Forex Knowledge hub PART-5
In the forex market, currencies are
traded in pairs (for example, if you buy the USDCHF
pair, you are actually buying the US dollar and selling Swiss Francs at the same time). Just
like the example above, you pay interest on the currency position you sell, and collect
interest on the currency position you buy.
What makes the carry trade special in the spot forex market is that interest payments
happen every trading day based on your position. Technically, all positions are closed at
the end of the day in the spot forex market - you just don't see it happen if you hold a
position to the next day.
Brokers close and reopen your position, and then they debit/credit you the overnight
interest rate difference between the two currencies. This is the cost of "carrying" (also
known as “rolling over”) a position to the next day.
The amount of leverage available from forex brokers has made the carry trade very
popular in the spot forex market. Forex trading is completely margin based, meaning
you only have to put up a small amount of the position and you broker will put up the
rest. Many brokers ask as little as 1% - 2% of a position - what a deal, eh?
Let's take a look at a generic example to show how awesome this can be.
For this example we'll take a look at Joe the newbie forex trader. It's Joe's birthday and
his grandparents, being the sweet and generous people they are, give him $10,000.
Schweeeet!
Now, instead of going out and blowing his birthday present on video games and posters of
bubble gum pop stars, he decides to save it for a rainy day. Joe goes to the local bank to
open up a savings account and the bank manager tells him, "Joe, your savings account will
pay 1% a year on your account balance. Isn't that fantastic?" Joe pauses and thinks to
himself, "At 1%, my $10,000 will earn me $100 in a year. Man that sucks!"
Joe, being the smart guy he is, has been studying BabyPips.com and knows of a better way
to invest his money. So, Joe kindly responds to the bank manager, "Thank you sir, but I
think I’ll invest my money somewhere else you.”
Joe has been demo trading several systems, including the carry trade, for over a year, so
he has a pretty good understanding of how forex trading works. He opens up a real
account, deposits his $10,000 birthday gift, and puts his plan into action. Joe finds a
currency pair whose interest rate differential is +5% a year and he purchases $100,000
worth of that pair. Since his broker only requires a 1% deposit of the position, they hold
$1,000 in margin (100:1 leverage). So, Joe now controls $100,000 worth of a currency pair
that is receiving 5% a year in interest.
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What will happen to Joe’s account if he does nothing for a year?
Well, here are 3 possibilities. Let’s take a look at each one:
1. Currency position loses value. The currency pair Joe buys drops like a rock in value. If the
loss brings the account down to the amount set aside for margin, then the position is
closed and all that’s left in the account is the margin - $1000.
2. The pair ends up at the same rate at the end of the year. In this case, Joe did not gain or
lose any value on his position, but he collected 5% interest on the $100,000. That means
on interest alone, Joe made $5,000 off of his $10,000. That’s a 50% gain! Sweet!
3. Currency position gains value. Joe’s pair shoots up like a rocket! So, not only does Joe
collect $5000 in interest on his position, but he also takes home any gains! That would be
a nice present to himself for his next birthday!
Because of 100:1 leverage, Joe has the potential to earn around 50% a year from his initial
$10,000. Here is an example of a currency pair that offers a 5% differential rate based on
current interest rates:
If you buy USD/JPY and held it for a year, you earn a "positive carry" of 5%.
Of course, if you sell USD/JPY, it works the opposite way:
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If you sold USD/JPY and held it for a year, you would earn a "negative carry" of 5%.
Again, this is a generic example of how the carry trade works. Any questions on the
concepts? No? I knew you could catch on quick! So, now it’s time to move on to the most
important part of this lesson: Carry Trade Risk.
Carry Trade Risk
Being that you are a professional trader, you already know what the first question you
should ask before entering a trade is, right?
“What is my risk?”
Correct! Before entering a trade you must always asses your max risk and whether or not
it is acceptable according to your risk management rules.
In the previous example with Joe the Newbie Trader, his maximum risk would have been
$9000. His position would be automatically closed out once his losses hit $9000.
Eh?
That doesn’t sound very good, does it?
Remember, this is the worst possible scenario and Joe is a newbie, so he hasn’t fully
appreciated the value of stop losses.
When doing a carry trade, you can still limit your losses like a regular directional trade.
For instance, if Joe decided that he wanted to limit his risk to $1000, he could set a stop
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order to close his position at whatever the price level would be for that $1000 loss. He
would still keep any interest payments he received while holding onto the position.
Carry Trade Criteria
It’s pretty simple to find a suitable pair to do a carry trade. Look for two things:
1. Find a high interest differential.
2. Find a pair that has been in an uptrend – where the currency you are long has been
gaining value against the currency you are short.
Pretty simple, huh? Let’s take a real life example of the carry trade in action:
This is a weekly chart of GBP/JPY. Up until recently, the Bank of Japan has maintained a
Zero Interest Rate Policy (current interest rate is 0.25% as of this writing - 11/01/2006).
With the Bank of England touting one of the higher interest rates among the major
currencies (currently at 4.75% as of this writing), many traders have flocked to this pair
(one of the factors creating a nice little uptrend in the pair). From the end of 2000 to mid-
2006, this pair moved from a price of 150.00 to 223.00 – that’s 7300 pips! If you couple
that with interest payments from the interest rate differential of the two currencies, this
pair has been a nice long term play for many investors and traders able to weather the
volatile up and down movements of the currency market.
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Of course, economic and political factors are changing the world daily. The interest rates
and interest rate differentials between currencies may change as well, bringing popular
carry trades (such as the Yen carry trade) out of favor with investors.
Summary
As you can see there are other ways to make money in the forex market without having to
buy low and sell high, which can be pretty tough to do day after day.
If you catch the right pair (one with a positive interest rate differential) at the right time,
then you’ll be sure to do well collecting money out of the market.
When properly applied, the carry trade can add significant income to your account, along
with your directional trading strategies.
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Are You Willing to Pay the Price?
HA! Made you click!
If you really thought there actually was a way for a lazy forex trader to get rich, SHAME ON
YOU!
No such thing exists. The word "lazy" and "trader" is an oxymoron. You have to be willing
to pay the price to become a trader.
Which brings us to our next lesson....?
So, you’ve gone through the School of Pipsology…five times, learned basic analysis and
money management techniques, and maybe even opened up a demo account and started
trading a plan you’ve created. (You do have a trading plan right?) Now you can sit back
and relax because it’s easy money from here on out, right?
Wrong!
You’ve just taken the first step.
You’ve only familiarized yourself with the very basic fundamentals of what it takes to
become a professional trader. Now it’s time to get on to the real work.
I’m sure you’re now thinking, “There’s more to learn?!”
Well, my friend, the learning never ends.
As with any profession, whether you’re a doctor, lawyer, athlete, assassin, spy, ninja,
ultimate fighter, musician or any other occupation that requires a high level of skill, you
can never stop learning and practicing. Otherwise, your skills will deteriorate and you’ll
slowly forget what you’ve learned.
This lesson will give you a peek into what it takes – education, time, money and
psychological stamina – to enter the most financially rewarding career on the planet: a
professional trader.
Education
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Imagine yourself in a legal situation and you decide to hire the cheapest lawyer you can
find. On the day you have to stand in front of a jury, your lawyer says to you, “Don’t
worry, while this is my first time, I’ve read ‘How to be an Awesome Lawyer in 28 Days for
Idiots’ a couple of times, so I know what I’m doing. You’ll be fine.”
Do you think your investment in that lawyer will pay off?
Probably not.
You’ll probably end up in prison with a tattoo covered cellmate named “Killer” for the rest
of your life.
Now I’m not a professional lawyer, but I’m pretty sure that it takes more than one book to
become one. More likely, lawyers have read and studied a wide range of books, journals
and case studies in order to fine-tune their practice. So why should it be any different to
become a professional trader?
Trading involves becoming proficient in a multitude of disciplines, including fundamental
analysis, technical analysis, sentiment analysis and self-awareness (also known as trading
psychology or what I call “mental analysis”).
Within those disciplines are different topics that should be studied individually.
For instance, while the School of Pipsology does a fantastic job of introducing the Elliot
Wave theory and making it easy to understand, there’s abundant amount of entire books
written on that single subject. The same thing goes with many other technical tools (i.e.
candlestick charting, Fibonacci numbers, pivot points, etc.), fundamentals and trading
psychology.
If you limit your education to a basic high-level overview of a few subjects, how do you
think that will help you acquire the skills needed to become a successful trader?
I’m not saying go out there and read everything there is to read on trading. While that
would be ideal, realistically it’s not possible.
What I am saying is this…
Before you enter a single trade, read and study enough to know why a tool works, how it
works and how well it has worked in many different situations. After you start trading
your live account, continue reading and studying some more. The forex market is dynamic
and continuously changing. (What market isn’t?) Being well versed in all the disciplines of
trading gives you the ability to adapt and make quick decisions in this fast-paced market.
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Time
Have you ever told yourself there’s never enough time in the day? I think we’ve all
thought that to ourselves at one point, but if you’re not willing to shift your priorities to
make time for trading, then forget about becoming a trader.
Sorry to put it so bluntly, but contrary to popular belief, trading is not a hobby.
Trading is not a hobby.
Trading is not a hobby unless you want to lose money.
Golf is my hobby. I pay to play golf. Golf is Tiger Wood’s business. Tiger Woods is paid to
play golf.
See the difference?
Trading is a business
You have to devote yourself to trading just like you would with any other business in order
to be successful.
So, it’s time (pun intended) to ask yourself this: “Can I balance my time and change my
lifestyle to make room for trading?”
I’d better hear a resounding “YES!”
But before you can even truly answer that question, you need to first figure out what your
daily priorities are and determine whether or not you can make trading THE number one
priority.
A good way to find this out for yourself is to list your daily activities, and then prioritize
them. If your daily priorities take up all of your time, then forget about trading.
So, take a moment to figure out what is going on in your life because it’s very important to
balance your time and priorities, not just to become a successful trader, but also to live a
content, meaningful life. We all want to be wildly profitable, and initially we may drop
everything else to get there, but in the end an unbalanced life will lead to personal and/or
professional failure.
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Capital aka Cash Money
It takes money to make money. Everyone knows that, but how much does one need to get
started in trading? The answer largely depends on how you are going to approach your
new start-up business.
First, consider how you are going to be educated. There are many different approaches in
learning how to trade: classes, mentors, on your own, or any combination of the three.
While there are many classes and mentors out there willing to teach forex trading, most
will charge a fee. The benefit of this route is that a well-taught class or great mentor can
significantly shorten your learning curve and get you on your way to profitability in a much
shorter amount of time compared to doing everything yourself.
The downside is the upfront cost for these programs, which can range from a few hundred
to a few thousand dollars, depending on which program you go with. For many of those
new to trading, the resources (cash money) required to purchase these programs are not
available.
For those of you unable or unwilling to pony up the cash for education, the good news is
that most of the information you need to get started can be found for FREE on the
internet through forums, brokers, articles and websites like BabyPips.com. We should all
thank Al Gore for inventing the Internet. Without him, there would be no BabyPips.com
This is no one “correct” path.
As long as you are disciplined and laser focused on learning the markets, your chances of
success increase exponentially. You have to be a gung ho student. If not, you’ll end up in
the poor house.
Second, is your approach to the markets going to require special tools such as news feeds
or charting software? As a technical trader, most of the charting packages that come with
your broker’s trading platform are sufficient (and some are actually quite good). For those
who need special indicators or better functionality, higher end charting software can start
at around $100 per month. Maybe you’re a fundamental trader and you need the news
the millisecond it is released, or even before it happens (wouldn’t that be nice!). Well,
instantaneous and accurate news feeds run from a few hundred to a few thousand dollars
per month. Again, you can get a complimentary news feed from your broker, but for
some, that extra second or two can be the difference between a profitable or unprofitable
trade.
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Finally, you need money/capital/funds to trade. How much exactly? Well, let’s be honest
here. If you’re consistent and practice proper money management techniques, and
without even knowing your monthly expenses, then you can probably start off with $50k
to $100k in trading capital. It’s common knowledge that most businesses fail due to
under capitalization, which is especially true in the forex trading business. So, if you are
unable to start with a large amount that you can afford to lose, be patient, save up and
learn to trade the right way until you are financially ready.
Psychology
Once you’ve made the time to get properly educated, demo trade, and save up sufficient
capital, the time will come where you will have to tackle the markets. By this time you
should’ve have learned the mechanics of trading and methods to analyze the market that
you are most confident using.
But are you ready to risk your hard-earned money?
Can you put your money where your mouth is?
Can you handle the (emotional, psychological and financial/economic) pressure of the
occasional losing streak and account drawdown?
Will you be able to control your excitement on a profitable trade?
Can you let go of your last trade and completely focus on your next opportunity?
What separates the profitable traders from the unprofitable ones is that profitable traders
can handle the pressure of risk and control their emotions. They realize that losing is just a
part of business. Those who have enough confidence in their methods and systems know
that a drawdown is a short-term setback and they will soon recover.
This final crucial lesson can’t really be taught. It will take time and experience. You have to
put in the hours. You will have to go through a gazillion different trades and different
market environments before you grasp and live these concepts. If you can’t do this or
aren’t willing to, then ultimately, trading may not be for you.
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Summary
For those willing to take the challenge and follow through, professional trading can be a
worthwhile goal. But before you dive too deep into forex trading, dip your toe or get your
feet wet in the shallow end first, and become familiar with the water. As you get more
comfortable, make your way slowly to the deeper end. Take your time.
Be honest with yourself.
Be ready to sacrifice your time and money.
Never stop learning and, most importantly, never quit.
Winners never quit and quitters never win.
The price of becoming top trader is extremely high, but certainly worth it.
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Forex Scams
Don't be a sucker.
One of the first things you must learn about the Forex market is that although it is
enjoyable and exciting, there is no magic button that will instantly turn your pennies into
millions of dollars. You may have already heard about Forex scams that are filling the
marketplace. These companies purposely mislead people into thinking that making money
in the Forex is easy and that they have found the “Magic Solution” to raking in booku
bucks with a simple click of a button.
