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Beware The Index Hugger on forex

Don’t be fooled by the warm and fuzzy name - index huggers are arguably the most vile, misleading vehicles in the investment market. These funds, sometimes called “closet trackers” or “pseudo trackers”, are mutual funds or portfolios of equities that are marketed as actively managed, but in fact keep so close to the relevant index, that one might as well have purchased a real tracker.

Let’s look at a little analogy:

Imagine that you are sick - dying. You go to the hospital because the hospital promises to care for its patients and to give specialized treatment. You check in and pay the hefty fees, but instead of the personalized care you expect, the staff simply leave you in bed, letting nature run its course - for better or worse. This is the kind of care you get when you accidentally buy into a closet tracker. You’d have been better off taking your chances at home. You’d save money and wouldn’t have any false assumptions.

These funds exploit investor ignorance, tricking people into paying for a service and a market-beating return that they won’t receive. This article will explore the closet tracking phenomenon and show how you can avoid being the latest unsuspecting victim. (To begin with the basics, see The Lowdown On Index Funds.)

Closet Trackers Abound
Research conducted in the Edinburgh, Scotland, by market research firm The WM Company found that almost 75% of “active funds” deviate only marginally from their benchmark index.

The study covered data from 1980 to 2000, and found that 40% of supposedly active funds deviate by between 0-3%, and a further 34% by 3-6%. The study also found that roughly three-quarters (127 out of 168) of funds simply do not beat the index. (To read more about the study, see Investors Lose As Pseudo Trackers Come Out Of The Closet.)

Many Buy Into These Misleading Funds
The above statistics have alarming consequences, particularly for inexperienced investors who do not know how the investment industry works. These investors expect something very different from what they often receive.

Anyone who is aware of business cycles and market crashes would logically expect fund managers to ensure that their portfolios perform reasonably well in all market situations. They would expect each stock purchase to be carefully considered, for any changes in the market or with respect to the individual companies to be reflected in immediate sales and purchases and so on. For such individuals, the realization that their money is in a closet tracker can be a rude awakening.

This is surely the real danger of closet trackers. People believe their investments are being managed in such a way as to minimize potential losses. They feel safe leaving their money in the stock market, secure in the knowledge that their money is being looked after. Yet, a closet tracker will go up and down with the market, fully exposed to stock market cycles.

If the S&P index goes up (or down) by 5%, most American funds will go up (or down) by about the same amount. This is a fundamental reality of the investment industry, but the buyers of closet trackers are usually unaware of this reality – until the market takes a dive.

Why They Exist
These funds have little, if anything, to offer investors; however, for the fund company, closet trackers are great. They are cheap, easy to run and fees are paid for a non-existent service. Accordingly, closet trackers enable large brokerage houses to run – not manage – hundreds or even thousands of portfolios with a passive one-size-fits-all approach. It suits them just as much as it does not suit the investor.

Unfortunately, regulatory measures have not caught up with investor distress so far. If somewhere in the prospectus the fund mentions that it will attempt to mirror or track an index, then unfortunately it is a case of “buyer beware”. The investor might think he or she is getting something tailor-made but the fine print says it’s strictly off the rack (For more on the importance of reading the fine print, see Don’t Forget To Read The Prospectus!)

Spotting a Closet Tracker
If you want a tracker, you’re much better off buying a real one - you will pay much less in fees and will know what you are getting. However, if you want active management, you’ll need to find a fund or broker that can outperform consistently in different market situations or one who does not even attempt to beat a benchmark. You may, for instance, prefer a small portfolio of 5-15 stocks, each genuinely actively managed with its own stop (buying or selling limits), ongoing monitoring and control and so on.

Index huggers are simply not “managed” in the true sense of the word. Unless a fund manager can, in some way, do better than the market itself in terms of returns, you do not need him or her. For a broker or fund manager, being a nice guy is not enough. No matter how charming the fund company of a closet tracker is, and irrespective of how glossy and impressive the brochures or internet sites are, these are bad investments in financial terms.

You can spot these funds by asking the right questions. These include:

• What features do you offer that I can’t get from a tracker (personalized information, communication, tailor-made portfolio)?
• How exactly does your active management operate, and how does it help?
• Do you benchmark with an index and if so, which one?
• Do you beat it consistently and if so, by how much? (To learn how to measure your fund manager’s performance, see Active Share Measures Active Management.)

Understand the Pitfalls of Both Styles Before You Buy

• Active management – It is not easy to find a consistently outperforming fund or broker. Getting reliable information on performance is time consuming, can be complex and may not always be possible. Past performance simply cannot be extrapolated into the future. In short, you may prefer not to bother with the hassle of active management. (For more on the risks and rewards, see Words From The Wise On Active Management.)

• Index Trackers – There are different indexes and differently composed trackers. So, some homework or reliance on the seller is still needed. Either way, it is not all safe sailing. However, the fact remains that trackers are cheaper and, at least on a relative scale, you do really know what you are getting. There is no doubt that the tracker route is more transparent and straightforward. (For more, see You Can’t Judge An Index Fund By Its Cover and Money Management Matters.)

The Bottom Line
Unfortunately, closet trackers will probably always exist. Closet trackers are just too cheap, easy to run and profitable, and there are just too many naive investors out there, for such funds to disappear. But, informed investors can identify and avoid them.

For the market as a whole, regulation and investor education are the solutions. Regulators need to ensure that firms and individuals are not allowed to sell funds that promise something they don’t deliver - otherwise, the old “buyer beware” principle prevails, and many buyers are not and will never be aware of this problem.

Related articles

• The Return of The Market-Beating Fund Manager (online.wsj.com)
• The Analyst: Contrarian expert with an excellent pedigree (independent.co.uk)
• Analysis: Index-trackers up stakes in battle for investors (reuters.com)

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The New World Of Emerging Market Currencies

In the shadow of more industrialized economies, interest in emerging market assets has increased in recent years. Although these assets tend to be somewhat volatile, the return is often worth the risk, as emerging market funds have produced higher percentages of wealth than benchmark rates. (For the latest news and information on emerging markets, check out Emerging Market News at Forbes.com.)

Compared to the more domestic S&P 500 benchmark, emerging market fund returns have been higher and varied widely, from as little as 20% to as much as 189%, as managers dove into assets in Hong Kong, Singapore and South Africa. Interest in these emerging economies also spurred demand for the regions’ corresponding currencies: the Hong Kong dollar, Singapore dollar and South African rand. This presents opportunities not only for the hedge fund trader and larger institutional speculator, but also for retail investors, who are also privy to these assets as brokers open up their platforms to include such profitable, yet relatively unknown, currency pairs.

An opportunist’s dream, the emerging market currencies offer plenty of potential for the novice as well as the more tenured trader. These emerging market pairs act very similarly to their G7 counterparts, providing plenty of potential for profitability. Read on to travel through the world of emerging market currencies. (For related reading, see What Is An Emerging Market Economy?)

Emerging Characteristics
Emerging market currencies don’t trade much differently than the more recognized G7 currency pairs. Although these currencies do have some drastic differences, the overview is very similar to the fluctuations in the more common European euro, British pound and Japanese yen trades. Like other major economies, these emerging market economies are dictated by monetary policy as well as political considerations, including both external and internal factors. As a result, retail and novice forex traders can actually carry over the experience they have obtained in the major industrial currencies and apply it to emerging market currency pairs.
Monetary Policy
Monetary policy can be similar between emerging countries, as their economies are continually driven and adjusted by central bank decisions. For example, similarities in policy can be seen in South Africa and Mexico. In fact, the only noticeable nuance between the two is the institution of a trade weighted system. This simply means that the currency is stabilized against a basket of currencies that is issued by the biggest trade partners of the country. The creation of the basket helps to isolate the usually free floating or managed floating currency from wild speculative fluctuations that can wreak havoc on a country’s currency and its economy. In South Africa, the Reserve Bank of South Africa very loosely institutes this rule, allowing the South African rand to float freely versus other major currencies like the euro and U.S. dollar.

