Interesting Trading and Market Links from April

I follow a large number of trading/markets related blogs and websites. When I find stuff I think is worth sharing, but that I won’t be addressing with my own blog post in response I share them on on Facebook and Twitter. These are the ones I posted in April for readers who didn’t see them on the other channels.

The LA Times gives us its perspective on forex trading.
Foreign currency trading is easy — an easy way to lose money
And my response.

Expert thoughts on covered call writing.
Writing covered call split strikes

Interesting anatomy of a forex trader graphic.

http://www.ibfx.com/Content/Images/ibfx-anatomy-of-a-trader.jpg

Bad title, but interesting discussion nevertheless.
Twitter Now a Source for Bernie Madoff-ish Investment Returns

Here’s something the folks in the interest rate market are watching.
Chart of the Day: Fed Ownership of the Yield Curve

LBR is always worth paying attention to.
Linda Raschke: Stick to the Plan and Become a Better Trader

Hattip to Mark Wolfinger for pointing this post out.
Portfolio Theory is Dead, Now What?

Another new entrant in the forex brokerage business.
OptionsXpress to enter the retail forex market

Interesting new set of stats from Oanda
Top 100 Traders Stats | OANDA fxTrade

Book Review: Investing with Volume Analysis

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John Forman - The Essentials of Trading author

If you want to learn just about everything there is to know about incorporating volume in your trading or investing you’re going to want to pick up a copy of Investing with Volume Analysisby Buff Dormeier. The author is a Chartered Market Technician (CMT) and an experienced money manager and he’s pulled together for this book a very comprehensive collection of volume studies and indicators, including some of his own devising.

This isn’t just some encyclopedia of volume analysis tools, though. There is considerable discussion of how to implement them, including studies demonstrating their performance. The author also discusses recent developments (high frequency trading, etc.) in the markets and their impact on volume and the analysis thereof.

My one issue with the book is that it has the feel of a manifesto, especially early on, and there are some religious undertones which may bother some readers. Most of that stuff is in the first few chapters which provide some background and historical perspective of volume and technical analysis. At times I found the reading slow going through that section, though it gets easier later.

All in all, I found this a very useful book. If you are looking to use volume in your trading/investing and market analysis, this is definitely the book for you.

Make sure to check out all my trading book reviews.

Struggling with support & resistance and knowing what the key market levels are? Check out the Price Distribution Analysis methods I use.

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Bernanke’s view on inflation, I think

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John Forman - The Essentials of Trading author

Fed Chief Ben Bernanke did his first post-FOMC press conference yesterday. Predictably, he got a question about the impact of energy and food prices on the public and the whole issue of the impact of QE on inflation and the value of the dollar. There’s a lot of screaming and yelling about this subject in the press and among market participants. Bernanke held to his line, though, about inflation being low and these food and energy things being transitory, which annoyed a bunch of folks.

Here’s what I think Big Ben is reading the inflation situation. I’ll try to explain by way of example.

Imagine that you have $100 in your budget. Your housing (rent or mortgage) is $35.  Food runs $25. Utilities and other expenses are another $25. Gasoline costs $15. Now let’s say gasoline prices double, so your cost goes to $30. What happens? If you cannot increase your income or borrow money you’ll have to cut $15 from among the other categories. That means your demand for other goods and services will go down.

Extend this example to the whole US economy. If income isn’t rising, then rising food and energy prices means money not available to spend on other things. That means less demand, and by extension lower prices in those sectors. What that tallies up to is no net change in overall prices. Even if income is rising, as long as it’s rising less rapidly than the increase in food and energy prices there will still be the dampening impact on prices elsewhere in the economy.

Below is a chart from the St. Louis Fed showing disposable income over the last 10 years. It show’s a year-over-year growth rate between 3% and 4% in the most recent figures. How does that compare to the change in food and energy prices? Just a fraction, right?

Of course, folks can borrow to make up the shortfall. Are they? To find out we need to look to the money supply figures.

Here’s the chart for the Monetary Base, which is the lowest level of money supply that is directly influenced by what the Fed does.

Again, we’re looking at year-over-year changes here. Notice the big spike up in 2008 when the Fed got aggressive about dealing with the financial crisis. In late 2009 and early 2010 we can see a spike up in the growth rate from QE1. The growth rate actually went negative in the latter part of 2010, though, before QE2, after which it has bounced back again.

The monetary base, however, does not reflect borrowed money. That’s in the bigger aggregates, especially M3. The Fed stopped publishing M3 a few years back, but we can see a continuation version created by the folks at ShadowStats.

Notice in the chart how the y/y change in M3 has been negative since late 2009 or early 2010. That basically means the amount of debt outstanding has been falling. In other words, folks in the US have not been borrowing to finance purchases beyond their income. Quite the opposite. They’ve been reducing debt (though write-offs are a factor here).

So what we have is income not rising at the same pace as increases in food and energy prices and debt shrinking, not expanding. That means there’s less money available to be spent on other goods and services. That is helping to depress prices in those sectors, which is why Bernanke is not worried about general inflation yet, but does have concerns about economic growth. At least that’s how I think he’s viewing things.

Struggling with support & resistance and knowing what the key market levels are? Check out the Price Distribution Analysis methods I use.

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Which is leading – the Dollar or Oil?

Yesterday, after days of listening to the equity-oriented reporters and commentators on CNBC yammer about the dollar moving commodities around I read a blog comment from a forex guy saying the dollar was being driven by oil. I just couldn’t take it anymore and decided to run some numbers.

Here’s the deal. Neither market is leading the other. They are trading roughly in tandem.

