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The Logic Of Technical Analysis - Lesson 1.

Range Bound vs. Momentum Forex Trading

Support and Resistance

At the core of all technical analysis theory are two very simple concepts: support and resistance. Support can be defined as a “floor” through which the currency pair has trouble falling below. There is no scientific formula for calculating support; it is something that is typically “eyeballed” by traders, and hence involves somewhat of a subjective element. Resistance, on the other hand, is simply the opposite: it is the upper boundary through which a currency pair has trouble breaking. Like support, resistance levels are somewhat subjective. Generally, if the market touches a certain level a number of times and cannot sustain a break above that level, it can be identified as resistance. See the charts below for an example of identifying support and resistance. The reason why price has trouble breaking these levels is the presence of actual orders around these levels. A support level is simply a price area where buy orders tend to be, and so it takes more than normal selling pressure to break that level. Similarly, a resistance level is a price area where sell order tend to be, and so it takes more than normal buying pressure to break that level.

Support and Resistance in Range-bound Markets

The simplest way of using support and resistance in trading is to simply trade the range: in other words, traders can simply buy at support, and sell at resistance. A key advantage of this is that the market is range-bound approximately 80% of the time, making it a very viable strategy for most market conditions.

The downside of range-bound trading, though, is twofold:

• Range-bound trading generally does not yield substantial gains on a per-trade basis. • When the market breaks out of the range, it often will make big moves. As a result, traders using range-bound strategies can suffer overwhelmingly large losses when the market breaks out of the range.

The chart below illustrates the concept of range-bound trading.

Note how this pair repeatedly fails to cross beyond certain support and resistance levels, and simply fluctuates between an upper and lower band.

Support and Resistance in Momentum Markets

Another way to use support and resistance is to trade outside of the range; in other words, to anticipate a breakout. This involves placing orders to buy above resistance and to sell below support. The rationale is that the market will gain momentum once it breaks out of the range, and thus by placing orders just below/above support/resistance, traders will be able to make big gains when the market moves out of the range. Momentum trading is a bit counter-intuitive, as it involves buying at a higher price and selling at a lower price. Below is a chart that illustrates the concept of momentum trading. Note how the pair accelerates once it breaks out of a narrow range.

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Price Channels In Forex Trading

Support and Resistance do not have to be horizontal lines, and often in a market that is moving higher or lower, trend lines effectively connect the high points or the low points to create a price channel that acts similarly to a horizontal range. Support and resistance levels function in the same manner in a trending market as in a rangebound one. However the line that is following the trend--support in an uptrend or resistance in a downtrend) should be considered by far the stronger of the two. Only when there is a trade with minimal risk involved should you enter a position based only on the resistance line above the price in an uptrend.

The same trend lines can be drawn in a bear market where the price is continuously moving lower. There is no exact formula for drawing such lines. Some traders prefer to connect only the bodies of the candles and to exclude the high and low points outside of the open and close, but that is not a requirement. If the line does not look valid to you, chances are it is not relevant, because other traders are using the same charts.

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Candlestick Patterns In Forex Trading

Candlestick charts convey information pertaining to price action, or the movement of a currency pair’s price over the specified amount of time. Each candlestick contains four attributes: the opening price of the currency pair at the time the candle opened the closing price; the high of the time frame • the low of the time frame. On a daily chart, each candle represents a 24 hour period; on an hourly chart each candle represents an hour, and so on. A visual analysis of a candlestick is as follows:

Key Definitions

Body: The difference between the opening price and the closing price. This is the wide portion of the candle that is colored red or green.

Wick or Shadow: The thin portion of the candle that represents the extreme high and low points for the time period represented by that candle.

Key Concept: Candlesticks Signal Reversals

Candlesticks can be used to identify trend reversals in the market. So why are candlesticks so important in trading? Simply put, it is because they are the best gauge of what is going on in the market at the present time. Candlesticks give us insight into the emotions of the market participants. Although traders may come and go over time, human emotion remains constant. A certain series of events creates a candlestick pattern, and when we see that pattern we know exactly what has transpired. Ultimately, candlesticks can easily be used to identify potential reversals of trends in the market - especially when used in conjunction with other indicators.

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Fibonacci Retracements

Levels at which the market is expected to retrace to after a strong trend. Based on mathematical numbers that repeat themselves in all walks of life, Fibonacci retracements attempt to measure the likely points that a currency pair will retrace, or pull back to within a range. The key numbers in FX trading are 38.2%, 50%, and 61.8%.