In order to protect the wild fluctuations in the market, a trade-weighted basket is instituted to back the currency. Recently, the central bank has loosened the policy considerably as interest rates have become a more focused concern for the markets. However, with considerations in consumer and producer prices, along with overall industrial production, the South African central bank tends to rule in favor of rate hikes or cuts, much like U.S. Federal Reserve Chairman Ben Bernanke, in adjusting the benchmark interest rate. The same is applied in Mexico, where the governor makes adjustments in the corto (central bank rate) at monthly meetings. (For more insight, see Formulating Monetary Policy.)

Comparatively, central bank policy is quite different in the Singapore and Hong Kong economies. With a similar peg to the dollar as in the Chinese yuan, there is little need for central bank consideration in Hong Kong. Since the establishment of the Hong Kong Monetary Authority (HKMA) in 1993, the main focus of the central bank has been to stabilize the underlying HKD along with the banking sector, rather than maintain the stability and growth of the economy. In this way, the HKMA maintains a linked exchange rate system where the domestic currency is linked to an anchor currency, usually the British pound or the U.S. dollar.

In addition, the corresponding value of the exchange rate is backed by the equivalent value in circulation with U.S. dollars in order to maintain the stability of the underlying currency. The system is somewhat similar in the Singapore economy, as the SGD is floated by a managed, rather than trade weighted, basket of currencies. Including the economy’s biggest trade partners and competitors, the contents of the basket are widely undisclosed in order to maintain the integrity of the basket and exclude it from monetary pressures and speculative fluctuations. However, broader guesses include an overweight in euros and U.S. dollars while also including the Chinese renminbi, Malaysian ringgit and Japanese yen.

On the monetary front, the Monetary Authority of Singapore issues a biannual monetary bias regarding its review of the economy in April and October. This bias helps to dictate intermediate direction in monetary policy while measuring the width of the band that restricts the overall movements of the underlying currency. Ultimately, the institution of such regimes in both economies has helped to keep the Asian currency pairs in relatively narrow ranges with intraday fluctuations keeping within a tight 30-50 point range, similar to the major Japanese yen ranges. (To read more, see Get To Know The Major Central Banks and Using Currency Correlations To Your Advantage.)
Ranges and Volatility
Another consideration is the range and volatility of emerging market currency pairs. Once again, similar to major industrial denominations, there are certain times of the day where market conditions promote a more liquid and active market. The boost in volume is similar to the major currencies where, for example, British pound trading tends to pick up in volume at the beginning of London market hours and tends to lay low around the Asian market hours. Similarly, South African rand trading picks up during the London start as well, lending to ranges as wide as 2,000 points per day, but it slows to a crawl when approaching the U.S. market midday session. Comparatively, the Hong Kong dollar tends to remain relatively low on all sessions as the currency is seemingly unaffected by mass speculation. The low-key market interest keeps the currency under constant barriers, helping to restrict the range of movement to relatively smaller 25-30 pip fluctuations. Knowing these simple nuances will help in identifying profitable currencies and their opportunities to suit each individual trader.

How to Trade: An Emerging Example
Let’s take a look at a textbook trade, applying our technical analysis that would normally be placed on a major currency pair trade. In our example, we are going to initiate a position in the South African rand. Usually a more volatile pair, it acts much like the British pound / Swiss franc currency cross - this simply means higher ranges and wider stops.(For related reading, check out Making Sense Of The Euro/Swiss Franc Relationship.)

Source: FX Trek Intellicharts

Figure 1: A wild ride: the rand offers a lot of potential

• Taking a look at the uptrend: At the beginning of the year, we see the U.S. dollar gain as traders in the market see the previous appreciation in the South African rand as slightly overextended, and find major support at the 6.0000 handle. Rising a whopping 15,000 points over the course of six months, dollar demand topped out as longer term resistance mad capped gains near the 7.5715 figure.With sentiment of dollar buying still somewhat positive during this period of Federal Reserve rate stabilization, traders looking to make a longer term profit are likely to pare back gains and re-initiate bids on a pullback.
• Applying technical levels: In Figure 2, the chartist applies the everyday stochastic oscillator and Fibonacci retracements to isolate an entry on the longer term daily time frame. As a result, an opportunity presents itself as the emerging market pair consolidates perfectly on the 50% Fibonacci of the May 2006 – July 2006 advance at 6.7457. Confirmation of an uptrend is obtained through the forming golden cross in the stochastic oscillator. (To learn more, read Advanced Fibonacci Applications and Retracement Or Reversal: Know The Difference.)
  

  Source: FX Trek Intellicharts

  Figure 2: Applying technical indicators: the chartist isolates an entry

  
  

• Taking a closer look: Looking closer into the price action, the trader will also note the channel that has formed with additional support emerging from the lower trendline. With the golden cross almost completed, the entry here would be a bounce off of the Fibonacci level. In this case, the trader would do well to place the entry above the high of the first candle showing a reversal in the downtrend at Point A (Figures 3 and 4).

Source: FX Trek Intellicharts

Figure 3: Taking a closer look

Placing the entry: This would place the entry 10 points above at 6.8285, ensuring that when our stop entry is executed, momentum is still there to move the position higher. A corresponding stop would be applied to below the low, as it corresponds with some wiggle room for the long position below the Fibonacci level. In this instance, this would be 15 points below at 6.7035. Granted, this is a stop positioned more than 100 points away, but remember that the currency has been known to move almost 2,400 points in one session, which justifies the wider stop (Figure 4 below).

Ultimately, the long position pays off before finding considerable resistance at the even 8.000 handle as the Reserve Bank of South Africa elects to raise interest rates again, giving the rand some strength to build on. Nonetheless, this gives our trade almost 12,000 points of profit, more than a 100:1 risk/reward ratio before the longer term trend reserves, taking the currency pair lower.

Source: FX Trek Intellicharts

Figure 4: Point a marks the spot

Conclusion
Although relatively unknown and different, emerging market currency pairs offer extended opportunities to both the novice FX traders and seasoned veterans. With market conditions similar to more accepted major currency pairs, traders are able to carry over their knowledge and experience in G7 denominations to isolate trading opportunities in the emerging market realm. However, much like how crosses compare to major currency pairs, these underlying denominations do offer differing personalities and will take time to understand. Despite this, the efforts are worthwhile, allowing investors to broaden their growth horizons and enter an opportunistic world only previously accessible to the larger institutional trader.

Related articles

• IMF: EU Needs Bigger Rescue Fund (huffingtonpost.com)
• Recovery builds but Europe, inflation pose risks: IMF (reuters.com)
• “IMF Global Economic Forecast Revised Up on Emerging Market Growth & US Tax Cuts” and related posts (moneymorning.com)

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Permanent Portfolio Locks In Long-Term Profits

It’s most often during difficult economic times that the “permanent portfolio” comes back into vogue. But the strategy doesn’t require a crisis to be successfully implemented. Nor is it only during steep market breaks that it reaps the greatest benefits. Indeed, the permanent portfolio has proven itself for over 30 years as a fundamentally sound means of protecting and growing investment assets.

The permanent portfolio is the brainchild of Harry Browne, a two-time Libertarian Party candidate for President of the United States, who claimed that his method of asset allocation was a fail-safe program for wealth creation. And the numbers support him. Between 1970 and 2003 the permanent portfolio averaged gains of 9.7% annually, with its single worst performance in 1981 when it lost a mere 6%. So what is the permanent portfolio, and what are the underlying investment principles that vouchsafe such remarkable returns?