I first looked at 5 minute bar prices for front month oil futures and the Dollar Index from late on May 4 to early May 13. They showed a negative correlation between % changes in the price of the two markets of about -46%. That means they are largely inversely correlated, though not completely, which is about what we’d expect to see.

I then did and offset where I look to see if current period price changes in one market correlated to price changes one period forward in the other. By that I mean, for example, does a rise in oil in the 1:05 time period correlated to a change in the dollar in the 1:10, or vice versa. Nothing. Looking at things both in terms of oil leading and the dollar leading I got correlations of near zero.

My thought was that maybe 5 minutes was just too long a timeframe to catch a lead-lag I decided to look at 1 minute bars. The timeframe is shorter (about a day and a half), but there were some sharp moves during that time frame, so I’m comfortable with it being representative.

The results? No real difference. The straight correlation between price changes came out as -52%. The forward correlations were again so close to zero as to mean no real correlation.

The conclusion? Neither market is leading the other – at least not on any consistently measurable basis. They are simply trading off the same drivers. Yet more evidence those in the media often don’t provide correct or useful information.

Looking at 15 Trading Rules

The following 15 trading rules were posted by zentrader.ca having been taking from Trend TV. While I agree with many of them, I have a problem with a few of the rules. See below.

1. Don’t be a tradeaholic
Agreed

2. You trade to make money – not for fun, games, or to escape boredom
Definitely

3. Never add to a bad trade
If you have a specific strategy which includes adding to a trade which has gone against you, that’s one thing. Just “averaging down” is usually a bad play.

4. Once you have a profit on a trade, never let it turn into a loss
This can be a really good plan for psychology purposes, but it may or may not be appropriate for the type of strategy/system you employ.

5. No hoping, no wishing, no would’ve, no opinions, no should’ve
It’s hard not to second-guess, and reviewing thinging after the fact is part of the learning process, but never do it in trade.

6. Don’t be a one way trader – be flexible, opportunities on both sides
More opportunities doesn’t necessarily mean better trading. Some systems, markets, and/or traders are just better one-way only.

7. Know your risk on each trade. Trade with stops to limit losses
Definitely yes on the first part. The second part is up for debate in some ways.

8. Look for 3-1 profit objective trade
Totally disagree. This can’t be taken in isolation. You can have fantastic results with a smaller R/R ratio. It depends on your system’s or method’s win %.

9. When initiating a trade, always get your price (use a limit order)
Depends on your system.

10. When liquidating a bad trade, always use a market order
Hard to disagree with.

11. Have a plan. Trade it. Monitor it.
Absolutely

12. Make 10 points on a million trades, not a million points on one trade
This is the difference between trend trading and other types. In trend trading you are going for infrequent big wins.

13. Learn from your own mistakes
Goes without saying.

14. Pay attention to weekly lows and highs
Again, depends on your trading system or methodology, but often useful.

15. Technicals and fundamentals are equally important
Depends on timeframe.

What about you? Any thoughts on the rules above?

Stock Traders – Oblivious or Stupid?

After hearing yet another professional stock guy on CNBC mention QE3 like it was still a real possibility, I have to ask the question:

Are these guys completely oblivious, stupid, or in just simply in denial?

The thing that had me laughing yesterday (it was either laugh or cry) was how completely out of touch this one trader clearly was. His reasoning for being bullish on stocks is that we’re in a win-win situation. We’ll either get good economic growth or QE3, he suggested.

Wow! Really? Those are the only two possible courses? Might want to re-think that. And this was a professional on the floor of the NYSE!

I don’t know what these stock guys are looking at or paying attention to, but it’s not the same stuff the fixed income and forex folks are following.  Those of us in the latter markets heard Bernanke say at his press conference that it would take something very significant for the Fed to embark on QE3 as he feels the inflationary risks outweigh any potential benefit. This has been backed-up by other Fed speakers since, and the minutes from the last meeting of the FOMC, released yesterday, focused a lot on exit strategy.

Either a strong economy or QE3? It’s that sort of brilliant analysis that confirms the view of fixed income and forex market folks that the equity markets are always the last to figure things out. Remember how stocks rallied right into October of 2007 even after it was clear months before that from what was happening in interest rates and currencies that something was very wrong?

Taking Advantage Of A Weak U.S. Dollar

Between 2003 and 2008, the value of the U.S. dollar fell compared to most major currencies. The depreciation accelerated during 2007-2008, impacting both domestic and international investments.

The impact of the rise or fall of the U.S. dollar on investments is multifaceted. Most notably, investors need to understand the effect that exchange rates can have on financial statements, how this relates to where goods are sold and produced, and the impact of raw material inflation.

The confluence of these factors can help investors determine where and how to allocate investment funds. Read on to learn how to invest when the U.S. dollar is weak.

The Home Country
In the U.S., the Financial Accounting Standards Board (FASB) is the governing body that mandates how companies account for business operations on financial statements. FASB has determined that the primary currency in which each entity conducts its business is referred to as "functional currency". However, the functional currency may differ from the reporting currency. In these cases, translation adjustments may result in gains or losses, which are generally included when calculating net income for that period.

What does all this technical-speak mean when investing in the U.S. in a falling dollar environment? If you invest in a company that does the majority of its business in the U.S. and is domiciled in the U.S., the functional and reporting currency will be the U.S. dollar. If the company has a subsidiary in Europe, its functional currency will be the euro. So, when the company translates the subsidiary's results to the reporting currency (the U.S. dollar), the dollar/euro exchange rate must be used. For example, in a falling dollar environment, one euro buys $1.54 compared to a prior rate of $1.35. Therefore, as you translate the subsidiary's results into the falling U.S. dollar environment, the company benefits from this translation gain with higher net income. 

