The Finance Book Club

Part 2 - Trade the FX Market
Chapter 4 - Understand Market Structure
The Players
I’ll try to be as brief as possible where we’ve already talked about some of this before in other books.

1. Banks - big banks
   1. Interbank market - trading between banks
   2. Price discovery happens here
   3. Bank traders are market makers who take directional risk anticipating client flow

   
   

I know that XTX share has been going up annually and it may be the largest now.

1. Corporations and hedgers
   1. Big companies need to buy and sell currency daily
   2. There are many reasons why - for ex. Exporter selling goods to a foreign buyer
   3. Cross-border M&A
   4. Corporates are ‘more methodical and less active’

   
   

2. Hedge funds
   1. Searching for speculative profits
   2. Discretionary/macro funds - try to forecast trends and movements
   3. Short-term hedge funds with a macro approach are known as ‘fast money’

   
   

3. Commodity Trading Advisers, systematic and model funds
   1. Hedge funds that trade with algos, pattern recognition, correlation
   2. Their activity has eroded the performance of trend-following models

   
   

4. Real money
   1. Trading FX against an underlying asset
   2. Example of a US bond fund buying 2B EUR worth of Greek bonds; their cash balance is in USD but they need to pay for the bonds with EUR so the real-money client calls a bank, buys 2B EUR and sells USD
   3. Includes pension, mutual, bond funds, and insurance companies, equity hedgers

   
   

5. High Frequency Trading
   1. Profit from small movements and variations in FX
   2. Arbitrage, market-making, economic data trading, short-term correlation
   3. Contributes to noise

   
   

6. Central Banks
   1. Monetary policy
   2. Moral suasion
   3. FX intervention
   4. Diversification
   5. Intervention recycling (discussed in ch. 5 but I still don’t really understand what it is)

   
   

7. Sovereign wealth funds
   1. Trade actively in large amounts like central banks

   
   

Different currencies have different personalities

1. Developed Markets vs Emerging Markets
2. DM is the G10/G7 but includes CHF and DKK
3. Majors vs. Minors, etc.
4. European vs. commodity currencies
5. AUD influenced by copper, gold, iron ore
6. CAD influenced by oil, natural gas
7. NZD influenced by dairy

1. Skandies - SEK, NOK, DKK; not Finland as it’s part of the EU; DKK is pegged to the EUR so not useful in speculation
2. EM

1. Crosses
   1. The family of currencies belonging to one country for example the CAD crosses are EURCAD, USDCAD, CADCHF, CADJPY, NZDCAD, AUDCAD, GBPCAD

2. High yield vs low yield
   1. Carry trades - you can earn interest by holding a higher yielding currency against a lower yielding one
   2. Conversely it is unattractive to sell the higher yielding currency as swap fees will be higher
   3. Lately EUR, CHF and JPY have been lower yielding and tend to be safe havens
   4. EM and AUD,NZD are higher yielding and riskier
   5. Carry trades can be very profitable until they unwind suddenly “Like a fire in a disco, there is not enough time for everyone to get out of carry trades all at once and this leads to panic. As a general rule, high yielders go up slowly and down quickly (the distribution of returns is skewed).”
   6. Low yield currencies are sometimes called ‘funding currencies’ because they form the other side of a carry trade

USD (king dollar)

1. Has many unusual traits because it is the global currency, the world’s reserve currency
2. USD appreciates when the economy is doing very well OR very poorly thus it creates a ‘smile’ shaped graph

1. If global growth is ‘decent’ and US growth is ‘moderate’ the dollar sells off
2. In a recession the dollar rises which is counterintuitive; investors fear the global economy will follow suit and the USD is a safe haven
3. Global trade is finances in USD so less trade means fewer dollars in circulation which means a possible shortage of USD
4. BD reminds us that the why is less important than the what

Managed currencies

1. Non free-floating pairs
2. CNY, CNH, KRW, SGD, RUB, CHF and sometimes JPY
3. This can make these currencies unattractive to macro speculators because the central bank decisions will outweigh any macro factors
4. Domestic investors with inside information have a substantial edge over other traders
5. Dangerous for new traders

Volatility and Liquidity

1. You should watch a market for a month or two before you trade it (but BD says he is not a fan of paper trading)
2. Volatility regimes change over time
3. BD mentions that VAR traders learned this the hard way in 2008
4. You cannot trade as large a position in a volatile asset as your risk of ruin is higher
5. BD says many experienced traders never fully learned this
6. You need to normalize position size based on volatility
7. Liquidity is harder to measure than volatility but its effect is slippage (when liquidity is unavailable)
8. Higher spreads often mean lower liquidity
9. High volume currencies almost always have better liquidity

1. Traders want high vol and high liquidity
2. Says BD “Almost all traders should stick to liquid G10 FX because it is most liquid. There are numerous idiosyncratic issues involved in trading less-liquid currencies.”

Volatility and Liquidity vary by regime

1. Volatility tends to slowly unwind and then skyrocket after a disturbance

As you can see, volatility in FX is decreasing, but I suspect this is part of a cyclical effect and it may be on its way up, especially as folks increasingly lose confidence in fiat currencies.

1. FX vol and equity vol are loosely correlated

Volatility and liquidity vary by time of day

1. London/NY overlap is the most volatile - 6:00AM-11:00AM NY time
2. This is the best time to trade FX in general
3. Some currencies are more active in their own active time zones

1. London open (7:00 AM London time)
   1. Often an ‘inflection point’ as big risk takers process info that came in since yesterday
   2. An aggressive trading move often begins here

2. New York open (7:00 AM NY time)
   1. Beginning of the overlap
   2. NY will often extend the move begun by LON
   3. Then it will reverse later in the day
   4. This pattern was ‘especially prevalent’ during the Eurozone crisis
   5. LON would come in and sell Euros, NY would do the same and then around 8:00 AM NY (only one hour later?) EURUSD would squeeze higher for the rest of the day
   6. These intraday patterns can be ‘surprisingly persistent’ (and profitable I would guess but for one problem - there isn’t really any such pattern - feel free to hunt for it yourself and be sure to let me know that I’m wrong and you’re smarter than me)