1. Asset Allocation
Browne agreed with the modern portfolio theory that an important key to investment success is proper asset allocation. But Browne’s allocations are unique in the world of investing; indeed, they’re the essence of the permanent portfolio. Browne believed one’s resources should be divided into four equal components, comprised of:

• 25% stocks made up of stock index funds, which would capture the full upside of any broad market move, i.e., the S&P 500 or Russell 2000. Browne patently did not advise investors to pick their own equities for this portion of the portfolio.
• 25% bonds, specifically long-term U.S. obligations, i.e., 30-year Treasuries.
• 25% gold, for which Browne recommended bullion coins rather than paper obligations.
• 25% cash, for which Browne recommended potentially the safest of all possible investments, a Treasury Bill money market fund (For more read What is a permanent portfolio?)

2. Philosophy
But why this allocation in particular? Browne believed that each of the aforementioned four asset classes would thrive in one of the four possible macroeconomic scenarios that exist.

• Stocks would thrive during periods of economic prosperity.
• Bonds would do well in deflation and acceptably well during periods of prosperity.
• Gold during periods of high inflation would rapidly increase in value as the only true defense against a deteriorating currency. (Read 8 Reasons To Own Gold.)
• Cash would act as a buffer against losses during a routine recession or tight-money episode, and would act well in deflationary times. (Read Recession-Proof Your Portfolio.)

What Browne understood – and attempted to exploit – was the almost complete lack of correlation between the four components. That is, each asset class rarely moves in tandem with any other, and if it does, it doesn’t do so for a prolonged period of time. The phenomenon is also well understood by most sophisticated money managers, but Browne applied the principle in the creation of a defensive investing posture within a passive system.

3. Operations
The system Browne built was meant to be left alone. Trading in and out of positions defeated the purpose of the permanent portfolio. Instead, Browne advised the portfolio be rebalanced any time one or more of the four equal asset allocations strayed too far from its ideal 25% holding. So, if, for instance, after one year the gold holding appreciated to be worth 40% of the portfolio, while the other three segments remained equally proportioned at 20% each, one simply sold off the 15% excess in gold and distributed it equally among the three laggards.

Here, too, however, Browne set parameters. He advised rebalancing only when one segment dropped to below a 15% allocation or rose to above 35%. At that point only should all four asset classes be rebalanced to 25%.

This was the extent of the investor’s involvement in the portfolio. Truly passive, the permanent portfolio does not rely on market timing or finding the best stock picking fund manager in order to succeed. (If volatility and emotion are removed, passive, long-term investing comes out on top, see Buy-And-Hold Investing Vs. Market Timing.)

4. Results
There have been a number of studies that back-tested Browne’s portfolio over three decades, and the results are impressive. In no single year was a loss incurred that was greater than six percent – and this was the first goal of Browne’s project: to avoid taking a big loss. As for overall performance, the studies reveal that for the 33 years, between 1970 and 2003, the portfolio rendered 9.7% annually.

And for those interested in real time results that include the crash of 2008, there exists a Permanent Portfolio Fund (MUTF:PRPFX) that, although slightly modified from Browne’s original model, provides an excellent sampling of what the permanent portfolio is capable of. Between 2003 and the summer of 2009 – a period which includes the dire results of 2008 – the permanent portfolio returned an annualized 8.92%.

In arguably the worst market in 90 years, that is, in 2008 alone (January 4, 2008-January 2, 2009) the fund dropped a mere 9.11%.

5. Risks and Modifications
The permanent portfolio fund is only one of many variations on the original theme promoted by Browne. And to date, it rates as very successful. The fund rating agency, Morningstar, dubs it with its highest five-star rating over three, five and 10 years and gives it five stars overall. Noteworthy for them is the minuscule standard deviation on the fund, which means investors sleep easier for the minimal “whipsaw” action in the fund on a daily basis. (The bell curve is an excellent way to evaluate stock market risk over the long term Stock Market Risk: Wagging The Tails.)

Managers of the fund have seen fit to deploy their resources in six target areas rather than four. They are: precious metals, Swiss francs, global real estate stocks, natural-resources stocks, domestic growth stocks and U.S. bonds.

The only generally-recognized drawback to the permanent portfolio (and, indeed, to the fund that shares its name) is that it will underperform broad sectors of the market for lengthy periods of time should there be an extended run in one particular asset class.

In the 1990s, for example, the permanent portfolio fund did not keep pace with the overall stock market, catching up only in subsequent years as bonds, cash and precious metals outperformed. In short, the permanent portfolio requires time to work. It should be considered a get-rich slowly scheme. (For a complete guide, see the Industry Handbook Tutorial.)

Conclusion
Asset allocation is widely understood to be the most important factor in generating long-term investing profits, and Harry Browne’s approach continues to prove itself as sound a method as any for doing so. Even more so, perhaps, because it takes as its departure point the potential negative impact of all economic scenarios on one’s investment portfolio. When it comes to investing, the best offense is a good defense.

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• Rebalance Your Portfolio (bargaineering.com)
• Rebalancing your RRSP can boost gains (moneyville.ca)

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Forecast The FX Market With The COT Report

Between 2001 and 2004, volume in the foreign-exchange market increased more than 50%, illustrating the overall rise in popularity of currency trading. The advent of online trading following the technology boom has allowed many equity and futures traders to look beyond their more traditional trading instruments. Most short-term traders or speculators trade FX based on technical analysis, so equity and futures traders who use technical analysis have made the switch to FX fairly easily. However, one type of analysis that traders have not been able to transfer over to currencies is volume-based trading.

Since the currency market is decentralized and there is no one exchange that tracks all trading activities, it is difficult to quantify volume traded at each price level. But in place of volume-based trading, many traders have turned to the Commodity Futures Trading Commission‘s Commitments of Traders (COT) report, which details positioning on the futures market, for more information on positioning and volume. Here we look at how historical trends of the COT report can help FX traders. (Find out how to gauge the psychological state of a currency market in Gauging Major Turns With Psychology.)

What is the COT Report?
The Commitments of Traders report was first published by the CFTC in 1962 for 13 agricultural commodities to inform the public about the current conditions in futures market operations (you can find the report on the CFTC website here). The data was originally released just once a month, but moved to once every week by 2000. Along with reporting more often, the COT report has become more extensive and – luckily for FX traders – it hasalso expanded to include information on foreign currency futures. If used wisely, the COT data can be a pretty strong gauge of price action. The caveat here is that examining the data can be tricky, and the data release is delayed as the numbers are published every Friday for the previous Tuesday’s contracts, so the information comes out three business days after the actual transactions take place.

Reading the COT Report
Figure 1 is a sample euro FX weekly COT report for June 7, 2005, published by the CFTC. Here is a quick list of some of the items appearing in the report and what they mean:

• Commercial – Describes an entity involved in the production, processing, or merchandising of a commodity, using futures contracts primarily for hedging
• Long Report – Includes all of the information on the “short report”, along with the concentration of positions held by the largest traders
• Open Interest – The total number of futures or options contracts not yet offset by a transaction, by delivery or exercise
• Noncommercial (Speculators) – Traders, such as individual traders, hedge funds and large institutions, who use futures market for speculative purposes and meet the reportable requirements set forth by the CFTC
• Nonreportable Positions – Long and short open-interest positions that don’t meet reportable requirements set forth by the CFTC
• Number of Traders – The total number of traders who are required to report positions to the CFTC
• Reportable Positions – The futures and option positions that are held above specific reporting levels set by CFTC regulations
• Short Report – Shows open interest separately by reportable an non-reportable positions
• Spreading – Measures the extent to which a non-commercial trader holds equal long and short futures positions

Figure 1

Taking a look at the sample report, we see that open interest on Tuesday June 7, 2005, was 193,707 contracts, an increase of 3,213 contracts from the previous week. Noncommercial traders or speculators were long 22,939 contracts and short 40,710 contracts – making them net short. Commercial traders, on the other hand, were net long, with 19,936 more long contracts than short contracts (125,244 – 105,308). The change in open interest was primarily caused by an increase in commercial positions as noncommercials or speculators reduced their net-short positions.