Consider the following example to see how Fibonacci retracements work: Suppose an asset is on an uptrend, going from 0 and 1000. After the asset reaches 1,000, how far will it retrace - meaning how far will it fall - before resuming its initial uptrend? We can do this by using the Fibonacci retracement numbers to gauge how deep of a pullback we could expect after the top “boundary” is reached.

So, mathematically, it works like this:

The 38.2% line. Calculate 38.2% of the size of the significant price move. The size of the significant price move in this case is (1,000) minus the lower boundary (0). In this case, the size of the significant price move is 1,000 pips. .382 x 1000 = 382 pips. It is expected that the asset will retrace 382 points from its peak. Assuming the asset is going up from 0 to 1,000, it would retrace 382 pips from 1,000. 1,000 - 382 = 618. Accordingly, this is a key level to look out for; you may want to buy here (at 618), as it is expected the upward trend will resume after reaching this retracement level.

The 50.0% line. Same situation; 50% of the significant price move (1,000 pips) is 500. Take that off from top (1,000) since it is an upward trend. 1,000 - 500 = 500. Look for the upward trend to resume at that point.

The 61.8% line. 61.8% of the significant price move is 618. 1,000 - 618 = 382. If the asset retraces to this point, it is viewed as an opportunity to buy.

If the asset were trending lower - meaning it had gone from 1,000 to 0 - then you would use the Fibonacci numbers to calculate the retracement regarding how far the price may rise before resuming the downtrend again. You would calculate the Fibonacci retracements in the same manner, except you would draw from the high point of the significant price move to the low point of the move. Parameters: 38.2%, 50.0%, and 61.8% are the most common Fibonacci Levels. The 38.2% level is considered the least significant of the three major Fibonacci levels. The larger the percentage line (i.e. 61.8%) the greater the likelihood that the price will find support. Please keep in mind that other retracement levels exist in Fibonacci Studies that are not widely watched by the market. These levels include 21.4% and 78.6% as well as 127.2% and 161.8% extensions. Most charting packages do not even reference these levels and most traders would argue that if the market retraces 100% of a previous move, the original trend is no longer valid. Other Fibonacci studies called fans and arcs are quite mathematically complicated and are similarly ignored by most traders.

 Key Concept: Look for Confirmation

Traders should enter when confirmation - for example key candlestick patterns - emerge at Fibonacci levels. Traders can also seek confirmation from a variety of other indicators, as we will see as the course continues.

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How To Draw Fibonacci Retracement Lines

Drawing Fibonacci lines is easy. It can be broken down into three easy steps: Identify the bottom and top of the overall trend. The bottom is referred to as support, and the top is referred to as resistance. While they are subjective, support and resistance levels can easily be determined simply by looking at a chart

Using a charting package you are comfortable with, draw Fibonacci lines from the support level to the resistance level. The three lines should appear: one at 38.2% of the difference from the top and the bottom; one at 50%; and another at 61.8%. These are the key Fibonacci levels around which you should look for potential opportunities to enter trades.

After that, simply look for price action to confirm an opportunity to enter a trade.

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Using Moving Averages

Moving averages simply measure the average price or exchange rate of a currency pair over a specified time frame. For example, if we take the closing prices of the last 10 days, add them together and divide the result by 10, we have created a 10-day simple moving average (SMA).

There are also exponential moving averages (EMAs). They work the same as a simple moving average, except they place greater weight on the more recent closing prices. The mathematics of an exponential moving average are complex, but fortunately most charting packages calculate them automatically and instantaneously.

Parameters. The most commonly used time frames for moving averages are 10, 20, 50, and 200 periods on a daily chart. As always, the longer the time frame, the more reliable the study. However shorter term moving averages will react more quickly to the market's movements and will provide earlier trading signals.

The charts (top) below show examples of how moving averages, when confirmed by price action, can signal trading opportunities. In second chart we see moving averages applied to the USD/CHF currency pair. Notice the Hammer candlestick pattern that penetrates the 200 moving average (Black Line). This reversal pattern and the fact that it bounces off of the 200 moving average shows that the downside momentum is lost, and signals that a rally may follow. Here we see a classic candlestick pattern, as only the long wicks breach below the long term moving average (200-SMA). As it pierces the 200-day SMA on this daily chart for the USD/CHF, we see a subsequent rally of the pair.

