Momentum / Lagging Indicators

So how do we spot a trend? The indicators that can do so have already been identified as MACD and moving averages. These indicators will spot trends once they have been established, at the expense of delayed entry. The bright side is that there’s less chance of being wrong.

On this 1-hour chart of EUR/USD, there was a bullish crossover for MACD at 3:00 am EST on 08/03/05 and the 10 period EMA crossed over the 20 period EMA at 5:00 am. These two signals were all accurate, but if you waited for both indicators to give you a bull signal, you would have missed out on the big move. If you calculate from the start of the uptrend at 10:00 pm EST on 08/02/05 to the close of the candle at 5:00 am EST on 08/03/05, you would have watched a gain of 159 pips while sitting on the sidelines.

Let’s take a look at the same chart so you can see how these crossover signals can sometimes give false signals. We like to call them “fake-outs”. Look at how there was a bearish MACD crossover after the uptrend we just discussed.

Ten hours later, the 20 EMA crossed below the 10 EMA giving a “sell” signal. As you can see, the price didn’t drop but stayed pretty much sideways, then continued its uptrend. By the time both indicators were in agreement, you would’ve entered a short trade at the bottom and set yourself up for a loss. Bummer, dude!

Oscillators / Leading Indicators

An oscillator is any object or data that moves back and forth between two points. In other words, it’s an item that is going to always fall somewhere between point A and point B. Think of when you hit the oscillating switch on your electric fan.

Think of our technical indicators as either being “on” or “off”. More specifically, an oscillator will usually signal “buy” or “sell”, with the only exception being instances when the oscillator is not clearly at either end of the buy/sell range.

Does this sound familiar? It should! Stochastics, Parabolic SAR, and the Relative Strength Index (RSI) are all oscillators. Each of these indicators is designed to signal a possible reversal, where the previous trend has run its course and the price is ready to change direction.

Let’s take a look at a few examples.

On the 1-hour chart of USD/EUR below, we have added a Parabolic SAR indicator, as well as an RSI and Stochastic oscillator. As you have already learned, when the Stochastic and RSI begin to leave their “oversold” region that is a buy signal.

Here we get buy signals between the hours 3:00 am EST and 7:00 am EST on 08/24/05. All three of these buy signals occurred within one or two hours of each other, and this would have been a good trade.

We also got a sell signal from all three indicators between the hours of 2:00 am EST and 5:00 am EST on 08/25/05. As you can see, the Stochastic indicator remained in the overbought for a pretty long time - about 20 hours. Usually when an oscillator remains in the overbought or oversold levels for a long period of time, that means there is a strong trend occurring. In this example, since Stochastic stayed overbought, you see there was a strong uptrend present.

Now let’s take a look at the same leading oscillators messing up, just so you know these signals aren’t perfect. Looking at the chart below, you can quickly see that there were a lot of false buy signals popping up. You’ll see how one indicator says to buy, while the other one is still saying sell.

Around 1 am EST on 08/16/05, both RSI and Stochastic gave buy signals, while Parabolic SAR still showed a sell signal. Yes, Parabolic SAR gave a buy signal 3 hours later at 4 am EST, but then Parabolic SAR turned into a sell signal one bar later. If you actually look at the bar with the Parabolic SAR below it, notice how it’s a strong looking red bar with very short shadows. Also, notice how the next bar closed below it. This would not have been a good long trade.

On the last two oversold (buy) signals given by Stochastic, notice how there is no indicator at all for RSI, but Parabolic SAR is giving sell signals. What’s going on here? They are each giving you different signals!

What happened to such a good set of indicators?

The answer lies in the method of calculation for each one. Stochastic is based on the high-to-low range of the time period (in this case, it’s hourly), yet doesn’t account for changes from one hour to the next. The Relative Strength Index (RSI) uses change from one closing price to the next. And Parabolic SAR has its own unique calculations that can further cause conflict.

That’s the nature of oscillators – they assume that a particular chart pattern always results in the same reversal. Of course, that’s hogwash.

While being aware of why a leading indicator may be in error, there’s no way to avoid them. If you’re getting mixed signals, you’re better off doing nothing than taking a ‘best guess’. If a chart doesn’t meet all your criteria, don’t force the trade! Move on to the next one that does meet your criteria.

Leading vs. Lagging Indicators

We’ve covered a lot of tools that can help you analyze charts and identify trends. In fact, you may now have too much information to use effectively.

In this lesson, we’re going to look at streamlining your use of these chart indicators. We want you to fully understand the strengths and weaknesses of each tool, so you’ll be able to determine which ones work for you and your trading plan…and which ones don’t.

Leading versus Lagging Indicators

Let’s discuss some concepts first. There are two types of indicators: leading and lagging.

