Chapter 11

Rocking and Rolling: Speculating with Currencies

In This Chapter

bullet Exploring foreign exchange rates

bullet Trading the spot market

bullet Weighing in on the U.S. dollar index

bullet Trading the euro, pound, yen, and Swiss franc

bullet Maintaining your sanity in a 24-hour-a-day market

In a global economy, investors have come to realize that stocks and bonds are not the only games in town. Currencies are among the fastest growing segments of the capital markets.

Aside from the currency futures, foreign currencies trade in a busy spot market. In fact, explaining how much of the action in currencies takes place in the spot market takes up a good portion of this chapter.

The major goals of this chapter are to introduce you to the currency market, provide a broad overview of the important role it plays in forging relationships between other markets, and give you a good sound base from which to expand your foreign exchange (or as it’s known in the business, forex) activities.

My first experience in the currency markets was with trading the U.S. dollar index. I broke all the rules and lost some money, but I discovered some valuable lessons that have enabled me to make some profitable trades since then.

These days, because of time commitments and a general distaste for volatility, I still trade currencies, but I do so by using mutual funds and exchange-traded funds (ETFs). On my Web site, www.joe-duarte.com, I provide recommendations on both for my subscribers. This is a nice development in the evolution of trading that enables me to participate in a market that I truly love while not having to suffer the hair-raising action that can go along with directly trading currencies and currency futures. That doesn’t mean you should fool yourself into thinking that by using ETFs and mutual funds you can stop being careful and vigilant. These trading vehicles can be just as treacherous as the real currencies if you’re not on the ball.

If participating in the currency markets indirectly sounds like your cup of tea, be sure to check out the currency mutual-fund timing system that I explain on my Web site, or check out Chapter 5, where I discuss trading futures and currencies by using ETFs. In this chapter, I deal mostly with the straight skinny on trading currencies.

Understanding Foreign Exchange Rates

Internal and external factors influence foreign exchange rates. Internal factors can be determined by something as simple as whether a country has specific controls or limits on its currency. The most current example of a controlled currency is the Chinese yuan, which the Chinese government maintains in a narrow trading band. This has changed some since the Chinese government began loosening the trading band on the yuan in July of 2005 by removing the currency’s peg (link) the U.S. dollar.

Other global currencies, especially the ones coming from emerging markets and less developed countries, also are controlled by their respective governments. External factors deal mostly with trade issues (disputes) or the market’s perception of the political and economic situation in a given country. Of course, wars and natural disasters also qualify as potential market-moving events.

The most important influences on currency values are

bullet Interest rates: As a rule, higher interest rates lead to higher currency prices.

bullet Inflation rates: Higher inflation tends to lead to a weaker currency. This general rule doesn’t apply when the rate of inflation is leading a country’s central bank to raise interest rates. In that case, despite higher inflation, the markets are likely to bid up that country’s currency as they expect interest rates there to continue to rise.

bullet Current account status: Countries that tend to export more than they import tend to have stronger currencies than countries that import more than they export. This relationship is soft, however, because some countries, such as Japan, purposely keep their respective currencies weak by selling them in the open market just to keep their exports high. These countries don’t export their currencies; instead, their central banks sell them into the open market by making trades just like any other trading desk. The net effect is to increase the amount of a country’s currency that is floating in the markets, thus decreasing its value to indirectly affect the balance of trade.

bullet Budget status: Countries with budget surpluses, again, as a general rule, tend to have stronger currencies than countries with budget deficits. This rule also is soft, because it doesn’t hold up all the time. For example, the United States has chronic budget and current-account deficits, but the U.S. dollar experiences long rallies in which its strength is quite impressive.

bullet Political stability: Along with interest rates and economic fundamentals, politics are more than likely the most consistent determinants of the exchange rates that are quoted on a regular basis. Despite a fairly strong economy, an otherwise strong dollar during the Clinton administration suffered during the Monica Lewinsky scandal.

bullet Foreign policy: The U.S. dollar’s status as the world’s reserve currency was damaged by the war in Iraq. In fact, the dollar was already weakening before the war started as traders feared Bush administration policies, such as lower taxes and the potential for increased government. The 9/11 attacks, with their negative effects on the U.S. economy and the spiraling costs of the war indeed led to a series of U.S. budget deficits, and the dollar continued to weaken into 2008.

