THEFOREXEDGE

UNCOVERTHESECRETSCAMSANDTRICKSTOPROFITINTHEWORLD’S

LARGESTFINANCIALMARKET

JAMESDICKS

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The tougheconomic timeshavehurtallofus inmanydifferentways. I toohavebeenaffectedover theyears.Youknowthesaying“It’snotabouthowmanytimesyougetknockeddownbuthowmanytimesyougetbackup.”Keepthat inmind. Just because thingsget toughdoesn’tmeanyouhave togiveup.Keepworkinghard,and thingswillalwaysgetbetter.

Iwouldliketodedicatethisbooktothosewhohaveworkedhardandnevergivenup.Tothosewhoseethisastheirnextstep togettingbackupI sayworkhard. Iwouldalso like toespecially thankmy team,orshall I saymyfamily, that has stuck byme formany,many years. Thanks RJ, Rob, Robert,Michael T., Adam (RIP),Michael N.,Terrance,andRocky.Youguysarethebest!

CONTENTS

PrefaceAcknowledgmentsDisclaimerIntroduction

PART1THEFOREXMARKETANDALTERNATIVES

Chapter1TheForexMarketandFraudChapter2YouversusThemChapter3ForexOptionsChapter4ContractsforDifferenceChapter5SpreadBettingChapter6ForwardsandSwapsChapter7TradingasaBusiness

PART2REGULATIONINTHEFOREX

Chapter8CommodityFuturesModernizationActChapter9TheFarmBillChapter10Dodd-FrankWallStreetReformandConsumerProtectionActChapter11RegulatoryActionintheForex

PART3FOREXBROKERSCHEMES

Chapter12Back-OfficeSoftwareScamsChapter13SlowServersandErrorsChapter14SlippageandStopHuntingChapter15ForexBrokerMarginScamsChapter16TheDemoBaitandSwitchChapter17TheBrokerB-BookChapter18DealingDeskorNot

PART4HOWTOTRADEANDWHERETOTRADE

Chapter19TradingStrategiestoBeattheBrokerChapter20WhichBrokerstoTradeWithandWhy

PART5FOREXTRADINGSTRATEGIES

Chapter21TheSimpleS/RPriceActionStrategyChapter22TheContrarianBBStrategyChapter23HedgingStrategies

Chapter24ForexOptionsStrategies

PART6FOREXAUTOMATEDTRADING

Chapter25ForexAutomationChapter26ForexRobotReviewsChapter27Back-TestingChapter28EADemoversusLive

ConclusionGlossaryBibliographyIndex

PREFACE

It is amazing for me to actually be sitting here and writing this book. It seems like onlyyesterdayIstarteddownthisroadoftradingintheforexmarket.Ithasbeenafunandfast-paced adventure inmy quest for the ultimate in portfolio diversification. The first book Iwrotewas specifically to introduce people to theworld of trading in the over-the-counterspotforexmarket.Thebookwasonlyanintroduction;onethatwouldsharewhatIbelievedto be the next great frontier in trading. That book,ForexMade Easy, is still in print andcontinuessellingwell.Ithasserveditspurpose,andIhaveseentheforexmarketgofromavirtually unknown investment opportunity in the United States to a common and familiarmarketplace.

Istartedthehardway,bytrialanderror.Ienteredtheforexandstartedtradingusingapracticeaccountandthenopenedoneofmymanyliveaccounts.Ittookmeanumberofyearstofeelconfidenttradingintheforexmarket.Imademanymistakes,butIlearnedfromallofthem.NottosayIdidn’tmakethesamemistaketwice,becauseunfortunatelyIdid.ButIdon’tmakeahabitofdoingthesamethingoverandoveragainunlessitissuccessful.

Thisbringsmeto thepointof thisbook.Over thepast11yearsof tradingtheforex,Ihavestarted to see somepatternsdevelop,patterns thathavecausedmemuchconcernandthat forcedme tospenda tremendousamountof time investigating thevery forexbrokers Ipersonallytradedwith.Ihaveseensomesuspecttradefillsandorderrejections,raisingmysuspicionsaboutthesebrokersbeingabletodovariousdeceitfulthingsinordertohindermefrombecoming a successful trader, and I haveheard similar allegations fromothers.But Ihaveneverreallyhadanyconcreteprooftheyweredoingituntilrecently.

During my investigations, I discovered that my broker actually had someone on theinsidewatchingaccountstotrytodetecthowatraderwastrading.Ifthebrokercould,infact,determinewhattradingstyleorstrategyacustomerwasusing,thebrokerwouldstarttotradeagainstthecustomer.Ifthatdidn’twork,thebrokerwoulddeployvariousdevioustacticstobeat the customer out of his or her money. I am going to share these findings with youthroughoutthisbook.

Butnottoworry—youcanstilltradetheforexmarket;youjustneedtoarmyourselfwiththerighttools,knowledge,andtraining.Iamgoingtosharewithyousomestrategiesthatyoucan use to beat the brokers at their own game.Don’t be discouraged about the fraudulentactionsofafewbrokers.Keepinmindthattheequitiesmarkets,sadly,dohaveunscrupulouspracticesandbrokers.Butyoucanstillmakemoneyby tradingequities;againyouneed toknowandunderstandyourenvironment.

Ihavemadesomedrasticchanges inmy tradingstrategiesaswellaswhere I trade; Iwillsharethatwithyouinthepagestofollow.Ihavealreadystartedonmynextbookintheforexseriesandhaveseveralothersreadytofollow.Oneofthetopicsthatwewillexploreinthisbookwillbe forexoptions. Ibelieve thiswillbe thenextbigopportunity in the forexmarketplace and is already used widely by major corporations, hedge funds, and banks.Forexoptionswillallowtraderstousesomeofthesamestrategiesthatequitiestradersusewiththeiroptions.

Whateveryoudo,don’tput thisbookdown;makesureyouread throughitbeforeyou

placeanothertrade.

ACKNOWLEDGMENTS

ItwouldnotbefairifIdidn’tquicklysaythankstoafewpeopleforhelpingtoputthisbooktogether, forhelpingmebringmypersonal investigations in the retail forexmarketplace toview.Asalways,Iwanttosaythankstothebestpublisherandmyonlypublisher,McGraw-Hill,toJennifer,Peter,andtheirMcGraw-Hillteam.Caroline,Ihavetosaythankstoyouforyouryearsofassistanceonourforexbookprojects—again,thanksforbeingpartoftheteam.Myright-handman,Jack,thanksforalwaysreviewingmywritingforgrammarandspellingmistakes;weallappreciateit.MichaelT.,asalways,thanksforyourassistanceinhelpingtogetthisbookoutinatimelymanner;thiswasabigproject,andIcouldnothavecompleteditwithoutyourhelp.Lastandmostimportant,tomyfamily,fortheirpatienceduringthisprojectandtheirunderstandingaboutthelongnightsandweekendsIhadtoputingettingthisbooktocompletion,thankyou.Iwouldliketoaddaspecialacknowledgmenttoagoodfriend,Adam,who was in the trenches with me trading for years and who was tragically killed in amotorcycleaccidentatayoungagejustpriortothebookbeingreleased.Thanks,Adam,forallyourhelp.

DISCLAIMER

The information in this book is for educational purposes only. I am not giving advice orspecific financial recommendations. Youmust seek guidance from your personal advisorsbeforeactingonthisinformation.Tradingcanresultinlosses.Iacceptnoresponsibilityforanylossesyoumayincur.Donotinvestmorethanyoucanaffordtolose.

NFAANDCFTCREQUIREDDISCLAIMERS

Trading in the forexmarket is a challenging opportunitywhere above-average returns areavailableforeducatedandexperiencedinvestorswhoarewillingtotakeabove-averagerisk.However,beforedecidingtoparticipateinforextrading,youshouldcarefullyconsideryourinvestmentobjectives,levelofexperience,andriskappetite.Donotinvestmoneyyoucannotaffordtolose.

Forextrading,futurestrading,andoptionstradingallhavelargepotentialrewards,butalso large potential risk.Youmust be aware of the risks andbewilling to accept them inorder toinvest intheforex,futures,andoptionsmarkets.Don’t tradewithmoneyyoucan’taffordtolose.

Thisbookisneitherasolicitationnoranoffertobuyorsellforexfuturesoroptions.Norepresentation isbeingmade that anyaccountwillor is likely to achieveprofitsor lossessimilar to those discussed in this book. The past performance of any trading system ormethodologyisnotnecessarilyindicativeoffutureresults.

There is considerable exposure to risk in any forex transaction. Any transactioninvolving currencies involves risks including, but not limited to, thepotential for changingpolitical or economic conditions that may substantially affect the price or liquidity of acurrency.

Moreover, the leveragednatureof forex tradingmeans thatanymarketmovementwillhaveanequallyproportionaleffectonyourdepositedfunds.Thismayworkagainstyouaswell as for you.The possibility exists that you could sustain a total loss of initialmarginfundsandberequiredtodepositadditionalfundstomaintainyourposition.Ifyoufailtomeetanymargincallwithinthetimeprescribed,yourpositionwillbeliquidated,andyouwillberesponsibleforanyresultinglosses.Investorsmaylowertheirexposuretoriskbyemployingrisk-reducingstrategiessuchasstop-lossorlimitorders.

CFTCRULE4.41

Hypothetical or simulated performance results have certain limitations. Unlike an actualperformancerecord,simulatedresultsdonotrepresentactualtrading.Also,sincethetradeshavenotbeenexecuted,theresultsmayhaveundercompensatedorovercompen-satedfortheimpact,ifany,ofcertainmarketfactors,suchaslackofliquidity.Simulatedtradingprograms

ingeneralarealsosubjecttothefactthattheyaredesignedwiththebenefitofhindsight.Norepresentation isbeingmade that anyaccountwillor is likely to achieveprofitsor lossessimilartothoseshown.

INTRODUCTION

Ithasbeennearly10yearssince Iwrotemyfirstbookonforex. I, likemanyofyou,haveworked my way through many trials and tribulations of trading. This book is yet anotherinstallmentofwhatIhavelearned,orshallIsay,whatIhaveexposedinrecentyears.

BeforewegetintowhatIbelievewillbeoneofthemostimportantbooksyouwillhaveon your shelf concerning forex and your trading, I want to reiterate how exciting thismarketplaceis.Theforexisstillthelargestfinancialmarketintheworld,andalthoughthereis still no centralized location to trade, the forex market is becoming more accessible toindividual traders. I believe over the next three to five years you will see some excitingimprovementsthatwillultimatelybenefitthesmallretailtrader.

WhenIfirststartedtalkingabouttheforexmarketbackin2000,itwastrulythe“WildWest”ofinvesting.Therewereveryfewregulationsandcertainlylimitedoversight.Thathaschanged over the last 11 years, and just the last 2 years have brought the most changesaffectingoversight,whichaddedmanynewregulatorychanges.

As I sharewith youmy insight,what I havediscovered andwhat I have investigatedoverthelastfewyears,youwillseeanalarmingpatternthatIonlywishIknewaboutearlierandcouldhavesharedwithyoupriortothisbook.Butunfortunately,likeyou,Ilearnedmostof this throughmy own tradingwhilewatching anomalies that probablywere not quite sorandom.Iamgoingtostayawayfromfinger-pointingandoutrightnamingsomebrokerswhoIfeelareunscrupulousandwhomIhaveevenreferredpeopletointhepast,notknowingtheirtactics. I see no reason to do that at this point. I will make sure that you have all theinformationathandtobeabletochooseyourbrokerwisely.

Tokeepmyloyalfollowersuptospeedandthosewhoarenewtothemarketplaceintheknow, I will continue to keep my www.jdfn.com Web site up to date with pertinentinformationtohelpyoumakeyourdecisionsabouttrading.Keepinmindthatthesiteisfreeandthatitisdesignedfortraders,bytraders.Thesetradersareprovingatremendoussupportnetworkforyoubypostinguniqueinsightsintotheforexmarket,aswellastheiropinionsonvarious brokers and trading opportunities. I encourage you to log on andgive back.Shareyourexperiencesandyourtradinginsight.Themorethatyouparticipate,themorebeneficialtheinformationbecomes.

AsIbeganmyforextrading,likemanyofyou,Istartedwithapracticeaccount,ordemoaccount.UnfortunatelyIthought,asmanyofyoudo,thatdemoaccountswereexactlythesameastherealthing,usingthesamepriceandexecutions.Ithoughtwhatbetterwaytolearnthemarketthantoperfectyourtradingusingvirtualmoney.Whynotmakebadtradesonpurposeandlearnfromyourmistakes.Whenyouareconfidentthatyoucanconsistentlymakemoney,then,andonlythen,yougolive.SoIthought.

Well,theunfortunaterealizationisthattheliveaccountsdon’ttradelikeademoaccount.The brokers don’t care how you trade your demo account, but if you start trading a liveaccountwithrealmoneyandstartwinningonaconstantbasis,youwilldrawtheireofthebrokers,andtheywillbasicallyseekyououtanddestroyyou.That’sstronglanguage,butinmyexperienceitisthetruth.

Inowknowthat,incertaininstances,ifacustomerisconsistentlysuccessful,heorshe

can actually be blacklisted. I am serious! You can actually be put on a blacklist. In myinvestigations,Ihaveseentheactualblacklistaccountsatcertainbrokeragehouses.Shouldyougetonthatlist,youwillnolongerbesuccessfulonaconsistentbasisnomatterhowgoodyouareattrading.Youmightaswellthrowinthetowelbecauseyouaredonethere.

Inmyownexperience,Iwasrunningmyveryfirstmanagedaccountintheforexmarketusing spot forex. I had nine straight month-over-month successes with no drawdowns,meaning I never lost anymoney bymonth’s end.Of course, Iwould have some losses, orintermonthdrawdowns,butneveralosingmonthinninestraightmonths.

ThenIreceivedane-mailfromthebrokeroneday,sayingthatIwasgoingtobemovedtoanewservertobetterexecutemytrades.Thee-mailsaid,“Pleasemaketheappropriatechangessothatyourtradingplatformwillworkcorrectly.”Sureenough,comeMonday,Iwasonanewserver.Youcanonlyimaginewhathappenedfromthenon.Thisisasrealasitgets.Ineverhadanotherwinningmonthagain,andIultimatelyhadtoclosetheaccount.

You cannot imagine my frustration; I traded for nearly a year with precisionlikeaccuracy,slayingpipsonadailybasiswhilewatchingmyaccountssoartonewhighsmonthaftermonthonlytowindup,nomatterwhatIdid,inalosingtrade.Itwassofrustrating.Overthecourseoffourmonths,Iwitnessedallthegamesbrokersplay,butIdidn’texactlyknowtheyweregamesatthetime.Myintenseinvestigationhasledmetothegamesthatwerebeinginitiatedagainstme,andIwanttosharethemwithyouinthecomingchaptersofthisbook.

TheunfortunaterealityisthatIamandhavealreadybeguntobeblacklistedwithintheindustry,andfranklyIdon’tcare.Iamgoingtoexposetheforexindustryandthebrokersthatpreyonunsuspectingtraderslikeyouandme.

Keepinmindthat this isnotabookonthenegativeaspectsof trading.Thisisabookthat will expose what brokers are doing, and I will show you how you can use thatinformationagainstthem.Youcanstillmakemoneytradingthismarket,andyoucanmakelotsof money. But as so many have realized, you can lose lots of money too. As with anyinvesting,Ithinkthebiggestthingtonoteisthatallinvestingshouldbedeeplyconsideredandthatyourrisktolerancemustbetakenintoaccountbeforemakinganyinvestment.Theforexmarketplaceisnodifferent.Itisagreatwaytodiversifyyourportfolio,butyoushouldstilluseriskcapital thatyouarewillingtolose.Keepinmindthatyoucanreducesomeofthisriskbyusinglessmargin.

Whilereadingthisbook,youwillseethatIhavetakenmanystepstohelpensureIhavemorecontrolofmy trading.Youwillseeand learnhowIstayaheadof thebrokers. IwilldiscloseupfrontthatIsimplycannotopenlydiscussallthosestrategies,orIwillbegivingtheverybrokersIamtryingtoexposemoreinformationonhowtobeattoday’straders.Thisisnotabookforbrokerstouseagainstus,butfortraderstouseagainstbrokers.Intheend,Iwill do my best to make my personal trading strategies available to you either throughpersonalappearancesorthroughwww.jdfn.com.Togetherwecanbeatthesebrokersandhelpcreateafairandorderlymarketplaceandalevelplayingfield.

I have suffered from the tough economic times, as many of you have. With all theregulatory oversight and changes in the forexmarket,my business has had to readjust andchange no less than four times. This time I am fighting back. I am creating the necessaryinfrastructuretocompeteinthishighlyregulatedindustry,andIamdriventoshiftthefocusonindividual customer success. I believe that the success of your business depends on thelongevityofyourcustomer.Inthepast,Ihavereliedonotherbrokerstoensuresuccessforme,mycompanies,andmycustomers,butnotanymore.Iamgoingtoweedoutthebadones,

and I am going to personally take an active role in wheremy readers and customers aretrading.Iwanttoseemycustomersusingastraight-throughprocess,avoidingallthegamesthat the current brokers are playing. If your brokerage firm says it is amarketmaker or itcreatesamarket…run!Thebrokerisagamemaster,forsure.

IamcreatingatradingenvironmentthatisexactlywhatIwant,andIfigureifitisgoodenoughformyaccountsandme,itwillbegoodenoughforyou.HowIdothisisjustsomeofwhatIamgoingtosharewithyouinthisbook.Firstwehavetolearnwhatisgoingoninthemarketplace,howtorecognizethegames,andhowtoavoidthem.Thenwemustlearnwherewecanapplywhatwehave learned so thatwecanbe successful andbeginachievingourpersonalfinancialgoals.

Iwant to challengeyou to spend thenecessary time tounderstand the concepts Iwillexplain. I want to challenge you to forget all the garbage you are reading on the variousmessageboards.Ihavepersonallyreadinsideinformationfrombrokersdiscussinghowtheycreatefalseaccountsonthemanymessageboardsandchatrooms;thebiggestonesoutthereare disseminating false and misleading information to traders like you and me. Don’t besurprised; it happens; I have seen it firsthand. I know of brokers asking employees, usingfalsenamesandaccounts,topostinformationinchatroomsaboutotherbrokers’customerssothat unsuspectingnew traders seehowbadother brokers areor how theynickel-and-dimetheir customers. I have read inside memorandums on how the brokers are bashing otherbrokers or postingmisleading facts about themselves.This practice is rampant.Right nowyouareprobably as flabbergastedas Iwaswhen I first started learningabout thiskindofactivity.

Beforeweallstartplayingtheblamegame,keepinmindthatmytradingknowledgeofthe forexandmy forexcareerhaveevolved likemanyofyours, and Ihavealways sharedwhatIknewtobecorrectwithothers.SoifyoureadanythingthatmaycontradictsomethingIhavesaidinthepast,thensobeit.Ihavelearnedmorethroughmyin-depthinvestigationsoftheindustry,andthatiswhatIamsharingwithyounow.

Iknowthatyouaresaying toyourself, if this issobad,howcanJamesbe trading it?Well,thatiswhatyouaregoingtolearn,andthatiswhatIamgoingtoshare.Whileyouarereadingthroughthepagestocome,Ichallengeyoutogooutanddosomeresearchyourselftoseefirsthandsomeofthegamesthesebrokersareplaying.Gotothechatroomsandforumsandnoticewhichbrokers are sponsoring and advertisingon them.Read the comments andrebuttalsthatareclearlymadebyinsidersoremployees.Itisalmostcomicalwhenyouaremadeawareofthiskindofactivity.IknowthatonebrokeralmostsolelysponsorsoneofthebiggestforexforumsontheWebtoday,andthatbrokercontrolsallthecontentonthesite.Ifyou see a broker advertised on a forum or message board, run, or at the very least besuspicious.

That leadsme tomyownbooks. Ifyouevercomeacross reviews thatmaynotbesopositive,keep inmind that Iknowfora factothercompetitorshavesought todiscreditmybooks.Why?Simple.Ihavealwayssharedstrategiestohelpotherstradethemarketsmoresuccessfully.Ihavelotsofreadersandprospectivetradingcustomerswantingtoknowwheretheyshouldtrade,andifIdidnotrecommendaparticularbroker,thenyoucanonlyimaginewhatthebrokersthoughtofmeandwhatIwassaying.Thisbookwillbenodifferent;infact,ifanything,itwillbefarworseforthebrokersandcompetitors.Atthetimeofthiswriting,someprettystrongallegationsareflyingaroundfederalcourtaboutcertainbrokers.Iknowtheseactionswillcomeandgo,butIamsurethatyouandIwillbenefit, since thebrokers

willhavenochoicebuttocleanuptheiracts.I alsoknow thatmanyof thebrokersout there,primarilybecauseofnew regulations,

have started changing their practices, but not all. Someof the so-called bucket shopswillprobablyneverchange.Ibelievethatregardlessofwhetherthebrokershavechangedornot,theyshouldnotbeletoffthehooksoeasily.Ifyouusedtostealcarsbutnolongerdo,thatdoesn’t make you innocent. Unfortunately, I have to say that I no longer recommend thebrokersIusedtorecommend.ButIhaven’tstoppedtrading;IjusttooktheinformationthatIamsharingwithyouandarmedmyself;Imovedontogreenerpastures.

IhopeyoucantakewhatIhavebroughttothesepagesandmodifyyourexistingtradingplan. Ifyouarenew to themarketplace, this information shouldhelpyoudesignyourownsuccessfultradingplan.

I look forward to readingyourmanysuccessful stories in theyears tocome;youwillalwaysbeabletopostthoseatwww.jdfn.com.

AsIalwayssay,HappyInvesting!

PART1THEFOREXMARKETANDALTERNATIVES

CHAPTER1THEFOREXMARKETANDFRAUD

HOWTHEFOREXSTARTED

In theory, foreign exchange (forex) trading dates back to ancient times when traders firstbegan exchanging coins from different countries and groups. In 1944, the postwar forexsystemwasestablishedasaresultofamultinationconferenceheldatBrettonWoods,NewHampshire,andremainedintactuntiltheearly1970s.

Atthisconference,representativesfrom45nationsmettodiscusstheforexsystem.TheconferenceresultedintheformationoftheInternationalMonetaryFund.Italsoproducedanagreementthatfixedcurrenciesinanexchangeratesystemthattolerated1percentcurrencyfluctuations to gold values, or to the dollar, that was previously established as the goldstandard.Thesystemofconnectingthecurrency’svaluetogoldortheU.S.dollarwascalledpegging.

In1971,theBrettonWoodsAccordwasfirsttestedbecauseofdramatic,uncontrollablecurrencyratefluctuations.Thisstartedachainreaction,andby1973,thegoldstandardwasabandoned by President Richard M. Nixon. The fixed-rate system collapsed under heavymarketpressures, andcurrencieswere finally allowed to float freely.Thereafter, the forexquicklyestablisheditselfasthefinancialmarket—theworld’slargestfinancialmarket.

WHERETHEFOREXMARKETIS

Forextradingisnotboundtoanyonetradingfloorandisnotamarketinthetraditionalsensebecausethereisnocentralexchange.Insteadtheentiremarketisrunelectronicallyamonganetworkofbanks,continuouslyovera24-hourperiod.Thismarketisconsideredanover-the-countermarket,providingoff-exchangespotforeigncurrencytransactions.

Banks have a natural flow of forex business from their customers, who buy and sellcurrencyaccordingtoindividualneeds.Thebanksmustmanagetheircurrencydepositsinthechanginglightoftheircustomers’transactions.

Investmentmanagersdealgloballyandmusttakepositionsinthecurrencies,aswellasinmoretraditionalinstrumentssuchasbondsandequities.Forexample,ifafundisinvestedinU.S.bonds, themanagermustdecide if the fundshouldbe invested inU.S.dollarsoradifferentcurrency.Again,itisaquestionofhedging,anotherlayerofrisktomanage.

WHERETHEFOREXMARKETISGOING

According to the Bank for International Settlements, as of April 2010, the average dailyturnoveringlobalforexmarketsisestimatedat$3.98trillion,agrowthofapproximately20percentoverthe$3.21trilliondailyvolumeasofApril2007.Somefirmsspecializingontheforexmarkethaveputtheaveragedailyturnoverinexcessof$4trillion.The$3.98trillionbreakdownisasfollows:

•$1.490trillioninspottransactions•$475billioninoutrightforwards•$1.765trillioninforexswaps•$43billioncurrencyswaps•$207billioninoptionsandotherproducts

Inadditiontotheabove-listedgrowth,retailtransactionsontheforexwillcontinuetogrow.The United States will remain comparatively small in the overall growth of forextransactions,withoverseas,China,andsurroundingareasbeingthedrivingforcebehindthehugegrowth.

Withallthenewregulatoryoversightoftheforexindustry,Ihavenoticedthattheforexbrokers are starting to lookatdifferentbusinessmodels.Theywill continue tooffer retailoff-exchange forex, but the forex brokers in theUnited States are going to be looking intoofferingswaps,forwards,andotherregulatedinvestmentvehicles.

ThewordIamhearingonthestreetisthatiftheforexbrokersaregoingtobesohighlyregulatedintheUnitedStates,thentheymightaswellgetinalltheway.WhatImeanbythisisthattheforexbrokersaregoingtobeofferingcommoditiesandequitiesinthenearfuture.

Inadditiontocommoditiesandequities,youaregoingtoseeforexoptionsbecomemuchmoremainstreamfor theaverage retail forexcustomer. I alreadyknowof twobrokers thathavenot traditionallycarriedaforexoptionsproductbutwillbeofferingsuchproductsbythetimethisbookhasbeenprinted.

While thebigequitiesbrokersareout therestruggling togetnewcustomers, theforexbrokers are not having that problem since, by continuing to add new trading services thatincludeequitiesandcommodities, theyare theonesgettingall the leads.Asa resultof thechangesinforexservices,thebigequitiesbrokerswillstartlookingatthebigforexbrokersastargetsforacquisitions,thusincreasingthecustomeracquisitionsofthebigequitybrokers.Solookforindustrywideconsolidationcomingsoon.

WHOARETHEVICTIMS?

Thesedays,andparticularlyintheUnitedStates,thereisahugeinvestment-orientedculture.The list of financial investing instruments freely available to the retail individuals isexpandingdaybyday.Wecanchooseamongforexcurrencytrading,options,futures,stocks,bonds, real estate, franchises, and other business ventures that contribute to reinforce theeconomyofthecountrywhilesecuringgoodprofitsandmakingthemarketsmove.

Thisvarietyandfreedomhasallowedsomeunscrupulousindividualsandcompaniesto

simulate legal investment schemes and abuse the investors through the promotion ofunrealisticreturnsandwell-elaboratedbutdeceitfulprograms,onlyseekingtomakemoneyforthemselves.

Anyonecanbethepreyof thesefraudsters,andespeciallythoseofyouwhothinkyouwillneverfallforsuchascheme.Financialswindlersarequitecleverandknowverywellhowtomanipulateandtargetallkindsofpotentialinvestors,fromthewealthiestonesdownto precisely those who might be struggling with financial difficulties or have little or nocapital.

The less wealthy will be more sensitive to the offers that promise large returnsovernight.Oneofthemostemployedsalespitchesisthatonlythe“guru”isabletoshowyouhowtobecomerichandteachyouthepreciseand“proven”investmentstrategiesthatallthewealthypeopleorthe“bigboysin-the-know”usuallyemploy.

Don’t getmewrong; I personally followmany so-called gurus, though I always takeeverythingtheysaywithagrainofsalt;butyoucannotgoaroundwithblindersonandbesonegative that you can’t see the forest for the trees. I havegotten little goldennuggets frommanypeopleout therewhomaynotbethebest tradersorhavethebest intentions,but theycertainlygavemesomegreatideasthatIwasabletoresearchanddevelopintosomereallygoodtradingstrategies.

Thevictimsofinvestmentscamscomefromverydiversebackgrounds.Amongthem,wecanfindsuccessfulprofessionalsandpoliticalfigures,aswellasthousandsofhardworkingpeople. However, all of them share two important characteristics: unlimited greed and adesperateneedtobelievewhateverfeedsorpromisestofeedthatgreed.

INVESTMENTFRAUDSTERS:WHOARETHEY?

Manyof these swindlers and scammers arevery successful, and the total amountof stolenfundshasbeenestimatedatbillionsofdollarsayear.Theywillconvinceyouoftheirlegalityanduseeveryingenioustricktheycanthinkoftoassureyouthattheyaretherealthingsothatthey can gain your trust and cooperation.Theywill offer you such an exclusive and time-limitedopportunitytomakelotsofmoneyeasilyandquickly,movingyouaroundandpushingyour“greedandneed”buttonssocleverlythatyouwillbelievewhattheysayifyouarenotpreparedanddonotknowabouttheirusualmodusoperandi.

Ifyoufindyourselfonthespotinapressuresituation,thebestadviceistotakeastepbackandgooutanddosomehomework.Youcanrestassuredthatinmostcases,oratleastinthelegitimatecases,youwillbeabletostilltakeadvantageofanyspecialdeals,andtherewillbesometoholdontoandsometostayawayfrom.

Thereasonit issodifficult toidentifyfinancialscammersis that theydonotexhibitadefiniteprofile.Therefore,youwillneedtogetridofanystereotypeyoumighthaveaboutthelooks or attitudes of a potential fraudster as a first step in protecting yourself. It could beanyonearoundyou,previouslyknownorunknown.Theonlycommontraitamongallofthemisthattheypossessatremendousandcompellingpowertoconvinceotherpeopletobelieveinthem.

Someofthesefraudstersmaynothavealwaysbeenso.Thereareinstanceswherehighlytrustedandesteemed individuals in theaccountingor legalbusiness, financialbrokers,and

evenmedicaldoctorshavesuccumbedtotemptationandrenouncedtheirethicstomakequickmoney through an investment scam, and, of course, tobenefit from their formerly acceptedandtransparentsocialposition.

In other instances, some of the legitimate investment programs failed because of badmanagementorunpredictableevents,andthedirectorsendedupmishandlingorlosingtheirinvestors’funds.Whetherplannedornot,theresultsofaninvestmentscamarethesame;you,astheclient,willloseyourhard-earnedmoney.

HOWTHEFRAUDSWORK

Fraudsterswill try to imitate themarketing pitch of perfectly legal investment companies.Therefore, the method they might use to contact their potential victims is not always anindicationofascam.Gettingintouchwithcustomersdirectlybyphoneandmailinglistsorindirectly through advertising and the Internet are some of themethods employed bymanylegitimatebusinessestoidentifyandselectpeoplewhomaybepotentialinvestorsandmightbeinterestedintheirfinancialproductsandservices.Investigatecarefullyandindependentlytheir approach and understand how these swindlersmight benefit from either of the abovemarketingschemes.

DirectPersonalContactthroughTelephoneandMailingLists

Swindlers will usually contact hundreds of potential investors, either by telephone or bymail,aftergettingspecificallytargetedmailinglistsfromothersources,suchassubscriptionsto investment-related publications and financial forums. The swindlerswill say enough tocatchyourinterestsoyouwillwriteorcallformoreinformation,butlittleenoughsotheycanremainundertheradaroftheauthorities.

IndirectContactthroughAdvertisingandtheInternet

Regulatory agencies usually monitor all advertising in major publications. However, thisdoesnotstopswindlersfromusingthistypeofmediatosetuptheirbait-and-switchsystem,offeringamazinglyattractiveprofitsaimingtocatchinvestorsunawareinashort-termmove.Someotherswillchoosesmallerpublicationswhere there is lessriskofbeingcaughtbyaregulator.

Oneaspectofthisis theforexbrokerdemobaitandswitch,whichIdescribeinmoredetailinChapter16.

As a result of its increased expansion and potential, the Internet has attracted thosefraudsterstoo,andtheyuseittoimplementthesameoldscams,formerlyconductedthroughnormalmailorphone,butnowthroughe-mail,subscriptionslists,andflashyWebsitesthatareadvertisedinstrategicplacessuchassocialmedia,forums,andinvestment-relatedsites.

UsingYourOwnProfessional,Social,orEvenFamiliarCircles

Oneoftheeasiestandmosteffectivelyusedmethodsisthereferralscheme,wherethefirst

investorsreceivelargeprofitsontimeandsowillbeeagertorecommendtheforexprogramtotheirfamilymembers,friends,andcolleagues.Mostoftenthoseprofitsarepaidfromtheinvestors’ own funds (as there is no forex trading backing up the investment) or from theinvestmentsofothervictims.

Thepowerofreferralfromoneinvestortoanotherissostrongthatthefraudsterswillnotneedtofindanynewvictims.Theinvestorswillcometothem,andwhatisevenbetter,theywill already be convinced of the authenticity, profitability, and trustworthiness of thefakeforexinvestmentprogram.Thismethodisreallymorerelatedtopyramidschemes.Mostof us are familiarwith the biggest of them all, the one that originated inNewYork in the1990s (orpossiblyearlier).Ultimately, themanbehind thatoneendedup inprison for therest of his life. BernieMadoff prided himself on his social ties and built his business onreferrals.Intheend,thebusinesscamecrashingdown,andeveryonelostmoney.

Iamnotsayingdon’tinvest;youreallydon’thaveachoice.Well,Iguessyouhavetwochoices:sitonthesidelinesandletinflationwipeoutanyrealvalueofyoursavings;orgetoff thesidelines,usegoodmoneymanagementanddiversification,andtaketheappropriaterisktoreward.Youwilllosemoney,andyouwillmakemoney,butobviouslyyourgoalistomakemorethanyoulose.Todothat,youwillhavetotakesomecalculatedrisks.Mostofthetime,referralsareagoodwaytofindinvestmentopportunitiessolongasyoudosomeduediligence.

The“Facade”:LookingGoodEnoughtoBuildaReputation

Somefraudsterswilltrytolookreallyprofessionalandreputablebyrentingluxuriousofficesinthehigh-classfinancialareasofthecity.Somewillgosofarastohaveenoughpersonneltogivetheimpressionofbeinganimportantandbusycompany.Theywillevenrequireyoutoaskforanappointmentandkeepyouwaitingforawhile,buildingupyour interestwithanapparentnonchalanceingettingyouraccountundertheirbelt.

Thosescammersmightalsoparticipateinseveralpublicassociationsandgivetheimageoftheperfectcitizen;meanwhiletheonlypurposeforallthesceneryistogetasolidgrasponyouraccount.

ButtonsTheyPushandWeaknessesTheyExploit

Asstatedearlier,greedisthemainelementthatwillattractplentyofpotentialvictimstothefraudster’sevilplan.Fraudsterscanpromiseyouanythingasbigasitcanbe,butintheendthey do not have the intention to fulfill those promises.All theywant is your hard-earnedmoney,andtheywantitassoonaspossible.Hereisalistofthekeyelementsthataresignsofapotentialinvestmentscam:

•Creating expectations for huge profits. This really is not so difficult. Remember, pastperformance is not an indication of future performance. Contemplate your potentialinvestmentwiththedollarsthatyouarewillingtoloseandthatyoucanaffordtolose.Youneverknowwhatwillhappeninthemarkets,especiallytheforexmarket.Theforexmarketcanbedrasticallyaffectedbyanymajornewseventfromaroundtheglobe.Some money management firms will offer profits big enough so they can catch your

interest, but not so excessive that you might become suspicious. These unscrupulouspeople may suggest that the investment has a greater potential and will gauge yourreactionstofollowonwiththescammingscheme.Bearinmindthatifthereturnsonagiven investment seem too good to be true, you might be the prey of one of theseswindlers.

•Omitting thementionof therisks involved.The last thinga scammerwantsyou to thinkabout is thatyoumighteventually loseyourmoney.Theemphasiswillalwaysbeseton“lowrisk”and“guaranteed”returnssothatyoumightbelievethereisnoriskatall.Ifyouinsistandaskabout thepotential risks, fraudsterscouldeventuallyadmit therearesomebutassureyouthattheyareverysmallandthattheprofitswillbemuchhigher.Ingeneral,fraudsterswill trytochangethesubjectquicklyorevenshowimpatienceandtrytoturnyoudownsoyouwon’tinsistontheissue.

•Creatingasenseofurgencyandexclusivity.Limitedoffers, limited time—fraudstersarealways in a rush and will urge you to invest “right now” because you might miss theopportunity.Youmaybetoldaboutaveryspecialoffer,onlyfortheselectfew.Therealreasonbehindthisisthatthefraudstersdonotwantyoutothinkabouttheiroffersindepth,asyoumightbecomesuspiciousanddecidetocheckfurtherorturntheofferdown.Theyarealsoinarushbecausetheymightalreadybeplanningtoleavetheplaceverysoon.

•Buildingtrust.Scammerswillcentertheireffortsonconveyingtotalconfidenceaboutthereturns of the investment they want you to get in, the solidity of the proposal, and thealmostno-risksituationsothatyoutrust themenoughto lendthemyourfundseasilyandquickly.Themessage they intend topass is that theopportunity they areofferingyou ispracticallyafavor; theymightevensuggestthat ifyouarenotinterested, theywillbringtheoffertosomeoneelse,tryingtoappeardetachedfromthefactthatitisyourmoneytheywanttopocket.Ofcourse,thisattitudeisaimedatgettingthepotentialinvestortoreactbyexpressinghisorherinterest,andvoilá—themystificationisalmostdone!Swindlersarerealmastersatmanipulatingandcontrollingtheconversation,andsothereislittlechancefortheinvestortoaskthemembarrassingquestions.Anothertypicalexampleishowtheycanbuildconfidencebywordofmouthof initialinvestorswhoarepaidlargeprofitsandbecomeinadvertently“recruited”tospreadtheword to their friends or relatives. This is mostly seen in the high-yield investmentprogram–typeschemes.Afteraperiodduringwhichconsistentprofitsarepaidoutontime (from thenewdepositsof themost recentvictims),older investorsbecomeboldandstartinvestinglargersumsofmoney,andnewinvestorsareattractedtotheschemebecause of the excellent reputation the swindler has built by recycling new paymentsinto fake profits. In the end, after pocketing enough of themonies, the swindler willleavethescene.Another scheme swindlers can employ to gain trust in their supposed forex tradingabilitiesisthe“slowapproach,”wheretheyofferforecastsfreeofchargeandneveraskforthepotentialinvestor’smoneyupfront.Halftheinvestorsaregivenoneforecast,andthe rest are given the opposite forecast.After several cycles, the remaining fewwhohavehadallthe“good”forecastswantdesperatelytoinvestwiththeswindler,becausethey believe undoubtedly in the swindler’s accuracy at predictingmarket prices. Theswindlermightevenprotestalittleandplayhardtogetinordertoincreasetheanxietyofpotentialinvestors.Remember, there isnodefiniteprofile for an investment scammer. It couldbe anyone

from the anonymous caller on the phone to awell-dressed executive in an expensiveofficetoasupposedlyinformativeandeducationalforexWebsitetofriendsoffriends,withorwithoutaseriesofimpressivetitlesandawards.

FirstandExternalSignsofPotentialInternet-BasedScams

You have to take a close look at the overall Web site content. Are there strange andnonprofessional names; noncredible claims and excessive guarantees; serial, cut-and-pasteFAQsandtemplateswiththesameexactcontentfordifferentforexinvestmentWebsites;lackofcorporateidentityinlogosandimages?Theseareallsignsofpotentialscams.

Themostblatantsignistheinvestmentplanitselfandthelackofdetailabouthowtheexceptionally high returns are really obtained. Never invest if the company or itsrepresentativesareunabletoprovidecompletedisclosureabouttheirfinancialactivitiesandoverallbusinessmanagement.

PreventiveActions

1.HowtoFindOut

Asafundamentalrule,youshouldneverparticipateinanyinvestmentactivitythatyoudonotfullyunderstand,andyoushouldneverbelieveanyperformanceclaimsthatyouwouldnotbeable to replicate by using the samemethods. Fraudsterswho try to promote alleged forexinvestmentswillusuallymakeclaimsofpossessingspecialandsecrettechniquesthatallowthem toobtainextremelyhighprofitswithconsistency,but seldomwill theygo intodetail,becausemost of the time those are fake claims—the only secret activity those fraudstersengageinistowipeyouraccountclean.

If“profits”arethere,theywillmostoftenbearecyclingofyourowndepositedfunds.Do not risk your savings on what is being advertised, especially if the returns that are“guaranteed”seemtoogoodtobetrue,unlessyouknowexactlywhatyouaredoingandthereistransparencyinregardtothemethodsthatareemployed.Here is a list of somequestions you can ask thatwill undoubtedlymake fraudsters feel

uncomfortableandprobablyalsowillleadthemtobackoffandturntoaless-informednewprey.

•Personaldata.Ifyouhavebeencontactedbyatotalstrangerthroughaphonecallore-mail,asktheoriginatorwhereheorsheobtainedyourpersonaldata.

•Risks.Askthepromoterabouttherisksoftheinvestmentbeingproposed.Eachandeveryinvestmentinvolvessomerisks—especiallythosethattheoreticallyofferexcessivelyhighreturns.

•Documentation.Fraudsterswillbequitereluctanttogiveyouaccesstowrittendocumentsandriskdisclosures,asthosecouldbeusedagainstthemincaseofafraudtrial.Askforadditional information and a detailed explanation of thewhole investment that is beingproposed, as well as a complete risk disclosure statement. This will usuallymake thescammersrunaway.

•Management and performance. Ask for the names of the company’s management staff.

Some people who operate dishonest forex investment businesses might give you falsenames,butthefactthatyouarecheckingintodetailscanalarmthem.Investigatethepastofthecompanyitself:Askhowmanyyearsithasbeeninbusiness.Asktosee its trackrecordandtradingperformance,whichshouldbeproportionate tothattime.Somestart-upbusinessescanbetotallyreputable;however,itisimportanttodigalittleintothepastactivitiesofthepeopleyouaretalkingto.Ofcourse,ascammerwon’tbeatalleagertotalkaboutthis.Asking for written performance reports is a must, and it’s even better to have themcertifiedbyanaccountantorequivalent.Itistruethatthepastperformanceisinnowaya guarantee that the future performance will be similar; however, a well-establishedcompanywithseveralyearsofactivityshouldbeable toproduce thosereportseasilyandinaverifiableform.Ask for a personalmeeting and visit the firm’s office. If it is a scam, the fraudsterssurelydon’twantyoutoseewheretheyoperatefromorriskbeingrecognized.

•Thirdparties. Is thecompanycapableofprovidingverifiableand trustworthy referencesthat you can contact? Would the representatives agree to further explain the forexinvestmentproposalandsubmititforanalysistomorepreparedthirdparties,suchasyouraccountant, banker, attorney, or investment advisor? Hesitation and excuses on this areclearindicationsthatyoushouldabsolutelynotinvestwithsuchanindividualorcompany.

•Regulationsand legalconditions. Inquire aboutwhich regulatory agencies supervise theinvestments you are being offered and ask if they are traded on a regulated exchange.Regulationsimplyastructureofprotectionandstrictruleenforcementthroughsanctionstothose individuals or companies that do not observe them. A fraudulent investment willneverbeunderregulation.Tellthepersonwhoisproposingthedealtoyouthatyouwanttocheckthecompany’sstatusbeforedeciding.If it is a scam, prepare to hear some evasive responses. Finally, ask about the legalframethatthecompanyusestosolveanydisputeorcontroversythatmightarise.Ifthereisanysignofdiscomfortorimpatiencefromthevendoratthispoint,donotgofurther.There are some Web sites where people can post and vent their frustrations andexperiences.Mostof these siteshavehidden agendas. If youdig around the sites thatseem to only have negative information, it is more than likely you will find that thenegativecommentsaretheworkofacompetingcompany.Itisokaytoreadthepostings—justtakewhatyoureadwithagrainofsalt.

•Accounting.Askhowyourmoneywillbemanagedandinwhattypeofaccount,aswellaswhichkindofaccountingstatementsyoucanexpecttoreceiveandhowoften;alsoaskifthereisaregularauditingofthecompany’srecords.Youalsoneedtoknowthedetailedcostsofthefund’smanagement—forexample,whataretheperformancefees,commissions,andoverallmanagementfees—andyouwanttoobtainallthisinformationinwrittenform.Finally, and most important, ask how you will be able to liquidate the contract andrecoveryourmoneyifyoudecidetoterminatetheinvestmentagreement,includinganytypeofspecificcostsanddelays.

Youshouldobtainstraight,detailed,andtransparentanswerstothesequestions.2.HowtoProtectYourself

Investigatebeforeyouinvest.Thepreviouslistofquestionswillnotguaranteeyouhonestandstraightforward feedback from the individual who is promoting the investment scheme;however, thequestionswillhelpyouinthedetectionofdubioussituations.Thelast thingaconartistwantsistobecheckedupon,andfraudstersarehighlyexperiencedinevadinganyquestionsthatcouldexposetheirtruecolors.Bearinmindthattheywilltrytoemphasizethe“huge profits to bemade” andminimize or simply ignore some of your queries,which ispreciselywhatwillexposetheiragenda.Mostfraudsterswilltrytooperateundertheradarby:

• Choosing either types of investments or locations that have little or no regulatoryrequirements

•Adoptingdifferentnames•Changingtheirpromotiontechniques• Insisting on the exclusive urgency of the investment, thus not allowing you the time to

investigate•And,ingeneral,targetingill-informedpotentialvictimsthathavenoideahowtoverifytheir

claimsorcheckthecompany’sactivities

This is why there are so many forex scams. Until recently, the forex market had beenunregulated.Manyofthecommoditiesprofessionalswhowerenotsoprofessionalandwhohad disciplinary actions against themmoved to the forexmarketplace. This allowed thesepeopletocontinuetradingwithoutviolatingthedisciplinaryordershandeddownbytheU.S.CommodityFuturesTradingCommission (CFTC).The goodnews is thatwith all the newregulatoryreform,theforexmarketiswellonitswaytobecomingagreatmarket.

Onethingiscertain:therearenoguaranteesthatanyinvestment,evenalegitimateone,willmakemoney,butyoucanbeabsolutelysurethatyourmoneyisalreadylostthemomentyoulendittoafraudster.Youcangoalongwaytoprotectingyourselfbydoingresearch:

•Contactlocalinstitutionsandthemedia.Lookforcomplaintsfiledagainsttheindividualor the company at the local police department, Better Business Bureau, consumerprotectionorganizations,andlocalnewspapers;alsolookontheInternet.YoumightstartbycontactingtheNationalFraudInformationCenter(NFIC)atwww.fraud.orgorcalltheNFIC hotline at 1–800–876–7060; this is a public service of the National ConsumersLeague,andthestaffcandirectyoutootheragenciesforinformation.

•Contacttheregulatoryoffices.Individualsandcompaniesthatofferinvestmentsandotherfinancial instruments are, at least in theUnited States, subject to one ormore types ofregulations.Itmightbemoredifficulttoresearchoperationsinothercountries,buthereisa short list of institutions that can be of help in verifying what the specific legalrequirementsareforaparticular investmentand inchecking thebackgroundof thefirmsthataresolicitingyourfundsorwithwhichyouintendtoinvest:

UnitedStates:CFTC,www.cftc.govNationalFuturesAssociation(NFA),www.nfa.futures.org/basicnetUnitedKingdom:FinancialServicesAuthority,www.fsa.gov.uk Cyprus: Cyprus Securities and Exchange Commission,

www.cysec.gov.cy/licence_members_1_en.aspxIreland:MiFID,www.mifid.ie/index.htmlGermany:BaFin,www.bafin.de

Futures contracts and options on futures are regulated by the CFTC, which is a federalagency,aswellastheNFA,whichisaself-regulatoryorganizationauthorizedbyCongress.TheNFAmaintainsadatabaseoffutures-relateddisciplinaryinformationthat investorscanaccessbycalling theDisciplinary InformationAccessLineat800–621–3570or800–676–4NFA.

Conductingathoroughinvestigationbeforeriskingyourhard-earnedmoneyinadubiousinvestmentproposalwilltaketimeandeffortonyourpart.Thisisamustandistotallyworththe time and trouble.When you contact the regulators, youwill be able to find out if theindividualorbusinessisdulyregisteredandhastheappropriaterightstoworkintheforexinvestment business.Additionally, youwill find out if the business has been the object ofpublicclaimsordisciplinaryactionsinthepast.OtherinstitutionsthatyoucancontactintheUnitedStatesincludethese:

•Theofficeofthelocalpublicprosecutor•Thestateattorneygeneral•Thestatesecuritiesadministrator•Federalpostalinspectorsifthepromotionoftheschemeisbeingsentthroughthemail•TheFederalBureauofInvestigation3.KeepCloseTrackofYourMoney

Afterhavingcompletedalltheabovesteps,eveniftheforexinvestmentyouarebeingofferedseemscompletelylegitimateandyoudecidetoinvest,youstillneedtocontinuemonitoringandbealertforanysignsofthingsthatmightgowrong:asuddenlackofcommunicationwiththe individual or company that sold you the investment, failure to receive accountingstatements or important documents that were promised, lack of further information ordiscrepancies between what was stated in the beginning and actual data, and, especially,failureofscheduledpayments.

If at a certain point you become suspicious and cannot obtain the proper answers orresolve the previously described situations, you should immediately try to get out of thatinvestmentandask fora liquidationofyourmonies—and ifneeded, threaten tocontact theauthorities. If there is fraud going on, the companymight prefer to send yourmoney backratherthanriskingitsschemebeingdiscovered.

Bepreparedtohearnewexcuses,explanations,andreasonswhyyoushouldkeepyourinvestmentwiththecompany.Insistonarefundnomatterwhatthepeopletheretellyouanddonotacceptanyexcusesorfurtherattemptstoconvinceyoutothecontrary.

Ifyougetyourfundsback,consideryourselflucky.Mostofthetimeyouwillnot,andinthatcaseyoushouldimmediatelyreportthesituationtotheauthorities.Infact,evenifyougetyour investment back, you should contact the authorities if you still suspect fraud wasinvolved.

CHAPTER2YOUVERSUSTHEM

Tobesuccessfultradinginthespotforexmarketplace,youwillneedtoarmyourselfwithalltheknowledgeandtoolsyoucanfind.Thebrokersareouttogetyou,atleastmostofthem.With ever-changing regulatory oversight, the industry is on its way to being the greatestfinancial marketplace in the world. It will take regulatory oversight to get rid of the badpracticesthatsomeofthebrokersouttherearestillusingtoseparateyoufromyourmoney.

To beat the brokers at their own game youwill need to know a few things.Wewillcovermanyofthosethroughoutthisbook,andinmostcasesyouwillultimatelyfeelthatitisyouversus them.That’sokay soas longasyouknowwhat to look for andhow toprotectyourselfwhiletradingthisexcitingmarketplace.

HOWFOREXBROKERSMAKEMONEY

Aforexbrokeragefirmisabusinessjustlikeanyother,andassuch,itmustgenerateaprofitin order to ensure the firm’s permanence and functionalities.Brokers provide a service tobothindividualandcorporatetraders,actingasintermediariesbetweentheinterbankanditsclients.Amongthebrokers,wecanfinddifferentlevelsofethicsandtrustworthiness,rangingfrom the mere “bucket shops” with little or no care at all for the client’s needs and themindsetofacasinoownertobiggercompanieswherealltheethicalcriteriaaremetandtotaltransparencyandefficientcustomerservicearetheirguidelines.

Brokers are an integral part of themarket’s hierarchical structure,which beginswithfirst-tier financial institutionsandgoesondown;dependingon theircompanysize,capital,structure,andvolumeofoperations,brokerscanbeplacedinthesecondorthirdtier.

OVERVIEWOFTHEMARKETSTRUCTURE

TopTier=CentralBanks,LargestInvestmentBanks

At this level, all transactions are totally transparent, and every participant can see all theratesofferedfromoneanotherthroughtheElectronicBrokingServicesSpotDealingSystem,whichaccountsforthecurrencypairsinvolvingtheeuro,U.S.dollar,yen,andSwissfranc.AllothercurrencypairsarehandledthroughReutersDealing3000SpotMatching.

Thistieriscomposedbythelargestcentralbanksoftheworld,whicharefreetotradeallcurrenciesatanyratestheydecidetoagreeupon.

SecondTier=SmallerBanks,MultinationalBankBranches

and Financial Institutions, Large Funds, and WealthyPrivateInvestors

Largemultinationalcorporationsandbanks, including their subordinatebranches, representthesecondtierof theforexmarket.Thecommercial requirementsofcurrencyexchangeareoffered rates that usually differ from the interbank exchange rates, and quotes can also besignificantlydifferentfrombanktobank.Hugecapitalfundsandwealthyprivateindividualscanhaveaccesstoavariablearrayofliquidityprovidersfortheirtransactions,andthereforetheycanbeconsideredasbelongingtothislevel.

A fewretailbrokers, especiallyelectroniccommunicationnetworks (ECNs),canalsobeclassifiedassecond-tierinstitutions.

ThirdTier=MarketMakersandSmallerInvestors

Thegreatmajorityofretailforexbrokersfallinthiscategory,andmostofthemonlyinteractwith a single liquidity provider from the second tier. Only ECNs and a few high-levelbrokerages,althoughalsobeingclassifiedas“retail,”canofferdirectaccesstoavarietyofliquidityprovidersandthushavetobeplacedunder thesecond-tier label,as theysendthetradingordersfromtheclientsdirectlytotheinterbank.

TYPESOFRETAILFOREXSERVICEPROVIDERS

Therearebasicallytwotypesofbrokersthatprovideaccesstotheretailforexmarket:ECNsandmarketmakers(seeTable2.1).Theirpresenceallowssmallinvestors(whowouldn’tbeabletoparticipatedirectlyatthetop-tierlevels)tospeculateandtradecurrenciesalongsidebig financial institutionsandprivatewealthy individuals,without theneed todeposit largesumsofmoneytobeabletoenterthemarkets.

Table2.1SomedifferencesbetweenECNsandmarketmakers

ECNs usually require larger deposits but provide amore direct relationshipwith theinterbank.Many of them can be considered to be at the second-tier level.Marketmakersseldomallowtheirclientstointeractdirectlyatthoselevelsandbelongtothethirdtier.

Finally,allthemuchsmallertraderswithsmalleramountstoinvestmakeupthelowesttier.

Marketmakersemployvariouswaystoroutetheirclients’orders:someareoffsetinasortofinsidemarketbetweendifferentclients’oppositetrades;inothersthemarketmakerstake the other side of the trade; one more way is to hedge the position through liquidityprovidersorhigher-tierinstitutions.Themostcommontoolsthattheforexbrokersemploytomakemoneyfortheirbusinessare

listedbelowandthencommentedonindetail.

•Spreadsanddifferencesamongliquidityproviders•Theuseofleverage•Commissionsandrolloverorswapfees•Hedging•Interestcollection•In-housetrading•Recruitmentofintroducingbrokers(IBs)andaffiliatesThelistcontainsmostlyethicaloptionsthatbrokersemploytoreceiveapaymentfortheir

services. There are also less ethical and blatantly unethical procedures, such as thefollowing:

•Countertrading,ortradingagainstthetraders•Controllingthetradingplatformthroughplug-ins•Manipulatingpricesdirectly•Penalizingprofitability

HOWETHICALDEALERSEARNTHEIRMONEY

SpreadsandDifferencesinLiquidityProviders

Theprimarysourceofincomeisthespread,orpricedifferencebetweenthebidandaskratesoffered by the broker. These differ from rates the broker receives through the liquidityproviders,whichcanofferthebrokeraverysmallspreadorevennospread,thusearningthedifference in the broker’s favor. Also, in the case of in-house trades, the rate differentialremainsinitstotalityinthehandsofthebroker,astherearenoexternalinterventions.

Theaskpriceisthepricethatthetraderpayswhenopeningalongposition(buyingthecurrencypair),andthebidpriceistheamountatwhichthetraderwillbeabletosellbackthatsamepositiontothemarket.Inversely,short-sellingacurrencypairisdoneatbidpricesandclosedataskprices.Thisdifferenceisexpressedinpips,whichisthestandard,smallestunitofmeasureandisusuallybetween2and5pipsformostbrokers.Thisiswhatthebrokerearnsonallyourtransactions,nomatterifthefinaloutcomeispositiveornegativeforyouraccount.

The rates that thebroker receives from the liquidityprovidersarealsooftendifferentfromtheratesofferedonthetradingplatform,withasmallergapbetweenbidandask;orifthebrokerhasaccesstoadiversityofchoices,asisthecaseforECNs,thebrokercanpickthe best rate on both sides of the transaction, giving an additional boost to the broker’sbenefit.Although1pipcanseematinysum(0.0001ofthevalueofthecurrencypairor0.01onyen-basedpairs),tradesarecountedbystandardlotsofUS$100,000(where1piponmostmajorsequals$10).Additionally,highleveragesandtheoverallamountoftransactionsinamarketthatmovestrillionsofdollarseveryday(nearly$4trillioninApril2010,accordingtotheBankforInternationalSettlements)accountforaquitehandsomeprofitforthebrokers.

Normal market fluctuations creating preferred or void price zones account for thedifferencesinbid/askspreads,andthesamegoesforslippage(whentherearenobuyersorsellersatagivenprice,theexecutionofanorderhastobedoneatthenextavailableprice).Thisisalsowhybrokersthatofferfixedspreadsorguaranteedfills(orboth)havetoemployother strategies to limit their risk exposure, and most probably will give you a delayedexecutionor“serverdisconnections,”especiallyatnewstimes,whenthiskindofvolatilityismorelikelytooccur.Whenthereisnocounterpartytotaketheoppositesideofatrade,therisksareontheirsidetoassumetheguarantee,andsotheyusedelaysandrequoteswhenevertheyneedtoprotectthemselvesfromsucharisk.

Leverage

Highleverageisanadditionalsourceofmultipliedincome,asthespreadsareautomaticallyleveragedand therefore thebroker’sgainsareproportionally increased.Forexample,ona1:50leverage,brokerswouldearn50timesmoreonthespreadsthantheywouldbeabletodowithnoleverageor1:1.Recentregulationshavelimitedthemaximumleverageto1:50onmajorcurrencypairsand1:20onexotics;however,thereareplentyofoffshorebrokerswhostillofferashighas1:400and1:500leverages.

CommissionsandSwap

One of the advantages of forex trading is the commission-free operation. Only Sharia-compliantaccountsarechargedacommissioninplaceoftheswapsonmostmarketmakers’trading platforms. ECNs do charge a commission on every trade independently from theoutcome,plus thespread,which isusuallyverysmallexceptonveryvolatilesessionsandparticularlyduringnewsreleases.

Theswaporovernightrolloverfeeisarequirementfromtheliquidityproviders,whichispassedon to theclients (with thepossibilityof slightlydifferent rates from thoseof thebanks;infact,almosteveryretailbrokerdiffersfromeveryotheronthisparticular).Swapsare calculated in regard to the interest rates of both currencies involved in a pair (thedifferencebetweenpaid andborrowed currency), and thebrokerwill pay the swap to thetraderwhentheratioispositiveontheopenpositionsandwillcollecttheovernightfeeifthedifferenceisnegative.Asthesecalculationsalsotakeintoaccountthebidandaskprices,thepaidswapratioisalwayssmallerthanthecollectedswap;thereforethebrokeralwaysendsatanadvantage.

Makesurethatyoucheckoutyourbrokerofchoicecarefully.Somebrokerswilltrytoget out of paying the swap fee when you are long the high-yielding currency pair. Forinstance,Iknowsomebrokersthatwon’tpayoutanyswapsifyouareinaminiaccount.Iknow some brokers that won’t pay out swaps on some pairs regardless. I have also hadbrokersthatonlypaidafterIquestionedwhyIwasn’tgettingpaid.

Finally,somebrokersalsochargepaymentprocessingfeesatthemomentofdepositingor withdrawing from your account. These fees are usually very small; they are meant tocompensateevenifpartiallysomeofthebroker’sexpenses.Youwillfindthesesortsoffeesspecificallyrelatingtowiretransactionsofpaymentsinandoutofyouraccount.Thisusedtobea rampantpractice,andbrokerswould literallygouge theirclients.Manybrokers todayaresocompetitiveforanaccountthattheywilleitherwaivethisfeeornotchargeitatall.

Hedging

Hedging is performed through offsetting the broker’s exposure in onemarket direction byestablishinganequivalentposition inanothermarket to reduce the risks.This canbedonethroughoptiontrading,insurancepolicies,andotherinvestmentvehicles.

Whenhedging,youwillmorethanlikelyhavetogooffshore,asrecentU.S.regulationshavedisallowed this sortof trading.Youcanalwaysuseacorrelatedhedge.This iswhenyoufindanothercurrencypairthatwillmimicormirrorwhatyouarecurrentlytrading.Themorecorrelateditis,themoreriskyoucanreducebetweenyourtrades.

Therecanbe some inherentproblemswithhedging in the samecurrencypair. Ihadatradethatwasperfectlyhedged,andstill theaccountwasliquidated.Bydesign,youwouldthinkthatbybeinglongtheEURandshorttheEUR,youwouldhaveaperfecthedge.Well,thinkagain.Firstyouwouldnotusea stop, sinceyouhaveaperfecthedge.Sohere is theproblem.Iamhedgedbothsides,andthemarketmovesbigonnews.

Thebank(liquidityprovider)decidestogoaftermyaccount.Ihadtheaccountupabout25percentinamonth,andobviouslythebankdidn’tlikeit.Sowhenthemarketmovedbig,thebankhelduponesideofthebidandask.Thatwaythespreadwaswidened,inthiscase,about150pips.Seriously,intheworsttradegonebadIhaveeverexperienced,theaccountwas seen as overleveraged at that time, since Iwas technically open on both sides of the

trade. So when the spread opened, the account dropped and hit its margin call, the bankclosed the trade and liquidated the account, and then the bank just covered the trade andrevertedtoanormalspread.

By theway, Iwas on the phone the entire time this happened trying to get out of thetrade,andthebankwouldn’tletmeout.Ultimatelythebanktoldme,“That’stradingthespotintheover-the-countermarket;yougetwhatyouget.”Iamstilltryingtogetcreditbackforthatgarbage.

InterestCollectedonExchangeOperations

Earnedinterestondepositedfundsandontheconversionandholdingofdifferentcurrenciesisanotheralternativethataddstothebroker’sprofits.Somebrokerspaybackapartofthisinteresttotheclient,butmostofthemdonot.

In-HouseTrading

Smallretailoperations,belowonestandardlot,areusuallykept“in-house,”wherebrokersoffset opposite positionswhenever possible among their own client pool. Trades can’t beconveyed to the interbank because of their insufficient size, and very few market makersmanage to group some of themwhen the entries are equivalent. (SeeChapter 17,where IdiscussB-books.)

IBs=Affiliates

Brokeragehousesmakemoneyeachtimeatradeisopenedbyanyoftheirclients.ThesameholdstruefortheIBs,oraffiliates.

Although this canbe considered as an indirectwayof earning, brokers increase theirprofit potential by recruiting IBs for their firmor signing up affiliates and offering them ashare of the spread incentives.These individualsmost often are given a branded personalWebsitetochannelnewclientstothebrokeragehouse;andgiventhattheirearningsbasicallydependon the amountof lots traded, eitherwinningor losing, it canbevery rewarding tobothparties,unfortunatelyquiteoftentothedetrimentofthecustomer.

KeepinmindthattheIBisreallyanintermediary.InmostcasesthebrokerjustpaystheIBpartofthespread,andthatdoesn’tnecessarilymeanthatthespreadisanyhigherforyou,the trader,whetheryouare tradingdirectly through thebrokeror throughyour IB. In somecasesthebrokerwillincreasethespreadtocovertheaddedexpenseoftheIBtothebroker.

WHAT DO SHADY BROKERS DO TO EARN YOURMONEY?

Countertrading

Tradingagainstclientscreatesaconflictofinterestandisahighlyunethicalpractice.Butitis

veryprofitableforthebroker.Whenalltheconditionsofferedseemtoogoodtobetrue—lowspreads, high leverage, no trading or payment processing fees, and high paid rolloverinterests—youcansuspectthatthebrokeristradingagainstyouto“earn”yourmoney.

Brokersusuallymakethemajorityoftheirincomeonyourlosingtradesratherthanfromthespreadsoranyearnedinterestonthecapitalthatyouhavedepositedintheaccount.

Plug-Ins

Oneofthemostpopularforexplatformscomesalongwithaninterestingvirtualplug-in.Thisplug-in allows thebrokers tomanipulate prices and set a series of parameters that allowsthemtoexerttotalcontrolofclientaccounts.Allactionsareautomated,includingtriggeringstopsatparticularlevels,movingstopsandlimits,settingafixedslippage,overridingclientparameters, performing selective and fixed execution delays, disabling pending orders atspecific times (usually on news releases), programming platform freezes, selectivelyprocessingorrejectingtradingrequests,etc.

There are many other platforms that brokers are using with back-office software tomanipulatethemarketandultimatelytakeyourmoney.Asaresult,wewillbetalkingaboutspecificstrategiestomakethetradingenvironmentamuchmorelevelfield.

DirectPriceManipulation

Prices can be manipulated through sudden spikes and widening of spreads that do notcorrespond to the realmarket activity.Theyalso canbemanipulated throughhunting stopsand by overly delaying orders, causing excessive slippage. In the equities market, thesemanipulative practices are sometimes called flash trades. All these will be discussed indepthinlaterchapters.

ProfitabilityBlacklisted

Banningprofitabletradersisasuresignofascambroker.Assoonasthesebrokersseethatyouaremakingprofitssteadily,theywillcloseyouraccount,usuallyinvokingsomeobscurereason.Ihavepersonallyseenbrokeraccountlistingslabeled“Blacklisted.”Thebrokerwillliterally seek out these profitable accounts and then do everything possible to destroy theaccounts’value.

Iknowthatbrokersusetradersaswell;theirjobistoreviewprofitableaccounts.Thenthebroker’straderisinstructedtolookfortradingpatternsoftheprofitabletradingcustomer.Soifyouareusing,say,a50-daymovingaverageandthebroker’straderfiguresitout,thebrokercanthenstart tradingagainstyou.Thebrokernowknowswhenyouget inandwhatyouarelookingat.Thejobofthebroker’straderistobeatyouatyourowntrades.

Thesebrokersalsoclassifytheirclientsintotwogroups:thosewholosemoney(whichisaround95to98percentofalltraders,especiallynewcomers)andthosewhowinandmakemoney.Atthebeginningofthebroker-clientrelationship,theassumptionisthatyouraccountbelongs to the losinggroup.After awhile, ifyouhavebeenmakingconsistentprofits,youwillbereassignedtothewinninggroup,andtradingconditionswillstarttobecometighter:more requotes and delays in execution, sudden server disconnections, selective use of the

above-mentionedvirtualplug-ins,etc.Ihavebeenthereanddonethat,seenall thegames,andtheywillfindyou.Again,we

havetodeploysometacticsofourowntobeatthebrokersattheirowngame.Iknowyouareprobably saying that if thebrokersare sounscrupulous,whykeep trading?Greatquestion!The answer is becausewe can stillmakemoney, so there is no reason to stop trading theworld’slargestfinancialmarketjustbecauseofafewbadbrokersorbanks.

Also, your trades will be grouped with all those of the winning group and hedgedagainst on the interbank to offset any profits made on those positions. Those brokers aremostly interested ingetting“losing”accounts,given the fact that the tradesnever leave thehouse;whenaclienttakesaloss,allthemoneygoesinthebroker’spocket.

Anoverseasbrokertoldmethattheruleofthumbwasthatbrokersmakeabout120to125percentoftheclients’depositedfunds.

CANYOUTRADETHEFOREX?

Iknowwhatyouaresaying.Afterreadingthisfar,youareaskingyourself,“CanItradetheforex?”Theanswerisyes,youcantradetheforex.Whenyougetdonereadingthisbook,youwillbebetterarmedwiththerighttoolsandknowledgetogooutandstarttradingtheforexwitharenewedsenseofconfidence.

Istilltradetheforexmarketandloveit.Justlikeyou,Idon’tenjoybuttingheadswithanunscrupulousbroker that isout to stealmymoney. I amonaconstant lookout for tricksorthingsinmytradingaccountthatdon’taddup,andIamalwayslookingforgoodbrokers.Bytheway,justbecausesomebrokersusedtousesomeoftheunscrupuloustacticsoutlinedinthisbookdoesnotmeanthattheycan’tchangetheirstripes,sotospeak.

There is alwaysmanagement turnover, andwith new regulatory oversight, the biggerbrokersare tryingveryhardtostayontherightsideof theindustry.Don’tbeafraidto testotherbrokersorgobacktoonesyoumaynothavelikedinthepast.Justmakesureyouaretestingthemwithmoneyyoucanaffordtolose.Youneverknow.

WHY98PERCENTOFTRADERSLOSEMONEY

Accesstotheforexmarketsisarelativelyrecentpossibilityforindividualtraders,thankstothedevelopmentofcommunicationtechnologies.Thiseasyaccesshasalsocontributedtoallthe hype and inaccurate comparisons to “get-rich-quick” schemes, which abound on theInternet. The promotionalmaterials of some brokerages (although they always include thelegaldisclaimersinsmallletters)arealmostalwaysslantedtoappealtopeople’sneedsorgreed.Thewordseasyandrichareusedsooftenthatpeopleendupthinkingthat’sthenaturaloutcomeofforextradingand,whatisworse,thatforextradingisnothingmorethanameregamblingactivity.

Nothingisfurtherfromreality;thetradingofforexisnotagameoragamble;instead,it’s a tough and potentially very rewarding business if would-be traders are willing todedicatetheirtimeandeffortstolearn,understand,andthoroughlydevelopalltheskillsandabilitiesthatareneededinthisprofession.

Just as a medical student wouldn’t think of performing surgery on a patient withouthavingmasteredallthesurgicalskillsandknowledgeavailableandpracticingformanyyearstobecomeaflawlessphysician,thesamemindsetmustbeingrainedineveryforexstudentifheorshereallywantstoachieveconsistentanddurableresults.

Thefundamentalreasonwhy98percentoftraderslosemoneyandareforcedtoquittheforexarenaintheirfirstyearisduetoatotallackofeducationonthesubject.Buttherearealsootherobviousreasons,whichIamgoingtocategorizeanddescribebelow.

Inmyyearsofexperiencebothtradinganddealingwithbrokers,Ihavecometorealizethatundercapitalizedaccountsaredoomedtofail.Yousimplyhavetohavetheappropriateamountofaccountsize,dependingonyourtypeoftrading.Abrokeroncetoldmethathisfirmholds all accounts under $5,000 because it knows that 98 percent of themwill lose theirmoney.

The broker doesn’t have to trade against you per se, just hold the other side of yourtrade.Thebrokerknowsyouwillmakeenoughmistakestowipeoutyouraccount,andwhodoyouthinkprofitsfromyourlosses?That’sright—thebroker.

Inmyopinion,therearethreebasicareasthatcanexplainatrader’sfailuretomeethisorhergoalsthroughforex:technical,emotional,andexternal.Technicalreasonsaremostlyrelatedtopropereducation,abilities,andskills.Emotionalreasonsinvolvethetrader’sownpersonalitytraitsandreactions,aswellascommonbeliefsthatmaybeusefulinlifebutarecounterproductive in this particular industry. External reasons, although still somewhat thetrader’s responsibility, are trickier to handle and depend on the behavior of third parties.Let’sexamineeachareainmoredetail.

TECHNICALREASONSWHYTRADERSLOSE

1.NotHavingEnoughEducation

This is thebasiccauseofall tradingfailures.Newtradersdonotbother taking the timetolearn what moves the different currencies or to get a grip on fundamentals or technicalanalysis; they just jump into the markets blindly, hoping the trades will take care ofthemselves.

2.NotPracticingEnough

Althoughlackofproperpracticeiscauseforfailure,thisisadouble-edgedsword.Toomuchtradingonademoaccountcanbeharmful lateron,becausewhen tradingon thedemo, thetrader tends tobecomecarelessabout theoutcome,sinceheorsheisn’t incurringanyrisk.The need for practicing is paramount.Demo accounts are good for learning the platform’soperation, but the conditions are usually quite different from those of actual live accounts,becausetherearemanybrokersthatallowtradingaccountstobeopenedwithaverysmallamountofcapital.

Tradersshouldstarttradingsmalluntiltheyobtainacceptableresultsandapropergraspof themarket behavior before tradingmore. By practicing beforehand, the trader acquiresgreaterexperienceinthemarkets.

3.Tradingwith“ScaredMoney”

Disclaimersalwaysenforcethisrule,butinpracticeitisseldomrespected.Youshouldnevertradewithfundsthatyoucannotaffordtolose.Thereasonisprettyobvious;eventhemostcool-headed individualswill crashpsychologically in frontofa loss, and theaddedstresswillleadtopoordecisionmakingandfurtherlossesinadwindlingspiral.

