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Inside Scoop

by Michelle Gebhardt, Executive Editor

A DVE RT I SE M E NT

VOLUME 10, NO. 9 | SEPTEMBER 2011

GAUGE FX TRADES USING RISK SENTIMENT


PLUS: Kavanaughs Currency Outlook | Options Day Trading Tips

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CONTENTS
By Brian dolan

18 RISKY

gauge fx trades using risk sentiment

BUSINESS

28 HOT CURRENCIES TO WATCH


By Paul J. Kavanaugh, CTA

PUBLISHER Wasendorf & Associates Inc. Russell R. Wasendorf Sr., Chairman and CEO Karris Golden, President and COO P.O. Box 849 Cedar Falls, IA 50613 EDITORIAL EXECUTIVE EDITOR: Michelle Gebhardt MANAGING EDITOR: Kira McCaffrey Brecht CONTRIBUTING WRITERS PRODUCTION CREATIVE DIRECTOR: Sara Kies DESIGNER: Sarah Judisch DESIGNER: Samantha Schmiesing WEB DEVELOPER: Jeff Kennedy CONTACT SFO Customer Service: 800.590.0919 SUBSCRIBE TO SFO

32 THE FX WORLD: EXPAND YOUR BOUNDARIES


By Greg Michalowski By Gregory Brown

38 7 OPTIONS DAY TRADING TIPS

departments

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Tech Support Technical Strategy Ask Dr. Duke Eye on Futures Trade of the Month

8 9 11 14 16

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Copyright 2011 by Wasendorf & Associates Inc. All rights reserved. No part of this publication may be reproduced or transmitted in any form by any means, electronic or mechanical including photocopying, recording or by any informative storage and retrieval system without the written permission of Wasendorf & Associates Inc.s president. This publication is strictly the opinion and conjecture of its writers and is intended solely for informative and educational purposes and is not to be construed, under any circumstances, by implication or otherwise, as an offer to sell or a solicitation to buy or trade in any commodities or securities herein named. This publication is not meant to recommend, promote or in any way imply the effectiveness of any trading system, strategy or approach. Information is obtained from sources believed to be reliable, but is in no way guaranteed. Further, there is no guarantee of any kind that is implied or possible where projections of future conditions are attempted. The publisher is not liable for typographical errors.

Trading
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Commodity futures, securities, options and forex trading involve risk and are not suitable investments for everyone. Any investment should be carefully considered in light of an investors personal financial objectives and risk tolerance. Articles and/or advertisements contained herein may provide hypothetical or simulated performance results. Hypothetical or simulated performance results have certain inherent limitations. Unlike an actual performance record, simulated results do not represent actual trading. Also, because the trades have not actually been executed, the results may have over- or undercompensated for the impact, if any, of certain market factors such as the lack of liquidity. Simulated trading programs are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. Further, past performance does not guarantee future results.

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There is a substantial risk of loss in trading commodity futures, options and off-exchange foreign currency products.Past performance is not indicative of future results.

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TECH SUPPORT
LEARN TO USE STOCKTWITS
By Phil Pearlman

StockTwits offers high-quality trading ideas for stocks, options and futures as news is breaking. Members research assets using ticker pages that stream what other traders are thinking and doing while taking the trade. If there is uncommon volatility or volume in a name, StockTwits ticker pages will have information (and color) on it as it

Phil Pearlman walks you through the StockTwits website.

is happening. StockTwits members can follow specific stocks and other members in their Home stream. Members share ideas in real time and receive feedback from the community by entering it in the message box. StockTwits streams pick up messages where the dollar sign precedes the ticker name $AMZN. The StockTwits Chartly platform is a humongous chart sharing platform that allows members to filter charts posted by other members by asset or sentiment. It is also a live

pattern recognition resource for those learning technical analysis. Its free to set up an account and tap into the power of the StockTwits stream. A search box at the top of the site allows members to follow stocks by visiting the ticker page. The StockTwits Discovery Tool highlights members with similar interests. The StockTwits Suggested Stream features the most knowledgeable StockTwits members.

Each week, StockTwits publishes The StockTwits 50 List, which shows the best stocks with the best setups.Its a great place to begin your research as you prepare for the week.

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TECHNICAL STRATEGY
1.5300 1.4800 1.4300 1.3800

EUR/USD and EUR/USD Implied Vol (1mth)

8 9 10 11 12 13

By John Kicklighter

The euro/dollar (EUR/USD) exchange rate is the forex markets most liquid pair. In fact, according to the Bank of International Settlements (the central bank to the worlds central banks) Triennial Survey, the pair accounts for 28% of the average daily turnover on a $4 trillion-a-day market. What moves the exchange rate of such a prolific asset? A currency represents the value of all the fundamental and financial nuances of its economy. That role is further complicated when we measure its value against another currency. However, lucky for us, there are only a few major catalysts that can move a market this deep and EUR/USD in particular is a special case.

