Trading Techniques

In trading, as in life, no two traders are exactly the same and an approach to the market can be equally successful with contradictory styles. Though a multitude of trading styles exist their approach can generally be classified into one of two categories – fundamental or technical analysis. No matter which school of thought you may fall in always keep an open mind to the other as you could always discover a profit winning technique.

Fundamental Analysis

Fundamental analysis involves the interpretation of various economic and political factors that may have an impact on financial markets. By analysing the cause and effect relationship of market behaviour, the fundamental analyst seeks answers to many questions. In any market price, is directly influenced by the forces of supply and demand. Buyers want to acquire a product at the lowest possible price, sellers want to sell it at the highest price possible. The fundamental analyst may analyse economic data such as balance of payments, gross domestic product, levels of overseas debt, the unemployment rate, capital expenditure levels, consumer price index, housing approvals, retail sales, inflation, government policies, business conditions, Federal Reserve actions, consumer saving and spending preferences. They do so with a view to determining the implications of any changes in these economic indicators to that of the share prices, interest rates, foreign exchange rates, or the price of an instrument traded in the financial markets. The fundamental analyst is concerned with forecasting short and medium term trends in the markets.

In a floating exchange rate environment, the exchange rate responds to many factors including the flow of imports and exports, the flow of capital, relative inflation rates, etc. We can start formulating views on a particular currency simply from the daily deluge of information we can get from the media. Once involved in the Foreign Exchange market, we can “train” our minds to “dissect” this information in order to formulate a view. Having a view will be a great start. From there, many approaches can be undertaken to base your investment decision. Let’s take a look at some examples of recent events and economic news and their affect on the major currencies throughout the world.

Political Uncertainty – Scandal in the U.S. White House

Political uncertainty can weigh very negatively on a countries currency. In January 1998 stories began to surface that U.S. President Bill Clinton has had an 18-month affair with a 21 year-old White House intern, and then urged her to lie about it. The President’s problems stemmed from allegations that he obstructed justice or suborned perjury by encouraging the young intern, Monica Lewinsky, to actually lie under oath. The allegations of misconduct by Clinton seriously eroded confidence in the administration and caused increasingly nervous investors to sell their long U.S. dollar positions that they had accumulated over the previous several months. USD/DEM was trading around 1.8400 (with an actual high of 1.8435) early in the Asian session on Monday the 19TH. As the scandal built steam throughout the week, the U.S. dollar continued to break down as heightened tension surrounding the future of the U.S. presidency continued to spark a frantic exit of long dollar positions.

After establishing a low of 1.7515 marks, the market bounced due to a booming economy, Clinton’s forceful State of the Union address, and some old-fashioned threats to Iraqi leader Saddam Hussein, all helped to ease the turmoil and the scandal over the alleged affair. Nonetheless, this example shows how negative political uncertainty can weigh on a country’s currency.

Monetary Policy – Interest Rate cuts by the Reserve Bank of Australia

Interest rate changes are usually one of the most important determinants of short-term movements in exchange rates. Other things being equal, higher-interest rate currencies will tend to appreciate against lower-interest rate currencies. This is for the intuitively obvious reason that investment in securities carrying a higher interest rate will yield greater returns than investment in securities with a lower interest rate. Now, the first in a series of rate cuts in Australia was on July 31ST of ’96. After much speculation, the Reserve Bank of Australia cut interest rates by 0.5%, the first time we had seen a change in our monetary policy since December 1994 (or roughly 2 1/2 years!). Obviously, this was a very important event and the AUD fell immediately after the announcement. The move was sharp as the market was really caught by surprise because the majority view was that we were probably not going to get a rate cut until later in the year.

A trading strategy in the AUD could have been adopted to take advantage of this possible rate cut. Let’s just say that your view is such that you expect the RBA will cut rates sooner rather than later in the year. Now, on the weekend before the rate cut there was much talk in the newspapers, television newscasts, and in the market that if in fact a rate cut was going to happen- than it would happen as early as that week. Thus, you could have come in on Monday and sold the AUD in anticipation of investors liquidating some of their long AUD positions.

The direction of currencies are difficult to predict, and definitely has the element of risk, but in this case we would have expected the AUD to behave this way due to the narrowing of the interest rate differentials, particularly against the YEN and the CHF where a high yield advantage had been enjoyed throughout the year.

This example also highlights the versatility of the product. Unlike a foreign exchange contract where you are basically trading the AUD against the USD, you could have traded the AUD against a number of cross rates.