How to Use Moving Averages in Trading

Enter when a strong trend pulls back to a moving average line. Enter on a moving average crossover

Gauge overall trend. Moving averages display a smoothed out line of the overall trend. The longer the term of the moving average, the smoother the line will be. In order to gauge the strength of a trend in a market, plot the 10, 20, 50 and 200 day SMA’s. In an uptrend, the shorter term averages should be above the longer term ones, and the current price should be above the 10 day SMA. A trader’s bias in this case should be to the upside, looking for opportunities to buy when the price moves lower rather than taking a short position.

Confirmation of price action. As always, traders should look at candlestick patterns and other indicators to see what is really going on in the market at the time. The chart above points out the Bullish Engulfing pattern that occurs just as the pair bounces off the 20 day EMA. Hitting the 20 day EMA, in conjunction with the candlestick pattern, suggests a bullish trend. Traders should enter once the Bullish Engulfing candle is cleared.

Crossovers. When a shorter moving average crosses a longer one (i.e. if the 20 day EMA crossed below the 200 day EMA), that is viewed by many as an indication that the pair will move in the direction of the shorter MA (so, in the aforementioned example, it would move down). Historically, moving average crossovers have not been accurate trade indicators, but they do offer insight into the market’s psychology. Accordingly, should the pair move in the opposite direction of the shorter EMA and thus cross it, this should be viewed as an opportunity to enter a position.

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Relative Strength Index

What is RSI?: RSI is an indicator that falls under the category of oscillators, and it is an extremely simple indicator to use. RSI works well in range-bound markets, but it has limited value in trending or breakout markets. RSI was created by Welles Wilder, who also created ATR, Parabolic SAR and other well-known indicators.

The Concept of Oscillators: Oscillators are chart studies that are designed to show the strength of the current price in relation to the recent price action. As such, they display the short term momentum of the market, giving signals that the bias of the market is shifting before the price actually changes directions. The principle upon which oscillators are based is that of regression to a mean. Essentially, a large part of a statistical sample should be within a certain number of standard deviations from the mean of the sample, and if the price strays too far from this center, then it will likely revert back to the rest of the sample. In terms of trading, the price should not rise or fall too far in too short a time. Oscillators are not usually displayed on the same graph as the price itself, but are most often placed at the bottom of the chart to show that the fluctuations do not occur on the same scale as the price movement.

What RSI Does: Like all oscillators, RSI offer indications of when a currency pair is overbought/oversold. RSI essentially calculates the strength of all upward candles (green) against the strength of all downward candles (red) over the course of the specified time frame.

Parameters: When pulling up RSI on a chart, the charting application will prompt you to select how many periods you would like to include in your study. The most commonly number used is 14, and most traders do not alter this default setting. Some traders do use 9 or 25 period RSI's instead of the standard 14. Of course, increasing the number of inputs will decrease the number of signals and increase the reliability of these signals. Decreasing the number of inputs would have the opposite effect.

How to Use RSI in Trading:  Can be used to determine overbought/oversold levels, Used to spot divergences, which indicate potential weaknesses in trends.

Overbought/Oversold: If RSI is above 70, the pair is considered to be overbought. Some traders enter short at this point, but this can be dangerous as the price may still be rising. Enter short when the RSI crosses back under 70, as this may indicate that the momentum has turned. If the RSI is below 30, the pair is considered to be oversold; enter when RSI crosses back above 30. Like most oscillators, RSI works best when the market is range-bound - in other words, when the market is expected to simply gravitate between an upper and lower level. In trending or momentum-driven markets, using the overbought/oversold levels offered by RSI is generally of limited value.

Divergence. : RSI can also be used to signal when a trend is weakening. If a currency pair makes new highs in its price but RSI does not - meaning there is divergence between the price movement and RSI - it may signal that the trend is not strong, and that a reversal may be imminent. If candlestick patterns confirm, a trader can use this as an opportunity to enter a position.

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Moving Average Convergence And Divergence MACD's

MACD is a commonly used technical indicator derived from exponential moving

averages that can be used in both momentum and rangebound markets. Like RSI it is an oscillator plotted at the bottom of the chart, and it shows the momentum of the market relative to its recent history. MACD’s can be used as an oscillator (indication that the asset will revert back to its mean valuation) OR a momentum indicator (indication that the trend is strong and will continue). The parameters used in the MACD line is the difference between the 12 and 26 day EMA. The signal line is the 9 day EMA of the MACD. Visually, the MACD consists of three elements:

MACD line. This is simply the difference between the 12 and 26 day EMA. It is a line plotted on the chart.

