Currency Trader Magazine 2011-09

8/4/2019 Currency Trader Magazine 2011-09

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eptember 2011

olume 8, No. 9

Strategies, analysis, and news for FX traders

ANALYZING THE DOLLAR/SWISS AUGUST BOTTOM P. 20

The SNB vs.

the Swiss Franc rally:

Can the bank stem the tide?

p. 6

The gold bubble

and the dollar

p. 12

Improving trend signalwith the Parabolic Tim

Indicatorp. 22

Understanding theCanada-Aussie cross

p. 28


2/362 September2011CURRENCY TRADER

CONTENTS

Contributors................................................. 4

Global Markets

Swiss National Bank battles the trend ......6

Switzerlandscentralbanknallytookoffthe

glovestobattleitsskyrocketingcurrency.Hasit

puttherallydownforthecount,oraretherea

fewmoreroundstogo?

By Currency Trader Staff

On the Money

Is the price of gold irrationally high? .....12

Analysisofotherbubblesraisesquestionsabout

goldsabilitytosustainitshyperbolicrun.

By Barbara Rockefeller

Spot Check

Dollar/Swiss.............................................. 20

TheAugustreversalintheUSD/CHFpairwas

trulyauniqueevent,butextrapolatingfromits

characteristicsprovidessomeperspectiveon

themarketstrajectory.

By Currency Trader Staff

Trading StrategiesFiltering trend signals with the Parabolic

Time Indicator ..........................................22

Anindicatorthatanalyzesthedurationof

pricemovesprovestobeausefullterforthe

parabolicsystem

By Daniel Fernandez

Advanced Concepts

The Canada-Australia cross rate ............28

Combiningthesetwotrendingcurrencies

resultsinatrendingcrossratewhosereturns

aredirectlylinkedtoexpectedinterest-rate

differentialsandrelativeassetreturns.

By Howard L. Simons

GlobalEconomicCalendar........................ 32

Importantdatesforcurrencytraders.

Events....................................................... 32

Conferences,seminars,andotherevents.

Currency Futures Snapshot.................33

International Markets............................34

Numbersfromtheglobalforex,stock,and

interest-ratemarkets.

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CONTRIBUTORS

4 September2011CURRENCY TRADER

Editor-in-chief:MarkEtzkorn

[email protected]

Managing editor:MollyGoad

[email protected]

Contributing editor:

HowardSimons

Contributing writers:

BarbaraRockefeller,DanielFernandez

MarcChandler,ChrisPeters

Editorial assistant and

webmaster:KeshaGreen

[email protected]

President:PhilDorman

[email protected]

Publisher, ad sales:

BobDorman

[email protected]

Classifed ad sales: MarkSeger

[email protected]

Volume8,Issue9.CurrencyTraderispublishedmonthlybyTechInfo,Inc.,POBox487,LakeZurich,Illinois60047.Copyright2011TechInfo,Inc.Allrightsreserved.Informationinthispublicationmaynotbestoredorreproducedinanyformwithoutwrittenpermissionfromthepublisher.

TheinformationinCurrencyTradermagazineisintendedforeducationalpurposesonly.Itisnotmeanttorecommend,promoteorinanywayimplytheeffectivenessofanytradingsystem,strategyorapproach.Tradersareadvisedtodotheirownresearchandtestingtodeterminethevalidityofatradingidea.Tradingandinvestingcarryahighlevelofrisk.Pastperfor-mancedoesnotguaranteefutureresults.

For all subscriber services:www.currencytradermag.com

ApublicationofActiveTrader

CONTRIBUTORS

qHoward Simons is president of Rosewood

Trading Inc. and a strategist for Bianco Research.

He writes and speaks frequently on a wide range

of economic and nancial market issues.

qBarbara Rockefeller(www.rts-forex.com) is an inter-

national economist with a focus on foreign exchange. She has

worked as a forecaster, trader, and consultant at Citibank and

other nancial institutions, and currently publishes two daily

reports on foreign exchange. Rockefeller is the author ofTechni-

cal Analysis for Dummies, Second Edition (Wiley, 2011), 24/7 Trading

Around the Clock, Around the World (John Wiley & Sons, 2000), The

Global Trader (John Wiley & Sons, 2001), and How to Invest Interna-

tionally, published in Japan in 1999. A book tentatively titled How

to Trade FX is in the works. Rockefeller is on the board of directors

of a large European hedge fund.

qDaniel Fernandezis an active trader with a

strong interest in calculus, statistics, and econom-

ics who has been focusing on the analysis of forex

trading strategies, particularly algorithmic trad-

ing and the mathematical evaluation of long-term

system protability. For the past two years he has

published his research and opinions on his blog Reviewing Eve-

rything Forex, which also includes reviews of commercial and

free trading systems and general interest articles on forex trading

(http://mechanicalforex.com). Fernandez is a graduate of theNational University of Colombia, where he majored in chemistry,

concentrating in computational chemistry. He can be reached at

[email protected].
mailto:metzkorn%40currencytradermag.com?subject=mailto:mgoad%40currencytradermag.com?subject=mailto:kgreen%40currencytradermag.com?subject=mailto:pdorman%40currencytradermag.com?subject=mailto:bdorman%40currencytradermag.com?subject=mailto:seger%40currencytradermag.com?subject=http://www.currencytradermag.com/http://www.rts-forex.com/http://mechanicalforex.com/mailto:[email protected]:[email protected]://mechanicalforex.com/http://www.rts-forex.com/http://www.currencytradermag.com/mailto:seger%40currencytradermag.com?subject=mailto:bdorman%40currencytradermag.com?subject=mailto:pdorman%40currencytradermag.com?subject=mailto:kgreen%40currencytradermag.com?subject=mailto:mgoad%40currencytradermag.com?subject=mailto:metzkorn%40currencytradermag.com?subject=


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GLOBALMARKETS

Conventional market wisdom says central banks cantfight trends, but in this case the Swiss franc might be theexception. Since early August the massive flight-to-safetybull trend in the Swiss franc vs. the U.S. dollar and theEuro has reversed (Figure 1). The sharp V bottom rever-sal evident on both daily charts has some market watcherssaying the dollar/Swiss and Euro/Swiss pairs have estab-

lished significant lows.In gauging what might be ahead for the Swiss currency,

lets look at whats been behind the massive Swiss francappreciation that has unfolded throughout much of 2011and what the Swiss National Bank (SNB) did to spark therecent bounce.

Swiss economicsFirst, the Swiss economy is export-driven, which means

the 20-percent appreciation in the Swiss franc vs. thegreenback over the past 12 months negatively impactedthe countrys manufacturing andexport sector. Currency appreciationmakes your goods look more expen-sive, says David Vermeire, economistat Moodys Analytics.

Recent economic data has, in fact,revealed an overall slowing trend.

Growth in the second quarterslowed, says Jay Bryson, globaleconomist at Wells Fargo, noting thatSwitzerlands Q1 GDP came in at 2.6

percent, compared to 2.9 percent in Q42010.

Purchasing managers datarevealed manufacturing has con-tracted. According to Bryson, the PMI(Purchasing Managers Index, a gauge ofmanufacturing growth) stood at 59 asrecently as March 2011. In June it wasat 53.4, and at 53.5 in July.

Based on the PMI, I would expectto see some slowing in second quarterGDP as well, Bryson adds. The mar-ket is expecting a 2.3-percent reading

Swiss National Bank

battles the trend

Switzerlands central bank finally took off the gloves to battle its skyrocketing currency.

Has it put the rally down for the count, or are there a few more rounds to go?

BY CURRENCY TRADER STAFF

FIGURE 1: SIGNIFICANT REVERSAL?

The reversal evident on both charts has some market watchers saying the USD/

CHF and EUR/CHF pairs have established significant bottoms.

Source for all charts: TradeStation


7/36CURRENCY TRADERSeptember2011

for the second quarter.Nomura forecasts 2011 Swiss GDP at 2 percent, 2012 at

1.9 percent, and 2013 at 1.6 percent. Moodys Analyticspredicts a 2-percent GDP pace for 2011 and 2.2-percent for2012.

However, growth forecasts would be revised down if thecurrency resumes its appreciation trend. (Forecasts) are atthe mercy of international markets right now, notes IeshaMontgomery, associate economist at Northern Trust.

Switzerlands export-driven economy is especially vul-nerable because the country tends to produce so-calledhigh-value-added products such as pharmaceuticals,machinery and electronics, watches, and precision instru-ments.