1.3300 1.2800 1.2300 1.1800 EURUSD EURUSD Imp Vol (Inv)

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EUR/USD and US FRA/OIS (3mth)


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FIGURE 1: Euro/Dollar and U.S. FRA/OIS (3 month)

BULLISH FLOWS
In fundamental circles, FX traders consider the U.S. dollar a safe haven currency. Though, rather than acting as a magnet for capital whenever market

participants are looking to transfer funds away from risky investments, the dollar really shines when liquidity is at a premium. The U.S. markets (specifically the Treasury and money markets) are the deepest in the world, and this imbues the currency with a special safe haven appeal. And given that the EUR/ USD is the most liquid asset in

the world, it is particularly adept at following the need for capital.

MEASURE LIQUIDITY
Therefore, when we want to verify a strong and lasting trend for the U.S. dollar (bearish EUR/ USD move), an indicator of fear and liquidity can help act as a gauge of conviction. Rather than attempting to intuit these

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Source: dataBloomberg

THE LIQUIDITY GAUGE

conditions, a great indicator of liquidity demand is the spread between U.S. Forward Rate Agreements (FRA) and Overnight Index Swaps (OIS). In Figure 1, we set the EUR/ USD price action (blue line) against the liquidity spread (red line). The spread actually is inverted, because the dollar is the second currency in the pair. As we can see, when liquidity is tight (the red line is low), the momentum behind the U.S. dollar builds, and the currency generates a greater level of strength.

It works best to confirm medium-term, dollar bull trends as a signal to take profit.

ENTRY SIGNAL
For entry, I typically use basic technical analysis (I prefer using trendlines and moving averages) and fundamental analysis to enter on a bearish EUR/USD (dollar bull) trend. From there, I use the liquidity gauge to assess its strength in terms of momentum and pace. If the liquidity measure is rising very aggressively, it typically supports a lasting and equally

strong rally for the dollar. When momentum on the liquidity measure flags, it is a strong sign that the dollars run will soon come to an end. Alternatively, when trading a EUR/USD bear trend that does not develop alongside a notable rise in liquidity, I plan for a much shorter trend by setting my profit targets and stop closer. John Kicklighter is senior currency strategist at DailyFX.com.

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ASK DR. DUKE


DEAR DR. DUKE,
I have an S&P 500 Index (SPX) August iron condor with strikes 1150/1160/1380/1390. I opened 10 contracts for a credit of $2. My planned adjustment strategy is the long hedge that you recommend. However, I am pondering the pros and cons of adjusting with a bull call spread instead. Under the long hedge adjustment scenario, I will buy one 1380 September call. On the other hand, I may adjust with an August 1370/1380 bull call spread. I can buy 10 of these spreads for $2 each. ment. It allows me to hold the position longer to give it a chance to recover, while keeping losses to a minimum. Alex; Richland, WA
DEAR ALEX, I would not consider buying the 1370/1380 call spreads to be a viable adjustment. We are trading the iron condor on SPX as a classic delta neutral income generation trade. Our first objective is to minimize our price risk due to the index price trending strongly in one way or the other. We monitor that price risk by keeping delta reasonably small or delta neutral. Our second objective is to maintain a steady rate of profit generation via time decay. We monitor our profit potential by keeping our position theta large and positive. We are minimizing our price risk. I am always wary of putting more capital at risk in a losing trade. Its often best to close the trade. The proposed call spreads would require an additional $2,350. The result will be a position that is essentially

I am always wary of putting more capital at risk in a losing trade.


This will consume all my initial credit, but it will make my max loss (above 1160) extremely small. I can hold the position until expiration with very little downside risk. Should the position recover at any point? I can sell the bull call spread and make a small profit. At first glance, it looks like the bull call spread is a better adjust-

delta neutral, but the positions theta will have turned negative. We are no longer making money from time decay. We have locked in a minimal loss if the market continues upward, but we also have tied up more capital, and time works against us. By contrast, you could buy a September $1,380 call for about $1,100.This adjustment requires less money, but it reduces your delta risk substantially. More important, theta remains positive. Alternatively, you could close the position today for a small loss. It would be much better to either close the position now or adjust with the September call. Buying the call spreads puts more capital at risk and transitions our trade into a negative theta position, one that loses money with the passage of time.
Kerry W. Given, Ph.D. (aka Dr. Duke) is the founder and managing director of Parkwood Capital LLC and the author of No Hype Options Trading.

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There is a substantial risk of loss in trading commodity futures, options and off-exchange foreign currency products. Past performance is not indicative of future results.

EYE ON FUTURES
ABOUT RISK
By Curt Wagaman

Many successful traders will tell you that most of their efforts are focused on managing risk rather than making profits. This is exactly the opposite of how many traders think. Consider the following: Youve crafted a technical trading strategy that trades exclusively in one market. You back tested it to death, being careful not to over-optimize. You concluded that the strategy has performed well in the past and meets your criteria to move forward. You begin to paper trade the strategy and have found that if you adhere to the rules set forth in your trading plan, then you achieve very similar results as those obtained from back testing. For the sake of discussion, lets say that your strategy has a 65% winning percentage and achieves a risk/reward ratio of 2:1.