3. ECB fix (1:15 LDN time)
   1. BD tells us about something that doesn’t exist anymore PFFT

4. US Economic data (8:30 AM and 10:00 AM NY, mostly)

1. The rest of this section is BD telling us about data that comes out at random times

1. Option expiry (10:00AM NY)
   1. Most currency options expire this time
   2. This creates a burst as ‘market-makers hedge the change in their deltas’
   3. My question is if you are really going to be thinking about this with everything else going on? BD goes on to mention all kinds of other options that expire at different times

2. 4:00PM WMR Benchmark fix LDN time
   1. “Many, many FX players, especially real money, use the WMR fix to value their foreign bond and equity holdings”
   2. As a result there is a large spike
   3. Essentially marks the end of the LON session
   4. 3:00-4:00 is a period where some discretionary traders square up for the day
   5. Huge volumes
   6. Not price-sensitive
   7. Often there is a reversal at 4:02 or so when pressure abates
   8. However BD advises against systematically going against WMR fix moves
   9. The month-end WMR fix will be the biggest
   10. “Watch for crazy moves around 4:00PM LDN (11:00AM NY) on the last day of every month. The hours leading up to the month end fix also see a fair amount of craziness as traders and hedgers try to pre-position for the inevitable flurry in the WMR window.”

A quick glance at some charts convinces me that there is no such craziness except maybe in US equities? Can you find it? I’m not very convinced by anything he’s telling us in this chapter so far.

1. Bank of Canada noon rate - burst in USDCAD noon NY ‘as traders and hedgers try to pre-position for the inevitable flurry in the WMR window”

Let’s check shall we?

The trading server I’m using says it is

LON == GMT
So that means the server is GMT-1.
NY is GMT-5.
That means 16:00 LDN = 11:00 NY = 15:00 server time.
So I’m looking for the 15th bar of each day.
A day begins with the first bar on the daily period line. It will show up as 14:00 on the time scale as each day starts at 0:00. Just to add confusion - on Fridays there are only 21 bars as this broker shuts down early so that the last session of the day coincides with NY close the way most do. Also there is the issue of daylight savings time, so I’ll have to check if this pattern is altered in March and November. Time sure can be confusing in Forex!

I’m going to say a ‘burst’ is significant if bar 15 is at least 33% taller than bar 14. That’s maybe a bit too lenient, maybe I should have demanded 50%?

If it’s a hit it gets a blue line and if not, a red. Just eyeballing it we can see that it’s fairly randomly distributed.


It seemed to be occurring regularly if not frequently going backwards through this year but then I hit June and it basically dissolved. That’s a feature of randomness and I can’t blame it on DST. Entering March (going backwards) I began to count either the 15th or 14th bar and the reliability only improved somewhat. Still, I wouldn’t expect nearly this many blue lines if all hours were created equally. I suspect there is some kind of volatility pattern that occurs to favour the middle of the day, but that could just as easily be the LON/NY overlap as any WMR jockeying. About 60/196 days = 30%, so possibly statistically significant but probably not tradeable. In any case, BD would advise against using this as an entry technique.

 

1. CME close (3:00PM NY)
   1. Benchmark to the close of the futures markets at 2:00PM Chicago
   2. Models and algos using the 3:00PM CME close as a mark-to-market rate and want to exit or enter as close to that rate as possible

2. China fix (9:15AM Shanghai)
   1. PBoC daily fixing rate
   2. Usually a non-event but sometimes like when China devalued its currency it was a major focus

3. Tokyo fix (8:55AM Tokyo)
   1. USDJPY mostly, no surprise
   2. Mostly corporations and life insurance

4. API and energy dept data
   1. Crude estimates - Tuesday 4:30PM NY
   2. DOE numbers - 10:30 AM NY Wednesday - and gets the most attention
   3. Important for CAD and NOR
   4. BD says the numbers themselves are too far outside his expertise and produce counterintuitive moves instead
   5. “Instead of taking a view on the inventory numbers, I watch crude oil closely after the data come out and quickly enter or exit CAD trades based on movements in crude oil.” Which it seems to me, should be anyone’s sensible approach to all this nonstop data or heck, cut out the middleman and just watch the chart for any move!

5. NYMEX Open and Close
   1. 9:00AM NY and 2:30PM NY critical times for crude oil traders
   2. CAD, NOK, MXN

6. Friday Close
   1. Liquidity dries up after 3:00PM
   2. Holding a position into the weekend leaves you open to gap risk
   3. Some of BD’s worst memories are being offside on a trade over the weekend

7. Sunday Open
   1. FX markets open 7:00AM Wellington, NZ time. Which is 1:00PM NY (or 3:00PM NY depending on the time of year??? That can’t be right, BD.)
   2. Liquidity is very poor until Tokyo and Singapore open UNLESS
   3. Major news over the weekend and then it’s interesting (gaps)

8. NZD Date change
   1. NZD rolls at 7:00 AM Wellington time unlike the rest that roll at 5:00PM NY time

9. Equity open/close
   1. 9:30AM NY and 4:00PM NY

10. Twilight Zone
    1. 5:00-6:00PM NY - this is basically the first hour of the trading day - low liquidity and I’ve noticed most brokers widen their spreads to counter night-trading systems.
    2. BD advises not to trade then
    3. If news comes out there can be wild spikes as liquidity is nonexistent
    4. BD cites the example of the US credit downgrade which came out at 5:20PM NY
    5. BD admits overtrading in the afternoon when there is not much reason to trade (also guilty)

11. BD recounts once more (actually the first time) how he makes the most money from 7:00AM NY to 11:00AM NY and then gives back 20-40% from 11:00-5:00PM
12. So trade the LON/NY overlap and do something else when volumes are low - research, prepare, exercise, play video games or write a book about fx trading (I may do all of these, BD!) Sit on your hands the rest of the time.
13. “When volumes are low, any one transaction can move the market disproportionately because there is not enough volume to take the other side. Therefore, you will find that outside of the LDN/NY overlap there will be a disproportionate number of moves that do not make sense.”
14. During illiquid periods price still moves because large corporates still need to transact. “Unless you are the one executing the flow, you have no edge. I cannot stress this enough. Trade the LDN/NY overlap and then put in your stop loss and take profit orders and stop trading.”

This is what happens if you disregard this excellent advice:

Right at the point where I entered, price immediately got shot down. I did this. I caused this to happen. Some day I’m going to figure out how retail traders get targeted like this while corporations can carry on their business like gentlemen.

What are the best short-term trading currencies?

