HL 6 - The 'Long' & 'Short' of a disaster trade

I had the good fortune of seeing a quarter of my capital being wiped out last week due to one bad trade. I had written in the previous post that I was Long on the EUR going into the week. This decision backfired on me. I only hope that my first few lessons in the currency markets is as enriching as my experiences with the equity markets. I ended the week with a lot of new insights and experiences, but was out on money. I hope the former turns out to be greater than the latter!

Before we proceed, let me dwell a bit on why Interest Rates are so important in the currency markets and the effect that changes in interest rates have on currencies. Imagine two countries, A and B. Country A has 'high' interest rates while B has 'low' interest rates. Investors look at A and B and observe that Interest Rates in A are higher than in B. As everybody desires high returns on their investment, they start investing in assets in Country A. To buy assets in A, investors need to exchange their home currency for A's currency. This increases the demand for A's currency. The age-old laws of demand-and-supply result in Country A's currency appreciating relative to other currencies in the short term. So if an investor holds A's currency (i.e. he is 'Long' A's currency), he will find the value of his investment going up over time.

Now its easy to see how a rise in A's interest rates will lead to further appreciation of its currency. At the risk of stating the obvious, we see that if rates in A go up, investors respond by demanding more of A's currency; in turn resulting in A's currency appreciating further....The opposite effect occurs if interest rates were to drop in Country A.


The week was eventful, with the meetings of the Federal Reserve and the European Central Bank. As expected, both chose to keep their respective Interest Rates unchanged and the markets, reacted by loading up on the US Dollar. Since every position in currencies is a combination of a 'Long' and a 'Short', being on the 'Long' side of the Euro-US Dollar (EUR-USD) implies being 'short' on the US Dollar. It didn't help that I was short on the US Dollar. Result: Disaster.

The 25% drop highlights the beauties of that golden word 'leverage'. Imagine putting up just Re.1 to take a position that is worth Rs.10. That is 'leverage'. The implications are easy to see. The underlying instrument on which I took the position moves up, my returns are magnified by Mr. Leverage. On the other hand, the underlying moves down and Mr. Leverage forsakes me! And makes me pay through my nose for the 'indiscretion'. I got the bad side of Mr. Leverage during last week's trading.

I have never considered myself a good 'market timer'. On those occasions when I have tried, I have failed miserably! The adjoining chart is another example of my 'talents' in market timing. The EUR-USD had already gone against me by then, when I saw a 'Double Top' on the chart. (See the horixontal line linking the two 'tops' in the chart). Unfortunately for me, the EUR broke the Double Top on the way down. When this happens, then generally, and according to the Laws of Technical Analysis, it tends to move in the same direction...in this case...Down!

For some reason, I didn't liquidate on the downward breakout. After a prompt drop, the EUR started consolidating somewhat. By this time, I had 'woken up' to the gravity of the situation...and placed a 'Stop' at the day's low. I expected the probability of the Stop getting triggered to be remote, but I went wrong.

But, as they say, Mr. Murphy reared his head and stopped me out of the trade...Precisely at the BOTTOM!!!

From the chart, it seems that the EUR was just waiting for me to get out of it! 14 contracts out of the way and it started rising again.

In more ways than one, I almost 'willed' the trade to go against me. It helped me appreciate the effects of leverage, the importance of limiting exposure to a single trade and the importance of having an exit strategy in place. I had the last one right...I was ready to take a 1% hit off my purchase price before exiting. The EUR hit that 1% level and I was out. What happened after that shouldn't have bothered me because I was sticking to my system. And it didn't.

The disaster trade also got me thinking on 'program trading' that is proliferating the investing world today. There are programs that will buy when a certain level is reached and sell when a particular level is hit. This seems good to me, but I still cannot bring myself to put 100% trust in the system and build a trading strategy that will be at its mercy.

Trading is about developing a system that works for you and then sticking to it. I am currently in the process of finding the one that works for me...

The journey beckons.

HL 5 - A Week of Falling Wedges

Figures: AUD-USD, EUR-CAD 30-min chart
Source: Fxtrade




The week gone by...

Its not without reason that they say the Greenback is the reserve currency of the world. The US Dollar has this uncanny habit of shrugging off 'negative' data and rallying against other currencies, leaving a lot of those who bet against the Dollar licking their wounds. (I am one of them!)

The Dollar rallied early in the week on the back of positive and 'strong' manufacturing data. A lot of shorts had been building up on the EUR in the earlier week, and despite some late week short-covering, most of the shorts stayed put on their position. Towards the end of last week came the much awaited payrolls data. This number along with the other 'indicators' like GDP growth, inflation, trade deficit etc., has the potential of moving the markets. The markets had already 'discounted' the much lower than expected first quarter GDP growth in the US economy. So the only indicator which could give the market 'direction' the coming week was the payrolls data.

That it came lower than expectations didn't make a difference. The US Dollar didn't as much as bat an eyelid and after a brief drop, continued rallying against major currencies.

The week ahead...
The ECB is expected to meet to decide for or against a rate hike. My feeling is that it will leave interest rates unchanged for the time being, and probably raise it to 4.00% in its June meeting. Also manufacturing data is expected from Germany and France. The markets, in my opinion, have already discounted the 'unchanged rate' scenario and this implies that the EUR could see sideways movement, without much hype and hoopla.

Falling Wedges
This brings me to the technical developments for the past week. One saw a building up of the 'Falling Wedge' pattern for the US Dollar against major currencies. The AUD-USD and EUR-CAD charts illustrate this phenomenon. The encouraging development towards the end of the week was the 'breaking' out from the Falling Wedge. If this isn't a false breakout, one can expect these currencies to rally against the US Dollar.

Conclusion
I am staying Long on the EUR going into next week, leaving the position unhedged. I feel that the week could see the EUR gaining against the US Dollar. I am also Long on the USD versus the INR. Although the US Dollar rallied against major currencies, it faltered against the INR. Strong portfolio and FDI flows into India led to the Rupee appreciating versus the Dollar. The Reserve Bank of India is wary of intervening to keep the INR from appreciating more, for fear of stoking inflation. How it manages to walk the tight rope of balancing a strong currency and inflation remains an interesting event for observers.