If Switzerland was a maker of routine goods, theywould be in deep trouble already,explains Greg Anderson, director of FXstrategy at Citi FX. But they are a makerof luxury goods high-end goods and as a result, they have a little more

pricing power and a little fatter marginsthan, say, some Asian countries.However some analysts point out the

Swiss economy isnt doing too badly especially compared to its closestneighbors; the weak link is export-drivencurrency risk. We feel the currencystrengthening poses a downside riskto the outlook, Moodys AnalyticsVermeire says. But the (Swiss) economyis doing quite well. Its been a strongperformer compared to the Eurozone.It doesnt have fiscal problems.

(Switzerland) has fairly low unemploy-ment, and we are seeing continuedstrength for consumer spending.

Switzerlands largest trading part-ner is Germany, followed by the U.S.,Italy, France, and the UK, according toVermeire. Given their heavy trading withEurozone countries, the Swiss tend toplace a greater importance on the Euro/Swiss exchange rate (EUR/CHF) thanthe dollar/Swiss rate (USD/CHF).

From Jan. 1 through Aug. 30, the Swissfranc gained approximately 12.5 percent

vs. the U.S. dollar, while it rose 5.5 percent vs. the Euro paring 23 and 17 percent moves, respectively, at the Aug.9 bottom in the USD/CHF and EUR/CHF pairs. Citi FXsAnderson offers some perspective on how much volatilityhas increased for the Swiss currency in recent months.

In 2005, the Swiss franc traded in a range between 1.53and 1.56, a range of 2.36 percent, he says. On Aug. 26 one session only it traded in a 2.94-percent range.

There are already signs the francs appreciation hasimpacted exports and growth prospects. Expressed inSwiss franc terms, exports in June were down almost 11percent year-over-year thats a pretty big drop, WellsFargos Bryson says. Swiss manufacturers invoice in dol-lar terms. Lets say you want to buy a Rolex. That will costyou $5,000. But because the Swiss franc has strengthened

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GLOBALMARKETS

20 percent over the last year, that is 20 percent less Swissfrancs, Bryson explains.Exporters are starting to feel it, Northern Trusts

Montgomery says. One company asked workers to workan extra two hours per week for no extra pay for18 months. It is starting to affect their competitivenessabroad. The strengthening currency is also expected toput a dent in the Swiss tourism industry.

These currency-driven economic pressures havemanifested themselves in the political sphere, as well.Politicians are feeling pressure from businesses whoare seeing their businesses become less profitable, says

Charles St-Arnaud, FX strategist for Nomura.The strength of the Swiss franc is destroying the Swisseconomy, says Brian Dolan, chief currency analyst atForex.com. Swiss manufacturers are talking about need-ing to relocate outside of Switzerland if it stays strong.They are already through the fat and into the muscle of theSwiss economy.

The bull runAlthough the Swiss francs story since 1973 is almost exclu-sively one of appreciation vs. the dollar, the trend has espe-cially accelerated over the past year or so (Figure 2). The

dollar/Swiss rate fell from about 1.1700

in June 2010 to .7200 (38 percent) inearly August 2011. Meanwhile, Euro/Swiss fell from 1.4500 in May 2010 to1.0000 (29 percent) in early August.

Switzerland, a traditionally neu-tral country militarily, has alwaysbeen synonymous with banking andfinancial secrecy, and the Swiss franchas long been known as a safe-havencurrency that attracts funds in timesof international tension, or financialuncertainty or upheaval.

It has a long-standing reputa-

tion as a safe haven, but it was moreattractive to speculators than the yenbecause the SNB was widely assumedto have given up on intervention it was seen as impotent, says SeanCallow, senior currency strategist atWestpac Institutional Bank. Thisview has been proven incorrect, butonly belatedly, and with interest ratesalready around zero the SNBs policychoices are limited.

The fact that Switzerland is a pret-

FIGURE 2: THE LONG APPRECIATION

For almost all the floating-rate era, the Swiss franc has gained strength vs. the

U.S. dollar. The past year marked one of the sharper downswings in the USD/

CHF rate.


9/36

ty solid country with good fundamentals is both a giftand a curse, according to Northern Trusts Montgomery.Because of the (good fundamentals), people are buyingtheir currency, she says.

Another factor increasing the attractiveness ofSwitzerland is its sound fiscal and trade outlook. In2010, (the country) saw a 0.4 percent GDP surplus,Montgomery says. The 2011 forecast is for a 0.2 percentdeficit, but it could swing deficit/surplus.

Safety playAmid cascading waves of Eurozone sovereign-debt con-cerns, U.S. fiscal woes and the recent global equity market

sell-off, investors piles cash into the Swiss franc, Japaneseyen, and gold, which have all posted impressive gains inrecent months.

Citi FXs Anderson says the massive Swiss gains areprimarily (from) risk aversion, and I would blameEurozone risk aversion as the biggest factor.

Anderson also notes that although both the yen andfranc have benefited from safe-haven flows, unlike theyen, the franc is underpinned by a very strong economythat has outperformed expectations over the past year anda half.

According to Nomuras St-Arnaud, the massive inflowsinto the Swiss franc had an extraordinary impact because

of the relatively small size of the Swiss economy. GDPfor Switzerland in 2010 was $529 billion in U.S. dollars,he says. That compares to the U.S. at 14.5 trillion, Franceat 2.5 trillion and Germany at 3.3 trillion. [Switzerland] isreally small and it doesnt need a lot of flows to make a bigdifference in the economy.

SNB makes a moveGiven the anecdotal evidence the increasingly strongfranc was adversely impacting Swiss exporters, the Swissmonetary authorities took action in early August. The firststep was the move by the SNB on Aug. 3 to cut its target

3-month LIBOR to zero-to-0.25 percent (from zero-to-0.75percent).In addition to the rate cut, Swiss officials have been

talking the currency down by threatening interven-tion or even pegging the currency to the Euro. The peg isconsidered by many to be a drastic measure unlikely tohappen anytime soon, as such a move would require anactual change to the Swiss constitution. It was a reminderto traders and investors that we (the SNB) have solutionsthat we can put in place, we are not defenseless, saysNomuras St-Arnaud.

The question is whether the SNB will really have teeth ifpush comes to shove, or if the bank is mostly posturing.

It does look and feel as if the central bank is committedto preventing further Swiss franc strength, Forex.comsDolan says, citing recent reports that UBS had sent a noticeto banks and depositors indicating it might impose a tem-porary levy on Swiss franc holdings. It is more likely theywill go with capital controls, or restrictions on foreignersholding Swiss francs.

Dolan adds the SNB also has another, more direct,option in its toolbox. They could impose a tax on foreigndeposits they could cut rates to negative, he says, not-ing, however, that for now it looks like the SNB has beensuccessful in shifting safe-haven flows into gold and theyen.

Outright SNB intervention also remains an option. Butseveral rounds of intervention in 2009 and 2010 that wereultimately chalked up as a loss make it a less likely solu-tion this time. The SNB is owned by regional govern-ments, similar to if the U.S. Fed was owned by individualstates in the U.S., St-Arnaud explains. It pays a dividendbased on profit at the end of the year. Regional govern-ments are concerned about losing that fiscal revenue.

Market reactionThe Dollar/Swiss and Euro/Swiss pairs bounced dramati-cally in August in response to the SNBs various threats.

CURRENCY TRADERSeptember2011 9



GLOBALMARKETS

The Swiss franc depreciated around 14 percent vs. the Eurobetween Aug. 9 and Aug. 30 (Figure 3). We saw morethan a 10 percent move in a week, St-Arnaud says. Itshook up the markets. A lot of investors who were longSwiss franc decided to sell Weve had a good ride sinceApril, well take the profits now and leave.

Citi FXs Anderson says the move may have shaken allthe speculative and professional money out of the market,but he also has a warning. The thing to keep in mind isthat Switzerland is a country with, I think, about 9 millionpeople, right next to the Eurozone, which has 338 millionpeople. If (Eurozone investors) are in a panic and want toget their money out of their own currency into a nearbysafe haven, it will be very hard to stop that.

In other words, European debt issues remain the wildcard in the Swiss scenario. What theyve done to date

will probably stall further appreciation if the Euro cri-sis doesnt get any worse, Anderson says. If it does get

substantially worse, theyll need to do more. In order for itto be a firm, hard bottom, Eurozone fundamentals need tohave bottomed.