Sadly, the number of Forex scams is rising. The Commodities Futures Trading Commission
(CFTC) released a report citing that in recent years, they have seen a sharp increase in the
rise of Foreign Exchange scams. The CFTC warns consumers to be cautious of sales
solicitations in newspapers, radio or television. You’ve probably even seen some of these
companies. I hear about them all the time from people whenever I try to explain the
Forex. The first thing they say is that they think the Forex is a scam. That makes me so
angry! The Forex is a tremendous investment opportunity for people and because of these
scammers, they miss out on a good way to make money.
The truth is that no matter how you slice or dice it, education is the only fool proof way to
consistently make money in the Foreign Exchange. Even after you finish reading through
BabyPips.com, your journey as a FX trader is only the beginning. I have never met a
successful Forex trader who stopped learning. There is always something new to learn and
you must actively seek out as much information as you can.
The best investment you can ever make is in yourself.
Don’t spend your money on a company that promises huge returns; even if they show you
their track record. It might look pretty and colorful; and I’m sure that the line on the graph
that seems to keep going higher and higher makes it look like there is no way you could
lose money, but don’t let them fool you. In fact, I could take my broker statement right
now, touch it up with Photoshop and voila! – I have now just become the most successful
trader on the planet. Pretty impressive huh? I know I’m laying it on pretty thick, but I
really want to prevent you from falling into any traps. Instead of giving your hard earned
money to someone else, you could put that money aside into a trading account and take
the time to educate yourself.
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Notice that I didn’t say you should put your money into a trading account and start
trading.
Keep that money in your account and gradually add to it as you continue to learn. Before
you know it, your account size will be bigger than you realized, and to top it off, you’ll
have a wealth of Forex education under your “traders” belt.
So remember, Forex scams DO exist. Be wary of them and hold onto your money. The
good news is that there ARE legitimate Forex companies out there. Make sure you do
thorough research on a company if you are thinking about giving them a shot. Ask other
traders on the forums if they've had experiences with them. There is a wealth of
information on the Internet so do your homework and you’ll be just fine.
Related Links:
Rising Number In Forex Scams
http://www.cftc.gov/enf/enfforex.htm
Public Warnings For Forex Scams
http://www.cftc.gov/opa/enf98/opaforexa15.htm
A List Of Known Forex Scammers
http://www.quatloos.com/forex-bulletins.htm
How To Report A Forex Scam
http://www.quatloos.com/forex-problems.htm
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Leverage the Killer
Most professional traders and money managers trade one standard lot for every $50,000
in their account.
If they traded a mini account, this means they trade one mini lot for every $5,000 in their
account.
Let that sink into your head for a couple seconds.
If pros trade like this, why do less experienced traders think they can succeed by trading
100K standard lots with a $2,000 account or 10K mini lots with $250?
No matter what the forex brokers tell you, don’t ever open a “standard account” with just
$2,000 or a “mini account” with $250. The number one reason new traders fail is not
because they suck, but because they are undercapitalized from the start and don’t
understand how leverage really works.
Don’t set yourself up to fail.
We recommend that you have at least have $100,000 of trading capital before opening a
“standard account”, $10,000 for a “mini account”, or $1,000 for a “micro account”.
So if you only have $60,000, open a “mini account. If you only have $8,000, open a
“micro” account. If you only have $250, open a “demo account” and stick with it until you
come up with the additional $750, then open a “micro account”.
If you don’t remember anything else in this lesson, I plead that you at least remember
what you just read above.
Okay, please re-read the previous paragraph and ingrain it in your memory. Just because
brokers allow you to open an account with only $250 doesn’t mean you should and I’m
going to explain why.
I believe most new traders who open a forex trading account with the bare minimum
deposit do so because they don’t completely understand what the terms “leverage” and
“margin” really are and how it affects their trading.
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It’s crucial that you’re fully aware and free of ignorance of the significance of trading with
leverage. If you don’t have rock solid understanding of leverage and margin, I guarantee
that you will blow your trading account.
Leverage Defined
The textbook definition of “leverage” is having the ability to control a large amount of
money using none or very little of your own money and borrowing the rest.
For example, in forex, you can control $100,000 with a $1,000 deposit. Your leverage,
which is expressed in ratios, is now 100:1. You’re now controlling $100,000 with $1,000.
Let’s say the $100,000 investment rises in value to $101,000 or $1,000. If you had to come
up with the entire $100,000 capital yourself, your return would be a puny 1% ($1,000 gain
/ $100,000 initial investment). This is also called 1:1 leverage. Of course, I think 1:1
leverage is a misnomer because if you have to come up with the entire amount you’re
trying to control, where is the leverage in that?
Fortunately, you’re not leveraged 1:1, you’re leveraged 100:1. You only had to come up
with $1,000 of your money, so your return is a groovy 100% ($1,000 gain / $1,000 initial
investment).
Now I want you to do a quick exercise. Calculate what your return would be if you lost
$1,000.
If you calculated it the same way I did, which is also called the correct way, you would
have ended up with a -1% return using 1:1 leverage and a WTF! -100% return using 100:1
leverage.
You’ve probably heard the good ol’ clichés like “Leverage is a double-edge sword.” or
“Leverage is a two-way street.” Well….as you can see, these clichés weren’t lying.
Margin Defined
So what about the term “margin”? Excellent question my bright padawan learner.
Let’s go back to the earlier example:
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“For example, in forex, you can control $100,000 with a $1,000 deposit. Your leverage,
which is expressed in ratios, is now 100:1. You’re now controlling $100,000 with $1,000.”
The $1,000 deposit is “margin” you had to give in order to use leverage.
Margin is the amount of money needed as a “good faith deposit” to open a position with
your broker. It is used by your broker to maintain your position. Your broker basically
takes your margin deposit and pools them with everyone else’s margin deposits, and uses
this one “super margin deposit” to be able to place trades with the interbanks.
Margin is usually expressed as a percentage of the full amount of the position. For
example, most forex brokers say they require 2%, 1%, .5% or .25% margin.
Based on the margin required by your broker, you can calculate the maximum leverage
you can wield with your trading account.
If your broker requires 2% margin, you have a leverage of 50:1. Here are the other popular
leverage “flavors” most brokers offer:
Margin Required Maximum Leverage
5% 20:1
3% 33:1
2% 50:1
1% 100:1
.5% 200:1
.25% 400:1
Aside from “margin required”, you will probably see other “margin” terms in your trading
platform. There is much confusion about what these different “margins” mean so I will try
my best to define each term:
Margin required: This is an easy one because I just talked about. It is the amount of
money your brokers requires from you to open a position. It is expressed in percentages.
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Account margin: This is just another phrase for your trading bankroll. It’s the total amount
of money you have in your trading account.
Used margin: The amount of money that your broker has “locked up” to keep your
current positions open. While this money is still yours, you can’t touch it until your broker
gives it back to you either when you close your current positions or when you receive a
margin call.
Usable margin: This is the money in your account that is available to open new positions.
Margin call: If the equity in the account drops below your usable margin, a margin call will
occur and some or all open positions will be closed by the dealing desk at the market
price.
Margin Call Example
Assume you are a successful retired British spy who now spends his time trading
currencies. You open a mini account and deposit $10,000.
When you first login, you will see the 10,000 in the "Equity" column of your "Account
Information" window.
You will also see that the "UsedMrg" ('Used Margin') is "$0.00", and that the "UsblMrg"
('Usable Margin') is 10,000, as pictured below:
Your Usable Margin will always be equal to Equity less Used Margin.
Usable Margin = Equity – Used Margin
Therefore it is the Equity, NOT the Balance that is used to determine Usable Margin. Your
Equity will also determine if and when a Margin Call is reached.
As long as your Equity is greater than your Used Margin, you will not have Margin Call.
( Equity > Used Margin ) = NO MARGIN CALL
As soon as your Equity equals or falls below your Used Margin, you will receive a margin
call.
( Equity =< Used Margin ) = MARGIN CALL, go back to demo trading
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Let’s assume your margin requirement is 1%. You buy 1 lot of EUR/USD.
Your Equity remains $10,000. Used Margin is now $100, because the margin required in a
mini account is $100 per lot. Usable Margin is now $9,900.
If you were to close out that 1 lot of EUR/USD (by selling it back) at the same price at
which you bought it, your Used Margin would go back to $0.00 and your Usable Margin
would go back to $10,000. Your Equity would remain unchanged at 10,000.
But instead of closing the 1 lot, you, the adrenalin junkie chopsocky retired spy that you
are, get extremely confident and buy 79 more lots of EUR/USD for a total of 80 lots of
EUR/USD. You will still have the same Equity, but your Used Margin will be $8,000 (80 lots
at $100 margin per lot). And your Usable Margin will now only be $2,000, as shown below:
With this insanely risky position on, you will make a ridiculously large profit if EUR/USD
rises. But this example does not end with such a fairy tale.
Let me paint a horrific picture of a Margin Call which occurs when EUR/USD falls.
The EUR/USD starts to fall. You are long 80 lots, so you will see your Equity fall along with
it. Your Used Margin will remain at $8,000. Once your equity drops below $8,000, you will
have a Margin Call. This means that some or all of your 80 lot position will immediately be
closed at the current market price.
Assuming you bought all 80 lots at the same price, a Margin Call will trigger if your trade
moves 25 pips against you.
25 PIPS!
Humbug! The EUR/USD pair can move that much in its sleep!
How did I come up with 25 pips? Well each pip in a mini account is worth $1 and you have
a position open consisting of 80 freakin’ lots. So…
$1/pip X 80 lots = $80/pip
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If EUR/USD goes up 1 pip, your equity increases by $80.
If EUR/USD goes down 1 pip, your equity decreases by $80.
$2,000 Usable Margin divided by $80/pip = 25 pips
Let’s say you bought 80 lots of EUR/USD at $1.2000. This is how your account will look if it
EUR/USD drops to $1.1975 or -25 pips.
As you can see, your Usable Margin is now at $0.00 and you will receive a MARGIN CALL!
Of course, you’re a veteran international spy, you’ve faced much bigger calamities. You’ve
got ice in your veins and your heart rate is still 55 bpm.
After the margin call this is how your account will look:
The EUR/USD moves 25 PIPS, or less than .22% ((1.2000 – 1.1975) / 1.2000) X 100% and
you LOSE $2,000!
You blew 20% of your trading account! (($2,000 loss / $10,000 balance)) X 100%
In reality, it’s normal for EUR/USD to move 25 pips in a couple seconds during a major
economic data release.
Oh I almost forget…I didn’t even factor in the SPREAD!
To simplify the example, I didn’t even factor in the spread, but I will now to make this
example super realistic.
Let’s say the spread for EUR/USD is 3 pips. This means that EUR/USD really only has to
move 22 pips, NOT 25 pips before a margin call.
Imagine losing $2,000 in 5 seconds?!
This is what happened to our popular British spy all because he didn’t understand the
mechanics of margin and how to use leverage.
School of Pipsology - 219
The sad fact is….most new traders don’t even open a mini account with $10,000. Because
our spy friend had at least $10,000, he was at least able to weather 25 pips before his
margin call.
If he only started off with $9,000, he could only weather a 10 pip drop (including spread)
before receiving a margin call. 10 pips!
More Leverage
Hopefully I’ve done my job and you now have a better understanding of what “margin” is.
Now I want to take a harder look at “leverage” and show you how it regularly wipes out
unsuspecting or overzealous traders.
We’ve all seen or heard online forex brokers advertising how they offer 200:1 leverage or
400:1 leverage. I just want to be clear that what they are really talking about is the
maximum leverage you can trade with. Remember this leverage ratio depends on the
margin required by the broker. For example, if a 1% margin is required, you have 100:1
leverage.
There is maximum leverage. And then there is your true leverage.
True leverage is the full amount of your position divided by the amount of money
deposited in your trading account.
Huh?
Let me illustrate an example:
You deposit $10,000 in your trading account. You buy 1 standard 100K of EUR/USD at a
rate of $1.0000. The full amount of your position is $100,000 and your account balance is
$10,000. Your true leverage is 10:1 ($100,000 / $10,000)
Let’s say you buy another standard lot of EUR/USD at the same price. The full amount of
your position is now $200,000 and your account balance is still $10,000. Your true
leverage is now 20:1 ($200,000 / $10,000)
You’re feeling good so you buy three more standard lots of EUR/USD, again at the same
rate. The full amount of your position is now $500,000 and your account balance is still
$10,000. Your true leverage is now 50:1 ($500,000 / $10,000).
School of Pipsology - 220
Assume the broker requires 1% margin. If you do the math, your account balance and
equity are both be $10,000, the Used Margin is $5,000, and the Usable Margin is $5,000.
In a standard account, each pip is worth $10.
In order to receive a margin call, price would have to move 100 ips ($5,000 Usable Margin
divided by $10/pip).
This would mean the price of EUR/USD would have to move from $1.0000 to $0.95000 – a
price change of 5%.
After the margin call, your account balance would be $5,000. You lost $5,000 or 50% and
the price only moved 5%.
Now let’s pretend you ordered coffee at a McDonald’s drive-thru, then spilled your coffee
on your lap while you were driving, and then proceeded to sue and won against
McDonald’s because your legs got burned and you didn’t know the coffee was hot. To
make a long story long, you deposit $100,000 in your trading account instead of $10,000.
You buy just 1 standard lot of EUR/USD – at a rate of $1.0000. The full amount of your
position is $100,000 and your account balance is $100,000. Your true leverage is 1:1.
Here’s how it looks in your trading account:
In this example, in order to receive a margin call, price would have to move 9,900 pips
($99,000 Usable Margin divided by $10/pip)
This means the price of EUR/USD would have to move from $1.0000 to $0.0100! This is a
price change of 99% or basically 100%!
Let’s say you buy 19 more standard lots, again at the same rate as the first trade. The full
amount of your position is $2,000,000 and your account balance is $100,000. Your true
leverage is 20:1.
School of Pipsology - 221
In order to be “margin called”, price would have to move 400 pips ($80,000 Usable Margin
divided by ($10/pip X 20 lots)
That means the price of EUR/USD would have to move from $1.0000 to $0.9600 – a price
change of 4%.