Signal line. The signal line is the 9 day EMA of the MACD line. Like the MACD, it is a line plotted on the bottom of the chart.

Histogram. The MACD histogram is simply a bar chart located at the bottom of the chart, where the MACD and signal lines are plotted. The histogram is simply a visual representation of the difference between the MACD and the signal line.

The “zero” point of the histogram - meaning the point where the bars cross above and below - is referred to as the centerline.

Trade Signal. When the MACD crosses the signal line, a trade signal is issued. Traders can enter positions following the direction of the MACD.

Overbought/Oversold. No specific numbers indicate whether it is overbought or oversold, but if it is relatively far from its mean compared to its recent history, this may suggest that it is due for a reversion.

Divergence. When the pair makes new highs/lows but the MACD does not, this suggests divergence, and that the trend may in fact be weakening with a reversal in store. Consider the chart below for some examples as to how the MACD indicator can be used.

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Trading With Stochastics

Stochastic is an oscillator that works well in range-bound markets. Stochastic is an oscillator - meaning it offers a measurement of the deviance of currency pair’s rate (price) from its normal levels. Like all oscillators, stochastic offers indications of when a currency pair is overbought/oversold. Accordingly, it works well in markets that are not trending, but rather just fluctuating back and forth between an upper level (resistance) and a lower level (support).

Parameters. Stochastic typically has three parameters that users must specify: %K, %D, and number of periods. Here is one commonly used setting for those parameters: 5 for %K, 5 for %D, 3 for number of periods and %K is the fast moving line; it measures the relative strength of the asset, like RSI. %D is a moving average of %K, and hence is a much slower line.

Different Inputs. The fast stochastic only requires two inputs, which are normally 5 and 5. The slow stochastic requires a third input, which is the number of periods used in taking a moving average of the fast %D line. Unlike MACD (which commonly uses 12, 26, and 9) or RSI (which uses 14), Slow stochastic has a number of popular settings that can be used. 5, 3, and 8 is one commonly used setting. 15, 3, 3 is used by conservative traders who are interested in receiving less signals, while 8, 5, 5 and 5, 5, 3 are more aggressive settings for traders who are looking for fast signals. The tradeoff between accuracy and speed is something every trader must consider when choosing the inputs they will use in stochastics.

How to Use Stochastic in Currency Trading: Can be used to determine overbought/oversold levels, like RSI. Can be used in a crossover fashion like moving averages. Used to spot divergences, which indicate potential weaknesses in trends. Crossover. When %K crosses %D (when fast crosses slow), it can be interpreted as a trade opportunity. Traders can enter positions following the direction of %K.

Overbought/Oversold. Look for both %K and %D to be above/below the 20/80 levels. If they are both above 80, it may be a good opportunity to sell, as the asset is overbought and expected to return back to a normal level. Alternatively, if it is below 20, the asset is oversold - and hence it may be a prime buying opportunity, as a range-bound market would imply that the currency pair will head back to a more “normal” asset price.

Divergence. Stochastic can also be used to determine when NOT to enter a position. For instance, if a trend looks strong, traders can look to stochastic to see if there is any divergence between the movement of the asset and the stochastic lines. If, for example, a currency pair is headed upwards sharply and is making new highs, but the stochastic is not making new highs or even heading downwards, then this suggests that the trend is weak, and the prices may come back down. Conservative traders can use look for divergence as a caution not to enter a trade based on momentum, while more aggressive traders can use divergence as a signal to enter a position before the trend actually starts retracing.

Slow versus Fast Stochastic. There are two types of stochastic, slow and fast. Both display the same two lines, and both can be interpreted in the same manner for crossovers, overbought/oversold conditions, and divergence. The difference is that the %D line of the slow stochastic is smoothed out by taking a moving average of the %D line of the fast stochastic. This makes the slow stochastic more accurate in the trade signals it provides but somewhat slower to react to the changing market price.

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Using Bollinger Bands For Forex Trading

Bollinger Bands are an excellent range-bound indicator that measures standard deviation from the moving average developed by John Bollinger, Bollinger Bands consist of three lines:

A moving average (Often omitted in most charting packages). A upper band two standard deviations above the moving average. A lower band two standard deviations below the moving average. Bollinger bands are an excellent range-bound indicator - meaning they work best when the market is not strongly trending, but rather fluctuating between a high barrier (resistance) and a lower barrier (support). Bollinger bands operate under the logic that a currency pair’s price is most likely to gravitate towards its average, and hence when it strays too far - such as two standard deviations away - it is due to retrace back to its moving average. Parameters: Standard deviation of 2; moving average of 20 (usually omitted). How it can be used: Range-bound market. In range-bound markets, trading with Bollinger Bands is fairly simple: it essentially involves selling at the top band and buying at the bottom one. Note how the bands are nearly horizontal when the market is in an established range. This is when reversals at the bands are more effective.