Why Geography Matters
Understanding the accounting treatment for foreign subsidiaries is the first step to determining how to take advantage of currency movements. The next step is capturing the arbitrage between where goods are sold and where goods are made. As the U.S. has moved toward becoming a service economy and away from a manufacturing economy, low-cost provider countries have captured those manufacturing dollars. U.S. companies took this to heart and started outsourcing much of their manufacturing and even some service jobs to low-cost provider countries to exploit those cheaper costs and improve margins. During times of U.S. dollar strength, low-cost provider countries produce goods cheaply; companies sell these goods at higher prices to consumers abroad to make a sufficient margin.

This works well when the U.S. dollar is strong; however, as the U.S. dollar falls, keeping costs in U.S. dollars and receiving revenues in stronger currencies - in other words, becoming an exporter - is more beneficial to a U.S. company. Between 2005 and 2008, U.S. companies took advantage of the depreciating U.S. dollar as U.S. exports showed strong growth that occurred as a result of the shrinking of the U.S. current account deficit to an 8-year low of 2.4% of gross domestic product (GDP) (excluding oil) during 2008. (For background reading, see Current Account Deficits.)

However, just to complicate matters slightly, many of the low-cost provider countries produce goods that are unaffected by U.S. dollar movements because these countries "peg" their currencies to the dollar. In other words, they let their currencies fluctuate in tandem with the fluctuations of the U.S. dollar, preserving the relationship between the two. Regardless of whether goods are produced in the U.S. or by a country that links its currency to the U.S., in a falling U.S. dollar environment, costs decline. (For more insight, read Floating And Fixed Exchange Rates.)

Up, Up and Away …
The price of commodities related to the value of the dollar and interest rates tends to follow the following cycle:

Interest Rates are Cut Þ U.S. Dollar is Pulled LowerÞ Gold and Commodity Index BottomÞ Interest Rates Turn Up Þ Bonds PeakÞ Stocks Peak Þ Dollar Rises Þ Gold and Commodity Index Peak Þ Interest Rates Peak Þ Bonds Bottom Þ Stocks Bottom Þ Interest Rates are Cut Þ Cycle Begins Again 

At times, however, this cycle does not persist and commodity prices do not bottom as interest rates fall and the U.S. dollar depreciates. Such a divergence from this cycle occurred during 2007-2008 as the direct relationship between economic weakness and weak commodity prices reversed. During the first five months of 2008, the price of crude oil was up 20%, the commodity index was up 18%, the metals index was up 24% and the food price index was up 18%, while the dollar depreciated 6%. According to Wall Street research by Jens Nordvig and Jeffrey Currie of Goldman Sachs, the correlation between the euro/dollar exchange rate, which was 1% from 1999-2004, rose to a striking 52% during the first half of 2008. While people disagree about the reasons for this divergence, there is little doubt that taking advantage of the relationship provides investment opportunities. (For related reading, see Forex: Venturing Into Non-Dollar Currencies.)

Profiting From the Falling Dollar
Taking advantage of currency moves in the short-term can be as simple as investing in the currency you believe will show the greatest strength against the U.S. dollar during your investment timeframe. You can invest directly in the currency, currency baskets or in exchange-traded funds (ETFs).

For a longer-term strategy, investing in the stock market indexes of countries you believe will have appreciating currencies or investing in sovereign wealth funds, which are vehicles through which governments trade currencies, can provide exposure to strengthening currencies.

You can also profit from a falling dollar by investing in foreign companies or U.S. companies that derive the majority of their revenues from outside the U.S. (and of even greater benefit, those with costs in U.S. dollars or that are U.S.-dollar linked).

As a non-U.S. investor, buying assets in the U.S., especially tangible assets, such as real estate, is extremely inexpensive during periods of falling dollar values. Because foreign currencies can buy more assets than the comparable U.S. dollar can buy in the U.S., foreigners have a purchasing power advantage. 

Finally, investors can profit from a falling U.S. dollar through the purchase of commodities or companies that support or participate in commodity exploration, production or transportation. (For more on this strategy, read Commodity Prices And Currency Movements.)

Conclusion
Predicting the length of U.S. dollar depreciation is difficult because many factors collaborate to influence the value of the currency. Despite this, having insight into the influence that changes in currency values have on investments provides opportunities to benefit both in the short and long-term. Investing in U.S. exporters, tangible assets (foreigners who buy U.S. real estate or commodities) and appreciating currencies or stock markets provide the basis for profiting from the falling U.S. dollar. 

Profit From Forex With Currency ETFs

Does a falling U.S. dollar or rising euro interest you? Do you want to protect your dollar-denominated assets or profit from a rise in European currency? If so, traditionally you would have to trade currency futures, open up a forex account, or purchase the currency itself to profit from changes in currencies. However, currency exchange-traded funds (ETFs) are a simpler way to benefit from changes in currencies without all the fuss of futures or forex by simply purchasing ETFs in your brokerage account (IRA and 401(k) accounts included).

In this article, we will look at why currencies rise and fall and check out the different types of currency ETFs available to investors. (To go more in depth into currency ETF trading, check out Currency ETFs Simplify Forex Trades.)

Tutorial: Introduction To The Forex Market

Why Currencies Move
Foreign exchange rates refer to the price at which one currency can be exchanged for another. The exchange rate will rise or fall as the value of each currency fluctuates against another.

Factors that can affect a currency's value include economic growth, government debt levels, trade levels, and oil and gold prices among other factors. For example, slowing gross domestic product (GDP), rising government debt and a whopping trade deficit can cause a country's currency to drop against other currencies. Rising oil prices could lead to higher currency levels for countries that are net exporters of oil or have significant reserves, such as Canada.