Exploring Basic Spot-Market Trading

The spot market is where most of the currency trading is done. It’s operated nearly exclusively by large banks and corporations. Here’s the lowdown on the basics of the spot market:

bullet Trades on the spot market are made continuously Monday through Friday, starting in New Zealand and following the sun to Sydney, Tokyo, Hong Kong, Singapore, Bahrain, Frankfurt, Geneva, Zurich, Paris, London, New York, Chicago, and Los Angeles before starting again.

bullet When big banks and institutions trade currencies on the spot market, they are usually exchanging your currency with another individual party. Both parties usually know and recognize each other.

bullet One third of foreign exchange transactions in the world are done on an over-the-counter basis in the spot forex market, with no exchange being involved. Over-the-counter trades are made directly between two individuals or institutions, usually by phone.

bullet The interbank market, where most of the transactions in the spot market take place between banks and corporations, is a network of banks that serve as intermediaries or market makers or wholesalers. Participants buy and sell currencies in the interbank markets, where trades are settled within two days. The two-day settlement is fair to both parties, allowing plenty of time for money to change hands, considering the amount of time it sometimes takes to gather large sums together in one place.

bullet The retail market is where the rest of the currency transactions take place. Individual traders conduct these trades over the phone and via the Internet by using brokers as intermediaries. Settlement on the retail market is defined as the transaction day plus one day.

Dabbling in da forex lingo

Like anything else in life, foreign exchange (forex) has its own language, and your currency trading skills grow faster when you get the terms right early on; that is, before risking your money-making trades in this volatile but mostly sensible market.

Foreign exchange transactions are exchanges between two pairings of currencies, with each currency having its own International Standardization Organization (ISO) code. The ISO code identifies the country and its currency, using three letters. The pairing uses the ISO codes for each participating currency. For example, USD/GBP pairs the U.S. dollar and the British pound. In this case, the dollar is the base currency, and the pound is the secondary currency. Displayed the other way, GBP/USD, the pound is the base currency, and the dollar is secondary.

My favorite thing about currencies is the pip, the smallest move any currency can make. It means the same thing as a tick for other futures and asset classes. Incidentally, whether Gladys Knight trades currencies anywhere, with or without The Pips, remains unknown.

The four major currency pairings are

bullet EUR/USD = euro/U.S. dollar

bullet GBP/USD = British pound sterling/U.S. dollar (also known as cable from the days when a Trans-Atlantic cable was used to coordinate and communicate exchange rates between the dollar and the pound)

bullet USD/JPY = U.S. dollar/Japanese yen

bullet USD/CHF = U.S. dollar/Swiss franc

When you read an exchange rate that’s quoted on a screen, you’re reading how much of one currency can be exchanged for another. If you see GBP/USD = 1.7550, that means you can exchange one British pound for 1.7550 dollars. The base currency is the pound; it’s the one that you’re either buying or selling.

When you trade currencies, you are, in effect, buying one currency and simultaneously selling another, or vice versa.

When you view a trading screen, you see a frame with two prices. One side is marked “sell” and gives you the selling price, and the other side is marked “buy” and gives you the buying price. If you want to sell, you click on the sell side. If you want to buy, you click on the buy side. To reverse or close out your trade, you do the opposite of your current position.

Currency on the spot market is bought and sold in groups made up of 100,000 units of the base currency. On the spot market, buyer and seller are required to deposit a margin, which usually is 1 to 5 percent of the entire value of the trade. In other words, if you buy 100,000 GBP/USD at 1.7550, you put down the appropriate margin in dollars, while the seller of sterling, who is buying your dollars, reciprocates by putting down an appropriate margin in sterling.

