TRADING FOR A LIVING

I Individual Psychology. 4. Why Trade? 5. Fantasy versus Reality 6. Market Gurus 7. Self-Destructiveness 8. Trading Psychology 9. Trading Lessons from AA 10. Losers Anonymous 11. Winners and Losers III Classical Chart Analysis 18. Charting 19. Support and Resistance 20. Trend and Trading Range 21. Trendlines 22. Gaps 23. Chart Patterns

THE SPOT MARKET

The foreign exchange markets revolve around spot (that, is the FX spot market). For now, let’s abstract from bid–ask spreads (to which we return later) and remember what we said earlier about prices: “Every price is a ratio of quantities.” With this in mind, and recognizing that you have to quote the price of one currency in terms of another, the convention for quoting the spot exchange rate between, say, U.S. Dollars (USD) and Swiss Francs (CHF) is written USD|CHF (said “Dollar–Swiss”) and identifies the number of Swiss Francs per Dollar. Sounds backward, doesn’t it? USD|CHF or “Dollar-Swiss” means “Swiss per Dollar.” Don’t blame me; I didn’t make this up! We sometimes see this as USD|CHF 1.2500 or USD|CHF S = 1.2500 Written differently, as an explicit ratio of quantities When we quote USD|CHF (or any currency pair), we recognize the first currency, in this case the U.S. Dollar, as the “underlying” asset, that is, the thing that is being traded. The second currency, CHF, is the one that identifies the units in which the price of the underlying currency is being quoted; in other words, it indicates the number of units of that currency that is equal to (i.e., trades for) one unit of the underlying currency. In this example, Dollar-Swiss quotes the price of one USD in terms of CHF. In the professional or interbank market, to buy Dollar-Swiss (USD|CHF) means to buy Dollars with Swiss Francs (or more pedantically, to buy Dollars and pay for them with Swiss Francs or, said slightly differently, to buy Dollars CHF USD 1 2500 1 . 84 FOREIGN EXCHANGE and to sell Swiss Francs, which you recall, although it sounds like two trades, characterizes one single transaction). Understanding this, then, informs us exactly what my colleague who was “buying Dollar-Yen” was doing. He was buying USD with JPY (or buying United States Dollars and selling Japanese Yen). Of course, you can buy Dollars with Yen, but you could also buy Dollars with Swiss Francs or any number of other currencies. Returning to USD|CHF, someone on our FX desk once told me that you can think about any spot quote like “USD|CHF 1.2500” in the following way: Separating the “USD|” from the “CHF 1.2500,” replacing the “|” with a “1,” and putting an “=” between the terms gives: USD 1 = CHF 1.2500 Of course, there is no reason (other than convention) to quote this exchange rate in terms of “Swiss Francs per Dollar.” As mentioned earlier, we could (although we generally don’t in the interbank market) quote CHF|USD. This would simply be the reciprocal or multiplicative inverse of 1.2500, namely, .8000. If 1.25 Swiss Francs trade for 1 U.S. Dollar, then USD .8000 should trade for 1 Swiss Franc. What would USD|JPY S = 111.00 mean? It would mean that 111 Japanese Yen trade for 1 U.S. Dollar. Put another way, it takes 111 Yen to buy 1 Dollar. Alternatively, 1 U.S. Dollar will buy 111.00 Japanese Yen. There is already one point of possible confusion, that is, how far out (i.e., how many decimal places) should FX be quoted. With USD|CHF, we quoted out four decimal places, while with USD|JPY we quoted out only two decimal places. As a general guide, keep in mind the number 8. Between USD|CHF and CHF|USD, we would quote both out four decimal places (making a total of eight figures beyond the decimal points); by this gauge, when we quote USD|JPY, we go out only two decimal places, so, if we were to consider JPY|USD, we would have to go out six decimal places with this quote (again, making a total of eight numbers quoted beyond the decimal points). Yen is one of the primary exceptions, though; most currency pairs are quoted out four decimal places regardless. The fact that Japanese Yen is an exception, though, can come in handy for instructional purposes. As a general rule of thumb, if you are looking at an unfamiliar page or table of FX quotes, start by locating the exchange rate between U.S. Dollars and Japanese Yen; this provides an excellent point of