4.HavingNoMoneyManagementRules

Thefirstandforemostruletobeestablishedinatradingplanshouldspecifyhowriskwillbemanaged.Failingtodothiscouldleadtocommittingtoohighapercentageofthecapitalandincreasingthepossibilitiesofgettingamargincallorevenblowingtheaccountinitsentirety.Thisgoeshandinhandwiththenextreason—employinganexcessoftrueleverage.

5.Overleveraging

True leverage differs from the broker’s allowed leverage. You are trading at 1:1 trueleverage if your total equity is $10,000 and your position size is one mini-lot ($10,000exposure). Using your broker’s maximum leverage capabilities is a recipe for disaster,increasingthepotentiallossesinthesameproportionaseventualprofits.Bettingthefarmonasingletradeisnotagoodpolicy.

Brokers offer higher leverages so that you might open larger positions, thereforeincreasingtheincometheyobtainthroughthespreads;forahigherpipvalue,theygetahighertotalspreadvalue.

6.TradingwithoutaCompleteTradingPlan

Thetradingplanisaforextrader’sbusinessplan.Ifyoudon’thaveaplan,youwon’thaveanedgetoturnthemarketinyourfavor.Youneedtobuildandwritedownacompletetradingplan,whichshouldincludeaseriesofspecificrulesaccordingtotheparticularstrategyyouwill apply: entry rules, exit rules,moneymanagement and risk-to-reward trade evaluation,timeframesthatwillbeusedforentries,typesofsignals,andindicators.Allofthisisneededandthensometohelpyousetarealisticandachievablegoal.

Ifyoudon’thaveaplan,yourtradingwillhavenofocusordirection.Thetradingplanshouldalsoincludepersonalandpsychologicalaspectsthatwillhavetobeinplacebeforeyou click on that BUY or SELL button. Finally, you must set a daily trade limit (youespeciallyneed to stick toadaily trade limit toavoidpotential losingstreaks) so thatyoudon’tfallintothenextcategory:overtrading.

7.Overtrading

Gettingenthusiasticafterafewwinningtradesandtakingrevengetradesafterafewlossesboth lead to the samemistake. Although scalpers might disagree, taking too many trades,lockingyourprofitstooearly,andusingstopsthataretootightforthetimeframeemployed

willcertainlymakeyourbrokerveryhappytocollectallthosespreads.Butintheend,thisisalosingstrategyforyou,asyourprofitsendupbeingsmallerthanthespreadsyou’vepaid.

8.ChoosingBadTimestoTrade

Thebesttimefortradingiswhenthereisplentyofliquidity,thatis,whenatleasttwoofthebiggestmarketsareopen.Intimesoflowvolume,volatilitybecomeserratic,andtradersgetmixedsignals.Bank tradersdominate themarket inquieter timeswith theircustomerorderflow.Itisbettertostayoutofbetween-sessionhours.Also,themostsignificantmovesoccurshortlyafternewsreleases.Thereishighvolume,andliquidityandchangesinpricereflectarealandimportantcurrencyflow.

9.TakingintoAccountOnlyHalfoftheElementsofaCurrencyPair

Boththebaseandquotecurrencystrengthmustbeassessedbeforemakingatradingdecision.Whenactinguponthebehaviorofasinglecurrency,youaremissinghalfofthetraderealityofthatparticularcurrencypair.

10.ImplementingInsufficientlyTestedStrategies—Dilettantism

Many traders are eager to jump in andoutof strategies,withoutdedicatingenough time tobackandforwardtestingtoseeifaparticularstrategyreallycanbeprofitable.Instead,theydiscarditatthefirstsignofaloss,thusnotallowingthemethodtoshowitsrealresultsandscope.

11.TradingTooManyPairs

Currencypairsexhibitadifferentbehaviorfromoneanother.Ifyourattentionisspreadovertoomanyofthem,youwon’tbeabletounderstandeachoneindetail.Focusisneededhere,masteringonepairatatime.

12.ChoosingtheWrongTimeFrame

Some traders attempt to trade longer termwhile applying stops andprofit-taking rules thatbelong to smaller time frames. If your trades are too short term, youwill bewastingyoureffortsinspreadspaidtothebroker;ifyoutrytoforecastwhatwillhappennextmonthandbase your trading decisions on distant overviews, you will not pay attention to what ishappeningatthemoment.Tradeinthenow.

13.TradingagainsttheTrend

Identifythemaintrendanddonottrytopicktopsorbottoms.Tradeinthedirectionthepriceismoving.

14.UsingTooManyIndicators

Throwing a bunch of indicators on a chart will create confusion and lead to analysis-paralysis,especiallywhenthesignalsyougetareinconflictwithoneanother.Trycleaningupyourchartsanddonotemploymorethantwoindicators,orbetter,learntoidentifypriceactionbyitself.

Most,ifnotall,indicatorsarelaggingandonlyshowwhathasalreadyhappened.

15.MakingCarelessExits

Exitingatradehastobeplannedascarefullyasorevenmorecarefullythantheentries.Stoplosses are emergency exit levels, but if you see that a trade is not working the way youexpected,noneedtowaituntilthestopsarehit;trytominimizethelosses.Ontheotherhand,whenyouareintoawinningtrade,don’tcutoutprofitstoosoonevenifthetensionbuildsupwhile monitoring the position. Wait patiently until the price reaches your expected targetprofit, and observe carefully any signs of reversal. Don’t jump out because you werefollowingawhimorbecauseitistooboringtowaititout.Tradingisboringandstressful,butit’srewardingifyoufollowtherules.

16.WatchingOnePairandTradingAnother

Itisusefultoobservethecorrelationsbetweencurrencypairs,butyoushouldn’tassumethatthepairyouwanttotradewillbemovinginthesamedirectionorwiththesameimpulseofthepairyoujustnoticedmoving.Eachpairhasitsownreasonsthatdetermineitsbehavior.Tradethepairthatmoved.

17.NotAssessingProperlytheMarket’sTechnicalCondition

It is important to observe when a market is overextended in any direction, as this is aconditionwherepriceactioninreversalcouldbeparticularlysuddenandstrong.Thiscouldresultinblowingoutstoplosses.Alwayschecktheoverallsituationbeforeenteringatrade.

EMOTIONAL AND PERSONALITY REASONS WHYTRADERSLOSE

Contrary towhat youmay think, emotional risks are subordinate to technical reasons in agreatnumberofoccasions.Thelackofpropereducationleadsatradertofailbytakingout-of-proportionrisks,tradingtoomanylotsinregardtotheiractualequity,andopeningrandompositions without a specific plan, thus missing an edge on the markets. The emotionalfrustration you will experience thereafter is a consequence of not possessing enoughknowledgeofforexandthereforebeingatthemercyofcontinuousupsanddownsandstressaccumulationbecauseofthelossesincurred.

Emotional self-control is an important asset, but by itself it will do nothing for your

tradingresultsifitisnotpairedwithathorougheducationandsufficientpracticetodevelopappropriatetradingskills.

1.ActingfromBasicEmotionsRelatedtoMoney

Fear and greed are the most basic emotions that lead traders to lose control of theirperformance. Fear of losing money that you can’t afford to lose (see technical reason 3above,“Tradingwith‘ScaredMoney’”)cancauseyoutoclosepositionstooearlyandthuscutyourprofits too soon.Evenworse, fearof losingmoneycancauseyou to leave losingpositionsopenuptothepointofnoreturninthehopethatthemarketwillcomebackinsteadofcuttingyourlossesassoonaspossible.Greedcausesproblemswhenyouareinthemiddleofawinningstreakandwantmoreandmore, leadingtoovertradingandgivingbacktothemarketallthatwaspreviouslyearned.

Inaddition to theemotionsof fear andgreed, Iwouldaddneed: the need to producemoremoneyandmakea tinyaccountgrowenough tomakea livingoutof itbyprojectingunrealistic goals and false expectancies alongwith thewrong idea that forex tradingwillmakeyourichinnotime.

2.BeingAfraidtoTakeaLoss

Oneofthemostdeeplyingrainedbeliefsisthattakingalossimpliesapersonalfailure.Thisissomethingweallwouldliketoavoid.Noonewantstobelabeledaloser.Wehavebeentaught to strive for success, and failure is frowned upon in our normal professional life.However,lossesarepartofthewholesceneofforextrading,andyouhavetocarefullyplansoyoudonotcompromisetheoverallperformanceinthelonghaul.

Thereisnothingwrongintakingaloss.Itdoesn’tdiminishyourvalueasatrader—onthecontrary.Youcan’tcontrolthemarketreactions,butyoumustbethemasterofyourownreactionstothemarket,andthisincludesacceptingthefactthatyouwillsometimesbewrongaboutthemovementofatrade.

3.TradingonaHunch

Usingfeelingsandemotionstoenteratradeinsteadofusingacarefullythought-outplanisamenufordisaster.Revengetradingalsofallsunder thiscategory.Youseeasurgeinpricesandyoubuy,oryouseeasuddenspikedownandyousell,without taking intoaccount thewholepictureorthecharacteristicsofthetimeframeyouarewatching.Yougetaseriesoflosses,fearrearsitsuglyhead,andyoufeel theneedandgreed,whichpushesyoutoopentradeaftertrade,hopingtomakebackallthemoneyyoulost.

4.FeelingaLackofConfidence

Theonlywaytobuilduptrueconfidenceinyourtradingistogetpositiveresults,andthosewillonlycomeafteryoulearnthisbusinessthoroughly.Afewluckytradesaren’tenough,astheymightpropelyouintotheoppositeemotionalflaw—overconfidence.

5.FeelingOverconfident

Oneoftheworstthingsthatcouldhappentoanewtraderistostartbyexperiencingaseriesofwinningtradesbychance,withouthavingarealgraspofthemarket’sbehaviormechanics.Yousuddenlyfeelall-powerfulandtakesuccessforgranted,losingperspectiveandthinkingforexiseasy.Youwillbemorelikelytotradecarelesslyandwithoutaplan,andyouwillbetotallyunpreparedwhenthefirstbiglosscomesaround.

6.DoingTooMuchAnalysis

Trying to look beyond what is obvious and elaborating complicated theories about themarketswillhinderyourabilitytoseeandtradewhatisreallyhappeninginplainsight.Keepitsimple.

7.Trading24HoursaDay

Stayingtoolonginfrontofthescreenwithoutproperrestreducesyourabilitytofocusandbuilds up stress and fatigue in your brain andwhole body.Youneed to be totally focusedwhentakingonatrade,andthisisonlypossibleforalimitedamountoftime.Donottradewhen you are tired or when your attention is driven away by other daily preoccupations.Spendlesstimeinfrontofthecharts,butwhenyoudospendtimewiththem,becompletelyawareandawake.

8.LackingtheWilltoFollowYourOwnRules

Atradingplan isonlyasgoodasyourability tostick to its rules.Traders thatalwaysfindexcuses to bend the rules based on emotional reactions are only justifying their lack ofdisciplineandwillhavepoorresultsinthelongrun.

9.BeingFearfulof“PullingtheTrigger”

Evenwithawell-thought-outplan,sometradersfreezewhentheirstrategytriggersa trade,andsotheyconsistentlymissgoodentries.Itistruethatnottradingwon’tbringlosses,butitwon’tbringprofitseither.Trustyourplanandhavethecouragetoputitintopracticewhenthetimeisright.

10.MovingStops

Thisisanotherversionof“lettinglossesrun”andistheresultofa“hope-and-pray”stateofmind.Youshouldnevermoveastoptoawiderdistance.Ifyourpreplannedstopishit,eitheryou were trading in the wrong direction, so moving the stops would only add to theimpendingdisaster,or itwas tootightandyou’llneedtoreassessyourriskmanagement inregardtothetimeframeyouaretradingtoavoidsuchasituationinthefuture.

11.GivingUpBecauseofDisappointment

Tradingshouldbetreatedasabusinessatalltimes,andthisincludessettingaspecifictimetoworkonyourtrades,independentlyoftheirindividualoutcomes.Ifyoustartthedayonthewrongfoot,justtakethelossandcontinuewithyourdailyplan.

12.CountingYourChickensbeforeTheyHatch

Settingrealisticgoalsisgood,butdaydreamingaboutprofitstobemadeorworryingaboutpotentiallossesisofnouse.Focusonyourplan,waitforthetrigger,andthenjustconcentrateonyourtradeuntilitcomestocompletion.

13.FeedingonAdrenaline

Many people get into forex trading because of the emotional rush it gives them, just likegamblersget.Thisattitude is far frompositiveandcanhavedisastrouseffectsondecisionmaking.Theidealsituationistobeasrelaxedaboutyourtradesasyoucan—youshouldbealertandinterested,butnotexcited.Youneedatranquilmindtobeabletoexerttotalfocus.

14.FeelingtheNeedtoBe“IntheMarket”atAllTimes

Takingtradeswithoutarealtriggerjustbecauseyouwanttobe“inthemarket,”orbecauseyou feel boredwaiting for the appropriate setup, is the same as entering trades randomly.Whentherearenoreasonstotrade,juststayout.

EXTERNALREASONSWHYTRADERSLOSE

1.ChoosingtheWrongBroker

This should be the first lesson to learn before entering the forex arena. Gather as muchinformationaspossibleaboutthepotentialbrokersoyoucanchooseagoodone,andavoidbeingruinedbyascamorjustplainunethicalbucketshops.

2.SettingYourStopsintheOpen

Evenwithadecentretailbroker,stopswilloccasionallybesought.Usingstopsthataresetatobvious levelsor that are set too tightly for the time framechosenwill invariably turn theoddsagainstyou.Besuretoallowyourtradesenoughspacetobreatheandevolve.

3.FollowingOtherTraders’Decisions

Sharing thoughts andanalyseswith fellow traders is adouble-edged sword, especially fornewcomerswhohavelittleunderstandingof themarketsandseemdesperately inneedofa

guideormentor.Notallthetradersthatpubliclypostthepositionstheyareabouttoenterareprofitable;infact,trulysuccessfultradersseldomparticipateinsuchsocialmedia;theyaretoobusy trading andperfecting their strategies.Youneed tomakeyourowndecisions anddevelopyourmethod(s),evenifonlyadaptedfromaprovensystem.

4.AdoptinganAutomatedStrategyBasedonHypotheticalResults

Thereareseveral“black-box”systemsforsaleoutthere,withamazingperformancerecords,thathaveneverreallybeentestedonaliveaccount.Hypotheticalperformanceisequivalenttonoperformanceatall,giventhatdemoconditionsare totallydifferentfromthoseofrealtrading.Keepinmindthat theonlytruemotivationbehindthosesystemsisfor theseller tomakemoneyoutofinexperiencedtraders.

5.BeingInfluencedbyRumors

Arumororforecastcirculatingbeforenewsreleasescanbeemployedtotakeacloserlookatthesituationbutshouldneverbejumpeduponblindlywithoutacarefulexaminationofboththecurrencypair’sactualpriceactionand the timingof the rumor itself.Thesourceof therumorisalsoacluetoitsrealmotives,asoftenthepurposeistocreateexactlytheoppositereaction to whichever direction the market is about to take and then to profit from theconfusion.

6.HavingaPoorUnderstandingofFundamentals

Newsreportsoneconomicreleasesaretobecarefullyexamined,astheyareoftenbiasedoroffer just one side of the picture without taking into account all the elements involved.Wheneverpossible, readnews releasesat the sourceand learn to interpret andunderstandthemcorrectly.

Toconclude,beingsuccessfulatforextradingistheresultofadedicatedandconsistenteffortto learn the necessary skills and perfect them through continuous practice andpreparation.Beingabletoidentifythetradingstylethatbestsuitsyourtalentandpersonality,aswellasyour capital needs and time availability, will ultimately allow you to be successful inachievingyourforextradinggoals.

Finally,neverstopreviewingyourperformancetospotanyweakpointsyoumayneedtocorrect,aswellas to recognizeyourpositive trades.Thiswillallowyou to increaseyourconfidenceandmaintainfocusonthestrategyyouhavedeveloped.

CHAPTER3FOREXOPTIONS

WHATAREFOREXOPTIONS

Forex, or currency, options are financial derivatives where the underlying instrument is acurrency pair. The buyer of such an option acquires the right to buy (call) or sell (put) acurrencypairatagivenpriceandspecificexpirationdate,butdoesnothavetheobligationtodoso. Inversely, the sellerofacurrencyoptionwillhave theobligation tobuyor sell theinstrumentwhenitisexercised.

Originally this type of tradingwas performed in over-the-counter (OTC)markets andreserved to institutional traders as well as large corporations, which used the options toreduce the risks by hedging the exposure theymight have in a particular foreign currency.Today,thankstoelectronictradingandwidermarketaccessattheretaillevel,tradingforexoptions isbecomingmoreandmorepopularasanalternativeorevenacomplement to thepositionsopenedatdirectspotforexrates.

Thereareseveralonlineforexbrokersthatincludetheavailabilityoftradingoptionsoncurrency pairs among the financial instruments they handle. I will keep an updated list ofthesebrokersatwww.jdfn.com.Afewfuturesandstockoptionsplatformsdooffercurrencyoptionsandspotforextrading,andmostofthemwillallowyoutotradeoptionsonsingle-currency futures (Globex). Although there might be some differences in volatility, tradingfuturesoptionsonthebasecurrencyofaparticularcurrencypaircanbeanalternative,butdirect correlationwith the spot currencymarketmightbe lost if theaim is touse them forhedging.

Somebrokerswillofferbothlongandshortcallandputoptions(vanillaoptions),whileotherswillonlyofferthelongtypes.Therearemanybinaryoption-specificintermediaries;afew include touch and boundary alternatives. Most often, forex options belong to theEuropeanstyle(discussedlaterinthischapter).

FOREXOPTIONSVERSUSSTOCKOPTIONS

In essence, both currency and stock options follow the same principles; however, they dohave significant differences, starting from the fact that a forex option implies a doublecontract. For example, when buying a long call on EUR/USD, you are simultaneouslyacquiring a call on the euro and a put on theU.S. dollar. This particularitymakesmarketforecastingmoredifficult,asbothcurrencieshavetobeassessedandwillnotalwaysmoveinperfectcorrelation.

Another important issue is volatility: currencymarkets tend tomovemuch faster andexhibitmoredirectionalswingsthanthegreatmajorityofstocks,andtheyalsoreactswiftly

in frontofmajor economicnews releases andgeneral international events.Forex currencypairshaveahigherlevelofleveragecomparedwiththatofstocks,thusincreasingtheprofitpotential but also the risks. Forex options are more sensitive to political and economicfactors,whereasstockswilltakeintoaccounttheeconomicvariablesthataffectthespecificcompany.

Another riskworthmentioning is thecounterparty risk,which ismoreoftenpresent incurrencyoptionsthanstockoptionsbecausethecurrencyoptionsaremostlyOTCinstruments.If the broker or firm that holds the other side of the transaction goes into bankruptcy, anyoptionscontractsyouareholdingasaclientmightbecomeworthlessandwillnotcarrythefinancialobligationtodelivertheforeigncurrency.Thisoccursbecausethereisnoprotectionthroughacentralclearinghousewhenthedealerscannotmeettheexerciseobligations.

Finally, currency options can be traded continuously throughout the year, as the forexmarketisalwaysopen,whileoptionsonstockscanonlybetradedwhenthestockmarketsarefunctioningduringnormalbusinesshours.

HOWTOFINDAFOREXOPTIONSBROKER

Manydifferentoptionstradingalternativesareavailable,andeachoneexhibitsdistinctrisklevelsandoverallcharacteristics.PlainvanillaforexoptionsarestandardoptionscontractsthataretradedthrougheitheranexchangeoranOTCdealingdesk,whereyoucanbuyorsellstandardcallsorputs.There isgood liquidity,andyoucanusuallyget real-timestreamingquotesandenterorexit themarketat any timeduring the tradingweek.Then thereare theexoticoptions,whichareaderivativeofthestandardvanillakind,includingbinaryoptionsandotherstyles.

Theonlinebrokerwillprovideelectronicaccesstocurrencyexchangeliquiditypools;however,manyofthemconsideroptionsasOTCtransactions,andthetradeswillbedirectlyperformed with the broker as the counterpart, instead of matching the orders with othertraders.Withmanyfirmsthatofferforexoptionsalongwithspotforextrading,youwillfindaconsiderablearrayofstrikeandexpirationpricesforyoutochoosefrom.Somefirmsmightalsoletyoudecideontheexpirystyle.

Findingtheappropriatebrokertotradeforexoptionscantakesometime,becausetherearenotasmanyasplain-currencytradingbrokerages,andnotallofthemofferallthevariousstylesorpossiblecombinations.Thebestapproachistofirstlearnaboutallthevariantsthatareavailableandmakeapreliminarychoiceof thestyleyouwouldprefer toemploy; thenopenademoaccountondifferentplatformsandseewhichonesuitsyoubest.Youneed tomakesurethateverythingyouwillrequirefortradingisavailable.

Someoftheoptionstrategiesaremorecomplicatedtounderstandthanothers,andyouwillhavedifferent levelsofdocumentationon thespecificoptions.Somebrokersoffer thepotential foryou to tradedirectlyaparticularstrategywithasingleclick,andsomedon’t.Also, there are differentways of handling the expiry and option exercising. And althoughsomebrokersdonotofferanonlineplatform, theywillallowyou to tradeoptions throughtheir dealingdeskvia telephone.Somewill haveboth capabilities.Theminimumdepositsrequiredwillalsovaryfrombrokertobroker.Finally,mostretailforexbrokerswillrequirehighlevelsofprotectivecapitaltoallowthesellingofoptionscontracts,aswritingoptions

carrieshighrisksofloss.Doathoroughonlinesearch,onethatincludescheckingforothertraders’commentsand

evaluations in forums or reviews, just as youwould dowhen looking for a forex tradingplatform;oryoucanvisitwww.jdfn.com.Then,whenyouthinkyouhavefoundwhatyouarelookingforandhavethoroughlytestedtheplatform,besuretoaskallthepertinentquestionswith the customer support desk before committing realmoney.Youwill need to know thetradingaccountminimumsandmargin requirements, andyouwill alsoneed toknow if theoptions contracts can be opened and closed at any time or if youwill be locked out untilexpiration;inaddition(especiallyifitisnotclearlysignaledontheplatform),youwillneedtofindoutabouttheproceduresthatareusedtoallowyoutoexercisetheoptionsonexpiry.

ADVANTAGESANDDISADVANTAGES

Trading forexbyusingoptions,byeithercombining themwith spot forexorusing themontheirown,keepsmostoftheadvantagesoftraditionalforextradingwhileeliminatingmanyofitssetbacks.Forexample:

•Thereisnoleverageforthepurchaseofforexoptions.Forthesamereason,youdon’thavetopayinterestonleveragedpositions.

•Theriskislimitedtotheamountpaidatthemomentofacquiringtheoption(thepremium),andyougetanunlimitedprofitpotential.

•Youcanchoosethestrikepriceandexpirationdateforyourtransaction.•Thepositionsdonotneedtobemonitoredasoftenaswithforextrading:optionsareless

stressfulandcansaveyoutime.•Thereisnoneedformargin(exceptonshortoptions).Therefore,youneedlessmoneyto

guaranteethetransactionthanforcashforexpositions.•You can use forex options alongwith normal forex trades to limit the risks and lock in

profitsthroughhedging.•Thereisnoneedtoriskhugeamountsofcapitalwhentryingtopredictthemarketmovesin

tradingfundamentaleconomicevents;thereareoptionsstrategiesthatallowyoutoprofitinsuchsituationsindependentlyoftheoutcomewithaverylimitedrisk.

•Besidesstandardcallandputoptions,youhaveavastarrayofchoicesinbinaryandsingle-paymentoptionstrading(SPOT)options.

Ofcourse,therearealsodownsidestoforexoptions:

•Theycanbemoredifficulttouse.•Theyarelimitedintime(theexpirationdate).•You need the price of the underlying currency pair tomove enough so that it covers the

premiumpaidtojustgettobreakeven(thiswouldbeequivalenttogettingbackthespreadpointsinforextrading,butpremiumscanbemuchwider).

•Thepremiumisvariableinregardtothestrikepricesandexpirationdates.Thustherisk-to-rewardratioofthetransactionwillalsobevariableandlesseasytocalculate.

•Sometypesofoptionsareaone-timechoiceandcannotbetradedbackintothemarket,forexample,SPOToptions.

•Thefixed-dateexpirationandstrikecanbecomeahindrance,asitisdifficulttopredicttheexactdateandpricelevelsatwhichthemarketwillbemoving.

However,despitethoseinconveniences,forexoptionscanstillbeaveryvaluableinstrumenttoaddtoyourtradingtoolboxeithertoearnprofitsortoreducetherisksontraditionalforexpositions.Theycanbeparticularlygoodwhenthereishighermarketvolatility,forexample,duringeconomicreportsorspecialevents.

OPTIONSONCURRENCYFUTURES

Currencyfuturesoptionsofferanotheralternativefortradersandhaveagreateravailabilitythanforexoptionsongeneralonlineoptions-tradingbrokerages.Theunderlyingassethereisa single-currency future.Theadvantageof tradingoptionsoncurrency futures is thatwhileforexoptionsaremostlytradedintheOTCmarket,theycanbetradeddirectlyoncentralizedexchangesliketheChicagoMercantileExchange(CME),whichhastheworld’swidestarrayofcurrencyfuturesandoptions.

OPTIONSTYPES

Therearetwobasictypesofoptions,callsandputs(equivalenttobuyandsell,respectively),whichcanbeeitherboughtorsolddependingonthecombinationyouchooseofbothmarketdirection and market volatility. Transactions made with options include the payment of apremium,calculatedaccordingtoaspecificformulathatIwilldescribeinmoredetailintheoptionspricingsectionofthischapter.

In the forex optionsmarket, just as in the spot forex scene, every transaction is dual.Whenyoubuyacall,youareautomaticallybuyingaputatthesametime.Thereisusuallyawide selectionof alternatives to thepriceof theunderlyingexpectedvolatility (delta) anddateatwhichtheoptionwillbeexercised.Tradersgetaquotethatstatesthepremiumoftheoption,thatis,theamounteitherthatthetraderhastopayforthetransaction(longoptions)orthat the trader will receive (short options). If the actual exchange rate of the underlyinginstrumentplacestheoptionsout-of-the-money(OTM),theywillexpireworthless.

Long(Buying)CallsorPuts

When buying calls or puts, the trader pays the premium and has the right to exercise theoption at the strike price, either buying the underlying asset in the case of a long call orsellingitiftheoptionisalongput.

If the market price of the underlying at the moment of the expiry makes the optionprofitable, the traderwill exercise theoption andwill gain thenet differencebetween theprofitsmademinusthepremiumalreadypaid.Iftheoptionisnotprofitable,thetraderletsitexpireworthless,andhisorhernetlosseswillbelimitedtotheamountofthepremium.

Theprofitpotentialisunlimitedifthemarketrallies(longcalls)orsellsoff(longputs).In both cases, the risk is limited to the loss of the net premium that has been paid for the

option.

Short(Selling)CallsorPuts

Here theseller receives theamountof thepremiumupfrontandacquires theobligation toexercisetheoptionatthestrikeprice,eithersellingtheunderlyingassetinthecaseofashortcallorbuyingitinthecaseofashortput.Ifthemarkethasfallen,youwouldhavetosellthecallatalesserpriceandlosethedifferenceminusthepremiumyouhavealreadyreceived;inthesameway,ifthemarkethasrallied,youhavetobuytheputandwilllosethedifferencetoitsstrikepriceminustheamountofthepremium.

Theprofitislimitedtothenetpremiumthathasbeenreceivedatthemomenttheoptionwaswritten(sold).Therisksareunlimitedeitherwhenmarketsrally(shortcalls)orwhenmarketsfall(shortputs).

UseofDifferentOptionsTypeswithTradingScenarios

LongCall

Theseoptionsare tobeusedwhenyouexpect theunderlyingmarketprices torise(bullishdirection) and are also bullish on the potential volatility. We can use Figure 3.1 as anexample.

Figure3.1LongcallEUR/JPY

OnFebruary 20, 2011, Iwas expecting the euro to strengthen against the yen and theEUR/JPYtoperformasignificantriseabovethecurrentmarketpriceinthenextfewweeks.Idecided to buy a EUR/JPY call option. Among the alternatives offered, I chose an OTMstrikepriceat115.04andanexpirationdatesetatApril4.

Thepremiumpaidforthisoptionwas120pips.OnApril4,2011, theoptionexpired in-the-money(ITM),whichwas470pipsabove

thestrikeprice,astheEURJPYspotrateincreasedto119.74.Ithenexercisedtherighttobuytheunderlyingcurrencypairatthe115.04strikeprice.Tolockintheprofits,Iimmediatelysolditbacktoclosetheposition.

Theprofitsrealizedonthistransactionarecalculatedasfollows:

Spotpriceatpositionclose–strikeprice=profitinpips119.74–115.04=470pips

Profitinpips–thepremiumpaid=netprofit470–120=350pipsnetprofit

Should the spot forex rate have been quoted below the strike price of 115.04, the optionwouldhavestillbeenOTMatexpiry.Asnoprofitscouldberealizedinsuchasituation,Iwouldhaveallowedtheoptiontoexpireworthless,andmylosswouldhavebeenlimitedtothe120pipspaidaspremiumwithnofurtherrisks.

Itisimportanttonotethattocalculatethebreakevenpointforthistransaction,Ineedtoadd the premium paid to the strike price; thismeans that to be at least at that level (zeroprofit–zero loss) Iwouldneed thepriceof theEUR/JPY tohave reached115.04+1.20=116.24.

Buyingalongcalloptionistheeasiestwaytoprofitinabullishmarket.Youcanreapsignificantandpotentiallyunlimitedbenefits if thecurrencypair rallies;andshouldyoubewronglypositionedorifthemarketdecidestosuddenlypullback,yourrisksandlosseswillbelimitedtotheamountofmoneyyouhavealreadypaidwiththepremium.LongPut

IwillusealongputoptionifIambearishinregardtothemarketdirectionandbullishonitsvolatility.

This time let’s look at a failedoption trade, depicted inFigure3.2. I had thought theAUD/USDwould bounce from a resistance and fall for the next fewweeks.Therefore onApril10,2011,Iboughtalongputoptionthatwouldexpireonemonthlater,settingthestrikepricealsoOTMat1.0514.Thecostofthepremiumforthisoptionwas98pips,givingmeabreakevenpricelevelat1.04160.Ifthepricehadfallenbelowthislevel,Iwouldhavehadaprofit.

Figure3.2LongputAUD/USD

However,thepricerallied321pipsabovethestrikepriceatthemomentofexpiration,soIdidn’texercisemyrighttotheoption,lettingitexpireworthlessinstead.Ionlylosttheamountalreadypaidfor thepremium,98pips,whichisonlyabout30percentof thelossIwouldhavehadtoassumeonanormalspotforextrade.

Like a long call, a longput is a verygoodand easyway to limit the risks to a fixedminimumwhile offering theopportunity ofmakingunlimitedprofits if themarket directionchoseniscorrect.Onthismodality,youwillbeexpectingthecurrencypairratetodecrease.ShortCall

Shorting,orwritingacalloption,canbeusedwhenyouarebearishonbothmarketdirectionandmarketvolatility.Ashortcalloptionisalsoreferredtoasanakedcall.It’sapositionthatcarries a lot of risk, as its loss potential is unlimited should the market go against thedirectionchosen.

Figure3.3showsashortcalloptionontheGBP/USD.Withthisoption,Iwasexpectingthepricetokeepfallingbelowthestrikeprice,alsoOTMatthemomentforwhichtheoptionwassold.Thistimethebreakevenlevelwasplacedabovethestrikeprice,asIreceivedtheamountofthepremiumsetforthisoptionat150pips;thuspricecouldgoagainstmydirectionuntil1.5630.MyaimwastotakepossessionofaGBP/USDshortpositionatthemomentofexpiry,withtheopenpriceat1.5480.

Figure3.3ShortcallGBP/USD

However,hereagainthemarketdecidedtorallyfurtherandendedat1.6192,leavingmewithaGBP/USDposition712pipsintothenegativeagainstthelocked-openprice(1.5480),whichturnsouttobea562-piplossafterdeductingthepremiumof150pipsIhadalreadygained with the transaction. You can easily see how the risk potential becomes nearlyunlimitedwith this type of option, and it should only be taken (withmuch caution though)when the direction is clearly confirmed, or it should be employed along with otherinstruments inaspecificstrategy,as Iwilldiscuss lateron inChapter24on forexoptionsstrategies.ShortPut

Whenwe expect themarket to be bullish but its volatility to decrease, a short put optioncouldbeattempted.Similartoashortcalloption,thistypeofoptionisalsoreferredtoasanakedput.

Figure 3.4 offers an example of a short put. As you can see from the figure, thebreakevenpricelevelisbelowthestrikeprice,astherisksaretothedownside.Witha115-pip premium received, this is the amount youwill have to deduct from the strike price tocalculatethelevel.

Figure3.4ShortputEUR/USD

When theoptionexpired, itwasautomaticallyexercised, and Igot a longpositiononEUR/USDfromthestrikepriceat1.4104,whichwas413pipspositive,plusIgottokeepthe115-pippremium.Althoughtheonlyprofitmadeontheoptionwasthepremium,Iwasnowwell positionedon themarket and could sell theEUR/USDpositionback to bank the 413pipsprofited,astheoptionexpiredITM.

Sellingputsalsocarriesanunlimitedlosspotential;however,itallowsyoutobuytheunderlyingatacheaperprice.

Finally,Table3.1providesashortsummaryforaquickvisualreference.

Table3.1

OPTIONSSTYLES

Themost commonly traded forexoptionsbelong to eitherof the followingbasic styles forplainvanillaoptions:EuropeanstyleorAmericanstyle.

European-styleoptionscannotbeexercisedbeforetheirexpirydate;however,youcansellthembackintheoptionsmarketatanytimeinbetween.

American-styleoptionsdifferfromEuropeaninthatitispossibleforthebuyertotakepossessionof theunderlyingassetprior to theexpirationdate.Theyalsocanbenegotiatedbackinthemarket.

Inanyoftheabove,thebuyeracquireseitherarighttobuyorsellaspecificnumberofcontractsontheunderlyingassetatagivenpriceanddate(longcallorput)ortheobligationtosellorbuytheunderlyingatitsstrikepriceatafuturedate(shortcallorput).

A thirdstyle isexotics,which includeSPOTandbinaryoptionsaswellasother lesscommonsubstyles.Anexoticoptionisanytypeofoptionthatdiffersfromthestandardcallsandputsthatcanbefoundonmajorexchanges.

Vanilla forex options have a very specific structure of their expiration and payouts.Exotic forex options contracts can bemuchmore flexible than vanillas and have variableoutcomes.

Traditional options (American options) have an advantage in that their premiums areusually lower than those of SPOTs and they grant you greater flexibility, as they can benegotiatedbackbeforetheirexpirationdate.SPOToptionsareeasiertosetupandexecute.

SPOT,BINARY,ANDDIGITALOPTIONS

Thesameasforotheroptionstransactions,youwillhavetopayaquotedsum,thepremium,which, in return, gives you an optional right. If you win the option, you will receive thepremiumpaidplusagivenpercentageofthisamount,calledthereturnorpayout,whichhasbeenstatedupfrontatthemomentofbuyingtheoption.Onsomebinaryoptions,ifyoulose,youwill receivea smallpercentageof thepremiumasa consolationpayout.Therearenoadditionalcommissionsorfees.

Unlikevanillacallsandputs,theamountofthepayoutdoesnotincreasewithariseinthe underlying asset or a fall below the strike price; instead it is a fixed sum thatwill beearnedatagivenpoint.

Thesestylesofferthetradersaneasierwayoftrading.Youchooseaparticularscenarioforacurrencypairanddonotneedtomonitoranythingelseuntilitplaysout.Ifyouareright,youreceivethepayout.Ifyouarewrong,youonlylosethepremiumpaid.Someofthealternativestochooseinclude:

•One-touchSPOT.Youreceiveapayoutifthepricetouchesacertainlevel.•No-touchSPOT.Youreceiveapayoutifthepricedoesn’ttouchacertainlevel.•DigitalSPOT.Youreceiveapayoutifthepriceisaboveorbelowacertainlevel.•Doubleone-touchSPOT.Youreceiveapayoutifthepricetouchesoneoftwosetlevels.•Doubleno-touchSPOT.Youreceiveapayoutifthepricedoesn’ttouchanyofthetwoset

levels.

For example, you are bullish on theEUR/USDand think the pairwill break1.4200 in 10

days.IfonthatdatethepriceoftheEUR/USDistradingatorabove1.4200,youwillcollectthepayoutincashinyouraccount.Butifthepriceisstillbelowthatlevel,yougetnothing.

What are some disadvantages of these options? For one, the cost of the premium isusuallyhigher thanonstandardvanillaoptions.Alsoyoucannotchangeyourmindandsellbacktheoptionbeforeitsexpirydate.Anotherissueistherisk-to-rewardratio,whichcan’tbe calculated as it would be on a normal forex trade, because on this kind of option therewardwillalwaysbeinferiortotherisk.Thusyouneedtoberightmuchmoreoftentoendupwith a net profitable scene, as losing tradeswill cost youmore than you canmake onwinningtrades.

OPTIONVALUEANDPRICING

The value of an option is established bymeans ofmathematicalmodels,which have beendevelopedbyquantitativeanalysts.Theobjectiveoftheseformulasistopredictthechangesinanoptionvalueinregardtothechangesintheconditionsandelementsthatformit.Thevariablesthatwillbepresentinaforexoptionvaluecalculationare:

•Thepriceoftheunderlyingasset(thespotforexrateofthecurrencypair)•Thelocalcurrencyinterestrate•Theforeigncurrencyinterestrate,ordividendyield•Thestrikeprice(whichistherateatwhichthecurrencywillbeexchangedattheexpiry)•Theexpirationdateoftheoption•Thevolatilityexpectedforthecurrencypairratethroughouttheactivelifeoftheoption

The most common mathematical model used in forex options, and especially for theEuropean style, is theBlack-Scholes-Mertonmodel. Thismodel uses five basic variablesbearingnamesmostlyfromtheGreekalphabet(frequently,asagroupthevariablesarealsoreferredtoas“theGreeks”):

•Delta.Measuresthechangesoftheoptionvalueinregardtotheunderlyingasset•Gamma.Isaderivativeofdelta•Theta.Showshowfasttheoptionlosesvalueinregardtotime•Vega(notaGreeklettereventhoughitmaysoundlikeone).Measurestheeffectsofchanges

inthevolatilityoftheunderlyingandthewaytheyaffecttheoptionvalue•Rho.Measuresthechangesandeffectsthatstemfromvariationsintheinterestrates

Thanks to thesecalculations,wecangaugehowthevalueofanoptionwillchangeas timegetsclosertotheexpirationdate,orwecanstudythepossibleimpactofavolatilityincreaseofthecurrencypairrates.Thishelpsinevaluatingandquantifyingalltherisksimpliedintheownershipofanoption,thusallowingmorepreciseriskmanagement.

Therefore,wehaveaseriesoffactorsthattogetherdeterminethepriceorpremiumofaforexoption.

IntrinsicValue

Thisistheexercisevalueoftheoptionatthatmoment.Therearethreepossibledescriptionsforthisvalue:ITM,OTM,andATM(at-the-money).

•ITM.Thestrikepriceislowerthanthecurrentmarketpriceoftheunderlyingassetforcalloptionsorhigherinthecaseofputoptions.

•OTM.Thestrikepriceishigherthanthecurrentmarketpriceofthecurrencypairforcalloptionsorlowerinthecaseofputoptions.

•ATM.Thestrikepriceisexactlyatthecurrentmarketprice.

Thechangesthatoccurintheunderlyingassetprice(inthecaseofforexoptions,thecurrencypaironwhich theoption is taken)will increaseordecrease thevalueof theoption.Theireffectswillbeoppositeoncallsandputs.Iftherateofthecurrencypairrises,calloptionswillhaveagreatervaluewhileputswilldiminishinvalue.Whentherateoftheunderlyingisfalling,calloptionswillreducetheirvalueandputswillincrease.

TimeValue

Thisvaluerepresentstheuncertaintyofthepriceovertime.Thelongerthetimetoexpiry,thehigherthisvaluewillbe,thusincreasingthecostofthepremium.Itcanalsobeconsideredasthe price that an investor is willing to pay above the intrinsic value of an option, in theexpectationthatitsvaluewillincreaseatacertainpointbeforeitsexpirationduetopositivechangesintherateofthecurrencypairorunderlyingasset.Themoretimeavailableforthemarketconditionstoevolveinthebenefitanddirectiontakenbytheinvestor,thehigherthetimevaluewillbe.

Thetimeleftuntilexpirationwillaffectthetime-valueelementofthepremium.Aswecome closer to the expiration dates, both calls and puts will see their value decreaseproportionally,evenifbeingITM.

DifferentialinInterestRates

Changes in the currency’s interest rates will modify the relationship between the actualmarketrateofacurrencypairandthestrikepriceoftheoption.Theeffectsofthechangesontheoptionpremiumaresmallandsecondary,but theycanbemeasuredandwill reflect thecostsordividendsfromrollover.

Volatility

Volatilityisquitesubjectiveandthusdifficulttoquantify;however,itbearsaverysignificantimpact on the time value of the option premium. A greater volatility will increase thepossibilityof reaching the strikeprice in less time, thus increasing thevalueof theoptionpremium.

Volatilitymeasuresthepotentialvariabilityofthepriceoftheunderlyingasset.Ifgreaterfluctuationsofpricesareexpected,thepremiumvaluesforbothcallsandputswillincrease.

Bothinterestratedifferentialsandvolatilityarefactoredintothetimevalue.

OPTIONSVOLATILITY

Volatility isoneof theelements taken intoaccount in the timevalueofa forexoption.Theimpactofthechangesthatoccurinthisfactorcanbegoodorbaddependingonthestrategiesthatyouplantoimplement.Boththegeneralmarketdirectionandthevolatility—bullishnessorbearishness—are tobeconsidered inmostof thebasicvanillaoptionsstrategies,whicharedescribedindetailinChapter24.

Inadditiontotheimpliedvolatility(IV),whichisequivalenttovega,thehistoricalorstatistical volatility of an underlying asset has to be taken into account if we want todetermineifthepriceoftheoption’spremiumisaboveorbelowitsfairvalue.Thiscanbeveryusefulindecidingifthebeststrategyistobuyaparticularoptionorsellit.

A lower volatility implies lower premiums, but also lower margins are required onwrittenoptions.Whenyoudecidetoshortanoption,yourbrokerwillallocateaportionofyouraccountastheinitialmargintoguaranteeagainstamoveofthemarketintheoppositedirection.Marginswill alsovary according to the levelsof IVof the currencypair as theoptionunderlying.

Itcanhelp topredict thepriceseitherwhen theyreach toofar, looking thenfora turnback to themean, orwhen they exhibit extremevalueswithout any event to back up thesevalues. Most of the time, this can happen when future events are already priced into thevolatilityvalues,andsoitcanbeasignaltoexpectsignificantmovestooccur.

OPTIONSGREEKS

TheGreeksareaseriesofcalculationsusedtomeasurerisksandserveasguidelinesfortheevaluationofprofitandlosspotentialindiverseoptionsstrategies.Knowinghowtointerpretthosevaluesiscrucialinordertohavethemostaccurateideapossibleabouttheprofitabilityofaparticularsystemanditsunderlyinginstrument.

Threebasic elementsmustbe to taken into account to interpret those risk and rewardcapabilities:priceaction,volatilityfluctuations,andthecorrelationofvalueandtime,whichwilltendtodecline.

ThemostusedGreeksinforexoptionsaredelta,gamma,theta,andvega.

Delta

This is aGreekvalue that is derived fromanoptions pricingmodel, and it represents theequivalenceof theunderlying asset (in this casewith forexoptions, the currencypair); itsvaluecanbedifferentforthebidandaskpriceseveninanoptionwiththesamestrikepriceand expiry date. Delta is representedwith a positive percentage on calls (ranging from avalueofzerowhenanoptionistotallyOTMtoavalueof100whenitisfullyITM)andwithanegativepercentageonputs(rangingfromvalue0forOTMoptionstovalue–100).

AcallforexoptionwillbeITMwhenitsstrikepriceislowerthanthecurrentpriceofthe underlying currency pair plus the premium paid. A put forex option will require thecurrentpricetobetradingbelowthestrikepriceandminusthepremiumpaid.

A long call option onEUR/USDwith a strike price at 1.3900 and a premiumof 100

pointswillstartbeingITMwhenthemarketratefortheEUR/USDsurpasses1.4000.AlongputoptiononAUD/USDwithstrikepriceat1.0900andapremiumof140points

willstartbeingITMwhenthemarketrateforthecurrencypairfallsbelow1.0760.

Gamma

ThisGreekvalueisalsorepresentedasapercentage,anditisalsoderivedfromanoptionspricing model. It is used to calculate how many delta points the option will increase ordecreaseforeachpipgainedorlostontherateofthecurrencypair.Itmeasurestherateofchangeofdeltainrespecttothevalueoftheunderlyingasset.WhentheoptionsaredeeplyITMorOTM, itsvaluewillbe small. Itsgreatervalueshowswhenanoption isnear-the-moneyorATM.

Theta

Thisvalueisexpressedinpointsperday,anditscalculationdependsonthetimeleftuntiltheexpirydate.The closer anoption is to its expiration (where all options lose thewholeoftheir premiumvalue), the faster this valuewill increase. It showshowmuchof theoptionvaluewillbelostafteroneday’stime.

Vega

AnotheroftheGreekvalues,vegaindicatestheexpectedamountanoptioncangainorloseinvalue,dependingona1-pointincreaseoftheIV.

ItisbettertobuyoptionswhentheIVislowbecauseyouwillbepayingasmallertimepremium; and when there is a rise in the volatility later on, the price of the option willincrease.Forthesamereasons,sellingorwritingoptionsshouldbeperformedwhentheIVishigh,asyouwillbereceivingabiggerpremium;andadecreaseinvolatilitythereafterwillreducethepriceoftheoption.

Embedded in the structureof anyoptions trading strategyaredelta-,vega-, and theta-associatedpositions,aswellasthoseofotherminorGreeks.Ineitherstandardorcombinedoptionstransactions,thenetvalueofthepositionscanbecalculated,which,inturn,willgiveusanevaluationoftheamountofpotentialrisksandrewardsofthatparticularstrategy.

Forexample,ifyoubuyaforexoption(longcallorput),therisksyouincurwilldependonthepricemovinginthewrongdirection,adecreaseintheIV,andatime-basedreductionof the intrinsicvalueof theoption.Shouldyoube a seller (short call orput), youwill beincurringriskifthepricemovesintheoppositedirectionortheimpliedvolatilityincreases,butthetime-valuedecreasewillnotbeadeterminant.

FOREXOPTIONSQUOTESCREEN

Atypicalforexoptionsquotescreen(seeFigure3.5)willshowanarrayofavailablecallandput options with different bid and ask strike prices and expiration dates, as well as theunderlying current rates. It should include, at the least, some extra information, such as

volatilityanddelta,toallowyoutochoosethebestalternativeforyourstrategy.InFigure3.5,wealsocanseewhatthebreakevenrateisforanygivenoption.Thiswill

greatlydifferfrombrokertobroker.Inthecaseofcurrencyfuturesoptions,youshouldfindadditional useful information including volume, open interest, and other Greeks such asgamma, vega, and theta values; there should also be alternatives to customize your datadisplay,aswellasa seriesofdifferentexchanges fromwhichyoucanchoose to trade theoption.Here is a short summaryof themain elements that canbepresentonyour forexoptions

screen:

•Symbol. The underlying currency pair or futures symbol (for example,EUR/USD for thespot forex EUR/USD currency pair or 6E plus the option-specific letters for Euro Fxfutures).Thescreenshouldalsoshowtheactualmarketrateandcanincludesuchdetailsasthehigh,low,open,andcloserates;percentageofchange;averageprice;timeandfeedprovider;etc.

•Bidandaskprices.Thelatestpricesofferedtobuyorselltheoptionwithamarketorder.Bothwillconstantlyvaryalongwith theunderlyingratesand theirownproximity to theexpirydates.Itisveryimportanttoconsiderthewidthofthespreadbetweenthebidandaskprices toevaluate therisks,especially ifyouwillbe tradingshort term.Usually themost activeoptions exhibit a tighter spread.Theseare also called intrinsicbid andaskprices.

•Extrinsicbidandaskinpoints.Thetimepremiumbuiltintotheoptionpriceatthemomentofthetransaction,whichdecreasesintimeuntilthereisnoneleftatexpiration.

Figure3.5Abasicforexoptionsscreen

•Strikeprice.Thepriceatwhichtheunderlyingcurrencypairwillbesoldorboughtifthetrader decides to exercise the option.Onwritten (short) options, itwill be the price atwhichthetraderwillhavetosellthecurrencypairiftheoptionisexercisedatexpiry.Call options will have a higher premium when the strike price is lower, while putoptionswillcostmorewhenthestrikepriceishigher.Oncalls,thepriceoftheoptiondecreasesateachriseinlevel.ThestrikepriceissuccessivelylessITMormoreOTM,

andsoitsintrinsicvaluebecomessmaller.Theinversesituationoccurswithputs,whichgo from less OTM toward more ITM with every rise of the strike price, and theirintrinsicvaluethusgetsbigger.

•IVpercentageonbidandask.Theexpectedleveloffuturevolatility,whichisbasedontheactualpriceoftheoptionandincludesseveralothervariablesconcerninghowmuchtimeremainsuntilitexpiresplusthedifferencebetweenthestrikepriceandthecurrentpriceofthe underlying currency pair. IV is usually calculated with the Black-Scholes pricingmodel.

•Deltapercentageonbidandask.Thevaluethatrepresentstheequivalenceoftheoptioninregardtotheunderlyingcurrencypair.Itwillbereachingtoward100forcallsand–100for puts themore the option is ITM.Thatwould be themaximum equivalence, and theoptionpricewouldthenmoveatthesamepaceasthecurrencypairrate(pointforpoint).Anoptionwithadeltavalueof50wouldbemovinghalfapointwhenthecurrencypairmoves1pip.Deltavaluesarepositiveforcallsandnegativeforputs.Asforthepremium,theywillbehigheroncalloptionsat a lower strikepriceandonputoptionsat ahigher strikeprice.

•Gammapercentageonbidandask.Relatedtothedeltavalue,apercentagethatshowshowmany delta points the option will increase or decrease if the underlying currency pairmoves1point.

•Vegaforbidandask.TheGreekvaluethatindicateshowmuchthepriceisexpectedtoriseorfallinregardtoa1-pointincreaseofIV.Itisbettertobuyoptionswhenthisvalueislow.

•Thetaforbidandask.TheGreekvaluethatindicateshowmuchoftheoptionvalueisgoingtobelostperdayuntilitreacheszeroatexpiry.

•Volume.Thenumberof transactions thathavebeenperformedon thatparticularoption inthetradingsession.Optionsthatshowlargevolumesusuallywillhavetighterspreads,asthereismuchcompetitiongoingontoacquirecallsorputsonthem.

•Open interest. The values that show how many contracts (pending options orders) areopenedbutnotyetinthemarketforanygivenoption.

CHAPTER4CONTRACTSFORDIFFERENCE101

Contractsfordifference,orCFDs,havebeenusedformore than20years,but theydidnotbecomepopularwithretailtradersuntilthelastdecade.Essentially,aCFDisaderivative—itsvalue isbasedon theperformanceofanunderlyingfinancial instrument,suchasstocks,mutualfunds,bonds,commodities,currencies,andmarketindexes—usedtospeculateonthefuturevalueofanassetbytakingeitheralongorshortposition.

The investor, or “buyer,” and CFD provider, or “seller,” agree to pay the differencebetween the current asset price and its valueon the contract date.For a longposition, thesellerwouldpaythedifferencetothebuyeriftheassetpricerises,andthebuyerpaysiftheassetpricegoesdown.Forshortpositions,thoseresultsarereversed.

THEHISTORYOFCFDs

LondontraderscreatedthefirstCFDsasawaytohedgeriskwhentradingequitieswithoutpayingaU.K.taxappliedtostocktransactions.TheCFDservedasanequityderivativethatenabled investors tospeculateonstockmovements,upordown,withoutowning theactualshares.CFDsexplodedinpopularitywhenbrokeragehousesallowedthemtobe tradedonmargin and packaged them with electronic trading platforms that provided investors withreal-time price information and enabled live trades.Using the leverage ofmargin trading,investorshadthepotentialforhigherreturns(andlosses),sincetheyonlyputdownasmallpercentageoftheunderlyingasset’sactualvalue.

Brokerage houses jumped into the market with CFD products. Initially limited toequities on the London Stock Exchange, their offerings soon expanded to include thecommodity,bond,andcurrencymarkets.ThemostpopularCFDproductsarethosebasedonthemajorworldwideindexes,suchastheCACinFrance,theDAXinGermany,theFTSEinGreatBritain,theDowJones,andtheNASDAQmarkets.

TheU.S.SecuritiesandExchangeCommissiondoesnotallowtradinginCFDsunderitsregulationoftheOTCmarket.Thederivativesaretradedinmanyothercountries,includingAustralia, Canada,Germany, France, Ireland, Italy, Japan,NewZealand,Norway, Poland,Portugal,Singapore,SouthAfrica,Spain,Sweden,andSwitzerland.

CFDTRADING

TradingofCFDsoccursbetweenindividual investorsandCFDproviders—typically, largebrokerage houses. Contract terms for CFDs are not standardized among the differentproviders.EachprovidercandictateitsowntermsorchangethosetermsforanyparticularCFD.However,almostallCFDcontractscontainanumberofcommonelements.

TheCFDcontractisinitiatedbytheinvestortakingapositioninaparticularfinancial

instrumentthroughanopeningtrade.Thepositionisonlyclosedwhenthetradeisreversedwithasecondtransaction—thecontracthasnoexpirydate.Atclosing, theprofitor loss isdetermined by the price differential between the opening and closing trade. The CFDprovidermayassessseveralfeesorchargesonthetradeoropenposition,includingaccountmanagementfees,bid/offerspread,commissions,andovernightfinancing.

BecausetheCFDneverexpires,ifapositionisleftopenovernight,itisrolledoverandtheprofitorlossiscredited(ordebited)totheinvestor’saccountafteranyfinancechargesare deducted. Most markets allow CFDs to be traded on margin. As with other margintrading,theinvestormustmaintainaqualifyingaccountbalance.

ModernbrokeragetechnologyconstantlycalculatestherequiredmargininrealtimeandprovidesaWebinterfaceforthetradertoviewhisorheraccountbalance,marginbalance,and trading profits and losses.Of course, if the trader’s account balance drops below theminimumlevelrequired,heorshecanbesubjecttoamargincall.Iftheaccountbalanceisnot quickly increased to the new minimum level, the brokerage house can liquidate theposition.

CFDCOSTS

MostCFDproviderschargeadailyfinancingfeeforlongpositionsleftopenovernight.Thefeeistypicallybasedonanestablishedbenchmark,suchastheLIBORintheUnitedKingdomor theReserveBank rate inAustralia. If the investor takesa shortposition,heor shemayreceiveadailyfeeinlieuofdeferringtransactionproceeds,sothattheCFDisstillsettledupon the closing trade for the cashdifferencewith theopening trade.ACFD that controlsequity shares is also usually charged a commission based on the size of the position. Thetrader does have the optionwithmostCFDproviders to forgo commissions in favor of alargermarketmaker(MM)bid/offerontheequities.

THEUSEOFMARGINTOINVESTINCFDs

A CFD trade provides two types of margin: initial and variation. The initial marginrequirementcantypicallyrangebetween3and30percentforequitiesandbetween0.5and1percent for other instruments, including commodities, currencies, andmarket indexes. Theratedependson thequalityof the financial instrument’scontractedandperceived risk.Forexample,followingthecollapseoftheU.S.brokeragehouseLehmanBrothersin2008,initialmargins rose precipitously across all markets in response to the volatility the collapsecaused.

Variation margin is required if the CFD position moves against the investor. Forexample,ifthetraderbought1,000sharesofastockat$1pershareandthepriceloweredto90 cents, the CFD provider would deduct $100 in variation margin (1,000 shares × –10cents)fromtheclient’saccount.Thesecalculationsareallmarkedtomarketinrealtime.Theeffect of variationmargin on the trader’s account balance is ongoing and occurs instantly;however, initial margin is deducted from a customer’s account at the time the contract ispurchasedandthenisrecoupedatsettlementwhenthetradeisclosed.

Many investors thinkof initialmargin as a deposit toward theCFD’spurchaseprice.Themarginpercentagedependsonthebroker’spoliciesandthetrader’srelationshipwiththebroker.Margincanalsobelowforthemostpopularlytradedstocksandhighforstocksthatarelessliquid.

CFDsANDSTOP-LOSSORDERS

Like other trades, CFDs can be controlled with a stop-loss order that triggers a closingtransactioniftheunderlyingsecurity’spricereachesapredeterminedlevel.Oncetriggered,the sell order is executed according to the CFD provider’s business terms and withconsiderationformarketliquidity.Ifmarketliquidityisinsufficient,thestop-losssellordermaynotbeexecuted,andtheinvestor’spositionwillremainunchanged.

Beawarethatthestop-lossorderisonlyatargetprice—themarketactuallyhastotradeatthatpricetotriggerthestoploss.Ifthepricemovespastthestop-lossorderpriceinonestep, theordermaybeexecutedat thenextprice traded,or itcannotbe traded if that’s theCFDprovider’spolicy.That scenariodoesnotoftenhappenwithhighly liquid instrumentssuchasmarketindexesandcurrenciesbutcanbeaproblemwiththinlytradedequities.Ifthestockmarketisclosed,itcanalsobeproblematicbecausethepricedifferencebetweenoneday’sclosingpriceandthenextday’sopeningpricecanbesignificant.

Tomitigate that risk,manyCFDprovidersofferaguaranteedstop-lossorder (GSLO)that ensures that a stop-loss order is executed if triggered.The trader pays a premium forGSLO,andthereareusuallyotherrestrictions.Forexample,mostprovidersdonotallowtheGSLOtobemorethan5percentbelowthecurrentpriceofthesecurity.

CFDsaretypicallyboughtOTCthroughabrokerageorthroughanMM,andthatchoicewillaffectthepriceofthecontract.TheCFDproviderdictatesthetermsoftheCFDcontract,specifiesitsmarginrequirements,andliststhefinancialinstrumentsavailablefortrade.MMsare the most popular source of CFDs. TheMM provider sets the price for the CFD andacceptstheriskofallpayouts.MostMMshedgetheirpositions,eitherbybuyingorsellingtheunderlyingsecurity,byusingportfoliohedges,orbyconsolidatingtheirclients’positionsandthenoffsettingtheirlongandshortpositions.

ACTS BY THE CORPORATION ON EQUITY-BASEDCFDs

Corporate acts, suchas thepaymentofdividends, stock splits, and rights issues, affect thecorporation’s share prices and, therefore, the price of a CFD for those shares. However,becausetheholderofaCFDpositiondoesnotactuallyowntheunderlyingshares,heorshewouldnotreceivethosedividends,splitshares,orrightsissued.Instead,theCFDproviderpaysanequivalentsumtotheholdersofalongCFDpositionanddeductsthatsumfromshortpositions.Ingeneral,anycorporateactthathasaneconomiceffectontheunderlyingsecurityisappliedtotheCFD;however,theholderofaCFDneverreceivesnoneconomicbenefits,suchasvotingrights.

CFDRISKS

TradinginCFDscomeswithanumberofrisks,includingcharges,fees,andlossofprincipal.ThefollowingisasummaryoftheprimaryriskstradersinCFDsface.

MarketRisk

The obvious risk is that the market will move in the opposite direction of the investor’scontract.ThesamemarketriskthattradersofanysecurityfaceincreaseswithCFDsbecausetheyaretradedonmargin.Marginleverageincreasespotentialgainsandlosses.However,itis that risk/benefit thatmotivatesmostCFD traders, as away to either increase profits orhedgepositionstominimizelossesonothertrades.Marketriskcanbemitigatedwiththeuseofstop-lossorders.

LiquidationRisk

CFDproviders require investors tomaintainminimumvariationmargin,and if thepriceoftheunderlyingassetmovesagainst the trader’sposition,additionalmargincanberequired.InvestorsthatcannotprovidethatmarginquicklyriskhavingtheproviderliquidatetheirCFDcontractatalosstothem.Theinvestoristhenliableforpayingthatloss.

CounterpartyRisk

CFDcounterpartyriskisthepotentialforfinancialinstabilityorinsolvencyonthepartofacounterpartytotheCFDcontract.Ifthecounterpartycannotmeetitsfinancialcommitment,theCFD will have little or no value regardless of the paper value of the transaction.Counterparty risk exists in many derivatives traded OTC. Counterparty risk can result inseverelossestotheCFDinvestoreveniftheunderlyingsecurity’spricemovesinthetrader’spredicteddirection.ProvidersofOTCCFDsarerequiredbymarketrulestoseparateclientfunds from their own accounts in order to protect clients in case the company becomesinsolvent.

CFD RISK COMPARED WITH THAT OF OTHERINVESTMENTOPTIONS

CFDproviderspromotethecontractsasanalternativetootherinvestmentproducts,suchasdirect investments in equity shares and other derivatives including futures, options, andcoveredwarrants.BecauseCFDsaretradedoutsideoftheexchanges,nofirmstatisticsareavailableontheiruse;however,itisestimated,forexample,thatCFDsaccountforbetween20 and 40 percent of the volume of the London Stock Exchange.Among those alternativeinvestments,CFDsaremostcloselyassociatedwithfuturesandoptions.

Futures

For most professional traders, futures are the preferred investment vehicle for trading inindexesandinterestratesbecausetheyaretradedontheexchanges.Ontheotherhand,CFDshaveadvantagesoverfuturesinthatthecontractcanbesmallerinsizeanditspricingmoretransparent because it mirrors the underlying financial instrument. The price of futurescontractstendstodecayastheyreachtheirexpirydate.

Interestingly,CFDprovidersoftenusefuturestohedgetheiropenpositions.Toprotectagainstpricedecay,traderstypicallyrollovertheirCFDpositionsintothenextfutureperiodasliquidityforthefuturesoptiondriesupinthelastdaysbeforeitsexpiry.

Options

Professionalsalsolikeoptionsbecause,likefutures,theyareexchange-tradedandcentrallycleared. Options can also be used by traders to hedge risk or speculate on markets. TheprimaryadvantagethatCFDshaveoveroptionsisthesimplicityoftheirpricingstructureanddiversityoffinancialinstrumentsthatcanbecontrolledthroughtheCFD.Likethepricingoffutures, the pricing of options is complex and decays as the option nears its expiry date.However,CFDsarenotsuitableforuseinriskreduction,asoptionsare.

CoveredWarrants

Like trading inoptions, trading in coveredwarrantshas increased inpopularity in the lastdecade as an inexpensive strategy for speculatingmarketmovements; albeit CFDs offer awider range of investment asset options. Comparedwith those of coveredwarrants, CFDcostsareusuallylower.

Exchange-TradedFunds

Aswith CFDs, exchange-traded funds are popular vehicles formaking short-term bets onmarketmovements and can be bought for awide range of financial instruments, includingcommodities,indexes,andsharesonforeignmarkets.

CFDTRADINGSTRATEGIES

The twomostpopularCFD tradingstrategiesare thosebasedon technicalanalysisandonfinancialnews.CFDscanbeusedasapuremarketdirectionbet,althoughinvestorslookingtomakesuchabetaretypicallyemployingamoreadvancedstrategy.

Applying technical analysis and observing market indicators improve the investor’sprobability of correctly calling the market direction. Combined with the availability ofleveraged CFD trading through margin, an investor can earn impressive gains. Technicalanalysis is critical for the short-term trader, who should consider when key support andresistance levels are broken and should also take into account other indicators, such asmomentindicators,movingaverages,andtrendlines.

Financial news can also predict market direction. Earnings reports, insider tradingreports, mergers and acquisitions, and executive turnover are all news events that could

foreshadowchangesinthevalueofassociatedfinancialinstruments.Ofcourse,earlyaccesstothenewsisimportant.Themarketreactsquickly,andifyoudon’thearnewsuntilhoursordayslater,thechancesarethatthevaluationshavealreadychanged.

Still, even if one correctly assesses each indicator, tradingCFDs is not risk-free.Notrading strategy works all the time, and so investors need to plan their CFD positionscarefullytomaximizetheirchancesofsuccess.Predictingshort-termpricefluctuationscanbehugelyprofitable,butinvestorsneedtokeepinmindthatvaluationsreacttomanyinfluences.Systematic trading can override market indicators, and any stock can be affected byunexpectednews.Othervariables thatcanaffectmarkets includeagricultural reports, forexrates,inventorydata,unemploymentfigures,andweatherforecasts.

Investorsshouldestablisha tradingplan thatdeterminesentryandexitpoints,ensuresriskmitigation,andappliessoundmoneymanagementprinciplestomaximizetradingsuccess.Consider a trial period using the various trading systems available to identify the one thatworksbestforyourtradingstyle.

CHARACTERISTICSOFASUCCESSFULCFDTRADINGSYSTEM

Therearemanytradingsystemsthathavebeendevisedandpromoted.Someare inflexible;othersallowforsomesubjectivitybythetrader.Whicheversystemyouchooseordesignforyourowntrading,itshouldhaveseveralcharacteristicstoensuresuccess.Thesystemshouldidentify potential investments that offer a positive reward-to-risk ratio. It should have amethodologyfordeterminingagoodentrypointintotheinvestmentandsafeguardsthattriggeran exit—whether for taking profits or cutting losses. Finally, it should make a rationaldecisionregardingthesizeofthepositionsothatyoucanbenefitifitmovesinyourdirection,yetnotlosesignificantlyifitdoesn’t.

ThosecharacteristicsareevenmoreimportantwhentradinginaleveragedCFD.Yoursystem should identify an entry signal that strongly suggests the position will becomeprofitable immediately. It should determine where your stop loss should be set, whetherbased on a predetermined value or percentage or on the support level of key marketindicators.Andthetrade’spotentialrewardshouldbeindicated,anditshouldbeatleasttwotothreetimesthepotentiallossfortheriskstobejustified.Finally,yoursystemmustensurean exit is made while the trade is profitable and not allow the price to swing back intonegativeterritorybeforeyouclosethetrade.

WHENSHOULDYOUINVESTINCFDs?

The flashybrochuresofferedbyCFDproviders list thebenefits theyclaimyou receivebyinvestinginCFDs.Obviously,theprovidershaveavestedinterestinconvincingyoutotrade,butwhenshouldyoureallyinvest?

The first thing potential CFD traders must determine is whether CFDs are even anappropriateinvestmentvehicleforportfolios.Bytheirnature,CFDsaredesignedforshort-

termtrades,andtheinvestormustcomparethecostsofspeculatingthroughtheCFDversustradingtheunderlyingassetdirectly.

In theUnitedKingdom,whereCFDsoriginated, the cost of direct trades includes thestamptaxthatCFDsweredesignedtoavoid.Thetradermustcalculatethesavingsgainedbynotpaying thestampdutyandcompare thosewith theadditional financecostsof theCFD.Settingasideanycommissioncostsforthemoment,calculatingthebreakevenpointbetweenthetwoinvestingoptionsiseasy.

The funding cost incurred by a CFD comprises the additional cost of taking a CFDpositioncomparedwiththatofmakingatraditionaldirectstockpurchase.Atypicalfundingchargeisabout3percentappliedtothe80percentofthepositionthatismargin-financedbytheCFDprovider.Comparatively,atraditionalstocktradecanincuranimmediatestampduty—in theUnitedKingdom, that fee is0.5percent.Thebreakevenpointwilloccurwhen theCFD’sfundingcostsexceedthesavingsitprovidesonthestamptax.

IntheU.K.example,theCFDfundingcostsmatchthe0.5percenttaxonthetransactionvalue in about 11weeks [(0.5/0.8) × (365/3) = 76 days]. Thus, if you expect to hold thepositionforlessthan11weeks,usingtheCFDtospeculateontheasset incurslowercoststhantradingthestocksdirectly.

Obviously, this is a simplistic calculation, and other ancillary costs are incurred;however, it is useful as a general comparison. And for the shortest-term trades and daytrades, which have zero financing costs, the argument for CFDs is overwhelming. Theeconomyof theCFD trade increases as the position is tradedmore than youmay initiallyhaveanticipatedorasyourexitpriceisreachedmorequickly,asthestamptax’sdilutionofnetreturnsisavoidedandfinancingcostsarelowerthanexpected.

THEADVANTAGESOFCFDs

While the decision to trade CFDs should consider many factors carefully, in general, thefollowingcharacteristicsofCFDtradingprovideanadvantagetotraders:

•Liquidity.TheCFDpricedirectlymirrorstheunderlyingmarketforthatasset,whichmeansyoubenefitfromthemarket’sliquidityandthatoftheCFDprovider.

•Margintrades.MostprovidersofferCFDsonmarginsothatinvestorsneedonlydepositasmall percentage of the trade value to control the entire asset value. Margin leverageenhancestheinvestors’potentialreturn.Foralowercostpertrade,marginallowsyoutogain10timesthepotentialreturn(ormore)versusadirecttrade.

•Tax-efficient trades. CFDs deliver tax benefits because their investment costs, such asinterestpayments,areusuallytaxdeductible.Also,ratherthanlockinginataxablecapitalgain through a direct share position, the investor can sell the CFD tomanage how thecapitalgainisrealized.

•Lowertransactioncost.Brokercostsaretypicallymuchlowerthandirectsharepurchasethroughfull-servicebrokers.Also,insomejurisdictions,thestampdutyassessedagainstlongstockpositionsdoesnotaccruetotheCFD,sincetheinvestorneveractuallyownstheunderlyingasset.

•Transparentexecution.CFDtradesarenomoredifficultorcomplex than tradingshares.

Alltransactionsoffercompletetransparency.•Longandshorttrades.Truespeculationisenabled,asCFDtraderscanprofitfromadown

market.CFDstradeonafinancialasset’spricemovementonly—theinvestordoesnotownthe asset. Therefore, selling is as simple as buying. Prior to the introduction of CFDs,shortingasharetypicallyincurredanadditionalbrokeragefee.WithCFDs,theproviderusuallypaysinteresttotheinvestoronshortpositions.

•Ability to trademultiplemarkets fromoneaccount.ThroughCFDderivatives, investorscanspeculate inmanymarkets through thesameaccountof record.CFDprovidersofferproducts that trade in internationalmarkets, commodities, indexes, oil, preciousmetals,bonds,andmanyotherassetclasses

•After-hourtrades.Providersextendtheirhoursofoperationsothatinvestorscantradeinthe more active markets (such as the FTSE or Dow) after close of business on thoseexchanges.

•Nopredeterminedexpiry.Traderscanspeculateacrossanytimeperiod.•Flexiblecontracts.ThequantityandthevalueoftheCFDareattheinvestor’sdiscretion.

Anynumberofsharescanbetraded.•Lesscomplexvaluations.Unlikecomparableinvestments,suchasoptionsandwarrants,the

priceofCFDsisadirectreflectionoftheunderlyingmarket.•Dividends received sooner. CFDs pass the dividend to the investor on the share’s ex-

dividenddate,whichcanbeuptoamonthsoonerthanthedividend’sactualpaymentdate.Overthelongterm,thisfeatureofCFDsoffsetsfinancingcharges.

•Benefitfromcorporateacts.CFDsreflecttheunderlyingmarketand,therefore,receivethebenefits that corporate acts, such as share splits, dividend increases, and rights issues,provide.

•Accesstostop-lossorder,GSLO,andcontingentorderprotections.Investorscanexecutesophisticatedtradingsystemsbylockinginrisk.

•Ability tohedgeanexistingportfolio.CFDsareanexcellenthedging tool.Forexample,theinvestorcanhedgealongpositionusingaCFDtoshortthestock.

THEDISADVANTAGESOFCFDs

Conversely, CFDs are not for every investor, and these characteristics may represent thedisadvantagesofCFDstomanytraders.

•Lossesmagnifiedbymarginleverage.Justasmarginleveragecanexponentiallyincreaseyourtradingprofits,itmagnifiesyourlosses.

•Higherrisks. If themarketmoves in theoppositedirection,youcan losemore thanyouractualmargininvestment.Ifyouhavetomeetamargincall,otherassetsmayhavetobesold,reducingthoseprofitsorlockinginlosses.Investorsinashortpositionareexposedtohugepotentiallosses.