Location, location, location

Some special currency trading issues are dependent upon where your dealer is located. If you’re trading in the spot market and your dealer is in the United States, you deposit your margin in dollars. If, however, you’re trading through a foreign dealer or using a currency other than the one required by the broker, you have to convert your capital and margin requirements to the currency of the foreign dealer. Each situation is different, but you need to check out all the variables before making any trades.

Here’s how it works: If you’re trading the USD/JPY (U.S. dollar/Japanese yen) pair, the value of your trade will be calculated in yen, JPY. If your broker uses the dollar as his home currency, then your profits and losses in this trade are converted back to dollars at the relevant USD/JPY offer rate.

Although trading currencies may seem confusing, you can work it out by carefully studying exchange rates and doing some practice trades. Most online currency dealers will enable you to open a practice account so that many of the nuances of trading currencies become self-evident with practice.

Don’t get cross over crossrates

Crossrates are the exchange rates between non-U.S. dollar currency pairings. Andy Shearman of Trader House Network, www.traderhouseglobal.net, offers a nice example of how crosses work, as well as other tutorials that you may find helpful. An adaptation of his example follows to show the cross between the pound sterling and the Swiss franc. Say your trading screen shows the following crossrates:

bullet EUR/USD = 1.0060/65

bullet GBP/USD = 1.5847/52

bullet USD/JPY = 120.25/30

bullet USD/CHF = 1.4554/59

These four pairings are key crossrates. For example, the GBP/USD pairing is the bid (1.5847) and ask (1.5852) price for the British pound sterling and the U.S. dollar exchange rate at the moment. The difference between them, 0.0005, is the spread, which amounts to the commission that the dealer collects.

So to calculate the GBP/CHF (British pound for Swiss franc) crossrate, do the following:

1. Find the GBP/USD exchange rate.

Bid: 1.5847 Offer (ask): 1.5852

2. Find the USD/CHF exchange rate.

Bid: 1.4554 Offer: 1.4559

3. Multiply the bid amount for the GBP/USD exchange rate by the bid amount for the USD/CHF exchange rate, and then do the same with the offer amounts.

1.5847 × 1.4554 = 2.3063 and 1.5852 × 1.4559 = 2.3079

4. Jot down the answers.

GBP/CHF = 2.3063/2.3079

The calculations work for all currencies if you follow these steps. Foreign exchange quotation services and trading software also give you the amounts, perhaps a little quicker.

Electronic spot trading

Aside from traditional phone-based trading, you can trade currencies in the spot market electronically, but you need to be prepared to sit in front of your screen and manage your trade actively. Otherwise, you risk losing large sums rapidly.

You also need to know that you’ll pay more for trading currencies in the spot market than the pros do. That’s because you’re a little guy, and they’re not. That’s the way of the world, and you need to know that before you get into trading anything.

Something else to keep in mind is that some foreign-currency Web sites and brokers will tell you that trading on their site is commission free. That isn’t true. They do collect a fee that amounts to the spread between the bid and ask prices on the currency quotes. If you keep that in mind, you’ll save yourself a lot of grief, and you can get on with trading.

Getting your charts together before you trade

In order to trade forex, you need a good command of technical analysis. You can apply the principles of technical analysis that I discuss in Chapter 7, because the same general principles and indicators apply to foreign exchange rates.

Some particulars about forex that you need to keep in mind are that currencies tend to trend for a long time, usually months to even years. However, within the major long-term trends (see Figure 11-1), counter-trend moves usually occur, and a large degree of intraday volatility is common. Some other factors common to long-term currency trends like the one shown in Figure 11-1 include

bullet Long-term bull (and bear) markets can last for years. The bull market for the euro shown in Figure 11-1 lasted at least eight years. Yet, there are pauses and changes in the trend that often fool you into thinking that the long term trend has ended. Figure 11-2 enlarges and displays two periods in the multiyear bull market that are classic examples of how long term bull markets can behave and how indicators can help you make better trades.

bullet Trend lines are especially useful. In Figure 11-1, you can see the very big picture of the euro’s bull market. The three trend lines demarcate the three stages of the bull market until 2008. The first trend line (up trending) shows the first multiyear run up in the euro, from 2001, after 9/11, until 2005. The break below the uptrend line was a signal that the market had entered a correction. The second trend line (down trending) covers the period of the correction that started with the double top in 2004 and lasted until 2006, when the downtrend line was broken and the next leg in the bull market started.

bullet Trend indicators work well in the currency markets. Note the intermediate-term tops (Figure 11-2) marked by the Relative Strength Indicator (RSI stands for loss of momentum) and its nice correlation with the MACD oscillator (MACD means change of trend). See Chapter 7 for more about oscillators.