Using the COT Report
In using the COT report, commercial positioning is less relevant than noncommercial positioning because the majority of commercial currency trading is done in the spot currency market, so any commercial futures positions are highly unlikely to give an accurate representation of real market positioning. Noncommercial data, on the other hand, is more reliable as it captures traders’ positions in a specific market. There are three primary premises on which to base trading with the COT data:

• Flips in market positioning may be accurate trending indicators.
• Extreme positioning in the currency futures market has historically been accurate in identifying important market reversals.
• Changes in open interest can be used to determine strength of trend.

Flips in Market Positioning
Before looking at the chart shown in Figure 2, we should mention that in the futures market all foreign currency exchange futures use the U.S. dollar as the base currency. For Figure 2, this means that net-short open interest in the futures market for Swiss francs (CHF) shows bullish sentiment for USD/CHF. In other words, the futures market for CHF represents futures for CHF/USD, on which long and short positions will be the exact opposite of long and short positions on USD/CHF. For this reason, the axis on the left shows negative numbers above the center line and positive numbers below it.

The chart below shows that trends of noncommercial futures traders tend to follow the trends very well for CHF. In fact, a study by the Federal Reserve shows that using open interest in CHF futures will allow the trader to correctly guess the direction of USD/CHF 73% of the time.

Figure 2: Net positions of noncommercial traders in the futures for Swiss francs (corresponding axis is on the left-hand side) on the International Monetary Market (IMM) and price action of USD/CHF from April 2003 to May 2005 (corresponding axis is on the right-hand side). Each bar represents one week. Source: Daily FX.

Flips – where net noncommercial open-interest positions cross the zero line – offer a particularly good way to use COT data for Swiss futures. Keeping important notation conventions in mind (that is, knowing which currency in a pair is the base currency), we see that when net futures positions flip above the line, price action tends to climb and vice versa.

In Figure 2, we see that noncommercial traders flip from net long to net short Swiss francs (and long dollars) in June 2003, coinciding with a break higher in USD/CHF. The next flip occurs in September 2003, when noncommercial traders become net long once again. Using only this data, we could have potentially traded a 700-pip gain in four months (the buy at 1.31 and the sell at 1.38). On the chart we continue to see various buy and sell signals, represented by points at which green (buy) and red (sell) arrows cross the price line.

Even though this strategy of relying on flips clearly works well for USD/CHF, the flip may not be a perfect indicator for all currency pairs. Each currency pair has different characteristics, especially the high-yielding ones, which rarely see flips since most positioning tends to be net long for extended periods as speculators take interest-earning positions.

Extreme Positioning
Extreme positioning in the currency futures market has historically also been accurate in identifying important market reversals. As indicated in Figure 3 below, abnormally large positions in futures for GBP/USD by noncommercial traders has coincided with tops in price action. (In this example, the left axis of the chart is reversed compared to Figure 2 because the GBP is the base currency.) The reason why these extreme positions are applicable is that they are points at which there are so many speculators weighted in one direction that there is no one left to buy or sell. In the cases of extreme positions illustrated by Figure 3, every one who wants to be long is already long. As a result, exhaustion ensues and prices begin reversing.

Figure 3: Net noncommercial positions in GBP futures on IMM (corresponding axis is on the left-hand side) and price action of GBP/USD (corresponding axis is on the right-hand side) from May 2004 to April 2005. Each bar represents one week. Source: Daily FX.

Changes in Open Interest
Open interest is a secondary trading tool that can be used to understand the price behavior of a particular market. The data is most useful for position traders and investors as they try to capitalize on a longer-term trend. Open interest can basically be used to gauge the overall health of a specific futures market; that is, rising and falling open interest levels help to measure the strength or weakness of a particular price trend. (To learn more, read Gauging Forex Market Sentiment With Open Interest.)

For example, if a market has been in a long-lasting uptrend or downtrend with increasing levels of open interest, a leveling off or decrease in open interest can be a red flag, signaling that the trend may be nearing its end. Rising open interest generally indicates that the strength of the trend is increasing because new money or aggressive buyers are entering into the market. Declining open interest indicates that money is leaving the market and that the recent trend is running out of momentum. Trends accompanied by declining open interest and volume become suspect. Rising prices and falling open interest signals the recent trend may be nearing its end as fewer traders are participating in the rally.

The chart in Figure 4 displays open interest in the EUR/USD and price action. Notice that market trends tend to be confirmed when total open interest is on the rise. In early May 2004, we see that price action starts moving higher, and overall open interest is also on the rise. However, once open interest dipped in a later week, we saw the rally topped out. The same sort of scenario was seen in late November and early December 2004, when the EUR/USD rallied significantly on rising open interest, but once open interest leveled off and then fell, the EUR/USD began to sell off.

Figure 4: Open interest in the EUR/USD (corresponding axis is on the left-hand side) and price action (corresponding axis on right-hand side) from January 2004 to May 2005. Each bar represents one week. Source: Daily FX.

Summary
One of the drawbacks of the FX spot market is the lack of volume data. To compensate for this, many traders have turned to the futures market to gauge positioning. Every week, the CFTC publishes a Commitment of Traders report, detailing commercial and non-commercial positioning. Based on empirical analysis, there are three different ways that futures positioning can be used to forecast price trends in the foreign-exchange spot market: flips in positioning, extreme levels and changes in open interest. It is important to keep in mind, however, that techniques using these premises work better for some currencies than for others.

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An Introduction To Oscillators

Oscillators are indicators that are used when viewing charts that are non-trending. Moving averages (MA) and trends are paramount when studying the direction of a stock. A technician will use oscillators when the charts are not showing a definite trend in either direction. Oscillators are thus most beneficial when a company’s stock either is in a horizontal or sideways trading pattern, or has not been able to establish a definite trend in a choppy market.

When the stock is in either an overbought or oversold situation, the true value of the oscillator is exposed. With oscillators a chartist can see when the stock is running out of steam on the upside, the point at which the stock moves into an overbought situation. This simply means that the buying volume has been diminishing for a number of trading days which means traders will then start to sell their shares. Conversely, when a stock has been sold by a greater number of investors for a consistent period of time ranging from one to six months or longer, the stock will enter an oversold situation. (For related reading, see The Basics of Money Flow.)

The Relative Strength Index
In the example below, you can see Microsoft’s (Nasdaq:MSFT) lower range of the relative strength index (RSI) is 30 and the upper range is 70. The midrange is 50. We now understand that the RSI becomes oversold at the 30 level and overbought at the 70 level. Some charts and theories would use 20/80 as the low/high boundary. For some technicians, these numbers may be far too conservative, causing the trader to be too late on the buy side and therefore miss out on capital gains. Also, if traders use the 80 high mark, they may miss the true selling point on the overbought side.

Arrows are shown at the entry points at which the RSI bounces off the 30 level. By drawing a horizontal channel between the $66 and $72 price levels, we have marked the horizontal trading pattern. Notice that the RSI tends to remain well above 50 while the price action is inside this horizontal channel. Here the RSI shows a somewhat overbought situation, but no major selling pressure is evident.  Many investors believe Microsoft can be purchased at any level because they will hold it in their portfolios for the long-term and are not concerned with trading it short-term. (To learn more about RSI, see Ride The RSI Rollercoaster.)

Source: TradeStation

J. Welles Wilder, Jr. developed the RSI and first shared it with the technical community in his book ”New Concepts in Technical Trading Systems.” It’s a must read for anyone planning to use oscillators to determine buy and sell points.