Most analysts seem to be leaning toward the Augustlow being a significant, if not necessarily all-time bottom.Lows are probably in place in the Euro/Swiss and dol-lar/Swiss, Westpacs Callow says. The most likely nextstep is engineering negative interest rates so it costs moneyto hold the franc. A resumption of intervention on Euro/Swiss is also quite possible. I would expect it to be more ofa guerilla-style, keep-the-market-guessing approach, ratherthan the 2009-10 tactics, which seemed to involve predict-able lines in the sand.

Watch the sovereign-debt situationThe outlook for the franc is far from clear, but barring a

significant derailment of the global economic picture oran exacerbation of the European debt situation, conditionsappear to favor continued deprecia-tion in the franc.

Those who believe the U.S. will notsuffer a double-dip recession and thatEurope can keep muddling throughshould be attracted to buying dips inboth Euro/Swiss and Dollar/Swiss,Callow says.

Forex.coms Dolan offers a similartake and highlights levels to watchin the EUR/CHF pair. Continue to

look to buy Euro/Swiss on dips to the$1.1200-1.1300 area, he says. But if itgets below $1.10, thats an indicationof serious financial upheaval in theEurozone.

Most analysts say the Eurozonesovereign-debt issue is the key to theSwiss franc outlook. If stability emerg-es in the Eurozone, a firm bottom isprobably in place. But another waveof debt crises could send investorsrushing back into the Swiss franc.y

FIGURE 3: EURO/SWISS

The EUR/CHF pair gained more than 13 percent in a week after the SNB tooksteps to stem the tide of franc appreciation.


11/36

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The gold price chart looks like a bubble, and we knowwhat happens to bubbles. After a mania bursts, it takesdecades for prices to return to their trendline, let alone theprevious highs. Bubbles are commonly thought to arisefrom an excess of emotion and a shortage of clear thinking.In the case of the 1999 Nasdaq bubble, people bought anycompany with an e or a dot-com in its name withoutregard for product, earnings, management, or any othertraditional value factor.

But in the case of gold, its difficult to argue that buy-ers are irrational. After all, we do have the conditions thatcould lead to hyperinflation, most prominently excessive

budget deficits. So, is the gold price irrationally high?First lets look at a classic equity market bubble. Figure

1 shows the Nasdaq from 1980 to the present, with a linearregression line drawn from the beginning of the data tothe end of 1998. The linear regression line is extended for-ward from that point in red, showing the Nasdaq did notget back on trend until 2003, and still has not matched thehighest highs from 1999-2000.

Now lets look at a gold chart (Figure 2). The linearregression line is drawn from the beginning of the seriesin 1995 to the end of 2009, and extended forward in red. Ifwe were to get a crash like the Nasdaq tech wreck, we

would expect gold to trade at about$1,000 by 2015. Although extendinglinear regression lines is not a widelyaccepted analytical technique, itsmore than a statistical trick. It graphi-cally displays the wildly abnormalnature of the move and represents theepitome of overbought.

A move can be abnormal and yetnot irrational consider the Swissfranc (CHF) against the Euro and thedollar so far this year (Figure 3). Herewe have the example of an extrememove that is fully explained by thedeep desire of some investors for asafe haven. Recent dollar/Swiss(USD/CHF) prices are under the lin-ear regression trendline drawn fromthe beginning of 1999 to the end of2009, but nothing to set your hair onfire. The Euro/dollar (EUR/CHD),however, had a rising trendline overthe same period, making the Eurosdivergence from the regression linesextension even more shocking.

On the Money


ONTHEMONEY

Is the price of gold

irrationally high?

Analysis of other bubbles raises questions about golds ability to sustain its hyperbolic run.

BY BARBARA ROCKEFELLER

FIGURE 1: NASDAQ BUBBLE

After the tech bubble burst, the Nasdaq did not get back on trend until 2003, and

it still has not matched its 1999-2000 highs.

Sources for Figures 1-4: Charts Metastock; data Reuters and eSignal
http://www.currencytradermag.com/index.php/c/Key_Conceptshttp://www.currencytradermag.com/index.php/c/Key_Concepts


13/36CURRENCY TRADERSeptember2011 13

The other gold bubbleOne reason to worry about the current gold bubble is thatweve experienced a gold bubble in relatively recent his-tory, and it turned out like most other bubbles: horrible

losses for those who failed to exit in time.Gold inflated from $390.80 in November 1979 to ahigh of $874 (futures basis) less than two months lateron Jan. 22, 1980. Gold then proceeded to fall for the next20 years, reaching the double-bottom lows of $254.10 inJuly and August 1999 (Figure 4). This incident gave thosewho wanted to refute the argument that gold is an infla-tion hedge all the proof they could possibly want. Overthose 20 years, inflation rose by more than 100 percent.According to westegg.coms calculation, what cost $100 in1979 would cost $228.69 in 1999.

Current gold buyers cite different motivations. Some saythey are engaging in asset diversification and consider-

ing the disappointing equity marketperformance over the past decade,diversification is not a bad idea. Ifyou bought the S&P 500 at its March2000 high, you were underwater 30percent by the end of August 2011.Others are buying gold becausecertain central banks have said theyare buying gold. Another reason forinterest in gold is the attraction ofdoing something outside the box,although jumping on a bandwagon isnot particularly original.

However, as with the 1979-1980gold bubble, fear of inflation is thereal motivator of the current goldbubble. And these days we havemajor governments with debt-to-GDPratios at or over 100 percent, a ratingsdowngrade of U.S. debt, and prob-able default by a member of the EMU(Greece).

Inflation vs. hyperinflationIs the sovereign-debt crisis a justi-fication for buying gold as a store

of value? The answer lies in whether you believe we areat risk not only of inflation, but hyperinflation, which isdefined as an increase in prices of more than 50 percent ina single month.

Hyperinflation is actually quite rare, but there have been28 cases in the 20th century including Argentina, Brazil,Poland, and several USSR successor states in the past twodecades. (A 29th case is France at the time of the Frenchrevolution, at a time when the franc was paper money.)The most famous case was the German hyperinflation ofthe early 1920s, illustrated in Table 1 and Figure 5. The lat-ter graphic, which shows the devaluation of the deutschemark over a three-year period, is the scariest chart of alltime to gold buyers.

As a practical matter, hyperinflation causes a true cur-rency crisis. Regular inflation may promote currencydepreciation, depending on what else is going on in the

FIGURE 2: GOLD BUBBLE

A crash comparable to the Nasdaqs tech wreck would send gold to

approximately $1,000 by 2015.



ONTHEMONEY

economy and business cycle, but nota crisis per se. In fact, U.S. inflationis currently at historically low levels,and unless the economy revs up morethan anyone now thinks is likely,inflation is likely to remain low formany quarters and perhaps for yearsto come. Federal Reserve chief BenBernanke would not have said rateswould remain on hold (at near zero)

for another two years if Fed econo-mists had any indication inflation isunlikely to remain not only low, butabnormally low.

As a result, although the hyperin-flation argument for a dollar crisis isconspicuously absent, many analystspersist in forecasting inflation andperhaps hyperinflation. Why shouldanyone buy into the scenario in theface of hard evidence to the contrary?There is, unfortunately, a reason.

Historically, hyperinflation is

caused by excessive government defi-cits. As illustrated by Swiss economistPeter Bernholz inMonetary Regimesand Inflation (Edward Elgar, 2003), 12of the 29 cases of hyperinflation sincethe French Revolution were directlycaused by the financing of huge pub-lic deficits through money creation.

How much is huge? The histori-cal evidence points to public expendi-ture that is 40 percent funded by pub-lic debt. Deficits dont always result in

hyperinflation and currency deprecia-tion, but all cases of hyperinflationand currency depreciation were pre-ceded by huge public deficits financedby money creation. Be careful to notethe difference. Bernholz has stated ininterviews the debt he was referringto is money created by a central bankspecifically for government spending;it does not refer to debt purchased byforeigners or held by domestic entitiesthat do not resell it to the Fed. In fact,Bernholz estimates that only about 13

FIGURE 4: 20-YEAR DROP FROM THE 1980 GOLD BUBBLE

After exploding to the upside in 1979-1980, gold proceeded to fall for the next20 years while inflation rose by more than 100 percent.

