LONDON (AFX) - The euro was firmer against the dollar after data showed euro zone money supply remains elevated, suggesting that the European Central Bank will continue raising interest rates into next year.
Data out this morning showed euro zone M3 money supply in November jumped at an annual rate of 9.3 pct, well above October's 8.5 pct growth and beating analysts' forecast for a much more modest increase to 8.7 pct.
Average M3 annual growth over the September-November period was 8.8 pct, compared with 8.4 pct in August-October and again above the 8.4 pct growth rate expected. The rate also remains well above the ECB's 4.5 pct year-on-year reference rate for M3.
Calyon analyst Stuart Bennett said the ECB may take some comfort from the detail of the release, which showed that credit growth to residents and the private sector both slowed, but this will not be sufficient to prevent further interest rate hikes in 2007.
"The interest rate hikes are having some impact on the money supply data, but not a sufficiently strong enough one to stop the ECB from continuing to hike," he said.
"This should imply at least two more 25 basis point rate hikes in the first half of 2007, taking the refi rate to 4 pct from 3.5 pct currently and providing support for the euro during the first half of 2007," he said.
Meanwhile, the dollar failed to make much headway after a string of stronger-than-expected US data yesterday, including consumer confidence, existing home sales and Chicago PMI.
Bank of New York currency analyst Michael Woolfolk said there is a "notable lack of follow through dollar-buying following the recent bout of positive US data", but dollar buyers could return when activity picks back up next week.
"It appears that speculative players have decided to join their real money brethren on an extended year-end holiday this week, choosing not to mount another speculative attack of the dollar," he said.
"With activity winding to a close, the dollar is well positioned for some initial dollar buying next week," he added.
Saturday, December 30, 2006
Friday, December 29, 2006
Developing the "Holy Grail" Trading System
Before I get myself into trouble, let me point out that there is no "Holy Grail" trading system in the world - not yet anyway. If there is, please let me know. I don't mind paying a thousand bucks for it. However, a trading system close to the "Holy Grail" is indeed possible and I'll show you how to develop it.
But before we come to that, here's what we all know. Forex is the biggest financial market in the world, with its daily volume of transactions dwarfing the US stock markets by 10 to 1. Its sheer size also makes it the best market to trade in terms of (1) high liquidity - Forex trades are almost always instantly executed, thus minimizing slippage; and (2) open and fair - it is impossible for one to control or manipulate the market for any length of time, rendering "insider trading" impossible to carry out.
What moves Forex? Conventional thinking would imply economic fundamentals or factors such as the strength of a country's economy, which contributes to currency flows. Therefore, one would assume that everyone else would buy the US dollar against the British pound. Why not? The US economy is the largest in the world while that of Great Britain has fallen to fifth, behind the US, Japan, Germany and China.
The theory of "the bigger the economy is, the more attractive its currency will be" may be true but in reality, the sterling has advanced more against the dollar. Why is this so?
Let's dissect the market by taking a look at the players in the currency market. They are the financial institutions, commercial banks, insurance firms, pension funds, hedge funds, small funds, international businesses, private investors, retail traders and not forgetting, individuals. Each plays a part in determining the movement of a currency. We can divide them into two categories - "commercial" and "non-commercial".
The "commercials" engage in business activities requiring the use of currencies, whereas the "non-commercials" are into the Forex market for speculative purpose. Therefore the philosophies of the "commercials" and "non-commercials" are very much different - when the "commercials" buy, the "non-commercials" sell; and when the "commercials" sell, the "non-commercials" buy. It is this different point-of-view from two different types of traders, market makers or investors that moves the Forex market.
We have gone through the easy part of identifying the movers of the market. The question now is how to use this piece of information to trade Forex successfully and how to use the above information to develop a "Holy Grail" (almost) trading system.
Earlier, we have determined who the movers of the currency market are. The "commercials" are involved in a nature of business that requires Forex transactions. Examples would be commercial banks, insurance firms and international companies. On the other hand, the "non-commercials" are in the market solely for speculative purpose. Examples would be hedge funds, small funds, private investors, retail traders and individuals.
Best times to trade
Even though the Forex market opens 24 hours a day, 5 days a week, there are specific times in a day where the volume of transactions are high. These are the London session (3AM EST to noon EST), New York session (8AM EST to 5PM EST) and Tokyo session (7PM EST to 4AM EST), in the order of market volume size. Therefore the most profitable trades, in terms of price movement, are usually found in these times. It is advisable for traders to trade during these times.
Best currencies to trade
Every nation in the world has its own currency - the US dollar, Canadian dollar, Russian ruble, South African rand, Mexican peso, Thai baht, Indian rupee, and so on. However the most traded currencies, with the highest volume and liquidity, are the euro, Japanese yen, British pound and the Swiss franc, with euro (EUR/USD) being the most traded currency pair.
Tools of the trade
When it comes to trading Forex, there's only two methods that are utilized. The first is fundamental analysis and the other is technical analysis. Many traders argue that either one is better than the other. I prefer to use both. I will determine my entry and exit points based on technical analysis with the support of economic data or fundamental analysis. This will minimize the risk involved in my trades because the market doesn't lie. Technical analysis will show you why price is behaving in a certain manner and fundamental analysis will prove that you are right.
Best market to trade
Because the strength of a country's economy, which contributes to currency flows, doesn't just change on any external events, currencies tend to trend well. It takes some time for a material change in an economy's strength and therefore the direction of its currency. Due to this reason alone, Forex is a very trader-friendly market, compared to equities, futures, options, etc.
How to best trade the Forex market?
This is the million-dollar question. Remember our "commercial" and "non-commercial" friends? These guys will battle to see who will win ultimately. Here's how it works:
"Commercials" consisting of commercial banks, insurance firms and large companies are loaded with deep pockets and nearly unlimited funds when put together. When the price of a currency declines, the "commercials" will load their positions - they will buy because price is "cheap". When demand exceeds supply, price advances and the "commercials" will unload their positions - they will sell at a higher price for a profit.
Who will they sell to? It's the "non-commercials"! But before we come to a conclusion who the obvious losers in this game are, let me tell you that not all "commercials" will profit from the above example and not all "non-commercials" will lose. It all depends on when the entry or exit is made. Confused?
Let me explain.
When price declines and the "commercials" buy, they are practically buying into a falling price (this is possible because of the large funds at their disposal) in the hope that price will eventually advance and they will profit by selling at a higher price. However, there's no guarantee that 100,000 lots bought will each be sold at a higher price. It all depends on market forces - nobody can dictate or control the movement of a currency.
As for the "non-commercials", when price advances, they are practically buying into a rising price in the hope that price will advance even more for them to profit from it. As is the case above, market forces will determine whether this will hold true for the "non-commercials".
What does it all mean?
If you analyze the above, you will notice one common theme. In order to profit from the market, timing is essential - "buy low and sell high". Easier said than done! Every trader knows this. So how can one time his or her entry or exit?
Tricks of the trade
Here's how you should trade the currency market. You should develop your "Holy Grail" (almost) trading system based on the following. It worked for me, which is why it should work for you too.
- The market players usually based their trades on certain predefined price levels. They don't just enter or exit whenever they like. These price levels are the Support and Resistance that many of us come to know of. Currencies tend to move well between these Support and Resistance levels. The most common methods to determine the Support and Resistance levels are Fibonacci, Pivot Points, Trendlines and the Exponential Moving Averages.
- When the support and resistance levels are determined, the next step is to look at price action at these levels - whether price will break through or reverse. The most common method to analyze price action is through the use of Candlestick and Chart Patterns.
- Once you have determined the entry point from the above two steps, boost your confidence to trigger the trade with the use of indicators such as Stochastics, RSI and MACD. Even though these indicators are lagging in nature, the appearance of divergence in Stochastics, RSI and/or MACD is not!
- Always keep a wary eye on the latest economic data which affects the currency - beware of newsbreak which includes release of important economic data. Newsbreak of this kind will influence price movement significantly and render the technical analysis above meaningless.
