FXstreet.com Live Sessions Archives

Advanced Technical Analysis in FX

Date: May 31, 2005 14:00 GMT
Expert: Paul Brittain, Manager of Alaron's Las Vegas Division
Topics:
- Fibonacci Retracements
- Elliot Wave Theory
- Gann Fan
- Andrew’s Pitchfor

Who is Paul Brittain?
Paul Brittain entered the futures industry in 1983 and has gained experience in all aspects of the business. Promoted to a management position in a major trading firm in 1987, he spent many years working with other market professionals to develop options and futures trading techniques suitable for almost every type of trader, individual and commercials alike. He shares these trading methods with traders through his dealings as a broker with Alaron Trading as well as teaches them at www.commoditytradingschool.com a free education online seminar source he founded in 2004. Currently he produces and publishes four newsletters, The Beast, The Big MacDaddy', 'The Optionologist' and the 'Ca$h C.O.W.' for his customers.

Speech Material:

Advanced Technical Analysis in FX.

Click the image to view the Power Point: Advanced Technical Analysis in FX



Important Note: Take into account that the PowerPoint that will open by clicking the link is a large file and you may experience some difficulties when trying to open it.

Fibonacci Retracements, Elliot Wave Theory, Gann Fan and Andrew’s Pitchfork
Fibonacci
Fibonacci retracement percentages correspond to natural ratios discovered by the Greeks. They referred to the phenomenon as the Golden Ratio. The theory was then rediscovered by Fibonacci; a medieval, Italian Mathematician.

Elliot Wave Theory
The Elliot Wave Theory was developed by Ralph Nelson Elliot. This theory is based on the premise that market behavior is based on waves rather than random timing.

Andrew’s Pitchfork
Dr. Alan Andrews developed a channel technique to identify areas of support and resistance from a common baseline. The premise of the theory is to trade the channel depicted by the “tines of the pitchfork.

Gann Fan
W.D. Gann designed several techniques for studying price charts. He believed that specific geometric patterns and angles contained reoccurrences that could be used to predict price action.

***IN ORDER TO SEE A FULL DESCRIPTION OF EACH THEORY, PLEASE, DOWNLOAD THE POWER POINT ABOVE***

How do Crosses Differ From Majors

Date: May 26, 2005 14,00 GMT
Expert: Sam Shenker, Currency Analyst at FXCM
Topics:
- Introduction
- What Are Crosses
- How the Fundamental Data Impacts Crosses
- What Are Carry Trades?
- Trading Crosses
***Transcript will be available for Session Participants only***

Who is Sam Shenker?
Sam Shenker is a Technical Currency Analyst for Forex Capital Markets (FXCM). Sam is the author of the Daily and Weekly Technical Research reports at FXCM. His reports include: Daily Technicals, Weekly Crosses and the Weekly Futures Commitment of Traders Report. Prior to joining FXCM, Sam spent a number of years on Wall St and has traded many different products, including: equities, equity derivatives and futures. He also specialized in research and analysis of high yield bonds, corporate bankruptcies, restructurings, reorganizations and venture capital. He holds a Bachelors degree in Finance and Business Management from Pace University and is an active currency trader. Sam is frequently quoted on FXStreet.

Speech Material:

How Are Currency Crosses Different From Majors

Introduction:
Trading major currency pairs such as the GBP/USD, USD/JPY or more recently the EUR/USD have been the standard modes of speculation in the FX market. However with the increased liquidity of the FX market as a whole, currency crosses have become an increasingly popular trading vehicle. However, even seasoned FX traders sometimes look at the crosses with a mixture of curiosity and trepidation, as the crosses require the ability to think outside the “box” of the US Dollar.

As a trader I have always looked to broaden my horizons, and when I started trading the currency markets, I started as everyone else, with the majors. As time progressed I looked to expand my trading capabilities and looked at the crosses. Crosses presented their own unique challenges and initially seemed erratic and volatile. As time progressed I learned to trade each cross individually using both technical and fundamental analysis.

What Are Currency Crosses?
A currency cross is a combination of two different currencies with neither currency being a US dollar. Examples of currency crosses are pairs such as GBP/JPY and AUD/NZD. Since the currency trading world is a lot bigger than the 7 USD based majors, ignoring crosses as viable trading instruments can be like never opening the window to another world of opportunity.

Currency crosses reflect the economic state of the countries, business transactions and money flow between two different countries. (I.e. a large cross-border corporate acquisition can affect the cross and not the corresponding majors)

Currency crosses surged in popularity during the past few years as hedge funds and other financial institution began capitalizing on the interest rate difference between countries and price trends. Traditionally before the advent of currency crosses on trading platforms, anyone who wanted to do buy a cross pair such as AUDJPY had to make 2 transactions – first they had to buy AUDUSD and then buy USDJPY. For the most part, this is still the mode of operation on the interbank level. Yet, as the popularity of crosses continues to grow many brokers including FXCM has simplified the process for individual traders by calculating the cross rate for you and offering it as one trade on the trading platform.

The reason why cross trading was so compelling to hedge funds was because they were able to earn yield and return on a leveraged basis. Between August of 2002 and February of 2004, AUDJPY appreciated 33% in value not including the yield. So lets say on a conservative basis, Australia offered 4.75% interest rates at the time, while of course Japan offered zero. So this trade offered a positive 4.75% interest income. Now, 4.75% seems like pennies, but if you remember, hedge funds are leveraged and even if you include a conservative 10x leverage, that would be 47.5% in interest income if the currency did not move at all during that time frame. As we just said though, the currency of course did move and it moved 33% unleveraged. Leverage comes with risk and I am sure you can do the math yourself that if the hedge funds also leveraged their spot position, how much return they would have generated.

Carry Drives Crosses
When trading crosses, it is of utmost importance to keep a close tab on fundamental data. The primary driver behind cross trading has been interest rates and carry.

Anyone who is familiar with my weekly research report Currency Crosses: Trading Beyond Majors has come across the term Carry Trade and Currency Yield Spreads.

For those who are learning this for the first time, a carry trade involves borrowing a currency with a low interest rate and lending in the currency with a high interest rate, thus collecting the interest rate differential.

I primarily use LIBOR (London Interbank Offering Rate) rates to look at the yield spreads for indication, as they are generally the benchmark for sovereign bonds / interest rates.

Yet it is not just the absolute amount of interest yield offered by the country that is important, but rather the monetary policy bias of the central bank. For example, the fact that the UK has 4.75% interest rates and Japan has 0% has significantly benefited GBPJPY last year. However, over the past month GBPJPY has fallen 4%. The reason why it has fallen has been the fact that UK economic data over the past month has been very weak, triggering speculation that the Bank of England may not be raising rates again later this year like some have expected or even worse, contemplate lowering rates. This shift in monetary policy bias is one of the key drivers of most crosses. And monetary policy is generally very much contingent upon the health of the country’s economy and recent economic data. That is why it is important to follow the economic data portion of the Currency Cross report that I publish on a weekly basis because I review the top economic data releases and how they came out. Also, our weekly Trade or Fade report and the Charting Economic Surprises report also do a fantastic job of providing an overview on how the economy performed over the past week or month.

Carry trades only work in the spot market; you will not collect interest on the currency futures or options.

But before you rush out and start loading up on high interest rate crosses, you must consider all of the possible angles when it comes to trading crosses.

Yet Not All Crosses – You Must Look At All Angles
Not all crosses move based upon interest rates. Take EURCHF and EURGBP for example. These two pairs are very range-bound and offer very little in terms of appreciation potential even though there is a real interest rate differential. The reason is because for the most part, the EURUSD and the GBPUSD move in the same direction because they are being tossed around by dollar fundamentals. So if that is the case, then when the EURUSD rallies, the GBPUSD rallies as well, causing more of a negation and capping EURGBP moves. A similar case is seen in EURCHF, which is driven by flows in the EURUSD and USDCHF.

Crosses can be divided into volatile and non volatile
Volatile crosses include: GBP/JPY, GBP/CHF, EUR/AUD, EUR/CAD, EUR/JPY, CHF/JPY, AUD/JPY, CAD/JPY, AUD/CAD, AUD/NZD and NZD/JPY

Non volatile crosses include: EUR/CHF, EUR/GBP

So pretty much most of the crosses exhibit high volatility, which is perfect for short-term trading given proper amount of leverage.

Crosses adhere very well to technical setups, double tops and bottoms, head and shoulder patterns, channelling patterns, triangles. All of these setups are presented weekly in my report Currency Crosses: Trading Beyond Majors.

If you are looking to trade crosses my advice is first to observe the behaviour of the cross to the particular fundamental data and than use technical setups to enter the trade.

