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VII. FX Regulations
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Part I. What is the FX Market?
The Foreign Exchange market, also referred to as the Forex or FX market, is the largest market in the world with over $1.5 trillion changing hands daily and soon expected to top $2 trillion. Compare that to the New York Stock Exchange at $28 billion, the equities market at $191 billion, and the daily value of the futures market at $437.4 billion, and you will clearly see that the FX market alone is approximately three times the total amount of the US Equity and Treasury markets combined. affects our lives and our prosperity. The movement of different currencies between countries determines a very important price the exchange rate. It is the exchange rate that allows the currencies to be traded for profit. There are two major reasons to buy and sell currencies: 1) About 5% of daily turnover is from companies and governments that buy or sell products and services in foreign countries, then profits made are converted back into their domestic currency. 2) The other 95% is trading for profit or speculation, which translates to the tremendous profit- potential in this highly lucrative market. Trading for speculation in the FX market has increased tremendously throughout the years as institutions and individuals recognize the high profit potential in this highly lucrative market. Although speculative trading is increasing, not everyone involved in Forex is a speculator. Therefore, there is far less risk of manipulation within the FX market. Even in the case of central bank intervention, the overall effect on the FX market is relatively insignificant. Forex is a genuine market in which the prices of currencies are solely determined by the forces of supply and demand. As a result, all market participants, including individual traders, are well-protected from artificial manipulation of prices. Unfortunately, this protection for traders does not extend to other markets. In the equity market, everyone is a speculator, including individuals and corporations. When everyone is speculating for profit, manipulation of prices is inevitable. Consequently, traders in the equity market suffer immensely when prices are manipulated by various institutions. Until recently, large international banks dominated the FX market, only allowing access via telephone trading to major corporations, large funds, and high net worth individuals. This little known, underexposed, foreign exchange currency market can now be traded online and is available to the general public with a minimal capital investment of $300. Individual investors now have the opportunity to trade in the largest and most liquid financial market in the world.
Unlike other financial markets, the Forex market has no physical location and no central exchange. It operates through an electronic network of banks, corporations, institutional investors, and individuals trading one currency for another. The lack of a physical exchange enables the Forex market to operate on a 24-hour basis, spanning from one time zone to another, across the major financial centers around the world. The FX market plays a key role in transferring financial payments across borders and moving funds and purchasing power from one currency to another. This international market plays an extensive and direct role in national economies and has a major impact that
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Part II. Why Trade FX?
Foreign exchange is by far the preferred market choice for aggressive traders. The FX market offers unparalleled liquidity, no slippage, market transparency, trending markets, 24-hour access, low to zero transaction cost, high leverage, low account minimums, no bear-only market, and most importantly, above average profit potential. Enormous Liquidity The FX market is the most liquid market in the world. It can absorb trading volumes and per-trade sizes that may overwhelm any other market. Trading essentially consists of two parts: opening a position and closing of that position. Liquidity, which is highly correlated with volume, qualitatively evaluates how easily traders can enter and exit positions. A liquid market enables participants to execute large volume transactions with little impact on market prices. On the simplest level, the enormous liquidity alone is powerful enough to attract any investor to the FX market, as it suggests the freedom to open or close a position at will. In addition, technical analysis, the study of price movements, operates better in liquid markets. Illiquid markets make it much more difficult to accurately determine entry and exit points. No Slippage Traders in illiquid markets may experience delays and subsequently, suffer from slippage. In these markets, there may be delays in the execution of traders orders and thus, market orders could potentially be filled at a different price from the market rate when the order was initially placed. Furthermore, traders may experience difficulty in exiting or selling positions, which greatly compromises the ability to clear profitable trades. In the FX market, there is absolutely no slippage traders will always get in and out at the price they placed their orders. This is due to the tremendous amount of volume that the FX market generates. Market Transparency Market transparency is highly desired in a trading environment. It is a condition in which market participants are able to observe the detailed information in the trading process. Ultimately, the greater the market transparency, the more efficient the market becomes. The FX market offers the highest level of market transparency out of all financial markets. Informed traders are better off than uninformed traders because most financial markets could be exploited by those with private information. Traders in all financial markets rely on market transparency because it allows them to see a transparent spread, which enables them to employ their premeditated strategies while still flexible enough to accommodate an ever-changing marketplace. With the transparency of information, traders can exercise their risk management strategies in accordance to their fundamental and technical approaches. For example, in the case of Enron, inaccurate reporting by officers of the company resulted in the downfall of the company and losses of many shareholders. Markets where this could occur are considered a poor trading market. Furthermore, market transparency ensures the ability to trade from live, executable prices. Markets that do not offer executable prices and force traders to absorb slippage, obviously compromise traders profit potential. Trending Markets Although currency prices in the FX market may be volatile, they generally repeat themselves in cycles, creating trends. The trends can be analyzed by traders using technical tools. Since technical analysis statistically works better in markets characterized by cycles and trends, traders benefit from this attribute of Forex. The entire premise of technical analysis is based on the study of price movements. Through this analysis, traders can identify trends and capture key entry and exit points at which they should execute their trades and maximize their profit potential. 24-hour Access Forex is a true 24-hour, 6 days a week, market. FX trading begins each day in Australia and moves around the globe as the business day begins in each financial center first to Tokyo, then London, and New York.
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Unlike any other financial market, investors can respond to currency fluctuations caused by economic, social, and political events at the time they occur regardless if it is daytime or nighttime. The only breaks in trading occur during a brief period over the weekend. A trader is able to put on a trade during the London session, follow it during the New York session, and close the trade in the middle of the following day during the Tokyo session. This type of market access is invaluable to a market participant who needs to react quickly to global events. Low to Zero Transaction Cost The amount of cost to execute trades has dropped considerably in recent years. Transaction costs include all the expenses to actually execute a trade. Because transaction costs reduce profits, the lower the transaction costs, the more beneficial it is for the trader. Markets that have centralized exchanges tend to have higher transaction costs due to exchange and clearing fees associated with trading. Active stock and futures traders often see substantial portions of their gross profits going to broker commissions, exchange fees, and data/chart feeds. Transaction costs can also be increased with faulty executions. As regards the FX market, there are minimal to no brokerage fees and zero exchange and clearing fees since it is an over-thecounter market.. What you see is what you get, allowing you to make quick decisions on your trades without having to account for fees that may affect your profit/loss or slippage. High Leverage The FX market provides traders with access to much higher leverage than other financial markets. FX traders can benefit from leverage in excess of 100 times their capital versus the 10 times capital that is typically offered to professional equity day traders. In the FX market, the margin deposit for leverage is not a down payment on a purchase of equity; instead, it is a performance bond, or good faith deposit, to ensure against trading losses. This is very useful to short-term day traders who need the enhancement in capital to generate quick returns. Low Account Minimums Many individuals believe that entering the highly lucrative foreign exchange market requires large initial trading capital. This was indeed true prior to 1996, without the integration of online trading into the FX market. Today, individuals can get Started with a miniaccount for as little as $300. No Bear-Only Market One of the biggest advantages of trading FX is that there is no fear of a bear-only market. In many markets, high-return investments can often be difficult to sell after they are bought. However, in Forex, the major currency pairs always have buyers and sellers; hence, the FX investor should never worry about being stuck in a trade due to lack of market interest.
Above Average Profit Potential There is no question that speculative trading in Forex offers huge profit potential. It is an exciting way to earn exceptionally high returns on ones investment capital.
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The Foreign Exchange market, (FX or Forex) as we know it today, originated in 1973. However, money has been around in one form or another since the time of the Egyptian Pharaohs. While the Babylonians are credited with the first use of paper bills and receipts, Middle Eastern moneychangers were the first currency traders exchanging coins of one culture for another. During the middle ages, paper bills emerged as an alternative form of currency besides coins. These paper bills represented transferable third party payments of funds, which made foreign exchange much easier and less cumbersome for merchants and traders. From the infantile stages of Forex during the Middle Ages to World War I (WWI), the Forex market was relatively stable and without much speculative activity. After WWI, it became very volatile and speculative activity increased ten fold. Speculation in the Forex market was not looked on as favorable by most institutions and the public in general. The Great Depression and the removal of the gold standard in 1931 created a serious lull in Forex activity. From 1931 until 1973, the Forex market went through a series of changes. These changes greatly impacted the global economies at the time. There was little if any speculation in the Forex market during these times. Gold Exchange Standard The Gold Exchange Standard, which prevailed between 1876 and WWI, dominated the international economic system. Under the gold exchange standard, currencies gained a new phase of stability as they were supported by the price of gold. It abolished the age-old practice in which kings and rulers arbitrarily debased money and triggered inflation. However, the gold exchange standard had its weakness. As an economy strengthened, it would import heavily from abroad until it ran down its gold reserves required to back its money. As a result, money supply would shrink, interest rates would rise, and economic activity would slow down to the extent of recession. Ultimately, prices of goods would bottom out, appearing attractive to other nations. Consequently, this would cause a rush in buying sprees that would inject the economy with enough gold to increase its money supply, drive down interest rates, and recreate wealth into the economy. Such patterns prevailed throughout the gold standard until the outbreak of WWI, which interrupted trade flows and the free movement of gold. Several other major transformations occurred after the Gold Exchange Standard, leading to the birth of the current FX market: the Bretton Woods Accord, Smithsonian Agreement, and the Free-Floating System. Bretton Woods Accord The first major transformation, the Bretton Woods Accord, occurred toward the end of World War II. A total of 44 countries, including the United States, Great Britain, and France met in New Hampshire in July 1944, to design a new economic order.
The design of the Bretton Woods framework was to have the United States become an anchor for all free world currencies. The accord aimed at installing international monetary stability by preventing money from fleeing across nations and restricting speculation in the world currencies. Major currencies were pegged to the dollar, which was in turn tied to gold at a value of $35 per ounce. The dollar was the primary reserve currency and member countries were able to sell currency to the Federal Reserve in exchange for gold at the present rate. In addition to these interventions, the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (World Bank) were established to ensure that the Bretton Woods system would operate effectively.
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Once the Bretton Woods Agreement was founded, the participating countries agreed to try and maintain the value of their currency with a narrow margin against the dollar and a corresponding rate of gold as needed. Countries were prohibited from devaluing their currencies to their trade advantage and were only allowed to do so for devaluations of less than 10%. Trading under the Bretton Woods system had unique characteristics. Since exchange rates were fixed, intense trading took place around devaluation or revaluation, known as creeping pegs. Speculation against the British pound in 1967 demonstrated creeping pegs patterns. Despite all the efforts by the Bank of England and other central banks to support the pound, the pound was devalued. This failure was monumental because it was the first time that the central bank intervention failed under the Bretton Woods system. The failure of the central bank intervention continued with the dollar in the following years. As the Bretton Woods system was highly dependant on a strong US dollar, the dollar began to experience pressure in 1968, causing extreme speculation on the future of this system. The Agreement was finally abandoned in 1971, and the US dollar would no longer be convertible into gold. Smithsonian Agreement After the Bretton Woods Accord came to an end, the Smithsonian Agreement was signed in December of 1971. This agreement was similar to the Bretton Woods Accord, but it allowed for a greater fluctuation band for foreign currencies. The Smithsonian Agreement strived to maintain fixed exchange rates, but to do so without the backing of gold. Its key difference from the Bretton Woods system was that the value of the dollar could float in a range of 2.25%, as opposed to just 1% under Bretton Woods. Ultimately, the Smithsonian Agreement proved to be unfeasible as well. Without exchange rates fixed to gold, the free market gold price shot up to $215 per ounce. Moreover, the U.S. trade deficit continued to grow, and from a fundamental standpoint, the US dollar needed to be devalued beyond the 2.25% parameters established by the Smithsonian Agreement. In light of these problems, the foreign exchange market was forced to close in February of 1972. In 1972, the European community tried to move away from their dependency on the dollar. The European Joint Float was established by West Germany, France, Italy, the Netherlands, Belgium, and Luxemburg. Both agreements made mistakes similar to the Bretton Woods Accord and by 1973, collapsed. Free-Floating System The collapse of the Smithsonian agreement and the European Joint Float in 1973 signified the official switch to the free-floating system. This occurred by default as there were no new agreements to take their place. Governments were now free to peg their currencies, semi-peg, or allow them to freely float. In 1978, the freefloating, system was officially mandated. The value of the US dollar was to be determined entirely by the market, as its value was not fixed to any commodity, nor was the fluctuation of its exchange rate confined to certain parameters. While this did provide the US dollar, and other currencies by default, the agility required to adapt to a new and rapidly evolving international trading environment, it also set the stage for unprecedented inflation. Europe tried to gain independence from the dollar by creating the European Monetary System in July of 1978. This, like all of the earlier agreements, failed in 1993. The major currencies today move independently of other currencies. The currencies are traded by anyone who wishes to trade. This has caused a recent influx of speculation by banks, hedge funds, brokerage houses, and individuals. Central banks intervene on occasion to move or attempt to move currencies to their desired levels. The underlying factor that drives todays Forex market, however, is supply and demand. The freefloating system is ideal for todays markets.
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Part IV. Market Structure
Overview Unlike other financial markets, the Forex market has no physical location and no central exchange; hence, it is considered an over-the-counter (OTC) market. The FX market operates through an electronic network of banks, corporations, institutional investors, and individuals trading one currency for another. Forex traders and market makers are all linked to one another round the clock via computers, telephones, and faxes where currency denominations, amounts, settlement dates, and prices are negotiable. The lack of a physical exchange enables the Forex market to operate on a 24hour basis, spanning from one time zone to another, across the major financial centers around the world. The FX market is organized into a hierarchy, which consists of participants with different ranking. The standards that determine the participants positions are credit access, volume of transactions, and level of sophistication; those with superiority in these measures receive priority in the FX market. At the top of the hierarchy is the interbank market, which generates the highest volume in trades. Interbank Interbank is a credit-approved system where banks trade on the sole basis of their credit relationships with one another. In the interbank market, the largest banks are able to trade with each other directly, via interbank brokers or through electronic brokering systems such as Reuters and EBS. While all the banks can see the rate that everyone is dealing at, each bank has a specific credit relationship with the other bank and trade at the rates being offered. (community banks and banks in emerging markets), corporations, and institutional investors do not have access to these rates because they do not have established credit relationships with large commercial banks. Subsequently, these smaller participants are obligated to trade FX through a large bank, and often, this equates to much less competitive rates. The rates become less and less competitive as it trickles down the hierarchy of participants. Eventually, the customers of banks and foreign exchange agencies receive the least competitive rates. However, in the late 1990s, technological advances have eliminated the barriers that existed between the interbank and end-users of FX. Since 1996, retail clientele can connect directly to market makers via online trading. Average traders can enjoy the competitive rates and trade alongside the worlds largest banks.