A more detailed example of a trade deficit would be if a country imports much more than it exports. You end up with too many importers dumping their countries' currencies to buy other countries' currencies to pay for all the goods they want to bring in. Then the value of the importers' country currencies drops because the supply exceeds demand. (To learn more basics for currency pricing, check out Wading Into The Currency Market and our The Forex Market tutorial.)

How ETFs Work
For years, many investors have used ETFs instead of mutual funds to track major equity indexes, such as the S&P 500 and the Lehman Brothers three- to seven-year U.S. Treasury Index. 

ETFs have a few advantages over mutual funds, including:
They Are Easy to trade: They can be bought and sold anytime through any broker, just like a stock.  They Are Tax efficiency: ETFs typically have lower portfolio turnover and strive to minimize capital gains distributions so that investors are only taxed when they initiate a trade. Greater Transparency: ETFs disclose the exact holdings of their funds on a daily basis so you always understand precisely what you own and what you are paying for. Flexibility: Anything that you can do with a stock, you can do with an ETF. This includes shorting them, holding them in margin accounts and placing limit orders. With currency ETFs, you can invest in foreign currencies just like you do in stocks or any other ETF. You can even buy ETFs in your IRA.

Currency ETFs
Currency ETFs replicate the movements of the currency in the exchange market by either holding currency cash deposits in the currency being tracked or using futures contracts on the underlying currency.

Either way, these methods should give a highly correlated return to the actual movements of the currency over time. These funds typically have low management fees as there is little management involved in the funds, but it is always good to keep an eye on the fees before purchasing.

There are several choices of currency ETFs in the marketplace. You can purchase ETFs that track individual currencies. For example, the Swiss franc is tracked by the CurrencyShares Swiss Franc Trust (NYSE:FXF). If you think that the Swiss franc is set to rise against the U.S. dollar, you may want to purchase this ETF, while a short sell on the ETF can be placed if you think the Swiss currency is set to fall.

You can also purchase ETFs that track a basket of different currencies. For example, the PowerShares DB U.S. Dollar Bullish (NYSE:UUP) and Bearish (NYSE:UDN) funds track the U.S. dollar up or down against the euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc. If you think the U.S. dollar is going to fall broadly, you can buy the Powershares DB U.S. Dollar Bearish ETF.

There are even more active currency strategies used in currency ETFs, specifically the DB G10 Currency Harvest Fund (NYSE:DBV), which tracks the Deutsche Bank G10 Currency Future Harvest Index. This index takes advantage of yield spreads by purchasing futures contracts in the highest yielding currencies in the G10 and selling futures in the three G10 currencies with the lowest yields.

In general, much like other ETFs, when you sell an ETF, if the foreign currency has appreciated against the dollar, you will earn a profit. On the other hand, if the ETF's currency or underlying index has gone down relative to the dollar, you'll end up with a loss.

Follows Most Major Currencies
Currency ETFs can be an efficient tool that allow you to diversify away from the U.S. dollar and track the price movements for most major markets, including the: 
Australian dollar (or Aussie) British pound Canadian dollar (or Loonie) Euro Japanese yen Mexican peso Swedish krona Swiss franc (or Swissie) As currency ETFs grow in popularity you will see more and more different currencies being tracked as well as more exotic strategies being used.

The Risks
Some of the specific currency risks that come with currency ETFs include:
Political problems National debt Trade deficits Interest rate changes Government defaults Changing domestic and foreign interest rates Central banks or other government agencies selling the currency in large quantities Commodity price changes

It is important to recognize these risks and the effect they could have on the price of your currency ETF. If you fail to recognize a new political leader as a threat to your rising currency, you could be out a lot of money in a few short days.

The Bottom Line
As ETFs have grown in popularity, there has been an equal growth in the variety of options opening up for investors. These investment vehicles allow us to both hedge and speculate against changes in currency prices. However, like all investment there are risks and it is imperative to understand them before jumping in.

Why Interest Rates Matter For Forex Traders

The biggest influence that drives the foreign-exchange market is interest rate changes made by any of the eight global central banks. These changes are an indirect response to other economic indicators made throughout the month, and they possess the power to move the market immediately and with full force. Because surprise rate changes often make the biggest impact on traders, understanding how to predict and react to these volatile moves can lead to quicker responses and higher profit levels. (Read Get To Know The Major Central Banks for background on these financial institutions.)

Interest Rate Basics
Interest rates are crucial to day traders on the forex market for a fairly simple reason: the higher the rate of return, the more interest accrued on currency invested and the higher the profit. (Read A Primer On The Forex Market for background information.)

Of course, the risk in this strategy is currency fluctuation, which can dramatically offset any interest-bearing rewards. It is worth stating that while you may always want to buy currencies with higher interest (funding them with those of lower interest), it is not always a wise decision. If trading on the forex market were this easy, it would be highly lucrative for anyone armed with this knowledge. (Read more about this type of strategy in Currency Carry Trades Deliver.)

That isn't to say that interest rates are too confusing for the average day trader; just that they should be viewed with a wary eye, like any of the regular news releases. (Read Trading On News Releases to learn more.)

How Rates Are Calculated
Each bank's board of directors controls the monetary policy of its country and the short-term rate of interest at which banks can borrow from one another. The central banks will hike rates in order to curb inflation, and cut rates to encourage lending and inject money into the economy.

Typically, you can have a strong inkling of what the bank will decide by examining the most relevant economic indicators, namely: 

(Read more about the CPI and other signposts of economic health in our Economic Indicators tutorial.)

