Forex Trading Simulation

Executive Summary

This report elaborates the trading strategies that were adopted during the trading exercise. Active trading was carried out between 13th April 2015 and 4th May 2015, during which 76 transactions were carried out including day trades, forwards and limit orders. Owing to the large number of transactions, the report only elaborates the strategies that were adopted during the first day in a bid to identify their strengths and weaknesses. These strengths and weaknesses are in turn used to formulate a revised strategy, which is adopted throughout the remainder of the trading exercise. Some of the major shortcomings that were identified include the use of intuition as opposed to technical and fundamental analysis to determine the most optimal trades and lack of predetermined trading targets. These shortcomings are addressed and implemented on 14th April and adhered to until the 4th of May. Despite making deliberate attempts to apply fundamental and technical analysis in the trading exercise, a loss of 11,282.49 AUD was incurred during the period due to the lack of experience in the used of these tools. Another factor that contributed to dismal performance was the underutilization of hedging tools including the stop loss, forwards, and limit orders.

 

 

Introduction

For the better part of the trading period, fundamental analysis and technical analysis were leveraged to make strategic trading decisions. Technical analysis entails the use of historical prices to predict the future price of an underlying security in this case currency. The commonly used technical tools include charts, trends and indicators (Schlossberg, 2006). Essentially, currency prices are assumed to reflect all news available while charts, which are the major objects of analysis generally reflect the trend in these prices. Fundamental analysis, on the other hand entails measuring the intrinsic value of a security through an examination of economic indicators such as interest rates, inflation rates, political stability, economic performance and terms of trade. These indicators are believed to have a direct and to some degree, predictable impact on the value of a nation’s currency in the foreign exchange market. Also considered as the cornerstone of investing, fundamental analysis was a critical part of the trading strategy. It was therefore imperative to closely monitor the market in order to identify upcoming trends in these indicators beforehand when they were due for release (Chen, 2009).

Day Trading Strategy

Day trading is perhaps the most popular strategy among rookie traders. It simply means that a trader buys and sells currencies within the same day. To achieve this, they must have large amounts of capital in order to take advantage of small price movements in volatile currencies. Even though traders can leverage the volatility of currencies to reap huge profits, volatility can similarly result in massive losses. As such, a trader needs to identify the most effective entry points in order make to the best out of their investment. Several strategies can be adopted to this end including scalping, fading, daily pivots and momentum strategies. I personally adopted momentum strategies for most of my trades. This strategy entails utilizing news releases or identifying strong tending moves supported by high volume. I generally bought the currencies after new releases rode a trend until it exhibited signs of reversal.

The stop loss function in Easy Forex proved to be very instrumental for my strategy because they safeguarded me against sharp price movements. In order to make my strategy more effective, I set both a physical stop loss and a mental stop loss. With the physical stop loss, I specified the price level that generally stipulated the maximum amounts of money I could lose while the mental stop loss encouraged me to exit my positions when I noticed unexpected turns in the currency trends. Moreover, I also had a predetermined maximum loss that I could tolerate per day. Whenever I hit this point, I resorted to take the rest of the day off.

Hedging Strategies

Apart from the stop loss function, I also employed hedging strategies to shield myself against massive losses. To achieve this, I used forwards and limit orders.

Forward Contracts (Forwards)

Forward contracts basically allow investors to buy or sell assets at a given price on a specified future date. These contracts are more often than not used for hedging but they can also be used for speculative purposes. In currency trading, they are used to lock in the exchange rate at which currency is sold at a future date. In essence, currency forwards are hedging tools that do not require any upfront payment. They are also commonly referred to as “outright forwards”

Limit Orders

Limit orders are orders placed with brokers to buy or sell a given number of shares at a predetermined price or better. However, they might not be executed if the price specified by the investor is not met during the time interval during which the order is left open. Limit order also allow investors to regulate the length of time an order remains outstanding before it is cancelled.

Trading Activities

On the first day, I managed to open 15 positions and close 12 of them. I invested in some of the most volatile currencies in the market including the U.S. dollar (USD), the Japanese yen (JPY) and the Swedish Franc (CHF). The main reason why I chose these currencies was because they had all appreciated substantially since the previous week as illustrated in Appendix 1. This trend was however short-lived because all the three currencies generally remained stagnant for the better part of the week before they eventually depreciated toward the end. Notwithstanding, I was still in a position to make day trades. However, I did not have much luck with day trading either.

Japanese Yen (JPY) and Swedish Franc (CHF)

The price of the JPY spiked up slightly for the first 1 hour after the market was opened before it started to fluctuate with each hour being characterized by an opposite trend. I had optimistically open a trade for 60,000 JPY anticipating that the currency would appreciate but ended up closing the trade at a loss of 65.69 AUD. I suffered a similar fate with the CHF, which also kicked off with a spike that was accompanied by general downward trend. Like the JPY, I failed to capitalize on the movements and ended up closing the two trades with total loss of 174.79 AUD. Despite starting off on a bad note, I opened four other trades, three for 60,000 JPY each and one for 180,000 JPY. Out of these, I only made a profit amounting to 76.48 AUD on two JPY 60,000 trades and a loss of 65.68 AUD on the third 60,000 JPY trade.