- Remember to implement an appropriate "stop-loss" in case price goes against you - never risk more than 3% of your account per trade.
Here you have it. I have provided the five (5) essential steps for you to develop an almost "Holy Grail" trading system for yourself. All you need to do now is to try each specific method outlined above and see which works best for you. Paper trade using historical data - practice until you get it right, keeping in mind the five (5) steps above.
Trade Using News: 5 Most Watched Economic Indicators
Currencies do not become weaker or stronger randomly. A large portion of a currency's value is based on confidence in the economic strength of the country. Economic strength is judged by certain key indicators that are closely watched in FX trading. When these economic indicators change, the value of a currency will fluctuate. A currency is a proxy for the country it represents and the economic health of that country is priced into the currency.
Fundamental releases have become increasingly important market movers. When focusing on the impact that economic numbers have on price action in the FX market there are 5 indicators that are watched the most because of their potential to generate volume and to move prices in the market.
Why Does Economic News Impact Short-Term Trading?
The data itself is not as important as whether or not it falls within market expectations. Besides knowing when all the data is released, it is vitally important to know what economists are forecasting for each indicator. For example, knowing the economic consequences of an unexpected monthly rise of 0.3% in the Consumer Price Index, the Actual, is not nearly as vital to your short-term trading decisions as it is to know that this month the market was looking for CPI to fall by 0.1%, the Consensus.
Analyzing the longer-term ramifications of an unexpected monthly rise in prices can wait until after you've taken advantage of the short term trading opportunities presented by the data typically within the first thirty minutes following the release. Market expectations for all economic releases are published on our calendar and you should track these expectations along with the release date of the indicator.
Average Pip Ranges
1. Non Farm Payrolls - Unemployment
Avg. Move: 124 Pips
2. FOMC Interest Rate Decisions
Avg. Move: 74 Pips
3. Trade Balance
Avg. Move: 64 Pips
4. CPI - Inflation
Avg. Move: 44 Pips
5. Retail sales
Avg. Move: 44 Pips
(Data form DailyFX Research)
1. Non Farm Payrolls – Unemployment
The unemployment rate is a measure of the strength of the labor market. One of the ways analysts gauge the strength of an economy is by the number of jobs created, and the percentage of workers unable to find jobs. Strong job creation is indicative of economic growth, as companies must increase their workforce in order to meet demand.
Release Schedule: First Friday of the month at 8:30am EST
2. FOMC Interest Rate Decisions
The Federal Open Market sets the discount rate, which is the rate at which the Federal Reserve Bank charges member banks for overnight loans. The rate is set during the FOMC meetings by the regional banks and the Federal Reserve Board.
Release Schedule: 8 meetings scheduled per year. Date is known in advance so check the economic calendar
3. Trade Balance
The balance of trade measures the difference between the value of goods and services that a nation exports and the value of goods and services that it imports. A trade surplus results if the value of exported goods exceeds that of imported goods, whereas a trade deficit exists if imported goods exceed exported goods.
Release Schedule: Generally released around the middle of the second month following the reporting period. Check the economic calendar
4. CPI – Consumer Price Index
The CPI is a key gauge of inflation, as it measures the price of a fixed basket of consumer goods. Higher prices are considered negative for an economy, but since central banks often respond to price inflation by raising interest rates, currencies sometimes respond positively to reports of higher inflation.
Release Schedule: Monthly - around the 13th of each month at 8:30am EST
5. Retail Sales
Retail sales is a measure of the total goods sold by a sampling of retail stores. It is used as a gauge of consumer activity and confidence as higher sales figures would indicate increased economic activity.
Release Schedule: Monthly - around the 11th of each month at 8:30am EST
Fundamental releases have become increasingly important market movers. When focusing on the impact that economic numbers have on price action in the FX market there are 5 indicators that are watched the most because of their potential to generate volume and to move prices in the market.
Why Does Economic News Impact Short-Term Trading?
The data itself is not as important as whether or not it falls within market expectations. Besides knowing when all the data is released, it is vitally important to know what economists are forecasting for each indicator. For example, knowing the economic consequences of an unexpected monthly rise of 0.3% in the Consumer Price Index, the Actual, is not nearly as vital to your short-term trading decisions as it is to know that this month the market was looking for CPI to fall by 0.1%, the Consensus.
Analyzing the longer-term ramifications of an unexpected monthly rise in prices can wait until after you've taken advantage of the short term trading opportunities presented by the data typically within the first thirty minutes following the release. Market expectations for all economic releases are published on our calendar and you should track these expectations along with the release date of the indicator.
Average Pip Ranges
1. Non Farm Payrolls - Unemployment
Avg. Move: 124 Pips
2. FOMC Interest Rate Decisions
Avg. Move: 74 Pips
3. Trade Balance
Avg. Move: 64 Pips
4. CPI - Inflation
Avg. Move: 44 Pips
5. Retail sales
Avg. Move: 44 Pips
(Data form DailyFX Research)
1. Non Farm Payrolls – Unemployment
The unemployment rate is a measure of the strength of the labor market. One of the ways analysts gauge the strength of an economy is by the number of jobs created, and the percentage of workers unable to find jobs. Strong job creation is indicative of economic growth, as companies must increase their workforce in order to meet demand.
Release Schedule: First Friday of the month at 8:30am EST
2. FOMC Interest Rate Decisions
The Federal Open Market sets the discount rate, which is the rate at which the Federal Reserve Bank charges member banks for overnight loans. The rate is set during the FOMC meetings by the regional banks and the Federal Reserve Board.
Release Schedule: 8 meetings scheduled per year. Date is known in advance so check the economic calendar
3. Trade Balance
The balance of trade measures the difference between the value of goods and services that a nation exports and the value of goods and services that it imports. A trade surplus results if the value of exported goods exceeds that of imported goods, whereas a trade deficit exists if imported goods exceed exported goods.
Release Schedule: Generally released around the middle of the second month following the reporting period. Check the economic calendar
4. CPI – Consumer Price Index
The CPI is a key gauge of inflation, as it measures the price of a fixed basket of consumer goods. Higher prices are considered negative for an economy, but since central banks often respond to price inflation by raising interest rates, currencies sometimes respond positively to reports of higher inflation.
Release Schedule: Monthly - around the 13th of each month at 8:30am EST
5. Retail Sales
Retail sales is a measure of the total goods sold by a sampling of retail stores. It is used as a gauge of consumer activity and confidence as higher sales figures would indicate increased economic activity.
Release Schedule: Monthly - around the 11th of each month at 8:30am EST
Using COT Report To Forecast FX Movements
Between 2001 and 2004, volume in the foreign-exchange market increased more than 50%, illustrating the overall rise in popularity of currency trading. The advent of online trading following the technology boom has allowed many equity and futures traders to look beyond their more traditional trading instruments. Most short-term traders or speculators trade FX based on technical analysis, so equity and futures traders who use technical analysis have made the switch to FX fairly easily. However, one type of analysis that traders have not been able to transfer over to currencies is volume-based trading. Since the currency market is decentralized and there is no one exchange that tracks all trading activities, it is difficult to quantify volume traded at each price level. But in place of volume-based trading, many traders have turned to the Commodity Futures Trading Commission's Commitments of Traders (COT) report, which details positioning on the futures market, for more information on positioning and volume. Here we look at how historical trends of the COT report can help FX traders.
What is the COT Report?
The Commitments of Traders report was first published by the CFTC for 13 agricultural commodities in 1962 to inform the public about the current conditions in futures market operations (you can find the report on the CFTC website here). The data was originally released just once a month, but moved to once every week by 2000. Along with reporting more often, the COT report has become more extensive and - luckily for FX traders - it has now expanded to include information on foreign currency futures. If used wisely, the COT data can be a pretty strong gauge of price action. The caveat here is that examining the data can be tricky, and the data release is delayed as the numbers are published every Friday for the previous Tuesday's contracts, so the information comes out three business days after the actual transactions take place.