Bottom Line
You will begin to notice that one indicator looks very similar to others and using one indicator in conjunction with another is a very useful tool for determining the important entry/exit points. Using this indicator you can see how professional traders can be in and out of stocks long before the average investor, and you will also be able to find a comfortable trading range.

Related articles

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Currency Cross Triangulation

The major significance and importance of cross currency triangulation is due to the fact that many spot currency cross pairs are not traded against each other in the interbank market as standard pairs. With a realignment of the currency markets due to the adoption of the euro, cross currency pairs such as the EUR/JPY, GBP/CHF, GBP/JPY and EUR/GBP, as well as many other cross currency pairs, developed over time for many reasons. Major companies, importers and exporters, governments, investors, and tourists all needed a method to simultaneously transact business in euros while allowing for money and profits to repatriate back to their home currencies.

The major significance and importance of cross currency triangulation is due to the fact that many spot currency cross pairs are not traded against each other in the interbank market as standard pairs. With a realignment of the currency markets due to the adoption of the euro, cross currency pairs such as the EUR/JPY, GBP/CHF, GBP/JPY and EUR/GBP, as well as many other cross currency pairs, developed over time for many reasons. Major companies, importers and exporters, governments, investors, and tourists all needed a method to simultaneously transact business in euros while allowing for money and profits to repatriate back to their home currencies.

Notice that none of the base currencies in these pairs is a nation that has adopted the Maastricht Treaty (and therefore rejected adoption of the euro). With the European Union’s implementation of Rule 1103/97 on September 11, 1997, a formal legality existed for calculating conversions to euros. This rule also established convertibility to six, then three, decimal places and the adoption of triangulation as the legal norm for transacting business in the Eurozone. What this legality gave to investors, traders and bankers was a new means to trade currencies with a whole host of new profit opportunities. For this article, the focus will be about triangulation as a means to trade and profit. (For background reading, check out our Forex Tutorial.)

How Triangulation Changes the Process
Before triangulation existed, a company in the U.K. selling in Switzerland and receiving Swiss francs had to sell Swiss francs for U.S. dollars and the sell U.S. dollars for British pounds. Before cross currencies existed, repatriations occurred by triangulating pairs with U.S. dollars. So triangulation with crosses gave us a means to take advantage of bid-ask spreads in the interbank market.

Well-capitalized investors and traders can always find discrepancies on a daily basis between bid-ask spreads through the many cross pairs that exist today thanks to the inclusion of euros, although these arbitrage opportunities may last for as little as 10 seconds. Fortunately, computers linked directly to the interbank market can easily meet this challenge and profit through bid-ask spreads around the world from banks that make markets in currencies. (To learn more, see Arbitrage Squeezes Profit From Market Inefficiency.)

Example No.1
For example, suppose we know the bid and offer of AUD/USD and NZD/USD and we want to profit from AUD/NZD.

AUD/NZD bid = AUD/USD bid divided by NZD/USD offer equaling a certain rate
AUD/NZD offer = AUD/USD offer divided by NZD/USD bid equaling a rate

The product of the rate through the bid-ask spread will determine whether a profit opportunity exists.

Example No.2
Suppose that we have a three-pair triangulation opportunity such as GBP/CHF, EUR/GBP and EUR/CHF. GBP/CHF is quoted from EUR/GBP and EUR/CHF. Notice the base currencies within EUR/GBP and EUR/CHF. They equal the GBP/CHF, but we must make our euro conversions in order to achieve our objective.

GBP/CHF bid = EUR/CHF bid divided by EUR/GBP offer = a certain rate
GBP/CHF offer = EUR/CHF offer divided by EUR/GBP bid = a certain rate calculated in euros

Did you earn a profit in this example? It would depend on exchange rates. Notice conversion of euros from GBPs and CHFs. Triangulating currencies usually involves either euro or U.S. dollar conversions.

Example No.3
For example, suppose we triangulate a U.S. dollar conversion from CHF/JPY. CHF/JPY is simply USD/CHF and USD/JPY. The bid equals the division of the bid of the cross rate terms currency (top) by the offer of the base (bottom). To find the offer, divide the offer of the terms currency by the bid of the base.

If the USD/CHF rate is 1.5000-10 and USD/JPY is 100.00-10 for a CHF/JPY cross rate the bid would be 100.00 divided by 1.5010 or 66.6223 JPY/CHF. The offer would be 100.10 divided by 1.5000 or 66.7337 JPY/CHF.

Why Triangulate?
In most instances, triangulation involves profiting from exchange rate disparities. This can be accomplished in many ways. Suppose you institute two buys on a certain pair and one sell. Suppose you sell two pairs and buy one pair. Any number of triangulation opportunities exist every day from banks in Tokyo, London, New York, Singapore, Australia and all the paces in between. Yet these same opportunities may exist around the world trading the exact same pair. The most popular triangular opportunities are usually found with the CHF, EUR, GBP, JPY and U.S. dollars in order to convert from euros to home currencies. (To learn more, read Forex Currencies: Currency Cross Rates.)

The basic formula always works like this. A/B x B/C = C/B. The cross rate should equal the ratio of the two corresponding pairs. What is EUR/GBP equal to? EUR/USD divided by GBP/USD - just like GBP/CHF is equal to GBP/USD x USD/CHF.

What is noticeable more and more is that many brokers, including retail currency brokers, are including cross currency pairs in their dealing rates section of their trade stations. One can now trade the GBP/USD as easily as the USD/GBP and the EUR/USD as easily as the USD/EUR. The difference between the interbank market and the retail side of trading is the spot market. Because prices in the interbank market are so ephemeral, many may want to transact their business through the spot market where they know their trade will be executed.

Traders can easily transact any triangular arbitrage opportunities with two or three currency pairs crossed by many nations as well as take advantage of any other bid-ask spread opportunities. For the small retail trader with limited funds, this would probably work. But for the well-capitalized trader it may not because the spot market doesn’t always reflect exact exchange rates, so larger traders may have to wait on certain spot prices before transacting their business, a wait they may not be willing to risk in terms of profits.

The Bottom Line
In conclusion, many opportunities exist for the arbitrage and triangular traders that don’t always include exchange rate arbitrages. Traders may want to capitalize on merger and acquisition opportunities through the currency markets, swap trades, forward trades, yield curve trades and option trades. The same opportunities exist for each one of these markets.

Related articles

• CHF, JPY, AUD stay strong (forexlive.com)
• Currencies Spread Betting: What do you Need to Know? (prnewswire.com)
• CHF buyers still dominate the market (forexlive.com)

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How To Talk Like An Investor on forex

When it comes to understanding the long and short of investing, most beginner investors must learn what seems like a new language. In fact, the phrase “the long and the short of it” originated in financial markets. In this article we discuss certain key terms that will help you better understand and communicate with other market participants. These terms are used in the equity, derivative, future, commodity and forex (or currency) markets. You will learn what buying, selling and shorting really mean to investors and how they can use certain terms interchangeably with more confusing words like bullish and bearish. To compound the issue, options traders add in a few other terms like writing a contract versus selling one. When you can communicate properly, you will be better informed and can make wise investment decisions.

The Long and the Short of It
The financial markets allow you to do a few things that are really common in everyday life and a few things that aren’t. When you buy a car, you own that car. In the stock market, also known as the equity market, when you buy a stock, you own that stock. However, you are also said to be “long” on the stock or have a long position. Whether you are trading futures, currencies or commodities, if you are long on a position, it means you own it and hope it will increase in value. To close out of a long position, you sell it.

Shorting will likely seem somewhat foreign to most new investors because shorting a position in the equity market is selling stock you don’t actually own. Brokerage firms allow speculators to borrow shares of stock and sell them on the open market, with the commitment to eventually return the shares. The investor will then sell the stock at the day’s price in the hope of buying it back at a lower price while pocketing the difference. Catalog companies and online retailers use this concept daily by selling a product at a higher price, and then quickly buying it from a supplier at a lower price. The term originates from the situation where a person tries to pay a bill but is “short” on funds.