If you did get margin called and your trade exited at the margin call price, this is how your
account would like:
You would have realized an $80,000 loss! You’ would’ve wiped out 80% of your account
and the price only moved 4%!
Do you now see the effects of leverage?!
Leverage amplifies the movement in the relative prices of a currency pair by the factor of
the leverage in your account.
Here’s a chart of how much your account balance changes if prices moves depending on
your leverage.
Leverage % Change in Currency % Change in Account
100:1 1% 100%
50:1 1% 50%
33:1 1% 33%
20:1 1% 20%
10:1 1% 10%
5:1 1% 5%
3:1 1% 3%
1:1 1% 1%
School of Pipsology - 222
Let’s say you bought USD/JPY and it goes up by 1% from 120.00 to 121.20. If you trade one
standard $100K lot, here is how leverage would affect your return:
Leverage Margin Required Return (Gain)
100:1 $1,000 +100%
50:1 $2,000 +50%
33:1 $3,300 +33%
20:1 $5,000 +20%
10:1 $10,000 +10%
5:1 $20,000 +5%
3:1 $33,000 +3%
1:1 $100,000 +1%
Let’s say you bought USD/JPY and it goes down by 1% from 120.00 to 118.80. If you trade
one standard $100K lot, here is how leverage would affect your return (or loss):
Leverage Margin Required Return (Loss)
100:1 $1,000 -100%
50:1 $2,000 -50%
33:1 $3,300 -33%
20:1 $5,000 -20%
10:1 $10,000 -10%
5:1 $20,000 -5%
3:1 $33,000 -3%
1:1 $100,000 -1%
School of Pipsology - 223
The more leverage you use, the less “breathing room” you have for the market to move
before a margin call.
You’re probably thinking I’m a day trader, I don’t need no stinkin’ breathing room. I only
use 20-30 pip stop losses.
Okay let’s take a look:
Example #1
You open a mini account with $500 which trades $10K mini lots and only requires .5%
margin.
You buy 2 lots of EUR/USD. Your true leverage is 40:1 ($20,000 / $500). You place a 30 pip
stop loss and it gets triggered. Your loss is $60 ($1/pip x 2 lots).
You’ve just lost 12% of your account ($60 loss / $500 account). Your account balance is
now $440.
You believe you just had a bad day. The next day, you’re feeling good and want to recoup
yesterday losses, so you decide to double up and you buy 4 lots of EUR/USD. Your true
leverage is about 90:1 ($40,000 / $440). You set your usual 30 pip stop loss and your trade
loses. Your loss is $120 ($1/pip x 4 lots).
You’ve just lost 27% of your account ($120 loss/ $440 account). Your account balance is
now $320.
You believe the tide will turn so you trade again. You buy 2 lots of EUR/USD. Your true
leverage is about 63:1. You set your usual 30 pip stop loss and lose once again! Your loss is
$60 ($1/pip x 2 lots).
You’ve just lost almost 19% of your account ($60 loss / $320 account). Your account
balance is now $260.
You’re getting frustrated. You try to think what you’re doing wrong. You think your setting
your stops too tight.
The next day you buy 3 lots of EUR/USD. Your true leverage is 115:1 ($30,000 / $260). You
loosen your stop loss to 50 pips. The trade starts going against you and it looks like you’re
about to get stopped out yet again!
But what happens next is even worse! You get a margin call!
School of Pipsology - 224
Since you opened 3 lots with a $260 account, your Used Margin was $150 so your Usable
Margin was a measly $110. The trade went against you 37 pips and because you had 3 lots
opened, you get margin called. Your position has been liquidated at market price.
The only money you have left in your account is $150, the Used Margin that was returned
to you after the margin call.
After four total trades, your trading account has gone from $500 to $150. A 70% loss! It
won’t be very long until you lose the rest.
Trade No. Starting
Account
Balance
Number of
Lots Used
Stop Loss
Size (pips)
Trade Result Ending
Account
Balance
1 $500 2 30 -$60 $440
2 $440 4 30 -$120 $320
3 $320 2 30 -$60 $260
4 $260 5 50 Margin Call $150
A four trade losing streak is not uncommon. Experienced traders have similar or even
longer streaks. The reason they’re successful is because they use low leverage. Most cap
their leverage at 5:1 but rarely go that high and stay around 3:1.
The other reason experienced traders succeed is because their accounts are properly
capitalized!
While learning technical analysis, fundamental analysis, building a system, trading
psychology is important, I believe the biggest factor on whether you succeed as a forex
trader is making sure you capitalize your account sufficiently and trade that capital with
smart leverage.
Your chances of becoming successful are greatly reduced below a minimum starting
capital. It becomes impossible to mitigate the effects of leverage on too small an account.
Low leverage with proper capitalization allows you to realize losses that are very small
which allows you to trade another day.
Example #2
School of Pipsology - 225
Bill opens a $5,000 account trading $100,000 lots. He is trading with 20:1 leverage. The
currency market moves on a regular basis anywhere from 70 to 200 pips in one day. In
order to protect himself, he uses tight 30 pips stops. If the market goes 30 pips against
him, he would be stopped out for a loss of $300.00. He felt that was reasonable but he
underestimated how volatile this market is and found himself being stopped out
frequently.
After being stopped out four times, he’d had enough. He’s decided to give himself a little
more room, handle the swings, increases his stop to 100 pips.
Bill’s leverage is not 20:1 anymore, his account is down to $2,800 (his four loses at $300
each) and he’s still trading one $100,000 lot. It’s now over 25:1.
He decides to tighten his stops to 50 pips. He opens another trade using two lots and two
hours later his 50 pip stop loss is hit and he losses $1,000. He now has $2,800 in his
account. His leverage is 35:1.
He tries again with two lots. This time the market goes up 10 pips. He cashes out with a
$200 profit. His account grows slightly to $3,000.
He opens another position with two lots. The market drops 50 points and he gets out.
Now he has $2,000 left.
He thinks what the hell and opens another position. The market proceeds to drop another
100 pips and because he has $1,000 locked up as margin deposit, he only has $1,000
margin available, so he receives a margin call and his position is instantly liquidated.
He now has $1,000 left which is not even enough to open a new position.
He lost $4,000 or 80% of his account with a total of 8 trades and the market only moved
280 pips. 280 pips! The market moves 280 pips pretty darn easy.
Are you starting to see why leverage is the top killer of forex taders?
How Leverage Affects Transaction Costs
Besides amplifying your losses, leverage also has another way of killing you. It’s a much
slower kind of death, though, kind like being constantly exposed to high levels of
radiation. Most traders don’t see it coming and by the time they notice it, they’re dead.
School of Pipsology - 226
This killer I’m talking about is the associated transaction cost of using high leverage.
Not only does leverage amplify your losses, it also amplifies your transaction costs as a
percentage of your account.
Let’s say you open a mini account with $500. You buy five mini $10k lots of GBP/USD
which has a 5 pip spread. Your true leverage is 100:1 ($50,000 total mini lots / $500
account). But check this….you paid $25 in transaction costs (($1/pip x 5 pip spread) x 2
lots)). That is 5% of your account! With one trade, and the market not even moving yet,
you’re already down 5%! If your trades lose, your account balance shrinks. As your
account balance shrinks, your leverage increases. As your leverage increases, the faster
your transaction costs eats away at the little money you have left. This is the slow and
silent killer I’m talking about.
The higher your leverage, the higher your transaction cost as a percentage of your trading
capital.
If you have a mini account, and open a trade with a 5 pip spread, which equals $5
transaction cost, look at how the relative value of your transaction costs increases with
more leverage.
Leverage Margin Required (MR) Cost as % MR
200:1 $50 10%
100:1 $100 5%
50:1 $200 2.5%
33:1 $330 1.5%
20:1 $500 1%
10:1 $1,000 .5%
5:1 $2,000 .25%
3:1 $3,300 .10%
1:1 $10,000 .05%
Now you’ve learned how leverage can magnify your profits and losses, but also your
transaction costs.
School of Pipsology - 227
Leverage does not equal margin.
Leverage is how many times you lever your whole account.
The maximum amount that you are allowed to lever is dependent on your margin
requirement.
Don’t Underestimate Leverage
Most beginners underestimate the potentially devastating damage leverage can wreak on
their accounts. Understanding leverage enough to know when to use it and when NOT to
use it is critical to your success!
Leverage is a very powerful tool but both old and new traders use it to destroy their
trading capital simply because they take too lightly its destructive force or ignore it
altogether. It’s a pity, but the more of them the easier it is for us smart traders to make
money. Sad but true.
High leverage is a favorite selling point for most forex brokers. Yes they pitch that you can
make a huge killing using huge leverage, but know you could easily be killed by huge
leverage as well.
Brokers want you to trade with a short-term mindset. They want you to trade as much as
possible as often as possible. It’s the only way they make money. One or two pips are
important to them. The more you trade the more they make on the spread. It’s not in
their best interest to tell you to let your trades run longer than the same day.
If you want to give yourself the best chance to succeed, first learn to trade profitably
without leverage.
Play it safe. Protect your capital.
When you can make more pips more than you lose consistently, then, and only then,
should you use unleash this weapon of mass destruction called leverage. Destroy traders
(or your broker) taking the opposite side of your trade. Don’t destroy yourself.
Forex trading should be treated as a job or business. Don’t think that just because brokers
allow you to use high leverage with a low minimum deposit that you can “make a quick
<insert choice of currency here>” or “get rich quick”. Approach the currency markets with
respect.
Be realistic in your expectations and be willing to properly educate yourself.
School of Pipsology - 228
If you don’t, you will die.
Okay, not really, but your account will die.
Commodity Currencies
In today's lesson, we will be taking a look at commodities and how they relate to
commodity currencies.
What is a commodity currency?
In this crazy trading universe we call the Forex, a commodity currency is a currency whose
country's exports are largely comprised of raw materials (precious metals, oil, agriculture,
etc.).
There are dozens of countries that fit this description, but the most actively traded
currencies are the New Zealand Dollar, Australian Dollar, and the Canadian Dollar.
Because their currencies are all called dollars, they are also known as the commodity
dollars or "Condoles" for short.
These three currencies are among the major currency pairs, which mean they have great
liquidity and volatility for active trading.
How do commodities affect commodity currencies?
Raw materials compose such a large portion of these countries exports, a rise in
commodity prices can possibly lead to a rise in the value of a country's currency, and vice
versa.
Let's take a look at the major commodity currencies and see how much their movement
correlates to certain commodities...
Canadian Dollar and Oil
Oil is the life blood of the industrialized world and thus a highly watched and traded
commodity. While gold is often nicknamed “Black Gold”, we prefer to call it “Black Crack”.
Many countries that produce “black crack” and hold massive reserves of "black crack"
School of Pipsology - 229
tend to benefit from rises in oil prices, including Canada. We like to call these countries
the Black Crack Mafia.
Canada is one of the world's largest producers of oil (black crack dealers) and holds oil
reserves (black crack stash) second only to Saudi Arabia, which makes Canada very reliant
on its most prized commodity. It is also the largest supplier to the world's biggest oil
consumer (black crack addict) - the United States. Because oil is such a big part of the US
economy, rising oil prices tend to have a negative effect on U.S. equities and the U.S.
Dollar.
Wait a minute! Rising oil prices tend to be good for Canada/bad for the U.S., while falling
oil prices tend to be bad for Canada/good for the U.S. - how can we play this idea in the
Forex markets? Anyone? USD/CAD??? Right! In fact let's take a quick look at a chart
overlaying oil prices and the USD/CAD:
As you can see from the chart above, price movements USD/CAD and Oil are inversely
correlated from each other - meaning as oil trends higher, USD/CAD tends to trend lower
and vice versa.
Since January 1988, USD/CAD and Oil have had about a 68% inverse correlation to each
other. This is a pretty strong correlation. As a currency trader, knowing this can add
another tool to your toolbox when analyzing USD/CAD and help you make longer term
trading decisions.
School of Pipsology - 230
Australian Dollar and Gold
Everyone loves gold - how can you not love it? It's metal, shiny and makes pretty cool
jewelry. Besides that, gold is used in many, many applications like highly conductive
wiring, reflective coating, and dentistry - you should check out Big Pippin's new grill!
In the financial world, gold is viewed as a safe haven against inflation and it is one of the
most highly traded commodities. Okay, so how does all of this tie into Forex trading?
Great question! To answer that, we'll take a look at the Australian Dollar.
For many traders out there, trading the Australian Dollar is just like trading gold. Australia
is one of the world's largest producers of gold and it exports comprise over 50% of
commodities, including precious metals.
These commodities account for a large portion of Australia's Gross Domestic Product; so
many traders watch the rise and fall of commodity prices, especially gold, which can
influence the direction of the Australian Dollar. Let's take a look at a comparison chart of
gold and the "Aussie:"
These commodities account for a large portion of Australia's Gross Domestic Product; so
many traders watch the rise and fall of commodity prices, especially gold, which can
influence the direction of the Australian Dollar. Let's take a look at a comparison chart of
gold and the "Aussie:"
School of Pipsology - 231
This is a monthly chart that compares the price movement of gold and the AUD/USD all
the way back to January 1980. As you can see, the two's movements were virtually the
same, and from January 1980 to about January 2002 one can view gold as a leading
indicator to AUD/USD.
The "red stars" above show major turning points in gold. These turning points seemed to
occur before major turning points in AUD/USD. This relationship changed around 2002 as
gold and AUD/USD movements were practically the same until gold shot up in value in
2005 to 2006.
Just as we learned with oil and USD/CAD, traders can watch gold prices to get an extra
edge in their analysis of AUD/USD as gold movements can give possible clues to where
AUD/USD is headed. For those who can’t trade gold directly, AUD/USD’s strong
correlation to gold makes a great substitution. You can trade AUD/USD in the spot Forex
market as a proxy for gold, which is traded in the futures market.
School of Pipsology - 232
New Zealand Dollar
Much like its neighbor to the west, Australia, New Zealand's economy is also export-driven
with commodities comprising much of its exports. While most trader's view on the "Kiwi"
is that it’s not directly linked to one specific commodity, its correlation to commodities in
general is a substantial one.