Enough testing has been done to deduce these numbers as statistically significant. For our purposes, the specific numbers arent all that important. What we will assume from these numbers is that if everything is conducted exactly the same in a live account and market conditions remain the same as those tested in, then we should have a winner on our hands.

Think about professional traders, CTAs and others who have experienced prolonged success. Even the elite have losing trades, losing streaks and subsequent drawdowns in their accounts.

DRAWDOWNS
Risk of ruin illustrates how inevitable losing streaks can wipe out an account. Its calculated by looking at the probability of winning, the probability of losing and how much is at risk each trade. Flip a coin thousands of times, and youll find streaks where one side appears many times in a row. This is the losing streak. Even with a coin weighted 65/35 in favor of success, you will still undoubtedly experience bad spells. If you consistently risk too much per trade and trade long enough, youll go bust. Bottom line expect the best, but always plan for the worst and manage risk accordingly.
Curt Wagaman is an instructor and professional trading mentor for the futures training division of PFGBEST.

NOT SO FAST
First, ceteris paribus rarely exists in trading. Second, sticking to your trading plan in the face of adversity and psychological factors isnt easy. Third, a 2:1 risk/reward ratio sounds nice. However, pose this question to yourself: What percentage of your account are you risking per trade? Many traders have an opinion on the optimal risk per trade, but the point is you cannot afford to risk too much.

Sticking to your trading plan in the face of adversity and psychological factors isnt easy.

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TRADE OF THE MONTH


LOOKING FOR A BREAKOUT
By Casey Stubbs

As of mid-August, the euro/ dollar (EUR/USD) is in a tight consolidation range. Traditionally, EUR/USD is a trending pair, which is why it is a favorite among traders. However, now traders are confused as to which way is best to trade it. The good thing about the current tight range is that it creates an opportunity for a breakout. The breakout could

be quite significant and travel for some time. Figure 1 shows a pattern you should be looking for if the eventual breakout is a downward movement. Notice how it tests the trendline and the key resistance level before making a strong break to the south. A breakout in the upward direction involves the same principles as the downward breakout in terms of testing the trendline and the key resistance area. Keep in mind that we need to take an entry based on price action and what the market is

doing, not our bias on which direction we feel that it may go. A strong breakout from a channel is a very high-probability trade, and traders can risk a relatively small amount of capital for the chance to have huge gains.

THE TRADE
Buy price would be: 1.4700 Target would be: 1.5200 Stop loss would be: 1.4600
Casey Stubbs is the founder of Winners Edge Trading.

Source: Tradestation chart from FXCM

1.503 1.492

EUR/USD Daily Chart

1.481 1.470 1.459 1.448 1.437 1.426 1.415 1.404 1.393

The current price range on the EUR/USD lasted for 5 months as breakout is coming in the near future

1.382

If this level gets broken, then we could see 1.3300

1.371

1.349 1.337 1.326

FIGURE 1: Daily Euro/Dollar Chart Through Aug. 8, 2011

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RISKY BUSINESS? RISK SENTIMENT


USE FOREX TO TRADE

GAUGE FX TRADES USING RISK SENTIMENT

BY BRIAN DOLAN

Even if youre not actively trading forex, paying attention to whats happening to FX risk assets can provide important signals for other major financial markets. For traders crossing over to forex markets from stocks or commodities, the flow of market news and data in currencies can be overwhelming. Avoid paralysis by analysis by using risk sentiment to

form short-term FX trading strategies. RISK SENTIMENT Risk sentiment (aka risk appetite) is a relatively new market term used to express investors' attitudes. Bullish and bearish describe stocks, but risk sentiment applies to a broader swath of financial markets. If investors are confident in the economic out-

look and news and data are supportive, theyre seeking risk. They have an appetite for risk. The risk is said to be "on," typically sending stocks and commodities higher and safe assets lower. If bad news on the economy is dominant or data is disappointing, sentiment shifts toward risk aversion, or "riskoff" mode. Investors typically dump so-called
Source: Bloomberg, FOREX.com

1 weak/no correlation 0.8 0.6 0.4 0.2 0 -0.2 -0.4 Mar-08 Nov-09 Aug-08 Sep-10 Jun-09 Jan-09 Feb-11 Oct-07 Apr-10 Jul-11

strong positive correlation

start of Great Financial Crisis May-02 May-07 Dec-01 Dec-06 Mar-03 Nov-04 Aug-03 Sep-05

Jun-04

Jan-04

Feb-06

Oct-02

Jul-01

Apr-05

FIGURE 1: S&P 500 and AUD/JPY 60-Day Correlation


Figure 1 plots the 60-day rolling correlation over the last decade between AUD/JPY and the S&P 500, to use two examples of risk assets. Note that prior to 2006, the relationship was nonexistent, fluctuating between negative and positive and never reaching statistically significant levels of correlation one way or the other. With the bursting of the U.S. housing bubble and the Great Financial Crisis of 2007-09 (GFC), a strong positive correlation materialized. Whats behind that? And more important, how long will it persist?

