Lessons from the Pros

Q) Could you please advise in your opinion, which period Moving Average works best, and for which time frame in Forex?

Ed Ponsi) Moving Averages can be extremely effective in Forex trading. For example, during a recent rally in the EUR/JPY pair, the 50-day Simple Moving Average acted as support. Once the price broke through and closed beneath the moving average several days ago, the 50-day SMA acted as resistance (see figure 1).

Figure 1) 50-day Simple Moving Average acts first as support, then as resistance on EUR/JPY. Source: Saxo Bank Does this mean that the 50-day SMA is the “holy grail” of moving averages? No, unfortunately there is no one moving average that will work all of the time. This is also true in the equities and futures markets. Part of our job as traders is to observe and identify which moving averages are working well at any given time, and then use this information to our advantage.

Q) I keep hearing about the “Carry Trade”. What is it and how does it work?

Ed Ponsi) That’s a very timely question. Imagine that you could borrow money at an extremely low rate of interest, or even interest-free. You could then take that money and invest it in a certificate of deposit, bond, or other fixed income instrument, and collect interest. Your profit would be the difference between the interest you collect, and the interest you must pay on borrowed funds.

A similar situation exists in the currency markets. Japan’s benchmark interest rate was actually zero percent for several years up until 2006. During that same time, the U.S. raised its benchmark interest rate from 1.0% up to 5.25%. Forex traders could borrow money from Japan at zero percent, and invest it in the U.S. at 5.25%. Because of this, institutional traders piled into long positions in the USD/JPY currency pair to take advantage of this difference in interest rates.

The trouble is, this interest rate differential is now beginning to shrink. The U.S. ended its campaign of rate hikes last year, and Japan began to raise rates. Now, instead of borrowing at zero percent, traders must pay 0.5% for money borrowed from Japan. The interest rate differential between the U.S. and Japan is now just 4.75% (5.25% – 0.5%) and will shrink even more if Japan raises rates again, or if the U.S. cuts interest rates. This makes the Carry Trade less attractive, and as a result, traders have rushed for the exit on USD/JPY (see figure 2). Similar damage has been done to EUR/JPY and GBP/JPY, as the once weak Yen has come roaring back, reaching three-month highs against the Euro and U.S. Dollar.

Q) How many ‘pips’ from my entry should I place my stop loss and target?

Ed Ponsi) Great question. First of all, be sure to use a stop on every trade – this is crucial to protect your account. Since Forex is a tremendously ‘thick’ market and trades 24 hours per day, gaps are rare. This means that your stop is more dependable in Forex than it is in virtually any other market.

Regarding the number of pips, let’s compare this to the stock market. How far away should I place my stop in a stock trade? You’d probably answer that it would depend on that stock’s volatility and on the time horizon for my trade, and you’d be correct. Google is a much more volatile stock than General Electric, so if all other considerations are equal, your stop for Google would be much wider than it would be on the relatively tame GE. In this regard, Forex is exactly the same – you must consider the volatility of the currency pair you are trading.

Consider the GBP/JPY (Great Britain Pound/ Japanese Yen) and EUR/GBP (Euro/ Great Britain Pound) currency pairs; GBP/JPY moves more than 200 pips per day (thanks to a recent spike in volatility), and EUR/GBP moves about 35 pips per day. If all other considerations are equal (including time frame and time horizon), your stop on a GBP/JPY trade should be about six times as wide as your stop on a EUR/GBP trade, because the former has about six times greater volatility than the latter. If this wider stop creates an unacceptable level of risk, then do not enter the trade. When volatility is taken into consideration, we can see that there is no point in using a set number of pips to place a stop or an exit. Instead, incorporate levels of support and resistance that fall within your allowable risk parameters to create stops. If no such levels are available, it may be best to find another trade.

Q) Could you give me any advice for my first year of trading (other than don’t try it)?

Ed Ponsi) Thank you for your question. It’s rare that anyone steps into the trading arena and experiences instant success – in fact, it’s probably better if they don’t. Traders who are blessed with ‘beginners luck’ tend to develop unrealistic expectations and let their guard down, whereas traders who must fight their way through the learning curve have a greater appreciation of the value of good risk management, and tend to be more realistic and cautious.

Luckily, Forex traders can use free practice accounts, called demo accounts, to gain valuable experience in the currency market without risking real capital. To acquire one, please google the term “Forex demo account” and many results will appear. The quotes are in real-time, and most platforms include free charts and news. You can witness the market’s reaction to news events, practice order placement (including entries, stops and exits), and test your strategies in live market conditions.

Once you are comfortable with the platform, you can continue to practice until you are ready to graduate to live trading. Once you are ready, set modest, achievable goals and increase them gradually – you should be concerned mainly with consistency and following correct procedure. If you set your goals too high, it creates unnecessary pressure and stress which can lead to the violation of your risk management rules, so err on the side of caution and aim low at the start. You can always increase your goals later, when you become more experienced and have attained consistent profitability.

If I didn’t get to your question this time, I apologize. To everyone who sent kind comments, thank you, I am sincerely grateful. To everyone out there, best of luck to you in trading.