Currency crosses also give an opportunity for diversification as there is low or no correlation between the crosses such as EUR/GBP and CHF/JPY, thus giving an opportunity to diversify between different crosses.

Swing Trading in the Forex

Date: May 19, 2005 14:00 GMT
Expert: Paul Brittain, Manager of Alaron's Las Vegas Division
Topics:
- FX Background Info
- Margin and Leverage
- What is Short Selling?
- Fundamental Analysis
- Basic Technical Analysis

Who is Paul Brittain?
Paul Brittain entered the futures industry in 1983 and has gained experience in all aspects of the business. Promoted to a management position in a major trading firm in 1987, he spent many years working with other market professionals to develop options and futures trading techniques suitable for almost every type of trader, individual and commercials alike. He shares these trading methods with traders through his dealings as a broker with Alaron Trading as well as teaches them at www.commoditytradingschool.com a free education online seminar source he founded in 2004. Currently he produces and publishes four newsletters, The Beast, The Big MacDaddy', 'The Optionologist' and the 'Ca$h C.O.W.' for his customers.

Speech Material:

Swing Trading in the Forex

Click the image to view the Power Point: Swing Trading in the Forex Market

Important Note: Take into account that the PowerPoint that will open by clicking the link is a large file and you may experience some difficulties when trying to open it.

A swing trading method is designed to exploit both trending markets and retracement periods. Retracement occurs as a result of market participants overshooting the fair value of a currency in overzealous buying or selling. Speculators tend to “jump on the bandwagon” late in a market move pushing prices to unsustainable levels. The market will then retract to more reasonable prices. Swing traders trade without bias, and will look to reverse a position shortly following a reversal signal.

A true swing trading strategy doesn’t attempt to predict the duration of a trend, it is intended to identify the direction of the market and trigger an entry at a technically reasonable price. For example a long position would be executed following a down trending market at a point in which the method indicators deem to be a possible reversal point. Similarly, a short position would be executed following an uptrend at a point in which the system identifies as a possible reversal point. The vital assumption is that all upward price action must eventually be followed by a downtrend and all downtrends are inevitably followed by an upturn.

An ideal method is based on two the use of computerized momentum indicators with a “common sense” filter. Our entry signals are produced using a crossover of the 3 and 7 period simple moving average and the ever-popular MACD, or the Moving Average Convergence/Divergence. In other words we are using the MACD in order to qualify the moving average crossover signal. Using MA crossovers alone may result in false signals, but a trend confirmation indicator such as the MACD will reduce the ocurrances.

The MACD was developed by Gerald Appel to determine both the direction of a trend and the momentum driving the price of a commodity. The MACD indicator considers two exponential moving averages and the difference between those two averages. By looking at an average of the difference in the two moving averages, as opposed to the averages themselves, we are able to get a more accurate signal.

The MACD is effective in identifying the beginning of a credible trend. Using this indicator as an entry signal is preferential in that it provides a relatively slow trigger. As a result, false signals are uncommon.

Once the trend begins to reverse its momentum, it is advantageous for a trader to take profits rather than attempt to guess the duration of the current trend.

A quicker exit signal is required to prevent open profits from being “left on the table”. For this reason, we have opted to base exit solely on the crossover of the moving averages if we have not already been stopped out.

Click the image to enlarge

The MACD and Moving Averages indicators are correlated, however, the crossovers tend to have quicker reversal signals. Thus, by using the slower indicator on entry this method avoids many false reversal signals. Similarly, using the quicker indicator to signal trade liquidation will avoid leaving excessive profits on the table after a trend reversal.

Stops should be placed on the relative high or low of the previous three price bars. If the high or low of the entry is beyond the high or low of the previous three bars use the nearest relative high or low. For example if the preplanned swing trading method calls for a short entry at a time in which the high of the previous three bars are lower than the entry the first high above the entry should be used. Stops should be trailed following the same rules (see Common Sense Filter for additional insight).

A technical long or short signal should not be followed blindly. It is important to take upcoming fundamental news and market abnormalities in consideration. For example, traders should be reluctant to accept a short signal in a market that is trading near multi day lows. Additionally, economic reports sometimes have a profound impact on the day of their release. It is sometimes appropriate to delay or eliminate entry of trades on or prior to the announcement of major reports in order to avoid the “knee jerk” reaction” as fresh news hits the marketplace.

Traders should also consider diversification of their futures holdings, for instance. Executing trade signals in the Euro and the Swiss Franc, which are highly correlated, will likely leave result in excess risk. In other words, don’t leave all of your eggs in one basket.

The rules on stop placement can and should be adjusted in some circumstances. For instance, tighter stops may be appropriate in a market that has made extreme moves in recent sessions. If placing a stop at a relative high or low means risking excessive amounts of open profits a discretionary stop should be placed.

Swing traded can be generated based upon a combination of technical indicators. Because it is strictly a technically based method (i.e. it will sell “short” a market at zero) there are inherent weaknesses that can be avoided by executing only those trades that fit the risk preference and financial ability of the trader. Doing so may enhance the performance results of the method. A trader that is undercapitalized is often forced to liquidate positions at a loss that would have ultimately become profitable.

Traders that are working with enough risk capital to participate in more than one market at a time should consider diversifying their trades. For example, holding positively correlated trades simultaneously will increase overall volatility. Thus, traders may want to accept signals in two or three currencies given that they are properly capitalized.

Acceptance or rejection of signals lies at the discretion of the trader. Before trading the system, each individual must assess their tolerance for risk and determine the weights that they would like to attribute to each currency.

FX Background Info
What is FOREX?
The term FOREX is an acronym for Foreign Exchange. It is a worldwide cash inter-bank market using as floating exchange rate system to trade spot market currencies. FOREX is becoming increasingly popular among speculators for several reasons. This is the largest and most liquid market in the world, with an estimated daily average of more than $1.5 trillion trading hands. To give you some perspective, it would take several moths of trade at the New York Stock Exchange to match the amount of capital traded daily in FOREX.

Similar to the NASDAQ platform, FOREX is an over the counter market. In other words there is no physical location in which trades are executed. Most of the trades executed on the exchange are transactions between the over 600 large international banks, with each of these banks acting on behalf of large firms and governments.

When does trading occur?
Due to the global nature of the market, FOREX trading can be done 22 hours per day. The Asian session gets underway on Sunday evening at 7:00 pm EST, the London session begins at 2:00 pm EST, and the final New York session begins trade at 7:00 am EST and ends at 5:00pm EST.

How does the FOREX market work?
A trade in the foreign exchange market is the simultaneous purchase of one currency and sale of another. In other words, in every transaction a trader is long one currency and short the other. A position is expressed in terms of the first currency in the pair. For this reason, currencies are always traded in pairs, for example if you have purchased Euro and sold dollars it would be state as a Euro/Dollar pair.

Margin and Leverage
The FOREX market allows traders to control massive amounts of leverage with minimal margin requirements, some firms offer as much as 100:1 leverage. For example, traders can control a $100,000 position with $1,000, or 1%.

Obviously, leverage can be a powerful tool for currency traders. While it does contribute to the risk of a given position, leverage is necessary in the FOREX market. This is because the average daily move of a major currency is about 1%, while a stock typically sees much more substantial moves.

Leverage can be seen as a free short-term credit allowance, allowing traders to purchase an amount of currency exceeding that of their account balance. As a result traders are exposed to an increased level of both risk and opportunity. The most effective way to manage the risk of trading with leverage is to diligently follow a disciplined trading style with uses of stop and limit orders. It is imperative that traders “obey” the system, rather than trading on emotion.

What is Short Selling?
Short selling in FOREX is similar to that in the futures market. By definition, when a traders goes short he is selling a currency with the expectation that the price will drop allowing a profitable offset. If the market moves against the trader’s position, he will be forced to buy back the contract at a higher price. The result is a loss on the trade.

There is no limit to how high a currency can go, giving short sellers a unlimited loss scenario. Theoretically, a short seller is exposed to more risk than a trader with a long position, however through use of stop orders traders can mitigate their risk regardless of long or short. It is imperative that traders are well disciplined, and execute previously planned trades as opposed to spontaneous triggers.

There are obvious benefits to short selling. This aspect of the FOREX market allows traders to profit from declining markets. The ease of selling contracts before buying it first is in contrast to typical stock trades. Market prices have a tendency to drop faster than they rise giving short sellers an opportunity to capitalize on this phenomenon. Similarly, prices will often rally gradually with increasing volume. As prices begin to reach a peak, trading volume will typically taper off. This is a signal that many short sellers look for to initiate a trade. When a reversal does occur, there will typically be more momentum than the corresponding up move. Volume will increase throughout the sell-off until the prices reach a point in which sellers begin to back off.