1. Trade a basket of currencies to avoid news risk for any particular country.
2. This is also beneficial if you’re trading large volumes. 500M AUDUSD is tought to manage because the short-term market can’t handle it but if you split it vol-weighted between AUD, NZD, CAD, GBP, EUR and JPY it’s easier to get in and out one leg at a time.
3. Know the gap risk over weekends
   1. Gaps account for 25-40% of returns on a 1-3MN horizon (hard to believe if you look for gaps on an FX chart!)
   2. The gaps can be estimated using options, fairly accurately (BD doesn’t say how)
   3. Square up or reduce size to avoid account destruction

4. BD does say how!
   1. Estimate using history
      1. “look at historical data for a given event and take the average and median moves. The Bloomberg function ECMI is useful for this type of analysis. Looking at how currencies moved over the same event in the past is usually a good way to estimate gap risk”
      2. The options calculation to figure this out is too complex - BD simply asks an options trader
      3. “If you work at a bank or have an institutional relationship with a bank, you can simply ask, ‘‘What is the options market pricing as jump risk for event X?’’ and they will give you an answer, usually in basis points.”

BD ends the chapter by talking about non-USD crosses. If you were interested in, say, trading 130 CADMXN for some strange reason, it makes more sense to vol-weight 75 USDMXN long and 100 USDCAD short than to straight trade 130 CADMXN because it’s the more volatile USD side of that trade that drives the price anyway.

Chapter 3 - Currency Trading Basics
This is where going through a book backwards really pays off as we can skip most of this since we’ve already learned it and we’ve already covered most of what we didn’t already know.

1. FX market is 5.1Trillion/day in turnover
   1. Of this 2.0T was spot FX - FX traded for immediate settlement
   2. FX can also be traded via forwards and futures
   3. Forwards depend more heavily on interest rates

2. Bitcoin is not a currency, BD says, because it’s too volatile! (I wonder if he still feels that way. Probably)
3. Pip does not mean ‘percentage in point’ or ‘price interest point’ but is an old British slang for a smallest amount or the dots on a die. (interesting!)
4. The front part of a currency quote that doesn’t often change is the ‘big figure’ So if USDCAD is 1.0355 then 1.03 is the big figure and is often omitted when quoting verbally.
5. You would say “dollar cad is figure 55/56” (not loonie?)
6. USDJPY 102.41/43 “dollar yen is forty-one, forty-three”
7. If you work a bank or hedge fund you’ve got to speak the lingo!
8. At a bank
   1. Millions == “bucks” so 15 bucks = $15M
   2. Banks rarely have voice trades below $1M
   3. Billions == “yards”

9. FX is a negative sum game because of transaction costs (spreads)
10. “Never sacrifice reliability, service, or professionalism to get a better spread.”
11. “The heart of the FX market is made up of two primary ECNs: EBS and Reuters. Although these platforms are slowly losing market share to newer, smaller ECNs, their prices are still considered the primary market. Other ECNs include Hotspot, Currenex, FXALL, FXConnect, ParFX, and many others.”
12. ‘Crossing the spread’ is when the spread between two competing ECNs has no overlap and becomes a viable arbitrage opportunity which quickly will bring the prices back into alignment.

1. “Pay the offer == buy on the right side of the two-way price
2. hit the bid” == sell on the left side of the two-way price
3. Risk price == market trade? But BD also calls this crossing the spread so maybe I got this wrong
4. “In the long run, transacting on risk prices all the time generates profits for the marketmaker banks and retail platforms but it is a simple and efficient way to trade, especially for beginners.”
5. “Footprint’ of a trade is the liquidity risk taken by a market-maker as it tries to fill your deal at one price
6. “Leaving a bid” == buying with a pending order
7. “Leaving an offer” == selling with a pending order
8. Limit orders do not cross the spread (?)
9. But limit orders are not guaranteed to fill
10. Random micro movement in FX == bid/offer bounce
11. Limit orders are sometimes called take profit orders (but now I realize this is all non-retail lingo as a retail trader would never use these interchangeably)
12. If done orders and loop orders
    1. ‘If done’ is a limit order that creates another order
    2. ‘Loop order’ creates new limit orders multiple times - usually used by traders who own options

13. BD says market orders are only for wholesale - weird. So different from crossing the spread.
14. No worse than price - used only in wholesale.
    1. A corp wants to sell 200M AUDUSD
    2. They are worried about the market moving against them
    3. So no market order
    4. They still want the bank’s expertise
    5. The bank provides an ‘at worst’ price
    6. If the execution is better than ‘at worst’ the bank shares the savings with the customer, so halfway between ‘risk price’ and ‘at best’

15. “Yours at 0.6640”
    1. After a corporation calls a bank for a two way price on NZD
    2. They get a quote for 0.6640/0.6650 - a ‘10 point’ spread. (so it seems I’m in the wrong thinking that points != pips. They do it’s just silly retail MT4 that calls pipettes points?)
    3. The corp thinks this is fair so he says ‘yours at 0.6640’ which is code for ‘I sell at the left-side price of the two-way price’.
    4. Now the corp has transferred the risk and the bank is long 130M NZDUSD
    5. BD likes this old-fashioned way of making 2-way prices as it is ‘clean and easy’. All ‘onus’ is on the market-maker and puts the customer at ease because risk is fully transferred to the market maker immediately

16. “Mine”
    1. Means ‘I buy”

17. TWAP and VWAP
    1. “Time-weighted average price”
    2. “Volume-weighted average price”
    3. Used by high volume algo traders
    4. A large order is cut up and executed over time
    5. Allows a smaller footprint
    6. TWAP will try to cross the spread as little as possible
    7. If price rises above a preset limit it shuts off and the trade will not continue until price comes back if at all (a good lesson for retail)
    8. Generic format “BUY (or SELL) X amount of CURRENCY PAIR over Y minutes with a limit price of Z.”
    9. Pro: reduces footprint
    10. Con: takes a long time to execute and sustains market risk
    11. Ideal for when you think the market will move in your favour
    12. If the market will rise the TWAP is a bad idea. Get a ‘risk transfer’ price or do the trade ‘at best’
    13. VWAP differs from TWAP in that it places trades based on volume executing when the volume is high

18. Iceberg order
    1. Used in wholesale
    2. When an order is large and likely to leave a large footprint
    3. This order is stealthy as it shows only a portion of what is intended to trade but repeats it multiple times
    4. So how is this different from a loop order?
    5. Popular in less liquid currencies
    6. Con: traders looking for liquidity might not deal with smaller orders because it will move the market against them
    7. By showing the full size of your big order you increase the chances someone with a ‘legitimate interest’ in the other direction will transact with you (now this seems like real trading - bullying, hiding, stealth - where is the trading book that thinks in these terms!?)
    8. Another con: after you sell your initial amount you go back ‘in the queue’ to wait for other orders at the same rate to be executed before your next order will transact. This can be detrimental.
    9. BD dislikes iceberg orders calling them overused. “It is better to show a reasonable market amount.”