Likewise, note how the double-top failure marked on the chart corresponds with the failure in the RSI and the break below the zero line on the MACD. A momentum failure, coupled with major breaks in the trend indicators and a break below a four-year rising trend line, was a clear sell signal that a change in the up-trend was coming.

Figure 11-1: The multiyear bull market in the Euro.

Figure 11-1: The multiyear bull market in the Euro.

Figure 11-2: Intermediate-term tops marked by RSI.

 Figure 11-2: Intermediate-term tops marked by RSI.

Using long-term charts to track currencies is a great way to trade forex instruments. The long-term charts are your guides to the prevailing trend. However, within a long-term trend, you can find significant counter-trend ebb and flow, during which you can trade against the long-term trend by

bullet Going long, or buying when the long-term chart is pointing up

bullet Looking for opportunities to go short when the long-term trend is down

bullet Using shorter-term charts to guide your shorter-term trades, both long and short

Counter-trend moves are an ever-present part of the market that require adjustment. As such, you always need to keep the long-term trend in mind so you don’t grow too comfortable trading in the wrong direction, or counter to the long-term trend line.

When a currency breaks below a long-rising trend line, you must consider that the long-term trend has changed direction. The trend may not change every time this situation occurs. In fact, some markets return to the original trend soon after a break. A counter-trend rally is another possible trading scenario. In a counter-trend rally, the market remains in a long-term up- or downtrend, but trades in the opposite direction for a short to intermediate period of time that can last for days, weeks, or even months before returning to the long-term trend.

You can see a counter-trend rally in Figure 11-3, which shows a one-year chart of the euro that focuses on the period of trading labeled double top, pictured in Figure 11-1.

Figure 11-3: This chart shows a perfect example of how a counter-trend rally materializes.

 Figure 11-3: This chart shows a perfect example of how a counter-trend rally materializes.

The vertical line in the middle of the chart connects these three key points:

bullet The reversal of the euro

bullet A bottom in the RSI indicator

bullet A bottom in the MACD indicator

Long-term charts are best used for keeping an eye on the big picture. When you see something that looks small on a long-term chart, use a short-term chart to magnify the time frame. Figure 11-2 magnifies the double-top and momentum failure in Figure 11-1, and Figure 11-3 highlights the counter-trend rally that occurred as the double top was forming. When you look at the shorter-term chart, the momentum failure looks much clearer, and your decision making therefore is enhanced.

Take your long-term charts seriously, but remain flexible. If you’ve been trading in a certain direction for weeks or months, you’re bound to get a fairly good reversal. Any reversal can be big enough to change the long-term trend, so you can play every reversal as one that may be the big one. Figures 11-1 through 11-3 show how the currency markets can have fairly long-term moves in either direction, up or down, even though the dominant trend remains constant.

Keep your time frames in perspective. Intraday charts are useful for short-term trading. What looks like a major trend reversal on a three-day chart using 15-minute candlesticks may not amount to much in the big picture. But it’s enough of a shift for you to use your short-term strategy.

Understanding the nuances of each individual currency is also important. For example, as well described in Currency Trading For Dummies by Mark Galant (Wiley), the trading patterns in the British pound and the Swiss franc are different than those of the euro and the U.S. dollar. So as you get more advanced in your trading, you can begin to factor in the specifics of each individual currency and how they can affect your trading.

Setting up your trading rig

Currency trading is heavy metal. So like heavy-metal bands, you need some serious hardware and software to keep your shirt on and your trousers dry.

