part0026

In my foreword to this book I made the statement that there are only two risks in trading. The risk on the trade itself, and the financial risk we are taking in opening any new position. Of these two, it is the risk on the trade itself that is the most difficult to quantify and assess, and this is what this book is all about. I do, of course, explain everything you need to understand about money management in a separate book, but the key to success as a forex trader, and indeed any other form of trading or investing, is to assess and quantify the risk you are taking in opening a new position. In other words is this a high risk trade, a medium risk trade or a low risk trade?

The methods and techniques you will learn here will help you to understand how the markets work and how you can can assess this risk for yourself, quickly and easily. And I do this using three distinct approaches, which although very different from one another, all connect together to provide a unified picture as a result. A three dimensional picture if you like, very different from the one dimensional approach most traders adopt.

One of the reasons many traders ultimately fail is they trade in a vacuum, with little or no knowledge of the broader markets or the linkages that exist between them. This myopic approach to trading may have worked in the past, but in the last few years, with financial markets in turmoil, the rule book has been torn up, as you will discover later.

The old trading methodologies and approaches no longer work. For example, the currency markets are no longer driven simply by interest rate differentials. They are highly politicised and manipulated as individual countries attempt to protect their own export markets by competitive devaluation. Moreover, quantitative easing has now entered the trading lexicon, with central banks happily printing money, further distorting the financial markets.

To succeed as a trader now requires a much deeper understanding of market behaviour, of market sentiment, of money flow, and risk appetite, which can be achieved using a trilateral approach.

These are the three strands of market analysis which when combined, provide the three dimensional view of the market, which few forex traders use. Without it, failure awaits. With it, trading becomes stress free, as each trading opportunity is based on a complete view of the market, the money flow, and consequent risk.

In many ways it can be likened to the three strands of a rope. Individually they are weak, but when combined, the strength of the rope is greater than the sum of its constituent parts. This provides the framework for any trading decision across multiple time frames.

The first is that every decision taken by every investor, trader or speculator, in every financial market everywhere in the world is about money. Nothing else – just money.

Does this sound like an obvious statement? Perhaps it is, but it is also the single reason most forex traders lose as they sit fixated on one currency chart wondering why the pair has moved against them.

Market prices are the result of the combined decision making by investors and speculators across all markets with two objectives in mind. Either to increase their wealth or to protect what they have.

When a market participant buys a high risk asset class, they are relinquishing liquidity in return for some future gain, and prepared to take on higher risk. On the other hand, when a market participant sells a high risk asset class, they are looking for a safe haven to protect their gain, and will consequently buy a low risk asset class as a result. However, once risk appetite returns, high risk assets will be bought again.

This is the cyclical process all markets follow minute by minute and day by day, as money flows from high risk to low risk assets and back again, all driven with one thing in mind. To maximise potential returns on that money.

Every asset class in every one of the financial markets has a different risk profile and as a result, market sentiment and risk appetite ebb and flow continually. It is this constant flow of money which drives the markets. Understand the money flow, and you begin to understand market behaviour in all its forms. Consider this simply analogy of risk appetite.

Suppose you are deciding whether to buy or rent a house. If house prices are falling or perhaps just flat, your decision might be to rent. Why? Because your risk tolerance is low. You are frightened house prices may fall further, so you decide to stay liquid, and not to invest your cash in bricks and mortar. Instead you might simply decide to invest somewhere safe, but with a low return.

However, as house prices start to rise, you may decide to buy. Why? Because your risk tolerance is higher. You feel prices are likely to continue rising and are therefore prepared to relinquish your current liquidity in return for a future, and better, gain. In other words, an increase in the capital value of your house.

So how does this simple analogy play out in the financial markets? In truth, very simply, through the four principle capital markets as follows:

So what is the risk profile of each of the above markets, and how does this help us to quantify risk and market sentiment? Let's start with bonds.

Bonds are generally considered to be a safe haven asset, and are the basic ingredient of the world's debt capital markets, which in turn are the cornerstone of the world's economy. In sheer size, the bond market dwarfs the forex market, and yet all we ever hear as forex traders is how large the currency exchange market is, and how many transactions are executed each day.