A leading indicator gives a buy signal before the new trend or reversal occurs.

A lagging indicator gives a signal after the trend has started and basically informs you “hey buddy, pay attention, the trend has started, you’re missing the boat.”

You’re probably thinking, “Ooooh, I’m going to get rich with leading indicators!” since you would be able to profit from a new trend right at the start. You’re right – you would “catch” the entire trend every single time, IF the leading indicator was correct every single time. But it’s not.

When you use leading indicators, you will experience a lot of fake-outs. Leading indicators are notorious for giving bogus signals which will “mislead” you. Get it? Leading indicators that "mislead" you? Ha-ha. Man we're so funny we even crack ourselves up.

The other option is to use lagging indicators, which aren’t as prone to bogus signals. Lagging indicators only give signals after the price change is clearly forming a trend. The downside is that you’d be a little late in entering a position. Often the biggest gains of a trend occur in the first few bars, so by using a lagging indicator you could potentially miss out on much of the profit. Which sucks.

Oscillators and Trend Following Indicators

For the purpose of this lesson, let’s broadly categorize all of our technical indicators into one of two categories:

1. Oscillators

1. Trend following or momentum indicators

Oscillators are leading indicators.

Momentum indicators are lagging indicators.

While the two can be supportive of each other, they're more likely to conflict with each other. We’re not saying that one or the other should be used exclusively, but you must understand the potential pitfalls of each.

Carry Trade Criteria

It’s pretty simple to find a suitable pair to do a carry trade. Look for two things:

1. Find a high interest differential.
2. Find a pair that has been in an uptrend – where the currency you are long has been gaining value against the currency you are short.

Pretty simple, huh? Let’s take a real life example of the carry trade in action:

This is a weekly chart of GBP/JPY. Up until recently, the Bank of Japan has maintained a Zero Interest Rate Policy (current interest rate is 0.25% as of this writing - 11/01/2006). With the Bank of England touting one of the higher interest rates among the major currencies (currently at 4.75% as of this writing), many traders have flocked to this pair (one of the factors creating a nice little uptrend in the pair). From the end of 2000 to mid-2006, this pair moved from a price of 150.00 to 223.00 – that’s 7300 pips! If you couple that with interest payments from the interest rate differential of the two currencies, this pair has been a nice long term play for many investors and traders able to weather the volatile up and down movements of the currency market.

Of course, economic and political factors are changing the world daily. The interest rates and interest rate differentials between currencies may change as well, bringing popular carry trades (such as the Yen carry trade) out of favor with investors.

Carry Trade Risk

Being that you are a professional trader, you already know what the first question you should ask before entering a trade is, right?

“What is my risk?”

Correct! Before entering a trade you must always asses your max risk and whether or not it is acceptable according to your risk management rules.

In the previous example with Joe the Newbie Trader, his maximum risk would have been $9000. His position would be automatically closed out once his losses hit $9000.

Eh?

That doesn’t sound very good, does it?

Remember, this is the worst possible scenario and Joe is a newbie, so he hasn’t fully appreciated the value of stop losses.

When doing a carry trade, you can still limit your losses like a regular directional trade. For instance, if Joe decided that he wanted to limit his risk to $1000, he could set a stop order to close his position at whatever the price level would be for that $1000 loss. He would still keep any interest payments he received while holding onto the position.

The Carry Trade

Did you know there is a trading system that can make money if price stayed exactly the same for long periods of time?

Well there is and it’s one the most popular ways of making money by many of the biggest and baddest money manager mamajamas in the financial universe!

It's called the Carry Trade.

A carry trade involves borrowing or selling a financial instrument with a low interest rate, then using it to purchase a financial instrument with a higher interest rate. While you are paying the low interest rate on the financial instrument you borrowed/sold, you are collecting higher interest on the financial instrument you purchased. Thus your profit is the money you collect from the interest rate differential. For example:

Let's say you go to a bank and borrow $10,000. Their lending fee is 1% of the $10,000 every year. With that borrowed money, you turn around and purchase a $10,000 bond that pays 5% a year.

What's your profit?
Anyone?
You got it! It's 4% a year! The difference between interest rates!

By now you're probably thinking, "That doesn't sound as exciting or profitable as catching swings in the market." However, when you apply it to the spot forex market, with its higher leverage and daily interest payments, sitting back and watching your account grow daily can get pretty sexy.

How Does the Carry Trade Work for Forex?

In the forex market, currencies are traded in pairs (for example, if you buy the USDCHF pair, you are actually buying the US dollar and selling Swiss Francs at the same time). Just like the example above, you pay interest on the currency position you sell, and collect interest on the currency position you buy.

