Order Of Magnitude

We regularly size our forex positions based on the amount of risk we are willing to assume.  To detail a feel for the steps that are gone through for each trade, we're going to go through all the steps based on a hypothetical scenario.  Our situation is a young, go-get-er that is managing a ¥1M account.  Because this guy understands that he's young and can take on more risk (not to mention it makes our math easier), he is willing to lose 10% of his account on any one trade (which is not recommended, you should know your own risk levels).

The trader has been looking at the USD/CAD pair, over several timeframes.

USD/CAD - Jan 22, 2010

The trader feels that the recent short term rally is pushing into over-extended territory, and believes that the long term trend will once again assert itself and push the price back down to support around 1.025.  Examining moving averages, trendlines and other forecasting tools, the trader settles on a short entry price of 1.062.  If the price moves against him and pushes above 1.075 then the trader knows the gig is up, the long term trend has been broken and he should be out of the trade.  The total loss the trader is willing to take is: 1.0750 - 1.0620 = 130 pips.

The USD/CAD pair has all of it's profit and loss calculated in Canadian dollars.  So if the trader is going to risk 10% of his portfolio of ¥1M, first determine what ¥100k would be in Canadian dollars.  CAD/JPY is about 85.25, so the maximum ¥100k loss would work out to be $1,173.02 Canadian.  Now, what position size would result in 130 pips, being equal to the maximum drawdown of $1,173.02ish Canadian?

The position size would be: 1,173.02 / (1.0750 - 1.0620) =  90,232.31 CAD.  Now, all transactions on the USD/CAD pair are done in the base currency, which in this case is USD.  So converting the 90,232.31 into its US equivalent of  85,431.04.  This means that if out Japanese investor wants to cap his risk at ¥100,000, then a short position of 85,000 USD/CAD entered at 1.062 and stopped out at 1.075 would put a ceiling on the losses with the price targets from the chart.

This simple example is missing a couple of larger points, like the exchange rate between JPY and CAD messing with the total profit and loss, as well as interest charged/rewarded for the currency position.  This example also doesn't take into account any margin requirements, transaction fees, spread on the bid/ask or other risk factors.

Why would this Japanese trader enter this trade, if they were only planning on losing 10% of their account?  Looking at recent bottoms in the chart, the trader has determined that a price target of 1.03 is where they would close the short position, which would equate to 320 pips of profit and more than double the 10% of their account that was at risk.  Of course, the price can move in any direction, and every trader should do their own research.

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FINVIZ has for a long time been our go to for quick charts, scans and news.  They sweetened the deal adding Forex Majors, Gold, Silver and Oil.  Now it would appear they give you quotations for Futures 24/7.

If you like what FINVIZ provides, you may want to consider signing up for their Elite program.

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A longer term pattern that may turn into a head and shoulders reversal on the AUD/USD currency swap.

Head of 0.940 to a neckline of 0.895 is about a 450 pips measure giving a target of 0.850  A stop could be placed at 0.9320 where a breach of the shoulders would invalidate the pattern, and honestly we'd feel a whole lot better getting out at 0.920 where there was more recent highs made.  Now on a closer timescale:

If price can get below and hold below 0.8840 then we'll enter a position so that a rise to 0.92 would at most deplete 10% of risk able capital.  Every standard lot of $100k you move, a pip will cost $10, so a move to our stops would cost $3600.  Remember to do your own research.

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We've been in and out of several positions on AUD/USD in the past couple of weeks.  We slightly ahead in trading with a few excellent positions balancing out a few more that stopped out.  Tonight the Reserve Bank of Australia is releasing its GDP numbers, and as a result we're analyzing recent price action to determine what plays, if any, we would like to make

On a longer term timeframe, the 55 day moving average is rising, and is recently above current trading at around 0.9133.  The rising long term daily average points us towards only entering on the bullish side if an opportunity presents itself

There is also a loose symmetric triangle forming starting around the beginning of November.  The triangle points to a price tightening inward towards 0.9125, which is close to the SMA(55) on the daily.  We believe this tightening is foreshadowing an upcoming price move.

For a longer term trade, the recent lows around 0.8905 (Nov 2nd) and 0.8946 (Nov 27th) are important when determining a stop.  Since we'd like to take advantage of the difference in interest rates, a longer term trade is in our favour, which leads us towards a 0.89 area for a stop to allow for more volatility.  Allowing for more volatility will most likely result in a longer term trade where we can collect the interest difference.