Breakouts on Volatility.: When the Bollinger bands contract (meaning grow narrower), this suggests that volatility is contracting, and that the pair is trading in a tighter range. Typically, volatility contracts right before the market makes a big breakout. Accordingly, contracting volatility - symbolized by tight Bollinger Bands - should be a sign to traders that the market may be ready to make a big break.

The chart above shows the bands have contracted to a very narrow range, preceding a breakout. Once the bands start to expand outwards, this is a signal to enter in the direction that the price is moving. So, as the chart shows, if the price is at the top of the bands and the bands start to widen, it is a signal to go long.

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Forex Market Structure

FX Market Structure: The FX market is an over-the-counter market with no centralized exchange. Traders have a choice between firms that offer trade-clearing services. Unlike many major equities and futures markets, the structure of the FX market is highly decentralized. This means that there is no central location where trades occur. The New York Stock Exchange, for example, is a totally centralized exchange. All orders pertaining to the purchase or sale of a stock listed on the NYSE are routed to the same dealer and pass through the hands of a single clearing firm. This structure requires buyers and sellers to meet at the NYSE in order to trade a stock that is listed on this exchange. It is for this reason that there is one universally quoted price for a stock at any given time. In the FX market there are multiple dealers whose business is to unite buyers and sellers. Each dealer has the ability and the authority to execute trades independently of each other. This structure is inherently competitive as traders are faced with a choice between a variety of firms with an equal ability to execute their trades. The firm that offers the best services and execution will capitalize on this market efficiency by attracting the most traders. In the equities markets, the execution of trades is monopolized and there is no incentive for a clearing firm to offer competitive prices, to innovate, or to improve the quality of their service. The FX market has clear advantages over the equities markets in terms of efficiencies created by decentralization and competition.

Forex Market Participants

While the foreign exchange market was traditionally exclusive to all but a select group of large banks, advances in technology and reductions to capital flow barriers have brought in a variety of new participants. Because all of these participants affect the supply of and demand for currencies, it is important to understand the role each plays in the market.

Commercial and Investment Banks

Commercial and Investment banks make up the "Interbank" market and trade on electronic brokerage systems (EBS). These banks trade among themselves via strong credit relationships, and account for the largest portion of FX trading. These banks trade on a proprietary basis (they trade for themselves) and through customer flow (they fill orders for clients outside of the Interbank market). The Interbank market consists of the world's largest Commercial and Investment banks and caters to the majority of commercial turnover as well as enormous amounts of speculative day-trading volume. These banks will trade among themselves via credit relationships they have established with one another as part of a system of balancing accounts. Large Corporations, Hedge Funds, Central Banks are all customers on the Interbank market. Aside from trading exclusively amongst themselves, these banks also trade with large corporations, hedge funds, central banks, or specialized dealers that cater to smaller retail traders. For example, when a large international corporation based in Japan needs to pay its employees in the United States, they must buy USD with JPY. To buy USD, this corporation will go to a bank to make the transaction. This trading amounts to billions of dollars daily, or about ¾ of daily FX volume. Due to their size and the large volume that they trade, these banks have unique access to: Important information on direction and size of capital flows. This means they may be able to make reasonable short-term predictions on FX movements based on the large positions they hold and trade. Significant capital power they might use to defend their proprietary positions at significant technical levels. This is often what creates support and resistance. Large research departments that offer fundamental and technical analysis to prop traders. All of these factors make it requisite for a good trader to take advantage of all the resources these banks provide. Possible trading opportunities as well as information on the particular interests of banks is disclosed in much of the research these banks create.

Central banks

Central banks have access to huge capital reserves. Central banks have specific economic goals. Central banks regulate money supply and interest rates. Central banks are large players with access to significant capital reserves. They enter the FX market primarily in a supervisory capacity in order to stabilize money supply and interest rates. Central banks closely monitor economic activity, and have many options available to them to regulate their economies. Many of these options relate to specific policies that greatly impact the FX market. Central banks set the overnight lending rates to change the rate of interest paid on their domestic currency. They buy and sell government securities to increase or reduce the supply of money. They buy and sell their domestic currency in the open market to influence exchange rates. Knowing the policy of a central bank and its opinion of the domestic economy will allow a trader to anticipate what actions the central bank is most likely to take in future policy meetings.