orientation. If the number is between, say, 80 and 300, you can bet that it’s Yen per Dollar or The Foreign Exchange Spot Market 85 USD|JPY; on the other hand, if it starts with a .0-something, it’s Dollars per Yen or JPY|USD. The Major Spot Quotes Given the five major currencies, we summarize their standard interbank quoting conventions with the four quotes below (accompanied by representative spot values): USD|CHF 1.2500 USD|JPY 111.00 EUR|USD 1.2500 GBP|USD 1.8000 The first two quotes (USD|CHF and USD|JPY) are similar in some sense and the second two quotes (EUR|USD and GBP|USD) are similar in some sense. Let’s stop for a minute and think about these. One of these pairs is called an American quote and the other pair is considered a European quote. Take a minute and guess which is which. (For the record, conjectures on this are almost always wrong!) The first two quotes have in common the fact that the underlying asset is the U.S. Dollar. The second pair of quotes have in common the fact that the prices are quoted in terms of U.S. Dollars. To keep these labels straight, ask yourself, in terms of what units are Americans used to seeing prices quoted? U.S. Dollars, of course. For that reason, the bottom pair (Euro- Dollar and Sterling-Dollar) are American quotes. EUR|USD 1.2500 means that Euro 1 = USD 1.2500 (or that the price of 1 Euro is 1.25 U.S. Dollars). GBP|USD 1.8000 means that Pound Sterling 1 = USD 1.8000 (or the price of 1 Pound is 1.80 U.S. Dollars). An American who is contemplating taking a vacation to Rome or London would have to ask, “How many of my Dollars would I have to pay to get one of those Euros or to get one of those Pounds?” This is clearly viewed from the American perspective. Having said that, can we rationalize the first set of quotes above as European quotes? If a Swiss family were to plan a vacation to Disneyland (the real Disneyland—none of this Euro Disney stuff), they would have to ask themselves, “How many of our Swiss Francs will we need to buy Dollars?” To my knowledge, they do not take Swiss Francs in Disneyland. This is clearly the European perspective. What about USD|JPY? Obviously this currency pair has nothing to do with Eu- 86 FOREIGN EXCHANGE rope (indicating the exchange rate between an Asian currency and a North American currency), but it is still referred to as a European quote. The logic behind the name of this convention (that is, the convention with the U.S. Dollar as the underlying currency) goes back to the end of World War II—after which most of the major European currencies (with the exception of the British Pound) were quoted in this manner versus the U.S. Dollar (e.g., USD|DEM or Dollar-Deutsche Mark, USD|ITL or Dollar-Italian Lira, USD|FRF or Dollar-French Franc, USD|ESP or Dollar-Spanish Peseta). USD|JPY follows the quoting convention that was used for most of the European currencies and is labeled accordingly. European quotes are also sometimes known as “banker’s quotes” (as this, historically, was the interbank norm). There are other designations for FX quotes, but they simply involve more jargon. You may hear people talk about base currency and counter or quote currency; with USD|CHF, the Dollar is the base and the Swiss Franc is the quote or countercurrency. You may also hear about “direct quotes” and “indirect quotes”; these require raising the issue of foreign and domestic (that I proposed to avoid at the start); I will not use this terminology at all, as I do not find it helpful and consider it confusing at best. SPOT EXERCISE #1 1. What is the name of the exchange rate quoting convention (i.e., American or European) between U.S. Dollars and Canadian Dollars if we quote USD|CAD? 2. What would it mean if USD|CAD S = 1.2000 3. If USD|CAD S = 1.2000, what would CAD|USD S = ? 4. What is the name of the exchange rate quoting convention between Australian Dollars and U.S. Dollars if we quote AUD|USD? 5. What would it mean if AUD|USD S = .7500 Nicknames Many of the currency pairs are referred to using nicknames. As mentioned, GBP|USD is known as “Cable”; USD|CHF is sometimes referred to as “Swissy”; AUD|USD is “Aussie”; NZD|USD is “Kiwi”; and so on. An entertaining site containing the nicknames in local vernacular for the Euro (with translations) can be found (under Slang Words) at http://en.wikipedia.org/wiki/Euro.