Top on that list of needs is an electronic brokerage service that enables you to do straight through processing (STP), where you trade directly with the dealer through your computer by using integrated quotations and transactional and administrative functionality. You can gain access to STP through your online broker, and you can gain access to a decent system through many online brokerage-services providers. You can find other online brokerages that offer STP by using your favorite online search engine.

You need to evaluate different brokers before deciding on one. A good electronic brokerage service gives you access to live, streaming data and enables you to make direct trades through your broker’s Web site.

Most online brokers offer plenty of free goodies that you can look at to get a feel for how the forex markets work. They also offer free real-time quotes and a good basic charting service that you can use. Here are a couple of good ones:

bullet Electronic Brokering Services (EBS) at www.icap.com

bullet Nostradamus at www.nostradamus.co.uk

I also maintain a good Web page with currency information on my Web site’s directory: www.joe-duarte.com/free/directory/software-forex.asp.

Here are some other essentials for forex trading:

bullet A reliable margin account broker. For details on margin and how to choose a broker, see Chapters 3, 4, and 17.

bullet A fast and reliable Internet connection. You need a good, reliable, broadband connection with your computer terminal dedicated to trading — not instant messaging for your teenager or educational stuff for your homeschooler.

bullet A big-time computer system on which you can run several big programs at the same time without crashing. You need as much memory and storage as you can muster. A gigabyte of RAM (random access memory) is a good start, but if you’re going to run multiple monitors, you may need more, plus the setup for it. You need a good printer for printing your statements and a good backup system. If you plan to take a break and keep a position open, a good Wi-Fi setup for a laptop is a good idea. You also need all the security — antivirus, firewall, and spyware protection — that you can muster to keep your personal data from being stolen.

bullet Good trading software on which you can open and manage positions and conduct big-time technical analysis.

bullet Separate computer monitors so you can

• Handle market data

• Submit dealing instructions

• Look at charts and indicators all at once to keep tabs on all your open positions

• Adjust your stops and place other orders

• Keep an eye on how much money you have in your margin account

Two screens is a good number to get you started, but some traders may need more, especially when they trade more than one market at a time.

Using the right orders for your forex trading goals

You can use market orders when trading forex futures and other instruments, but because the forex markets move so fast, you need to set some automatic exit and entry points to manage your risk as part of your armaments.

A stop loss is the same kind of order in all markets: It gets you out either at your specified price or the closest possible price depending on market conditions. Same thing’s true of a limit order, which you use to set your entry point at a predetermined price.

Some other useful orders for the forex market include

bullet Take profit orders (TPO): A TPO enables you to get out of your position at a price that you target before you enter the trade. This kind of order specifies that a position needs to be closed out when the current exchange rate crosses a given or set threshold. You can set up a TPO above a long position and below a short position.

bullet One cancels the other (OCO) orders: An OCO is an order that has two parts; actually, it’s made up of two separate orders bundled into one package. An OCO is made up of a stop-loss order and a limit order at opposite ends of a spread. When one order is triggered, no matter which direction the market is trending, the other is terminated. In effect, you enter an entry point and protect your position by limiting your losses immediately. Here’s how the OCO works:

• Going long: If you’re going long in the market, you set the stop loss below the market spread and the limit-sell order above the market spread. If the base currency rate breaches the limit-order threshold, then your position automatically is sold at or near the price at which you set the limit, and you no longer need the stop loss, which then is canceled. Alternatively, if the rate falls to the stop-loss trigger price, the position is closed out at or near the trigger price and you no longer have any need for the limit order.

Going short: If you’re shorting the market, you set the stop loss above the market spread and the limit order below — just the opposite of the long position. If the exchange rate rises to the stop-loss trigger price, the position is closed out, thus canceling the limit order. If the exchange rate falls to the limit-order trigger price, the limit order is activated, you buy back the position at the predetermined limit-order price, and the stop-loss order is canceled.

Sampling the goods

Here’s a simple example of a trade in the spot market:

bullet Say you buy a 100,000 lot of GBP/USD at the offer price of $1.7550.

