Are You Ready to Make Money With Currencies?
Wednesday, October 21, 2009 | Teeka TiwariRating:
We got some great comments back from last week's article on trading currencies. It appears that many of you are already getting your feet wet in this exciting area, or you're ready to get started. This week I want to talk about some of the advantages of trading currencies on an exchange rather than through a forex broker. I also want to talk about some strategies I use when trading currencies.
The Exchange Advantage
The key benefits to trading on an exchange are transparency and security of your funds. The exchanges take no principal position against their order flow. Every trade is reflected right there for everyone to see.
Every trade that takes place on an exchange such as the Chicago Mercantile Exchange (CME) is guaranteed by the exchange. Even if the counter-party on the other side of the trade were a Lehman Brothers and goes bust, the exchange will make good on your positions.
Up until a few years ago, I would have given this less credence as a real advantage. But we have seen some massive financial names flame out: Refco, Bear Stearns and Lehman Brothers were all organizations considered unthinkable to fail.
For the most dynamic highly leveraged day-trading, though, going through forex brokers still has an edge over the exchanges, with the key decider really being the amount of leverage one can employ. Forex offers 100-to-1 leverage and, in some instances, as high as 200-to-1.
CME currency contracts typically offer leverage ratios in the 20-to-1 range, and you have to pay commissions. Forex trades are commission-free. However, forex can end up costing you more, as brokers get compensated via the bid/ask spread.
The exchanges, specifically the CME, are more individual-investor-friendly, in my opinion.
A 'Micro' Approach to Trading Currencies
Just recently, the CME launched a series of new currency pair contracts called E-Micros. They are a truly revolutionary financial product.
Each E-Micro contract is one-tenth the size of a standard currency pair. (Currencies are traded in pairs -- that is, going long one and selling another against it.)
A big fear for novice investors just starting out with futures is that they might get saddled with a couple of hundred thousands gallons of heating oil or have to come up with millions to cover bad currency trades.
The E-Micro currency contracts are typically for $10,000 to $12,500 worth of the underlying currency. This is a far cry from normal-sized $100,000 - $125,000 contracts.
The other advantage is that the margin requirements on the Micros are very low, ranging between $300 and $600 per contract.
Smaller-Than-Small Contracts Can Mean Far Less Risk
For someone looking for a very low-risk way to enter the world of currencies, the CME’s new E-Micro contracts are an excellent tool. If you are totally wrong, you are not going to get killed on a one-lot position of an E-Micro currency contract. These contracts take a lot of the fear factor out of currency trading.
Whenever you are trading something new, you want to trade the smallest size possible until you get comfortable. E-Micros are the perfect product for the brand-new, budding currency trader. The CME even offers free real-time quotes on their currency pairs.
If you are thinking about currency trading, I would strongly recommend using the E-Micro product as means to get your feet wet first before attempting to employ more-advanced, highly leveraged strategies on forex.
Leverage by itself isn’t either good or bad, the same way a gun isn’t either good or bad. It’s all in the application of the tool.
A Little Leverage Goes a Long Way
If I’m day-trading, using very narrow stops, then I’m going to want as much leverage as possible. And this makes forex much-more-attractive for me for those types of trades.
If I’m position-trading, or trend-following, then I’m going to want to be on a recognized exchange for a number of reasons ... the most-important being that, when I position-trade, I can maintain my position for many months at a time. By being on an exchange, I virtually eliminate counter-party risk.
When you trend-follow, you will also typically use a wider stop than when you day-trade. When trend-trading, I’ll typically risk between 1% and 2% of my total equity per trade. I would never risk that much when I’m day-trading with 100-to-1 leverage. Even a minor price shock could wipe me out.
As I wrote last week, when day-trading with massive leverage, you want to be in and out of most of your position within seconds. You want to have a very firm idea of where the key intraday retracement levels are. (A retracement is a price reversal that goes against the current trend.)
This isn’t easy to figure out, but its also not rocket science either. All it takes is some solid research.
Track the 'True Range' of the Trend
I’ll share a quick strategy with you that I use.
I keep track of the 20-day Average True Range (ATR), an indicator that measures volatility, of each of the currencies (and other futures) I trade. The 20-day ATR tells me what the average overall movement of the underling security has been over the last 20 days.
Key intraday retracements typically occur as a percentage of a two-ATR reading.
Let's say a currency has an ATR of 40 pips. ("Pips," as we discussed last week, are the smallest units of measurement that currencies are traded by. For example, if the Euro's bid/ask spread is quoted at 1.4755 by 1.4757, then it would have a two-pip spread.)
This tells me that, on an average day, the currency will have a 40-pip range between yesterday's and today’s high and low.
Trading With a Currency's Trend
When a currency is trending, either up or down, you will get contra-trend moves. These are moves that happen in the opposite (contra) direction of the primary trend, and they serve to shake out the weak hands.
These moves are typically (but not always) a fraction of a two-ATR movement.
Usually a currency (or any other future) that is trending in a single direction won’t experience an entire two-ATR move in an opposite direction to its underlying trend, unless the primary trend is changing direction.
It’ll get very close on occasion, but typically it won’t experience a two-ATR reversal.
When I find a currency that is trending and I’m looking to day-trade it, the first thing I do is look at the last few months' worth of price data and see what the maximum contra-ATR movement has been. Again, I’m looking for the max ATR movement that goes against the primary trend.
Usually, the typical retracement is around 75% of the two-ATR figure before the primary trend reasserts itself.
It’s going to be different for every financial instrument. For some futures, a percentage of three-ATR works better than two-ATR. It just depends upon the trading history of the underlying.
Setting up the Position
Anyway, when I see the pullback occur, I buy it once it hits the threshold that has held up in the past. I have my stop-loss just fractionally below this point. If the currency/futures contract that I’m trading bounces, then "happy days," because I’ll probably see an almost-full two-ATR move higher intraday.
As the position moves in my favor, I rapidly reduce my leverage level. And as long as it's acting right, I’ll carry a piece of the position for the entire trading day. If, however, it hits my stop, then I just get out and move on to the next trade.
As a word of warning, I would not suggest that this strategy be the basis of your entire trading methodology. It’s just one strategy. I like to use this approach as a method to lower my overall cost basis when I am position-trading a long-term uptrend or downtrend.
Trend-following investors make some of the biggest money in futures trading. However trend-following can also be a little bit boring. Also, when futures aren’t trending, you can whipsawed for months at a time, which can lead to pretty serious drawdowns.
Feed Your Inner 'Action Junkie' With Currencies
Retracement trading around a core trend position can be very exciting and extremely profitable. So long as you don’t overload your retracement position-sizing so that it engulfs your core position trade, it's a great way to lower the holding cost of your core position while also having the extra added benefit of feeding one's inner "action junkie" without wrecking your account.
As traders, we have to make our personality drawbacks work for us. I’ve seen plenty of irrational and emotional people make millions through trading. The key for these folks was not in berating themselves for being what they thought they should be.
No -- the key to success for these people was making their shortcomings work for them rather than against them.
Trend-following requires a large amount of discipline that very few people can muster up. Marrying a retracement strategy to a trend-following strategy is a great way to put your inner action junkie to work for you instead of against you.
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Teeka Tiwari
Chief Investment Officer
ETF Master Trader
