Euro at 3-Month Low as Greece May Leave Eurozone

The euro fell today, reaching the lowest level in more than three months against the US dollar, as speculation that Greece may leave the eurozone drove away investors from the shared 17-nation currency.
Greece is still unable to form a coalition government after a week of talks and negotiating. Even if the a government would be formed, the country may still leave the currency union as the Hellenic Republic is reluctant to implement austerity measures that are very unpopular among Greeks. Experts say that in the long term an exit of Greece from the eurozone may benefit both the country and the euro, but in the short term an impact could be very negative.
EUR/USD fell from 1.2901 to 1.2866 as of 8:50 GMT today, while the intraday minimum of 1.2860 was the lowest since January 23. EUR/JPY was down from 103.17 to 103.04.
If you have any questions, comments or opinions regarding the Euro, feel free to post them using the commentary form below.

Pound Gains, Threatens Economy of UK

The Great Britain pound rose today as the safe haven role of the currency helped it to profit from speculation that Greece may leave the eurozone. The strength of the sterling caused worries that it may hurt the UK economy.
The pound gains appeal as the Swiss franc loses it due to the euro-peg. Economists are worried, though, that a strong currency may harm efforts to bring the United Kingdom out of recession. Ian Stannard, the head of European currency strategy at Morgan Stanley, explained:

The U.K. economic backdrop may not be brilliant, but it’s enjoying a haven status because of the political uncertainty in the euro zone. The advantage of sterling over a traditional haven like the Swiss franc is that its asset market is more liquid. The downside is that the strength of the pound may backfire as it hurts exports.

GBP/USD rose from 1.6063 to 1.6072 and GBP/JPY went up from 128.49 to 128.70 as of 8:18 GMT today.
If you have any questions, comments or opinions regarding the Great Britain Pound, feel free to post them using the commentary form below.

Fundamental vs. Technical Analysis in Forex

The forex market has experienced enormous popularity in the past few years, thanks to technology and the flexibility offered by the genre for the average retail forex trader.  You can trade anytime and from anywhere, but success still depends on knowledge, experience, and emotional control, factors that impatient newcomers to this investment medium are loath to admit before they crash and burn.  Yes, casualty rates are high due to high risks, and specialized training is a must have from the get go.

For stock traders that wish to try their hand in this “greener pasture”, minor adjustments are necessary before committing real capital in the forex market.  A trader’s “best friends” continue to be fundamental and technical analysis, although a few nuances must be accommodated up front.

Fundamental Analysis

Stock traders tend to be deep in fundamental analysis skills related to financial statements, selected sector performance, and business cycle impacts.  In the forex world, the fundamentals are not so “isolated”.

• Nearly anything and everything can make the markets move, some things more dramatically, but sensitivity to events is definitely moved up a notch. 
• Currencies come in pairs and do not have “intrinsic” value. 
• Traders invest in a “position” that has “relative” value, depending on the nature of the economic health or the currencies respective countries. 
• Every position equates to a “long” in one and a “short” in the other. 
• Bankruptcy is not a concern, especially for the major pairs connected with the Dollar, but cyclical waves occur more frequently.

Experienced traders soon recognize that they cannot compete on a fundamental data interpretation basis with large global banks and hedge funds that devote considerable resources to this activity.  One needs awareness of key data release calendars to prevent being blindsided by a sudden disruption in the market, and an intuitive capacity to understand how major fundamentals will impact the market.  The objective then becomes to join a potential trend and ride it for all it is worth, accepting that if the market reverses, then you act quickly to minimize the damage.

Technical Analysis

Technical tools take on a greater importance in this medium since both volatility and sudden directional changes create a rather chaotic trading environment.

• Traders focus on a few favorite indicators and continually review a variety of timeframe snapshots to validate the certainty of a forceful trend, either up or down. 
• Fibonacci retracement ratios take on a more surreal nature as consistent signifiers of support and resistance. 
• Searching for high probability setups is facilitated by technical analysis as the only way to optimize both entries and exits in a very fickle market.
• Understanding trader psychology also helps in recognizing some of the subtler forex gyrations.

Pricing movements in the forex market, however, do replicate wavelike patterns and often suggest a tendency that can be anticipated with experience.  Technical indicators and pattern recognition skills do easily transfer from other trading mediums, but a quicker and defter touch is the distinguishing characteristic.  The action is swift, and you can easily miss a major market move in the blink of an eye.

