may mean running through 100 practice trades to get a good feel for the strengths and weaknesses of the approach. Just because that approach loses three trades in a row, it does not mean it doesn’t work. If you and I were flipping a coin where I won on heads and you won on tails, we know that we would each win on about half of the flips. But if tails came up three times in a row, that does not mean that there is something wrong with the coin, it is just chance. We would still know that after a series of 100 flips, we would each still have won and lost about half of the flips. Think of this as you are working on ways to trade the market. Don’t be too quick to judge that approach on a small number of trades. Think long-term when judging and then if the results are acceptable, be consistent in taking the trades and your trading results will also start to show some consistency.

One thing experienced FX traders will look at is the relationship between currency pairs and use that information for an edge in their trading. A good example would be the relationship between the EUR/USD and the USD/CHF. Because of the similarity of the economies in Switzerland and the Eurozone, the EUR and the CHF will react in a similar fashion when compared to the USD. You can see on the charts below how the EUR/USD was in a strong uptrend while the USD/CHF was in a strong downtrend. The reason they move in opposite directions is based on the fact that the USD is listed second in the EUR/USD, which makes the USD the counter currency, while the USD is listed first in the USD/CHF, which makes the USD the base currency. The relationship is not pip for pip, but it is close enough to use this to our advantage. How? If a trader thought the USD was strengthening, they could sell the EUR/USD or buy the USD/CHF. The choice can come down to the rollover on each pair credited or debited to your account at the end of the day’s session. You would first want to check the rollover for selling the EUR/USD and compare that to buying the USD/CHF. Naturally one would choose the trade that either pays interest to you or if you pay on both positions, one would choose the pair with the smaller debit amount. Any little edge does add up over a period of time and this is one of the more popular.

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Even though we have covered the structure of the currency pair symbol in past articles, it can still be a little confusing for new FX traders as it is unique to this financial market. A single currency has to be measured against something in order to judge or measure it’s changing value from day to day. The value of a share of a company’s stock in the US equity markets is measured in US Dollars, but obviously that can’t work in judging the value of the US Dollar itself. So the value of a currency is compared to different currency in order to measure it’s strength or weakness, which explains the reason for a currency pair. If we are looking at the EUR/USD, we see that it is the relationship between the Euro and the US Dollar that we are measuring. Since the EUR is listed first, it is called the base currency and is the currency that is being measured. Since the USD is listed second in the pair, it is called the quote or counter currency and is used to measure and quote the value of the first currency listed in the pair. So a EUR/USD quote of 1.57 means that one Euro is worth 1.57 in US Dollars or $1.57. A EUR/JPY quote of 164 means that each Euro is worth 164 Japanese Yen. More importantly, since the Euro is the base currency in both of these pairs, we want to keep in mind that this is the currency we are measuring, so if we see a strong move up on a chart of the EUR/USD, it means that the EUR is getting stronger than the USD. If we see a strong move down on the EUR/USD chart, this means that the USD is getting stronger than the EUR. If we were to use the same structure in a share of Dell, we would list the symbol as DELL/USD since we are measuring the value of Dell in US Dollars. Naturally this is not necessary as we understand that the quote is in US Dollars. However in the FX market it is necessary to be specific about what we are using to quote the value of a currency, since it’s value is measured in many different currencies to accommodate the needs of those who use the FX markets for the actual exchange of one currency for another.

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