Fundamental Analysis
Speculators attempt to forecast future price movements based on a combination of fundamental factors. Predictions are often based on economics, politics, and statistical studies of supply and demand factors. The use of fundamentals in price forecasting requires traders to have an in depth knowledge of a particular market.

Basic Technical Analysis
Technical analysis is the study of historical prices in an attempt to predict future price movements. There are two basic components to which technical analysis is based on: prices and volume. Use of indicators that incorporate these two components exploit the impact of supply and demand in the marketplace.

Due to the nature of the FOREX markets, positions are normally short lived. For this reason entry and exit points are crucial for success and must be based on various technical analysis tools. While fundamental analysis focuses on what “should” happen, technical analysis is based on what “has” happened.

Identifying the overall trend, whether it is short term or long term, is the most elementary element of trading with technical analysis. A weekly or monthly chart should be used to identify a longer-term trend, while a daily or intraday chart must be used for examining the shorter-term trend. After determining the direction of the market, it is important to identify the time horizon of potential trades and apply those strategies to the appropriate trend.

Support and Resistance
In their simplest form, support and resistance act as the floor and ceiling of a current trading channel. Theoretically, this is the price at which the market should reverse its direction.

Resistance is a price level above the current market price. At this level, selling pressure should be strong enough to overcome the buying. As a result prices will likely experience a reversal of an uptrend. Similarly, support is a price level below where the market is currently trading. At support levels, buying interest should deter a down trending market. If the market price penetrates support or resistance, the levels may reverse. For example, if the market breaks out to the upside above levels of resistance new support will be at the previous resistance.

Support and resistance can be identified by re-occurring prices. If the market reaches a certain threshold before reversing, and then repeats the pattern this would fit the criteria. Perhaps the biggest advantage of support/resistance identification is to determine advantageous entry and exit points. For example, if the market is approaching support and it seems unlikely that prices will have enough momentum to penetrate below this level, traders should look for a long entry.

Averages
One of the easiest indicators to understand is the moving average. Although there are variations, the moving average shows the average price of a currency over a specified period of time. Most traders opt to use moving averages to supplement other indicators, however, it may be useful to combine the use of MA’s with different time frames. Buy signals are usually triggered when the shorter-term average crosses the longer-term average. Sell signals occur when the shorter averages crosses below the longer one. Uses of such indicators are based on the premise that “the trend is your friend”.

Pivot Points
The definition of pivot point is the average of the high, low and settlement price. Pivot points are primarily used as support and resistance levels. The Primary Pivot Point acts as the best support/resistance level. Many traders use pivot points in intra-day trading, even many that don’t trade according to pivot points keep track of them as a way to predict the transactions of other traders. These points can be calculated using the following formulas:

Pivot = (H+L+C)/3

R1 = 2P-L

S1 = 2P-H

R2 = (P-S1)+R1

S2 =P- (R1-S1)

R3 = (P-S1)+ R2

S3 = P- (R2-S1)

Resistance Level 2 – The market often sees significant resistance at this price level. Price movement above R2 is normally in a strong trend and will often continue higher (during the session).

Resistance Level 1 – Prices often reverse at R1, penetration of this point may lead to a substantial rally (during the session).

Primary Pivot – The strongest of S/R level, prices will normally trade above or below this area before breaking in one direction or the other. Beware of false signals, it is often advantageous to wait for a few shake-outs before entering the market. If the market is above the Primary Pivot, be a buyer on dips. If the market is trading below this level, get short following a rally.

Support Level 1 – Prices tend to reverse at S1, if the market successfully breaks the S1 a substantial sell-off may follow (in the trading session).

Support Level 2 – Prices often see strong support at S2, a break below this level typically signifies a strong trend, and the market often continues to fall lower (in the trading session).

Price Volume Rules
· Increasing volume in a rising price environment signals excessive buying pressure and could lead to a substantial advances.
· Increasing volume while prices are falling may signal a bear move.
· Decreasing volume while prices are climbing may indicate a plateau, and can be used to predict a reversal.
· Decreasing volume with a weaker price environment shows that fresh sellers are reluctant to enter the market and could be a sign of a future downtrend.
· Excessive volume while prices are high indicates that traders are selling into strength and often creates a price ceiling.
· Excessively low volume while prices are low indicates that traders are buying on weakness and often creates a floor.

While many financial scholars insist that technical analysis is a waste of time, history is an undeniable resource. Analyzing charts can be looked at as a roadmap to success. It is obvious that past events do not guarantee future price movements, but identifying and understanding reoccurring patterns can be helpful in speculation.

Getting the Bigger Picture in Forex

Date: May 17, 2005 14:00 GMT
Expert: Rob Booker, Currency Analyst
Topics:
- What is a Big Picture Trader?
- How to understand the reasons behind price moves
- Learn to understand how and when trends develop
- The 5 Habits of Big Picture Traders
- How to ruin it all and lose all of your money
***Transcript will be available for Session Participants only***

Who is Rob Booker?
Rob Booker trades profitably for his own account and manages money for others. Rob has trained hundreds of fx traders around the world. He has helped them develop their own trading systems, but more importantly, Rob focuses on helping traders deal with the mental, psychological, and discipline issues related to training. For Rob, successful trading is more mental than anything else.

Speech Material:

Getting the Bigger Picture in Forex
1. What is a Big Picture Trader
? A big picture trader has enough experience and knowledge and wisdom to understand what is going on “beneath the charts” or, in other words, behind the scenes, to create price movement. A big picture trader understands the fundamental considerations of a trade on a specific currency pair. A big picture trader knows – immediately, at any given time – the major technical considerations when considering a currency pair.

It might even be easier to help you understand the importance of becoming a big picture trader if I describe to you the opposite: the small fry trader.

A small fry trader is one who loses 50 pips on a trade and says, “I wonder why that happened?” A small fry trader watches the market launch 100 pips in one direction and then says to himself, “I wonder why that happened?” A small fry trader hears that Australian interest rates are going up, and either has no idea what that means, or asks the question, “I wonder what higher AUD rates will mean?” Small fry traders are constantly wondering why a pair stopped where it did, wondering why their stop loss keeps getting hit, wondering why they are unable to get in on the big moves, and wondering why they regularly choose watch the market during hours when there is no activity.

A big picture trader knows how to do that.

In short, a big picture trader is one who understands what is going on in the market, and can profit from that understanding. Most importantly, a big picture trader understands the principles by which a currency pair operates, and then applies those principles to make profits.

Analogy #1
The principles of physics govern the world around us. It is a true principle that if you drop an apple from a tree, it is going to fall. It is a true principle that if you send an object high enough into the earth’s atmosphere, it will orbit around the earth. These principles are true even if you do not understand them, agree with them, know about them. You can fall off a cliff to your death even if you have never heard of Isaac Newton.

Similarly, there are principles by which the currency markets are governed. When price moves up 100 pips, these principles are at work. We’ll call these the Currency Principles.

You can ignore Currency Principles and still make money – we all started on a demo account and made money. We were obeying Currency Principles and often did not even know it. You can’t ignore them for long and still make money – they catch up with you. This is what we learned when we switched from demo to live and started bleeding pips.

When we lost money in that first live account, we switched into a higher gear and we started scrambling to stop the losses (usually these losses are large and that’s why we start to panic more quickly than we ever did when trading for fake money). When we started looking for ways to stop the losses, we began to realize something really important:

WE HAD NO IDEA WHAT WE WERE DOING.

That’s when trading became really difficult, right? We all took a deep breath and realized that live trading was harder than demo trading. We could not explain why, but we knew it was so much more difficult that most of us considered quitting.

A big picture trader does not quit, but rather seeks out Currency Principles. As you learn and apply true principles in the currency markets, you profit. You ignore these same principles at your peril.

2. How hard is it to become a big picture trader, to learn Currency Principles?
Learning how to learn true Currency Principles is more important than learning a set system or a really cool strategy. When you learn how to discover true Currency Principles for yourself, you have a toolbox that can never become outdated.

That’s why this is not a live chat where I am going to list every Currency Principle that I have learned. This brings us to our first truth:

Truth #1
You can learn true Currency Principles from others, but you have to learn how to discover them on your own.

There are two things you need to become a big picture trader and to learn Currency Principles: experience and knowledge. They come in no particular order, and neither is more important than the other, and one is useless without the other. To put it another way:

To become a big picture trader, you need equal parts of experience and knowledge. Let’s talk about two kinds of each.

Knowledge #1: Book Knowledge
You should prioritize a list of books on trading (I’ll help with that below). Then you should read them and become so familiar with them that you can easily talk about the principles those books contain.

Knowledge #2: Mentor Knowledge
You can learn from the mistakes and successes of another trader, and sometimes this type of knowledge can speed up the process of becoming a profitable trader.