Since January 1990, its correlation is 63%, when compared to the Commodity Research
Bureau Index (CRB Index), one of the world’s standards for commodity prices.
This chart shows how commodity prices and the New Zealand Dollar have moved in
tandem with each other over the past 25+ years.
Since January 1990, the NZD/USD and CRB Index has had approximately 60% correlation.
So, as commodity prices rise and fall, traders can look for similar movements in the
NZD/USD because of New Zealand's dependency on its commodity exports.
Like gold and oil, a trader can express their general views and ideas on commodities by
trading NZD/USD.
School of Pipsology - 233
Summary
We have just learned about relationships between commodities and commodity
currencies. There are a few things to remember before you start applying the ideas learn
here today.
Short term moves in commodities usually do not directly affect a commodity currency
immediately. Analyzing commodities for use with currencies is probably best suited for
longer term outlooks, trading, and investing.
Keep in mind that even though we see strong correlations between the commodity
currencies and commodities, exports are only a portion of a country’s economy. Always
take a look a country’s overall economy, interest rates, and political situation as well.
Combining all of these aspects and adding commodity movements in the mix can present
a clearer picture and possibly better trading ideas in these currencies.
So, for those of you into Oil, Gold, and commodities in general, check out the “Condoles.”
With the leverage and liquidity advantages available in spot Forex trading, currencies can
be an awesome alternative to trading straight forward commodities or for hedging your
commodity investments! Don’t be scurrrrreedd…Check’em out!
School of Pipsology - 234
Currency Crosses
After going through the School of Pipsology and doing a little demo trading, there’s
probably one thing you’ve noticed about trading currencies – it’s all about the US Dollar!
Or is it?
Well, with central banks across the world holding trillions in USD reserves, commodities
priced in the Greenback, and other major financial transactions passing through the dollar
daily, it pretty much IS all about the dollar.
In general, approximately 90% of all transactions in the almost US$2 trillion daily traded
Foreign Exchange market involves the dollar. Wow!
Also, in your demo trading, I’m sure you’ve noticed that no matter what major pair you
trade (i.e. EURUSD, AUDUSD, USDCHF, etc.) that US news pretty much dominates the
movement regardless of data releases from anywhere else. So, why look at anything else
besides the major currency pairs?
Well, serious trading opportunities can be found by following the other major currencies
with currency crosses, especially if you want to avoid the unpredictable volatility that US
dollar can bring.
Hopefully, this lesson will open up your outlook on Crosses and give you basic
understanding on how to analyze them.
What is a Currency-Cross?
Basically, a currency-cross is any currency pair in which the US Dollar is neither the base
nor counter currency. For example, GBPJPY, EURJPY, EURCAD, and AUDNZD are all
considered currency crosses.
Back to Basics
When it comes down to it, currency trading is all about matching weak currencies and
strong currencies.
School of Pipsology - 235
Just find a country that has weak a fundamental outlook or maybe a distressful political
situation, and then match it with a country with positive or better fundamentals (i.e. rising
employment, growing trade surplus, etc) or maybe a positive political outlook, then you
can match their currencies together to make an intelligent directional trade.
Let’s take a look at a recent, real world example:
On January 11th, 2007, both the Bank of England and the European Central Bank were set
to release their decisions on their interest rate policy. Leading up to that morning, the
markets speculated that the ECB hint that they would raise interest rates soon and the
BoE would hold any hikes. Well, what a surprise the market got as the Bank of England
raised rates to 5.25% and the ECB held rates at 3.50% on concerns of slowing growth in
the Eurozone.
So, why would a currency trading pro, such as yourself, play a currency cross instead of
matching either the Euro or the British Pound with the US Dollar? Well, here are a couple
of scenarios to think about:
1. US Retail sales numbers were coming out soon after the interest rate decisions. If you had
a weak outlook on the Euro and went short EURUSD, then a weak US Retail report would
probably been bad for your trade as the US dollar would sell off.
2. Or if you maintained a strong outlook on the British Pound and decided to go long
GBPUSD, then a dollar rally on a strong US retail sales report would have been very bad for
you trade.
After the interest rate releases, we know the outlook on the Euro is weaker and the
outlook of the British Pound is stronger, why don’t we just short EURGBP? By taking this
trade you get rid of the event risk of upcoming US data, plus you get a positive carry on
your position!
Here’s how you may have faired taking a short trade on EURGBP using this analysis:
School of Pipsology - 236
As you can see from the chart, had you shorted at 0.6650 an hour or so after the interest
rate decisions were announced, you would have caught the slow and steady move to
0.6600, and possibly further until fundamentals change for either the Euro or the Pound.
Again, this is just one example of matching weak with relatively stronger currencies. With
six major currencies other than the US dollar, there are plenty of possibilities to find
profitable trades, and avoid erratic volatility with the US dollar.
Synthetic Pairs
You’ve done your analysis and you’ve come to the conclusion that the British Pound looks
strong and the Swiss Franc may get weaker.
Or maybe the Australian dollar is looking pretty good against the Canadian dollar, but you
look in your trading platform and see that your broker doesn’t have GBPCHF or AUDCAD.
Oh no! I guess that’s an opportunity missed, right? Heck No! You can create a “synthetic”
pair to go long on GBPCHF or AUDCAD.
To create synthetic pairs using the four major currency pairs and three commodity
currencies is relatively easy. All it takes is to buy or sell two pairs with equal position sizes.
Let’s say you want to go long the British Pound against the Swiss Franc, or buy GBPCHF.
You would have to buy GBPUSD and buy USDCHF at the same time. Still not clear? Let me
show you…
School of Pipsology - 237
Pretty simple, right? The only trick to it is making sure you buy the same amount of each
pair.
Using our GBPCHF example, let’s say the current exchange rate for GBPUSD is 1.9000 and
the exchange rate for USDCHF is 1.2500 and you want to buy US$10,000 worth of each
pair. Here’s how you do it:
For pairs with USD as the counter currency (i.e. AUDUSD, GBPUSD, EURUSD, etc.), then
you would take the dollar amount you want to purchase and divide it by the exchange
rate:
US$10,000 (desired position size) divided by 1.9000 (current rate of GBPUSD) = 5263 Units
of GBPUSD
For pairs with USD as the base currency (i.e. USDCHF, USDJPY, USDCAD), just purchase
amount of units you want to buy because you are buying US dollars
$10,000 (desired position size) * 1 Unit = 10,000 Units
So, to buy US$10,000 worth of GBPCHF, we purchase 5,263 units of GBPUSD (if your
broker doesn’t offer flexible lot sizes you can always round up or down) and 10,000 units
of USDCHF. Got it? Great! I knew you would!
Summary
School of Pipsology - 238
As you can see, there are many, many trade opportunities presenting themselves in the
foreign exchange market other than figuring out what the Greenback will do any given day
- and now you know how to find them! Just remember a few things:
• Do your due diligence/analysis and match the weak currencies with strong currencies.
• What if the pair you are looking to trade is not available with your broker, no sweat right?
You now know how to create synthetic pairs by simultaneously going long or short two
major pairs to create one currency cross.
• Last tip; please be conscientious of the pip value of the cross you are trading. For example,
a standard lot (100,000 units) of EUR/GBP will be approximately $19.70 per pip. Some
crosses will have a higher or lower pip value than the majors. This information is good to
know for your risk analysis.
• So, on the days you many not see any opportunities in the major pairs, or if you want to
avoid the volatility of a US news event, check out some the currency crosses. You may
never know what you may find! Good luck!
Divergence Trading
What if there was a low risk way to sell near the top or buy near the bottom of a trend?
What if you were already in a long position and you could know ahead of time the perfect
place to exit instead of watching all your unrealized gains vanish before your eyes because
your trade reverses direction?
What if you believe a currency pair will continue to fall but would like to go short at a
better price or a less risky entry?
Well there is a way. It’s called divergence trading.
Divergence is basically price action measured in relationship to an oscillator indicator. It
doesn't really matter what type of oscillator you use. You can use RSI, Stochastic, MACD,
CCI, etc. etc. The great thing about divergences is that you can use them as a leading
indicator and after some practice, it’s not too difficult to spot.
When traded properly, you can be consistently profitable with divergences. The best thing
about divergences is that since you’re usually buying near the bottom or selling near the
top, your risk on your trades are very small relative to your potential reward. Cha ching!
Higher Highs and Lower Lows
Just think “higher highs” and “lower lows”.
School of Pipsology - 239
If price is making highs, the oscillator should also be making higher highs. If price is making
lower lows, the oscillator should also be making lower lows.
If they are NOT, that means price and the oscillator are diverging from each other. Hence
the term, divergence.
There are TWO types of divergence:
1. Regular
2. Hidden
Regular Divergence
A regular divergence is used as a possible sign for a trend reversal.
If the price is making lower lows (LL), but the oscillator is making higher lows (HL), this is
considered regular bullish divergence.
If the price is making a higher high (HH), but the oscillator is lower high (LH), then you
have regular bearish divergence.
School of Pipsology - 240
Hidden Divergence
A hidden divergence is used as a possible sign for a trend continuation.
If price is making a higher low (HL), but the oscillator is making a lower low (LL), this is
considered hidden bullish divergence.
If price is making a lower high (LH), but the oscillator is making a higher high (HH), then
you have hidden bearish divergence.
School of Pipsology - 241
How to Trade Divergences
Here’s how you could trade divergences:
Divergence Type
Price Oscillator Trade
Regular Higher High Lower High SELL
Regular Lower Low Higher Low BUY
Hidden Higher Low Lower Low BUY
Hidden Lower High Higher High SELL
Divergences act as an early warning system alerting you when the market could reverse.
For example, if bulls have steadily pushed EUR/USD higher, the appearance of divergence
between price and indicator could mean that bulls are running out of gas and price will
soon fall
Please keep in mind that I use divergence as an indicator, not a signal to enter a trade! It
wouldn't be smart to trade basely solely on divergences as too many false signals are
given. It’s not 100% foolproof, but when used as a setup condition and combined with
additional confirmation tools, your trades have a high probability of winning with
relatively low risk.
On the flip side, I think it is just as dangerous trade against this indicator. If you're unsure
about which direction to trade, chill out on the sidelines.
School of Pipsology - 242
Divergences don’t appear that often, but when they do appear, it’d behoove you to pay
attention. Regular divergences can help you collect a big chunk of profit because you’re
able to get in right when the trend changes. Hidden divergences can help you ride a trade
longer resulting in bigger-than-expected profits by keeping you on the correct side of a
trend.
The trick is to train your eye to spot divergences when they appear AND choose the
proper divergences to trade. Just because you see a divergence, it doesn’t necessarily
mean you should automatically jump in with a position. Cherry pick your setups and you’ll
do well.
9 Rules for Trading Divergences
There are nine cool rules for trading divergences. Learn 'em, apply 'em, and make money.
Ignore them and go broke.
1.
In order for divergence to exist, price must have either formed one of the following:
Higher high than the previous high
Lower low than the previous low
Double top
Double bottom
Don’t even bother looking at an indicator unless ONE of these four price scenarios have
occurred. If not, you ain’t trading divergence buddy. You just imagining things.
Immediately go see your optometrist and get some new glasses.
School of Pipsology - 243
2.
Okay now that you got some action (recent price action that is), look at it. Remember,
you"ll only see one of four things: a higher high, a flat high, a lower low, or a flat low. Now
draw a line backward from that high or low to the previous high or low. It HAS to be on
successive major tops/bottom. If you see any little bumps or dips between the two major
highs/lows, do what you do when your significant other shouts at you - ignore it.
3.
Once you see two swing highs are established, you connect the TOPS. If two lows are
made, you connect the BOTTOMS. Don’t make the mistake of trying to draw a line at the
bottom when you see two higher highs. It sounds dumb but peeps regularly get confused.
School of Pipsology - 244
4.
So you’ve connected either two tops or two bottoms with a trendline. Now look at your
preferred indicator and compare it to price action. Whichever indicator you use,
remember you are comparing its TOPS or BOTTOMS. Some indicators such as MACD or
Stochastic have multiple lines all up on each other like teenagers with raging hormones.
Don’t worry about what these kids are doing.
5.
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If you drew line connecting two highs on price, you MUST draw a line connecting the two
highs on the indicator as well. Ditto for lows also. If you drew a line connecting two lows
on price, you MUST draw a line connecting two lows on the indicator. They have to match!
6.
The highs or lows you identify on the indicator MUST be the ones that line up VERTICALLY
with the price highs or lows.
7.
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Divergence only exists if the SLOPE of the line connecting the indicator tops/bottoms
DIFFERS from the SLOPE of the line connection price tops/bottoms. The slope must either
be: Ascending (rising) Descending (falling) Flat (flat)
8.
If you spot divergence but price has already reversed and moved in one direction for some
time, the divergence should be considered played out. You missed the boat this time. All
you can do now is wait for another swing high/low to form and start your divergence
search over.
9.
Divergences on longer timeframes are more accurate. You get less false signals. You will
also get less trades but your profit potential is huge. Divergences on shorter timeframes
will occur more frequently but are less reliable. I personally only look for divergences on 1-
hour charts or longer. Other traders use 15-minute charts or even faster. On those
timeframes, there’s just too much noise for my taste so I just stay away.
School of Pipsology - 247
Divergence Cheat Sheet
Type Bias Price Oscillator Description Example
Bullish Lower
Low
Higher Low Indicates
underlying
strength. Bears
are exhausted.
Warning of
possible trend
direction change
from down to
up.
Bearish Higher
High
Lower High Indicates
underlying
weakness. Bulls
are exhausted.
Warning of
possible trend
direction change
from up to
down.
Bullish Higher
Low
Lower Low Indicates
underlying
strength. Good
entry or reentry.
Occurs
during
retracements in
an uptrend. Nice
to see during
price retest of
previous lows.
“Buy the dips”
School of Pipsology - 248
Bearish Lower
High
Higher
High
Indicates
underlying
weakness.
Found during
retracements in
a downtrend.
Nice to see
during price
retests of
previous highs.
