IQP Final Report on Trading, Investment, and Portfolio Management PDF
Document Details
Worcester Polytechnic Institute
2017
Erik Paulson, Vishal K. Rathi, Htay Aung Win
Tags
Summary
This report details an interactive qualifying project (IQP) focused on trading, investment, and portfolio management in the forex market, specifically the EUR/USD pair. The authors, Erik Paulson, Vishal K. Rathi and Htay Aung Win, discuss essential market knowledge, trading systems, and the performance of their individual strategies. The report concludes with recommendations for future projects.
Full Transcript
Trading, Investment and Portfolio Management BY: ERIK PAULSON VISHAL K. RATHI HTAY AUNG WIN Submitted: February 2017...
Trading, Investment and Portfolio Management BY: ERIK PAULSON VISHAL K. RATHI HTAY AUNG WIN Submitted: February 2017 Approved by: PROFESSOR HOSSEIN HAKIM PROFESSOR MICHAEL J. RADZICKI An Interactive Qualifying Project Report submitted to the faculty of WORCESTER POLYTECHNIC INSTITUTE in partial fulfillment of the requirements for the degree of Bachelor of Science in Electrical and Computer Engineering. Abstract The goal of this project was to become familiarized with the forex market and develop profitable trading systems. The first few sections of the report will cover the background knowledge about the forex market essential to trade. The background section covers the important forex terminologies, several market analysis techniques, and different forex trading platforms. After the background section, the report talks about the methodology to develop trading systems. Next, the report goes into details of each member’s trading system as well as the performance of each system along with the trades executed. Finally, the report ends with a conclusion section which talks about the things learned in this project and few recommendations for future projects. I Acknowledgements We would like to thank the following people and institution: Our student partner, Rohit R. Raney, from Northeastern University who is currently pursuing a Bachelor of Science degree in Management Sciences. He helped us when he was a part of our team in A term 2016. We would like to thank our advisors for this project, Professor Hossein Hakim and Professor Michael J. Radzicki. They provided us with much guidance and advice, and our project would not have been what it is without them. Finally, we would like to thank Worcester Polytechnic Institute for making this IQP project possible. II Table of Contents Abstract.......................................................................................................................................................... I Acknowledgements....................................................................................................................................... II List of Figures................................................................................................................................................ V 1. Introduction.............................................................................................................................................. 1 Project Description.................................................................................................................................... 2 2. Background............................................................................................................................................... 3 2.1 Financial Markets and Asset Classes................................................................................................... 3 2.1.1 Stocks........................................................................................................................................... 3 2.1.2 Bonds........................................................................................................................................... 4 2.1.3 Cash Equivalents.......................................................................................................................... 4 2.1.4 Commodities................................................................................................................................ 5 2.1.5 Currencies.................................................................................................................................... 5 2.1.6 Real Estate.................................................................................................................................... 6 2.2 The Forex Market................................................................................................................................ 7 2.2.1 Why do we decide to trade Forex?.............................................................................................. 8 2.2.2 Why do we mainly trade EUR/USD?............................................................................................ 8 2.3 Forex Terminology.............................................................................................................................. 9 2.4 Order Types....................................................................................................................................... 14 2.4.1 Market order.............................................................................................................................. 14 2.4.2 Limit order.................................................................................................................................. 14 2.4.3 Stop Order.................................................................................................................................. 14 2.5 Market Behavior............................................................................................................................... 15 2.6 Fundamental Analysis....................................................................................................................... 19 2.6.1 US Employment Report.............................................................................................................. 19 2.6.2 Gross Domestic Product............................................................................................................. 20 2.6.3 Retail Sales................................................................................................................................. 21 2.6.4 Trade Balance............................................................................................................................. 21 2.6.5 Key terms in fundamental analysis............................................................................................ 23 2.6.6 Using news to trade the forex market....................................................................................... 26 2.6.7 Analysis of Past News Releases Effects on the Market.............................................................. 27 2.7 Technical Analysis............................................................................................................................. 30 III 2.7.1 Technical Indicators................................................................................................................... 30 2.8 US Dollar Index (USDX)..................................................................................................................... 45 2.9 Trading Platforms.............................................................................................................................. 47 2.9.1 TradeStation vs. MetaTrader vs. fxTrade................................................................................... 47 2.10 Risk Management........................................................................................................................... 50 2.11 Money Management...................................................................................................................... 51 3. Methodology........................................................................................................................................... 52 3.1 Individual Trading Strategies............................................................................................................. 54 3.1.1 Erik’s Trading Strategy............................................................................................................... 54 3.1.2 Vishal’s Trading Strategy............................................................................................................ 57 3.1.3 Htay’s Trading Strategy.............................................................................................................. 64 4. Conclusion............................................................................................................................................... 72 4.1 Recommendation for further research............................................................................................. 74 References.................................................................................................................................................. 76 Appendices.................................................................................................................................................. 79 Appendix A.............................................................................................................................................. 79 Vishal’s Trades.................................................................................................................................... 79 Erik’s Trades........................................................................................................................................ 86 Htay’s Trades....................................................................................................................................... 87 Appendix B.............................................................................................................................................. 90 IV List of Figures Figure 1 FOREX trading hours................................................................................................................. 7 Figure 2 FOREX line chart............................................................................................................................ 10 Figure 3 FOREX bar chart............................................................................................................................ 10 Figure 4 FOREX candlestick chart................................................................................................................ 11 Figure 5 Upward trending FOREX chart example....................................................................................... 15 Figure 6 Downward trending FOREX chart example................................................................................... 16 Figure 7 FOREX Volatile market example................................................................................................... 16 Figure 8 FOREX sideways market example................................................................................................. 17 Figure 9 Using support and resistance lines to trade sideways market..................................................... 