You may be interested to know that some people consider shorting to be unpatriotic or “bad form.” During the Great Depression, John Pierpont Morgan (J.P. Morgan) was famous for the phrase, “Don’t sell America short.” He was attempting to influence short sellers from pushing stocks lower. (The debate against short selling rages on to this day. See Short Selling: Making The Ban and Questioning The Virtue Of The Short Sale.)

The Currency Caveat
When trading foreign currencies in the “spot” market (currencies and many commodities are traded in the futures or spot markets), you are usually long one currency and short another. This is because you are exchanging one currency for another and therefore, various world currencies trade in pairs. For instance, if you think the U.S. dollar is going to rise but the euro is going to fall, you could short the euro and be long on the dollar. If you feel the dollar is going to rise and the Japanese yen will fall, you could be long on the dollar and short on the yen. (Also check out our Forex Tutorial for more in-depth explanations.)

Sentiment Speak
Other terms that are often new to beginning investors are “bullish” and “bearish.” The term bullish is used to describe a person’s feeling that the market will go up, while bearish describes a person who feels the market will go down. The most common way people remember these terms is that a bull attacks by ducking its head and bringing its horns upward. A bear attacks by swiping its paws down. Chicago is the home of commodity and futures markets; these markets are so ingrained within the identity of the city that the professional basketball team is the Bulls and the professional football team is the Bears. In fact, the Chicago Cubs’ mascot is a bear cub. Only the White Sox seem to be the odd one out in this correlation. (To learn more, see The Wall Street Animal Farm: Getting To Know The Lingo.)

It is also common for investors to use the terms “long” or “short” to describe their market sentiment. Instead of saying they are bullish on the market, investors may say they are long on the market. Similarly on the downside, investors may say they are short on the market instead of using the term bearish. Either term is acceptable when describing your market sentiment; if you are bearish, you may also say you are short; if you are bullish, you may also say you are long. It is important to remember that short and long usually imply that you have a certain position in whatever market you are trading, but as you can see, that isn’t always the case.

Derivative Dialects
The derivative market is also known as the options market. Options are contracts in which one party agrees to buy or sell a certain security (security is a generic term for any financial product) at a set price and set time to another party. Options are very common in the equities market but are also used in the futures and commodities markets. The forex, or currency, market is known for very creative derivatives known as exotic options. For our purposes, we’ll refer to options in the stock market since it is most investors’ first introduction to derivatives.

Options come down to calls and puts; call options give the contract buyer the right to purchase stock shares at a set price on or before a set date. Usually another investor will sell a call contract, which means they believe the stock will stay flat or go down. The person who buys the call is long on the contract, whereas the person who sells the contract is short.

A put option allows the contract buyer to sell stock at a set price before a set date. Like a call option, there is usually another investor willing to sell the option contract, which also means that investor believes the stock will either stay about the same price or rise in value. So the person who buys the option contract is long on the contract and the person who sold the contract is short.

Selling options while using the derivative dialect also gets more complicated because not only do they use the terms “sell” or “short” regarding the contract, option traders will also say they “wrote” a contract. Today, the contracts are standardized and no one really “writes” the contract, but the term is still very common. Covered calls are often one of the first option strategies investors learn; these involve the purchase of a stock and the sale of a call contract at the same time. The stock purchased acts as “collateral” in case the call is exercised by the option buyer and the seller can relinquish the shares while keeping the premium gained for selling the option. Because investors are buying a stock and selling a call at the same time, they use a “buy-write” order. (Refer to our Options Basics Tutorial to explore these topics in more detail.)

Market Double Talk
At this point, you may find yourself going back to reread some of the vocabulary that was just discussed. Let’s do a quick recap. Investors will either say they are bullish, or long, on the market, or bearish, or short, on the market. If we are long one currency in the forex spot market, we are short another currency at the same time. This can be confusing but not nearly as confusing as the options market.

In the options market, we can say we are bullish on a stock and then short a put because while being bullish, we can either buy a call or sell a put. We can be bearish on a stock and be long on a put because if we are bearish, we can either buy a put or sell a call. This may also mean that we are short on the market by going long on a put or long the on market by shorting a call. You can imagine the linguistic laughter that comes from a group of option buyers talking to each other.

In many cases, and not just in the financial world, overcoming the language barrier will be one of the vital keys to success. Investing carries with it its own language barricades that must be broken down by translating the terms and subduing the syntax.

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Free Market Maven: Milton Friedman

Milton Friedman and John Maynard Keynes are as integral to the story of economics as Adam Smith and Karl Marx. What Keynes wrought, Friedman undid, and supporters of the free market are deeply in debt to this Chicago school academic for his effort. In this article, we will look at the life and contributions of Milton Friedman. (To learn more about these great economic thinkers, read our related article The History Of Economic Thought.)

The Father of Income Tax Withholding
Milton Friedman was born in Brooklyn in 1912, one of four children born to Jewish immigrants. He studied at Rutgers University, Chicago University and Columbia, focusing on mathematics and economics. During his Ph.D., WWII broke out and Friedman took a break to work for the Treasury Department. He was part of a think tank that brought about income tax withholding as a “temporary” measure to help fund the war. Though he never questioned the necessity of it in wartime, Friedman later regretted having forced withholding on Americans. Friedman was appalled when the government made the emergency measure a permanent part of its peacetime taxation. (Learn how Milton Friedman’s monetarist views shaped economic policy after World War II, read Monetarism: Printing Money To Curb Inflation.)

First Blood - Attacking the Keynesian Assumptions
Friedman continued his studies after the war and began to show his free-market colors in a time of Keynesian domination. Taking up a teaching post at the University of Chicago, Friedman wrote free-market analysis of the damage done by rent controls and monopolistic practices in the medical profession. In 1957, Friedman launched his first direct attack against Keynesian thinking with “A Theory of the Consumption Function“ - an attack on one of the assumptions of Keynes’ model. (Learn more about Keynes’ models and policies in Giants Of Finance: John Maynard Keynes.)

Keynesians support short-term solutions to spur consumer spending and the economy. The idea is that by giving a temporary tax break like a stimulus check, the government can spur spending without giving up future tax revenues by making a meaningful tax cut – in short, the government gets to have its cake (economic recovery) and eat it too (maintain future taxes). Friedman took on this idea and analyzed actual empirical evidence. This was in contrast to Keynes and his followers who rarely did actual empirical studies.

Friedman showed that people adjusted their annual spending habits in response to real changes in their lifetime income, not temporary changes to their current income. In practice, this means that something concrete like a raise may prompt a family to spend more, but a short-lived boost from a stimulus check will not. This was the first crack in the Keynesian framework, but it was quickly followed by further attacks on the many dubious assumptions underlying the theory. (Find out how tax breaks can help the economy in our frequently asked question How do government-issued stimulus checks affect the economy?)

Friend of Investors and Savers
Instead of trying to boost the economy by trying to fool consumers, Friedman believed the same ends could be met by minimizing government involvement. This would be achieved by lessening taxes in the long term and ceasing inflationary policies. Inflation, Friedman pointed out, was just another attempt to fool consumers into thinking they were earning more, when the corresponding rise in the cost of living was actually canceling out any gains in wages. Friedman and the other economists at the Chicago school led attack after attack on concepts like the Keynesian multiplier and the damage of saving.

Friedman took issue with the Keynesian multiplier because it gave any form of government spending - even debt spending - a superior rating over private investment. Friedman pointed out that the more the government borrows to spend, the more pressure there is to inflate the currency to meet the payments in the future. Furthermore, government spending crowds out private investors who will sit on their capital when the government is paying for everything. Friedman argued that, at best, the multiplier was unjustified and the implications of government deficit spending needed to be looked at in a broader sense to measure the true impact.