Reading the COT Report
Figure 1 is a sample euro FX weekly COT report for June 7, 2005, published by the CFTC. Here is a quick list of some of the items appearing in the report and what they mean:
* Commercial - describes an entity involved in the production, processing, or merchandising of a commodity, using futures contracts primarily for hedging.
* Long report - includes all of the information on the 'short report', along with the concentration of positions held by the largest traders.
* Open interest - the total number of futures or options contracts not yet offset by a transaction, by delivery or exercise .
* Noncommercial (speculators) - traders, such as individual traders, hedge funds & large institutions, who use futures market for speculative purposes and meet the reportable requirements set forth by the CFTC.
* Non-reportable positions - long & short open-interest positions that don't meet reportable requirements set forth by the CFTC.
* Number of traders - total number of traders who are required to report positions to the CFTC.
* Reportable positions - the futures and option positions that are held above specific reporting levels set by CFTC regulations.
* Short Report - shows open interest separately by reportable & non-reportable positions.
* Spreading - measures the extent to which a non-commercial trader holds equal long and short futures positions.
Taking a look at the sample report, we see that open interest on Tuesday June 7, 2005, was 193,707 contracts, an increase of 3,213 contracts from the previous week. Noncommercial traders or speculators were long 22,939 contracts and short 40,710 contracts - making them net short. Commercial traders, on the other hand, were net long, with 19,936 more long contracts than short contracts (125,244 - 105,308). The change in open interest was primarily caused by an increase in commercial positions as noncommercials or speculators reduced their net-short positions.
Using the COT Report
In using the COT report, commercial positioning is less relevant than noncommercial positioning because the majority of commercial currency trading is done in the spot currency market, so any commercial futures positions are highly unlikely to give an accurate representation of real market positioning. Noncommercial data, on the other hand, is more reliable as it captures traders' positions in a specific market. There are three primary premises on which to base trading with the COT data:
* Flips in market positioning may be accurate trending indicators.
* Extreme positioning in the currency futures market has historically been accurate in identifying important market reversals.
* Changes in open interest can be used to determine strength of trend.
Flips in Market Positioning
Before looking at the chart shown in Figure 2, we should mention that in the futures market all foreign currency exchange futures use the U.S. dollar as the base currency. For Figure 2, this means that net-short open interest in the futures market for Swiss francs (CHF) shows bullish sentiment for USD/CHF. In other words, the futures market for CHF represents futures for CHF/USD, on which long and short positions will be the exact opposite of long and short positions on USD/CHF. For this reason, the axis on the left shows negative numbers above the center line and positive numbers below.
The chart below shows that trends of noncommercial futures traders tend to follow the trends very well for CHF. In fact, a study by the Federal Reserve shows that using open interest in CHF futures will allow the trader to correctly guess the direction of USD/CHF 73% of the time.
Figure 2 - Chart showing net positions of noncommercial traders in the futures for Swiss francs (corresponding axis is on the left-hand side) on the International Monetary Market (IMM) and price action of USD/CHF from Apr 2003 to May 2005 (corresponding axis is on the right-hand side). Each bar represents one week. Source: Daily FX.
Flips - where net noncommercial open-interest positions cross the zero line - offer a particularly good way to use COT data for Swiss futures. Keeping important notation conventions in mind (that is, knowing which currency in a pair is the base currency), we see that when net futures positions flip above the line, price action tends to climb and vice versa.
In Figure 2, we see that noncommercial traders flip from net long to net short Swiss francs (and long dollars) in June 2003, coinciding with a break higher in USD/CHF. The next flip occurs in Sept 2003, when noncommercial traders become net long once again. Using only this data, we could have potentially traded a 700-pip gain in four months (the buy at 1.31 and the sell at 1.38). On the chart we continue to see various buy and sell signals, represented by points at which green (buy) and red (sell) arrows cross the price line.
Even though this strategy of relying on flips clearly works well for USD/CHF, the flip may not be a perfect indicator for all currency pairs. Each currency pair has different characteristics, especially the high-yielding ones, which rarely see flips since most positioning tends to be net long for extended periods as speculators take interest-earning positions.
Extreme Positioning
Extreme positioning in the currency futures market has historically also been accurate in identifying important market reversals. As indicated in Figure 3 below, abnormally large positions in futures for GBP/USD by noncommercial traders has coincided with tops in price action. (In this example, the left axis of the chart is reversed compared to Figure 2 because the GBP is the base currency.) The reason why these extreme positions are applicable is that they are points at which there are so many speculators weighted in one direction that there is no one left to buy or sell. In the cases of extreme positions illustrated by Figure 3, every one who wants to be long is already long. As a result, exhaustion ensues and prices begin reversing.
Figure 3 - Chart showing net noncommercial positions in GBP futures on IMM (corresponding axis is on the left-hand side) and price action of GBP/USD (corresponding axis is on the right-hand side) from May 2004 to Apr 2005. Each bar represents one week. Source: Daily FX.
Changes in Open Interest
Open interest is a secondary trading tool that can be used to understand the price behavior of a particular market. The data is most useful for position traders and investors as they try to capitalize on a longer-term trend. Open interest can basically be used to gauge the overall health of a specific futures market; that is, rising and falling open interest levels help to measure the strength or weakness of a particular price trend.
For example, if a market has been in a long-lasting uptrend or downtrend with increasing levels of open interest, a leveling off or decrease in open interest can be a red flag, signaling that the trend may be nearing its end. Rising open interest generally indicates that the strength of the trend is increasing because new money or aggressive buyers are entering into the market. Declining open interest indicates that money is leaving the market and that the recent trend is running out of momentum. Trends accompanied by declining open interest and volume become suspect. Rising prices and falling open interest signals the recent trend may be nearing its end as fewer traders are participating in the rally.
The chart in Figure 4 displays open interest in the EUR/USD and price action. Notice that market trends tend to be confirmed when total open interest is on the rise. In early May 2004, we see that price action starts moving higher, and overall open interest is also on the rise. However, once open interest dipped in a later week, we saw the rally topped out. The same sort of scenario was seen in late Nov and early Dec 2004, when the EUR/USD rallied significantly on rising open interest, but once open interest leveled off and then fell, the EUR/USD began to sell off.
Figure 4 - Open interest in the EUR/USD (corresponding axis is on the left-hand side) and price action (corresponding axis on right-hand side) from Jan 2004 to May 2005. Each bar represents one week. Source: Daily FX.
Summary
One of the drawbacks of the FX spot market is the lack of volume data, but to compensate for this, many traders have turned to the futures market to gauge positioning. Every week, the CFTC publishes a Commitment of Traders report, detailing commercial and non-commercial positioning. Based upon empirical analysis, there are three different ways that futures positioning can be used to forecast price trends in the foreign-exchange spot market: flips in positioning, extreme levels and changes in open interest. It is important to keep in mind, however, that techniques using these premises work better for some currencies than others.
What is the COT Report?
The Commitments of Traders report was first published by the CFTC for 13 agricultural commodities in 1962 to inform the public about the current conditions in futures market operations (you can find the report on the CFTC website here). The data was originally released just once a month, but moved to once every week by 2000. Along with reporting more often, the COT report has become more extensive and - luckily for FX traders - it has now expanded to include information on foreign currency futures. If used wisely, the COT data can be a pretty strong gauge of price action. The caveat here is that examining the data can be tricky, and the data release is delayed as the numbers are published every Friday for the previous Tuesday's contracts, so the information comes out three business days after the actual transactions take place.
Reading the COT Report
Figure 1 is a sample euro FX weekly COT report for June 7, 2005, published by the CFTC. Here is a quick list of some of the items appearing in the report and what they mean:
* Commercial - describes an entity involved in the production, processing, or merchandising of a commodity, using futures contracts primarily for hedging.
* Long report - includes all of the information on the 'short report', along with the concentration of positions held by the largest traders.
* Open interest - the total number of futures or options contracts not yet offset by a transaction, by delivery or exercise .