United States Dollar (USD)

Because most of the losses and profits were still negligible. I did not hesitate to make more trades. Following my intuition, I was successfully able to take advantage of the fluctuations in dollar prices, making a profit of 528.44 AUD on first 500 USD trade. After this success, I got carried away and opened three more 500 USD trades. Meanwhile, the JPY was fluctuating but there was no apparent overall trend. Fearing that the currency would also start to fluctuate like its counterparts, I decided to close the trade making a massive loss of 1,215.07 AUD loss on the 180,000 JPY trade. I closed one 500 USD trade, making a loss of 211.40, and opened another one in a frantic attempt to recover the massive losses I has made so far. Unfortunately, I only made a total profit of 116.38 AUD. Before the day closed I opened three trades, which I intended to close the following day hoping that the trend I had witnessed at the start of the day would repeat itself the following morning.

Strengths and Weaknesses of Initial Trading Strategy

At the end of the day I had made a cumulative loss of 1,117.07 AUD. The worst mistake I made was that I did not set a target for the total profit I intended to make for the day. Moreover, I had not decided on the maximum loss at which I would stop trading nor did I utilize the stop loss function provided by Easy Forex to shield myself against massive losses like the one I incurred after closing the 18,000 JPY trade. I also thought that intuition and lack were all I needed to make successful trades. However, I learned the hard way that I could only maximize my overall profitability through fundamental and technical analysis. In this regard, I had to search the internet to find out how the various macroeconomic events that had occurred during the day influenced the prices of the currencies I had traded with. Other than that, I had to keep an eye out for events that would potentially influence the strategic decisions I would make the following day.

Revised Trading Strategy

After realizing that I had to make strategic decisions in order to ensure that I made reasonable returns from the market, I decided to change my strategy slightly from day trading to a mix of a longer term trading strategy in tandem with the day trading strategies. This is evidenced on April 15th when I opened 8 trades and closed only one by the end of the day. Because I still had enough funds in the account to hedge against unexpected spikes in currency prices, I had the capacity to wait out short term undesirable trends and take advantage of favorable long term trends.

Implementing the new strategy was however easier said than done. First, it was very difficult to come by relevant information especially regarding some currencies such as the CHF. For instance, Yahoo Finance, which is one of the most reliable sources of market information for most currencies only had two hits on news and information relating to the CHF/AUD index, both of which were from September 2014. Nonetheless, I could make inferences about the future trends in this index by comparing new and information relating to other indices such as the USD/CHF and the USD/AUD. I particularly learnt that it was technically advisable to take a long position in the USD/CHF on April 13th because the USD had formed a bottom against the CHF as evidenced by the Three Inside Up candle stick pattern that had been produced by the dollar. Additionally, the near-term resistance was at 0.9474 and there was a 38.25 Fibonacci retracement, with a break above that witnessed on a daily closing basis exposing the 50% level at 0.9599 (Vecchio, 2015). At the same time, there was evidence suggesting that the US economy had started to recover from the winter weakness. For instance, USD Advance Retail Sales, Retail Sales ex Auto and Retail Sales Control Group had increased by 0.9%, 0.4% and 0.3% respectively in March 2015.

The general equilibrium condition for the domestic economy stipulates that an increase in money supply must be offset by a reduction in the interest rate, because such a reduction would increase the domestic demand for money (Montiel, 2009, p. 427). An increase in the domestic demand for money would in turn be accompanied by an increase in domestic output in order to maintain the equilibrium in the domestic money market. Generating an increase in demand for domestic output is consequently achieved through devaluation of the local currency in a bid to make exports more expensive compared to imports. This is consistent with the above technical analysis and the trend that was witnessed in the value of the USD between 13th April and 18th April 2015.

From the foregoing, it is evident that technical and fundamental analysis play a significant role in determining the future movements in foreign currencies and are therefore critical in currency trading. After appreciating this fact I made deliberate attempts to carry out technical and fundamental analysis before deciding to trade with any currency. Using this strategy, I managed to generate a cumulative profit of 1,471.61AUD on 14th April 2015. Unfortunately, due to lack of experience I was not able to maintain this profitability and ended up making a cumulative loss of 11,282.49 AUD by the end of the trading exercise. This loss would however been much worse if I did not use hedging tools such as forwards and Limit orders. I made a total profit of 716.57 AUD from two forward contracts and a profit of 526.57 AUD from a limit order. Nevertheless, I underutilized these hedging tools.

 

 

References

Chen, J., 2009. Essentials of Foreign Exchange Trading. Hoboken, NJ: John Wiley and Sons.

Montiel, P. J., 2009. International macroeconomics. Malden, MA : Wiley-Blackwell.

Schlossberg, B., 2006. Technical analysis of the currency market : classic techniques for profiting from market swings and trader sentiment. Hoboken, N.J.: John Wiley.

Vecchio, C., 2015. EUR/USD Surges Back Above $1.0650 after March US Retail Sales Miss. [Online]
Available at: http://finance.yahoo.com/news/eur-usd-surges-back-above-130500706.html
[Accessed 13 May 2015].

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