Lessons from the Pros

The Fed and the Fib

Greetings from New York! Last week’s Fed meeting created an interesting trade setup; although the Fed did not change the Fed Funds rate, comments that were released caused EUR/USD to plunge by nearly 170 pips in a matter of minutes. This pushed the exchange rate down to 1.3104, just below the 38.2% Fib level on the hourly chart (located at 1.3112). This level had previously acted as support earlier in the week (see figure 1).

Figure 1: Hourly chart of EUR/USD plunges to the 38.2% Fib, in reaction to the Fed. Source: Saxo Bank

The Fibonacci retracement was drawn from the January 23 lows of 1.2763 to the January 27 highs of 1.3328. Within minutes of testing the Fib level, the exchange rate shot more 40 pips higher to 1.3147, which we can see represented as the high price on the 15-minute chart below. The bounce was enough for Forex news traders to turn a quick profit before EUR/USD began sinking again (see figure 2).

Figure 2: 15-minute chart shows EUR/USD bounce off of the 38.2% Fib. Source: Saxo Bank

In addition to this initial bounce off of the Fib, there were several other bounces from the same level over the next hour. The point is, although we sometimes emphasize the longer term time horizons when dealing with Fibonacci, it can be used for short term trades – in this case a reaction to a major news event. Notice that it is never suggested that one should try to catch the initial move lower, because that occurred during fast market conditions. Instead, the trader who exhibits patience can play the reaction to the initial move, and trade in calmer market conditions.

Question of the Week

Q) Hi Ed, I have traded for quite some time and for the last six months have studied the Forex market. I plan to go live with a small amount of money ($5000) to see how well I do. It seems that the shorter time frames, i.e. 1 hour and 4 hour would suit a small account better than to trend trade and sustain the draw downs. Do you have any suggestions on the above topics?

Ed Ponsi) Thank you for your email; you raised several interesting points, the first of which was account size. My main concern is that you don’t blow up your account and lose your $5000. Now $5000 may not mean much to you personally, but that is not the point. Here’s what I want to see happen; I want you to survive long enough in this game that you can become a profitable, consistent trader.
Now that the new micro accounts are available, $5000 can go a long way. Consider a trade on the EUR/USD currency pair; on a standard sized account, the value of one pip equals $10. This means that any series of trades that results in a loss of 500 pips will wipe out the account (500 x $10 = $5000). In a mini account, EUR/USD has a value of $1 per pip, meaning that any series of trades that results in a loss of 5000 pips would result in an account blow up (5000 x $1 = $5000). But in the new micro accounts, the pip value of EUR/USD is only ten cents! You would have to lose a total of 50,000 pips to result in a broken account (50,000 x .10 = $5000). This is similar to being able to play in a professional poker tournament, sitting at the same table as the best players in the world, without having to risk more money than you would lose in a friendly game of penny poker.

Micro accounts just became popular last year, and many traders aren’t even aware that they exist. This is a big deal because it means you can sustain larger draw downs without risking large sums of money; in other words, your style of trading does not have be dictated by the size of your account.  Many traders who are undercapitalized assume that they must day trade in order to avoid large losses, but with micro accounts traders can customize the size of the trade. For example, let’s assume that you have a $5000 micro account and you are trading EUR/USD (one pip = 10 cents).  Which of the following trades creates the greatest amount of risk?

1) Risking 1000 pips on a one-lot position trade (10 cents x 1000 = $100)
2) Risking 100 pips on a 10-lot swing trade (10 cents x 10 lots = $1; $1 x 100 pips = $100)
3) Risking 10 pips on a 100-lot day trade (10 cents x 100 lots = $10; $10 x 10 pips = $100)

Of course, the answer is that the risk of $100 is the same on all three. In conclusion, you could be a day trader, or a position trader, or a swing trader – in fact you could do all three at once– in a $5000 micro account. Your style of trading need not be dictated by the size of your account. Good luck! 

Have a question about Forex trading? Send an email to eponsi@tradingacademy.com and we may use your question in an upcoming newsletter. Until next time, best of luck to you in trading.

Ed Ponsi