Using Inter-Market Analysis to Trade Forex

Using Inter-Market Analysis to Trade Forex
By Ed Ponsi, President of FXEducator.com

Many regular readers of this column know that I sometimes use cross-market analysis to find Forex trades. If you think that sounds complicated, keep reading and you'll see that it's easier than it sounds. You might recall last October's article, "Using Stocks to Trade Forex," where the S&P was used as an indicator to trade the GBP/JPY currency pair. Recently, a trade setup presented itself where I was able to use a major support level on the S&P 500 as an indicator to place a trade on another currency pair that is known to follow that index.

Let's begin with a very long-term look at the S&P 500; we can do this by checking the continuous monthly chart of the E-Mini futures contract. From this chart, it's very clear that the 800 area acted as support and helped form the bottom during the bear market of 2001-2002, and was re-tested early in 2003. That same level and the area just below it has been tested repeatedly during our current bear market, during both 2008 and 2009 (see figure 1).

Figure 1: S&P 500 monthly chart returns to test major support near the 800 level. Source: Saxo Bank

There are certain currency pairs that have a strong correlation to the equity markets; in other words, when the stock market goes down, these currency pairs go down with it, and when the market rises, it pulls these currency pairs up in its wake. This relationship exists across many currency pairs that include the Japanese Yen, such as GBP/JPY and EUR/JPY, and after considering a variety of alternatives, a plan began to form. The general idea was this; if the S&P 500 bounces off of that support level, then the JPY pairs should bounce as well. We would wait for the S&P 500 to drop below 800, and then if it rebounded above that level, we would go long EUR/JPY. That is exactly what occurred on the morning of February 17, 2009. This occurred just before 10 am New York time, about one half hour into trading. That time of day is infamous for reversals in U.S. stocks, and since we were trading a currency pair that mirrored the action in the equity markets, we were counting on a similar reversal in EUR/JPY.

Figure 2: EUR/JPY climbs to first target, then falls back to break even. Source: Saxo Bank

After entering the trade, the EUR/JPY floated back and forth, just drifting sideways. What happened? The S&P 500 failed to hold above 800, but it wouldn't fall back either, treading water above 790. Finally, after lunch, stocks mounted enough of a rally to pull EUR/JPY up to our first target, and after all that time we were happy to ring the register with half of the trade. Following our plan, we raised the stop on the remainder of our trade to our entry point – the breakeven point - and let the rest of the trade run. This would guarantee a worst case scenario of a profit on the first half of the trade, and a break even trade on the second half.

We had locked in a winner, but a bigger bounce never materialized, and the S&P sank into the close. This pulled EUR/JPY back down to our entry point, where the second half of the trade was closed for a breakeven trade. While the result wasn't everything we had hoped for, we did well – the trade was not a home run, but not a strikeout either. The important thing was that we were able to lock in a profit and at the same time give our winner a chance to run. Experience teaches us that if traders keep doing the right things, like eliminating risk, locking in profits and letting winners run, then good things can happen.
Question of the Week

Q) I have recently decided against trading on Fridays, because the strategies that are so effective during the week seem to fail me miserably on Fridays and I end up losing money. Is there any advice you can give on successful Friday trading? Thanks.

Ed Ponsi) Thank you for your question, it's good that you're paying attention to important patterns in your trading. There is nothing wrong with trading on Fridays per se, but we need to pay attention to the time of day – not just where we are located, but everywhere. I'll give you an example; let's assume you are trading in New York. When it's 10 am in New York on a Friday, it might not be a bad time to trade because London traders are still active. London is five hours ahead of New York, so when it is 10 am in New York, it is 3 pm in London – still a few hours of good trading remain from the world's capital of Forex trading (London is responsible for about one third of all Forex volume).

But what if the time is 2 pm on a Friday in New York? Well, that would mean that the time is 7pm in London, and those traders have closed up shop for the week. Also, when it is 2 pm on Friday in New York, it is already Saturday morning in Asia, so we can't expect any volume from that part of the world. You might notice that as Friday wears on, intraday candles have a tendency to get smaller and smaller. When I worked as an equity trader, we would close our positions and take off every Friday afternoon between Memorial Day and Labor Day, due to low volume and a lack of interest on the part of many market participants. The idea was that you could either keep trading a market that won't move and bang your head against the wall, or you could preserve your capital and find a more useful way to spend your time. A low volatility market can be frustrating, so if you sense that the keg is kicked and the party is over, there is nothing wrong with closing out your short-term positions and walking away.