•Toolowcapitalrequirements.Lowmarginrequirementsencourageundisciplinedinvestorstoovertrade.

•Dailyfinancecharges.Positionsheldovernightincurafinancingchargetypicallybasedonaleadingindex(LIBOR,U.S.primerate,etc.)andappliedasapercentageoftheposition

value.Thoseinterestpaymentsaddupandincreaseforlongpositionsheldforanextendedtime to the point that they roughly equal the value offered bymargin leverage after sixmonthsinmanycases.

•Interestcharges.TheCFDtraderpaysinterestontheentirecontractvalue,asopposedtotraditional margin lending for direct share purchases that only charge on the actualinvestment.

•Collateralrequirement.CFDsaremarkedtomarket,andlossesareappliedtoyouraccountbalanceinrealtime.Thiscanresultinmargincallsforadditionaldepositstoyouraccountorliquidationoftheposition.

•Providerinflexibility.CFDprovidersdeterminethemarginlevelforeachcontract.Tradersare expected to set that level and manage their money around it.Many providers alsoreservetherighttoadjust themarginlevelofopenCFDs.Youmaybeforcedtodepositmoremoneytoavoidhavingthepositionclosedout.

•Noshareholderrights.AsaCFDowner,youdonothaveshareholderrightsbecauseyoudonotowntheunderlyingasset.

•Nobrokertransfers.Again,youdon’towntheunderlyingasset;youhavepurchasedatwo-party contract and must deal with the provider that opened the position for you. Yourpositioncannotbetransferredtoanotherproviderorbroker.

•Dividendliability.TheownerofashortCFDpositionisliableforpaymentofanydividendissuedifthepositionismaintainedpastthedividendrecorddate.In general, the disadvantages of CFDs are very apparent, understandable, and

foreseeable to evennonprofessional traders.The risks are higher, as they are for all othermargintrading,butitcanbeexpectedthatmostinvestorswillbuywitheyeswideopen.

SUMMARY

The popularity earned byCFDs in the retailmarkets since 2000 has provided liquidity toCFDprovidersthathasallowedthemarkettoexpandbeyondequitysharestooffertradersawide range of investment opportunities.CFDs have been amajor source of funding to theforex and indexmarkets.Traders executing a short-term investment strategyor longer-termhedging seeclear advantage in the riskprofileofCFDs, and individual investorswant theopportunitytospeculatewithoutpayinghighfees.

CHAPTER5SPREADBETTING

SPREADBETTING

Spreadbettingisn’texactlyrocketscience.Itisbasicallyasimpleprocess,butsimilartothewaypeopleoftenfeelaboutdrivingacar,manypeopledecidethatitisverydifficult—evenwithouttryingitout.

You can’t start spread betting without understanding the basic rules. People managemanyriskythings—it’sallaboutfollowingtherulesandpracticingyourskillsbeforeyoucanbesuccessful.

Solet’sbeginunderstandingwhatspreadbettingisallabout.Itisalwaysadvantageousto learnhow toenjoya safebetat anysportingevent.Wecanstartbyunderstandingwhatspreadbettingis.

WHATISSPREADBETTING?

Spreadbettingisacategoryofgamblingthatmightbeusedasasubstituteforregulartrading.Just as you can in regular trading, you can place spread bets onmany stocks of the samemarket.Itisalotlikebinarybetting,butitdoesn’thavefixedodds,becauseyourprofitsorlosseswilldependonpricemovements.

HOWITWORKS

Youcanenterorexitspreadbettingatanytime.Thesebetscanbeplacedatacertainstakethatisequaltothetickvalue(actually,thepointvalue)usedinregulartrading.Let’stakeanexample.IfalongspreadbetisplacedontheFTSE100stockindexusingastakeof£20,theprofitorlossofthespreadbetwouldchangeby£20foreachpointthatmovesintheFTSE100price.

Spreadbettingisactuallyspeculatingonthestockmarketwithoutbuyinganystock.Thespreadisarange—itisthedifferenceintwopricesthatareconcernedwithshares

orstocks.Outofthesetwoprices,oneisofferedbythemarketwhenyouwanttobuystock,andtheotheriswhatyougetwhenyouwanttosellit.

Aspreadbettingcompanydecidesonitsownspread,andthusthespreadofanystockdependsonthespreadbettingcompanyyouaredealingwith.

Thehighpriceisknownastheofferprice—thepricethatyougetwhenyouwanttobuystock.Thelowpriceisknownasthebidprice—thepricethatyougetwhenyouwanttosell

stock.Thisfollowsinreal-lifetradingaswell,butthereisadifference.Inspreadbetting,you

donotbuyorsellanystock—youonlygambleonthewayitwillmove.Thereal-lifemarketsdeterminetheresultofthebetdependinguponthevaluesyouplaced.

In real-life trading,youcanbet thatacertainvaluewill increaseordecrease.This isknown as taking a position. So if you think that the value of a certain stock is going toincrease,youwillassumealongpositionand“buy”thestock.

Ifyouownedstockinreal-lifetradingandyouthoughtthatitwasgoingdowninvalue,youwouldwant to sell itbeforeyou lostmoney.Thiswouldbea short sell, and itwouldmeanthatyouaregoingto“sell”thestockandbuyitlater.

If things happened in just theway you predicted, youwouldmake a profit by buyingbackthestockatalowerpricelater.

Butinspreadbetting,youcantakeashortpositionwhenthevalueofthestockisgoingtodecrease.Ifthestockvaluefallsbelowthepriceatwhichwagersstart,youwillwinthebet.Longpositionsmakeaprofitwhenstockvaluesrise.

Whatdoyouwin?Theamountdependsuponthestakeyouplaced.Wealreadysawanexampleearlier.Let’stakeanotherone.Let’ssayyouplaced£15perpoint.Youassumedalongpositionattheofferpriceof4002onthestock,andthevaluesshotupto4020.Nowyoucan“sell”(itmeanstoconcludethebet).Soyourwinningwouldbe£15×(4020?4002)=£270.

Nowlet’sconsideranothercase.Let’ssaythat thestockvaluedecreasesat theendofthebet.Inthatcase,youwouldlosemoney.Forexample,ifitfellfrom4002to3995,yourlosswouldbe£15×(4002?3995)=£105.

Thismathisprettysimple,andit’seasytofindouthowmuchyougainedorlost.

THEBEGINNINGOFSPREADBETTING

Different people have different views about when spread betting began, and a number offinancialhistoriansmapouttheoriginofspreadbettingtotheUnitedStatesandtheunfetteredbucketshopsthatflourishedintheinitialyearsofthetwentiethcentury.

But itwas in 1974whenStuartWheeler cameupwith the idea of giving investors achance to bet on theups anddowns in thegoldmarket.Thiswas the first official caseofspreadbetting,andthusitwasbornthatyear.

Wheelerhadanideatomakeanindextogiveinvestorsachancetobetongoldmarketmovementwithout actually buying any real gold. This new companywas named InvestorsGold Index,but later theBankonEngland raised anobjection to that name, and so itwaschangedtoIGIndex.

The premise for thewhole ideawas simple yet brilliant. By breaking the traditionalbarriers and opening up the surroundings, Wheeler helped a new bracket of investors toassumetheirpositionsinthemarketwithoutgoingthroughheavilyregulatedchannels.

Butthatwasthen.Sceneshavechangednow.Withalltheimprovementsthathavebeentakingplaceinthebettingarena,nowyoucanbetevenviayourmobilephone.Andsincethemarketsarealwaysopen,youcanbetatanyhour.

Plus therearemanyother typesofspreadbetting.Nowyoucanselect frombungee to

binarybets,astheindustryisforeverinnovating.Beforewemoveontodelvedeeperintothesubject,itisimportanttorealizethatwhile

spreadbettingcangiveyoumagnifiedprofits,itcanalsoresultinbiglosses.

WHATYOUNEEDTOKNOW

Thoughtsaboutbiglossescanturnintonightmares.Don’tletriskfactorsbringyoudown.Dosufficient researchonspreadbettingbeforeyoubegin thisnewand lucrative journey.Herearesomequickpointersforyou.Gothroughthem,becauseifyouwanttostartsomethinginspreadbetting,thesepointswillhelpyoualot.

1.WhereMoneyIs

Spread betting is essentially gambling and not investing. You are betting on the futuremovements of a commodity or a share price. Keep in mind that the odds of winning aremostlyinthecompany’sfavor,andthereisagreatriskofloss.

2.TaxBreak

Sincespreadbettingisgambling,whateverprofitsyoumakearefreeofanycapitalgainstax.Butthatisattractiveonlyifyouaremakingmoney.

3.AFewPracticeShots

Mostcompanieswillallowyoutogoforapracticerunbeforeyoutouchtheactualmarket.Theywillprovideyouwithanonlinesimulatorfortrading.ThebiggestplayersinthismarketareCantorIndexandIGIndex.

4.PainBarrier

Createastop-lossbarrierforyourself.Thislimitshouldbeusedtocloseyourtradeatsomelevelifpricesaremovingagainstyou.

5.TheRightTiming

There are some spreadbettorswhoclose their tradedaily, but if youwant, you can leavepositionsformuchlonger.TherewasawomanwhotooktwobetsonGooglesharesat£1and£2 for a point each and held her position for almost two months. She made a profit of£27,000.

6.TechnicalSupport

Ifyouwakeupone finemorninganddecideonbettingonsomeshares, thiswouldn’tbea

successfulstrategy.Manysuccessfulspreadbettorsusechartingtoolsthatshowhowstockshaveperformed.This isbetter thanusingyourgut feeling tobeton things.Therearemanytoolsavailablethesedaystohelpinbetting.

7.TheKatrinaEffect

Oil speculationswere going up after the occurrence ofHurricaneKatrina. Currencies arealsofamousfortrading,andforexisoneofthemostcommonareas.Infact,trendshavebeenshiftingfromstockstoforex.

8.TheGoldenTouch

Apartfromforex,peoplearealsobettingongold.Soifgoldexcitesyou,thismightbeyourspreadbettingniche.

9.RiskReduction

Manyinvestorsusespreadbettingtoprotecttheirpositions.Thegeneralriskwarningsapplyhereaswell.

For instance, let’s say someonewho has £5,000 invested in an FTSE 100 tracker isworriedaboutastockmarketfall.Thepersoncouldprotect,orhedge,thepositionbysellingitonaspreadbet.Ifthegivenindexclosesat,say,5,386,theinvestorcansellitat£1.86forapoint(£5,000/5,386).SoforeverypointtheFTSE100falls,theinvestorwillmake£1.86tocoverthelossesinthetrackerfund.

TYPESOFSPREADBETTING

Spreadbettingcanbedoneonanykindof activity. It canbe financial, sporting, social,orpolitical.Spreadbettingstartedwithfinancialcompanies,anditwaslaterfollowedbysportsbetting companies. Plus the Internet has bestowed innumerable capabilities to the spreadbettingworld,asyoucanseemanyonlinespreadbettingcompanies.Thefourmaintypesofspreadbetsare:

•Futurestyle.Thisisthedefaultstyle.Whenpeopletalkaboutspreadbetting,thisistheonetheyaretalkingabout.Inthistype,youbetonthefuturepriceofacommodity.

•Dailybets.Thesearestraightforwardbets,andtheyexpireasthedayends.Sincetheyoffertighterspreads,traderslikethemalot.

•Rollingdailies.Thesebetsdonotexpireasthedayends.Instead,theyrollovertothenextday.Theyarekeptopenovernight,andsoyouhavetopayextrainterest.

•Binarybets.Theseareabitdifferentfromtypicalspreadbetting.Thesebetshaveonlytwooutcomes(andthustheyarecalledbinary).

It’sOn(Line)2

IGIndexwasthefirstU.K.-basedspreadbettingcompany.Itstartedinthe1970sandallowedpeopletobetongoldprices.IGIndexwasfollowedbyCityIndex,whichwasfollowedbyFinspreads. These days, customers canmake bets online or on the phone.Over 25 onlinespread betting companies operate in the United Kingdom. Some companies chargecommissions,whileothersdon’t.

FinancialSpreadBetting

This can be explained in one sentence: financial spread betting is betting for a living ormaybe for a second income. There is no concept of chance or unpredictability in thisdefinition.Trading in financialmarkets involvesmaintaining thebalance inprobabilityandfindingwhattofavortominimizelosses.

Spreadbettingisagoodideafortradingfinancialmarkets—itischeap.Ifyouwanttosetuptrades,stockbrokerswillchargeyou.Thisoneisrelativelysimpler.Thereisasmallsetofinstructions.Followtheinstructionsandyoucanmakeaspreadbet.Plusitistax-freeintheUnitedKingdom.

Anothermajorplusisthatyoudon’tneedalotofcashtostartfinancialspreadbetting.Keepinmindthatthespreadwouldbebiggerthanwhatyourstockbrokerchargesyou.Thisisbecausespreadbettingcompaniesdonotchargeyoucommission.

Thespreadbasicallydiffersfromonesharetoanother,anditmightbelargeforsome.But you can ignore that and move on to other points. Also, the spread differs from onecompanytoanother.Soonceyougainexperience,trytoshoparound.

ForexSpreadBetting

Thisisoneofthehottestareasinspreadbetting,andpeopleareindulginginitmoreandmorethesedays.Workingwithforexislikeworkinginothermarkets.Inthisgenre,youcanbetoncurrencypairs.Forexample,youcanbetonwhethertheGBP/USDvalueisrisingorfalling.

Forex ratesmeasure the relative value of currencies.You can gamble on the relativevalueof twocurrencies that are in apair.This is forex spreadbetting.Forexpairs are animportantpartofanumberof investmentportfolios,and theyare thesecondhighest tradedgenreinthespreadbettingbusiness.

Forexmarkets are very volatile because they are strongly influenced by political andeconomicpressures.

Whenyougambleonforex,youcanviewtwopricequotes.Theyareknownasbidandoffer.Incaseyouthinkyourcurrencypairisgoingtomoveup,youshouldexecutetheofferlevel.Offeristhehigherquote.Andifyouthinkthatthecurrencyyouwanttogambleonisgoingdown,thenyoushouldsellitatthebidlevel.Thisisthelowerofthetwoquotes.

Bookies of spread bettingmake profits from the variation between the offer and bidquotes.Thespreadisthepartthattheyearnbypermittingyoutotradeviathem.

Stop-lossordersaregenerallynotguaranteedtogetexecutedatacertainlevelunlesstheguaranteedstophasbeenpaidfor.Normalmarketscenarioswillseestop-lossordersthatareactivatedneartheprearrangedorderlevels.

Note thatmajor economic data can result in slippagewhen the bookie hands you theclosestpriceexitat thetimeofexecution.Tradersmightalsofaceslippagewhentheyhold

trades over holidays orweekends. If youwant to run bets over theweekend, it is best toplacelowones.

Ifyouwanttospread-betonforex,hereareacoupleofpoints:

• Traders do not own the currencies on which they are betting. They only bet on pricefluctuations.

•Bookiesmaywidenthespreadlevelastheeconomicdataarereleased.

SportsSpreadBetting

Sports spread betting isn’t a new concept either. It started when CharlesMcNeil, a mathteacher from Connecticut, invented a different way to bet on sports. He later moved toChicagoandbecameabookmakerthere.

ThisideagainedpopularityintheUnitedKingdominthe1980sandwaslaterfollowedinNorthAmerica.Thewayofwagering in sports spreadbetting is a bit different.Bettorsgenerallywagerthatthevariationbetweenthescoresoftwosportsteamswillbegreaterthanorlessthanaspecifiedvaluethatwasdecidedbythebookmaker.

Whenthebettorspread-betsonanygamesuchasgolfing,heorshedoesnotnecessarilyhave to select a player that will possibly be the winner. Though this might help, it’s notalwaysthewinningstrategy.

Sometimesthismethodworksbecausecostsshowtheprobabilityofaplayerwinning.Butsomeplayersperformwellconsistently,weekafterweek—whichisgood.

Spreadbettingisgoodforthosewhopreferbettingwhileusingtherulesofprobability.Thismakesabettorable tobuyor sell thebets. Itdependsupon theplayer—howwellorpoorly he or she is going to play the game. It is just one among lots of spread markets,particularlyongolf.Beforeaconteststarts,everyplayerreceivesaspreadthatdependsonthemarkthatthebookieshopetoscore.

SpreadBettingintheUnitedKingdom

The spread betting industry is now dealing inmillions of pounds. There are over 83,000tradersinjusttheUnitedKingdom—andthefirmsaremultiplyingrapidly.Theglobalspreadbettingaudienceisestimatedtobeabout£650millionayearforretailoperatorrevenue,andthisnumberisgrowingat20to30percentperyear.

Therearemorethan25spreadbettingcompaniesintheUnitedKingdom,andthereisatough competition that has brought spreads down. About a decade ago, the spread on abenchmarkindexliketheFTSE100indexwasabout10points.Andnowithasgonedownto2.Therehavealwaysbeenconsolidationrumors,butmostpeoplebelievethatthereisenoughgrowthinthemarketthatallthespreadbettingproviderscanbeeasilyaccommodated.

Morethan40,000peopleintheUnitedKingdomhavespreadbettingaccounts,andmostofthemaremale.Butthatshouldn’tupsettheladiesbecausethenumberoffemalebettorsisrisingtoo.Thesespreadbettorsareusuallyself-employedpeopleorthosewhoworkintheinsurance,finance,orITsector.

Spread betting attracts the samemarkets as CFDs, i.e., experienced traders who areactiveinthemarketandrealizetherisksthatcomewithgearingandmargins.Alargepartof

spreadbettingiscomposedofvolume-baseddaytradingandshort-termstradesthatcomeinandoutoftheirpositions.

Experienced traders make spread bets for the reason that if they make £5,000 fromspreadbetting,theycankeepthewhole£5,000,ratherthangivingaportionofittotaxes.

Aswithanyothertypeofgambling,youcanmakemoneyandyoucanlosemoney.Onanaverage,most traders have6 losses out of 10.But donot bedisheartenedby this number,becausetheprofitsthataremadeinthe4winningtradesaremorethanthelosses.

IfyouwanttobeginspreadbettingintheUnitedKingdom,makesureyouhaveasoundincome.Spreadbettingisnotforunemployedpeopleorthosewithlowincome.Youwouldneedaminimumof£100tobegintrading.Thisisanamountthatyoushouldbeabletoaffordtolose.Sobasically,thisdealingisforpeoplewhocantakesmallandcalculatedrisks.Thisisnotfortheshyandweak.Soifyoulosemoney,don’tstartcomplainingorwritingtoTVshowsaboutit.

Thismarketisgearedhigh,soyoucanwinorlosemoneyreallyfast.Thegoodpartisthat it is all “zero sum.” So themoney youmake will have to come from somewhere orsomeone,withsomeonelosingandsomeonewinning.

Ifyouare from theUnitedStates,youcan’tdeal in spreadbettingunlessyouhaveanoffshore corporation and understand the regulatory guidelines for having and using anoffshorecorporation.ThisisbecauseWebsiteslikeCapitalSpreadarehighlyregulatedbytheU.K.government,notallowingthemtoinfringeontheU.S.lawsthatprohibitAmericancitizensfromtradingoutsidethecountry.

TherearemanyestablishedspreadbettingcorporationsintheUnitedKingdomthatarebackedbylargeandreputedbookmakers.Ifyouwanttoopenanaccountwiththem,youneedalocalmailingaddress.Toseeacurrentlistofthemostwidelyusedspreadbettingbrokers,gotowww.jdfn.com.

SPREADBETTING:ISITREALLYTAX-FREE?

Thesimpleanswerisyes.Spreadbettorsevadethe18percentU.K.capitalgainstax,whichshareholdershavetopayontheirtradingprofits.Andthereisnocommissionontradesandnostampdutyeither.Plusyoudon’thavetopayincometaxondividendsthatarechargedathighrates(sometimeseven50percentforthehigh-incomegroup).

Butthereisanexception:spreadbettingistax-freeonlyifitisn’tyourprimaryincomesource. Sowhen you open a spread betting account, do not enter your job description as“trader,”becauseitwillbedifficultforyoutoclaimthetaxrebatelaterwhenInlandRevenuequeriesyouaboutyourmoney.

Thesinequanonisthatifyoupaytaxesandyouwinatspreadbetting,youarenotliableto pay taxes on those profits.But if youhave no regular taxable income, then youwill beclassifiedasaprofessionalgambler,andthusyouwilllosetheBIM22017exemption.Keepinmind,though,thatHMRevenueandCustomsisreluctanttoclassifypeopleasprofessionalgamblers, because then they can claim relief against spread betting companies and theirgamblinglosses.SoaslongasyoupayPAYE(withholdingtaxes),youcan’tbeclassifiedasaprofessionalgambler,andthusyoudon’thavetopaytaxonyourwinnings.

Most of the peoplewho indulge in spread betting don’t do it for a living, and so, to

repeat thepointalreadymade in this section, theydon’thave topay taxes.And thepeoplewhodoit fora livinggetsmartaccountantswhofigureoutawaytosavethemfromtaxes.Youcan’tstopamillionairetraderfromhavinga“subsistenceincome”fromasmallbusinessforwhichheorshepaystax.Getthepoint?

SPREADBETTINGSTRATEGIESANDTIPS

1. Spread betting is easily accessible to new investors, but it is less lucrative because ofwiderspreads.

2.Itisbesttostartbyopeningademoaccountwithanyspreadbettingfirm.3.Youwill receiveavirtual£10,000 toplay.Youcan tradewith thatmoneyas if itwerereal.Planonspendingabouttwotofourmonthstogetabasicunderstandingandtodevelopyourwinningstrategy.Donotstartinvestingunlessyouseethatyouaregettingconsistentprofitseachweek.Ifyoutradeinhaste,youwillendupinlosses.

4.Areyoureadytotradeusingrealmoney?Makesureyoustartoutsmall.Itisalotharderthan it looks.Donot investhuge sums thinking thatyouhaveunderstood it all.Yes, it isenticing,andmanypeoplewanttostartoffwithbigtrades,buttheresultscanbepainful.Youwillfindmanyprovidersthatwillpermityoutostartsmall.

5.Determinewhatyouaregoingtotrade.Differentassetshavedifferentwaysoftrading,andtheyneeddifferentskillsets.Ifyouaskme,youshouldstartwithsimpleU.K.FTSEstocks—bluechipstocksifpossible.Itisalsowisetoselectsharesthathavelessvolatility,likebank and insurance company stocks. Forex is also very volatile for starters, and so youmightwanttopracticeabitbeforeyouentertheforexspreadbettingmarket.Donotdealinvolatilemarketssuchasoil.Newtradersliketodealinoil,sincetheythinkithasalotofprospects,butactuallythismarketisveryriskyfornewbies.

6.Whenyoustart,donotbeginwithtradingtoomanymarketsatonce.Chooseacoupleofmarketsandsticktothemuntilyoudevelopmoreskillandconfidence.Ofcourse,tradinginmanymarketsgivesmoreprofitopportunities,butittakesalotofexpertise.

7.Whenyouhavetouserealmoney,keepinmindthatcompanieswillallowyoutocreateanaccountwith£200,butit’sbesttostartwith£1,000.Thiswillallowyoutotakeupmorelossesthanwith£200ifthebetsizeiskepttoasmallfraction.Amaxriskof2percentisbest,butsinceyouhaveasmallaccount,use5percent.

8.Whenselectingcompanies,makesureyoudonotbeginwithmorethanfivecompanies.Donotshortoutatthisstage,asitispsychologicallyharder.

9.Do notmakewagers in running bets.As you open a fresh spread bet, you should thinkabout the size, direction, and duration of the trade, alongwith the exit strategy and bestentryprice.Theexitstrategyincludestwoimportantparts:theinitialtargetforprofitandastop-losspointincasethemarketmovesagainstyou.

10.Ifyouwanttomakemoneytrading,youneedanobjectiveanddisciplinedapproach.Sodecidethelevelthatyouwanttotrade,anddonotfallforthetemptationandbuytooearly.Youcanalsosetmarketordersoutof the regularhours to trademoreeffectively.Plus itreducesthepsychologicalpressuresthatyoumightfaceasanewtrader.

11. Before opening each spread bet, write your plan down—why did you opt for thisdecision, stop-loss level, trade size, and exit strategy. In case you decide not to open a

position evenafteryouexamined it closely,writedownwhyyoudid that.Whenyoudoenteratrade,notedownthefillpriceandrecalculatetherisks.Ifthepricehitsalevelthatprovesyourtradewrong,exititimmediately.Itisimportanttohavecleartargets—elseyouwill start gamblingusingyour emotionsor gut feeling,whichdoesnotwork.Manynewtraders take profits too early and stick with the losses, thinking that the trade willeventually improve in the future.Whenyoudonot have aplan, youwill goby impulse,whichisabadthing.

12.Onceyouhaveanalyzedallfactorsandrisks,placeyourbet,butbewarethatsometimesspreadsmightnotrevealtherealmarketprice.Theyonlyreflectwhattheinstrumentpriceis,accordingtothemarket.

Spread betting is becoming more and more popular overseas and is certainly a way toincrease your overall portfolio. I would caution that this may be more risky than otherinvestments thatyoumaybeused to.Planonusingonlyriskcapital thatyouarewilling tolosewhilelearninghowtospread-bet.

CHAPTER6FORWARDSANDSWAPS

Amongseveralotherinterestingfinancialderivatives(so-calledbecausetheirvalueisbasedupon the value of an underlying asset) that allow investors to manage and reduce theirportfoliorisks,wecanfindforwardsandswaps.

These are linear payoff derivatives contracts, contrary to options, which have anonlinearpayoff.ForwardsandswapsareOTCinstruments,thusoperatinginanonregulatedmarketandrequiringcustomerstohaveabankingrelationship.

DEFINITIONS

Aforwardisanycontractinwhichliquidationisdeferredtoaposteriordate,definedonthenegotiation.Forward transactionsareoneof themostcommonderivativesemployed inallkindsoffinancialactivities.

Thistypeofcontractallowsyoutopurchaseafixedamountoftheunderlyingassetatafixed price for a specific time period that starts at a future date, independently of thefluctuationsthatthemarketcanpresent.Shouldpricesrise,youareprotected,asthepriceyouagreed topaywill remain the same for the termof theagreement.A forwardcontractwillallow you to reduce your exposure to price fluctuations, thus facilitating the financialplanningofacompany’sbudget.

Aswapisacontractinwhichbothpartiesagreetoexchangeaseriesofmoneyflowsatafuturedate.Thoseflowscanbebasedonshort-terminterestrates,oronstockindexes,oronanyothervariable.Aswapisusedtoreducethecostandriskoffinancingabusinessortoovercomethebarriersoffinancialmarkets.

Thistypeofcontract issimilar toaforward,but thesettlementprocedurediffers.Youwill agree to purchase a definite amount of the underlying asset at a fixedprice and for aspecifictimeperiod.Ifthemarketpricesrise,youreceivethedifferencebetweentheagreedcontractpriceandtheactualmarketvalue;ifthespotmarketpricefortheunderlyingislower,you have to pay the difference. In this sense, swap contracts are equivalent toCFDs.Thefixedpriceallowsyoutobeprotectedagainstmarketvolatility,andtheexposuretopriceriskisshared.

CLASSIFICATIONOFFORWARDS

InterestRateForward

Forwardrateagreements(FRAs)arespecificindividualcontractsbetweentwopartieswhoagreetoenteraninvestmentataparticularfuturedateandataparticularinterestrate,fora

theoretical nominal amount.At the expiration date, the difference between the cashmarketvalueandtheinterestrateagreedintheFRAisliquidated.

TheFRAisafuturescontractusedforriskcoverageoninterestrates.AsitisanOTCinstrument, itscharacteristicsarenotstandardizedand thuscanbeperfectlyadjusted to thecustomer’s needs. There is no movement of funds between the customer and the bankingentity.

TheFRAisidentifiedbymeansoftwonumbersthatrefertotheperiodfromthecontractdate until the liquidation date and at opening; that is the period stipulated in the signedcontract. Both periods are expressed inmonths. For example, FRA 2/5 indicates that thisFRAwillbeliquidatedintwomonths,whilethecontractperiodisthreemonths,meaningthecontractwillexpirefivemonthsfromthecontractsignaturedate.TheopeningoftheFRAistheperiodbetweentheliquidationdateandtheexpirationdate.

TheFRAhelpsinvestorsprotectthemselvesagainstunfavorablechangesintheinterestrates,anditallowsinvestorstosettheinterestrateforaloanordepositpriortothecontractdate.

YouwouldbuyanFRAwhenyouneedtobeprotectedfromapossibleriseininterestrates;youwillsellanFRAwhenyouneedtoguardagainstapotentialdecreaseininterestrates.Suchacontracteliminatesuncertaintyabouttheevolutionofthoserates.TheFRAisacoverage instrument, which is not dependent on the financial or investment operation; itscontractdoesnotrequirethepaymentofanypremium.

ForwardonCurrenciesorExchangeRate

Aforwardoncurrenciesorexchangeratesallowstheparticipantstoenterintoagreementsonforex rate transactions to be realized at specific moments in the future. The size andexpirationof this typeofdelayedcontract arenegotiatedbetween thebuyerand the seller,andtheexchangeratesareusuallyquotedat30,60,or90daysor6,9,or12monthsfromthedateonwhichthecontractissubscribed.

ForwardoverAssetsThatDoNotPayInterestorDividends

Theseassetsareusuallycommoditiesthatpresentananomalyinthedelayedprice,producedbecause, among other reasons, the market is not an efficient market. This happens, forexample, with oil, where it is impossible to sell short because you cannot borrow thecommodity and users that store oil do so because the consequences of a lack of thiscommodityareterrible,andthustheydonotwanttolendittoanybodyelse.

CLASSIFICATIONOFSWAPS

VanillaorInterestRateSwaps

Thesearecontractswhereapartyofthetransactionagreestopaytheotherpartyaninterestrate established in advance, and the second party agrees to pay the first party a variable

interestrateoverthesamenominalvalue.Theonlyexchangethattakesplaceisthepaymentof the interests on capital, while the payments that correspond to the capital itself do notparticipate in the transaction. This type of contract is the most common in the financialmarkets.

A normal interest rate swap is a contract where one of the parties performing thetransactionagreestopaytotheotherpartyaninterestratethathasbeenfixedinadvanceoveranominalamount,alsofixedinadvance,andthesecondpartyagreestopaytothefirstpartyavariableinterestrateoverthesamenominalamount.

Interest rateswapcontractsare financialexchangeswhere theobjectsof theexchangearepaymentobligations,correspondingtoloansofdifferentcharacteristics,whichrefertoaparticular notional value in the same currency.Usually fixed interests are exchangedwithvariableinterests,althoughonlyvariableinterestscanalsobeexchangedovertwodifferentreferencebases.Thatmeansthataswapisnotreallyaloan,asitisexclusivelyanexchangeofinterestrateflowsandasnobodyisborrowingthenominalamountfromanyone,meaningthattheprincipalquantitiesarenotexchanged.

CurrencySwaps

Theseareavariationoftheinterestrateswaps,wherethenominalvalueonwhichthefixedinterestrate ispaidandthenominalvalueonwhichthevariable interestrate ispaidcomefrom two different currencies. The traditional form of the exchange rate swap implies acombinationofapurchase(sale)onthecashspotmarketandacompensatorysale(purchase)for the same party in the “forward” delayed market. But this sometimes can refer tocompensatorytransactionswithdifferentexpirationsorcombinationsofboth.

Acurrencyswapisanagreementbetweentwocommercialpartiestoexchange,fortheduration of an agreed-upon time period, two interest flows from two different currencies.Thiswillgenerallybeatthetimeofexpirationoftheagreement.Theprincipalamountofthetransactionisatanexchangerateestablishedatthestartingpoint,usuallythecashspotvaluefor that date. This exchange between parties is what is covered against a nonfavorableevolutionofexchangerates.

The simplest types of currency swaps that exist will vary depending on the ratesexchanged,wherewewillhave:

•Fixedagainstvariablecurrencyswap•Variableagainstvariablecurrencyswap•Fixedagainstfixedcurrencyswap

Oneoftheadvantagesofaswapcontractistheabsenceofriskfortheprincipalamountonthe contract, as the eventual noncompliance only affects the differential between rates orbetweenpricesorthechangeinthedebtstructureofferedbyinterestrateswaps.

Thedisadvantagesarethehighamountneededfornotionalprincipals,thehighercostsofintermediariesandsetup,and,finally,thedifficultiesencounteredifyouwanttoliquidatethetransaction before its expiration because of the low possibilities of finding a counterpartywishingtoassumethespecificconditionsofthatparticularcontract.

CommoditySwaps

Thisvariantmakesitpossibletoseparatetheriskofthemarketpricefromthecreditrisk,anditallowsacommodityproducertorunasimplefactorythatprocessescommoditieswithouttaking any price risks. A typical financial problem is the funding of producers throughcommodities,astheinternationalcommoditymarketsareoftenveryvolatile.

Forexample,internationalpricesofoilcandecrease30percentinafewdays.Forthisreason, the companies that produce commodities are generally considered high-riskbusinessesinregardtocreditsforinvestments.Therefore,thesetypesofswapsaredesignedtoremovepricerisksandreducethefinancingcosts.

Theoperationofacommodityswapisverysimilartothatofaninterestrateswap.Forexample,athree-year-periodswaponoilisanexchangeofmoneybasedonthesolepriceofoil (there is no physical exchange of the commodity at any moment); thus the swapcompensatesanydifferencethatexistsbetweenthevariablemarketpriceandthefixedpriceestablishedbymeansoftheswap.Thatis,ifoilpricesfallbelowtheestablishedprice,thesecondpartypaysthedifferencetothefirstparty;andif thepricesrise, thefirstpartywillpaythedifferencetothesecondparty.

StockIndexesSwaps

Themarketofswapsonstockindexesallowsyoutoexchangetheperformanceofthemoneymarket for theperformanceof a stockmarket.This stockmarket performance refers to thesumofdividendsreceived,capitalprofits,andlosses.

Through this process, we can obtain the same profitability as if we had invested instocks,andwecanobtainthatprofitabilityatthesametimetheswaptransactionisfinanced;butwecanalwayskeepthecapital,whichcanthenbeinvestedinotherassets.

ExchangeRateSwaps

Inthistypeofcontract,oneofthepartiesagreestoliquidateinterestsoveraspecificamountofprincipalinaparticularcurrency.Inexchange,thatpartyreceivesinterestoveraspecificamountofprincipalinanothercurrency.Thisisavariationoftheinterestrateswap,wherethenominalamountonwhichthefixedinterestrateispaidandthenominalamountonwhichthevariable interest rate ispaidare from twodifferent currencies.Contrary to the interestrate swap,here theprincipal amounts are exchangedat thebeginningandat theendof theswapcontractduration.

At the same time, these instruments can be used to transform a loan in a particularcurrencyintoa loaninanothercurrency.Itcanbesaid thataswapisa longpositioninanobligationcombinedwithashortpositioninanotherobligation.Aswapcanbeconsideredasa portfolio of contracts at a given term. Presently, financial institutions frequently receiveswapsasdeposits.

CreditSwaps

Thistypeofcontractisusedtomanagecreditrisksthroughthemeasurementandspecificationofthepricesofeachoftheunderlyinginstruments:interestrate,period,currency,andcredit.Thoseriskscanbetransferredtoaholderinamoreefficientmanner,allowingcreditaccess

atalessercostandadjustingtotherelationshipbetweencreditsupplyanddemand.Credit risks are narrowed down to a potential noncompliance risk. There are two

modalitiesofcreditswaps:defaultswapsandtotalreturnswaps.

•Defaultswaps.Inadefaultswap,thesellerofacreditriskguaranteespaymenttotheotherpartyifthecreditstatusagreeduponintheswapchangesinregardtothereferencedcredit,usuallyacorporatebond.

•Totalreturnswaps.Conversely,totalreturnswapsallowthesellerofthecreditrisktokeeptheassetandreceiveareturn,whichfluctuateswiththemodificationofthecreditrisk.Theseller pays a total rate of return over a referenced asset. This is generally a bond thatincludes any price consideration in exchange for periodical payments at a floating rateplusanypricereduction.

Whenthesekindsofswapswereinvented,theywereusuallyemployedsolelybythebankstoprotectbankingcredits.Presently, theyhavebecomeverypopularcoverage instruments,astheyallowyoutokeeptheassetwhile,atthesametime,fragmentanddistributetherisk.

This will allow a bank to free up credit lines and continue lending money to itscustomers,eveniftheamountexceedsitsexposurelimitsforthatcompanyorindustry,usingthepartialortotaldischargeofthecreditriskthroughatotalreturnordefaultswap.

PROFITABILITY

Forwards

Acompanycansettletheparitiesofdifferentcurrenciesinthefuture,reducingtheexposuretotheirvolatilityrisks.Onalocalcurrencyforward,youareestablishingthefuturebidoraskpriceofaforeigncurrencyinregardtothelocalcurrency.

Thiseliminatestheriskoffluctuationofexchangerates,allowsyoutochooseamountsandspecificdatesforthesettlement,anddoesn’taffecttheliquidityofthecompanybecauseyou do not need to have any funds available at the moment of the agreement nor at itsexpiration.

On a forex forward, you can establish future parities between foreign currencies andperform the contracts in a similarwayasdescribed above.These contracts canbe agreedupon either with a fixed expiration date or with the expiration within a few days’ range.Profitsonforwardsarevariable,dependingonthecurrencies’interestrates.

For example, a company that exports a commodity to other countries and is thereforeexposed to theexchange ratebetween its localcurrencyand the foreigncurrencies thatarepaid for its sales can cover its exchange risk in advance by selling, at a future date, thecurrenciesitexpectstoreceiveinthefuture.

Swaps

In these contracts, you agree upon the exchange of future currency flows for differentcurrencies where both parties decide on the amounts and expiration dates. The contracts

allowthephysicalexchangeandholdingofcurrenciesorcompensationofobligations.Thebenefitofoperatingwithforwardsandswapsisthatyoudonotrequirecashflowat

themoment of establishing the contract. The forwards don’t increase your company’s debtlevels;andtheagreementscanbedoneoverthephone,withthebankworkingwithyouonthecontractprivately,whichisnotsubjecttoanytaxesoranycommissionsoradditionalcosts.

Forexample,ifacompanyplanstosettleitsfloatingdebtbymeansofaninterestswapand has uncertain expectancies about the behavior of the rates, it could acquire a sellingoptiononatreasurybondwithasimilarexpiration.Thiswaytheinterestratesrise,andtheoptionisexercisedtocompensatethehighcostoftheswapgeneratedbytherateincrease.Ifthe rates decrease, the option will expire worthless, but there will be a profit, as thevariable-ratedebthasbeenfixedatalowervaluethantheactualrate.

RISKS

Forwards

•Creditrisk.•Interestraterisk.Thisoccurswhentherearefluctuationsintheinterestrates,whichaffect

thefinalcostofthetransactions.•Exchangeraterisk.

Swaps

•Differential risk. If a swap is covered with a bond and there is a change in the swapdifferential in regard to the bond, there could be losses (or profits) in the swapprofitability.

•Baserisk.Whenaswapiscoveredwithafuturescontractandthereisadifferencebetweenthe reference rate and the implied rate in the futures contract, a loss or profit can begenerated.

•Creditrisk.Thereisaprobabilitythatthecounterpartydoesnothonoritsobligations.•Reinvestmentrisk.Thisriskisderivedfromthecreditriskwhentherearechangesinthe

paymentdates;itisnecessarytoreinvestineachrotationdate.•Exchangeraterisk.Thereisthepossibilitythattherewillbeapositivefluctuationofthe

currency or currencies that are going to be liquidated when the transaction will beeffective(purchaseorsale).Inthiscase,attheendofthecommercialoperation,youwillhavetopaymoreofyourowncurrency(oranyother)toacquirethesameamountoftheothercurrencyagreeduponinthecontract,whichaffectsthefinalcostofthetransactions.

HOWARETHESETRANSACTIONSPERFORMED?

ForwardsandswapsareusuallyrealizedoverthetelephoneortheInternet,andthedealisclosedwhen there is an agreement upon the coupon rate, basis for the floating rate, days,

startingdate,expirationdate,rotationdate,applicationoflaws,anddocumentation.These transactions are immediately confirmed through a telex or fax followed by a

writtenconfirmation.Thedocumentationusedinthemaincurrencycentersisusuallyoneoftwostandardforms,theoneofferedbytheBritishBankers’Association(theBritishBankers’AssociationInterestRatesandCurrencySwaps)ortheoneofferedbytheInternationalSwapDealersAssociation.

WHOARETHEINTERESTEDPARTIES?

Themarketofforwardsandswapsusuallycomprisesallconventionalcurrencyusers:

•Commercial importers of goods and services. In their normal course of operation, theyperform transactions for a specific amount of one or several currencies to be paid at afuturedateinexchangeforreceivingmerchandiseorservicesfromanothercountry.

•Commercialexportersofgoodsandservices.Herethetransactionsareperformedforthecurrencyorcurrenciestobereceivedatafuturedateinexchangeformerchandisesentorservicesrenderedtoanothercountry.

• Companies that owe obligations in foreign currency. Typically, in this group arebusinessesthatacquirecreditsinanyothercurrencythantheirlocalcurrencytobepaidatafuturedate.

•Otheragents(privateorpubliccompanies, institutional investors,particularinvestors,etc.).Thisgroupconsistsofthosewhobythenatureoftheiractivitiesareexposedtothefluctuationofexchangeratesorinterestrates.

HOW DO THEY ACTUALLY STAND BEFOREREGULATORYENTITIES?

InMarch 2011, the U.S. Treasury Department was considering the application of tougherrules for forex forwards and swaps. Nearly $2 trillion a day is employed in commercialtransactions. These transactions are essential to multinational corporations and biginternationalinvestors,astheyprotectthemfromlosingmoneyduetocurrencyvolatility.

Thisisaseldom-regulatedmarket,andtransactionstakeplaceinaprivateenvironment.Mosttransactionsarebetweenbiginternationalbanksandcommercialpartiesthatagreeonapriceandexecuteacontract,thetermsofwhicharealsoprivate.

If these transactions were to be regulated, the new rules would require them to berealizedpubliclyontradingplatforms,andtheneedforusingaclearinghouseasintermediarywouldincreasethecosts.Byusingclearinghousesandotherintermediaries,eachpartywouldneedtopostcollateralasaguaranteeofthedeal,whichisnotthecaseinmostprivatedeals.

Another riskwould be an increase of the exchange rate volatility, asmost firms andinvestorswouldtrytogrouptheirbuyingorsellingofcurrenciesatextremepricesinordertocontrol their costs. In addition, a lot of transactions would most probably be redirectedoutsidetheUnitedStates.

Objections to these new regulations were that unlike other types of swaps, forex

contractsarelessspeculative,astheyimplyaneffectiveexchangeofgoods(onecurrencyforanother).Alsotheseareshorter-termcontractswheremarketconditionsdonothaveenoughtimetocausehugechanges,whichcouldgeneratebiglossesforeitherparty.

OnApril20,2011,theU.S.TreasuryDepartmentfinallyannouncedthatitwouldexemptforexforwardsandswapsfromthenewrulesandfromthecentralclearingrequirementsoftheDodd-FrankAct.TheTreasuryconcludedthat:

Centralclearingrequirementswillstrengthentherestofthederivativesmarket,butcould actually jeopardize practices in the forex swaps and forwardsmarket that helplimitriskandensurethatitfunctionseffectively.Themarketplayssuchanimportantroleinhelpingbusinessesmanagetheireverydayfundingandinvestmentneedsthroughouttheworld that disruptions to its operations could have serious negative economicconsequences. (“Fact Sheet: Notice of Proposed Determination on Foreign ExchangeSwaps and Forwards,” April 2011,http://www.treasury.gov/initiatives/wsr/Pages/facts.aspx)

TheTreasuryDepartmentwarnedthatalthoughexemptfrommandatorycentralclearing,forex forwards and swapswould be subject to new reporting requirements and reinforcedbusinessstandards.Thedepartmentstatedthatplansareinprogressthathavealreadystartedtocreateaglobalforexrepository.Thiswillallowtheexpansionofreportingfeaturestotheregulatory entities and to the markets, thus increasing the transparency of the overalltransactions.

CHAPTER7TRADINGASABUSINESS

By now you have taken the next step in your trading. You may be thinking that this issomethingthatyouwanttodofull-time,somethingthatcanreplaceyourcurrentincome.Thatmaybetrue,butkeepinmindthatmanyhavetriedbeforeyou.Ibelievethatyoucan,butitwilltakehardworktomaketradingafull-timejob.

Whenmostpeoplehearthatyouareorwanttobecomeaforeigncurrencytrader, theythink ofmaking lots ofmoney and traveling around theworld.This can be true, but in allseriousness,ifyouwanttotradefull-timeasyourprimarysourceofincome,youaregoingtobesittinginfrontofyourcomputer.Nowdon’t takethis thewrongway: tradingisexcitingandcanbeverylucrative.Butitisnotaget-rich-quickbusiness.

You will have to take your bumps along the way. I would suggest that you plan onspendingafewyearsdialinginyourstrategiesandmoneymanagementplans.Youcanmakemoneywhiledoingthis,butyoucanalsolosemoney.Intrading,itisn’thowmuchyoulose;itisthesimplefactthatyoumakemorethanyoulose.Alotoftradersmakethemistakeofnotwanting to accept losses. Losses are okay as long as they are part of your overallmoneymanagementplan.

Mostpeopledon’tthinkabouttradingasabusiness,butIlearnedlongagothatthebestreturnscanfrequentlybemadebylookingatthingsdifferentlyfromthewaymostpeopledo.If you change your thinking and start looking at trading as more than just investing, butactually as a business that provides income for you and your family, I think you will bepleasantlysurprisedatthebenefitsyoureceive.

Inthefirstplace,asmallbusinessisabouttheonlygreattaxshelterstillavailablethatthe IRS hasn’t been able to strip away. Not that it hasn’t tried. But Congress has beenstubborninitssupportoftheideathatitistheentrepreneurialspiritthatmakesthiscountrywhat it is, and so it has consistently avoided reducing the benefits that businesses offer totheir owners. Naturally, it doesn’t hurt that most representatives and senators either havesmallbusinessesorhaverelativeswhohaveone,butlet’sbethankfulforthelittlefavorsweget,nomatterwheretheycomefromorinwhatform.

Asyouwill read in thisbookandprobablyalreadyknow, tradingforexasabusinesshascertainlytakenaturnforcomplication.Themanynewregulatoryreformbillsaremakingit harder for traders to dowhat they used to do in the spotOTC forex industry. It is stillrelativelyeasytoopenanaccountandtradeonyourownaccount.Butifyouareplanningontrading someone else’s money, then you will have to conform to all the new regulatoryrequirements.

THETAXCODE

The tax code classifies people in the securities business into three categories: dealers,investors,andtraders.Thedealerclassificationisbeyondthescopeofthisbookbecauseit

involvespeoplemakingamarket instocksandothersecurities for investors. Investorsandtraders,however,areveryimportantandaffectboththewaywebuyandsellcurrenciesorsecuritiesandthedeductionsweareallowed.

Mostpeopleconsider themselves investors.They investand lookfora returnon theirmoney.Investors,however,don’tgetanytaxbenefits,otherthanthepotentialofcapitalgainstaxtreatmentonanythingtheybuyandholdformorethanayear.

Itiscommonthatintheforexindustrybrokersdonotsendyoustatementsyoucanuseforyourtaxes.Rather,itisleftuptoyoutomaintainarecordofyourtrades.Mostbrokershaveaprettydetailedsoftwarereportingsystemthatwillassistyouinrunningyourtradingactivity,butdon’ttakethatforgranted.Youwillneedtothinkaheadabouthowyouaregoingtoreportyourtradingactivityonyourtaxreturns.

Ipersonallyfindthistobesomewhatridiculous.Intheequitiesbusiness,yourbrokerswill send you a year-end statement that they file with the IRS and that you will need toincludeonyourtaxes.Atleastmybrokersdo.TothinkthatreportingprofitstotheIRSisleftup to the forex trader is unimaginable. And so is the idea that the IRS hasn’t closed thisloophole.

If,insteadofbeinganinvestor,youdecidetobeatrader,hereisapartiallistofbenefitsintheformoftaxdeductionsyouget:

•Thecostofyourtradingeducation•Financialsoftware•Booksandaudiotapeandvideotapecoursesininvestingandtrading•Accountingfees•Brokerageaccountfeesandcommissions•Officeequipment(computers,Internethigh-speedconnectionfees,addingmachines,phones,

phonecharges,etc.)•Interestonyourmarginaccountsandanyotherinvestment-relatedinterestexpense•Financialadviceandtraining•Taxadvice•Legaladvicerelatedtoyourbusiness•Entertainmentandmealsduringwhichbusinessisconducted•Traveltoseminars,tradeshows,andotherbusiness-relatedtripsanywhereintheworld•Magazinesubscriptionsrelatedtoinvestingandtrading•Tripstolookatcorporationsyouareconsideringinvestingin•Theportionofyourhomeexpense that qualifies as ahomebusiness andaportionof all

expensespaidonmaintainingtheproperty,utilities,etc.•Automobileexpenses

Youcantellthelistisratherinclusiveandbeneficial.Interestingly,asyoubegintolearnthenuancesandcombinealltheadvantages,theyadduptoarathertidysum.

HOWTOBECOMEATRADER

TheIRScodedoesnotdefinetradeorbusinessasitrelatestothebusinessoftrading.The

lawthathasdevelopedcomesfromcourtcasesanddecisionsmadeinthefavoroftaxpayerswho havemade this claim. The key elements in the cases were length of holding period,frequencyoftrades,andpurposefortrading,thatis,wastheperson’sintenttomakemoneyfromdividendinterest,long-termgain,orshort-termtrading?

Ifyouareacurrency trader, it isprettyeasy to showyour intent, since that isallyoushootfor.Ifyoualsotradestocks,youcanstillmakeaclaimfortraderstatusevenifyouholdsomeofthemlongterm,althoughitisdoubtfulyouwillanyway.

Whileweallhopeourbusiness,includingourtradingbusiness,makesatonofmoney,therealityisitwon’talwaysdoso.Thegoodnewsisthatiftradingisabusiness,thenyourexcessexpensescanbeusedtooffsetincomefromothersourcesjustlikeanyotherbusinesswouldallowyoutodo.Itisawin-winsituation.

Let’sdiscussusing trader status as it relates toyourpersonal tax returnby creating asmallsoleproprietorship.Inthiscase,youwouldplaceyourordinarybusinessexpensesonSchedule C, and you would report your income or loss on Schedule D, since it is stillconsideredcapital.Noself-employmentincomeiscalculatedontheincome,andyourtradinglossesarestilllimitedto$3,000peryearbutcanbecarriedoverindefinitely.Youcanalsouseanylossesinthestockmarkettooffsetgainsinthecurrencymarket.

Althoughthebenefitsofthisstrategyaregood,thereisanotherway,andoftenabetterway, to operate the business. That is by incorporating the business and creating your owntradecorporation.

Atradecorporationisyournewlegalentityinwhichtoconductyourtrading.Therearenear-term advantages, longer-range asset protection, and family financial planningadvantages.Therewillbesomeextracost forsetupandoperation,butasyouwillquicklysee,theadvantagesfaroutweighthecost.

Yourfirstadvantageisclarityofpurpose.Ifyouformacorporationforthepurposeoftradingandconductthetradingintheseparateentity,therewillbenoquestionregardingyourtraderstatus,norwilltherebeanissueaboutyourpersonaltaxreturnandthedeductionsyoutake.Thisisnottosuggestthatoperatingthingsinthesoleproprietorshipstatusisinthegrayareaofthetaxcode.Itisn’t.

Somepeopleliketokeeptheirvariousbusinessesseparate,protectassetsfromdifferentcreditors, and do estate and financial planning as they go. If you fall into this category ofindividuals, you should consider using a corporation as the entity to operate your tradebusiness.

Ihavepersonallyprobablytakenthistotheextreme.Itdoescostalittlemoremoneytobeextracareful,buttoprotectassets,ItendtoopenseparatecorporationsforeachseparatebusinessventureIamdoing.ThiswayIamnotcomminglingassets,sotospeak,amongothercompanies.Iprimarilydothisforthereductionofliability.Thatwayifforsomereasonyoudoeverget sued, the lawsuit isbasically relegated to the specificcorporation inquestion.Startinga tradingbusiness isnodifferent, sinceyourassets in the tradingcompanyarenotyourspersonallybutthecompany’s.

WHATKINDOFCOMPANY

Therearethreetypesofcorporations:C,SubS,andLLC.ACcorporationisconsidereda

regular corporation.ASubScorporation is sonamedbecauseof the taxcode section thatgivesitbenefits.TheLLCisstructuredtoovercomesomeofthestructuraldifficultiesoftheSub S corporation. (Interestingly, about the time the individual states got through adoptingmassivelegislationtogetaroundthetaxcode,Congressdecideditdidn’twanttobeoutdoneandamendedmost,butnotall,ofthedifficultportionsoftheSubScode.)

Tobefairtobothyouasthereaderandmeastheauthor,ImustnowdisclosethatIamgoing to make sweeping generalities about which corporations are best and why. Theproblemiseveryone’scircumstancesaredifferentandvolumeshavebeenwrittenaboutthe“best”structuretouse.Nevertheless,wewillattempttoweedthroughthetangleofredtapetouncoversomesolidideas.

TheCcorporation isprimarilyused forpubliccompanies,multipleshareholderswhoaren’tinterestedindistributingprofitsandlosses,butwanttobuildanentityandindividualbusinesses that benefit from a medical reimbursement plan or some types of retirementprograms.

For some people, the medical reimbursement can be a great deal because under thecurrent law, individualsand joint filersare limited tomedicaldeductionsaftera2percentlimitationofadjustedgrossincome.

Excepting the medical situation, you will likely benefit greatest in either a Sub ScorporationoranLLC.Thereasonisthatbothhavetaxflowbenefitsattheshareholderlevel.Thismeansthecorporationdoesn’tpayaseparatetax,buttheshareholders(intheSubS)andthemembers(intheLLC)paytaxonanygainortakelossespersonallyifthereareany.Thisgivesyouthebenefitofapersonaltaxshelterinyearswherethereisalossinthecompany.

Itshouldbenotedthatifyouaregoingtobetheonlyshareholderofyourcompany,thentheSubScorporationisprobablytheoneyoushouldconsider.Beingasingle-memberLLChasitscomplications.TheIRSwillbasicallyconsideryouasoleproprietorshipifyouhaveanLLCandyouareasinglemember,meaningthatyouaretheonlyowner.Ifthisisthecase,thenyouwillbasicallybegivingupthecorporatebenefitsthatyouarelookingfor.SolooktotheSubStoprovidethecorporateflexibilityyouneed.

ThebenefittousingaSubSisthatithasbeenaroundthelongest,andsomostCPAsandattorneysarecomfortablewithit.ThebenefitoftheLLCisthatyoucandosomeinterestingfamily,estate,andassetprotectionplanning.

Let’stakealookatafewexamples.Let’ssayyouformanLLCtradecorporation.InanLLC,youareallowedtoissuemultipletypesofshares.Becauseyouwouldliketoshiftsomeofyourtradeincometoyourchildren,youissuethemapreferredclassofstockthathasnovotingrightsbuthasapreferenceofincomeuptoacertainlevel.

This “income-shift” strategy allows you to maintain 100 percent control of yourcompanyandall theassets,but shiftsdollars toyourchildren,whoare ina lower incomebracketthanyou.Thechildrencanusethemoneytopaytheirbills.

Anothertwistonthisstrategyistopayyourchildrenasalaryoutofthecorporationforworktheydo.Thework,dependingonageandability,wouldgivethemearnedincomeandallow them to set up an IRA or other retirement program at an early age.While incomeshiftingtakesmoneyoutofyourpocketandputsitinsomeoneelse’s,yougetthededuction;andifyoucancontrolwhathappenstothemoney,itisthesameashavingit.Anotherbenefitto helping your children grow an early retirement program is that you may at least havesomeonetosupportyouifthingsdon’talwaysgoasyouwouldlike.

LLCshaveanotheradvantage;theycanbeusedtoprotectassets.Ifyoufindyourselfina

situationwhereyouneedtobeprotected,youcanputyourassetsinanLLCandgive,sell,orotherwisestructuretheshareownershipinsomeoneelse’sname.Youcancontinuetodrawasalary from the company and control the operation of the company through special shares,whichcanbedraftedtogiveyouspecificrightstodoso.

Theassetsnowbelongtosomeoneelseandarenolongerattachablebythecreditor,andthe income you receive is not attachable because it is a salary. (Some states give certaincreditorsrightstolienaportionofsalary,butthiscanbeadjustedtofitthesituation.)Pleasenote, in thisexampleyouhaveactuallygivenup thesesharesand theassets theyrepresent.This can be a shame.On the other hand,without that happening, youwould have lost theassetstoacreditornotofyourchoosing.

Byusingthisstructure,youatleastshiftedtheassettosomeoneyouknow,andyougetincomegeneratedfromthecompanyintheformofasalary.Iwouldalsoliketopointoutthatthereare lawsgoverning fraudoncreditors.These lawsdonotpreventyou fromproperlyprotecting yourself and your family, but they are intended to stop what are called shametransactions,wherethereisnotruthorsubstancetoyouractions.Sinceweareonlytalkingabout proper planning, these and other strategies should all be available to you and usedwhenneeded.

OFFSHOREBUSINESS

Nowlet’stalkaboutoneothermethodforsettingupabusiness,butinthiscasewewilltalkaboutsettingupanoffshorebusiness.Youhearaboutitallthetime,aboutpeoplesettingupoffshore businesses. It is certainly more expensive, but it is also much more secure forliabilityprotection.

Alotofpeoplehavesetupoffshorebusinessestoprotecttheirprofitsbypayinglessintaxesandsoforth.Well,thisisnotwhyIwouldrecommendsettingupanoffshorebusiness.Iwould primarily recommend that one consider setting up an offshore business for assetprotectionand/orliabilityprotection.Thesimplefactofthematteristhatifyoumakemoney,youshouldpaytaxes.Notmorethanyourfairshare,butyoushouldcertainlybepayingyourtaxes.Furthermore,theIRSisnotstupid,soyoucanbesurethatifyouthinkyoucangetawaywithnotpayingyourtaxes,thinkagain.

Okay, with that said, let’s look at some specific examples of setting up offshorecorporationsandprotectingyourassets.Thebestplacetosetupanoffshorecorporationisina country that is still under theCommonwealth (formally known as theCommonwealth ofNations andwhat used to be called theBritishCommonwealth).The laws aremuchmorebeneficialtoyourcorporation.

SomeofthemoreproactiveplacestosetupanoffshorecorporationwouldbeBelize,Panama, Seychelles, Cook Islands, Cayman Islands, and British Virgin Islands. There areothers, such as up-and-comingDubai in theUAE,but they aremore expensive and a littlehardertosetupinthansomeoftheotheronesIhavelisted.

Thecost tosetuponeof theseoffshorecompanies isa littlemore thanwhat itwouldcostintheUnitedStates.IntheUnitedStates,youcaneasilysetupacompanyforabout$150to$300;foranoffshorecorporation,youwillpay$2,000to$10,000.IfyouwanttoopenaU.S.corporationoraforeigncorporationortrust,youcangotowww.jdfn.com,whichoffers

detailedinformationandhelpinfindingtherightcompanytoassistyou.ThereisalsoalinktoalawfirmthatIusethatcansetupaU.S.corporationinanystateyouwant.

So for liability’s sake, let’s say you open a company inBelize, and to better protectyourself,youcreateanoffshoretrustintheBahamas.YouwouldhavetheoffshoretrustownthecompanyinBelize.Youwouldmakethebeneficiaryofthetrustsomeoneotherthanyou,maybeatrustyouhaveintheUnitedStateshastheownership.Youthencanbeadirectorofthecorporationandopenabankaccountonitsbehalf.Butifyouwanttotaketheliabilityonestepfurther,youcanopenyourbankaccountin,say,theBritishVirginIslands.

NowkeepinmindthatifyouareaU.S.citizenandyouopenabankaccountinanothercountry,youwillhavetofiletheappropriateformswiththeIRS,lettingtheagencyknowthatyouhaveaforeignbankaccountthatyoucontrol.Alsofortaxpurposes,ifyouownaforeigncorporationandyouare themajorityownerof thatcompany, the IRSconsiders the foreigncorporationtobeacloselyheldcorporationandwilltaxtheforeigncorporationasitwouldanyofyourotherassets.Theremaybesomeadditionaltaxesthatgoalongwiththataswell.YoushouldtalktoyourCPAbeforetakingthismuchmoreaggressiveapproachtoprotectingyourassets.

Intheexampleabove,weactuallydon’thaveanyownershipofthecompany,sincewehaveatrustintheBahamasthatownsthecompanyandwearenotthebeneficiaryofthetrust.However,inthisexampleIwouldstillclaimthecompanyascloselyheld,sinceIdidn’tsetthecompanyupfortaxreasonsbutforliabilityreasons.

Ifforsomereasonsomeonewantstosuethecompany,heorsheisgoingtohavetosueacompanythatisdomiciledinBelize,thatisownedbyatrustintheBahamas,andthathasabank account in the British Virgin Islands. Good luck with that one. But, again, if you’remaking lots of money and your trading business is really doing well, you may want toconsider protecting your hard-earned dollars from unscrupulous attorneys and frivolouslawsuits.

PART2REGULATIONINTHEFOREX

CHAPTER8COMMODITYFUTURESMODERNIZATION

ACT

The Commodity Futures Modernization Act of 2000 (CFMA) was signed into law byPresidentClintononDecember21,2000.The lawrepresenteda sweepingoverhaulof theprovisions of the Commodity Exchange Act (CEA). The law was prompted due todisagreementsbetweentwogovernmentregulatoryagencies:theCFTCandtheSecuritiesandExchangeCommission(SEC).

When the SEC proposed easing its broker-dealer regulations for securities firms thatwere engaged inOTC derivatives, theCFTC objected, and a power struggle ensued. TheCFTCquestionedboththelegalityofderivativesforsecuritiesandthelegalityofoversightundertheCEA.

ThelawaddressedsomevagueareasregardingthestatusofOTCderivativesandhybridinstruments under the CEA through a number of statutory exclusions and exemptions. Inaddition, the law also addressed some unclear provisions regarding the status of certainnonretailswapsundertheSecuritiesActof1933andtheSecuritiesExchangeActof1934byclarifying that while such swaps are not securities under those statutes, specific fraud,manipulation,andinsider tradingprohibitionswouldneverthelessapply tocertainsecurity-basedswapagreements.Thislegislationreceivedagreatdealofcriticismin2001afterthefailureofEnronforitstreatmentofenergyderivativestermedthe“Enronloophole,”andevenmorecriticismfollowedtherescueofAmericanGeneralInsurance.

Whatmakessectionsofthis lawsoimportantwouldnotbetrulyfeltbyallofusuntil2008. The effects of the lawwere well known to large banks, brokerages, and insurancecompanies, but were very much overlooked by the general public. The issue was creditdefaultswaps,andinlate2008thepublicreceivedacrashcourseinaninvestmentthatmostpeoplehadneverevenheardof.

A credit default swap is often referred to as an insurance policy that will protect alenderifaborrower(e.g.,homeowner)defaultsonaloan.Whenalenderpurchasesacreditdefaultswapfromaninsurancecompany,theliabilityoftheloanbecomesacreditthatmaybe “swapped” for cash upon the loan defaulting. The difference between a traditionalinsurancepolicyandacreditdefaultswapisthatanyonecanbuytheswap,eventhosewhohavenodirectinterestintheloanbeingrepaid.Thistypeofbuyerisknownasaspeculator.Iftheborrowerdefaultsontheloan,notonlydoesthelenderreceivepaymentbytheinsurancecompany,butthespeculatorreceivesmoneyaswell.Althoughthelendercanbeprotectedbyacreditdefaultswap,itisalwaysinthelender’sbestinterestthattheloanberepaidbytheborrower.

Incontrast,theonlywayforaspeculatortoprofitisiftheborroweractuallydefaultsontheloan;onlythenwillthespeculatorreceivecreditthat,inturn,canbeswappedforacashpaymentfromtheinsurancecompany.Acreditdefaultswapboughtbyaspeculator isoften

referredtoasa“bettofail”becauseofitsdependenceonaborrowerdefaultingonaloan.Credit default swaps have existed since the early 1990s, but the market for them

increasedtremendouslystartingin2003withavolumeofabout$3.7 trillion;bytheendof2007theoutstandingamountwas$62.2trillion,fallingto$38.6trillionbytheendof2008afterthemarketbegantocollapse.Creditdefaultswapsarenottradedonanyexchange,andthereisnorequiredreportingoftransactionstoanyregulatorybody.

Duringthe2007–2010financialcrisis,thislackoftransparencybecameahugeconcernforregulators.Theyalsofeltthatthemassivesizeofthismarketandthelackofcentralizedclearingcouldposeasystemicrisktotheeconomy.Thoseconcernswerefirstrecognizedasbeingsignificantwhenthefinancialdominosbegantofallin2008;thechainreactionbeganwiththefailureofBearStearns.

In the days andweeks leading up toBear’s collapse, the spread on the bank’s creditdefaultswapswideneddramatically,indicatingahugesurgeofbuyerstakingoutprotectionon the bank. This widening helped create a perception that Bear Stearns was vulnerable,which reducedBearStearns’s access to capital and led to its forced sale to JPMorgan inMarch2008.

The next domino fell in September 2008 with the bankruptcy of Lehman Brothers,resultingincloseto$400billionbecomingpayabletothebuyersofthecreditdefaultswapsagainst the unexpectedly insolvent bank. However, since most positions were hedged, thenettingofthepositionsmeantthatonlyabout$7.2billionactuallychangedhands.Nextinlinethat same month was insurance giant American International Group (AIG). It required abailout from the federal government because it had been excessively selling credit defaultswaps protection without hedging against the possibility that the reference entities mightdeclineinvalue;thisexposedthegiantinsurancecompanytopotentiallossesofover$100billionandledtothecoiningofthefamousphrase“toobigtofail.”

Todayalmosteverybody in theworldknowsabout the financialcrisisand theactionstaken by the U.S. Treasury, the Federal Reserve, Congress, and two different presidentsthrough theTroubledAssetReliefProgramandbankbailouts.But these issuesalsospreadaroundtheglobe,causingfinancialemergencieseverywhere.Sothequestionis,whywouldaninsuranceproductcausesomanyproblems?

MostAmericansareusedtotheconceptofinsuranceandthereservesrequiredinorderto meet obligations for claims; so why? Because credit default swaps are not actuallyinsurance.Iknow,ifitwalkslikeaduck,quackslikeaduck,andlookslikeaduck,itmustbeaduck;butinthiscaseit’sstillnotconsideredaduck—orinsuranceeither.Thereforetherearenoreservestobackupthepotentialliabilityfacedbytheinsurancecompany.

Now even though buying a credit default swap also resembles placing a bet, and thecommontermincreditswaps“bettofail”wouldcertainlygivesomeonetheimpressionthatit’sgambling,it’snotconsideredgamblingbecausespecificwordingwasputintothelawthatwouldkeep it frombeing considered thatwayand thuskeep it frombeing subject to stategaminglaws.Thesesimilarities,however,didnotgounnoticedbystateregulatorsaroundtheUnitedStates.

The law’s treatment of credit default swaps has receivedmuch attention for the twoissues mentioned above. It has been argued by state insurance commissioners that creditdefault swaps should have been regulated as insurance and that the CFMA removed avaluablelegaltoolbypreemptingstatebucketshopandgamblinglawsthatcouldhavebeenusedtodeclarecreditdefaultswapsasillegal.In1992,theFuturesTradingPracticesActof

1992 preempted those state laws for financial derivatives covered by the CFTC’s swapsexemption; however, a gap in theCFTC’s powers prohibited it from exempting futures onnonexemptsecurities.

This loophole in the lawmeant that,before theCFMA, theCEA’spreemptionofstategamblingandbucketshoplawswouldnothaveprotectedacreditdefaultswapasnonexempt.The application of state laws to a credit default swapwould depend upon a challenge incourt,findingthataswapwasagambling,bucketshop,orotherwiseillegaltransaction.Thiswas an important issue that led to the specific exclusion of credit default swaps and allsecurity-based swaps from being labeled as gambling,whichwould have fallen under thejurisdiction of state gaming laws or resulted in being classified as insurance products thatwouldbesubjecttostateinsuranceregulations.ThelobbyistsdidtheirjobwellintheirclaimthattheyweresimplytryingtokeepbusinesshereintheUnitedStates,andthestagewassetforthelargestshellgameinhistory.

TherewerethosewhohadwrittenthattheCFMAwasenactedinparttoavoidhavingOTC derivatives transactions move offshore. AIG, which was the poster child for creditdefaultswapabuse,locateditscontroversialderivativesdealer(AIGFinancialProducts)inLondon, and it conducted its regulatory credit default swap transactions through a Frenchbank because of the bank regulatory capital provision that allowed banks (notAAA-ratedparties) to receive a reduced credit risk weighting for their obligations—including creditdefaultswapsowedtootherbanks.

Theseactionshelpeddisguisejusthowmuchriskexistedinthesystem,andwhenthosedominosbegan to fall,wewere finally able to see just howbig theproblemhadbecome.WhilemostAmericansbelievethatthebailoutsweretocoverbadloans,therealitywasthatthebailoutsweresimplycoveringthegamblingdebtsoflargefinancialinstitutions.

Wecanall imaginehowdifferent this latest crisiswouldhavebeen if this legislationhadnotbeenpassedorhadbeenwrittenwithmorecommonsense.Wecanprobablyallagreethat the likelihoodexists that creditdefault swapswill be rememberedas thecatalyst to areal estate market bubble and bust that nearly destroyed the world’s economy, and hadindividualstatesbeenallowedtoregulatethisareathathadbeenexcludedbytheCFMA,oureconomywouldnothavesufferedsomuchharm.

CHAPTER9THEFARMBILL

REGULATIONINTHEFOREXMARKET

Asmentioned inearlierchapters, the forexmarket isknownasa spotmarket.Youmaybefamiliarwithsimilarmarketssuchasthespotgoldoroilmarket.Whatdifferentiatesaspotmarketisthefactthatthisisacashmarketthatisnormallytradedforimmediatedeliveryofthe commodity. However, when it comes to the retail forex spot market, no delivery ofcurrenciesistakingplace,onlytheopeningandclosingofpositionsthatareusuallyplacedusingamarginaccount—inotherwords,purchasedorsoldusingleverage.

In the case of the forex, there is nothing to deliver. Therefore it did not qualify as acommodity.Infact,itsimplyfellbetweentheregulatorycracks,sothatnoregulationofthisburgeoning industry existed other than the CFTC stepping in when outright fraud wasreported.Whilethelackofregulatoryflaminghoopshelpedthisnewareaofinvestinggetafootholdandgrowrapidly,therewasadownside,onethatalwaysrearsitsuglyheadwhenitinvolvespeople’smoney—corruption.

Because there was no regulation in this new industry, brokers began appearingeverywhere.Thesecompaniescouldmakeanyoutrageousclaimthattheywantedtoinordertogain investmentdollarsbecause therewereveryfewpeoplearoundto tell themno.Thelackofregulationledtoagreatmanyabusesandcaughttheattentionofthoseresponsibleforprotectingthepublic.Oneresultofthisscrutinywaschangesinthelaws,andanotherwastheimplementationofoversightinthisfledglingindustry.

ThefirstrealchangewasalawthathadbeenkickingaroundCongressforyears;itwasknownas the2008 farmbill,orH.R.6124.OnMay22,2008,Congresspassed theFood,Conservation, and Energy Act (a.k.a. the farm bill), which included the CFTCReauthorizationActof2008(amendingtheCEA).ThislegislationreauthorizedtheCFTC’sauthority through 2013 and gave it enhanced jurisdiction over forex transactions. The newCFTCforex rules,which includenewregistrationandcapital requirements,area resultofthisnewlegislation.Nowyoumightwonderwhatfarminghas todowith theforexmarket,andthatwouldbeaveryreasonablequestion.Oneoftheareascoveredunderthefarmbillhadtodowithcommodities,whicharearegularpartoffarming.Commoditiesincludecorn,orangejuice,wheat,cattle,andhogs,justtonameafew;commoditiesalsoincluderesourcessuchasgold,silver,andoil.

Whydoesallthismatter?Becauseunderthenewfarmbill,commoditiesalsoincludedthe spot forexmarket.Finally thisnew investmentvehiclewould face regulationunder theCFTC.Forthefirsttime,theCFTCwouldbeempoweredbyCongresstowritenewrulesthatwouldregulatethefast-growingforexmarket,andthosenewregulationswouldbegintoclearout those firms that had been abusing the public trust by taking advantage of unsuspectinginvestors.