The Need for a Disciplined Approach

Due to the intensity of the currency markets, a successful trader must have a step-by-step trading plan that governs his every move before, during, and after a position is closed.  The plan must incorporate both fundamental and technical analytics, along with prudent risk and money management principles.  Lastly, invest the time necessary in practicing on a “free” demo system that trades virtual cash with real time quotes.  Fine-tuning your trading plan will pay dividends later when real capital is on the line.

Investing in an Economic Downturn or Recession

It has been known for many moons, and over many business cycles, that during every economic downturn, or recession, things follow a similar path. One of the first things we see is a bear market in equities. Short-selling in the stock markets is a bit tricky, however, particularly with regulators around the globe deliberately trying to curtail it, so this is not the equivalent of going long in a bull market. So it came to be known that during recessions, cash is king. This is particularly true of our current situation because the credit contraction this time around is particularly severe, making cash that much more attractive. OK, so cash is definitely king, but cash in itself does not constitute returns unless you use it to buy equities on the cheap, at which point it is no longer cash. You could also argue that during a deflationary period such as this, cash does constitute returns because it gains purchasing power. The jury is still out on how deflationary this recession is going to be however. In the meantime, what do you do with your cash (if you have any)?
The answer is simple. Change it to a different form of cash. By far the best investment one can make going into a recession is to enter some smart positions in the currency market, or forex. If you look at a daily or weekly chart of the S&P 500 or Dow Jones Industrials, or just about any index out there, and compare it to most Japanese Yen (JPY) charts, you will see a striking resemblance – they are in fact almost mirror images of one another. In financial markets, this is known as an "inverse correlation". There are several reasons for this correlation. One of them is something known as the carry trade. During the strong economic expansion over the past few years, investors have been seeking high yields by borrowing currencies with a low interest rate (such as JPY), and buying currencies with a high interest rate (such as the Australian Dollar, or AUD), and pocketing the difference. This works great because interest is risk-free, and if you highly leverage yourself, it can bring in amazing returns. This also worked even better because it became a self-fulfilling prophecy: The more investors bought these higher-yielding currencies, the higher its value went, so you could profit not only from the interest, but now even more so from the fact that the currency you are buying is going up in value. This worked so well for so long, that investors started to forget about a little thing called “risk”. It seemed like this was a risk-free way to make money. This is a tell-tale sign of a financial bubble in the making. Risk appetite grew until it came to a point where investors were acting irrationally. Alan Greenspan’s term “irrational exuberance” comes to mind.
As the US economy began to enter an economic downturn, and then a recession, investors began to feel their appetite for risk decreasing dramatically, and they began to exit these positions. This is called the “unwinding” of the carry trade, which put pressure on the high-yielding currencies like AUD, and since everyone who traded their JPY in for high-yielders now had to buy JPY again, it drove the value of JPY up. JPY has also historically been known as a “safe-haven” currency because it is backed by a large, mature, and stable economy. This added its appeal as the economic downturn became more serious. Add to that the large volume of speculative investment, and you have a recipe for a very strong move up in the JPY. The Swiss Franc (CHF) is another good example of a low-yielding currency reaping the benefits of the recession.

Forex Hedging

There are a number of forex dealers, dare I say even the majority, who allow clients to practice what is commonly referred to as “hedging” in the forex. What this means is that they allow clients to open both long and short positions in the same currency pair, at the same time. Other dealers, on the other hand, automatically close your positions when you enter orders that are exactly opposite to your open positions. There is an ongoing debate among retail traders about whether the practice of “hedging” is useful or not. There are traders out there who swear by “hedging” and others who think it is absolute bollocks.

First off, let’s differentiate this type of hedging from hedging in other markets.

“In finance, a hedge is a position established in one market in an attempt to offset exposure to the price risk of an equal but opposite obligation or position in another market.” (Wikipedia)

An example of this would be someone who believes in the inherent weakness of the Canadian dollar (CAD), but is afraid that escalating violence in the Middle East may push oil prices up. Since CAD has been known to have a fairly strong positive correlation to oil, the investor decides to sell CAD (long USD/CAD) based on his belief that the CAD fundamentals are weakening, but he hedges this position by buying some oil. This way, if oil does spike, driving up the value of CAD, he will lose out on his short CAD position, but this loss will be somewhat offset by his long oil position. Note that hedging is not meant to eliminate the risk, but only to mitigate it. It is a form of insurance against overwhelming loss. What it does, if done properly, is to smooth out the equity curve of a portfolio, which has benefits which are beyond the scope of this article.

The careful reader will notice immediately that the last words of the definition above read “in another market”, which automatically invalidates the buying and selling of the same currency pair as a hedge. There is no other word to describe this practice however, so you will see it in quotes whenever I refer to it, to differentiate it from the real hedging described in the example.