18 Figure 10 EUR/USD after interest rates announcement............................................................................. 27 Figure 11 EUR/USD after nonfarm payroll report....................................................................................... 28 Figure 12 EUR/USD after Boston FED president speech............................................................................. 29 Figure 13 Fast and slow simple moving averages (SMA)..................................................................... 31 Figure 14 Exponential and simple moving averages........................................................................... 33 Figure 15 Example chart with MACD indicator................................................................................... 35 Figure 16 Example chart of center line crossover............................................................................... 36 Figure 17 Example chart of signal line crossover................................................................................ 37 Figure 18 Example chart of overbought/oversold conditions............................................................. 38 Figure 19 Example chart with RSI indicator......................................................................................... 40 Figure 20 Example of bullish and bearish divergence using RSI.......................................................... 41 Figure 21 Example using Bollinger bands............................................................................................ 43 Figure 22 Weights of each currency in the US dollar index........................................................................ 45 Figure 23 Example USDX chart.................................................................................................................... 46 Figure 24 EUR/USD chart............................................................................................................................ 46 Figure 25 Overall account growth and equity growth................................................................................ 55 Figure 26 Example trade 1.......................................................................................................................... 56 Figure 27 Example trade 2.......................................................................................................................... 56 Figure 28 Support lines on the market data chart...................................................................................... 58 Figure 29 Resistance lines on the market data chart.................................................................................. 59 Figure 30 Example short term buy trades using the trading strategy........................................................ 60 Figure 31 Short trades during the March 2016 ECB interest rates decision............................................... 61 Figure 32 Monthly performance 1.............................................................................................................. 62 Figure 33 Monthly performance 2.............................................................................................................. 62 Figure 34 Overall account and equity growth............................................................................................ 63 Figure 35 Average time for all trades executed.......................................................................................... 63 Figure 36 Example trade which lasted only 11 minutes with 11 pip profit................................................ 67 Figure 37 EUR/USD 15 minute chart showing clear resistance and support levels.................................... 68 Figure 38 EUR/USD 30 minute chart showing clear resistance and support levels.................................... 68 Figure 39 1-hour EUR/USD chart displaying the resistance/support, MACD, SMAs, market entries, exits and trend line.............................................................................................................................................. 69 Figure 40 4-hour EUR/USD chart displaying resistance and support level and indicators......................... 69 Figure 41 Overall account growth and equity growth of second demo account....................................... 70 Figure 42 depicting the total profit on third demo account....................................................................... 71 V VI 1. Introduction Trading and Investments have a long history. Barter System is a very good example of an old system which involved trading. This system has been used for centuries and long before the money was invented. People traded services and goods for other services and goods in return. In ancient times, this system involved people in the same area trading goods amongst themselves. In the modern world which is technologically advanced, the original barter system has vanished but the concept of the barter system still exists. People have discovered newer ways of trading but the idea is still the same. Trading and Investments are mostly done through the internet these days. In addition to having such a long history, trading and investing are useful skills for individuals that would like to save and accumulate wealth. Different reasons to increase the savings can be retirement plans, college funds for children, traveling, etc. The social security Act established in 1935 in the United States currently provides financial safety to Americans after their retirement but this act can be removed anytime in the future. In fact, it is predicted that it might be repealed in the near future because the social security administration is expected to run out of money. In this scenario, people will want to ensure the security of their finances for their retirement. One of the best ways to do this is to trade and invest money in different financial assets, including stocks, bonds, options, futures, foreign exchange currencies (forex) or commodities. While there are some similarities between trading in the stock market and trading forex, they are sufficiently different such that strategies must be developed to be specialized for one or the other. This project will focus on trading in the context of the forex market, in particular trading of the EUR/USD currency pair due to the fact that it generally has the largest average movement during a time period which is most convenient for those living in the United States. First, some general but important definitions related to finance will be discussed. Then an elaboration on the choice of forex for the focus of this project will take place, followed by important terminology particular to forex. Next, the types of trading orders will be discussed and then market behavior guidelines and the methods used to analyze the market, i.e. fundamental analysis and technical analysis. Finally, the individual trading strategies will be discussed for the members of this project. 1 Project Description The goal of this project will be to develop a manual trading strategy that generates profitable trades in the Forex market. The first step to achieving this goal will be to understand the different financial markets especially the Forex market. Therefore, the group will make efforts to get the background knowledge in order to achieve the project goals. Once, the group becomes familiarized with the Forex market and the terminologies associated, demo trading accounts will be set up on MetaTrader and FXTrade trading platform to practice trading. Each member of the group will develop a personal trading strategy which they will use to make trades. The goal will be to learn from each and every trade made in order to become a better trader. This report will start off with the subject knowledge first and then will go into details of the trading strategies developed and the outcomes which followed. 2 2. Background 2.1 Financial Markets and Asset Classes Asset classes may be defined as a group of securities which behave similarly and are subject to the same laws. There are three main asset classes, namely: equities (or stocks), fixed income (or bonds), and cash equivalents (or money market instruments). Other than these main three, some professionals consider other things as asset classes such as currencies, commodities, real estate, and others. 2.1.1 Stocks Stocks, equities, or shares are essentially different ways of representing the same thing, that is, partial ownership of a company. When one owns stock in a company they are known as a shareholder (usually quite small), and the more stock one has in a given company, the more of the company one owns. This is simply a relatively efficient way of raising capital for the company. Being a shareholder provides several benefits including (but certainly not limited to) a share of the company’s earnings, and this is what enables traders to make money. Most stocks are traded on exchanges which have historically been physical locations, but today, exchanges are mostly implemented electronically in computer networks. The stock market is a mechanism to simplify the linking of buyers and sellers. Some examples of exchanges are the NYSE, and the NASDAQ which are the two largest exchanges in the US. In particular, the NYSE is regarded as the most prestigious exchange, wherein a large number of trades are made in person on a trading floor. In contrast, the NASDAQ trades through electronic networks, as previously mentioned. Stock prices change continually as a result of market driving forces which often, cannot be predicted. But in general, they change because of supply and demand, that is, when a stock is in high demand, the price of the stock moves up. Conversely, when the stock is in low demand, i.e. more people want to sell than buy the stock, then the price falls. The price movement of a particular stock can be thought of as an indicator as to what the investors believe the company is worth, which is indirectly a reflection of its value and expected growth. 3 2.1.2 Bonds Bonds exist as a result of large organizations’ need to borrow money. But typically banks cannot provide such large sums of lending money, so they sell bonds to a public market. This way the buyer of the bond is essentially lending money to the seller of the bond, with the understanding that the money will be paid back by a certain date (maturity) with interest payments at a certain rate (called coupons). Bonds do not have the possibility of making large percent returns of money as stocks do, but they are very low-risk securities known as fixed income securities since the buyer knows how much money he will make if he holds it until the maturity date - that is - the date by which the issuer has to repay the amount borrowed. By the definition of a bond, it is debt, thus buying it makes one a creditor, rather than a shareholder as in stocks. This contributes to the reduced risk because, in the event of bankruptcy, the bondholder has a higher claim to the assets of the company and so they will be paid before a shareholder. While bonds often appear less attractive than stocks (due to their low returns), they have some very important uses. Clearly, for a retiree, the risk associated with stocks may be undesirable and so their wealth should shift into bonds. Going to university is another example of a period of time where financial risk must be reduced and investing in bonds would be appropriate. 