The CFTC said that it had seen a very large increase in cases of new investmentopportunitiescomingonthescene,andsomeofthemwereverycomplexinnatureandopenforabuse.TheCFTCspecificallyclaimedthatitnoticedasignificantriseinforeigncurrencytradingscams.

TheCFMA,whichwas passed in the year 2000, gave theCFTC the jurisdiction andauthoritytoinvestigateandtakeactionagainstawiderangeofunregulatedfirmsthatofferedforeign currency futures and options contracts to the retail public using counterparties thatwerenotregisteredasfuturescommissionmerchants.

The first major change dealt with the requirement to be a registered entity with theNational Futures Association (NFA), which is the self-regulatory organization (SRO)responsiblefortheoversightofthecommoditiesindustry.Whilemanybrokerswerealreadymembers,quitea fewwerenot.Thesecondmajorshiftwas in theareaofnetcapital; thisreferstotherequiredfinancialreservesthatbrokerswouldneedtohaveonhandinordertoprotecttheirclients.

Theregulationoffinancialreserveswasimplementedinstages,requiring$10millioninnetcapitalbeginning120daysaftertheenactmentofthisclause,$15millionbeginning240days after the enactment of this clause, and $20 million beginning 360 days after theenactmentof thisclause.Thesesinglechangesmanaged topushmanysmaller firms,whichcouldnotmeetthenetcapitalrequirement,outofbusiness.

The changes that were felt most by the investing public were both painful andunnecessary.Priortothesenewregulations,marginleveragewasavailableupto400:1;buttheNFAandCFTCbelieved that customerswere at toogreat a risk and first dropped themaximumleverageto100:1andthenultimatelyallthewaydownto50:1.Whiletheargumentaboutprotectingcustomersfromharmseemednoble,thefactremainedthatcustomerscouldtradeforeigncurrencyfuturesfromcommodityfirmsatleveragesthatexceeded300:1.Thiscontradictiondidnotgounnoticedduring the industry’sfight toblock thesenewrulesfromtakingeffect.

While these new rules certainly had a profound effect on the brokers who acted ascounterparties to trades, another matter of enormous change occurred in the regulation ofmoneymanagersandIBs.Therulesaddedrequirementsforthesegroupsthathadnotexistedinthepast.

Moneymanagerswouldneed to registerwith theNFAascommodity tradingadvisors(CTAs);theywouldberequiredtoholdacommoditieslicenseandpassqualificationexamsthatwoulddemonstrate their understandingof this business inwhich theywere trading fortheircustomers.TheexamsthatneedtobepassedaretheSeries3andtheSeries34,bothofwhichareadministeredthroughtheFinancialIndustryRegulatoryAuthority(FINRA).FINRAistheSROresponsiblefortheoversightofthesecuritiesindustry.

UnderthewatchfuleyeoftheNFA,brokers,CTAs,andIBswouldnolongerbeabletomakeoutrageousclaimsofsuccessorpromisesoffinancialreturnsunlesstheycouldactuallydemonstrate that what they were saying was true. These types of rules would allow theregulatory bodies responsible for the industry to properly police the behavior of bothmembersandnonmembers,thusprotectingtheinvestingpublicfromharm.

CHAPTER10DODD-FRANKWALLSTREETREFORMAND

CONSUMERPROTECTIONACT

Atboth thepersonal andbusiness levels, these constant regulatory changeshave created anightmareformanyinthefinancialindustryandevenmoresointheforexmarketplace.Forme, theDodd-FrankAct, yet again, forcedme to changemybusinessmodel and basicallyeliminated my already changed business practice stemming from the previous regulatorychanges.

Justlikemanyothersinbusiness,whenthesemajorchangestookeffect,Ihadtofollowalong.Insomecases,hardworkingpeoplelosttheirjobs,andthatwasatravesty.IknowofmanycorporateexecutivesthatbelievetheDodd-FrankActwasthefinalstraw,sotospeak,for their businesses. Many business owners decided to move their business offshorecompletely. In most of these cases, people lost their jobs, and even more, the businessservices of asset management ceased to operate for U.S. citizens. Most of these nowdisplacedcompaniesareonlyworkingfornon-U.S.citizens;whichspeaksvolumesabouttheprocessofourcongressionaloversight.

In Chapter 8, we discussed the significant damage caused to our economy by creditdefaultswapsundertheCFMA.Wenowneedtodiscusstheresponsetothefinancialcrisisthatwe,asanation,faced,andtheimpactthatthosechangeshavehadontheforexmarket.

The financial crisis that began in 2007 and continued until 2010 caused a politicalfirestorm throughout the United States and sparked demands for improvements in ourregulatorysystem.InJune2009,despiteawaveofcriticismfromhisopposition,PresidentObamaproposednewlegislationthatwouldprofoundlytransformtheregulatorystructureoftheU.S.financialsysteminwaysandscopenotseensincethe1930s.ThelawgotitsnameafterbeingintroducedintheHouseofRepresentativesbyCongressmanBarneyFrankandintheSenateBankingCommitteebythenChairmanChrisDodd.Theoriginalproposalfromthepresidentthatwastermed“ANewFoundation”andincludedthefollowingpartsasitsgoals:

•Theconsolidationofregulatoryagencies,theeliminationofthenationalthriftcharter,andanewoversightcounciltoevaluatesystemicrisk.

• Comprehensive regulation of financial markets, including increased transparency ofderivatives(eliminatingOTC).

• Consumer protection reforms, including a new consumer protection agency and uniformstandardsforplainvanillaproducts,aswellasstrengthenedinvestorprotection.

•Toolsforfinancialcrises,includingbotha“resolutionregime”complementingtheexistingauthority of theFederalDeposit InsuranceCorporation (FDIC) to allow for the orderlywinding down of bankrupt firms and a proposal that the Federal Reserve receiveauthorization from the U.S. Treasury for extensions of credit in “unusual or exigentcircumstances.”

•Variousmeasuresaimedatincreasinginternationalstandardsandcooperation;includedinthis sectionwere proposals related to improved accounting and tightened regulation of

creditratingagencies.

TheDodd-FrankAct,accordingtotheofficialtitle,was:

A bill to promote the financial stability of the United States by improvingaccountability and transparency in the financial system, to end “too big to fail,” toprotect theAmerican taxpayer by ending bailouts, to protect consumers from abusivefinancialservicespractices,andforotherpurposes.

Thelawchangestheexistingregulatorystructurebycreatingahostofnewagenciesinordertostreamlinetheregulatoryprocessregardingfinancialinstitutions,increaseoversightof specific institutions regardedas a “systemic risk,” andamend theFederalReserveAct.The law establishes stringent standards and supervision to protect the U.S. economy,Americanconsumers,investors,andbusinesses.Itendstaxpayer-fundedbailoutsoffinancialinstitutions,providesforanadvancedwarningsystemonthestabilityoftheeconomy,createsrulesonexecutivecompensationandcorporategovernance,andeliminatestheloopholesthatledtotheeconomicrecession.

Eitherthenewagenciesaregrantedexplicitpoweroveraparticularaspectoffinancialregulation,or thatpower is transferred fromanexistingagency.All thenewagencies, andsomeexistingones that arenot currently required todo so, arealso requiredunderDodd-FranktoreporttoCongressatleastannually.SomenewlycreatedagenciesincludetheOfficeofFinancialResearch,theFinancialStabilityOversightCouncil,andtheBureauofConsumerFinancialProtection.Changeswerealsomadetoexistingagencies.Theinstitutionsimpactedby these new changes include the Federal Reserve, the FDIC, the Securities InvestorProtectionCorporation,andtheSEC.

For those of us involved in the forexmarket, it is important to note that prior to thepassageof theDodd-FrankAct, investmentadvisorswerenot required to registerwith theSECif theinvestmentadvisorhadfewerthan15clientsduringtheprevious12monthsanddidnotholditselfoutgenerallytothepublicasaninvestmentadvisor.ButtheDodd-FrankActeliminatedthatexemption,therebyrenderingnumerousinvestmentadvisors,hedgefunds,andprivateequityfirmssubjecttonewregistrationrequirementsanddrivingalargenumberoutofthecountryoroutofthebusinessentirely.

Let’sbreakitdownforthoseofyouwhotradetheforex.Howdoesitimpactyou?

• You cannot engage in OTC foreign currency transactions unless you trade through agovernment-approvedfirm.Inotherwords,thefirmmustberegisteredwiththeCFTCandbeamemberoftheNFA.

•The former exemption formoneymanagers or financial advisorswhohad fewer than15clientsisnowgone.Soiftheyintendtomanageforexaccountsorofferadvicetoclientswho reside in the United States, they must becomemember firms of the NFA. This issimilartoregulationsyoumighthaveheardofthatmakeonlinegambling(suchaspoker)illegal forU.S.citizens;even if thecompanyyouaredealingwith is“offshore”andnotlocatedwithin theUnited States, it is illegal, and theU.S. government can go after theoffendingfirm.

•Youcannotengageinspotmetaltransactionsunlessyouintendtotakedeliverywithinthe

allowedtimeperiod.Theonlynonconspiracyrationaleforthisparticularactioncouldbetoinhibitspeculation.However,sincespeculationinmetals,throughtheuseofcommoditycontracts, is still permitted, it isunclearwhat the truegoalof thispartof theact reallywas.

Thereductionsinmarginleverageforthespotmarketfrom100:1to50:1thatwerewrittenintotheCFTCrulesthattookeffectinOctober2010seemtomatchtheperceivedintentionofthesechanges.Thereasongivenbyregulatorswastoreducetheriskofusinghighleveragethatcustomersexperiencewhentradinginthespotmarket.Butsincetheleverageavailablethrough commodity firms for both currency and metals is still higher than the previouslyavailable leverage in the spotmarket, one can only surmise that the true intentionwas tomovethistradingtothelong-establishedandregulatedCME,wherethecontractswouldbetradedasfuturescontracts.

InJanuary2011,Rep.MicheleBachmann(R-Minn.)introducedlegislationtorepealthewidelycriticizedDodd-FrankfinancialreformmeasurethatPresidentObamahadsignedintolaw.Bachmann,whomadethemoveshortlyafterbeingsworninforherthirdterm,assailedthelawasprotectingWallStreetattheexpenseoftaxpayers.

“I’m pleased to offer a full repeal of the job-killingDodd-Frank financial regulatorybill,” Bachmann said. “Dodd-Frank grossly expanded the federal government beyond itsjurisdictionalboundaries.ItgaveWashingtonbureaucratsthepowertointerpretandenforcethelegislationwithlittleoversight.”

ItappearsthattheDodd-FrankActmayberepealedthroughapiecemealprocess.AsofMay2011,itisreportedthattheHouseFinancialServicesCapitalMarketsSubcommitteehaspassed several bills that would repeal or revise several of Dodd-Frank’s more onerousprovisions.Amongthem:

•TheDataCollectionReliefAct(H.R.1062),sponsoredbyRep.NanHayworth(R-N.Y.),would repeal Section 953(b) of the Dodd-Frank Act. Section 953(b) requires publicissuerstodiscloseboththemedianannualtotalincomeforallemployeesexcepttheCEOandtheannualtotalincomeoftheCEOandtocalculatetheratiocomparingthetwofigures.

• The Small Company Capital Formation Act (H.R. 1070), sponsored by Rep. DavidSchweikert(R-Ariz.),wouldamendthe1933SecuritiesActtoexemptsecuritiesofferingsbelow$50millionfromSECregistration.Currently,theofferingthresholdis$5million.

• The United States Covered Bonds Act (H.R. 33), sponsored by subcommittee chairmanScottGarrett(R-N.J.),wouldcreateaU.S.coveredbondsmarket.

•TheSmallBusinessCapitalAccessandJobPreservationAct(H.R.1082), introducedbyRep. Robert Hurt (R-Va.), would repeal Dodd-Frank’s requirement that private equityfundsregisterwiththeSEC.

•TheBusinessRiskMitigationandPriceStabilizationAct(H.R.1610),introducedbyRep.MichaelGrimm(R-N.Y.),wouldexemptlegitimateendusersfromderivativesregulationmandatedunderthereformact.

•TheAsset-BackedMarketStabilizationAct(H.R.1539),introducedbyRep.SteveStivers(R-Ohio),would restore credit rating agencies’ protection against expert liability underthe1933actbyrepealingaDodd-Frankprovisionthateliminatedtheexemption.

•TheChurchPlanInvestmentClarificationAct (H.R.33),sponsoredbyRep.JudyBiggert(R-Ill.),wouldamendthe1933acttoallowchurchplanstoinvestincollectivetrusts.

At a session in early May 2011, in a bill delaying implementation of swaps andderivatives regulations in Dodd-Frank, Frank Lucas (R-Okla.), chairman of the HouseAgricultureCommittee,said:

EffortsofDodd-Franktoincreasetransparencyandstabilityinourfinancialmarketswill be for naught if the regulatory process is rushed.We need to acknowledge thatDodd-Frank set impractically tight deadlines for the implementation of dozens ofregulationsthatwilltoucheverysegmentoftheeconomy.

HistorywilltellusiftheDodd-FrankActsurvivesthedislikethatWallStreethasforitandthepoliticsofprovidingfundingthatisrequiredfromthecongressionalrepresentativesinWashington,D.C.

CHAPTER11REGULATORYACTIONINTHEFOREX

In the early days of the retail forex,market abuses of the investing publicweremuch toocommon,resultinginaninitiallybadreputationfortheburgeoningforexmarket.Infact,ifwego back no further than 2007, we can see case after case in which investors became theunwittingpreyofunscrupulousforexfirms.

Inthischapter,Iwilldiscusssomeoftheoldercases.Iwillnotdescribethesecasesintheirentiretiesbecausetheyarelengthy;however,whatIwanttoshowyouaresomeofthethings that are and have been going on in the industry. In the earlier years, most of theimproprietiesweremorerelatedtofuturesthanspotforex.

TheCFTCbannedmanyunprofessionalbrokersintheindustryfromthefuturesmarkets.SomeoftheseindividualsmovedtotheunregulatedretailspotforexintheUnitedStates.

Inmanyofthescamsatthetime,thebrokerswouldtaketheircustomers’money,tradingit in the spot forex and in the futures market, or just not trading it at all—which, in myopinion,ismoreappropriatelylabeledasstealing.

Youwillreadthattheindustryhadabadreputationforcustomersusingthemarketforillicitpurposessuchasmoneylaundering.Thecashmarketswereaneasyplace to laundermoney.Criminalsweresendingincashtobetradedthroughoffshoredestinations.

Some of these practices resulted in much stronger and tighter anti–money launderingpractices.Thatcoupledwith thechangesmadeafter9/11reducedmoney launderingwithinthe spot retail forex significantly, as the broker becameprimarily responsible for knowingwherethemoneywascomingfrom.

CFTCCASE#1

February11,2004U.S.COMMODITYFUTURESTRADINGCOMMISSIONCHARGESFLORIDAFOREIGNCURRENCYOPTIONSFIRMWITHDEFRAUDINGCUSTOMERSCompanyandFirmLiedWhenPitchingForeignCurrencyOptionstoCustomers.ForexBrokerAlsoCharged.

The CFTC filed a complaint in a Florida federal district court against a Floridacorporation and residents of Boca Raton, Florida, and the surrounding area for allegedlydefrauding customers they solicited to trade foreign currency options. The complaint alsochargedaNewYork–basedforeigncurrencydealerwithliabilityasaprincipalfortheactsofitsIB.

AfederaldistrictcourtjudgeissuedarestrainingorderfreezingtheassetsoftheIBandprincipals. The restraining order also prohibited those defendants and the broker fromdestroyingdocuments.

ThecomplaintallegedthatstartinginMay2002,theIBandprincipalssolicitedatleast

267membersoftheretailpublictotradeforeigncurrency(forex)optionsthroughthebroker.Accordingtothecomplaint,theIBusedaggressive,high-pressuresalestactics,including(1)makingfalsepromisesof largeprofits, (2)misrepresentingthebroker’sexpertiseandtrackrecord,and(3)downplayingtherisksinherentintradingforexcurrencyoptionscontracts.

ThecomplaintalsoallegedthattheIBfailedtodisclosethatoneoftheprincipalshadpreviouslybeenenjoinedbyafederalcourtfromcommittingsolicitationfraudinconnectionwithoptions,andthattheCFTChadissuedaceaseanddesistorderagainstthisperson,alsoprohibitinghimfromcommittingoptionsfraud(CFTCDocketNo.94–8,December9,1993).

Thecomplaintfurtherallegedthatthispersonwasresponsibleforthemajorityoftradingdecisionsmadeonbehalfof theIB’scustomersandthathemadedeceptiveandmisleadingstatementstocustomersandprospectivecustomersregardingtheprofitpotentialandinherentrisksassociatedwith tradingforeigncurrencyoptionscontracts.Thecomplaintalleged thattheseactionsviolatedtheantifraudprovisionsoftheCEAandCFTCregulations.Asalleged,theIB’spresident,vicepresident,andcompliancemanager,werechargedinthecomplaintastheIB’scontrollingpersons.

According to the complaint, more than $3 million of the IB’s customer funds wasdepositedandtradedatthebrokerage.Thecomplaintallegedthat, throughanexclusiveIB-brokeragebusinessrelationshipinwhichtheIBactedasthebroker’sagent,thebrokerpaidtheIBover$800,000incommissionsinconnectionwiththecustomers’accountsthattheIBintroduced.

Thiswasmoreofacasewhere the former futures individualshadpreviouslybeen introubleandmovedtotheforexmarket.

CFTCCASE#2

AnotherblatantcaseresultedinanorderfromtheU.S.districtcourtthattheownerandhiscompanywouldhavetopayover$33millioninrestitutionandcivilpenaltiesforengaginginfraud in the sale and solicitation of illegal forex futures contracts and misappropriatingcustomerfunds.

Theownerwasalsosentencedto97monthsinprison.Thefirmsolicitedcustomerstoparticipateinaforexfund,andinordertodosothefirmmisrepresentedtheprofitandrisksinforextrading,it issuedfalseaccountstatements,anditusednew-customermoniestopayoffothercustomers’fictitiousprofitsontheirinvestments.

This case represented a typical Ponzi scheme,which is an incredibly common themewhen it comes to investment scams.On that subject, let’s takeabrief lookathowaPonzischemeworksandsomeofthewaystorecognizethesigns.

WhatIsaPonziScheme?

A Ponzi scheme is an investment fraud that involves the payment of purported returns toexisting investors from funds contributed by new investors. Ponzi scheme organizers oftensolicitnewinvestorsbypromisingtoinvestfundsinopportunitiesclaimedtogeneratehighreturnswith littleornorisk.InmanyPonzischemes, thefraudstersfocusonattractingnewmoney to make promised payments to earlier-stage investors and to use for personal

expenses,insteadofengaginginanylegitimateinvestmentactivity.

WhyDoPonziSchemesCollapse?

With little or no legitimate earnings, the schemes require a consistent flowofmoney fromnewinvestorstocontinue.Ponzischemestendtocollapsewhenitbecomesdifficulttorecruitnewinvestorsorwhenalargenumberofinvestorsasktocashout.

HowDidPonziSchemesGetTheirName?

TheschemesarenamedafterCharlesPonzi,whodupedthousandsofNewEnglandresidentsintoinvestinginapostagestampspeculationschemebackinthe1920s.Atatimewhentheannualinterestrateforbankaccountswas5percent,Ponzipromisedinvestorsthathecouldprovide a 50 percent return in just 90 days. Ponzi initially bought a small number ofinternational mail coupons in support of his scheme, but he quickly switched to usingincomingfundstopayoffearlierinvestors.

WhatAreSomePonziScheme“RedFlags”?

ManyPonzischemessharecommoncharacteristics.Lookforthesewarningsigns:

•High investment returnswith littleorno risk.Every investment carries somedegreeofrisk, and investments yielding higher returns typically involve more risk. Be highlysuspiciousofany“guaranteed”investmentopportunity.

•Overlyconsistentreturns.Investmentstendtogoupanddownovertime,especiallythoseseeking high returns. Be suspect of an investment that continues to generate regular,positivereturnsregardlessofoverallmarketconditions.

•Unregisteredinvestments.Ponzischemestypicallyinvolveinvestmentsthathavenotbeenregistered with the SEC or with state regulators. Registration is important because itprovides investors with access to key information about the company’s management,products,services,andfinances.

•Unlicensedsellers.Federalandstatesecuritieslawsrequireinvestmentprofessionalsandtheir firms to be licensed or registered. Most Ponzi schemes involve unlicensedindividualsorunregisteredfirms.

•Secretiveorcomplexstrategies.Avoidinginvestmentsyoudon’tunderstandorforwhichyoucan’tgetcompleteinformationisagoodruleofthumb.

•Issueswithpaperwork.Ignoreexcusesregardingwhyyoucan’treviewinformationaboutan investment in writing, and always read an investment’s prospectus or disclosurestatement carefully before you invest.Also, account statement errorsmaybe a sign thatfundsarenotbeinginvestedaspromised.

•Difficulty receiving payments. Be suspicious if you don’t receive a payment or havedifficulty cashing out your investment. Keep in mind that Ponzi scheme promoterssometimesencourageparticipantstorolloverpromisedpaymentsbyofferingevenhigherinvestmentreturns.

CFTCCASE#3

InDecember2007,theCFTCconcludedanactionthathadbeenfiledin2005regardingforexboiler room fraud. That action resulted in $3.4million in sanctions against a firm and itsprincipalafterconcludingthattheyhaddefraudedcustomerswholostmorethan$1.7milliontradingintheforex.

TheCFTCwasawardedadefaultjudgmentorderagainstthefirm.Thejudgmentfoundthat the firm had fraudulently operated a foreign currency (forex) boiler room, and thejudgmentpermanentlyprohibitedthedefendantsfromengaging,directlyorindirectly,inanybusinessactivitiesrelatedtocommoditytrading.

The original complaint alleged that beginning in December 2001 the defendantsfraudulently solicited investments from at least 160 retail customers in forex contracts.During those solicitations, the defendants made false promises of high returns; failed todisclosehiddencommissioncharges;issuedaccountstatementsthatfalselycharacterizedtheundisclosedcommissionsastradinglosses;madefalserepresentationsregardingtheriskofforex trading, as well as their experience and past performance in trading forex; andmisappropriatedcustomerfunds.

In April 2007, the court granted the CFTC’s summary judgment motion and orderedpenalties, including more than $2 million in monetary sanctions, against the firm, itsprincipals,andemployees.

CFTCCASE#4

Oneof thebiggerandmoredisturbingCFTCcaseswasresolved in2009whentheagencyobtainedanemergencycourtorderfreezingassetsheldbytwoMinnesotaresidentsandtheirfirms.AllwerechargedbytheCFTCwithfraudandmisappropriationinconnectionwithoff-exchangeleveragedforeigncurrency(forex)trading.

Thecourt’sorderalsoprohibitedthedestructionofbooksandrecordsandprovidedtheCFTCaccesstosuchdocuments.TheCFTCchargedthedefendantswithrunningamassiveforexscheme thatdefraudedhundredsofcustomersofmore than$190million.Thecourt’sorder originated from a CFTC complaint, filed under seal in November 2009 in the U.S.DistrictCourtfortheDistrictofMinnesota,chargingthedefendantswithrunningamassiveforexschemesince2006.

The complaint also charged that the defendants misappropriated customer funds topurchase property, develop a hotel and casino, buy seven luxury cars, and purchase ahouseboatandasubmarine,aswellasfundtheirfrequentgambling.

The defendants allegedly solicited customers to trade forex by fraudulently claimingthat,since2003,theyearnedmorethan10percentannualprofitsandsustainednolosses.Thedefendantsalsoclaimedthatcustomers’fundswereplacedinmanaged,segregatedaccountswith a Swiss company that was majority-owned by one of the firm’s principals sinceDecember2008.

Instead,defendantsmisappropriatedcustomerfundsandcontinuedtosolicitandacceptfundsuntilJuly2009,eventhoughtheSwissFinancialMarketSupervisoryAuthorityplacedtheSwissforexfirminquestionintoreceivershipinDecember2008andintobankruptcyin

May 2009. The defendants allegedly perpetuated their fraud by providing customers withaccount statements that falselydepicted their accounts as earning from10 to 12percent inannualprofits.

CFTCCASE#5

EvenfirmsoutsidetheUnitedStatesarenotimmunetotheactionsoffederalregulators.OnDecember 7, 2010, the CFTC announced the filing of an enforcement action in the U.S.DistrictCourt for theDistrictofUtahagainst aprivateMexican financial servicesholdingcompany, and its foreign currency (forex) trading division, with issuing false customerstatementsandmisrepresentingtradingresultsonthecompany’sWebsiteinconnectionwiththe company’s foreign currency trading enterprise. This particular group had never beenregistered,inanycapacity,withtheCFTC.

TheCFTC’scomplaintallegedthat,fromatleast2005to2010,thedefendantsacceptedat least$28millionfrommorethan800U.S.customersfor thepurposeof tradingforexonbehalfofcustomers inpooledaccounts.Thecomplaintfurtherallegedthat, fromJune2008through April 2009, the defendants reported trading profits when, in fact, they lostapproximately$19.4million.

Thedefendantsallegedlyreportedtradingprofitsinatleasteightseparatemonths,whentheyactuallyincurredsubstantialtradinglosses,oftenexceeding$1millionpermonth.SonoplaceissafefromtheCFTCwhenitseeswrongdoingintheforexmarkets.

CFTCCASE#6

OnJanuary26,2011,initsfirstactionsincethenewrulestookeffectinOctober2010,theCFTCdecidedtosue14foreigncurrencyfirmsinanationwidesweep.TheCFTCannouncedthat it simultaneouslyfiled13enforcementactions in federaldistrictcourts inChicago, theDistrict of Columbia,Kansas City, andNewYork, alleging that 14 entitieswere illegallysolicitingmembersof thepublic toengage in foreigncurrency(forex) transactionsand thattheywereoperatingwithoutbeingregisteredwiththeCFTC.

These new regulations require entities that wish to participate in the forexmarket toregister with the CFTC and abide by regulations intended to protect the public. Theseregulations require that forex dealers take steps to protect investors, includingmaintainingminimum capital and proper records, which would reduce risk and increase transparencythroughouttheindustry.

Intheforexmarket,entitiesknownasretailforeignexchangedealers(RFEDs)orfuturescommission merchants (FCMs) may buy foreign currency contracts from or sell foreigncurrencycontracts to individual investors.Under theCEAandCFTC regulations, anentityacting as an RFED or FCM must register with the CFTC and abide by the rules andregulations designed for investor protection, including those relating to minimum capitalrequirements,recordkeeping,andcompliance.Further,withafewexceptions,suchanentityalso must be registered with the CFTC if that entity solicits or accepts orders fromU.S.investorsinconnectionwithforextransactionsconductedatanRFEDorFCM.

Inallbuttwoofthecomplaints,theCFTCallegedthatadefendantactedasanRFED;thatis,itofferedtotakeortooktheoppositesideofacustomer’sforextransactionwithoutbeing registered. In the remaining two complaints, the CFTC alleged that the defendantssolicitedcustomerstoplaceforextradesatanRFEDwithoutbeingregisteredasanIB.

Ineverycomplaint, theCFTCalleged that thedefendantssolicitedoracceptedordersfromU.S. investors to enter into forex transactions in violation of the act. TheCFTChadmovedforpreliminaryinjunctionspreventingthesedefendantsfromoperatingunlessanduntiltheycompliedwiththeCEAandCFTCregulations.TheCFTC’scomplaintsalsosoughtcivilmonetarypenalties,tradingandregistrationbans,disgorgement,andrescission.

I stronglyurge thepublic tocheckwhethera forex firm is registeredbefore investingfunds.IfacompanyoperatingintheUnitedStatesisnotamemberoftheNFAorregisteredwiththeCFTC,aninvestorshouldbewaryofprovidingfundstothatcompany.

WhiletheCFTCrepresentsregulatoryoversightandenforcementactionsagainstforexfirmsatthefederallevel,theNFAisanSROchargedwiththeoversightofitsmembers.Inmanycases,theendresultofNFA-originatedactionscanbeseeninCFTCactionslikethoseIhavejustdiscussed.TheNFAalsohastheabilitytosanctionandbarmembers.Let’stakealookatafewofthesecases.

NFACASE#1

InApril2010,theNFApermanentlybarredaforexfirm,registeredasaCTAandlocatedinIllinois, fromNFAmembership.The decision by theNFAalso barred the firm’s principalfromNFAmembershipforaperiodoftwoyears.Thefirm’sprincipalwouldhavetopayafineof$5,000inordertoreapplyforNFAmembershipaftertheexpirationofthetwo-yearbar.

ThedecisionthatwasissuedbyanNFAhearingpanelwasbasedonanNFAcomplaintfiledinAugust2009andasettlementoffersubmittedbytheforexfirmanditsprincipal.Aspartof its settlement, the firmagreed topermanentlywithdraw fromNFAmembershipandconsenttofindingsthatitcommittedtheviolationsallegedinthecomplaintwithoutadmittingordenyingtheallegations.

The panel found that the firm used a misleading Web site, as well as misleadingcustomeraccountdocuments.Asallegedinthecomplaint,alltheU.S.customerswithwhomthe NFA spoke expressed confusion regarding the nonregulated forex firm that they weredoingbusinesswith,aswellaswhichentitieswereactuallyregulatedbytheNFA.

NFACASE#2

InOctober2010, theNFAordereda forexdealermemberfromNewYork topaya fineof$320,000asaresultofacomplaintissuedbytheNFAandasettlementoffersubmittedbythefirmanditsprincipal.Thecomplaintallegedthatthefirmengagedincertainpriceslippagepracticeson theMetaTraderplatformthatwerefavorable to itandcauseddisadvantageoustradingconditionsforcertaincustomers.

The complaint also charged that the forex firm failed to supervise the MetaTraderplatform used for its forex business and also failed to supervise the firm’s operations. Inadditiontohavingtopaythefine,thefirmhadtoprovideappropriaterefundstoitscustomersas a result of these asymmetrical slippage practices. The firm and its principal neitheradmittednordeniedthecharges.

NFACASE#3

At the same time in another case theNFAordered a forexdealermember located inNewJerseytopaya$459,000fineasaresultofacomplaintissuedbytheNFAandasettlementoffersubmittedbythefirmanditschiefexecutiveofficer.

TheNFA’sBusinessConductCommitteeallegedthattheforexfirmengagedinabusivemargin,liquidation,andpriceslippagepracticesthatbenefitedthefirmtothedetrimentofitscustomers. The committee also alleged that the firm failed tomaintain records for certainunfilled orders, failed to adequately review the activities and promotionalmaterial of thefirm’s unregistered solicitors, and failed to supervise the firm’s operations. In addition tohaving topay thefineamount, theforexfirmalsohad toprovideappropriaterefunds to itscustomers as a result of these detrimental margin, liquidation, and asymmetrical slippagepractices.Thefirmanditschiefexecutiveofficerneitheradmittednordeniedthecharges.

ItisclearfromthesecasesthattheCFTCandtheNFAtaketheabusesofcustomersveryseriously andwill not hesitate tobring appropriate action inorder toprotect the investingpublic.Withthatinmind,itistheresponsibilityofthemembersoftheinvestingpublictodotheirownduediligencewhenchoosingaforexfirm.Remembertheoldsaying,“Ifitsoundstoogoodtobetrue,itprobablyis.”

NFACASE#4

OnJune30,2008,theNFAissuedacomplaintchargingabrokerwithfailuretoimplementanadequate anti–money laundering program. The complaint also charged the broker andprincipal with failure to supervise and failure to implement an adequate anti–moneylaunderingprogram.

OnApril24,2009,adesignatedpaneloftheHearingCommitteeissuedadecisiontothebrokerandprincipalafterahearingwasheld.ThehearingpaneldeterminedthattheNFAdidnotprovethefailuretosupervisecharge;therefore,CountIIwasdismissedwithprejudice.Thehearingpanel ordered the broker to pay a $250,000 fine and to retain an independentauditingfirmtoconductfoursemiannualauditstoreviewcompliancewiththeBankSecrecyAct, the implementingregulations, theNFA’santi–money launderingrules,and thebroker’sownanti–moneylaunderingprocedures.

On January 21, 2010, the NFA’s Appeals Committee issued a decision affirming thehearingpanel’sdecisionabout thebroker. Inaddition, theAppealsCommitteereversed thehearing panel’s finding that the NFA did not establish that the principal violated NFAComplianceRule2–36(e)andorderedtheprincipaltopaya$50,000fine.

Oneofthemorehigh-profilefraudswasthedownfallandultimatebankruptcyofRefco.

Let’stakealookathowtheRefcocollapsehasaffectedtheretailforexindustry.

THEREFCOIPOANDSCANDAL

Oneofthemorehigh-profilefraudswasthedownfallandultimatebankcruptcyofRefco,Inc.,which specialized in forex and commodities. The company was actually one of the mainfuturesbrokersontheCME.In2005,thecompanystartedtocometumblingdown.RefcowasforcedintofilingChapter11bankruptcyfromcreditors.NewsabouttheCEO’sinvolvementinthecompany’smassfraudpracticeswasabouttobreak,includingthefactthattheCEOhidthecompany’sbaddebts,whichstemmedfromloansbyBawagP.S.K,thefourthlargestbankinAustria.

Thetimingofthebankruptcywasironic,comingshortlyontheheelsofaninitialpublicofferingRefcowasinvolvedin.Thisraisedtheeyebrowsofsomeoftheregulatorsand,ofcourse, some of Refco’s newest investors. By holding the looming revelations from thepublic,itwasevidentthatthemanagementmayhavehelpedinflatethestock’sinitialoffering.

The shares were offered to the public at an initial price of $22 per share through anumberofdifferentinvestmentbanks;someofthebankswerethelargestonWallStreet.Youcanimaginetheblackeyetheywereabouttoreceive,sincethebanksshouldhavedonetheirduediligenceonthecompany’sfinancialsinthefirstplace.

A quick review of how the Refco stock did will show that the shares were tradedpublicly for about two months, with a high of $30.12 on September 7, 2005. The fraudannouncement happened in October of the same year, barely amonth after the high. As aresult, investors ran for the hills in a panic, sending the 26.5million shares of the newlypubliccompanycrashingtojust$0.80ashare.

Apparently theCEOwaspadding the company’s financials byhiding$430million inbad debts through various subsidiaries. This would create a problem for Refco’s othercompaniesincludingitsforexbrokeragebusiness.

RefcoFX,LLC,hadjustover17,000retailcustomerbrokerageaccountsatthetimethatit declared bankruptcy. In the bankruptcy proceedings, Bank ofAmerica, alongwith othermajorcreditors,convincedthebankruptcycourt that thecustomerswereactuallyunsecuredcreditors.Refcohadn’tsegregatedthecustomers’funds,eventhoughthecompanyhadtoldthecustomersitdid,causingthecustomerstobecomeunsecuredcreditors.

This legal action by the large creditors essentially sealed the fate of theRefco forexcustomers.Theywerenow treated asunsecured creditors andhad towait in line after thesecured creditors got their money. This probably would not happen in today’s regulatoryenvironment.Butyouneverknow.

Another forex firm tried tocome inandactuallybuy thecustomers fromRefco,but itwas unsuccessful in doing so. The customers basically lost anything they had left in theiraccountsandwereabletorecoverjustpenniesonthedollar,ifanything.

Refcocreditorsultimatelylostabout$2.4billionintotalandrecoupedabouthalfofthatback.

RECENTCASES

Let’stakealookatsomeofthemostrecentlitigationgoingonintheindustryonaretailbasis,atthetimeofwriting.

AlargelawfirminFloridahasrecentlyfiledaclass-actionlawsuitagainstaprominentforexbrokerallegingfraudandracketeeringbythenation’slargestforexdealer.

The lawsuit, filed in the U.S. District Court for the Southern District of New York(Manhattan Division), alleges that the broker has bilked thousands of customers out ofhundredsofmillionsofdollarsusingdeceptiveandunfair tradepractices, includingfalselyportrayingitsforextradingplatformasafair,transparent,andtrueforeigncurrencyexchangewheninsteaditisa“riggedgame”designedtosystematicallyseparatecustomersfromtheirmoney.

The plaintiff brought the action on behalf of himself and all others similarly situated,accusingthebrokeroffraudbymisrepresentingitselfasatradingplatformthatisfreefromdealerinterventionormanipulation.Instead,theplaintiffalleges,thebrokerusedanumberofdevices and tricks, including software applications, designed specifically to interferewiththecustomers’trades.

Thecomplaintfurtherallegesthatthebrokerengagedinapatternofracketeeringactivityby collaboratingwith its software developers and programmers to develop a “diabolical”softwareapplicationthatprovidedthebrokerwithamyriadoftoolsandsystemcommandsinwhich to interfere with customers’ trades, including routing trades to “slow” servers andsendingfalse“error”messageswhencustomersattemptedtocloseoutprofitabletrades.

Finally,theplaintiffallegesinthecomplaintthatthebrokerluredthousandsofcustomersto its trading platform by promoting a “demo account,” which was touted as providingcustomers with a true market trading experience. Instead, he claims, once “live” tradingcommenced, the broker deployed specially designed software to manipulate customers’trades.

Thelawfirmbelieves thiswillbeanimportantstepinbolsteringaccountability inanindustry that has been largely unregulated since inception. The law firm believes, as thecomplaint alleges, that the broker has taken advantage of the trust placed in it by itscustomers, causing substantial financial harm to this group of people, and the firm iscommittedtoworkingtorecoverthoselosses.

Thereisunfortunatelyamultitudeoflitigationonthehorizonforsomeofthesecrookedforexdealers. Iwould suggest thatyou simply stay informedaboutwho isdoingwhat andwhen.Youcanalwaysgotowww.jdfn.comtostayuptodateoncurrentlitigationintheforexmarket.

PART3FOREXBROKERSCHEMES

CHAPTER12BACK-OFFICESOFTWARESCAMS

Bythetimeyoureadthis,youshouldhavecometorealizethatmostforexbrokersusevarioustactics toseparateyoufromthedeposits inyour tradingaccount.Butasa trader, itmaybedifficult to recognize thevarious toolsyourbroker isusingagainstyou.Brokershaveverysophisticatedandspecializedsoftwareattheirdisposaldesignedspecificallyforthepurposeoftradingagainstyourpositions.Inthischapter,wetakeadeeperlookintowhatyourbrokerisdoingtoyou,asyouwillsoonrealizethereismoretothestorythanyourbrokerjusttakingacounterpositiontoyourtrade.

Theadvancedsoftware thatbrokershave inplaceallows them to“steal”money rightfromunderyournosewithoutyourevenknowingitistakingplace.Haveyoueverwonderedwhywhen using your practice account or demo account, you never seem to have a losingtrade?Haveyoueverwonderedwhybrokerssoaggressivelypushtheirpracticeaccountsordemoaccounts?

Thereisareasonforthismadness,atleastfromthebroker’sstandpoint;itflowsrightintothenextquestion.Nowthatyouhavedecidedtotraderealmoneyandyouhavefundedyour account,why is it you can’t seem to place a profitable trade, even thoughyou’re notdoinganythingdifferentlythanyouwereinyourdemoorpracticeaccountprovidedbyyourbroker?

Howcould this be? In a demoor practice account, you are receiving straight-throughpricing(STP),withyourbroker’scommissionsormarkupaddedtoittogiveyouthebidandaskprices.Thisisprettystraightforward;whenyouplacethetradeinthedemoorpracticeaccount,thepriceyouseeisthepriceyouget;however,moveaheadtoyourliveaccount,andthisisnotalwaysthecase.Brokershaveafinancialincentiveforyoutolosemoneyaslongas they are the counterparty to the trade; themore you lose, themore theymake. So let’sdiscusssomeofthesinistertoolsyourbroker-dealerhasleveragedagainstyoutoensureyourlossesandafinancialwindfallforyourbroker-dealer…atyourexpense.

VIRTUALDEALERPLUG-IN

IwouldliketostartbydiscussingtheVirtualDealerPlug-In;soundsharmlessenough,right?The Virtual Dealer Plug-In has a number of ways to take advantage of the unsuspectingcustomer. It allows the broker-dealer to compete with you and have complete success incomparison with your trade account bymanipulating trades with manual execution ordersthroughforexsymbolsorgroups.

TheVirtualDealerPlug-Inimplementsanumberoffeaturesthatleavetradersbelievingthey are placing legitimate orders; however, the broker can delay your order fill times byseveral seconds to allow formarketmovement against you from the time you placed your

tradeuntilthebrokerfillsyourorder.Theplug-inalsowillcheckyourlimit,stoplevels,andfreeze levels, allowing the broker to make the difference at your expense. Virtual DealerPlug-Insalsoprocesspending-orderactivations,stoptriggers,andstop-outs;thiswillallowthebrokertoliterallymovethemarkettotriggeryourstopandtakeyououtofatradewithaloss.

These plug-ins have the ability to stream prices for instant executionwith adjustableslippagerates.Thiswillallowapredeterminednumberofpipstobeaddedtoanyentryorexityouplace in themarket, increasing thebroker-dealer’sbottomlineasyou losemoney.TheVirtualDealerPlug-Inwilluseautomatedshiftparameterstomovethelimit,stoplevels,andfreezelevelsaccordingtothepreset listofnewseventsandtimes.Anditwilldisablesettings,modifyinganddeletingpendingordersduringnewsevents,leavingthetradertotallyhelpless during the market’s most active times, often resulting in substantial loss or evenliquidationofyourtradeaccount.

SLIPPAGE

TheVirtualDealerPlug-Inallowsthebroker-dealertoworkyourorder.Allbrokersreceivea number of prices from their prime bank; however, they only show you an aggregated oraverageprice.Usingslippage,yourbrokercanfillyourtradeat theworstpricethemarkethastooffer,fillthetradeforitselfatthebestpriceinthemarket,andholdthecounterpositionto the trade. This is instant profit for the broker-dealerwith virtually no risk; the broker-dealersimplymakesupthedifferencefromwhereitfilledyouattheworstpriceandwhereitisholdingthetradeatthebestprice—inessence,freemoneyforthebroker-dealer.

GAP

ThisVirtualDealerPlug-Indecreasesthelikelihoodthatamarketgapwillimpactthebrokeradversely.Ifthemarketgapsorthepricemovesbeyondthegapspreadpreviouslysetbythebroker-dealer,thebroker-dealercanissuearequotetothetrader,makingthetradeyouplacenull and void.However, if the price jumpswithin the spread, the pricewill be taken anddelivered.

NEWS TRADING AND VOLATILE MARKETCONDITIONS

Brokers can set spreads to widen at a time of volatility, usually around news events orimportant announcements. Brokers set the Virtual Dealer interface to increase spreads attimes when themarketmay bemost volatile, thus penalizing traders for tradingwhen themarketismostactiveandliquidallthewhileincreasingthebrokers’profitmargin.

To top it off,many brokers trade against you using your owndeposits!How can thishappen?Verysimply;whatbrokerswilldoisputallthecustomerdepositsintotheirprime

brokeraccountandallowyoutotrademarginonyourposition.However,usingthebrokers’leverage,youonlyevertouchafractionofthedepositedamount,leavingalargeportionoftheaccountbalanceuntouchedinthebroker’saccount.Whenyouplaceyourpositionatthemarket,brokerswilluse thedeposits left in theprimebrokeraccountas thecounter to thetrade, potentially using your ownmoney to trade against you and keeping themoney theysystematicallysiphonfromtradesyouplaceastheirprofitwithoutevertouchinganyoftheirowncapital.

Iwasinasituationnottoolongagowhenanacquaintancewhoworksatamajorforexbrokerwasbraggingtomehowmuchhisfirmwastradingintheforexeveryday.I thoughtthatwasprettyboldconsideringthatthefirmwasessentiallytradingcustomers’money.Thefirmmaytradesomeofitsmoney,butinrealityitisjustplacingtradesagainstitscustomer.Ifitrunsadealingdesk,thenitisplacingtradesagainstitscustomers.Andifitisnotrunningadealingdesk,itisprobablyplacingtradesagainstitscustomers.EvenifitisrunningSTP,itisstillgettingaccesstoallitscustomers’moneythatisfreefrommargin.

Theseareonlyafewofthetoolsandautomatedsystemsthatbrokershavespentmillionsofdollarstopurchaseanddeveloptotradeagainsttheircustomers.Asyoucansee,evenifyour broker claims not to have a dealing desk, in today’s technology-driven environmentbrokersnolongerneedatraderattheotherendtomaketheorders.Theycanrelyoncomplexcomputeralgorithms,dealerinterfaces,andsoftwareplug-instodothejobwithnearflawlessexecution.

CHAPTER13SLOWSERVERSANDERRORS

In this chapter—one of themost important in this book—Iwill talk about not onlywhat Iknowfromanextensive two-year investigation that Iconductedonmyownbutalsowhat Ihavelearnedfrompersonalexperienceinmytrading.Unfortunately,whatIdiscoveredwasthatthedeviouspracticesIfoundarenotspecifictojustonebrokerbutapplytomany;weallknowbrokerswhousesomeoftheseunscrupuloustactics.

Withthatsaid,letmeclarifythatnotallbrokersarebad.ButIhavefound,throughmyowntradingexperiences,thatmostofthemseemtobethatway.Asnotedabove,Ispentthebetter part of two years investigating the brokers in the forex industry. It was a personalcrusade.ThereasonIspentsomuchtimetryingtogettothebottomofwhatwasgoingonissimple.Iwantedtoknowwhyaperfectlysoundandtestedtradingstrategycouldgobadallofa sudden,andhavenothing todowithchangingmarketconditions. Ihavewitnessedmyaccountsgodownfornospecificreasonandfeltsomethingstrangewasgoingon.

During my investigations, I uncovered how brokers use latency to their advantage.Latency,or slow fills, is abenefit tobrokers andcertainlynot somethingwewant to dealwith;butwhenwearesettingupourtradingsystems,wewanttomakesurethatwehavethemostdirectaccesstothebanksaspossible.

Thatmeans every server youuse, includingyourdesktopor laptop, and everybrokeryouemploywillslowthetransactiondown.Everytimeabrokerisbetweenyourtradeandthebank,thingscangowrong.Theproblemisthatwecannoteasilygodirectlytothebank.Mostprimebanks,suchasBankofAmerica, requirevery largeminimumdeposits to tradedirectlywiththem.Youcantradedirectlywiththemasyourtieroneprovider,but theyaregoingtorequirethatyouhaveatminimum$150milliontoopenyouraccount.

Thereareothersuchbanksouttherethatwillprovideaninterimorentry-levelsolution.Theywillrequiremuchlessmoney,someaslittleas$500,000,andthentheyaggregatethebalances tobasicallyhavetheironeaccountwithaprimebank.Thiswillhelpyouinyourexecutions,butintheendyouhavetoknowwhatisgoingonsothatyoucanbeatthebanksandthebrokersattheirowngame.

Slow servers are somethingmost commonly used by brokers that are trading againstyouraccount.Thereasontheywanttoslowdownyourtradeexecutionissothattheycangointo themarketplaceandgetabetterprice themselvesbefore takingyour trade,whether toopenorclose.Anytimeyouhaveslowfillsonyourtrades,youshouldimmediatelysuspectthatsomethingisgoingon.

Youwillmainlyseethishappenwhenyouaretradinglargeamountsorifyouraccounthasbeenprofitableforsometime.Oneofthethingsthatyoucandotohelpprotectyourselfistocontinuallytaketheprofitsoutofyouraccount.Everytimeyouhitapredeterminedgrowthinyouraccount,youshouldsimplywithdrawtheexcess.

Atsomepointyouwillbetradingthebank’smoneyliterally,insteadofyourmoney.Ifyouwanttokeepcompoundingyourprofits,openanotheraccountatadifferentbroker;thatwayyoucanstayofftheradarandeludedetectionasatraderthatmakestoomuchmoney.

Duringmyinvestigations,Ihaveseenvariouse-mailsthatwerecommunicationswithinabrokerageandthatspecificallytalkedaboutprovidingdifferentserverstodifferentlevelsofcustomers.Thedifferentserverseachhave theirownspecialsettings.MetaTraderalonehasatleastfiveservers.IfyouarefamiliarwithtradingwithMetaTrader,thenyouknowthatyoucanseeamultipleofdifferentservers.

In my case, when I was trading one of my most successful accounts, I was using aMetaTraderterminal.Aboutninemonthsintonomonth-over-monthdrawdowns,Ireceivedane-maillettingmeknowthatmybrokerwasworriedaboutmynotgettingthebestfills,andsothefirmwasmovingmetoanewserver—abetter,fasterserver,accordingtothecompany.Thefunny(ornotsofunny) thingwas that Ineverhadaprofitablemonthagainafter Iwasmoved to thenewserver. Iwas inundatedwitherrors, slowfills,andnofills.The latencywasridiculous;mytradeshadslippageonwhatseemedtobeeverysingletrade.

Further,readingthroughthee-mailsthatIhadaccessto,IwasabletofindthatnotonlydothebrokersthatuseMetaTraderhavemultipleMetaTraderservers,buttheyactuallyhavespecificserversforslowingdownthetrades.Inaddition,Ifoundthattheseserversnotonlyslow the trade but also have amyriad, sometimes thousands, of different settings to assistbrokersinseparatingyoufromyourmoney.

Ifyouaskedthosebrokersaboutthemanyserverswiththousandsofsettings,theywouldsaythatallthoseserversandsettingsareneededforriskmanagement.Thatmightbeso,buttheriskmanagementtheyaretalkingaboutismanagingtheriskthatyouaremakingmoneybuttheyarenot.Sotheyhavetoeliminatetherisk,atyourexpense.Iknowthisbecausethatiswhatnumerousbrokersdid tome,and this iswhat theysaidwhenIconfronted themabouttheirslowfills,errors,slippage,etc.

So pay close attention to your trades; if for some reasonwhen you push theTRADEbuttonyourorderisnotgoingthroughinmilliseconds,thensomethingmaybewrong.Putyourbrokeronthespot;usee-mailandfindoutwhatisgoingon.Ifyoufindthatyoucannotgetofftheslowserver,thenchangebrokers.

Use the e-mails as your chain of information and save them for your records. I havefoundthatwhenyoutalktoyourbrokersonthephone,theywillsayonething;butwhenyougetane-mailresponse,theyaremuchmorelikelytotakeapositionandsticktoit.Keepinmindthatthebrokersarerequiredtorecordtheircalls.

OFF-PRICEQUOTES

Youwill find the errors of off-pricequotes primarily onMetaTrader terminals, but I haveseentheerrormessageonotherbrokerplatformsaswell.Thisisyetanotherwaytoeliminateyour chances of making money trading. The “off-price quote” error message will usuallycomeupinfast-movingmarketswhenthebrokerwillhaveahardtimeshoppingyourorder.

Whenyou see this errormessage, you know that the broker isworking your trades. Ihavebeenintradesandtriedtogetout,onlytoclicktheCLOSETRADEbuttonandgettheoff-pricequoteerror.Worseyet,Ihavebeeninprofitabletradesandattemptedtoclosethetradesrepeatedly,insomeinstances10to20times—andrepeatedlygottheerrormessage—beforeIfinallygotmytradesexecuted,onlytofindthatI lostmoneyonthetrades.Bet thebrokerdidn’tlosemoneyonmytrades.

Youcangotoyourlogsonyourcomputerandseethegamesthatarebeingplayed.Thesoftwaretradingplatformsthatyouusewillnormallyleavelogsofthetradesonyoursystem.MetaTraderdefinitelydoes.Youcansiftthroughtheselogsandseetheerrorsandwhentheyoccurred.Quitefrankly,thelogsarefairlyinterestingtoreadafterthefact.Youcanclearlyseepatternsofwhenthebrokersarespecificallytargetingyou.Gotowww.jdfn.comtoseemoreonhowtofindandreadyourlogs.

TRADECONTEXTBUSY

ThisisanerrorthatismoreprevalentusingexpertadvisorsorrobotsonMetaTrader.Ifyouareusingrobotsandhappentobeusingseveralonthesamecurrencypair,youwillfindthiserrorcomeup.Basically,whatishappeningisthatyourindividualrobotsaretryingtohittheserveratthesametimetogetinoroutofatrade.Yourrobotscanonlymakeonetradeatatime.Thereisalsoaknownsettingontheback-officeMetaTradermanagerusingthedealerplug-insthatcanallowthebrokertorejecttheorderofwhomeverthebrokerwantstofreezeoutofatrade.

WORKINGORDERS

Ah,theworkingorder,whataridiculouserror!Iamnotevensuremybrokerknewthatthiswasatradingterminalerror.Ihavepersonallywitnessedthisonetoomanytimes.Infact,thiserrorcamefromasoftwareplatformfromabrokerwithanemployeewhosworetomethathisfirmdidn’tworkmyorders.

Onmorethanoneoccasion,Ihavetriedtoopenorcloseatrade,onlytoplacethetradeand then, after clicking the TRADE button,waitwhile the tradewould just sit there. Theterminalwouldbeflashing“workingorder.”Seriously,canyoubelievetheorderscreenjustsat there flashing “workingorder,” and itwould sometimes take up to aminute before thetradewouldexecute.BetthebrokergotabetterpricethanIdid.

Yousee,thebrokerwouldsimplyworktheordertogetabetterpriceandthenoffermethehigherprice.Bythetimetheorderwasworked,thebrokerwouldmakethespreadonthetradeplusthedifferenceinpriceitgavemeforthetrade—inexcusable!

Please keep in mind that whenever you have any of these issues, you can call thebroker’stradeordealingdeskandbasicallygivethepersonthereahardtime.Mostpeoplewillsaysorry,thepriceisthepriceonthefirstgo-around,butifyoustaypersistent,youwillultimatelygetwhatyouareaskingfor.

Intheend,thebrokerdoesnotwantyoutofileacomplaintwiththeNFA.Hint,hint...don’tputupwiththatgarbage.Allbrokershavesoftwarethatcantellthemexactlywhatthepricewasatanygivensecond,includingthespreadsthatwereofferedataspecifictime.

SERVERBUSY

This isanothererroryouwill findwhenthebroker isworkingyour trade.All theseerrorswillbasicallyfallundertheslowservercategory,sincetheseareallvariationsofwaysforthebrokertoslowyourtradedownandultimatelymakemoneyonthetrade.Youwillmostlikelyseethisduringbusymarketconditionsbutnotallthetime.Intheenditcomesdowntothebrokermakingmoney—notyou.

Ihavehadsituationswhenthe“serverbusy”errormessagewasahugeproblem.Inoneinstance,Iwastradingwithmultipletradesandlotsontheboard.Themarketstartedmovingon me, and I started to close trades. I kept getting the “server busy” message and wascanceling the order to get it placed; ultimately what happened was that my orders wereclosedandthebrokerdoubledupmyorderssothatIwasnowinthemarketontheotherside.Mytrademanagerdidn’tshowtheopenpositions,andthenextdayIfoundoutthatIwasstillinthetradetheotherway.Luckyforme,Imademoney,soIdidn’thavetobeatupanyoneatthebroker’soffice.

CHAPTER14SLIPPAGEANDSTOPHUNTING

SLIPPAGE

Let’s talkaboutoneofourfavorites,slippage. I thinkallofuswhotradefind thatatsomepointduringourtradingweexperienceslippage.Well,theforexmarketiscertainlyripeforthispractice.Withthebigmovementsintheforexmarket,itiseasyforthebrokerstocreateslippage.Soyouneedtokeepaneyeontheunscrupulousbrokersoutthere.

Therehavebeensomesubstantial investigationsunderwaybytheNFAonitsmemberretailforexfirms.YoucanvisittheNFA’sWebsiteforacurrentlistofregisteredforexfirms.TheNFAwants to seewhether firms take advantage of small pricemovements that occurbetweenthetimewhenacustomerordersatradeandthetimewhenthattradeisexecuted—slippage.IpersonallyknowofseveralcomplaintsaboutthisverypracticethatareabouttobefiledwiththeNFAonnumerousbrokerswithintheindustry.Foranever-growingnumberofretail forex traders, this is something that just isn’t commonknowledge—the fact that theirbrokersmaybetradingagainstthem.

Theforexdealerisusuallyontheothersideofthecustomer’strade,andsoitbecomesbeneficial for the broker tomake sure the price has some slippage. Even if the broker issendingyour tradestraight throughto the liquidityprovider, itbecomesmoreprofitableforthebrokertoslipthepriceabit.Thisslippagegoesrightintothebroker’spocketasprofitonthe transaction. Normally in the equities markets, brokers buy and sell stocks for theircustomerswithbest-priceexecutionatoppriority.

Hereistheworstpart:Inthefineprintatthebottomofyourcustomerapplicationwhenyou open your account, you will find language that basically says that the brokersacknowledgethetradingconflict;furtherthefine-printtextwillgoontosaythatthebrokersmay takepositionsagainst theircustomers. Itnormallystates that thebrokerscanbasicallyofferanyprice theychoose,atany time.Youwillseesomedisclosures that reveal that thebrokersmayevenofferdifferentpricestodifferentcustomers.

Thisbecomesamore significantproblemas the retail off-exchange spot forexmarketkeepsgrowing.Retail forex tradesnowmakeupabout$300billion in turnoveraday,andthismaybeaconservativenumber;theactualnumbermaybefarmorethanthat.Theoverallforex turnover is now on average better than $3 trillion a day, and some estimates put itcloser to$4 trillionaday,a significantgrowthsincemyfirstbookwas released in2003–2004,whichreportedthattheretailforexturnoverwasabout$1.9trillionaday.

The forex dealers will have you believe that they are acting within the rules andregulations; these regulations are currently set by theCFTC and theNFA.However, theseregulatory agencies have stepped up their oversight on the retail forex industry and areconducting numerous inquiries and investigations, all aimed at creating a fair and orderlymarketplacefortheretailforexindustry.Let’shopetheysucceed.

Larry Dyekman, a spokesman for the NFA, recently said this about retail forexcustomers:“Theyjusthavetoacceptthatriskiftheywanttotrade.”TheNFAistheSROforthefuturesindustrythatallretailforexdealersmustbelongto.Mr.Dyekmangoesontosaythat NFA rules require dealers to fill a customer’s order as close to the asking price aspossible.Butthataskingpriceissimplythepricethedealerhasquotedtothetrader.Thereisnorequirementthatitbebasedonpricesavailablefromotherdealersorbanks.

Iamcertainlynotastrangertothepracticesofslippage.Ihavehadnumerousbrokersslipmytrades.Itisinterestingtoobserve;Iplacealotoftradesandwatchasthebrokersgothroughtheday.Whenandhowmuchthebrokerswillslipyourtradeswilldependonhowfastthemarketis.Theydon’talwaysslipthepricefromwhenyouenterittowhentheyfillit.Add slippage to slow fills, andyou start to seewhere the brokers are reallymaking theirmoney.Ihavehadslippageof30to40pipsbefore.

Thebestthingtodowhenyougetatradethathasslippageistakeascreenshotandsaveit; thencallyourbrokerandcomplain.Brokershaveaback-office tool thatallows themtolookbackatthepricesandspreadsbytick.Ifthatdoesn’thelp,thenyoumayneedtofileacomplaintwiththeNFA.

MetaTraderDealerPlug-Ins

Asmentionedearlier, ifyouareusingMetaTrader throughoneof thebrokersout there,becautious; some of the dealers use a back-office “dealer plug-in.” I have actually seen thisfromabrokerfriendofminethathadaccess.Youwouldbeamazed,andactuallyfurious,atwhatitcando.

There is literally a drop-down menu that the broker can select to create automaticslippage on your account or on any series of customers or groups of accounts the brokerwantstoaddslippageto.Justdropthemenudown,clickonthenumberofpipsyouwanttomakethemarketslip,andpresto,instantprofitforthebrokers!

NotallbrokersareusingtheMetaTraderdealerplug-ins.However,youwillwanttoaskyourbroker if ituses them.Iamsureyouwillbe toldnoway!However,brokerswillusethem because they have the ability to use them. I have a list atwww.jdfn.com that showsbrokersthatmayhavetheabilitytousetheplug-ins.Thislistisnot100percentaccurate,norisitgoingtotellyouthatthebrokeractuallyusestheMetaTraderplug-ins.Whatthelistwilltellyouiswhichbrokershavetheplug-insavailabletothem.

There is one specific third-party MetaTrader provider that does not have the bestreputationintheindustry.Thisthird-partysoftwareproviderbasicallyallowsbrokerstouseMetaTraderfromtheprovider’saccesspoint.Theprovidersupportsthesoftwareandgivesback-officeaccessandreportingtotheforexbrokertouse.Thisthird-partyvendoristheonethatusestheMetaTraderplug-insthemost.ThelistonmyWebsitewillgiveyousomenamesofbrokersthatusethisthird-partyvendor.Ifyourbrokerisonthelist,thereisachancethatitisusingtheMetaTraderdealerplug-insagainstyou.WetalkedmoreaboutthisinChapter12onback-officesoftwarescams.

IfyouareusingMetaTraderasyourtradingplatform,thenyouhaveprobablyseensomeofthechangesmade,dependingonyourbroker,totheorderentryscreen.MetaTraderbrokerscan configure the software with basically unlimited setting possibilities. With the tradeservers,oneofthesettingsistheabilitytocontrolhowyourtradeisexecuted.Thebrokercan

putyouoninstantexecutionormarketexecution.InstantExecution

Thefirstmethod,instantexecution, isshowninFigure14.1. In theboxnext to“Type,”youwillseethat“InstantExecution”isselected.Nowlookatthebottomofthefigure;youwillsee that there is a checkbox and the instruction “Enable maximum deviation from quotedprice.”Belowthatisanotherboxthatwillallowyoutoselectyour“Maximumdeviation”inpipsfromtheprice.Thisallowsthetraderstoselectthemaximumslippagetheyarewillingtotaketogettheirtradeexecuted.

Figure14.1

Inthisexample,“2”isselected.Themoreslippagethattradersarewillingtotake,themore likely the tradewillgetexecutedwithouthaving toberequotedor rejected,eitherofwhichwouldultimatelydelaythetradeexecution.Thoseofyouthathaveusedthisplatformformanyyearswillprobablybeabletorememberthatthiswasthemostcommonsettingthatbrokersused.MarketExecution

ThesecondtypeoforderthatbrokerscanuseonMetaTraderisamarketexecution.InFigure14.2,asyoudidforthepreviousfigure,lookfortheboxnextto“Type.”Inthisexampletheboxshows“MarketExecution.”Thereisnoboxthattraderscanchecktoenableamaximumdeviationfromthequotedprice,noristhereaboxinwhichtraderscanselectthenumberofpipstheyarewillingtotakeonslippagetogettheirtradeexecuted.Nowtheorderisfilledatmarketby thebrokerandnowhasanotice that says that atorderbymarket execution, thepricewillbequotedbythedealer.

Figure14.2

This type of orderwill drastically reduce rejected orders or slippage; however, younowhavenocontroloverhowmuchslippageyouarewillingtotakeinordertohaveyourtradefilled.Thebrokerwilljustfillyouatthenextbestprice.Whatyouwillfindinthistypeoforder,inmyopinion,isalittlemorelatency.Thebrokersarenowgoingtohavetheabilityto actually work your trade more, meaning go out in the marketplace to their liquidityproviders and get a better price before they fill you. Keep in mind that this is doneelectronically, so when I say “go out in the marketplace,” I’m speaking figuratively. Thebrokersaresimplyusingaback-officesoftwareprogramtolookattheirliquidityprovidersandfindthebestprice,apricebetterthanyouwillbegetting.

WhenIwastradingandfirstsawthistrade,IsawmycontrolofslippagegofromwhatIwaswilling to accept to no control at all, often having 5 to 10 pips of slippage on everytrade.Andsometimestheslippagewasevenmoreandthelatencytoo.Ihavehadordersthatwouldtake30to40secondstofillwiththismodel.

BrokersoftenrefertothismodelasanSTP.Aswell,somebrokersrefertothismodelasanelectroniccommunicationnetwork, forwhich theyuse themarketingpitch tosay thatthey only act as an intermediary and charge you a commission. I know of one broker thatspecifically uses this model, and I have discovered some startling information in myinvestigations about how brokers are able to use slippage order rejects, requotes, etc., tomakemoremoneythantheymakeontheircommissions.

TheCFTC and theNFAhave already fined several companies for theirmanipulativepracticeswithintheforex,andatleastoneofthemwasusingtheMetaTraderdealerplug-ins.

Hereisatypicalcomplaint:

COMPLAINT:OnJune30,2010,theNFAissuedaComplaintagainstaforexbrokerengaginginmarginandliquidationpracticesthatincludedslippagepracticesthathadadetrimentalimpactoncertaincustomersofbroker.DECISION:OnOctober27,2010,NFA’sBCCissuedaDecisionacceptinganOfferofSettlement submitted by broker in which broker neither admitted nor denied the

allegationsoftheComplaintandagreedtosettlethecaseonthefollowingterms:brokeragreedtorefundtocustomers theamountofnegativeslippagetheyexperiencedonthetradesthatwereplacedintheiraccountsbetweenMay1andJuly31,2009,andwhichwereattributable to theVirtualDealerPlug-in thatbrokerusedon its institutionalandretailservers.OUTCOME:Brokeragreedthatinthefutureanyandallslippageparametersthatbrokerusesindeterminingwhetheracustomer’sorderwillbeexecutedorrequoted,shallbesymmetrical innatureandneitheradvantageousnordisadvantageous tocustomeror tobroker.

STOPHUNTING

If you have ever traded in the forexmarket, or any othermarket for thatmatter, you haveprobablyhadastoporderfilled.Youtypicallyfindthemarketgoingagainstyou,andasifbymagic, thepricehitsyourstop, takesyououtof themarket,and thengoesrightback in thedirectionyouthoughtthepricewasgoing.

Areyouoneof those traders that think themarkethas it in foryou?Thatsomething iswrongbecauseeverytimeyouplaceatrade,themarketgoesagainstyou?Ihavefeltthatway.Mostofthetimeitissimplyaflawinyourtradingplan;youneedtoworkontheplanalittlemore,stopchasingthetrades,andwaitfortherighttimetoenter.Thiswillcutdownonthetradesgoingagainstyoueverytime.

Ofcourse,thiswon’tstoptheunethicalpracticesofstophunting.Let’stalkmoreaboutthat.

Let’slookatatypicalexample:YouthinkthattheUSD/CHFisheadingup.Youhaveenteredalongpositionat0.8732

andhavesetyourstopat0.8632,whichisslightlybelowanobviousdoublebottom.Yousetyourinitialtargetat0.8932,givingyoua2:1ratioofrewardtorisk.Unfortunately,thetradebeginstogoagainstyouandbreaksdownthroughthesupport.Yourstopishit,andyou’reoutof thetrade.This iswhyweusegoodmoneymanagement; in theevent thatyouarewrong,youwon’tkeepchasing the tradeor,worseyet,cost-averagingdown,only tooverleverageandseeyouraccountliquidated,wipedout.

Hereistheworstpart:Youhavestayedupfor24hourswatchingthetradeandhopingitwillcomeback.Youhavetriedeverything,andyoufinallytakeastepbackandthetradehitsyourstop.Justthenthetradeturnsaroundandgoesrightbackinthedirectionyouwanted,justasyouoriginallythoughtitwould.Asyouwatchwithasickfeeling,thecurrencypairmovesuppast0.9000.Don’tstartsecond-guessingyourself.Iknowitisabadfeeling,andsomeofyoumightsay,“IfonlyIhadset thestop justa little lower.”Infact, Ihavesaid that,andIhavedonethatonlytolosemore.Setyourmoneymanagementaheadoftimeandknowwhereyourlevelsareandthenplaceyourtrade;donoteverresetyourstop.Waitforthetradetoleveloutandturnbeforeyoureentertheposition.

Keepinmind, though, thatyourstopbeinghitwaslikelynotacoincidence.Therearestophuntersoutthere,andbrokersusesoftwareandtechnologytoautomaticallylookforyourstoplevels.

The stop hunters and the software can bothmove themarket slightly. Bymoving themarket,theycaneasilypickoffagroupofstops.Ihavebeenstoppedoutonthehighendwithas much as a 150-pip move, instantly. More often than not, you will easily see brokersmovingthemarket15to20pipstotakeoutstops.Thebigbanksmaypushpricesupordownonalargerleveltryingtotakestopsout.

Mostamateurtradersarepredictableinplacingtheirstops.Theyareusinglevels,suchas roundnumbers like0.8700or0.8750;while in theequitiesmarketswealwayssaystayawayfromnickel,dime,andquarterstops:0.05-,0.10-,0.25-,0.50-,and0.75-typelevels.Addalittle tothoselevels.Ifyouthinkthatastopisatacertainlevel, imaginehowmanyotherpeoplearegoingtothinkthat.Stayawayfromthoselevels.Don’tfollowtheherdtotheslaughter.

Therearemanywaystocontinuetotradeandstayawayfromthestophuntersandtheirtools.Oneistousearobotthatusesthestopasamarketorder.Therobotwilltakeyourstopand store it on your computer; andwhen the stop is reached, the robotwill send it to thebrokerautomaticallyasamarketorder.Thiswillhelp,butmorethanlikelyyouwillstillbefacedwithslippageorordererrors,notfillingtheorderrightway.

Anotherwayisnottouseastopbutinsteadonlytradeenoughinyouraccountthatyouarewillingtoloseinitsentirety.Ifyouchoosethis typeof trading, thenmakesureyouaredialedintowhatyouarewillingtolose.Youcanhavemultipleaccountswitheitherthesamebrokerormorethanonebroker.Bytradingthiswayyoucanusethemargincallasyourstop.

Youcanalwaystradesmallsothatyouraccountcanhandlealargerstop.Thebrokerswillseeyourstopsofaroutthatthereisnotmuchtheycando.Youneedtoplanonalong-termstrategyforthistypeoftrading;sometimesyoumaybeinthetradeforweeks.

The NFA has some specific rules on brokers’ marketing materials and what theirassociatedpersons(APs)cansayaboutslippageandpricechanges.

NFAComplianceRules2–29and2–36dealwithallformsofcommunicationwiththepublicbyNFAmembersorAPs.

Nomembersorassociatesmayrepresent that theyoffer tradingwith“no-slippage”orguaranteethepriceatwhichatransactionwillbeexecutedorfilled,unless:

•Theycandemonstratethatallordersforallcustomershavebeenexecutedandfulfilledatthepriceinitiallyquotedonthetradingplatformwhentheorderwasplaced.

•No authority exists, pursuant to the contract, agreement, or otherwise, to adjust customeraccountsinamannerthatwouldhavethedirectorindirecteffectofchangingthepriceatwhichanorderwasexecuted.

CHAPTER15FOREXBROKERMARGINSCAMS

Scamsmaynotbe the rightword—whenyou search the Internet,youwill find thatpeoplemarketing theirservices,morespecifically theforex, love touse thewordscambecause itgetstheirproductsandservicesrankedhigher.Ihavealwayslovedthemanysitesouttherethatblasttheso-calledgurusandscammers.Why?Mostofthecompaniesandpeoplebashingthescammersaresellingtheexactsamething.

Without a doubt, youneed to checkout those you are dealingwith andwhat they aresaying;youmaybeabletolearnsomethingwithoutgettingscammed.Butkeepanopenmind.While there are a few bad apples out there, not all brokers are engaging in deceptivepractices.Furthermore,mostofthesepracticesarenotasrampantastheyoncewerenowthatallthenewregulationsareinplace.

But arming yourself with knowledge will help you recognize if you are in for sometrouble.

As has always been the case, forex brokers have offered large leverage to enticeprospectivecustomerstotrade.Thatwastheallure:putlittlemoneyatriskforpotentialhugerewards.However,over-leveragingyouraccountwillwipe itout faster thananythingelse,and the brokers know, or shall I say, knew, that. By offering high leverage, the MMencourages traders to trade extremely large positions.As the trading volume increases, sodoesthebrokers’profits.Whenthishappens,theinvestoralsoincreasestheriskoflosing.

Mostinstitutions,likebigbanksandcorporations,useminimalleverage,suchas10:1orso;theretailsidehashadaccesstoleveragereaching400:1.Thenormwas100:1or200:1dependingonthetypeofaccountyouhad,buttherecentregulationshavenowloweredthoselevelssubstantiallybasedonwhichcurrencypairyouaretrading.

Aself-regulatingbody for the forexmarket, theNFAwarns traders ina forex trainingpresentation of the risk in trading currency. The NFA says off-exchange foreign currencytradingcarriesahighlevelofriskandmaynotbesuitableforallcustomers.Theonlyfundsthat should ever be used to trade in foreign currency trading, or any other type of highlyspeculativeinvestment,arefundsthatrepresentriskcapital—inotherwords,fundsyoucanaffordtolosewithoutaffectingyourfinancialsituation.