The FX market is no longer reserved for big corporations; it is now made available to all types of consumers. Furthermore, the boundless opportunity to trade foreign exchange awaits all aspiring corporations and individual traders. Market Hours The spot FX market is unique to any other market in the world since trading is available. 24 hours a day. Somewhere around the world, a financial center is open for business, and banks and other institutions exchange currencies every minute of the day with only minor gaps on the weekend. The FX market opens at 5 pm (EST) on Sunday and close at 1 pm (EST) on Friday. The major financial centers around the world overlap due to their time zones. The International Date Line is located in the Western Pacific. Each business day begins in Wellington, New Zealand, then Sydney, Australia, followed by the Asian financial markets starting with Tokyo, Japan, Hong Kong, China, and finally Singapore. Only a few hours later, markets will open in the Middle East. When the markets in Tokyo are starting to wind down, Europe opens for business.
Other institutions in the market, such as corporations, online FX market makers, and hedge funds trade FX through commercial banks. However, many banks
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Finally, New York and other major U.S. centers start their day. Towards the late afternoon in the United States, the next day arrives in the Western Pacific areas and the process begins again. Hence, the FX market is opened 6 days a week, 24 hours a day.
Markets within the FX Market Although spot trading accounts for 48% of all FX transactions worldwide, the three main markets, Tokyo, London, and New York, represent almost 70% of the worlds FX volume. Foreign exchange activity does not flow evenly, and throughout the course of the international trading day, there are certain markets characterized by very heavy trading activity in some (or all) currency pairs. At other times, the same markets are characterized by light activity in some (or all) currency pairs. Foreign exchange activity tends to be the most active when markets overlap, particularly the U.S. markets and the major European markets; i.e., when it is morning in New York and afternoon in London. As Japans economy has dwindled over the past decade, Japanese banks have been unable to commit to FX, the large amounts of capital they once did in the 1980s. Despite this, Tokyo is the first major market to open, and many large participants use it to get a read on dynamics or to begin scaling into positions. Approximately 10% of all FX trading volume takes place during the Tokyo session. Trading can be relatively thin.
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Hedge funds and banks have been known to use the Tokyo lunch hour to run important stop and option barrier levels. Japanese yen, New Zealand dollar, and Australian dollar pairs tend to be the biggest movers during Tokyo hours as other currencies are quite thin and usually remain constant.
London is by far the most important and influential FX market, with approximately 30% of all worldwide transactions. Most big banks dealing desks stem from London and the market is responsible for roughly 28% of the total world spot volume. London tends to be the most orderly market due to the large liquidity and ease of completing transactions. Most large market participants use London hours to complete serious foreign exchange deals.
New York is the second most important market that represents approximately 16% of total worldwide market volume. In the United States spot market, the majority of deals are executed between 8am and 12pm, when European traders are still active. Trading often becomes slower in the afternoon as liquidity dries up. In fact, there is a drop of over 50% in trading activity since California never served to bridge the gap between the U.S. and Asia. As a result, traders tend to pay less attention to market development in the afternoon. New York is greatly affected by the U.S. equity and bond markets, thus the pairs will often move closely in tandem with the capital markets.
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Part V. Key Players in the FX Market
With the advances of technology and especially the opening on the Internet, the foreign exchange market has expanded from simple foreign exchange and bank transactions to a more speculative nature. Today, an increasing number of FX transactions are trading for profit or speculation, which translates to the tremendous profit-potential in this highly lucrative market. There are five major players in the FX market; Commercial/Investment Banks, Central Banks, Corporations, Hedge/International Funds, and individuals. Commercial and Investment Banks Commercial and investment banks account for the largest portion of FX trading volume. The lnterbank market caters to both the majority of commercial turnovers as well as enormous amounts of speculative trading everyday. Their primary role in the FX market is essentially selling currencies, as other participants execute trades through them. Banks trade currencies because it is highly lucrative and it limits their credit exposure on Letters of Credit. Banks gain profits by acting on their clients behalf and making trades. About three quarters of all foreign exchange trading is between banks. They generate billions of dollars worth of currency in a days volume. Below is a list of the top financial institutions in the world as rated by Euromoney Magazine in their May, 2001 edition. Central Banks Central banks play a significant role in the FX market as they can influence spot price fluctuations. Central banks generally do not speculate in currencies, but they use currencies to promote acceptable trading conditions to their banking industries by affecting money supply and interest rates through open market operations or the active trading of government securities. Central banks also often attempt to restore order to volatile markets through interventions. The reasons for central bank interventions may be a result of a variety of factors: to restore stability, protect a certain price level, slow down currency movements, or to reverse a trend. An example would be the recent intervention by the Bank of Japan to push down the value of the yen. On the surface, this may disturb many traders to make their investment decisions. However, it has been proven time and again that central banks can only influence currency values for short periods. Over time, the markets adjust to the changes, creating trend formations that may be very beneficial to traders. Trend strategies may guide FX traders to take advantage of these trends in the market. Central banks normally keep sizeable amounts of foreign currencies on hand; hence, their influence is so great that the mere mention of central banks interventions would violently move the market. As their investments are generally more long-term, central banks trades are quite profitable. The major central banks include: The Federal Reserve, European Central Bank, Bank of England, Swiss National Bank, Bank of Japan, and Bank of Canada. The Federal Reserve (Fed): The Federal Reserve Board (Fed) is the central bank of the United States. They are responsible for setting and implementing monetary policy. The board consists of a 12-member committee, which comprise the Federal. Open Market Committee (FOMC). The voting members of the FOMC are the seven Governors of the Federal Reserve Board, plus five Presidents of the twelve district reserve banks. The FOMC holds 8 meetings per year, which are widely watched for interest rate announcements or changes in
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growth expectations. The Fed has a high degree of independence to set monetary authority. They are less subject to political influences, as most members are assigned long term positions that allow them to remain in office through periods of alternate party dominance in both the Presidency and Congress. The U.S. Treasury is responsible for issuing government debt and for making fiscal policy decisions. Fiscal policy decisions include determining the appropriate level of taxes and government spending. The U.S. Treasury is the actual government body that determines dollar policy. That is, if. they feel that the USD rate in the foreign exchange market is under- or overvalued, they are in the position of giving the NY Federal Reserve Board the instructions to intervene in the FX market by physically selling or buying USD. Therefore, the Treasurys view on dollar policy, and changes to that view, is very important to the currency market. The European Central Bank (ECB): The European Central Bank (ECB) is the governing body responsible for determining the monetary policy of the countries participating in the European Member Union (EMU). The Executive Board of the EMU consists of the President and Vice President of the ECB and four other members. These individuals along with the governors of the national central banks comprise the Governing Council. The ECB is set up so that the Executive Board implements the policies dictated by the Governing Council. New monetary policy decisions are typically made by a majority vote in biweekly meetings, with the President having the casting vote in the event of a tie. The primary objective of the European Central Bank is to maintain price stability. ECB is considered inflation paranoid as it has strong German influence. ECB aand the ESCB are independent institutions from both national governments and other EU institutions, giving them total control over monetary and currency policy. The European central bank is a strict monetarist and much more likely to keep interest rates high. Two edicts of monetary policy are: to keep a harmonized Consumer Price Index (CPI) below 2% and an M3 annual growth (Money supply) around 4.5%. Refinance rate is the main weapon used by the ECB to implement EU monetary policy. ECB watches the fiscal discipline of its members closely. ECB is considered an untested central bank and doubts linger as to how they will react to any future crisis. The ECB keeps close tabs on budget deficits of the individual countries as the Stability and Growth Pact states that they must be kept below 3% of Gross Domestic Production (GDP). The ECB does intervene in the FX markets, especially when inflation is a concern. Comments by members of the Governing Council frequently move the EUR and are widely watched by FX market participants. Bank of England (BoE): The Bank of England (BoE) is the central bank of the United Kingdom. The bank was founded in 1694, nationalized in 1946, and gained operational independence in 1997. The BoE is committed to promoting and maintaining a stable and efficient monetary and financial framework as its contribution to a healthy economy. In 1997, parliament passed the Bank of England Act, giving the BoE total independence in setting monetary policy. Prior to 1997, the BoE was essentially a governmental organization with very little freedom. Treasurys role in setting monetary policy diminished markedly since 1997. However, the Treasury still sets inflation targets for the B0E, currently defined as 2.5% annual growth in Retail Prices Index (RPI), excluding mortgages (RPIX). The treasury is also responsible for making key appointments at the Central Bank. The BoEs nine member Monetary Policy Committee (MPC) is responsible for making decisions on interest rates. Although the MPG has independence in setting interest rates, the legislation provides that in extreme circumstances the government may intervene. The Bank of Englands main policy tool is the minimum lending rate or base rate. Changes to the base rate are usually seen as a clear change in monetary policy. The BoE most frequently affects monetary policy through daily market operations (the buying/selling of government bonds). The BoE is infamous for attempting to influence exchange rates through impure market interventions.
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Swiss National Bank (SNB): The Swiss National Bank is the central Bank of Switzerland. The Swiss National Bank enjoys 100% autonomy in determining the nations monetary and exchange rate policies. In December 1999, the SNB shifted from a monetarist approach to an inflation-targeting one (2% annual inflation target). Discount rate is the official tool used to announce changes in monetary policy; however, it is rarely used as the bank relies more on the 3-month London Interbank Offer Rate (LIBOR) to manipulate monetary policy. The LIBOR is the rate at which major international banks lend to one another; it primarily serves as a benchmark for short-term interest rates. SNB officials often affect the Franc spot movements by making remarks on liquidity, money supply, and the currency itself. Intervention is frequent; however, most often intervention is used to enforce economic policy. It is also used in open market operations, such as raising or lowering interest rates, to affect the value of its currency. As a country where international trade has been the primary source of the countrys economic development, its preference is for a weaker franc, in order for its exports to remain competitive. SNB is highly regarded and the franc is considered by most market participants to be the worlds best managed currency. The Bank of Japan (BOJ): The Bank of Japan (BoJ) is the key monetary policymaking body in Japan In 1998 the Japanese government passed laws giving the BoJ operational independence from the Ministry of Finance (MoF). It was given the complete control over monetary policy. However, despite the governments attempts to decentralize decision-making, the MoF still remains in charge of foreign exchange policy. The MoF is considered the single most important political and monetary institution in Japan. MoF officials frequently make statements regarding the economy, which have notable impacts on the yen. The BoJ is responsible for executing all official Japanese FX transactions at the direction of the MoF. However, it is important to note that the Bank of Japan does possess total autonomy over monetary policy and can have significant indirect impacts on foreign exchange rates. The BoJs main economic tool is the overnight call rate. The call rate is controlled by the open market operations and any changes to it often signify major changes in monetary policy. Since the introduction of a floating exchange rate system in February 1973, the Japanese economy has experienced large fluctuations in Forex rates, with the yen on a long rising trend. The reason for the yens strength, despite the excessive problems that have plagued the Japanese economy, is the fact that Japan has a trade surplus accounting for 3% of GDP. This is the highest of the G-7 countries and therefore creates a strong inherent demand for the currency for trade purposes, regardless of their economic conditions. The Japanese government is notorious for directly intervening on behalf of the yen through market interventions. BoJ interventions are frequent and violent. As an export-driven country, there are strong political interests in Japan for maintaining a weak yen in order to keep exports competitive. Accordingly, the BoJ has been known to go into the market and sell off the yen when its rate is perceived to be too strong. Bank of Canada (BoC): The Bank of Canada (BoC) is the central bank of Canada. The Governing Council of the Bank of Canada is the board that is responsible for setting monetary policy and is an independent Central bank that has a tight reign on its currency. This council consists of seven members: the Governor and six Deputy Governors. The BoC does not have regular periodic policy setting meetings. Instead, the council meets on a daily basis and may make changes in policy at any time. Due to its tight economic relations with the United States, the Canadian dollar has a strong connection to the US dollar. Corporations Corporations which comprise a diverse group of small and large corporations, importers/exporters, financial service firms, and consumer service firms, were the major traders in currencies for many years.
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Corporations main interests in foreign exchange are to perform transactions related to cross border payments. Multinational corporations may need to make payments to foreign entities for materials, labor, marketing/advertising costs, and/or distributions, which would require the exchange of currencies. The primary focus of multinational corporations in the marketplace is to offset risk by hedging against currency depreciation, which would affect future payments. Now, however, a minority has begun to use the marketplace as a speculative tool; meaning, they enter the FX market purely to take advantage of expected currency fluctuation. This group of corporations using the FX market for speculative purposes is growing, and as very active participants, they have a great impact on spot market prices. Corporations approach to trading tends to be longer-term since they use the market for covering commercial needs, hedging, and speculations. Hedge Funds and International Funds Global fund managers, hedge, large mutual, pension, and arbitrage funds that invest in foreign securities and other foreign financial instruments are relatively small. Although they may be small when compared to other market participants, they are the most aggressive. These groups can have substantial impacts on spot price movements as they are constantly re-balancing and adjusting their international equity and fixed income portfolios. These portfolio decisions can be influential because they often involve sizable capital transactions. A majority of the hedge funds are highly leveraged and actively seeking to profit in whichever way possible. Despite the highly criticized, sometimes devious nature of hedge funds, they are valued by traders because they often push the markets to retract from extreme levels. Hedge funds are used by high net worth individuals investing a minimum of $1 million. One of the best known Hedge Funds is the George Soros Quantum Group of Funds that made a billion dollar profit by shorting the British pound in 1992. International Funds are non-currency funds consisting of large capital, which exert substantial influence on the FX market. With more and more funds delegated to hedging activities, international funds are becoming a main driver of international capital and equities trends, which in turn, greatly affects the Forex market. FX Funds Funds that invest in the FX are commonly called Global Macro funds. These funds depending on size tend to take different positions in the FX market. Many large funds tend to carry large trade positions, exploiting global interest rate differentials. Others tend to seek out opportunities to take advantage of misguided economic policies or currencies that overshoot their real value; by entering large positions, they are bethng on a return to equilibrium. Others simply gauge global events and take a longer-term view on which currencies will strengthen or weaken in the next six to eight months. Fund participation in the FX market has risen sharply in recent years and its total trading share is now around 20%. There is no doubt that with the increasing amount of money some of these investment vehicles have under management, the size and liquidity of the foreign exchange market is very appealing. While relatively small compared to other market participants, when acting together, they can have a profound effect on the currency spot movements. Individuals Retail spot currency trading is the new frontier of the trading world. Up until 1996, foreign exchange trading was only available to large banks, institutions, and extremely high net worth individuals. Prior to online retail FX dealers, individuals could not realistically participate in the FX market from a speculative standpoint. The interbank market operated as a tight circle; it acted somewhat like a specialist, as it manipulated the fates of tiers 2 and 3 to accommodate its own needs. Accordingly, individual traders looking to trade FX could not find a market maker capable of providing competitive spreads, fair quotes, and equitable customer service. With the advancement of technology, the internet, and online trading platforms, retail clients are provided with access to trading that is highly comparable to the offerings of the interbank market. Spreads are slightly wider at 5 pips on most currency pairs, as opposed to
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the interbank standard of 3 pips, but execution is unsurpassed. Now retail clients and multinational institutions can participate in the FX market on a highly equitable playing field.