2.1.3 Cash Equivalents Cash equivalents are investments securities which have high credit quality and highly liquid. These are another of the three main asset classes and can serve as an indicator of the health of a company’s financial system. A particular company's’ ability to generate cash and cash equivalents can help analysts estimate whether it is a good investment choice. This is because it reflects the company’s ability to settle its payments in a short amount of time. The five types of cash equivalents are Treasury bills, commercial paper, marketable securities, money market funds and short-term government bonds. Treasury Bills are securities issued by the U.S. Department of Treasury. When these are issued, it is equivalent to saying that the company is lending money to the government. These bills can be provided in values of $1,000 to $5 million. The difference between the purchase price and the redemption value becomes the yield. 4 Commercial papers are used by large companies to settle short term debts such as the company's’ payroll. It is a promise to pay the face amount by the specified maturity date on the note. Marketable securities are assets and instruments that are easily converted into cash, making them extremely liquid. These are liquid because maturities often occur within one or fewer years. Additionally, these are not affected significantly by the rate at which they are traded. Money market funds are similar to checking accounts with higher interest rates from the deposited money. They provide organizations with efficacious tools to manage their money given that they are typically more stable in relation to mutual funds as an example. Also, its share price stays at a fixed $1 per share. Short-term government bonds are provided as funds for government projects by the government. They make use of the country’s domestic currency when issued and investors must consider political, inflation, and interest rate risks when investing in these types of bonds. 2.1.4 Commodities Commodities consist of all of the basic goods that are used in commerce. This can include fundamental food items such as cocoa and coffee, or metals used in industry and precious metals. The same principles of buying low and selling high with any investment, apply to commodities as well. However, commodities are leveraged significantly and trade by contract sizes instead of shares and this makes investing in gold, grains, oil, etc. much easier. 2.1.5 Currencies Currencies are accepted forms of money used for making exchanges within the respective country of the currency - and the asset class of focus for this report. For example, the official currency of the United States of America is the US Dollar (USD), that of Great Britain is the British Pound (GBP), and for the European Union - the Euro (EUR). There are some digital currencies such as bitcoin, dogecoin, and others, however, the exchange rates of these currencies can vary significantly in short amounts of time. Currencies are traded on the Foreign Exchange Market (FOREX market) where they are always traded in pairs by the ratio of the two currencies’ value. For example, the EUR/USD currency pair might be traded 5 at 1.10 which means that the Euro is currently valued as being worth 1.10 US Dollars. The value of currencies can vary by large amounts in relatively short periods of time based on any number of factors. This, combined with very high volume, liquidity, and leverage, makes the FOREX market an attractive option for traders. Exchange rates of currencies may be floating or fixed; floating if the value of the currency changes according to FOREX market changes, and fixed if the value is based on a different currency like gold or a currency basket. The value of EUR/USD for example is floating since both the Euro and US Dollar are floating currencies. There are as many tradeable currency pairs as there are currencies in the world and they are separated into major currency pairs and minor ones. The major currency pairs are those that trade the most volume against the US Dollar which are EUR/USD, GBP/USD, USD/JPY, USD/CHF, AUD/USD, and USD/CAD. The minor currency pairs are those which are not traded with the US Dollar - the higher volume ones consist of individual currencies from the major pairs, such as EUR/GBP, GBP/JPY, EUR/CHF. Additionally, there are exotic pairs which are not as liquid and possess much larger spreads such as the USD/HKD. 2.1.6 Real Estate Real estate is property consisting of land and the structures, resources, vegetation, etc. that are on it. It may be grouped into three categories. The first category, residential real estate can include undeveloped land, houses, condos, and townhouses. The second category, commercial real estate, can include office buildings, warehouses, or retail stores. The third category, industrial real estate are factories, mines, or farms. Real estate must be differentiated between ‘personal property’ and ‘real property’. Personal Property consists of movable assets, unlike real property which is fixed to a location permanently. Personal property includes intangible items such as financial investments but also physical items such as clothes, vehicles, electronics, and washing machines. Real property, on the other hand, is real estate that is any property which is physically attached to a piece of land. It is also important to note that it is specifically land which has been modified through lawful human actions. To clarify, renters and leaseholders, for example, do not own real estate since they only own the rights to occupy land or buildings. 6 The most common type of real estate investments is becoming a homeowner. However, since the prices of purchasing a home are often beyond what someone can afford, they borrow money in the form of a mortgage. Mortgages can be either fixed rate or variable rate - in the former case, they generally have higher interest rates than their variable rate counterpart, making them more expensive in the short term. This is because they are protected from substantial future scheduled payment increases. Variable rate mortgages simply do not have this protection. 2.2 The Forex Market The foreign exchange market, or more commonly known as the Forex market, is a global decentralized market for the trading of currencies. This is the largest, most liquid financial market in the world with an average daily trading volume exceeding over $5.3 trillion. Forex trading allows the trader to buy and sell currencies at current or determined prices. The trading process is conducted electronically over-the- counter (OTC), which means that all transactions occur via the internet. The market is open 24 hours a day, five and a half days a week and currencies are traded worldwide in the major financial centers of London, New York, Tokyo, Zurich, Frankfurt, Hong Kong, Singapore, Paris, and Sydney - across almost every time zone. This means even though the US forex market opens from 8 AM to 5 PM only, we can still trade forex on another market which is open. For example, when the trading session in the U.S. ends, the forex market begins in Tokyo and Hong Kong. Figure 1 FOREX trading hours The foreign exchange market does not determine the relative values different currencies but set the current market price of the value of one currency as demanded against another. That price is mainly determined by supply and demand. A currency's value fluctuates as its supply and demand fluctuates, just like anything else. An increase in supply or a decrease in demand for a currency can cause the value of that currency to fall. A decrease in the supply or an increase in demand for a currency can cause the value of that currency to rise. Many factors influence the price of the currencies, including current interest 7 rates, economic performance, current political affairs (both locally and internationally), as well as the perception of the future performance of one currency against another. For example, if the trader thinks the Eurozone is going to break apart, he can sell the euro and buy the dollar. If he thinks the price of oil is going down and based on historical correlation patterns, this phenomenon will affect the price of Euro, he might decide to buy Euro and sell USD. 2.2.1 Why do we decide to trade Forex? There are many reasons why we chose to trade on forex market instead of other financial markets such as stocks. One of the main reason is the liquidity of the market. Unlike many other financial markets, where it can be difficult to sell short, there are no limitations on shorting currencies subject to available liquidity. Traders can buy or short currencies whenever they want to and the order will be fulfilled instantly. Also, there is not much complexity in the process of making an order, everything can be done simply via the internet with few mouse clicks. The other factor that we consider forex market over other financial markets is that we can trade forex 24- hours a day. At the beginning of IQP, we agreed that our main goal is not just to fulfill the degree requirement but to consider part-time or possible full-time trading in future after we graduated and Forex suits this goal. Moreover, the deep liquidity available in the forex market allows the trader to trade forex with a considerable leverage (up to 50:1). This can allow the trader to trade even the smallest moves in the market and make money out of it. However, the leverage is a double-edge sword, as it can significantly increase the profit as well as the loss. 2.2.2 Why do we mainly trade EUR/USD? There are several currency pairs in the forex market. Some common currency pairs are EUR/USD (euro to USD), GBP/USD (Great Britain pound to USD), USD/JPY (Japanese Yen), and AUDUSD (Australian dollar / USD) and so on. There are several reasons why EUR/USD is our main focus currency pair. Firstly, EUR/USD is the world’s most liquid currency pair, which makes your order to be executed in no time. In addition to this, EUR/USD offers very low bid-ask spreads and also the non-stop availability of economic and financial data allow traders to constant re-evaluate their market positions and perception about the future movement of the market price. Since the market is large and the traders are constantly re- examining their positions in their market, this provides relatively high levels of volatility which can lead to 8 opportunities to make profit. The other currency pairs do have certain levels of volatility however, not many opportunities can occur due to there are not many people trading them as EUR/USD. 2.3 Forex Terminology Bid Price The bid price is the best possible price at which the trader can buy the instrument being traded at the current time. In the forex market, the bid price is the highest price the broker will pay to purchase the instrument off the trader. Ask Price The ask price is the best possible price at which the trader can sell the instrument being traded at the current time. In the forex market, the ask price is the lowest price that the broker will sell the instrument to the trader. Base Currency Base currency is usually the currency of the home market in which a trader is buying or selling. Currency Pair “Currency pair is the exchange rate relationship between two currencies, where on currency is