InJuly2009,theNFAfoundthatabrokerwasconductingabusivemargin,liquidation,andpriceslippagethatbenefitedthebrokertothedetrimentofitscustomers.Inaddition,theNFAfoundthat thebrokerfailed tomaintainrecordsforallunfilledordersplacedprior toMay2009.

TheNFA’s2009auditofthebrokerfoundthatthefirmengagedinleverageandmarginpractices that were harmful to its customers. For example, the broker adopted a policywhereby,everyFriday,itloweredtheleverageforallitsaccountsthatwereallowedtotradeat200:1leverage,whichincludedthemicroaccounts,toa100:1leverage.Theeffectofthisweeklyadjustmentwas to increase themargin requirementon theseaccounts from0.5 to1percent. As a result of the broker’s practice of adjusting the leverage-margin levels onFridays,theaccountsofmanyofitscustomersbecameunder-marginedeventhoughtheywere

adequatelymarginedpriortotheleverageadjustment.In order to bring the undermargined accounts back into compliance with the higher

marginrequirement,thebrokerwouldliquidatethelargestlosingpositionintheseaccounts.However, sometimes the losing liquidated position contained multiple contracts, and theliquidationofonlyaportionof the losingpositionwassufficient tosatisfy thenewmarginrequirement.

Nevertheless, thebrokerwould arbitrarily liquidate thewholeposition.Thisnotonlywould result in the account being overmargined but would preclude the customer frompossibly realizing a potential gain on that portion of the position that was unnecessary toliquidate.

Thebrokerdidnotdisclosetoitscustomersinaccountopeningdocuments,onthefirm’sWeb site, or through any othermeans that if their accounts traded at 200:1 leverage, theywouldbesubjecttotheseroutineweeklyleverage-marginadjustments.

Thebrokerclaimed that itprovidede-mailnotifications to itscustomerseveryFridayinforming them of the leverage-margin adjustments to their accounts. Yet the broker wasunable to show that all affectedcustomers received these e-mails.Thebroker justified theFridayleverage-marginadjustmentasameansofreducingweekendmarketriskforaccountstradingat200:1leverage,which,asnotedabove,includedallmicroaccountcustomers.

Furthermore,whilepromotingmicroaccountstosmallinvestorsandthe200:1leveragethatthemicroaccountsenjoyed,thebrokerfailedtogivemicroaccountcustomersadequatedisclosure of the higher risk associated with the 200:1 leverage, which the brokeracknowledgedbyadoptingitspracticeofadjustingleverage-marginlevelseveryFridayforaccounts trading at these leverage levels. In addition to the broker’s weekly practice ofroutinelyadjusting leverage-margin levels foraccounts tradingat200:1 leverage,when thebroker anticipated a significant market move over the weekend due to some importantweekend event or potential development, the broker further adjusted the leverage for itscustomers’accountsbyincreasingthemarginrequirementto2percent.

Thisoccurredonthreeoccasionsin2008and2009:onFriday,December19,2008,inanticipation of the potential weekend bankruptcy of GM; on Friday, March 13, 2009, inanticipationofaG–20meetingthatwasscheduledfortheweekend;andonFriday,June12,2009, in anticipation of a G–8 meeting that was scheduled for the weekend. In all threeinstances,thebrokerhadampleadvancenoticeoftheeventinquestionbutfailedtoprovidecustomerswithanyadvancenoticeofthemarginchange.

Most of the positions that the broker liquidated on the aforementioned three dates, inanticipationof adversemarketmoves over theweekend,wouldhave experiencedminimalgains or losses if they had remained open over the weekend instead of being liquidated.However, because of the liquidations that occurred on these dates, affected customersrealizedoveralllossestotalingnearly$425,000.

Oneofthebroker’sforeigncustomershadhermarginrequirementadjustedto2percentonFriday,June12,2009,priortotheweekend’sG–8meeting.Thebrokerthenliquidatedthelargestopenlosingpositionintheaccountatalossofover$25,000.TheinvestorreceivednopriornoticefromthebrokerthatitwasincreasingthemarginrequirementandliquidatingthepositionsonJune12.

Had the investor received prior notice of the margin increase, she would have sentadditionalfundstothebrokertosatisfythehighermarginrequirementandthuseliminatetheneedtoliquidatepositionsintheaccount.

Yetanothercustomer,thisonefromtheUnitedStates,hadthemarginrequirementforhisaccountincreasedfrom0.5percentto2percentonFriday,December19,2008,supposedlyinanticipationofthepotentialweekendbankruptcyofGM.Thebrokerthenliquidatedanumberof theclient’sopenpositions tomeet the increasedmarginrequirement,withoutgivinghimpriornoticeoftheseliquidations.

Asaresultofthebroker’sactions,theclient’saccountsufferedalossofnearly$15,000.Anothertroublingaspectofthebroker’spracticeofadjustingleverageandmarginlevelsonFridays,whetherasaroutinematterorforspecialcircumstances,wasthatthebrokerwouldwait until late in the day to make the adjustment. As a result, customers would acquirepositionsonFridaysatoneleverage-marginlevel,unawarethathours,or,insomecases,onlyminutes,laterthatsameday,themarginrequiredtomaintainopenpositionsovertheweekendwouldbeincreased.

The broker’s practice of routinely and repeatedly adjusting leverage and marginrequirements on Fridays, without giving affected customers adequate prior notice of theadjustment, denied customers the opportunity to deposit additional funds to maintain theiropenpositions,orat theveryleast,selectwhichpositions to liquidate,andcausedthemtoexperiencesignificantlossesintheiraccounts.Assuch,thebrokerbreacheditsobligationtoupholdhighstandardsofcommercialhonorandjustandequitableprinciplesoftrade.

This is an actual case from the NFA, and you can read more about it online atwww.jdfn.com. You can also readmore online about howmargin can affect the way youtrade.Oneofthebiggestthingsyoucandotohelpprotectyourportfolioistopracticegoodmoney management. Make sure that when you do use margin, it is part of your moneymanagementoverallplan.Thatwayyoucanfactorinwhatyouarewillingtoriskandwhatyourdrawdowncanbe.

CHAPTER16THEDEMOBAITANDSWITCH

DEMOACCOUNTWARNING

Icouldspendalotoftimeonthistopic,especiallysinceIhavebeenavictimofitovertheyears. After spending a tremendous amount of time testing and investigating, I started todiscoverwhatwasreallygoingonbehindthecurtain,sotospeak.

Traders should takenotice that theNFAhas specific rules and regulationsbecauseofsomeofthebait-and-switch–typetacticsthatbrokershaveusedinthemarketplace.Iknowofrecentlitigationwiththisspecificsuspectactionoutlinedinthecomplaint.

In the forex market, brokers offer customers the ability to use a demo account, or apracticeaccount,tohelpbuildtheirconfidence.Youcanlogon,openupyourdemotradingaccount,andstartmaking trades.There isnothingwrongwith this,and it isagreatway todevelopyourtradingplan.Makelotsoftradesandlearnfromyourmistakes.

I certainly did this and was taught this concept. I was told by the people I knew atvariousbrokerages that tradingyour demo is nodifferent from trading a live account.TheonlyproblemwiththisisthatIwasnottoldeverything.Iwasnottoldthatthebrokersdonotwastetheirtimewithdemoaccounts;theysimplyturnthemon.Therearenospecialserversto manipulate the feeds or the orders. In some ways, it is more like an ideal forexmarketplace.Thelivemarketwilltradedifferentlyfromwhatyouareexperiencingwithyourdemoaccount.

The primary reason for this is there is no need for all the gamesmanship in a demoaccountasthereisinaliveaccount.Thebrokerswillnotstartplayingallthegamespriortoyouopeningandfundinga liveaccount.Onlyafteryougo“live”willyoumake itonto thebrokers’secretradarscreensofcustomersthataremakingmoney.

THEBAIT

This iscertainlynot isolated toanyonebroker, although Idobelieve thepractice ismuchlesswidespreadthanitusedtobe.Thebrokerwillstartbymarketingthedemoaccountsasbeingidentical tradingtothereal thing.Youcanopenademoaccount,andyouareoffandrunning.

Somebrokersallowyoutoselectthetypeofdemoaccountyoucanuse:aminiaccountorastandardaccount.Andsomebrokerswillgiveyoutheoptionofselectingthesizeoftheaccountyouwanttotradeandtheamountofmarginyouwanttouse.Allthisishelpfulandsomethingthatyouwillwanttodoregardlessofhowthedifferencesendup.

Whether the resultsyouexperiencewithyourdemoaccount tradingwillbesimilar towhatyougetwhenyoubegintotradelivewilldependonthegamesyourbrokerisplaying

withliveaccounts.Ifyouarewithareputablebrokerage,youmayactuallybeabletohaveagoodideaofwhatyouaregoingtoexperiencewhentradingliveinthemarket.

I cannot tell you howmany people have come tome to tellme how great theyweredoingintradingintheirdemoaccountsandhowtheyhavemadehundredsofprofitabletradeswithoutaloss.Ofcourse,thatisgreat,butthenexttimeIwouldseethem,whatIwouldhearishowmuchmoneytheylostwhentheyopenedafunded,liveaccount.

There were the occasional traders that said the reason they lost was because theychangedthewaytheyweretradingfromwhentheytradedasuccessfuldemoaccount.Theytoldmetheycouldnotdothesamethingintheirdemoaccountthattheyweredoinginaliveaccount.

Changingstrategiesdoesn’tmakemuchsenseifyouplantodevelopatradingplanandtestyourplan.Youwillneedtomakesurethatyoutradeitthesameway.

Regardless, though, you are still going to have trouble duplicating your demo tradingsuccesswithmost brokerswhenyougo live.Most brokers are notmanipulating the demoaccountserversorplayingmanyofthegamesthatwehaveexposedinthisbook.Thesamecan’tbesaidforlivetrading.

TheNFAhassomespecificrulesinplacetogovernsomeofthemisleadingmarketingthatbrokersmakeinreferencetotheirdemoaccounts.

NFAComplianceRules2–29and2–36dealwithallformsofcommunicationwiththepublic by NFAmembers and APs. Rule 2–29 covers communications with the public bymemberswho solicit customers to trade on-exchange futures and options on futures,whileRule2–36coverscommunicationswiththepublicbymemberswhosolicitretailcustomerstotradeforex.

Thisisprimarilywhyyoudonotseetheoldertacticsthebrokershavetakeninthepast.Theyknowwhattheyaredoingnowandjustdonottellyouhowgreatyourdemotradingisgoing.Youwillstillneedtopaycloseattention.

THESWITCH

Sonowcomestheswitch;afterallthemarketingthatthebrokershavedonetogetyouinthedoorandopenademoaccount,thebrokersworkonyoutoopenaliveaccountandfundit.There isnothingwrongwith that,but theunscrupulousbrokerswill take it to thenextstep.Whenyouopenyourliveaccount,youwillstarttoexperiencesomeanomalies,problemsthatyoudidn’texperiencewithyourdemoaccount.

Afewthingswillstarttohappen:Youwillnotbeabletoexecutetradesasefficientlyasyoudidonthedemoaccount.Thedealingdeskwillnowwatchyourtrading,orifyourbrokerdoesnothaveadealingdesk,acomputerwillwatchyourtrades.Youmaystarttoseesomeerrorswhenyouplacethetrade.Youwillbegintoexperienceinvalidprices,slowfills,etc.Thisalonewillchangethewayyourtradingplanworks.

Ifyouaresuccessfulattrading,youwillmakethebroker’s“notsogoodlist.”Thislistwilleithergetyoublacklisted,wherenothingyoutradeisexecuted,orgetyoutransferredtoaslowserverwherethebrokercanslowyourtradeexecution,givingyouunfavorablefillsand,ofcourse,plentyofslippage.

ArecentlitigationfiledwhileIwaswritingthisbookbroughttolightsomeofthevery

thingsIamdiscussing.Theplaintiffclaimstohavelostover$150,000tothebrokerovertheyears.The lawsuit dealswith the demoaccounts,which serve to attract clients but donotsimulate realmarket conditions;when clients do switch to live, they receive a completelydifferentexecution.Thelawsuitfocusesontheexecutionitself,whereit isclaimedthat thebroker is in fact anMM that actively goes after profitable clients. Themain excerpts arebelow:

Tofurtherbolstercustomers’confidenceinitsplatform,brokerenticedcustomerstousebroker’spracticeordemoaccount(hereinafter,the“DemoAccount”)tosimulateatradingexperience.ButtheDemoAccount, just likethemyriadadvertisements,misledcustomers about the true nature, functionality, and performance of the platform. Oncelured into opening an account, customers were subjected to a staggering array ofstratagemsandploys,someusingextremelysophisticatedcomputersoftwarebaseduponcomplexalgorithmsandhigh-speedcomputers,todeceivethecustomersintobelievingthat their tradingwasbeing affectedbynormalmarket forces,while in reality brokertradedagainstitsowncustomers.Andtheso-called“DemoAccount”—whichwasheldoutbybrokeras thesinequa

nontopersuadeprospectivecustomerstotradewithbroker—wasthemostcunningandcrippling canard of all. By trading through the “Demo Account” without being atfinancialrisk,thecustomerwasallowedtoexperiencedirectmarketpricing,freefrombroker-dealerinterferenceormanipulation.Theswitchpulledbybrokeronhowtradingoccursoncethecustomeropensa“live”accountandstartstradingwithrealmoney,isnothing short of a modern-day equivalent of the classic street con game known as“Three-cardMonte.”Once“live”tradingbegan,directmarketpricingwasreplacedbyprofounddealerinterferenceandtrademanipulation.

FUNDEDPRACTICEACCOUNT

Afundedpracticeaccountisbasicallyalivetradingaccountinwhichyouplacerealmoneysothatyoucanstarttestingyourtradingstrategy.Therearestillsomebrokersthatwillallowyoutotradewithmicrolots.Mostofthesebrokersareoffshore.Inanycase,thepointistofindanaccountwhereyoucanmakenumerous tradesonasmall scale,notworryingaboutwhatyouarerisking.

Soifyouput$1,000inasmallaccountthatallowsyoutotrademicrolots,youcandowhat Icall“dialing itdown.”Unlikeademo tradingaccountwithhypotheticalmoney,youareusingrealmoneytotradeliveinthemarket.

It is trulyamazinghowdifferentlyyou tradewhenyouareusing realmoney.Whetheryouhave$1or$10,000,youstilltradetherealcashdifferentlythanthehypothetical.Whenplacingthetradeswithrealmoney,youwillstartthinkingabouthowmuchyouwanttomakeandhowmanypipsyouneed.Thenallofasuddenyougetatradethatgoesagainstyou.

Nowyouhave to start saying to yourself, I need to stick tomymoneymanagement; Ineedtocutmylosses.Don’tbeafraidtotakealoss.Whenyoustarttradingbiggeraccounts,donotfocusonthedollars;whenyoulookatthedollars,youwillhaveamoredifficulttimewhenyouhavecashontheline.

Percentagesarepercentages,but forwhatever reason,10percentof$100,000 looksalotdifferent from10percentof$1,000.So ifyougetaccustomed tousing thepercentages,andnotthedollars,yourmindwillallowyoutotakethenextstepinyourtrading.Youcanuse pips as well, and so instead of the percentage or the dollar amount, you are simplywatchinghowmanypips,upordown,youraccountismoving.Iliketousepercentage.

It is good to use funded practice accounts or even the demo account to master thisprocess.Thelivefundedpracticeaccountisgoingtotradedifferentlythanthedemotradesdo;however,nobrokergameswillbeplayeduntilyoubeginmakingmoney.

CHAPTER17THEBROKERB-BOOK

Itisnosecretthatintheforex,yourbrokertradesagainstyou.Butwhatdoesthismeanforyou, the trader? It means that as you lose money, your broker or bank that acts as thecounterparty to your trademakesmoney.As the counterparty to your position, your brokerneedstokeeptrackofyou,thetrader.

WhatIwanttoaddressinthischapterissomethingyouwouldbehard-pressedtofindsearchingGoogle;it isinsiderinformation,anditwon’tmakethebrokersveryhappythatIamsharingitwithyou.Infact, ifyouaskaboutit,youwillfindthatmostbrokerswill justignore you or blow off your question. The book of business, or B-book, is where mostbrokersmaketheirmoney.Thebanks,inaddition,haveafewotherareasinwhichtheycanmakemoremoneythantheaveragebroker.

The B-book is a process. It is the accounting side of the back office where all thedecisionsaremade,anditisessentiallyhowyourbrokersseeyouandthedepositsinyouraccount.TheB-book shows if you are a profitable customer or not; remember, thismeansprofitable for the broker, not for you. If you are makingmoney, then the broker is losingmoneyeverytimeyouplaceaprofitable trade.Soyourbrokerpaysverycloseattention tohowyoutradeandifyouaremakingmoneyforyourselforforthebroker.

Forexisazero-net-summarket;thisisseeninthebroker’sB-bookaslossesorgains.Asyoumakemoneyorlosemoneyinyouraccount,thecounterpartytoyourpositionsmakesorlosestheexactoppositethatyoumakeorlose.Thisiscalledazero-sumgamewheretheexactgainsandlossesinyourforexaccountandthoseofthecounterpartytoyourpositionsaretakentogetherandaddedorsubtractedtoequalzero.

However, when you factor in commissions and spreads, it becomes a negative-sumgame,meaningthatitbecomespossibleforthecounterparty’sB-booktoshowagreatergainthanyouractualdeposits. Iwas toldduringmyinvestigations,byanoverseas forexbrokerrunningaB-book,thatanaccountwilltypicallyyieldabout120percentreturnondeposits.Atleastthatiswhatthebrokerconsidersyourdeposittobeworth.Soifyouputin$100,000,the broker would consider your account to be worth about $120,000, if you lost all yourmoney.

Thecounterpartytoyourpositionusesanumberofformulas,tactics,schemes,practices,andsoftwareprogramstomakeitnearlyimpossibleforyoutomakemoneytradingtheforexmarketwhenyouare in thebroker’sB-book.Whenall thingsareequal,youshouldhavea50–50chanceofmakingmoneyinatrade.Thepositionswillgoeitherinyourdirectionoragainstyou.It’sthatsimple.

Thismeans that mathematically you should automatically have one winning trade forevery losing trade you place in your account. Now let’s factor technical and fundamentalanalysis into theequation.Againassuming thatall thingsareequaland thatyouunderstandhowtouseandapply technicalanalysisandcomplimentary indicators tocreatea technicaltrading strategy,youexponentially increaseyourpercentagesof aprofitable tradebyusingsuccessfultradingstrategies.

Usingfundamentalstohelpdecidethemarket’sdirectionortrendwillfurtherincreasethepercentageof successful tradesyouplace.Fundamentaleventsare thenewsevents thatmovethemarkets.Theyarethedrivingforcebehindthedirectioninwhicheachcurrencyisgoing,andtheydecidethetrendandembeddedtrendofeachcurrency.

Whenyouaddyourtechnicaltradingstrategiestogetherwithyourfundamentalanalysisandprobabilitiesof50–50marketconditions,yourchancesofplacingatradethatwillmovein your direction should be near 70 percent. As any successful forex traderwill tell you,moneymanagement isakeycomponent tosuccessful forex trading.But thishas little todowiththepercentageofprofitabletradesyouwillplace.

AccordingtoarecentstudybytheCFTC,theaverageforextraderloses$15,000duringthe course of his or her forex trading.Aswe analyze this and dig a little deeper into theworkingsofyourbroker’sB-book,wecanconcludethatforeachnewcustomerthatopensaforex trading account, the counterparty has made it nearly impossible for you to place aprofitabletrade.

This is done through the broker’s risk operations department. The risk operationsdepartmentsetstheparametersforhowmuchriskthebroker,orbank,assumesinitsB-book.The counterparties’ basic strategies start offwith a number of simple strategies that targetcertaingroupsoftradersinordertosystematicallyseparatethecustomersfromthedepositsintheirtradeaccount.

Theriskoperationsdepartmentalsousesprobabilitiestodeterminerisk.Justasinyourtrading, past performance may dictate future expectations, and the counterparty’s riskoperationsdepartmentknows this.Thedepartmentuses anumberofvarious strategies andtechniquesinaprobabilitymodeltodeterminethelikelihoodthatyouwilllosemoneyinyourforextradingaccount.

Someofthebasicstrategiesusedbytheriskoperationsdepartmentmayinclude,butarenotlimitedto,holdingallforexaccountswithlessthan$5,000indepositsinitsB-booktobethecounterpartyandassume the riskof thatparticulargroupofcustomers’ trades.The riskoperations department knows that customers who deposit $5,000 or less are usually newtradersandhavelessexperiencethanmoreseasoned,veteranforextraders,whohavegreaterriskcapitaltoplaceintothemarket.Atraderwhodeposits$5,000orlesswillhavefewermarginsforerror.Ifatradegoesagainstyouwithasmalleraccountbalance,thelikelihoodthatyouraccountwillgetliquidatedorstoppedoutismuchhigher.

Theriskoperationsdepartmentmayalsoholdaccountswithhigherleverage.Ifyouareusing a high degree of leverage, the likelihood that your account will get liquidated orstoppedoutismuchhigherthanforthosecustomersusinglowleverageornoleverageatall.Thesearejustafewtacticsputintoplacebytheriskoperationsdepartmentandcategoriesitusestodeterminerisk,orthelikelihoodthatyouwilllosemoneyinyourforexaccount.

If your broker or bank is the counterparty to your trade, it assumes the risk as thecounterpartytoyourtradingposition.Thismeansinanet-sumtradingaccountthatwhenyoumakemoney,thebrokerorbankislosingmoney.InordertopreventlossestotheB-book,thecounterparty toyourpositionsroutesyour trade throughadealingdesk.Allbrokershaveadealing desk even if they are running an STP model. Dealing desks are there to provideliquidity and route trades butwork as the action end of the risk operations department.Adealingdesk,or itsequivalent, isseenasaprofitcenterbyyourbankorbroker,andthoseprofitscomefromyourlosses!

TheB-book sideof thebusiness is a closelyheld secret.That iswhyyoudonot see

much related to the processwhen looking on the Internet. Someof thiswill becomemoreexposedasthemarketcontinuestohaveregulatorychanges.Withoutadoubt,theB-bookpartofthebusinessisthebiggestareawherethebrokersareexploitingtheiropportunitiesagainsttheircustomers.

Keepinmindthatitisnotnecessarilyfraudorabadpractice.Ipersonallydon’thaveaproblemwithbrokersthatwanttobalancetheirbooks—meaningifyougolongtheEUR/USDandIgoshort,thebrokerhasabalancedbook.However,someofthebadbrokerswillstillusesomeof the tacticswehavebeendiscussing.Theywillslip theprocessonbothsides,making awider spread andmoremoney.Theywill slowyour execution so they can get abetterpricefromtheirliquidityprovideronbothsidesofthetrade,thusmakingextramoney.

Thenyouexperiencetradingagainstyou;thebrokerisgoingtolookandseeifithasabalancedbook;and if itdoesn’t, itwillmake thechoiceofwhether itwants togo into themarketplaceandoffsettherisk.Mostofthebigbrokerswilljustcarrytheriskversushedgingontheopenmarket.Thebrokerhastheabilitytooffsetitsrisk,inpartorfull.Sobeonthelookout for the broker scams and know that there is a B-book in the background tradingagainstyou.

CHAPTER18DEALINGDESKORNOT

The question ofwhether a broker has a dealing desk or not is really one thatmany forextraders have been asking for years. It wasn’t but a short time ago that retail traders (asopposed to broker’s traders) started to put the pieces together to determine that the forexbrokerswereouttogetthemandthattheprimarymethodtoseparateretailtradersfromtheirmoneywasadealingdesk.Ihavemetmanybroker’stradersovertheyearsthathaveworkedforsomeofthebiggerretailforexbrokers,andtheyworkedonthedealingdesk.

When I first got into forex trading, I was using one of the newer forex brokers. Iremembervisitingthefirmwhenitmoveditsoffices,whichwassortofanupgrade,sinceithadgottensobig.Iwastakingatourofthenewfacilities,andmy“tourguide”showedmethefirm’sdealingdesk(ortradingdesk,orwhateveryouwanttocallit).Itwasinteresting,tosay the least; it looked like a control center forNASA,with lots of computer screens andpeopleattheirdesks.

Thesepeoplewerebroker’s tradersworkingon thedealingdesk for thebroker; eachtraderhadhisorherownB-book,so tospeak.The traderswerespecifically targetingandtradingagainst thebroker’s customers for thebroker.Of course, thebroker’s traderswerearmedwithallsortsofsophisticatedtoolsandsoftwaretobeattheretailtraderswhentheyplacedtheirtrade,thustheconflictofinterest.

Withall therecent regulatorychanges,manyof thebigforexretailbrokersnowclaimthat theydonothaveadealingdesk.Well,don’tbefooled; theydo.Theymaynotcall itadealingdesk,but theyhavesomething thatconducts thesamesortofoperations,onlymuchfaster.Someofthebrokerscalltheirolddealingdeskoperationsatradedesk,ortheydon’tevencallitanything;theyjustautomateit,anditrunsagainstyourtradesautomaticallywhenyouplacethem.

Most of the brokers out there have somemeans to sway the trading in their favor. Inorder to be successful in trading the forex, you have to be smart, stay a step ahead of thebrokers,andknowhowtobeatthemattheirowngame.Itcanbedone,anditisdoneeveryday;therearestilllotsofforextradersmakinggreatamountsofmoney.Butifyoudon’tarmyourselfwiththerightinformationandtools,youwon’thaveachancetobeatthesebrokers.

Thebroker’s traders that arewatchingyour tradeon thedealingdeskare specificallygettingpaidtomakethebrokermoney.Thewaytheymakemoneyforthebrokeristocauseyoutolosemoney.Thebroker’straderswillusetheirtradingterminaltoviewthebroker’sliquidity providers’ pricing. The broker’s traders will have a B-book that they areresponsiblefor.Whenthecustomertradeappearsonabroker’sterminal,thebroker’strader—we’llcallhimDave—getstowork.

DavedecidestobuytheEUR/USDat1.4022by1.4025.Hewillquicklylookatthebidandaskavailablethroughthebroker’sliquidityproviders.Davewillmatchthetradeandfindabetterrateforthebrokerthanwhatisbeingofferedtothecustomer.Thearbitrage,orthedifferenceinthisspreadandthesetrades,iswhatthebrokermakesasaprofit.Nowaddinsomeslippage,andthebrokermakesalotmore.

Let’stakethisastepfurther.Saythebrokerwantstomakemoremoney.ThebestwayforthebrokertodothisistotaketheothersideofDave’strade.WhenDaveplaceshistrade,the broker simply holds the trade and does not lay the trade off to the broker’s liquidityproviders. The brokerwill act as the counterparty to the trade by taking the other side. IfDavebuys,thebrokersells.

The brokerwill hold the trade until the customer loses. The brokerwill also deploysomeothertrickstoensurethebroker’sprofitability.Someofthesetacticsincludeslippage,off-pricequotes,andwideningofthespreads.Andthesearejustafewtricksthatthebrokercando.Indeployingthesetactics,thebrokeronlyhasonethingonitsmind,beatingyououtofyourhard-earnedmoney.

As I have noted in this book already, during a recent civil court action throughdiscovery,Ireadane-mailwrittenbyaforexbroker’strader,atraderthatwasworkingonthebroker’sdealingdesk.Inthee-mail,thebroker’stradersaid,“Ihaveidentifiedwhatthetraderisusing.Icandefinitelybeatthiscustomer.”Thebroker’straderwentonfurthertosay,“Icanfindothersandbeatthem.”Ifyouareusingsomethingeasytoplacetrades,thebrokerwillfindoutandsimplyusethesamethingtotradeagainstyou.

AUTOMATEDDEALINGDESK

Justbecausebrokerstellyoutheydon’thaveadealingdesk,don’tbelieveit.Inmostcasesthebrokershavesimplyautomatedtheprocess.Theydonotneedadealingdeskorahumantrader.Infact,humansaretooslowcomparedwithcomputersandservers.Thebrokerswillusesophisticatedsoftwareandprogrammingtotradefasterthanthecustomers.Thebrokerscanslowthetradesdown,creatingslippage.Inessence,thebrokerscansimplydowhatevertheywanttowithoutyouknowing.

Ithinkitisimportanttosaythatbrokershavetomakemoney;thatiswhytheystartedabusinesstobeginwith.Asyoucansee,though,itisunfortunatelytooeasyforthemtodothewrongthinginanefforttoenhancetheirbottomline.Whatwouldbefair?ThesmartestandfairestwayforbrokerstooffertheirservicestocustomersistouseanSTPmodelwherethebrokerssimplytakeyourorder,matchitwiththeirliquidityprovidersatthebestprice,andthenaddamarkup.

PROFESSIONALDEALINGDESK

Professionaldealingdesk—Ithinkthatisanoxymoron.Thereisonebrokerthatclaimsthatitrunsitsdealingdeskinaprofessionalmanner.Thebrokeractsasthecounterpartytoyourtrade,whichmeansittakestheothersideofyourtradeusingyourmoney.Thatdoesn’tseemprofessionaltome.

Iwillletyoucallaroundandaskthebrokerswhichonehasaprofessionaldealingdesk.Whenyoufindtheone,takenote.Thisisthesamebrokerthatisresponsiblefortheinternale-mail noted above, saying that the firm uses slow servers and other tools to beat itscustomersoutoftheir trade, includingrecognizingthecustomers’tradingpatternsandusingthosepatternstotradeagainstthem.

Incontrast, anotherbroker IamfamiliarwithactsasanMM,meaning that thebrokerruns a dealing desk.The broker does say that its operations are 100 percent automated; itsimplyaddsamarkupandtakestheothersideofeverytrade.Thebrokerusesaprocessthattakesthecustomer’strade,automaticallylooksatthebroker’sliquidityprovidersforthebestprice,matches that best price to the customer’s order, and then executeswith the broker’smarkup.

TRUEECNTECHNOLOGY

ThefuturewillseetrueECNtechnologybecomecommonplaceinretailforextrading.Forexretail traders need to have the ability to participate in the overall forex marketplace byprovidingincreasedliquidityandadditionalforexcurrencyprices.

Something much like the level II–type technology of the mid–1990s would work. Ifcustomerswereabletooffercurrencypairsattheirownprice,itwouldcreateadeeperpoolofliquiditywithawideravailabilityofpriceswithoutallthemanipulation.Therehavebeensomeeffortsinthepasttodothis,butnotwithmuchsuccess;andsomebrokersclaimtobeECNs,buttheyarenotinthetruesenseasfarasIamconcerned.

Right now, the problemwith allowing retail traders to participate in the counterpartyside of forex trading is one of regulation. Rules state that only registered entities can becounterpartiestoatrade,thusmakingitdifficultfortheretailtradertooffercurrencypairsasanMM.Butthiswillchangesoon.

OnesuchbrokerthatclaimsthatitisanECN,andthatitwasthefirsttooffertrueECNtechnologytotheretailforexindustry, isfullof it.Thisbrokerisoneofsuspect integrity.Iknewofoneof thebroker’spreviousownerswhoused tobragabouthowmuchmoneyhecould make trading against his customers. He would carry his laptop around, makinghundredsofthousandsadayjustbyopeninghislaptopandusinghisback-officesoftwaretomove themarketor slow-fill customers, amongother sinister-type techniqueshehadathisfingertips;therewasnorealECNtechnologyavailabletohiscustomers.

Intheend,youwillneedtoutilizeallthestrategiesandtrainingyoucansothatyoucanbeatthebrokersattheirowngame.

PART4HOWTOTRADEANDWHERETOTRADE

CHAPTER19TRADINGSTRATEGIESTOBEATTHE

BROKER

Aswebegin thischapter, let’s takea fewmoments tounderstandhowwecansuccessfullytradetheforexmarketafterwhatwehavelearnedgoesonbehindthescenes.

Not all forexbrokers are stealingyourmoney andnot all forexbrokers arebad.Yousimplyhavetoreaduponthem,conductyourownduediligence,andultimatelyopenademoaccounttoseeforyourselfhowthebroker’spricingfeedandexecutionswork.Keepinmind,the demo account will not be representative of the live account you will ultimately beactivatingwith realmoney.However, opening and using a demo accountwill give you anideaofwhattolookforwhenyoudofundyourliveaccountwiththebroker.Onceyouopenyourliveaccount,startsmallandtestthebrokertoseewhatkindoffillsyouaregetting.

Ihave testedmanybrokersover the last12years; somewere terribleandsomewerefine,butIhaveyettofindthegreatbroker,andIamstilllooking;buttotradeinthismarketyoumust have a broker. I think it is prudent tomention thatwith all the recent legislationaimedattheforexmarket,mostofthebigbrokershavestartedtoconform.Theyarenotdoingwhattheyoncedid.

TheentirelandscapeofforexisnotdissimilartowhathappenedwhenthestockmarketmovedtowardautomationwithNASDAQ.Thereweremanyyearswhenretailtraderswherein the dark and always behind the moves, and don’t think for a minute things aren’t stillhappening in the equities market that are aimed at getting the small retail trader. Tradingequitiesandusinganequitiesbrokerisnodifferentfromtradingontheforexmarket.Youstillneedtobecarefulandwatchyourfillsveryclosely.

Therearemanystrategiesouttherethatcanhelpyoustayaheadofthebrokers.Manyofthestrategiesthatyouwillwanttousewillrequireyoutostayoffyourbroker’sradarscreen.Hereareafew:Don’tletyourbrokerseeyourstopsandlimits.Don’tletyourbrokerseeyouholding on to large amounts of profits.Withdraw your profits periodically and keep yourtradingaccount relatively small.Youcanalsousebig stopsand limits, so longasyouarewellwithinyourmoneymanagementplan.

TRADEBEFORETHENEWSSTRATEGY

Gettinginaheadofthemoveiscrucialtomakingmoneyinanytrade,butthekeyistoknowtheprecisetimetotradeandthedirectionthemarketwillmove.Oneoftheessentialfactorsforanyforexmoveinvolvesnewsevents,orwhatIliketocallthe“fundamentalsoftrading.”Wecanusefundamentalstofindthemarketdirectionandthenuseour“technicalindicators”totimethepreciseentryandexitpoints.

Oneofthebiggestmarket-movingeventsistheannouncementofinterestratedecisions.Iamgoingtoprovideyouwithasimplemathematicalcalculationfordecidingifanycentralbank is going to raise interest rates, lower rates, or keep rates on hold before theannouncementgoespublic.

Let’sstartoffbyexaminingaformulaoftenusedbytraderstopredictthetargetrateforacentralbank’sshort-terminterestrates.ProposedbyJohnTaylorin1993,theTaylorruleiswidely accepted by economists today as a gauge for appropriate interest rate levels inconjunctionwithcurrenteconomicconditions.Weareabletopredicthowmuch,ifatall,acentral bank should change short-term rates as real inflation or real GDP diverges,respectively, fromthe target inflationaryratesorpotentialGDP.Tofind theshort-termratetarget, you take the central bank’s target interest rate and compare it with GDP growthexpectationsandinflationaryfigures:

i=N+0.5(Y–Y)*)+0.5(P–P)*

whereiistheshort-termnominalinterestrateN is theneutralratesubtractingtheshort-terminterestratewithtargetGDPandinflationatthemean

YistheGDPforecastedgrowthrateY*istheobservedGDPgrowthratePistheforecastinflationaryrateP*isthetargetedgrowthrate

When this formula to forecast future expectations suggests that the GDP growth rate orforecastedinflationrateisabovetrendtargetlevels,theshort-termratesshouldbeincreasedby half the difference between the forecasted inflation rate and target trend levels. If theforecasted GDP growth rate or forecasted inflationary rate is below the trend and targetlevels,theshort-terminterestratesshouldbereducedaccordingly.

Youcanalsofactorin

i=N+a(P–P*)+b(u–U*)

whereiisthetargetshort-termnominalinterestrateNistheneutralrateaistheinflationgapcoefficientPisactualinflationP*istheinflationarytargetbistheunemploymentgapcoefficientUistheactualunemploymentrateU*isthenonacceleratinginflationrateofunemployment

Remember to use Taylor’smodel in conjunction with the current unemployment rates andinflationary numbers for forecasting future interest rate decisions. This will help youunderstandthemarket’sdirectionbeforethemovetakesplaceandallowsyoutogetinaheadoftheannouncement,thusmakingyourtradelessreactionaryandmorecalculated.

Thesuccessofanytradingstrategydependsonanumberofkeyelements, fromtiming

yourentryandexitpointsprecisely toenteringatornear thebeginningofanyrunormovethat is setting up.Understand thatwith anymarket there is always a trend,whether it’s anuptrend,downtrend,orasidewaystrend.Therearealsoembeddedtrendsortrendswithinatrend.Youcanseethesesmallertrendssettinguponlowertimeframes.

Asaforextrader,thekeytobeatingthebrokerscomeswhenyoulearnhownottoplaytheir game!How can this be done?Youmight be trading in smaller time frames, and thebroker is taking a small piece of each trade through its various means of systematicallystealingfromyou.Thenyourprofitsaremuchsmaller,whichwillmeanthatyourlosseswillseem much larger, ultimately making it appear that you have poor money management oremotionaltradinghabits.Sohowcananindividualcombatthesescandaloustacticsputintoplacebythebroker?First,bypracticinggoodmoneymanagement.

MONEYMANAGEMENTFORMULA

HereisoneoftheformulasIuseformymoneymanagement:Accountbalancetimesthepercentageofacceptableloss,whichgivesyoutheamountof

moneyyouarewillingtoloseinatrade,whichisthendividedbythenumberofpipsinyourstop,whichequalsthenumberoflotsyoucantradeThisisreallyisasimplecalculation,butthereareafewsimplerulestofollow:

1.Amountyouarewillingtorisk.Todeterminethemostyoushouldriskatanyonetime,takeyouraccountbalanceandmultiplyitbynomorethan0.05 (5percent).Example:$5,000miniaccounttimes0.05equals$250.

2.Numberofpipsyouarewillingtorisk.Thisisdeterminedbythepriceatwhichyouaregettingintothetradeandwhereyourstopisplaced.Addthespreadtimes2tolimit“headfakes”inposition.

3.Lotsyoucantrade.Thenumberofpipspertradeisdeterminedbythedifferencebetweenthedollaramountatriskandthenumberofpipsinyourstoploss.

Note:Ifyouhaveanaccountbalanceof$5,000andyou’rewillingtorisk1percentofyouraccount balance on this trade (5,000 × 0.01 = 50), this gives the dollar amount of youraccountbalanceyouareputtingatriskonthisparticulartrade—inthiscase,$50.Ifthestoploss is25pips away fromyour entry price (including 2 times the spread), you divide thedollar amountby thenumberofpips inyour stop (50/25=2,) and thisnowgivesyou thenumberoflotsyoucantrade:

5,000×0.01=50/25=2Whenyoucombinegoodmoneymanagementwithyourtradingstrategies,thiswillhelp

you increase theoddsofplacingnotonlyaprofitable tradebutasuccessful tradeaswell.Oneway tobeat thebrokersat theirowngame is to trade longer-termstrategies.Look forswingorpositiontrades.Thesearetradesthatyoumayholdforasingledayoruptoseveraldays,thusutilizingtheoveralltrendofthemarketandminimizingtheimpactthebrokerswillhave by taking the counterposition to your trade.When the brokers determine your tradingstrategiesandstyle, theywillbeginpassing the tradesoffasSTPto thebanks toavoid thelossestotheiraccount.

Here’sastrategyyoucanuseforswingtrades;notethatthisisatradeIlooktoholdforaminimumof60minutesuptoseveraldaysoruntil the trendreverses.First, Iuseadailychart;onthedailychartIwilladda50,100,and200simplemovingaverage.Thesemovingaverages are often areas of support and resistance and are universally recognized indeterminingcrossesoffastandslowformajortrendreversals.

Iwillalsolookforchannelsortheoveralltrendofthemarketusingalinearregressionchannel,makingsurethatIamatornearlevelsofsupportandresistanceinconjunctionwiththechannel so that I can takeadvantageof the largermoves in themarket. If themarket istrending, Iwill add a Fibonacci extension to predictwhere themarket is heading. If I amenteringonacorrectionorpullback,IcanusetheFibonacciretracementtodeterminewherethemarketisheadingonthepullback.

NextIusea120-minute(2-hour)chart.Iusethecharttofindthenear-termtrend.Thistrendshouldmatch theoverall trend from thedailychart.On the120-minutechart, Iaddalinearregressionchannelandareasofsupportandresistance.Makesureyouaretradingwithsupportandresistance.

Foryourentrytime,usea60-minutechart.Youwillneedtoaddaparabolicstopandreverse(SAR),aCommodityChannelIndex(CCI)indicator,andatripleexponentialmovingaverage (TRIX) 10-length 9-signal smoothing line. You should place the trade when thecomplimentaryindicatorslineuptogether.LookforacrossoftheTRIXatthesametimeyousee the parabolic SAR reverse the trend direction. The trade should be enteredwhen thepricecrossestheSARinthedirectionofthenewtrend.

Youwillneedtoconfirmthatthetradestillhasroomtogo;thiscanbeconfirmedwiththeCCI.IftheCCIindicatorisbelow100,ithasmoreroomtotheupsideforalong;andiftheCCIisabove100,ithasmoreroomtothedownsideforashort.Allthreeindicatorsmustlineupwithinthreecandlesinthesamedirectioninorderforthistobeasuccessfultrade.

Last,takealookata15-minutechartforvolume;youarelookingforincreasingvolumetoconfirmthatthereisenoughtradingtakingplaceinthemarketforthemovetocontinue.Ifvolume is falling off, themovemay not have enoughmomentum to continue. If volume isincreasing, look for this as confirmation that themarket is moving and a price correctionmightbetakingplace.Thiswillallowyoutotradewiththeoveralltrendofthemarket,anditwillallowyoutakealargerprofitwithmoreaccuracyandeliminatethebroker’simpactonyourtrades.

RegardlessofsomeofthelessthanflatteringthingsaboutbrokersIhavewritteninthisbook, therewill alwaysbe individuals trading in the forex. It’s anexcitingmarket, it’s thelargest financial market in the world, and it’s only getting bigger. If you use goodmoneymanagementandignoreyouremotions,youwillbeonestepclosertomakingpositivetradesintheforex.Tryusingsomeofthestrategiesinthisbook,includingtheonesnotedabove,tobeatyourbrokerandstayaheadoftheforexgame.

CHAPTER20WHICHBROKERSTOTRADEWITHANDWHY

Thesubjectofthischapterisdifficult,tosaytheleast.Thequestionofwhatforexbrokertotradewithandwhyishardtonaildownbecauseitisbasicallyamovingtarget.Ihavetradedwithmanyforexbrokersovertheyears,andIcanonlyimaginehowmanyIwilltradewithinthefuture.

Inthischapter,IwilltrytocoverwhatbrokersareoutthereandwhatinformationIhaveonthematthetimeofthiswriting.ThebestwayforyoutostayontopofwhatbrokerIamusingandwhatbrokersother tradersareusing is togo tomyWebsiteatwww.jdfn.com;Iwill always have up-to-date information on various forex brokers posted, whether theinformationisfrommeorfromvisitorstothesite.

Withalltherecentlegislationandregulatorychanges,mostofthebigforexbrokersarebetterofffinanciallythantheyhadbeeninthepast,andthesmalleroneseitheraregoneorhavebeenacquiredinordertomeettheincreasesinnetcapitalrequirements.

FINANCIALS

You can go to the CFTCWeb site to see where the forex brokers stand on net capital:http://www.cftc.gov/marketreports/financialdataforfcms/index.htm.

FCMsmust filemonthly financial reports with the CFTC’sDivision of Clearing andIntermediaryOversightwithin17businessdaysaftertheendofthemonth.Selectedfinancialinformation from these reports is shown in Table 20.1. The most recent month-endinformation generally is addedwithin 12 business days after FCMs file their reports (butoccasionally information may be added later). For example, the seventeenth business-dayfiling “due date” for, financial reports completed for the end of February 2011—the dateFebruary28,2011,tobeprecise—wasMarch23,2011.Thetargetof12businessdaysforpostingthesedatawasApril8,2011.

Table20.1Brokers(allnumbersareinmillions)

ThereportswilllistthetypeofregistrationforbrokersaseitherFCM,BD,orRFED,aswellasotherinformationsuchasadjustednetcapitalandnetcapitalrequirements.

IwillincludeonmyWebsite,www.jdfn.com,thedataforthebrokersthatIamtalkingabout in this chapter as of the end ofMay 2011. One of the things that my team does isconstantlytestexecutionplatformsofvariousbrokers,lookingforthebestexecutions.Whenbrokers claim tomake changes for the better, I will go back and retest and include thoseresultsontheWebsitetoo.

FUNDAMENTALS

Besideslookingatthefinancialsforthebrokers,thinkaboutthebrokers’fundamentals,thingsthatreallymatter—thebusinessmodel,theirlong-termgoals,customeropinions,etc.Conductyourownduediligence.

Consider your relationship with the firm.What are you expecting?What is the firmexpecting?Yes,weallknowthattheplanistoopenanaccount,tradetheforex,and,thehopeis,makemoney,butisthatallyouexpect?Whataboutwhenthingsgowrong?Thebestwaytoknowhowthegoodtimeswillbeistogetanideaofhowthebrokerwilltreatyouinthebadtimes.Afterall, it’snotalwaysgoingtobesmoothsailing;occasionallyyouwillneedyourbroker’scooperationtocorrectissues;sowhatwillyourbrokerdo?

Tofindout,forexample,howbrokershandlebadfills,takealookatcustomerreviewsonline.Whileitistruethatmostpeoplewhopostcomplaintsdosobecausethey’reunhappywithasituation,keepinmindthefactthatpeoplewhoarecontentrarelypost.Sowhenyoulookatcomplaints,justimaginethatforeveryunhappypersonthereare100contentpeoplewhonever saidaword.Althoughangrycomplaintscanat timesbemisleading, lookat theresolutionsandexamine thesituation ifyouhaveenough information todoso. Ihavedonethis onmany occasionswhen evaluating a broker by using charts to see if the informationpostedbythecustomermatchestherealityofthecharts.Tobehonest,Ihavefoundthatsomeof the complaintswere not ultimately supported by the facts of the charts,whichmakes itdifficulttoholdthebrokerresponsibleforsomethingthatitdidn’tactuallydo.

Ihavealso seensituationswhere the traderwascompletely in thewrong,andyet thebrokercorrectedthesituationinfavoroftheclienteventhoughithadnoobligationtodoso.Somebrokersknowthattheindividualswhomadeunfoundedcomplaintswerewellawareofwhoreallymadethemistake,butthesebrokersunderstandthatcustomerservicegesturescan

goa longway,especiallywhen itcomes towordofmouth—and theseare thebrokersyoushouldbelookingfor.

Call the broker on the phone and ask some stupid questions. Why? Because goodbusinesspeopleknowthattherearenostupidquestionswhenitcomestoyourclients,andifyouaretreatedbadlyfor little things,youprobablyshouldn’texpectmuchbetterforbiggerissues.

Openanewaccount.Nobodysaysthatyouhavetofundtheaccount,butjustgoaheadandopenone.Thereasonissimple;byopeninganaccountyougettoseehowthebrokerwillhandleitsfirstinteractionwithyou.Isthebrokerefficient,ordoesthebrokerlosedocumentsoverandoveragain?Arethepeopleyouaredealingwithfriendly,ordotheytreatyoulikeyourbusinessdoesn’tmatter?Dotheyfollowtheregulationsaboutknowingtheircustomers,oraretheywillingtobendtherules?

Whythisisimportantcanbeansweredbyaskingyourselfafewquestions.Doyoureallywant a broker that loses documents to have access to your secure information and to holdyourmoney?Doyouwantarelationshipwithpeoplewhoappeartohavenointerestinyouortreatyoubadly?Cananyonewhoiswillingtobendorbreakrulesorregulationsbetrustedwithyourmoney?Theseareallimportantquestions,andalittlehomeworkonyourpartcanhelp you narrow the field. The relationship that you have with your broker needs to bemutuallybeneficial,andsoifthebrokerappearstobegivingawaytoomuchinordertogetyour business, then beware; brokers are in business to make a profit, and so too manyfreebiesmightindicatethattheyknowtheywillgetitbackfromyoulater.

Sowhatelsecanyoudotohelpleveltheplayingfield?Well,onethingyoucandoisconsideranIB.

IBs

First letme explain that IBs are firms that “introduce” customers to one or several forexbrokers.IBsbasicallyactasmarketingcompanies,buttheyusuallyoffertraining,support,orotherservicestotheclientsthattheyintroduce.Inmostcases,theIBsarecompensatedbythebrokersoutofthespreadsthatthecustomersalreadypay,andthecustomersarenotchargedanythingadditionalfortradesplacedintheiraccounts.

Many people think that they’re better off going directly to the broker, but there areadvantages to using an IB. For example, consider what we just discussed regarding duediligence.TheIBsalreadydidtheirduediligencebeforetheydecidedtoformarelationshipwith the brokers that they introduce their customers to because they don’t want to haveproblemswithabrokeranymorethanyoudo.

Inaddition,considerforamomentthescenarioofabadfillononeofyourtrades;ratherthanyouattemptingtopleadyourcasetothebroker,anIBcanactasanintermediaryonyourbehalfandfightforyoubyusingitscontactsatthebrokertomakethingsrightforyou.AnIBwill carry a little more weight than an individual customer fighting alone because the IBrepresentsmanyofthebroker’scustomers.AnIBcanalsohelpwhenpaperworkismissing,aswellasbetheretogiveyouanopinionwhenyouhavequestionsaboutplacingtradesorusingtradingstrategies.

Asaretailforextrader,youwillberelegatedtosomeof theseforexbrokers listedin

Table20.1.Somearebetterthanothers.Thebrokersinthetableareallfairlylarge.Youwillprobablyseesomeconsolidationwithintheforexindustry,butnotnecessarilyamongtheonesinthetable.

Ifyouweretrulycommittedtotradingtheforexandhadthemeanstotakethenextstep,youwouldbelookingtoopenyouraccountwithamoredirectroutetotheliquidityprovider.Some banks such as Citi offer a more institutional access point for you to trade foreigncurrency.Ifyougothisroute,youwillcircumventtheforexbrokersandtheirgames.

Don’tgetmewrong.Thebanksplaythesamegames,butatamuchdifferentlevel.TheproblemwithusingalargerbanksuchasCitiisthatmostofthesebanksrequirealotmoremoneyinyouraccounttogetstarted.Youcanfindsomebanksthatwillrequireaminimumof$25,000 to $50,000 to open a live trading account. Iwas speakingwith a prime bank theother day that requires a minimum of $100,000 to open a foreign corporate account and$500,000forapersonalaccounttouseitsprimebankingservices.

Ifyouwanttotradetheforex,youwillneedtohaveatradingaccountandmostlikelyataretailforexbroker.TheoneslistedinTable20.1havetheirprosandcons.ThereareotherbigretailforexbrokersintheUnitedStatesthatIhavenotlisted,andyoucangivethematryaswell.Thefunnythingaboutalltheseforexbrokersisthatwhenyoureadthereviews,youwillalwaysfindsomeonethatlikesthemandothersthatdon’t.Soultimatelyyouwillhavetomakeyourowndecisionsaboutwhatbrokeryouwanttouse.Iwouldsuggestthatyouopenademoaccountandthenfundaliveaccountwithasmallamountofmoneythatyouarewillingtolose.Then,aftermakingmanytradesinbothyourdemoandliveaccount,youcanmakethedeterminationofwhichbrokerisrightforyou.

PART5FOREXTRADINGSTRATEGIES

CHAPTER21THESIMPLES/RPRICEACTIONSTRATEGY

Thesupportandresistance(S/R)priceactionstrategy isa tradingmethodmostlybasedonprice action and its behavior at key levels,which are principally themain horizontal anddiagonalS/Rzones.

Horizontalzonesareconfirmedbyareasofaccumulationortightranging,whichIalsocall “decision zones,” where buyers and sellers enter a relationship of relative balance.Diagonalzonesaredeterminedbytrendlines.AnothersetofhorizontalS/RzonesisdefinedwithFibonacciretracementandextensionlevels.

Ianalyzethepriceactionofacurrencypairbyobservingtheparticularcandlepatternsatthoselevelsandaroundthedecisionzonesandbypayingattentiontothesuccessivecyclesof accumulation, distribution, and trending. Accumulation is manifested by price movinginsideatightrangeafterabreak,anditisusuallyfollowedbyaperiodofdistribution,whichtakesplacewithinamuchwider rangeabove thepreviousbreakand ischaracterizedbyapredominanceofstrongmovesinthedirectionofthemaintrend.

S/R levelsget stronger themore thepriceattempts tobreak the level and fails.Also,strongerS/Rsusuallytestbothsides,andpricewilltendtorespectsuchalevel.IfFibonaccilevels,dailypivots,andtrendlinescoincide,thezonewillbestrongerandabletosustainahigh-probabilitytrade.

Ihaveusedthisstrategyasanalternativetomymaintradingmethod(whichisbasicallycontrarianandshort termandpresently iscircumscribedto theAUD/USD)for the last twoyears to broadenmy choice of currency pairs. I place tradeswith a longer-term approachbecause it isvery simpleandcanbeapplied toanypairwith similar results.The strategyelementsthatfollowareusedtoconfirmthetradingplan.

STRATEGYELEMENTS

Indicators

IuseS/Rlevels,dailypivots,priceaction(chartandcandlepatterns),Fibonaccilevels,andtrendlines.Also,Itakeintoconsiderationthepsychologicallevelsandroundnumbersat00,20,33,50,66,and80endingpips.

TradingStyle

Thisrangesfromdaytradingtomediumterm.

TimeFrames

Iuse4-houranddailychartstosettheglobalS/Rlevels:•1-hourchartsasthemaintradingtimeframe•15-minutechartsfortheentries

Thestrategycanbeadaptedtolongerperiodsusingweeklyanddailychartsforsupportsandresistances,4-hourchartsasthemaintimeframe,and30-minutechartstopinpointtheentries.

TypeofOrders

Stopandmarketordersareusedmostoften.Sometimeslimitordersareusedwhenexpectingtheretestofaconfirmedlevel.

TimingoftheEntry

Whenwaitingforaspecificcandlepatterntobeconfirmed,andusingdirectmarketorders,entriesaredecidedonthecloseofthehourlycandleandaretakenonthe15-minutechartsformoreprecision.Thereisnospecifictimingwhenusingstoporders.

AnalysisHours

TheseoccurfromLondonopentoU.S.open,usuallyoneortwohoursbeforetheopeningoftheU.S.markets.

TradingHours

ThebestsessiontimetotradethisstrategyiswhentheLondonandU.S.marketsoverlap—usuallyfrom9a.m.tonoon,easterntime.

DistanceinPipsfromtheTriggerLevels

On stop orders, the distance used as a buffer from trigger price levels is 5 to 7 pips,dependingonthecurrencypair.

Instruments

My preferred instruments are the majors: EUR/USD, GBP/USD, EUR/GBP, USD/CHF,AUD/USD;secondareyenpairs:EUR/JPYandUSD/JPY.Thismethodcanbeusedonanycurrencyinstrument.

Risk-to-RewardRatio

Wherepossible,thisratioshouldnotbelessthan1:3.Sometradesbetween1:2and1:3canbetakeniftheprobabilitiesofsuccessarehigh.

MONEYMANAGEMENT

Riskparametersaresetatamaximumof2percentoftheequityforhigh-probabilitytrades(“A” trades) and at 1 percent on lower risk-to-reward ratio transactions (“B” trades).Positionsizeandtrue leveragewilldependonthecurrencypairchosenandthesizeof thestops.Herearesomeexamples:

Totalequity=$10,000Maximumrisk

Atrades=$200Btrades=$100EUR/USDtrade(pipvalue=$10perstandardlot)and20-pipstops

Atrade:$200/20=$10/pipallowable=1-standard-lotpositionsize,withtrueleverageat1:10

Btrade:$100/20=$5/pipallowable=0.5-lotpositionsize,withtrueleverageat1:5EUR/GBPtrade(pipvalue=$16.66perstandardlot)and15-pipstopsAtrade:$200/15=$13.33/pipallowable=0.8-lotpositionsize,withtrueleverageat

1:8B trade:$100/15=$6.66/pipallowable=0.4-lotposition size,with true leverageat

1:4Note:Ifyouaregoingtotradeseveraldifferentcurrencypairs,itisbesttouseanExcel

spreadsheettocalculatetheexactlotsizeforpairswherethequotecurrencyisotherthantheU.S. dollar. The amount ofmaximum allowable lots is obtained by dividing themaximumallowablevalueperpipbytheactualpipvalueforastandardlot.

Aspertheaboveexamples:EUR/USDandotherXXX/USDpairs=$10/$10=1lot

EUR/GBP=$13.33/$16.66=0.8lot,andsuccessively

EXITRULES

Thestop-lossruleforthisstrategyisbasedonrelativelytightstopsinregardtotheexpectedprofits.Thesewouldbetheprimaryexitsifthetradegoesagainstthedirectionchosen.Dependingon themain time frame and the trader’s ability tomonitor the trade actively,

threeexitmethodscanbeused:

1.AtargetprofitlevelsetaccordingtoS/Randrisk-to-rewardprojection2.Trailingstopssetaboveorbelowsignificantresistanceorsupportlevels3.Partiallockingofprofitsinhalfthepositionattheprojectedtake-the-profitlevelandstopstobreakevenontheremainder

BACK-TESTING

This strategy has been extensively back-tested on EUR/USD, GBP/USD, AUD/USD,NZD/USD,EUR/GBP,EUR/JPY,andUSD/JPY,with100 trades takenoneachpairover a

three-year period (2007–2009). It has been forward-tested on a real trading account fromFebruary2010toApril2011,givingsimilarresultsinbothbackwardandforwardtests.Theaveragewin/loss ratio tobeexpected is60:40,which isverygoodgiven thehigh risk-to-rewardrequirements.Itispossibletofindapproximatelytwoorthreegoodtradesetupspercurrencypairinamonth.

AFewChartsandTradeExamples

The twoEUR/GBP trades shown inFigure21.1were takenat thebeginningof the secondtrading week of April 2011. As the S/R levels were very clear, I didn’t use Fibonacciretracementsintheanalysis.

Figure21.1EUR/GBP—April10and11,2011

Afewdaysbefore,thepricehadalreadybrokenboththehigherhourlytrendlineandthedaily trendline, retesting the break at 0.87956 and falling back to the lows fromwhere itbouncedbackagaintotheupside.OnSunday,thetenth,aftertheweeklyopen,Idecidedtowaitforpriceactionaroundthepreviousresistanceat0.88519.

The resistance was pierced. However (as we will see in Figure 21.2), the priceconfirmedapinbarcandleandwasrejectedbackbelowtheresistancelevel;andalthoughithadreturnedbackabove thedaily trendline, I thought therewasanopportunityforashort-termcountertrendtrade,giventherejectionreactionatboththehorizontalresistanceandthediagonalcontinuationoftheprevioushourlyrisingtrendline.

Figure21.2ABtrade—shortmarketorderat0.8845

Being in a countertrendposition, I placedapending stoporderwith tighter stops (15pips)tobefilledat0.8845(5pipsbelowthepsychologicallevelandroundnumber0.8850;seeFigure21.2),with the targetprofitset30pipsbelow,at the levelof thesecondhourlyrisingtrendlinestartingfromthelowsonApril7(0.8815).

BecauseIwasmonitoringthe tradeat that time, the take-profit levelwasn’tsetonthetrade, since Iwould bewatching the price action at the rising diagonal support line. Thisallowed me to eventually perform a partial close, leaving the remainder of the positionrunningincasethemovewentmuchlower.

Afterreachingthetrendlinelevel,thepricemadeapinbar,andIdecidedtoclosehalfofthepositionattheinitialtargetprofit(0.8815),banking30pips,andtomovethestopsto0.8835ontherestoftheposition,justabovethehighoftheprevioushourlycandle.Thiswaytheriskwascoveredwithasmallprofitabovethe1:1risk-to-rewardratio(equivalentto5additionalpointsonthecompleteposition).Thepricewasagainbelowthedailytrendline,thuswithbearishpotential.

Although I generally don’t takemany countertrend trades with this strategy, I thoughttherewasafairpossibilityforpricestomoveinarangeandrevisitthelowsofthepreviousweek,withsmallrisk(1percentofequityasthiswasaBtrade)andarewardpotentialofatleasttwicetherisktaken.

The price again crossed the hourly trendline butwas contained by the strong supportareaat0.8790–0.8796.Iexitedthesecondportionofthetradeat0.8795,obtaining50pipsontheremainderoftheoriginalposition,withanetpipamountof40onthecompletetradeand2.66percentyieldonequity(1percent×2.66).

Isimplycouldhaveclosedthewholepositionat0.8815,gettingacomplete1:2risk-to-rewardratio;butintheendIgotaslightlyhigherprofit,attaininga1:2.6risk-to-rewardratio.IfIwouldhavebeenstoppedoutinthesecondportion,therisk-to-rewardratiowouldhaveendedat1:1.3.

Thedecisiontotakeacountertradewasalittlebitofftherules;however,thetradewasmanagedasperthestrategyinregardtorisklevels,positionsizing,andoverallcontrolofthe

position,asitwasbeingcloselymonitored.Assoonasthepreviouslydescribedshortwasclosed,Ienteredanothermarketorderat

0.8805(5pipsabovetheroundnumberand10pipsabovethesupportline)afterseeingthebounce(seeFigure21.3).Theprojection for this tradewasmuchhigher, targeting thenextroundnumberat0.8900.

Figure21.3AnAtrade—longlimitorderat0.8805

This trade was taken as a high-probability position because the previous highs hadpierced the former resistance level at0.88516and theoverall behaviorof themarketwasstill showing bullishmomentumon hourly charts, despite the temporary break of the dailytrendline.Thepreviouscorrectionproved tobea retestof thesupport lineat0.87956andbouncedbackswiftly.

Thestoplossforthispositionwassetat0.8785,20pipswitha2percentriskonequity,about 6 points below the recent low (0.87912).The target profitwas set at 0.8900 as theprojectionpoint,alittlebelowthe138.2percentFibonacciextension(0.8912extensionpointon the swing high from the previousweek’s lows at 0.8712 to the recent high at 0.8857),becauseoftheproximityoftheroundnumber.

Thecharts showaTP1 level,whichwasnotused tocloseaportionof the trade,butinsteadwasusedasamark tostart trailingthestops.Thefirstmarkwassetat0.8820(15pips of locked profits) as soon as the price went 45 pips above the entry, reaching theformerlypiercedresistance.Thesecondmarkfor trailingwassetat0.8850assoonas thebreakcandleclosed,andathirdtrailwassetat0.8872onthenexthourlyclose.

Thepricebarelytouched0.8900twice,andthetradedidn’tcloseuntilthefifthcandlethat broke the level. I was tempted to close manually, but as the profits covered alreadyamountedtoa1:3.3risk-to-rewardratio,Idecidedtogiveitachancetocometocompletionbyitselfandleftthetradealone.

Total pips made on this trade: 95 pips for a 1:4.75 risk-to-reward ratio and a 9.50percentyieldonequity(2percent×4.75).

EUR/USD—May4,2011

Figure21.4showsatradeIwasfinallyabletoenter,afterthinkingIhadmissedtheboatthepreviousdayatthetimeIfirstspottedtheinterestingworkingareaandformation.Thisisanexample of a short position enteredwith a limit order, set at the lower price level of theresistancearea.

Figure21.4EUR/USD—May4,2011

Ispottedthisopportunityonthefour-hourchartswhilecheckingonanothertradeIwasmonitoringontheAUD/USD,aboutonehourbeforetheNewYorkmarketsclosed.Thepairwasalreadytradingataround1.4825,andsoitwastoolatetoenteraspertherules,ortherisk-to-reward ratiowouldbe very small, given that the stops had to be placed above therangeandupperlineoftheresistancearea(1.4900)andtheadditionalspikeupto1.49386hadaddedmorethan30pipstotherisk.

Theeuro-dollarhadbeen inawide100–120-pip range,withasteadyresistanceareabetween1.4900and1.4880.The idealentryprice fora shortwas justbelow the range,at1.4875,witha2percent risk(despitebeingacountertrend trade, thepreviouspriceactionindicated it was a high-probability A trade) and 30-pip stop loss at 1.4905 (only 5 pipsabovetheroundnumber).

Ifthislevelbroketotheupsideagain,itwouldhavemeantthatthebullswerebackforafurtherriseforaprojectedtargetattheotherendoftherange(1.4770,thehigherlevelinthesupportareabetween1.4770and1.4753).

ItracedaFibonacciretracementonthepreviousswinghighfromtheApril26lowstothetipofthespikeandpinbar,confirming1.4770asthe38.2percentretracementandaddingto the probabilities of success. I placed a limit sell order at 1.4875 after the New Yorkmarketsclosed,justincasetherewasanotheropportunitytostepintothemarkets,withastoplossat1.4905andtargetprofitat1.4770.Ididthis,sincethetradedevelopmentwasmostprobablygoingtohappenwhileIwassleepingandI’dratherbeontheconservativesideof

thepicture,althoughthenextsupportatthe50percentlevelwasattainableandbeyond,asitprovedtobelateron.

Figure21.5 showshow the situation lookedon thedaily charts: thedaily candlewastradingnearitsclosepriceonehourlater,andIhadtowaitforittocloseunderthebrokentrendline for confirmation of the bearish tone of themove.The open price onMay 5waslowerthanonthepreviousday.

Figure21.5EUR/USD

On30-minute charts (the entry time frame),we can appreciate the coincidence of theFibonaccilevelswiththeprojectedentry.Thestoplossusedwasverytightinregardtotheprevioushighatthetopofthespike.However,asIsaidpreviously,thepricechosenwasthelevelatwhichIwouldconsiderthetradetohavefailedifsurpassed,giventhat thehighesttopoftherangeoftheresistancezonewasattheroundnumber1.4900(seeFigure21.6).

Figure21.6EUR/USD

ThetradewastriggeredwhenIwassleeping,andIhadanicesurprisetoseemyprofitsbanked when I reopened the trading platform the next morning. The total profit on thispositionwas105pips,givingarisk-to-rewardratioof1:3.5anda7percentreturnonequity(2percent×3.5).Notbadforaset-and-forgettrade.

If I had been able to activelymonitor the trade, Iwould probably have taken partialprofits(one-halfortwo-thirdsofthetrade)atthesetinitialconservativetargetprofit,tolettheremainderruntothenextsupportlevel.However,Iconsideredtherisk-to-rewardonthistradetobefairenough,andthepurposewastobeassafeaspossiblewhileminimizingtheoverallrisks.

Itisbettertoleavesomepipsonthetablethanaimtoohighandmissthepoint,justtosee the tradecomebackandblowoutyour initialstops. Inhindsight, this tradecouldhaveyielded a 1:8.75 risk-to-reward ratio and a 17.5 percent return on equity! (The price fellbelowthe261.8percentextensiononthepreviousswinglow.)

NZD/USD—April27,2011

Figure21.7presentsoneofthetypicalsetuppatternssoughtinthisstrategy:atrendingpairthatbreaksakeyresistanceorsupportlevel,followedbyaccumulationandthendistributioninawiderangebeforeresumingthetrendorreversing.

Figure21.7NZD/USD—April27,2011

AsshowninFigure21.8,aprevioustrendingphasehadendedonaV-typechartpattern,reaching the lowerpartof theR/Sareaat0.7995; it thenbouncedback to touch the risingtrendlineandagainreachedandpiercedtheresistanceareaattheroundnumberatthe0.8000level.Itthenmadeanothersmaller(fractal-type)Vpatternbeforebreakingthelevelfranklyandstarteditsaccumulationperiod.

Figure21.8NZD/USD

Let’s zoomout on30-minute charts to have an evenbetter picture of all the previousactivity:

Wehadtwostronglyrespectedlevelsduringtheaccumulationphase,oneat0.7990andtheotherat0.8005.Ithoughtthiswasagoodpriceforalongstopentry,justabovetheroundnumberandinthedirectionofthemaintrend;andafterseeingthedoublebottom(whichyoucanclearlyseeinFigure21.9)thathadformedthedaybefore,Igotmytriggerconfirmation.

Figure21.9NZD/USD

Thetradewasenteredbyopeningabuystoporder5pipsabovetheroundnumber,at0.8005,witha15-piptightstopat0.7990andrisklevel2percentofequity.Thetargetprofitwassetalittlebelowthe138.2percentFibonacciextensiononthepreviousswinghigh(from

thelowsat0.7820tothehighat0.8006),expectinga0.1:4.66risk-to-rewardratio.Thetradewastriggeredduringthenightandlasted17hoursuntilitreachedthetarget.

Almostattheendofthetrade,aftertheNewYorkmarketsclosed,whenthetradealreadyhad50 positive pips and had reached the 127 percent extension level, I moved the stops to0.8045, securing40pips, just in case therewas a sudden reversal.Finally, the targetwasreached, banking 70 pips,which represented a 9.32 percent return on equity (2 percent ×4.66).

Therehavebeenmanyotherdifferenttradesetupsinall thepairsundertest;however,thislastpatterniswhatIwouldconsiderthemostperfectsituationamongthemall.

CHAPTER22THECONTRARIANBBSTRATEGY

ThecorephilosophythatIprofessaboutadoptingacontrarianpointofviewontheforexmarketsisbasedontwopremises:thefirstisthatthemajoritywillmostoftenbegoinginthewrongdirection,andthesecondisthatpriceswillalwaystendtoregresstothemean.

Ifyouwatch themicrostructureofpriceactiononanycurrencypair closely,youwillnotice that in normal conditions, price exhibits a relatively stable behavior and seems tohoveraroundandcomebacktoaprecisevaluetimeaftertime.ThisiswhatIwouldcallthe“fairvalue”forthatinstrument.

Peoplearebuyingandsellinginashortrange,whichshouldn’tchangetheaveragevaluemuch.Eachbuyer needs to have a seller andvice versa.Then, at a certainpoint, externalforcesseemtoenterthemarket,andbothbuyersandsellerscanbecomeoverlyenthusiasticorfearful,initiatingacrowdbehaviorthatwillattractothermarketparticipants.Asaresult,an excess of supply or demand will take place, bringing the currency pair ratio to anoverpricedorunderpricedcondition.

Shortlyafter,themarketcomesbacktonormaloperationoncemore.Thepriceisbacktoits“fairvalue”again,whichwillhaveslightlyappreciatedordiminished,dependingonthestrength,direction,andfundamentalsupportofthepreviousextrememarketsentiment.

Thecontrarianpointofviewlookstospotthoseextrememovesandtriestobeaheadofthemajority: themarketstartstoclimb,afterawhileeverybodyisfranticallytryingtobuy,andthisiswhenthecontrarianwillstartthinkingaboutselling.

Ofcourse,Ihavetobeawareofthesubtlesignsofmarketexhaustionbeforethrowingmyself blindly into the fire of the action, as sometimes the extrememoves extend over alonger time span.However, every currency pairmoves in cycles, and those can be easilymeasuredandunderstood,providedwededicatesometimetoperformathoroughstudyofaparticularcoupleofcurrencies.

Thisstrategyhasprovedtobeexcellenttoworkshorttermonrangingmarkets,astradescanbetakenonbothdirectionssuccessfully;trendingrequiresmorewaitingtimeforpricetoreachtheappropriatebuyingorsellingzone.

STRATEGYELEMENTS

Indicators

•Three20-periodBollingerBands(BBs),with1.5,2,and2.5deviations;•34-,100-,and200-periodsimplemovingaverages•Dailypivots•Fibonacciretracementlevels•Trendlines•S/Rlevels

•Psychologicallevels(endingin00,20,33,50,66,and80)•Priceaction(chartandcandlepatterns)Ialsouseastochasticindicatorwithsettingsat5,3,3exclusivelyonthe1-minutechartstospotimmediatedivergencesforextremelyshort-termtrading.

TradingStyle

My trading style is basically day trading and short term, with some “scalping” tradeseventually.

TimeFrames

Shortterm(lessthan1day)andextremeshortterm

•Dailychartstoevaluatethemaindirection•30-minutechartstoevaluatetheshorter-termtrend•5-minutechartsasmaintrend•1-minutechartsforentriesandstochasticdivergences

Daytrading(1dayto1week)

•Dailychartstoevaluatethemaindirection•4-hourchartstoevaluatetheshorter-termtrend•30-minutechartsasmaintrend•5-minutechartsforentries

ThestrategycanbeadaptedtolongerperiodsusingweeklyanddailychartsforS/R,4-hourchartsasthemaintimeframe,and30-minutechartstopinpointtheentries.