The trade is valued at a total of $175,500.

bullet You need to put your broker’s margin of 2 percent, or $3,510, in your margin account. You get that amount by multiplying 0.02 × $175,500.

bullet You profit when your trade goes well and the GPB/USD exchange rate rises to $1.760.

Your profit is $500, or 100,000 × (1.760 – 1.7550), or a 14 percent yield.

The U.S. Dollar Index

The Federal Reserve Board introduced the U.S. dollar index in March 2003. The index was the result of the Smithsonian Agreement, which repealed the Bretton Woods Agreement. What does that mean? The Bretton Woods agreement fixed global currency rates 25 years earlier. The Smithsonian agreement, which was viewed as a victory for proponents of free markets, enabled global currencies to float based on market forces.

The U.S. dollar index is used by traders to get the big picture of the overall trend of the dollar and is widely quoted in the press and on quote services. It is similar to the Fed’s dollar index, which is a trade-weighted index, meaning that the Fed gives value to each individual currency in the index based on how much it trades within the United States. However, the value of each index is different, and they shouldn’t be confused with one another.

The U.S. dollar index has traded as high as the 160s and as low as the 70s, with the Trader’s Index making a new low in early 2008, as shown in Figure 11-4.

Figure 11-4: The long-term bear market in the U.S. dollar index.

 Figure 11-4: The long-term bear market in the U.S. dollar index.

The U.S. dollar index trades on the Chicago Mercantile Exchange. Here are the particulars of the index:

bullet A minimum tick is 0.004 and is worth $5.

bullet Futures contracts expire in March, June, September, and December.

bullet The overall value of a contract is 1,000 times the value of the index in dollars.

bullet Delivery is physical, meaning that you receive dollars based on the value of the index on the second business day prior to the third Wednesday during the month of the expiring contract. On the last trading day, trading ceases at 10:16 a.m.

bullet Delivery day is the third Wednesday of the contract month.

bullet No trading limits are placed on the U.S. dollar index. Trading hours are from 8:05 a.m. to 3:00 p.m., with overnight trading from 7 to 10 p.m.

The U.S. dollar index was modified at the inception of the euro and is weighted in a way that’s similar to the Fed’s trade weighted index, as follows (expressed in percentages):

bullet Euro’s weight: 57.6 percent

bullet Japanese yen: 13.6 percent

bullet British pound: 11.9 percent

bullet Canadian dollar: 9.1 percent

bullet Swedish krona: 4.2 percent

bullet Swiss franc: 3.6 percent

The U.S. dollar index is best used as an indicator of trends in the currency markets.

The U.S. dollar index isn’t as good of a trading vehicle as the individual currencies. The best way to trade the index is by using currency mutual funds or exchange-traded funds (ETFs). To trade the dollar’s uptrend use the Powershares U.S. Dollar Bull ETF (UUP). For downtrends use the Powershares U.S. Dollar Bear ETF (UDN). The Profunds Rising Dollar Fund (RDPIX) and Falling Dollar Fund (FDPIX) are two mutual funds that follow the general trend of the dollar. As a rule, though, I prefer to trade the individual currency ETFs. See Chapter 5 or visit www.joe-duarte.com for more details on how to use ETFs to trade currencies.

I know this book isn’t about trading mutual funds or ETFs, but one of the secrets of trading success is understanding what kind of a person you are. If you’re overwhelmed by the big expensive trading rig you need to make any money in forex and upset (I know I am) because you can’t take a coffee or bathroom break for fear the market will move against you and in the blink of an eye you’ll end up with a margin call, then you need to consider using these funds. By using the funds, you are, in essence, taking away a good portion of the problems that you can face by directly trading currencies. The funds are priced only once a day. If you check the dollar index a few times during the day, then you have a pretty good idea as to how your fund is going to close that day.

Trading Foreign Currency

Trading currencies can be exciting and lucrative. For me, it’s a great market because of the way politics affect the trends. Elections, strikes, and sudden developments, both good and bad, can lead to significant trading profits — if you stand ready to trade.