Predicting Central Bank Rates
Armed with data from these indicators, a trader can practically put together an estimate for the Fed's rate change. Typically, as these indicators improve, the economy is going well and rates will either need to be raised or, if the improvement is small, stay the same. On the same note, significant drops in these indicators can mean a rate cut in order to encourage borrowing.  (Read more about the factors that influence interest rate changes in Forces Behind Interest Rates.)

Outside of economic indicators, it is possible to predict a rate decision by:
Watching for major announcements Analyzing forecasts Major Announcements
Major announcements from central bank heads tend to play a vital role in interest rate moves, but are often overlooked in response to economic indicators. That doesn't mean they are to be ignored. Any time a board of directors from any of the eight central banks is scheduled to talk publicly, it will usually give an insight into how the bank views inflation.

For example, on July 16, 2008, Federal Reserve Chairman Ben Bernanke gave his semiannual monetary policy testimony before the House Committee. At a normal session, Bernanke reads a prepared statement about the U.S. dollar's value, as well as answers questions from committee members. At this session, he did the same. (Read more about the head of the Fed in Ben Bernanke: Background And Philosophy.)

Bernanke, in his statement and answers, was adamant that the U.S. dollar was in good shape and that the government was determined to stabilize it even though fears of a recession were influencing all other markets. 

The 10am session was widely followed by traders, and because it was positive, it was anticipated that the Federal Reserve would raise interest rates, which brought a short-term rally by the dollar in preparation for the next rate decision.

Figure 1: The EUR/USD declines in response to Fed's monetary policy testimony


The EUR/USD declined 44 points over the course of one hour (good for the U.S. dollar), which would result in a $440 profit for traders who acted on the announcement.

Forecast Analysis
The second useful way to predict interest rate decisions is through analyzing predictions. Because interest rates moves are usually well anticipated, brokerages, banks and professional traders will already have a consensus estimate as to what the rate is. 

Traders should take four or five of these forecasts (which should be very close numerically) and average them in order to gain a more accurate prediction.

What to Do When a Surprise Rate Occurs
No matter how good your research is or how many numbers you have crunched before a rate decision is made, central banks can throw a curve ball and knock all predictions out of the park with a surprise rate hike or cut.

When this happens, you should know which direction the market will move. If there is a rate hike, the currency will appreciate, which means that traders will be buying it. If there is a cut, traders will probably be selling it and buying currencies with higher interest rates. Once you have determined this: Act quickly! The market tends to move at lightning speeds when a surprise hits, because all traders vie to buy or sell (depending on hike or cut) ahead of the crowd, which can lead to a significant profit if done correctly. Be aware of a volatile trend reversal. A trader's perception tends to rule the market at the first release of data, but then logic comes into play and the trend will most likely continue on in the way it was going. The following example illustrates the above three steps in action.

In July 2008, the Bank of New Zealand had an interest rate of 8.25% - one of the highest of the central banks. The rate had been steady over the previous four months, as the NZD was a hot commodity for traders to purchase due to higher rates of return.

In July, against all predictions, the board of directors cut the rate at its monthly meeting to 8%. While the quarter-percentage drop seems small, forex traders took it as a sign of the bank's fear of inflation and immediately withdrew funds, or sold the currency and bought others - even if those others had lower interest rates.

Figure 2: The NZD/USD drops in response to a rate cut by the Bank of New Zealand   

The NZD/USD dropped from .7497 to .7414 - a total of 83 points, or pips, over the course of  five to 10 minutes. Those who had sold just one lot of the currency pair gained a net profit of $833 in a matter of minutes.

As quickly as the NZD/USD degenerated, it wasn't long before it got back on track with its current trend, which was upward. The reason it didn't continue free falling was that even though there was a rate cut, the NZD still had a higher interest rate (at 8%) than most other currencies. (Learn how commodities influence the New Zealand dollar in Commodity Prices And Currency Movements.)

As a side note, it is import to read through the actual central bank press release (after determining whether there has been a surprise rate change) to gain understanding of how the bank views future rate decisions. The data in the release will often induce a new trend in the currency after the short-term effects have taken place.

The Bottom Line
Following the news and analyzing the actions of central banks should be a high priority to forex traders because as they determine their region's monetary policy, currency exchange rates tend to move. As currency exchange rates move, traders have the ability to maximize profits - not just through interest accrual from carry trades, but also from actual fluctuations in the market. Thorough research analysis can help a trader avoid surprise rate moves and react to them properly when they inevitably happen.

How To Use Options To Make Earnings Predictions

The famous physicist Niels Bohr once said that "prediction is very difficult, especially about the future." While true for many aspects of quantum mechanics, traders and investors have several tools to help make accurate predictions in the financial markets. Oftentimes, these tools are derivative financial instruments that can help provide an aggregate picture of future market sentiment - tools like options. TUTORIAL: Options Basics

Such predictions can be particularly useful for active traders during earnings season when stock prices are most volatile. During these times, many traders and investors use options to either place bullish bets that lever their positions or hedge their existing positions against potential downside. In this article, we'll look at a simple three-step process for making effective earnings predictions using options.

Step 1: Analyze the Chain for Opportunities
The first step in analyzing options to make earnings predictions is to identify unusual activity and validate it using open interest and average volume data. The goal in this step is to find some specific options that may be telling for the future and create an initial list of targets for further analysis.

Finding these target options is a two-step process:

1. Look for the Unusual - Look for call or put options with current volume that is in excess of the average daily trading volume, particularly in near-term months.

2. Compare Open Interest - Make sure that the current volume exceeds the prior day's open interest, which indicates that today's activity represents new positions.

In Practice: Baidu
If we visit the Yahoo! Finance options analysis page for Baidu ADR (Nasdaq:BIDU), we may find an options chain like this:

Figure 1: An options analysis page for Baidu (BIDU).