TypeofOrders

Thesearemostlylimitorders,especiallyonlonger-termsetups.Bothmarketordersandlimitorderscanbeusedonshort-termpositions.Useonlymarketordersonscalping.

TimingoftheEntry

Onmarketentries,Iwaitforthecoincidenceofthethreelowertimeframes(trend,main,andentry)andthepricecomingbackfromthe2.5-deviationthroughthe1.5-deviationBB.Iwillwaitforonecandletocloseinsidethemiddlearea(betweenthe1.5deviations)andthenextonetoopeninthatsamearea(onthesmaller“entry”timeframe)beforeenteringthetrade.

Onscalpingentries,theentrywillbetriggeredbyacleardivergencespottedonthe1-minutestochastic.

Limitorderswill beplannedaccording to specific support, resistance, andFibonacciretracementlevels,jointlywiththesuccessivestepsofthe“routemap,”whichisdefinedbyalltheindicatorsused.

AnalysisHours

I do this daily, just after the New York close. During the weekend, I examine the daily,weekly,andmonthlychartstodrawthemostimportantlevelsofsupportandresistance.Iwillemployanadditionalreassessmentperiodabout2hoursbeforetheNewYorkmarketsopen,dependingonthepreviouspriceactionandiftherearetradesstillopen.TradingHours

Australian/Asiansessionsareusefulforquietrangingpriceactionandshorter-termtrades.Imakeuseofthe3-hourEurope/LondonandLondon/UnitedStatesoverlap,dependingonmyowntimeavailability.Totaltradingtimeissplitintwoorthreeparts.

DistanceinPipsfromtheTriggerLevels

Limitorderswillbesetat5pipsabovespread(forlongpositions)or5pipsbelow(forshorttrades).Usethepsychologicallevels00,20,33,50,66,and80.

Instruments

This strategy has been tested only on the EUR/USD and AUD/USD with the actualparameters.AlthoughIhavebeenusingitforgeneralanalysisonotherpairs,thesettingsforthe smaller moving average and the three BB periods and deviations would need to beslightlyadjustedtomatchtheparticularitiesofothercurrencypairs.

Risk-to-RewardRatio

Therisk-to-rewardratioisfrom1:1to1:3.Thelowerrisk-to-rewardratioiscompensatedbythehigherwin/lossratio.

MONEYMANAGEMENT

Riskparametersaresetatamaximumof2percentoftheequityforhigh-probabilitytrades(Atrades)andat1percentonlowerrisk-to-rewardratiotransactions(Btrades).

Positionsizeandtrueleveragewilldependonthecurrencypairchosenandthesizeofthe stops,which in turnwill dependon themain trading time frameused (see the “MoneyManagement”detailedexamplesinChapter21).

EXITRULES

Stop losses are set below the 2-deviationBB level,with similar parameters as entries inregardtopsychologicallevelsandroundnumbers.Dependingonthemaintradingtimeframeandthetrader’scapabilitytomonitorthetrade

actively,thesethreeexitmethods,firstpresentedinChapter21,canbeused:

1.AtargetprofitlevelsetaccordingtoS/Randrisk-to-rewardprojection2.Trailingstopssetaboveorbelowsignificantresistanceorsupportlevels,aspertheroutemap,psychologicalnumbers,andFibonaccilevels

3.Partiallockingofprofitsinhalfthepositionattheprojectedtake-profitlevelandstopstobreakevenon the remainder.Youmaywant to considerusing thisvariantonly forhigh-probabilityandswap-positivelonger-termtrades.

RiskManagement

Onlonger-termhigh-probabilityandswap-positivesetups,entriescanbesplitintwoorthreepartsfordoingaveraging-in.Therisk(maximumlossallowed)pertotalpositionremainsthesame,buttherecanbeseveralreentriesbasedonrecurringpricewavesinsidearangebeforeadefiniteimpulseinthedirectionchosen.

ExitsandLossManagement

Whenalonger-term,three-parttradeismomentarilygoingagainsttheoriginaldirection,thefirstpositioncanbepartiallyclosed(scalingoutthelossesone-tenthatatime)startingifandwhenitreaches100negativepips.Meanwhile, theothertradesarebalancingthelosswiththeirprofits,tryingtokeepatleasta2:1ratioorhigheruntiltheoriginaldirectionofthetrendresumesandallpartscancometocompletionatthetargetlevelthathasbeenset.

Anemergencystoplossissetat2percenttotalrisk.

Example

Let’sassumethefollowing:equity$10,000,totalallowableloss2percent=$200.Iwillusuallysetadistanceforthesecondtradeat50pipsfromthefirstentryandthe

sameforthethirdentry.Whenthepricegoes50pipsagainstmydirection,Iopenthesecondtrade.Iftheprice

goesanother50pipsnegative,Iopenthethirdtrade.Thefirsttradeisnow100pipsnegative;thesecondtradeis50pipsnegative.Thisisatotalmaximum100pipsonthefirsttradeand50onthesecond.Theemergencystopissetforalltradesata15-pipdistancefromthethirdentry(totalrisk=115+65+15=195,roughly200pips).

Myvalueperpiphastobe$1tomeettheriskrequirements.Thethirdtradegoesintopositive30pipsbutcomesbackagainstthedirection.Iexitthe

thirdtradewith20pips,givingbackone-thirdoftheprofits,andcloseone-tenthofthefirstposition[equivalentto8pips=(100–20)/10].

Netpips=12Ilooktoreenterthethirdtradeatthesamepriceasoratleastatabetterpricethanthe

exit.Theentrygetstriggered,andthepricegoesinmydirection60pips.Thesecondentryis10pipspositive.Icloseboth,banking70pips.Thefirsttradeisnow40pipsinthenegative.

Netpips=12+70=82Ireassessthelevelsandreenterthesecondpositionateitherthepreviouspriceor10to

15pipsfartherfromthefirstentry—inanycase,alwaysatabetterpricethantheexit.During the process, key levels are moving around and are used to determine the

probableexitsaslongasthepricehasn’trecovereduptothefirstentry.Thesecondentrygetstriggered10pipslowerthanbefore.Thefirsttradeis60pipsin

thenegative;thepriceretracesalittlebitandagaingoesinmydirectionfor30pips,anditisata20-pipdistancefromanotherkeylevelinshortertimeframes.Thepricegoesfurther,andIclosethetradewith40pips,lookingtoreenterthesecondposition,asalways,atthesameasoratleastatabetterpricethantheexit.Thefirsttradeis10pipsnegative.

Netpips=12+70+40=122Thepriceretraces20pipsbelowtheexitandhitsakeylevel,andIreenterthesecond

tradeata30-pipdistancefromthefirstentry.Thepricecontinuespastthefirstentryandisheadingtowardtheoriginaltargetlevel.Atthefirstentryprice,Iamalready30pipspositiveonthesecondtrade.Ibreakevenonthefirst,andIam112pipsaboveduetothepreviouslyclosedpositions.Plustheeventualpositiveswapisaddeddailytotheaccount.

Onlytwo-thirdsofthetotalpositionisopen;Ihavebanked142pips,whichrepresenta1.42percentreturnonequity(pipvalue=$1)—andthetradeisjuststartingtodevelop.Thetargetprofitissetatakeylevelwitha1:2risk-to-rewardratio.

Let’sdoacomparisonwith theoriginalscenarioat2percentriskandaverage50-pipstops:

Thefirstpositionstoppedoutminus50.Thesecondpositionstoppedoutminus50.Thethirdpositiontrailed to theentryof thefirstposition=positive100pips.Thetradewouldhaveremainedatbreakeven:–2percent–2percent+(2×2percent)=0.Withthisvariant,thereisanadvantageontraditionalentries(whenthedirectionisabsolutelycorrect)duetothecyclicalnatureofthemarketsandthepositiveswap.Shouldthetradebetotallywrongintheend,thelosswouldbeonly2percentorless(thankstothepartialcoveringandexitingofnegatives)andwouldhaveconformedtotheriskpolicy.

(Note: The above is a hypothetical situation to explain the process; a detaileddescriptionofaseriesofvarianttradestakenonmyrealaccountisincludedattheendofthischapter.)

BACK-TESTING

Thisstrategy,aswellasitsvariant,hasbeenback-testedexclusivelyandextensivelyontheEUR/USD and AUD/USD over a short 3-month period in late 2008. Given the excellentresults,Idecidedtolaunchtheforward-testinmylivetradingaccount,andIhavebeenusingit asmymain strategy since February 2009 up to now (May 2011). The averagewin/lossratiotobeexpectedisaround80:20.Thereareplentyoftradestobetakendailyonshortertimeframes.

CHARTSANDTRADEEXAMPLES

TheBasicSetup:Indicators

Indicators are no more than what their name suggests: a signpost on the road, a call foralertnessatacertainpointintimeandprice.

Pricesevolveinwavesorcyclesandmostof thetimeareboundwithinarange.Thatrange can be flat or horizontal (sideways market) or move inside diagonal boundaries:slightly ascending (bullish) or descending (bearish).After thousandsof hourswatching thecharts,either trading liveandforwardorusing thevisual toolsof thesimulatorplatform, Ihaveobservedthatpriceactionexhibitsarecurrentbehaviorwhenreachingorgettingnearthoseparticularsignposts.

Thewhole setup uses amulti–time frame approach, because I have also noticed thatwhenakey level isbrokenonasmallerperiod, theactionwillcontinueon thenextuppertimeframe(seeFigure22.1).

Figure22.1Basicsetupindicators

AShortDescriptionoftheCyclic“Route”

Thefollowingisroughlywhatcanbeexpectedatevery level inanyof themajororminorroutemaps.1.BBs,20Periods,2.5Deviations

Priceiscomingtooneof itsextremesandcaneitherbreakthis level to theoutside(whichsignals a high probability for a continuation of the current direction) or come near andreversebacktothelesserdeviationlevel.2.BBs,20Periods,2Deviations

This is thestandardsettingforBBs. It’snot reallyneededon thechartsbutkept thereasavisualaidtocomparethebehavioroftheothertwodeviationlevels.3.BBs,20Periods,1.5Deviations

This is the key level that signals a reverse move to the middle line or even all the waythroughtotheothersideofthebands.Whenacandlecloses“outside”thislevel(belowtheupper1.5-deviationband for a short positionor above the lower1.5-deviationband for a

longtrade)andthenextcandlealsoopensoutside,thepricewillalmostinvariablycontinuetoat least themiddle lineor the34-periodsimplemovingaverage,orSMA34(whichevercomesfirstdependingonthepositionofthemovingaveragesonthechart).Mostofthetime(about 80 to 85 percent) and especially on shorter time frames, the pricewill walk backthroughthewholesettowardtheoppositegroupofbands.4.MiddleLineofBBs(20-PeriodSimpleMovingAverage,orSMA20)

Thislinesignalstheexactmeanoftherange;however,itisusuallyweakerthanthefollowingmovingaverage(SMA34).Herethepricewillalmostalwaysbouncebackatabouthalfwaythrough the distance that separates it from the 1.5-deviation BB line if the markets areranging.Onstrongtrendingorcorrectivepriceaction,thislevelcanbeoverlooked,andthepricewillprefertoreactonthenext,especiallywhenthislinecomesbeforethe34-periodmovingaverageline.5.34-PeriodSimpleMovingAverage(SMA34)

This is a key level especially in trendingmarkets for EUR/USD andAUD/USD currencypairs.Thislevelmighthavetobeadjustedtomatchotherinstruments.

Thepriceherewillpracticallyalwaysbouncebackonceforaretesteithertothemiddlelineofthebands,ifitcomessecondtoit,ortothe1.5-deviationbandline,andthisoccursindependentlyofthedirectionofthetrend.ThisistheexitlevelImostlyuseforcountertrendtrades,asthepricewilltendtosticktoitandreactasifitwereatrendline.Whenbroken,thislevelwillalsoalmostinvariablyberetestedatleastonce.

Theconservativeleveltouseinthesecasesissomepointbetweenthemiddlelineofthebands and the SMA34, not the exact price level of the indicator. To determine this withfurther accuracy I will need to examine other elements in play such as S/R, pivots, andFibonaccilevels.6.100-PeriodSimpleMovingAverage(SMA100)

AfterthepricehasclearlybrokenandretestedtheSMA34,thisisthenextkeylevelthatisalmostalwaystestedorpiercedonce;thenthepriceisrejectedandcancomebacktocrossthrough the level later if ithasbeenclearlypierced.Theotherelements Iwillusehere todetermine further price action are its position in regard to the psychological levels (priceending in 00, 20, 33, 50, 66, and 80) and Fibonacci retracement zones, along with keysupportsorresistances.7.200-PeriodSimpleMovingAverage(SMA200)

Thisistheultimatekeyleveltodetermineatrendreversal,especiallyonlongertimeframes(4 hours and higher). This level is usually tested once or twice before being effectivelycrossed.Therefore,wecanexpectthepriceactiontobouncebackforsignificantcorrectionsonthepreviousmoves,andthisonahighertimeframecanyieldasignificantpipamount.When the Action Has Progressed on a Lower Time Frame, It Has to BeFollowedUpontheNextUpperTimeFrame

Multi–timeframeassessmentsaretobedonebothways.Iwillfirstanalyzethechartsfrom

thehigherperioddowntothesmallertimespanstoseetheoverallactionandtobeabletoenter at the best possible price. Then when a trade is in progress, I will be watchingsuccessivelyhowthepricebehavesinregardtotheabove-mentionedstepsorsignposts,fromthe lower timeframe(1-minutecharts)upward.Thekey toswitch to thenextperiod is thepricebehavioraroundSMA34andthemiddlelineofthebands.

When this area is clearly broken on the 1-minute charts, I will then watch the pricelocationonthe5-minutecharts.ShouldIalsobeabove(orbelow)theSMA34,Iwillsteptothe15-minute,30-minute,andsoonandevaluateinwhichprecisetimeframeisthepresentactionreallyoccurring(waveswithinwaves).

Ionceconstructedamulti–timeframeBBindicatorforanalysiswithallthreedeviationlevels on the four key time frames of the strategy, but the resulting chart looked quitecluttered. Itwas,however,very interesting tobeable to see at aglance theexactpoint inwhichthepricewasrelatedtotheglobalpicture.

Figure 22.2 provides a snapshot of a simplified version of such an indicator, onlyshowing the two deviations, 20-period BBs for three time frames (daily, 4 hours, and 30minutes)fromthepointofviewofthe4-hourchart.

Figure22.2Multi–timeframeassessmentchart

Short-TermTimeFrameSetup

Thedaily chart is themain analysis time frame for anyof the styles used (short term, daytrading.orlonger).Additionally,weeklyandmonthlychartscanbeusedtodeterminekeyS/Rlevels,buttheirsetupbehaviorisnottakenintoaccount.

IfweexaminethesetofchartsinFigure22.3,wewillseethefollowing:

Figure22.3Short-termtimeframesetup

•Dailychart.Thepricewas rejected from thekey levelSMA34andhas slightly crossedbackthroughthemiddlelineofthebands.Wehavetowaitforthecloseofthecandletosee if itmight consolidate between those two levels or if it is going back to the upperbands.Thetrendisbullish.

•30-minutechart(overalltrend).Thetrendherelooksbullish,butthepricehasreachedtheSMA200andbouncedback.Watchoutforaretestofthesupportandtheconvergenceofsmallermovingaverages.

•5-minutechart(maintradingchart).Themain trading timeframeis theone thatwillbeused tocalculate theappropriatestop levelsand trade targetsaccording to thatperiod’saveragerange.Onthe5-minutechartsIwilluseabout20to25pipsasamaximum.Iftheplanned trade seems to needmore than that, I will reassess the whole scene using thelonger-termsetupparameters.

•1-minutechart(entries).Ontheentrychart,thepricewillhavetosuccessivelycloseandopenabovethelower1.5-deviationBBforlongsandbelowtheupper1.5-deviationBBforshorts.Thetradecanbetakenonthesecondopeningcandle;orifthepricegoeshighertoo fast, I can set a pendingorder at that levelwhilewaiting for a retest, provided thedirectionisstillvalidonhighertimeframes.

DivergenceExtremelyShort-TermSetup

Ionlyusestochasticdivergenceson the1-minutechartswhenIwant toenter fastandveryshort-livedpositions,withtightstopsandnarrowexittargets(about10to15pips).

Figure22.4providesanexampleofatradetakenabout1hourago.

Figure22.4Divergenceextremelyshort-termsetup

Thistradewasmanuallyenteredat1.0668(1.0666bid+2-pipspread)onthenext1-minute candle after the stochastic cross up, with stops set at 1.0658 (2 pips below thepreviouslow)andexitedat1.0685.Asthisstyleoftradingrequiresfull-focusedmonitoring,theactualstopexitwouldbetriggeredsoonerthansimplylettingthepriceblowthestoploss,whichisonlysetasemergencyprotection.

Theriskallowanceusedwas1percent,aswecouldconsiderthesepositionstobeB-typetrades.Thetradeyielded17pipsfora1:1.7risk-to-rewardratioand1.7percentreturnonequity.Notbadforanoverall5-minutetradedurationplus1minuteforassessment.

AlthoughIprefer the lessstressfulmethodofplacingpendingordersandallowingthemarketstocometomypositions,thiswastheoriginalbasicsetupwhenIstartedtestingthisstrategy,averaging50 to70 tradesperday.Ofcourse, theenormousexpenditureofqualityfocused time was utterly draining, and after a month or two I started envisioning a moretranquilversionwithhigherpotential returns.However, sometimes Iwilldedicateanhourhereandtheretothisscalpingstyle,especiallyduringslowandrangingtimes,tokeepattunedtothemarket’spulseandtogaugeandupdatemyreactionskills.

Technically,therisk-to-rewardratiohereisbarely1:1;however—andassaidabove—this is only a small part of the whole strategy that fits into my own reaction training.Relatively “large” stops (10 pips) are only there to take care of eventual unpredictablesituations (power outages, server disconnections, etc.). Should the position go against mydirection, I usuallydon’t allowmore than4or 5pips (2 times the spread atmost) beforeexiting,astheseareveryshort-livedmoves,especiallywhencountertrending.

DayTradingorMedium-TermTimeFrameSetup

Thesameasfortheshorter-termsetup,thedailychartisusedasamainanalysistimeframe.InFigure22.5,wecanseethefollowing:

Figure22.5Day-tradingormedium-termtimeframesetup

•Dailychart.Thisisthesamescenarioasabove.ThepricehasbeenrejectedfromthekeylevelSMA34andhasslightlycrossedbackthroughthemiddlelineofthebands.Wehavetowaitforthecloseofthecandletoseeifitmightconsolidatebetweenthosetwolevelsorifitisgoingbacktotheupperbands.Thetrendisbullish.

•4-hourchart(overalltrend).Thechartshowsweareintoacorrectionphaseafterabearishtrend. The price is still above the SMA200, but the smallermoving average is turningwhiletheSMA100isnearlyflat.Thiscouldbesignalingaconsolidationphasesoon.

•30-minutechart(maintradingchart).Themaintradingtimeframeistheonethatwillbeused tocalculate theappropriatestop levelsand trade targetsaccording to thatperiod’saveragerange.Onthe30-minutechartsIwilluseabout50to60pips.Iftheplannedtradeseemstoneedmorethanthat,Iwillnottaketheposition.

•5-minutechart(entries).Ontheentrychart,thepricewillhavetosuccessivelycloseandopenabovethelower1.5-deviationBBforlongsandbelowtheupper1.5-deviationBBforshorts.Thetradecanbetakenonthesecondopeningcandle;orifthepricegoeshighertoofast,wecansetapendingorderatthatlevelwhilewaitingforaretest,providedthedirectionisstillvalidonhighertimeframes.

ANALYSISTIMEFRAME:THEDAILYCHART

Themost importantpartof thisstrategy is toevaluate,asaccuratelyaspossible, theactualpositionof thepriceonthedailyroutemapinrelation to the indicators.Thebeautyof thissetupisthat,atleastfortheEUR/USDandtheAUD/USD,thesettingswillworkforanytimeframeyoudecidetolookat.AsFigure22.6shows,priceactionexhibitsarecurrentbehaviormorethan80percentofthetimeateachstepoftheroute,andmarketwavesbecomealmostpredictable.

Figure22.6Analysistimeframe:thedailychart

SHORT-TERMTRADING

TrendAssessment:The30-MinuteChart

AsyoucanseefromFigure22.7, themain trend isdownbutpresently insidea correctivemove;however,itisstilltradingbelowtheSMA200.Expectaretestoftherecentlybrokenresistanceandconfluenceofsmallermovingaveragestothemiddlelineofthebands.Watchforpriceactionandontheoppositesideofthebands,shouldthepricerevisitthelows.

Figure22.7Trendassessment:the30-minutechart

MainTradingTimeFrame:The5-MinuteChart

InthecaseofFigure22.8,wewouldwaitforaretestofthemiddlelineofthebandsforaneventualmovefurthertotheupside.Thestoplevelsneededwouldbetoowideforthistimeframe;thereforeeitherwewaitforashortposition,ifthepricerevisitsthehighsandcomesbackbelowtheupperBB1.5deviation,orwewaitforafall tothepreviouslowsandtheconfluenceofmovingaverages.However,wehaveanothersupportattheSMA34level,andthepricecouldregainbullishstrength.Takenotradesinthemiddleoftheactiononthistimeframe;stopsshouldn’tbewiderthan20to25pips,atmost.

Figure22.8Maintradingtimeframe:the5-minutechart

EntryAssessment:The1-MinuteChart

LookatFigure22.9.Thebestentrypointforlongtradesherewouldbearoundthe1.0690–1.0700level,providedthehighertimeframesconfirmthedirection.Thelowersupportzoneisat1.0670,where thepricehasbeen respectedonbothsides in thepast. It is too late toenvisionashortentry(weshouldhaveentered,inanycase,whenthepricecamebackdown,opening below the upper 1.5-deviation BB) because the stops would have to be at leastabove thesecondprevioushighsandupper2.5-deviationBBandbecause thenext supportlevelatSMA100isatasmallerdistance,makingthebasicrisk-to-rewardratiolessthan1:1.

Figure22.9Entryassessment:the1-minutechart

DAYTRADINGORMEDIUM-TERMTRADING

TrendAssessment:The4-HourChart

You can see from Figure 22.10 that the price has justmade a correction to the SMA200,whichitdidnotpierce,andiscomingbackuptowardtheSMA34,havingclosedabovethemiddlelineoftheBBs.Thereisastrongresistanceareahere,whichhasbeenrespectedonbothsides.

Thetrendisstillbullish,butweneedtowatchcloselythepricebehaviorshoulditreachtheupperlevel,asitcouldbrieflyspiketoretestthehighsareaattheupperbandsandcomebackstrongertothedownside.Lookslikewemighthaveatighterrangingactionaroundthepresentlevels,asbandsarestartingtocurlandconverge.

Figure22.10Trendassessment:the4-hourchart

MainTradingTimeFrame:The30-MinuteChart

In Figure 22.11, the price is climbing and has almost reached the SMA200, then beingrejected,butitisstillinsidetheupperbands.Thesituationlooksbullish,butweareintoacorrection of the downtrend. Since the price will probably retest the broken level in the1.0800–1.0830 zone and the SMA200 hasn’t yet been pierced, we could expect a firstrejectionafterdoingso.

Figure22.11Maintradingtimeframe:the30-minutechart

Shortswouldneedgreaterstopsandwouldoffertoosmallarisk-to-rewardratioevenat thatpoint, as smallermovingbandsarecurlingupand theSMA34 isabout tocross theSMA100.Bettertowaitforanotherdiptothelowsandplanforlongs.

EntryAssessment:The5-MinuteChart

InlookingatFigure22.12,wewouldwanttowaitforthepricetocomebackatleastatthe1.0670–1.0690levelforlongs,with50-pipstopsafewpointsbelowthelowestlowsthatarevisibleonthechart.Ashortcountertrendentrycanbeenvisionedifthepriceclimbsbacktothe upper 1.5-deviation BB and stays below the upper deviation. Watch the price actionaroundthoselevels.

Figure22.12Entryassessment:the5-minutechart

Also,avariantlongtradecouldbeattemptedusingthesamestoplevel(below1.0630),with thefirstentryat1.0735 justabove theSMA34levelandearlyMayresistance. Inanycase,thepricewillmostlikelyfalltowardtheSMA34;andpriceaction,atthatmoment,willdeterminewhichisthebestchoicetoemploy.

VariantRealTradeExampleandSingle-TradeFollow-Up

Thisreal-lifeexamplebeganonJanuary12,2011,aftertheNewYorkmarketsclosed.Thedailychartswereshowingastrongbullishengulfingcandlethathadbouncedfrom

theSMA100andhadreachedtheSMA34.Thetrendwasbullish.However,itwastoolateforanentryatthatmoment.TheSMA100wasaround0.9860andclimbing.Idecidedtowaitforthenextcandlebehavior.OnJanuary13,IcouldseethattheSMA34waspiercedandthepriceclosedaboveit;thecandlelookedbearish(sortofaspinningtopwithlargerbody).

The4-hourchartsshowedatweezertopataboutmidday,andthepriceseemedtobeinawiderange.Theparitylevelhadalsobeenpierced.

Onthemaintradingtimeframe(30-minutechart),Icouldseethatthepricehadretestedthebroken levelat0.9920–0.9930aswellas theSMA200early in theday,being rejectedstronglyandcrossingallmovingaverages,reachingaboveparity.TheSMA200wasflat,andtheslopeoftheothertwomovingaverageswasgoingup.

Ontheentrytimeframe(5-minutechart),thepricewasstilltoohighforadirectentry(0.9978)andwastradingataconfluenceofnearlyflatmovingaverages.

The lowerdailyBB(1.5deviation)was flatat0.9885.Being thatparitywasalreadysurpassedandgiventhepreviousstrongengulfingcandle,Ibelievedthatthepricewouldgosignificantlyhigher,andIwastargetingtheupperdailyBBlevelandroundnumberat1.0200,below the previous highs.Given the ranging behavior in the 4-hour and 5-minute charts, Idecidedtoemploythevariant,asitwaspossibletohavesomefluctuationoftherange;andeven if therewasn’t and only one tradewere to reach the target, the risk-to-reward ratiowouldstillhavebeennearto1:1.5.

AsFigure22.13shows,Iplacedafirstlimitorder20pipsabovethelowerBBlevel,at0.9905,and5pipsabovetheroundnumber.Iplacedthesecondandthirdorders,aswell,at0.9855 and0.9805, respectively.The stop loss for all of themwas set at 0.9790, 15 pipsbelowthethirdentryand12pipsbelowthepreviouslowerlow(0.9802),whichwouldbethe key level where the trade direction would prove to be wrong. The total risk was 2percent.

Figure22.13AUD/USD

ThefirstorderwastriggeredonJanuary14,afewhoursbeforetheopeningoftheNewYorkmarkets.Thepricefellabout30pipsmoreandrecovered,barelytobreakeven+5.Itthenfellagain,2pipslowerbutabovethesecondentry,whichwasn’t triggered.Thepricerejected that level and opened the next Sunday above the Friday close with a small gap,ranged again toward the second entry levelmaking a higher low, and crossed allmovingaveragestotheothersideoftheBBs.Idecidedtoexitthetradeat1.0030earlyonday19,belowthepsychological level1.0033andnear the levelof theupperBBdeviationof2.5.

Themainreasonswerethatthepriceseemedtoberangingforawhileandthatthemovingaverageswerepointinginconflictingdirections,almostflat.

Theresult:netpips=125,equivalentto1.25percentofequity(thepositionsizeonthistriplesetupisalwaysat1:1trueleverageforthesecurrencypairsandstoplevels).

Iplacedthependingorderagainatthesamelevel(0.9905),leavingtheothertwoalsoinplace.Thefirstorderwastriggeredagainonday20bya4-hourcandle,whichbrokethroughthewholesetoflowerbandsandtriggeredthesecondorderabout2hourslater.

IexitedbothtradesonFebruary2,afterthepriceopenedoutsideoftheBBdeviationof1.5onthe4-hourchart,at1.0115(seeFigure22.14).

Figure22.14AUD/USD

Theresult:netpips=210onthefirst tradeand260onthesecondtradefora totalof470pipsand4.7percentreturnonequity.

Totalnetpipsonthevariantuptonow:125+470=595anda5.95percentreturnonequity.

Iwasnowwellabovethebreakevenlevel,witharisk-to-rewardratioofnearly1:3.Iconsidered the variant to be one single trade over a longer period of time, withmultiplerecurrententriesatspecificlevels.

Thedirectionwasstillvalid,andIkeptaneyeonthoseentrylevelsandfinaltargetforanextopportunityasthepricewasnowranginginsidetighteningBBsonthe4-houranddailycharts.

Given the subsequent price action and scope of the daily range, along with a newresistance level that formednearmyprojected target, andknowing thepricewas rejected,fallingtotheothersideoftherange,Ithenwaitedtoseehowthepricewasgoingtobehavearound the formerly respected support zone and psychological levels between 0.9866 and0.9833.

AsyoucanseefromFigure22.15,thepricedidn’tbreakat1.0200,nordiditattempttoreachthepreviousall-timehigh(1.0255).Instead,ithadmadealowerhighandadoubletop

(1.0189–1.0199resistancezoneonthe4-hourcharts),formingasymmetricaltrianglepattern.Idecidedtocloseallpendingordersandabandonthevarianttowaitforanimpendingbreak,mostprobablytothedownside,asbearishchannelswerestartingtoform,eachatasteeperanglethanthepreviousone.

Figure22.15AUD/USD

Figure22.16depictswhathappenednext.Thepricebrokethetriangleformation,afteralsopiercingtheSMA200anddoinganamplewhipsawmovetotestthecriticalbreakzone;then it broke the parity support level and then a key support level at 0.9950, going on topierce0.9866(thelevelIwaswatching)andbreakingitasinanever-endingavalanche.

Figure22.16AUD/USD

As you can see from Figure 22.17, I then placed (on March 16) a Fibonacciretracement/extensionindicatoronthe4-hourchartmeasuringthelevelsonthetrianglerangeof late January–early February (0.9866 to 1.0200). I noticed that the most recent low(0.9702)wasbelowthe138.2percentextensionoftherangeandthatthepricewasstronglyrejectedbackup. I decided towait a littlemore, and itmade a retest of thebroken lows,gettingoutofthebandzone.

Figure22.17AUD/USD

Thinkingthiswasagoodlevelforareturnbacktothebullishscene,Iopenedanormalpendingorderonthenextday,at0.9805(5pipsabovetheroundnumberandpreviouscandlelowleveloutsidethe1.5-deviationlowerBB).Thestoplosswassetat2percentriskand45pips,pricedat0.9760(10pipsbelowthe1.5-deviationBBlevel),conservativelytargeting0.9980(alittlebelowparityjustincase)fora1:3.88risk-to-rewardratio.Itrailedthestopto0.9930(locking125pips)onthatFridaytoleavethetradefortheweekend.ThetargetwasreachedonthefollowingMonday,withnetpips175anda7.75percentreturnonequity(2percent×3.88).

ADDITIONALANALYSISTOOLS

I will finally mention that I have used the Commitments of Traders Report on severalopportunities in net open interest and positions on currency futures to further gauge thepotentialforatrendreversalatmarketextremes.

CHAPTER23HEDGINGSTRATEGIES

Every trader’s portfolio should include several tools for its protection. Among them,diversification of assets is paramount, and it allows an additional practice: hedging as ameansoflockinginprofitsorreducingtherisksoflossinthetradingaccount.

Inallaspectsofmytrading,Iusevariousmethodsoftrading.Priortosomeofthemostrecentregulatoryrulechanges,onecouldhedgeonbothsidesofatrade.WhatImeanbythisisthatyoucouldhavegonelongontheEUR/USDandshorttheEUR/USD.Thiswouldhavegivenyouaperfecthedge.Now,youbasicallyhavetofindcorrelatedcurrencypairstoputaneffective hedge down. There are, of course, downsides to hedging along with positiveattributes.Wewilltalkaboutthatinthischapter.

WHATISHEDGING?

Letmestartbyexplainingwhathedgingisnot.Manyinexperiencedtradersthinkthathedgingissimplyplacinga trade in theoppositedirectionwith thesamequantityof lotsandin thesamecurrencypair.Thisisnotthemosteffectivewaytohedge.Itwon’tbelonguntilyougetintoanimpossiblesituationwhereyoucannotexitoneofthetradeswithoutcompromisingtheaccountasawhole,riskingor,worse,gettingamargincall(accountliquidation).So-calledhedgingonthesameinstrumentonlylocksintheloss.

MostofthetradersIknowthatuseaperfecthedge-typestrategyusuallytradeinsidethepositiontocreateprofitsuntiltheycancloseoutthehedge.

Let’sbrieflylookatthebasichedgethatmosttradersarefamiliarwithwhentradingtheforex.Thiswasaprevalentwayfortraderstoreduceriskpriortotheregulatoryrulechanges...orsotheythought.

As mentioned earlier, traders would buy the EUR/USD long and sell the EUR/USDshort, thuscreatingtheperfecthedge,simplymeaningthatregardlessofwhat the tradedid,thetraderwouldhavelockedinthegainorloss.Sometraderswouldusethisstrategyattheendoftheweek,sothatwhenthemarketreopened,theywouldbeprotectedagainstagapinthewrongdirectionof their trade.And some traderswoulduse the strategy tohedge theiropenposition,sothattheydidnothavetositinfrontofthecomputer.

Tradersweresoadamantabout thisstrategy that theyevenconsidered, insomecases,moving their trading accounts out of theUnitedStates to other countrieswhere the traderscouldstillhedgeinthesamecurrencypair.Well,thisstrategyisnotallthatgreat.Let’sbreakitdownandtakealookatafewexamples.

Ifyouareupinyourtradeandwanttohedgeit,thenyouwilllockinyourprofit,minusthenewspreadyouhavetopaytoopentheothersideofthetrade.Thesameholdstrueifyouareinalosingpositionbutyouwanttolockinthelossbeforeabignewsannouncementortheweekend.Youwilllockinyourlossandincuralittlemorelossbecauseyouhavetopaythespreadonthenewlyopenedlots.

Manytradersthatusethisstrategywilloftenstayinthehedgeandsimplytradeagainstit,orbettersaid,placemore trades.Let’s lookat thatscenario.Let’ssayyouhave10 lotslongon theEUR/USDand10 lotsshorton theEUR/USD.Itdoesn’tmatter ifyouhave theloss or gain locked in or if you are in a breakeven scenario; however, if you are close tobreakeven,youmaywanttojustconsiderclosingthetradeuntilaftertheweekendoranewsannouncementandtakeyourlossorgain.

Traderswilloftenbuild intoacoreposition.Sobeforeyouarehedgedandyou thinkthattheEUR/USDisgoingup,youstartbuying.Youbuy1lot,itgoesagainstyou,andthenyoubuymore;youcontinuetocost-averageastheEUR/USDgoesdownagainstyou.Finally,youhave10lotsopenlongontheEUR/USD.Allofasudden,thepairbreaksdownfurther,so insteadof cost-averagingdown,youopena10-lot shortEUR/USD trade.Nowyouarehedgedwithyourlosslockedin.

Theoreticallyyoucansitinthetradeandlosenomore.Atthispoint,youcandoafewdifferentthings:

Youcanaddlotstoeithersideofthetrade—whichmeansyouarenowlongorshortandnothedged,makingmoneyalong theway,pickinguppipsuntilyoubridge thegapofyourlocked-inlossonthehedge—andthenjustclosethetradeandbedone.

Oryoucanwaituntil the currencypair, in this case theEUR/USD, reachesa supportlevel and starts to turn up in your direction.At this point you can then close the 10 shortEUR/USD lots you had open, leaving you with your 10 long EUR/USD lots open. Manytraderswill,atthistime,addtotheirposition.Solet’ssayyouadd10morelongEUR/USDlotstoyouralreadyopenposition,givingyouatotalof20longEUR/USDopenlots.

Nowyouonlyneedthepricetomovehalfofwhatyouinitiallyneededtobreakeven.This works, and I know traders that only trade this strategy. However, it is risky, as thecurrencypairmightcontinue tobreakdownandcreatedouble theexposureforyou.Worseyet,youmaynothaveusedpropermoneymanagement,andnowyouareoverleveraged.Ifyouare going to trade thisway,make sure you take into consideration that youmight have todoubleyourposition.Youdonotwanttobeovermarginedoroverleveraged.

Let’stalkaboutwhathappensifyouareinthatsituation,becauseitisnotnecessarilyagoodplacetobe.ThisexampleisfromarealtradefromsomeoneIknowthattradesthistypeofhedgingstrategy.

ThetraderwaslongtheEUR/USDandwasinasignificantdrawdown.Thetrader,inmyopinion,hadactuallyovertradedtheaccount,andamajornewsannouncementwasscheduledforthenextday.Thetradercontinuedtocost-averagedownonthetrade,which,bytheway,cangetyouinsomedeeptroubleifyoudon’tknowwhatyouaredoing.Sointhiscase,priortothemajornewsannouncement,thetraderputonahedgeontheothersideoftheEUR/USD.

Thetraderwasnowperfectlyhedgedwitha loss lockedinuntilafter thenews,sohethought. The traderwas nowwatching as the horror unfolded.You see, the banks are notstupid; they see your trades, and in this case, the accountwas overmargined and the bankknewit.Thebankknewthatifitpushedthetrade,theaccountwouldgointoliquidationstatusandbeclosed.

Yes, thebankswill try to takeyourmoney.Sohere iswhathappened: thenewscameout,andthebank, inthiscase,heldonesideof thecurrencypair,meaningthat insteadofatwo-widespread,thebankincreasedthespreadenoughthatitcausedtheaccounttogointoliquidationstatus.

Sothebidstayedthesameandtheaskmoved150pipsaway.Thebankswillactuallydo

this, especially if you have a lot ofmoney on the trade, or you have beenmaking lots ofmoney,oryouareovermargined.Whatascam.Thehugespreadresultedintheaccountgoinginto liquidation, resulting in yet another forex account beingblownup.You can avoid thisscenariobyusinggoodmoneymanagementandtakingthisscenariointoaccountifyouplanoncost-averagingdown.You justhave to factorall that inaheadof timeso thatyouknowhowmanylotsyoucanputon.

InmybookForexTradingSecrets,Ihavedescribedoneofthefairlycommonhedgingstrategiesamongforextraders,whichemployseitherabasketofcurrencypairsor just twopairshighlycorrelated.Thistruehedgingisquiteaninterestingstrategy;however,thedegreeof relative correlation can vary and is never perfect, thus increasing the risks of wrongproportioning and adding some complication to the picture with the need for closelymonitoringthecorrelations,pipvalues,andswaprates.

Now,usingthesamebasecurrency,asisthecasewithfuturesoptions,oreventhesamecurrency pair, let’s examine a few alternatives based on forex options that you can use torealizeapracticallyperfecthedgetoprotectyourforextrades.

Hedgingcanbeconsideredasinsuranceagainstapotentialnegativeoutcome.Itwillnoterasetherisk,buttheimpactofawrongturninthemarketsunderunpredictableeventscanbegreatlyreduced.Theoriginalinvestmentisprotectedthroughanotherinvestment,thevalueofwhichwillhavetochangeproportionallyintheoppositedirection.

Itisimportanttounderstandthathedgingbyitselfisnotastrategytomakemoney,butaninstrumenttodiminishthepossibilityofaloss.Riskreductionalsoimpliesprofitreduction;however,intheeventualitythatyouroriginalinvestmentlosesmoney,yourdecisiontohedgewillhelpinmakingthatlossmuchsmaller.

Derivativesasfuturesandoptionsarefinancialinstrumentsthatcanbeappliedtopropup your forex trades, thanks to the development of strategies that allow you to offset theeventuallossesinyourtradingbyobtainingprofitsonthederivative.

Forexoptionscanbeusedinadditiontostop-lossordersorevenreplacetheneedforstops.When you buy an option, your profit potential is unlimited if the price continues tomoveagainstyourforextradeafteryourstophasbeenhit.Conversely,yourcurrentprofitsonatradearelockedinassoonastheforexoptionisbought;andifthepricescontinueinyouroriginal direction, the cost of the option can simply be considered as insurance against apotentialreversal.

Theoutstandingissuewithforexoptionstradingisthattherisk-to-rewardratiocanbeveryvariable,asthecostofthepremiumwillchangedependingonthestrikepricesanddatesofexpiration.

Before attempting to hedge a forex trade with forex options, you need to evaluatecarefullyif thebenefitsexpectedoutweighorat leastmatchthecosts.Themainpurposeofthisspecificstrategyistoprotectyoufromeventuallosses,nottomakemoney.Costscan’tbeavoided,butyoucaneliminatesomeoftheuncertaintyfromthesituation.

HEDGINGWITHCURRENCYFUTURES(GLOBEX)

LongAUD/USDLongPutAustralianDollar

Inthechartsthatappearinthissection,youcanappreciatehowtheGlobexcurrencyfuturesprices for theAustraliandollar are tightly correlated to theAUD/USDcurrencypair.Thishypothetical example will show how we can benefit from this correlation to apply aprotectiveoptiontolockintheprofitsalreadymadeonatrendingsituation.Example:

Let’s say I decided to enter the markets onMarch 23, 2011, with a long position on theAUD/USDonthenextdailycandleopenat1.0128,aftertherejectionfromtheSMA200andsubsequentbreakofthemiddlelineoftheBBssetup.

AsFigure23.1shows,thepairbreakstotheupsideandstartstrendingnicely,reachingahighat1.1010andturningdownforacorrection.Atthispoint,Icouldhaveclosedthetradeandmade882pips;however,asIamtradingwithalonger-termtargetof1.1200,Iwishtoholdonandbenefitfromthecarry.

Figure23.1

OnMay5,thepairbreaksthroughthemiddlelineofthebandsandpiercestheSMA100,alsobreaking the support zonebetween1.7020and1.0680. Iwant to limit the riskswhilestillholdingthroughapossiblegreatercorrection,andsoIdecidetobuyaputoptionontheAustraliandollarfutureswithastrikepriceat1.0800andoneforwardmonthexpirationdate(seeFigure23.2).

Figure23.2

TheoptioniscurrentlyITM.Myprofitsaresafeminusthecostofthepremiumandtheaddedpossibilitythattheoptionturnsprofitablebeforeexpiry,allowingmeeithertocloseitassoonastheAUD/USDresumesitstrendortoexercisetheoptionandtakeprofitsonboththeforextradeandtheunderlyingfuturesifthedowntrendcontinues.

ShortUSD/CHFLongPutSwissFranc

Herewehaveadifferent scenario in thecaseof theUSD/CHF,as the futurescurrencyweneedtouseforahedgeisthequotecurrency(theSwissfranc),whichisinverselycorrelatedtotheforexcurrencypair.Ifitwerethebasecurrency,wewouldbeusingalongcalloptiontoprotectashortposition,buthereweneedtoemployalongputoptionagain,thistimeontheSwissfrancfutures.Example:

I decide to open a short position on theUSD/CHF after the break of support area below0.9340(seeFigure23.3).Iwaitforaretestofthemiddlelineofthebandsandthementionedbrokenlevel,andsoIsetalimitorderat0.9340,whichistriggeredonMarch8,2011.

Figure23.3

The price keeps trending lower and makes several corrections and retests, until itreaches0.8555twomonthslater(785pips).Atthatpoint, theUSD/CHFdoesasignificantcorrection, crossingbackup through themiddle bands and reaching above themost recentS/RlevelandSMA34.

OnMay15,2011,seeingthattheSwissfrancfuturesarestillinaclearuptrend,IdecidetohedgemyUSD/CHFtradewithalongputoption,alsowithahigherstrikepriceandbeingITMat1.1600(seeFigure23.4).

Figure23.4

Theexpectedalternativesaresimilartothoseoftheprevioushedge;profitsontheforextrade are protected, and should the USD/CHF reverse its trend, the Swiss franc futuresoptionscontractwouldbefurtherITMwithaccruedvalue.

BULLISHHEDGINGWITHFOREXVANILLAOPTIONS

CoveredCall

Thisstrategyusesadirectlongspotforexposition,whichiscoveredbyashortcalloption.Itiscommonlyusedtolockintheprofitsalreadymadeonthecurrencytrade.

Therisksareunlimitedifthedirectionchangestothebearishside,whilethemaximumgainyou can expect is thepremium receivedon thewritten short call option.This usuallyallows the trader to hold on to a position in a strong bullish trend while periodicallygeneratingincomefromthesoldoptions.

(Avariantofthisstrategyistheprotectedcoveredcall:thisinvolvesaddingalongputOTM option to the above. This alternative is intended to limit the risks on the downsideshouldtherebeahugefallintheforexpairmarket’srate.)

Let’slookatanactualcase.Example:

OnMay16,2011,Ievaluatedthe1-hourAUD/USDchart,andseeingthattheresistancezonebetween1.0620and1.0635hadbeensignificantlypierced,Idecidedtoplaceacoveredcallonthepullback(seeFigures23.5and23.6).Ibought1lotofthecurrencypairat1.0602andprotected the trade with a 1-lot short call with a strike price set at 1.0000 (the premiumreceivedwasveryhigh,asthecalloptionwasdeeplyITM).

Figure23.5Coveredcalltradeexample

Figure23.6Coveredcallchart

Tosummarize:Buy1lotAUD/USDonMay16,2011,at7:12p.m.atrate1.0602Sell 1-lot call AUD/USD at 7:13 p.m. at rate 1.0597with a strike price of 1.0000 (firstoptionentry)

Nearly2½hours later I checked theplatformandnoticed that theAUD/USDratehadfallenandtheoptionwasshowingsomeprofits,andsoIdecidedtocloseandreopenanothershortcall,butthistimewithanOTMstrikeprice.

Iclosedthefirstoptionatrate1.0560with$317profitsonthepremiumdifferential.Isold another lot callAUD/USDwith a strike price of 1.0700 (second option entry) at thesamerate.

Thenextday,seeingthatthepairhadbeenranginganddidn’tgivemanybullishsigns,Idecidedtoclosethewholecoveredcalltransactionandwaiteduntiltheforextradewasinthepositive,closingitwithan11-pipprofit.

IalsoclosedtheAUD/USDtradeinpositiveonMay17,2011,at7:10p.m.at1.0613,with$113profits.

I furtherclosed thesecondoptionwitha$94 losson thepremiumdifferentialat7:11p.m.atthesameAUD/USDrate.

Thesecondoptiongavemeasmallloss(astheAUD/USDratewasclosertothestrikeprice, thus raising the premium since itwas anOTMcontract).Thiswas absorbed by thegainsobtainedonthefirstoptionandontheforextrade.

Netprofitsmade=$317+$113–$94=$336

ProtectivePut

When you need to protect your position against an eventual market correction, you canemployaprotectiveput.Thisstrategyusesalongspotforexposition,whichisthencoveredbyalongputoption.Themaximumlossyoucanincurislimitedtothepremiumcostpaidon

theput option,while yourprofits canbeunlimitedwhen themarketmoves inyourbullishdirection.

Iwill employ this strategywhen Iwant toprotectmy tradeagainstapotentialmarketcorrection.The risk and rewardprofileof this strategy isvery similar to thatofplacingalongcall.

Ifthereisasuddensell-offandthecurrencypairratesfall,thevalueoftheputoptionwillincreaseandtheprofitswilloffsettheeventuallossesontheforextrade,whiletheonlylossremainingisgoingtobethepremiumpaid.

If themarket risesabove thestrikepriceof theputoption, thiswillexpireworthless,andtheforexpositionwillbeaccumulatingprofits.Thelossontheoptionis limitedtothepremiumandallthegainsthatarebeingmadeontheforextrade,astheincreaseinrateswillbemuchgreaterthanthelossfromtheoption,leavingyouwithanetprofitabletransaction.Example:

Iopenedtheprotectiveput(seeFigures23.7and23.8)shortlyafterIopenedthecoveredcallandforthesamereasons,alsomostlytocomparetheprofitabilitypotentialbetweenboth:

Figure23.7Protectiveputtradeexample

Figure23.8Protectiveputchart

BuylongpositiononMay16,2011,at7:23p.m.1lotAUD/USDat1.0600rateOpen1-lotlongputonAUD/USD

Thestrategywasalsoclosedthenextdayandshortlyafterthepreviousstrategy,becauseoftherangingbehaviorofthecurrencypair.Iwaiteduntilthedifferentialbetweentheprofitsonthetradeoutweighedtheloss,sotocomeoutpracticallyatabreakevenpoint.

IthenclosedtheoptiononMay17,2011,at8:20p.m.witha$214lossonthepremiumdifferential.

Iclosedthetradeat8:21p.m.with$227inprofits:Netprofitsmade=$227–$214=$13

Collar

Acollarisanotheroneofthehedgingstrategiesthatwecanusetolimitpotentiallossesonaregular currency trading position. Both risk and reward are limited; the maximum loss isrestrained to the difference between the two strike pricesminus the net premium (paid orreceived)andminusthelossontheforexposition.Themaximumgainwillalsobelimitedtothe difference between strikes, adding to this the net premium and the profitsmade on thecurrencypairtrade.

Theelementsofthisstrategyaretobuyalongpositiononthecurrencypairandhedgeitwith two distinct forex options: one short call and one long put, both OTM. If the netdifference between the premium paid and received is positive, it will be added to thedifferencebetweenthestrikes.Ifitisnegative,itwillbesubtracted.

This strategy isquite similar toa longcall spreadand isused to increase theprofits,addingwrittencalloptions,andreducetherisksbymeansofbuyingtheputoptions.Example:

IwasexpectingabouncefromtherisingtrendlineonthehourlychartfortheUSD/CHFanddecidedtoimplementanoptionhedgingstrategy(seeFigures23.9and23.10).SoIbought1lotlongUSD/CHFat0.8850onMay16,2011,at11:42p.m.

Figure23.9Collartradeexample

Figure23.10Collarchart

IopenedashortcallontheUSD/CHFat11:44p.m.withastrikepriceof0.8800,andIopenedalongputat11:47p.m.withthesamestrikeprice.

[Note:Thiswasn’texactlyastandardcollarstrategyintheend,butinsteadalongtradedoubledwithashortsyntheticoption(seeChapter24,“ForexOptionsStrategies”).Tobeatrue collar, the short call should have been set with a strike price higher than the currentUSD/CHF rate, for example at 0.8900, so it would be OTM. In this case, there is nodifferencebetweenthestrikeprices,andonlythelongputisOTM.]

Intheearlyafternoonofthenextday,InoticedthattheratefortheUSD/CHFwashavingtroublebreakingpast the former rising trendline (which ithadbroken to thedownsideandwaspresentlyretesting).Idecidedtoexitthetradeatthatlevelwiththesmallprofitsmadeandkeeptheshortsyntheticoption,astheoutlookforthecurrencypairwasnowbearish.

IclosedtheforextradeonMay17,2011,at2:12p.m.with$128.67inprofitsat0.8862.About5hourslater,seeingthatthepremiumdifferentialwassignificantlyhigherintothe

positive,Idecidedtoclosetheforexoptions.I closed both options at 7:07 p.m.with a $26.99 loss on the long put and a $221.53

profitontheshortcall,wheretheUSD/CHFratewasat0.8806.

Netprofitsmade=$128.67+$221.53–$26.99=$323.21

HEDGINGWITHBINARYOPTIONS

Comparedwithvanillaoptions,binaryoptionsareconditionedbyadditionalfactorsinsteadof just the price and the expirationdate.They establish specific conditional scenarios thatwillvalidateorinvalidatetheoptioniftheycometrue.Thetraderwillchoosetheamountof

thepayoutheorshewishestoreceiveif theconditionsstatedareconfirmed.Thepremiumcostthathastobepaidrepresentsapercentageofthepayout.

Thisalternative,withitsfixedpayoutandup-frontriskdefinition,ismuchsimplerthanusingvanillaoptions.Thereisnospreadorcommissiontoworryabout,andtheoptionscanbeeasilycombinedwithforextradesusingstoplosses.Example:

The GBP/USD broke above the resistance level at 1.6424, and I decided to open a longpositiononApril21,2011,atthemarketopenprice,1lotat1.6432witha20-pipstoplossjustbelowthebreakat1.6412(seeFigure23.11).

Figure23.11Hedgingwithbinaryoptions

The potential loss for this transaction was $200 (20 pips × $10-pip value for theGBP/USD).

Iwantedtoprotectmytradeincasethepricebrokebackdowninthenextfewdaysandhitmystop,andsoIdecidedtohedgewithan80percentpayout$250GBP/USDputoptionat the levelof thepreviousbreakout.Thisway thecostof the stop lossonmy forex tradewould be totally offset by the payout if the price went lower than that level: $250 × 80percent=$200=zerorisk.

Tooffsetthecostoftheoption,Ineededtosecureaprofitofmorethan25pips(25×$10=$250paidforbuyingtheput)whentheforextrademovedinmyoriginaldirection.IfIhad thought that the price would end up higher than the breakout level at the date ofexpiration,Iwouldhavehedgedwithacalloption.

OtherExoticOptionsStrategies:BarrierOptions

Theadditionalelementintheseoptionsisthetriggeror“barrier”pricewheretheoptionwillbeeithervalidated(knock-in)orcanceled(knock-out).

Knock-InandReverseKnock-In

When this type of option meets the trigger price before expiration, it becomes a normaloption.Ifitdoesn’t,youlosethepremium,andtheoptioniscanceled.Theadditionaltriggerelementmakestheseoptionspossessalessexpensivepremiumthantraditionaloptions;andwhen the rate of the underlying forex currency pair reaches the barrier level, the optionscontractturnsintoanormalcallorputoption.

The greater the distance of the trigger price from the actual currency pair rate, thecheaperthepremiumwillbe,astherearefeweropportunitiesfortheoptiontobeknockedinbeforetheexpiry.Thereverseknock-insetsthetriggerbarrierITM,whileitwillbeOTMfortheknock-in.Knock-Out

Thisoptionwillexpireworthlesswhentherateoftheunderlyingcurrencypairreachesthetriggerpricebeforeexpiry.Ifitneverdoes,thecontractwillkeeprunningasanormalcallorputoption.

TriggersaresetOTM,belowtheactualrateofthecurrencypairforcallsandaboveforputs.Theseoptionswillbemuchlessexpensivewithincreasedvolatility,asmorevolatilityimpliesthattherearemorechancesfortheoptiontobeknockedoutbeforetheyexpire.

The closer the barrier is to the actual rate, the cheaper the options become as thechancesforaknock-outincrease.Areverseknock-outoptionwillhaveitstriggerssetITM,abovetheactualrateforcallsandbelowforputs.One-Touch

If the currency pair reaches the trigger level, a defined payout amountwill be paid to thetrades.Bothriskandreward(premiumcostandpayoutpercentage)arelimitedandknowninadvance.No-Touch

Heretheamountofthepayoutwillbegiventothetraderifthecurrencyratedoesnotreachthetriggerbeforetheexpirationdate.Theprofitpotential(payoutpercentage)getssmallerasthe trigger is at a greater distance from the actual currency pair rate, and chances of nottouchingthetriggerincrease.DoubleOne-Touch

This type of option includes two barriers and two distinct payout profit percentages. Thedoubleone-touchisusuallyemployedwhentherearehighlyvolatilemarketconditionsbutnocleardirectionofthemarket.Itwouldbesimilartoemployinglongstraddleorlongstranglevanillacontracts.Thepriceisexpectedtobreakoutofagivenrange.DoubleNo-Touch

Inversely, these options are chosenwhen traders expect themarket prices to keepmovinginsidearange,withlowvolatility.Theycanbeveryprofitableduringconsolidationperiods.Thedoubleno-touchoptionsalsoincludetwotriggerlevelsandaspecificpayoutpercentage

foreachoneofthemiftherateoftheunderlyingcurrencypairdoesnotreachthebarrier.Allcaneitherbeusedasstand-alonestrategiesorbecombinedwithoneanotheroreven

withotheroptiontypes,toreducetheoverallriskscenarioofaparticulartradingsituation.

DeltaHedging:HedgingaForexOptionwithCashPositions

This strategyapplies the inverse concept; this iswhereyouwillwant tohedgeanoptionscontract with a spot forex position counterpart. Some forex options brokers automaticallyinclude the availability of delta hedging on their platforms, but it can also be calculatedprovidedyouhavethedeltavalueofyouractualcallorputoption.Theaimofthismethodistoreducetheriskofpricemovementsoftheunderlyingcurrencypairandoffsetthosethroughacontrarianposition,basedonthevolatilityindexoftheforexoptionposition.

AlongcallontheEUR/USDwouldbedelta-hedgedbymeansofashortpositionontheEUR/USD.Thevalueofthedeltawilldeterminethesizeoftheforexspotpositiontokeepthebalance in thehedgeratiorelationshipbetweentheforexoptionpremiumvalueand thetrade.

Forexample,acalloptionwithadeltavalueof50percentwillhaveitspremiumvaluerisehalfapointforeachfull-pointincreaseoftherateoftheunderlyingcurrencypair.Thusthedelta-hedgedspotforexpositionsizewouldhavetobehalfthesizeoftheoptionposition:A1-lotlongcallEUR/USDdelta50percenthedgedwitha0.5-lotshortEUR/USDtradeThiswaytheforexoptionisfullyhedged,andthevariationsinthepremiumwillcorrelatetotheincreaseordecreaseoftheEUR/USDrateinthesameproportionasthatofthedelta.

CHAPTER24FOREXOPTIONSSTRATEGIES

Forex and options can be a highly profitable combination because of the high level ofvolatilityofmostforexcurrencypairs.Abasicforexoptionsstrategywillalwaysstartwithvanillaoptions:buyingacalloraput,whichexpresses thebullishorbearishviewsof thetraderinregardtothepotentialdirectionoftheexchangerateofthecurrencypair.Thisistheeasieststrategy,anditcanbeusedbyitselfwhenthedirectionofaparticularmarketisclearandtrending.

Forexample, infrontofaclearreversalcandlepattern,whichcouldbeadouble top,wecansimplybuyaputoption,sincewearelookingtoshortthecurrencypair.Thepotentiallossislimitedtothepremiumwehavepaid,anditsprofitpotentialisunlimited.However,weplantheexitataconvenientsupport,justaswewoulddowitharegularforextrade.

What can we do when the trend is not clear at all or when we are in an obvioussidewaysmarketsituation?Beyondthesimplevanillacallsandputs,wehaveavastarrayofcomplexcombinationsavailablethatwillallowyoutofitanoptionsstrategytotheparticularconditionsofthecurrencymarketatagiventime.

For example, ifwe expect that the currencypairwill performa strongmove, butwedon’t know if the rates will go up or down, we could use a long straddle, which is asimultaneous long put and callwith the same strike price.Conversely, ifwe think that themarketswillremainstableandinsideaclearrange,wecanbuildalongcondor,whichholdsfourdistinctoptions:bothlongandshort,ITM,andOTMinaprecisesetup,whichwillbedescribedindetaillaterinthischapter.

Somecombinations—forexample,callandputbackspreads—willevenyieldprofitsinwhateverdirectionthemarketevolves,whilealsoincludingadirectionalbias.Finally,someof them can have several different strike prices and expiration dates, for example, thecalendarspreadsorcallandputtimespreads.

OPTIONCOMBINATIONS

DebitSpreads

Alsoknownascallbullspreadsorputbearspreads,theseoptionsallowustomaintainthebiaswemighthaveinaparticulardirection,thusreducingtherisks:themaximumlosswillbe thedifferencebetween thepremiumpaidon longoptions and thepremium receivedonshortoptions.

Thebullcallspreadistheoptionsstrategytoemploywhentheoptionstraderisbullishontheunderlyingsecurityandwouldliketoestablishaverticalspreadonanetdebit.

The bear debit spread is useful when the options trader is bearish on the underlyingsecurity;averticalspreadcanalsobeestablishedonanetdebitbyimplementingthebearputspreadoptionsstrategy.

CreditSpreads

Similartothedebitspreads,creditspreadsdifferinthat,insteadofpayingthepremium,thetraderlookstomakeaprofitfromthepremiumreceivedfortheshortoptionswhilekeepingthe market bias. This is the case for put bull spreads and call bear spreads, which areappropriate to implementwhenyouarebullish inabearishmarketorviceversa.Also, inadditiontotheprofitsthatcanbeearnedontheoptionitself,youavoidtheriskofusingrealcashtosetthestrategyinplace,thankstothereceivedpremium.

Bothdebitandcreditspreadsaregood to implementwhen there isadirectionalbias,eitherwiththetrendorwithacontrarianpointofview.

Straddles

Straddlestrategiesallowyoutocapturepotentialbreakoutsafterconsolidationperiods,whenthemarkethasbeenmovinginarelativelytightrangeandtherearestrongexpectationsofashort-termchangeinvolatility.Itisveryimportanttosetthesamestrikepriceandexpirationdatesonbothoptions, asdifferent conditionswould increase thecostsof the strategy, thusdecreasing itspotentialprofitability. In thiscase,oneof theoptionswill expireworthless,andtheotherwillallowittobetradedforprofits.

ExoticOptions

Amongthese,youwill findAsianoptions,basedonaverageprices;barrieroptions,wherethepayoutdependsontherateoftheunderlyingcurrencypairreachingaspecifiedpricelevelor not; currency baskets, where the payout will depend on more than one currency pair;binaryoptions,wheretheprofitsaredefinedbyapercentageofthepremiumpaid;lookbackoptions, inwhichthepayout isbasedonthemaximumorminimumpricereachedalongthedurationoftheoptionscontract;compoundoptions,whereyoucansetoptionsuponoptionswithmultiple strike prices and different expiration dates; spread options; chooser options;andseveralothers.Thesekindsofoptionscanbeadaptedspecificallytothetrader’sneeds,andsothesecontractsarehighlyvariableandareevolvingovertime.

HOW TO CHOOSE THE RIGHT FOREX OPTIONSSTRATEGY

IdentifytheTradingOpportunity

Priortomakinganydecision,weneedtohaveaclearpanoramaofthemarketsituationanddirection for the specific currencypairwewant to trade (for example, longAUD/USDorshortUSD/CHForrangingmarketonEUR/GBP)inordertoidentifytheproperoptionamongthenumerousoptionsavailable,whichwillgivethebestoptimizedbalancebetweenpotentialreturnsandpremiumtospend.

EvaluatetheAvailableOptions

Evaluate the available options under the criteria of estimated volatility of the underlyingcurrencypairandthesubsequentpotentialfuturevalueoftheoption,includingtheGreeksifyouaretradingspreadsorotherstrategiesthatareneutralinregardtothemarketdirection.

ChoosetheStrikePrice

Therearethreealternativesamongwhichtoselecttheappropriatestrikeprice;ITM,ATM,orOTM.

If the option is ITM or close to that level, the premiumwill be higher because of ahigher delta value, but in return, youwill have a greater probability of ending ITM.Highgamma levels (when theoptions arenear themoney)will alsohavehigherpremiums, andgenerallyanOTMoptionwillyieldhigherprofitswhenyourdirectionalpotentialisstrong.

Howcanwechoosethebeststrikeprice,andwhatistheoptimaldistancethisstrikehastobe from thecurrent rateof thecurrencypair?Toevaluate this,weneed tocheck to seewhetherthevolatilityishighenough,andwealsoneedtotakeintoaccountanyfundamentaleventsthatcouldleadtheforexpairtoacertainlevel;finally,wealsoneedtoconsideritspotentialforareversiontothemean.

AssoonasanoptionisITM,itsvaluemovestowarddeltaparitywiththerate(1pointfor1point),withtheexceptionofthetimevalue,whichdecreaseswiththeproximitytotheexpirationdate.The risks of losses are limited to thepremiumpaid, and there is nootherpossibilityofdrawdown,independentlyofthebehaviorofthecurrencypairrates.

Theuseofforexoptionsalsoreducesorsubstitutesitselffortheneedtosetupastoploss;themoredistancetherateevolvesfromthestrikeprice,themorethevalueoftheoptionwill diminish.But if the rate recovers, the valuewill also reevaluate; thiswayour equityremainssafeinfrontofshort-termpriceaction.ITM,ATM,andOTM

Whenthestrikepriceislowerthantheactualmarketprice,acalloptionisITM,whileaputoptionwillbeOTM. Inversely,acalloptionwillbeOTMwhen thestrikeprice ishigherthan thecurrentmarketprice, andaputoptionwillbe ITM in that samesituation.Finally,bothtypesofoptionsaresaidtobeATMwhentheactualmarketpriceisthesameasorveryclosetothestrikeprice.

Though most platforms indicate the status of an option in regard to the relationshipbetweenthemarketpriceoftheunderlyingcurrencypairanditsstrikeprice,Table24.1canalsoserveasaremindertohelpyouidentifyifanoptionisITM,ATM,orOTM.

Table24.1

ChoosetheExpirationDate

Anexpirationdatethatisfarawayincreasestheprobabilityforanoptiontobeprofitable,butinreturnthehighthetalevelwillincreasethepremiumvalue.

We need to perform calculations and analyze them to determine our estimate of thepotentialfuturevolatilityoftheratesoftheunderlyingcurrencypair;wedothistoseeiftherearefairchancesfortheratetoadvancefarenoughtomaketheoptionbeITMbeforeorattheexpiry.

Volatility is 1 standard deviation price change at the end of a 1-year time period,expressedinpercentage.Forexample,iftheAUD/USDrateisat1.0000andhasavolatilityof 15 percent, during a 1-year period it should be trading in a range between 1.1500 and0.8500about70percentofthetime(1standarddeviation)andinarangebetween1.3000and0.7000about95percentofthetime.TheBlack-Scholesformulaassumesanormalandmostlysymmetricaldistribution,towhichweneedtoaddourowndirectionalbias.

VanillaOptionsStrategies

Ihavealreadydescribed the fourbasicbullish (longcallandshortput)andbearish (shortcall and long put) strategies in Chapter 3 (“Forex Options”). The previous chapter abouthedging included some of the options tradingmethods that are performedmatching vanillaoptionsanddirectspotforextrades.Therearemanymorecombinationsthatdonotinvolveforextradingbutinsteadusethepowerofoptionsbythemselves.

Let’s lookat theircharacteristicsand thegeneralconditions inwhich theyareusuallyemployed,includingsometradingexamplesandresults.

BULLISHSTRATEGIES

LongSynthetic

This strategy is built by placing one long call option and one long put option at the samestrikeprice.Bothrisksandrewardsareunlimited.Theposition isequivalent tobuying theunderlying currency pair. The position should be used when your views on the market

direction are bullish. The outcome is also similar to the outcome you get from buying theunderlying currency, but buying the options will be less expensive than placing the forextrade.Example:

On May 11, 2011, after seeing the EUR/USD rate pulling back to the recently brokenresistance,holdingabove1.4100,Idecidedtoplacealongsyntheticoptiononthispair(seeFigures24.1and24.2).

LongcallEUR/USD(rate1.4110)onMay11,2011,at11:38a.m.ShortputEUR/USD(rate1.4109)at11:39a.m.Strikeprice1.4050

Figure24.1Longsynthetictradeexample

Figure24.2Longsyntheticchart

I exited the optionwhen the price of the currency pair reached near the next resistancelevelat1.4180.

Closelongcallat1:12(EUR/USDrate1.4171)with$284profitsCloseshortputat1:13(EUR/USDrate1.4163)with$87profitsNetprofitsmade=$284+$87=$371

CallBackspread

Youwillneedthreeelementstoconstructthisstrategy:sellonecalloptionITMandbuytwocallsthatareOTM.

Themaximumlosspotentialislimitedtothedifferencebetweenthetwostrikesplusthenetpremium,whichinthiscaseshouldbeapositiveamount.Theprofitpotentialisunlimitediftherateoftheunderlyingcurrencypairrises,anditislimitedifitfalls.

It isbetter toemploy thismethodwhenyouareexpectinggreatvolatilityandarealsobullishontheunderlyingmarket.Youwillalsobeabletoobtainprofitswhentheratesfall,butthosewillbemuchgreateronmarketupsidemoves.Example:

Expecting a substantial price rise for theUSD/CADafter the price broke above 0.9670, IdecidedtoplaceacallbackspreadonthispaironMay19,2011(seeFigures24.3and24.4).

Figure24.3Callbackspreadtradeexample

Figure24.4Callbackspreadchart

ShortcallUSD/CAD(rate0.9682)onMay19,2011,at4:37p.m.withstrikepriceat0.9600LongcallUSD/CAD(rate0.9684)at4:39p.m.withstrikepriceat0.9700AnotherlongcallUSD/CAD(rate0.9684)withstrikepriceat0.9750

TheUSD/CADrateseffectivelywenttotheupside,andIclosedbothlongcallsonMay23,2011, at 3:18 p.m. (USD/CAD rate 0.9802) with $564 and $442.49 profits, respectively.ThenIclosedtheshortcallat3:24p.m.withan$850.23loss.

Netprofitsmade=$564+$442.49–$850.23=$156.26

CallBullSpread

Thecomponentsofthiscontractarealongcalloptionwithalowstrikepricedoubledwithashortcalloptionbearingahigherstrikeprice.

Thisisaverycost-effectivebullishstrategy,asthemaximumriskyouincuristhevalueofthepremiumpaidonthelongcallminusthepremiumreceivedontheshortcall.However,thiswillalsolimityourpotentialprofitstothedifferencebetweenbothstrikepriceslessthenetpremiumamountpaidforthespread.

You can employ this method when you are bullish on both market direction andvolatility.As the value of this contract is limited to the difference between the two strikeprices,thewiderthedistancefromeachother,themoreprofitscanbemade;butITMcallswill be more expensive, thus increasing the loss potential if the rates go in the oppositedirection.Example:

This call bull spread options contract is still open and expires on June 16, 2011. I amexpecting theUSD/CHF rates to rise at least to a 161.8 percent extensionon the previous

dailyswinghighandtoreach0.9190–0.9200(seeFigures24.5and24.6).

Figure24.5Callbullspreadexample

Figure24.6Callbullspreadchart

OnMay19,2011,Iplacedalongcallat4:24withastrikepriceof0.8800andashortcallat4:25p.m.withastrikepriceof0.8900.TheUSD/CHFrateatthemomentwas0.8832.Potentialloss=$731(premiumreceivedonshortcall)–$1,320(premiumpaidonlongcall)=–$589

Potential profits = 100 (difference between 0.8900 and 0.8800) × $11.20 (point value) –$589=$531,whichgivesarisk-to-rewardratioofnearly1:1

PutBullSpread

Thepayoutforthisstrategyisthesameasforthecallbullspread,butherewewillbeusingputoptionsinsteadofcalls.

Placeonelongputoptionatalowerstrikepriceandashortputoptionatahigherstrikeprice.

Theriskpotential is limited to thedifferencebetweenbothstrikepricesminus thenetpremium received, while the profits that can be made are also limited to the net amount

receivedforthespread(thepremiumreceivedontheshortoptionminusthepremiumpaidonthelongoption).

PutspreadsarealsoabullishstrategyandcanbechoseninsteadofcallspreadswhentheimpliedvolatilityishigherforthecalloptionsthatareITMinregardtoOTMputoptions.A higher volatility implies a higher premium, and placing a put spread would be a lessexpensivechoice.Example:

Thespreadpremiumattheopeningofthecontractwasnetpositive:$2,605–$2,220=$385(seeFigures24.7and24.8).

This timebothoptionscontractswere left toexpiryandendedwitha loss. Iboughtalongputandsoldashortputon theAUD/USDonMay16,2011,at5:23p.m.,andshouldhaveselectedanOTMoptionforthelongoption,whichwouldhavebeencheaper.Instead,the strike pricewas set at 1.0800 (theAUD/USD rate at themomentwas 1.0591) and at1.0850fortheshortputoption.Imadea$642profitontheshortput,butthiswasoffsetandoutweighedbythe$757lossonthelongput.

Figure24.7Putbullspreadtradeexample

Figure24.8Putbullspreadchart

LongputAUD/USD(rate1.0591)withthestrikepriceat1.0800ShortputAUD/USD(rate1.0591)withthestrikepriceat1.0850

Thecontractswerelefttoexpire(expirydateMay19,2011).LongputAUD/USD(rate1.0642)expiredwitha$757loss

ShortputAUD/USD(rate1.0642)expiredwith$642profitsNetlossonthestrategy=$642–$757=–$115

BEARISHSTRATEGIES

ShortSynthetic

This is the inverse procedure of a long synthetic, to be usedwhenwe are bearish on themarketdirectionoftheunderlyingcurrencypair.Toimplementthisstrategy,youwillneedtoopenoneshortcalloptionandonelongputoption,bothwiththesamestrikeprice.Therisksandpotentialprofitsaresimilaraswell:unlimitedlossifthemarketralliesintheoppositedirectionandunlimitedgainsiftheratesfall.