Experience #1: Demo Trading
Most traders never demo trade for long enough. Some dealers only allow traders a 1 month demo account. This is ridiculous. We all had the urge to skip from demo to live way too fast. I did it. You probably did it too. This did not make us bad people. It proved that we were a bit dumber than we thought, and it caused us, in the end, to be poorer than we wanted to be. If you want to learn true Currency Principles, you need to spend at least 2-3 months demo trading before you ever risk your first live pip.

Experience #2: Live Trading
The other thing that fascinates me about my own experience as a trader is how fast I was willing to risk my hard-earned money on my own limited trading experience. We all are greedy and hopeful about certain things; unfortunately, we usually end up paying for our foolish impulses. But the fact is that small live trades (read: risking VERY little at first) can teach you a lot about trading. There are many Currency Principles to be learned by trading live. Even with small amounts of money.

Let’s talk about each of these categories. I am going to do them out of order.

3. What Knowledge Your Need
There are four main areas in which you need to acquire as much knowledge as possible:
- Technical Analysis
- Money Management
- Money Markets / Interest Rates
- Economics (both Macro and Micro)

A word about TA: pick one oscillator only and learn as much as you can about it. If you don’t know what an oscillator is, visit this link:

http://www.investopedia.com/articles/technical/070301.asp

Or go to http://www.investopedia.com/ and search for the word “oscillator”.

4. Knowledge: Deep or Wide?
You want to go deep. This means, that you want to study how the four main categories relate to just 1 or 2 currency pairs – not 7. If you are trying to learn about 3 or 5 or 8 currency pairs – from TA, to Money Management, to Interest Rates, to Economics, your head is going to spin until it falls off. You will end up being dumber. It will not help you trade.

You need to go deep into a currency pair from the 4 main angles above.

Ok, now on to the categories of knowledge.

5. Mentor Knowledge
If you are going to hand over money or your time to someone else, for the purpose of learning from their experience, here are some things that you should look for:

a) Your mentor must accept that you must learn to learn, and learn to apply, true Currency Principles for yourself. If a mentor teaches you mechanical or discretionary systems, make sure you understand the underlying concepts about those systems. Mechanical and discretionary systems can break. But if you learn to build your own mechanical and discretionary systems, then you will have the tools necessary to succeed in the long term. Even if your mentor is hit by a bus.

b) In addition to knowledge about the 4 main areas, you should receive access to see all of the decisions your mentor/teacher makes about his trades. He should not make special, on the side trades that he/she does not tell you about. What's the point of that? Traders who have a scarcity mentality – who say “I can’t share my secret system with you” are morons. You are never going to have a secret system that, if you share it with someone else, will break or stop working. Most traders are not willing to share systems because their systems stink.

c) You should know up front from the mentor what their daily planning/strategy regimen is.

d) No expiration date on getting help.

Those are just a few considerations that you should have. I have lots more to say on this topic, but let’s move on.

6. Book Knowledge
You must set aside time every day or every week to read. I cannot emphasize this enough. Whether you buy the books or you read pdf versions online, you need to set aside enough time to AT LEAST read one book every two weeks. I hope you will read much more than that.

Here is a list of books that I have read and that I highly recommend.

MUST READ
Come Into My Trading Room
Trading for a Living
Technical Analysis of the Financial Markets
Technical Analysis Explained
Trading in the Zone
Market Wizards

SHOULD READ
Naked Economics
Secrets of the Temple
Blink
The Master Swing Trader
The Alchemist
The Professional Commodity Trader

There are many, many more books. Read as many as you can. Schedule your reading and make sure that you do it. Take notes on what you read. ]

Here are some links that are fantastic that you should read, which cover the US Federal Reserve. This is a hot topic right now and you need to learn all you can:

http://www.federalreserve.gov/policy.htm

http://en.wikipedia.org/wiki/Federal_Reserve

7. Demo Trading
If you don’t want to demo trade for at least 2 months, then I want you to practice the following exercise:

1. Take your wallet or purse;
2. While holding it, light it on fire.

You are simply too aggressive and impulsive if you dive into live trading too quickly. Use 8 weeks of demo trading, at least, to learn about which trading platform you like the best, how it works, how to use a charting program, how the pair you focus on reacts to news, how it reacts to certain moving averages and oscillators and support and resistance.

Most traders who jump into live trading feel like if they demo trade for too long they will miss out on something. That is like complaining that because you can’t run out into the middle of the highway, you are missing out on the pleasure of getting hit by a bus.

8. Live Trading
When you first switch to live trading, please trade the smallest lot size you are able to trade. If you pick a good dealer, you will be able to trade amounts smaller than $1 per pip. If $1 per pip is a meaningless amount to you, then trade for more. But keep the trade so small that it won’t matter if you win or lose. Use this first live trading time as a chance to test the systems that you developed in demo trading. You should not feel as if you have to get rich in your first few months of live trading. This relieves you of so much pressure.

Keep a detailed journal of your live trades. If you feel this is too much work, please do the following:

1. Stretch out your hands;
2. Pour battery acid on them.

This will keep you from ever trading again. It’s simply not worth trading if you are not going to keep a good record of what you do and why you do it – especially with real money. Record your reasons for getting in the trade, your feelings while you are in the trade, whether you got the high score on NBA Street v.3 while the trade was open, and if you could change anything to make the trade better.

9. The 5 Habits of Big Picture Traders
a) They might be early, but they are rarely late. This means that they work very, very hard to spot and take advantage of trends and reversals early. How do they do this? They learn everything they can about trends (do not buy the book by Michael Covel; it is worthless), about support and resistance, and about oscialltors.

b) They never risk more than they can afford to lose on one trade. Ryan Jones has a good primer on Money Management – his book The Trading Game. Alexander Elder advises traders to never risk more than about 3% of their account on any one trade. Early on in your trading, you should risk as little as possible (as close to nothing as possible).

c) They never stop learning. They read constantly, interview other traders, and stay current with the 4 major areas of knowledge.

d) They backtest. They either test their systems manually by going back through charts candle by candle, or they run their systems through computer models. Every week, you should make it a habit to do a review of last week and a preview of the week to come, and talk about your past trades and what you would change. Even better – replay a past week candle by candle and make trade decisions over again. This helps you learn.

e) They stay on target. Big Picture traders do not change their system every day or every time they experience a loss. They put a lot of time into developing their system in the first place. New traders give up and alter their system over and over again many times, and never learn if the system works.

10. How to ruin it all and lose all of your money
Last of all, there is a really easy to ruin everything and lose all your money:

Believe that you have learned everything you need to know. One of the fundamental Currency Principles is that you are never going to know everything. You are never going to be able to develop one system and put it on auto-pilot and never work on it again. You are never going to become so good that you do not experience losses.

Make the acquisition of knowledge and experience central to your trading career. Keep in touch and let me know how you are doing.

Risk Management: Backbone of Trading

Date: May 12, 2005 14:00 GMT
Expert: Zeeshan Ali, Director Operation, FortKnoxTrading.com
Topics:
- What is Risk Management?
- Why is Risk Management Important?
- Reasons behind improper Risk Management
- Defining Trading Range
- Effective Risk Management

Who is Zeeshan Ali?
Zeeshan Ali is Director Operations at FortKnoxTrading.com, a trading firm that provides traders with real time currency, futures and options advisory services. Zeeshan is an FX teacher, trader and analyst, with years of experience trading the foreign exchange markets. As a consultant for leading financial institutions in the United States and abroad, Zeeshan has addressed the issues of financial risk management procedures, risk evaluation and management.

Speech Material:

Since the foreign exchange trading is based on speculation, the risk factor is always very high. Forex Market is the largest and most liquid market in the world, therefore the market is very attractive to traders where they should be the most successful but their success is often limited due improper money management.

Risk Management is factor that is often left out and mostly ignored by the traders. Traders mostly focus on learning new trading analysis tools but risk management remains the integral part of making profits in trading. Foreign Exchange market can be very volatile at times and it is very easy to loose accounts in few minutes.

The most important thing to learn in trading is not just to apply the technical analysis but also to follow risk management techniques with discipline.

What is Risk Management?
Simply, risks are threats to your business or project. They are situations or events that can affect the outcome of your decisions and actions. Therefore, risk management is the identification, evaluation, and mitigation of risks to a business or project.

Risk is embedded in every opportunity a business faces. And poor risk management can result in large financial costs, or even failure. There are also risks associated with utilizing an internet-based deal execution software application including, but not limited to, the failure of hardware and software and communications difficulties.

Why is Risk Management Important?
All businesses exist for one clear reason: To make a profit. Poorly managed risks have tangible and dramatic effects on the bottom line. Therefore, sound risk management is important to ensure that your business can overcome any problems and continue to grow profitably.