19. Dark Pools
    1. Wholesale only
    2. Traders show an interest to buy or sell but attach no price
    3. If there’s a match both sides are filled at ‘midmarket’ from a ‘separate primary market price feed’.
    4. Increasingly popular as they allow traders to trade without showing their interest (and just imagine if retail could do that)

Understand P&L
real-time mark-to-market P&L accounting.
Profits and losses on currency trades are reported in the denominator currency

The roll

1. Roll, rollover, carry is the interest paid or received each day for holding spot positions
2. Roll is sometimes called tom/next short for tomorrow/next (not swap - which must be a retail term?)
3. BD says it is just about meaningless for short-term traders (I disagree, unless you mean intraday only)

What a strange chapter. I learned quite a bit actually but it seems like most of it was aimed at wholesale/bank traders not retailers. A lot of retail info was not even covered.

Chapter 2 - Very Brief History of FX
This is the kind of chapter I’d skip usually but knowing BD - that would likely be a mistake.

1. During the use of a gold standard it was illegal for US citizens to own (except for jewelry) gold or to trade it from 1933-1975.
2. WW1 countries found the gold standard inflexible as countries generated huge imbalances for war spending and inflation varied dramatically per country
3. 1944- Brettons Woods, etc
4. IMF & World Bank
5. US dollar overtakes GBP as global currency
6. When money started to flow out because of US balance of payment deficits the system broke down
7. Nixon recognized it was unsustainable and met with 15 advisers secretly, including the Fed Chair at thetime and future Fed chair Paul Volcker - Aug. 13-14 1971.
8. Aug. 15 Nixon abolishes the gold standard
9. 1973 currency trading begins as we know it
10. Many countries began to float their currencies
11. Value is determined by relative perceptions backed only by faith - the fiat system
12. Fiat - a decree, an arbitrary order
13. Paper is worth something because the government says so
14. Several instances of global intervention in currencies to support/restrain them when they go off the rails
15. The official G7 position is that rates are set by markets but extreme volatility is bad and won’t be allowed

A short history of currency trading

1. Telex era - 1971-1981 - only for HNWI
2. Direct Dealing 1981-1992 - Reuters - using voice brokers
3. Electronic Era - 1992-2001 - Reuters launches Dealing 2000 superior pricing and execution speed at the cost of human expertise; EBS launches a similar product
4. Algo era (2001-present) - hedge funds developed algorithms to trade electronically. At first simple arbitrageurs
   1. Now more volume is done by algos than humans
   2. 60/40 estimate in favour of algos
   3. Birth of retail trading (Oanda?)
   4. Especially in Japan - says BD. hmm -why so few Japanese retail traders on internet forums?
   5. Competition has led to tighter spreads, and a ‘more level playing field’ (really??)
   6. Leverage is lower since 2015 and again 2020

Algorithmic strategies

1. Data trading - algos read the economic releases and trade instantly based on hardcoded estimates of how the market will move (seems like this could be positive feedback-inducing)
2. Market-making - algos show a bid and an offer in the market and earn spreads from intraday noise
3. Correlation - algos watch other markets and trade fx based on those moves
4. Arbitrage - profit from price disparities
5. Trend-following - look for intraday trends and buy pullbacks to an MA or breakouts
6. Mean-reversion - the opposite of the above. Sell rallies, buy dips in nontrending currencies like USDCAD
7. Gamma - buy options and trade it electronically to generate income above the cost of the option
8. This is just a drop in the algo bucket. There are 100s more ways to trade using machines.

Part 1 - Understanding FX (FX101)
Chapter 1 - Introduction
We are right back where we started. Or rather where we didn’t start. The end is the beginning. Time is an illusion. All things must pass. Nothing’s forgotten. Every ending is a new beginning, etc. etc.

1. The usual diatribe against the low quality of trading books (deserved)
2. “Trading, like baseball, poker, golf, or any other highly skilled pursuit, can be a game not of inches but of millimeters.” (BD shows his Canadian-ness here, mixing up metric and imperial. Ah, but gun-owners know what a millimetre is)
3. In his 20s BD was skeptical of trading book authors - why give away the milk when the cow is worth a flippin’ fortune?!
   1. There are no secrets
   2. BD loves to write

4. BD writes a story possibly based on real life where Trump wins the election, sending markets into turmoil. The trader’s position was pro-dollar, so anti-Trump. After 19 hours they got rekt, and he catches a few hours sleep in a hotel and then goes back to work.
5. The market reverses and euphoria takes over
6. Can the trader admit he was wrong and buy his dollars back and get on board again?
7. Of course he can. This is not about politics. Or about being right. It’s about the best trade. Solving the puzzle. (there is no puzzle. There is no spoon.)
8. By 9:00AM he makes a big bet on the dollar and is profitable again.
9. Luck rules on any given day but skill dominates in the long run.
10. Trading
    1. Is hard
    2. Rewarding
    3. Serious intellectual pursuit (no)
    4. Incredibly fun (not when done properly)
    5. The ‘joy of attempting to solve an unsolvable puzzle’ (the solution is there is no puzzle, and nothing to solve)
    6. Nearly impossible test of self-discipline, self-control
    7. Disappointment, feedback, euphoria, self-doubt

11. Enjoy the ride (well I enjoyed this book and that will have to do since algo trading is not a thrill ride. It’s checking to see if things are still going according to plan a few times a day. That’s how I have time to do so much typing.)

Review of 'The Art of Currency Trading'
A damned good book from a guy who is probably a good trader since he’s an absolutely terrible comedy writer. Also note that this was one of the last books in the list of books to get a vote in the poll so it supports Clemmo’s Conjecture.

This book took me completely by surprise since I’d never heard of it or the author, and the table of contents just looked so GENERIC. I expected to breeze through it but I did not. Nearly every page had something new and important to say. I ended up going over it with more care than I intended, and it’s resulted in a massive file that’s nearly as long as the book itself. I will now have to say that every new trader should simply read the two Brents - Penfold and Donnelly.

