For those of you who have never heard of the foreign exchange market, you are missing out on the 24-hours-a-day market that is only closed Friday evening through Sunday afternoon. This fast moving market gives you the ability to leverage your transactions not by the typical 2x that you are allowed in the US Stock Markets, but up to 400x in some FOREX intermediaries (meaning for every $1 in your account you can control up to $400 of currency). While this huge leverage can significantly amplify your returns, it can also work against you just as fast until you are left with nothing. A commonly accepted figure is that 95% of Retail Foreign Exchange traders lose money while in this market; what separates the winners from the losers is money management and trading strategy.
What makes this market so unique is that you do not pay commissions to trade, you pay the bid/ask spread, which ends up going to your FOREX broker, The cost is not immediately deducted from your balance, it just goes into your account as an unrealized loss. You also receive the interest rates spreads on your positions; therefore, you gain an opportunity known as a Carry Trade, which involves borrowing a currency with a low interest rate and investing in a currency with a high interest rate. Take for instance borrowing Yen at .25% and investing that money in the USD at 5%: that set up will yield you 4.75% in interest a year, but when you account for leverage you can increase that amount significantly.
Now we will move on to the Reverse Scale Trading Strategy, which was introduced in a book by Braden Glett. The basic idea from the strategy is to do the opposite of Dollar Cost Averaging, and instead of adding to your losers, you add to your winning trades. There is a limit to this strategy if you are investing in the stock market, because you are limited by the amount of money in your account, individual company health, and sometimes illiquid markets. But with the FOREX market, you can add to positions using the significant margin available, more macro risk elements, and a very liquid $2 trillion daily volume market.
The reverse scale trading strategy suggests adding to stock positions once they have increased by 50% and cutting losses after a decrease of 33.33%. These percentages may be acceptable in the stock markets, but for a 50% increase in the EUR/USD currently trading around 1.30, we would have to wait for the FX rate to increase to 1.95 before we could add to our position. A move like that may take 10 years or so and the profit would not be similar to that of stock trades. We must adapt this strategy to the FOREX markets and understand that we will have some periods of time where we will see many small losses, but patience will be rewarded when there is a big move in the market.
The adaptations:
- Setting a fixed space in between trades, such as placing buy orders on the EUR/USD at 1.30, 1.32, 1.34, 1.36, if the EUR/USD is currently trading at 1.30 and setting a stop-loss at 1.29 or 1.28, depending on your risk tolerance.
- Not overleveraging your account at the start of the trade, but starting small to keep your losses small should you enter in at the time of a ranging market.
- Move up the stop-losses when you enter into another trade in your direction to protect your profit, such as if you initially bought at 1.30, and the EUR/USD increased to 1.32, you will move up the stop-loss on your 1.30 trade to 1.31, so you lock in yourself to breakeven.
- Trade in a basket of low-correlation currencies so that perhaps when one pair is ranging, you may have one that is trending, thus giving you the ability to profit in any environment
Another adaptation that I looked at was basically straddling the current price of a ranging pair with buy orders above the price and sell order below the price. This basically allows me to profit from a significant move one way or the other, should that move continue, such a when the EUR/USD rose from around 1.19 to about 1.30 during the period of March 2006 to May 2006.
Another good way to use this strategy is to invest in the Exotic-Emerging Currencies, which tend to be very volatile and tend to trend against the major pairs. By straddling the Exotic Currency pairs you can catch a giant move in one direction or the other, but you also have to adapt the reverse scale trading strategy to the individual pair because a pip could have a different value and usually require more margin (usually capped at 25:1, instead of the 400-50:1 when you trade the major pairs).
The ability to leverage in the FOREX market gives a small retail investor, like you or I, the ability to trade a strategy that imposes money management techniques diversified among a number of currencies. To gain a better understanding of this strategy, let’s take a look at a move in the USD/TRY, which fell from 1.67 to 1.47 during the period between June 2006 to September 2006.
I tried to keep each pip in each of the USD/TRY trade worth about $.10. If you look at the first blue box, the hypothetical trader went short the USD/TRY at 1.67, which means that he shorted 1670 units of the USD/TRY. He also went short 1620 units at 1.62, another short at 1.57, 1.52 and 1.47. He got stopped out of his position at 1.52 (red box) when the US Dollar rose against the Turkish Lira. The total profit for this trade would have been around $274.66, which is total of 2746.6 pips. And, on an account balance of $1,000, that represents a 27% return. You can see that there are significant opportunities existing with this strategy, and it can go either way because you are just relying on a move in a currency pair, regardless of the direction of that move.
This strategy offers a retail investor the ability to not make individual currency direction decisions, but it gives him or her the ability to stick to a systematic approach to profit from volatility and trends.
This analysis did not take into account changes in the spread of the exotic currency pairs, taxes, or carry from interest rates. Please comment if you have any questions in regards to this analysis.