Is Forex Trading a Zero-Sum Game?

Is Forex Trading a Zero-Sum Game?

By Ed Ponsi, President, FXEducator.com

Q) Hi Ed, I really enjoy your column every week. I have a question; I sometimes hear trading referred to as a zero-sum game. Could you please explain this, what does it mean?

Ed Ponsi) Thank you for your question. There is a misconception among some traders that every trade must have a winner and a loser. There is a great deal of misinformation out there, and there have even been books published recently that incorrectly state that Forex trading is a zero-sum game. In order to clear up the confusion created by these inaccuracies, let's first understand the meaning of that phrase.

Suppose you place a friendly bet with an acquaintance on the outcome of a football match. Each of you puts up an equal amount of money, let's say $100, and at the end of the game, one of you will walk away with $200 and the other will be $100 poorer. That is a zero-sum game in its purist sense; unless the game ends in a tie, there will be one winner and one loser, end of story.

Now let's apply this concept to the currency market; suppose you enter a long position on EUR/USD and at the same time, another trader takes a short position in the same currency pair. The broker simply matches the orders and collects the spread. This is exactly what the broker wants, to keep the entire spread and maintain a flat position.

Does this mean that in the above scenario one party has to win, and one must lose? Not at all, in fact both traders can win or lose; perhaps one has entered a short-term trade and the other has entered a long-term trade. Perhaps the first trader will take a profit quickly, but there is no rule that states the second trader must close his trade at the same time. Later in the day, the price reverses, and the second trader takes his profit as well. In this scenario, the broker made money (on the spread) and both traders did, too. This destroys the oft-repeated fallacy that every Forex trade is a zero-sum game.

By the way, stock trading is not a zero-sum game either. Suppose you buy 100 shares of XYZ at $40, and sell it at $50. Another trader buys it from you at $50 and sells it at $60. Yet another trader buys it at $60 and sells it at $70. Which trader lost money? None of them did, they all made $10 per share. What about traders who are short XYZ? There is no rule that states that anyone has to short XYZ stock, and it is highly unlikely that there are as many shorts as there are longs, or more precisely, that there are as many shares sold short as there are purchased long.

What type of trade can be accurately called a zero-sum game? Options come to mind; suppose you purchase some XYZ call options, where did they come from? In order for you to purchase those calls, someone else has to sell or "write" them. If the price of XYZ stock reaches the strike price and beyond, the buyer wins, and if it fails to do so, the seller wins. While this represents a true zero-sum game, it is clear that this situation is the exception, not the rule. Trading can be a zero-sum game, but that isn't always the case. I just wish people would think about these things a bit more deeply before they state or write that trading is a zero-sum game.

Q) Hi Ed, I very much enjoyed your comments in Micro FX accounts (read the comments here). I have recently been through exactly the same thought process, and an additional argument I made to myself was that with a micro account I can trade, say, 10 micro-lots (instead of 1 mini lot) which would allow me close half my position at a pre-determined profit target and let the rest run.

Follow-up question if you don't mind. There has been much talk amongst my fellow traders of the virtues of trading FX directly (through an ECN perhaps?) or using the broker as the counter-party. I'm guessing that the broker is the counter-party on all Micro accounts. Do you have a view on the pros and cons or do you know where I can find a considered opinion? Thank you as ever for your great articles.

Ed Ponsi) Thank you for your question, you are right on the money concerning mini and micro lots. Consider the above scenario where the broker matches the orders of two traders who take simultaneous opposing positions. The broker gets to keep the spread while remaining flat; this is a risk-free position for the broker. In the Forex market, most brokers have their own proprietary platform, and therefore can collect the spread (or at least a portion of it) on all of the trades that pass through their platform. In a sense, you could say that each Forex broker has their own little monopoly, and it's not surprising that they like it that way.

What about an ECN-style Forex broker? ECN stands for Electronic Communications Network, and it would give Forex traders a portal by which they could enter trades alongside the "big boys." An ECN for Forex traders would be fantastic for traders, and there is nothing I'd rather see than all of the big Forex brokers jockeying for position in a Level 2 style environment. The problem is, there is no incentive for the brokers to give up their own little fiefdoms. While the ECN model has been tried, it has never really succeeded – at least not yet. It won't work unless most or all of the big Forex names decide to participate, so while I would love to see it happen, I'm not holding my breath.