:

1969 19711972197319741975197619771978197919801981 198219831984198519861987 19881989199019911992 199319941995199619971998 1999200

0

50

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FIGURE 3: SWISS FRANC BUBBLE

The Swiss francs recent behavior vs. the dollar and Euro illustrates that a

move can be abnormal but not irrational. (EUR/CHF in red; USD/CHF in black)

:

19 97 199 8 199 9 2 000 20 01 20 02 2 003 20 04 20 05 2 00 6 20 07 2 00 8 20 09 201 0 201 1 20 12 2 013 20 14 2 015

0.65

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1.00

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1.40

1.45

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1.65

1.70



percent of U.S. government spending is financed by moneycreation. He sees no danger of hyperinflation in the U.S.

For hyperinflation to occur, you need not only excessivepublic deficits, but also compounding conditions, such aswages keeping pace (or nearly keeping pace) despite risingunemployment. This outcome is usually attributed to thepower of labor unions, which in the U.S. today are fairlywell de-fanged. Remember, when President Richard Nixontook the dollar off the gold standard in 1971 a de factocurrency devaluation he also imposed wage and price

controls. In fact, the biggestlosers from hyperinflation andcurrency devaluation are thewealthy who receive the bulkof their income from interestand dividends.

One of the consequencesof hyperinflation is the sub-stitution of another currencyfor the depreciating one. Inthe 1980s you could travelto many countries, includingBrazil and most of Africa, andnever change your dollars forlocal currency everyonewas happy to take dollars.The substitution of a hard cur-rency for the devaluing localone drives down the supply oflocal money.

A barbaric relicThis raises the intriguing question of what Americanswould use to substitute for a falling dollar. Gold doesntqualify its not money. The supermarket and phone

company wouldnt know how to account for payment ingold, even if we had gold coins available. Perhaps elec-tronic gold (e-gold) will take off and become popular.But until then, the absence of a currency to substitute fordollars poses interesting questions, including how themoney supply could contract, as substitution forces it to dounder the usual hyperinflation crisis. Clearly it would takecentral bank action.

The conditions Bernholz says are necessary for a mon-etary regime to recover from hyperinflation and a currencycrisis include: an independent central bank; and absolutelimitation of the amount of credit which can be lent by thecentral bank or other monetary authorities to the govern-

ment in the future to cover its budget deficit, or the lossesof government-owned or subsidized enterprises.

Other necessary fixes include: changing the exchangerate to another, more stable one; obtaining foreign bridgingloans; revaluing all private long-term credits at the expenseof debtors; and removing all capital and trade controls.Bernholz includes raising the money supply to levels con-sistent with GDP, but that assumes currency substitutionhas taken place, which probably is not likely in the U.S.

Those who read only a part of Bernholz and fear hyper-

inflation in the U.S. are failingto note some other issues thatdont apply to the U.S. First,Bernholz is from Switzerland,which has been neutral andmanaged to avoid war since1515. Deficit spending fordefense and war purposescomes under the same sternopprobrium as any other defi-cit spending. None of the 29hyperinflation cases Bernholzstudied involved a major geo-political leader. That doesntmean the rules dont apply tosuch a country, but it almostcertainly means that thoseunder its influence are morewilling to hold its debt thanpure academic economicswould dictate. Japan comes

to mind. Japan held $907 billion in U.S. dollars at the endof April 2011. Presumably many other countries that fallunder the U.S. defense umbrella (South Korea, Australia,Germany) are motivated to hold dollars, too.

All of Bernholzs 29 cases are drawn from actual hyper-inflation and currency crises in countries that were notthe issuer of the worlds reserve currency, including Zaire,Armenia, Kyrgyzstan, Zimbabwe, and Azerbaijan. Thesecountries could adopt dollars or Euros or some other cur-rency as their medium of exchange, driving their owndevaluing currencies out of business. As already noted,however, there is no readily available substitute currencythat would drive the devaluing dollar out of circulation.Many of the rescues of hyperinflated currencies, includingthe German one in 1923, entailed issuing a new currency.How, exactly, could the U.S. pull that off? It seems institu-tionally impossible.

Deficits dont always result in

hyperinflation and currency

depreciation, but all cases of

hyperinflation were preceded by

huge public deficits financed by

money creation.



ONTHEMONEY

The newly minted gold bugs think we need a return tothe gold standard. This is unworkable in about a dozenways. First, a gold standard does not eliminate inflation or deflation. Money supply is dependent on supplies thatcan surge and contract with the vagaries of mining dis-coveries and technology. As Bernholz points out, metallicstandards have the biggest resistance to inflation, followedby a discretionary paper money regime with an inde-pendent central bank. But the discretionary paper moneyregimes do a far better job of stabilizing GDP, unemploy-ment and real interest rates.

Second, there is not enough gold ever mined to fund theU.S. economy, let alone the rest of the world. Only about166,000 tons of gold have been mined throughout all his-tory, according to the World Gold Council, and of that,governments hold roughly 29,000 tons. All the gold in theworld is therefore worth about $7.5 trillion (at $1,500 perTroy ounce). U.S. money supply alone is $8.4 trillion (July2011) and there is an equal or larger amount outside theU.S. We could not return to the gold standard without a severecontraction in every single economy in the world.

A central bank constrained by a gold standard wouldlose control over internal price stability,employment, and market stability. Thisis the context in which economist JohnMaynard Keynes issued one of his mostquoted phrases: When stability of theinternal price level and stability of theexternal exchanges are incompatible,the former is generally preferable. Headded, There is no escape from a man-aged currency, whether we wish it ornot. In truth, the gold standard is alreadya barbaric relic.

It is important to note that Keynes did

not say gold itself is a barbaric relic, butrather the gold standard is a barbaricrelic. He was warning that a systemdependent on something as undersup-plied and subject to market fickleness asgold was inherently unstable.

De Gaulles teaching momentThe gold standard has another problem and one we have experienced before.Following complaints of a dollar short-age in the 1950s and early 1960s, Frenchpresident Charles de Gaulle in 1965

FIGURE 5: GERMAN MARK UNDER HYPERINFLATION

The devaluation of the deutsche mark over this three-year period is a

freightening chart for gold buyers.

Source: http://ingrimayne.com/econ/EconomicCatastrophe/HyperInflation.html

TABLE 1: MEASURES OF GERMANY HYPER INFLATION (PERCENTAGE CHANGESIN VARIOUS INFLATION MEASURES)

Dates Internal Prices Price of Dollars Cost of Living*

Feb.1920toMay1921 +4.6% -37.2% +39.2%May1921toJuly1922 +634.6% +692.2% +417.9%

July1922toJune1923 +18,094% +22,201% +13,573%

July1923toNov.1923 +854,000,000,000% +381,700,000,000% +560,000,000,000%

*IncludesonlyfooduntilJune1923.Alldataarefrom The Economics of Inflation: A Study of Currency Depreciation in

Post-War GermanybyCostantinoBresciani-Turroni(AugustusKelley).ThedatawerecalculatedbytheStatisticalBureau

oftheGermanReich.

::

The most famous case of hyperinflation occurred in Germany in the 1920.Source: http://ingrimayne.com/econ/EconomicCatastrophe/HyperInflation.html



launched an attack on the U.S.s exorbitant privilege ofbeing the reserve currency issuer, a position that providedautomatic buyers for U.S. debt and, thus, lower financingcosts for its government.

In response to this state of affairs, France announced itwould convert $300 million into gold; Spain followed witha $60 million conversion. The 1964 trade deficit was about$3 billion and, by mid-1965, U.S. gold reserves had fallento a 26-year low of $15.1 billion (valued at $35/ounce). DeGaulle was perceived to be playing the gold card to getthe U.S. to agree to the French proposal for a new inter-national reserve unit of account the CRU (collectivereserve unit), which would be gold-backed and give thebiggest voting rights to member countries with the mostgold.

In 1967 de Gaulle withdrew France from the U.S.-ledGold Pool (which eventually became the Group of Ten,or G10) established in 1961to provide emergency inter-vention funds. (The groupwas managed by the Bank ofEngland, whose pound sharedreserve currency status with

the dollar.) The purpose of theGold Pool was to share thecosts of maintaining the priceof gold at $35/ounce amongseveral central banks, ratherthan depleting U.S. goldreserves. However, the will-ingness of a single member,France, to act in its own interests rather than the collectivegood led directly to the collapse of Bretton Woods whenthe dollar had to be taken off the gold standard in August1971.