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Part VIII. Your Role in the FX Market Part IX. How Can Forex be Accessed?
At the most basic retail level, one can access Forex at any airport currency booth. For a service fee and a mark-up of 5-10%, one can buy or sell currencies. In fact, for many individuals, a trip to the currency exchange booth overseas is their first introduction to Forex. Investors wishing to speculate in the FX market can now access Forex through dealers offering margin accounts as small as $300, with a price spread that is as little as 4-5 pips. High net worth individuals, corporations, or fund managers with private banking relationship should be able to trade through their banks, while corporate clients requiring the actual delivery of currencies would create a credit relationship with a Forex dealer.
You may not realize it, but you already play a role in the foreign exchange market. Do you have some currency in your pocket or wallet? Do you have a checking or savings account? Do you have a mortgage? Do you run a business? Do you hold stocks, bonds, or other investments with a value expressed in a specific currency? A yes response to any of the above questions already makes you an investor in the currency markets. When you decide to hold assets in the currency of one country, you are investing in that countrys currency and economy. At the same time, you are also electing not to hold the currencies of other nations. For example, when you hold most of your portfolio (stocks, bonds, bank accounts, etc.) in US dollars, you are relying heavily on the integrity and value of the US dollar and economy, including the government that governs it. Concurrently, you are choosing not to hold the Japanese yen, British pound, or the euro. Almost all businessmen, businesswomen, and travelers actively trade currency. If you travel overseas, you would generally exchange your own currency for the currency of the country you are visiting. In view of this, it is not surprising that more and more prudent investors are deciding to diversify their portfolios by holding assets in multiple denominations within the FX market.
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I. What is Trading?
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Currency Pairs In the Forex market, currency trading is always done in currency pairs, such as USD/CAD or USD/JPY, reflecting the exchange rate between the two currencies. An exchange rate is merely the ratio of one currency valued against another currency. For instance, the USD/JPY exchange rate specifies how many US dollars are required to buy a Japanese yen, or conversely, how many Japanese yen are needed to purchase a US dollar. In a pair of currencies, the first currency is known as the base (dominant) currency, and the second one is referred to as the counter or quoted (subordinate) currency. In the USD/JPY example, the US dollar is the base currency that we wish to trade, while the Japaneseyen is the counter currency that the exchange rate is quoted in. In simple and practical terms, the currency pair is a structure that can be bought or sold. The base currency acts as the basis for all transactions, regardless if it is buying or selling. When you buy a currency pair, it is implied that you are buying the first (base) currency and selling the second (counter or quoted) currency. Alternatively, a trader sells the currency pair when he/she anticipates that the base currency will depreciate relative to the quoted currency.
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Lot Sizes and Margin The FX market attracts many new traders because currency trading can be conducted on a highly leveraged basis. Every trader should have a thorough
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For instance, the US dollar moves from 1.6000 to 1.6004 in the cable/dollar pair, it has moved 4 pips. When you have an open position, each upward or downward pip movement in the market price can be either a profit or a loss, depending on which currency (base or quoted) you bought and which one you sold. Calculating Profit/Loss Many Forex retail brokers assign a fixed dollar value per pip that varies according to the lot size and the makeup of each currency pair. For example, the pip value may be $10 per pip on each $100,000 lot of cable/dollar, while only $6.50 per pip on each $100,000 lot of dollar/franc. Other dealers offer a floating pip value that is calculated according to the lot size of each currency pair and the fluctuating exchange rate. For example, notice how the pip value on a 15,000,000 lot of dollar/yen is calculated based on a one-pip movement from 120.00 to 120.01:
The value of a pip is determined by the currency pair and the rate at which the pair is trading. For currency pairs where the dollar is not the base currency (EUR/USD, AUD/USD, NZD/USD, GBP/USD), each pip has a fixed value of $10. For example, if you are trading EUR/USD and the market moves 10 pips in your favor,
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In the above example, the bid price for EUR/USD is 1.1797, which indicates the price at which a trader can sell the currency pair. The ask price is 1.1801, indicating the price at which a trader can buy the currency pair. The difference between the bid and the ask price gives us a 4-pip spread in this example. The 4-pip spread represents the cost of the transaction. It is important to note that since the FX market is a decentralized market, the spreads that a trader receives for a given currency pair will vary according to the market maker one trades with. Generally, there is an average of 4-5 pips on the major currency pairs and 520 pips on the cross currency pairs.
Position Trading The objective of currency trading is to exchange one currency for another in the anticipation that the market rate or price will change, thus, increasing the value of the currency bought relative to the one sold. In trading language, a long position is one in which a trader buys a new currency at one price and aims to sell it later at a higher price. When a trader buys a currency and the price appreciates in value, the trader must sell the currency back in order to secure the profit. A short position is one in which the trader sells a currency in anticipation that it will depreciate. If a trader sells a currency and the price depreciates in value, the trader must buy the currency back in order to secure the profit. While a long position is to buy and a short position is to sell, an open trade or position is one in which a trader has either bought or sold a currency pair and has not sold or bought back the equivalent amount to effectively close the position.
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Spot Transactions
This type of transaction accounts for almost half of all FX market transactions. The exchange of two currencies at a rate agreed on the date of the contract for delivery in two business days (except for USD/CAD, which is the next business day).
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Since currency risk is replaced by interest rate risk, such transactions are conceptually different from spot transactions. They are, however, closely linked because foreign exchange swaps are often initiated to move the delivery date of a foreign currency originating from spot, or outright forward transactions to a more optimal moment in time. It is by using swaps that traders can hold a position without ever being delivered. This
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GBP/USD Trader A buys 2 contracts of GBP/USD on Thursday and closes them on the next day Contract Value: GBP 100,000 Opening Price: 1.6770 Yearly Interest Rate Differential: GBP 3.5% - USD 1% = 2.5% Calculation: GBP 100,000 x 2 x (2.5%/360) x 1 = 13.88 USD/JPY Trader A sells 3 lots of USD/JPY on Monday and closes them on the next day Lot Value: USD 100,000 or JPY 12,200,000 Opening Price: 110.00 Yearly Interest Rate Differential: USD 1% - JPY 0% = 1% Calculation: USD 100,000 x 3 (-1%/360) x I = -8.31 Triple Rollover on Wednesday Since there is a two-day settlement period in foreign exchange, the transactions that are opened on Wednesday at 5 pm which is the Thursday trading day should not get settled until Saturday. Of course, banks are closed during the weekend, so the transaction cannot effectively be settled until Monday (which begins on Sunday at 5 pm New York time). Therefore, for positions opened and held overnight on Wednesday, rollover fee is charged for the following Monday as well, meaning an extra two days of fees for the weekend. As a result, rollover fees are tripled in the FX market on Wednesday. It is important to understand that every transaction has a value day. If the deal is not
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and volume data to predict future market movements. There is an ongoing debate as to which methodology is more successful. Day or swing traders prefer to use technical analysis, focusing their strategies primarily on price action, while position traders use fundamental analysis focusing their efforts on determining a currencys proper current as well as future valuation. One clear point of distinction is that fundamental analysis studies the causes of market movements, while technical analysis studies the effects of market movements.
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Part I. How the Economy Works?
FX traders should have a proper understanding of the trading and investment environment. This requires some understanding of the economy and how it operates. An economy moves in cycles. Each cycle includes a period of economic expansion leading to a peak, followed by a period of economic contraction leading to a trough. After economic activity has reached a trough and bottomed out, a new cycle begins again with economic recovery and expansion. A period of at least six consecutive months of economic contraction is generally called a recession and if the downturn is extremely severe, as in the early 1930s, it is called a depression. The price movements of the major currencies follow these economic circular trends, forming well-defined patterns that can be tracked and predicted by fundamental and technical analysis. Theories Used to Analyze the Economy Several theories are utilized as tools to analyze the economy. These include: the purchasing power parity theory, balance model, and asset model. Purchasing Power Parity (PPP) The PPP theory asserts that exchange rates are determined by the relative prices of similar baskets of goods sold in different countries. It is expected that changes in inflation rates are to be offset by equal but opposite changes in the exchange rate. For example, a can of Pepsi costs 1.5 euros in France and $1.25 in the U.S. Based on the PPP theory, the 1.5 (euros) divided by 1.25 (USD) equals to 1.2. If the current exchange rate for EUR/USD is more than 1.2, the exchange rate overstates current market values and should depreciate until it reaches to the PPP value, which is 1.2. On the other hand, if the current exchange rate is less than 1.2, the exchange rate understates current market values and should appreciate until it reaches the PPP value. Therefore, the theory postulates that the two currencies will eventually move towards the exchange rate at which one euro can buy 1.20 US dollar. Every few years, the OECD (Organization for Economic Cooperation and Development) publishes PPP values for all currencies. These values, in turn, are used by traders to anticipate exchange rates. PPP is a long term indicator and does not take into account short term fluctuations based on market news or rumors. Another weakness is that it assumes goods are easily tradable with no costs to trade such as tariffs, quotas, or taxes. In addition to ignoring the costs to trade, this theory only accounts for goods and neglects services, where room for value differentials is significant. From empirical evidence, we learn that PPP is only applicable to longterm (3-5 years) price movements, when prices eventually correct themselves towards parity. Balance of Payments Model This model suggests that a foreign exchange rate must be at its equilibrium level the rate that produces a stable current account balance. The theory asserts that if a country has a trade deficit, its currency will depreciate. The cheaper currency renders the nations goods (exports) more affordable in the global market while making imports more expensive. The combination over time, forces imports to decline and exports to rise thus stabilizing the trade balance and the currency towardf equilibrium. In other words, the Balance of Payment Model is hinged on the theory that a currency will move as a result of a nations global trading position. Those countries that run a trade deficit will have their currency decline, while those with a surplus will have their currency appreciate. Critics of the Balance of Payment Model state that it does not take into consideration the flow of funds into financial assets, but focuses solely on the trade of goods and services from one country to another. This explains why a country like the United States, with a large trade deficit, did not have its currency suffer markedly in recent years. Asset Market Model The explosion in trading of financial assets has reshaped the way analysts and traders view currencies. The basic premise of this theory is that the flow of funds into other financial assets of a country (i.e. equities and
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bonds) increases the demand for that nations currency. Advocates point out that the proportion of foreign exchange transactions stemming from cross bordertrading of financial assets has dwarfed the extent of currency transactions generated from trading in goods and services through import and export. Since the asset market approach views currencies as asset prices traded in an efficient financial market, it asserts that currencies are increasingly demonstrating a strong correlation with asset markets. This helps explain the currency phenomena during the 1990s, when the Japanese stock market and yen depreciated while the U.S. stock market and US dollar appreciated a condition that was contrary to what the previous theories suggest, given the low level of Japanese interest rates relative to U.S. rates. In this case, interest rates did not have a strong influence. The price of comparable goods did not drive the market prices. The factor that exerted the greatest influence over the market was the net flow of funds into the investment sector. It is this variable that affected the demand for currencies to be bought and sold, one over the other. Factors that Affect the Economy Forex is a perfect market for applying trading strategies and disciplined methods of limiting risk while taking full advantage of favorable market conditions. A trader must learn how to analyze the market in order to become successful. There are a lot of factors that can cause a nations currency to fluctuate. The key concept is that the movement of currencies is based on supply and demand, which is influenced by both economic factors and confidence factors. Economic Factors Economic factors examine specific demand stemming from purchases, goods, services, or assets. Currencies are affected by changes in interest rates of a country, which in turn, affect inflation. If the currency value goes down, it costs more to import goods from another country; hence, the cost of living goes up, leading to inflation. Confidence Factors Confidence factors are general, and often nonquantitative, explanations for a past or prospective move. They include political events, market sentiment about the management of a countrys currency, or hunches concerning other players in the market. Political events can fall under this category. For example, if the leader of a country is suddenly removed from office or, worse yet, assassinated, the worlds confidence in that countrys currency is, at least in the short-term, sure to suffer. Approaches to Analyze the FX Market There are two distinct methods to analyze financial markets: fundamental analysis and technical analysis. Fundamental analysis is based on underlying economic conditions, while technical analysis uses historical prices to predict future movements. There is an ongoing debate as to which methodology is more successful. Technical traders focus their strategies primarily on price action, while fundamental traders focus their efforts on determining a currencys proper current and future valuation.
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potential changes to the economic, political, and social environment. By studying reports and events, fundamental analysts examine the underlying reasons for the fluctuation of the exchange rate, in either the past or the future, towards one direction or the other. They endeavor to do this before the rest of the market participants, placing themselves in a good trading position to earn profits. Two Main Factors in Fundamental Analysis There are two main factors that impact exchange rate movements from a fundamental perspective: trade flows and capital flows. Trade Flows One factor affecting exchange rates between two respective countries is the trade balance. Trade balance shows the net differences between a nations imports and exports. It is, by definition, the merchandise trade balance the net difference between the value of merchandise being exported and imported into a particular country. When an economys imports are more than its exports, the trade balance is said to be in deficit. If an economys exports are more than its imports, the trade balance is in surplus. Trade balances are important as they indicate a redistribution of wealth among countries. Generally, trade deficits negatively impact the value of a currency by forcing money to flow out of the country. Conversely, positive trade balances cause appreciation in the countrys currency. Capital Flows Capital flows take the form of both physical and portfolio investments. They measure the net amount of a currency that is being purchased or sold in capital investments. This provides a recording for an economys incoming and outgoing investment flows. A positive capital flow balance implies that foreign inflows into a country exceed outflows. A negative capital flow balance indicates that there are more physical or portfolio investments bought by domestic investors than foreign investors. Physical Investments Physical Investments are actual foreign direct investments by corporations, such as investments in manufacturing, real estates, and local acquisitions. All these transactions require foreign corporations to sell their local currency and purchase the foreign currency, which leads to movements in the Forex market. These movements represent the underlying changes in actual physical investment activity. Global corporate acquisitions are extremely important to currency movements as they involve more cash than stock. Portfolio Investments As technology advances, investing in global equity markets has become increasingly feasible. Subsequently, the dynamic stock market in any part of the world serves as an ideal potential for all, regardless of the, geographic location. As a result, a strong correlation has developed between a countrys equity market and its currency. If the equity market is rising, investment dollars enter the country to seize the opportunity. Conversely, if the equity market is falling, domestic investors sell their shares of local publicly traded firms and invest in other nations.