* Noncommercial (speculators) - traders, such as individual traders, hedge funds & large institutions, who use futures market for speculative purposes and meet the reportable requirements set forth by the CFTC.
* Non-reportable positions - long & short open-interest positions that don't meet reportable requirements set forth by the CFTC.
* Number of traders - total number of traders who are required to report positions to the CFTC.
* Reportable positions - the futures and option positions that are held above specific reporting levels set by CFTC regulations.
* Short Report - shows open interest separately by reportable & non-reportable positions.
* Spreading - measures the extent to which a non-commercial trader holds equal long and short futures positions.
Taking a look at the sample report, we see that open interest on Tuesday June 7, 2005, was 193,707 contracts, an increase of 3,213 contracts from the previous week. Noncommercial traders or speculators were long 22,939 contracts and short 40,710 contracts - making them net short. Commercial traders, on the other hand, were net long, with 19,936 more long contracts than short contracts (125,244 - 105,308). The change in open interest was primarily caused by an increase in commercial positions as noncommercials or speculators reduced their net-short positions.
Using the COT Report
In using the COT report, commercial positioning is less relevant than noncommercial positioning because the majority of commercial currency trading is done in the spot currency market, so any commercial futures positions are highly unlikely to give an accurate representation of real market positioning. Noncommercial data, on the other hand, is more reliable as it captures traders' positions in a specific market. There are three primary premises on which to base trading with the COT data:
* Flips in market positioning may be accurate trending indicators.
* Extreme positioning in the currency futures market has historically been accurate in identifying important market reversals.
* Changes in open interest can be used to determine strength of trend.
Flips in Market Positioning
Before looking at the chart shown in Figure 2, we should mention that in the futures market all foreign currency exchange futures use the U.S. dollar as the base currency. For Figure 2, this means that net-short open interest in the futures market for Swiss francs (CHF) shows bullish sentiment for USD/CHF. In other words, the futures market for CHF represents futures for CHF/USD, on which long and short positions will be the exact opposite of long and short positions on USD/CHF. For this reason, the axis on the left shows negative numbers above the center line and positive numbers below.
The chart below shows that trends of noncommercial futures traders tend to follow the trends very well for CHF. In fact, a study by the Federal Reserve shows that using open interest in CHF futures will allow the trader to correctly guess the direction of USD/CHF 73% of the time.
Figure 2 - Chart showing net positions of noncommercial traders in the futures for Swiss francs (corresponding axis is on the left-hand side) on the International Monetary Market (IMM) and price action of USD/CHF from Apr 2003 to May 2005 (corresponding axis is on the right-hand side). Each bar represents one week. Source: Daily FX.
Flips - where net noncommercial open-interest positions cross the zero line - offer a particularly good way to use COT data for Swiss futures. Keeping important notation conventions in mind (that is, knowing which currency in a pair is the base currency), we see that when net futures positions flip above the line, price action tends to climb and vice versa.
In Figure 2, we see that noncommercial traders flip from net long to net short Swiss francs (and long dollars) in June 2003, coinciding with a break higher in USD/CHF. The next flip occurs in Sept 2003, when noncommercial traders become net long once again. Using only this data, we could have potentially traded a 700-pip gain in four months (the buy at 1.31 and the sell at 1.38). On the chart we continue to see various buy and sell signals, represented by points at which green (buy) and red (sell) arrows cross the price line.
Even though this strategy of relying on flips clearly works well for USD/CHF, the flip may not be a perfect indicator for all currency pairs. Each currency pair has different characteristics, especially the high-yielding ones, which rarely see flips since most positioning tends to be net long for extended periods as speculators take interest-earning positions.
Extreme Positioning
Extreme positioning in the currency futures market has historically also been accurate in identifying important market reversals. As indicated in Figure 3 below, abnormally large positions in futures for GBP/USD by noncommercial traders has coincided with tops in price action. (In this example, the left axis of the chart is reversed compared to Figure 2 because the GBP is the base currency.) The reason why these extreme positions are applicable is that they are points at which there are so many speculators weighted in one direction that there is no one left to buy or sell. In the cases of extreme positions illustrated by Figure 3, every one who wants to be long is already long. As a result, exhaustion ensues and prices begin reversing.
Figure 3 - Chart showing net noncommercial positions in GBP futures on IMM (corresponding axis is on the left-hand side) and price action of GBP/USD (corresponding axis is on the right-hand side) from May 2004 to Apr 2005. Each bar represents one week. Source: Daily FX.
Changes in Open Interest
Open interest is a secondary trading tool that can be used to understand the price behavior of a particular market. The data is most useful for position traders and investors as they try to capitalize on a longer-term trend. Open interest can basically be used to gauge the overall health of a specific futures market; that is, rising and falling open interest levels help to measure the strength or weakness of a particular price trend.
For example, if a market has been in a long-lasting uptrend or downtrend with increasing levels of open interest, a leveling off or decrease in open interest can be a red flag, signaling that the trend may be nearing its end. Rising open interest generally indicates that the strength of the trend is increasing because new money or aggressive buyers are entering into the market. Declining open interest indicates that money is leaving the market and that the recent trend is running out of momentum. Trends accompanied by declining open interest and volume become suspect. Rising prices and falling open interest signals the recent trend may be nearing its end as fewer traders are participating in the rally.
The chart in Figure 4 displays open interest in the EUR/USD and price action. Notice that market trends tend to be confirmed when total open interest is on the rise. In early May 2004, we see that price action starts moving higher, and overall open interest is also on the rise. However, once open interest dipped in a later week, we saw the rally topped out. The same sort of scenario was seen in late Nov and early Dec 2004, when the EUR/USD rallied significantly on rising open interest, but once open interest leveled off and then fell, the EUR/USD began to sell off.
Figure 4 - Open interest in the EUR/USD (corresponding axis is on the left-hand side) and price action (corresponding axis on right-hand side) from Jan 2004 to May 2005. Each bar represents one week. Source: Daily FX.
Summary
One of the drawbacks of the FX spot market is the lack of volume data, but to compensate for this, many traders have turned to the futures market to gauge positioning. Every week, the CFTC publishes a Commitment of Traders report, detailing commercial and non-commercial positioning. Based upon empirical analysis, there are three different ways that futures positioning can be used to forecast price trends in the foreign-exchange spot market: flips in positioning, extreme levels and changes in open interest. It is important to keep in mind, however, that techniques using these premises work better for some currencies than others.
Money Management Matters
Put two rookie traders in front of the screen, provide them with your best high-probability set-up, and for good measure, have each one take the opposite side of the trade. More than likely, both will wind up losing money. However, if you take two pros and have them trade in the opposite direction of each other, quite frequently both traders will wind up making money - despite the seeming contradiction of the premise. What's the difference? What is the most important factor separating the seasoned traders from the amateurs? The answer is money management.
Like dieting and working out, money management is something that most traders pay lip service to, but few practice in real life. The reason is simple: just like eating healthy and staying fit, money management can seem like a burdensome, unpleasant activity. It forces traders to constantly monitor their positions and to take necessary losses, and few people like to do that. However, as Figure 1 proves, loss-taking is crucial to long-term trading success.
Note that a trader would have to earn 100% on his or her capital - a feat accomplished by less than 1% of traders worldwide - just to break even on an account with a 50% loss. At 75% drawdown, the trader must quadruple his or her account just to bring it back to its original equity - truly a Herculean task!
The Big One
Although most traders are familiar with the figures above, they are inevitably ignored. Trading books are littered with stories of traders losing one, two, even five years' worth of profits in a single trade gone terribly wrong. Typically, the runaway loss is a result of sloppy money management, with no hard stops and lots of average downs into the longs and average ups into the shorts. Above all, the runaway loss is due simply to a loss of discipline.
Most traders begin their trading career, whether consciously or subconsciously, visualizing "The Big One" - the one trade that will make them millions and allow them to retire young and live carefree for the rest of their lives. In FX, this fantasy is further reinforced by the folklore of the markets. Who can forget the time that George Soros "broke the Bank of England" by shorting the pound and walked away with a cool $1-billion profit in a single day? But the cold hard truth for most retail traders is that, instead of experiencing the "Big Win", most traders fall victim to just one "Big Loss" that can knock them out of the game forever.