So we have determined so far that “hedging” is not the same as hedging. In order to go further, we should also define several other terms:

Equity – specific to a retail forex account, this word describes the “value” of the account at the present time. It is calculated by taking the total value of all open positions in the market and adding that value to the account balance. For example, if you have a $10,000 account and one open position that is currently losing $1,000, your equity is $10,000 - $1,000 = $9,000. If you have open positions, this value fluctuates every time your positions do. If you were to liquidate all your positions at current prices, your account balance would become equal to your equity.

Balance – the amount of money you have in the account as margin. This amount varies only when positions are closed, but is not a good measure of the total value of your account, as it does not account for open positions. To judge the value of an account, equity should always be used instead of balance.

Understanding the above terms is crucial in judging whether “hedging” is beneficial or not, since they will be affected differently when a “hedge” is applied.

So what does happen when a “hedge” is applied? When an exact “hedge” is applied, meaning that you buy and sell the same amount of the same currency, your net position in the market is zero (you are market neutral). You are buying and selling the exact same thing at the exact same time, so it doesn't matter which way the market moves, the gain in one trade will be exactly offset by the loss in the other trade. The only thing that has happened is that you have paid your broker the commission or spread payment twice. This is also true of "hedged" trades which are not exactly equal. If you buy x units of EUR/USD and you simultaneously sell y units of EUR/USD, then your net position is x-y units of EUR/USD, where a negative value indicates a net short position and a positive value indicates a net long position. You can see from here that if x=y, then we have a net position of 0. Let's study 2 cases where one trader uses the "hedge" option and another trader simply closes his trade in order to become market netural, that is, to close his positions.

Case 1: No "hedging"

$10,000 account

Open 1 mini lot (10,000 units) long EUR/USD at 1.2500/02 (1.2502 is ask price, so this is the one used)

EUR/USD goes to 1.2000/02 and we exit (1.2000 is used)

Total loss of 0.0502 or 502 pips

Total loss is 502 x $1 = $502 ($1 is the EUR/USD pip value on a mini lot)

Equity = $9,498

Case 2: "hedging"

$10,000 account

Open 1 mini lot long EUR/USD at 1.2500/02 (1.2502 is ask price, so this is the one used)

EUR/USD goes to 1.2000/02 and we enter a 1 mini lot short (at 1.2000)

Now we are market neutral (our equity does NOT change regardless of where EUR/USD goes). We have, in effect, closed our position.

However, our platform says we have 2 positions open:

1. -502 pips = -$502
2. -2 pips = -$2 (due to spread)

Equity = $9,496

Then price continues downward to 1.1000 and we have:

1. -1502 pips = -$1502
2. +998 pips = $998

Equity = $9,496 (unchanged because we are "hedged")

Adding our two positions together yields an account equity of -$504. Compared to Case 1, where we lost only $502 and had no trades to worry about any more. Now we have lost $2 more due to paying an extra spread, AND we still have to worry about having open positions.

It may not seem like much, losing 2 pips more than in case 1, but you are in effect doubling your spread, and forex is not a game where you can afford to throw away perfectly good pips. Add to that the fact that you still technically have 2 trades open, and the inherent risk of slippage or other execution problems when it comes to trying to close these 2 trades, and you have another possible disadvantage.

So we can safely say that in most common cases, "hedging" offers no advantage to the trader, and in fact adds to his costs, and should therefore be avoided.

There is however, a fringe example where it could be argued that "hedging" does provide some benefit. This scenario is sometimes encountered before major economic releases such as the NFP, and it banks on the fact that markets usually become very volatile and illiquid at such times. This can cause spreads to widen and it can lock you in or out of your trades, as all potential counterparties pull their orders from the market. Some traders claim that some market makers will allow you to enter trades at times like these, but won't let you exit in profit. A way around this is to actually open another "hedge" trade in order to make yourself market neutral while you are in profit, and then wait until normal market conditions are restored to exit both trades. While this may very well be true, I would stay away from any market maker that engages in such practices, not only because it is unethical, but also because they will reverse your trades if they find out that what you are doing is technically scalping, and most market makers, particularly ones that engage in such shady practices, are not scalper friendly. Remember, they have your money, and can decide what will and won't happen to it.