“Sell the rallies”
pair, you are actually buying the US dollar and selling Swiss Francs at the same time). Just
like the example above, you pay interest on the currency position you sell, and collect
interest on the currency position you buy.
What makes the carry trade special in the spot forex market is that interest payments
happen every trading day based on your position. Technically, all positions are closed at
the end of the day in the spot forex market - you just don't see it happen if you hold a
position to the next day.
Brokers close and reopen your position, and then they debit/credit you the overnight
interest rate difference between the two currencies. This is the cost of "carrying" (also
known as “rolling over”) a position to the next day.
The amount of leverage available from forex brokers has made the carry trade very
popular in the spot forex market. Forex trading is completely margin based, meaning
you only have to put up a small amount of the position and you broker will put up the
rest. Many brokers ask as little as 1% - 2% of a position - what a deal, eh?
Let's take a look at a generic example to show how awesome this can be.
For this example we'll take a look at Joe the newbie forex trader. It's Joe's birthday and
his grandparents, being the sweet and generous people they are, give him $10,000.
Schweeeet!
Now, instead of going out and blowing his birthday present on video games and posters of
bubble gum pop stars, he decides to save it for a rainy day. Joe goes to the local bank to
open up a savings account and the bank manager tells him, "Joe, your savings account will
pay 1% a year on your account balance. Isn't that fantastic?" Joe pauses and thinks to
himself, "At 1%, my $10,000 will earn me $100 in a year. Man that sucks!"
Joe, being the smart guy he is, has been studying BabyPips.com and knows of a better way
to invest his money. So, Joe kindly responds to the bank manager, "Thank you sir, but I
think I’ll invest my money somewhere else you.”
Joe has been demo trading several systems, including the carry trade, for over a year, so
he has a pretty good understanding of how forex trading works. He opens up a real
account, deposits his $10,000 birthday gift, and puts his plan into action. Joe finds a
currency pair whose interest rate differential is +5% a year and he purchases $100,000
worth of that pair. Since his broker only requires a 1% deposit of the position, they hold
$1,000 in margin (100:1 leverage). So, Joe now controls $100,000 worth of a currency pair
that is receiving 5% a year in interest.
School of Pipsology - 201
What will happen to Joe’s account if he does nothing for a year?
Well, here are 3 possibilities. Let’s take a look at each one:
1. Currency position loses value. The currency pair Joe buys drops like a rock in value. If the
loss brings the account down to the amount set aside for margin, then the position is
closed and all that’s left in the account is the margin - $1000.
2. The pair ends up at the same rate at the end of the year. In this case, Joe did not gain or
lose any value on his position, but he collected 5% interest on the $100,000. That means
on interest alone, Joe made $5,000 off of his $10,000. That’s a 50% gain! Sweet!
3. Currency position gains value. Joe’s pair shoots up like a rocket! So, not only does Joe
collect $5000 in interest on his position, but he also takes home any gains! That would be
a nice present to himself for his next birthday!
Because of 100:1 leverage, Joe has the potential to earn around 50% a year from his initial
$10,000. Here is an example of a currency pair that offers a 5% differential rate based on
current interest rates:
If you buy USD/JPY and held it for a year, you earn a "positive carry" of 5%.
Of course, if you sell USD/JPY, it works the opposite way:
School of Pipsology - 202
If you sold USD/JPY and held it for a year, you would earn a "negative carry" of 5%.
Again, this is a generic example of how the carry trade works. Any questions on the
concepts? No? I knew you could catch on quick! So, now it’s time to move on to the most
important part of this lesson: Carry Trade Risk.
Carry Trade Risk
Being that you are a professional trader, you already know what the first question you
should ask before entering a trade is, right?
“What is my risk?”
Correct! Before entering a trade you must always asses your max risk and whether or not
it is acceptable according to your risk management rules.
In the previous example with Joe the Newbie Trader, his maximum risk would have been
$9000. His position would be automatically closed out once his losses hit $9000.
Eh?
That doesn’t sound very good, does it?
Remember, this is the worst possible scenario and Joe is a newbie, so he hasn’t fully
appreciated the value of stop losses.
When doing a carry trade, you can still limit your losses like a regular directional trade.
For instance, if Joe decided that he wanted to limit his risk to $1000, he could set a stop
School of Pipsology - 203
order to close his position at whatever the price level would be for that $1000 loss. He
would still keep any interest payments he received while holding onto the position.
Carry Trade Criteria
It’s pretty simple to find a suitable pair to do a carry trade. Look for two things:
1. Find a high interest differential.
2. Find a pair that has been in an uptrend – where the currency you are long has been
gaining value against the currency you are short.
Pretty simple, huh? Let’s take a real life example of the carry trade in action:
This is a weekly chart of GBP/JPY. Up until recently, the Bank of Japan has maintained a
Zero Interest Rate Policy (current interest rate is 0.25% as of this writing - 11/01/2006).
With the Bank of England touting one of the higher interest rates among the major
currencies (currently at 4.75% as of this writing), many traders have flocked to this pair
(one of the factors creating a nice little uptrend in the pair). From the end of 2000 to mid-
2006, this pair moved from a price of 150.00 to 223.00 – that’s 7300 pips! If you couple
that with interest payments from the interest rate differential of the two currencies, this
pair has been a nice long term play for many investors and traders able to weather the
volatile up and down movements of the currency market.
School of Pipsology - 204
Of course, economic and political factors are changing the world daily. The interest rates
and interest rate differentials between currencies may change as well, bringing popular
carry trades (such as the Yen carry trade) out of favor with investors.
Summary
As you can see there are other ways to make money in the forex market without having to
buy low and sell high, which can be pretty tough to do day after day.
If you catch the right pair (one with a positive interest rate differential) at the right time,
then you’ll be sure to do well collecting money out of the market.
When properly applied, the carry trade can add significant income to your account, along
with your directional trading strategies.
School of Pipsology - 205
Are You Willing to Pay the Price?
HA! Made you click!
If you really thought there actually was a way for a lazy forex trader to get rich, SHAME ON
YOU!
No such thing exists. The word "lazy" and "trader" is an oxymoron. You have to be willing
to pay the price to become a trader.
Which brings us to our next lesson....?
So, you’ve gone through the School of Pipsology…five times, learned basic analysis and
money management techniques, and maybe even opened up a demo account and started
trading a plan you’ve created. (You do have a trading plan right?) Now you can sit back
and relax because it’s easy money from here on out, right?
Wrong!
You’ve just taken the first step.
You’ve only familiarized yourself with the very basic fundamentals of what it takes to
become a professional trader. Now it’s time to get on to the real work.
I’m sure you’re now thinking, “There’s more to learn?!”
Well, my friend, the learning never ends.
As with any profession, whether you’re a doctor, lawyer, athlete, assassin, spy, ninja,
ultimate fighter, musician or any other occupation that requires a high level of skill, you
can never stop learning and practicing. Otherwise, your skills will deteriorate and you’ll
slowly forget what you’ve learned.
This lesson will give you a peek into what it takes – education, time, money and
psychological stamina – to enter the most financially rewarding career on the planet: a
professional trader.
Education
School of Pipsology - 206
Imagine yourself in a legal situation and you decide to hire the cheapest lawyer you can
find. On the day you have to stand in front of a jury, your lawyer says to you, “Don’t
worry, while this is my first time, I’ve read ‘How to be an Awesome Lawyer in 28 Days for
Idiots’ a couple of times, so I know what I’m doing. You’ll be fine.”
Do you think your investment in that lawyer will pay off?
Probably not.
You’ll probably end up in prison with a tattoo covered cellmate named “Killer” for the rest
of your life.
Now I’m not a professional lawyer, but I’m pretty sure that it takes more than one book to
become one. More likely, lawyers have read and studied a wide range of books, journals
and case studies in order to fine-tune their practice. So why should it be any different to
become a professional trader?
Trading involves becoming proficient in a multitude of disciplines, including fundamental
analysis, technical analysis, sentiment analysis and self-awareness (also known as trading
psychology or what I call “mental analysis”).
Within those disciplines are different topics that should be studied individually.
For instance, while the School of Pipsology does a fantastic job of introducing the Elliot
Wave theory and making it easy to understand, there’s abundant amount of entire books
written on that single subject. The same thing goes with many other technical tools (i.e.
candlestick charting, Fibonacci numbers, pivot points, etc.), fundamentals and trading
psychology.
If you limit your education to a basic high-level overview of a few subjects, how do you
think that will help you acquire the skills needed to become a successful trader?
I’m not saying go out there and read everything there is to read on trading. While that
would be ideal, realistically it’s not possible.
What I am saying is this…
Before you enter a single trade, read and study enough to know why a tool works, how it
works and how well it has worked in many different situations. After you start trading
your live account, continue reading and studying some more. The forex market is dynamic
and continuously changing. (What market isn’t?) Being well versed in all the disciplines of
trading gives you the ability to adapt and make quick decisions in this fast-paced market.
School of Pipsology - 207
Time
Have you ever told yourself there’s never enough time in the day? I think we’ve all
thought that to ourselves at one point, but if you’re not willing to shift your priorities to
make time for trading, then forget about becoming a trader.
Sorry to put it so bluntly, but contrary to popular belief, trading is not a hobby.
Trading is not a hobby.
Trading is not a hobby unless you want to lose money.
Golf is my hobby. I pay to play golf. Golf is Tiger Wood’s business. Tiger Woods is paid to
play golf.
See the difference?
Trading is a business
You have to devote yourself to trading just like you would with any other business in order
to be successful.
So, it’s time (pun intended) to ask yourself this: “Can I balance my time and change my
lifestyle to make room for trading?”
I’d better hear a resounding “YES!”
But before you can even truly answer that question, you need to first figure out what your
daily priorities are and determine whether or not you can make trading THE number one
priority.
A good way to find this out for yourself is to list your daily activities, and then prioritize
them. If your daily priorities take up all of your time, then forget about trading.
So, take a moment to figure out what is going on in your life because it’s very important to
balance your time and priorities, not just to become a successful trader, but also to live a
content, meaningful life. We all want to be wildly profitable, and initially we may drop
everything else to get there, but in the end an unbalanced life will lead to personal and/or
professional failure.
School of Pipsology - 208
Capital aka Cash Money
It takes money to make money. Everyone knows that, but how much does one need to get
started in trading? The answer largely depends on how you are going to approach your
new start-up business.
First, consider how you are going to be educated. There are many different approaches in
learning how to trade: classes, mentors, on your own, or any combination of the three.
While there are many classes and mentors out there willing to teach forex trading, most
will charge a fee. The benefit of this route is that a well-taught class or great mentor can
significantly shorten your learning curve and get you on your way to profitability in a much
shorter amount of time compared to doing everything yourself.
The downside is the upfront cost for these programs, which can range from a few hundred
to a few thousand dollars, depending on which program you go with. For many of those
new to trading, the resources (cash money) required to purchase these programs are not
available.
For those of you unable or unwilling to pony up the cash for education, the good news is
that most of the information you need to get started can be found for FREE on the
internet through forums, brokers, articles and websites like BabyPips.com. We should all
thank Al Gore for inventing the Internet. Without him, there would be no BabyPips.com
This is no one “correct” path.
As long as you are disciplined and laser focused on learning the markets, your chances of
success increase exponentially. You have to be a gung ho student. If not, you’ll end up in
the poor house.
Second, is your approach to the markets going to require special tools such as news feeds
or charting software? As a technical trader, most of the charting packages that come with
your broker’s trading platform are sufficient (and some are actually quite good). For those
who need special indicators or better functionality, higher end charting software can start
at around $100 per month. Maybe you’re a fundamental trader and you need the news
the millisecond it is released, or even before it happens (wouldn’t that be nice!). Well,
instantaneous and accurate news feeds run from a few hundred to a few thousand dollars
per month. Again, you can get a complimentary news feed from your broker, but for
some, that extra second or two can be the difference between a profitable or unprofitable
trade.
School of Pipsology - 209
Finally, you need money/capital/funds to trade. How much exactly? Well, let’s be honest
here. If you’re consistent and practice proper money management techniques, and
without even knowing your monthly expenses, then you can probably start off with $50k
to $100k in trading capital. It’s common knowledge that most businesses fail due to
under capitalization, which is especially true in the forex trading business. So, if you are
unable to start with a large amount that you can afford to lose, be patient, save up and
learn to trade the right way until you are financially ready.
Psychology
Once you’ve made the time to get properly educated, demo trade, and save up sufficient
capital, the time will come where you will have to tackle the markets. By this time you
should’ve have learned the mechanics of trading and methods to analyze the market that
you are most confident using.
But are you ready to risk your hard-earned money?
Can you put your money where your mouth is?
Can you handle the (emotional, psychological and financial/economic) pressure of the
occasional losing streak and account drawdown?
Will you be able to control your excitement on a profitable trade?
Can you let go of your last trade and completely focus on your next opportunity?
What separates the profitable traders from the unprofitable ones is that profitable traders
can handle the pressure of risk and control their emotions. They realize that losing is just a
part of business. Those who have enough confidence in their methods and systems know
that a drawdown is a short-term setback and they will soon recover.
This final crucial lesson can’t really be taught. It will take time and experience. You have to
put in the hours. You will have to go through a gazillion different trades and different
market environments before you grasp and live these concepts. If you can’t do this or
aren’t willing to, then ultimately, trading may not be for you.
School of Pipsology - 210
Summary
For those willing to take the challenge and follow through, professional trading can be a
worthwhile goal. But before you dive too deep into forex trading, dip your toe or get your
feet wet in the shallow end first, and become familiar with the water. As you get more
comfortable, make your way slowly to the deeper end. Take your time.
Be honest with yourself.
Be ready to sacrifice your time and money.
Never stop learning and, most importantly, never quit.
Winners never quit and quitters never win.
The price of becoming top trader is extremely high, but certainly worth it.
School of Pipsology - 211
Forex Scams
Don't be a sucker.
One of the first things you must learn about the Forex market is that although it is
enjoyable and exciting, there is no magic button that will instantly turn your pennies into
millions of dollars. You may have already heard about Forex scams that are filling the
marketplace. These companies purposely mislead people into thinking that making money
in the Forex is easy and that they have found the “Magic Solution” to raking in booku
bucks with a simple click of a button.
