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More Forex Q&A With Ed Ponsi:MAY 1, 2007
Forex Expert Edward Ponsi: The Forex Answer Man February 27, 2007
Forex Insight with Abe Cofnas: Forex Contagion and the Lessons of Feb 27th

The Forex Answer Man

Ed Ponsi is a globally recognized name as a lecturer and teacher and is the former Chief Trading Instructor for Forex Capital Markets. An experienced professional trader and money manager, Ed has advised hedge funds, institutional traders, and individuals of all levels of skill and experience. He is a regular contributor to TradingMarkets.com, SFO Magazine and FX Street, and is currently writing his first book for Wiley Finance.

More Forex Q&A With Ed Ponsi

We've had an exciting week in the currency markets, highlighted by the Euro's rise to a new multi-year high vs. the U.S. Dollar. As usual we've received many great questions from our readers, thank you one and all. Let's get right to some answers...

Q) When a currency appreciates, how does it impact the stock market of that country?

Ed Ponsi) Great question! Imagine that you are the manager of a fund that can invest in the stock market of any country. Your charts indicate that while the U.S. S&P 500 index is breaking out to new highs, Japan's Nikkei 225 index is struggling to keep pace (see figure 1).

Figure 1: Side by side analysis of the S&P 500 stock index (left) and the Nikkei 225 stock index (right). Source: Bloomberg.com

Since you want to obtain the best possible return for your investors, you decide to liquidate your holdings in the Nikkei and invest the proceeds in strong stocks that are members of the S&P 500. When you close your positions in Nikkei stocks and withdraw the funds, you receive the proceeds in Japanese Yen. Well, you can't buy U.S. stocks with Japanese Yen; you'll have to exchange Yen for U.S. Dollars. Essentially, you are selling the Japanese Yen and buying the U.S. Dollar.

Now if you are the only player in the market who is making this exchange, the impact on currencies will be negligible. But imagine the impact if many large institutional investors are selling Yen and buying U.S. Dollars for the same reason. This would create a stream of capital flowing out of Japan and into the U.S., which would cause the Yen to weaken at the expense of the U.S. Dollar. We could say that a strong stock market pulls capital in from countries that have weaker stock markets, and causes the underlying currency to strengthen.

Q) Why is it that when the Reserve Bank of New Zealand (RBNZ) raised interest rates by a further 25 basis points the market reacted by selling, dropping the New Zealand Dollar by almost 1 cent? I had read that the market buys on anticipation and sells on the fact, however I would have thought the even higher yield would have made it more attractive to investors and thus strengthened the NZD.

Ed Ponsi) Thank you for your question. The RBNZ did raise its official cash rate to 7.75% on April 26, pushing the New Zealand Dollar to new highs vs. the U.S. Dollar and the Japanese Yen. This does make the "Kiwi" (the nickname for the New Zealand Dollar) more attractive to traders who seek to collect interest from the "carry trade". However, the New Zealand Dollar subsequently sold off because of comments from the central bank's governor, Alan Bollard. Bollard, who is essentially New Zealand's equivalent of Fed Chief Ben Bernanke, made some particularly pointed comments about the currency, saying "The exchange rate is now at levels that are both exceptional by historical standards, and unjustified on the basis of medium-term fundamentals."

It's not every day that you hear the head of a central bank state that strength in his currency is "exceptional" and "unjustified". I'd put this on the same level as Alan Greenspan's infamous "irrational exuberance" comment, when he reminded U.S. investors that stock markets can indeed fall. The Kiwi responded to Bollard's comments by dropping sharply from its recent highs (see figure 2).

Figure 2: NZD/USD plunges as Bollard calls New Zealand rates "unjustified". Source: FX Trek

The inference here is that the Reserve Bank of New Zealand may consider intervening in its own currency to inhibit further strength. In an intervention, the central bank tries to directly influence exchange rates by buying or selling its own currency. If the RBNZ wants to weaken the Kiwi, it will sell New Zealand Dollars and buy Euros, U.S. Dollars, and/or other currencies. Central banks turn to intervention as a last resort, as it is expensive and there is no guarantee that it will actually succeed.

