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Using Currencies to Get Back what you Lost

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Using Currencies to Get Back what you Lost

Post by Sean on Sat Oct 25, 2008 12:53 am

Good Day Currency Traders!

As I said yesterday, you don’t have to be a rocket scientist to trade foreign currencies. On the contrary, depending on your trading strategy, you may just watch a handful of indicators to choose your own Forex trades.

I personally watch five indicators (or “profit triggers”) religiously to choose my currency trades. I gave you two of these triggers yesterday to help you gauge where the dollar is heading. Once again, you want to know where the dollar is heading because if you know where the dollar is going, then you know where the major currency pairs are going.

Well today, I want to show you how you can use the Japanese yen in the same way. You want to watch the Japanese yen, because if you know where the yen is heading, then you know where the most important “carry trades” are going.

The Magic of the Carry Trade – When It Works
A carry trade happens when a trader wants to earn the interest from a high-yielding currency, so he pairs it with a very low-yielding currency, and then keeps the difference between the two country’s interest rates.

Well, it’s not secret that Japan has the lowest interest rate of any major currency around. Right now, the yen only pays 0.50% (that’s right…only ½ of 1%!). Compare that to the British pound that pays 4.5% or the New Zealand that pays 7.5%.

So obviously, you would rather earn 4-7% rather than half of 1%. However, a carry trade like this only works when the markets are stable or heading higher. Otherwise, you can’t earn daily interest.

For instance, say you made US$22 a day in daily interest but lost US$100 a day as your carry trade currency depreciated. Obviously, this trade would not be worth your time. However, if the pair remains at the same level or goes up in value, then it’s nice to get the “extra kicker” of the daily interest.

Falling Stock Markets Spell Danger for Carry Trades
So how do you know when it’s the right time to invest in carry trades? The answer leads us to my third profit trigger. To be a successful Forex trader, you need to watch the stock markets. Specifically, I watch the Dow Jones Industrial Average ($INDU) and Japan’s Nikkei ($NIKK).

Take a look at the chart below and you’ll see what I mean. I charted the yen at the top of the graph and the Dow Jones at the bottom. Notice: As stocks slide off, the yen heads higher. Also, when stocks head higher, the yen suffers.


Stocks Up = Yen Down and Vice Versa

[You must be registered and logged in to see this image.]

Stocks and the yen have this inverse relationship because of the nature of risk in the markets. Let me explain. Traders invest in stocks when they are willing to stick their necks out and take on a little risk. This is generally when stocks are flying high.

But when the stock markets start to drop, stock traders run quickly out of the stock market and into undervalued, beaten down assets. They pour their money into these beaten down assets and camp out until stocks start rising again. In the Forex world, we call this a “risk-adverse environment.”

The yen fits the bill in a risk-adverse environment. You can’t get much more beaten down than the Japanese yen. The yen always gets creamed when stocks prosper, so as stocks start to fall, the beaten down yen finally catches a break.

So if I have a strong opinion about the U.S. stock market or Japan’s Nikkei, then by default, I have a strong opinion about the Japanese yen ($XJY on stockcharts.com). This enables me to buy or sell the “cross-rates” (the non-dollar pairs) – especially the yen cross rates.

Recently, I saw a short-term bounce coming in stocks. Therefore by default, I knew the Japanese yen was about to suffer. Sure enough, that’s exactly what happened. Stocks rallied, the yen tanked and I made a profit.

Once I thought the bounce was over in stocks, I locked in these profits by closing the position. It was a really sweet trade to say the least…and I would have never known about it if I hadn’t been monitoring the stock movements.

Let Fear Be Your Guide When Markets Turn Upside Down
However, I do have one more “yen gauge” that I use that also adds in confirmation for me. This leads me to my fourth indicator: the VIX (Volatility Index)

The VIX (symbol $VIX at stockcharts.com) tracks call and put option activity on the S&P 500. However, more simply put, it’s a “fear gauge.” It shows how nervous stock investors are to enter the markets.

When the VIX has an unusually high reading, you know that investors are running scared so they’re selling off stocks. When fear gets to these extreme points, it usually shows there will be a bottom soon in stocks. Historically, this has been a great gauge to use in order to pile in near the bottom in the U.S. stock market.

Let’s take a look at what it looks like below. You’ll see the yen on top and the VIX below it in the candlestick chart

[You must be registered and logged in to see this image.]

Remember, if the VIX is unusually high, then we know a near-term stock market bottom should be coming soon. If that’s the case, then we know the yen is about to peak, and eventually start falling again as stocks rise. As a Forex trader, I know to start buying pairs that effectively short the yen like the USD/JPY and the EUR/JPY.

Watch the Interest Rates and Find Out Where Money Is Flowing
My final profit trigger is fairly easy to watch: Global interest rates.

I keep an eye on global interest rates by visiting [You must be registered and logged in to see this link.] and looking on their home page. They always have a current reading on what the interest rates are for each major country. Also, under their “calendar” tab, I can find out about when interest rate decisions will be coming and what analysts expect them to be (whether rates will rise, fall or stay the same).

In general, a high interest rate tends to draw money towards that country’s currency and a lower interest rate tends to force money away from that country’s currency. It’s easy to see why. Naturally, traders want to earn higher interest on your trades. That’s why the carry trade works most of the time.

I say most of the time because when times are shaky and stocks are in “sell off” mode, then carry trades fall apart. Carry trades suffer when stock markets are falling (this is a risk-adverse environment again). These trades hate the high volatility that comes along with a bear market.

In a bear market (down stock market), the low-yielding currencies finally get their time to shine. But in good times (up stock markets), higher yielding currencies perform the best.

If I hear the analysts say a certain central bank is likely to raise interest rates soon, then I know that there’s a good chance that money will move towards that currency.

Therefore high interest rates (especially rates heading higher) attract investment money like a magnet to its currency. As money flows into that currency, it makes the currency rise in value.

But, as interest rates fall, money starts to flee and look for greener pastures elsewhere in the world. When money pours out of a currency, the value of that currency goes down.

So the direction of interest rates highly influences the direction of a country’s currency especially over the long run.

Put Your Five Profit Triggers to Work!
Put these five triggers to use and you’ll find that you get an edge in your investing/trading. In order to be successful in your trading, all you need to do is follow your trading strategy and manage your risk (so you have time to let your trading style work in your favor). It’s that simple.

There’s a wise proverb that says “wealth is gained here a little and there a little” and I’ve found that to be true. You will pick up US$100 here and US$1,000 there but over time it all adds up to hundreds of thousands of dollars throughout the years.

Have a great weekend!
Sean

Sean

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