Sadly, the number of Forex scams is rising. The Commodities Futures Trading Commission
(CFTC) released a report citing that in recent years, they have seen a sharp increase in the
rise of Foreign Exchange scams. The CFTC warns consumers to be cautious of sales
solicitations in newspapers, radio or television. You’ve probably even seen some of these
companies. I hear about them all the time from people whenever I try to explain the
Forex. The first thing they say is that they think the Forex is a scam. That makes me so
angry! The Forex is a tremendous investment opportunity for people and because of these
scammers, they miss out on a good way to make money.
The truth is that no matter how you slice or dice it, education is the only fool proof way to
consistently make money in the Foreign Exchange. Even after you finish reading through
BabyPips.com, your journey as a FX trader is only the beginning. I have never met a
successful Forex trader who stopped learning. There is always something new to learn and
you must actively seek out as much information as you can.
The best investment you can ever make is in yourself.
Don’t spend your money on a company that promises huge returns; even if they show you
their track record. It might look pretty and colorful; and I’m sure that the line on the graph
that seems to keep going higher and higher makes it look like there is no way you could
lose money, but don’t let them fool you. In fact, I could take my broker statement right
now, touch it up with Photoshop and voila! – I have now just become the most successful
trader on the planet. Pretty impressive huh? I know I’m laying it on pretty thick, but I
really want to prevent you from falling into any traps. Instead of giving your hard earned
money to someone else, you could put that money aside into a trading account and take
the time to educate yourself.
School of Pipsology - 212
Notice that I didn’t say you should put your money into a trading account and start
trading.
Keep that money in your account and gradually add to it as you continue to learn. Before
you know it, your account size will be bigger than you realized, and to top it off, you’ll
have a wealth of Forex education under your “traders” belt.
So remember, Forex scams DO exist. Be wary of them and hold onto your money. The
good news is that there ARE legitimate Forex companies out there. Make sure you do
thorough research on a company if you are thinking about giving them a shot. Ask other
traders on the forums if they've had experiences with them. There is a wealth of
information on the Internet so do your homework and you’ll be just fine.
Related Links:
Rising Number In Forex Scams
http://www.cftc.gov/enf/enfforex.htm
Public Warnings For Forex Scams
http://www.cftc.gov/opa/enf98/opaforexa15.htm
A List Of Known Forex Scammers
http://www.quatloos.com/forex-bulletins.htm
How To Report A Forex Scam
http://www.quatloos.com/forex-problems.htm
School of Pipsology - 213
Leverage the Killer
Most professional traders and money managers trade one standard lot for every $50,000
in their account.
If they traded a mini account, this means they trade one mini lot for every $5,000 in their
account.
Let that sink into your head for a couple seconds.
If pros trade like this, why do less experienced traders think they can succeed by trading
100K standard lots with a $2,000 account or 10K mini lots with $250?
No matter what the forex brokers tell you, don’t ever open a “standard account” with just
$2,000 or a “mini account” with $250. The number one reason new traders fail is not
because they suck, but because they are undercapitalized from the start and don’t
understand how leverage really works.
Don’t set yourself up to fail.
We recommend that you have at least have $100,000 of trading capital before opening a
“standard account”, $10,000 for a “mini account”, or $1,000 for a “micro account”.
So if you only have $60,000, open a “mini account. If you only have $8,000, open a
“micro” account. If you only have $250, open a “demo account” and stick with it until you
come up with the additional $750, then open a “micro account”.
If you don’t remember anything else in this lesson, I plead that you at least remember
what you just read above.
Okay, please re-read the previous paragraph and ingrain it in your memory. Just because
brokers allow you to open an account with only $250 doesn’t mean you should and I’m
going to explain why.
I believe most new traders who open a forex trading account with the bare minimum
deposit do so because they don’t completely understand what the terms “leverage” and
“margin” really are and how it affects their trading.
School of Pipsology - 214
It’s crucial that you’re fully aware and free of ignorance of the significance of trading with
leverage. If you don’t have rock solid understanding of leverage and margin, I guarantee
that you will blow your trading account.
Leverage Defined
The textbook definition of “leverage” is having the ability to control a large amount of
money using none or very little of your own money and borrowing the rest.
For example, in forex, you can control $100,000 with a $1,000 deposit. Your leverage,
which is expressed in ratios, is now 100:1. You’re now controlling $100,000 with $1,000.
Let’s say the $100,000 investment rises in value to $101,000 or $1,000. If you had to come
up with the entire $100,000 capital yourself, your return would be a puny 1% ($1,000 gain
/ $100,000 initial investment). This is also called 1:1 leverage. Of course, I think 1:1
leverage is a misnomer because if you have to come up with the entire amount you’re
trying to control, where is the leverage in that?
Fortunately, you’re not leveraged 1:1, you’re leveraged 100:1. You only had to come up
with $1,000 of your money, so your return is a groovy 100% ($1,000 gain / $1,000 initial
investment).
Now I want you to do a quick exercise. Calculate what your return would be if you lost
$1,000.
If you calculated it the same way I did, which is also called the correct way, you would
have ended up with a -1% return using 1:1 leverage and a WTF! -100% return using 100:1
leverage.
You’ve probably heard the good ol’ clichés like “Leverage is a double-edge sword.” or
“Leverage is a two-way street.” Well….as you can see, these clichés weren’t lying.
Margin Defined
So what about the term “margin”? Excellent question my bright padawan learner.
Let’s go back to the earlier example:
School of Pipsology - 215
“For example, in forex, you can control $100,000 with a $1,000 deposit. Your leverage,
which is expressed in ratios, is now 100:1. You’re now controlling $100,000 with $1,000.”
The $1,000 deposit is “margin” you had to give in order to use leverage.
Margin is the amount of money needed as a “good faith deposit” to open a position with
your broker. It is used by your broker to maintain your position. Your broker basically
takes your margin deposit and pools them with everyone else’s margin deposits, and uses
this one “super margin deposit” to be able to place trades with the interbanks.
Margin is usually expressed as a percentage of the full amount of the position. For
example, most forex brokers say they require 2%, 1%, .5% or .25% margin.
Based on the margin required by your broker, you can calculate the maximum leverage
you can wield with your trading account.
If your broker requires 2% margin, you have a leverage of 50:1. Here are the other popular
leverage “flavors” most brokers offer:
Margin Required Maximum Leverage
5% 20:1
3% 33:1
2% 50:1
1% 100:1
.5% 200:1
.25% 400:1
Aside from “margin required”, you will probably see other “margin” terms in your trading
platform. There is much confusion about what these different “margins” mean so I will try
my best to define each term:
Margin required: This is an easy one because I just talked about. It is the amount of
money your brokers requires from you to open a position. It is expressed in percentages.
School of Pipsology - 216
Account margin: This is just another phrase for your trading bankroll. It’s the total amount
of money you have in your trading account.
Used margin: The amount of money that your broker has “locked up” to keep your
current positions open. While this money is still yours, you can’t touch it until your broker
gives it back to you either when you close your current positions or when you receive a
margin call.
Usable margin: This is the money in your account that is available to open new positions.
Margin call: If the equity in the account drops below your usable margin, a margin call will
occur and some or all open positions will be closed by the dealing desk at the market
price.
Margin Call Example
Assume you are a successful retired British spy who now spends his time trading
currencies. You open a mini account and deposit $10,000.
When you first login, you will see the 10,000 in the "Equity" column of your "Account
Information" window.
You will also see that the "UsedMrg" ('Used Margin') is "$0.00", and that the "UsblMrg"
('Usable Margin') is 10,000, as pictured below:
Your Usable Margin will always be equal to Equity less Used Margin.
Usable Margin = Equity – Used Margin
Therefore it is the Equity, NOT the Balance that is used to determine Usable Margin. Your
Equity will also determine if and when a Margin Call is reached.
As long as your Equity is greater than your Used Margin, you will not have Margin Call.
( Equity > Used Margin ) = NO MARGIN CALL
As soon as your Equity equals or falls below your Used Margin, you will receive a margin
call.
( Equity =< Used Margin ) = MARGIN CALL, go back to demo trading
School of Pipsology - 217
Let’s assume your margin requirement is 1%. You buy 1 lot of EUR/USD.
Your Equity remains $10,000. Used Margin is now $100, because the margin required in a
mini account is $100 per lot. Usable Margin is now $9,900.
If you were to close out that 1 lot of EUR/USD (by selling it back) at the same price at
which you bought it, your Used Margin would go back to $0.00 and your Usable Margin
would go back to $10,000. Your Equity would remain unchanged at 10,000.
But instead of closing the 1 lot, you, the adrenalin junkie chopsocky retired spy that you
are, get extremely confident and buy 79 more lots of EUR/USD for a total of 80 lots of
EUR/USD. You will still have the same Equity, but your Used Margin will be $8,000 (80 lots
at $100 margin per lot). And your Usable Margin will now only be $2,000, as shown below:
With this insanely risky position on, you will make a ridiculously large profit if EUR/USD
rises. But this example does not end with such a fairy tale.
Let me paint a horrific picture of a Margin Call which occurs when EUR/USD falls.
The EUR/USD starts to fall. You are long 80 lots, so you will see your Equity fall along with
it. Your Used Margin will remain at $8,000. Once your equity drops below $8,000, you will
have a Margin Call. This means that some or all of your 80 lot position will immediately be
closed at the current market price.
Assuming you bought all 80 lots at the same price, a Margin Call will trigger if your trade
moves 25 pips against you.
25 PIPS!
Humbug! The EUR/USD pair can move that much in its sleep!
How did I come up with 25 pips? Well each pip in a mini account is worth $1 and you have
a position open consisting of 80 freakin’ lots. So…
$1/pip X 80 lots = $80/pip
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If EUR/USD goes up 1 pip, your equity increases by $80.
If EUR/USD goes down 1 pip, your equity decreases by $80.
$2,000 Usable Margin divided by $80/pip = 25 pips
Let’s say you bought 80 lots of EUR/USD at $1.2000. This is how your account will look if it
EUR/USD drops to $1.1975 or -25 pips.
As you can see, your Usable Margin is now at $0.00 and you will receive a MARGIN CALL!
Of course, you’re a veteran international spy, you’ve faced much bigger calamities. You’ve
got ice in your veins and your heart rate is still 55 bpm.
After the margin call this is how your account will look:
The EUR/USD moves 25 PIPS, or less than .22% ((1.2000 – 1.1975) / 1.2000) X 100% and
you LOSE $2,000!
You blew 20% of your trading account! (($2,000 loss / $10,000 balance)) X 100%
In reality, it’s normal for EUR/USD to move 25 pips in a couple seconds during a major
economic data release.
Oh I almost forget…I didn’t even factor in the SPREAD!
To simplify the example, I didn’t even factor in the spread, but I will now to make this
example super realistic.
Let’s say the spread for EUR/USD is 3 pips. This means that EUR/USD really only has to
move 22 pips, NOT 25 pips before a margin call.
Imagine losing $2,000 in 5 seconds?!
This is what happened to our popular British spy all because he didn’t understand the
mechanics of margin and how to use leverage.
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The sad fact is….most new traders don’t even open a mini account with $10,000. Because
our spy friend had at least $10,000, he was at least able to weather 25 pips before his
margin call.
If he only started off with $9,000, he could only weather a 10 pip drop (including spread)
before receiving a margin call. 10 pips!
More Leverage
Hopefully I’ve done my job and you now have a better understanding of what “margin” is.
Now I want to take a harder look at “leverage” and show you how it regularly wipes out
unsuspecting or overzealous traders.
We’ve all seen or heard online forex brokers advertising how they offer 200:1 leverage or
400:1 leverage. I just want to be clear that what they are really talking about is the
maximum leverage you can trade with. Remember this leverage ratio depends on the
margin required by the broker. For example, if a 1% margin is required, you have 100:1
leverage.
There is maximum leverage. And then there is your true leverage.
True leverage is the full amount of your position divided by the amount of money
deposited in your trading account.
Huh?
Let me illustrate an example:
You deposit $10,000 in your trading account. You buy 1 standard 100K of EUR/USD at a
rate of $1.0000. The full amount of your position is $100,000 and your account balance is
$10,000. Your true leverage is 10:1 ($100,000 / $10,000)
Let’s say you buy another standard lot of EUR/USD at the same price. The full amount of
your position is now $200,000 and your account balance is still $10,000. Your true
leverage is now 20:1 ($200,000 / $10,000)
You’re feeling good so you buy three more standard lots of EUR/USD, again at the same
rate. The full amount of your position is now $500,000 and your account balance is still
$10,000. Your true leverage is now 50:1 ($500,000 / $10,000).
School of Pipsology - 220
Assume the broker requires 1% margin. If you do the math, your account balance and
equity are both be $10,000, the Used Margin is $5,000, and the Usable Margin is $5,000.
In a standard account, each pip is worth $10.
In order to receive a margin call, price would have to move 100 ips ($5,000 Usable Margin
divided by $10/pip).
This would mean the price of EUR/USD would have to move from $1.0000 to $0.95000 – a
price change of 5%.
After the margin call, your account balance would be $5,000. You lost $5,000 or 50% and
the price only moved 5%.
Now let’s pretend you ordered coffee at a McDonald’s drive-thru, then spilled your coffee
on your lap while you were driving, and then proceeded to sue and won against
McDonald’s because your legs got burned and you didn’t know the coffee was hot. To
make a long story long, you deposit $100,000 in your trading account instead of $10,000.
You buy just 1 standard lot of EUR/USD – at a rate of $1.0000. The full amount of your
position is $100,000 and your account balance is $100,000. Your true leverage is 1:1.
Here’s how it looks in your trading account:
In this example, in order to receive a margin call, price would have to move 9,900 pips
($99,000 Usable Margin divided by $10/pip)
This means the price of EUR/USD would have to move from $1.0000 to $0.0100! This is a
price change of 99% or basically 100%!