Reasons behind Improper Risk Management:

· Unrealistic Expectations
Many traders trade with unrealistic expectations of profit potential and also they lack the discipline required for trading. The main reason for this is incomplete training. In forex trading, the most common mistake is pre-mature trading. Although traders with years of experience also makes mistakes but a trader should learn, develop and test technical implementations in forex trading through paper trading.

· Use of higher leverage
The other reason for major losses is the use of higher leverage. Leverage seems very attractive to those who are expecting to turn small amounts of money into large amounts in short period of time. However, leverage is a double-edged sword. Most traders analyze the charts correctly and place sensible trades, yet they tend to over leverage themselves (get in with a position that is too big for their portfolio), and as a consequence, often end up forced to exit a position at the wrong time.

For example, if your account value is $10,000 and you place a trade for 1 lot, you are in effect, leveraging yourself 10 to 1, which is a very significant level of leverage. Most professional money managers will leverage no more then 3 or 4 times. Trading in small increments with protective stops on your positions will allow one the opportunity to be successful in Forex trading.

· Emotions
Another and one of the biggest reasons for improper risk management are emotions. Fear, Hope and Greed one or all of them at a time can attack the human mind and it is very easy to miss out on your risk management strategy.

Defining Trading Range
A lot of people will advise you to trade using Stop and Limit. But the fact is you must know what range to use. Using wrong range can lead you to continuously change you trading style and you might end up loosing some of you strong analytical skills.

For defining better risk strategy for yourself, you must be aware of limitations of your trading style. You must know the limitations of market in that timeframe. This will enable you to define the trading range.

Few factors which are integral part of defining trading range for you are:
· How much do I believe the market will move and where do I want to take my profit? You must always able to define which level the currency heading to, so that you know which level to target and which level to exit. Always don’t try to capture all the expected range. Try to base your trade inside the expected trading range.

· How much am I willing to lose before I exit the position?
This is more of psychological questions more than anything. Stop Loss helps traders to control risk by capping losses. Stop Loss are counter measures and you don’t want them to be hit but they are there to keep the things going out of hand. They can easily prevent the account being ended in a single entry.

· Where should I place my stop and limit orders?
A trader should understand his/her trading style and must know how much loosing trades the account can take. This helps in adjusting loss and profit levels.

· Understanding drawbacks and adjusting to them
There will be number of times when you the market will just fill you stop and then moves in the direction of profit. You must stay consistent with you stops and never keep on changing them. Best way to define what stop suits you style best is trading through paper trading for some substantial time.

Also you must understand that you stop will be filled 5 pips quicker than the size of your stop and the profit will be filled 5 pips more than you Limit order. This is due to the difference between the buy and selling price.

Effective Risk Management Tips:
· Don’t Trade in uncertain markets
Always trade with the trend. There is a saying that “Trend is Friend”, so if you enter with the trend, there are always more chances of you trade coming out as a winning one. If you are not sure of the trend, just don’t trade. When in doubt, get out. Only trade when you feel confident about your trading strategies.

· Use Risk Money
Don’t trade with the money you cannot afford to loose. Always divide you total trading amount into risk money and backup amount. You must be aware how much you can loose.

· Increasing and decreasing the number of Lots
You must understand which level should be reached before increasing or decreasing you number of lots. Foe example, you might choose to trade 1 lot of each currency for every $10,000. You must wait before the account reaches that level before increasing the number of lots. It is common to keep on increasing number of lots with every winning trade which is not a good strategy because in case of loosing, all trades will go down and all the recent profit along with original equity can go out with that.

Similarly trades must understand that in case of loosing trades, they might left with low margin. They must adjust their number of lots accordingly because if they keep on using same number of lots, they are actually taking more risk. Don’t try to cover loss with taking more risk. A stable risk management will automatically allow a trader to recover from losses.

· Building Backup
Always build backup money. The more backup you have, the more effective trading gets. Increase in backup money basically increases the risk money and eventually affects the confidence level of the trader. Backup also helps in unexpected losses.

· Switching between trading style
Another important thing to remember is to switch between trading styles. Trader must know market conditions and fundamental news to choose between aggressive or normal trading style. Trader should be able to switch according to market conditions and must know when to go for trade aggressively and when to wait for trades which are based around more strong levels.

· Using Minimum Risk Factor
A simple thing is that more risk factor you eliminate, the chances of winning trades becomes that more. It is better not to enter a trade when you are not totally sure of the indicator. Trade more on strong support and resistance levels. Guessing key reversal points can be risky. Therefore, let the market tell you when it is over by a patterned reverse in direction.

· Being ready for unexpected
Always have backup for unexpected. There is always possibility of unexpected or very volatile moves. These moves are usually short duration, so one must have the capability both mentally and financially to survive the unexpected. If you are not ready for that then they really hurt and you can easily lose with what you are left.

· Trading in different Items
It is better not to put all you trades in single currency. The reason is that if you loose, you loose all. Widening your trading range can help you get hold on your trades and combination of them can provide your trading better support.

· Avoid undersized accounts
Try not to trade with undersized accounts. Remember there is always a recommended amount for each trading style which also includes backup money. So never trade with accounts that don’t have the right size because there will be more chances that you end up loosing all your money. The only way to make money is to use right sized accounts for better risk strategy.

· Always target positive Risk: Reward ratio
Always target a high reward and low risk. Avoid take small profits and large losses. If you trade excessively, 1:2 is suggested risk: reward ratio. It means that if you are taking 30 pip risk (stop), you must look for 60 pip profit.

· Never Let Profit Turn into Loss
Never turn a profit into a loss. If you are using a stop-loss order, then raise your stop-loss so as to lock in a profit. Most of the major brokers now have trailing stop facility, though each one differs from one another but you can always determine which trailing stop suits your style of trading.

· Keep Track Record of your trades
Always keep record of your trades, especially with comments regarding any mistakes you made or anything you learned from this trade or any observation you had.

The records will also allow you to analyze your strong and weak points, so that in future you can base more on strong points and try to cover or avoid weak points.

In the end, I would like to say, no matter how good you get, important of risk management remains the same. So if you are starting currency trading or not getting you trades right, these are few tools and tips to go through once.

Please feel free to contact me regarding any trading strategy or tool, or to share or discuss any trading thoughts.

Email: zeeshan@fortknoxtrading.com
Website: http://www.fortknoxtrading.com

The importance of risk diversification and process in FX trading

Date: May 11, 2005 14:00 GMT
Expert: Kenneth Stenberg, Partner/CIO at ACT Currency Partner AG
Topics:
- The importance of a portfolio approach to trading
- The importance of an investment process
- The importance of rules

Who is Kenneth Stenberg?
Kenneth Stenberg has been trading foreign exchange for over 25 years, first at international banks in Helsinki, London, Hong Kong and New York. Thereafter he embarked on a career in corporate treasury, managing proprietary trading units in Helsinki, Singapore and Zurich. He is presently Partner/CIO at ACT Currency Partner AG in Switzerland in charge of alpha and currency overlay programs. Mr Stenberg holds a Master of Science (Econ) degree and majored in finance.

Speech Material:

- The importance of a portfolio approach to trading
- The importance of an investment process
- The importance of rules

Having traded foreign exchange for profit professionally for many years I am always struck by the approach many people seem to have to risk taking in the forex markets. When they talk about trading they are actually talking about betting on one horse (currency) at a time. They look at a myriad of currencies and try to decide which one would provide the best risk adjusted return for the race ahead (trading day). It may well be that they have never before been betting on the particular currency pair before and have no knowledge of its particular behavioral characteristics before risking their money on it. Different currencies behave very differently as some are intrinsically more volatile than others and require a completely different approach to risk management.

I find that approach to trading a sure way to loose in the end as it is too much like gambling. The odds are always against you and although you will be winning some you will be loosing more and in the end you will be calling it quits.

In my opinion, trading should be much more like investing and the same rules apply to trading as they do to investing.

1.My first advice would be that you should spread your risk. We do not need to be experts in Portfolio Theory, to understand that a portfolio of assets is less subject to volatility than a single asset. This is true in spite of the fact that currencies correlate with each other. Of course, if you decide to trade exclusively in US-dollar against other currencies you will not have much benefit from risk diversification but if you trade in a few non-USD crosses and some USD crosses you will benefit from diversification. Foreign exchange is just like any other asset class in that respect. Betting on a single currency pair randomly is like playing roulette. Unless you can by some divine guidance always pick the right number you will not win in the long run. If you spread your risk and do it wisely you will have some winners and some losers which will allow you to stay in the game for much longer. How many currencies should you then trade? In my experience not more than 8 pairs simultaneously. More than that is difficult to analyse properly. The important thing is consistency. One should not try to pick different currencies every day as this will hinder from developing the all important feeling for the currency pair. One must learn the behavior of the currency one intends to take a position in. This cannot be done in a few weeks. It takes years to be able to consistently make profit in the FX market and a random approach will not work, in my opinion. Looking at the same currencies can be boring day out and day in but practice is what counts in FX trading too. This brings us to my second advice. Just like trying to win at roulette you need a structured process in order to stand a chance to win in the long run.