Jul-06

risk assets and seek shelter in safe haven assets. RISK OFF CURRENCIES In currencies, the Swiss franc (CHF) and the Japanese yen (JPY) are the primary havens when risk is off. Part of this is due to shortcovering. Both are lowyielding currencies that are typically sold when risk is on as part of the carry trade strategy. If the market environment deteriorates, short-JPY and -CHF positions need to be covered. The Swiss franc historically has functioned as an insulated alternative to major currencies. The JPY benefits from Japans traditional trade surplus and vast pool of domestic savings. Its not reliant on foreign lenders (95% of Japanese government debt is domestically owned). The USD can be twofaced as a safe haven, weakening in a risk on environment as safe haven demand for U.S. Treasuries fades, possibly even on the back of

TAKING A RISK
Risk assets markets that expose investors to greater potential risks and rewards (typically stocks and commodities). In the forex space, risk assets are long carry trade pairs (long higher yielding/short lower yielding currency), like long Australian/Japan (AUD/ JPY) or New Zealand/Japan (NZD/JPY) currently, and long commodity currencies, such as Australian dollar (AUD), New Zealand dollar (NZD), Canadian dollar (CAD) and the Norwegian krone (NOK) against safe haven currencies. Long emerging market currencies like the Mexican peso (MXN), South African rand (ZAR) and the Turkish lira (TRY) also function as risk assets in the currency world.

PLAYING IT SAFE
Safe haven assets popular during times of market turmoil or extreme uncertainty. Among major financial markets, government bonds of highly rated nations are the preferred refuge U.S. Treasuries, German bunds and Japanese government bonds (JGBs). Precious metals, such as silver and gold, also have acted as safe haven plays, especially with plights in the euro (EUR) and U.S. dollar (USD). At other times, the metals may tend to follow overall commodity trends.

upbeat U.S. data (which is good for risk appetite), but then strengthening if markets turn risk averse, potentially after worse-than-expected U.S. data (bad for risk

sentiment). As you can see, the USD reaction to U.S. data frequently can be counter-intuitive but viewed through the lens of risk sentiment. It makes more sense.

CHANGING TIMES Risk sentiment has been a dominant driver of market moves. In terms of risk sentiment, investors clearly fell into the abyss following the Great Financial Crisis but also have resurfaced to find a vastly altered landscape. As major central banks cut rates to near zero, investors have been forced to chase yield more than ever. Decent returns in traditionally safe assets (i.e. bonds) are scarce, so they are forced into more

risky assets. Traditional asset managers (pension funds and endowments) have plunged headlong into commodities. Another reinforcing element is the increased prevalence of algorithmic trading programs (algos), both on the institutional and retail level. Many rely on inter-market statistical relationships as key drivers. In terms of the outlook, the anemic recoveries in the major economies suggest rates will remain low through 2012 and likely into 2013,

while algos will continue to proliferate, suggesting the risk on/risk off dynamic will remain a viable trading approach for several years. MEASURING RISK SENTIMENT Gauging sentiment is always a questionable proposition, whether its consumer confidence or risk appetite, but forex markets provide an easyto-read guide of if risk is on or off. Examine carry trades, especially the JPY- and

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There is a substantial risk of loss in trading commodity futures, options and off-exchange foreign currency products. Past performance is not indicative of future results.

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There is a substantial risk of loss in trading commodity futures, options and off-exchange foreign currency products. Past performance is not indicative of future results.

CHF-crosses. If theyre down or falling, risk is off, and the low-yielding JPY and CHF are being bought both on short-covering and flight to safety. If the environment is especially severe and markets are in a panic, the USD may see additional strength against currencies other than JPY and CHF, likely propelling those crosses even lower. In one risk off scenario, the USD might be bought against EUR (sending EUR/USD lower), while the JPY is bought against the USD (sending USD/JPY lower), amplifying the move down in EUR/JPY. For more concrete measures of risk sentiment, I focus on options volatility of major currency pairs and the Volatile Index in stocks. Rising volatility suggests heightened risk aversion and vice versa. U.S. Treasury bond yields are another way to gauge risk appetite (yields down, risk off/ yields up, risk on) and

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an intraday move of more than five basis points in the 10-year gets my attention. TRADING ON RISK SENTIMENT There are two ways to approach this topic: For those actively trading forex For those trading other markets, say, stocks or commodities Keep in mind that my views are based on the current state of intermarket correlations, which invariably will break down in some cases. Thats why its important to maintain a healthy sense of daily data and news on the major currencies, individual stocks and commodities, as well as the longer-term drivers.