Corporations

Corporations primarily use FX to hedge against currency depreciation. Corporations also buy and sell currencies in order to meet payroll for international offices. Foreign exchange plays an increasingly important role in the daily business of corporations as globalization forces them to make and receive payments in foreign currencies. When international transactions of goods are made, a transaction of currency is also necessary. Whether it is to pay employees abroad or to pay for products coming from a foreign nation, corporations must exchange their local currency for the domestic currency of the nation they are trading with. When a corporation agrees to buy or sell goods to a client in foreign nation at a future date, it runs the risk of its local currency depreciating in the meantime. If a corporation believes that its local currency is expected to depreciate, and as a result the outstanding position is at risk, it would most likely enter the FX market and buy the domestic currency of the country with which it is trading.

Global Managed Funds

Many profit-seeking managed funds invest in foreign financial instruments. When they purchase and sell these instruments, an FX conversion is always necessary. Global fund managers (large mutual, pension, and arbitrage funds) invest in foreign securities and other foreign financial instruments. These investments can have substantial impacts on spot price movements because these firms constantly re-balance and adjust their international equity and fixed income portfolios. These portfolio decisions can be influential because they often involve sizable capital transactions. Major changes in equity or bond markets of respective countries dictate the roles of Global Managed Funds in the FX market. When equity markets are performing well they will attract substantial global capital, which will drive a domestic currency higher. To purchase stocks or bonds in a foreign nation, managed funds must exchange their local currency for the domestic currency of the country in which they are purchasing financial instruments. Many of these funds implement currency-hedging strategies. When they wish to hedge existing investments so they don't incur the risks of depreciating currencies, they can also generate significant selling flows. Under the umbrella of Global Managed Funds are pure FX funds (Global Macro Funds).

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Forex Market Correlations

Oil: The price of light sweet crude oil can have a tremendous effect on the FX market, specifically affecting currencies such as the Canadian Dollar (CAD), U.S. Dollar (USD), as well as the Japanese Yen (JPY) for somewhat different reasons. In fact, as oil has broken above the $50 psychological level, the impact of high oil prices continues to have a severe impact on the global economy. The following daily chart illustrates the rally oil has enjoyed over the course of the past year. Note the price of oil as well as the corresponding price of the USD/CAD during the same period of time.

CAD: Oil represents around 8% of the Canadian economy, therefore for every dollar higher the price of oil moves, the Canadian economy tends to benefit. On the other hand, if oil moves to the downside, the Canadian economy tends to suffer. The Canadian economy depends on exports such as Lumber, Oil, as well as consumer staples such as wheat and other grains. Being the ninth largest producer of crude oil in the world, Canada’s currency has a strong positive correlation with oil prices. In fact, over the past year (2004-2005), the weekly correlation has been close to 70%. This means that if oil prices rally, the Canadian dollar also has a high likelihood of rallying, but unfortunately the pitfall of this relationship is that the opposite scenario is true as well. When oil prices fall, the Canadian dollar will also fall. Higher commodity prices have benefited resourcerich Canada, but have hurt Canadian exports to countries such as the US, which accounts for two thirds of total exports from Canada.

USD: Canada is the number one supplier of oil to the US; in fact the US consumes more oil from Canada than from the Middle East. Due to the fact that the US and Japan are considered very industrialized nations, high oil prices tend to cut into the US’s ability to stay productive. High oil prices can have a sever effect on such industries such as the Airlines, Chemical, Automotive, and Industrial Production. The price of oil has a very strong correlation or relationship to the USD/CAD.

USD/CAD: In fact the USD/CAD pair has a “double barrel” reaction to the change in the price of oil. As oil moves higher, it tends to benefit the CAD while putting a strain on the USD. For that reason, the USD/CAD tends to move with swift reactions as the price of oil moves higher or lower. As oil traded near the psychological $50/barrel, the USD/CAD traded near the 1.2500 large round figure. As oil crossed above $50, the USD/CAD sank below 1.2500. The opposite also holds true. As oil subsequently fell below $50, the USD/CAD broke above 1.2500. Traders who realize this inter market correlation can trade the FX market with a bias, depending on its respective commodity market.