Despite Bollard's comments and the threat of a potential intervention, the New Zealand Dollar/ U.S. Dollar (NZD/USD) currency pair has since rebounded and is once again trading within 100 pips of .7500 - a level not seen by this currency pair since 1982 (see figure 3). It would seem that Bollard is trying to "jawbone", which means he is trying to convince traders to sell the NZD by implying that the central bank will also sell NZD. If he can convince traders to sell the Kiwi, the NZD might weaken without the benefit of a direct intervention. The effects of jawboning tend to be short-lived, as traders will quickly turn a deaf ear to words that are not backed by action.

Figure 3: NZD/USD still trades near multi-decade highs. Source: FX Trek

Q) Hi Ed, I've been using and combining trading techniques that I've learned from several different instructors. This worked well for a while but lately my returns have diminished. What should I do?

Ed Ponsi) I'm sorry to hear that you've encountered difficulties. It seems as if you are switching between two methods, and what often happens when we do this is we end up not using either method. Here's what I would do: I'd stop trading for a week or so until I could definitely determine exactly how I'm going to trade. This will also help you to distance yourself from the market for a time, which allows us to view it more objectively.

In a week or two, I'd return to the market with fresh eyes. Then I'd start trading on a demo account, using whichever technique I determined would be best. Test it out in a demo account for at least a few days to be sure that your technique is working under current market conditions. If so, then you can return to live trading.

Stepping away from the market will allow you to regain your objectivity, and it will also allow you to evaluate exactly which trading techniques you wish to use. Choose the direction that you want to take and then stick with it. Then you can come back to the market with a clean slate. It's probably a good idea for most traders to do this type of self-evaluation from time to time. Good luck!

Final Thought

The "Golden Week" holiday celebration has begun in Japan. Golden Week is a collection of four national holidays that fall within a seven-day period, the first of which was April 29th. Expect trading during the Asian session to be lighter than normal this week due to this series of holidays.

Have a question about Forex trading? Send an email to eponsi@tradingacademy.com and we may use your question in an upcoming newsletter. Until next time, best of luck to you in trading.

I realize that foreign exchange trading, or Forex, is a brave new world for many traders out there. As someone who has successfully made the switch from equities to Forex, I'm happy to explain the similarities and the differences between these two trading vehicles, and hopefully shine a light on some of the advantages of Forex. I firmly believe that if more traders were aware of these advantages, many of them would switch to currency trading in a heartbeat. Let's get to your questions...

Q) Regarding the times of days when breakouts are likely to be supported by volume, would any time from 7 a.m. GMT to 4 p.m. GMT be a good assumption for high-volume trading?

Ed Ponsi) What a great question! Many equities traders use volume as an indicator, and give more credence to moves that occur on high volume. Since the Forex market is much larger than any stock market, this makes the collection of accurate volume data extremely difficult. How can Forex traders apply this philosophy of volume to their market? We do so by paying close attention to the time of day.

7 a.m. GMT to 4 p.m. GMT (Greenwich Mean Time, which is the standard measurement of time in the Forex market) is an excellent time for high volume trading, because these are the hours during which traders from London and Europe are most active. Make no mistake about it, London is the world's capital of Forex trading, and is responsible for about 30% of all Forex volume. To be even more specific, the open of the U.K. session (between 3-5 GMT a.m.) and the beginning of the US session (11-13 GMT) have really high volume, as these are the most liquid times of the Forex trading day. I would give respect to breakouts that occur between 7 a.m. GMT to 4 p.m. GMT, and also (to a lesser extent) to breakouts that occur in the early part of the Asian session, around midnight GMT. On the other hand, breakouts that occur during a time of day that is notorious for low volume (late in the U.S. session or late in the Asian session, for example) can be ignored or even faded, because these breakouts tend to occur on relatively light volume.