2.My second advice would be that you need a structured investment process with predefined rules. Why does one need this? The answer is because in any single trading day you will be bombarded by all kinds of information that distract you from rational decision making. You very easily let your emotions take over and start hoping that the market will turn or that your profit will become a little bit bigger yet. It is very useful to have roadmap for the trading day ahead before you enter the market. The map should include predefined entry and exit points for all the currencies that you trade in. With this I mean that not only should you have your stop-losses clear to yourself but also take profit levels. Predefined take profit levels are at least as important as stop-losses because by that you make sure that you do not consistently take profit too soon as this is very easy to do. It is only human. Pre-determined stop-losses and take profit levels allow you to keep your stop-losses closer to your entry points than your take profit levels. Whatever system/technique you use to analyse the markets and make trading decisions be sure to decide in advance what needs to be done and when. Just by letting the market decide for you takes away your independent thinking and leads to poor results. This leads me to the third topic.

3.Rules are very important in trading. A disciplined approach to trading is key to success. And that does not mean that there would not be room for creativity. It just means that we apply some common sense to our trading. Such simple rules are for instance that we always have a valid stop-loss in the market whenewer we have a position. And that we stick to that stop-loss and never change it unless it is done in a trailing fashion as our position moves more into the money. Or that we do not take profit randomly but follow our roadmap as explained above. One must have enormous patience sometimes in order not to take profit too soon. It is good to have rules that make sure that you stick it out. Other useful rules are for instance that you should never increase to an existing position on a Wednesday as this is often when the market sees either a top or bottom or that at times of Full Moon or New Moon one should trade with only limited risk as the chances for undesired volatility is elevated. There are of course an enormous variety of rules that can be applied to trading but the important thing is that you have them and stick to them. The term “style drift” is nowadays used to describe a situation where a given strategy is no longer adhered to and which gives cause for worry almost without exception. “Style drift” has nothing to do with strategy development which is a good process when it happens in a controlled manner but rather a development where rules are abandoned. It is in situations like these that some of the biggest losses have been made in the markets without mentioning any names or examples. We all know them only too well.

Fractal Dimension Index (FDI). What it is, how it works and how to trade with it

Date: May 10, 2005 14:00 GMT
Expert: Erik Long, President of Tetrahex and Principal of Ceres Capital LLC
Topics:
- What is?
- How it works?
- How to trade with it?

Who is Erik Long?
Erik Long has been active in the study of evolutionary feedback systems since his university days at UCLA and CSU from 1987-1992. After obtaining a Bachelors in Bio-Anthropology and Economics, Erik went on to study evolution of markets with the accomplished academic and entrepreneur Dr. Gerald Fecht and notable mathematician Dr. Viktor Fontaine. Erik founded Tetrahex in 1996 as a forum to discuss evolution, entropy, and later fractals in financial markets. In the process Tetrahex later formed into a corporation, offering it's services to private industry. In 1998 Erik studied for his Post Graduate Diploma in Economics at the University of London. Since that time Erik has developed proprietary trading systems for Altea Trading from 2000-2002. Erik has also consulted in non-linear methodologies for Nexbridge Inc., 2000-2002. Erik is one of the founding members of the System Select Group at Peregrine Financial Group, 2002-2004. Mr. Long became a founding principal of Ceres Capital LLC in 2004. Erik Long has been published in Futures magazine and Stocks & Commodities magazine. Mr. Long has been a sponsored member of the New York Academy of Sciences since 1997 and listed in Who'sWho in America since 2003. Erik is available for presentations on a case by case basis.

Speech Material:

Hello, this Q&A session is the second part of a series of discussions about fractal analysis. The April presentation was a broad overview of the Fractal Finance toolbox and some of the supporting trading applications. I also included a PowerPoint presentation about chaos and fractals that was prepared for the Cornerstone Investment Group. I have included it again in today’s Q&A for those of you that missed it last time.

While the last Q&A was more general, I have decided to make this one specific to an indicator that we have developed and used successfully in our trading. The name of the indicator is the Fractal Dimension Index (FDI). It is a measure of the fractal dimension of a time price chart or any data in a time series. This presentation is based on an article I wrote for the May, 2003 issue of Stocks & Commodities magazine. More information is available at http://www.fractalfinance.com and http://www.cerescapital.net

Introduction
Chaos is evident just about everywhere: in lightning, weather patterns, earthquakes, and financial markets. It may appear to be a random event, but it isn’t. In a nutshell, chaos is a nonlinear, dynamic system that appears to be random but is actually a higher form of order.

Social and natural systems, including private, governmental, and financial institutions all fall within this category. People design these complex systems only to find that these systems take on a life of their own. Each of the system networks is sustained by complex feedback loops that re-enter the system at unpredictable points in their cycles. These feedback loops create an illusion of randomness.

When we discuss Chaos theory and trading, we are trying to define an apparently random event in the marketplace that has some degree of predictability. In order to do this we need a tool that is a representation of order from chaos. The tool that we will use here is the fractal. The fractal is commonly defined as an object with self-similar individual parts. In the markets, a fractal can be thought of as an object or “time series” that appears similar across a range of scales. Markets look this way when you compare a 3 minute time scale to a 30 minute time scale to a 3 day time scale. Each frame may zigzag a little differently, but when viewed from afar they have similar attributes on each scale.

Almost all chaotic systems have a quantifying measurement known as a fractal dimension. The fractal dimension is a non-integer dimension that describes how an object takes up space. Objects in space (and the systems that create them) are infinitely complex. If you examine any object with a microscope, more detail is revealed as the scale changes. In addition to levels of detail, most objects in nature demonstrate self-similarity, the organizing principal of fractals. Because of this, fractals will maintain their dimension regardless of the scale used. This is evident in natural phenomena such as mountains, coastlines, clouds, hurricanes and lightning.

Similarity across scales is important in trading because each time frame of a market will have a similar fractal pattern. This also demonstrates that markets are natural phenomena rather than mechanical processes. As such, markets can only be forecasted reliably with principles applicable to nonlinear, natural systems. Fractal geometry is such a tool.

Fractal Dimension Index (FDI)
The fractal dimension index (FDI) is a tool that applies the principles of chaos theory and fractals. This specialized indicator identifies the fractal dimension of the market by using re-scaled range analysis and an estimated Hurst exponent. It does so by using all available data on the time/price chart to determine the “volatility” or “trends” of a given market.

FDI is the same type of tool used by eminent fractal scholars Benoit Mandelbrot, H.E. Hurst, and Edgar Peters in their examinations of time series analysis. With FDI you can determine the persistence or anti-persistence of any equity or commodity that you display in your graphing program. A persistent time series will result in a chart that is less jagged, subject to fewer reversals, and resembles a straight line. An anti-persistent time series will result in a chart that is more jagged and prone to more reversals. Essentially, FDI will tell you whether a market is a random, independent system or one with bias.

The famous mathematician Benoit Mandelbrot used the Hurst exponent to experiment with time series found in cotton prices. He developed a method to measure irregular natural objects and named the measurement the fractal dimension. Thus, the FDI is based on the work of Mandelbrot and Hurst.

To view the formula for the FDI, click the image to enlarge

Background
In order to trade with the FDI effectively, I think it is necessary to have some historical knowledge. I am going to borrow a passage from my article that imparts this rather well. If you are interested in further information I recommend reading Chaos and Order in the Capital Markets, by Edgar Peters.

The history of the FDI begins with British dam builder and hydrologist H.E. Hurst (1900–78). He worked on the Nile River Dam Project in the early 20th century. Hurst searched for patterns in the Nile Delta as an effort to solve a hydrological problem.

The problem involved the storage capacity of the dam reservoir. This is important to hydrologists because if the dam is too high, resources are wasted. If the dam is too low, water will overflow. To solve this problem, Hurst considered the relationship between annual rainfalls, the extremes of high/low water, and the reservoir’s level.

Most hydrologists assumed that water inflow was a random process with no underlying order. Hurst came to a different conclusion after studying almost a millennium of Nile overflows. He found that large overflows tend to be followed by larger overflows. There appeared to be cycles, but their lengths were non-periodic and standard statistical analysis revealed no patterns between observations.

Hurst developed his own analytical method to explain the non-periodic cycles. To identify a nonrandom process, he tested the Nile using Albert Einstein’s work on Brownian motion, a widely accepted model for a random walk. Einstein found that the distance a random particle travels increases with the square root of time used to measure it. This is called the T1/2 rule, and is commonly used in finance and economics.