For active forex traders, trading on risk sentiment involves waiting on significant data. If you want to trade FX on risk sentiment and news hits, ask: Is the outlook brightening or darkening? Is this good or bad for risk sentiment? And degree does matter. You need to judge the magnitude of the news to estimate the extent of the market reaction. Is it a little bad, really bad or downright atrocious? If youre unsure or looking for confirmation, just watch the FX risk pairs (JPY and CHF crosses and commodity currencies) and the other gauges outlined above. Then its a simple matter of going with the risk sentiment result in the FX risk assets.

ened, you might consider alternative JPY-crosses. At the beginning of July, FX risk pairs plunged, indicating rising risk aversion, and yet stocks remained buoyant for a period, only to subsequently move lower. FX risk remained depressed in the middle of July, but stocks diverged again and rallied to near prior highs. That final bearish divergence played out into the end of the month, with FX risk plunging again and shares following suit. IMPORTANT BAROMETER For traders not active in FX, keeping an eye on FX risk barometers can provide clues to market direction in other markets. See Figure 2 for a recent example. FX is the largest market in the world and the crossroads of international capital flows, so I always look at FX as the dog that wags the tail. Major financial markets have exhibited a degree of interconnectedness in recent years

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One caveat is to remember currency pair selection and be mindful of recent individual currency developments. For example, risk may be off on a disappoint-

ing U.S. data report, and you may be tempted to sell a JPY-cross, say AUD/JPY. But if the Reserve Bank of Australia (RBA) is hiking or Aussie data recently bright-

Source: Bloomberg, FOREX.com

104 102 100 98 96 94 92 90 FX shows sharp rise in risk aversion 88


1-Jun-11 8-Jun-11 15-Jun-11 22-Jun-11 S&P 500 29-Jun-11 6-Jul-11 13-Jul-11 EUR/CHF 20-Ju1-11 27-Ju1-11

104 102 100 98 96 94 FX shows sharp rise in risk aversion FX indicates risk aversion remains, but stocks diverge bearishly 92 90 88

ERU/JPY

FIGURE 2: Using FX Risk Assets To Gauge Sentiment


Figure 2 shows the S&P 500, EUR/CHF and EUR/JPY over June and July 2011, normalized to start at 100 to highlight relative movements. Note the multiple divergences between FX risk assets and stocks. In June, the FX risk pairs were above stocks, suggesting the S&P was too bearish, and stocks eventually rallied into the end of June.

that needs to be factored into trading strategies, no matter which market youre trading. The common denominator is risk sentiment, and many recent market moves can best be explained by asking if risk is on or off. Risk sentiment can be used as the basis for trading strategies in forex and for spotting directional shifts or di-

vergences in other major markets. Understanding risk barometers helps you gauge risk appetite and cut through the fog of fundamental analysis.

Brian Dolan is the chief currency strategist at FOREX.com. Foreign Exchange and other leveraged products involve significant risk of loss and are not suitable for

all investors. The charts, data, information, reference to any events or trends and opinions in this report are for general information use or illustrative purposes only and are not intended as an offer or solicitation to any product offered. There is no guarantee that any event or trend is likely to be repeated or that profits will be or are likely to be achieved.

HOTto Watch Currencies


By Paul J. Kavanaugh, CTA
Knowing the key fundamental factors likely to drive price movement is an essential starting point for trading in the forex futures markets.

September 2001
THE U.S. DOLLAR
Since its peak of 12,129 in September 2001, the U.S. dollar index fell by more than 40% to its March 2008 low of 7,080. Then as the financial meltdown of 2008 developed, we saw a 25% move higher as global currency speculators lost their appetite for risk and sought out the relative safety and security of the U.S. dollar. See Figure 1.
Source: CQG

121,290

120,000

115,000

The U.S. dollar declined by 40% 2001-2008

110,000

105,000

100,000

95,000

90,000

85,000

80,000

75,000
70,805 $50,485.00 41.62%

70,000 2008 2009 2010 2011

1999

2000

2001

2002

2003

2004

2005

2006

2007

FIGURE 1: Semiannual U.S. Dollar Index Chart

March 2009
By March 2009, the U.S. dollar was once again above 8,800 for the first time since April 2006. Then the Fed began its first round of quantitative easing (QE1). The dollar resumed its downtrend, slipping 17% to 7,421 by November 2009, when sovereign debt concerns took center stage in the global news. See Figure 2.
Flight to quality rally
92,500

QE1
90,000

QE2

87,500

85,000

82,500

80,000

U.S. dollar in May 2011 lowest since July 2008

77,500

75,000

72,500

2005

2006

2007

2008

2009

2010

2011

FIGURE 2: Monthly Continuation U.S. Dollar Index Chart

June 2010
Once again currency speculators ran to the U.S. dollar for safety. By June 2010, the greenback was nearly 20% higher again above 8,800. Subsequently the dollar declined again as the Fed announced and then implemented another round of fiscal stimulus that came to be known as QE2. By May 2011, the U.S. dollar had declined once again to the lowest levels since July 2008, when the financial crisis took hold.

COMMODITY CURRENCIES
During the 2001-2011 decade, the Australian dollar moved up 130% from its April 2001 low of 0.4774 to its July 2011 high of 1.1005. Similarly, the Canadian dollar moved up 78% from its January 2002 low

of 0.6170 to its November 2007 high of 1.1043. Over the same period of time, the continuous commodity index (CCI), which consists of (or tracks) 17 commodity futures markets, increased by 278% from its October 2001 low of 18,283 to its April 2011 high of 69,109. FX futures traders often refer to these currencies as commodity currencies, because the economies of Australia and Canada are significantly dependent on

Source: CQG

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commodity exports of gold for the Australian currency and crude oil for the Canadian dollar.