Let’s say you buy 19 more standard lots, again at the same rate as the first trade. The full
amount of your position is $2,000,000 and your account balance is $100,000. Your true
leverage is 20:1.
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In order to be “margin called”, price would have to move 400 pips ($80,000 Usable Margin
divided by ($10/pip X 20 lots)
That means the price of EUR/USD would have to move from $1.0000 to $0.9600 – a price
change of 4%.
If you did get margin called and your trade exited at the margin call price, this is how your
account would like:
You would have realized an $80,000 loss! You’ would’ve wiped out 80% of your account
and the price only moved 4%!
Do you now see the effects of leverage?!
Leverage amplifies the movement in the relative prices of a currency pair by the factor of
the leverage in your account.
Here’s a chart of how much your account balance changes if prices moves depending on
your leverage.
Leverage % Change in Currency % Change in Account
100:1 1% 100%
50:1 1% 50%
33:1 1% 33%
20:1 1% 20%
10:1 1% 10%
5:1 1% 5%
3:1 1% 3%
1:1 1% 1%
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Let’s say you bought USD/JPY and it goes up by 1% from 120.00 to 121.20. If you trade one
standard $100K lot, here is how leverage would affect your return:
Leverage Margin Required Return (Gain)
100:1 $1,000 +100%
50:1 $2,000 +50%
33:1 $3,300 +33%
20:1 $5,000 +20%
10:1 $10,000 +10%
5:1 $20,000 +5%
3:1 $33,000 +3%
1:1 $100,000 +1%
Let’s say you bought USD/JPY and it goes down by 1% from 120.00 to 118.80. If you trade
one standard $100K lot, here is how leverage would affect your return (or loss):
Leverage Margin Required Return (Loss)
100:1 $1,000 -100%
50:1 $2,000 -50%
33:1 $3,300 -33%
20:1 $5,000 -20%
10:1 $10,000 -10%
5:1 $20,000 -5%
3:1 $33,000 -3%
1:1 $100,000 -1%
School of Pipsology - 223
The more leverage you use, the less “breathing room” you have for the market to move
before a margin call.
You’re probably thinking I’m a day trader, I don’t need no stinkin’ breathing room. I only
use 20-30 pip stop losses.
Okay let’s take a look:
Example #1
You open a mini account with $500 which trades $10K mini lots and only requires .5%
margin.
You buy 2 lots of EUR/USD. Your true leverage is 40:1 ($20,000 / $500). You place a 30 pip
stop loss and it gets triggered. Your loss is $60 ($1/pip x 2 lots).
You’ve just lost 12% of your account ($60 loss / $500 account). Your account balance is
now $440.
You believe you just had a bad day. The next day, you’re feeling good and want to recoup
yesterday losses, so you decide to double up and you buy 4 lots of EUR/USD. Your true
leverage is about 90:1 ($40,000 / $440). You set your usual 30 pip stop loss and your trade
loses. Your loss is $120 ($1/pip x 4 lots).
You’ve just lost 27% of your account ($120 loss/ $440 account). Your account balance is
now $320.
You believe the tide will turn so you trade again. You buy 2 lots of EUR/USD. Your true
leverage is about 63:1. You set your usual 30 pip stop loss and lose once again! Your loss is
$60 ($1/pip x 2 lots).
You’ve just lost almost 19% of your account ($60 loss / $320 account). Your account
balance is now $260.
You’re getting frustrated. You try to think what you’re doing wrong. You think your setting
your stops too tight.
The next day you buy 3 lots of EUR/USD. Your true leverage is 115:1 ($30,000 / $260). You
loosen your stop loss to 50 pips. The trade starts going against you and it looks like you’re
about to get stopped out yet again!
But what happens next is even worse! You get a margin call!
School of Pipsology - 224
Since you opened 3 lots with a $260 account, your Used Margin was $150 so your Usable
Margin was a measly $110. The trade went against you 37 pips and because you had 3 lots
opened, you get margin called. Your position has been liquidated at market price.
The only money you have left in your account is $150, the Used Margin that was returned
to you after the margin call.
After four total trades, your trading account has gone from $500 to $150. A 70% loss! It
won’t be very long until you lose the rest.
Trade No. Starting
Account
Balance
Number of
Lots Used
Stop Loss
Size (pips)
Trade Result Ending
Account
Balance
1 $500 2 30 -$60 $440
2 $440 4 30 -$120 $320
3 $320 2 30 -$60 $260
4 $260 5 50 Margin Call $150
A four trade losing streak is not uncommon. Experienced traders have similar or even
longer streaks. The reason they’re successful is because they use low leverage. Most cap
their leverage at 5:1 but rarely go that high and stay around 3:1.
The other reason experienced traders succeed is because their accounts are properly
capitalized!
While learning technical analysis, fundamental analysis, building a system, trading
psychology is important, I believe the biggest factor on whether you succeed as a forex
trader is making sure you capitalize your account sufficiently and trade that capital with
smart leverage.
Your chances of becoming successful are greatly reduced below a minimum starting
capital. It becomes impossible to mitigate the effects of leverage on too small an account.
Low leverage with proper capitalization allows you to realize losses that are very small
which allows you to trade another day.
Example #2
School of Pipsology - 225
Bill opens a $5,000 account trading $100,000 lots. He is trading with 20:1 leverage. The
currency market moves on a regular basis anywhere from 70 to 200 pips in one day. In
order to protect himself, he uses tight 30 pips stops. If the market goes 30 pips against
him, he would be stopped out for a loss of $300.00. He felt that was reasonable but he
underestimated how volatile this market is and found himself being stopped out
frequently.
After being stopped out four times, he’d had enough. He’s decided to give himself a little
more room, handle the swings, increases his stop to 100 pips.
Bill’s leverage is not 20:1 anymore, his account is down to $2,800 (his four loses at $300
each) and he’s still trading one $100,000 lot. It’s now over 25:1.
He decides to tighten his stops to 50 pips. He opens another trade using two lots and two
hours later his 50 pip stop loss is hit and he losses $1,000. He now has $2,800 in his
account. His leverage is 35:1.
He tries again with two lots. This time the market goes up 10 pips. He cashes out with a
$200 profit. His account grows slightly to $3,000.
He opens another position with two lots. The market drops 50 points and he gets out.
Now he has $2,000 left.
He thinks what the hell and opens another position. The market proceeds to drop another
100 pips and because he has $1,000 locked up as margin deposit, he only has $1,000
margin available, so he receives a margin call and his position is instantly liquidated.
He now has $1,000 left which is not even enough to open a new position.
He lost $4,000 or 80% of his account with a total of 8 trades and the market only moved
280 pips. 280 pips! The market moves 280 pips pretty darn easy.
Are you starting to see why leverage is the top killer of forex taders?
How Leverage Affects Transaction Costs
Besides amplifying your losses, leverage also has another way of killing you. It’s a much
slower kind of death, though, kind like being constantly exposed to high levels of
radiation. Most traders don’t see it coming and by the time they notice it, they’re dead.
School of Pipsology - 226
This killer I’m talking about is the associated transaction cost of using high leverage.
Not only does leverage amplify your losses, it also amplifies your transaction costs as a
percentage of your account.
Let’s say you open a mini account with $500. You buy five mini $10k lots of GBP/USD
which has a 5 pip spread. Your true leverage is 100:1 ($50,000 total mini lots / $500
account). But check this….you paid $25 in transaction costs (($1/pip x 5 pip spread) x 2
lots)). That is 5% of your account! With one trade, and the market not even moving yet,
you’re already down 5%! If your trades lose, your account balance shrinks. As your
account balance shrinks, your leverage increases. As your leverage increases, the faster
your transaction costs eats away at the little money you have left. This is the slow and
silent killer I’m talking about.
The higher your leverage, the higher your transaction cost as a percentage of your trading
capital.
If you have a mini account, and open a trade with a 5 pip spread, which equals $5
transaction cost, look at how the relative value of your transaction costs increases with
more leverage.
Leverage Margin Required (MR) Cost as % MR
200:1 $50 10%
100:1 $100 5%
50:1 $200 2.5%
33:1 $330 1.5%
20:1 $500 1%
10:1 $1,000 .5%
5:1 $2,000 .25%
3:1 $3,300 .10%
1:1 $10,000 .05%
Now you’ve learned how leverage can magnify your profits and losses, but also your
transaction costs.
School of Pipsology - 227
Leverage does not equal margin.
Leverage is how many times you lever your whole account.
The maximum amount that you are allowed to lever is dependent on your margin
requirement.
Don’t Underestimate Leverage
Most beginners underestimate the potentially devastating damage leverage can wreak on
their accounts. Understanding leverage enough to know when to use it and when NOT to
use it is critical to your success!
Leverage is a very powerful tool but both old and new traders use it to destroy their
trading capital simply because they take too lightly its destructive force or ignore it
altogether. It’s a pity, but the more of them the easier it is for us smart traders to make
money. Sad but true.
High leverage is a favorite selling point for most forex brokers. Yes they pitch that you can
make a huge killing using huge leverage, but know you could easily be killed by huge
leverage as well.
Brokers want you to trade with a short-term mindset. They want you to trade as much as
possible as often as possible. It’s the only way they make money. One or two pips are
important to them. The more you trade the more they make on the spread. It’s not in
their best interest to tell you to let your trades run longer than the same day.
If you want to give yourself the best chance to succeed, first learn to trade profitably
without leverage.
Play it safe. Protect your capital.
When you can make more pips more than you lose consistently, then, and only then,
should you use unleash this weapon of mass destruction called leverage. Destroy traders
(or your broker) taking the opposite side of your trade. Don’t destroy yourself.
Forex trading should be treated as a job or business. Don’t think that just because brokers
allow you to use high leverage with a low minimum deposit that you can “make a quick
<insert choice of currency here>” or “get rich quick”. Approach the currency markets with
respect.
Be realistic in your expectations and be willing to properly educate yourself.
School of Pipsology - 228
If you don’t, you will die.
Okay, not really, but your account will die.
Commodity Currencies
In today's lesson, we will be taking a look at commodities and how they relate to
commodity currencies.
What is a commodity currency?
In this crazy trading universe we call the Forex, a commodity currency is a currency whose
country's exports are largely comprised of raw materials (precious metals, oil, agriculture,
etc.).
There are dozens of countries that fit this description, but the most actively traded
currencies are the New Zealand Dollar, Australian Dollar, and the Canadian Dollar.
Because their currencies are all called dollars, they are also known as the commodity
dollars or "Condoles" for short.
These three currencies are among the major currency pairs, which mean they have great
liquidity and volatility for active trading.
How do commodities affect commodity currencies?
Raw materials compose such a large portion of these countries exports, a rise in
commodity prices can possibly lead to a rise in the value of a country's currency, and vice
versa.
Let's take a look at the major commodity currencies and see how much their movement
correlates to certain commodities...
Canadian Dollar and Oil
Oil is the life blood of the industrialized world and thus a highly watched and traded
commodity. While gold is often nicknamed “Black Gold”, we prefer to call it “Black Crack”.
Many countries that produce “black crack” and hold massive reserves of "black crack"
School of Pipsology - 229
tend to benefit from rises in oil prices, including Canada. We like to call these countries
the Black Crack Mafia.
Canada is one of the world's largest producers of oil (black crack dealers) and holds oil
reserves (black crack stash) second only to Saudi Arabia, which makes Canada very reliant
on its most prized commodity. It is also the largest supplier to the world's biggest oil
consumer (black crack addict) - the United States. Because oil is such a big part of the US
economy, rising oil prices tend to have a negative effect on U.S. equities and the U.S.
Dollar.
Wait a minute! Rising oil prices tend to be good for Canada/bad for the U.S., while falling
oil prices tend to be bad for Canada/good for the U.S. - how can we play this idea in the
Forex markets? Anyone? USD/CAD??? Right! In fact let's take a quick look at a chart
overlaying oil prices and the USD/CAD:
As you can see from the chart above, price movements USD/CAD and Oil are inversely
correlated from each other - meaning as oil trends higher, USD/CAD tends to trend lower
and vice versa.
Since January 1988, USD/CAD and Oil have had about a 68% inverse correlation to each
other. This is a pretty strong correlation. As a currency trader, knowing this can add
another tool to your toolbox when analyzing USD/CAD and help you make longer term
trading decisions.
School of Pipsology - 230
Australian Dollar and Gold
Everyone loves gold - how can you not love it? It's metal, shiny and makes pretty cool
jewelry. Besides that, gold is used in many, many applications like highly conductive
wiring, reflective coating, and dentistry - you should check out Big Pippin's new grill!
In the financial world, gold is viewed as a safe haven against inflation and it is one of the
most highly traded commodities. Okay, so how does all of this tie into Forex trading?
Great question! To answer that, we'll take a look at the Australian Dollar.
For many traders out there, trading the Australian Dollar is just like trading gold. Australia
is one of the world's largest producers of gold and it exports comprise over 50% of
commodities, including precious metals.
These commodities account for a large portion of Australia's Gross Domestic Product; so
many traders watch the rise and fall of commodity prices, especially gold, which can
influence the direction of the Australian Dollar. Let's take a look at a comparison chart of
gold and the "Aussie:"
These commodities account for a large portion of Australia's Gross Domestic Product; so
many traders watch the rise and fall of commodity prices, especially gold, which can
influence the direction of the Australian Dollar. Let's take a look at a comparison chart of
gold and the "Aussie:"
School of Pipsology - 231
This is a monthly chart that compares the price movement of gold and the AUD/USD all
the way back to January 1980. As you can see, the two's movements were virtually the
same, and from January 1980 to about January 2002 one can view gold as a leading
indicator to AUD/USD.
The "red stars" above show major turning points in gold. These turning points seemed to
occur before major turning points in AUD/USD. This relationship changed around 2002 as
gold and AUD/USD movements were practically the same until gold shot up in value in
2005 to 2006.
Just as we learned with oil and USD/CAD, traders can watch gold prices to get an extra
edge in their analysis of AUD/USD as gold movements can give possible clues to where
AUD/USD is headed. For those who can’t trade gold directly, AUD/USD’s strong
correlation to gold makes a great substitution. You can trade AUD/USD in the spot Forex
market as a proxy for gold, which is traded in the futures market.