Hurst divided the Nile data into segments and examined the logarithmic range and scale of each segment in comparison to the total number of segments. This process is called re-scaled range analysis. The range is re-scaled because it has a zero mean and is expressed in terms of local standard deviation.

The re-scaled range value scales with an increase in the time increment by a power-law value equal to H, or the Hurst exponent. Using re-scaled range analysis, Hurst showed that water overflows tended to repeat, meaning that the natural overflows were partially predictable.

The famous mathematician Benoit Mandelbrot used the Hurst exponent to experiment with time series found in cotton prices. He developed a method to measure irregular natural objects and named the measurement the fractal dimension. Thus, the FDI is based on the work of Mandelbrot and Hurst.

Trading with the FDI
Before explaining how to derive the FDI, I will first explain how to trade with it. The technique can be modified for individual traders, but there are some basics that you need to know. The FDI is useful because it determines the amount of market volatility. The easiest way to use this indicator is to understand that a value of 1.5 suggests the market is acting in a completely random fashion. As the market deviates from 1.5, the opportunity for earning profits is increased in proportion to the amount of deviation.

The entire scale is based on a range of 1 to 2, suggesting extreme linearity to extreme volatility. A great example that is often used to describe the fractal dimension is its use in geography. If you examine an island and plot the fractal dimension, you will be able to determine how jagged the edges of the island are for a particular measurement scale. An island with a 1.7 fractal dimension is highly jagged, with many more peaks and troughs on the periphery. An island with a fractal dimension of 1.3 is much more linear, approaching a single dimension or a straight line. If you examine this island on a map, the coastline will be straighter.

Applying the FDI to the market is similar to studying an island on a map. The price plot is analogous to the periphery of the island. The FDI indicator thus determines how close the price plot is to two dimensions (a plane) or one dimension (a line).

Because the price plot on your chart will never be one extreme or another, you need to measure the “fraction of the dimension.” This is why the FDI number is a fractal dimension. The further away this dimension is from 1.5, the more confident you can be that the market is not random. When a market is not random, it is more predictable. If the FDI is closer 2, the probability is higher that the next move will be in the opposite direction of the current move. An FDI closer to 1 signals a trending market in one direction.

This knowledge alone gives the trader an incredible advantage, because it can indicate which markets have the most opportunity. If trading a basket of Forex markets, futures or stocks we certainly do not want to include those markets near a 1.5 FDI. If none are close to 1.5 we can still determine the market(s) with the largest degree of “predictability” by omitting those closer to 1.5.

Another point to make about the FDI is the amount of historical data necessary for accurate readings. This is debatable and varies between researchers. Feder recommends 2000 or more data points I personally use 2000 and then use the V-statistic and a correlation function to estimate the amount of forward looking memory in the analysis. I then only use the data from the 2000 that is relative to the immediate future forecast.

I recommend the following for the neophyte:

1) Use 2000 data points.
2) Determine your trading style. If you are a range trader, only trade markets with a higher FDI. If you are a breakout trader, only trade markets with a low FDI. If you trade both, only trade markets with a high or low FDI.
3) Never trade markets near a 1.5 FDI.
4) When I say low FDI or high it is not necessarily a specific number (although you can do this). As an example, you may trade a Forex market with an FDI of 1.38 and notice that in the last 1000 data points the FDI is never higher than 1.43. Obviously all markets trend and range. So you will have to look at your chart and determine what an acceptable trend range FDI is or range trade FDI for this specific market. Remember that the FDI is also measuring the dimensionality of the market. In general a certain market may be trendy, but it still has range trade regions.
5) The same logic in #4 above applies to selecting markets. If I am a breakout trader, I am not going to trade a market with an FDI of 1.38 if two others are 1.29 and 1.26.
6) Rate of Change in FDI. I have created oscillators that measure the rate of change in the FDI. These have been very useful for entry and exit signals. The movement of the FDI is useful in itself.

These are some basic methods for trading the FDI. If you have other ideas, I would be happy to hear from you.

Click the image to enlarge

Note: This chart demonstrates the FDI in actual use. The indicator at the bottom is the FDI. Specifically the red line. The indicator above the FDI is a standard stochastic indicator. Notice that the FDI is in a steady decline prior to the run up in EURUSD price. This indicates an increasingly trendy market. Even though the price appears to be pulling back right now, I would stay long the contract until the FDI begins to climb.

Computing the FDI
Computing the FDI is not terribly complex. It can be programmed into a variety of trading platforms, including TradeStation, MetaStock, and CQG. To begin, you must compute the Hurst exponent. This can be derived with the formula displayed in the sidebar, “The fractal dimension.”

Once you have computed the Hurst exponent, you must derive the fractal dimension of the time series. This is easily accomplished using the formula D=2-H. I use “2” here because you are using two dimensions for this computation. The value of “D” is the fraction of a dimension between 1 and 2 that your price data represents. Logarithmic returns are used to compute FDI. Because logarithmic returns sum to cumulative returns, most analyst agree that this is most appropriate for financial analysis. Although you may substitute price data for logarithmic returns, this is not recommended.

When experimenting with the FDI, remember that a large data set is required. The results may appear distorted if there is not enough data. The question of how much data is enough is speculative at best and still debated.

Another postulate is the length of time necessary for each data period. Some researchers believe that shorter time periods, such as daily data, are subject to more noise from random information. If this is the case, FDI is less accurate with finer slices of sequential data. The individual length of each period will come into play as noise is filtered.

In terms of time frames for the chart, I believe that the trader must use his own best judgment. If you are trading a market with 1 minute charts and there is sporadic price movement then there is obviously too much market noise. Move up to something higher. If you are trading a market that never moves, then there is not enough liquidity, find another market. Note: Forex markets will not have time or liquidity issues as often as other markets. This is due to the size of the market itself.

In Summary
Ultimately, the FDI is a great way to filter markets and create trading strategies. This is a nonlinear tool that allows you to forecast market movement. Although it is not a directional indicator, I believe that you will find it is a great complement to them. It is also a leading indicator in contrast to other linear trend following indicators. If you have further questions, please feel free to contact me at elong@cerescapital.net.

Visual Content:

Click the image to view the Power Point: Chaos Theory and the Markets

Important Note: Take into account that the PowerPoint that will open by clicking the link is a large file and you may experience some difficulties when trying to open it.

Non-Farm Payrolls - What Really Happens

Date: May 5, 2005 14:00 GMT
Expert: Edward Ponsi, FXstreet.com FX Educator
Topics:
- Trading the NFP
- Analyzing the Data
- Future Implications

Who is Edward Ponsi?
Edward Ponsi has been recently appointed new FXstreet.com FX Educator and is the president of FXEducator LLC.

Speech Material:

Hello everybody, this is Ed Ponsi, currency trading instructor for FXEducator. It’s great to be here with you today. I’d just like to thank everyone who participated in our March seminars on FX Street, the response was unbelievable and I’d like to thank all of you who attended.

v Once again we are on the eve on the notorious U.S. Employment reports, which are usually released on the first Friday of every month. These reports have shown a tendency in recent years to create huge swings in the currency market, creating large gains and losses in traders’ accounts. Judging from the volume of email that I receive on this subject, one thing that is on everyone’s mind is the activity surrounding the U.S. Non Farm Payroll report. So, in the interest of keeping up with current events, let’s take a closer look at this subject, and try to shine a light on the activity that occurs around the time of this release.

The U.S. employment report is undoubtedly a volatile event, and brisk moves of several hundred pips are not uncommon at this time. The potential for fast, easy money is tempting to many traders. Like sailors who follow the song of the Sirens, they may be steering directly toward disaster.

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First, a little background about the report itself. What is it really? Every month, the US Bureau of Labor Statistics www.bls.gov compiles a series of reports that when combined give analysts and traders a snapshot of the US employment situation. The Non Farm Payroll report is just one piece of this puzzle.

The Establishment Survey measures the number of jobs created in establishments such as factories, mines, stores, and offices. It not only measures the total number of jobs created, (which is the number upon which everyone is focused), but also breaks those jobs down according to various segments, such as manufacturing, retail, construction, government, etc. Think of it as looking at the employment situation from the perspective of the employer.

The Household Survey is a separate survey that measures employment-related statistics, most notably the Civilian Unemployment Rate. For example, last month’s report surveyed 60,000 US households. Think of the Household Survey as looking at the employment situation from the perspective of the employee.

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What we can see on this slide are the jobs created according to the Establishment Survey’s monthly Non Farm Payroll figure, represented by the bars rising on the screen. The results for March, released last month, show that only 110K jobs were created during the month, well below analysts’ estimates of about 225K and a sharp drop from February’s number, which was revised lower to 243K from 262K. Over the past year or so, analysts have had a very difficult time predicting this number with any degree of accuracy.