expressed in terms of the other”. For example, USD-GBP (US dollar against British Pound) is a currency pair. Forex Line Chart “A line chart draws a line from one closing price to the next closing price”. Here is an example of a line chart: 9 Figure 2 FOREX line chart Forex Bar Chart “A bar chart shows the opening and closing prices as well as the highs and lows. The vertical bar indicates the currency pair’s trading range as a whole. The bottom of the vertical bar indicates the lowest traded price for that time period and the top of the vertical bar indicates the highest traded price for that time period”. Here is an example of a bar chart: Figure 3 FOREX bar chart Candlesticks Chart Candlestick chart is similar to a bar chart but is graphically richer. Candlestick charts indicate the high-to- low range with a vertical line but the body in the middle indicates the range between the opening and closing prices. Usually, the middle body is either red or green in color. For the red bar, the bottom of 10 the block is the opening price and the top of the block is the closing price. For the green bar, the positions are reversed. The way the color of the candlestick bar is determined is as follows: If the price closed higher than it opened, the candlestick would be green. If the price closed lower than it opened, the candlestick would be red. For trading, the candlestick chart is the most widely used because of various reasons. Candlesticks are easy to interpret and use. They are particularly very useful at identifying market turning points. An example of the candlestick chart is as follows: Figure 4 FOREX candlestick chart Market Entry Market entry is when a trader decides to open a position either by buying or selling a currency pair in forex. Market Exit Market exit is when a trader decides to close the open position for either a profit or loss. Long Position Long position is characterized by buying a financial instrument such as a currency pair with the hope that the price will appreciate in order to generate a profit. 11 Short Position Short position is characterized by selling a financial instrument such as the currency pair with the hope that the price will go down in order to generate a profit. Overbought “Overbought situation arises when the price movement has risen 150% faster or stronger than normal, rising too far in response to net buying. A price movement that becomes overbought is expected to soon make a contrarian move. In other words, the price of the currency pair is expected to soon fall”. Oversold “Oversold situation arises when the price movement has fallen 150% faster or stronger than normal, declining too far in response to net selling. A price movement that becomes oversold is expected to soon make a contrarian move. In other words, the price of the currency pair is expected to soon rise”. Pip Pip measures the amount of change in the exchange rate for a currency pair. It stands for “Price Interest Point”. For currency pairs displayed to four decimal places, one pip is equal to 0.0001. Yen-based currency pairs are an exception and are displayed to only 2 decimal places (0.01). Some financial brokers have also started offering fractional pips which is called a pipette. It provides an extra digit of precision for certain currency pairs. Spread Spread is the difference between the bid and ask price of the currency pair. Stop buy Stop buy is a buy order for a currency pair that is above the current market or current price and it becomes a market order when the specified price is reached. Stop-buys are used by traders to establish positions in markets which they perceive to be rising in value. 12 Stop loss Stop loss is the price specified by the trader at which he closes his position (long or short position) to exit the market in order to ensure that in the situation of a loss (the trade went against the trader thought process), the trader is able to minimize losses. Stop loss is a very important tool that comes in very handy because it helps you to cut your losses. Slippage Slippage is the difference between the expected price of a trade and the price, the trade actually executes at. Usually, slippage occurs during periods of higher volatility and when market orders are executed. In the forex market, slippage mostly occurs when a limit order or stop loss occurs at a worse rate than originally set in the order. The main reason of slippage is the volatility in the market which occurs during news events and the volatility makes it impossible to execute an order at a specific price. Therefore, forex brokers execute the trade at the next best price. 13 2.4 Order Types 2.4.1 Market order A market order is the most basic type of trade order. Through a market order, the trader can put open a short or long position at the price which is currently available. A market order is executed immediately. The advantage that a trader gets through a market order is that the trader is guaranteed to get the trade filled. However, the trader does not get a guarantee of price through a market order. A market order to go long is filled at the ask price while the market order to go short is filled at the bid price. 2.4.2 Limit order A limit order is an order to go long or short at a specified price or better. A buy limit order can only be executed at the specified limit price or lower. While a sell limit order can only be executed at the specified limit price or higher. Limit order allows the trader to open a position in the market the desired price. The primary advantage of a limit order is that it prevents negative slippage. However, a limit order doesn’t guarantee a fill because if the price of the currency pair moves away from the trader’s specified price, the order is never placed. Limit orders allow traders to enter and exit trades with precision but it is important to execute them correctly and be on the correct side of the market. 2.4.3 Stop Order A stop order is an order to buy or to sell a security e.g. a currency pair when the security’s price reaches or passes a specified level. At that time, the stop order becomes a market order and the broker obtains the best possible price. A stop order to buy must be at the price above the current price and the stop order to sell must have a specified price below the current market price. 14 2.5 Market Behavior The behavior of the forex market can be trending, sideways and volatile. A trending market is one in which price is generally moving in one direction. Trends are usually noted by higher highs and higher lows in an uptrend and lower highs and lower lows in a downtrend. An example of an upward trend market and downward trend market is shown below: Figure 5 Upward trending FOREX chart example 15 Figure 6 Downward trending FOREX chart example A volatile market is one in which there are sharp jumps in the price within a short period of time. An example of the volatile market is shown below: Figure 7 FOREX Volatile market example 16 Sideways market is one in which there are small and insignificant price movements in both directions. This type of market is directionless. An example of such market is shown below: Figure 8 FOREX sideways market example All of the above market types can be traded successfully with different trading strategies. For trending markets, Trend Following trading system can be used. For volatile markets, the Volatility Expansion trading system can be used. For the sideways market, Support and Resistance trading system can be used. The first step to trading in a trending market is to find the trend. One of the ways to find a trend is to look at the highs and lows. If the chart has higher highs and higher lows then it means that an upward trend has formed. If the trend continues then new highs will continue to be created. Once a trend is identified, traders can enter into the market through the use of a breakout which is putting an entry order. If the price breaks the entry order set value then an order will be entered into the market. By using this technique, the trader can make sure that they never enter the marker if the price never breaks above the previous high. To exit out of the marker, traders can utilize stop order to make it a profitable trade. Trading in the volatile markets can be difficult. There will be sudden high jumps creating a high-pressure situation for the trader. Volatility expansion strategy involves grabbing quick profits in the market. A 17 trader who uses this strategy must have a set range that the price of the currency pair must exceed in a given direction before a long or short order is entered. This strategy is used to enter the market quickly during a sudden price jump and exit out with profits. Trading in volatile markets can be very risky and is not for someone who can’t take big losses. The first step to trading in a sideways market is to identify that the currency pairs are moving sideways. The next step is to locate support and resistance which are used to describe price levels where prices have bounced off in the past. So, if the price bounced off a low or bounce off a high then that low and high price can be considered support or resistance. Here is the example with support and resistance lines: Figure 9 Using support and resistance lines to trade sideways market The support and resistance lines caused the price to bounce off them in the past so it is assumed that they may cause the price to bounce again in the future. So, the trader should buy when the price is approaching a line from above and sell when the price is approaching a line from below. The exit strategy should have a positive risk: reward ratio which means that the profit target should be further than where the stop loss is set. 18 2.6 Fundamental Analysis Fundamental analysis in forex is a type of market analysis which involves studying of the economic situation of countries to trade currencies more effectively. It gives information on how the big political and economic events influence currency market. Figures and statements given in speeches by important politicians and economists are known among the traders as economic announcements that have a great impact on currency market moves. Traders use this information to determine the changes in the market. The Economic calendar is created by economists where they predict different economic figures and values according to previous months. Bloomberg maintains an economic calendar where they maintain all the economic reports. Some of the information which is included in each report is date, time, currency, data released, and actual, forecast and previous data. Some of the important economic data which can affect the market significantly are: Gross Domestic Product Employment Data Jobless rate Retail Sales ECB minutes FED minutes 2.6.1 US Employment Report Date of release: First Friday of the every month Time of release: 08:30 AM EST Released on the first Friday of every month by the Bureau of Labor, the U.S nonfarm payroll report is one of the most highly anticipated economic releases for the currency traders. This report not only carries extreme daily volatility but can also hurt a long-term currency trader. The employment data in this report is comprised through the compilation of two surveys: the household and establishment or payroll survey. The household survey is based on the interviews with US households and the establishment survey is built on interviews with US businesses. This is key to the report as it shows 19 what US manufacturers and other businesses are thinking about when it comes to the economy. If businesses see positive economic growth in the future then they are likely to increase hiring and boost the survey results. Some of the statistics that come with this report include the unemployment rate, number of jobs created, the average hours worked per week and the hourly wages. In the recent employment report, the unemployment rate dropped to 4.9% which shows the positive growth in US economy. Some analysis that can be performed on this report includes: 1. A higher payroll figure is good for the US economy. More job additions help to contribute to stronger economic growth. Consumers who have money will spend more which leads to an overall growth. 