Q) Why is there so much emphasis on Fibonacci in Forex trading? Why don't we hear more about it in the stock and futures markets?

E.P) Fibonacci works in Forex trading because it is a part of the Forex trading culture. To me, Fibonacci is not particularly effective in the stock or futures markets for the simple reason that it is not a part of the culture of those markets. If enough traders in one market use a similar technique, that technique can become effective simply because so many of them are using it to place their buy and sell orders. This is called a self-fulfilling prophecy.

For example, suppose that a trader decides to create a random calculation and uses the results of that calculation to create support and resistance levels. If this trader is the only one using the calculation, he or she will be the only one using those support and resistance levels. His orders alone will not create sufficient buying or selling pressure to move the market, or change the direction of the price.

However, if this trader can convince many other traders to use the same calculation, all of those traders will then have the same support and resistance levels, and their orders will begin to congregate at those levels. The combined buying or selling pressure created by those combined orders may be great enough to change the direction of the price when it reaches that level.

If the majority of traders begin to use the same calculation – including very large traders such as banks and global hedge funds – the results of the calculation will become uncannily accurate and impossible to ignore. This is essentially what has already occurred with Pivot Points in futures trading, and also describes the current status of Fibonacci in the foreign exchange markets. Because it is an ingrained part of the Forex culture, the effect of Fibonacci on that market is impossible to ignore (see Figure 1).

Figure 1: On the weekly chart, USD/CAD encounters resistance at the 50% retracement of a major move. Source: Saxo Bank.

Q) Regarding Fibonacci retracements, I notice that in your writings 78.6% and 23.6% are not mentioned. Is there any special reason why you focus on the 38.2%, 50%, and 61.8% Fibonacci retracements?

E.P.) I purposely omit what I consider to be all but the most significant Fibonacci levels from my analysis. Fibonacci is a self-fulfilling prophecy, so the most obvious levels will see the most action. I tend to avoid the less-obvious levels, along with Fibonacci extensions, Fibonacci circles, and other esoteric Fibonacci derivatives because fewer people use them and therefore there is less of a chance for the creation of a self-fulfilling prophecy. Basically, I want to use what the institutions use and see what they see, and I want to avoid analyzing anything that institutions do not use. Since institutional traders are the ones that move the market, we want to align our analysis with theirs. We want to see what they see, and ignore what they ignore (see figure 2).

Figure 2: EUR/JPY catches a tremendous bounce at the 61.8% Fib level in early February of 2007. Note that the 78.6% level is ignored. Source: Saxo Bank.

Q) I sometimes struggle to know where it is best to measure Fibonacci retracements from - is it the last major move or from the very bottom of the original trend?

E.P.) This is the most common Fib question - A good general rule of thumb is to draw from a major high point to a major low point, if you are measuring a downtrend. When measuring an uptrend, reverse the process and measure from a major low point to a major high point. Use the highest and lowest price points of a recent move or leg of a trend. You can also draw from the very beginning of a trend as well. Don't be afraid to draw more than one; the fact is you can draw multiple Fib levels on the same chart. Many Fib traders do exactly this, and then look for areas where the Fib retracements converge.

For me, the bare minimum time frame for a Fibonacci retracement would be one day, but when I draw a retracement usually I am covering a period of weeks or months. Again, try to pick the one that seems most obvious...which one really sticks out? That's the one that most people will use, including the institutions and hedge funds, and therefore it is the one that is most likely to work.

Until next time, best of luck to you in trading!

If you have questions for Ed Ponsi about Forex trading, please send them to eponsi@tradingacademy.com

DISCLAIMER:
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results.

Reprints allowed for private reading only, for all else, please obtain permission.

Forex Contagion and the Lessons of Feb. 27
March 8, 2007

Abe Cofnas has spent over a decade as an equity broker, futures trader, and technical analysis instructor. Abe was one of the first professional trainers in the world to provide web-based interactive training exclusively on Forex trading. Since 2001, Abe's Forex Trader column in Futures Magazine has been a mainstay of the publication, providing innovative observations and educational tips on Forex trading to a world readership of over 65,000 traders. You'll enjoy learning Forex from this master!