Learning Tough Lessons
Traders can avoid this fate by controlling their risks through stop losses. In Jack Schwager's famous book "Market Wizards" (1989), day trader and trend follower Larry Hite offers this practical advice: "Never risk more than 1% of total equity on any trade. By only risking 1%, I am indifferent to any individual trade." This is a very good approach. A trader can be wrong 20 times in a row and still have 80% of his or her equity left.
The reality is that very few traders have the discipline to practice this method consistently. Not unlike a child who learns not to touch a hot stove only after being burned once or twice, most traders can only absorb the lessons of risk discipline through the harsh experience of monetary loss. This is the most important reason why traders should use only their speculative capital when first entering the forex market. When novices ask how much money they should begin trading with, one seasoned trader says: "Choose a number that will not materially impact your life if you were to lose it completely. Now subdivide that number by five because your first few attempts at trading will most likely end up in blow out." This too is very sage advice, and it is well worth following for anyone considering trading FX.
Money Management Styles
Generally speaking, there are two ways to practice successful money management. A trader can take many frequent small stops and try to harvest profits from the few large winning trades, or a trader can choose to go for many small squirrel-like gains and take infrequent but large stops in the hope the many small profits will outweigh the few large losses. The first method generates many minor instances of psychological pain, but it produces a few major moments of ecstasy. On the other hand, the second strategy offers many minor instances of joy, but at the expense of experiencing a few very nasty psychological hits. With this wide-stop approach, it is not unusual to lose a week or even a month's worth of profits in one or two trades. (For further reading, see Introduction To Types Of Trading: Swing Trades.)
To a large extent, the method you choose depends on your personality; it is part of the process of discovery for each trader. One of the great benefits of the FX market is that it can accommodate both styles equally, without any additional cost to the retail trader. Since FX is a spread-based market, the cost of each transaction is the same, regardless of the size of any given trader's position.
For example, in EUR/USD, most traders would encounter a 3 pip spread equal to the cost of 3/100th of 1% of the underlying position. This cost will be uniform, in percentage terms, whether the trader wants to deal in 100-unit lots or one million-unit lots of the currency. For example, if the trader wanted to use 10,000-unit lots, the spread would amount to $3, but for the same trade using only 100-unit lots, the spread would be a mere $0.03. Contrast that with the stock market where, for example, a commission on 100 shares or 1,000 shares of a $20 stock may be fixed at $40, making the effective cost of transaction 2% in the case of 100 shares, but only 0.2% in the case of 1,000 shares. This type of variability makes it very hard for smaller traders in the equity market to scale into positions, as commissions heavily skew costs against them. However, FX traders have the benefit of uniform pricing and can practice any style of money management they choose without concern about variable transaction costs.
Four Types of Stops
Once you are ready to trade with a serious approach to money management and the proper amount of capital is allocated to your account, there are four types of stops you may consider.
1. Equity Stop - This is the simplest of all stops. The trader risks only a predetermined amount of his or her account on a single trade. A common metric is to risk 2% of the account on any given trade. On a hypothetical $10,000 trading account, a trader could risk $200, or about 200 points, on one mini lot (10,000 units) of EUR/USD, or only 20 points on a standard 100,000-unit lot. Aggressive traders may consider using 5% equity stops, but note that this amount is generally considered to be the upper limit of prudent money management because 10 consecutive wrong trades would draw down the account by 50%.
One strong criticism of the equity stop is that it places an arbitrary exit point on a trader's position. The trade is liquidated not as a result of a logical response to the price action of the marketplace, but rather to satisfy the trader's internal risk controls.
2. Chart Stop - Technical analysis can generate thousands of possible stops, driven by the price action of the charts or by various technical indicator signals. Technically oriented traders like to combine these exit points with standard equity stop rules to formulate charts stops. A classic example of a chart stop is the swing high/low point. In Figure 2 a trader with our hypothetical $10,000 account using the chart stop could sell one mini lot risking 150 points, or about 1.5% of the account.
3. Volatility Stop - A more sophisticated version of the chart stop uses volatility instead of price action to set risk parameters. The idea is that in a high volatility environment, when prices traverse wide ranges, the trader needs to adapt to the present conditions and allow the position more room for risk to avoid being stopped out by intra-market noise. The opposite holds true for a low volatility environment, in which risk parameters would need to be compressed.
One easy way to measure volatility is through the use of Bollinger bands, which employ standard deviation to measure variance in price. Figures 3 and 4 show a high volatility and a low volatility stop with Bollinger bands. In Figure 3 the volatility stop also allows the trader to use a scale-in approach to achieve a better "blended" price and a faster breakeven point. Note that the total risk exposure of the position should not exceed 2% of the account; therefore, it is critical that the trader use smaller lots to properly size his or her cumulative risk in the trade.
4. Margin Stop - This is perhaps the most unorthodox of all money management strategies, but it can be an effective method in FX, if used judiciously. Unlike exchange-based markets, FX markets operate 24 hours a day. Therefore, FX dealers can liquidate their customer positions almost as soon as they trigger a margin call. For this reason, FX customers are rarely in danger of generating a negative balance in their account, since computers automatically close out all positions.
This money management strategy requires the trader to subdivide his or her capital into 10 equal parts. In our original $10,000 example, the trader would open the account with an FX dealer but only wire $1,000 instead of $10,000, leaving the other $9,000 in his or her bank account. Most FX dealers offer 100:1 leverage, so a $1,000 deposit would allow the trader to control one standard 100,000-unit lot. However, even a 1 point move against the trader would trigger a margin call (since $1,000 is the minimum that the dealer requires). So, depending on the trader's risk tolerance, he or she may choose to trade a 50,000-unit lot position, which allows him or her room for almost 100 points (on a 50,000 lot the dealer requires $500 margin, so $1,000 – 100-point loss* 50,000 lot = $500). Regardless of how much leverage the trader assumed, this controlled parsing of his or her speculative capital would prevent the trader from blowing up his or her account in just one trade and would allow him or her to take many swings at a potentially profitable set-up without the worry or care of setting manual stops. For those traders who like to practice the "have a bunch, bet a bunch" style, this approach may be quite interesting.
Conclusion
As you can see, money management in FX is as flexible and as varied as the market itself. The only universal rule is that all traders in this market must practice some form of it in order to succeed.
Like dieting and working out, money management is something that most traders pay lip service to, but few practice in real life. The reason is simple: just like eating healthy and staying fit, money management can seem like a burdensome, unpleasant activity. It forces traders to constantly monitor their positions and to take necessary losses, and few people like to do that. However, as Figure 1 proves, loss-taking is crucial to long-term trading success.
Note that a trader would have to earn 100% on his or her capital - a feat accomplished by less than 1% of traders worldwide - just to break even on an account with a 50% loss. At 75% drawdown, the trader must quadruple his or her account just to bring it back to its original equity - truly a Herculean task!
The Big One
Although most traders are familiar with the figures above, they are inevitably ignored. Trading books are littered with stories of traders losing one, two, even five years' worth of profits in a single trade gone terribly wrong. Typically, the runaway loss is a result of sloppy money management, with no hard stops and lots of average downs into the longs and average ups into the shorts. Above all, the runaway loss is due simply to a loss of discipline.
Most traders begin their trading career, whether consciously or subconsciously, visualizing "The Big One" - the one trade that will make them millions and allow them to retire young and live carefree for the rest of their lives. In FX, this fantasy is further reinforced by the folklore of the markets. Who can forget the time that George Soros "broke the Bank of England" by shorting the pound and walked away with a cool $1-billion profit in a single day? But the cold hard truth for most retail traders is that, instead of experiencing the "Big Win", most traders fall victim to just one "Big Loss" that can knock them out of the game forever.