Trading the euro against the dollar

The euro is a convenient currency because it encompasses the policies and the economic activity and political environment of a volatile but predictable part of the world — Europe.

France, Italy, and Germany, the largest members of the European Union (EU), normally operate under high budget deficits and tend to keep their interest rates more stable than the United States, where the free-market approach and a usually vigilant Federal Reserve make more frequent adjustments on interest rates. The general tendency of the Fed is to make the dollar trend for very long periods of time in one general direction.

Aside from the technical analysis, here are some general tendencies of the euro on which you need to keep tabs:

bullet The European Central Bank is almost fanatical about inflation, given Germany’s history of hyperinflation in the first half of the 20th century and the repercussions of that period, namely the rise of Hitler. That means that the European Central Bank raises interest rates more easily than it lowers them.

bullet The European Central Bank’s actions become important when all other factors are equal, meaning politics are equally stable or unstable in the United States and Europe, and the two economies are growing. For example, if the U.S. economy is slowing down, money slowly starts to drift away from the dollar. In the past, that meant money would move toward the Japanese yen; however, because the market knows that Japan’s central bank will sell yen, the default currency when the dollar weakens is often now the euro.

bullet The flip side is that the market often sells the euro during political problems in the region, especially when the European economy is slowing and the economy in the United Kingdom (UK), which often moves along with the U.S. economy, is showing signs of strength.

As usual, you want to closely monitor major currencies and the crossrates. It’s okay to form an opinion and have some expectations, but the final and only truth that should make you trade is what the charts are showing you. The direction that counts is the one in which the market is heading.

The UK pound sterling

The pound is active against the dollar and the euro, offering good opportunities to trade both pairs (GBP/USD and USD/GBP; see the section “Dabbling in da forex lingo,” earlier in this chapter). The United Kingdom is a pivotal nation because it bridges the economical, geographical, and ideological divide between the United States and Europe.

Economically, the United Kingdom is more free-market oriented than Europe, and it tends to share a more common set of views with the United States. At the same time, the United Kingdom can’t totally disassociate itself from Europe, given its history and its geography.

The upshot is a currency that is affected by politics at home and on the two continents to which its destiny is so closely related.

Because the United Kingdom is an oil producer, the pound can be affected more directly by oil prices than other currencies. The relationship between oil and the pound is fading, however, because production in the United Kingdom’s North Sea oil fields is steadily decreasing.

The Japanese yen

The Japanese yen is a manipulated currency, which basically means it is kept low artificially by the Japanese government.

The combination of low interest rates, the lasting economic effects from the bursting of the Japanese real-estate bubble, and the collapse of the stock market and the banking system in Japan have forced its government to keep the yen’s value low by selling it in the open market when it reaches a certain level.

The main purpose of maintaining a weak currency is to keep the Japanese export machinery operational. Over the long term, however, a weaker currency will continue to hurt Japan’s chance of achieving a lasting recovery.

The most useful time to trade the yen is when political and potential military problems are taking place in Asia. China’s rise as a global power can eventually lead to a major and uncontrolled weakening of the yen. The best way to trade the yen is not against the dollar but rather to use crossrate analysis, especially against the euro and the Swiss franc.

The Swiss franc

The Swiss franc is considered a reserve currency, or one that is reliable and tends to hold its value when others don’t. It also is a currency to which traders and other investors flow during times of global crisis. Its strength is based on three traditional expectations in the market:

bullet Reliable economic fundamentals: Switzerland has a history of low inflation and current account surpluses. It also is a country whose banking system is well known for holding the deposits of extremely wealthy and stable clients.

bullet Gold reserves: The Swiss franc still is backed by gold, because Switzerland’s gold reserves significantly exceed the amount of currency it has placed in circulation. Switzerland has the fourth largest holding of gold in the world. Relative to Gross Domestic Product (GDP), the level of international reserves — with or without gold — is far ahead of all other countries.

bullet Little political influence: Switzerland’s political neutrality enables it to set a monetary policy that operates (essentially) in a vacuum and thus enables its central bank to concentrate its effort on price stability. In December 1999, the Swiss National Bank changed the way it manages monetary policy, from one that traditionally targeted the money supply to one that targets inflation. The bank’s goal is a 2 percent annual inflation rate.