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economy starts to follow a particular pattern or trend. They are used by traders to predict changes in the economy. Lagging indicators are economic factors that change after the economy has already begun to follow a particular pattern or trend. Economic indicators may range from interest rates and central bank policies to natural disasters. The fundamentals are a dynamic mix of distinct plans, erratic behaviors, and unforeseen events. Therefore, it is better to get a handle on the most influential contributors to this diverse mix than it is to formulate a list that includes all of the indicators, as that is merely impossible. Some indicators are more significant than others, with respect to their influence on the FX market, but most closely looked at is the data related to interest rates and international trade. Below is a brief overview of some of the major economic news, events, reports, and announcements that can have a significant effect on currency market movement: G7 Meetings There are periodic meetings of financial leaders from the United States, Great Britain, Germany, Japan, France, Italy, and Canada who gather to discuss world monetary policies. Recently, Russia has taken part in this forum as an observer; hence, this group is sometimes referred to as the G-8. Inflation Price index numbers are used to assess inflation. Inflation is a rise in the general level of prices in an economy. When the price of goods rises, there is a general increase in prices, which constitutes inflation. This price level increase has a direct impact on currency exchange rates. If the general price level falls, it is called deflation. The currency of countries with low inflation will normally rise in value, while the currency of countries with high inflation will fall. Gross Domestic Product (GDP) The Gross Domestic Product (GDP) is the sum of all goods and services produced by both domestic and foreign companies in the economy in a year. GDP is a good indicator for the pace at which a countrys economy is growing or shrinking as it measures the countrys economic output and growth. In order to measure the performance of an economy, economists are usually most interested in the real rate of change of GDP. Real GDP is calculated by adjusting nominal GDP for inflation or deflation. When real GDP increases from the previous year, the currency becomes stronger. Interest Rates Interest rates are charged by various financial institutions. For example, the Prime Rate is an interest rate charged by banks to reputable customers and the Federal Funds Rate is an inter-bank rate for borrowing reserves to meet margin requirements. If there is an uncertainty in the market in terms of interest rates, any developments regarding interest rates could have a direct affect on the currency markets. Generally, when a country raises its interest rates, the countrys currency will strengthen in relation to other currencies as assets are shifted to gain a higher return. The timing of interest rate moves is usually known in advance. Nominal and Real Rate of Interest The rate of interest reflects the cost of borrowing money. Since the rate of inflation affects the purchasing power of money, the rate of interest is affected by it. Just like GDP can be adjusted for the effects of inflation, interest rates can also be adjusted for inflation. The rate of interest is categorized as nominal and as real rate of interest. The nominal rate of interest is the rate of interest advertised or stated in a financial contract. The real rate of interest is the rate of interest that is adjusted for the loss in purchasing power due to inflation. To calculate the real rate of interest, subtract the rate of inflation from the nominal rate of interest.
Rate of Inflations - Nominal Rate of Interest = Real Rate of Interest
Producer Price Index (PPI) The Producer Price Index (PPI) measures the average changes in selling price as indicated by domestic
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producers for their output in various industries. The FX market tends to focus on the PPI for seasonally adjusted finished goods on a monthly, quarterly, semiannual and annual basis. PPI is an accurate precursor of the important Consumer Prices Index (CPI) figure. Consumer Price Index (CPI) The Consumer Price Index (CPI) is a primary indicator of inflation that measures the average price for goods and services most commonly used by a typical household. By definition, it is a measure of the average price level paid by urban consumers (80% of population) for a fixed basket of goods and services. It reports price changes in over 200 categories. Items included in the CPI reflect prices of food, clothing, shelter, fuel, transportation, health care and all other goods and services that people buy for day-to-day living. These items are divided into seven categories (housing, food, transportation, medical care, apparel, entertainment, and other), each of which is weighted by its relative importance. The CPI also includes various user fees and taxes directly associated with the prices of specific goods and services. Personal Income and Personal Consumption Expenditures (PCE) The PCE, constituting the largest component of GDP, represents the change in the market value of all goods and services purchased by individuals. Personal income represents the change in compensation that individuals receive from all sources including: wages and salaries, proprietors income, income from rents, dividends and interest, and transfer payments (Social Security, unemployment, and welfare benefits). The release of these two figures gives the savings rate, which is the difference between disposable income (personal income minus taxes) and consumption, divided by disposable income. The ever-declining savings rate has become a key indicator to watch as it signals consumer spending patterns. Trade Deficits When the export value is smaller than import value, the result is a trade deficit. This renders an outflow of currency, which in turn makes a currency weaker. Industrial Production Industrial Production is the quarterly measure of the change in the amount of goods and services produced per unit of input. It incorporates labor and capital inputs. The unit cost of labor component is a useful indicator of any emerging wage pressures. The importance of productivity has grown over the past few years since the Federal Reserve has begun attributing its growth trend to relatively low levels of inflation. When this figure increases, the currency becomes stronger. Unemployment Rates The unemployment rate is calculated with the number of people unemployed in the labor force represented in a percentage. The labor force is the sum of people who are employed and those who are receiving unemployment benefits. Although it is a highly proclaimed figure (due to simplicity of the number and its political implications), the unemployment rate gets relatively less importance in the market because it is known to be a lagging. Business Inventories Business inventories and sales figures consist of data from other reports such as durable goods orders, factory orders, retail sales, and wholesale inventories and sales data. Inventories are an important component of the GDP report because they help distinguish which part of total output produced (GOP) remains unsold. When inventories of unsold output are high, it means the economy is slowing down and the currency is becoming weaker. Durable Goods Orders Durable Goods Orders measures the new orders placed with domestic manufacturers for delivery of hard goods. A durable good is defined as a product that lasts an extended period of time (three years and over) during which its services are extended. These include large ticket items such as capital goods (machinery, plant and equipment), transportation, and defense orders. They are extremely important in that they anticipate changes in production and thus, signal turns in the economic cycle. Rising figures are often supportive to a currency in the short term.
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Retail Sales The retail sales report measures total receipts of retail stores and includes the retail sales for both durable and non-durable goods. It reflects broad consumer spending patterns and is adjusted to normal seasonal variation, holidays, and trading-day differences. This is a true indicator of the strength of consumer expenditure. Rising figures are often supportive to a currency in the short term. Housing Starts The Housing Starts report measures the number of residential units on which construction is begun each month. A start in construction is defined as the beginning of excavation of the foundation for the building and is comprised primarily of residential housing. Rising figures are often supportive to a currency in the short term. The U.S. Central Bank, the Federal Reserve (Fed), has full independence in setting monetary policy to achieve maximum non-inflationary growth. There are primarily three policy signals that the Federal Reserve manipulates to assert control over the countrys economy. These are: the Discount Rate, Fed Funds Rate, and Open Market Operations. The Discount Rate is an interest rate at which the Fed charges commercial banks for emergency liquidity purposes. Although this is more of a symbolic rate, changes in it imply clear policy signals. The Discount Rate is almost always less than the Fed Funds Rate. Fed Funds Rate is clearly the foremost interest rate. It is the rate at which depositary institutions charge one another for overnight loans. Changes are made in the Fed Funds rate when the Fed wishes to send clear monetary policy signals. Generally, announcements of changes in this rate create a large impact on all bond, stock, and currency markets. The Federal Open Market Committee, also known as the FOMC, holds the responsibility to make decisions on monetary policy. It is this committee that makes the crucial decisions on interest rate announcements, which are made eight times per year. There are twelve sustains a large trade deficit of approximately $500 billion, which makes the U.S. rely heavily on capital flows. Hence, the dollar is a capital flow dominated currency.
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members altogether and they include the president of the Federal Reserve Bank of New York, the seven members of the Board of Governors, and the remaining four seats carrying a one-year term each are rotated among the presidents of the 11 other Reserve Banks. USD Trading Aspects The US dollar is involved in over 90% of all currency trades. The Treasury and Federal Reserve have favored a strong dollar for the past two decades, and occasionally, interventions are applied to support this policy. Prior to 9/11, the USD was considered one of the worlds safest currencies to trade. It still is the safest currency to some extent, however, the States vulnerability to terrorism has somewhat diminished this belief. Many emerging market countries peg their local currencies to the dollar in efforts to stabilize their own economy. Most of the worlds raw materials trade, even if it does not involve the U.S., is charged in USD. Since the interest rate differentials between U.S. treasuries and foreign government bonds are useful tools to determine potential currency movements, market participants closely follow the US Dollar Index that depicts the strength of the currency. It is important to closely monitor USD/CAD prior to important U.S. economic announcements as the pair often provide early indications of potential market reactions. The value of the dollar against one currency is sometimes impacted by the exchange rate of another currency pair that may not even involve the dollar. To illustrate, a sharp rise in the yen against the euro (falling EUR/JPY) may cause a general decline in the euro, including a fall in EUR/USD. For more information on the US dollar, refer to section 7: Tools & Resources. Euro (EUR) Overview of the European Monetary Union Economy The European Union (EU) developed as an institutional framework for the construction of a united Europe. The EU consists of 15 member countries that share the euro as a common currency. The EU has a single monetary policy dictated by the. European Central Bank (ECB). The decision making body is the Governing Council which consists of the Executive Board and the governors of the national central banks. The Executive Board consists of the ECB President, Vice-President, and four other members. These same 15 countries constitute the European Monetary Union (EMU). The EMU is the worlds second largest economic entity with a GDP valued over 8 trillion USD in 2002. The EMU is both a trade and a capital flow driven economy, therefore, trade is very important to the economies within the EMU. The EMU exports account for 19% of total world trade while imports account for 17%. It is primarily a service-oriented economy since services in 2001 accounted for approximately 70% of the total GOP.
EUR Trading Aspects: The EUR/USD is the most liquid currency pair in the world and its movement is used as the primary gauge of both general European and U.S. strength/weakness. The EUR/USD exchange rate is sometimes impacted by movements in cross exchange rates (nondollar exchange rates), such as the EUR/JPY or EUR/ GBP pairs. For instance, positive news in Japan could potentially cause a significant drop in the EUR/USD pair following the drop in the EUR/JPY
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exchange rate. Even though USD/JPY may also be declining, euro weakness will spill onto a falling EUR/USD. The EUR/USD rate serves as an indicator of movements in other currency pairs. There is a strong negative correlation between EUR/USD and USD/CHF, reflecting a consistently similar relation between the euro and Swiss franc. Since the Swiss economy is highly dependently on the EU economy, an upward spike in the EUR/USD is often accompanied by a downward dip in USD/CHF, and vice versa. EUR/JPY and EUR/CHF are very liquid currency pairs that are usually the indicator for general Japanese or Swiss strength/weakness. The EUR/USD and EUR/GBP crosses are great trading currencies, as they move systematically, have very little gapping, and have tight spreads. Since the EU is comprised of so many governments under parliamentary coalitions, it is highly susceptible to political instabilities, which in turn affects the value of the EUR. Political instability may include threats to coalition governments in France, Germany, or Italy. Political or financial instability in Russia may also cause devaluation of the EUR because of the substantial amount of German investment in Russia. Devaluations of the euro due to political instability in the EU are often fully manifested in the EUR/USD exchange rate. FX traders should pay close attention to comments by members of the Central Bank Governing Council and trade EUR crosses accordingly. For more information on the euro, refer to section 7: Tools & Resources, page 88. Japanese Yen (JPY) Overview of the Japanese Economy Japan has the third largest economy in the world, with a GDP valued over 4 trillion USD in 2002, and is a key member of the G7 Japan is one of the largest exporters in the world and is responsible for over 400 billion USD in exports per year. Its large industrial base (almost 40% of GDP) and limited natural resources create a high dependence on imported raw materials from foreign countries. The primary trade partners for Japan in terms of imports and exports are the U.S. and Japan is also the largest creditor (lender and investor) in the world; however, exporters tend to keep the majority of their profits invested in U.S. assets. Japans economy tends to be both capital and trade flow driven as international investors contribute to a high influx of currencies into Japans equity and fixed income markets. Furthermore, Japan attracts substantial amounts of inflows into its markets. JPY Trading Aspects The Japanese yen is a key indicator for Asian strength or weakness. This being said, economic crises or political instability in other Asian economies can often have dramatic impact on the yen spot movements. The yen is closely monitored by the single most important political and monetary institution in Japan, the Ministry of Finance (MoF). Despite Japans gradual measures to decentralize decision-making, the MoFs influence in guiding the currency is more significant than the influence of the ministries of finance of the U.S., U.K., or Germany on their countries. The Bank of Japan (BoJ) is also a very active participant in the FX market. Together, the two parties guide the movement of the yen through interventions. There are three main factors behind the BoJ and the MoF intervention: when the JPY moves by 7 or more JPY in under 6 weeks, when the yen is getting very strong, especially when it reaches above the 115 level, and when market participants hold positions in the opposite direction. The JPY is easily influenced by political speeches, particularly those pertaining to intervention. Generally, the JPY tends to trade in an orderly fashion during Japanese and London hours, but this trading pattern becomes variable in the U.S. hours. However, the most dangerous time to trade JPY is during lunchtime in Japan (10-11pm EST) because at this time, the market becomes illiquid and prone to volatility. FX traders should closely monitor banking stocks as movements in banks can often lead to movements in the yen. USD/JPY is one of the most popular major currency pairs in the FX market. The USD/JPY exchange rate is
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sometimes impacted by movements in cross exchange rates such as EUR/JPY. For example, a rising USD/ JPY could be a result of an appreciating EUR/JPY, rather than direct strength in the dollar. Therefore, it is important to pay close attention to potential EUR/JPY price movement when trading the USD/JPY pair. Great British Pound (GBP) Overview of the British Economy The United Kingdom (U.K.) is the worlds fourth largest economy, with a GDP valued over 1.4 trillion USD in 2001. It is also a key member of the G7. The U.K. has a service oriented economy, with manufacturing representing only one-fifth of national output. Their capital market systems are one of the most developed in the world; hence, their finance and banking have become the strongest contributors to the GDP. The U.K. is also one of the largest producers and exporters of natural gas in the EU. The energy production industry accounts for 10% of the nations GDP. Its largest trading partner is the EU, which accounts for over 50% of all the countrys import and export activities. GBP Trading Aspects The GBP has always played a significant role in the FX market and accounts for approximately 6% of the worlds currency trading volume. Although its presence is not as evident in other currencies, it maintains a strong presence when compared to the euro and USD. Because of the intimate trading relationship between the U.K. and EU, moves in the EUR/GBP pair often leads to fluctuations in GBP/USD. A rise in EUR/GBP (depreciating in sterling) could lead to a like decline in GBP/USD. News or speeches by political figures indicating that the U.K. is closer to joining the euro will usually put pressure on GBP, causing it to depreciate in value. Conversely, reports indicating that the U.K. may not join the single currency project will cause the GBP to appreciate in value. Since the largest energy companies worldwide are located in the U.K., GBP is positively correlated to energy prices. Switzerland (Confederatio Helvetica Franc - CHF) Overview of the Swiss Economy Switzerland is the nineteenth largest economy worldwide and the only major currency that does not belong to the G7. Switzerlands stable economy has a per capita GPD that is greater than any other Western European economy. It has a prosperous tourism industry and the worlds most advanced banking system. Similar to the British economy, the back bone of the Swiss economy stems from banking and insurance sectors. The two, combined, comprise over 70% of the countrys total GDP. It is important to note that, with the sophisticated banking system, Switzerland has become the worlds largest destination for offshore capital, which totals over $2 trillion in offshore assets. Since the country lacks significant natural resources, its economy is highly dependent on services and manufacturing businesses. International trade has always been the foundation and primary source of the countrys economic development. CHF Trading Aspects: J Switzerlands neutral political status makes the CHF a safe currency to trade. During international chaos involving countries outside of Europe, the Swiss franc is the second safest choice against the US dollar. In 1990, the franc broke its historically high exchange rate against the US dollar. However, its strength decreased significantly in. 1991, when it suffered adjustment periods. The trend in Swiss franc is highly dependent on outside events and international economic stability, as opposed to domestic economic news. Since the law requires that the franc be 40% backed by gold, the CHF is strongly correlated to the prices of precious metals. In regards to currency pairs, the USD/CHF is relatively illiquid and tends to gap; therefore, most active trading of the CHF occurs in EUR/CHF. Due to the lack of liquidity in USD/CHF,
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price movements typically follow those in EUR/USD and EUR/CHF. Because of the close proximity of the Swiss economy to the EU, the Swiss franc is positively correlated to the euro. This relationship is most evident in the inverse relationship between USD/CHF and EUR/USD. To illustrate, a sudden move in EUR/USD is most likely to cause an equally sharp move in USD/ CHF in the opposite direction. FX traders tend to favor USD/CHF because they can use EUR/USD and EUR/CHF as leading indicators for trading USD/CHF. Evidently, news of Switzerland joining the European Union (EU) would have negative impact on the CHF as the euro would overpower the CHF. At the present, economists and politicians remain uncertain on the long-term fate of the Swiss franc. Whether it is capable of maintaining its independence from the euro continues to be a debate. Canadian Dollar (CAD) Overview of the Canadian Economy Canada is the second largest country in the world but had a GDP of only 700 billion USD in 2001, making it the seventh largest world economy. Canada is also one of the leading members of the G7 countries. Economically and technologically, the nation has developed in parallel with the United States. As an affluent, high-tech industrial society, Canada closely resembles the U.S. in its market-oriented economic system, pattern of production, and high living standards. The United States accounts for more than 85% of Canadas exports and produces three-quarters of its imports. The Canadian economy is highly dependent on natural resources such as gold and oil; Canada is the worlds fifth largest producer of gold and the fourteenth largest producer of oil. In 1997-98, the government recorded a surplus for the first time in 28 years and the following year marked the first back-to-back surplus in almost 50 years. CAD Trading Aspects: The Canadian economy is highly dependent on gold and oil so price movements in these commodities greatly affect the value of the CAD. Additionally, since the United States is the biggest trading partner of Canada, the U.S. economy exerts a strong influence on the CAD. The USD/CAD rate often moves as a result of sentiment encompassing the U.S. economy. In the first half of 2003, the CAD peaked a six-year high, exceeding the 0.75 USD mark. FX traders should closely follow the interest rate differentials between the cash rates of Canada and the short-term interest rate yields of other industrialized countries. These differentials can be good indicators of potential money flows as they indicate how much premium the Canadian dollar (loonie) will yield in short-term fixed income assets, or vice versa.