Is this book really that good? Some of it may simply be because of the way I’ve approached the Forex game. For me personally this book filled in a LOT of the missing pieces of the puzzle as I have felt that my fundamentals game is weak and I don’t really know how to improve it since fundamental analysis suffers from the same excess of senseless gurus and academic uselessness that TA does. If I had started with fundamentals I may not have found this book to be anything special. I can’t say yet.

Either way I’m really looking forward to incorporating some of BD’s ideas into my technical trading, on a demo account first, of course. I wonder how much of this, if anything, can be automated?

I forgot to give the link for my notes with footnotes.

Also, I started subscribing to Donnelly's newsletter, which I recommend, and he did an interesting analysis of 'round number bias' in Bitcoin.

If we can believe his histograms there is some obvious preference for 00s and 50s, with some very minor preference for other round numbers. There is some mystery about why 50s are even more popular than 00s in Bitcoin though.


Then he goes on to say that BTC has hit an all time high at 69,000 because immature traders love the numbers 69 and 420. This seems more speculative than proven at this stage. However there's no doubt traders love to goof around at least from what I can gather from FinTwit.

Day and Swing Trading the Currency Market by Kathy Lien

About Kathy Lien

1. Managing director of fx strategy for BK asset mgmt
2. ‘A financial market prodigy’ (how does one establish precocious genius in finance?)
3. Graduated from Stern school of business at 18
4. Made markets in G20 currencies at JPMorgan
5. Joined FXCM in 2003; started DailyFX.com
6. 2008 joined GlobalFutures & Forex Ltd as director of currency research
7. 2012 CNBCcontributor and guest host
8. Has published books, and is basically famous for FX
9. The “queen of the macro forex trade” !
10. This is the 3rd edition of this book (2016)

Chapter 1 Foreign Exchange—The Fastest Growing Market of Our Time

1. FX is an OTC market with no central exchange and clearing house where orders are matched
2. Instead dealers and market makers are connected by telephones, computers, fax (still??) creating a cohesive market
3. Many institutions now offer exchange-traded FX but the underlying price is the spot fx price
4. Volume is 50x greater than the NYSE and NASDAQ combined ($5.3T)

EURUSD and Corporate Profitability

1. Inadequate hedging caused Volkswagen and other European companies to lose $1B in profits when the Euro rose against the dollar in 2003 due to rising trade and budget deficits in the US

Nikkei and U.S. Dollar

1. Kathy Lien (KL from now on) goes on one of those weird sequences of forward-thinking using half a dozen assumptions to generate future assumptions (Du Toit’s ‘relational analysis’), each one trying to outdo itself in terms of being ungrounded in fact:
   1. Japan comes out of 10 years of stagnation
   2. Mutual and hedge funds were underweight JPN equities
   3. Economy begins to turn around
   4. Global macro funds rush to add to portfolios to take advantage of recovery
   5. Hedge funds borrowed $ to pay for exposure
   6. These borrowed dollars are sensitive to interest rates
   7. Increased borrowing costs will raise the dollar’s financing costs
   8. Fed might need to continue to raise rates due to ‘huge current account deficit” (haha)
   9. but she guesses wrong, expecting the Fed tightening cycle to continue
   10. The lesson is stop trying to predict the future; but I think that’s what ‘macro’ is in a nutshell.

   
   

George Soros

1. The man who broke the bank of England - already featured prominently in the book club
2. KL describes the ERM fiasco but we’ve already done that

Chinese Yuan Revaluation and Bonds

1. The RMB was pegged to the US dollar
2. Artificially held at USDRMB 8.27
3. Criticized for making Chinese goods artificially cheaper
4. CHN gov had to sell yuan and buy USD each time the currency appreciated above the ceiling
5. The USD was used to buy treasuries
6. CHN became the largest holder of US treasuries
7. 2005 dollar peg ends
8. Now it’s floated against a basket of currencies in a narrow range
9. If the CHN gov ever allowed it float freely it would have an impact on fixed-income because they would no longer need to buy treasuries
10. Bond investors will have to watch to avoid this risk

Compare FX with futures and equities

1. FX trading was accessible only by large institutions and CTAs
2. Then the market opened up to retail with leverage, platforms, charts and real-time news
3. This access to low-cost (and value!) info made the popularity of FX surge
4. Equity and FX traders added FX to their portfolios

Characteristics of FX markets

1. Largest in the world with growing liquidity
2. 24 hours/5.5 days per week
   1. Determine your own trading day
   2. Avoid gaps on news
   3. Trade after your job ends

   
   

3. Long or short profits
4. No trading curbs and short selling requires no uptick
5. Instant execution platforms reduce slippage and ‘errors’
6. Extremely high leverage which magnifies profits and losses

Characteristics of Equities Market

1. Liquidity depends on daily volume
2. Trading only from 9:30-17:00 NY time with limited after-hours
3. Exchange fees
4. Uptick rule for short trades
5. More steps involved in completing a trade (no longer true?)

Lower Transaction Costs

1. Equity traders are more vulnerable to liquidity risk
2. Transaction costs are lower (still true?)
3. Low transaction costs makes retail fx the best market for short-term traders

Customizable Leverage

1. A double edged sword but few can resist it
2. FX offers the highest leverage available for any market (still true?)
3. No trading ‘curbs’ (I assume this is like limit up/limit down in futures?)

Online trading reduces errors (really?)

Limited Slippage

1. Two-way quotes confirmed within milliseconds
2. Equity markets tend to operate under a ‘next best order’ system, where you might not get executed at your chosen price but whatever’s available next. (but it seems this is a risk in fx as well)

Perfect Market for Technical Analysis (no such thing)

1. KL says it’s ‘clear’ that at one point all manner of technical indicators have given correct signals but that’s like saying at some point my broken clock tells the correct time.

Countries can be analyzed like stocks

1. Invest in countries growing faster funded in the currency of countries growing slower

The rest of this chapter is not a patch on Donnelly

FX vs Futures
We’ve mostly covered this but KL claims that futures have ‘prolonged bear markets’ compared to FX.
a) that seems absurd
b) if it is true that makes futures a great market to short...so….??