Learning Tough Lessons
Traders can avoid this fate by controlling their risks through stop losses. In Jack Schwager's famous book "Market Wizards" (1989), day trader and trend follower Larry Hite offers this practical advice: "Never risk more than 1% of total equity on any trade. By only risking 1%, I am indifferent to any individual trade." This is a very good approach. A trader can be wrong 20 times in a row and still have 80% of his or her equity left.
The reality is that very few traders have the discipline to practice this method consistently. Not unlike a child who learns not to touch a hot stove only after being burned once or twice, most traders can only absorb the lessons of risk discipline through the harsh experience of monetary loss. This is the most important reason why traders should use only their speculative capital when first entering the forex market. When novices ask how much money they should begin trading with, one seasoned trader says: "Choose a number that will not materially impact your life if you were to lose it completely. Now subdivide that number by five because your first few attempts at trading will most likely end up in blow out." This too is very sage advice, and it is well worth following for anyone considering trading FX.
Money Management Styles
Generally speaking, there are two ways to practice successful money management. A trader can take many frequent small stops and try to harvest profits from the few large winning trades, or a trader can choose to go for many small squirrel-like gains and take infrequent but large stops in the hope the many small profits will outweigh the few large losses. The first method generates many minor instances of psychological pain, but it produces a few major moments of ecstasy. On the other hand, the second strategy offers many minor instances of joy, but at the expense of experiencing a few very nasty psychological hits. With this wide-stop approach, it is not unusual to lose a week or even a month's worth of profits in one or two trades. (For further reading, see Introduction To Types Of Trading: Swing Trades.)
To a large extent, the method you choose depends on your personality; it is part of the process of discovery for each trader. One of the great benefits of the FX market is that it can accommodate both styles equally, without any additional cost to the retail trader. Since FX is a spread-based market, the cost of each transaction is the same, regardless of the size of any given trader's position.
For example, in EUR/USD, most traders would encounter a 3 pip spread equal to the cost of 3/100th of 1% of the underlying position. This cost will be uniform, in percentage terms, whether the trader wants to deal in 100-unit lots or one million-unit lots of the currency. For example, if the trader wanted to use 10,000-unit lots, the spread would amount to $3, but for the same trade using only 100-unit lots, the spread would be a mere $0.03. Contrast that with the stock market where, for example, a commission on 100 shares or 1,000 shares of a $20 stock may be fixed at $40, making the effective cost of transaction 2% in the case of 100 shares, but only 0.2% in the case of 1,000 shares. This type of variability makes it very hard for smaller traders in the equity market to scale into positions, as commissions heavily skew costs against them. However, FX traders have the benefit of uniform pricing and can practice any style of money management they choose without concern about variable transaction costs.
Four Types of Stops
Once you are ready to trade with a serious approach to money management and the proper amount of capital is allocated to your account, there are four types of stops you may consider.
1. Equity Stop - This is the simplest of all stops. The trader risks only a predetermined amount of his or her account on a single trade. A common metric is to risk 2% of the account on any given trade. On a hypothetical $10,000 trading account, a trader could risk $200, or about 200 points, on one mini lot (10,000 units) of EUR/USD, or only 20 points on a standard 100,000-unit lot. Aggressive traders may consider using 5% equity stops, but note that this amount is generally considered to be the upper limit of prudent money management because 10 consecutive wrong trades would draw down the account by 50%.
One strong criticism of the equity stop is that it places an arbitrary exit point on a trader's position. The trade is liquidated not as a result of a logical response to the price action of the marketplace, but rather to satisfy the trader's internal risk controls.
2. Chart Stop - Technical analysis can generate thousands of possible stops, driven by the price action of the charts or by various technical indicator signals. Technically oriented traders like to combine these exit points with standard equity stop rules to formulate charts stops. A classic example of a chart stop is the swing high/low point. In Figure 2 a trader with our hypothetical $10,000 account using the chart stop could sell one mini lot risking 150 points, or about 1.5% of the account.
3. Volatility Stop - A more sophisticated version of the chart stop uses volatility instead of price action to set risk parameters. The idea is that in a high volatility environment, when prices traverse wide ranges, the trader needs to adapt to the present conditions and allow the position more room for risk to avoid being stopped out by intra-market noise. The opposite holds true for a low volatility environment, in which risk parameters would need to be compressed.
One easy way to measure volatility is through the use of Bollinger bands, which employ standard deviation to measure variance in price. Figures 3 and 4 show a high volatility and a low volatility stop with Bollinger bands. In Figure 3 the volatility stop also allows the trader to use a scale-in approach to achieve a better "blended" price and a faster breakeven point. Note that the total risk exposure of the position should not exceed 2% of the account; therefore, it is critical that the trader use smaller lots to properly size his or her cumulative risk in the trade.
4. Margin Stop - This is perhaps the most unorthodox of all money management strategies, but it can be an effective method in FX, if used judiciously. Unlike exchange-based markets, FX markets operate 24 hours a day. Therefore, FX dealers can liquidate their customer positions almost as soon as they trigger a margin call. For this reason, FX customers are rarely in danger of generating a negative balance in their account, since computers automatically close out all positions.
This money management strategy requires the trader to subdivide his or her capital into 10 equal parts. In our original $10,000 example, the trader would open the account with an FX dealer but only wire $1,000 instead of $10,000, leaving the other $9,000 in his or her bank account. Most FX dealers offer 100:1 leverage, so a $1,000 deposit would allow the trader to control one standard 100,000-unit lot. However, even a 1 point move against the trader would trigger a margin call (since $1,000 is the minimum that the dealer requires). So, depending on the trader's risk tolerance, he or she may choose to trade a 50,000-unit lot position, which allows him or her room for almost 100 points (on a 50,000 lot the dealer requires $500 margin, so $1,000 – 100-point loss* 50,000 lot = $500). Regardless of how much leverage the trader assumed, this controlled parsing of his or her speculative capital would prevent the trader from blowing up his or her account in just one trade and would allow him or her to take many swings at a potentially profitable set-up without the worry or care of setting manual stops. For those traders who like to practice the "have a bunch, bet a bunch" style, this approach may be quite interesting.
Conclusion
As you can see, money management in FX is as flexible and as varied as the market itself. The only universal rule is that all traders in this market must practice some form of it in order to succeed.
Martingale Trading
Imagine a trading strategy that is practically 100% profitable - would you be interested? Most traders will probably reply with a resounding "Yes", especially since such a strategy does exist and dates all the way back to the eighteenth century. This strategy is based on probability theory and if your pockets are deep enough, it has a near 100% success rate. Known in the trading world as the martingale, this strategy was most commonly practiced in the gambling halls of Las Vegas casinos and is the main reason why casinos now have betting minimums and maximums and why the roulette wheel has two green markers (0 and 00) in addition to the odd or even bets. The problem with this strategy is that in order to achieve 100% profitability, you need to have very deep pockets - in some cases, they must be infinitely deep. Unfortunately, no one has infinite wealth, but with a theory that relies on mean reversion, one missed trade can bankrupt an entire account.Also, the amount risked on the trade is far greater than the potential gain. Despite these drawbacks, there are ways to improve the martingale strategy. In this article, we'll explore the ways you can improve your chances of succeeding at this very high risk and difficult strategy.
What is Martingale Strategy?
Popularized in the eighteenth century, the martingale was introduced by a French mathematician by the name of Paul Pierre Levy. The martingale was originally a type of betting style that was based on the premise of "doubling down". Interestingly enough, a lot of the work done on the martingale was by an American mathematician named Joseph Leo Doob, who sought to disprove the possibility of a 100% profitable betting strategy.
The mechanics of the system naturally involve an initial bet; however, each time the bet becomes a loser, the wager is doubled such that, given enough time, one winning trade will make up all of the previous losses. The introduction of the 0 and 00 on the roulette wheel was used to break the mechanics of the martingale by giving the game more than two possible outcomes other than the odd vs. even or red vs. black. This made the long-run profit expectancy of using the martingale in roulette negative and thus destroyed any incentive for using it.