School of Pipsology - 232
New Zealand Dollar
Much like its neighbor to the west, Australia, New Zealand's economy is also export-driven
with commodities comprising much of its exports. While most trader's view on the "Kiwi"
is that it’s not directly linked to one specific commodity, its correlation to commodities in
general is a substantial one.
Since January 1990, its correlation is 63%, when compared to the Commodity Research
Bureau Index (CRB Index), one of the world’s standards for commodity prices.
This chart shows how commodity prices and the New Zealand Dollar have moved in
tandem with each other over the past 25+ years.
Since January 1990, the NZD/USD and CRB Index has had approximately 60% correlation.
So, as commodity prices rise and fall, traders can look for similar movements in the
NZD/USD because of New Zealand's dependency on its commodity exports.
Like gold and oil, a trader can express their general views and ideas on commodities by
trading NZD/USD.
School of Pipsology - 233
Summary
We have just learned about relationships between commodities and commodity
currencies. There are a few things to remember before you start applying the ideas learn
here today.
Short term moves in commodities usually do not directly affect a commodity currency
immediately. Analyzing commodities for use with currencies is probably best suited for
longer term outlooks, trading, and investing.
Keep in mind that even though we see strong correlations between the commodity
currencies and commodities, exports are only a portion of a country’s economy. Always
take a look a country’s overall economy, interest rates, and political situation as well.
Combining all of these aspects and adding commodity movements in the mix can present
a clearer picture and possibly better trading ideas in these currencies.
So, for those of you into Oil, Gold, and commodities in general, check out the “Condoles.”
With the leverage and liquidity advantages available in spot Forex trading, currencies can
be an awesome alternative to trading straight forward commodities or for hedging your
commodity investments! Don’t be scurrrrreedd…Check’em out!
School of Pipsology - 234
Currency Crosses
After going through the School of Pipsology and doing a little demo trading, there’s
probably one thing you’ve noticed about trading currencies – it’s all about the US Dollar!
Or is it?
Well, with central banks across the world holding trillions in USD reserves, commodities
priced in the Greenback, and other major financial transactions passing through the dollar
daily, it pretty much IS all about the dollar.
In general, approximately 90% of all transactions in the almost US$2 trillion daily traded
Foreign Exchange market involves the dollar. Wow!
Also, in your demo trading, I’m sure you’ve noticed that no matter what major pair you
trade (i.e. EURUSD, AUDUSD, USDCHF, etc.) that US news pretty much dominates the
movement regardless of data releases from anywhere else. So, why look at anything else
besides the major currency pairs?
Well, serious trading opportunities can be found by following the other major currencies
with currency crosses, especially if you want to avoid the unpredictable volatility that US
dollar can bring.
Hopefully, this lesson will open up your outlook on Crosses and give you basic
understanding on how to analyze them.
What is a Currency-Cross?
Basically, a currency-cross is any currency pair in which the US Dollar is neither the base
nor counter currency. For example, GBPJPY, EURJPY, EURCAD, and AUDNZD are all
considered currency crosses.
Back to Basics
When it comes down to it, currency trading is all about matching weak currencies and
strong currencies.
School of Pipsology - 235
Just find a country that has weak a fundamental outlook or maybe a distressful political
situation, and then match it with a country with positive or better fundamentals (i.e. rising
employment, growing trade surplus, etc) or maybe a positive political outlook, then you
can match their currencies together to make an intelligent directional trade.
Let’s take a look at a recent, real world example:
On January 11th, 2007, both the Bank of England and the European Central Bank were set
to release their decisions on their interest rate policy. Leading up to that morning, the
markets speculated that the ECB hint that they would raise interest rates soon and the
BoE would hold any hikes. Well, what a surprise the market got as the Bank of England
raised rates to 5.25% and the ECB held rates at 3.50% on concerns of slowing growth in
the Eurozone.
So, why would a currency trading pro, such as yourself, play a currency cross instead of
matching either the Euro or the British Pound with the US Dollar? Well, here are a couple
of scenarios to think about:
1. US Retail sales numbers were coming out soon after the interest rate decisions. If you had
a weak outlook on the Euro and went short EURUSD, then a weak US Retail report would
probably been bad for your trade as the US dollar would sell off.
2. Or if you maintained a strong outlook on the British Pound and decided to go long
GBPUSD, then a dollar rally on a strong US retail sales report would have been very bad for
you trade.
After the interest rate releases, we know the outlook on the Euro is weaker and the
outlook of the British Pound is stronger, why don’t we just short EURGBP? By taking this
trade you get rid of the event risk of upcoming US data, plus you get a positive carry on
your position!
Here’s how you may have faired taking a short trade on EURGBP using this analysis:
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As you can see from the chart, had you shorted at 0.6650 an hour or so after the interest
rate decisions were announced, you would have caught the slow and steady move to
0.6600, and possibly further until fundamentals change for either the Euro or the Pound.
Again, this is just one example of matching weak with relatively stronger currencies. With
six major currencies other than the US dollar, there are plenty of possibilities to find
profitable trades, and avoid erratic volatility with the US dollar.
Synthetic Pairs
You’ve done your analysis and you’ve come to the conclusion that the British Pound looks
strong and the Swiss Franc may get weaker.
Or maybe the Australian dollar is looking pretty good against the Canadian dollar, but you
look in your trading platform and see that your broker doesn’t have GBPCHF or AUDCAD.
Oh no! I guess that’s an opportunity missed, right? Heck No! You can create a “synthetic”
pair to go long on GBPCHF or AUDCAD.
To create synthetic pairs using the four major currency pairs and three commodity
currencies is relatively easy. All it takes is to buy or sell two pairs with equal position sizes.
Let’s say you want to go long the British Pound against the Swiss Franc, or buy GBPCHF.
You would have to buy GBPUSD and buy USDCHF at the same time. Still not clear? Let me
show you…
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Pretty simple, right? The only trick to it is making sure you buy the same amount of each
pair.
Using our GBPCHF example, let’s say the current exchange rate for GBPUSD is 1.9000 and
the exchange rate for USDCHF is 1.2500 and you want to buy US$10,000 worth of each
pair. Here’s how you do it:
For pairs with USD as the counter currency (i.e. AUDUSD, GBPUSD, EURUSD, etc.), then
you would take the dollar amount you want to purchase and divide it by the exchange
rate:
US$10,000 (desired position size) divided by 1.9000 (current rate of GBPUSD) = 5263 Units
of GBPUSD
For pairs with USD as the base currency (i.e. USDCHF, USDJPY, USDCAD), just purchase
amount of units you want to buy because you are buying US dollars
$10,000 (desired position size) * 1 Unit = 10,000 Units
So, to buy US$10,000 worth of GBPCHF, we purchase 5,263 units of GBPUSD (if your
broker doesn’t offer flexible lot sizes you can always round up or down) and 10,000 units
of USDCHF. Got it? Great! I knew you would!
Summary
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As you can see, there are many, many trade opportunities presenting themselves in the
foreign exchange market other than figuring out what the Greenback will do any given day
- and now you know how to find them! Just remember a few things:
• Do your due diligence/analysis and match the weak currencies with strong currencies.
• What if the pair you are looking to trade is not available with your broker, no sweat right?
You now know how to create synthetic pairs by simultaneously going long or short two
major pairs to create one currency cross.
• Last tip; please be conscientious of the pip value of the cross you are trading. For example,
a standard lot (100,000 units) of EUR/GBP will be approximately $19.70 per pip. Some
crosses will have a higher or lower pip value than the majors. This information is good to
know for your risk analysis.
• So, on the days you many not see any opportunities in the major pairs, or if you want to
avoid the volatility of a US news event, check out some the currency crosses. You may
never know what you may find! Good luck!
Divergence Trading
What if there was a low risk way to sell near the top or buy near the bottom of a trend?
What if you were already in a long position and you could know ahead of time the perfect
place to exit instead of watching all your unrealized gains vanish before your eyes because
your trade reverses direction?
What if you believe a currency pair will continue to fall but would like to go short at a
better price or a less risky entry?
Well there is a way. It’s called divergence trading.
Divergence is basically price action measured in relationship to an oscillator indicator. It
doesn't really matter what type of oscillator you use. You can use RSI, Stochastic, MACD,
CCI, etc. etc. The great thing about divergences is that you can use them as a leading
indicator and after some practice, it’s not too difficult to spot.
When traded properly, you can be consistently profitable with divergences. The best thing
about divergences is that since you’re usually buying near the bottom or selling near the
top, your risk on your trades are very small relative to your potential reward. Cha ching!
Higher Highs and Lower Lows
Just think “higher highs” and “lower lows”.
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If price is making highs, the oscillator should also be making higher highs. If price is making
lower lows, the oscillator should also be making lower lows.
If they are NOT, that means price and the oscillator are diverging from each other. Hence
the term, divergence.
There are TWO types of divergence:
1. Regular
2. Hidden
Regular Divergence
A regular divergence is used as a possible sign for a trend reversal.
If the price is making lower lows (LL), but the oscillator is making higher lows (HL), this is
considered regular bullish divergence.
If the price is making a higher high (HH), but the oscillator is lower high (LH), then you
have regular bearish divergence.
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Hidden Divergence
A hidden divergence is used as a possible sign for a trend continuation.
If price is making a higher low (HL), but the oscillator is making a lower low (LL), this is
considered hidden bullish divergence.
If price is making a lower high (LH), but the oscillator is making a higher high (HH), then
you have hidden bearish divergence.
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How to Trade Divergences
Here’s how you could trade divergences:
Divergence Type
Price Oscillator Trade
Regular Higher High Lower High SELL
Regular Lower Low Higher Low BUY
Hidden Higher Low Lower Low BUY
Hidden Lower High Higher High SELL
Divergences act as an early warning system alerting you when the market could reverse.
For example, if bulls have steadily pushed EUR/USD higher, the appearance of divergence
between price and indicator could mean that bulls are running out of gas and price will
soon fall
Please keep in mind that I use divergence as an indicator, not a signal to enter a trade! It
wouldn't be smart to trade basely solely on divergences as too many false signals are
given. It’s not 100% foolproof, but when used as a setup condition and combined with
additional confirmation tools, your trades have a high probability of winning with
relatively low risk.
On the flip side, I think it is just as dangerous trade against this indicator. If you're unsure
about which direction to trade, chill out on the sidelines.
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Divergences don’t appear that often, but when they do appear, it’d behoove you to pay
attention. Regular divergences can help you collect a big chunk of profit because you’re
able to get in right when the trend changes. Hidden divergences can help you ride a trade
longer resulting in bigger-than-expected profits by keeping you on the correct side of a
trend.
The trick is to train your eye to spot divergences when they appear AND choose the
proper divergences to trade. Just because you see a divergence, it doesn’t necessarily
mean you should automatically jump in with a position. Cherry pick your setups and you’ll
do well.
9 Rules for Trading Divergences
There are nine cool rules for trading divergences. Learn 'em, apply 'em, and make money.
Ignore them and go broke.
1.
In order for divergence to exist, price must have either formed one of the following:
Higher high than the previous high
Lower low than the previous low
Double top
Double bottom
Don’t even bother looking at an indicator unless ONE of these four price scenarios have
occurred. If not, you ain’t trading divergence buddy. You just imagining things.
Immediately go see your optometrist and get some new glasses.
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2.
Okay now that you got some action (recent price action that is), look at it. Remember,
you"ll only see one of four things: a higher high, a flat high, a lower low, or a flat low. Now
draw a line backward from that high or low to the previous high or low. It HAS to be on
successive major tops/bottom. If you see any little bumps or dips between the two major
highs/lows, do what you do when your significant other shouts at you - ignore it.
3.
Once you see two swing highs are established, you connect the TOPS. If two lows are
made, you connect the BOTTOMS. Don’t make the mistake of trying to draw a line at the
bottom when you see two higher highs. It sounds dumb but peeps regularly get confused.
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4.
So you’ve connected either two tops or two bottoms with a trendline. Now look at your
preferred indicator and compare it to price action. Whichever indicator you use,
remember you are comparing its TOPS or BOTTOMS. Some indicators such as MACD or
Stochastic have multiple lines all up on each other like teenagers with raging hormones.
Don’t worry about what these kids are doing.
5.
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If you drew line connecting two highs on price, you MUST draw a line connecting the two
highs on the indicator as well. Ditto for lows also. If you drew a line connecting two lows
on price, you MUST draw a line connecting two lows on the indicator. They have to match!
6.
The highs or lows you identify on the indicator MUST be the ones that line up VERTICALLY
with the price highs or lows.
7.
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Divergence only exists if the SLOPE of the line connecting the indicator tops/bottoms
DIFFERS from the SLOPE of the line connection price tops/bottoms. The slope must either
be: Ascending (rising) Descending (falling) Flat (flat)
8.
If you spot divergence but price has already reversed and moved in one direction for some
time, the divergence should be considered played out. You missed the boat this time. All
you can do now is wait for another swing high/low to form and start your divergence
search over.
9.
Divergences on longer timeframes are more accurate. You get less false signals. You will
also get less trades but your profit potential is huge. Divergences on shorter timeframes
will occur more frequently but are less reliable. I personally only look for divergences on 1-
hour charts or longer. Other traders use 15-minute charts or even faster. On those
timeframes, there’s just too much noise for my taste so I just stay away.
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Divergence Cheat Sheet
Type Bias Price Oscillator Description Example
Bullish Lower
Low
Higher Low Indicates
underlying
strength. Bears
are exhausted.
Warning of
possible trend
direction change
from down to
up.
Bearish Higher
High
Lower High Indicates
underlying
weakness. Bulls
are exhausted.
Warning of
possible trend
direction change
from up to
down.
Bullish Higher
Low
Lower Low Indicates
underlying
strength. Good
entry or reentry.
Occurs
during
retracements in
an uptrend. Nice
to see during
price retest of
previous lows.
“Buy the dips”
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Bearish Lower
High
Higher
High
Indicates
underlying
weakness.
Found during
retracements in
a downtrend.
Nice to see
during price
retests of
previous highs.
“Sell the rallies”
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