Ashortsyntheticistheequivalenttobeingshortthecurrencypair.Example:

OnMay19,2011, Idecided toopena short syntheticcontracton theAUD/NZD,as Iwasexpectingthepairtofallandbreakbelowitsrecentlowsonthe30-minutechart(seeFigures24.9and24.10).Isoldacallandboughtaputwiththestrikepriceat1.3500.

Figure24.9Shortsynthetictradeexample

OnMay19,2011,at4:00p.m.,Iplacedashortcallanda longputontheAUD/NZD(rate1.3466),bothwiththestrikepriceat1.3500.

The next day (May 20), the rate of the currency pair had effectively fallen about 80pointsandexhibitedapossiblebottomingpattern.Thepricewentbacktoretestthatsupportat 1.3480–1.3485, and I decided to close theoptions, obtaining aprofit of$252.54on thelongputand$202.10ontheshortcall.

Closedlongputat5:03p.m.with$251.54profitsClosedshortcallat5:04p.m.with$202.10profitsNetprofitsmade=$251.54+$202.10=$453.64

PutBackspread

Forthisbearishstrategy,twolongputoptionsOTMandoneshortputoptionITMareneeded.

Figure24.10Shortsynthetictradechart

The risk is limited to the difference between both strike prices minus the premiumreceived on the short put option. This is what you will lose if the market rates for theunderlyingcurrencypairrallyagainstyourdirectionalbias,whileontheothersideyoucanexpecttwoprofitalternatives.Onrisingprices,thegainswillbelimitedtothenetpremiumreceived,butifthecurrencypairfallsfurther,yourprofitscanbeunlimited.Youwillchoosethismethodwhen the directional bias is turned to the downside but a higher volatility isexpected.

Thenetpremiumatthemomentofbuyingallthreeoptionsshouldbeapositiveamount,beingthatyouareshortmorethanyouarelong.Youcanstillprofitfromawrongdirectionalthoughwithlimitedgains.Thisstrategybearssomesimilaritytothelongstraddle;however,thecostofaputbackspreadwillbecheaper,andprofitsarelimitedononeofthesides.Example:

OnMay16,2011,IwasexpectingtheAUD/USDtokeepfallingbelowitsrecentlowsanddecidedtouseaputbackspreadstrategy(seeFigures24.11and24.12).

Figure24.11Putbackspreadtradeexample

Figure24.12Putbackspreadchart

Theoptionpremiumspaidwere–$470and–$334onthelongputsforatotalnegativeof–$804; and the amount received on the short put was $858, giving a net positive of $54credit.LongputAUD/USD(rate1.0558)at12:22p.m.withstrikepriceat1.0500LongputAUD/USD(rate1.0558)withstrikepriceat1.0450ShortputAUD/USD(rate1.0554)at12:24p.m.withstrikepriceat1.0600

About6hourslater,Isawachartpatternthatmademechangemyviewsonthecurrencypair,and Idecided to exit at a loss after thepricebouncedbackup from the support formedataround1.0590–1.0600.

Iclosedbothlongputsat6:23p.m.withlossesof$224and$186,respectively.AndIclosedtheshortputat6:24p.m.with$162profits.

Netlossonthetransaction=$162–$224–$186=–$248

Ishouldhavewaitedalittlemore,asthepricethereafterwentbackdownandIcouldhaveavoidedsomeoftheloss.ButIchosenottotaketheriskoflosingthemaximumamount.

CallBearSpread

Theelementsfor thismethodareoneshortcalloptionata lowerstrikepriceandonelongcalloptionatahigherstrikeprice.

Themaximumlosspotentialisthedifferencebetweenbothstrikeslessthenetpremiumreceived. The maximum profits to be made with this strategy are also limited to the netpremiumreceived(theshortcallpremiumreceivedlessthelongcallpremiumpaid).

You will want to employ this strategy when you believe the rates of the underlyingcurrencypairwillbegoinglower.Example:

OnMay16,2011,theEUR/USDwasinastrongbearishtrendonthe30-minutecharts,andIdecided to place a call bear spread set of options, profiting from the recent 61.8 percentpullbackonthepreviousswinglow(seeFigures24.13and24.14).

Figure24.13Callbearspreadtradeexample

At3:27p.m.onMay16,2011,IopenedwithashortcallEUR/USD(rate1.4224)atastrikepriceof1.4000,andat3.28p.m.Iplacedalongcallatastrikepriceof1.4300.

A fewhours later and fearing that the euro-dollar pricemight bouncebackupoff thesupportzonearound1.4150,Idecidedtoclosethesetupwiththerateat1.4168:Iclosedtheshortcallat7:47p.m.(rate1.4168)with$364profitsandthelongcallwithalossof$300.

Netprofitsmade=$364–$300=$64

PutBearSpread

Thebenefitsofthissetuparesimilartothoseofthecallbearspread,andbothstrategiesaimforafalloftheunderlyingcurrencypairrates.

Thespreadiscomposedofoneshortputoptionatalowerstrikepriceandonelongputoptionatahigherstrikeprice.

Themaximumprofitstobemadearelimitedtothedifferencebetweenbothstrikepricesless the net premium paid for the whole position. On the other side, themaximum lossesincurredare limited to thenetpremiumpaid (the longputpremiumpaid less the shortputpremiumreceived).

Thedecisionbetweenchoosingthecallbearspreadversustheputbearspreadwillbetakenbycomparingthemarketpricesonbothtoseewhichofthemisgoingtoyieldahigherpayoff.

Figure24.14Callbearspreadchart

Example:

Thecontract is still openwithanexpirationdateof June16,2011 (seeFigures24.15 and24.16).

Figure24.15Putbearspreadtradeexample

Figure24.16Putbearspreadtradechart

OnMay19,2011,at4:14p.m.,IopenedalongputontheGBP/USD(rate1.6178)withastrikepriceat1.6250andashortputwithastrikepriceat1.6050.Myexpectationsarefora projection for theGBP/USD rates to reachMarch lows in the first instance and Januarylowsasasecondpossibility,beforethedateofexpiry.

Atthatmoment,thenetpremiumforthispositionwas$2,052paidless$1,062received,a$990netpotentiallossifthemarketdoesn’tfall.Thebreakevenrateforthisstrategyis99pointslowerthantheopeningrate(1.6079),andtheexpectedfirsttargetpayoffwasaround1.5979,thus100pointsfora$1,000potentialpayoff.Therisk-to-rewardratiohereisslightlybetterthan1:1.

NEUTRALSTRATEGIES

Neutral strategiesareusefulwheneverwedonothaveacleardirection for theunderlying

currencypair.Straddles,strangles,guts,calendarspreads,verticalspreads,butterflies,andcondorswillofferusanopportunity toobtainprofitsunderstableconditionsor in frontofvolatilefundamentaleventswithnospecifictrendinsight.

LongStraddle

Thissetupwillbecomposedofonelongcalloptionandonelongputoption,bothwiththesamestrikeprice.Profitpotentialisunlimitedineitherdirectionthemarketmoves,andtherisksyouwillincurarelimitedtothetotalpremiumpaidonbothlongoptions.

Thestraddlecanbeemployedwhenyouareexpectingthemarkettobreakoutofagivenrange with much volatility, for example, under impending news releases. You will makemoneyifthescenarioisbullishorifthepricesoftheunderlyingcurrencypairfall,providedthebreakevenpointisreached,coveringthecostofbothpremiumspaid.Example:

The transaction is still open and has an expiration date set at June 16, 2011 (see Figures24.17and24.18).

Figure24.17Longstraddletradeexample

Figure24.18Longstraddletradechart

OnMay19,2011,IplacedalongstraddleontheAUD/USD,expectingthispairtobreakabovethe1.0680–1.0700resistancelevelandreachlastApril’sall-timehighsat1.1010asthefirsttargetandfurtherhighsat1.1200–1.1250inextensionfromthepreviousdailyswinghigh.

OnMay19,2011,at3:43p.m.,IopenedwithalongputAUD/USD(rate1.0615)andalongcall,bothwitha strikepriceat1.06500. If this setup fails, Iwill loseamaximumof$3,053 (total cost of both premiums paid). The potential gains, should the rate of theAUD/USDreachthefirsttargetbeforeoratexpiry,wouldbe$3,600foranetprofitof$547andonthesecondtarget$6,000foranetprofitof$2,947.

ShortStraddle

Thissetupissimilartothelongstraddle,exceptthatwewouldbeexpectingstablepricesandalowvolatility.Anexamplewouldbepricesoftheunderlyingcurrencypairevolvinginsideagivenrange.Herewewillbesellingashortcalloptionandashortputoption,bothwiththesamestrikeprice.

Shortstraddlesaremuchriskierthanotherstraddletradesorothertradesingeneral,asthe losses canbeunlimited in either direction themarketmoves,while theprofitswill belimited to thenetpremiumamount receivedwhen selling theoptions.The ideabehind thismethodistoprofitfromtheeffectsoftimeupontheoptionspremiumvalue,whilepricesmustexhibitverylittlechangeforittobereallyprofitable.Example:

ThetransactionisstillopenandexpiresonJune16,2011(seeFigures24.19and24.20).

Figure24.19Shortstraddletradeexample

Figure24.20Shortstraddletradechart

IexpectedtheEUR/GBPratetomovesidewaysoverthefollowingweeks;Itookashortstraddlewiththefollowingcharacteristics:May26,2011,at12:22–12:23a.m.ShortputandshortcallEUR/GBP(rate0.8647),bothwitha0.8600strikeprice

I chose a lower strike price than the current rate, as I am expecting a slightly bearishprojection toaround thatpriceand0.8570near theexpirationdate. If theprice remainsonthatrange,IwillkeepbothpremiumsminustheremainingvalueoftheoptionsifIdecidetoclose them before the expiry or to close them completely should both options expireworthless.

LongStrangle

Thisstrategy,likethelongstraddle,isbestemployedwhenvolatilityishighandisexpectedto increasewhile themarket direction is not clear orwhen a largemove is forecast. Thedifferenceisthatthestrikepriceswillbeatagreaterdistancefromeachother.

Withthisstrategy,webuyonelongcalloptionandonelongputoption,bothOTM;thatis, the strike price of the call has to be at a higher strike price in regard to the currentunderlyingrate,andthestrikepriceoftheputneedstohavealowerstrikeprice.

BeingOTMlowersthecostofthepremium,butinreturnwealsohaveahigheramountofpointsthatthemarketwillhavetoriseorfalltobeprofitable.

The potential profits on this strategy are unlimited inwhichever direction themarketmoves.Themaximumlosswillbelimitedtothetotalpremiumpaidforbothcallandputlongoptions.Example:

ThislongstrangleisstillopenandexpiresonJune16,2011(seeFigures24.21and24.22).

Figure24.21Longstrangletradeexample

Figure24.22Longstrangletradechart

OnMay26,2011,at12:31a.m.,IdecidedtoopenalongstrangleoptionsetupontheUSD/CHF,aftera61.8percentretracementonthepreviousdailyswinglow,andexpectingthecurrencypairtomovefurtherbutstillnotbeingsureifthedowntrendiscomingtoitsendornot.Ibelievethepairmightreach0.9000beforetheexpirationdate,whichwassetatJune16,2011.

LongcallUSD/CHF(rate0.8726)withstrikepriceat0.8750LongputUSD/CHF(rate0.8726)withstrikepriceat0.8650Whicheverdirectionthemarketchoosestotake,Iwillneedtheratestomoveabout148

pointsfortheoptionscontractstobeatabreakevenlevel:$942+$714(premiumspaid)=$1,656/$11.20pipvalue=$147.85

Theprojectedtargettotheupsideat0.9000will,ifreached,yieldnetprofitsaround$1,400(pointsabovethebreakevenlevelmultipliedbythepipvalue).

ShortStrangle

Thishasasimilarprofiletotheshortstraddleandthesamedifferencesthatwefindbetween

long strangles and long straddles. This option setup is to be used when we expect thevolatilitytobelowandthepricesoftheunderlyingcurrencypairtoremainstableorinsideatightrange.Aswedidforthelongstrangle,wewilluseOTMoptions.

The elements of this strategy are one short callwith a higher strike price (above thecurrent rate) and one short put with a lower strike price (below the current rate). Thepotentialprofitsarelimitedtothenetpremiumamountreceivedinwritingtheoptions,whilethemaximumlossesareunlimitedwhicheverdirectionthemarketmoves.

Herethestrikepricesareatagreaterdistancefromeachotherthanontheshortstraddle,which will reduce the premium received but in return will increase the opportunities forendingwithaprofitableresult.Example:

TheshortstrangleisstillopenandexpiresonJune16,2011(seeFigures24.23and24.24).

Figure24.23Shortstrangletradeexample

Figure24.24Shortstrangletradechart

At 12:44 a.m. onMay 26, 2011, I decided towrite the put and call contracts for theEUR/GBP,as I expect the ratesof thecurrencypair to remain insidea100–130-pip rangeuntilexpiration.

ShortputEUR/GBP(rate0.8658)withstrikepriceat0.8600ShortcallEUR/GBP(rate0.8658)withstrikepriceat0.8700

Iwillhavetowatchtheevolutionofthissetupclosely,becauseifthepricecrossesfurtheroneitherside,Imighthavetoclosethemearliertolimitthepotentiallosses.

LongGuts

Elementsofthestrategysetupincludeonelongcalloptionatalowerstrikeprice(ITM)andonelongputoptionatahigherstrikeprice(alsoITM).

Theprofits for thismethodareunlimited ineitherdirection themarketevolves,whilethemaximumlosswillbelimitedtothetotalpremiumpaidplusthedifferencebetweenbothstrikeprices.

Thissetup issimilar to the longstrangle; thedifference is that ina longgutsyouwillonlybebuying ITMoptions,while for a long strangleyouneed tobuyOTMoptions.Thefunctionalityof the longguts is tobeusedwhenyouarebullishonvolatility.Figure 24.25presentsanexampleofalonggutschart.

Figure24.25Longgutschart

ShortGuts

Similartotheshortstrangle,thisstrategydiffersinthatitwilluseITMoptions,whereastheshortstrangleemploysonlyOTMcontracts.

The elements that confirm the setup are one short call option at a lower strike price(ITM)andoneshortputatahigherstrikeprice(alsoITM).

Risk and reward profiles are inverse to that of the long guts; the maximum profitpotential is limited to the net premium received on writing both short options, while themaximumlossisunlimitedwhicheverdirectionthemarketmoves.Ashortgutschartisshown

inFigure24.26.

Figure24.26Shortgutschart

CalendarSpreads

This typeof spreadoption intends to takeadvantageof timedecay.Bothcall andput timespreadsareemployedwhenthetraderbelievesthepriceswillremainrelativelystable(lowvolatility)andthereisaneutraltoslightlybearishmarketbias.Also,bothprofitsandlossesarelimitedineitherdirectiontotheunderlyingratemoves.

Thestrategyinvolvessellingtheoptionthatwillexpirefirstandbuyingtheoptionthatwillexpirelater.Usuallythereisaboutamonthdistancebetweenthedatesonbothcontracts.Inwritingtheoptions,youwillreceivethepremiumupfrontandbenefitfromthedevaluationofthecontractovertime;therisksinherentinsellingnakedshortpositionsarethenprotectedby the subsequent buying of the long positionwith a farther date of expiration, should theunderlyingcurrencypairmoveagainstthefirstexpiringposition.

Thebesttimedistanceforthefirstoptionislessthan30daystoexpiration,andOTMcontractswillyieldbetterresults.CallTimeSpread

Theelementsofthesetuparetowriteashortcalloptionwithacloserexpirydateandbuyalongcalloptiontoexpirelater.PutTimeSpread

Ifyouwant toplaceaput timespread,youwillhave toshortaputoption thatwillexpiresoonerandthenbuyalongputoptionwithanexpirationdateatagreaterdistance.

The only difference between the call and put time spreads is that with the calls youexpect themarket rates to increase,whilewith theputsyouexpect theunderlyingcurrency

pairpricestofall.

CallRatioVerticalSpread

Thisneutralstrategyistobeemployedwhentheoutlookonvolatilityisbearish(seeFigure24.27).

Figure24.27Callratioverticalspread

•Elements.OnelongcalloptionITMandtwoshortcalloptionsOTM.•Riskandreward.Theprofitsarelimitedtothedifferencebetweenbothstrikepricesminus

thenetpremiumpaid.Losseswillbeunlimitediftheunderlyingcurrencypairrallies,butwillbelimitedonabearishscenario.

PutRatioVerticalSpread

Thesamewayaswewouldusethecallratioverticalsetup,thisstrategyistobeemployedwhenthereisanexpectationofastable,low-volatilityevolutionoftheunderlyingcurrencypairpricesandanexpectationofaneutralbiasinmarketdirection(seeFigure24.28).

Figure24.28Putratiobutterflyspread

•Elements.TwoshortputoptionsOTMandonelongputoptionITM.•Risk and reward. Here again, the profitswill be limited to the difference between both

strike prices minus the net premium paid. Losses will be unlimited if the underlyingcurrencypairfalls,butwillbelimitedtothenetpremiumpaidonabullishscenario.

ButterflyStrategies

LongCallButterfly

Thelongcallbutterflycanbeemployedwhenweexpecttheunderlyingmarkettoshowlowvolatility(seeFigure24.29).Thestrategyresemblesashortstraddle,butherethelossesarelimited.Inaddition,thestraddleischeapertoacquire,sinceyougetthepremiumamountatthemomentofwritingtheoptions,whilewiththelongbutterflyyouhavetopaythepremiumupfront.Youwillearnprofitswhenthemarketremainsstableforthedurationoftheoptions.

Figure24.29Longcallbutterfly

•Elements.TwoshortcalloptionsATM,onelongcalloptionITM,andonelongcalloptionOTM.

•Risk and reward. Losses and profits are limited in this strategy. The maximum gain toexpect is limited to thenetpremium received from the spread,while themaximum losswillbelimitedtothenetamountthatresultsfromdeductingtheITMstrikepricefromtheATMstrikeprice,minusthenetpremiumpaid.

ShortCallButterfly

Theshortcallbutterflycanbeemployedwhenweexpecttheunderlyingmarkettobevolatileand break out of a given range in either direction (see Figure 24.30). The payout for thisstrategyissimilartothatofthelongstraddle,asbothhavelimiteddownsiderisks.

Figure24.30Shortcallbutterfly

•Elements.TwolongcalloptionsATM,oneshortcalloptionITM,andoneshortcalloptionOTM.

•Riskand reward. As is the casewith the long call butterfly, losses and profits are alsolimited in this strategy.Themaximumgainwill be limited to the net premium receivedfrom thewhole spread,while themaximum losswill be limited to the net amount thatresults from deducting the ITM strike price from the ATM strike price, minus the netpremiumreceived.Itwillbelimitedtothepremiumpaidforthethreeoptions.

LongPutButterfly

Options tradingstrategy is takenwhen theoptions trader thinks that theunderlying securitywillnotriseorfallmuchbyexpiration.•Elements.TwoshortputoptionsATM,one longputoptionITM,andone longputoption

OTM.•Riskandreward.Aswiththelongcallbutterfly,thelongputbutterflyissimilartoashort

straddleinthatyouneedtoexpectalowvolatilitymarket,buthereyourlossesarelimitedif the market goes against your direction, while in a short straddle you would riskunlimited losses. Themaximum amount to profit from this strategy is limited to the netpremium that you have received from the whole setup. Losses are also limited to thedifferencebetweentheATMstrikepriceandtheITMstrikeprice,minusthenetpremiumpaid.Figure24.31showsanexampleofalongputbutterfly.

Figure24.31Longputbutterfly

ShortPutButterfly

Theshortputbutterfly(seeFigure24.32)canbeemployedwhenweexpectthevolatilityto

behighandthemarkettomoveheavilyineitherdirection—forexample,beforeanimportantnewsrelease.Thepayoutforthisstrategyissimilartothatofthelongstraddle,asbothhavelimiteddownsiderisks.Althoughprofitsarelimited,thestrategyitselfcangiveyougreaterreturnsonyourinvestment,sincethecosttoimplementisclosetonothing.

Figure24.32Shortputbutterfly

•Elements.TwolongputoptionsATM,oneshortputoptionITM,andoneshortputoptionOTM.

•Riskandreward.Lossesandprofitsarealsolimitedinthisstrategy,justastheyarefortheshort call butterfly.Themaximumgain to expect is limited to thenet premium receivedfrom thewhole spread, while themaximum losswill be limited to the net amount thatresults from deducting the ITM strike price from the ATM strike price, minus the netpremiumreceived.

CondorStrategies

Condorsetupsarequitesimilartobutterflystrategies.Thedifferencebetweenthemisthatthedoublestrikeprice“ATM”issplitintwostrikeprices,oneITMandtheotherOTM.

In order to calculate the risk and reward potential for a condor, it is easier to breakdown the setup into two spreads: long call or put spread and short call or put spread.Maximum losses as well as maximum profits are limited for either long or short condorcontracts.LongCondor

Elements(callorputoptions)

•Onelongoption,ITM(belowthecurrentunderlyingrateforacallandaboveforaput)•Oneshortoption,ITM

•Oneshortoption,OTM(abovetheactualpriceofthecurrencypairforacallandbelowforaput)

•Onelongoption,OTM

Equivalenceofthetwospreads

•Onelongcallorputspreadatalowerstrikeprice•Oneshortcallorputspreadatahigherstrikeprice

Alongcondor(seeFigures24.33and24.34)willbeusedwhenthetraderisexpectingthemarketpricestoremaininsideastablerangeuntiltheexpirationdate.

Figure24.33Longcondorcalls

Figure24.34Longcondorputs

• Profitability. The maximum profits of a long condor are made when the rate of theunderlyingcurrencypairistradingbetweenthetwomiddlestrikeprices.Tocalculatethiswith the two-spread equivalence, you need to take the spreadwith the greater distancebetweenstrikepricesandsubtractthenetpremiumpaidforthespread;thatwouldbethemaximumprofit.

•Risks. The maximum loss of a long condor will occur when the rate of the underlyingcurrencypairistradingatthe“wings”ofthetotalspread(nearorattherateofeithertheoptionwiththeloweststrikepriceortheoptionwiththehigheststrikeprice).Inregardtothetwo-spreadequivalence,theamountofthelossisthelesserofthedifferencebetweenthelowerstrikespreadminusthehigherstrikespread,minusthetotalpremiumpaidforthewholesetofcontracts.

ShortCondor

Elements(callorputoptions)•Oneshortoption,ITM(belowthecurrentunderlyingrateforacallandaboveforaput)•Onelongoption,ITM•Onelongoption,OTM(abovetheactualpriceofthecurrencypairforacallandbelowfor

aput)•Oneshortoption,OTM

Equivalenceofthetwospreads•Oneshortcallorputspreadatalowerstrikeprice•Onelongcallorputspreadatahigherstrikeprice

Ashortcondor(seeFigures24.35and24.36)willbeusedwhenthetraderisexpectingthatthemarketpriceswillbreakoutofarangebutdoesnothaveaclearbiasconcerningthedirectionofthemove.

Figure24.35Shortcondorcalls

Figure24.36Shortcondorputs

• Profitability. The maximum profits of a short condor are made when the rate of theunderlying currencypair is tradingbeyond thewings (thehighest and lowest “external”strikeprices).Tocalculatethiswiththetwo-spreadequivalence,themaximumprofitwillbethegreaterinregardtothedifferencebetweenthelowerstrikepricespreadminusthehigherstrikepricespread,plusthetotalpremiumreceivedforthewholesetupofoptionscontracts.

•Risks. The maximum loss of a short condor will occur when the rate of the underlyingcurrencypairistradinginthecenterofthetotaloptionspread.Infact,inthetwo-spreadequivalence, the maximum loss will be the result of selecting the spread that has thegreaterdistancebetweenstrikepricesandaddingtothisthenetpremiumreceived.

EXOTICOPTIONSSTRATEGIES

BinaryOptions

Tobegintradingbinaryoptions,youneedtosearchforabinaryoptionsbrokerandopenanaccount;binaryoptionsareaspecializedtypeofoption,andonlyafewselectbrokerswilloffer this. You can go to www.jdfn.com to find a list of some brokers that offer binaryoptions. These types of options are usually not offered on a centralized exchange but areusuallyOTCfinancialinstruments.

Thefirststepistochoosetheunderlyingcurrencypair,preferablyoneyouarefamiliarwith and usually follow or trade. You can specialize in a single market or trade severaloptionsatatimeondifferentmarkets.

Youwillthenhavetodecideabouttheexpirationdateforthebinaryoption,whetheryou

intend to obtain results in the short term or plan for a longer time frame. The analysis toperformthereaftermusttakethistimeelementintoaccount.

Most binary options brokers offer contracts with expiration times and dates that canrangebetween1hourto1monthormore.Afewofthemalsoofferextrashort-termoptionsavailabilitywhereyoucanchooseanoptionthatwillexpirein15minutesoreven5minutes.Thisisimportanttoknowinordertodetermineapredictionwiththebestpossibleaccuracy.

Finally,youwillneedtoselectthedirectioninwhichyouthinktherateofthecurrencypairwillevolveattheexpiration.Ifyouarebullishandthinktheratewillbehigher,you’llhavetobuyacalloption;ifyouarebearishandthinktheratewilldecreasebytheexpiry,youwillneedtoplaceaputoption.

Ifyour forecast is correct,youwill earnahigh returnonyouroriginal investment, asbinaryoptionsusuallyofferpayoutpercentages that rangebetween70and85percent.Youcan also choose to trade multiple options as an additional advanced strategy, which willallowyoutoalwaysbeITM.

MoneyManagement

Thesamebasicmoneymanagementrulesofforextradingwillapplytooptionsaswell.Nostrategywillperformallthetime,andtherewillbelossesalongthewaythatyouhavetobepreparedtoassumeaspartofthewholetradingpicture.Youshouldalsotrytominimizetherisksinregardtoyourtotaltradingamount.•Riskamount.Never riskmore than8.5percent of your total account on a single options

contract.Thiswayyoucouldbewrong11timesinarowandstillhaveenoughmoneytokeeptrading.

•Confidence.Donot tradewhenyouareunsureorhavenotperformedenoughresearchoranalysis inselecting theoptions.Optionsweredesignedfor insurancepurposesonopenpositions.Sooptionscanbeagreatwaytogeneratesomecash.However,optionscanbeveryrisky;somakesureyouhavepaper-tradedandhavebuiltupyourconfidence.

•Diversification.Reducetheoverallrisksbytradingdifferenttypesofoptionsondifferentcurrency pairs and also combining them with regular forex trades; also use differentexpirationtimes.

•Fundamentals.Keepaneyeoneconomicreleasesandeitherwaitfortheannouncementstopredict themarketdirectionoruse themtoanticipate themarket’svolatilityandto tradespecificrange-breakingstrategies.

• Trend. As you would for a regular forex trade, identify the main trend and follow itsdirection.

SomeBasicBinaryStrategies

BullishBinaryStrategy

Iwill employ a bullish strategywhen I believe the rate of the underlying currency pair isgoingtoappreciateinthefollowingperioduptotheexpirationtimeordate.

Forexample,afteranimportantsell-offontheAUD/USD,thepriceisnowsittingaboveastrongsupportat1.0500,andI think that in thenextfewhours therewillbeasignificant

pullback,resumingtheupwardtrend.Iexaminetheoptionsavailableanddecidetobuyacallthatexpiresin2hours,witha

premiumof$1,000anda75percentpayout.ThismeansthatifmyanalysiswascorrectandtheAUD/USDrateclimbsabove its currentprice, theoptionwillbe ITM,and Iwill thenreceive the initial investment back plus the 75 percent profits = $750 net profit on thetransaction.BearishBinaryStrategy

AbearishstrategyisappropriatewheneverIexpectthattherateofaparticularcurrencypairwilldecreaseinvalueandthereisadownwardtrend.

Let’ssaythemarketjustmadeanimportantcorrectionontheUSD/CHFbearishtrend.Myanalysis tellsme that thepriceof thecurrencypairwillnow turnbackand resume itsmovetothedownside,andsoIdecidetobuyaputoptionwithapremiumof$1,200andan80percentpayout.IftheUSD/CHFrateisloweratthetimeoftheoptionexpiration,Iwillreceivethe$1,200backplusthe80percent,foranetprofitof$960.

Range/VolatilityStrategies

“In-the-Range”Options

Whenpricesoftheunderlyingcurrencypairhaveevolvedinsideasteadyandstablerange,thebeststrategyistobuyanoptionwherethepriceattheexpirationwillbeinsidethatrangefortheoptiontobeITM.SeeFigure24.37.

Figure24.37In-the-rangeoptions

“Out-of-the-Range”Options

Whenthemarketappearstobehighlyvolatileorifweexpectafundamentalreleasetocause

abreakofaparticular range foracurrencypair,wewill selectanout-of-the-rangebinaryoption.SeeFigure24.38.

Figure24.38Out-of-the-rangeoptions

BinaryFenceStrategy

Fencetradingoffersthetraderagreaterpotentialtowin,whicheverdirectiontheunderlyingcurrencypairmoves.Forthisstrategy,Iwouldusetwodistinctbinaryoptions:oneputandonecall.

IntheexampleshowninFigure24.39,IdecidedtobuyaputoptionaftertheAUD/USDbrokebelowthesupportandwastradingat1.0800.Afewhourslater,thepriceseemedtobeholdingaboveanothersupportzoneat1.0600,andIboughtasecondoption,thistimeacallwiththesameexpirationdateandaimingtoendabove1.0600.

Figure24.39Binaryfencestrategy

If theAUD/USDexpireswith its rate between 1.0600 and 1.0800, Iwill bewinningbothoptionsandearnadoublepayout.

Another possible scenario would be that the price expires above 1.0800 (or below1.0600),andsooneoftheoptionswouldbealoser.Forexample,iftheAUD/USDexpiresabove1.0800,Iwouldbewinningthecalloptionandlosingtheputoption;conversely,ifthecurrency pair expires with its rate below 1.0600, I would be winning the put option andlosingonthecall.

Let’s say I invested $1,000 on each option, bothwith the same 80 percent payout atexpiry.

Onthefirstabsolutewinningscenario,thenetprofitsmadewouldbe$1,600($800ontheputplus$800onthecall).

Onthesecondalternative,Iwillhaveinvested$2,000(forbothoptions)andgetback$1,800(myinvestmentplus80percentprofits);thusmylosswouldonlybe$200,equivalentto10percentofthetotalinitialinvestment.

Withthisstrategy,Icouldtradeuptoeighttimesandloseseventimes;stillmakinganetprofitonthewholeseriesiftheeighthoptiontradeisatotalwin:

7lossesof$200=$1,400plus1winof$1,600=$200netprofit

PART6FOREXAUTOMATEDTRADING

CHAPTER25FOREXAUTOMATION

Forex automated trading is certainly thewave of the future. It wasn’t toomany years agowhentherewasreallynothingoutthereonaretailbasiswhenitcametotradingautomationin the retail forex.Typically therehasalwaysbeenautomation in the financialmarkets.Ascomputingpowergotstrongerandmorerobust,computermanufacturerswereable tomakesmaller,lessexpensivemachinesthatindividualtraderscouldafford.Todayoursystemsareveryaffordable,andmosttradershaveallthetechnologyandspeedtheyneedandaneasy-to-obtaincomputertradingsystem.

When I first started using basic forex automation, there was only a handful ofprogrammersmakingtheirsystemsavailablefortraderstouse.Afterafewmonths, though,programmers started coming from everywhere, offering the next great thing. Some of thesystemsareokay,whileothersareaflat-outscam,justtryingtogetyourmoney.Ihavetriedhundredsof automated systems, and Ihavecreated just asmanyproprietary systemsofmyown.Intheend,itdoesnotmatterwhatthesystemisifitworks.Theproofisinthepudding,sotospeak.

As noted above, automation is not something new. It has been prevalent among bothstockandforexbrokers,andtheyhavebeenusingcomputingpowerincreasinglyoverthelastseveral years to automate price feeds and to route orders.Black Fridaywas a product ofautomated trading. In fact, it was necessary to upgrade automated stock systems after theOctober 1987 market crash to ensure they could deal with unexpected spikes in tradingvolumefortheforeseeablefuture.

Duringmajor news announcements, retail forex traders and institutional traders causelargevolumespikesinanticipationofthenewstobereleased.Ifaforexbroker’sautomatedsystems or dealing desks cannot keep up with the trading volumes, then price requotes,slippage,andotherundesirabletradeerrorswillinevitablyoccurwhiletryingtoeitherfillorliquidatepositions.Severalforexbrokersareimplementingsystemstoautomaticallywidenthespreadbefore,during,andafternewsevents,todiscouragetradersfromoverloadingtheirsystems.Mostof themoresophisticatedforexrobotscontaincode thatallows the trader tominimizepossibleslippage.Therobotwillactuallybypassthetradeif thereisslippageorthespreadistoowide.

FOREXROBOTS

Over the last 10 years, the use of these forex robots has risen drastically. Starting out as“black-box”systemswiththeinstitutionaltraders,automatedsystemsarenowastapleofjustabout every kind of trader.Retail forex traders are increasingly turning not only to partialautomationbutalsotoforexrobotsforcompleteautomation.Forexautomated,oralgorithmic,

tradinghasmanyadvantages.Somequalitiescannotbeduplicatedbyahumantrader.Oneofthemainadvantagesofforexautomationisthatmanycomplexcalculationscanbeperformedacross several currencypairs in justmilliseconds as thepriceor currency changes in realtime.Decision-basedrulesthatstemfromthesecalculationsallowtheautomatedforexrobottoautomaticallyenterorexitatradeatthebestprice,andalmostinstantaneously.

Because ofmarket volatility, when a human trader finally decides on amanual entrypointorexitpoint,thepricemayhavemovedbyseveralpointsorpossiblymore.Thiscanbepartiallymitigatedbyenteringstop-lossandtake-profitorders.However,thoseoptionshavebeeneliminatedintheUnitedStatesbytheirownregulatorybodies.Withpartialautomationcomesomebenefitsaswell, sinceanautomatedforexscriptcanclose trades100 timesasfastastheirhumancounterparts;requotesaredealtwithmuchmoreefficiently.

EXPERTADVISORS

The forex expert advisor, known as anEA, is amechanical trading system used for forextrading.EAsaredesignedtoallowautomatictradingtotakeplace.Thisfreesthetraderfromcontinuously having to watch the market. In addition, there are some major mistakes thatinvestors make; EAs can eliminate some of thesemistakes altogether, allowing traders toconcentratetheirfocusonmakingaprofit.

AnEAcaninformclientsaboutthepossibilityofarbitragesituations,checkingmultiplepricefeedsandlettingthetraderprofitfromthedisparitybetweenthespreads.EAsareusedbybeginnersandexperiencedtradersalike.Regardlessofthelevelofexperience,EAscanbeused toassist tradersbyallowing themtowork indifferentmarketsandunderdifferentconditions.

EAs are designed in MetaQuotes Language 4, which is a builtin language forprogramming trading strategies. This language allows EAs to be programmed to tradeaccounts automatically by managing trading operations that range from directly sendingorders to the broker’s server, to placing and adjusting pending orders, to placing trailingstops.

There are hundreds of different and unique EAs in the market, all functioning inaccordancewith different rules.The common factor they share is the adherence to a stricttradingstrategyandtheconsistentwayofevaluatingallparametersatthesametime—oftenmoresuccessfullythananyhumancould.Nonetheless,itisimportanttorememberthatanEAis a trading robot and should be used with caution. It is essential to understand how itoperatesandhowitcanaffectyourtradingandstrategy,anditisequallyimportanttohaveatrustworthysourceandpointofcontactfortheEA.

I have been in the software business for many years, and so I have access to manyprogrammers.IhavespentyearsworkingwiththeEAsdevelopingmytradingstrategiesintoanautomatedsystemusingMetaTrader.TheproblemisthatMetaTraderhasitsowninherentproblems.ThebiggestistheMetaTraderplug-ins.Soregardlessofhowgoodyoursystemis,theoutputorresultswillbeskewed.AperfectexampleisanEAIamtestingrightnow.

TheEA is trading on theEUR/USDand is placing about 30 trades a day.TheEA isdoingverywell; it is about95percent accurate.But aswithmostEAs, the losses arebigenoughtokeepthebalanceabouteven.WhatIhaveseenlatelyisthatthebrokerisslipping

thetradesafewpipseachtime.Myresultsareskewed:manyofthesmallerlossesshouldbegains,andmanyofthesmallergainsshouldbelargergains.SincethisisascalpingEA,Iamtrading larger lots. The difference in profitability is huge. Great EA, but the MetaTraderproviderorbrokeriskillingtherealresults.Notmuchyoucando...orsoyoumaythink;moretocome.

TYPESOFEAS

ManydifferenttypesofEAsareoutthere.EachonehasitsuniquedifferencesandhasitsowntradingconditionsinwhichyouwoulddeploytheEA.BelowisalistofsomeofthedifferenttypesofEAsthatyoumayhavetriedorcomeacross:•News EA. A news EA is designed to take advantage of news events that lead to a big

movementinpriceatthetimethenewsisbeingreleased.ThesetypesofEAsweregreatafew years back, but many of the brokers are now using deceitful tactics such as slowservers, plug-ins, andwide spreads to eliminate the news experts. I can remember thegoodolddayswhenyoucouldgetinjustbeforenewsannouncementsusingstraddle-typeordersandreallymakesomebigreturns,butit’sprettyhardtodonow.

•BreakoutEA.ThebreakoutEAisdesignedtoopenatradewhenthepricebreaksthroughpredefined support and resistance levels. Breakout EAs can be very effective inconsolidatingmarketswhenthepriceisstaticormovingaroundinatightrange.

•Hedge EA. A hedge EA is any EA that places two separate and opposing positions andminimizesthelossononewhilecapturingmaximumprofitontheother.Ihavetestedmanyof these types of EAs, but none of them have been that great.With the rules that havechangedin theUnitedStates,youcannothedge in thesamecurrencypair.However,youcanstilltradeoffshoreandhedge.

ManyoftheseEAswillopenuplotsoftradesoneithersideofthebid/askandthenmanagetheirwayoutofthetradeforaprofit.Theproblemhereisthetransactioncost.IfyourEAisplacinglotsoftrades,youcouldendupdownjustbecauseofthepipspreadyouarepayingpereachtrade.

•ScalperEA.AscalperEAisthemostactivetypeofEA,placingandmonitoringtradesveryfrequently. It aims to secure smallprofits as soonas theyareavailable. Ihavebuilt andtestedasmanyofthesetypesasIcould.Ihavealwayslikedthescalpingmodel.Itdatesbacktomytimesofbeingadaytrader.Iliketobeinandoutofthemarket,knowwhatmyriskis,andbeoutofthattradequickly.ThescalperEAscangetyouinandoutofalotoftradesprettyquickly.

Therearenumerousbrokersouttherethatallowforexautomation,andtherearemoreeveryday;MetaTrader is not the only one.You cango towww.jdfn.com to see a current list offorexbrokersandsoftwarethathavethecapabilityofplacingtradesautomatically.

CHAPTER26FOREXROBOTREVIEWS

Automatedtradinghasbeenaroundformanyyears.Thebigbanksandinstitutionshavebeendoingthissortoftradingfarlongerthanretailcustomershavehadaccesstoortheabilitytodosuchtrading.

Wehavepreviouslydiscussedautomatedtrading,andletmejustsayIhavepersonallytestedmanyofthemosthighlytoutedEA“robots”outtheretoday.Inaddition,Ihavecreatedmanyproprietaryautomatedtradingalgorithmsofmyown.SomeoftheEAsthatIhaveusedtradeontheever-popularMetaTradersystems,whileotherstradeonmyinternalproprietarysoftware.ThetworobotsthatIwanttodiscusshereareFapTurboandMegadroid.

FAPTURBOREVIEW

Manyyearsago,afterreceivingallthevariousmarketinge-mailsandreadingallthehypeontheInternetconcerningFapTurbo,Idecidedtotestit.

Overall,IfoundFapTurbotobeagoodtradingrobot;Iwasverysuccessfulusingtheprogramandfeltthatitwaswrittenwell.

I have spent hundreds of hours going through and back-testing the various settings. Ialwaysuseddemoaccountsandback-testingprocessesthatallowedmetomanagetheresults.Thereareinherentproblemswithback-testing,whichwillbediscussedinthenextchapter.

OneofthethingsIlikedaboutFapTurbowastheabilitytochangetheoffsetsandtimeframes for the various strategies I used.My demo trading results were, oftentimes, muchbetterthanlivetrades;however,myliveaccountsmadeverygoodreturnsaswell.Infact,Iwentmanymonthswithoutamonth-over-monthlossonaliveaccountusingFapTurbo.Keepin mind that I used Fap Turbo with many other trading strategies that I would use whenmanuallytrading.

SoherewastheproblemIhadwithFapTurboand,ofcourse,withmanyof theotherrobots out there. If you are using Fap Turbo on your account and you are successful andmakinglotsofmoney,youaregoingtofailintheendunlessyouworkdiligentlytokeepyourprofits.Thebrokerswillworkjustashardtoknowexactlywhatyouareusing,andtheywillbeusingthelatestrobotsaswellinanefforttohelpthemdeterminehowtobeatyououtofyourhard-earnedmoney.

This iswhy itwas important to find settings thatwerenot known to thebrokers; thatway,evenifthebrokerswereabletodeterminewhatrobotIwasusing,theywouldnotbeable to easily determine my settings, since I was not using the preset settings. Having apersonalcustomsettingwillatleastprovidesomehelpwithbetterexecutions.

FapTurbohasofferedmanydifferentversionsandadd-ons,andIhavetriedthemall.Inmyopinion,FapTurboworksbestifyoutradesmallamountsandkeeptakingyourprofitsoutastheyincrease;thatwayyoucanstayundertheradarofthebroker.

FAPTURBOSHORT-TERMSCALPINGSTRATEGY

OneofthemainreasonsthatFapTurbohasbecomeoneofthetop-sellingforextradingrobotsisbecauseofitsshort-termscalpingstrategy,whichistheoneIhaveusedmost.FapTurboisconsideredahigh-frequency trading robotbecause it uses scalping toget in andoutof themarketforquickpips.Whenemployedwithtightstops,anaccountcanquicklygrow.Youdohavetotakeintoaccounttransactionalcostsatsomebrokers.

SCALPINGMULTIPLECURRENCIES

FapTurbomonitorsmanycurrencypairsdependingon theversionyouhave. Itcanuse thescalpingmethodtotradeallofthemsimultaneouslyifyouwanttousethatmethod.Keepinmind,though,thatyoudonotwanttousetoomanyrobotsatonetimeunlessyouhaveabigaccount.Youcanquicklyoverleverage,andthatwouldbebadnews.

SAFEFILTERSTORESTRICTBIGLOSSES

EverwonderwhysomanyEAsandother robotshavegreat-lookingequitycurvesor trackrecords?Well,mostoftenyoucansimplylookatthetradingresultsandlookforthestoplossusedinthetest.Youwillfindthatmanyofthesetoutedrobotsusebigstoplosses,sometimes300to500pips.Thisallowsforthemarketstocyclefromthehighstothelowswithoutthetraderbeingtakenoutofthetradeonastop.

Theproblemwiththatisevenifyouusegoodmoneymanagement,yourdrawdownwillbetoolargetoabsorbandthuswillcreateanaccountliquidationsituation.Somakesurethatifyouaretradingarobotthatusesbigstoplosses,youtradeverysmallamountsandfactora300–500-pipdrawdownintoyourmoneymanagement.

FapTurbohasabuilt-instop-lossfeaturethatcanbemanuallysettothenumberofpipsorthepercentageyouarewillingtoloseonanygiventrade.Thisfeaturewillallowyoutousetherobotswithintheirmoneymanagementsystems.Unlikesomeoftheotherrobotsouttherethathavebuilt-instops,FapTurbocancreateanextremelyuser-definedrisktolerance.

ASTEALTHMODEOPERATION

Someunscrupulousbrokers like to increasespreadsandhuntstopsonaccountsusingforextradingrobots.ButFapTurbousesastealthmodeoperationthatcanhidetheprofitandstop-lossvaluesfromthebrokers.Therobotwillstorethestoplossontheuser’scomputer,andwhenthepricereachesthestop,therobotwillsendtheorderasamarketorder.

Thiskeepsthebrokerinthedarkaboutwherethestopis.Theproblemwiththisisthatwhentherobotsendstheorderautomaticallytothebrokerasamarketorder,thebrokercouldkickitbackwithamultitudeoferrors,resultinginabiggerloss.

The same thing can hold true on the other side for profitability using a limit. I have

witnessedthisfartoomanytimes.Thetradegoesyourway,hitsyourlimit,andthensendstheorderin.Thebrokerslow-fillsthetrade,andyoucometofindoutthatyourprofitabletradejustbecamealosingtrade.

SOFTWARELICENSING

IamnotabigfanofhowFapTurbosellsitssoftware.Youpayaonetimefee,whichisnice,butyouhavetogototheFapTurboWebsiteperiodicallyandobtainnewcodestoenterfortheauthentication. Ifyou forget todo this,yourFapTurbowillquitworking,andyouwilldiscover that you haven’t had any trades,which is very frustrating, especially if you havebeenexperiencingprofitabletrades.Thenyourrobotgoesoffline,andyoumayhavemissedafewmoreprofitabletrades.Whenyougetyourrobotbackuprunningagain,youcatchthefirstlosing trade. All in all, it will affect the results of your trading. So you don’t want yoursystemtogodown.

OneofthethingsIhavefoundwithFapTurbo,andwithotherrobots,isthatifyouareusing a setting that is producing good results on a live account, don’t be surprised if thatchangesdown the road.Many times the robots,and themanyuniquesettings,onlywork incertainmarketconditions.Butthatisokay;justsaveallyoursettings,whichiseasilydonebyusingthesavefeatureforthesettingsmenusincludedwiththerobots.Youcanthengobacktothesettingswhenyoufindyourselfinthatsamemarketconditionagain.

OverallIliketherobot,andIcurrentlyuseitalittledifferentlybyrunningthroughsomeproprietarysoftwareprogramsthatwehavewritten,whichallowsthetradestoexecuteandthensendsthemthroughaportaltootherbrokers.

MEGADROIDREVIEW

This is one of the first robots I ever tested. I spent a lot of time both back-testing andforward-testing this robot. I have had great success with my results on a live account.Remember to always start using your robots on a demo account; thatway you can see theidiosyncrasiesofaparticularrobot.Eachrobotwillhavelittlequirksthatyouwillneedtounderstandbeforegoinglive.Whenyoudodecidetogolive,Iwouldsuggestthatyoustartwithyourrobot“dialeddown,”sotospeak,meaningusesmalllotsizes.Thiswillallowyoutocomparethedemotradingversusthelivetradingexecutionsofyourrobot.

TheMegadroidrobotonlytradesontheEUR/USDpair,andtherearesomesettingsyoucan use tomanipulate the trading frequency. It does not trade asmuch as onewould like.However,itisdesignedtobeveryspecificandtargetitsentrytimes,thusmakingitoneofthemostsuccessfulrobotsonthemarkettoday.

Whenyoufirst setup the robot, itmay takesome timebefore itplaces the first trade.Havepatience;itwillplacetrades,andyouwillseewhyitisoneofthebestrobotsonthemarket.

Iusemultiplerobotswhentrading,andIdothisbecauseitallowsforamorediversifiedapproachtomytrading.Theautomationisawaytodiversify,andsoisusingmultiplerobots.Byaddingthisstrategytomymanualtrading,Iamabletoputdownawell-diversifiedtrading

system.Oneofthekeyfeaturesyouwillwantagoodrobottohaveisastop-losscomponentthat

will keepyour account fromblowingup.Youcannot afford to loseyourpreviouswinningtradestoonebigsingleloss.Ihaveseenthishappentoomanytimes.Therobotwillmake20successful trades in a row, and then one big loser wipes all the profits away. ForexMegadroid,ondefault,willtrytousea3:1risk-to-rewardratio.

REVERSECORRELATEDTIMEANDPRICEANALYSIS

Mostrobotscanmakemoneyintherightmarketconditions.It’swhenthemarketconditionsor the trendchanges thatcauses the robots tostart losing.That isoneof the reasonswhyIsaveallmysettingsandmaintainasignificantarchivedlogofthem.ThatwayIknowwhichrobotwasused,whatsettingwasmaximized,andwhatthemarketconditionswere.Icantakethe same robot and change the settings to maximize my profit potential during differenttrendingmarkets.Bydoingthis,Icaneliminateoneofthebiggestdrawbacksofrobots, theinability to determine market conditions and adjust trading strategy to maximize currentmarkettrends.

Megadroidhasareversecorrelatedtimeandpriceanalysisfeaturethathelpstherobotto adapt to different changingmarket conditions.Megadroid then continues to profit in thenew trend. I don’t necessarily use this feature as set in stone; I still like tomaximize thesettingsfordifferentmarketconditions.

BUILT-INCLOAKING

AsIhavediscussedinthisbook,somebrokersareonlyinitforthemselvesattheexpenseoftheircustomers.Myrobottradingiswhatfirsttippedmeoffthatsomethingwasreallywrongwithsomeofthesebrokers.Somebrokerswillnotevenallowyoutouserobots,andothersareknown to specifically rejectanyorders thatcome fromrobots, especially if thebrokerfindsoutwhichoneyouareusing—andespeciallyifyouareprofitable.

AsImentionedbefore,oneofthethingsIhavedonetocombatthisistoruntherobotsonademoaccount(orasmallliveaccount),useamiddlewareprogramwedevelopedthatwillseethetrade,andmakethetradeswithnumerousbrokerssimultaneously.Youcannotdothis with proprietary robots, as that would be against their user agreements. We use thisstrategyonourinternalproprietaryrobotsthatwehavedeveloped.

Tohelp combat the problemwith brokers detectingwhich robots youmight be using,Megadroiduses twounique IDsettings.Megadroid recommends thatyouchange these twosettingsweeklytokeepthebrokersfromdetectingyourrobot.

I have installed and tested hundreds ofEAs;Megadroid is one of the easiest ones toinstall.Itshouldonlytakeyouaboutfiveminutestogetthisrobotupandrunning.Remember,itcouldtakeaweekormorebeforethefirsttradespopon.Overall,ofalltheEAsIhavetested,FapTurboandMegadroidarethebest.Therearelotsofrobotsoutthere,andastheforexmarketgrows,therewillbemanymore.Ihaveateamandatesting lab set aside specifically to test robots and develop new ones. I believe in this

technology.Ithasbeenaroundfora longtimeandwillonlygetbetter.Thebrokersarenotstupid,andsotheywillbeworkingjustashardtostopyoufrommakingmoney.Thatiswhyyoureallyneeda trueECN-typebroker,onewhoisgoingtoputyour trades throughto thebank.

CHAPTER27BACK-TESTING

Most know that it is important, but few know how to use it. A fundamental tool for yoursuccessinforextrading,back-testingisnothingmorethangatheringaseriesofdataoreventsandapplying to them the strategyor trading systemwewant to test sowecanmeasure itsefficiency.Thekeyquestionis,ifthegreatmajorityofforextraders“intheknow”knowthatback-testingisessential,whyisitthatnewtradersandevenexperiencedonesdonotemploythisfeatureatitsfullpotential?

Therearetwodistinctanswerstothis.Oneisthatmanycanfinditboringortiresome.They don’t understand or simply don’t care and prefer to jump into themarket with theirstrategyinademoaccountoreveninarealaccount.Thisisahugemistake;intheend,thosepeoplewillalwaysbeconsistentlosers.Always.Andwhy?Becausegreed,impatience,andeventheloveforeasyshortcutsthatmanypeoplepossessandtheirattitudetowardlifemakethem adventurous, and they enter the market “blinded.” Then, after blowing up their firstaccount,comesfrustration.

Thereisanothergroupthatusesback-testing,butthepeopleinthisgroupdonotknowhow to implement its features. These people are good-willed, but good intentions bythemselvesdonotgeneratepips;theseindividualscanalsoendupaslosers.

Bothgroupsoftradersalsolosebecausethisbusinessishighlyindividualistic;youhavenobodybyyoursidetotellyouwhattodoandespeciallywhatnottodo.Andsomistakespileupthatarenotanalyzedorunderstood.Iamcertainthat,givenenoughandappropriateguidancewhenusingdemoaccountsandlaterinrealaccounts,thousandsofdollarscouldbesaved.Justkeepinmindthatthedemoaccountwillbeskewedsomewhatfromlivetrading.Wededicatedanentirechaptertothattopicinthisbook.

That’swhyevengettinggoodresultsaftera lotofpractice indemoaccountsdoesnotautomaticallyguaranteeyouwon’tmakemistakesonarealaccountbecauseofyourlackofexperienceandlackofguidancetounderstandfullyaparticularstrategyanddoafollow-upoftheerrorsencountered.

Ifyoudonotperformback-testingaccurately,youwillhaveafairchanceofbecomingapermanent losing trader. If you try to implement a method on the real markets without aprevious statistical verification of its performance, youwill only be destroying your ownmoney.Whyisback-testingsoimportant?

1. Because it gives you a statistical certainty about the tool you are using and about itsefficiency,withtheprobabilityofsuccesswhenopeningandclosingaposition.

2.Becauseitwillreduceyourfearsonenteringthemarket.3.Becausewhen you trade forex, you need a high amount of confidence and trust in yourstrategy,knowingthatanythingcanhappeninthemarkets—andquiteoften,whenyouleastexpectit.

4.Becauseitwillallowyoutoidentifyandcorrectpossibleflawswithinyoursystembeforegoingliveandwillalsoallowyoutoidentifythebestmarketconditionstoemploy.

5.Because forex tradersarenot fortune-tellers.Don’t try toplaycasinowithyouraccountandtradeoninstinctorbecauseofahunch.Employingathoroughlyprovenmethodisbeingresponsible,andthispreciselyisafundamentalqualitythatatradermustpossess.

Inshort,back-testingistheactionofapplyingatradingstrategytowardhistoricaldata.Youwillbeverifyingalltheparametersandrulesthatcharacterizeyourparticulartradingmethodby testing themagainst thepast behaviorof themarkets; anddependingon the results, youwillmodifyorrefinetheconditionstoaddstrengthtoyoursystem.

Parameterswillhavetoincludethetimeframe,expectedprofitandmaximumallowedloss,profitgoals,andentryandexitconditionsbasedontechnicalorfundamentalindicators.Resultswillbeanalyzedinregardtooverallprofitability,percentageofwinningandlosingtrades,andrisk-to-rewardratio.

BACK-TESTINGMETHODS

ManualBack-Testing

Thisistheslowestofallthreemethodsandconsistsofadvancingthroughhistoricaldataonecandleorbaratatime,writingdownthetradingsignals,andrecordingprojectedentryandexitprices.Thismethodislimitedbytheamountofdatathatcanbeheldinonechart.Manualback-testingwillrequirethatyoukeepaccuraterecords,whichwillhelpyoubuildasoundexperienceintreatingforextradingasabusiness.

Let’sfaceit;thisisnottherealityoftoday’smarketplace.Mostback-testingmethodsaregoingtoneedtorunontickdatatobeefficientoraccurate.Thatmeanseverytimethemarketischanging,yourcomputersystemisstoringthatinformation.Canyouimaginetryingtostorethatmuchinformationmanually?Idon’tseethathappening.Evencomputershaveadifficulttime running back-testing. In fact, back-testing is so intensive, it will oftentimes kill acomputer.Lotsofdataandtimepointstocrunch.

SoftwareBack-Testing

Thisis,inmyopinion,thebestwaytoback-testastrategy,asitwillallowyoutoworkfasterandoverlongerperiodsoftime,beingthatthesoftwareautomaticallyprocessesthedata.Youwillbeexperiencingthesameconditionsasifyouweretradinglive,withtheaddedfeatureofbeingabletogobackwardandforwardatahigherspeedandsetthepreferredpaceforthedataoutput.

This is essentially oneof the things that I builtwhen Iwasonmymission to build aproprietarysoftwareuserinterfacefortraderstouseinretailforextrading.AsIwasbuildingthesoftware,Ihadtocreatethebackendofthesoftware,thestorage,the7-days-a-week–24-hours-a-daydatacenter.BecauseIhadaccesstoallthistechnology,Iwasabletocreatemyowndatastorage.Icanutilizethedatainourtestinglabs,andthatgivesmeaclearadvantageover smaller retail customers. I have in the past shared what I learned; this book is nodifferent.

ProgrammedBack-Testing

Settingupaprogrammed interfacewithall the rulesandparametersofyourstrategy is themostcomplicatedofallthreemethods,butitcouldbeusefulifyouintendintheendtotradebymeansofarobotorautomatedsystem.Thecomputergoesbackintimeandtakesthetradesaccordingtoyoursystemrules.

Thiskindofback-testingisthefastest,asyoudonotneedtoseethechartunfolding.Thecalculationsandtradesaremadeautomaticallybasedontheparametersyouhaveset,andyouonlyseetheendresults.

Thelimitationsithasare,first,thatitisdifficulttoprogramthesystemwithprecisionand,second,thatatthemomenttherobot“decides”totakethetrade,ittakesintoaccountonlythereal-timedata.Youwillalsostillneedtomanuallychecksomeofthetradestakentomakesure that theprogramis really trading inagreementwithyour rules,andyouprobablywillhavetomakemanyadjustmentsuntiltherobotinterpretstheconditionswithtotalaccuracy.

Forward-Testing

Clearly this isnotback-testing,but it is testing,andsoIwantedtocover it in thischapter.Oneof theabsolutebest thingsyoucandoforyour tradingis toforward-testyourstrategy.YoucandothiswithanEA,otherrobot,manualsystem,whatever.

Essentiallywhatyoudoistakeyourrobotoryourtradingplanandfollowittotheletter.Butinsteadoftakingoldinformationandback-testingyourstrategy,youaretakingreal-timedataandmakingtradesinrealtimebasedonthatreal-timeinformation.Youcanforward-testwitha liveaccountorademoaccount.Butwhendoingthissortof trading,youwant tobewatchingyourscreen;thatwayyoucanseewhatisreallyhappeningandhowyourtradesareopeningandclosing.Youwillbeabletoseesomeofthegamesthebrokersareplaying.Iliketoforward-testmyrootsandsystemsformonthsonend,maybeevenyears.ThatwaywhenIdomy research, I can seewhat the actual systemwasdoingwith the bids and asksof themarket,therealdataflowversusclosedtimeframesthataresomewhatstatic.

HOWTOBACK-TEST

Atfirstthiscantakesomeeffort,butassoonasyoudevelopacompletetemplate,itwillbeusefultoevaluateanystrategythereafter.

Yourtradingmethodmustbeclearlydefinedandhavespecificandnonsubjectiveentriesandexits,basedonsignalsgivenbyindicatorsorpriceactionpatterns.Youshouldnotusetoomanyindicators,asthosecouldbeconflictingandinterferewithdecisionmaking.Thenyou need to choose the currency pair to evaluate as well as the particular time frame,according to your personal trading style. For example, if you only trade a specificmarketsession,thoseshouldbethehoursuponwhichtoimplementtheback-test.

With thesedata,youcansetupa template inExcel toshowthecurrencypairyouareusing along with its entry and exit price. Between both prices you will also show themaximumprofitsmadeandmaximumlosses.Thisinformationwillbevitalforyouranalysis.Youcangroupallmaximumprofitsasaseriesofeventsfromwhichtoobtaintheaverageand

its standard deviation. This will offer some statistical certainty about the area of greaterconcentrationofthosemaximumvaluessothatlateronyoucandefineyourtake-profitlevel.For example, if 65 percent of the concentration of themaximumvalues of yourmethod isbetween70and90,youcouldchooseanyvalueofthatzoneforyourfuturetake-profit.

Youcanalsoincreaseordecreasethescopeofyourconcentrationofpipsandmakethecorrespondingadjustments.Thesameoccursinregardtothemaximumlosses,anditwouldhavetobereasonedasfollows:Howmanypipscanmymethodwithstandagainstmyoriginaldirection before closing or not closing a position and come back to be awinner (that is,discoveringwhichisthemoreaccuratestoploss).

Thekeyquestion is,howmanydatapointsshouldIevaluate?Ipersonally think thatarange between 200 and 400 trades (which would represent 3 to 5 months approximately,depending on your trading style) is theminimumneeded for a back-test in order to obtainefficientresults.Thisrequiresalotofeffort,ofcourse,butwillempoweryouwithastrategytestingmachinethatwillhelpyoufindthebestsystemforconsistentwinningsandnotjustforafewweeksorafewmonths.

Always remember that your take-profit level has to be greater than your stop loss. Ifyourmethodor typeof tradinggets35pipsonwinners and loses40pips,youare riskingyourcapital considerably.Othercasesareworse;winning5pipsand then losingup to20pipsissomethingabsolutelyillogical,andthesekindsofsystemsmustbediscarded.

Ihavetestedallsortsofstrategies,eventheonesthatclaimtobeaccurate99.9percentofthetime,andIhavefoundsomewherethatwasactuallythecase.Theproblemwiththesesortsofsystems is thatwhenyouactuallygo live ina realaccount,youdon’tget thesameresults. The first thing youwill notice is that some of the brokers have begun to play thegamesthatIhavetalkedaboutinthisbook.Andsoyourautomatedstrategycan’tmakeallthetradesitissupposedto.

Guesswhat? That changes the tested results; now you have new variables. You alsohavesomestrategiestoutedouttherethathavehugestoplosses,andsoifyouarewillingtotake a 300- to 400-pip stop loss, then youmay find some success. You better have a bigaccount,though,sothatyoucanabsorbtheintertradedrawdowns.

Otherstrategiestakethenegativerisk-to-rewardapproach;thiskindofstrategywillrisk100pipstoget10pips,anditwillmakeeightgoodtradesinarowandthenlosetwotradesin a row. Now you are upside down. You can’t beat good money management. That isparamount.Somakesureyouaretestingthatinyoursystemasyouback-test.Summarizing,wewouldhavefourbasicstepstoconstructasoundback-testingstrategy:

1. Obtain the appropriate and most complete historical market data for the currency pairundertest.

2.Decideupontheindicatororsetofindicatorsyouwillbeusingasentryandexitsignals.3.Buildyourtradingrules.4.Optimizeyourstrategybymodifyingtheappropriateparametersagainstthetradingrules,suchastotalbalance,marginlevel,maximumdrawdown,maximumprofit,andconsecutivelosingorwinningtrades,aswellasdifferentleveragesandspreads.

FOREXSIMULATORS

Learning, developing, and refining your own trading strategy requires a great amount ofpractice,repetition,andoptimization.Aforexsimulatorisspecializedsoftwarethathasbeendesigned to reproduce the conditionsof themarkets in real time, allowingyou to simulateforextrading.Itisaveryusefultoolfortrainingandimprovingyourtradingskills,andsoyoucan build up confidence in a particular method and compare several different strategieswithouthavingtoriskanyrealmoney.

Withsucha tool,youareable touploadandreviewhistoricaldataatanygiven time,goingbackwardandforwardasmanytimesasyouneed.Thiswillallowyoutoperformacontinuoustrainingonyourunderstandingofthebehaviorofaparticularcurrencypair,withitschartpatterns,priceaction,andsignals,overandoveruntilyoucanfeelconfidentaboutyourcomprehensionandoftheprobableresultsofyourmethods.

Sometradersseemtothinkthatitisbettertojumpdirectlyintothemarketswithademoaccounttoperformaliveforward-test.However,theuseofaforexsimulatorallowsyoutocovermonthsofdatainjustafewdays,limitingyourworktoaspecificmarketsessionandtestinseveraldifferenttimeframes.Besides,ifyouwanttotestatradingstrategyonademo,you firstneed toknowexactlywhatyouaredoing, and the trainingconfidenceandmarketknowledgethatyouwillacquirethroughtheuseofthesimulationsispriceless.

Several independent and specific tester software programs are available, as well astradingplatformsthatincludestrategytestingoptions,andyoucanalsofindtestingplug-insthatwillallowyoutoimplementthetestingonyourplatformofchoice.Someofthemarefreeofcharge;othershave tobepurchasedonceor requirea subscription. Ifyourown tradingplatformallowsyoutogobackintimeandmovethechartforwardonecandleatatime,youcan also perform manual back-testing, although this alternative will be slower. Forexsimulatorsallowyoutosetupamuchfasterpacetothesequenceofmarkettickdataandtofast-forwardtoprecisepoints in time,andsoyoucanjustemploythe timeyoureallyneedandcanworkonwiderranges,evenovermanyyears.

Simulators canalsobeused toback-test automated strategies.Youwill need tobuildyourrulescompletelyintheautomatedmodule,andtheresultswillbedeterminedbasedonthe historical data and your parameters over the time range selected, with no furtherintervention on your part during the test. This is the fastest way to obtain an accurateevaluationifyourowntradingmethodissuitabletobeautomated.

BenefitsofBack-TestingversusForward-Testing

•Time-saving.Youcanevaluateyearsofdatainjustafewdays,whichallowsyoutocorrectanyparametersandretestoverthesamedata.

•Statisticallymoreaccurate.Onademoaccount,anymistakeyoumakewillstayrecordedandwillmessupthestatisticsofyourstrategy,whilethesimulatorallowsyoutogobackandstartover,correctingthemistake.Also,let’ssaythatyourmethodrequiresyoutoopenatradeeverydayatmarketcloseandyouhappentomissoneormoredaysonthedemoaccount;yourstatisticalresultswillbeflawed.

•Notime limitation.You canperform the testing evenwhen themarkets are closedor onweekends, and you can pause whenever you need to and continue later. With a forexsimulator,youcontrolthetime.

AVOIDINGBACK-TESTINGMISTAKES

Oneofthemostcommonerrorsofback-testingastrategyistouseapproximatedinformationinplaceofinformationnotyetavailableatthemomentofthedecision-makingprocess.Forexample, some software programswill give you closing data in anticipation. If your ownmethodincludesclosingprices,youcannotopenthetradeuntilthecandleorbarofthetimeframeyouareusinghaseffectivelyclosed.

To avoid this, you need to make sure that you are only using the exact informationavailableatagivenpoint,especiallyifyouareemployinganautomatedalternative.Thisisusuallydonebychosingatick-by-tickoptionforthechartpriceevolution.Onmanualback-testingitiseasiertocheck.

Anothermistake that often comesup is the useof toomanyvariables for the test, forexample,toomanyindicators.Thiscanworkwellforawhileonpasttimeperiods,butitcanbecomeaproblemwhenthestrategyisappliedtofutureevents.Keepyourstrategysimple.Finally, your trading strategy should be able to stand powerfully against any unforeseen

events,when themarkets react toparticular fundamentals andbehaveerratically.Howcanyouprotectyourselfandstillgetpositiveresultsoutoftheback-testing?Byanticipatingtheeventualityofthoseeventsandthesubsequentdrasticmarketreactions:

• Increase the loss expectations in regard to the results given by the back-test, and checkwhetherthestrategywillstillbeprofitableunderthosenewconditions.

•Increasetheexpectedrisklevelpertradebasedonyourmaximumrisklevelallowed.Atacertainpoint,youmightfaceanunforeseeneventandthelossescouldbegreater.

• Set an appropriate maximum risk level and maximum drawdown that you are able totolerate. Make sure you plan for drawdowns according to the maximum historicaldrawdownsthatyourmethodcanexperienceoveranextensiveperiodoftime.Increasetheexpectedpercentageforeventualworsedrawdownsinthefuture.Thestrongertradingstrategieswillbeprofitableundervariousmarketconditions.There

arealsostrategiesthataredifficulttoback-test,especiallythosethatrelyontrendlinesandsometechnicalpatternsthatcannotbeadequatelyquantified.Finally,youhavetoacceptthattherewillbetimesinrealmarketconditionswhereyourstrategywillnotfunctionaswellasexpectedbecauseoftheirrationalityofthemarketsorunpredictabilityofcertainfundamentalevents.

METATRADERBACK-TESTING

Asdiscussedinthepreviouschapter,IhaveusedMetaTraderextensivelywhiletestingEAsandautomatedstrategies.HereIwanttodiscussafewkeythingsthatIhavewitnessedinmyback-testingusingthissoftwareplatform.

Ihavenoticedthatifyoudoanextensiveamountofback-testingusingMetaTrader,yourcomputerwilleventuallygetslower.WhatyouneedtodoisperiodicallycloseMetaTraderandthenjustreopenit.Iamnocomputerguy,butIhavewitnessedthattheback-testingwillgiveyoudifferentresultsonthesameparameterscansthemoreyouruntheback-test.OneofmyITguystoldmethattheMetaTraderplatformhassomesortofmemoryleak.Closingand

restartingtheprogramwillsolvetheproblem,sojustkeepthatinmindwhenyouareback-testingalotofstrategies.

I have read a lot of chat room posts and message boards debating the MetaTraderstrategytester.Therearelotsofprosandconsabouthowitworks,andasImentioned,therearesomeinherentproblems.ButifyouwanttorunthroughsomedifferentparametersofanEA,itisaprettygoodwaytoisolatewhatisgoingon.

Onethingtobeawareof is that thesystemisfaultyin that itsometimesdoesn’tplacetrades.ThestrategytesterwilltestyourEA,butsomeofyourtradesinaliveaccountwon’tbetakenbecauseoftheerrormessageyougetfromthebroker,suchasinvalidpriceandtradecontentbusy.Sothatskewsyourresultsabit.

MetaTraderHistoryCenter

MakesurethatwhenyouareusingMetaTrader’sstrategytester,youareusingthebestdatapossible;todothis,youwillneedtomaximizetheefficiencytogetthebestresult.Ifyouaregoing to use every tick, then youwillwant to do the following tomake sure that you aregetting themostcompleteandaccuratedataavailable.Whenyou runyour testandyouseemismatcheddataerrorsoflessthan89percentmodeling-qualitydata,thenyouneedtoadjustyourhistoricaldata.

Toadjustyourhistoricaldata,gotothetoolsmenu,openthehistorycenter,anddouble-clickthechartpairintheleftcolumnthatyouplantoback-test.Thenextthingyouwillseeisa listofdifferent timeframes.Thetimeframethatyoushouldstartwithis theM1,orone-minutetimeframe.TheM1isthetickdata,andsothiswillgiveyouthemostcompletedatato use during your back-test. If you download the latest data when you first turn on yourcomputer,youwillhavebettermodeling-qualitydata.

Thebestwaytogetthemostaccurateandcompletedatatoback-testistoturnonyourMetaTradersoftwareandleaveitrunningaslongasyoucan.Thisbringsinrealdatainrealtime. If you can find a broker thatwill give you a nonexpiring demo, then you are in themoney,sotospeak.Youcanthenleavethedemoaccountopeninrealtimeforaslongasyouwant.Whathappensisthatyourdemoendsupcollectingmonthsofreal-timedata,allowingyoutohaveamuchbetterback-testresult.

BACK-TESTINGLOG

Whenback-testing,Ihavealwayskeptalog.Ontheotherhand,ratherthankeepingalog,ifyou are usingMetaTrader or some of the other software platforms out there, they have anoptimizerthatcanhelpyoufindthebestconfigurationofyourstrategy.Forme,Iliketokeepalog.

I take whatever strategy I am working on and start back-testing each variable. It isimportant to be specific and make sure you write the results in your log. Start with thecurrencypairandthenworkdownfromthere.Tryall thedifferenttimeframesandthenallthedifferentmarketconditions. IfyouareusinganEA, try thedifferentoffsetsavailable. Ilikeusingoffsetsbecausetheywillhelpyouthrowthebrokeroffyourtrail.

Themoneymanagementparametersarebigparameters thatyouneedto test.Testeach

oneseparately:stoploss,takeprofits,etc.Back-testingisanimportantpartof the tradingprocess;spendtheappropriate timeon

thisstageofyourtradingprocesstohelpyoumaximizeyourtradingprofitpotential.

CHAPTER28EADEMOVERSUSLIVE

ForsomeonewhohastestedEAs,Icantellyouthereisalottoknow,anditrequireslotsofpatience.WehavediscussedEAsinpreviouschapters.HereIjustwanttocoversomeofthethoughtprocessesbehindusingtheEAsinademosituationversusalivesituation.

EAs will trade very differently on a live account versus a demo account, and thesedifferencesarewhatIwanttotalkabout.Brokersarenotallcreatedequal.ThefirstthingyouaregoingtowanttodobeforeyoustartusingyourEAonademoorliveaccountis toaskyourbrokerwhoprovidestheMetaTradersoftwareituses.

Somecompaniesarenotashonestasothers.IwillleavethatuptoyourGooglesearchesif youwant to knowmore specifics about which brokers to avoid. However,most of thebrokerstodayaregoingtosaytheyusesomesortofSTPmodelorprocessingmodel.