Yet the bond market is almost wholly ignored by forex traders. Why? Because it is perceived as complicated, full of jargon and probably not very relevant. However, here is a market of much greater size which gives you all the signals you need about risk, money flow and market sentiment, and yet it is ignored.

We all borrow money in a variety of different ways, and the bond market is structured in such a way as to allow all sorts of bodies, including countries, governments, municipal authorities and private companies, to borrow money for a variety of reasons. Let's take a simple example to see how the bond market works.

Suppose you need to borrow $10,000 for a new business venture, and you have a friend who is prepared to lend you the money. He has offered to lend this to you at 5% per annum on the life of the loan, which you have agreed is ten years, as he believes it is a low risk, guaranteed return. You are the issuer of an IOU, and your friend is the buyer of the IOU. In effect he is buying your debt, and relinquishing liquidity in return for a guaranteed safe and steady return.

Now to convert this into the language of bonds, what we have actually done is to issue a bond, often referred to as a 'note' of which the $10,000 is called the coupon, and the length of the loan is the bond's maturity, which in this case is ten years. So in the language of bonds, we have sold a ten year bond, with a coupon of $10,000. Our friend has bought the bond and lent you the money for your business venture.

This leads to the next question, which is why do people buy and sell bonds, and what does this tell us about money flow? And this is where we return to the word risk.

Bonds are generally perceived as a low risk investment. Therefore, if the money flow is into bonds, and away from other markets,clearly investors and speculators are nervous, and looking for a safer haven for their money. So, in general terms, bonds are a low risk asset class which will normally see inflows of money when markets are nervous. In addition, they are also the ultimate barometer of interest rates, inflation, public sector debt and economic growth, all key measures of the flow of money and currency exchange rates as a result.

But how do we analyse this huge market to help us in our trading? The answer is yield. This simple measure gives us all the clues and signals of market sentiment, risk appetite and consequent money flow. Yield tells us whether the market is buying or selling bonds and whether the yield is therefore rising or falling. Put this on a chart and you have all your analysis for bond markets, in exactly the same way as for any other instrument.

The final point concerning bonds is to recognise that whilst they are generally considered to be extremely safe, there are some bonds which are safer than others. And you don't have to go far back in history to find some glaring examples of bonds which would once have been considered risk free.

The European debt crisis is one such example, and continues to remain so. Bonds from certain member states have now been reduced to junk status, with the market only stabilising with the intervention of the ECB standing behind them as the lender of last resort. This would have been unthinkable, even a few years ago.

Even in the US, some of the municipal bonds are no longer considered to be quite as safe as before, as governments struggle under the weight of debt.

However, there is one class of bond which are still considered to be the ultimate safe haven, and these are US Treasury bonds. US Treasuries generally fall into three broad groups, namely Treasury bills or T-bills, Treasury notes and Treasury bonds. T-bills are those with a maturity of less than one year. Treasury notes are from one to ten years and Treasury bonds are more than ten years. Each will have its own yield curve that reveals market sentiment for the short, medium and longer term. This is the benchmark bond we will use when considering bond yields and what they can tell us as forex traders.

Just like bonds, commodities are generally ignored by the majority of forex traders, but for very different reasons. Bonds are ignored because they are considered to be complicated and confusing and of little value, an image I hope to shatter in this book.

Commodities, on the other hand, are ignored as they are seen as irrelevant. How wrong can you be, as in many ways they are even more important than bonds. As we will see later in the book, the relationship between bonds and commodities is one of the pivotal relationships in the financial markets. Why?

In simple terms, if bonds are purely about money and the cost of money, commodities markets are where real money is exchanged for real goods bought by real people to make real goods. In other words, the commodity markets play the central role of converting money into raw materials and in doing so, give us a clear insight into the fundamentals of world economics.

This relationship is the bridge if you like between the speculative world of paper based assets and the tangible world of real goods. It is the commodity markets that provide the pivotal insights into central bank policies, global economic growth and decline, currency flows and investor sentiment. A real world view where prices are largely dictated by supply and demand across continents.

Gold, of course, stands alone within the commodity sector as a unique constituent member, which is neither consumed nor used in any major industrial way, but is simply stockpiled in ever larger quantities. Its price has little to do with supply and demand, representing as it does, the ultimate safe haven hard asset and hedge against inflation. It is unique in every sense of the word, and we will look at the precious metal in detail.