2. An expected change in the payroll figure generally causes a mixed reaction in the currency markets. Forex traders usually wait for some time to gain a sense of the market directions after the report is released. As an example, if the unemployment rate drops or manufacturing payroll rises, currency traders will go with a stronger US dollar. But, in the opposite scenario, traders will anticipate a weak dollar. 3. A lower payroll figure is detrimental for the US economy. A lower jobs report will indicate that more people are jobless and hence reduces the spendings which shows that the economy is not growing. 2.6.2 Gross Domestic Product Date of release: Last day of each quarter Time of release: 08:30 AM EST Released on the last day of each quarter by the bureau of Economic Analysis, GDP report holds a lot of weight for forex traders. GDP is the total market value of all goods and services produced in a particular country. In U.S, this total consists of consumption, investment, government expenditures and net exports. The sum of all these numbers is the United States’ total gross domestic product which is compared to another year’s performance to derive the percentage of GDP growth. GDP data is designated to hold a lot of importance for currency traders because it serves as an evidence of growth in a productive economy while signaling contraction in a withering one. As a result, forex traders usually tend to seek higher rates of GDP or growth in a belief that the interest rates will follow the same direction. Some analysis that can be performed on the GDP report includes: 20 1. A lower than expected GDP will result in short positions of the domestic currency relative to other currencies. In the United States, a lower GDP figure would signal economic contraction and hurt the chances of a rise in US interest rates which would lower the value of US dollar-based assets. 2. An expected GDP figure requires analysis by the forex trader. The trader will compare the current data with the previous data and trade accordingly. 3. A higher than expected GDP will result in more long positions of the domestic currency relative to other currencies. Therefore, a higher US GDP figure will result in some appreciation of the US dollar against other currencies. 2.6.3 Retail Sales Date of release: On or about the 13th of every month Time of release: 08:30 AM EST Released on or about the 13th of every month by the Census Bureau and the Department of Commerce, the retail sales report also holds a decent amount of weight for the forex traders. Retail sales is an aggregated measure of the sales of retail goods over a stated time period, typically based on a data sampling that is extrapolated to model an entire country. Retail sales report can cause volatility in the market. The retail sales are directly proportional to the growth of an economy therefore, strong numbers will strengthen the dollar while weak sales will suggest a weak economy. The traders use this data to decide to go long or short for a currency pair. 2.6.4 Trade Balance Date of release: Around the 19th of the month Time of release: 08:30 AM EST Released around the 19th of every month by the Bureau of Economic Analysis, trade balance report is being increasingly used by investors and policymakers as a way to determine the health of the US economy and its relationship with the rest of the world. The indicator within the Trade Balance report that is most well-known is the nominal trade deficit which represents the current dollar value of US exports minus the 21 current dollar value of US imports. The report also covers trade balances for services such as financial and informational management etc. Investors can look at the trade balance report to make their strategies because it can move the markets if the data shows a marked change from the prior period. If the trade balance is positive then the value of the US exports is greater than the imports. This shows country’s growth as the exports are higher. But, if the trade balance is negative then the value of the US exports is lesser than the imports. Negative trade balance can put pressure on the economy of the country. 22 2.6.5 Key terms in fundamental analysis Inflation “Inflation is defined as the rate at which the general level of prices for goods and services is rising and consequently, the purchasing power of the currency is falling. As an example, if the inflation rate is 2%, then a candy which costs $1 in a given year will cost $1.02 next year. As goods and services require more money to purchase, the implicit value of that currency falls”. The general causes of inflation include the demand-pull inflation and cost-push inflation. If demand grows faster than the supply, prices will increase. Also, when business’ costs go up, they increase prices to maintain their profit margins. There can be several reasons for the increase in costs like taxes, increase in import costs etc. In the United States, there are two major price indexes that measure inflation. Consumer Price Index (CPI) is one of them. CPI measures the price changes in the consumer goods and services such as food, gas etc. The Bureau of Labor Statistics releases the CPI data every month. The comparison is done with the previous data to measure the change in inflation. The other price index is the Producer Price Index (PPI) which measures the average change over time in selling prices by domestic producers of goods and services. PPI measures price change from the perspective of the purchaser. The Bureau of Labor Statistics releases the PPI data every month. In the long run, the various PPIs and CPI should show a similar rate of inflation. This is not the case in the short run as PPIs increase before the CPI. Inflation can impact the currency markets in several ways. Besides for a growth in money supply, inflation is also driven higher by low-interest rates because the excess money pushed by low interest into the economy drives the prices up. Therefore, high inflation usually leads to the central bank raising the interest rates while lower than desired inflation rates can decrease interest rates. A higher interest might attract investors who are interested in getting a big return on their currency holdings while a low-interest rate currency might be shorted. This process only holds valid when growth is generally good for the country’s economy. If the growth is bad then high inflation can point to a recession which could lead to interest rates cut in the long run. 23 In conclusion, in a healthy economy, rising inflation likely points to higher interest rates which will favor the currency of the country. But, in bad economic conditions, this might not be true. Interest Rates Interest rates are very commonly used as an indicator in the fundamental analysis of the forex market. Interest rates play a crucial role in determining how expensive it is to borrow money from banks. Lower interest rates make borrowed money less expensive for businesses, therefore, results in an easier growth for them. Higher interest rates make borrowed money more expensive which makes it difficult for businesses to take out loans. High-interest rates for a particular currency will make it attractive to the foreign investors because of the increased rate of returns. Lower interest rates will decrease the demand for a currency, therefore, making it less desirable for investors. Interest rate changes are the biggest influence that drives the foreign-exchange market. These changes can be made by one of the eight global central banks. The interest rate changes are an indirect response to other economic indicators made throughout the month and they have the power to move the market immediately with full force. The calculation of these rates is controlled by each bank’s board of directors who control the monetary policy of the country. They use various economic indicators such as CPI, Employment data, housing data etc. to make their decision. The central banks will hike rates in order to curb inflation and cut rates to encourage lending and inject money into the economy. Traders can possibly predict central bank rates to trade the forex market. It is possible to predict a rate decision by analyzing the major announcements. Major announcements from central bank chiefs tend to play a vital role in interest rate moves. Without analyzing these announcements and trading at the time of the interest rate changes can be disastrous for the traders as there can be large unexpected swings in the market. Gross Domestic Product “Gross Domestic Product is the total market value of all goods and services produced in a particular country”. The four main categories which comprise GDP are consumption, investment, government expenditures and net exports. Like any other piece of economic data, GDP report holds a lot of importance 24 for forex traders. It serves as evidence of growth in a productive economy while the contraction in a withering one. As a result, forex traders will look for higher rates of GDP and hope that interest rates will follow the same direction. When the GDP report comes out, there are three basic reactions to price action that a trader can expect. A lower than expected GDP rate will likely result in traders shorting the domestic currency relative to other currencies. In the case of US, a lower GDP value would signal a weak economy and hurt the chances of a rise in US interest rates which lowers the attractiveness of US dollar-based assets. A higher than expected GDP reading will tend to strengthen the underlying currency versus other currencies. On the other hand, an expected reading will require a little more analysis by the forex trader where the trader can compare the current reading to previous readings and then trade accordingly. Political Conditions “The political landscape of a nation plays a major role in the economic outlook for that country. Forex traders are constantly monitoring political news and events to analyze how the country’s currency will be impacted. As an example, upcoming election in a country can be a major event for the forex market as exchange rates will often react more favorably to parties with fiscally responsible platforms and governments willing to pursue economic growth. A good example is a Brexit vote which had a major impact on the British pound when the UK voted to leave the European Union. British pound reached its lowest level since 1985 after the vote because the United Kingdom’s economic prospects were suddenly highly uncertain”. The political conditions of a country will also impact the central bank decisions in interest rates changes which will affect the forex market. 