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1. Always tune in to a live news source or channel during active trading. It is important to take note of the tremendous amount of data that is released at regular intervals. Identify the news source that can provide you with the latest breaking events and live broadcasts of scheduled speeches and reports by industry leaders. 2. Know when all scheduled announcements will take place that may influence your trading. Know exactly when each economic indicator is due to be released. A calendar of these reports is usually available from FX Trainers online resource links or can be found in most investment newspapers. Keep a calendar that contains the date and time of these events on your desk or near your trading station. Developing this positive habit will also help you make sense out of price action that might otherwise be unanticipated and erratic. 3. Get out of the market prior to any major announcement if you are a short-term, technical trader. If you must hold on to a longer term position, reevaluate your stop loss orders before these announcements are made. If it is mathematically sound, tighten your stop loss orders. you know what economists and other market pundits are forecasting for each indicator. Once again, market expectations for all economic releases are published by various sources on the Web and you should post these expectations on your calendar along with the release date of the indicator. Do not act too quickly should a particular economic indicator fall outside of market expectations. Each new economic indicator released to the public contains revisions to previously released data. For example, if durable goods rise by 0.6% this month, while the market is anticipating them to fall, the unexpected rise could be the result of a downward revision to the prior month. Look at revisions of older data. In this case, the previous months durable goods figure might have originally been reported as a rise of 0.6%, but now, along with the new figures, is being revised lower to perhaps a rise of only 0.1%. Therefore, the unexpected rise in the current month is likely the result of a downward revision to the previous months data. Have a basic understanding of what particular aspect of the economy is being presented in the data. For instance, you should recognize that the GDP is measuring the growth of the economy versus the CPI and PPI which are measuring inflation. Over time, you will become familiar with the nuances of each economic indicator and what part of the economy they are measuring. Pay attention to which indicators the markets are focusing on. During some periods, certain indicators are more important than others. Although most economic indicators are created with equal importance, some may have acquired much greater potential to move the markets than others. Therefore, know which indicators are more important during the time you are making your trading decisions. Lastly, do not succumb to paralysis by analysis. Given the multitude of factors that fall under the heading of The Fundamentals, there is a danger of information overload. Sometimes traders fall into this trap and are unable to pull the trigger on a trade. This is one of the
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reasons why many traders turn to technical analysis. To some, technical analysis is seen as a way to transform all of the fundamental factors that influence the markets into one simple tool, prices. However, trading a particular market without good fundamental knowledge about the exact nature of its underlying elements is rather risky. Achieve a balance between being uninformed and overwhelmed with economic data; be an informed FX trader who has enough knowledge of the underlying economic factors to make educated forecasts of market price movement.
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IV. Chart
Scaling of Charts Choosing the Proper Time Period Day or Intraday Trading Swing Trader Position Trader Three Methods of Plotting Charts Bar Charts Line Chart Candlestick Chart Common Candlesticks Candlestick Patterns Doji Bearish Engulfing Pattern Bullish Engulfing Pattern Piercing Line Pattern Dark Cloud Pattern Shooting Star Pattern Morning Star Pattern Even Star Pattern Harami Pattern Hammer Pattern Hanging Man Pattern
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II. Trends
Types of Trends Uptrend Downtrend Sideways Trend Classifications of Trends
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V. Pattern Interpretation
Principle 1 - Patterns take on Significance from their size and depth Principle 3 - Combine Pattern Trading with Other Techniques Identifying Support and Resistance Drawing Trend Lines (PAGE 62-66)
VII. Oscillators
Relative Strength Indicator (RSI) Moving Average Convergence and Divergence (MACD)
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VIII. Stochastics
Application of Stochastics in Trading 1) Detect overbought and oversold Conditions 2) Divergence 3) Trade Signals Rate of Change (ROC)
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Part I. Technical Analysis vs. Fundamental Analysis
Technical analysis concentrates on the study of market action while fundamental analysis focuses on the economic forces which cause prices to move. Both of these approaches attempt to achieve the same goal, that is, to determine the direction prices are likely to move. The only difference between the two is that they approach. the market from different angles. In essence, a fundamentalist studies the cause of market movement, while a technician studies the effect. On the surface, technicians may appear to ignore the fundamentals that drive market movement. It may seem that they are so absorbed by charts and data tables that they become ignorant of the underlying factors that move the market. However, a technical trader will explain to you that all the fundamentals are already represented in the price. In other words, the charts that depict price movements are actually a visual form that illustrates the fundamentals. All economic data are translated into patterns and trends of market prices that could easily be used for making important trading decisions. Basically, technical traders look at the charts to identify the trends in order to predict future prices. The bottom line when using any type of analysis, technical or fundamental, is to stick to the basics. The basics are the methods that work for you and have been proven to work over a long period of time. After finding a trading system that works best for you, other methods and strategies could be gradually incorporated as tools into your trading toolbox. by assessing the extent of market reversals. Technical analysis can be used on an intraday 5 minute, 15 minute, hourly, weekly, or monthly basis. Technical analysis is based on 3 assumptions listed in the table below.
Depending on the level of complexity, technical analysis may involve price charts, volume charts, and many other mathematical representations of market patterns. As you advance in your technical trading skills, technical indicators and mathematical ratios may be added to the charts to form a more comprehensive analysis of the market. Therefore, rather than merely relying on price charts, technicians may also use other tools in aid of forecasting future market values. Currencies rarely spend much time in tight trading ranges and have the tendency to develop strong trends. Over 80% of volume is speculative in nature and as a result, the market frequently overshoots and then corrects itself. A technically trained trader can easily identify new trends and breakouts, which provide multiple opportunities to enter and exit the market. Two Major Forms of Technical Analysis Technical analysis can be further divided into two major forms: Quantitative Analysis: uses various statistical properties to help assess the extent of an overbought/oversold currency. Chartism: uses lines and figures to identify recognizable trends and patterns in the formation of currency rates.
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trend is an overall directional price movement in a pre-defined time interval. It is estimated that 70% of the time, markets will fluctuate randomly or move between support and resistance levels. The rest of the time, market behavior is characterized by persistent price movements trends that break through support and resistance levels. The concept of trends forms the basis of the technical approach. Basically, the sole purpose of charting the price action of a market is to identify trends in early stages of their development for the purpose of trading in the direction of those trends. In fact, most of the techniques used in this approach are trend-following in nature; their intent is to identify and follow existing trends. Once a trend is defined, a sound strategy can reasonably predict its direction and duration. As a result, profits are accumulated and maximized, while losses are minimized. Types of Trends One of the first things you will hear in technical analysis is this saying: Never go against the trend; the trend is your friend. Prices can move in one of three directions, up, down or sideways. Once a trend is established in any of these directions, it usually will continue for some period. Based on the direction of movement, there are three types of trends: 1) Uptrend, 2) Downtrend, and 3) Sideways Trend. Uptrend An uptrend is a succession of higher highs and higher lows. It indicates a bull market in which the base currency is appreciating in value. In essence, an uptrend can be considered intact until a previous relative low point is broken. A violation of this condition serves as a warning that the trend may be over. Once an uptrend is confirmed, traders should enter a buying position; in other words, go long on the currency pair. Downtrend
A downtrend is defined as a succession of lower lows and lower highs. It indicates a bear market in which the base currency is depreciating in value. Generally, a downtrend can be considered intact until a previous relative high is exceeded. Once a downtrend is established, traders should enter a selling position, which is also known as shorting the currency pair. Sideways Trend
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A sideways trend indicates a highly volatile market in which prices are moving within a narrow range. In other words, the value of currencies is not appreciating or depreciating in value. Classifications of Trends There are three classifications of trends: primary, intermediate, and short-term. patterns and trend reversal patterns, which naturally correlate with the two above-described phases. Continuation Patterns Continuation patterns reflect a gap or pause in trading that the market needs during sharp trends. Such periods of consolidation are usually quite short and often slope against the original trend. In contrast, breakouts occur in the same direction as the original trend. Lets review, several common continuation patterns that can enhance your technical analysis. Although these patterns are normally considered bar patterns, we can also view them with candlestick charts. Channel or Rectangle A channel or rectangle is a pattern in which parallel lines can be drawn through or against price bar or candle highs and lows. Channels can be in several directions: horizontal (also called a rectangle), inclining, or declining. This pattern is easy to spot since it can be viewed as a brief sideways trend. If it occurs within an uptrend and breaks out on the upside, it is called a bullish rectangle. If the congestion occurs with a downtrend and breaks out on the downside, the formation is called a bearish rectangle.
Rally & Consolidation Phases Currency price movements can usually be put into two main categories, a rally phase and a consolidation phase (also known as congestion). During the rally phase, buyers of one side of a currency pair have the upper hand over sellers, since it is their enthusiasm that strengthens the currency they have chosen to buy. During the consolidation phase, the enthusiasm of both buyers and sellers of both sides of a currency pair becomes more balanced, as neither one is able to win out over the other. Eventually, one will dominate and another rally phase will commence in either direction. Obviously, every purchase must be offset by a sale, and visa versa. However, if buyers are enthusiastic, they are more willing to accept a higher price which increases the value of the bought currency. If sellers are pessimistic, they are more likely to only be willing to accept a lower price, which decreases the value of the sold currency. Technical traders can notice these price struggles as buyers and sellers battle. These battles between buyers and sellers appear in reoccurring patterns or formations that can be seen within their charts. These patterns can also be categorized into two groups, continuation
Traders frequently trade on the breakout of the channel or test the breakout by placing a small risk stop order inside or on the other side of the channel. Upon breakout, the market will most likely move in the direction of the original trend.
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When a channel follows a strong rally phase, we refer to this as a flag formation since the rally phase resembles a flagpole and the consolidation phase (channel) that follows it resembles a flag. A flag pattern is very reliable and often easy to see in the early stages of its formation. Triangles A triangle is a pattern in which the slope of price bar or candle highs and lows are converging to a smaller pricing area or point so as to outline the shape of a triangle. Triangles can either be symmetrical, ascending, descending, or expanding. The ascending triangle is recognized by a flat resistance line and an upward sloping support line. The descending triangle is identified by a flat support line and downward sloping resistance line. The much less common expanding triangle is a mirror image of a symmetrical triangle, but the tip of the triangle, not the base, is next to the original trend. Traders frequently trade on the breakout of a triangle or test the breakout by placing a small risk stop order inside the triangle. are distinguished by a noticeable slant in either direction.