The market moves of Feb 27th, when the Dow suffered its worst day in 4 years, was a classic case demonstrating the reality of inter-market phenomena and the illusion of a disconnect between fundamentals and technicals in market moves. Those who claim that fundamentals don' t count need to reassess their claims. No one really knows what sets off a sell-off (until after it is over), and we can't predict the next one with certainty. But during the sell off of Feb 27th we saw some of the inner realities of market structures reveal themselves in a triangulation of factors.

(chart from www.cqg.com)

First, the significance of the Forex market as a force in world capital flows and market moves became apparent when the Dollar Yen pattern started sliding. Its vibrations caused a remarkable synchronicity, as if both markets were dancing to the same beat. The Yen, in effect became the leading indicator for the equity markets.

February 27th also reminded equity investors that markets are not linear and they can suddenly enter into chaotic patterns. Forex traders, particularly carry traders, had a rude awakening. Carry traders have had profitable conditions for over 3 years by betting on selling yen and buying currencies with higher interest rates such as (NZD, and GBP). Having committed to a winning strategy it is hard to separate oneself from it, even in the face of evidence. But on Feb 27th many were reminded that there is no free lunch. Many of those who held carry trade portfolios (GBPJPY, NZDJPY) saw more than 20% draw downs in 1 day. Importantly, there were reports that the Yen strengthening caused the need for equity investors to liquidate positions to meet margin calls on carry trades that were suffering large drawdowns as the Yen surged. The carry trade involves global assets of over $100 billion and a lot of this money is borrowed. The sell off was a threat to liquidity. That is also why Gold did not go up, but sold off as well. Just the opposite of conventional wisdom, where Gold is hyped as a refuge in crises. A third factor that was precipitous was that Chinese equity markets sold off 9% partly in reaction to concerns over a US slowdown. This generated follow-on concerns of a Chinese slowdown. China will have great difficulties sustaining the GDP growth levels of recent years. The Chinese GDP is now being projected to be at 8.0% for 2007. Rather than fearing a Chinese slowdown, it would be better to look at its impacts. Traders should start seeing the Aussie become weaker as global demand slows for commodities. The catalyst triggering a convergence of these factors may have been the remarks of Alan Greenspan about the potential of a US recession. On March 5th yet another Yen surge triggered another example of emotional contagion as equity markets in Asia and Europe sold off and in the US equity markets triggered more weakness.

What we have in these events is a glimpse into the future of global markets and some important lessons. Global markets are interconnected more than ever and they are therefore subject to waves of emotional contagion. A statement by a foreign minister or central banker can create the equivalent of a chemical reaction-diffusion in the market. Events in one market will cascade into other markets as liquidity in a global phenomenon are not isolated. All markets become threatened. Traders in the equity markets focusing only on intraday charts are like swimmers at the beach ignoring the large waves that are forming because they are not seeing them. A lesson for equity traders is to that we have truly become a 24/7 trading world. Forex markets act as the jet stream of the world money flow and any shift Impacts all other markets. Equity traders and investors should have forex accounts that could in future equity sell-offs be used to create an effective hedge by trading in their forex account.

A final lesson regarding Feb 27th is that chaos creates opportunity. One didn' t need sophisticated indicators to see the compelling opportunity to sell USDJPY during the afternoon of Feb 27th. The warning signs were there by applying the classical tools of Support/Resistance and trend lines.

Even when the Yen surged, the trend lines came alive acting as invitations to the join the party. No other indicators were necessary for trading in this environment.

No one knows what the next tipping point will be, but we can learn from Feb 27th and its aftermath that understanding Forex is a necessity in our current era of the global capital markets. Yet knowledge has to be actionable. Watching the USDJPY fall, on the sidelines, without the ability to trade it, by not having a Forex account, can be a painful experience.

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