De Gaulles timing was conspicuous in that it forced a

crisis when a cyclical economic downswing was occurring.1967 was a bad year for the two reserve currency coun -tries. The U.S. was inflating a fiscal deficit for its unfundedwar in Vietnam, and the UK economy was weakening.Capital outflows from British pounds to U.S. dollars togold accelerated, with a record 80 tons of gold sold inLondon in a single five-day period. (The pound was deval-ued by 14 percent in November 1967 its first devalua-tion since 1949.) By the end of the year, U.S. gold reserveshad fallen to $12 billion.

By March 1968, the Gold Pool had sent nearly 1,000 tonsof gold to the Bank of Englands weighing room; the U.S.Air Force delivered emergency supplies of gold from Fort

Knox. On March 15, 1968, the U.S. asked for a two-weekclosing of the London gold market. In April, the Group ofTen gathered in Stockholm, a meeting that gave birth tothe Special Drawing Right (SDR). Note that SDRs werecalled paper gold, but they were never called money.SDRs are for the exclusive use of governments corpora-tions and individuals cannot use them. (For more infor-mation about the reserve currency issue, see The reservecurrency dilemma, Currency Trader, June 2011.)

At the time of Bretton Woods in 1944, the gold coverageof the dollar was about 60 percent. By the time the U.S.went off the gold standard in August 1971, gold cover-age had fallen to 22 percent. Under the gold standard, theonly way the Federal Reserve could expand money sup-ply would be to buy more gold at the expense of otherprojects, including the interstate highway system, defenseinitiatives such as SAC, and so on. Abandoning the gold

standard was a shock, buton the whole was a healthydevelopment for the globaleconomy, which expandedduring the next decade at afar faster pace than before.

Finally, in the event of aglobal banking liquidity cri-sis, the issuer of the reservecurrency has a responsibilityto provide cash to all othercentral banks. According toeconomic historian CharlesP. Kindleberger, the Bank of

Englands inability to perform this function in the 1930s(Britain went off the gold standard in 1931) was one of thecontributing causes of the Great Depression.

During the 2008-09 financial crisis, the Federal Reservelent to 14 central banks under dollar-swap lines. According

to the General Accounting Offices audit of the Fedreleased in July 2011, of the $16 trillion lent on a short-termbasis, the Fed gave more than $3 trillion to private foreignbanks such as Royal Bank of Scotland, Barclays, DeutscheBank, BNP Paribas, UBS and Credit Suisse. The Fed lent asmuch as $1 trillion to central banks under the swap linesagreement, just renewed in August for another year. Also,the European Central Bank (ECB) used the agreement for areported $500 million loan to a so-far unnamed Europeanbank.

Why do these banks want dollars? More than 90 per-cent of cross-border loans are dollar-denominated; theEurodollar market surpassed the domestic dollar market a

All the gold ever mined could

not fund the U.S. economy, letalone the rest of the world.
http://www.imf.org/external/np/exr/facts/sdr.htmhttp://www.imf.org/external/np/exr/facts/sdr.htmhttp://www.imf.org/external/np/exr/facts/sdr.htm


18/36

continued


few years ago. By December 2008, the Eurodollar marketwas $9.7 trillion, more than U.S. M2 money supply at thetime ($8.054 trillion) even if you subtract the banknotecomponent. And there are more dollar bank notes outsidethe U.S. than circulate inside the country.

In other words, if the U.S. returned to a gold standard,

it would have to give up infrastructure projects, defensespending, and social spending to buy gold to fund thebanking and commercial activities of foreigners. And inthe end, the U.S. would still be vulnerable to a mean-spir-ited foreign leader like de Gaulle who could demand thegold be shipped to him. You have to ask yourself whetherit would be wise to return to a system that has alreadyfailed, and failed at the instigation of a single foreignleader.

No turning backViewed from this perspective, the gold standard is anoverly burdensome price to pay for price stability. No U.S.

central banker or treasury official or politician enter-tains the idea because returning to a gold standard wouldcause a contraction of the U.S. economy to one-tenth ofwhat it is today. Unemployment would soar. The social

and political disruption would be tremendous. WilliamJennings Bryans cross of gold speech in 1896 correctlyidentifies the gold standard as contrary to the interests ofworkers (while it favors creditors and the rich).

Therefore, it is irrational to buy gold on the grounds theU.S. will return to a gold standard, either voluntarily or

because it is forced to do so by hyperinflation and a dol-lar crisis. It is not irrational to buy gold on the basis of itsprice rise. We know Western investors seek diversificationin gold. Various newly rich populations (India, China) aredemanding gold, along with several central banks. But itwould be irrational to continue to hold gold out of obses-sion if and when the bubble bursts.

When the gold bubble bursts, as all bubbles do anddont forget that governments have a vested interest inpreventing gold from becoming too big an obsession the sensible course of action for a smart trader is sell it justlike any other security, to lock in a gain or to prevent afurther loss.

So heres the only question you need to ask about gold:Wheres your stop-loss?y

For information on the author, see p. 4

ONTHEMONEY
http://www.managedfuturestodaymag.com/


19/36

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20/36

Dollar/SwissThe August reversal in the USD/CHF pair was truly a unique event, but extrapolating

from its characterics provides some perspecitve on the markets trajectory.

BY CURRENCY TRADER STAFF

After nearly a year of relentless appreciation in the Swissfranc, the currency made a sharp turnaround in August inresponse to steps taken (and threatened) by Switzerlandscentral bank to bring the market back to earth (see SwissNational Bank battles the trend, p. 6).

The U.S. dollar/Swiss franc pair (USD/CHF), whichhad already ended July at an all-time low monthly closeof .7855, tumbled another 10 percent over the next seventrading days to .7064 a move that has been matchedor exceeded only four other times since 1973 (and threeof those instances occurred over a three-day span inmid-December 2008 during the financial panic). The pairdropped 6.4 percent intraday on Aug. 9 alone; after a one-

day pause on Aug. 10, the market then rallied nearly six

percent on Aug. 11 (Figure 1). By Aug. 29, the pair hadrallied approximately 14 percent to around .8200, andappeared poised to break the string of seven consecutivelower monthly lows a streak that had not been matchedsince 1992.

Finding U.S. dollar/Swiss franc reversal moves as dra-matic as the Aug. 8-11 turnaround is an exercise in futil-ity literally. Using the close-to-close moves from Aug. 8to 9 and Aug. 10 to 11 (both at least 4 percent in absoluteterms) reveals this specific pattern has occurred preciselyzero times over the past 40 years; downsizing the requiredmove to 2 percent (a 2-percent close-to-close decline fol-lowed two days later by a 2-percent close-to-close rally)

produces only 10 previous instances.It is only by reducing the requiredmove to 1.5 percent that an analyz-able sample size of 29 instancesappears (although the relationshipof this pattern to the much-largerAugust 2011 pattern is certainlydebatable). Figure 2 shows the dol-lar/Swiss pairs median trajectoryover the next 40 days, along with theoverall performance of the USD/CHFpair (i.e., the median close-to-closechanges for all one- to 40-day moves

since 1973). The percentage of timesthe pair closed higher (than the closeof the final bar of the pattern) at eachinterval is also included (lighter blueline, right axis). The bullish post-pattern results are in stark contrastto the dollar/Swiss pairs long-termdownward bias, although the odds ofa gain are not solidly above 50 per-cent until approximately day 10. As ofAug. 30 (13 days after the conclusionof the pattern), the current up movehad far outstripped the patterns


SPOTCHECK

FIGURE 1: ABOUT FACE IN THE DOLLAR/SWISS PAIR

The pair dropped 6.4 percent intraday on Aug. 9 then (after a one-day pause)

rallied nearly 6 percent on Aug. 11.

Source for all: TradeStation


21/36

median performance which leavesopen the possibility of a near-termcorrection, even if the slightly longer-term bullish projection shown hereremains in place.

A related and even longer-termperspective is shown in Figure 3. Thischart shows the USD/CHF pairs one-to 26-week trajectory after a two-weekpattern: a 3-percent or larger declinefrom the close of one week to the nextweeks low, followed by a 3-percent orlarger rally from the same low to the

next weeks high (the conditions inplace as of the week ending Aug. 19).Again, these parameters represent amuch smaller move than the August2011 example, but it was necessary toreduce the size of the move to pro-duce the 25 examples represented inFigure 3.

The most interesting aspect of thischart (which shows both the medianand average post-pattern moves) isthat it shows a rally occurring throughweeks 6-8, after which the gains trail

off the markets long-term down-ward bias reasserts itself. At week 26,the median gain was barely positiveand the average was below 1 percent.After 52 weeks, the average and medi-an return was negative (not shown).