There are several breakout-based approaches to trading wedges. The most common approach is to give a bias to the same direction of the overall trend when the wedge is pointed in the opposite direction of the trend. Below is an example of a falling wedge in a downtrend:
When a triangle follows a strong rally phase, we refer to this as a pennant formation since the rally phase resembles a flagpole and the consolidation phase (triangle) that follows it resembles a pennant flag that tapers to a point. A wedge is a pattern that is similar to a triangle in appearance because it also has converging trend lines coming together at the tip. However, wedges
Trend Reversal Patterns Like most good things in life, all good trends must come to an end. In Forex, this is not unfavorable since we can simply reverse directions and go the other way. Fortunately, there are several trend reversal patterns that often signal the beginning of a new trend, or, at the very least, a strong countertrend move. Lets review three common trend reversal patterns that can enhance your trade system. Again, although these patterns are normally considered bar patterns, we can also view them with candlestick charts. Head and Shoulders Head and shoulders is a bar pattern that signals a trend reversal. In an uptrend, the market begins to
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slow down and forces of supply and demand are generally achieving equilibrium. Sellers come in at the highs (left shoulder) and push the market down until the bearish force slows down (beginning neckline). Buyers soon return to the market and ultimately push through to new highs (head). However, the new highs are quickly turned back and the downside is tested again (continuing neckline). Short-term buying reemerges and the market rallies once more, but fails to take out the previous high (right shoulder). Buying subsides and the market turns back to the downside again. The pattern is complete when the market breaks the neckline. Head and Shoulders can be in an uptrend or inverted in a downtrend. Below is an example of a head & shoulders pattern in an uptrend: Below is an example of a 1-2-3 top:
Double or Triple Tops and Bottoms Double or Triple Tops and Bottoms is another bar pattern that signals a trend reversal. In an uptrend, prices rally to a new high, pull back for an indefinite time period, rally to the same high price area again whereupon they reverse once again. This rally and pull-back action can occur two, three or more times, forming a double or triple top.
whatever is being studied. Depending on their level of sophistication, charts can help with much more advanced studies of the markets.
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Scaling of Charts Pricing on FX Charts is always displayed on the vertical or Y axis, either to the right or left side. Pricing information is plotted on an arithmetic scale which plots each price variance with the same vertical distance; hence, the distance from 1.1400 EUR/USD to 1.1450 EUR/USD is the same as 1.1500 EUR/USD to 1.1550 EUR/USD. Choosing the Proper Time Period A day or intraday trader trades in very short time frames of minutes and hours. So, an FX day trader usually sets up a screen page or pages with a daily, 120, 60, 30, 15, 10, 5, or 1 minute chart. Below is a sample 5 minute chart for day or intraday trading:
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Often, an FX swing trader uses data from previous weeks and months to open positions on Monday or Tuesday with a goal of closing these positions by Thursday or Friday. So, an FX swing trader normally sets up a screen page or pages with weekly, daily, 120, or 60 minute charts. Below is a sample daily chart for swing or momentum trading:
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A position trader opens and holds positions in the market for weeks or even months at a time. When trading with this style, the trader is not as concerned about the daily noise in the market. So, an FX position trader sets up a screen page or pages with monthly, weekly and daily charts. Below is an example of a weekly chart for position trading:
Three Methods of Plotting Charts With technical analysis gaining wider acceptance, technicians have developed more than one way of physically representing market data on charts. Most charting methods plot prices on the vertical (Y-axis) and the time period on the horizontal (Xaxis). Time frames can be anywhere from one minute all the way to one month. There are three widely used methods of plotting charts; they include bar, line, and candlestick charts.
Bar Chart
This method portrays pricing action using vertical bars. The bar represents the trading range for the stated time period. The bars themselves usually
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have at least one horizontal mark. The top of the bar records the highest price and the bottom records the lowest price. A mark, extending to the left, records the opening price and a mark, extending to the right, records the closing. One advantage of bar charts is that they can provide a lot of visual information on a single page.
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Line Chart Usually on a line chart, the openings, highs, and lows are ignored. Only the closing price is plotted. A continuous line, with various peaks and valleys, joins the closing prices. The line chart offers less visual information than other charts; however, it can be more helpful in some respects. For example, since the highs and lows are ignored, most of the market noise (short-term price fluctuations) is eliminated. This makes it much easier to spot trends and reversal patterns.
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Candlestick Chart These vertical lines on the top and bottom are also referred to as the upper shadow and the lower shadow. The rectangle itself is known as the body, which represents the pricing activity between the opening and closing prices. If the opening price is higher than the closing price, the opening price is recorded at the top of the body and the closing price at the bottom; the candle is displayed in a solid red body. When the opening price is lower than the close, the opening price is recorded at the bottom of the body and the closing price at the top; the candle is displayed with a solid blue body. The biggest advantage of using candlesticks is that they can make it easier to spot certain price patterns that may not be as apparent in other charts. The disadvantage, of course, is that candlesticks take up a lot more horizontal space, giving a smaller view of market activity.
This method was developed in Japan many centuries ago and basically provides the same information as bar charts. A candlestick or candle consists of a vertical rectangle, and often, a vertical line on top of the candle (wick) and a vertical line below the candle (tail).
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Common Candlesticks There are 5 different types of candlesticks that are extremely common in the FX market. These candlesticks are as follows: A shows the high and low with no shadows. B shows when the opening and closing prices are identical. C shows a very small trading range. D shows the opening and closing near the high. E shows the opening and closing near the low. A doji implies that the market has an unclear or undecided direction. Buyers and sellers are in equilibrium (equally strong). Opening and closing prices are equal; hence, a true doji has a horizontal line instead of a body. The color of the doji may be blue or red. A doji provides signals of potential market tops or bottoms. A doji formation is significant if it appears after a long blue candle in an uptrend or a long red candle in a downtrend. If there are two doji formations (double-doji), that means that the market is about to reverse.
Candlestick Patterns The information displayed in candlestick charts is identical to bar charts. Each one contains the opening, high, low, and closing prices. However, it is the way that candles are displayed that makes them unique and gives them different interpretive powers. While they can be used for any time period, candlesticks are used most often with daily price data. The most commonly used time scale for candlestick charts is 5 minutes 1 day. It is important to familiarize yourself with the various candlestick patterns. These patterns possess specific forecasting characteristics that indicate buying/selling opportunities.
Bearish Engulfing Pattern The bearish engulfing pattern is a trend reversal pattern, which typically occurs after a significant uptrend. It is formed when a red candle engulfs a blue candle. This indicates that sellers have gained control Bearish Engulfing of the market. The significance of the bearish engulfing pattern is dependent on the sizes of the two involved candles; the smaller the blue candle and the larger the red candle, the more significant the signal. Generally, it is a sell signal once a currency pair closes in this formation.
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Piercing Line Pattern The piercing line pattern is a bullish signal. It shows that there is strong buying power at lower levels and that the downward pressure is beginning to subside. The more the blue candle pierces into the red candle, the more significant the bullish signal.
Bullish Engulfing Pattern The bullish engulfing pattern is a trend reversal pattern that usually appears after a dramatic downtrend. It indicates that the downward momentum may be at an end. The formation of this pattern involves a red candle that is engulfed by a blue candle. The longer the blue candle, the more significant the trading signal is. Typically, it is perceived as a buy signal.
Dark Cloud Pattern A dark cloud cover is a bearish signal. This reversal pattern indicates that the buying pressure is weakening. The formation consists of the body of a red candle closing within the previous blue candle. The deeper the second candle covers the first candle, the stronger the signal.
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Shooting Star Pattern A shooting star is a reversal pattern that typically occurs after gaps. This is a bearish signal that has a long wick and a small body. It is usually located near the end of the trading range. This pattern shows that, the market has met with a strong selling pressure after it rallied. The color of the body can be either blue or red. More often it signals a downtrend reversal, as opposed to an uptrend reversal, is in the making.
Evening Star Pattern The evening star pattern is a bearish signal that occurs in an uptrend. It indicates that the market has hit a wall of sellers after a rally. This formation also involves three candles: a blue candle, followed by a small red or blue, then a long red candle. The last red candle does not touch the body of the second candle. Traders should not trade until confirming the close of the third candle.
Morning Star Pattern The morning star is a bullish signal reversal pattern that occurs in a downtrend. This formation involves three candles: a long red candle, a small red or blue candle, and a blue candle. The last blue candle usually has a long Morning Star body that does not touch the body of the second candle and closes well into the body of the first candle. It is very important that traders wait for the third candle to close prior to buying.
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Harami Pattern The harami pattern is a reversal formation that signifies a weakening trend. It is comprised of two candles: the first candle has a long body, while the second has a smaller body that is within the first candle and is in a different color than the first candle. The smaller the second candle, the stronger the reversal signal Hanging Man Pattern The hanging man pattern appears after a rally and is typically viewed as a bearish signal. Because the currency pair was not able to close higher than its opening price, the hanging man indicates weakening market sentiment. Prior to opening a new position, it is important to wait for the next candlestick to close. The next candlestick must close below the hanging mans body in order to confirm the trend reversal. Hammer Pattern The hammer formation appears after a significant downtrend and is typically viewed as a bullish signal. It is particularly important if it occurs after a number of down days. Traders may buy Hammer once a hammer formation appears, aspiring for an imminent trend reversal. It is even more effective when a currency reaches a double bottom and a strong support line is in place.
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Pattern Interpretation There are 3 principles that should help increase your ability to successfully interpret the market data displayed within price patterns. Principle I Patterns take on Significance from their Size and Depth The larger a pattern becomes, the greater its significance. Remember that patterns give us a visual picture of the battles fought between buyers and sellers. The bigger the battle and the longer it takes, the more exhausted the losing side becomes and the greater the probability for a new price movement. Principle 2 Do not wait for Perfect Patterns Novice traders will often miss out on great trade opportunities because a price formation is not a perfect match to the ones in the course. What they fail to grasp is that pattern interpretation is not perfect science. Experienced traders do not wait around to trade perfect patterns. They know that pattern interpretation is a subjective technique that must be adaptive. As a result, seasoned traders have their eyes wide open to a greater number of excellent opportunities available to them in the Forex market. Principle 3 Combine Pattern Trading with other Techniques A trader can be profitable trading high-probability patterns alone. However, when you combine other techniques, you can increase the probability of your success immensely. trend. These peaks and troughs are more commonly referred to as support and resistance levels. Support and resistance levels are points where a chart experiences recurring upward or downward pressure. Support is enough buying pressure to halt a decline in prices for an extended period. A support level is usually the low point in any chart pattern (hourly, weekly or annually). In contrast, resistance is enough selling pressure to halt an increase in prices for an extended period. A resistance level is the high or the peak point of the pattern. These points are identified as support and resistance when they show a tendency to reappear. The area in between these levels is called a channel. As prices move between the support and resistance level, they are moving within the channel. It is best to buy or sell near support or resistance levels that are unlikely to be broken.
Once these levels are broken, they tend to take up the opposite role. Thus, in a rising market, a resistance level that is broken, could serve as a support for the upward trend, whereas in a falling market; once a support level is broken, it could turn into a resistance.
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The following chart shows rising support and resistance levels in an uptrend. connecting two points or more. The validity of a trading line is partly correlated to the number of connection points. Yet, it is important to note that points must not be too close together.
This diagram is a trend line drawn by connecting three successive low points in an uptrend. There are several guidelines that are applicable when using support and resistance levels. These guidelines are listed in the table below.
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2) Oscillators are considered leading indicators and typically turn before price reversals. They work best in rallying or choppy markets, but give false signals in trending ones. Moving Averages (MA) Moving averages (MAs) are trend-following indicators that are the most popular among all technical indicators. They are lines overlaid on a chart indicating long term price trends, with short term fluctuations smoothed out. An MA tells the average price in any given point over a defined period of time. They are called moving because they reflect the latest average, while adhering to the same time measure. Moving averages are important technical indicators because they eliminate minor fluctuations and provide traders with a clear depiction of price over a length of time. MAs are widely used because they are easy to understand and calculate. A weakness for moving averages is that they lag the market. In other words, they follow market changes and do not necessarily signal a change in trends. To overcome this issue, shorter periods such as 5- to 10-day MAs are used. Moving averages with a shorter time frame are more reflective of the recent price action rather than older data that 40 or 200-day moving averages illustrate. There are three kinds of mathematically distinct moving averages: Simple MA, Weighted MA, and Exponentially Smoothed MA. Simple Moving Average The simple moving average is the most basic of all moving averages. A simple moving average assigns equal weight to each price point over the specified period. The FX trader defines whether the high, low, or closing price is used and these price points are added together and averaged. This average price point is then added to the existing string and a line is formed. With the addition of each new price point, the sample set drops off the oldest point. In short, it is the average of a specified number of prices for a specific period of time. Weighted Moving Average This indicator does not assign equal weight to all values in the data series; it can either assign more weight to the front or back. A front-weighted moving average gives greater weight to the newest data and a back-weighted moving average gives greater weight to the oldest data. However, a weighted moving average is most often used with giving more emphasis to the latest data. A weighted MA multiplies each data point by a weighting factor, which differs from day to day. These figures are then added and divided by the sum of the weighting factors. Essentially, a weighted MA enables the trader to effectively smooth out a curve while having the average more responsive to current price changes. Exponentially Smoothed Moving Average Among the 3 types of moving averages, exponentially smoothed moving averages (EMA) are the most commonly used. Instead of assigning equal weight to all data, it puts an emphasis on the most recent data. The exponentially smoothed MA considers data in the entire life of the instrument. Since it is mathematically smoothed, it generates a more stable moving average line. The mathematics behind this indicator is relatively more complex than the previous two types of moving averages. The EMA multiplies a percentage of the most recent price by the previous periods average price.
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Application of Moving Averages in Trading 1. Determine entry and exit points Moving averages may be used by combining two averages of distinct time frames. For example, a 5day MA may be paired with a 20-day MA or a 10-day MA with a 40-day MA. A buy signal is indicated when the fast moving average (one with the shorter time frame) crosses and closes above a slow moving average (one with the longer time frame). Conversely, a sell signal is indicated when the fast moving average crosses and closes below a slow moving average. 2. Determine direction of trend An upward moving average signifies an uptrend. A downward moving average signifies a downtrend. 3. Determine strength of trend The steep slope of a moving average indicates a strong trend. The flat slope of a moving average indicates a weak trend
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Most Commonly Used Moving Averages Moving averages are frequently viewed as support or resistance levels that are used in reference points. 200-day, 100-day, 50-day, 20-day, and 10-day moving averages are the most widely used in technical analysis. While a longer term moving average can help to define and support a particular trend, shorter term moving averages can provide lead signals that a trend is ending before prices dip below your longer term moving average line. For this reason, most traders will plot several moving averages on the same chart. For example, price movements above the 200-day exponentially smoothed MA are perceived as bullish, meaning that the market consists of more buyers than sellers. Conversely, price movements below the same MA would be considered bearish, meaning that there are more sellers than buyers in the market. There are various combinations of moving averages as their time interval matters (days or minutes). The longer the time frame is, the more accurate the trend.
Bollinger Bands Bollinger Bands is another trend-following indicator used to identify extreme highs or lows in relation to market price. Sometimes currency prices appear to remain in a range for extended periods of time. Some people use an upper boundary and a lower boundary to define the range. The upper boundary is
calculated as a moving average of a chosen period plus 5% of the price, and the lower boundary is the moving average minus 5%. These boundaries have the drawback of being too narrow to accommodate price levels when volatility is high, and too wide when volatility is low.