Is the Dollar Doomed?

Is the Dollar Doomed?

By Ed Ponsi, President, FXEducator.com

Q) Hi Ed, I read your Forex articles and find them very informative and interesting. I have one question or concern which I hope you could address concerning U.S. Treasuries and the flight to safety we have seen lately. As most of the G8 countries are now in official recessions, investors have been flocking to U.S. Treasuries as a "safe haven", thus driving up the U.S. dollar. I don't see the reason. My belief is that U.S. Treasuries are not safe. With trillions outstanding, I don't see how the U.S. government plans on repaying these securities. We all realize from the times we live in, that the intrinsic value of paper money is zero!

Ed Ponsi) Thank you for your email. You're right; the current rally in the U.S. Dollar is an artificial rally in my opinion. The greenback is not strong because it is a good currency, but because it is considered a safe port in what is turning out to be a really bad storm. Currencies and governments around the world are on the verge of collapse. Just imagine if your wealth was tied up in Russian Rubles, Mexican Pesos, or Iceland Kronas; you would do everything you could to reduce exposure to your damaged currency and put it in a more stable currency, such as the USD. U.S. Treasuries are considered safe, at least for the time being, since they are backed by the full faith and credit of the U.S. government. There may come a day when the USD collapses, due to failure to pay our huge debts and an increase in the money supply, but that is not likely to happen right now. Meanwhile, it is happening right now in other countries around the world.

For example, in a recent newsletter, titled "The Ruble is Rubble", I mentioned that the collapse of that currency was accelerating, as USD/RUB shot past the 31.00 handle; well, a few weeks later, we are testing 36.00, which just happens to be the level that the Russian government claimed they would defend. Well, they asked for it, and traders obliged by pushing right to 36! (See figure 1).


Figure 1: USD/RUB skyrockets as Russia devalues its currency. Source: Saxo Bank

Looking at that chart, I'm just glad that I'm not holding Rubles! Now check out this quote, attributed to a senior Icelandic official: "The Krona is dead. We need a new currency." That comment pretty much says it all, as Iceland's currency and government have both collapsed. Could Mexico be following in Iceland's footsteps? The Peso is getting clobbered by the greenback, recently breaking out of a massive ascending triangle pattern on the daily chart (see figure 2).


Figure 2: USD/MXN breaks out of a bullish ascending triangle pattern. Source: Saxo Bank

All of this mayhem is currently causing the USD to strengthen, but be careful; U.S. bailouts will likely cause the greenback to weaken in the long run, due to excessive borrowing and, most likely, excessive printing of dollars. The buck can't cheat reality forever, and at some point, when the current fears subside, the bill will come due. Gold is already looking pretty stout compared to most commodities, recently trading above $900 per ounce; could this be in anticipation of future USD weakness? That's a possibility we can't ignore.

Q) Hi Ed, I wonder if you can help. I am trading a rather small account for two weeks now – but I have no confidence and stress is my enemy. I am trying everything – even scalping, and maybe this is what got me scared. How can I conquer this – what could help? Maybe there is a way to decrease the stress, where psychological burden is not so big. Cheers, Adam

Ed Ponsi) Thank you for your question. Stress is a huge problem for traders, but there are effective ways to deal with it. When I started trading I was constantly stressed out, because I didn't have a plan – I'd just enter trades when it seemed like a good idea, and then monitor the trade constantly for signs as to whether I should stay in or get out. This seemed like reasonable behavior at the time, but now when I look back I can see that I was "winging it". Somewhere along the way, it sunk in that I had to have a definite plan for every trade. Now, before I enter any trade, I have to give exact answers to these questions:

Where is my entry point?

Where will I place the stop?

At what point will I move the stop? Where will the stop be located then?

Where is my exit (unless the exit is to be achieved through a trailing stop)? Should I use more than one exit? Where exactly will they be located?

Stress is created when we don't know what we're going to do next. If you are "flying by the seat of your pants" you will be constantly monitoring every tick, searching for a sign to determine your next move. But if you've already decided every possible move that you can make – in other words, if you've already completed the decision making process before entering the trade – the stress melts away. We can't force the market to move the way we would like, so don't worry about that; instead, we concern ourselves with the things we can control, such as creating and executing a good trading plan. This is one of the most important habits you can develop to be a successful trader, and you'll feel better too. Good luck!