Thebrokerswill say that theysend theorderdirectly to their liquidityprovider.Thismaybe thecase,but thebrokersaregoing toplaywith the tradebeforesending it through.TheMetaTraderplug-insallowthebrokerstoquicklyskimafewpipsofftheorderexecutionandmanipulatethetradetoputmoremoneyintheirpockets.

Itseemseventhegoodbrokersplaywiththeorderssome.Forexample,IwastradingonMetaTraderwithmybroker,whichIfeelisoneofthebetterones.Ijusthadfourshorttradeson the EUR/USD, and theywere all upwith a gain. Iwanted to close them out, and so Imanuallyclosedouteachofthefourorders.AndeveryoneoftheordersIclosedhada1-pipslippageonit.TheorderswereinitiallyplacedbyanEA,andImanuallyclosedtheordersinaslow-movingmarket.Iguessthemarketwasn’tslowenough.

Thepointis,payattentiontoyourordersandyouwillseewhatthebrokersaredoing;even the best brokers are still playing games. So when you are using an EA on a demoaccount,youwillnoticethattheresultsyougetfromforward-testingdon’texactlymatchtheresultsyougetfromtradinglive.

Aforward-testissimplyrunningtheEAinthemarketplaceinrealtime.IfyouareusingademoaccountandyouturnyourEAon,itwilltakeintoaccountslippageandspreadswhilemakingitstradingdeterminations.Ifyouareback-testingwithpastdata,theEAwillnotbeable to take into account accurately the slippage on each trade and the spreads beingmanipulatedbythebroker.

OneofthethingsyouwillseewhentradinganEAliveisthatsometimesitwon’tplaceanytrades.Ifyougoinandlookatthejournal,youwillseealltheerrormessagesthatcomeupwhentheEAis tryingtoplacea trade.Theerrorsare theoff-pricequotes,serverbuys,spreadtoowide,etc.

WhenyouaretestingyourEAinademoaccount,yourEAwillmorethanlikelyplacealotmoretradesandwillnothaveall theerrorsthat itgetswhenrunningonaliveaccount.Thedemoaccountmost likelywon’thave themiddleware running theplugins.Without theplug-insturnedon,thegamesaren’tbeingplayed.

OPENADEMOACCOUNT

It is best to open up a new demo and start with a good round number—say, $10,000–$100,000ifyouhavetheabilitytochoose—thatwayyoucantryanduseanumberthatwillbe a little closer towhat you are going to actually trade.When you are using your demoaccount with your EA, you can work on your money management; you can set yourappropriatedrawdowns.Thisisoneofthemostcriticalthingsthatyouwillneedtowatch.HowmuchwillyourEAtradeatonetime?Youdon’twantyourEAtoplaceatradeandthen,on some aggressive setting, place another trade, doubling your position and doubling yourexposure. Ifyouhaven’t taken intoconsiderationwhat thedoubleexposurewilldo toyouraccountandyoutakealoss,itcouldgetprettybadveryquickly.

OPENALIVEACCOUNT

WheneverImovefromademoinvestmentintoaliveenvironment,IliketodialmyEAdownandplacesomesmalllotsizestobegin.ThatwayIcanbasicallystartmytestingoveragainwithlimiteddrawdownandexposure.OverthenextfewdaysIwillbelookingtoseewhatmyEAisdoing,andIwillwanttocomparemytradelogswiththoseofthesameEAtradingonademoaccount.IfIdon’tseemanydifferencesandIhaveahandfuloftradestocompare,IwillturnupthevolumeonmyEAandletitgo.

IfIstartseeingsomeprettybiginconsistencies,Iwillstoptradingliveandgobacktothedemoaccounttodosomemoreforward-testing.AperfectexampleisanEAIhavebeentestingforaboutthreemonthsonademoaccount.Iwasforward-testingtheresults,andsoIwaslettingtheEAtradeinrealtimeonademoaccount.ThatwayIcouldseeexactlyhowtheEAwasplacingitstradesandmanagingrisk.

Let’stakethenextstep;justtheotherdayIplacedtheEAonaliveaccount,andthefirstthingInoticedwasthattheEAwasplacingmoretrades,almostdoublethatofwhenIhaditonademoaccount.ThesecondthingInoticedwasthatIwashavingswaprateschargedtomyaccountforholdingthepositionspastrollover.ThiswasdifferentfromwhatIhadbeenseeingwhenmyEAwastradingonademoaccount.

Thiscausedmetostart lookingintoallthetradesthathadbeenplacedusingthesamesoftwaresystem.AsImentionedearlier,whenImoveanEAfromthedemosidetothelivetradingaccountside,IdialtheEAdownsothatIhavelimitedrisk.InthiscaseIdidjustthat,and somy riskwas limited, and that allowedme to seewhatmyEAwas doing in a liveaccountwithrealmoney.

IstilllikedtheresultsIwasgetting;infact,Iwasprettyhappy.However,IhadtomakesomeadjustmentstomymoneymanagementplanthatIhadworkedonwhilemyEAwasindemomode,sinceIwasgettingalmosttwiceasmanytradesnow.Ididn’twanttohavetwiceas many trades open and then go against me and basically double the drawdown I wasexpecting.

Iwas also able to talk to the broker and solve the overnight swap issue. Therewasactuallyanerror inhow theMetaTraderproviderwaspassingon the swaps tomybroker.Regardless,Iwasbeingchargedincorrectly.Canyouimaginehowmanyotherpeopletradingarebeingchargedincorrectly?Yikes!isallIcansay.

Bediligentinyourtrading.Makesurethatyouarewatchingallyourtradesoratleastreviewingthemall.ItneverhurtstositandwatchyourEAwhenitisopeningandclosingitstrades.Ifyoureallywanttomakesurethatyourbrokerdoesn’thaveyouontheplug-ins,thenext timeyourEAplaces a few trades,manually close the trades.Make sure topay closeattentiontothepricewhenclosing;andifpossible,closethetradeduringsomeslowmarketconditionssothatthebrokercannotsaythatthemarketwasmovingfastandthatslippageisexpectedduring fast-movingmarkets.Asyouareclosingyour trades, lookat thepriceandthenseewhatthepriceisafterthetradehasclosed.

YouwillalsowanttowatchtoseehowlongittakesthetradetocloseonceyouclickontheCLOSETRADEbutton.Ifthetradetakesmorethanafewseconds(lessthan5),thenthereis a problem, and you will want to investigate more. One of the settings within theMetaTraderplug-insisserverdelay,ortradeexecutiondelay.Youcansetitfor5seconds,10seconds,etc.So ifyouareclosingyour tradesand theyseemtobe laggingabout thesameamountoftime,youhaveaproblemandneedtodiscussitwithyourbroker.

Don’t expect the people at your broker’s to be veryup frontwhenyou confront themaboutthegamesgoingon.Youmayhavetojustplanonchangingbrokers.IkeepanupdatedlistofbrokersthatIuseonwww.jdfn.com.Andasurveyisalwaysrunningonthesitesothatyoucanseewhatothertradersarerecommendingandwheretheyaretrading.

Iamalwaystestingbrokerswithrealmoneyandhavemovedmanytimes,andIknowIwillprobablymoveagainat somepoint, at leastuntil I setupmyownsystem that Iknowdoesn’tplaygames.Butfornow,Iwilljustpaycloseattentiontomytrades.

CONCLUSION

Nowyouhave justabout finished thebook. Ithas takenmemore than10years togain theknowledgethatIhavewrittenaboutinthisbookrelatedtowhatIhavefoundgoingonintheretailforexindustrybehindthescenes.WhenIfirstbegan,Ihadnoideawhattheretailforexbrokersweredoingtotheircustomers.I,likemanyofyou,havebeentakenadvantageofbysome of the unscrupulous brokers out there. I have lost large amounts ofmoney in singletradesspecificallybecauseof the tacticsweare talkingabouthere.But thatdidn’tstopmefromtrading,andeachtimeIlearnedalittlemoreandlearnedhowtobetterprotectmyself.Unfortunately I am sure this won’t be the last time I losemoney on a trade because of abroker.UntilIstartafirmmyself,Iwillalwayshavebrokerissues.Quitefrankly,evenifIhadmyownfirm,Iwouldhaveproblemswithmyliquiditybrokers.Butthatistrading,andIchoosetotrade.

Inthebeginningwhensomethinglookedstrangeinmyaccount—say,aslowexecutionorthe price slipping—I just didn’t know any better. It took the 10-plus years to piece it alltogether.Overthelast12monthsiswhenthelightbulbstartedtogooff.Thatledmetomyownpersonalinvestigationsandopenedmyeyestowhatwasreallygoingon.Ihavetriedtosharemanyofmydiscoverieswithyou,aswellassomeofthestrategiesthatIusetotradethismarkettoday.

Ilovetheforexmarket;itistheonlymarketthatIreallytradeactively.Itisthelargestfinancialmarketintheworldandwillonlygrow.Wehaveseentremendousgrowthoverthelast few years; I remember when I first started in early 2000 when daily turnover wasreportedat$1.9trillionaday.Todaythedailyturnoverisreportedtobeabout$3.9trillion.ThegrowthhasbeenstaggeringandwhatismoreamazingistheU.S.growthinretailforextrading.WhenIfirststarted,notahandintheroomwouldgoupwhenIwouldaskwhowastrading the forex.Nowyou can hearmention of the forex just about anywhere you go; thetopic certainly controls theTV financialnews shows today.Andwhynot?Currency is thedriving forcebehind theworld’seconomies,whicharenowmore interconnected thaneverbefore.

Therearesome25millionequitiestradersintheUnitedStatestodayandonlyabout2million forex traders. This will change as time goes on. A shift will begin to happen, asequitiesbrokersbegintoofferretailforextotheircustomersandasretailforexbrokersbeginto offer equities to their customers. In the end, there is a lot more upside to customeracquisitionandaccountgrowth in theforex than in theequitiesmarkets.Brokersknowthisandwillbelookingtocashinonthegrowth.Thegrowthwillbegoodforallofus,asitwillbringmoreregulationsandoversight.I’mnotsureifall thosechangeswillbegoodornot,butitwillmakeamuchfairermarketplaceforusall.

Don’tletwhatyouhavereadclosethedooronyourideasofbeingaforeigncurrencytrader. You are better off now that you knowwhat is going on than youwere before youstartedreadingthisbook.Justkeepinmindthattherearebrokerstryingtotakeyourmoney,sotradeaccordingly.Thismarketwillstillgiveuphugeprofitstothetraderswhoareusingtherighttoolsandhavetherighttraining—thetraderswhohavetherightmindsetandgreatmoneymanagementwillprevail.

Makesurethatyoutradesmart,andifyoufindyourselfthevictimofbrokerfoulplay,pickupthephoneandconfrontthatbroker.Putthebrokeronthespotanddon’tgiveupuntilyougetyourmoneyback.Ifyouseeapatterninthewayyourtradesareexecutedandyouarelosingmoney,thenchangebrokers.

Asyou finish thisbook,keep it handy so thatwhenyou recognize someof thegameshappening in your own trading, you can refer back to the book. Also remember to checkwww.jdfn.com on a regular basis for up-to-date information on various topics that I havewrittenaboutinthebookandwillbeupdatingonmyWebsite.Also,ifyoufindnewinsidertacticsthatarenotaddressedinthisbook,pleasegototheWebsiteandpostyourfindingsforalltoread.

GLOSSARY

AppreciationTheincreaseinthevalueofanasset.Arbitrage A technique that lets traders profit from differences in the price of a singlecurrencypairthatistradedonmorethanonemarket.

AskThepriceatwhichacurrencypairorsecurity isofferedforsale.Thequotedpriceatwhichaninvestorcanbuyacurrencypair.Alsoknownastheoffer,askprice,andaskrate.

AssetAnitemhavingcommercialorexchangevalue.Back-testing The process of testing a trading strategy on prior time periods. Instead ofapplyingastrategyforthetimeperiodforward,whichcouldtakeyears,atradercandoasimulation of his or her trading strategy on relevant past data in order to gauge thestrategy’s effectiveness.Most technical analysis strategies are testedwith this approach.Whenyouback-testatheory,theresultsachievedarehighlydependentonthemovementsofthetestedperiod.Back-testingatheoryassumesthatwhathappensinthepastwillhappeninthefuture,andthisassumptioncancausepotentialrisksforthestrategy.

Bankrate The percentage rate atwhich the central bank of a country lendsmoney to thecountry’scommercialbanks.

Base currency The first currency in a currency pair. The base currency is the currencyagainstwhichexchangeratesaregenerallyquotedinagivencountry.Examples:USD/JPY—theU.S.dollaristhebasecurrency;EUR/USD—theeuroisthebasecurrency.Seealsoquotecurrency.

BearmarketAnextendedperiodofgeneralpricedeclineinanindividualsecurity,anasset,oramarket.

BidTheprice atwhichan investor canplace anorder tobuya currencypair.Thequotedpriceatwhichaninvestorcansellacurrencypair.Alsoknownasthebidpriceandbidrate.

Bid/askspreadThepointdifferencebetweenthebidandoffer(ask)price.BinaryoptionAtypeofoptioninwhichthepayoffisstructuredtobeeitherafixedamountofcompensationiftheoptionexpiresin-the-moneyornothingatalliftheoptionexpiresout-of-the-money.Thesetypesofoptionsaredifferentfromplainvanillaoptions.Alsoknownasall-or-nothingoptionsordigitaloptions.

Bookofbusiness(BB)CommonparlanceintheU.S.financialservicessector.Itreferstothecollectionofclientsthatabrokerhasassembled.Itisoftenusedtorefertothevaluationofsuchclientfollowing.

BrettonWoods The site of the conference that in 1944 led to the establishment of thepostwarforeignexchangesystemthatremainedintactuntiltheearly1970s.TheconferenceresultedintheformationoftheIMF.Thesystemfixedcurrenciesinafixedexchangeratesystemwith1percentfluctuationsofthecurrencytogoldorthedollar.

BrokerAnagentthatexecutesorderstobuyandsellcurrenciesandrelatedinstrumentseitherfor a commission or on a spread. Brokers are agents working on commission and notprincipalsoragentsactingontheirownaccount.Intheforexmarket,brokerstendtoactasintermediariesbetweenbanks,bringingbuyersandsellerstogetherforacommissionpaidby the initiatororbybothparties.Thereare fouror fivemajorglobalbrokersoperating

throughsubsidiaries,affiliates,andpartnersinmanycountries.BullmarketAmarketthatisonaconsistentupwardtrend.BuylimitorderAnordertoexecuteatransactionataspecifiedprice(thelimit)orlower.BuyonmarginTheprocessofbuyingacurrencypairwhereaclientpayscashforpartoftheoverallvalueof theposition.Thewordmargin refers to theportion the investorputsupratherthantheportionthatisborrowed.

CableForextrader’sslangwordthatdesignatestheBritishpound–U.S.dollarexchangerate,GBP/USD.

CandlestickchartAchart thatdisplays thedaily tradingprice range(open,high, low,andclose).A formof Japanese charting that hasbecomepopular in theWest.Anarrow line(shadow)showstheday’spricerange.Awiderbodymarkstheareabetweentheopenandtheclose.Ifthecloseisabovetheopen,thebodyiswhite(notfilled);ifthecloseisbelowtheopen,thebodyisblack(filled).

CarryTheincomeorcostassociatedwithkeepingaforexpositionovernight.Thisisderivedwhenthecurrencypairsinthepositionhavedifferentinterestratesforthesameperiodoftime.Alsoknownasinterestratecarry.

Carrytrade In forex, the practice of holding a positionwith a positive overnight interestreturninthehopeofgainingprofits,withoutclosingtheposition,justforthecentralbank’sinterestratesdifference.

CentralbankAbank,administeredbyanationalgovernment,whichregulatesthebehavioroffinancialinstitutionswithinitsbordersandcarriesoutmonetarypolicy.

Chartist A person who attempts to predict prices by analyzing past price movements asrecordedonachart.

ClosingapositionSellingorbuyingaforexpositionresultingintheliquidation(squaringup)oftheposition.

ClosingmarketrateTherateatwhichapositioncanbeclosedbasedonthemarketpriceattheendoftheday.

CommissionThefeethatabrokermaychargeclientsfordealingontheirbehalf.ConfirmationWrittenacknowledgmentofatrade,listingimportantdetailssuchasthedate,thesizeofthetransaction,theprice,thecommission,andtheamountofmoneyinvolved.

ConsumerPriceIndex(CPI).Thestatisticalmeasureofinflationbaseduponchangesinthepricesofaspecifiedsetofgoods.

Contractfordifference(CFD).Specialtradinginstrumentthatallowsfinancialspeculationon stocks, commodities, and other instruments without actually buying. An arrangementmade in a futures contract whereby differences in settlement are made through cashpayments,ratherthanthedeliveryofphysicalgoodsorsecurities.

CorrespondentbankAforeignbank’srepresentativethatregularlyperformsservicesforabankthathasnobranchintherelevantcenter,e.g.,tofacilitatethetransferoffunds.IntheUnitedStatesthisoftenoccursdomesticallyduetointerstatebankingrestrictions.

CounterpartAparticipantinafinancialtransaction.Cover(1)Totakeoutaforwardforexcontract.(2)Tocloseoutashortpositionbybuyingcurrencyorsecuritiesthathavebeensold.

CrossrateTheexchangeratebetweentwocurrencieswhereneitherofthecurrenciesistheUSD.

CurrencyMoneyissuedbyagovernment—thisincludescoinsandpapermoney.Itisaformofmoneyusedasaunitofexchangewithinacountry.

CurrencypairThetwocurrenciesinaforextransaction.TheEUR/USDisanexampleofacurrencypair.

DayorderAbuyorsellorderthatwillexpireautomaticallyattheendofthetradingdayonwhichitisentered.

DaytradeAtradeopenedandclosedonthesametradingday.DaytraderAtraderwhobuysandsellsonthebasisofsmallshort-termpricemovements.DaytradingAstyleor typeof tradingwheretradepositionsareopenedandclosedduringthesameday.

Dealer An individual or firm that buys and sells assets from its portfolio, acting as aprincipalorcounterparttoatransaction.

Dealer plug-ins Devices used to intentionally delay traders’ orders, in order to induceslippage.Iftheslippageisinthecustomer’sfavor,thecustomer’sorderisexecutedattherequestedpriceinsteadofthebetterprice,allowingthebrokertokeepthesavings.Iftheslippageisnotinthecustomer’sfavor,thedifferenceispassedontothecustomerandthecustomerloses.

DealingdeskAdeskwhere transactions for buying and selling securities occur.Since theforexmarket is open around the clock, many institutions have dealing desks around theworld.Dealingdesks can also be foundoutside the forexmarkets, such as in banks andfinance companies, to execute trades in securities. The term desk may be a bit of amisnomer,given its connotationofa table sharedbyacoupleof traders.Large financialinstitutionsoftenhavedealingfacilitiesthatarestaffedbyhundredsofdealers.Inalargeinstitution,major currencies, such as the euro and yen,may have several dealing desksstaffedbydozensoftraderswhospecializeinthesecurrencies.

Demo account A trading account that allows investors to practice their trading withimaginarymoney.Ademoaccounttradessimilarlytoaliveaccountbyallowingexecutionoforders,moneymanagement,andstrategytestinginasaferatmospherethanaliveaccountcanoffersinceanylossessustainedarenot“real”inthedemoaccountenvironment.

DepreciationAfallinthevalueofacurrencyduetomarketforces.DeskTermreferringtoagroupdealingwithaspecificcurrencyorcurrencies.DevaluationTheactbyagovernmenttoreducetheexternalvalueofitscurrency.Digital option An option whose payout is fixed after the underlying stock exceeds thepredeterminedthresholdorstrikeprice.Thevalueofthepayoutisdeterminedattheonsetofthecontractanddoesn’tdependonthemagnitudebywhichthepriceof theunderlyingmoves.Sowhetheryouarein-the-moneyby$1or$5,theamountthatyoureceivewillbethesame.Alsoreferredtoasabinaryorall-or-nothingoption.

DiscretionaryaccountAnaccountinwhichthecustomerpermitsatradinginstitutiontoactonthecustomer’sbehalfinbuyingandsellingcurrencypairs.Theinstitutionhasdiscretionaboutthechoiceofcurrencypairs,prices,andtiming,subjecttoanylimitationsspecifiedintheagreement.

ECBSeeEuropeanCentralBank.ECNbrokerA typeof forexbrokeragefirmthatprovides itsclientsdirectaccess tootherforexmarketparticipants.ECNbrokersdon’tdiscouragescalping,don’t tradeagainst theclient,don’tchargespread(lowspreadisdefinedbycurrentmarketprices),butdochargecommissionsforeveryorder.

EconomicreleaseAscheduledannouncement related toaparticular fundamental indicator,whichincludesthedataofthepreviousreleaseandtheforecastvalue.Atthemomentofthe

release,revisionscanbemadetothepreviousreleasevalues,andthesewillbecometheactualrelease.Alsocalledaneconomicnewsrelease.

Euro The single currency of the European Economic and Monetary Union introduced inJanuary1999.Thisistheamalgamationofthefollowingcurrencies;afterJanuary1,2002,these currencies have been considered legacy currencies:Germandeutschemark, Italianlira, Austrian schilling, French franc, Belgian franc, Dutch guilder, Finnish markka,Portugueseescudo,Greekdrachma,Irishpunt,Luxembourgfranc,andSpanishpeseta.

EuropeanCentralBank(ECB)ThecentralbankforthenewEuropeanMonetaryUnion.ItisthemainregulatorybodyoftheEuropeanUnionfinancialsystem.

ExecutionTheprocessofcompletinganorderordeal.ExoticoptionsAnoptionthatdiffersfromcommonAmericanorEuropeanoptionsintermsof theunderlyingassetor thecalculationofhoworwhen the investor receivesacertainpayoff.Theseoptionsaremorecomplex thanoptions that tradeonanexchange,and theygenerallytradeOTC.Forexample,onetypeofexoticoptionisknownasachooseroption.Thisinstrumentallowsaninvestortochoosewhethertheoptionisaputorcallatacertainpoint during the option’s life. Because this type of option can change over the holdingperiod,itisnotbefoundonaregularexchange,whichiswhyitisclassifiedasanexoticoption.Othertypesofexoticoptionsincludebarrieroptions,Asianoptions,digitaloptions,andcompoundoptions,amongothers.

Expert advisor (EA) A plug-in tool used with trading platforms like MetaTrader 4 thatallowsforautomatedtradesbasedonparameterssetbythedeveloperoftheEAprogram.Theseprogramsintegrateintothetradingplatform,allowingautomationoforderentryandexecution.

FapTurbo An automated forex trading robot. It offers short-term scalping strategies thatmonitorfivecurrencypairs:EUR/CHF,GBP/CHF,EUR/GBP,USD/CAD,andEUR/USD.Thesoftwareautomaticallyentersandexitstradesbasedonpredeterminedparameters.

FastmarketRapidmovementinamarketcausedbystronginterestbybuyersandsellers.Insuchcircumstances,pricelevelsmaybeomittedandbidandofferquotationsmayoccurtoorapidlytobefullyreported.

Federal Deposit Insurance Corporation (FDIC) The regulatory agency responsible foradministeringbankdepositoryinsuranceintheUnitedStates.

FederalOpenMarketCommittee(FOMC)ThecommitteethatsetsmoneysupplytargetsintheUnitedStateswhichtendtobeimplementedthroughFedFundinterestrates,etc.

FederalReserveSystemThecentralbankingsystemintheUnitedStates.ThisisthemainregulatorybodyoftheU.S.financialsystem;itsdivision,theFOMC,regulates, amongother things, federal interest rates.Alsoknownas theFederal ReserveandtheFed.

Fibonacci retracements The levels with a high probability of trend break or bounce,calculatedatthe23.6percent,32.8percent,50percent,and61.8percentlevelsofthetrendrange.

FillTheprocessofcompletingacustomer’sordertobuyorsellacurrencypair.FillpriceThepriceatwhichabuyorsellorderisexecuted.FinancialriskTheriskthatafirmwillbeunabletomeetitsfinancialobligations.Flat(square)Termdescribinga tradingbookwithnomarketexposure.Aneutralstate thatoccurswhenallyourpositionsareclosed.

ForeignexchangeThepurchaseorsaleofacurrencyagainstthesaleorpurchaseofanother.

AlsoknownasforexandFX.ForexTermcommonlyusedwhenreferringtotheforexmarket.Forex clubs Groups formed in the major financial centers to encourage educational andsocialcontactsbetweenforexdealers.

Forex simulator Unlike a live forex demo account that functions in real time, a forexsimulatorenablesusers toupload,view,and reviewhistoricaldataatanygiven time.Aforex simulator isused toconfirma trader’sunderstandingof tradingpattern recognitionand trading signals. It allows traders topractice strategies through repetitionwithout theneedtobeinthemarketatthetimethemovementstakeplace.

ForwardAtransactionthatsettlesatafuturedate.Forward-testingTheprocessinwhichyoutakeasmallsetofdata,analyzealltheattributes,andgeneratetheoptimizedsetofattributes.Thisoptimizedsetofvaluesisappliedtoasetofunanalyzeddata.Everynewresultgeneratedplaysitspart ingeneratingthenextresultand participates until the final result is generated. Forward-testing is a calculator forforecastingfutureperformance.

FundamentalanalysisAnalysisofeconomicandpoliticalinformationwiththeobjectiveofdeterminingfuturemovementsinafinancialmarket.

FXSeeforeignexchange.Good-till-canceledorder(GTC)Abuyorsellorder that remainsopenuntil it is filledorcanceled.

HedgingAtypeoftransactionthatlimitsinvestmentriskwiththeuseofderivatives,suchasoptions and futures contracts. Hedging transactions purchase opposite positions in themarketinordertoensureacertainamountofgainorlossonatrade.Theyareemployedbyportfoliomanagers to reduceportfolio riskandvolatilityor lock inprofits.Hedge fundsusethissortoftransactionextensively.

InitialmarginThedepositacustomerneedstomakebeforebeingallocatedatradinglimit.InitialmarginrequirementTheminimumportionofanewsecuritypurchasethataninvestormustpayforincash.

InstantexecutionTheprocessofpassingmarketordersdirectly to the liquidityprovidersandexecutingtheorders instantlyat thecurrentmarketprice.Instantexecution isa termmostcommonlyusedwhendiscussingtheforexmarketandSTP.

InvalidquoteAnerrormessageusedbyMetaTrader4andmostoftenassociatedwithafast-movingmarketusingexpertadvisorsandmanualtrading.

KiwiAforexslangnamefortheNewZealandcurrency,theNewZealanddollar.LeverageTheuseofvariousfinancial instrumentsorborrowedcapital,suchasmargin, toincreasethepotentialreturnofaninvestmentortheamountofdebtusedtofinanceafirm’sassets.Afirmwithsignificantlymoredebtthanequityisconsideredtobehighlyleveraged.

LimitorderAnordertoexecuteatransactionataspecifiedprice(thelimit)orbetter.Alimitordertobuywouldbeatthelimitorlower,andalimitordertosellwouldbeatthelimitorhigher.

LiquidityAtermthatreferstotherelationshipbetweentransactionsizeandpricemovements.For example, amarket is liquid if large transactions can occurwith onlyminimal pricechanges.

LiveaccountAtradingaccountthatallowsinvestorstotrade“live”inthemarketwithrealmoneythroughaforexbrokeragefirm.

Long position In forex, when a currency pair is bought, it is understood that the primary

currencyinthepairislongandthatthesecondarycurrencyisshort.LotThe standard size of anorder or tradingposition.One lot is equal toUS$100,000oncurrencypairswheretheU.S.dollaristhebasecurrencyandisequaltoitsequivalentindollarswherethebasecurrencyisfromanothercountry.Theamountisusuallyexpressedinmultiplesof100.

Maintenance A set minimum margin that a customer must maintain in his or her marginaccount.

MarginTheamountofmoneyneededtomaintainaposition.Margin account An account that allows leverage buying on credit and borrowing oncurrenciesalreadyintheaccount.Buyingoncreditandborrowingaresubjecttostandardsestablishedbythefirmcarryingtheaccount.Interestischargedonanyborrowedfundsandonlyfortheperiodoftimethattheloanisoutstanding.

MargincallAcall foradditional funds inamarginaccounteitherbecause thevalueof theequity in the account has fallen below a requiredminimum (also termed amaintenancecall)orbecauseadditionalcurrencieshavebeenpurchased(orsoldshort).

MarketcloseThetimeofdaythatamarketcloses.Inthe24-hour-a-dayforexmarket,thereisnoofficialmarketclose.Often,5:00p.m.ESTisconsideredthemarketclosebecausevaluedatesforspottransactionschangetothenextnewvaluedateatthattime.

Marketmaker (MM) A person or firm that provides liquidity, making two-sided prices(bidsandoffers)inthemarket.

MarketorderAcustomerorderforimmediateexecutionatthebestpriceavailablewhentheorderreachesthemarketplace.

MarketrateThecurrentquoteofacurrencypair.MaturityThedateonwhichpaymentofafinancialobligationisdue.MegadroidA forex robot that attempts tomimic how successful traders trade.Megadroidusesa1-hourtimeframetotriggeritsentry.

MetaTrader A type of trading software used to help currency traders with forex tradinganalysisandtradeexecution.Metatraderprovideschartsandorder-takingmethods.

MomentumThetendencyofacurrencypairtocontinuemovementinasingledirection.OfferThepriceatwhichacurrencypairorsecurityisforsale;thequotedpriceatwhichaninvestorcanbuyacurrencypair.Alsoknownastheask,askprice,andaskrate.

Off-pricequotesQuotesthatoccurwhenorderlimitsaresettoacertainpriceandthepricehasalreadymovedtosomeothervalue.Forexample,youwanttobuyat1.3050,butbythetime the order arrives on themarket, the price is at 1.3060. The order is then rejectedbecausethereistoomuchdifferenceintheprice.

One-cancels-the-otherorder(OCO)Acombinationof twoorders inwhichtheexecutionofeitheroneautomaticallycancelstheother.

Open order A buy or sell order that remains in force until executed or canceled by thecustomer.

OpenpositionAnyposition(longorshort)thatissubjecttomarketfluctuationsandhasnotbeenclosedoutbyacorrespondingoppositetransaction.

OptionGreeksThemathematicalcharacteristicsoftheBlack-Scholesmodel,named,forthemost part, after the Greek letters used to represent them in equations. The five optionGreeksmeasure the sensitivity of the price of stock options in relation to four differentfactors:changesintheunderlyingstockprice,interestrate,volatility,andtimedecay.

OrderAcustomer’sinstructionstobuyorsellcurrencieswithacertainrate.

OverboughtSeeoverbought/oversoldindicator.Overbought/oversoldindicatorAtechnicalanalysistoolthatattemptstodefinewhenpriceshave moved too far and fast in either direction. This is usually calculated based on amoving average of the difference between the number of advancing anddeclining issuesoveracertainperiodoftime.Ifthemarketisconsideredoverbought,thetechnicalanalystwillsell;andifthemarketisconsideredoversold,heorshewillbuy.

OvernightpositionAtrader’slongorshortpositioninacurrencyattheendofatradingday.OversoldSeeoverbought/oversoldindicator.PipThesmallestincrementofchangeinaforeigncurrencyprice,eitherupordown.Thelastdigitintherate;forexample,forEUR/USD,1point=0.0001.

Pipette Fractional pip, 1/10 of a point. Additional decimal point quoted by some forexbrokers. It provides a greater accuracy of price movements. Examples: 1.27503 forEUR/USDor110.052forUSD/JPY.

PivotpointTheprimarysupportorresistancepointthatiscalculatedbasedonthepreviousperiod’shigh,low,andcloseprices.Itisusuallycalculatedondailyrates,butothertimeframescanalsobeused.

PointSeepip.PriceThepriceatwhichtheunderlyingcurrencycanbeboughtorsold.PricetransparencyTheabilityofallmarketparticipantsto“see”ordealatthesameprice.PrincipalvalueTheoriginalamountinvestedbytheclient.ProfitApositiveamountofmoneygainedforclosingtheposition.Alsoknownasagain.QuoteAsimultaneousbidandofferinacurrencypair.QuotecurrencyThesecondcurrencymentionedinacurrencypair.Thequotecurrencyistheonethatdeterminestheexchangerates.Examples:inthepairUSD/JPY,theJapaneseyenisthequotecurrency; in thepairEUR/USD, theU.S.dollar is thequotecurrency.Seealsobasecurrency.

RateThepriceatwhichacurrencycanbepurchasedorsoldagainstanothercurrency.RealizedprofitorlossThegainorlossforalreadyclosedpositions.ResistanceThepricelevelatwhichtechnicalanalystsnotepersistentsellingofacurrency.Thepricelevelforwhichtheintensivesellingcanleadtoanincreaseinprice(uptrend).

RevaluationThedailycalculationofpotentialprofitsorlossesonopenpositionsbasedonthe difference between the settlement price of the previous trading day and that of thecurrenttradingday.

Risk Inregard to theforex, therisk that theexchangerateonaforeigncurrencywillmoveagainstthepositionheldbyaninvestorsuchthatthevalueoftheinvestmentisreduced.

Riskmanagement The employment of financial analysis and use of trading techniques toreduceorcontrolexposuretofinancialrisk.

RolloverTheprocessofextendingthesettlementvaluedateonanopenpositionforwardtothenextvalidvaluedate.

Scalper A trader who trades for small, short-term profits during the course of a tradingsession,rarelycarryingapositionovernight.

Scalping A trading strategy that attempts to make many profits on small price changes.Traders who implement this strategy will place anywhere from 10 to several hundredtradesinasingledayinthebeliefthatsmallmovesinpricesareeasiertocatchthanlargeones.

Sell limit order An order to execute a transaction only at a specified price (the limit) or

higher.SellingshortAsituationwhereacurrencyhasbeensoldwiththeintentofbuyingbackthepositionatalowerpricetomakeaprofit.

Serverbusy Amessage related to trading forex using theMetaTrader 4 platform. This islimitedto themarketdemand.Asmore tradesareentered, theserverwillbeoverloadedandcausea“serverbusy”messagetoappearwhenatraderwantstobuyorsellacurrency.Asaresult,thetraderwillhavetoenterthetradeagain.

SettledpositionAclosedpositionforwhichallneededtransactionshavebeenmade.SettlementTheactualdeliveryofcurrenciesmadeonthematuritydateofatrade.Shortposition In forex,whenacurrencypair issold, theposition issaid tobeshort. It isunderstoodthattheprimarycurrencyinthepairisshortandthatthesecondarycurrencyislong.

Short squeeze The pressure on short sellers to cover their positions as a result of sharppriceincreases.

Slippage The difference between the expected price of a trade and the price atwhich thetrade actually executes. Slippage often occurs during periods of higher volatility, whenmarket orders are used and alsowhen large orders are executedwhen theremaynot beenough interest at the desired price level to maintain the expected price of the trade.Slippageisatermoftenusedinbothforexandstocktrading,andalthoughthedefinitionisthesameforboth,slippageoccursindifferentsituationsforeachofthesetypesoftrading.In forex, slippage occurs when a limit order or stop loss occurs at a worse rate thanoriginally set in the order. Slippage often occurs when volatility, perhaps due to newsevents,makes an order at a specific price impossible to execute. In this situation,mostforex dealers will execute the trade at the next best price. Traders can help to protectthemselvesfromslippagebyavoidingmarketorderswhennotnecessary.

SpotmarketThemarketwherepeoplebuyandsellactualfinancialinstruments(currencies)fortwo-daydelivery.

SpotpriceThecurrentmarketpriceofacurrencythatnormallysettlesintwobusinessdays(onedayfordollar/Canada).

SpreadThepointorpipdifferencebetweenthebidandaskpriceofacurrencypair.SpreadbettingAtypeofspeculationthatinvolvestakingabetonthepricemovementofasecurity.Aspreadbettingcompanyquotestwoprices,thebidandofferprice(alsocalledthespread),andinvestorsbetwhetherthepriceoftheunderlyingstockwillbelowerthanthebidorhigherthantheoffer.Theinvestordoesnotowntheunderlyingstockinspreadbetting;heorshesimplyspeculatesonthepricemovementofthestock.

StealthmodeA feature in some forex expert advisor programs that is designed to hide atrader’s take profit and stop loss from the broker. By hiding the take profit/stop loss, abrokerisunabletoseewherethetradershaveplacedtheirtake-profitandstop-lossorders,andthereforethebrokercannotmovethebid/askinanattempttoexecuteordersfortheirownbenefitinsteadofforthebenefitofthetrader.

SterlingAnothertermfortheBritishcurrency,thepound.StophuntingAstrategythatattemptstoforcesomemarketparticipantsoutoftheirpositionsbydrivingthepriceofanassettoalevelwheremanyindividualshavechosentosettheirstop-lossorders.Thetriggeringofmanystoplossesgenerallyleadstohighvolatilityandcan present a unique opportunity for investors who seek to trade in this environment.Understandingthatthepriceofanassetcanexperiencesharpmoveswhenmanystoplosses

aretriggeredcanbeusefulwhenseekingpotentialtradingopportunities.StoporderAnordertobuyorsellwhenagivenpriceisreachedorpassedtoliquidatepartorallofanexistingposition.Alsoknownasastop-lossorder.

StoporderAnordertobuyortosellacurrencywhenthecurrency’spricereachesorpassesaspecifiedlevel.Alsoknownasastop.

Straight-throughpricing(STP)An initiativeusedby companies in the financialworld tooptimize the speed at which transactions are processed. This is performed by allowinginformationthathasbeenelectronicallyenteredtobetransferredfromonepartytoanotherin the settlement process without manually reentering the same pieces of informationrepeatedlyovertheentiresequenceofevents.

Support The price level for which intensive buying can lead to a decrease in price(downtrend).

SupportlevelsApriceatwhichacurrencyorthecurrencymarketwillreceiveconsiderablebuyingpressure.

SwapAtransactionthatmovesthematuritydateofanopenpositiontoafuturedate.Take-profit order A customer’s instructions to buy or sell a currency pair which, whenexecuted,willresultinthereductioninthesizeoftheexistingpositionandshowaprofitonsaidposition.

TechnicalanalysisAnanalysisbasedonlyontechnicalmarketdata(quotes)withthehelpofvarioustechnicalindicators.

TickThesmallestpossiblechangeinaprice,eitherupordown.TradecontextbusyAmessagerelatedtotradingtheforexusingtheMetaTrader4platform.BrokersclaimthatallmarketexecutionordersonMetaTrader4willbefilledat thebestpriceavailableinthemarket,althoughtherecanbeadelayingettingaconfirmationfromtheirbanks.ThismessageappearsiftheCANCELbuttonispressedwhileanorderisintheprocessofexecution.

TradedeskAdeskwheretransactionsforbuyingandsellingsecuritiesoccur.Tradingdeskscan be found inmost organizations (banks, finance companies, etc.) involved in tradinginvestmentinstrumentssuchasequities,fixed-incomesecurities,futures,commodities,andforex.Atradingdeskprovidestraderswithaccesstoinstantaneoustradeexecutions.Alsoknownasadealingdesk.

TransactiondateThedateonwhichatradeoccurs.TrendThedirectionofamarketwhichhasbeenestablishedwith the influenceofdifferentfactors.

TurnoverThetotalvolumeofallexecutedtransactionsinagiventimeperiod.Two-waypriceAquoteintheforexmarketthatindicatesabidandanoffer.Unrealizedprofitor lossAnusually fluctuatingprofitor loss thatderives fromnonclosed(active)positions.Alsoknownasafloatingprofitorloss.

UsablemarginAmountofmoneyintheaccountthatcanbeusedfortrading.UsedmarginAmountofmoneyintheaccountalreadyusedtoholdopenpositionsopen.U.S.DollarIndex(USDX)AnindexthatmeasurestheperformanceoftheU.S.dollaragainstabasketofcurrencies:EUR,JPY,GBP,CAD,CHF,andSEK.

ValuedateThematuritydateofthecurrencyforsettlement,usuallytwobusinessdays(onedayforCanada)afterthetradehasoccurred.

VanillaoptionsAnormaloptionwithnospecialorunusualfeatures.Aplainvanillaoptionisyourplainrun-of-the-milloption,withyourstandardexpiryandstrikeprice.

Variationmargin Funds required to bring the equity in an account back up to the initialmarginlevel.Theyarecalculatedonaday-to-daybasis.

Volatility(VOL)Thestatisticalmeasureofthechangeinpriceofafinancialcurrencypairoveragiventimeperiod.

BIBLIOGRAPHY

BROKERS

Silvani,Agustin,Beat theForexDealer:An Insider’sLook intoTradingToday’sForeignExchangeMarket,Wiley,2008.

Solin,DanielR.,DoesYourBrokerOweYouMoney?IfYou’veLostMoneyintheMarketandIt’sYourBroker’sFault—YouCanGetItBack,PenguinGroup(USA),2006.

FINANCIALREGULATIONS

Acharya,ViralV.,ThomasF.Cooley,MatthewP.Richardson, IngoWalter,andNYUSternSchool of Business, Regulating Wall Street: The Dodd-Frank Act and the NewArchitectureofGlobalFinance,Wiley,2010.

Bonello, Frank, and Isobel Lobo, Taking Sides: Clashing Views on Economic Issues,McGraw-Hill,2011.

Buckley, Ross, International Financial System: Policy and Regulation (InternationalBankingandFinanceLaw),KluwerLawInternational,2008.

Davies, Howard, and David Green,Global Financial Regulation: The Essential Guide,Wiley,2008.

Dewatripont,Mathias,XavierFreixas,andRichardPortes(eds.),MacroeconomicStabilityandFinancialRegulation:KeyIssuesfortheG20,LondonPublishingPartnership,2011.

Elliott, David, and Carlos A. Pelaez, Financial Regulation after the Global Recession,PalgraveMacmillan,2009.

Goodhart, Charles, David Llewellyn, and Philipp Hartmann, Financial Regulation: Why,How,andWhereNow?Taylor&Francis,1998.

Kawai, Masahiro, and Eswar Prasad, Financial Market Regulation and Reforms inEmergingMarkets,BrookingsInstitutionPress,2011.

MacNeil,Iain,andJustinO’Brien.TheFutureofFinancialRegulation,HartPub,2010.Skeel,David,andWilliamD.Cohan,TheNewFinancialDeal:Understanding theDodd-FrankActandIts(Unintended)Consequences,Wiley,2010.

Spencer,PeterD.,TheStructureandRegulationofFinancialMarkets,OxfordUniversityPress(USA),2000.

Tarullo,DanielK.,BankingonBasel:TheFutureof InternationalFinancialRegulation,PetersonInstitute,2008.

Tatom, John A., Financial Market Regulation: Legislation and Implications, Springer-Verlag,2011.

U.S.CongressSenateCommittee,Turmoil inU.S.CreditMarkets:Examining theRecentActionsofFederalFinancialRegulators,Bibliogov,2010.

Vittas,Dimitri(ed.),FinancialRegulation:ChangingtheRulesof theGame,WorldBankPublications,1993.

FOREXSCAMS

Miller, Frederic P., Agnes F. Vandome, and JohnMcBrewster (eds.),Forex Scam, VDMPublishingHouseLtd.,2010.

OPTIONS

ChicagoBoardofTrade,CBOTHandbookofFuturesandOptions,McGraw-Hill,2006.Chorafas, Dimitris, Introduction to Derivative Financial Instruments: Bonds, Swaps,Options,andHedging,McGraw-Hill,2008.

Garner,Carley,andPaulBrittain,CommodityOptions:TradingandHedgingVolatility intheWorld’sMostLucrativeMarket,FTPress,2009.

Hull,John,FundamentalsofFuturesandOptionsMarkets,5thed.,PrenticeHall,2004.Hull,John,Options,FuturesandOtherDerivatives,6thed.,PrenticeHall,2005.Izraylevich, Sergey, and Vadim Tsudikman, Systematic Options Trading: Evaluating,Analyzing,andProfitingfromMispricedOptionOpportunities,FTPress,2010.

McCafferty,Thomas,OptionsDemystified,McGraw-Hill,2005.Natenberg, Sheldon, Option Volatility & Pricing: Advanced Trading Strategies andTechniques,updateded.,McGraw-Hill,1994.

Reehl,C.B.,TheMathematicsofOptionsTrading,McGraw-Hill,2005.Shover,Larry,TradingOptionsinTurbulentMarkets:MasterUncertaintythroughActiveVolatility,BloombergPress,2010.

Sinclair,Euan,OptionTrading:Pricing andVolatility Strategies andTechniques,Wiley,2010.

Whistler, Mark, Volatility Illuminated: Empowering Forex, Stocks, Options & FuturesTraders,CreateSpace,2009.

TRADINGPSYCHOLOGY

Elder,Alexander,TradingforaLiving:Psychology,TradingTactics,MoneyManagement,Wiley,1993.

Steenbarger, Brett N., The Daily Trading Coach: 101 Lessons for Becoming Your OwnTradingPsychologist,Wiley,2009.

TRADINGSTRATEGIES

Capre,Chris,PriceActionPivotPoints,HarrimanHouse,2011.

Carter,JohnF.,Mastering theTrade:ProvenTechniques forProfiting fromIntradayandSwingTradingSetups,McGraw-Hill,2005.

Cohen,Guy,TheBibleofOptionsStrategies:TheDefinitiveGuide forPracticalTradingStrategies,FTPress,2005.

Kaufman, Perry J., Alpha Trading: Profitable Strategies That Remove Directional Risk,Wiley,2011.

Kaufman,PerryJ.,NewTradingSystemsandMethods,4thed.,Wiley,2005.Knuth, Elaine, Trading between the Lines: Pattern Recognition and Visualization ofMarkets,BloombergPress,2011.

Norris, Jay, and Al Gaskill, Mastering Trade Selection and Management: AdvancedStrategiesforLong-TermProfitability,McGraw-Hill,2011.

Pesavento, Larry, and Leslie Jouflas, Trade What You See: How to Profit from PatternRecognition,Wiley,2007.

Ponsi,Ed,ForexPatternsandProbabilities:TradingStrategiesforTrendingandRange-BoundMarkets,Wiley,2007.

Stridsman,Thomas,TradingSystemsThatWork:BuildingandEvaluatingEffectiveTradingSystems,McGraw-Hill,2000.

Velez,Oliver,andGregCapra,ToolsandTacticsfortheMasterDayTrader:Battle-TestedTechniquesforDay,Swing,andPositionTraders,McGraw-Hill,2000.

INDEX

Pleasenotethatindexlinkspointtopagebeginningsfromtheprintedition.Locationsareapproximateine-readers,andyoumayneedtopagedownoneormoretimesafterclickingalinktogettotheindexedmaterial.

Note:fandtfollowingpagenumbersrefertofiguresandtables,respectively.

A

Accountingstatements,15Accumulation,207Adrenaline,38Advertising,8After-hourtrades,75AIG(AmericanInternationalGroup),119,120Algorithmictrading(seeForexautomatedtrading)AmericanGeneralInsurance,118American-styleoptions,53–54Analysis:

hoursof,209,224price,327–328technical,72usingtoomuch,36

Asianoptions,273Askprice:

defined,23onquotescreen,60,62–63

Asset-BackedMarketStabilizationAct,132ATM(at-the-money)status,56,274–275Automateddealingdesks,187Automatedtrading(seeForexautomatedtrading)

B

Bachmann,Michele,131Back-officesoftwarescams(seeSoftwarescams)Back-testing,331–342

avoidingmistakeswith,339–340contrarianBBstrategy,227–228

andforexsimulators,337–338importanceof,331keepinglogfor,341–342withMetaTrader,340–341methodsfor,333–335strategiesfor,335–337

BaFin,17Bailouts,119,121,129BankforInternationalSettlements,4BankofAmerica,144Banks:

central,20investment,20,26,203–204multinational,20

Barrieroptions,273Baserisk,101BawagP.S.K.,143B-book(bookofbusiness),181–184BDs(broker-dealers),200BearStearns,119Bearishstrategies,284–292

forbinaryoptions,312,313callbearspread,289,290f,291fputbackspread,284,286–288,287f,288fputbearspread,272,289,291,291f,292fshortsynthetictrade,284,285f,286f

Bidprice:defined,23,80onquotescreen,60,62–63

Biggert,Judy,132Binarybets(spreadbetting),84Binaryoptions:

asexoticoptions,53hedgingwith,265–269,266foverview,53–54strategiesfor,310–314

Black-boxsystems,318(SeealsoForexrobots)

Blacklisting,28,178Black-Scholes-Mertonmodel,55Bondsmarket,131Bookofbusiness(B-book),181–184Breakevenrate,60Breakoutexpertadvisors,320Breaks,taking,36–37BrettonWoodsAccord,3

BritishBankers’Association,101Brokerschemes(SeeFraud)Brokertransfers,77Brokeragehouses,66,69Broker-dealers(BDs),200Brokers:

banningof,133confronting,348–349criteriaforselectionof,199–204,201tdocumentationby,107forex(seeForexbrokers)honestyof,343reputationsof,153

Bullishhedging,256–265,261f,262f,264f,265fBullishstrategies,276–284,312–313

forbinaryoptions,311–312callbackspread,278–280,279f,280fcallbullspreads,272,280–282,281flongsynthetictrade,276–278,277fputbullspread,282–284,283f

BureauofConsumerFinancialProtection,129BusinessRiskMitigationandPriceStabilizationAct,131Busyservers,157–158Butterflystrategies,302–305f,302–306

C

Ccorporations,109,110Calendarspread,299,300Callbackspread,278–280,279f,280fCallbearspread,289,290f,291fCallbullspread,272,280–282,281fCalloptions:

covered,256,257–260,258f,259flong,46–49,48f,52tshort,47,50,51f,52t

Callratioverticalspread,301,301fCalltimespread,300CantorIndex,82Capitalrequirements,76CapitalSpread,88Cashpositions,268–269CCI(CommodityChannelIndex),198CEA(CommodityExchangeAct),117

Centralbanks,20Centralclearing,103CFDs(seeContractsfordifference)CFMA(CommodityFuturesModernizationAct),117–121,124–125CFTC(seeU.S.CommodityFuturesTradingCommission)ChurchPlanInvestmentClarificationAct,132CityIndex,84Clearinghouses,103Cloaking,328–329Collar,262–265,264f,265fCollateralrequirements,77Collectivetrusts,132Commissions,24–25,84CommitmentsofTradersReport,248Commodities,5,95CommodityChannelIndex(CCI),198CommodityExchangeAct(CEA),117CommodityFuturesModernizationAct(CFMA),117–121,124–125Commodityswaps,97Commoditytradingadvisors(CTAs),125Condorstrategies,306–310Confidence,36,311Consumerprotectionreforms,128Contingentorderprotections,76Contractsfordifference(CFDs),65–78

advantagesof,74–76andcorporateacts,69,76costsassociatedwith,67disadvantagesof,76–77equity-based,69historyof,65–66popularityof,78riskswith,69–71,76andstop-lossorders,68–69timingofinvestments,73–74trading,66–67,72–73useofmarginforinvestingin,67–68,75

ContrarianBB(BollingerBand)strategy,221–248back-testingof,227–228basicset-upindicatorsin,228,228fcyclic“route”in,229–231,231fdailychartin,237,238fdivergenceextremelyshort-termsetupin,232,234f,235elementsof,222–224exitrulesin,225–227medium-termtimeframesetupin,235–237,236f

medium-termtradingin,240–248,241f,242f,244–247fmoneymanagementin,224–225short-termtimeframesetupin,232,233fshort-termtradingin,223,237–240,238f–240f

Corporations:corporateacts,69,76informationabout,13–14typesof,109–111

Corruption,123Counterpartyrisk,41,70Countertrading,27Coveredcall,256,257–260,258f,259fCoveredwarrants,71Creditdefaultswaps:

overview,99regulationof,118–121

Creditratingagencies,128,132Creditrisk:

withforwards,100withswaps,101

Creditspreads,272–273Creditswaps,98–99CTAs(commoditytradingadvisors),125Currencies:

forwardon,95obligationsinforeign,102riskswithtrading,170

Currencybaskets,273Currencyfutures:

forexoptionson,46hedgingwith,253–256

Currencyoptions(seeForexoptions)Currencypairs:

observingcorrelationsbetween,34tradingtoomany,33(SeealsoForexoptions)

Currencyswaps,96–97Customerreviews,202CyprusSecuritiesandExchangeCommission,17

D

Dailybets(spreadbetting),84Dailychart,232,235,237,238f

Data:historical,333,337,341personal,13

DataCollectionReliefAct,131Daytrading:

incontrarianBBstrategy,223,235–237,236f,240–248,241f,242f,244–247finS/Rpriceactionstrategy,208

Dealers,106Dealingdesks,185–189

automated,187andECNtechnology,188–189professional,188

Debitspreads,272Defaultswaps,credit(seeCreditdefaultswaps)Delta:

inBlack-Scholes-Mertonmodel,55hedging,268–269overview,58onquotescreen,62

Demoaccounts:baitandswitchscamwith,8,175–180lackoflosingtradesin,149liveaccountsvs.,176–177,343–344mistakesrecordedwith,338opening,344–345testingforexrobotsin,327

Derivatives,65,117,131,253(SeealsoContractsfordifference)

DiagonalS/Rzones,207Differentialrisk,101Digitaloptions,53–54DigitalSPOToptions,54Disappointment,37Divergence,233,235f,236Diversification,311Dividends,76,77Documentation,13,107,137Dodd,Chris,128Dodd-FrankWallStreetReformandConsumerProtectionAct:

centralclearingrequirementsof,103overview,127–132

Doubleno-touchoptions,54,268Doubleone-touchoptions,54,267–268Duediligence,193Dyekman,Larry,160

E

EAs(seeExpertadvisors)ECNs(seeElectroniccommunicationnetworks)Education,lackof,30ElectronicBrokingServices,20Electroniccommunicationnetworks(ECNs),20–22

commissionswith,24anddealingdesks,188–189marketmakersvs.,22t

E-mails,155–156Emotions,34–38Enron,118Entrytiming,196,208–209,223–224Equities,5,131Equity-basedcontractsfordifference,69Errormessages:

off-pricequotes,156“ServerBusy,”157–158“TradeContextBusy,”156–157workingorders,157

ETFs(exchange-tradedfunds),71Ethics,22–26European-styleoptions,53–54Exchangeraterisk:

withforwards,100withswaps,101

Exchangerateswaps,98Exchangerates:

fluctuationof,99forwardon,95

Exchange-tradedfunds(ETFs),71Exitrules:

andcarelessexits,34incontrarianBBstrategy,225–227inspreadbetting,90andtiming,196

Exoticoptions:overview,53strategiesfor,310–314,313f,314ftypesof,273

Expertadvisors(EAs):demovs.live,343–346overview,319–321typesof,320–321

(SeealsoForexrobots;MetaTrader)Expirationdate,44,45,75,275–276Exporters,101Extrinsicbidandaskinpoints,60

F

Fairvalue,221,222FapTurbo,323–327FarmBill(Food,ConservationandEnergyAct),123–126FCMs(futurescommissionmerchants),140,200Fear,35FederalDepositInsuranceCorporation(FDIC),128,129FederalReserve,128,129FederalReserveAct,129Fees:

financing,67,77paymentprocessing,24–25

Fencetrading,312–314,314fFibonacciextensions,197,207–208Financialadvisors,130Financialcrisisof2007-2010,119,128Financialdata,200FinancialIndustryRegulatoryAuthority(FINRA),126Financialinstruments:

incontrarianBBstrategy,224inS/Rpriceactionstrategy,209(Seealsospecificinstruments)

Financialnews:economicreleases,311effectsonCFDtrading,72marketimpactof,182tradingbasedon,151–152

FinancialServicesAuthority(FSA),16Financialspreadbetting,84–85FinancialStabilityOversightCouncil,129Financingfees,67,77FINRA(FinancialIndustryRegulatoryAuthority),126Finspreads,845-minutechart,232,237,239,239f,242,242fFlashtrades,27Food,ConservationandEnergyAct

(seeFarmBill)Forecasts,39

Forexautomatedtrading,317–321affordabilityof,317andplug-ins,27problemswith,39(SeealsoBack-testing;Expertadvisors;Forexrobots)

Forexbrokers:ethical,22–26generationofprofitby,19–20optionbrokers,43–44shady,27–28

Forexoptions,41–63,271–314advantagesanddisadvantages,44–45bearishstrategieswith,284–292,312,313bullishstrategieswith,276–284,283f,312–313choosingstrategyfor,273–276,275tchoosingthewrong,38combinations,272–273oncurrencyfutures,46defined,41exoticoptions,310–314,313f,314ffindingbrokers,43–44Greeks,58–60neutralstrategieswith,292–310quotescreen,60–63,61fstockoptionsvs.,42–43stylesof,52–54typesof,46–52,48f,49f,51f,52f,52tvalueof,54–57volatilityof,57–58

Forexrobots,318–319FapTurbo,323–327MegaDroid,327–329

Forexsimulators,337–338Forex(foreignexchange)trading:

automated(seeForexautomatedtrading)averagedailyturnoverin,4earlyhistoryof,3–4futureof,4–5marketoverview,4,20–21spreadbetting,85–86,89

ForexTradingSecrets(Dicks),248Forwardcontracts:

defined,93functionof,93–94partiesinterestedin,102performanceoftransactions,101

profitabilityof,99–100regulationof,102–103riskswith,100typesof,94–95

Forwardrateagreements(FRAs),94–95Forward-testing:

back-testingvs.,338ofcontrarianBBstrategy,227withdemoaccounts,344overview,334–335ofS/Rpriceactionstrategy,211

4-hourchart,237,240,241fFrank,Barney,128FRAs(forwardrateagreements),94–95Fraud:

actionsforpreventionof,12–18demobaitandswitchscam,8,175–180marginscams,169–173methods,7–12perpetratorsof,6–7softwarescams,149–152victimsof,5–6warningsigns,12

FSA(FinancialServicesAuthority),16Fundamentalsoftrading(seeFinancialnews)Fundedpracticeaccounts,179–180Fundingcharges,74Futurestyle(spreadbetting),84Futurescommissionmerchants(FCMs),140,200Futurescontracts,71FuturesTradingPracticesAct(1993),120

G

Gambling,82,88Gamma:

inBlack-Scholes-Mertonmodel,55overview,59onquotescreen,62

Gapspread,151Garrett,Scott,131Globex,253–256Goals,37Gold,3,83

Greed,6,29,35Greeks,58–60Grimm,Michael,131Guaranteedstop-lossorder(GSLO),68–69,76

H

Hayworth,Nan,131Hedgeexpertadvisors,321Hedging,249–269

withbinaryoptions,265–269,266fwithcontractsfordifference,76withcurrencyfutures,253–256defining,249–250example,251–253withforexvanillaoptions,256–265,261f,262f,264f,265fmanagementof,4overview,25–26

Historicaldata,333,337,341Historicalvolatility,57HorizontalS/Rzones,207Hunches,36Hurt,Robert,131

I

IBs(seeInvestmentbanks)IDsettings(forexrobots),328IGIndex,81,82,84IMF(InternationalMonetaryFund),3Impliedvolatility(IV):

overview,57onquotescreen,62

Importers,102Indicators:

inback-testing,337incontrarianBBstrategy,222,228,228finS/Rpriceactionstrategy,208useoftoomany,33–34

Inflationarynumbers,195In-housetrading,26InstantExecution(slippage),162–163,162fInsurance,119

Interest:oncontractsfordifference,77onexchangeoperations,26onquotescreen,63

Interestraterisk,100Interestrateswaps,95–96Interestrates,56–57,94–95InternalRevenueService(IRS),107,108,113InternationalMonetaryFund(IMF),3Internationalstandards,128InternationalSwapDealersAssociation,101Internet:

fraudsconductedvia,8,12spreadbettingon,84

In-the-rangeoptions,312,313fIntrinsicvalue,56Investmentbanks(IBs),20,26,203–204Investmentmanagers,4Investors,106–107IRS(seeInternalRevenueService)ITM(in-the-money)status,56,274–275IV(impliedvolatility):

overview,57onquotescreen,62

K

Katrina,Hurricane,83Knock-inoption,266–267Knock-outoption,266–267

L

Latency,153–154Lawsuits,178–179Legalconditions,14–15LehmanBrothers,67Leverage:

withforexoptions,44andmarginscams,170overleveraging,31–32assourceofmultipliedincome,24

Limitorders,208,223

Linearregressionchannels,197Liquidation,93Liquidationrisk,70Liquidity,74Liveaccounts:

demoaccountsvs.,176–177,343–344fundedpracticeaccounts,179–180opening,345–346

LLCs,109–111LondonStockExchange,66,70Longcallbutterfly,302,303fLongcalls:

characteristics,52toverview,46–47useof,46–49,48f

Longcondor,306–307,307f,308fLongguts,298,299fLongpositions:

withcontractsfordifference,75financingfeefor,67(SeealsoLongcalls;Longputs)

Longputbutterfly,304,305fLongputs:

characteristics,52toverview,46–47useof,49–50,49f

Longstraddle,292–294,293fLongstrangle,295–297,296fLongsynthetictrade,276–278,277fLookbackoptions,273Lossmanagement,225Losses,29–34,38–39

acceptanceof,105beingafraidof,35–36expectationsabout,339

Lucas,Frank,132

M

Mailinglists,8Managementstaff,13Manualback-testing,333Margin:

withforexoptions,45

forinvestinginCFDs,67–68,75andvolatility,57

Marginscams,169–173Marketassessment,34MarketExecution(slippage),163–165,163fMarketexhaustion,222Marketmakers(MMs),21–22

andcontractsfordifference,67,69anddealingdesks,188electroniccommunicationnetworksvs.,22tencouragementoflargepositionsby,170

Marketorders,208,223Marketrisk,69–70Marketing,167,177McNeil,Charles,86Media,16Medicalreimbursementplans,110Medium-termtimeframesetup,235–237,236fMedium-termtrading,208,240–248,241f,242f,244–247fMegaDroid,327–329MetaQuotesLanguage4,319MetaTrader:

back-testingwith,340–341off-pricequoteerrormessages,156plug-ins,161–165,320,343–344servers,155slippagepracticeson,141

Microaccounts,171MiFID,17MMs(seeMarketmakers)Moneylaundering,133–134Moneymanagement:

incontrarianBBstrategy,224–225formulafortrading,196–198keepingclosetrackofyourmoney,17–18foroptions,311rulesfor,31withS/Rpriceactionstrategy,209–210

Moneymanagers,130Multinationalbanks,20Multi-timeframeassessments,228,230–231

N

NASDAQ,194NationalFraudInformationCenter(NFIC),16NationalFuturesAssociation(NFA):

complaintsfiledaboutslippage,159–161contacting,16finesfordealerplug-ins,164andmarginscams,170marketingrules,167,177membershipin,130overview,17registrationwith,125regulatoryactions,141–143rulesonbaitandswitchtactics,175

Netcapital,200Net-sumtradingaccounts,184Neutralstrategies,292–310

butterflystrategies,302–305f,302–306calendarspreads,299,300callratioverticalspread,301,301fcondorstrategies,306–310longguts,298,299flongstraddle,292–294,293fputratioverticalspread,301,302fshortguts,299,300fshortstraddle,294–295,294f,295fshortstrangle,297–298,297f,298f

News,financial(seeFinancialnews)Newsexpertadvisors,320NFA(seeNationalFuturesAssociation)NFIC(NationalFraudInformationCenter),16No-touchoptions,54,267

O

Obama,Barack,128Offerprice,80OfficeofFinancialResearch,129Off-pricequotes,156Offshorebusinesses,25,88,112–1131-minutechart,232,239–240,240f120-minutechart,197–198One-touchoptions,54,267Openinterest,63Options,71(SeealsoForexoptions)

OTCmarkets(seeOver-the-countermarkets)OTM(out-of-the-money)status,56,274–275Out-of-the-rangeoptions,312,313fOverleveraging,31–32Over-the-counter(OTC)markets,41,66,69Overtrading,32

P

Paymentprocessingfees,24–25Pegging,3Percentages,179–180Personalities,34–38Pips:

defined,23indemobaitandswitch,180distancefromtriggerlevels,209,224overview,196scopeconcentrationof,335

Plug-ins,27,150–151,161–165,320,343–344Ponzi,Charles,136Ponzischemes,135–137Practice,31Priceanalysis,327–328Pricemanipulation,27Professionalcircles,8–9Professionaldealingdesks,188Profit:

generationof,19–20ofinvestmentbanks,26

Profitability:withcondorstrategies,307–309offorwards,99–100ofswaps,100

Programmedback-testing,334Protectedcovercall,257Protectiveputoptions,260–262,261f,262fPutbackspread,284,286–288,287f,288fPutbearspread,272,289,291,291f,292fPutbullspread,282–284,283fPutoptions:

long,46–47,49–50,49f,52tprotective,260–262,261f,262fshort,51,52f,52t

Putratioverticalspread,301,302fPuttimespread,300

Q

Quotescreen,60–63,61f

R

Refco,Inc.scandal,143–144Referrals,frominvestors,9Regulation,133–145

ofadvertising,8CFTCcases,134–140ofcontractsfordifference,66anddealingdesks,186offorwards,102–103andfraud,14–15ofhedging,25ofleverage,24NFAcases,141–143recentchangesin,5recentlitigation,144–145Refco,Inc.scandal,143–144regulatoryoffices,16–17ofswaps,102–103ofusingoffshorebusinesses,88(Seealsospecificregulatoryacts,e.g.:FarmBill)

Reinvestmentrisk,101Retailforeignexchangedealers(RFEDs),140,200Retailforexserviceproviders:

accountswith,204typesof,21–22

Retirementprograms,110Return,53ReutersDealing3000SpotMatching,20Reversecorrelatedtime,327–328Reverseknock-inoption,266–267RFEDs(retailforeignexchangedealers),140,200Rho,55Risk(s):

withbutterflystrategies,302–304,306withcallratioverticalspread,301

withcondorstrategies,307,310withcontractsfordifference,69–71,76expectedlevelsof,339withforexoptions,44,45withforwards,100andfraud,10,13managementof,225andmoneymanagement,311withputratioverticalspread,301withspreadbetting,83withswaps,101intradingcurrency,170

Riskoperationsdepartment,183Risk-to-rewardratio:

incontrarianBBstrategy,224inS/Rpriceactionstrategy,209

Rollingdailies(spreadbetting),84Rumors,39(SeealsoTrends)

S

SAR(stopandreverse),198Scalping:

incontrarianBBstrategy,223expertadvisorsfor,321withFapTurbo,324–325

Scams(seeFraud)“Scaredmoney,”31Schweikert,David,131SEC(seeU.S.SecuritiesandExchangeCommission)SecuritiesAct(1933),117SecuritiesExchangeAct(1934),117SecuritiesInvestorProtectionCorporation,129Self-regulatoryorganizations(SROs),125Servers,153–158

busy,157–158andlatency,153–154

slow,154–156Shareholdersrights,77Shortcallbutterfly,303,304fShortcalls:

characteristics,52toverview,47using,50,51f

Shortcondor,308–310,309fShortguts,299,300fShortpositions,75

(SeealsoShortcalls;Shortputs)Shortputbutterfly,304–306,305fShortputs:

characteristics,52toverview,47using,51,52f

Shortstraddle,294–295,294f,295fShortstrangle,297–298,297f,298fShortsynthetictrade,284,285f,286fShort-termscalping,324–325Short-termtimeframesetup,232,233fShort-termtrading,223,237–240,238f–240fSingle-paymentoptionstradingoptions(seeSPOToptions)60-minutechart,198Slippage,159–165

andmarketfluctuations,23MetaTraderdealerplug-ins,161–165overview,161practicesonMetaTrader,141softwarescams,151

Slowfills,153–154,326Slowservers,154–156SmallBusinessCapitalAccessandJobPreservationAct,131Smallbusinesses,106SmallCompanyCapitalFormationAct,131Socialcircles,8–9Softwareback-testing,333–334Softwarelicensing,326Softwarescams,149–152

gapspreadwith,151newstrading,151–152slippage,151VirtualDealerPlug-In,150–151

Sportsspreadbetting,83,86Spotmarkets,123SPOT(single-paymentoptionstrading)options:

asexoticoptions,53andforexoptions,44,45overview,53–54

Spreadbetting,79–91beginningof,81–83overview,79–81strategiesandtips,89–91

astax-freeactivity,88–89typesof,83–88

Spreads:defined,22inliquidityproviders,22–23

S/R(supportandresistance)priceactionstrategy,207–220back-testingin,210–220,211f,212f,214–219felementsof,208–209exitrulesin,210moneymanagementwith,209–210

SROs(self-regulatoryorganizations),125Stamptax,74Stealthmode(FapTurbo),325–326Stivers,Steve,132Stockindexesswaps,98Stockoptions,42–43Stopandreverse(SAR),198Stophunting,27,165–167Stoporders,208Stop-lossbarriers,82,90Stop-lossorders,68–69,76,85Stops:

moving,37settingatobviouslevels,38

STP(straight-throughpricing),150Straddlestrategies,273Straight-throughpricing(STP),150Strikeprice,44,45,61,274–275SubScorporations,109,110Supportandresistancepriceactionstrategy(seeS/Rpriceactionstrategy)Swaps:

calculationof,24defined,94functionof,94partiesinterestedin,102performanceoftransactions,101profitabilityof,100regulationof,102–103riskswith,101typesof,95–99

Swingtrades,197SwissFinancialMarketSupervisoryAuthority,138Symbol(quotescreen),60

T

Take-profitlevel,336Tax(es):

withcontractsfordifference,65,75withspreadbetting,82,88–89stamptax,74

TaxCode,106–108Taylorrule,194–195Technicalanalysis,72Technicalsupport,83Telephone,fraudsconductedvia,8Theta:

inBlack-Scholes-Mertonmodel,55overview,59

Thirdparties,14Third-partysoftware,161–16230-minutechart,232,237,240–242,241fTimevalue,56Timing:

ofexit,196ofinvestments,73–74inspreadbetting,82–83oftrades,32,33

Totalreturnswaps,99TradeContextBusyerrors,156–157Tradesize,90Trader(s):

emotionsandpersonalityof,34–38payingattentiontoother,38reasonsforlosingmoney,29–34,38–39stepstobecoming,108–109intaxcode,106–107

Trading,105–113,193–198acceptinglossesin,105buildingrulesfor,337forex(seeForextrading)identifyingopportunityfor,273–274in-house,26moneymanagementformulafor,196–198news,151–152andoffshorebusinesses,112–113stepstobecomingatrader,108–109taxcodefor,106–108tradebeforenewsstrategy,194–196

andtypesofcorporations,109–111Tradingaccounts,204

(SeealsoDemoaccounts;Liveaccounts)Tradinghours,209,224Tradingplans,32,37Transactioncosts,75Transparency,119Trends,33,83,311Triggerpricelevels,209,224Tripleexponentialmovingaverage(TRIX),198Trust,11–12UUnemploymentrates,195UnitedKingdom:

contractsfordifferencein,74spreadbettingin,86–88

UnitedStatesCoveredBondsAct,131Unlicensedsellers,137Unregisteredinvestments,136U.S.CommodityFuturesTradingCommission(CFTC):

banningofbrokersby,133andCFTCReauthorizationAct,124complaintsfiledaboutslippage,160contacting,16disagreementsbetweenSECand,117DivisionofClearingandIntermediaryOversight,200finesfordealerplug-ins,164overview,17registrationwith,130regulatoryactionstakenby,134–140swapsexemption,120

U.S.SecuritiesandExchangeCommission(SEC):andCFTC,117effectsofDodd-FrankActon,129registrationwith,131regulationofcontractsfordifference,66

U.S.TreasuryDepartment,102,103,128

V

Valuation,76Vanillaforexoptions:

binaryoptionsvs.,265hedging,256–265,261f,262f,264f,265f

strategiesfor,276stylesof,53–54

Vanillaswaps,95–96Variationmargin,68Vega:

inBlack-Scholes-Mertonmodel,55overview,59–60onquotescreen,62

VirtualDealerPlug-In,150–151Volatility:

andexpirationdate,275–276andforexautomatedtrading,319offorexoptions,57–58impactof,57importanceof,41andsoftwarescams,151–152

Volume(oftransactions),63

W

Wheeler,Stuart,81Workingorders,157

ABOUTTHEAUTHOR

JamesDicks is president and CEO of a group of financial companies, including a forexhedgefund.HefoundedForexMadeEasy,oneofthelargestintroducersofspotretailforexcustomers in the United States. He has been investing in various aspects of the financialmarketsformore than25years, includingtheareasofportfoliodiversification that includeassetclassessuchasrealestate,equities,andforeigncurrency.Formoreinformation,visitwww.JamesDicks.com.