For Swiss franc traders, the keyquestions are the extent to which thebig August rebound might correct,whether there are more European debtdebacles on the horizon, and whetherSwiss monetary policies will be suffi-cient to sustain the reversal.y

CURRENCY TRADERSeptember2011 21

FIGURE 2: DAILY REVERSAL PATTERN

The bullish post-pattern results diverge from the dollar/Swiss pairs historicaldownward bias.

FIGURE 3: WEEKLY REVERSAL PATTERN

Price rallies through weeks 6-8, but the markets long-term downward bias

subsequently reasserts itself.
http://www.currencytradermag.com/index.php/c/Key_Conceptshttp://www.currencytradermag.com/index.php/c/Key_Conceptshttp://www.currencytradermag.com/index.php/c/Key_Conceptshttp://www.currencytradermag.com/index.php/c/Key_Conceptshttp://www.currencytradermag.com/index.php/c/Key_Concepts


22/3622 October2010CURRENCY TRADER22 September2011CURRENCY TRADER

The biggest of weakness of trend-following techniques istheir susceptibility to losses during ranging conditions.Almost any trend-detection tool can generate profits whenthe market is engaged in extended trends, but almost all ofthem will give back those gains when the market swingsback and forth in a trading range or choppy congestion.

The Parabolic Stop-and-Reverse (PSaR) system is atrend-following technique developed by Welles Wilder

that revolves around his parabolic stop a trailing stopdesigned to move closer to prices as time passes. When theparabolic stop level is penetrated, the current position isliquidated, a new trade in the opposite direction is simul-taneously established (the stop-and-reverse component),and the parabolic stop is then calculated for the new posi-tion. (Calculating the parabolic stop provides an exam-ple of the stops calculation.)

Although the basic PSaR systemis generally good at highlighting thecurrent trend, it tends to get whip-sawed by even relatively mild retrace-ments, making it a less-than-idealcomponent of an algorithmic tradingsystem. If you attempt to trade thePSaR mechanically, youll find biggains from sustained trends are ofteneliminated during trading-rangeperiods when the PSaR repeatedlyswitches from one side of the marketto the other.

To address this problem, the fol-lowing system uses a new indicatordesigned to filter PSaR signals andallow trades only when the trendidentified by the PSaR has a highprobability of follow-through.

The PSaR Time IndicatorAnalyzing the PSaR shows that whena trend move that is as long as thelongest move in the immediate pastdevelops, the move has an increasedprobability of success until an equally

TRADINGSTRATEGIESTRADINGSTRATEGIES

Filtering trend signals withthe Parabolic Time Indicator

An indicator that analyzes the duration of price moves proves

to be a useful filter for the parabolic system.

BY DANIEL FERNANDEZ

The strategy always has a position in the direction that meaningful trends are

forming, and it exits when the opposite-direction PTI line exceeds the 70th

percentile. Source for all: MetaTrader

FIGURE 1: SAMPLE SIGNALS



long move forms in the opposite direction.We will attempt to capitalize on this with a new indica -

tor, the PSaR Time Indicator (PTI), which calculates thepercentile rank of the current PSaR cycle length (i.e., theduration of the most recent trend as defined by the PSaR)relative to the longest cycle length of the past 50 periods:a value of 100 means the current cycle is the longest of thepast 50 days; a value of 75 means the current cycle is 75

percent of the length of longest cycle of the past 50 days,and so on. The indicator plots separate lines for up-trend-ing and down-trending cycles so only cycles of the sametype are compared, as shown in Figure 1. (MetaTradercode for the indicator canbe copied from the CurrencyTrader website by clicking here.)

PTI strategyThe system we will test trades PSaR signals according tothe cycle lengths determined by the PTI. The strategy goeslong whenever the uptrend PTI exceeds 70 percent andcloses a trade when the downtrend PTI value exceeds 70;the rules are reversed for shorts.

Like the original PSaR, the new system is always in themarket. However, because the system factors cycle lengthinto its trade signals, it ignores many smaller price swings,thus avoiding many of the whipsaw trades that plague thebasic PSaR.

The system adjusts its position size according to volatil-ity using the 14-day average true range (ATR):

Positionsize=0.01*(accountbalance)/(contractsize*14-dayATR)

For example, assuming a $100,000 account balance,$100,000 contract size, and a 14-day ATR of 0.0123, the

trade size would be:

(0.01*100,000/(100,000*0.0123))=0.81,or$81,000.

Figure 1 shows several sample trades from 2009 in theEuro/U.S. dollar pair (EUR/USD). The strategy alwayshas a position open in the direction that meaningful trendsseem to be developing; once the opposite-direction PTI line

exceeds the 70th percentile, the trade is reversed. The sys-tem operates on the basic PSaR premise following themost recent trend move and always being in the market but it applies a more robust approach to consider deter-mining what constitutes a viable trend signal.

Testing the systemThe strategy was tested on daily data in the Britishpound/U.S. dollar (GBP/USD), Australian dollar/U.S.dollar (AUD/USD), and Euro/U.S. dollar (EUR/USD)pairs from Jan. 1, 2000, to June 1, 2011. Table 1 summarizesthe systems performance, as well as the trading costsfor each currency pair. Generally, the results suggests the

strategy works better on currency pairs that tend to pro-duce relatively steady trends (EUR/USD and AUD/USD);performance deteriorates significantly in pairs with muchmore non-directional volatility (GBP/USD). The overallportfolio results were best in terms of their risk-adjustedreturn, with an average compounded annual profit to max-imum drawdown ratio of 0.46 outperforming any of theindividual currency pairs in this regard.

The systems equity curve was particularly smooth forthe most recent five years of the test period, althoughprofits accumulated slowly during the first four years oftrading (Figure 2). However, despite its general ability tocapture trends, Figure 3 shows 2008 a year of massive

TABLE 1: STRATEGY PERFORMANCE

EUR/USD AUD/USD GBP/USD Portfolio

Avg. annual profit 6.62% 5.42% 2.21% 15.88%

Max. drawdown 16.68% 18.84% 23.14% 34.53%

Ann. profit/drawdown 0.40 0.29 0.10 0.46

Reward/risk 1.63 1.8 1.42 1.7

Win % 54% 47% 44% 48%

Profit factor 1.9 1.58 1.14 1.58

No. of trades 93 90 110 293

Avg. risk per trade 2.31% 2.27% 2.24% 2.27%

Ulcer Index 5.56 7.18 11.61 15.48

Spread (pips) 2 3.5 3.5 -
http://www.currencytradermag.com/index.php/c/Strategy_codehttp://www.currencytradermag.com/index.php/c/Strategy_codehttp://www.currencytradermag.com/index.php/c/Key_Conceptshttp://www.currencytradermag.com/index.php/c/Key_Conceptshttp://www.currencytradermag.com/index.php/c/Key_Conceptshttp://www.currencytradermag.com/index.php/c/Strategy_code


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trends resulting from the financialcrisis was actually only slightlypositive (+10.08 percent). Most trend-following systems (especially thosebased on breakout techniques) put upsome of their best all-time numbersin 2008. In the case of the PTI, verystrong, swift directionality usuallycatches the system off guard; becauseof the PTI cycle-duration filter, it takestime for the system to switch direc-

tion, which often leads to significantlosses during highly volatile periods the system takes a significant lossbefore it aligns itself with the newtrend.

Although the system had five nega-tive years, these were very small com-pared to the profitable ones: The larg-est losing year was 13.87 percent andthe largest profitable was 74.35 per-cent. The PTI system also shows thepotential to be a good complementarystrategy for other trend-following

systems, as its best years (2005-2006)were generally the worst ones formany trend-following systems.

Was the PTI successful in reducingPSaR losses from whipsaws duringranging markets? Figure 4 shows howthe system behaved during a rang-ing period when the PSaR oscillatedstrongly between down-trending andup-trending signals. While the unfil-tered PSaR would have taken morethan 20 positions within this period,the PTI strategy took only four.


TRADINGSTRATEGIES

The PTI helped filter out whipsaw trades, but it also resulted in the strategy

reacting slowly and taking losses when large trends unfolded quickly, as was the

case in 2008.

FIGURE 3: 2008

After generating profits slowly during the first four years of the test, the systems

equity curve trended higher very smoothly during the last five years.