History of Foreign Exchange

Foreign exchange has been around as long as transactions have involved crossing country borders. No doubt, trade took place even before national boundaries and modern currencies existed. But once a country or region established a money of their own, then currency transactions became necessary. (Strictly speaking, this need not always have been the case if the two currencies were convertible. In other words, if two countries both used gold coins and the values of those coins were based entirely on the weights of the metal they contained, then there should have been a single exchange rate between those currencies).1 Although there are many interesting accounts of the early forms of money2 (dealing primarily with the use of precious metal in the form of coins), the fundamental economic principle on this topic typically goes by the name of Gresham’s Law. Thomas Gresham, in 1558, stated that bad money always drives out good money. What this means is that currency which has been debased (such as clipped or “sweated” coins or coins made of an inferior or lower precious metal content) tends to drive “better money” (whole coins or coins with a higher metal content) out of circulation (i.e., induce hoarding). When was the last time you saw a “real silver” U.S. dime, quarter, or half-dollar? John Kenneth Galbraith wrote, “It is perhaps the only economic law that has never been challenged.”3 Prior to 1900, most national currencies were backed by gold and/or silver (and were, therefore, in a sense, immediately and directly comparable). Britain adopted a gold standard around 1820. Germany and France also moved to a gold standard for their currencies in 1871 and 1876, respectively. In China, they resisted a gold-backed currency because of the dominance of silver in that part of the world. On paper, the official gold 63 standard in the United States set the value of one ounce of gold at USD 20.67—from 1834 through 1933. The United States, during the recovery after the Civil War, guaranteed that the Dollar could actually be converted into gold (but not silver) via the Coinage Act of 1873 (despite many political objections in the ensuing years); the most eloquent dissent was William Jennings Bryan’s famous “Cross of Gold” speech (advocating “easy money,” meaning currency not backed by the presence of ever scarce gold) delivered during his unsuccessful bid for the presidency in the Election of 1896). Bimetallism (the backing of fiat currency by silver and gold) was instituted soon thereafter in the United States, but the U.S. currency reverted to convertibility into gold alone in 1900. It is important to note that prior to 1900, with some high profile exceptions (such as England, Spain, and Portugal), international trade was not a significant part of many countries’ economic activity. Wheat was grown in a country, it was turned into flour in that country, it was baked into bread in that country, and that bread was consumed in that country. As transportation technology advanced (as well as the state of the art of preserving previously perishable products for extended conveyance), local specialization and the trade associated with it became increasingly important, and, consequently, more extensive economic interaction between geographies. Following World War I, Germany was burdened with large reparation payments, so large in fact that some economists (including John Maynard Keynes of Keynesian Economics fame) thought them unrealistic and potentially debilitating. As Germany (whose currency was no longer backed by gold) expanded their money supply, in part in an effort to help meet their payment responsibilities, the economy spiraled out of control. One U.S. Dollar exchanged for around 8 Marks at the end of the World War I (1918–1919); by November 1923, at the peak of the hyperinflation, one Dollar was worth 4.2 trillion Marks. Workers were paid every day before noon and then raced to the stores to buy anything they could, aware that prices changed hourly. Eventually, political intervention (the Dawes Plan) and the introduction of a new currency (the Rentenmark, so named because of its backing by land and industrial plants) together helped somewhat to stabilize the German economy. Clearly the excessive growth of money in an economy can have negative effects. Up until the global depression of the late 1920s and 1930s, most major currencies, with the exception of the German Mark, were freely traded and, as mentioned, via the gold standard, convertible into precious metal. The Great Depression changed all that. On April 5, 1933, with approximately 25% of the U.S. work force unemployed and with the world in the throes of a global depression, U.S. President Franklin Delano Roosevelt 64 FOREIGN EXCHANGE abandoned the gold standard, suspending the convertibility of Dollars into gold, and ordered all U.S. citizens to surrender their gold holdings. Milton Friedman and Anna Schwartz, in their classic A Monetary History of the United States, 1867–1960, assert that one of the primary causes of the Great Depression, and a significant factor in both the length and severity of that economic crisis, was the reduction in the supply of money in the economy; they estimate that the money supply fell by about a third between 1929 and 1933. In their words, the Great Depression was a “testimonial to the importance of monetary forces.” If money serves to facilitate trade, obviously the scarcity of money can grind an economy to a halt. It appears as if, for an economy, too much money can be a bad thing and not enough money can be a bad thing as well. Although the United States did abandon the gold standard, gold, nevertheless, did continue to be used as a settlement vehicle for international trade at the national/central bank level. In 1933, the United States officially reset the price of gold to USD 35 per ounce. This peg was maintained until 1971. As Europe entered World War II, many large economic powers were forced off the gold standard. In the case of England, their gold reserves were depleted in an effort to arm themselves for the impending military conflict. As the war approached its conclusion (July 1944), a landmark event took place: the Bretton Woods Conference. This is recognized as the first attempt ever to institute an international monetary system. As a student of economics, I always envisioned this event as taking place on a smoky battlefield in France; Bretton Woods is actually a beautiful resort community in New Hampshire, U.S.A. and the sessions were held at the Mount Washington Hotel. At these meetings, attended by representatives from the Allied countries, there was a strong resolve to avoid the previous mistakes of past postwar settlements. John Maynard Keynes, the same prominent British economist who had misgivings over the World War I German reparations, was an active and vocal participant at this conference, and an important contributor to the ultimate results of this meeting. Among other things, the Bretton Woods Agreement set up both the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development, which later morphed into the World Bank, and resurrected the importance of the Bank for International Settlements (or BIS). More relevant for this book was the establishment of a fixed exchange rate system in which most of the major European currencies were pegged to the U.S. Dollar and, in an effort to provide even more stability to the new world economic order, the Dollar was pegged to gold (at the aforementioned rate of USD 35 per ounce).

WHAT ARE “INTEREST RATES”?

An interest rate is the price of money. The nice thing about defining the interest rate as the price of money is that you don’t have to specify whether it is a rate for borrowing (a cost) or a rate for lending (a benefit), though, as with every price in the financial markets, you should be prepared to encounter a bid–ask spread in the world of interest rates as well. If you decide to borrow USD 100 today, then in one year’s time you would be obliged to pay back USD 105.20. That ratio, USD 105.20/USD 100, reflects the interest rate. That being said, if you borrow USD 100 today at an interest rate of r = 5.20%, then in one week you would pay back only USD 100.10. Where did this come from? You would have to scale the interest rate for the time period involved (and here I assume that one week is exactly 1/52 of a year). The math would look like this FV = PV(1 + rt) (3.1) where we use PV to refer to the Present Value or Principal FV to refer to the Future Value r to indicate the (annualized) interest rate and t to reflect the time period over which the borrowing or lending takes place (measured in years) For the example we just looked at 100.10 = 100(1 + (.0520)(1/52)) and, for our earlier example: 105.20 = 100(1 + (.0520)(1)) This convention is known as simple interest and, if the time frame under consideration is a year or less, this is one of the most common ways in which interest is calculated.