The descending line represents the Household Survey’s Unemployment Rate. March’s result of 5.2% (actually 5.17%) was stronger than the expected result of 5.3% and also stronger than February’s figure of 5.4%. What this is telling us is that the pool of available labor is shrinking at a faster than expected pace. In fact, we can see that according to last month’s report, the pool of available labor (represented by the descending red line on Image 2) is now at its lowest point in several years.

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Now, what happens when the pool of workers shrinks? Well, employers begin to chant the old mantra “good help is hard to find” because in fact, good help does indeed become harder to find when the pool of available workers shrinks. In order to obtain or keep quality workers, employers must now pay higher wages. Image 3 shows the inverse relationship between the unemployment rate and hourly earnings. Clearly, when the unemployment rate falls, hourly earnings rise. This “wage inflation” can potentially increase the cost of creating, manufacturing, and distributing products.

Now consider this for a moment; the information contained in the Establishment Survey and the Household Survey, including all of the components or sub-numbers contained within them, along with statistics relating to Hourly Earnings and the Average Workweek, are all released simultaneously. And in addition to all of that, revisions of the previous month’s statistics are also released at the same time. In other words, a tremendous amount of information is being dumped on the market all at once, so there is a lot more going on than just a simple headline number for the jobs report. This confluence of statistics occurs on the first Friday of every month

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The market whips around wildly while trying to digest all of this information, which explains these frantic fluctuations in exchange rates that we see whenever this report is released. Take last month for example; the NFP ‘headline’ number was 110,000, obviously much worse than expected. Weaker jobs creation means that the economy is not as strong as anticipated. Image 4 shows a five-minute chart of EURUSD on April 1, 2005, as the market reacts to the employment reports. The knee-jerk reaction is to sell the USD, and the greenback was sold off pretty hard too, as EURUSD gained 100 pips in just a few minutes. As you may know, since the US dollar is the ‘counter or quote’ currency in the EURUSD currency pair, this pair rises as the dollar weakens.

But what about the implications of the Unemployment Rate? Remember we said that a shrinking pool of laborers makes good workers hard to find, and forces employers to pay top dollar if they want high-quality employees. This can potentially lead to inflation, if the higher cost of this labor is passed on to consumers. It also leads to inflation as the extra money that is now in the pockets of these employees leads to greater spending. One way that the U.S. Federal Open Market Committee keeps inflation in check is by raising interest rates. Remember, last month Alan Greenspan and company warned us about inflation and hinted that U.S. rates may begin to rise more quickly.

If the pace of interest rates hikes begins to increase, that would be considered positive for the US Dollar because higher interest rates act like a magnet, pulling capital in from around the globe. For example, higher yields on US Treasuries make them a more attractive investment to overseas buyers. These investors must exchange their domestic currency for US Dollars, which will then be used to purchase US Treasuries. If many investors repeat this process of exchanging their domestic currencies for the US dollar, that demand causes the greenback to strengthen.

Taking this into consideration, traders changed their minds and decided they wanted to be long, not short, the US Dollar. In response, the EURUSD pair plunged nearly 200 pips.

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This type of market reaction to the Employment report is not unusual. Here we can see the reaction to the February Non Farm Payroll and related reports. We can see that on the five-minute chart, within the first candle the pair makes a wild round-trip before trending higher for the remainder of the morning. I wonder how many traders had their stops hit within that first five minutes.

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Here’s the reaction to January’s report. The point is, Non Farm Payrolls is an unpredictable and dangerous event, and traders should approach it with extreme caution.

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Even institutional traders and hedge funds move to the sidelines before this information is released. Image 7 shows an hourly chart of the EUR/USD pair just before the April 1 employment report. In the hours leading up to the release of the report, the Bollinger bands squeeze together, indicating that volatility has fallen. This is because so many traders have moved to the sidelines. Not just individual traders, but institutions, banks, and hedge funds as well.

Another factor to take into consideration is the possibility of pent-up demand. Consider that large institutional traders (like banks and hedge funds) rarely enter a position all at once; instead, they build positions gradually. Imagine that an institution is slowly building a huge short position in the U.S. dollar. Let’s assume that the U.S. Non-Farm Payroll report is scheduled for release in a few days. Since this report often creates major swings in the market, the institution temporarily stops adding to its position, just in case an overwhelmingly positive report is released. This institution (and perhaps others) still wants to short the USD. If the numbers are released and the result is not overwhelmingly positive, but close to expectations, these institutions resume what they had been doing all along, and short the dollar. This is one reason why currencies can strengthen or weaken in response to a seemingly benign report.

A key error that many inexperienced traders make is to place a trade based on analysts’ estimates before an economic indicator is released. Let me give you an example. Suppose that consensus estimates call for U.S. Non-Farm Payrolls to increase by 200,000. A trader decides to go long the USD before the actual report is released, because the creation of 200,000 new jobs would be good news for the U.S. economy. When Friday comes, the report is released and it turns out the estimates were correct, 200,000 new jobs were created. In response, the market does nothing. This is because the market already assumed the result of 200,000 jobs; it was the consensus estimate. “But Ed”, says the student, “200,000 new jobs! That’s good news for the economy, right?” Maybe so, but since the 200,000 figure was already “priced in”, there is no market reaction. If the number had been much higher or lower than the estimates, then the market would move as it quickly “prices in” the new information.

Sadly, there will be traders who will sustain heavy losses upon the release of this report. As we can see from these charts, the reports usually ignite a big move in the market, but that move doesn’t usually take the form of a straight-line directional move. Instead, we see the exchange rates often swing wildly and unpredictably from one direction to the other; wreaking havoc with stops and limit orders. Because of the unpredictable nature of this event, most market makers will not guarantee stop and limit orders in the time immediately before or after this release. This means that Forex traders who attempt to trade this event are doing so without one of their greatest edges, the price certainty and ability to define their risk. It also means that they are risking everything on the trade, since they cannot be certain that their stop will be filled, and before the day is over some traders will seriously damage their accounts.

Conspiracy Theory
I have received a few emails suggesting that the action surrounding the Non Farm Payroll report is “rigged”, and that market participants conspire to create the wild swings in exchange rates. While I do try to approach the subject with an open mind, I’d like to point out the Forex market is very different from the equities markets. For example, I received one recent question (referencing last month’s NFP report) that asked, “Ed, don’t you think the banks ran the price up and then brought it back down?” I can understand the reasoning behind this belief, because experienced equities traders are very familiar with the concept of market manipulation. In the stock market, it’s not unheard of for major market players to team up and push an illiquid stock either higher or lower. However, this is usually done in low-volume, low-liquidity situations where anyone with significant buying or selling power has the ability to move an illiquid stock. The high liquidity of the currency market, coupled with the high volume of orders at the time of the release of the employment reports, make this the worst possible situation in which to attempt any form of market manipulation.

What actually happens in the currency market at the time of the employment release has more in common with a Marx Brothers film than a Machiavellian conspiracy. Remember, there is a ton of information hitting the market all at once, and for a brief moment everyone is in the same situation – nobody knows what to do! The market makers are often as lost as the traders; remember, market makers derive their quotes from the major participants in the Interbank market, the world’s biggest banks. Some of these Interbank dealers have been known to actually stop quoting exchange rates at the time of the release, because they simply see no advantage in buying or selling currencies at a moment of mass confusion. Of course this only creates additional chaos, as the market makers are now momentarily blinded, with no guide to follow regarding Interbank quotes.

So what is a trader to do when confronted with a situation where the market is likely to make wild, unpredictable swings? How should he or she deal with the fact that one of the greatest edges in all of trading, the guaranteed stop/limit order, will not be available at this time?

Every trader has their own style and their own way of dealing with the market, but it’s undeniable that an important part of trading is to understand when to trade and when not to trade. Some traders deal with the Non Farm Payroll number by avoiding it completely. Think about it, if you’re a good trader and confident in your abilities, would you really want to risk everything on a random event? Consider this, if the market’s reaction to this event were a linear move in one direction, your chance of success would be about fifty-fifty. In other words, you would either win big or lose big; but what we have shown here today is that the recent reactions to this event do not tend to be linear. Instead we see unpredictable gyrations in exchange rates, occurring at a point in time when the trader may have difficulty entering or exiting positions.

I never forgot a saying that a trader friend once said to me; “An amateur is concerned with how much he can make; a professional is concerned with how much he can lose.” I’m certain that for every person that brags about how much they made on the NFP report, there will be at least one who quietly surveys the wreckage of his or her account. Keep in mind that the decision to trade or not trade at the appropriate time is a choice that requires discipline and can having a dramatic impact on your trading future.