Whilst commodity markets provide the real world bridge between money and goods, those same commodities in turn provide a bridge between commodities and individual currencies. A commodity based economy will sell its raw assets overseas in return for hard currency, which in turn is likely to be reflected in the currency itself.

Conversely, of course, an economy lacking in base commodities will need to import to maintain economic growth. A country such as Japan for example, has to import virtually all the base commodities such as oil, gas, and metals, a fact which is often seen in the CAD/JPY pair, which correlates relatively closely to crude oil.

All of these relationships will be explained and explored, but as a broad asset class, commodities are generally considered to be high risk, with the exception of gold. Finally, the one relationship with commodities that is pivotal, is the one with the US dollar. As all commodities are priced in US dollars, and money flows both in and out of the currency of first reserve, this is once again reflected in raw commodity prices.

The third of the four capital markets is probably one that is very familiar to you. If few forex traders ever consider the importance of bonds or commodities, fewer still look at equity markets, and the signals these markets convey. However, just like bonds and commodities, equities tell us a great deal, not least about risk appetite and market sentiment and, as you would expect, there is a strong relationship between equities and bonds. After all, equities are viewed as high risk, offering higher returns, whilst bonds are considered to be low risk with conservative returns.

As a result, there is a continuous flow of money between these two markets, with a consequent and related flow, both in and out of particular currencies and currency pairs. Equity markets provide us with a barometer of market sentiment, which in turn is reflected in the broader economy, and associated markets such as commodities.

A further facet to the relationship between currencies and equities is from an investing perspective. The best example of this is the relative strength of the Japanese yen and consequent flow into and out of the Nikkei 225. A weak yen usually results in inflows into Japanese shares from overseas investors, looking for better returns. This is a classic example of the linkages and relationships which exist at all levels and across the four capital markets, but which are rarely considered by most traders, or even investors.

First, it is the axis around which all the other markets revolve. Why? Because it is purely concerned with money and, as such, is the most liquid of all the markets. Currencies can be converted instantly – the flow is instant and immediate, allowing market participants to change direction in a flash, as risk sentiment changes on market news or economic data.

Every decision in every market, whether as an investor, speculator, government, bank or institution is about money, risk and return, which is why the forex market is the hub around which all the others rotate.

Second, it is the most complex of all four markets. Why? Because it is the market in which the central banks, governments and politicians all manipulate their home currency in one way or another, either for economic or political reasons.

Self preservation comes first in the forex market, and this aspect will continue to be a key element of price action over the next few years. The game changer for forex traders began in 2008 with the start of the financial meltdown. Since then, the rules have changed dramatically. No longer do currencies trade on simple interest rate differentials driven by inflation, growth and economic data. Now protectionist policies, market manipulation and artificial stimulus are all part of the mix.

Third, it is the only market where buying or selling of an instrument can take place against several other instruments. As mentioned in the foreword to the book, trading currencies is unlike any other. For example a bank or large hedge fund wishing to sell the US dollar can do so against a raft of other currencies using a variety of mechanisms to achieve this end. They will often do this, in order to mask their activities by constructing complex trading and hedging strategies.

Fourth, it is unique in the sense it cannot be 'pigeon holed' in terms of risk. The forex market covers every level of risk from high to low, with currencies such as the Yen and the Dollar representative of fiat based safe havens. It is truly representative of all the colours of the rainbow in terms of risk and risk appetite. This in turn is reflected in the buying or selling of particular currencies or currency pairs with consequent money flow, which brings us full circle to the other markets.

Finally, the foreign exchange market is entirely unregulated which presents opportunities for the unscrupulous, and problems for us as forex traders. With no central exchange there is no volume reporting, and as I will explain later, volume is one of the key indicators of market sentiment, whether in a cash market such as equities, or in an unregulated market such as the forex market.

Markets move on risk and sentiment, which is reflected in the consequent flow of money. No market trades in isolation, and all markets are inter connected via a variety of linkages. These linkages exist in all timeframes and can be seen on every price chart, and used effectively by all types of traders, whether as an intraday scalper, or a longer term swing or trend trader.

This relational view is underpinned by the fundamental and the technical elements, which complete the picture, and provides a three dimensional view of the risk on each and every trade.