Comparing Market Hours and Liquidity

1. FX volume is 5x that of futures market
2. FX is 24h/day but Futures has a ‘confusing’ timetable which varies by product

The rest of the chapter is either self-repetition or repetition of other books we’ve read.

Haven’t we seen this exact diagram before?

“What used to be a game dominated and controlled by the ‘‘big boys’’ is slowly becoming a level playing field where individuals can profit and take advantage of the same opportunities as big banks.”
Hmm...nah.

Dealing Stations - Interbank Market

1. Majority of FX volume is interbank trading
2. As Donnelly mentioned, when trading crosses, most interbank traders will simply buy the associated major pairs separately and create a synthetic quote/trade, so if a buyer wants NZDCAD, they would buy USDCAD and NZDUSD instead, because those currencies have better liquidity. Is it more efficient to do this in retail as well? Interesting.

Chapter 2 - Historical Events in the FX Markets
If you think history is boring you should keep in mind that it often rhymes if not outright repeats itself and so knowing what happened before you became a trader or before you were born is very, very useful.

1. Bretton Woods - anointing the dollar as the world currency - July 1944
   1. 44 nation reps meet in NH after WW2
   2. They agree economic instability was one of the causes of the war
   3. Agreement developed by John Maynard Keynes and Harry Dexter White
   4. Proposed to Great Britain as part of the Lend Lease Act - a US act designed to help postwar development in the UK
   5. Results:
      1. Formation of key international authorities (IMF, World Bank, GATT) designed to promote fair trade and international economic harmony
      2. Fixing of exchange rates between currencies (no longer in effect)
      3. Convertibility between gold and the US dollar - making the USD the global reserve currency (no longer in effect)

2. Aug. 15 - 1971 - BW is replaced by the Smithsonian Agreement - the start of free market capitalism
   1. Pioneered by Nixon
   2. Still uses fixed exchange rates and so doomed
   3. The fear was that countries would race to devalue their currencies and create a global depression (hmmmmmmmm)
   4. USD floating range was extended to 2.25% from 1%
   5. Gold ends up shooting up in price, the US trade deficit grew and so the US dollar needed to be devalued beyond the limit
   6. The FX markets were forced to close in Feb. 1972! (can you imagine that now?)
   7. The markets reopened March 1973 with a floating dollar
   8. This allowed the markets to self-regulate but it also set the stage for inflation
   9. When oil prices rose it became stagflation

3. Plaza Accord - Devaluation of the US Dollar (1985)
   1. Basically Bretton Woods 2 - at the Plaza Hotel in New York
   2. The rising dollar is causing problems, and with US trade deficits growing, while JPN and GER accounts are growing there are protectionist fears
   3. The solution is to devalue the USD - Sept. 22 1985 - allowing for a controlled dollar decline
   4. US - agreed to lower interest rates and cut its budget deficit
   5. France, UK, Germany, Japan - agreed to raise interest rates
   6. Germany - agreed to tax cuts
   7. Japan - agreed to treat the Yen with a lighter hand and let it rise
   8. Guess who didn’t keep their promise?
   9. USA! USA!
   10. And guess which promise? The promise to cut the budget deficit! Sound familiar? The US is addicted to debt, baby!
   11. The sharp rise in the yen may have started the 10 year recession in Japan
   12. The US enjoyed growth and price stability
   13. The USD falls 50% against the yen and 46% against the Deutschmark (what a trade!)
   14. US economy becomes more export-oriented, JPY and GER become importers

4. The George Soros story
   1. Oh, Ok, one more time before bedtime!
   2. Franco-German initiative sets up the European Monetary System (EMS) in 1979
   3. The EMS sets up the Exchange Rate Mechanism (ERM) as one of the main inflation reduction and stabilization gadgets
   4. ERM gives every participating currency an exchange rate based on a basket - the European Currency Unit (ECU)
   5. The countries were expected to maintain their currencies within a 2.25% band of the rate set by the ERM
   6. ERM was an ‘adjustable-peg’ system and 9 re-alignments occurred 1979-1987
   7. Up to 1992 it seemed to be working - but then the re-united Germany started printing money to deal with rising inflation due to increased gov. spending
   8. Germany must increase interest rates
   9. The Mark begins to rise as a result
   10. Other central banks must follow suit (Irving Fischer’s interest parity theory)
   11. Soros realized the weak UK economy and high unemployment would not permit the British government to maintain the ERM
   12. The Quantum fund bets against the pound because the UK will either devalue or leave the ERM
   13. He goes short the pound and long the Mark, and made ‘great use’ of options and futures for a $10B position which in those days was ‘gargantuan’.
   14. Other investors follow suit (which begs the question - what really caused the downward pressure, the ERM or the City?)
   15. The BoE tries to defend the pegged rates with a massive $15B reserve spend
   16. Sept. 16 1992 - ‘Black Wednesday’ - the bank announced a 2% interest rate rise from 10% to 12%.
   17. Then to 15% a few hours later.
   18. At 7pm Chancellor Lamont admitted defeat and Britain leaves the ERM, the pound plummets, Soros makes a mint - about $2B on his $10B investment.
       

5. Asian Financial Crisis
   1. Up to 1997 investors were attracted to the ‘Asian tiger’ economies, and investment income flowed into the Asian currencies and they appreciated causing a bubble
   2. Current account deficits ballooned in Thailand and some loans to high-ranking gov officials and South Korean conglomerates became non-performing (not paid back?)
   3. Then Japan reported $400B in nonperforming loans
   4. The economy slows down, real estate falls, the stock market drops, the yen depreciates
   5. Investors see opportunity in a depreciating yen adding selling pressure to other Asian currencies
   6. Asset prices fall, Japan loses 2 years of output and sparks a banking crisis
   7. Central bank reserves are depleted; mass short speculation,
      Attached Image

      
   8. The Thai baht is devalued 48%, then nearly 100%
   9. The Indonesian Rupiah falls 228%!
   10. The IMF comes to the rescue!
   11. The Asian currencies now keep ample reserves on hand to fend off future speculator attacks

6. The Euro (1999)
   1. The largest monetary changeover ever
   2. Launched electronically on Jan 1 1999, and in circulation in 2002
   3. Each member must meet criteria for admittance
      1. Budget deficit < 3% GDP
      2. Gov debt < 60% GDP
      3. Inflation rate <1.5% above average of the 3 countries with the lowest inflation rates
      4. Long term gov bond interest rates < 2% above average

