The secrets to trading forex

Acclaimed US forex trader Kathy Lien, author of “Day Trading & Swing Trading the Currency Market,” is currently in Australia.

When starting out trading forex – or even shares for that matter – it’s handy to have some exact rules to follow. A set of rules is precisely what we need to lift our confidence, our profits, and to limit the number of costly mistakes we make.

A few simple guidelines can make all the difference.

Kathy Lien, executive director of research at GFT has written a book about what to do – and more importantly, what not to do – when trading forex. She advises traders on how to profit from news releases and from short-term fluctuations, which currencies are the best to trade and at what times, how to make a good yield and capital trading the leveraged carry trade (more on this below), the best technical and fundamental strategies to employ – plus handy tips that even hard-core traders won’t have heard about.

Some of these tips are strategies that professional traders employ, which are rarely taught to beginners. The good news is that many are dead easy to employ.

Trading news releases is one of the most popular pastimes for forex traders. Traders place their trade either just before or after a major economic announcement such as nonfarm payroll figures in the US or CPI figures in Australia – and wait for the knee-jerk reaction as the market digests the information. But to the frustration of many traders, currency pairs following a release often shoot in the least expected direction, or barely budge at all.

Lien tells us to never place a forex trade five minutes before an economic release (spreads can widen). Better to place it 15 to 20 minutes before the release is due out, she states. And if you decide to trade after an economic release only do so if the news is significantly better or worse – greater than 100 percent – than the market’s forecast. Otherwise you may find yourself nursing a trade that’s going nowhere fast. This is a handy rule of thumb to follow.

Lien learnt these skills as a trader on the forex trading floor of a big US investment bank. These traders are the ones that trade millions of dollars worth of currencies daily, and who’s primary objective is to rack up big profits for the bank.

Want to learn a trading tip that professional traders use and that requires little more than a keen eye and a candlestick chart? Lien reveals a very popular strategy in the world of professional trading, called the inside day strategy. “New traders are frequently amazed by its ease, accuracy and reliability,” she notes.

Lien states that an “inside day” occurs when the day’s high and low on a currency pair do not exceed the previous day’s high and low. She says that the more inside days that occur in a row, the higher the likelihood of an upside surge in volatility, or breakout scenario.

Identifying inside days using a daily chart tends to lead to an even greater probability of success than hourly charts, which is good to know.

“If you are using the inside day strategy, you will see that inside days are more common on intraday charts and far less common on daily charts. This is why they are extremely accurate when they do appear on daily charts; the rarest things can be the most valuable.”

Lien says that traders that use daily charts might look for breakouts ahead of market major economic releases for a specific currency pair. This strategy works for all currency pairs, she says, but is most effective in the tighter range pairs such as the USD/GBP, USD/CAD, EUR/CHF, EUR/CAD and AUD/CAD.

Long before you can begin applying these techniques, however, as a beginner trader you must first decide on a trading strategy to follow and choose a currency pair or a combination of currency pairs to trade (remember, currency pairs can be highly correlated with each other either positively or negatively. This means that if you trade currencies in combination you need to know how they react beforehand because the wrong combination can cancel out or double your exposure).

Lien demonstrates that there are two ways to trade forex – trend following and range trading, and that your chosen strategy should determine which currency pairs you decide to buy and sell.

In short, traders should apply range-trading strategies to range-trading currency pairs and trend-trading strategies to trend-trading currency pairs. “The CHY/JPY, for example, is a great currency pair for a range-trading strategy and a horrible one for a trend-trading strategy.”

“A person with a range-trading strategy should look to trade only currency pairs like the CHY/JPY, while trend traders should avoid the CHY/JPY.”

Ever notice that when a currency pair hits a double zero or round number that the rally is usually bigger than rallies off other prices? Lien notes that stop-loss orders are usually placed just beyond round numbers and traders tend to cluster take-profit orders at the round number. “Traders are human and humans tend to think in round numbers,” says Lien. “As a result, take-profit orders have a very high tendency of being placed at the double zero level.”

Double zeros represent numbers where the last two digits are zero – for example, 107.00 in the USD/JPY or 1.2800 in the EUR/USD.

She says that the double zero strategy puts traders on the same side as market makers. It can position you for a quick contra-trend move at the double-zero level, she says.

“This type of reaction is perfect for intraday FX traders as it gives them the opportunity to make 50 pips while risking only 15 to 20 pips.”

Another strategy is the leveraged carry trade, the favoured strategy for global hedge fund managers and investment banks. The good news is that it’s a strategy that everyday forex traders can employ successfully over the long term. The best time frame for the leveraged carry trade strategy is at least six months.

In short, the strategy involves buying a currency offering a high interest rate, like the Aussie dollar, and selling a currency that offers a low interest rate, such as the Swiss franc.

Lien provides an example: Let’s say the Australian dollar offers an interest rate of 4.75 per cent, while the Swiss franc offers an interest rate of 0.25 per cent. The trader can earn a profit of 4.50 per cent (the 4.75 per cent in interest earned less the 0.25 per cent in interest paid), provided that the exchange rate between Australian dollars and Swiss Francs does not change. If you add leverage to the mix – of say five times – the return becomes 22.5 per cent on just the interest rate differential.

Executing the Carry Trade

Buy AUD and SELL CHF (long AUD/CHF)

Long AUD position: investor earns 4.75 per cent

Short CHF position: investor pays 0.25 per cent

With spot rate held constant, profit is 4.50 per cent, or 450 basis points.

If the currency pair also increased in value due to other traders identifying this opportunity, the carry trader would earn not only yield but also capital appreciation.

Source: Day Trading & Swing Trading the Currency Market