Friedman Makes a Depressing Discovery
In his book, “A Monetary History of the United States” (1963), Milton Friedman and his coauthor Anna Schwartz showed how it was monetary policy, and not a failure of free market capitalism, that led to the Great Depression. Friedman surveyed almost a century of monetary policy during crashes, booms, recessions and depressions, and came to the conclusion that the Fed was a main cause of the depression because it shrunk the money supply by over a third between 1929 and 1933. This contraction turned a crash, something the U.S. had bounced back from many times before, into an extended depression. The connection was never made before because no figures on money supply were published until after Friedman and Schwartz’s book. (Learn more about the Great Depression in  What Caused The Great Depression? and The Great Depression (1929) section of our Crashes Special Feature.)

Free Market Hero and Hard Money Advocate
Friedman began to focus more and more on the role of money in the economy. Originally, he supported a gold standard to check inflation and prevent bank runs, but he moved toward a hard money policy where the amount of money in circulation would increase at the same pace as the nation’s economic growth. He believed this would be a sufficient check to keep governments from printing as much money as they pleased, while still increasing the money supply enough to allow growth to continue. In 1962, Friedman’s book “Capitalism and Freedom” set him up in the academic and public arenas as one of the rare defenders of free market capitalism.

“Capitalism and Freedom” espoused the free-market solutions to many problems and caught a lot of attention for proposing a negative income tax for people under a certain income and school vouchers to improve the education system. Friedman also wrote a regular column in Newsweek to explain both free-market principles and his monetary stance. In the 1980s, Friedman took his defense of the free market onto the airwaves with a PBS show called “Free to Choose” followed by a book of the same title that arguably made him the most famous economist alive.

Friedman Advocates for Currency Trading
In keeping with his opposition to Keynesian thinking, Milton Friedman took an active dislike to the Bretton Woods Agreement, an attempt to fix currencies rather than let them float in free-market fashion. In 1967, Friedman was positive that the British pound was overvalued and attempted to sell it short. He was refused by all the Chicago banks he called and vented his indignation in his Newsweek column, laying out the necessity of floating currencies for both public futures and a currency trading markets.

Friedman’s articles inspired Leo Melamed of the Chicago Mercantile Exchange to push for the creation of a forex market in 1972. Melamed consulted with Friedman about the probability of Bretton Woods falling apart – an event the viability of the new markets depended on. As Friedman assured Melamed, the Bretton Woods agreement collapsed and one currency after another was given over to float. The currency market is now the largest in the world, and is much more efficient than arbitrary pegging. (Learn the basics of the forex market by reading Getting Started In Forex.)

Stagflation and the Rise of Monetarism
Before his public success in the 1980s, Friedman had already gained considerable clout in economic circles. When the Keynesian system buckled under stagflation in the 1970s, academics began to take Friedman’s anti-inflation, hard money policies much more seriously. Monetarism started to eclipse Keynesian solutions. Friedman and other Chicago School economists became economic advisors to many governments. Collectively, they urged policies for hard money and small government, a throwback to the days of Adam Smith. (Read Stagflation, 1970s Style to learn more about how Milton Friedman’s monetarist theory helped bring the U.S. out of the economic doldrums.)

Friedman and the Chicago school garnered several Nobel Memorial Prizes in Economic Sciences for their work in dismantling the most damaging Keynesian concepts, but Friedman said himself in a 1998 speech, “We have gained on the level of rhetoric, lost on the level of practice.” By this he meant that academic circles had accepted free market principles as superior to Keynesian thinking, but governments were still enamored with Keynes. According to critics of Keynesianism, Keynesian economics is attractive to governments because it justifies even their most wasteful projects and excuses the bureaucratic excesses of big government. Friedman and his colleagues brought another alternative to big government, but felt that few governments were willing to give up the reins. (To learn more about the Nobel Memorial Prize in Economic Sciences, read Nobel Winners Are Economic Prizes.)

Nobel End
Milton Friedman came to the forefront of economics at a time when free market economists were in short supply. At every opportunity, Friedman argued passionately against government intervention and in favor of the free market. A firm believer in freedom, both in the markets and in personal life, Friedman was a member of the Mont Pelerin Society and later served as its president. He allowed that free market capitalism may not be the perfect solution, but asserted that it was by far the best out of all the alternatives known to us today.

Friedman’s awards and recognition are numerous, including his 1976 Nobel Memorial Prize, but the highest praise is that he continued to toil tirelessly defending freedom and debating all comers right up to his death in 2006. Countries like India and China that took Friedman’s message to heart and, many believe they are now reaping the economic benefits as a result. Friedman’s free market ideals provided a new way of looking at the economy and offered alternative ways for countries to build and maintain strong economies.

Related articles

• Friedman and the Paleomonetarists (krugman.blogs.nytimes.com)
• How not to talk to young people (sheffnersweb.net)
• Uncommon Knowledge with Milton Friedman (powerlineblog.com)

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Forex: Demo Before You Dive In

Because forex (FX) is a decentralized market in which dealers disseminate their own price feeds through proprietary trading platforms, it is crucial to learn the features and idiosyncrasies of each type of trading software before committing real funds to an account. Fortunately, in retail, FX traders can test out each platform using demo dollars. Every reputable dealer in FX allows potential customers to download a free demo version of its software. This is critical if the customer is to become acquainted with the platform’s layout and the means of order entry. Here we’ll discuss the importance of demo trading and let you know what you should look out for when trying different platforms. (If this seems a little over your head, check out our Forex Walkthrough Charts, Economics, Trading, or you could start at Beginner.)

Basic vs. Integrated Platforms
Looking at the following screen images, you can see how some platforms integrate everything from charting to news, while others have very simple layouts that focus only on price quotes, order entry and reporting.

Figure 1 – A very straightforward platform from FXCM. The primary focus is on execution – quotes, positions and account balances are all clearly marked and visible.

Figure 2 – A more integrated platform from Oanda that tries to combine quotes, charts and account balances all on one screen.

Figure 3 – Another integrated platform, this time from FX Solutions, that squeezes a trade summary, quotes and market news headlines all into one screen.

Placing Orders
As a trader, you should always try out dealer demos before trading live – it’s the only way to become familiar with the different features of various platforms. For example, some platforms simply use pop-up tickets, while others actually mark the order location on the chart. Typically, to buy a currency pair, you simply click on the offer part of the quote (the ask), and to sell, you click on the bid part. Some platforms allow you to choose market or limit orders after the quote window pops up, while others force you to make your selection beforehand. (For more information on placing orders, see The Basics Of Order Entry.)

It’s a good idea to place at least 20 demo trades on each platform before trading actual money, just so you can master the specifics of order entry on each platform. A trader should never trade live unless he or she can confidently answer all of the following questions:

1. How do I place a limit order?
2. How do I set a stop?
3. Can I set a limit and a stop at the time of entry?
4. Are the spreads on the platform fixed or variable?
5. What is the lot size that I can trade (1,000 units, 10,000 units, 100,000 units)?
6. Can I mix and match the lot sizes?
7. Can I call the dealing room directly if my internet connection goes down?

Figure 4 – A simple market order ticket on the FX Solutions platform that clearly shows that the user is selling 1 lot of GBP/USD.

Figure 5 – An example of an order ticket on the FXCM platform that allows the trader to attach stop and limit parameters to a market buy order of EUR/USD.

Figure 6 - From the Oanda platform, a limit order in EUR/USD that quotes all the way to five decimal places (i.e. 1/1000th of a penny!) and automatically makes the order good for a week.