25 2.6.6 Using news to trade the forex market As we discussed earlier, there is a set economic calendar which has all the information about the major news events in the future. Major news events can bring a lot of volatility in the Forex market. Therefore, careful risk considerations have to be taken into account when trading in the Forex market around the news events. A lot of times, the market behaves in the completely opposite direction as to what was anticipated which makes it a lot harder for traders to generate profits in the market around news events. To decide if to trade around news events depends on the risk aversion of the trader. A person who is risk averse should not enter the market around the major news events. However, a person with high risk taking capabilities can attempt to make big profits by entering the market when important financial news and data are released. Pre-Event News Trading Pre-event trading utilizes sentiment analysis on the most port to analyze what the market anticipates from that particular event. Most of the trading platforms and other companies do a pre-news-event analysis where they make both qualitative and quantitative predictions about the news event. The information predicted has good accuracy most of the times. Therefore, the trader can use this predicted information before the event to make a trading strategy. This kind of trading is highly risky as the market can go completely in the opposite direction once the news is announced. Event Trading Event trading is for someone who doesn’t want to utilize the sentiment analysis to make a trading strategy. The trader will enter the market after the news comes out so the trader can analyze how the market is behaving and enter the market accordingly. This kind of trading is lower risk compared to pre- event trading and profits generated can be low. Post Event Trading This type of trading is for someone who wants to focus on long-term profits mainly. The trader will analyze how the news event will affect the overall market in the long run. 26 2.6.7 Analysis of Past News Releases Effects on the Market This section has few examples of how the market reacted after a major news event. ECB cutting interest rates - March 10th 2016 Figure 10 EUR/USD after interest rates announcement The above chart is from 10th March 2016 when ECB President Mario Draghi announced that ECB is cutting its main interest rate from 0.05% to 0% and taking the deposit rate even deeper into negative territory from -0.3% to -0.4%. As a result of this news, Euro dropped 1.6% against US dollar to $1.0822 before jumping as high as $1.1218 as shown in the chart above. It was one of the biggest one-day swings in the currency’s history with a pip size of more than 300. This particular news event was very difficult to trade because of the quick reversal of the currency pair. Only traders who are willing to take a huge risk should enter the market. 27 US Nonfarm Payroll Report - September 10th 2016 Figure 11 EUR/USD after nonfarm payroll report On Friday, September 2nd, 2016, the Labor Department released the monthly non-farm payroll report. It stated that employers added 151,000 jobs in August and the unemployment rate was unchanged at 4.9%. It confirmed that the economy is performing well but doesn’t provide the threat of overheating that might have caused an interest-rate increase sooner rather than later. As we see in the chart, the market became very volatile around the news release. 28 Boston FED President speaks about economic forecast - September 9th, 2016 Figure 12 EUR/USD after Boston FED president speech Boston Federal Reserve Bank President Eric Rosengren said on Friday, September 9th that he backed gradual interest rate hikes. The FED has three meetings left this year and the majority of economists believe that FED will hold off raising rates until December. But the possibility of FED rising interest rates impacted US dollar positively against other currencies on Friday. Higher interest rates would make US dollar attractive to foreign investors hence, resulting in the appreciation of the currency in the market. The US Dollar Index (DXY) was up 0.38% after the news. The above chart shows the EUR/USD chart after the news. As we can see, US dollar increased in price against Euro showing the effect of the news. 29 2.7 Technical Analysis Technical analysis is a method for predicting the movement of the market price through analyzing the past market data. By using tools and market price charts, traders identify patterns that can suggest future market performance. The tools which are used for identifying the future market activity by evaluating the past market price are called technical indicators. Such tools play an important role in trading as they can give some sense of what the market movement (trending or sideways) will be and the entry and exit prices. 2.7.1 Technical Indicators Technical indicators are used mostly to identify the future market movement, trends, breakouts, support resistance prices and when to enter or exit the market. There are generally two types of indicators, leading indicators, and lagging indicators. Leading Indicators Leading indicators are those created to proceed the price movements of a security giving predictive qualities. A leading indicator is thought to be the strongest during periods of sideways or non-trending ranges. The majority of leading indicators are oscillators which means that these indicators are plotted within a bounded range. Examples of the most well-known leading indicators are the Relative Strength Index (RSI) and the Stochastic Oscillator. Lagging indicators Lagging indicators follow the price movements and have less predictive qualities. Such indicators tend to be not very helpful during choppy or sideway periods as they are lagging behind the market price data but they are highly useful for trending markets. Some of the most well-known lagging indicators are moving averages and the Bollinger Bands. Simple Moving Average (SMA) A simple moving average indicator is an arithmetic, moving average that is calculated by adding the closing prices for a number of time periods and then dividing this by the number of time periods. Short-term SMA responds quickly to changes in market prices while long-term SMA takes longer to react. 30 Formula: SMA = (Sum (Price[i]) for I = 1 to n) / n Where n is the time period. Figure 13 Fast and slow simple moving averages (SMA) Utilization SMA is mostly used as an indicator to identify the beginning of a trend. The crossing of short-term SMA overlong-term SMA signals the beginning of an uptrend while the crossing of short-term SMA under the long-term SMA indicates the beginning of a downtrend. The short-term SMA can also act as a level of support when the price experience a pullback. Support levels become stronger in accordance with the increase in the number of time periods. Strength SMA is widely used mainly due to its simplicity and effectiveness. Also, SMA is one of the best indicators to identify the start of the trend. The latter being a very strong feature since getting onto the trend early maximizes the profit. 31 Weakness SMA is a lagging indicator which gives a signal after a certain amount of time the trend has changed direction. At that point, the trader has already suffered some kind of loss if invested in previous trend direction. Thus the delayed response of SMA makes it non-ideal indicator to use in sideways or choppy market. Exponential Moving Average (EMA) Exponential moving average or exponentially weighted moving average indicator is a type of moving average that is similar to simple moving average (SMA) except that every price value point is weighted according to its age. Thus the EMA emphasizes on most recent price values and more sensitive to price changes than SMA. Formula : EMA = WM (P – EMAp ) + EMAp 2 Where WM = weighted multiplier (obtained by 𝑊𝑀 = 1+𝑡𝑖𝑚𝑒 𝑝𝑒𝑟𝑖𝑜𝑑 ) P = closing market price EMAp = previous Exponential Moving Average 32 Figure 14 Exponential and simple moving averages Utilization EMA is commonly used to identify the start or change of a trend. It’s mostly used together with an SMA to confirm the beginning or ending of a trend. One of the ways to make use of EMA-SMA combination is to look for the signal EMA generates first, then compare it with the one generated by the SMA. If both SMA and EMA indicates the same direction of the trend, it is most likely that the market will move in that direction. Strength EMA is also a new trend indicator which works similar to simple moving average (SMA). The main difference is that EMA is more sensitive to current price changes and have a faster response than SMA. The advantages of EMA over SMA is that it signals the trader before the SMA does so that traders can enter the market early. 33 Weakness Since EMA is very sensitive to the price change, it can give false signals to enter or exit the market. This disadvantage can be compensated by using SMA along with EMA, however, the trade-off will be a late entry to or exit from the market. Moving Average Convergence Divergence (MACD) Moving Average Convergence Divergence (MACD) is a popular short-term momentum technical indicator. The MACD turns two trend-following indicators (moving averages), into a momentum oscillator by subtracting the longer moving average from the shorter moving average. The moving average consists of three components : Signal line – the 9 day EMA of the MACD line MACD line – the difference between the 12 and 26 period exponential moving average (EMA) Block histogram – the difference between the MACD and the signal line Formula : 𝑀𝐴𝐶𝐷 = 𝐸𝑀𝐴[𝑁1] 𝑜𝑓 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 − 𝐸𝑀𝐴[𝑁2]𝑜𝑓 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒, 𝑁2 > 𝑁1 34 Figure 15 Example chart with MACD indicator Utilization Center Line Cross Over: The MACD also can be used to determine the current and upcoming trend nature of the market. The MACD line oscillates above and below the zero line, which is also known as the center line. The positive value means the 12 EMA value is getting greater and greater than the long term EMA and thus depicts an uptrend (upside momentum) and buy orders are favorable in this case. Negative MACD value means downtrend (downside momentum) is occurring, thus short orders might be profitable. 35 Figure 16 Example chart of center line crossover Signal Line Cross Over: Another common use of MACD is the signal line crossovers. Crossovers can last a few days or a few weeks, depending on the strength of the move. The market is bullish when the MACD turns up and crosses above the signal line, this is also known as bullish crossover. The market is bearish when the MACD turns down and crosses below the signal line. 36 Figure 17 Example chart of signal line crossover Strength MACD is a very good momentum and trend indicator. Short-term momentum swings are also easily recognized by MACD as well. Weakness One of the disadvantages of MACD is that it’s a lagging indicator which is mainly suitable for a trendy market. Also, trader utilizing MACD can get whipsawed in and out of positions before being able to capture a strong change in momentum. Additionally, it does not work well in a stable, non-volatile market (it’s important that which time frame is being used to look at the market). Stochastic Oscillator A commonly used momentum indicator that displays the location of the close relative to the high-low range over a set number of periods. It indicates the overbought and oversold conditions of the market on a scale of 0-100%. Oscillator readings below 20% indicate oversold and readings above 80% are considered overbought. 