JPY: Japan imports 99% of the oil they use, as they are also considered a highly industrialized economy. Their economy tends to benefit when oil prices decline, as their economy is usually put under strain during periods of higher oil prices. Most major industries such as the Auto and industrial production industries depend on oil on a day-today basis. As the price of oil has continued to rise over the course of the past few years, Japanese industries are not able to sustain the same level of growth over the long term due to this increased cost of production. Because oil can have such a severe impact to not only the JPY economy, but also the US and major European economies, it is one of the most widely watched commodities. We may not see this correlation on a day-to-day, minute-to-minute basis, however it is important to note these inter-market relationships and how they influence the long-term trends.

Gold

In addition to oil, the price of gold tends to have a very strong correlation or relationship with such currencies as the CHF, and an opposite or reverse correlation to the USD. Until recently, the CHF was backed by gold, in the same way the USD was a few decades ago. Gold is considered a ‘safe haven’ for capital during times of political and/or economic unrest. As capital flows out of the USD, Gold tends to benefit, as capital is attracted to tangible assets such as precious metals, primarily gold, in times of uncertainty. On the other hand, during prosperous times, capital will leave the safety of gold, and move into more speculative financial instruments such as the equity markets. Notice on the following daily charts, how gold and the USD/CHF are an almost perfect mirror image of each other, reflecting the flow of capital out of USD and into Gold or out of Gold and into the USD. USD/CHF & EUR/USD: The price of gold also tends to have a double barrel effect on the USD/CHF. As the price of gold increases, the USD tends to decline in value while the CHF tends to benefit. Since both Gold and the CHF are considered very safe, conservative financial instruments, any movement in either one, tends to have a strong impact on the other. As the price of gold rises in value, capital tends to flow out of the USD, while the CHF tends to benefit. In addition, the EUR/USD pair tends to have a strong correlation to the price of gold, and a reverse relationship to the USD/CHF. Although the EUR currency itself is not back by gold, it is often times considered to have a strong correlation with this precious commodity. In fact the EUR (EUR/USD) has been considered the “anti-dollar” due to the fact that as capital flows out of the USD, investors are constantly looking for a relatively safe financial instrument, at least for the short term. It is important to look at the reasons ‘why’ the US dollar may lose value. This could occur due to a high difference in interest rates such as the GBP/USD or AUD/USD. But more importantly, the USD tends to lose value during times of economic and/or political instability inside the US. When this occurs, capital tends to search for financial instruments that generally benefit as an “alternative investment” to the USD. If the US economy is put under strain, perhaps the EUR economy will be the recipient of capital as investors look for a more favorable ‘risk to reward’ investment.

Copper: Australia is the world's second largest producer of this precious metal, mining nearly 261 tons annually, trailing only South Africa's output of 345 tons. More than half of Australia's exports are metals creating a high correlation between metals and the Australian dollar. Gold and copper particularly have a large effect. The price of copper plays a very large role in not only in the Australian economy, but also in many different sectors. For example, the housing (homebuilder) sector uses a great deal of copper for plumbing and other fixtures. The Australian economy has also benefited from their very strong housing market over the past few years. All of these elements are related in terms long-term economic cycles. With the US economy, and many other economies around the world falling under strain, the FOMC (US) and other central banks around the world lowered interest rates to encourage economic growth around the world. Lower interest rates made it easier for the average consumer to buy new homes or refinance existing properties. This alone has had a great benefit to the Australian dollar. However, due to poor returns in the equity markets such as the Dow Jones Industrial Average and NASDAQ, investors looked to other financial instruments and commodities such as gold, silver, and copper to hedge their equity portfolios. So one could say that low interest rates stimulated the housing market, which in turn drove up the demand for those products and components that are used in the manufacturing of homes; i.e. copper. Traders tracking the AUD should also note the price action of copper as well as the fundamental reports released from Australia that relate to their housing markets. As copper, gold, and the Australian housing market soured, the Reserve Bank of Australia raised interest rates to combat the risk of inflation. As AUD interest rates climb quickly, capital from around the world looked to the AUD as it paid a significantly higher yield than other majors such as the USD, CHF, CAD, and JPY. In fact one of the only currencies that currently has a higher interest rate is the NZD, which benefits for some of the same reasons and macro economic forces. Buying a currency with a higher interest rate, and selling another with a lower interest rate is known as a ‘carry trade’. Looking down the road, those interested in the carry trade should not only study the current interest rates but as well the ‘anticipation’ of future interest rates. The FX market moves in anticipation of higher or lower interest rates based on what information we have at the present time. The FX market, like any market is a “forward looking mechanism”. Therefore, if an Australian economic number is released that indicates that the housing market and/or AUD economy is slowing, or at least, has failed to sustain previous growth, traders may anticipate the Reserve Bank of Australia to cease raising interest rates, and perhaps consider cutting them down the road. In other words, simply buying the AUD/USD (positive carry trade) is not sufficient in order to be a profitable trader. We must not only study interest rates, and the charts, but as well the market’s anticipation for future price action and the future outlook of the economies around the world.