Regional Turmoil – The Southeast Asian Currency Crisis

In May 1997, Thailand’s currency- the Thai Baht, came under attack from foreign fund sales and speculators who decided that Thailand’s slowing economy and political instability meant it was time to sell. On July 2ND, the ASIAN currencies were dealt a rude shock when Thailand announced that the country’s exchange rate would be subject to a managed float after 13 years of pegging it to a U.S. dollar-dominated basket of currencies. The announcement effectively devalued the baht by about 15-20 percent and sent ripples through the region’s financial markets. Specifically those cross rates where you feel the rate cut would have had the most dramatic effect.

Consequently, their regional neighbours, specifically Central banks in Malaysia and the Philippines had to quickly intervene to support their respective currencies from an onslaught of speculators and foreign fund sales. Eventually, Central Banks in Indonesia and South Korea had to follow suit. Basically, the whole region was flocking out of their respective currencies and scrambling to buy safe-haven currencies, especially U.S. dollars.

On October 22, the Australian dollar finally caught the “Asian cold” when a series of articles in our newspapers depicted that the Southeast Asian currency crisis is having a negative impact on Australia. Even though only about 10% of our exports go to Southeast Asia, we were now seen as guilty by association as viewed by offshore funds. Further, 50% of our exports go to the China region, so a slowdown in Hong Kong and China- due to their trading partners woes in Southeast Asia, would mean a ballooning of our Balance of Payments (or trade deficit)- a situation which would weigh heavily on our currency.

Central Bank Intervention – Intervention by the Bank of Japan and the Reserve Bank of Australia

Central Banks in the world may sometimes intervene in the FX markets to support their currencies. Let’s first take a quick look at some intervention by one of the world’s most powerful central banks – The Bank of Japan (BOJ), and how it affected the USD/JPY exchange rate. On December 17th in ’97, on the heels of positive reaction to a two trillion yen income tax cut announced by the Japanese Government, the BOJ was estimated to have sold more than one billion dollars for yen. The USD/JPY fell quickly from the day’s high of 131.53 to as low as 125.70. Japan’s Vice Finance Minister Sakakibara later commented that Japan had taken steps to counter excessive weakening of the Yen.

On the 9TH of January 1998, the Reserve Bank of Australia (RBA) officially intervened to support the Aussie Dollar for the first time since 1993. The AUD/USD had been testing 0.6320 earlier that day, an important level which held solid earlier in the week, and traders had been betting a break there would see it quickly to much lower levels. However, upon the intervention, the Aussie leapt to 0.6390 in a matter of minutes. This was a very significant move by the RBA as it signalled to the market that they might be taking a stand to defend our currency. Up until the intervention, the Aussie had been seen as a riskless selling opportunity by speculators since it was assumed the RBA was prepared to accept the AUD depreciation as a logical consequence of events in Asia (of note, the AUD/USD actually rebounded to just short of 69 cents before falling back).

Firstly, the AUD/USD hit an all-time low at 54.85 in August of 1998. Since then we had a nice recovery to 67.45, and then a gradual falling away to its current levels of 50.00.

Now, of note, Australia is a leading world producer of Gold, and hence, the AUD value has a strong correlation with the price of Gold. Second, since more than 60% of Australia’s exports are commodities the AUD also has a strong historical correlation with the influential Commodity Research Bureau’s index. Unfortunately for the Aussie dollar, both Gold prices and Commodity prices have been under real pressure over the past two years. In fact, Gold actually hit a 20 year low in 1999 at $256.90 U.S. dollars per ounce, and the CRB index actually hit a 24 year low in February 1999 at 182.76.

Technical Analysis

Technical analysis is the study of market action (movement in price of a commodity or financial instrument), primarily through the use of charts for the purpose of forecasting future price trends. This approach to price prediction is based on the premise that price movements follow consistent historical patterns. Those who engage in technical analysis study charts or statistics that measure price movements and try to find repetitive patterns. They start with the basic bar chart that plots high, low and closing prices of foreign exchange contract over the life of the contract. Current activity is watched carefully for familiar patterns of price movement.

The uptrend, downtrend and sideways trend patterns experienced in the past are used to alert a chartist to such a movement forming in the current market. The chartist also watches daily volume numbers (the number of contracts traded each day) and open interest numbers (the number of contracts not yet offset). These numbers are used to assess the strength of a trend. Complex strategies also involve patterns such as the head and shoulders and symmetrical triangle. Sound a bit confusing? Don’t be put off. Below is a list and description of the number of technical analysis classes currently offered by Man International as well as other educators around the financial
markets.