FIGURE 2: EQUITY CURVE



Relative cycle lengths are particu-larly small during ranging periods,which inevitably leads to a greatreduction in the number of positions.The figure shows the outcome duringthis period was basically neutral, aspositions were entered and closed ata pivotal point (near the center of therange) generated by the PSaR cyclelengths and price action.

The strategy also performed quite

well when trading ranges developedwithin larger, longer-term trends(Figure 5). The orange circled posi-tions are losing trades; the green onesare winners. Although in this casethe strategy took two losing tradesbecause of the low trigger thresholdfor down-trending positions (becauseof the recent prevalence of shortdown cycles), the system was profit-able during both the consolidationand trending phases of the move, suc-cessfully gauging market direction,

thanks to PSaR cycle length.Overall, the PTI helped reduce

losses in ranging conditions andimproved upon the original PSaRconcept. The values used in testingwere not optimized, and thus offersome promise of the strategys robust-ness. Areas for further explorationinclude introducing separate cycle-length thresholds for entries and exitsand applying the strategy to a differ-ent currency portfolio.y


During a period when the PSaR oscillated strongly between down-trending and

up-trending signals, the PTI-filtered strategy reduced the number of signals from

20 to four.

FIGURE 4: SUCCESSFUL FILTERING

The system was profitable during both the consolidation and trending phases of

the move.

FIGURE 5: CONSOLIDATIONS AND TRENDS



Earlyinatradetheparabolicstopisfartheraway

frompriceandprovidessomeroomforcountertrend

movement.Astimepasses,itdrawsprogressively

closertoprices.Forsimplicity,thefollowingdiscus-

sionisgivenintermsoflongtrades;therulesare

invertedforshorttrades.

Theformulaforcalculatingtheparabolicstoplevel

(P)fortomorrowstradingday(whenusingdailypricebars)is:

Ptomorrow= Ptoday+ AF(EPtrade Ptoday)

Where,

Ptoday = todays parabolic stop value.

AF = acceleration factor, which begins at a default

value of 0.02 and increases in 0.02 increments for

each bar that establishes a new high during thetrade, to a maximum of 0.20. The larger the accel-

eration factor, the more closely the stop trails price.

EP = the extreme price since the trade was initi-

ated (highest high if long, lowest low if short).

Assumealongtradewasestablishedyesterdayin

acurrencypairatapriceof1.2545,withaninitial

stop-lossof1.2475thatisstillineffecttoday.Todays

highof1.2580washigherthanyesterdayshighof

1.2560,whichmeansitstheextremeprice(EPin

theformula)sincethetradebegan.Thecalculations

fortomorrowsparabolicstoplevelare:

Ptomorrow= Ptoday+ AF(Htoday Ptoday)

Where,

Htoday = Todays high (the extreme price).

Becausethisisthefirstdayofthecalculation,there

isnoparabolicstoplevelfortoday.Thismeansthe

initialstopforthetrade(1.2475)mustbeusedas

Ptodayintheformula.Plugginginthesevaluesresults

in:

Ptomorrow= 1.2475 + .02(1.2580 1.2475) =

1.2477

Iftomorrowthestockralliestoanewhighof1.2600,thisbecomesthenewEPandtheparabolicstop

levelforthefollowingdaywouldbe:

Ptomorrow= 1.2477 + .04(1.2600 1.2477) =

1.2482

Notethattheaccelerationfactorincreasedfrom0.02

to0.04,andthatthepreviousdaysparabolicvalue

isnowusedintheformula.

TheAFincreasesby0.02onlyforabarthat

establishesanewEP(highprice)inthetrade.Ifthepairhadnotmadeanewhigh,theprevioushighof

1.2580wouldhavebeenusedastheEPandtheAF

wouldhaveremainedat0.02.

Calculating the value of the PSaR

ThevalueofthePSaRiscalculatedforeachbar

accordingtotheequationPSaR(n+1)=PSaR(n)+

AF*(EP-PSaR(n))whereEPisthehighest/lowest

pointsincethelastPSaRshiftedaboveorbelowa

barscloseandAFisanaccelerationfactorwhichis

usually0.02andincreaseswitheachPSaRcalcula-

tion(beforeashift)toamaximumvaluewhichis

generallychosenas0.2.Wheneverthereisaswitch

ofthePSaRfromabovetobelowpriceorviceversa

thevalueofthePSaRforthenewcycleiseitherthe

EPvalueforthepreviouscycleorthehigh/low.The

indicatorthereforesignalsanup-trendingmovement

whenitscalculatedvalueisbelowthecurrentprice

andadown-trendingmovementwhenevertheoppo-

siteistrue.

Calculating the parabolic stop

TRADINGSTRATEGIES


http://www.activetradermag.com/http://www.activetradermag.com/http://www.activetradermag.com/http://www.activetradermag.com/



TRADINGSTRATEGIESADVANCEDCONCEPTS

It almost sounds like a bad vaudeville joke: What doyou get when you cross Canada with Australia? Severalthings come to mind, actually, and this is where that lineof thinking shall end. We have looked at the CAD indi -vidually (see Canadian Dollar: Remember the forgottencurrency, February 2006) and as a cross rate to both theEuro and the yen (see Canada on the cross rates, May

2010). And Australia has been addressed both by itself (seeWhats down with the Australian dollar? March 2008),as a spread to the New Zealand dollar (see Getting car-ried away with the kiwi, July 2008), and as a factor in theIndonesian rupiah (see Indonesian rupiah: River deep,Bali high, March 2011).

Both Canada and Australia have large resource sectors,and both have very

large customers intheir neighborhoods(the U.S. and China).Both countries sufferedless in the 2007-2009global financial crisis,as their banks did notgo overboard on thesort of egregious risk-taking seen in the U.S.and Europe, althoughthis may be the resultof Canadas protected

status for its banksmore than anythingelse. Australia wasone of the first G-20countries to raise itsshort-term interestrates (in October 2009)to slow its growthrate and inflationarypressures. Canada, amember of the moreexclusive G-7, becamethe first country in

The Canada-Australia

cross rateCombining these two trending currencies results in a trending cross rate whose returns

are directly linked to expected interest-rate differentials and relative asset returns.

BY HOWARD L. SIMONS

The AUD/CAD FRR6,9 differential led the cross rate by the expected three months into the start

of 2011.

FIGURE 1: AUD/CAD CROSS RATE AND EXPECTED INTEREST RATE DIFFERENTIALS



that group to raise its short-term interest rates at the startof June 2010.

A well-behaved cross rateThe global financial crisis of 2007-2009 and the free-moneyresponses to it by most of the worlds central banks hadthe nasty side effect of placing many short-term inter-est rate markets in a state of perma-expectations thebelief that while short-term rates are quite low now, theymust rise and rise soon. This would have been a nicer

theory if it had been supported by any actual evidence,but such has not been the case. Japan has demonstratedperma-expectations can last longer than you care to playthe game of waiting for rates to rise, and the U.S. seemsdestined to follow this path as well.

The AUD/CAD cross rate is something of an exception,perhaps because neither central bank turned on the print-ing presses just to see what would happen. If we calculateboth currencies forward rate ratio between six and ninemonths (FRR6,9), which is the rate at which we can lock inborrowing for threemonths starting sixmonths from now

divided by the nine-month rate itself, wesee the AUD/CADFRR6,9 differential ledthe cross rate by theexpected three monthsinto the start of 2011(Figure 1). If the mar-ket expected Canadianshort-term rates tostart rising fasterthan their Australiancounterparts, the CAD

firmed against theAUD and vice versa.After the start of 2011,this relationship andmost others of its kindstarted to weaken asartificially low short-term interest ratesand money printingaround the world dis-torted many marketsignals.

This relatively neat

and tidy behavior (yes, we must appreciate the irony hereas neither countrys self-image is very big on the neat andtidy quotient) extends to the very investable relative stockmarket performance of the two countries. Mapping therelative total returns of the Canadian and Australian stockmarkets in USD terms inversely to the cross rate reveals avery strong contemporaneous correlation between the twomarkets (Figure 2). As the CAD strengthens on the crossrate, Canadian equities will outperform Australian equi-ties, and vice versa. Once again, this is a demonstration of

how much international equity diversification has turnedinto nothing more than an expensive way to trade curren-cies.

Carry and volatilityIf international equity diversification is a closet currencytrade, then all parties involved are getting a little morecomfortable with that closet. If we map the excess returnfrom borrowing and lending the CAD against the rela-tive equity market performance, we find the relationship

As the CAD strengthens within the AUD/CAD cross rate, Canadian equities will outperform

Australian equities, and vice versa.