What makes the carry trade special in the spot forex market is that interest payments happen every trading day based on your position. Technically, all positions are closed at the end of the day in the spot forex market - you just don't see it happen if you hold a position to the next day.

Brokers close and reopen your position, and then they debit/credit you the overnight interest rate difference between the two currencies. This is the cost of "carrying" (also known as “rolling over”) a position to the next day.

The amount of leverage available from forex brokers has made the carry trade very popular in the spot forex market. Forex trading is completely margin based, meaning you only have to put up a small amount of the position and you broker will put up the rest. Many brokers ask as little as 1% - 2% of a position - what a deal, eh?

Let's take a look at a generic example to show how awesome this can be.

For this example we'll take a look at Joe the newbie forex trader. It's Joe's birthday and his grandparents, being the sweet and generous people they are, give him $10,000. Schweeeet!

Now, instead of going out and blowing his birthday present on video games and posters of bubble gum pop stars, he decides to save it for a rainy day. Joe goes to the local bank to open up a savings account and the bank manager tells him, "Joe, your savings account will pay 1% a year on your account balance. Isn't that fantastic?" Joe pauses and thinks to himself, "At 1%, my $10,000 will earn me $100 in a year. Man, that sucks!"

Joe, being the smart guy he is, has been studying BabyPips.com and knows of a better way to invest his money. So, Joe kindly responds to the bank manager, "Thank you sir, but I think I’ll invest my money somewhere else yo.”

Joe has been demo trading several systems, including the carry trade, for over a year, so he has a pretty good understanding of how forex trading works. He opens up a real account, deposits his $10,000 birthday gift, and puts his plan into action. Joe finds a currency pair whose interest rate differential is +5% a year and he purchases $100,000 worth of that pair. Since his broker only requires a 1% deposit of the position, they hold $1,000 in margin (100:1 leverage). So, Joe now controls $100,000 worth of a currency pair that is receiving 5% a year in interest.

What will happen to Joe’s account if he does nothing for a year?

Well, here are 3 possibilities.Let’s take a look at each one:

1. Currency position loses value. The currency pair Joe buys drops like a rock in value. If the loss brings the account down to the amount set aside for margin, then the position is closed and all that’s left in the account is the margin - $1000.
2. The pair ends up at the same rate at the end of the year. In this case, Joe did not gain or lose any value on his position, but he collected 5% interest on the $100,000. That means on interest alone, Joe made $5,000 off of his $10,000. That’s a 50% gain! Sweet!
3. Currency position gains value. Joe’s pair shoots up like a rocket! So, not only does Joe collect $5000 in interest on his position, but he also takes home any gains! That would be a nice present to himself for his next birthday!

Because of 100:1 leverage, Joe has the potential to earn around 50% a year from his initial $10,000.

Here is an example of a currency pair that offers a 5% differential rate based on current interest rates:

If you buy USD/JPY and held it for a year, you earn a "positive carry" of 5%.

Of course, if you sell USD/JPY, it works the opposite way:

If you sold USD/JPY and held it for a year, you would earn a "negative carry" of 5%.

Again, this is a generic example of how the carry trade works. Any questions on the concepts? No? I knew you could catch on quick! So, now it’s time to move on to the most important part of this lesson: Carry Trade Risk

Trade-Weighted U.S. Dollar Index

There is also another kind of dollar index used by the Federal Reserve. It is called the “trade-weighted U.S. dollar index”.

The Fed wanted to create an index that could more accurately reflect the dollar’s value against foreign currencies based on how competitive U.S. goods are compared against other countries.

The main difference between the USDX and the trade-weighted dollar index is the basket of currencies used and their relative weights. The weights are based on annual trade data.

Currencies and Weights

Here is the current weighting of the index:

Euro area	18.08
Canada	16.293
Japan	10.035
Mexico	9.823
China	13.377
United Kingdom	4.822
Taiwan	2.755
Korea	4.047
Singapore	2.061
Hong Kong	2.035
Malaysia	2.11
Brazil	1.955
Switzerland	1.412
Thailand	1.416
Philippines	0.825
Australia	1.212
Indonesia	0.878
India	1.145
Israel	1.039
Saudi Arabia	0.665
Russia	0.924
Sweden	1.167
Argentina	0.46
Venezuela	0.451
Chile	0.591
Colombia	0.423
Total	100

*Weights as of December 15, 2005

For more information on exchange rate indexes for the U.S. dollar, see "Indexes of the Foreign Exchange Value of the Dollar"

Weights for the broad index can be found at http://www.federalreserve.gov/releases/H10/Weights

If you’d like to see historical data, check out http://www.federalreserve.gov/releases/h10/Summary/