Notice that the highlighted near-month call options are trading with volumes significantly higher than their open interest, which suggests that the options are being accumulated by traders and/or investors. We could also look at the current day's volume and compare it to the average daily volume to draw similar conclusions, but open interest is generally considered to be the most important to watch.

Step 2: Determine the Magnitude with Straddles
The second step in analyzing options to make earnings predictions is to determine the magnitude of the anticipated move. Since most options appreciate in value when volatility increases, implied volatility can tell us when the market is anticipating a big move to the upside or downside. Luckily, straddles are designed to take advantage of implied volatility, so we can use them to calculate an exact magnitude. (To learn more about volatility, see Option Volatility: Why Is It Important?)

Straddles represent an options strategy that involves purchasing call and put options with the same strike price and expiration date. By purchasing an at-the-money straddle, options traders are positioning themselves to profit from an increase in implied volatility. Therefore, looking at the price of the at-the-money straddle can tell us the magnitude of this implied volatility.

In Practice: Google 
If we purchase one at-the-money Google (Nasdaq:GOOG) call option for $1,200 per contract and one at-the-money GOOG put option for $1,670 per contract, then the cost of the at-the-money straddle will be $2,860 plus any commissions paid. With GOOG's underlying shares trading at $575.50 per share, this means that we can expect a move of approximately 5% or $2,860 / ($575.50 x 100).

The at-the-money straddle for GOOG will then look something like this:

Figure 2: An at-the-money straddle for Google.

Step 3: Decide on Hedging or Leveraging
The third and last step in analyzing options to make earnings predictions is to determine the direction of the move. While we only really have access to trading volume, we can use the bid and ask prices and trading data to make fairly accurate assumptions. Simply put, trades hitting the bid price are likely selling transactions, while those hitting the ask price are likely buying transactions. (For background on the bid-ask, see The Basics Of The Bid-Ask Spread.)

Traders and investors can also look at the option chain for various types of options strategies that are most likely to occur around earnings season. For example, similar volumes in put and call options in the same price and expiration dates may signal a straddle bet on volatility, while call options being sold could indicate long-term investors hedging their positions by selling calls – a bearish indicator.

TUTORIAL: Option Greeks

Traders and investors can find this information by looking at real-time trades through their brokerage platforms or by using one of many websites that provide real-time trading information - or by simply using delayed data from websites like Investopedia or Yahoo! Finance.

Bottom Line
While using options data to predict earnings moves may be part art and part science, many financial experts find it invaluable when predicting not only earnings moves, but also mergers and acquisitions and other anticipated price movements. Using this simple three-step process, you can make your own earnings predictions using options data:

1. Identify unusual options trades and validate them by comparing the current day's volume to the open interest and/or daily trading volume.

2. Determine the magnitude of the move higher by calculating the cost of an at-the-money straddle, which provides an idea of anticipated volatility.

3. Discover the direction of the trade by looking at the bid and ask prices, as well as analyzing the overall option chain to look for the potential types of trades being placed.

As you put this technique to use, you'll find that the future becomes much easier to predict. (For additional reading, also take a look at Option Strategies For A Down Market and Profit On Any Price Change With Long Straddles.)

by Justin Kuepper (Contact Author | Biography)

Justin Kuepper has many years of experience in the market as an active trader and a personal retirement accounts manager. He spent a few years independently building and managing financial portals before obtaining his current position with Accelerized New Media, owner of SECFilings.com, ExecutiveDisclosure.com and other popular financial portals. Kuepper continues to write on a freelance basis, covering both finance and technology topics.

What should I look for when choosing a forex trading platform?

A trading platform is a piece of software that acts as a conduit for information between a trader and a broker. A trading platform provides information such as quotes and charts, and includes an interface for entering orders to be executed by the broker. Trading platform software can be locally based, meaning it is installed on the trader's computer and can be used with Windows, Mac and Linux systems - different brokers offer different options in this respect. Alternatively, some brokers offer software that is web based. These platforms often run using Java, a dynamic web language. The advantage of web-based trading platforms is that they can be used by almost any computer with internet access. Trading platforms are often available free-of-charge, but some brokers allow traders to purchase platforms that have a higher functionality for a fee. Other brokers provide platforms with different levels of functionality for traders who are more active. Online Forex Trading
Online forex trading requires the same things from a trading platform that are required for trading any other type of security. The platform must act as a go-between for the retail forex broker and the forex trader. Platforms must also provide real-time and historical data to the trader and provide the him or her with access to all of the types of orders that need to be available to trade forex efficiently. (For more on this, read Place Forex Orders Properly.)
Third-party forex trading software is also often used, as many retail forex brokers' platforms have an application program interface (API), which allows traders to integrate third-party or even proprietary software into the platform.

Some factors to consider when looking for forex software are:
Is it free? If there is a nominal charge, what additional features are made available? What technical indicators are available in the charting component? Is the software Windows, Mac or internet (Java or HTML) based?  Can you trade from the charts? What is the order interface? What types of orders are available? Is historical data made available through the software? Does the platform allow for backtesting of strategies? Is the graphical user interface (GUI) pleasing to look at? Is the GUI conducive to monitoring a lot of information at once? Does the platform have an API that allows additional software or programming? Most forex brokers allow customers to open a demo account prior to funding a full account or mini account. Be sure to try out each broker's software during their trial periods to help determine which forex trading software is best.

What is an overnight position in the forex market?

Overnight positions represent all open long and short positions that a forex trader possesses as of 5:00pm EST, which is consider the end of the forex trading day. The new trading day is considered to occur right after 5:00pm EST. At that point in time, the trader's account either pays out or earns interest on each position depending on the two currencies' underlying interest rates, which is called rollover. For example, a trader has bought Canadian dollars and is selling U.S. dollars. If the Canadian interest rate is at 3.00% and the U.S. interest rate is at 2.50%, the trader will then receive a payment that equals 0.50% into his account.