To understand the basics behind the martingale strategy, let's take a look at a simple example. Suppose that we had a coin and engaged in a betting game of either head or tails with a starting wager of $1. There is an equal probability that the coin will land on a head or tails and each flip is independent, meaning that the previous flip does not impact the outcome of the next flip. As long as you stick with the same directional view each time, you would eventually, given an infinite amount of money, see the coin land on heads and regain all of your losses plus $1. The strategy is based on the premise that only one trade is needed to turn your account around.
Examples
Scenario No.1 (Head or Tails 50/50 Chance):
Assume that you have a total of $10 to wager, starting with a first wager of $1. You bet on heads, the coin flips that way and you win $1, bringing your equity up to $11. Each time you are successful, you keep on betting the same $1 until you lose. The next flip is a loser and you bring your account equity back to $10. On the next bet, you wager $2 in the hope that if the coin lands on heads, you will recoup your previous losses and bring your net profit and loss to zero. Unfortunately, it lands on tails again and you lose another $2, bringing your total equity down to $8. So, according to martingale strategy, on the next bet you wager double the prior amount (or $4). Thankfully, you hit a winner and gain $4, bringing your total equity back up to $12. As you can see, all you needed was one winner to get back all of your previous losses.
However, let's consider what happens when you hit a losing streak like in scenario No.2:
Once again, you have $10 to wager with a starting bet of $1. In this scenario, you immediately lose on the first bet and bring your balance down $9. You double your bet on the next wager, lose again and end up with $7. On the third bet, your wager is up to $4, your losing streak continues and now you are down to $3. You do not have enough money to double down and the best you can do is bet it all. If you lose, you are down to zero and even if you win, you are still far from your initial $10 starting capital.
Trading Application
You may think that the long string of losses such as in the above example would represent unusually bad luck, but when you trade currencies, they tend to trend and trends can last for a very long time if you are caught in the wrong direction. However, the key with martingale when applied to trading is that by "doubling down" you in essentially lower your average entry price. In the example below, at two lots, you need the EUR/USD to rally from 1.2630 to 1.2640 to break even. As the price moves lower and you add four lots, you only need it to rally to 1.2625 instead of 1.2640 to break even. The more lots you add, the lower your average entry price. Even though you may lose 100 pips on the first lot of the EUR/USD if the price hits 1.2550, you only need the currency pair to rally to 1.2569 to break even on your entire holdings. This is also a clear example of why deep pockets are needed. If you only have $5,000 to trade, you would be bankrupt before you were even able to see the EUR/USD reach 1.2550. The currency may eventually turn, but with the martingale strategy, there are many cases when you may not have enough money to keep you in the market long enough to see that end.
What is Martingale Strategy?
Popularized in the eighteenth century, the martingale was introduced by a French mathematician by the name of Paul Pierre Levy. The martingale was originally a type of betting style that was based on the premise of "doubling down". Interestingly enough, a lot of the work done on the martingale was by an American mathematician named Joseph Leo Doob, who sought to disprove the possibility of a 100% profitable betting strategy.
The mechanics of the system naturally involve an initial bet; however, each time the bet becomes a loser, the wager is doubled such that, given enough time, one winning trade will make up all of the previous losses. The introduction of the 0 and 00 on the roulette wheel was used to break the mechanics of the martingale by giving the game more than two possible outcomes other than the odd vs. even or red vs. black. This made the long-run profit expectancy of using the martingale in roulette negative and thus destroyed any incentive for using it.
To understand the basics behind the martingale strategy, let's take a look at a simple example. Suppose that we had a coin and engaged in a betting game of either head or tails with a starting wager of $1. There is an equal probability that the coin will land on a head or tails and each flip is independent, meaning that the previous flip does not impact the outcome of the next flip. As long as you stick with the same directional view each time, you would eventually, given an infinite amount of money, see the coin land on heads and regain all of your losses plus $1. The strategy is based on the premise that only one trade is needed to turn your account around.
Examples
Scenario No.1 (Head or Tails 50/50 Chance):
Assume that you have a total of $10 to wager, starting with a first wager of $1. You bet on heads, the coin flips that way and you win $1, bringing your equity up to $11. Each time you are successful, you keep on betting the same $1 until you lose. The next flip is a loser and you bring your account equity back to $10. On the next bet, you wager $2 in the hope that if the coin lands on heads, you will recoup your previous losses and bring your net profit and loss to zero. Unfortunately, it lands on tails again and you lose another $2, bringing your total equity down to $8. So, according to martingale strategy, on the next bet you wager double the prior amount (or $4). Thankfully, you hit a winner and gain $4, bringing your total equity back up to $12. As you can see, all you needed was one winner to get back all of your previous losses.
However, let's consider what happens when you hit a losing streak like in scenario No.2:
Once again, you have $10 to wager with a starting bet of $1. In this scenario, you immediately lose on the first bet and bring your balance down $9. You double your bet on the next wager, lose again and end up with $7. On the third bet, your wager is up to $4, your losing streak continues and now you are down to $3. You do not have enough money to double down and the best you can do is bet it all. If you lose, you are down to zero and even if you win, you are still far from your initial $10 starting capital.
Trading Application
You may think that the long string of losses such as in the above example would represent unusually bad luck, but when you trade currencies, they tend to trend and trends can last for a very long time if you are caught in the wrong direction. However, the key with martingale when applied to trading is that by "doubling down" you in essentially lower your average entry price. In the example below, at two lots, you need the EUR/USD to rally from 1.2630 to 1.2640 to break even. As the price moves lower and you add four lots, you only need it to rally to 1.2625 instead of 1.2640 to break even. The more lots you add, the lower your average entry price. Even though you may lose 100 pips on the first lot of the EUR/USD if the price hits 1.2550, you only need the currency pair to rally to 1.2569 to break even on your entire holdings. This is also a clear example of why deep pockets are needed. If you only have $5,000 to trade, you would be bankrupt before you were even able to see the EUR/USD reach 1.2550. The currency may eventually turn, but with the martingale strategy, there are many cases when you may not have enough money to keep you in the market long enough to see that end.
Dollar steadies after data shows US economy stable
By Rika Otsuka
TOKYO, Dec 29 (Reuters) - The dollar steadied on Friday after paring losses against the euro in the previous session on a raft of data that showed the U.S. economy may be in better shape than earlier thought.
The U.S. currency has been unable to shake off market expectations in the past few months that the slowing economy could force the Federal Reserve to start cutting interest rates next year.
The dollar fell on Thursday after Yves Mersch, a member of the European Central Bank Governing Council, said euro zone rates remain low in historical terms, highlighting the risk that the dollar's rate advantage could narrow further.
Stronger-than-expected monthly readings for existing home sales, consumer confidence and the Chicago manufacturing index helped the dollar to trim losses against the euro on Thursday.
"It is rather puzzling that market participants are not buying the dollar much despite the strong data," said a trader at a big Japanese bank.
"Players are staying bearish on the currency," he added.
The euro edged up to $1.3162 by 0500 GMT from $1.3150 in late U.S. trading on Thursday.
The dollar was steady at 118.91 yen, little changed from late New York trade on Thursday. It stayed in sight of a two-month peak of 119.23 yen marked on Tuesday.
The euro edged up to 156.54 yen, near a record high of 156.73 yen hit on Thursday.
Market activity in Tokyo was subdued on Friday, after many Japanese companies finished this year's business on Thursday, traders said.
No major economic indicators are due from Japan or the United States, while Germany's GfK consumer sentiment survey for January will be released at 0700 GMT.
Bond and stock markets in Japan were open for a half-day on Friday and will resume trading on Thursday, Jan. 4.
HIGH-YIELDERS BENEFIT
Expectations that the ECB will further boost rates next year from the current 3.5 percent helped the euro to find favour.
"It is easy for investors to chase the euro as it is clear that the currency's yield will continue to rise," said Nobuo Ibaraki, forex manager at Nomura Trust and Banking.