The two major factors to keep an eye on when trading the franc are

bullet Economic data: The franc can be affected by several key economic reports, including

• The release of Swiss M3, the broadest measure of money supply

• The release of Swiss CPI

• Unemployment data

• Balance of payments, GDP, and industrial production

bullet Crossrates: Changes in interest rates in the EU or the United Kingdom can alter crossrates and have an effect on the U.S. dollar. For example, if the euro or the pound rises and the Swiss franc weakens against them, the franc also is likely to move with regards to the dollar, thus offering traders like you three potential trading vehicles. The general tendency is for a sudden move in EUR/USD — which can be triggered by a major fundamental factor, such as an unexpected change in government, a terrorist attack, or a major economic release — to cause an equally sharp move in USD/CHF in the opposite direction.

The panic response

The Swiss franc often is a financial instrument of refuge for wealthy individuals, corporations, and traders. After the events of September 11, 2001, and the July 2005 bombings in the London Underground, the Swiss franc was the immediate beneficiary of the flight to quality trade, as traders acted on reflex, at least initially, and moved money toward traditional safe havens. The U.S. dollar used to be more of a safe haven prior to September 11, 2001, but that distinction has changed. The markets have adjusted their expectations based on the fact that even though no more major attacks have occurred in the United States, the United States nevertheless remains the primary target of Al-Qaeda. Whenever a major terrorist attack occurs, the markets always react as though the attack may be followed by a strike on the United States. Besides the Swiss franc, other safe havens include U.S. Treasury Bonds, U.S. Treasury Bills, and Eurodollars.

Arbitrage Opportunities and Sanity Requirements

The 24-hour trading day in spot currency markets — and its potential for activity whenever any major event occurs and develops — offers great opportunities for arbitrage, or trading both on the long and short side by using different currencies. Arbitrage is a sophisticated strategy that you can use when you become experienced at trading.

Here are some basic arbitrage rules to keep in mind:

bullet Currencies move in response to news events. Keeping a calendar of economic releases for Europe, the United States, the United Kingdom, Japan, and Switzerland is a good habit to get into. When a major economic release is outside the realm of expectations, currencies will move, and you can be poised in those situations to make large sums of money in short periods of time.

bullet Major events, such as September 11, 2001, hurricanes, and other natural disasters also make the currencies move. I’m not trying to be morbid, but trading on bad news is a fact of life. As a trader, you can make bad-news decisions that are profitable if you’re watching for them.

bullet Keep an eye on crossrates and bond markets. These areas move together, and they often move in opposite directions. After you become comfortable with currencies, you may want to consider setting up trades in interest-rate futures and currencies, which can serve as either a hedge or a profit-making opportunity.

bullet Research your opportunities in the options markets, and develop a program that includes options. Currency and interest-rate futures offer option opportunities. By using currency and/or interest-rate options, you can protect your currency positions at a fraction of the cost of owning the direct contract or lot.

bullet Use the hypothetical trading systems. Available on the Internet, you can use these Web tools to try different strategies or dissect new charting setups. ActionForex.com has some good demos. Get comfortable with the way the currency markets work first, however, before you risk any large sums of money.

bullet Beware of using mini accounts. Although mini accounts enable you to trade forex for $300 or less, such trades are a good way to get hurt, given the speed at which these markets can move. Instead, you need to be well capitalized before you make your move into this trading arena.

bullet Don’t give up your day job unless you’re a truly gifted trader. Most people are not gifted traders, and they need to use the currency markets only as part of an overall strategy to build wealth steadily and to protect their overall investment program and goals.

Don’t try to trade around the clock. Much of the action in currencies takes place overnight. Europe and Asian trading in currencies can be extremely powerful, and any open position that was profitable when you went to bed can be wiped out by morning. Use your stops wisely, and close out any positions that make you uncomfortable when you’re done for the day.