The 5:00pm EST deadline is a very strict division. If a trader entered into a position on Monday at 4:59pm EST and closes it on the same Monday at 5:03pm EST, this will still be considered to be held overnight because it was held past 5:00pm EST and then is subject to rollover. Likewise, a position opened on Monday at 5:01 pm EST will not be considered an overnight position unless it remains open past the following Tuesday at 5:00pm EST.

Investing In IPO ETFs

An IPO ETF is an exchange-traded fund (ETF) that tracks initial public stock offerings (IPOs) of various companies. Many investors are attracted to IPO ETFs because they follow a large pool of initial public offerings, rather than exposing the investor to one or a few selected companies. This process serves two main purposes:

1. To create greater ease and familiarity with IPO investing.

2. To allow for a greater degree of diversification against the traditionally volatile and unpredictable IPO market.

TUTORIAL: Exchange-Traded Fund Investing

The Origins of IPO ETFs
The First Trust IPOX-100 (NYSE:FPX) was the first available IPO ETF, launching in early 2006. IPOX-100 follows the U.S. market for IPOs based on the IPOX-100 U.S. Index - like the soaring stock prices following Google's (Nasdaq:GOOG) initial public offering in 2004. (To learn more about IPOs, read our IPO Basics Tutorial.)

The creation of IPO ETFs is a direct result of the many successful IPOs that were offered between 2004 and 2005. The attraction to investing in a company at its IPO is that the investor can get in on the ground floor of a newer company with high-growth potential. In the past, investors have reaped large gains from successful IPOs, like the 2006 public offering of Chipotle Mexican Grill (NYSE:CMG), in which the stock price doubled on its first day as a public company. This vehicle came together at a time when the popularity of ETFs was soaring, and many investors distinctly remembered the investment losses realized by those who took the risk of investing in one-off IPO securities in the late 1990s. (For more, read The Murky Waters Of The IPO Market.)

IPOX: Not All-Inclusive
However, the IPOX Index has specific stipulations that would prohibit it from including IPOs like that of Chipotle. The IPOX Composite does not include companies with a more-than-50% gain on the first day of trading; this was put in place to avoid those securities that were thinly traded or overly volatile. Many IPOs are known for being bid up within the first weeks or months, only to drop back down to the original prices (or below) by the end of their first year on the market.

The index also excludes issuing companies for a variety of other reasons. Only United States corporations are accepted, and a number of investment vehicles are excluded, such as real estate investment trusts, close-ended funds, American depositary receipts from non-U.S. companies and American depositary receipts from foreign companies, as well as unit investment trusts and limited partners.

Companies that meet the requirements for the IPOX Composite also need to have a market capitalization of $50 million or more. Additionally, the initial public offering must provide at least 15% of total outstanding shares. Another way that the IPOX-100 Index Fund does not allow for enormous first-day gains (like that of Chipotle) to be included within the portfolio is through only investing in securities after they have already been on the market for a period of seven days. In addition to having to be publicly traded for this period, securities are removed from the fund on their 1,000th day of trading, which means that the index could suffer when a major performer is removed.

Rules of the Fund
Google is a good example of how this 1,000-day limit can hurt the index. Google was the top performing company in the IPOX-100 index when the IPOX-100 ETF was launched, but exceeded the 1,000-day limit in 2009. The 2008 decline in the performance of the IPO index suggests that IPO ETFs are especially vulnerable to economic declines. The IPO index that the IPOX-100 ETF follows struggles to perform during difficult economic periods. Also, the vulnerability to a single major company in the index illustrates the inherent danger in IPO ETFs.

Another timing-based rule the fund has in place is that companies are added or removed from the index on a quarterly basis, which could potentially limit the IPOX-100 ETF's returns. For example, if a company peaks during the quarter before the fund adds it, an ideal investing opportunity may be lost.

IPO ETFs Under Fire
Some critics charge that investing in an IPO ETF is risky. The risk of investing in companies that are going public is often associated with the "dotcom bubble" of start-up companies. In the late 1990s, many companies were valued unusually high, which created a public buzz around initial public offerings. However, many of these companies collapsed shortly after the IPO, and investors lost considerable amounts of money. In recent years, underwriters seem to have adjusted to more accurate pricing for IPOs, and thus the IPO index has been more stable and predictable. Another potential problem for IPO ETFs is that the IPO companies, usually relatively small corporations, will be more prone to failing in a down market than well-established companies will. (For more, see Market Crashes: The Dotcom Crash.)

The Bottom Line
It is yet to be seen whether this unique way of gaining exposure to IPOs will grow, but it is certainly unique. While there are some rules that make IPO ETFs risky and limited in returns(i.e. they invest and divest on a quarterly basis; they have a seven-day purchasing rule, and 1,000-day selling rule), the funds are becoming more reliable and stable as the market becomes more comfortable with them. (To learn more about ETFs, see Introduction To Exchange-Traded Funds and Exchange Traded Funds Special Feature.)

The Morning Forex Fake-Out Trade

Many traders are aware that when a market opens there are often whipsaw-like actions (or what some may call "fake outs") before a stronger trend emerges. With currencies the market is open 24 hours during the week, therefore many traders don't see the forex market as having an "opening" session. Yet this is not true. Banks in different parts of the world open for business, and with that, a larger volume enters the market. Therefore currencies are not immune from the morning "fake out." As stop levels are cleared on either side of the open price, a stronger trend will often emerge. This trend may not last, but by knowing there is often a fake out followed by a stronger move, traders can position themselves for taking advantage if they implement the proper strategy. (For related reading, also take a look at How To Become A Successful Forex Trader.)