So in conclusion, by “hedging” your positions, you are doubling your transaction costs (spread), you are exposing yourself to double the execution risk (slippage), and in return, you get NOTHING AT ALL. It would seem that the only reason forex dealers allow this practice is so that they can fatten their wallets by taking advantage of inexperienced traders and collecting the extra spread. Some traders argue that they consistently make money using this technique, which may very well be true, but they are making money despite using it, not because they are using it. There is a world of difference between the two. They could easily make more money by not "hedging" and donate their extra earnings to a worthwhile organization rather than donating it to their broker.

Also, please be advised that as of May 15, 2009, the National Futures Association (NFA) no longer allows regulated FCMs to practice "hedging" in forex in an attempt to stop unscrupulous brokers from taking advantage of inexperienced market participants.

Mechanics of a Forex Trade

For those who are thinking about entering the forex market for the first time, there is some very basic information that is often overlooked. For example, what exactly is happening when you enter a trade? Well it’s simple really, but important to understand. Say, for example, that you have a shiny new $10,000 account. You find a great entry on EUR/USD that you want to take. You enter a 1 mini lot long position with a 100 pip stop loss and a 200 pip take profit target at a price of 1.2500. What just happened? In the meantime, what you have done so far is you borrowed USD12,500 and traded it in for EUR10,000. Now EUR/USD moves in your favor and hits your take profit order at 1.2700. What that order does is sell the EUR10,000 that you are holding and buys USD at the current rate, meaning you get USD12,700 because the rate is now 1.2700. Now you pay your original loan back to your broker, which was USD12,500 and congratulations! You have just pocketed $200 on your first trade. Please note that in the above example we did not consider any spread or other transactions costs – it is assumed that the entry price of 1.2500 was the ask price, and the exit price of 1.2700 was the bid price.

Forex Price Dynamics

In order to gain an understanding of what actually moves the prices, or exchange rates in the interbank market, we must first understand that for any transaction to take place, there must be a buyer and there must be a seller – there must be a counter party for every trade. Open interest in the forex can be loosely defined as the combination of all resting (limit) orders. Many market participants set such orders either above (sell limit) or below the current price (buy limit). These orders are to be filled only when price reaches the set level. For example, say we are trading EUR/USD and the current bid price is at 1.2500. We set a sell limit order at 1.2501. When will our order get triggered? Once all the sell orders at 1.2500 have found buyers, the bid price will move up to the next available level, which is 1.2501. Once buyers enter the market at that price (they would actually be paying the ask price, and the broker would collect the difference), they become the counter party to our trade and our order is filled. One way to look at it is that there are essentially 2 types of orders: limit orders and market orders. There are other types, but they can always be classified as sub-types of these two. Limit orders are set to execute if and only if a set price level is reached, while market orders are set to execute at the current market price. Alternately, limit orders can be described as providing open interest, while market orders can be described as consuming open interest. This is a very important distinction because it is the backbone of price dynamics.

It should be noted that the only relationship between bid and ask prices is that the ask price, by its definition, should never be lower than the bid price. In every other aspect, the two are unrelated, so the spread between the two varies according to where the open interest lies. During times of low liquidity there may be no one interested in buying above 1.2450 and no one interested in selling below 1.2550, making the spread 100+ pips. This is not necessarily the product of shady dealer practices (though at the retail level it may be), but is more likely caused my normal market mechanics – all open interest was either consumed by market orders, or withdrawn (limit orders can be cancelled before they are executed). This type of situation normally happens when important, unexpected information enters the market, such as an NFP reading that is way off the mark. In that case, open interest in one direction will be consumed by a barrage of market orders, and open interest in the other direction will be withdrawn by market participants cancelling their orders. This is equivalent to saying that liquidity is “drying up”, and that the bid price will gap down until it finds a buy limit order, and likewise, the ask price will jump up until it reaches a sell limit order. Note that no one has come in and “set” the spread. The spread is not a parameter that can be set, but is rather the result of market mechanics at their most basic level. It also should not be a surprise that, although today’s technology is lightning fast, there are delays between market order entry and execution, during which time the open interest at the desired level can be consumed, particularly in fast moving markets. In such circumstances, there is no longer a counterparty to take the market order at the desired level, and it can either be filled at a worse price (slippage), or it can be re-quoted. Again, this is not necessarily indicative of any malpractice by your broker, but is more often than not a natural result of market mechanics and the delays inherent in communication media. It should be noted however, that once prices have moved through several tiers and they reach the retail level, they may or may not have been “massaged” by someone along the way (a practice known as price shading). This is the reason many quote for their preference in trading through an ECN rather than a traditional retail broker. In reality, there are advantages and disadvantages to both. You can explore exactly how and why this is true in our follow-up article How Forex Brokers Work.