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A better solution, Bollinger Bands, establishes trading parameters, or bands, based on the moving average and a set number of standard deviations around this moving average. While the upper boundary is a chosen moving average plus X number of standard deviations, the lower boundary is the moving average minus the same number of standard deviations. Bollinger bands are very similar to moving averages but are correlated with price actions of the currency, rather than a fixed percentage amount. Because standard deviation is a measure of volatility, Bollinger Bands are dynamic indicators that adjust themselves (widen and contract) based on the current levels of volatility in the market being studied. Generally, the higher the volatility, the wider the band is; the lower the volatility, the narrower the band is. John Bollinger, the inventor of the Bollinger Bands, recommends using a simple 20-day moving average and 2 standard deviations. A simple moving average is recommended because the sensitivity is less intense, which equates less market noise. The Bollinger Bands include 3 lines: the upper band, lower band, and the centerline. The centerline is simply the moving average, also known as the pperiod in the Bollinger Bands. The upper and lower bands are, respectively, the center line plus or minus twice the standard deviation; this statistically implies that 95% of price movement should be contained between the two bands. When prices reach the upper or lower boundaries of a given set of Bollinger Bands, this is not necessarily an indication of an imminent trend reversal. It simply means that prices have moved to the limits of the established parameters. Therefore, traders should use another study in combination with Bollinger Bands to help them determine the strength of a trend.
Methods of Interpreting Bollinger Bands 1. Breakouts When the price breaks above the upper band or below the lower band, some traders believe that it is an indication that currency price is in the midst of a breakout. Consequently, these traders would take a position in the direction of the breakout. 2. Overbought & Oversold Indicators When the price touches the upper band, it may be interpreted as a sell signal because it is assumed that the currency pair is overbought, and may revert to the middle of the moving average band. Alternatively, when the price touches the lower band, it is interpreted as a buy signal because it is assumed that the currency pair is oversold and may spring back towards the top of the band. Oscillators Oscillators are derived from the underlying currency to provide signals regarding overbought and oversold conditions. Since the market fluctuates, prices tend to overshoot or overextend. The most common oscillators are described below. Relative Strength Indicator (RSI) The most popular oscillator is the relative strength indicator. It was created by J. Welles Wilder Jr. to measure the strength or momentum of a currency pair. This indicator is calculated by comparing a currency pairs current performance against its past performance or its up days versus its down days. RSI is plotted on a vertical scale that measures from 0 to 100. An RSI above 70 indicates an overbought condition, which in turn indicates a sell signal. An RSI below 30 represents an oversold condition, which
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implies a buy signal. Moreover, a sell signal is indicated when the market price is high and the RSI value begins declining. Conversely, a buy signal is indicated when market price is low and the RSI value begins to rise. This theory underlying this indicator implies that prices cannot rise or fall forever. By studying the RSI, traders can determine with a reasonable degree of certainty when a reversal will take place. However, be very cautious of trading on RSI values alone. From time to time, an RSI can remain at very high or low values for quite sometime without prices reversing their course. During these times, the RSI is simply illustrating that the market is quite strong or weak but shows no signs of changing its course. The RSI can be adjusted to various levels of time sensitivity. Depending on the style of trading, the RSI can be manipulated to suit the traders needs. For instance, a 5-day RSI is very sensitive and tends to give many signals that may not all be sustainable. On the other hand, a 20-day RSI tends to be relatively less choppy and give fewer signals. Long-term or position traders may find that shorter time frames used for an RSI will yield too many signals, and perhaps lead to over-trading. However, shorter time frames are probably ideal for day traders who are seeking to capture the shorter-term price fluctuations. Finally, look for divergences between market prices and the RSI. If the RSI turns up in a slumping market or turns down during a bull run, this could be a good indication that reversal is about to take place. Wait for a confirmation before you act on divergent indications for your RSI studies. A divergence between the RSI oscillator and the current market price trend is an accurate indicator that a market turning point Is imminent. However, to be on the safe side, wait for confirmation before you act on divergent indications from RSI values. Moving Average Convergence and Divergence (MACD) MACD, developed by Gerald Appel, has become another popular oscillator used in the FX market. It is simply a more detailed method of using moving averages to identify trading signals from price charts. In essence, MACD is the difference between a shorter period exponentially smoothed MA and a longer period exponentially smoothed MA. This indicator is used to confirm trends and to indicate reversals and overbought/oversold conditions. The MACD is composed of two lines on the charts and are displayed as crossovers that give buy and sell signals. The MACD line is usually a solid line that signifies the difference between two MAs with different time periods. The Signal line is usually a dashed line that represents the MACD smoothed with another exponentially smoothed MA. Generally, the MACD plots the difference between a 26-day exponential MA and a 12-day exponential MA. Application of MACD in Trading 1) Crossovers The most common way to use the MACD is to buy or sell a currency pair when it crosses the signal line or zero. A buy signal is indicated when the MACD rallies above the signal line and a sell signal is denoted when it falls below the signal line. 2) Overbought Whenever the MACD rises, or when the shorter moving average moves away significantly from the longer moving average, the currency pairs price movements are likely to start slowing down and soon return to more middle-ranged levels. 3) Divergences When the MACD diverges from the trend of the currency price, this may signal a trend reversal. For instance, if the MACD turns positive and makes higher lows while prices are still sinking, this could be
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a strong buy signal. Conversely, if the MACD makes lower highs while prices are aspiring, this could signify a strong sell signal Stochastics This popular indicator examines the strength and momentum of a currency pairs price action by measuring the degree by which a currency is overbought or oversold. Stochastics provide a trader with information about the closing price in the current trading period relative to the prior performance of the market being analyzed. The stochastic formula is established on the basis that prices tend to close near the upper part of the trading range during an uptrend and close near the lower part of the trading range during a downtrend. When using the formula, one attempts to identify the points in the rising market where the closes are grouped nearer to the low prices than high prices, which would signal a trend reversal is in progress. Vice versa, in a falling market, stochastics attempt to identify closes grouped nearer to the high prices, which would also signal a trend reversal in progress. Stochastics are measured and represented by two separate lines. They are both plotted on a scale from o to 100. The different values on this scale suggest different market behaviors. While high values indicate a bullish market, low values imply a bearish market. It is important to note that stochastics do not work well in choppy or sideways markets. When prices are fluctuating in a narrow range, the stochastics value lines may cross too many times, indicating that the market is moving sideways. Furthermore, stochastics are most useful in measuring the strength of a trend. When prices are making new highs or lows and the stochastics are moving in the same direction, the trend is very likely to continue. Application of Stochastics in Trading 1) Detect overbought and oversold conditions Readings above 80 represent strong upward movements and overbought conditions. On the other hand, readings below 20 indicate strong downward movements and oversold conditions. 2) Divergence Divergence occurs when the stochastic values are flattening out or moving in the opposite direction of prices. Divergences can be used as reliable indicators of possible trend reversals. Therefore, many traders close their current positions and/or enter new positions in the opposite direction from the direction of the current trend that is believed to be terminating. 3) Trade Signals Stochastics can be a very useful indicator for timing the market. One of the most important buy and sell signals for technical analysis is when the stochastics value lines cross. Strong overbought signal is indicated when the currency pair makes a new high and the lines cross the 80 level. Conversely, the currency pair is severely oversold and ready to reverse when it makes a new low and the lines cross below 20 to confirm that low. Rate of Change (ROC) ROC is one of the simplest indicators to utilize, while being as effective as other indicators. It compares the current price (or todays price) with the price of x time periods ago. The result is displayed as a continuous value that fluctuates below and above the median. Although the jaggedness of the ROCs appearance makes it difficult to spot trend reversals, it is a useful tool for trend analysis. The 12-day ROC is an excellent short-to-intermediateterm overbought/oversold indicator. The higher the ROC, the more overbought the currency; the lower the ROC, the more likely a rally will take place. However, as with all overbought/over-sold
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indicators, it is prudent to wait for the market to begin correcting (i.e., turn up or down) before placing your trade. A market that appears overbought may remain overbought for some time. In fact, extremely overbought/oversold readings usually imply a continuation of the current trend. The 12-day ROC tends to be very cyclical, oscillating back and forth in a fairly regular cycle. Often, price changes can be anticipated by studying the previous cycles of the ROC and relating the previous cycles to the current market. The Basic Theories In addition to the technical indicators, successful traders incorporate basic theories into their trading strategies. These theories enrich a traders trading skills, allowing them to make logical and sound decisions. There are two fundamental theories that are commonly used: Fibonacci Retracement Theory and Elliott Wave Theory. Fibonacci Retracement Fibonacci retracement levels are a sequence of numbers discovered by the noted mathematician Leonardo da Pisa during the twelfth century. These numbers describe cycles found throughout nature and when applied to technical analysis, can be used to find pullbacks in the FX market. Fibonacci retracement involves anticipating changes in trends as prices near the lines created by the Fibonacci studies. After a significant price move (either up or down), prices will often retrace a significant portion (if not all) of the original move. As prices retrace, support and resistance levels often occur at or near the Fibonacci Retracement levels. Fibonacci retracement levels can easily be displayed by drawing a trend line between a perceived high point to a perceived low point. By taking the difference between the high and low, the user can insert the percentage ratios to achieve the desired pullbacks. These levels represent areas where the pullback may subside; thus, signaling opportunities to enter and exit positions. The most commonly used levels are 38.2%, 50%, and 61.8%. Application of Fibonacci Retracement Levels in Trading Fibonacci levels are used by drawing a trend line between two significant points recent top and bottom prices then inserting retracement levels. For example, the red lines in the chart show the high and low points from which the retracement levels are measured. The blue lines represent the corresponding Fibonacci retracement levels. When price moves to one of the levels and stops, it is likely that the correction may be over and the trend will likely resume. If it is a downtrend, the retracement of the correction would be up. If it is an uptrend, the retracement would be down.
Typically, these levels can be used to signal the prices at which traders should exit and enter positions. For example, an uptrend began to develop at the price of 1.1050 for EUR/USD. Fibonacci retracement levels were applied and the 38.2%, 50%, and 61.8% appeared at 1.1410, 1.1607, and 1.1806. The market continued in an uptrend and pulled back a little at the retracement levels. It is the perfect timing to exit a position when the market retraces at these levels. After the market retraces slightly, it resumes to its uptrend. Once the trend broke the 61.8% level, a trader would anticipate that the price will now move towards the 50% and enter another long position. Theoretically, a trader could
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exit before retracement occurs and enter new positions once the currency pair resumes its uptrend.
Factors to consider when using the Fibonacci Levels: The longer the time frame, the more significant the retracement level. If there are two different levels that are close together, such as a 50% of a monthly chart and a 61.8% of a daily chart, this enhances the importance of that level. Rates must close well beyond these retracement levels to signify that the levels have been broken. If there is a confirmation of the support or resistance in other studies, such as RSI or MACD, this increases the probability that the correction will end at these levels.
Elliott Wave Theory Ralph Nelson Elliott, an engineer from the 1930s, claimed that the Dow Jones Index along with other related markets, move in rhythms or waves similar to the ocean tides which moves from low tide to high tide. According to Elliotts 5-wave theory, market trends often develop in five identifiable waves. Waves number 1, 3, and 5, move in the direction of the current trend and waves number 2 and 4 move counter-trend. In addition, Elliott asserted that under normal circumstances, wave number 5 appears similar to wave number 1. He observed that wave number 3 is usually the longest wave. Finally, he stated that wave number 4 should not touch the top of wave number I in an uptrend.
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crucial to determine the role of a wave in relation to the greater wave structure. Thus, the key to Elliot Waves is to be able to identify the wave context in question. Ellioticians also use Fibonacci retracements to predict the tops and bottoms of future waves. The diagram of the Impulse Wave is the basic building block of the Elliott wave structure. Elliott classified price movements in patterned waves that can indicate future targets and reversals. Waves moving with the trend are called impulse waves, whereas waves moving against the trend are called corrective waves. The Elliott Wave Theory breaks down impulse waves and corrective waves into five primary and three secondary movements respectively. The eight movements comprise a complete wave cycle. Time frames of wave cycles can range from 15 minutes to years and decades. The challenging part of Elliott Wave Theory is figuring out the relativity of the wave structure. A corrective wave, for instance, could be composed of sub-impulsive and corrective waves. It is therefore The diagram below shows the corrective patterns that consist of various wave sequences.
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The diagram below shows a unique type of corrective patterns.
This is not to say that you should go to the other extreme. Do not get too caught up in the mathematics involved in putting together each study. It is much more important to understand how and why studies can and should be manipulated based on the time periods and sensitivities that you determine are ideal for the currency you are trading. These ideal levels can only be determined after applying several different parameters to each study until the charts and studies begin to reveal the details behind the details.
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Principle 9: 78 Understand the Market Discount Mechanism Principle 10: 78 Diversify With Multiple Currency Pairs Principle 11: 78 Never Chase Trades Principle 12: Know When to Leave a Trade Principle 13: Approach Trading as a Business Business/Trading Plan Research the Market Record Activities with Trading Journals 79 79 79 79 79
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Principle 1: Always Start with a Demo Account It is always tempting to start implementing your trading system once you have finished or even while you are still reviewing this course. However, it requires time and skills to take full advantage of all your tools supplied by the company. As a novice trader, we highly recommend practicing and honing your skills before using real cash. We are all familiar with the saying, Practice makes perfect. Allow yourself enough time to digest and absorb the various trading strategies and concepts before risking real money. You can maximize your profit potential so much more if you spend some time to exercise your trading principles in a demo account. It is highly beneficial for all novice traders to begin trading with a demo account. The only difference between a demo account and a real trading account is the fact that the figures in the demo account do not represent real cash. In other words, you do not have to deposit real cash to act as a trading capital. Besides the
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cash factor, there really is no difference between the two accounts. In fact, real live data are used for the trading account as well as for the demo account. For instance, Trader A and Trader B are both trading online. Trader A is trading with a demo account and Trader B with a regular trading account. The executable prices that Trader A would see on the trading platform with the demo account are exactly identical to the prices of Trader Bs trading platform with the real account. Both accounts are developed a strong trading system that works in a demo account, it is bound to succeed in a real account. Brokers provide all traders a free demo account to practice. During this time, familiarize yourself with the setup of the trading platform. Make sure you master the skills to open and close a position, to enter various types of orders (stop-loss and limit orders), and to execute all basic functions in the trading platform. Using a demo account may buy you time to practice. all the other 12 principles of money management and learn how to take advantage of the charts. Principle 2: Trade with Sufficient Risk Capital When establishing a trading account, never use funds that you cannot afford to lose. In other words, ensure that the money you might lose will not affect your life. This means that you should not borrow funds to trade. Currency trading involves risk the possibility of loss. Losses are part of the game for all traders, but even more so for newer traders as they tend to experience higher percentages of losing trades. If you use essential or borrowed funds, you will find yourself changing your entire trading system, especially after a small floating or an actual loss. Traders with insufficient risk capital cannot afford to lose; therefore, they frequently change their risk-to-reward ratios of good trades and find themselves making unnecessary stops. To avoid the above scenarios from happening to you, it is important to seriously consider how much capital you will need. This component to determine the amount of initial trade capital required for a trading system to operate effectively is perhaps the most important and
the most overlooked application of risk and money management. Most often traders fail when they are misled by the false belief that a winning trading strategy will always produce a net profit. What these traders fail to consider are the two parameters which most often consume a traders capital: consecutive losing trades and maximum drawdown. Lets consider an example of two traders, A and B, both using the same trade system. When determining the percentage of the initial trading capital to risk on trades, the two traders differ; Trader A only risks 1 percent on every new position while Trader B risks 5 percent. Lets assume that both traders begin trading simultaneously and both generate 20 consecutive losses immediately. Trader A would have only lost 20 percent of his/her trading capital while Trader Bs initial trading capital would have been wiped out. Even if the subsequent trades are highly profitable, Trader B would be left with an empty account but Trader A may pretty well regain his/her full trading capital and perhaps generate a profit.