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These webinars are presented by The Admiral, whose career encompassed trading as a sole proprietor and as a partner in the Designated Primary Market Maker (DPM) structure at the CBOE. Along the way, The Admiral made millions and lost millions and taught many individuals to become successful options traders. Today, strategy and trading analysis are part of his many active roles.

4Q TRADING OPPORTUNITIES
One of the best approaches to forex trading in the fourth quarter may be trading risk appetite versus risk aversion using the U.S., Australian and Canadian dollar FX futures. Risk aversion is best described as the preference for certainty versus uncertainty. When traders seek safety, they often move assets to the U.S. dollar, causing it to move higher. Conversely, when traders are hungry for better returns, they may look to be long Australian and Canadian dollars. In addition, the sovereign debt concerns over the eurozone nations likely will re-take center stage in the global media as the structural problems plaguing the single currency remain unsolved. Therefore, we could see the euro under significant pressure in the fourth quarter and potentially a test of the 1.20001.2500 level against the U.S. dollar. Paul Kavanaugh is senior currency markets analyst at PFGBEST. Download his currency report.

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Expand Your Boundaries


By Greg Michalowski

The FX World::

You only trade equities, but you notice the foreign exchange market has gotten lots of attention in recent years. Nevertheless, you are a traditionalist, and trading forex seems for lack of a better term foreign. By using basic technical analysis and tools, you may find that trading forex is very similar to your equity trading. Liquidity ($4 trillion/day) is a key benefit of the forex market. There are several traders, both retail and institutional, who trade off prices that are transpar-

ent (i.e. virtually the same for all). The advantage is all traders are looking at the same (or very similar) charts. Since the charts are the same, technical traders can apply visual technical tools that determine key support or resistance. DEFINING RISK If everyone can draw the same upward sloping trendline, then trading entry levels can be defined for the risk-conscience traders at those points. If the price moves above the trendline, the bias turns bullish (i.e. buy). If

the price dips below that trendline, the bias turns bearish (i.e. sell). As a result, energy is often found at these levels. The energy either stops/slows the market's directional move and reverses the price action or leads to a move through the level with momentum continuing through the break. LEVEL THE PLAYING FIELD This helps level the playing field among institutional traders with power to move the market and retail traders who cannot. Retail tradSource: Bigcharts.com

SPX Daily

SMA (100)

SPX Daily

7/01/11 1,375 1,350 1,325 1,300 1,275 1,250 1,225 1,200 1,175 1,150 1,125 1,100 1,075 1,050 1,025 1,000

Aug

Sep

Oct

Nov

Dec

11

Feb

Mar

Apr

May

Jun

FIGURE 1: Daily S&P 500 Chart

ers need only trust that the visual technical levels mean something to the market. If true, there should be price movement at these energy points. In other words, follow the technical levels and dont worry what the institutional traders may be doing. TECHNICALS WORK ON ALL CHARTS If you were to look at the S&P 500 index and apply the same visual technical tools like trendlines and moving averages, there is similar energy at the key levels. After all, there are a lot of traders who trade the S&P index, and the price is transparent to all traders. Like forex, retail traders need only trust the visual technical levels derived from the tools. VISUAL CLUES Figure 1 shows a daily chart of the S&P 500 index. As a technician, I focus on simple and visual tools like trendlines and moving averages. I like the 100 and 200 bar simple moving averages (SMA).

I drew key trendlines and applied the moving averages on the chart (green arrow is 100 day SMA, blue line is the 200 day SMA). Take a look at the price action near the SMA levels (the white numbered circles 1-6). At the white circle 1, the price held below the 100 day SMA, and the price fell. At white circle 2, the price broke above the 100 day SMA, and this started a trend move higher. More recently at white circle 5, the price bounced very nicely off the 200 day SMA twice. At each point, the trader can define risk and execute trades as per the bias (price moves above or holds the SMA buy; price moves below or holds sell). USING CHANNELS Looking at the trendlines, the black numbered circles outline the uptrend and channel trendlines. The gold square boxes defined a narrower channel within a channel. In March 2011, at black circle 5, the trendline going back to Septem-

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ber 2010 was broken, and the price fell sharply. Like the SMAs, the trendlines are risk-defining levels that traders focus on for trade clues. SAME IN FOREX Figure 2 shows the euro/ dollar (EUR/USD) with the same 100 and 200 day SMAs and the ma-

jor trendlines/channels drawn. Like the S&P chart, if you follow the 100 and 200 day SMAs, you can see levels where moves were initiated. At the start, the price is consolidating sideways after a trend moves lower. The price moves above and below the moving averages, but most of the

action occurs between the two moving averages. When the price breaks above or below the SMAs and fails, note how the price heads to the other extreme. Traders can use the failed breaks to their advantage, too. BUY SIGNAL SEEN At white circle 4, the price moves above the 200 bar SMA, giving a buy signal. A short time later at white circle 5, 6 and later at 7, the price finds support against the 100 day SMA. The price moves higher. More
Source: FXDD