   4. Benefits of Euro membership
      1. Removes exchange rate fluctuations
      2. Improves certainty of investment
      3. Diminished transaction costs: FX conversion, hedging, cross-border payments
      4. Prices are more transparent
      5. Foreign investment is attracted to a larger market
      6. ECB controls inflation with lower interest rates
      7. Just ask the UK about the benefits of the EU now! lol

   5. Cons
      1. No sovereign monetary policy
      2. Interest rates are out of alignment with smaller economies

Chapter 3 - What moves the Currency Market

1. Don’t say supply and demand….
2. “currencies move primarily based on supply and demand”

Capital Flows and Trade Flows

1. Constitute a country’s balance of payments
2. KL makes the case that the USA’s increasingly large trade deficit will weaken the dollar but ..meh? Has it? I suppose it’s true if you consider asset bubbles to be a symptom of dollar weakness, but the DXY has mostly risen over time.
3. Capital flow measures the net in and out flow of capital
   1. Physical flow
      1. actual foreign direct investments by corporations
      2. Real-estate, manufacturing, local acquisitions, global mergers
      3. Represent the underlying changes in actual physical investment
      4. Flows react to a country’s economic health and investment environment
      5. Example of China joining the WTO and relaxing its foreign investment rules
      6. China’s cheap labour has produced much foreign investment

   2. Portfolio flow
      1. Equity
         1. No matter where you’re located you can invest in a stock market of many countries
         2. If an equity market is rising generally foreign money boosts the local currency
         3. The Dow is highly correlated with USD

      2. Fixed-Income
         1. Appealing during times of global uncertainty
         2. Short-and-long term yields of international gov bonds are indicative of capital flows
         3. Monitor the spread differential between the 10y treasury yield and yield on foreign bonds
         4. International investors move money from one country to another seeking yield
         5. 2y gov bond spreads gauge the short-term flow of funds
         6. Fed fund futures estimates US funds flow as they price in future expectations of interest rate policy
         7. Euribor futures are a barometer for Euro region’s expected future interest rates, and policy movements

Trade Flows - measuring exports vs imports

1. Trade flow represent the net balance of trade for a country
2. Net exporters have a net trade surplus - their currency is more likely to rise
3. Net importers buy more goods from abroad than they sell - their currency is likely to fall
4. This keeps things in balance
5. Even day and swing traders should keep up with economic reports says KL

Trading Tip - Charting Economic Surprises

1. Chart economic surprises against price action

This chart shows how much an economic indicator has deviated from its consensus forecast (how surprising it is).

1. The blue line is price
2. The white line is a simple regression line
3. According to KL there were 14/15 positive economic surprises in November, but USD sold off in December when the data was released.
4. EU then corrected itself in January, so if dollar longs were patient, knowing that the US economy was stronger than the Eurozone would have benefited them. (the problem is, who can be this patient, and also, is the lag between economic fact, and chart reaction reliably around 1MN?)
5. This method of analysis is called ‘variant perception’ - invented by ‘legendary’ hedge fund manager Michael Steinhardt - 24$ average returns for 30 consecutive years
6. Charts will ‘rarely’ offer such clear cut signals but they may offer other analytic value by spotting other outlier data
7. Large positive and negative surprises in economic data can yield clues to future price action (but if I have to endure a month of contrary price action why wouldn’t I just wait for price to move back the other way? )

Technical Analysis

1. Before mid-1980s fundamental trading was the only game in town
2. KL says no one will ever settle the argument between fundamental vs. technical and she is probably right
3. Most traders start with TA as it is ‘easier to understand’ and ‘does not require hours of study’
4. TA could not anticipate events like 2001-09-11 (but then neither could fundamental analysis so I’m not sure what KL is trying to say)

Currency Forecasting - what bookworms and economists look at
There are seven major models for forecasting currencies, which include:

1. the balance of payments theory
   1. A misnomer KL says as it only considers current account balance not the ‘actual’ balance of payments
   2. States that exchange rates should be at their equilibrium level that produces a stable current account balance
   3. Countries with trade deficits have lower value currencies because exporters to that country must sell that currency in order to get paid
   4. Balance of payments has two parts
      1. Current account
         1. Measures trade in tangible items like cars or manufactured goods
         2. The balance is the surplus or deficit between exports and imports

      2. Capital account
         1. Measures flow of money such as investments in stocks/bonds

   5. BOP data can be found on the website of the Bureau of Economic Analysis (bea.gov)
   6. Trade Flows
      1. Trade balance is difference between imports/exports
      2. A positive trade balance boosts currency, negative suppresses it

   7. Capital Flows
      1. incoming/outgoing investment

   8. Equity Markets
      1. A ‘major place’ for high-volume currency movements
      2. Foreign investors are major participants
      3. In a recession foreign investment tends to flee, converting currency back to their home denomination and pushing domestic rates down

   9. Fixed income / Bond Markets
      1. Similar to equities

   10. BoP Summary
       1. KL says it's the most important and useful tool for those interested in fundamental analysis.
       2. Limited in that it doesn’t consider international capital flows
       3. International capital flows often dwarf trade flows and this has given rise to the asset market model

2. purchasing power parity
   1. Believes FX rates should be based on relative prices of a similar basket of goods between two countries
   2. Changes in one nation’s inflation rate should cause an opposite reaction to the other nation’s exchange rate
   3. If inflation rises it should depreciate the country’s currency
   4. Basket of Goods
      1. Just about anything you can think of in consumer goods and services, government services, construction, etc.

   5. Big Mac Index
      1. The Economist
      2. Mentioned before

   6. OECD PPP Index
      1. Organization for Economic Cooperation and Development has a more formal index
      2. Available at the OECD website - OECD.org (more specifically https://data.oecd.org/conversion/purchasing-power-parities-ppp.htm#indicator-chart and https://data.oecd.org/conversion/exchange-rates.htm)
      3. Should not be taken as definitive says KL

   7. Limitations
      1. Only for long-term fundamental analysis (it seems being wrong all the time is OK as long as you’re wrong for a long time, at least in finance!)
      2. Time horizon of 5-10 years (safely beyond the ken of any forecasting)

3. Interest rate parity
   1. Theory states that if two different currencies have different interest rates, then the difference should be reflected in the premium or discount for the forward exchange rate to prevent riskless arbitrage
   2. If US interest is 3%
   3. JPY interest is 1%
   4. USD should depreciate by 2%
   5. This future exchange rate is reflected in the forward exchange rate today
   6. Forward rate is said to be discounted because it buys fewer JPY than in the spot rate
   7. The JPY is said to be at a premium
   8. KL says there’s very little proof of its effectiveness in recent years - so why waste our time?!