The Taxman Cometh
One function that most new FX traders overlook is tax reporting. Because FX is a global, unregulated market, dealers as a general rule do not provide any documentation to the tax authorities in the trader’s country of residence. Tax reporting is solely the responsibility of the trader. Dealers simply produce detailed transaction histories – in an electronic format – from which the traders must then compile their own tax reports. Such an arrangement clearly calls for a trading platform with highly organized and flexible reporting functions. But reporting quality varies greatly from dealer to dealer: all dealers will provide you with a full transaction report, but how those transactions are laid out could mean the difference between spending hundreds of hours on reconciliation or taking one minute to print out a final report to present to your accountant. Note the different approaches to reporting in the following platforms:

Figures 7 and 8 – Note how the FXCM platform elegantly separates closed trades, outstanding orders and floating positions and then tidily summarizes all the key activity in an account summary.

Figure 9 – The Oanda platform requires the trader to do his/her own trade reconciliation.

Some FX traders may generate as many as 1,000 trades in a year. A platform that reconciles all those trades into an easy-to-understand, end-of-year income statement, breaking down all profits and expenses, can be invaluable. Reporting, though hardly the glamorous part of FX trading, is a crucial part of a trader’s personal record keeping and can have significant tax ramifications.

Tax treatment of currency trading is very much dependent on the individual’s tax status. Most dealers will not advise you regarding tax matters, nor should you take their advice if they do, because they lack the expertise to deal with the multitude of tax authorities around the world. You should always consult with a tax professional before choosing a course of action.

A final note on taxes and reporting: as you try out the various dealers’ platforms, you will find that certain functions are common across most software. The devil is in the details, which can determine the difference between profits and losses.

Trade Like It’s Real
Once you have mastered the mechanics, you can use the demo platform to experiment with various trade sizes and styles and determine your trading personality. Are you a short-term momentum trader who likes high leverage and tries to capture 20-30 point intraday moves? Or do you prefer using smaller sizes to hold longer-term positions that could potentially yield hundreds of points? Demo trading can help you discover what type of trading suits you best.

Always remember, however, that demo trading is in no way similar to trading real money. You may be perfectly calm about sustaining a $10-million loss with fake money, but might become completely unhinged over a $100 loss in your real account. To make demo trading as productive as possible, you need to trade the demo account as though the money were real. For example, if you plan on funding your real account with $5,000, don’t trade a demo account that has $100,000. The thrill of a $1-million trade can give you a temporary high, but it will only hurt when you have to transition to a real account, because you will have no sense of proportion and will likely make drastic errors in judgment.

Conclusion
Even after you decide to trade live, demo trading can be very valuable. Many successful traders will test strategies and set-ups on practice accounts before they try them out with real money. Although demo trading will not guarantee you profits in real life, almost all traders agree that if you cannot first achieve success on a demo, you are almost certain to fail in your live account. This is why demo trading is vital to the growth and development of all FX traders.

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Market Speculators: More Help Than Harm

Speculators get a bad rap, especially when oil prices spike or a currency’s value is shattered. This is because the media often confuses the line between speculation and manipulation. Manipulation leads to overall economic damage, whereas speculation performs several important functions that keep our economy healthy. In this article, we’ll look at the function of speculators in the market.

What is a Speculator?
Before we get too deep, we have to make a distinction between a speculator and your typical middleman. A middleman can be thought of as the means by which products are dispersed. It would be a very different world if the products we need and/or want were produced nearby. More often than not, every product in your house has at least a component that has taken an international voyage to get there. The markup of the middleman usually matches the materials and overhead costs used to ship, sort, bag and display those products in a store near you, plus some profit to keep the middleman fulfilling this function. This gets maple syrup to Hawaii, Korean laptops to New York and other products to destinations where a higher profit can be realized.

In contrast, the speculator makes his/her money through contracts that allow him/her to control commodities without ever directly handling them. Generally speaking, speculators don’t arrange shipment and storage for the commodities that they control. This hands-off approach has given speculators the erroneous image of aloof financers jumping into markets they care nothing about in order to make profits from the producers – the salt-of-the-earth types that legislators are always claiming to defend. (To learn more, see How Do Speculators Profit From Options?)

Avoiding Shortages
The most obvious function that people overlook when criticizing speculators is their ability to head off shortages. Shortages are dangerous because they lead to price spikes and/or rationing of resources. If a drought kills off half the yield of hay in a given year, it’s natural to expect the price of hay to double in the fall. On wider economies of scale, however, these shortages are not as easy to spot. That’s why commodities speculators help to keep an eye on overall production, recognizing shortages and moving product to places of need (and consequently higher profit) through intermediaries – the middlemen who use futures contracts to control their costs. In this sense, speculators act as financers to allow the middleman to keep supply flowing around the world.

More than merely financing middlemen, speculators influence prices of commodities, currencies and other goods by using futures to encourage stockpiling against shortages. Just because we want cheap oil or mangoes doesn’t mean we should blame speculators when prices rise. More often, other factors, such as OPEC and tropical hurricanes, have raised the risk of a more volatile price in the future, so speculators raise prices now to smooth down the potentially larger future price. A higher price dampens current demand, decreasing consumption and prompting more resources – more people to take up mango growing or more funds for oil exploration – to go into increasing stockpiles. This price smoothing means that, while you might not appreciate paying $5 for gas or a mango, you will always be able to find some.

Preventing Manipulation
While people may recognize speculators’ importance in preventing shortages and smoothing prices, very few associate speculation with guarding against manipulation. In markets with healthy speculation, that is many different speculators participating, it is much harder to pull off a large-scale manipulation and much more costly to attempt it (and even costlier upon failing). Both Mr. Copper and Silver Thursday are examples of ongoing manipulations that eventually collapsed as more market speculators entered opposing trades. To avoid manipulation in markets we need more speculation, not less. (For more, read The Copper King: An Empire Built On Manipulation.)

In thinly traded markets, prices are necessarily more volatile, and the chances for manipulation are increased because a few speculators can have a much bigger impact. In markets with no speculators, the power to manipulate prices swings yearly between producers and middlemen/buyers according to the health of the crop or yield of a commodity. These mini-monopolies and monopsonies result in more volatility being passed on to consumers in the form of varying prices.

Consequences and Currency
Even when we leave the level of commodities and go into one of the largest markets in the world, forex, we can see how speculators are essential for preventing manipulation. Governments are some of the most blatant manipulators. Governments want more money to fund programs while also wanting a robust currency for international trade. These conflicting interests encourage governments to peg their currencies while inflating away true value to pay for domestic spending. It’s currency speculators, through shorting and other means, that keep governments honest by speeding up the consequences of inflationary policies. (To learn more, check out Forces Behind Exchange Rates.)

Show Me the Money
Speculators can make a lot of money when they are right, and that can anger producers and consumers alike. But these outsized profits are balanced against the risks they protect those same consumers and producers from. For every speculator making millions on a single contract, there is at least an equal number losing millions on the trade – or a dollar on each of a million smaller trades. In very volatile markets, like those after a natural disaster or black swan event, speculators often lose money on the whole, keeping prices stable by making up the difference out of their deep pockets.

Hug a Speculator
Taken cumulatively, speculation helps us far more than it could ever hurt us by moving risk to those who can financially handle it. Despite the misunderstanding and negativity speculators have to face, the potential for outsized profits will continue to attract people, as long as governments don’t regulate them into oblivion. With all the negativity aimed towards short-sellers and speculators, it’s easy for us to forget that their activities maintain prices, prevent shortages and increase the amount of risk they undertake. I don’t want to become a speculator, but it’s important that we preserve speculative investing for the people who do – more than important, it’s a necessity for a healthy market and vibrant economy. You don’t have to become a speculator, or even hug the next one you see, just remember that the next time you pay $5 a gallon for gas, it’s so we’ll still have some left over for next week, year, decade and century. (For more, see Getting A Grip On The Cost Of Gas.)

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