1.49570 1.47650 1.45670 1.43750 1.41830 1.39910 1.37990 1.36010 1.34090 1.32170 1.30250 1.28330 2 May 2011 24 May 2011 15 Jun 2011

D
3 Nov 2010 25 Nov 2010 17 Dec 2010 10 Jan 2011 1 Feb 2011 23 Feb 2011 17 Mar 2011 8 Apr 2011

FIGURE 2: Daily Euro/Dollar Chart

Greg Michalowski explains what to look for so you can get started in the forex market.

recently, at white circle 8, the price bounced nicely off the 100 day SMA, and rallied more than 700 pips over the next 12 trading days. It is this energy that forex traders look for at these key visual levels. Like in the S&P, the visual trendlines/channels also do their job in defining risk and creating energy in the forex market. Did you notice the number of times the price touches the channel trendlines on the top and bottom of the major

upward channel (defined by the black circles)? At each level, traders are able to define risk and trade against the level. Near the high, the price breaks above the top channel trendline indicative of an acceleration of the bullish momentum. In May 2011, the price moves back into the channel at black circle 6, and the failed upside break starts a large corrective move that takes the price 800 pips through the trendline started in February 2011.

FINDING OPPORTUNITIES Trading the S&P and foreign exchange may be more similar than you may think. In markets like the S&P and the EUR/USD that are transparent and have lots of liquidity, the visual technical tools give trading opportunities with clearly defined risk. Its a matter of seeing them.

Greg Michalowski is chief currency analyst at FXDD.

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There is a substantial risk of loss in trading commodity futures, options and off-exchange foreign currency products. Past performance is not indicative of future results.

1. EXPIRATION DRAWINGS
Don't trade options based on expiration drawings. Before you pull the trigger on an option trade, you must know when the option expires. Dont think you always need to take the options all the way to expiration. For the most actively traded markets, there will be too much movement in between your opening trade and expiration. Taking all your options to expiration usually means your profit/loss will fluctuate more then you want. Trading options close to expiration should only be done by seasoned professionals. If your plan is based on option expiration, you are tying up capital that can be used for other trades. If you want to be involved in the market, you should think in terms of how to get out of an option trade if you are right on market direction and have a profit.

BALANCE
You risk getting margin calls the longer you hold a position. This can happen even if you're right on the market, but it certainly will if your options start netting a loss. Be careful how you balance your option play. How much your option moves versus the underlying futures contract is called the delta. It will be a number between -1 and 1. If the delta is .25, your option will move the same direction as the futures but only 25% as far. If the futures move four ticks, your option will move one.

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There is a substantial risk of loss in trading commodity futures, options and off-exchange foreign currency products. Past performance is not indicative of future results.

SPREADS:
If your delta is -.25, the option will move one tick to four but in the opposite Ratio Spreads direction as the futures Butterflies contract. Know your deltas. A lot of retail option traders (RANKED BY MOST TO LEAST RISK) like to balance the amount of money it takes to buy an option by selling other options that add up to approximately the same dollar amount. This can lead to identical deltas, in which case your position is no longer bullish or bearish. Its perfectly hedged! The delta of the whole position equals all the option deltas added together. Example: Buy two 100 calls Sell four 120 calls The delta for a 100 call is .50, and the delta for a 120 is -.25. One side adds up to +1.00 and the other to -1.00, which is a perfect hedge. Also, the more naked options that are part of the combination, the more risk/reward. If you buy three options and sell four as part of a spread strategy, you are naked one option. A 3:4 spread ratio is less risky then 2:4 or 1:4, etc.
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Professional traders are always ready to take a winning trade and put the profits on the books. Too many traders look at the graphs of how an option spread or strategy will settle at expiration. However, this has little to do with what the market is doing right now. Futures have expiration dates, just like options. Do you trade a September futures contract thinking about taking the position to expiration? The longer you hold open positions, the more the inherent risk that markets will do something completely new and unexpected. Commodity futures have a way of turning on a dime. The call or put you bought or sold can decrease in value just as fast as it went up in value. Gregory Brown is president of Sequence Trading Group LLC.

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Unlike many option texts, Rookies Guide features step-by-step instructions and extensive examples. This book illustrates how to analyze alternatives and explains how to select a plan thats right for you. Master option basics, and youll move on to powerful strategies to earn high returns with limited risk. These strategies can help ensure your portfolio survives a market downturn.

AbouT ThE AuThor

Carr fills a void for the self-directed investor His approach to the market is a great resource for the technically or fundamentally oriented individual. The rich content can be readily applied as-is or serve as a launching point to expand an existing method. Nicely done!
Clare White, CMT, Optionetics, Inc.