4. The monetary model
   1. Exchange rates are determined by a nation’s monetary policy
   2. Countries that have a stable policy over time should have appreciating currencies
   3. Erratic or expansionist policies should see the value depreciate - explain the USD then
   4. Three factors influence exchange rates with this model
      1. The national money supply
      2. Expected future levels of national money supply
      3. Growth rate of a national money supply
      4. KL claims this model is very successful during times of expansionist policy as for example when Hong Kong raised its interest 300% and fended off speculation but again, explain USD

   5. Limitations
      1. disregards trade and capital flows
      2. Example of AUD 2014 when it had higher interest rates, growth rates and inflation rates than EUR and USD but yet AUD appreciated in value
      3. The model has struggled since the era of floating currencies because it fails to take into account capital inflows as a result of higher interest yields

5. Real Interest Rate Differential Model
   1. This theory holds that exchange rates are determined by a country’s interest rate
   2. Higher interest = higher currency
   3. Foreign investors are attracted to to higher yields
   4. A persistent change in rates (perceived) is expected to have a greater effect
   5. Mixed results in practice
   6. Limitations
      1. Disregards current account balance, political stability, inflation, economic growth

6. The Asset Market Model
   1. The flow of funds into the financial assets of a country, such as equities and bonds, increases demand for that currency
   2. Funds invested now dwarfs funds exchanged by goods and services for import/export
   3. Basically the opposite of the Balance of Payments model as it considers capital account instead of current account
   4. Dollar-driven
      1. Holds the most sway over pundits due to the outsized influence of US equity markets

   5. Limitations
      1. Over the long run there may not be any relationship between equity market performance and currency performance
      2. Example of weak DAX and EURUSD correlation

7. currency substitution model
   1. An enhanced version of the monetary model as it considers investor flows
   2. Shifting private and public portfolios has an effect on currencies
   3. Currency substitution - investors are chasing yield, money flows change
   4. This becomes a self-fulfilling prophecy
   5. Limitations
      1. Among major currencies this has not been convincing
      2. Better in underdeveloped economies

These are all part of a whole ‘forecasting diet’ says KL, but it seems to me they are all just bad models for which economics is justly pilloried.

Chapter 4 - A Deeper Look at the FX Market

1. Best times to trade?
2. Most market-moving economic data?
3. Currency correlations and how can we use them?

KL makes a bunch of generalizations about currency pairs that don’t always hold true anymore. I’m going to skip most of the session info as known.

Chapter- 5 What Are the Most Market Moving Economic Data?

1. The most significant moves happen within the first 20 minutes of a data release

Does this agree with Donnelly? Better check.

1. The ability for reports to move markets shifts over time; some important reports fade (like GDP) and others become dominant (like NFP)
2. Breakout traders can use all this info to weight positions

Chapter 6 - What Are Currency Correlations, and How Can We Use Them?

1. Currencies have a tendency to move together, just as many indices, and other markets do
2. Correlations change over time (they may be at least partly illusory/chance and/or cyclical)
3. You can use Excel to calculate correlations yourself (or just look up a web tool, most of them are similar)

Chapter 7- Trade Parameters for Various Market Conditions

1. Keep a trading journal
2. Working as a desk trader KL was required to keep a journal and have a justification for every trade with entry/exit levels
3. You had to know where stops would be placed to calculate the worst case losses and manage risk
4. Trading journal setup used by KL
   1. Currency pair checklist
      1. List all currencies available to trade
      2. 3 columns for current high/low and a ‘series of triggers’ on the right
      3. Newer traders should start with following only the four major currency pairs, which are the EURUSD, USDJPY, USDCHF, and the GBPUSD,
      4. Takes 20 min. To fill out - helps ‘get a clear visual’ of which ones are trending or ranging
      5. “Picking tops and bottoms should only be a strategy that is used in clear range trading environments and even with that, traders need to be careful of contracting ranges that can lead to breakout scenarios.”

A ‘simplified’ version of the daily market overview sheet that KL uses. I’d hate to see the complex version.

KL says that recording the prices helps her keep track of where the current price is within the previous price action. BUT - isn’t that what a chart is for??

The next five columns help with trend identification. Again - why not just use a chart.

1. 2. Trades that I am waiting for
   1. Sample entry:
   2. April 5, 2015
   3. Buy AUDUSD on a break of 0.7850 (previous day high)
   4. Stop at 0.7800 (50-day SMA)
   5. Target 1—0.7925 (38.2% Fibonacci retracement of Nov-Mar bull wave)
   6. Target 2—0.8075 (Upper Bollinger)
   7. Target 3—10-day Trailing Low
   8. This ties in with Brent Donnelly’s assertion that writing down your plan is a good practice as it makes fuzzy thinking concrete, and I suppose that’s what KL is doing here, as much as much as it seems like busy work to me. It’s probably excellent practice for manual traders.
   9. “Before every battle, warriors will regroup to go over the plan of attack—in trading, you want to have the same mentality. Plan and prepare for the worst-case scenario and know your plan of attack for the day!”

2. 3. Existing or completed trades
   1. Used to enforce discipline and learn from mistakes
   2. Understand why some trades resulted in losses (unlucky randomness) and others result in profits (lucky randomness)
   3. Take note of:
      1. taking profits too early,
      2. letting losses run,
      3. getting emotional about trading,
      4. Ignoring economic releases, or
      5. entering a trade prematurely.

   4. KL believes the best trades are supported by technicals and fundamentals

She outlines a top-down approach

1. Take an overall technical survey
2. Pick pairs that have retraced to attractive levels for entry on a medium-term
3. For non-cross (USD) pairs determine if technical views coincide with fundamental views on the dollar and with upcoming data releases
4. The reason to examine the dollar specifically is because 80% of all currency trades involve it, making US fundamentals crucial
5. For crosses determine if the technical view coincides with fundamentals using Fib retracements, ADX, MAs, Osc, and other technical tools
6. Look at the positioning of the COT report or the FXCM speculative Sentiment index to see if they are supportive
7. Between two equally compelling trades she will choose the one with the positive interest rate differential

Noted..