The euro has risen 11 percent against the dollar and 12 percent versus the yen this year, aided by stagnating rates in the United States since mid-year and prospects for only a gradual rise in Japanese rates from the current 0.25 percent.
Despite expectations that the Bank of Japan will bump rates up to 0.5 percent before the end of March, few in the market believe the yen's yield disadvantage will shrink quickly.
Investors' demand for higher-yielding currencies buoyed the Australian and New Zealand dollars on Friday.
The Aussie struck a fresh 9-1/2-year high against the yen, while the kiwi scaled a one-year peak against the yen and matched a one-year high versus the dollar hit on Thursday.
Sterling hovered close to eight-year highs against the yen.
Expectations in the market that the Bank of England may push rates higher in 2007 has helped sterling climb 14 percent against the dollar this year.
A spike in the Chinese yuan that appeared to bring it to par with the Hong Kong dollar on Friday was in fact a mistyped price quotation, an official with the China Foreign Exchange Trading System said.
Earlier, the price quote had indicated that the Chinese yuan had reached parity with the Hong Kong dollar for the first time since 1992.
TOKYO, Dec 29 (Reuters) - The dollar steadied on Friday after paring losses against the euro in the previous session on a raft of data that showed the U.S. economy may be in better shape than earlier thought.
The U.S. currency has been unable to shake off market expectations in the past few months that the slowing economy could force the Federal Reserve to start cutting interest rates next year.
The dollar fell on Thursday after Yves Mersch, a member of the European Central Bank Governing Council, said euro zone rates remain low in historical terms, highlighting the risk that the dollar's rate advantage could narrow further.
Stronger-than-expected monthly readings for existing home sales, consumer confidence and the Chicago manufacturing index helped the dollar to trim losses against the euro on Thursday.
"It is rather puzzling that market participants are not buying the dollar much despite the strong data," said a trader at a big Japanese bank.
"Players are staying bearish on the currency," he added.
The euro edged up to $1.3162
The dollar was steady at 118.91 yen
The euro edged up to 156.54 yen
Market activity in Tokyo was subdued on Friday, after many Japanese companies finished this year's business on Thursday, traders said.
No major economic indicators are due from Japan or the United States, while Germany's GfK consumer sentiment survey for January will be released at 0700 GMT.
Bond and stock markets in Japan were open for a half-day on Friday and will resume trading on Thursday, Jan. 4.
HIGH-YIELDERS BENEFIT
Expectations that the ECB will further boost rates next year from the current 3.5 percent helped the euro to find favour.
"It is easy for investors to chase the euro as it is clear that the currency's yield will continue to rise," said Nobuo Ibaraki, forex manager at Nomura Trust and Banking.
The euro has risen 11 percent against the dollar and 12 percent versus the yen this year, aided by stagnating rates in the United States since mid-year and prospects for only a gradual rise in Japanese rates from the current 0.25 percent.
Despite expectations that the Bank of Japan will bump rates up to 0.5 percent before the end of March, few in the market believe the yen's yield disadvantage will shrink quickly.
Investors' demand for higher-yielding currencies buoyed the Australian
The Aussie struck a fresh 9-1/2-year high against the yen
Sterling hovered close to eight-year highs against the yen
Expectations in the market that the Bank of England may push rates higher in 2007 has helped sterling
A spike in the Chinese yuan
Earlier, the price quote had indicated that the Chinese yuan had reached parity with the Hong Kong dollar for the first time since 1992.
Wednesday, December 27, 2006
Dollar retreats in holiday thinned-trading
By Gertrude Chavez-Dreyfuss
NEW YORK, Dec 27 (Reuters) - The dollar weakened on Wednesday in light post-Christmas trading as a weak housing industry data added to the perception of a U.S. economic slowdown.
Investors focused on the diverging interest rates outlook between the euro zone and United States, where fresh economic reports of a sluggish economy tend to reinforce expectations of of interest rate cuts next year in the world's largest economy.
The euro rose 0.4 percent against the dollar to $1.3147. The dollar was flat against the Swiss franc at 1.2224 francs . Sterling, meanwhile, was up 0.3 percent at $1.9591 .
Reports that the United Arab Emirates' has decided to increase the proportion of its euro reserves over the next few months may have also weighed on the dollar, analysts said.
"All in all, it's not looking to be a positive backrop for the dollar," said Shaun Osborne, chief currency strategist at TD Securities in Toronto.
Osborne cited Tuesday's weak numbers for both Richmond and Dallas Federal Reserve manufacturing surveys including a report on Wednesday showing a sharp fall in U.S. mortgage applications.
The Mortgage Bankers Association said U.S. mortgage applications plummeted last week to the lowest level in nearly five months, dragged down by a plunge in demand for home refinancing loans. For more click on [ID:nNAT002350].
Data on November's new home sales due at 10 a.m. (1500 GMT) is seen as a key in determining if and when the Fed would begin cutting interest rates.
"So we've got the two bugbears of the dollar -- housing and manufacturing -- which are not flashing very positive signals at the moment," said Osborne.
The euro, on the other hand, continued to rack up gains, with the European Central Bank expected to raise interest rates further next year from the current 3.5 percent.
The single currency earlier hit a 6-1/2 year high versus the Swiss franc at 1.6083, buoyed by expectations that euro zone interest rates are set to rise further in 2007. By contrast, the Swiss National Bank slashed its 2007 interest rate outlook after raising rates earlier this month.
Against the yen, the dollar fell 0.6 percent to 118.41 yen, after Jiji news agency reported late on Tuesday that the Bank of Japan is likely to discuss raising rates to 0.5 percent next month.
Jiji, citing no sources, added that the decision could be postponed to February or later in the event of anything unexpected happening in financial markets.
"There was a bit of a turn in the yen that may have been the catalyst for more dollar weakness," said Daragh Maher, currency strategist at Calyon.
However, a trader at Forex.com in Bedminster, New Jersey doubted this report. "We believe this to be highly unlikely as far as event risk, but, the revaluation of the Chinese yuan is a real event," he said.
NEW YORK, Dec 27 (Reuters) - The dollar weakened on Wednesday in light post-Christmas trading as a weak housing industry data added to the perception of a U.S. economic slowdown.
Investors focused on the diverging interest rates outlook between the euro zone and United States, where fresh economic reports of a sluggish economy tend to reinforce expectations of of interest rate cuts next year in the world's largest economy.
The euro rose 0.4 percent against the dollar to $1.3147
Reports that the United Arab Emirates' has decided to increase the proportion of its euro reserves over the next few months may have also weighed on the dollar, analysts said.
"All in all, it's not looking to be a positive backrop for the dollar," said Shaun Osborne, chief currency strategist at TD Securities in Toronto.
Osborne cited Tuesday's weak numbers for both Richmond and Dallas Federal Reserve manufacturing surveys including a report on Wednesday showing a sharp fall in U.S. mortgage applications.
The Mortgage Bankers Association said U.S. mortgage applications plummeted last week to the lowest level in nearly five months, dragged down by a plunge in demand for home refinancing loans. For more click on [ID:nNAT002350].
Data on November's new home sales due at 10 a.m. (1500 GMT) is seen as a key in determining if and when the Fed would begin cutting interest rates.
"So we've got the two bugbears of the dollar -- housing and manufacturing -- which are not flashing very positive signals at the moment," said Osborne.
The euro, on the other hand, continued to rack up gains, with the European Central Bank expected to raise interest rates further next year from the current 3.5 percent.
The single currency earlier hit a 6-1/2 year high versus the Swiss franc at 1.6083
Against the yen, the dollar fell 0.6 percent to 118.41 yen
Jiji, citing no sources, added that the decision could be postponed to February or later in the event of anything unexpected happening in financial markets.
"There was a bit of a turn in the yen that may have been the catalyst for more dollar weakness," said Daragh Maher, currency strategist at Calyon.
However, a trader at Forex.com in Bedminster, New Jersey doubted this report. "We believe this to be highly unlikely as far as event risk, but, the revaluation of the Chinese yuan is a real event," he said.
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