TPI

Prior to co-authoring Mind Over Markets, Jim Dalton sponsored Pete Steidlmayers original work Markets and Market Logic. Jim trades full time and advises two hedge funds and several trading firms. He is a discretionary trader and a long-time proponent of using the Market Profile to facilitate trading. He has been a member of the Chicago Board of Trade and the Chicago Board Options Exchange, which he served as vice president during its formative years. He shares his vast experience in two books, Mind Over Markets and Markets in Profile, as well as the Field of Vision DVD course.

michaelsJ.Freeburg carr Foreword by nel on

Power Trading with Market Generated Information


James F. Dalton, Eric T. Jones & Robert B. Dalton

Dalton.Jones.Dalton

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If you are an active trader who struggles with issues of discipline, impulsivity and consistency, you may have a neurological condition known as attention deficit disorder (ADD). Dont let the term deficit fool you. Only one of the six types of ADD identified by Dr. Daniel Amen is inattentive; the others often involve hyperfocus. I was diagnosed with adult ADD in 2006, while struggling to complete my doctorate in clinical psychology. Finishing the dissertation was

a big challenge, but it pales in comparison to the challenges of trading with ADD. PREVALENCE ADD, along with its hyperactive variant ADHD, is the most widely diagnosed neurobehavioral disorder among schoolage children, affecting almost 10% of individuals in the U.S. between the ages of 3 and 17. Psychologists believe the cause is partly genetic and partly environmental. Close relatives

of children with ADD have a five times greater chance of having the disorder, and boys tend to be diagnosed three times as often as girls. Adult ADD is much less commonly diagnosed than the childhood condition, largely because adults find ways to compensate for their organizational shortcomings (delegate it!). There is no opportunity to delegate in trading, so ADD traders eventually face their perplexing mind. SYMPTOMS ADD is known by its symptoms; the causes are still obscure. The disorder impairs ones ability to organize information and consistently follow rules, even when one wants to. Therefore, for ADD traders, author Mark Douglas simple advice is, quite frankly, impossible to implement. Although individuals with ADD are often underachievers in the trading world, they typically have been successful in

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previous entrepreneurial ventures, where they tend to be the creative force. Unfortunately, business skills do not translate well into the trading world. Traders with ADD, who often have high IQs, seem to constantly outsmart themselves. A highly intuitive mindset driven by compulsive creativity causes them to miss the obvious or sabotage good trades. Among the other common symptoms, ADD traders report: Impulsivity Excessive multitasking Acts of irresponsible risk taking Inability to follow a trading plan Overtrading to the point of addiction Hyperfocus on momentto-moment price action Tendency to become overstimulated (tranced-out) by informational input Traders with adult ADD often feel like their worst enemy, because it gets worse when they try harder.

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If you answered yes to: 0 or 1 question: You appear to have few symptoms of adult ADD. Most likely, you are already a profitable trader. 2-5 questions: You have some of the symptoms of adult ADD I have noticed in traders. I suspect you are a break-even trader. More than 5: You have many of the symptoms of ADD that I have noticed in traders. You are likely to have a boom-bust or steadily declining equity curve.

ADD & YOUR BRAIN


ADD is a brain condition. There are two aspects of brain function affected by ADD: metabolism in the prefrontal region and certain neurotransmitter levels.

The prefrontal cortex (PFC) is the area of the brain responsible for executive function, i.e. reflective and organizational tasks. Adult ADD shows up in a single-photon emission computerized tomography SPECT scans as areas of low metabolism in the PFC. In order to compensate, in-

dividuals with ADD seek stimulation. This is why prescription stimulants may help some people. For traders, risk-taking is the preferred stimulant. However, in trading, the need for stimulation and the need for self-discipline work against each other. Additionally, low levels of the neurotransmitters dopamine and norepinephrine also have been associated with adult ADD. NEXT STEPS ADD treatment needs to be individualized. Some

people will respond well to stimulants, but for others, stimulants make the symptoms worse. The standard prescription drugs did not work for me, so I sought alternative approaches.

Dr. Kenneth Reid holds a Ph.D. in clinical psychology. He has been an independent trader since 1996 and a trading coach since 2002.
This article is for educational purposes only. Consult with a physician or mental health professional in your area for a diagnosis and/or treatment.

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Gregory Browns tips on options day trading gives you a taste of what you can get in Octobers SFO. Make sure you sign up for his free webinar to get the final three (and most important) tips. We move from this months forex theme to day trading next month. Learn about an analytical tool that will help ease your decision-making process. Get more information on trading future spreads. Do you understand the single in/scale out method? You have a chance to get the information you need next month. We are getting close to harvest season. Tim Hannagan of PFGBEST will be looking at grains in his feature story. You read him each week in SFOs free newsletter, but options writer Jeff Augen will contribute a longer, more in-depth story about the changing statistics of the market in the monthly magazine, too. You will be able to get a discount on his books, including one that is reviewed next month. Augens books will not be the only discounts available. So, be looking for great deals next month if you are looking to add to your library. SFO will have its usual columns: Trade of the Month Tech Strategy Eye on Futures Contributing authors next month: Jeff Augen (and webinar host) Ross Beck (and webinar host) Jim Dalton Kerry Given Tim Hannagan Donna Heidkamp Mark Hodge (and webinar host) Steven L. Miller John Sarkett Quint Tatro Curt Wagaman

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