The Rally Continues

Featured Article

January 23, 2007

By Ed Ponsi, Online Trading Academy, Equities, E-mini Futures, Options, Technical Analysis Strategies, Platform Immersion, and Personal Trading Plan Instructor

The incredible rally in the Great Britain Pound/Japanese Yen currency pair (GBP/JPY), which we wrote about in this space
last
week, continues unabated. After a 50% Fibonacci pullback created a bottom on January 8, the pair has now raced higher by 1200 pips (see figure 1). I realize that many of the readers are new to foreign exchange, and perhaps are not fully aware of the significance of the prior statement. Let’s break it down into dollars and cents.

Figure 1: The Great Britain Pound continues to rally against the Japanese Yen.

One pip is the smallest possible increment of movement in a currency pair. The current value of one pip in the GBP/JPY pair is
US $8.25 (the value of a pip can vary from one currency pair to the next). So, an extremely fortunate trader who was able to catch 1000 of the 1200 pips (it would be unreasonable to assume that a trader would capture all 1200 pips) would be sitting on a profit of $8250.00 per lot.

The next logical question would be, “What do you mean when you say ‘per lot’?” One lot is a unit of standardization in the currency market, similar to one contract in the futures market. The smallest trade you can place in a standard sized account (as opposed to a mini account) is one lot. So, in a scenario similar as the one listed above, a two-lot trade would have netted the trader $16,500 ($8250 x 2), and a ten-lot trade would have yielded $82,500.

How much money would a trader have to invest in order to enjoy these returns? Foreign exchange (also known as Forex) offers a high degree of leverage, with some market makers offering buying power of 200-to-1 or higher. It’s important to note that this high degree of leverage is not a requirement, and traders can customize their buying power to suit their personal temperament and risk profile. If a trader were to use leverage of 100-to-1, he or she would have to put up only $1000 U.S. Dollars to control a one-lot position in most currency pairs. Of course leverage is a double-edged sword, as it magnifies losses as well as gains.

At this point, the question that I hear most often (especially from stock traders) is, “How much interest do I have to pay to use that much leverage?” Equity traders usually assume that they have to pay interest for leverage, because in the world of stock trading that is the way it has always been done.

What if I were to tell you that you could have collected interest on the aforementioned trade instead of paying it? Yes, in addition to the huge gain from the rally in GBP/JPY currency pair, many traders actually earned interest on the trade. This is the ‘icing on the cake’ in Forex trading. It is usually required that in order to collect interest, you must give up some of your leverage for example, you may be required to reduce your leverage from 100-to-1 down to 50-to-1. Leverage of 50-to-1 is more than sufficient to meet the needs of most Forex traders.

If all of this is new to you, it may seem too good to be true. I’m a former stock trader, and I can certainly remember feeling that way when I was introduced to Forex trading. Maybe now it is becoming clear why hedge funds and institutions have always traded the foreign exchange markets because the smart money naturally gravitates toward the best available opportunity. Now that the world of foreign exchange has finally been opened up to everyone, we see that more and more individuals are making the decision to trade Forex as well.

Can It Continue?

I’ve heard this question asked numerous times over the past week; “How long can the GBP/JPY rally continue? Has the GBP/JPY pair peaked?”

Of course it can go higher just because the pair has already had a nice run doesn’t mean that this incredible rally is over. It certainly does seem a bit extended here, and a nice deep pullback would be more than welcome, but to give traders a different perspective I’d like to introduce a long-term monthly chart. In this time frame, the formation of a massive bottoming pattern is revealed
(see figure 2).

Figure 2: A massive bottom forms in the GBP/JPY currency pair.

If GBP/JPY breaks cleanly above 250.00, how great is the potential upside? Let’s look back even further, to get a clear picture of where this currency pair was trading prior to the formation of this pattern
(see figure 3).

Figure 3: GBP/JPY 30-year monthly chart.

The longer-term perspective reveals that this pair could continue to run for years. The Forex market is famous for its long-term trends, which can continue for weeks, months, or years. This is one of the main reasons why trend following traders favor the currency markets.

Deny, Deny, Deny

After months of hawkish rhetoric, the Bank of Japan (BoJ) finally had their chance to raise interest rates last week – and declined. This is reminiscent of a parent who constantly speaks about discipline, but never puts the theory into practice. We have heard months of tough talk, with very little action. The BoJ is apparently in the exact opposite mode as the Bank of England, which says little but allows their actions to speak loudly instead.

The Bank of Japan is widely believed to have backed down due to government pressure, and both the central bank and the government are spinning like tops to deny this. The problem is, with everyone from Japan’s Prime Minister to the head of the BoJ screaming that it isn’t true, it’s almost impossible to escape the perception that they have something to hide.

Government pressure on the BoJ has not been covert. Three days prior to the interest rate decision, one of the most powerful members of the ruling Liberal Democratic Party (LDP), Hidenao Nakagawa, said that a rate hike could not be justified due to recent economic weakness. That same day, economic policy minister Hiroko Ota warned that a rate hike could push Japan back into a deflationary spiral.

The result of all this is that it now appears that the BoJ is not really in charge of monetary policy, but is just a puppet of the LDP. The market’s response was swift and harsh, with the Great Britain Pound/ Japanese Yen (GBP/JPY) currency pair reaching 240.00 for the first time this century. The Yen took a beating from all of the other major currencies as well. You can bet that there will be a rate hike next month, if for no other reason than to attempt to restore some semblance of credibility to the Bank of Japan.

Fast Fact

According to the Los Angeles Times, the $50 billion per year Canadian tourism industry has seen visits by U.S. travelers drop by 28 percent over the past five years. The decline is blamed on several factors, most notably the strength of the Canadian Dollar. One U.S. Dollar is now valued at about 1.17 in Canadian currency. Five years ago, in January of 2002, one U.S. Dollar bought about 1.60 Canadian Dollars. This scenario is not unusual, as a reduction in the inflow of tourists is a common side effect of a strong currency.

If you’d like to learn more about Forex and the information presented above, please click here for our
Forex course
schedule.

Until next time, best of luck in trading!

Disclaimer
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

Lessons from the Pros

Featured Article

The Rally Continues

SHARE THIS