37 Figure 18 Example chart of overbought/oversold conditions Utilization Overbought condition depicts a downside movement of the market is likely to occur and thus short orders are likely to be profitable. Oversold condition displays upside movement of the market is likely to occur and thus long orders are likely to be profitable. Strength Stochastic oscillator indicates an either upside or downside market moving is likely to occur. It can be used for different time frames with different speed of oscillator and lastly, is a good indicator in the stable and non-volatile market. Weakness Stochastic oscillator is basically a bounded oscillator thus breakouts can occur and the market will move out of the bounded price. Since it’s specialized in the bounded market, it’s not much profitable in the volatile or trendy market. 38 Relative Strength Index (RSI) The relative strength index (RSI) is an oscillator type momentum indicator developed by technical analyst Welles Wilder, which works similar to the stochastic oscillator. The RSI compares the magnitude of recent gains and losses over a specified time period to measure the speed and change of price movements of an asset. It’s primarily used to identify overbought and oversold conditions. The RSI is expressed in a range of 0-100 and it’s considered overbought for RSI 70 or higher and oversold for RSI 30 or less. The RSI is calculated by using the following formula : RSI = 100 – 100 / (1+RS) Where RS is an average gain over the specified time frame / average loss over the specified time frame. The default time frame for comparing up or down periods is 14 (14 trading days). 39 Figure 19 Example chart with RSI indicator Utilization The RSI equation indicates the movement of the market. For example, when the RSI is 0, this indicates that the average gain over the last 14 days is zero (thus the market is moving downwards). Similarly, when the RSI is 100, it indicates the average loss over the last time frame is zero and the marking is moving in an upward direction. The longer the time frame is, the more accurate the RSI is. 40 Figure 20 Example of bullish and bearish divergence using RSI Divergences Something to make notes of while utilizing RSI is the occurrence of divergences. Divergences are basically defined as when there are two or mountain-peaks like price movements while the market is moving either is upward or downward direction (Figure). There are two kind of divergences, bearish divergence and bullish divergences. Bullish divergence is when you have higher high peaks (basically, the second peak is higher than the first peak) and Bearish divergence lower low (second one lower than the previous low). Such divergences can be used to identify the direction of the price market. From the other point of view, such divergence peaks signal a potential reversal point, at least for certain values before the trend continuing moving in the same direction as before. In this situation, we can either buy or short make money out of such small reversal movements. 41 Strength The RSI is a very good momentum calculator. With larger time frame, it indicates the momentum of the market more accurately than many other indicators. Also with overbought and oversold conditions being less than 30 and more than 70 respectively instead of being closer to the extreme values, it allows us more time on either buy or short early to maximize the profit or wait till it gets deeper into the defined conditions to avoid loss if reversal happens but still makes decent profit. Weakness Just like all other bounded oscillator type indicators, RSI is susceptible to possible breakouts. Although RSI provides relatively accurate perception of price movements, however being a lagging indicator, it does not do well in a market which is volatile, i.e., the direction of the market is changing frequently. Bollinger Bands The Bollinger Bands indicator is a technical indicator created by John Bollinger in the 1980s. It consists of three lines on a chart that do not intersect each other. The middle line is simple moving averages and the bands enveloping it are the two standard deviations away from the center line. Since volatility is based on standard deviation, which changes as volatility increases and decreases. The bands widen when volatility increases and narrow when volatility decreases. The following equation is the formula for the Bollinger Bands : Middle Band = 20-day simple moving average (SMA) Upper Band = 20-day SMA + (20-day standard deviation of price x 2) Lower Band = 20-day SMA - (20-day standard deviation of price x 2) 42 Figure 21 Example using Bollinger bands Utilization Many traders believe that the closer the price moves to the upper band, the more overbought the market, and the closer the prices move to the lower band, the more oversold the market. When the bands come close together, constricting the moving average, it is called a squeeze. A squeeze signals a period of low volatility and is considered by traders to be a potential sign of future increased volatility and possible trading opportunities. Conversely, the wider apart the bands move, the more likely the chance of a decrease in volatility and the greater the possibility of exiting a trade. However, these conditions are not trading signals. The bands give no indication when the change may take place or which direction price could move. Technically, prices are relatively high when above the upper band and relative low when below the lower band. However, relatively high should not be regarded as bearish or as a sell signal. Likewise, relatively low should not be considered bullish or as a buy signal. Approximately 90% of price 43 action occurs between the two bands. Any breakout above or below the bands is a major event. The breakout is not a trading signal. The mistake most people make is believing that that price hitting or exceeding one of the bands is a signal to buy or sell. Breakouts provide no clue as to the direction and extent of future price movement. Strength The Bollinger band is a very good volatility indicator. Since 90% of the price action is supposed to contain within the bands, once the price reaches either upper or lower bands, traders can set their position in the market, either buy or short. Weakness The Bollinger bands are supposed to contain 90% of the price action however, breakouts can occur due to major events (for example employment rate changes). Moreover, Bollinger Bands are not meant to be used as a standalone tool. They should be used together with basic trend analysis and other indicators for confirmation since just Bollinger Bands alone do not give solid signals of market movements. 44 2.8 US Dollar Index (USDX) “The US Dollar Index is a leading benchmark for the international value of the US dollar and the world's most widely-recognized, publicly-traded currency index”. The US dollar index measures the value of the US dollar relative to a basket of top 6 currencies: EUR, JPY, GBP, CHF, CAD, and SEK. Each currency has a different weight in the index. Because not every country is of the same size, it is only fair that each is given appropriate weights when calculating the US dollar index. Here are the current weights of each currency: Figure 22 Weights of each currency in the US dollar index The formula for calculating USDX is: 𝑈𝑆𝐷𝑋 = 50.14348112 ∗ 𝐸𝑈𝑅𝑈𝑆𝐷 −0.576 ∗ 𝑈𝑆𝐷𝐽𝑃𝑌 0.136 ∗ 𝐺𝐵𝑃𝑈𝑆𝐷 −0.119 ∗ 𝑈𝑆𝐷𝐶𝐴𝐷 0.091 ∗ 𝑈𝑆𝐷𝑆𝐸𝐾 0.042 ∗ 𝑈𝑆𝐷𝐶𝐻𝐹 0.036 USDX can be useful for a forex trader in different ways. USDX gives the trader an idea of the relative strength of the US dollar around the world. When the market outlook for the US dollar is unclear, the USDX provides a better picture. In the wide world of forex, the USDX can be used as an indicator of the US dollar’s strength. 45 Since USDX is comprised of more than 50% by the Euro zone, EUR/USD currency pair is inversely related. Here is a USDX chart: Figure 23 Example USDX chart The corresponding chart for EUR/USD is shown below: Figure 24 EUR/USD chart 46 Both of the charts shown above seem to be a mirror image of each other. This information could be particularly useful for a trader who is trading EUR/USD pair. USDX can be thought of as a strong indicator for EUR/USD currency pair. If the USDX makes significant movements, currency traders react to the movement accordingly. Therefore, forex traders use the USDX as a key indicator for the direction of the USD. Here are the two tips a trader should always remember when trading the currency pairs involving US dollar: If USD is the base currency (USD-XXX), then the USDX and the currency pair should move the same direction. If USD is the quote currency (XXX-USD), then the USDX and the currency pair should move in opposite directions. Most of the forex trading platforms including fxTrade, MetaTrader do not have a built-in indicator for plotting the USDX. As discussed earlier, USDX can be a really strong indicator to measure the overall strength of the US dollar and therefore, can be quite useful for forex traders. Therefore, the team decided to develop the USDX indicator on the MetaTrader 5 trading platform using MQL5 which is a development language for the platform. The code for plotting this indicator is given in Appendix B. 2.9 Trading Platforms “A trading platform is a piece of software that acts as a conduit for information between a trader and broker. A trading platform provides information such as quotes and charts and includes an interface for entering orders to be executed by the broker”. Most of the trading platforms come equipped with most of the indicators to be used for technical analysis. 2.9.1 TradeStation vs. MetaTrader vs. fxTrade For this project, three trading platforms were recommended by our advisors. A free account was created for each of the member in the group on TradeStation. MetaTrader and fxTrade are free trading platforms and individual accounts can be created easily. 