This table illustrates how many consecutive losing trades (CL) it takes to completely empty an account, based on the percentage of capital risked per trade (R), which is assumed to be constant for all trades. There is always a probability that any trading system will generate as many consecutive losing trades or percent drawdown as required to completely exhaust any amount of trading capital. The mathematical equations that arrive at this conclusion are relatively complex. The important thing is that however small the chance of experiencing such drawdown is, this probability exists.
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FX traders can start a mini account with as low as $300; however, to fully capitalize on trading, it is desirable to apply the 6 % test. The 6 1/2 test is a useful tool to decide how much to start trading. The test poses a simple question: if you experience a 50% drawdown after 6 months of trading, will you have enough left to continue trading? If the answer is yes, you probably have enough to begin trading; if the answer is no, you should probably wait. For instance, a novice trader wants to open a mini account with $500. The math is simple. After experiencing a 50% drawdown, the trader would be left with $250 in the account. Is $250 sufficient to trade? Even if the trader is very modest and only opens one lot at a time, he/she is already risking 40% of the capital in one trade. For a novice trader, $250 is too small of a trading capital and the trader would easily be margined out. Therefore, we recommend that novice traders should invest more than $300 dollars as their initial trading capital in mini accounts. Principle 3: Establish Maximum Exposure It is vital to establish a daily, weekly, and even monthly maximum exposure amount that you are willing to accept. It is highly recommended that traders working with limited risk capital should never exceed more than 5-10% of their total risk capital as their daily maximum exposure. For traders working with larger amounts of risk capital, especially professional Forex fund managers, the daily maximum exposure should never exceed more than 2-5% of their total risk capital. Principle 4: Limit Your Losses Use A Stop Loss Limiting losses is essential to becoming a successful FX trader. Way too often, traders say they will exit a trade when it goes 200 pips against them, then when they are down 200 pips, they say they will exit when it goes down another 100 pips. Before you know it, they are down 1000 pips, or even worse, get margined out. Unfortunately, the scenario mentioned above is extremely common amongst novice traders, especially since FX spot trading is such highly margined. In order to keep this from happening to you, you must develop and implement strict disciplinary measures that ensure
you exit losing positions before they turn into disasters. Allowing losses to get out of hand is one of the biggest reasons why traders fail. An effective way of limiting losses is to enter a stop loss. When you place your trade, you may choose to enter a stop loss that protects you from losing too much. Determine how many pips you are willing to risk for that trade. Enter the amount into the system and you are set. If the market price moves in the direction that is unfavorable to you, the stop loss will kick in and exit the position if the specified rate is reached. In the diagram below, the current market price for the USD/JPY is 109.87. Because it is a shorting position, the stop loss must be greater than the current exchange rate. For day traders, an average of 30 pips is recommended for stop loss orders because it accommodates short-term price fluctuations but is effective when a strong trend develops in the opposite direction. In this example, the rate that is 30 pips above 109.87 is 110.17. If the market price for USD/JPY were to reach 110.17, the position would be stopped out.
The stop loss order is a highly effective tool for limiting losses because it does not let your emotions get in the way. Rather than allowing you to have the leeway to make irrational decisions when the market rate is moving in the unfavorable direction, it exits the position
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immediately, thereby, limiting the maximum loss that you may experience for that trade. For more information regarding stop loss orders, refer to section two: Currency Trading Basics. Principle 5: Let the Profits Run Many traders have no problems limiting their losses, but have difficulty letting their profits run. They insist on exiting trades at the first sign of profits. As time passes, they see that their small profit could have been substantially larger had they held on longer to their position. Early exits can be problematic for traders and is a leading cause of mediocre results.
position at 1.6700 instead, he would have made a profit of 800 pips or $8000, which is more than 5 times the original amount gained. Therefore, when strong trends are identified in charts and when the favorable price movements are supported by strong economic data, let your profits run. Principle 6: Maintain Proper Risk vs. Reward Ratio A good risk vs. reward ratio is an essential part of any trade process. A major problem for novice traders is simply the fact that they do not take this into account. Risk is the maximum value you are willing to lose and reward is the amount of profit that you will be content with. Does it make sense to risk $400 in order to gain $200? Many beginners seem to think so, but lets do the math. Even if your trade method is 60% successful, you will still lose more than you gain. You have to be more successful, at least 70%, to show a profit. Generally, the minimum risk vs. reward ratio should be 1:2, 1:3, 1:4, or even 1:5, meaning that for every dollar you risk in a trade, you expect to make 2, 3, 4, or even 5 dollars in return. Poor traders will often take 3:1 or worse and wonder why they are not making money. When you have such a low risk/reward, you may have many successful trades but your first string of losses will eat up your capital. Principle 7: Dont Fight the Trend You have probably heard the saying The trend is your friend a thousand times, but do you actually follow it? You would be amazed by how many new traders fail because they insist on trading against the trend. When you think about it, short-term trading really is a simple game. If there are more buyers than sellers, you buy; if there are more sellers than buyers, you sell. In essence, trending markets are depicting who is in control and fighting the trend is almost always a losers game.
Consider the example above. The GBP/USD has begun an uptrend in early September, 2003. Lets say a position trader bought one lot at 1.5900. At the first sign of a slight downturn, he closed the position at 1.6050 to pocket his profit. On the surface, the 150 pips or $1500 (150 pips x $10) profit seems to be marvelous; however, if he had held on to his position for a couple more weeks and exited at the rate of 1.6700, he would have made a much larger profit. If he had closed his
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Principle 8: Add To Winning Trades and Never Add to Losing Positions Another important aspect of a good money management plan is adding to open trades. Only add to a winning position and to do so with no more than half the number of lots currently being traded. Do not add equal or more lots than you originally started with to maximize your profit. Of course, if your original position started out with the lowest number of lot size possible, you may add the equal amount. However, do not be tempted to add 5 lots to an original 2 lot position, even if it is a winning one. One of the biggest mistakes novice traders make is the continual buying of a losing position. Why do traders do this? It is usually due to a belief that the market is about to reverse or has already reversed and is now moving in the direction they originally anticipated. Many traders will justify it by saying they are just averaging down and getting a more favorable price, but in reality they are dooming themselves to failure. As short-term traders, capital preservation is most important and putting too much at risk jeopardizes success. If you are right, the market should prove you correct within a reasonable short amount of time. If you are wrong, you should absorb the loss and move on. So, we repeat: never add to a losing trade. Principle 9: Understand the Market Discount Mechanism A key concept that novice traders have a hard time grasping is the fact that markets are forward looking and have a discount mechanism in place. Traders who do not understand this concept often become discouraged and quit because the market doesnt make any sense. How many times have you seen market participants expecting some sort of good economic number that comes in as expected and the market sells off? Novice traders get burned trading these situations because they do not understand that the market already knew it was coming. Understanding that all markets are forward looking is crucial to trading success and will help you demystify markets and their movements.
Principle 10: Diversify With Multiple Currency Pairs Always limit your rise by diversification. You can diversify your trading by opening positions in different currency pains. Diversification accomplishes two investment goals: spreading of rise and increasing profit potential. If one currency trade in another currency pair can recover the first loss and leave you with additional profit. However, not all currency pairs give us true diversification. Some pairs mirror each other so often that, in essence, you are merely working twice as hard on the same basic trade strategy with no real diversification. For example, the USD/CHF moves in a very similar fashion to the EUR/USD. Therefore, make sure the currency pairs you choose to diversify with have economies that are fundamentally different from each other.
Principle 11: Never Chase Trades It is 1:00 am and you see a nice trade setting up on your charts. You mark it down in your notebook and decide to trade it tomorrow If it sets up. When you wake up the next morning, you see the trade did exactly what you thought it would; the pair is now 150 pips past your entry. What do you do? Poor traders cannot stand the fact that they have missed the trade and will enter the market regardless of the fact that it has gone many points past their entry point. The result is typical. They end up getting in just as momentum changes and incur large losses. Markets are always moving especially in foreign exchange. Missing trades is a part of trading; accepting it and having the discipline not to chase will save you grief and money.
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Principle 12: Know When to Leave a Trade If the reason you entered a trade disappears, there is no reason to stay in the trade. Many novice traders will see their reason evaporate and stay in the position until they are stopped out. Poor traders do not like to admit they are wrong and continually trading their way out of it. This repeated behavior is obviously detrimental to their profit/loss and often results in catastrophes. On the other hand, good traders condition themselves to get out by implementing smart trading strategies. If their reason reappears, they can always reenter the trade at a more appropriate time without having to be exposed while they wait. Principle 13: Approach Trading as a Business Trading is a business and should be taken seriously. Like any other business, always start with a business plan, a thorough research of the market, and records of business activities. Business/Trading Plan Trading is not a hobby or a quick scheme to get rich. It is a serious business for people who are willing to devote the time, effort, and capital necessary for success Successful trading requires constant planning. Good traders are always mindful how their positions are holding. Generally, we recommend traders to begin their trading career with a trading plan that outlines: what you plan to trade, how you plan to trade, what style to trade, what strategies to trade, how to handle winningllosing trades, and goals for the day, the week, and the month. Writing down these key questions and answers will benefit you in many ways as it will help solidify these concepts and should make you a more disciplined trader.
Research the Market To become a successful trader, you will require forking out some time and effort to study the history, markets, and new trading techniques. This will enable you to increase your market comprehension and rapidly advance your trading techniques and skills. Knowledge is power; the more knowledge you have, the more successful you will become. Record Activities with Trading Journals Trading journals are tremendous assets to any successful traders. A good trading journal should include: thoughts at the moment of trade, trade logic, and price and outcome information. When reviewed periodically (monthly or quarterly), the journal will give you insights into your trading habits and will allow you to quickly pinpoint problematic areas and address them before they become detrimental.
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their trading system which, in turn, will lead to greater success. Attitude #2: Greed The FX market offers the potential for making huge profits in a relatively short period of time without the appearance of performing much work. Vast fortunes seem to be only moments away! This is where greed enters the picture. Traders begin to envision unrealistic returns from their trading. Greed can emerge when you are in a winning trade. You simply want more and so you convince yourself that the market will keep on going in your favor, It can also surface when you are in a losing trade and convince you that the market will turn around anytime to give you your profits.
Trading is definitely one of the most challenging tasks a person can undertake as it requires constant mental toughness in the face of a constantly changing emotional environment. To be successful, a trader has to achieve a mental state of total control. Traders can do this by focusing on winning and losing attitudes. Losing Attitudes Attitude #1: Fear Traders must first identify and confront their fear. The most common anxiety is the fear of failure, which distorts our perception. It narrows the amount of information we can process and drastically limits the choices that we perceive are available. It is the main reason why the majority of traders cut their profits short and let their losses run. How can this paralyzing emotion be controlled? First, focus on applying your trade system, mentally practicing the mechanics of the trade. Second, always remember that trading is not about proving anything to anybody. Third, give yourself permission from the very beginning to make some mistakes as you develop your trading skills. Fourth, truly accept the reality that all good trading systems have losses and temporary drawdown periods. Finally, you must learn to completely trust your ability to respond to whatever information the market offers you. Traders who take these proactive steps toward controlling their fears will be more apt to stick to
To exterminate greed, first and foremost, you must always be on the lookout. First, never think that you are immune; consider putting notes near your trade station to remind you. Second, periodically review your trading performance and see how often you altered or abandoned your trading system as each variant signifies greed. Third, be careful that you never think in terms of what you can buy with a certain number of pips or amount of profit which will lead you away from your original trading system. Attitude #3: Revenge At times, a trader can lose more than he/she intended to risk. You may be willing to take responsibility for what you originally intended to risk on a trade. However, you may not want to take responsibility for losing more. When the market took more than you agreed because you have deviated from you original trading system, you may be compelled to get it back. The best way to overcome this negative attitude is to remember that the market does not have feelings nor can it pre-determine its actions. Take responsibility for all of your trading decisions, even those decisions that seem to be irrational afterwards. In addition, refuse to succumb to feelings of anger towards yourself or the market when things do not go your way.
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Attitude #4: Carelessness Traders are most vulnerable to carelessness after experiencing a large profit or a large loss. After a large profit, especially when this profit is a series of winning trades, you may feel invincible. When you feel that you have figured out how the market usually works and where it will most likely move next, you will become careless about your trading system. Being overconfident leads you to pay less attention to details and eventually become careless. A large loss can be just as problematic. The negative emotions generated by a series of losing trades can easily lead to carelessness and a loss of motivation. This often leads to further losses instead of regaining your loss capital and additional profit. Therefore, be extra careful during times of large profits and large losses. During these periods, try to take a break from trading and reenter the market with your original trading system. Winning Attitudes: Attitude #1: Confidence The first attitude required for successful trading is confidence. We are not referring to being arrogant or cocky like many traders can be. The confidence we are referring to is the mental state of anticipating good results based on a proven system, hard work, and discipline. New traders can begin to develop this healthy confidence by taking enough time to correctly practice trade their system, thereby proving to themselves that their system really works. The easiest method to build your confidence is to use the free demo account provided by a broker. During this time, you can practice placing orders and following the rules of your system while the market is open so you can watch the prices change. Additionally, records of your winning and losing trades will also be provided. When you achieve consistent profit in this manner for at least three to four weeks, you would have built the confidence to begin live trading with real money.
Attitude #2: Determination Traders must possess the intensity to do whatever it takes to win at trading. This will include continual studying, practicing, and applying proven concepts. It also means sticking to your trading system and not allowing a momentary impulse, based on fear or greed, to control or alter your decisions. All trading, especially day trading requires the ability to continue trading even when results have not been good. Due to the dynamic nature of markets and trading systems, bad times are frequently followed by good times. Conversely, good times are frequently followed by bad. Some of a traders greatest winners will follow a string of losers. This is why it is extremely important for traders to be determined to apply their methods and stick to their system. Ultimately, with persistent determination, one can overcome all obstacles.
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