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Forex Money Management

Traders can do to several things to ensure they have solid money management habits. There are a few key guidelines that every trader, regardless of their strategy or what instrument they are trading, should keep in mind:

Risk-Reward Ratio. Traders should establish a risk-reward ratio for every trade they place. In other words, they should know much they are willing to lose, and how much they are seeking to gain. Generally, the risk-reward ratio should be 1:2, if not more. This means risk should equal no more than one-half of the potential reward. Having a solid risk-reward ratio can prevent traders from entering positions that ultimately are not worth the risk.

Stop Loss Orders. Traders should also employ stop-loss orders as a way of specifying the maximum loss they are willing to accept. By using stop-loss orders, traders can avoid the common scenario where they have many winning trades but a single loss large enough to eliminate any trace of profitability in the account.

Why Do Most Traders Lose Money? : The fact is that most traders, regardless of how intelligent and knowledgeable they may be about the markets, lose money. What could be the cause of this? Are the markets really so enigmatic that few can profit, or are there a series of common mistakes that befall many traders? The answer is the latter, and the good news is that the problem, while it can be emotionally and psychologically challenging, can be solved by using solid money management techniques.Most traders lose money simply because they do not understand or adhere to good money management practices.. Part of money management is essentially determining your risk before placing a trade. Without a sense of money management, many traders hold on to losing positions far too long, but take profits on winning positions prematurely. The result is a seemingly paradoxical scenario that in reality is all too common: the trader ends up having more winning trades than losing trades, but still loses money.

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Using Stop Loss Orders

Using Stop-Loss Orders to Manage Risk Using Stop-Loss Orders to Manage Risk. Due to the importance of money management to long-term successful trading, the use of a stop-loss order is imperative for any trader who wishes to succeed in the currency market. The stop-loss order allows traders to specify the maximum loss they are willing to accept on any given trade. If the market reaches the rate the trader specifies in his/her stop-loss order, then the trade will be closed immediately. As a result, the use of stop-loss orders allows you to quantify your risk every time you enter a trade. There are two parts to successfully using a stop-loss order: (1) initially placing the stop at a reasonable level and (2) trailing the stop - meaning moving it forward towards profitability - as the trade progresses in your favor. Placing the Stop-Loss: Here are two recommended ways of placing and trailing a stop-loss order:

 Two-Day Low: This technique involves placing your stop-loss order approximately 10 pips below the 2 day low of the pair. The idea behind this technique is that if the price breaks to new lows, the trader does not want to hold the position. For example, if the low on the EUR/USD’s most recent candle was 1.2900, and the previous candle’s low was 1.2800, then the stop should be placed around 1.2790 - 10 pips below the 2 day low - if a trader wishes to enter. As another day passes, the trader can raise the stop to 10 pips below the new two-day low.

Parabolic SAR: One type of volatility-based stop is the Parabolic SAR, an indicator that is found on many currency trading charting applications. Parabolic SAR is a volatility-based indicator that graphically displays a small dot at the point on the chart where the stop should be placed. Below is an example of a chart using Parabolic SAR.

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Types Of Traders

Different Styles of Trading: There is no precise definition, however the following are considered the general trading styles. Day traders: will typically take positions for a few minutes up to a few hours, and day traders usually don't hold positions overnight. They will also usually use very short-term charts such as the 15-minute charts.

Swing traders: may take a position for a few hours to a few days or even a week or two. They may use 1-hour or more charts to do so.

Position traders: typically hold positions for an even longer period of time than the Swing trader and this may last a few weeks or a few months. A carry trade: is one that is made based on the difference in interest rates (short the lower yielding currency to gain returns on a higher yielding currency), and may last for a few years or more.

Longer-term trader: is the longer the time periods used for the charts. Typically the use daily, weekly, or even monthly charts is popular. I believe every trader should at least start out with the longer-term charts to determine general trend as well as the significant support and resistance levels. Keep in mind that if you are a day-Trader you don’t want to use a 15-minute chart to enter a position and hold that position for days.

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