47 Comparison MetaTrader is the most popular trading platform for anyone who trades forex. MT4 and MT5 mobile versions have more than a half million users. One of the reasons for its popularity is that the platform is free. The platform can be downloaded for free and once a demo or real account is created, the data is updated in real time. MetaTrader also has a scripting language which is called MQL4. This language is C based and can be used to write indicators and trading strategies. There is also an active community of MT4 users who contribute indicators and EAs to the Mt4 forum. TradeStation doesn’t primarily focus on the Forex market as it supports trading of most of the financial assets (stocks, futures, options etc.). TradeStation uses EasyLanguage as its programming language for traders to write their trading strategies and automate their trades. Both MQL4 and EasyLanguage have significant differences. In EasyLanguage, all the code is executed on the close of each bar of the chart to which the strategy is applied. If the chart consists of daily bars, the code will be executed on the close of each daily bar. If the user wants to execute the code more frequently, the chart time frame will have to be reduced. However, the MQL4 code uses a function called start() that executes on each tick. Typically, the main strategy code occurs within the start() function. There’s no practical way to detect the close of the bar so strategies in MetaTrader typically execute on every tick or on the bar’s open. Unlike EasyLanguage, MQL4 doesn’t restrict strategies to the data for the chart on which the strategy has been applied. TradeStation and EasyLanguage follow the convention of using slippage to account for the fact that trades are not usually filled at the market price. Slippage is the dollar cost added to the trade to account for this. However, MQL4 uses a somewhat sophisticated approach to trading costs and fill prices. In MetaTrader, each price is actually two prices, bid price and ask price. The bid is the lower price whereas ask is the higher price. Buy orders are always filled at the ask price while sell orders are filled at the bid price. Therefore, because of the more sophisticated approach MetaTrader uses to represent order filling, fill prices in MT4 for historical simulations are likely to be more accurate than in TradeStation. The fxTrade platform is provided by Oanda Corporation which is a Canadian-based foreign exchange company providing currency conversion, online retail foreign exchange trading, online foreign currency transfers and forex information. Real accounts can be opened with Oanda to trade forex for as low as $1. The fxTrade platform is simple and easy to use. Even though it doesn’t have any programming language 48 to automate trading, it can be used to place trades as it can connect to the Oanda real accounts. FxTrade can only be used to trade forex. The team decided to use MetaTrader and fxTrade to make most of the trades. Both demo and real accounts were used to execute the trades. 49 2.10 Risk Management Risk management is an essential part of a trading system. A trader who has generated substantial profits can lose it all in one or two trades if proper risk management is not employed. One of the best ways to manage risk is to plan the trades. Successful traders commonly quote the phrase ‘Plan the trade and trade the plan’. Stop-Loss and Take-Profit are two key ways in which traders can plan ahead when trading. Successful traders know what price they are willing to pay and what price they are willing to sell. Another aspect of risk is determined by the amount of trading capital available. Risk per trade should always be a small percentage of your total capital. A good starting point for stop loss can be 2% of the trading capital. So, if the trader has $10,000 in the account, the losses will be limited to 2% of the trading capital which is $200. In forex, it makes more sense to use pips in the calculation. In the case of mini lots, one pip is approximately $1 and if the stop loss is 30 pips, then the risk per trade is $30. In a similar way, the trader should also set the take-profit so that the trade is closed when the profit reaches that point. For short-term traders, 5 - 10 pips can be an appropriate number for take-profit but it depends on the expected return for the trader. Another big risk magnifier is leverage. Forex market is a much-leveraged market which means that $1,000 are needed to trade $50,000 if the leverage is 50:1. High Leverage is available because the market is so liquid that it is easy to cut out a position very quickly. In the case of profit, high leverage can amplify the profits quickly but it can also amplify the losses very quickly. Therefore, the trader has to keep into leverage into consideration when managing trades. The risk is inherent in every trade one makes. Losses are part of trading but if they are properly managed then the overall trading system will be profitable. The trader should be able to accept the losses and learn from them. With a disciplined approach, properly managing risk and good trading habits are the keys to successful trading. 50 2.11 Money Management “Money management is the process of budgeting, saving, investing, spending or otherwise in overseeing the cash usage of an individual or group. It is another very essential part of forex trading”. One of the ways to manage money successfully is to take many frequent small stops and try to harvest profits from the few large winning trades. The other way would be to take many frequent small gains and take infrequent but large stops. Both of them are valid ways of properly managing the money as the goal is to generate net profit out of the trades. Choosing what method to use depends on the personality of the trader. The first method generates many psychological instances of pain but it produces few major moments of ecstasy. On the other hand, the second method offers many instances of happiness but also offers few big instances of pain. Therefore, it depends on the personality of the trader while choosing one of the two methods. Money management in forex is flexible and as varied as the market itself. But, it is an important part of forex trading, therefore, some form of it should be practiced by the trader in order to be profitable. 51 3. Methodology This chapter discusses the methodology used by the team to develop a profitable trading system. This chapter highlights the general practices used to create a trading system and the goals of it. The research was done to identify the important aspects of a profitable trading system and those were incorporated into the developed systems which are discussed in the next chapter. Trading and investments also follow scientific methodologies. Therefore, for a trader to establish a successful and profitable business which trades, scientific approach is needed to develop the trading systems. Before developing a trading system, it is very important for a trader to identify the objectives of the system. Once the goals and objectives are clearly understood, the trader will be able to build a system which meets those goals. Some of the objectives which traders should consider while building their systems include: High annual return Low account draw-down High percentage of profitable trades High average profit per winning trade Low average loss per losing trade Less holding trades overnight Small amount of time in the market High risk/reward ratio Fixed stop-loss trades Time of the day when trades are executed Account intra-time period draw-down target Expected earnings High win/loss ratio High sharpe ratio The above list contains the most common objectives that many traders take into consideration when developing the trading systems. Every trader puts different weights on each objective based on the needs of the trading system. After the objectives have been determined, the trader needs to carry out extensive 52 research of the market before developing the system. When developing a system for the forex market, the trader needs to look at things like the currency pairs to trade, trading platform, leveraging, technical indicators to use, fundamental analysis, important news events, macroeconomic data etc. After the research, the trader should gather all the information collected and start building the initial version of the trading system. The next step is to test the trading system built with the past market data. This step is really important to test the effectiveness of the trading system and find out the possible flaws. Analysis of the system must be done using a performance report which most trading platforms provide. This process might need several iterations before the trader becomes satisfied with the trading system. Possible changes include different combinations of the technical indicators, different weights on each indicator etc. Once the trading system has been optimized, the trader must manage the risk of the system. The trader can optimize position sizing, take profits and stop losses. These are the three most important factors to execute trades using the system. After the risk management step, a walk forward analysis should also be done on the system. This would test the system’s performance on factors such as time of the day, day of the week and month of the year. This would allow a trader to determine the optimal times to execute trades with the trading system. After this final step, the trader must be able to take the developed system in real-time and start executing trades with fair confidence. Project’s Objectives The high-level objectives that the team intends to focus on for developing the trading systems for this project include: Utilizing technical indicators and support/resistance trading strategy to trade profitably Learning to use fundamental analysis to execute trades Managing risk and money well while trading Learning the trading platforms like MetaTrader well to trade Developing understanding of the important news events and macroeconomic data and how they affect the forex market Develop an overall good understanding of the forex market Developing the skills to analyze the news events and market data well Developing objectives for the trading system and sticking to them Using scientific approach to developing the systems Learning the laws and regulations of the forex market Utilizing all the knowledge obtained to develop profitable trading systems 53 The team intends to achieve the above objectives in the process of forex trading system development. The next chapter of the report discusses the manual trading systems developed and analyses their performances. 3.1 Individual Trading Strategies 3.1.1 Erik’s Trading Strategy Development The development of an effective trading strategy for use in the FOREX market, in particular, the EUR/USD currency pair involved careful preparation. This began with an analysis of how daily news events affect the behavior of varying types of markets, with particular attention paid to the effects on EUR/USD. Understanding the effects of news is critical since a trader must be able to predict when the rules of his/her strategy will be valid. For example, one might determine that a particular strategy is only consistently profitable when there are no significant news events that have recently occurred and none are expected to happen soon. In general, significant news events such as the US unemployment report will have unpredictable effects on the market and may cause large swings in the EUR/USD currency pair due to many inconsistent factors. Additionally, careful study of the various technical indicators and their appropriate use is important when developing a strategy. The more quantitative information that can be determined to be advantageous for a strategy, the more likely it is that a trend can be predicted and a profitable trade is made. Once sufficient background information is studied, it is necessary to test and evaluate the performance of the strategy in live trading on a virtual trading account. For this strategy, the technical indicators of Bollinger Bands, Moving Average Convergence Divergence (MACD), and two exponential moving averages (EMA) were made use of. While it was initially successful, a mistake was made of leaving a trade unattended overnight before a significant