TUTORIAL: Forex Currencies

Opens to Watch
Not every currency's open is worth paying attention to. Ideally, traders will want to watch the most liquid currency pairs, and also look for pairs that see a large increase in volume/participants as the country/zone opens.

Because of how major market's business days overlap with one another, the European open is an ideal candidate for trading the open. One main reason for this is that pairs such as the GBP/USD or EUR/USD are not as heavily traded prior to the open, but when Germany opens followed one hour later by London at 3am EST (please be aware of impacts of daylight savings time) volume ensues. The yen is traded heavily in the Tokyo session but as London opens there is an overlap with the Tokyo session resulting in increased volatility for the GBP/JPY and EUR/JPY. The CHF/USD is also worth watching.

Therefore we have several pairs to watch starting at about 1:30 (pre-market open) till about 4am EST (one or two hours after the markets open) to watch for a set-up. Since not all signals will occur at the same time, several pairs can be traded.

The Set-Up
Prior to a major market opening, forex pairs will often move within relatively small ranges. This is not always the case though. There may be a lot of movement prior to the European open, on days such as this the set-up will be harder to see (and may not exist), therefore caution is warranted on using this strategy on such days. The set-up should be watched for on a 15 minute chart.

1. We ideally want a calm pre-market, or one that has a definable pre-market range. This range will be marked on our chart pre-market and then we will watch for the European open to begin.

2. A breakout of that range is likely to occur. We do nothing as this is quite possibly a false breakout. Ideally we want this breakout to be small, 10-30 pips (or no more than one third of the daily average range).

3. We watch for an engulfing candle pattern (or any candle which shows a strong movement in the opposite direction over one or two bars) in the opposite direction of the original breakout (for example, if the range breakout was down, we watch for a bullish engulfing pattern).

4. We make a trade in the direction of the engulfing pattern.

5. A stop is placed just below the low (high) of the bullish (bearish) engulfing pattern.

6. Profit target(s) is based on average movement during the early European session or the daily average range (trades will generally take longer to exit if using the larger daily figure).

7. Similar to a trailing stop, a new engulfing pattern in the opposite direction of our trade can be used as an optional exit. (For more on stops, see Trailing Stop/Stop-Loss Combo Leads To Winning Trades.)

Potential Issues
Before showing examples of the trades, there are several things traders should be aware of. No strategy is perfect, therefore the best outcome is to aim to maximize the good trades, and minimize the losing ones (because they will occur). Here are few guidelines which can be added to the system to aid in its effectiveness:

Not all signals will provide an entry and exit within the first couple of hours (see figure one). Occasionally signals will develop later in the session, and the exit may come much later. In this case a limit order can be placed for the exit, or a trailing stop used. Look for a false breakout against a strong longer term trend. Trades that go with a longer term trend have a higher chance of success. Trade with the larger trend! Trading multiple lots is effective, as it will allow for multiple exits. For example one lot can be exited when an engulfing pattern in the opposite direction of the trade occurs, and another exit could be placed at a rate where daily average movements indicate the trade could run out of steam. If the trade continues to run in the trader's favor, and they are still holding a position, it should be exited before the close of the European session or the U.S. session if trading in a U.S. pair. If multiple entries and exits are occurring (numerous engulfing patterns in both directions) do not make more than two trades in a given direction. If a legitimate breakout has not occurred, save the system for another day. If an initial breakout has momentum and runs more than 40 pips outside the pre-open range, do not make a trade in the opposite direction of this momentum even if an engulfing pattern occurs. Engulfing patterns are allowed to be off by a couple pips, as long as it still shows there has been a sharp change in sentiment and direction.

TUTORIAL: Forex Trading Rules

Trade Example
Figure 1 shows a trade in the EUR/USD. A breakout lower occurred; a signal was given to enter by a bullish engulfing pattern. The trader enters long and the pair proceeds to move in her favor. The first potential exit occurs at the first bearish engulfing pattern. With an entry at 1.4074, and an exit at 1.4120 (top and bottom of engulfing bars respectively) this provides a nice gain. Potential exit number 2 is at a rate where daily averages indicate the pair may run out of steam. At this time the daily average movement was 120 pips/day. Therefore this target is placed 100 pips (always use less as the target is more likely to be hit) away from the low of the day thus far. If other signals have not occurred or the trader has a remaining portion of the position it should be exited before the end of the U.S. session. Stop is at 1.4055.

Figure 1. EUR/USD 15 Minute Chart

Figure 2 shows a trade in the EUR/JPY and has a few differences. Our entry is similar except the candle is not an engulfing pattern, yet over two bars we see a strong upward move, erasing prior losses. We enter at 117.70. Stop is placed at 114.50. Trade moves in our direction but a strong downward move (exit 1) gets us out rather quickly with a 10 pip gain. If trading multiple lots, and the stop is not in danger the rest of the position could be exited at the close of the European session around noon EST. At this time, the daily average move was approximately 110 pips. Therefore another target could have been 90 pips above the low at 114.50, providing a target of 115.40. The market did reach this point but not till much later in the day – an order could have been placed here, and stop loss could have been moved up to Potential Exit #1.

Conclusion
The forex markets are open 24 hours a day, but there are still times of the day when more participants enter the markets, and these opening sessions can provide great opportunities. By watching for quick changes in direction a trader can join in on a potentially emerging trend, often with a small stop compared to the potential. No strategy is perfect, but by watching for false breakouts, reversals and using multiple exits, the trader has the potential to capture a large portion of the daily average movement.