FIGURE 2: RELATIVE EQUITY PERFORMANCE HAS FOLLOWED CROSS RATE


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became an extremelyclose one during 2008and remained that

way into 2010 (Figure3). In a broader mac-roeconomic sense,we can say thepolicy responses tothe financial crisismade both macroeco-nomic growth andthe premia paid forrisky assets beholdento artificially steepyield curves; as carryexpanded, equitymarkets followed.Although it was notsupposed to be thisway, as the late WalterCronkite might havesaid, Thats the wayit is.

Longer-maturitysovereign bonds pres-ent a different lookin time relative to thecurrency carry trade.

If we compare therelative performanceof bonds for eachcountry against theexcess return on thecurrency carry trade,we see much greaterconvergence betweenthe markets from 2001to 2005 (Figure 4) thanwas the case withequities. Canadianbonds have outper-

formed after 2005largely as a functionof a continued bullmarket in governmentdebt in the U.S. Thenet result is, whileequities are supposedto have greater spe-cific risk and thereforeprovide greater diver-sification, an investornow receives greaterdiversification for sov-

ONTHEMONEY


ADVANCEDCONCEPTS

Mapping the excess return from borrowing and lending the CAD to the relative equity market

performance shows this relationship became extremely close during the financial crisis of 2008

and remained that way into 2010.

FIGURE 3: RELATIVE EQUITY PERFORMANCE LINKED TO CARRY RETURN

The relative performance of bonds for each country vs. the excess return on the currency carry

trade shows a greater convergence between the markets from 2001 to 2005. Canadian bonds

have outperformed after 2005 mostly because of the continued U.S. bull market in government

debt.

FIGURE 4: RELATIVE BOND PERFORMANCE NOT LINKED TO CARRY RETURN
http://www.currencytradermag.com/index.php/c/Key_Conceptshttp://www.currencytradermag.com/index.php/c/Key_Conceptshttp://www.currencytradermag.com/index.php/c/Key_Concepts



ereign debt than for equities.Finally, lets take a look at the cross rate in terms of the

insurance options traders are willing to pay. If we mapthe excess volatility of CAD forwards for an AUD holder,defined as the ratio between option implied volatility andhigh-low-close volatility, minus 1.00, we find it has tendedto move inversely to the direction of the AUD per CADcross rate (Figure 5).

The Canadian dollarlong has been one of themore straightforwardmarkets for new cur-rency traders becauseit tends to be one of thetrendiest of the majorcurrencies (see Let thetrend be your friend:The majors, January2009); the Australiandollar was second inthat ranking. Given the

presence of two trend-ing currencies, shouldanyone be surprisedtheir cross rate is notonly a trending mar-ket in itself, but thatit flows directly fromexpected interest ratedifferentials and islinked directly to rela-tive asset returns?

The only thing thiscross rate doesnt pro-

vide is a measure of diversification for global equity inves-tors. That is a small price to pay. After all, when was thelast time you heard a profitable trader talking about howwell he or she was diversified?y


The excess volatility of CAD forwards for an AUD holder has tended to move inversely to thedirection of the AUD/CAD cross rate.

FIGURE 5: EXCESS VOLATILITY FOLLOWS THE TREND IN AUD/CAD CROSS RATE

Japan has shown how perma-expectationsabout rising interest rates can remain

unfulfilled for longer than most people are

willing to wait; the U.S. seems destined to

follow this path.



CPI:Consumerpriceindex

ECB:EuropeanCentralBank

FDD(rstdeliveryday):Therstdayonwhichdeliveryofacom-modityinfulllmentofafuturescontractcantakeplace.

FND(rstnoticeday):Alsoknownasrstintentday,thisis

therstdayonwhichaclear-nghousecangivenoticetoa

buyerofafuturescontractthatitntendstodeliveracommodityin

fulllmentofafuturescontract.Theclearinghousealsoinformstheseller.

FOMC:FederalOpenMarketCommittee

GDP:Grossdomesticproduct

ISM:Instituteforsupplymanagement

LTD(lasttradingday):Thenaldaytradingcantakeplaceina

futuresoroptionscontract.

PMI:Purchasingmanagersindex

PPI:Producerpriceindex

Economic Release

release(U.S.) time(ET)

GDP 8:30 a.m.

CPI 8:30 a.m.

ECI 8:30 a.m.

PPI 8:30 a.m.

SM 10:00 a.m.

Unemployment 8:30 a.m.

Personal income 8:30 a.m.

Durable goods 8:30 a.m.Retail sales 8:30 a.m.

Trade balance 8:30 a.m.

Leading indicators 10:00 a.m.

GLOBALECONOMICCALENDAR

September

1 U.S.:AugustISMmanufacturingreport

2 U.S.: Augustemploymentreport

3

4

5

6 Brazil: Q2GDPandAugustCPIandPPI

7

U.S.:FedbeigebookAustralia: Q2GDPCanada:BankofCanadainterest-rateannouncementJapan: BankofJapaninterest-ratean-nouncement

8

U.S.:JulytradebalanceAustralia:AugustemploymentreportFrance:Q2employmentreportMexico: Aug.31CPIandAugustPPIUK: BankofEnglandinterest-ratean-nouncement

ECB: Governingcouncilinterest-rateannouncement

9

Canada:AugustemploymentreportGermany: AugustCPIUK:AugustPPILTD:Septemberforexoptions;U.S.dol-larindexoptions(ICE)

10

11

12 Japan:AugustPPI

13France:AugustCPIUK: AugustCPI

14 U.S.: AugustPPIandretailsalesIndia: AugustPPIUK: Augustemploymentreport

15U.S.: AugustCPIHong Kong: Q2 PPI

16

17

18

19Hong Kong:Q2GDPLTD: Septemberforexfutures

20

U.S.:AugusthousingstartsandFOMCinterest-rateannouncementGermany: AugustPPIHong Kong:June-Aug.EmploymentreportSouth Africa: Q2employmentreport

21Canada: AugustCPISouth Africa: AugustCPIFDD: Septemberforexfutures

22U.S.:AugustleadingindicatorsBrazil: AugustemploymentreportHong Kong:AugustCPIMexico: Sept.15CPI

23 Mexico: Augustemploymentreport

24

25

26

27

28U.S.: AugustdurablegoodsFrance:Q2GDP

29

U.S.: Q2GDPCanada: AugustPPIGermany: AugustemploymentreportSouth Africa: AugustPPI

30

U.S.: AugustpersonalincomeFrance:AugustPPIIndia:AugustCPIJapan: AugustemploymentreportandCPI

October

1

2

3U.S.: SeptemberISMmanufacturing

report4

5 UK: Q2GDP

6

Brazil: September PPIUK:BankofEnglandinterest-rateannouncementECB: Governingcouncilinterest-rateannouncement

Theinformationonthispageissub-

ecttochange.Currency Traderis

notresponsiblefortheaccuracyof

calendardatesbeyondpresstime.

Event: SixthAnnualFreeParisTradingShowDate:Sept.16-17Location: Paris

For more information:Gotowww.salonAT.com

Event: TheWorldMoneyShowVancouver2011Date:Sept.19-21Location:VancouverConventionCentreFor more information:Gotowww.moneyshow.com/vcms/?scode=013104

Event:TheFutures&ForexExpoLasVegasDate:Sept.22-24Location: CaesarsPalace,LasVegasFor more information:Gotowww.moneyshow.com/events/Forex_Options_Expos.asp

Event:FIAFutures&OptionsExpoDate:Oct.10-12Location:HiltonChicagoFor more information:Goto

www.futuresindustry.org/expo

EVENTS
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CURRENCYFUTURESSNAPSHOTas of Aug. 29

The information does NOT constitute trade

signals. It is intended only to provide a brief

synopsis of each markets liquidity, direction,

and levels of momentum and volatility. See

the legend for explanations of the different

fields. Note: Average volume and open

interest data includes both pit and side-by-

side electronic contracts (where applicable).

LEGEND:

Volume: 30-day average daily volume, in

thousands.

OI: 30-day open interest, in thousands.

10-day move: The percentage price move

from the close 10 days ago to todays close.20-day move: The percentage price move

from the close 20 days ago to todays close.

60-day move: The percentage price move

from the close 60 days ago to todays close.

The

Currency Trader Magazine 2011-09

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Transcript of Currency Trader Magazine 2011-09