Resistance has shown itself in the 0.9320-ish area a few times with highs at 0.9328 (Oct 21st), 0.9322 (Nov 25th) and 0.9323 (Dec 3rd)

Tightening in to hourly bars, it becomes apparent that the area around 0.9175 has been a source of resistance frequently in the last 2 weeks

Our plan is to watch smaller timeframes (hourly and 10 minute) if the price action moves towards 0.91.  We will not purchase higher than 0.9125 and will maintain a 0.89 stop.  This equates to 225 pips of risk worst case.  We will calculate the position size so that this maximum loss will equate to no more than 10% of our available capital (Rule #1).  If we maintain an exit at 0.9320, we are looking at 195 pips of profit.  This 1.15 Risk to Reward does not meet our requirements for a solid trade.

If we decide to tinker and adjust the upward price target to the October high of 0.9406 (changes Risk/Reward to 0.8) , or move up our stop to the 0.9020 (changes Risk/Reward to 0.53) level we are just trying to justify a trade that was objectively thrown out.  That said, the GDP news is a large chunk of fundamental information and if the real numbers beat the consensus estimates of 0.4, and the market starts to significantly move showing that the information is not yet priced in, we may entertain the higher stop of 0.9020 if the strength of the hourly timeframe is significant.  Otherwise, we'll let this one pass.

[UPDATE: RBA's GDP disappointed @ 0.2 as opposed to a 0.4 expected value.  The pair immediately shed 50 pips in 2 minutes while we were on the sideline]

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The Options Industry Council released a study that compared equity buy and hold against active and passive collar strategies.  You can grab the study here.

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Gold as an investment is being tossed around more and more.  Gold is near all time highs, and as of this writing is over $1000USD / oz.  Although it hasn't yet closed over that level.  If you pull pack and take a look at a longer timeframe of the continuous contract, most can pick out a multi-part inverse head and shoulder pattern.  We always recommend a part of your portfolio be set in actual assets, and precious metals are easy to get and rather value dense.  This time however, we're looking to use the SPDR Gold Shares ETF, which trades under GLD in New York.  They shave off 0.4% every year for doing all the paperwork, and are one of the ETFs with the best correlation to actual spot gold prices.

We're never ones to just rush out and buy something, because it looks good.  Right now Gold, as well as the ETF, are at a critical point.

Support and Resistance for GLD

The power of the current trend is undeniable, and we've been in this confluence of resistance before.  If the H&S pattern holds, a measured move to $1200 within the measure of the head of the pattern (~ $700) to the resistant neckline (~ $1000).  Although, if it turns out to be a false signal, there isn't a lot of proven support until under the $850 level.  The whole world is watching, and the speculators are speculating, so we decided to check out the pricing in the options.

GLD Call Premium

GLD Put Premium

The curve is more natural than the graph depicts because the strikes start moving up by $5 instead of $1 at $100.  We want to be prepared for a move in either direction.  We thought we would explore selling covered at the money calls.

100 shares of GLD ~ $9870

1 GLD Jan 2010 $99 Call ~ $620

This means that our cost of out pocket is $9260 (including about $10 in fees).  If we die tomorrow and the stock closes higher than $99, we'll net about 6.2% on expiration day, which is 126 days away.  Annualized this play works out to 12.7%.

If you'd rather try to bring in the expiration date, to more rapidly see time decay in action.  Selling a GLD Oct 2009 $99 (~$280), you'd be $9600 out of pocket (again including about $10 in fees) and a close above that would result in about a 3.1% profit over 35 days.  Annualized the October play works out to 36%.

In either case, you have no downside protection, and your profits are capped.  Our plan is to watch, and if the price of GLD breaks down below $90, we'll take our loss and exit the position.  If the price of gold manages to hold, or remains range bound, we'll let time decay work it's magic, and roll our short call contract forward a few months closer to December.  If the price breaks out and continues to trend upwards, we will wait until the premium of the contract erodes to about 2%, then close it and short another at-the-money covered call.

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USD.CAD - July 23rd

Last night the Loonie gained a cent against it's southern neighbour.  The recent gains can be attributed to the BoC saying that the recession is currently over in Canada, coupled with the march up in the price of oil.  Difficulty is that as the pair moves towards parity, Canadian exporters start to feel pain, as almost 80% of all Canada's exports go to the US.

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Las Vegas Sands Near Term

Las Vegas Sands has been showing a pattern of higher highs and lows since early March, and a break above $8 would leave very little overhead resistance.

Las Vegas Sands Long Term

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Equivolume: SIRI

Sirius showed up on two bullish weekly scans this week.  Appears that it has been enjoying the ride up all equities have been experiencing.  Sirius rose to the top of our scans because on a percentage basis,  it is up by orders of magnitude from it's 0.05 Feb. low.  A very small speculative position is in our future, with a stop out at 0.30.

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Financiers are crafty, and the creation of the rocket fuelled 3 times leveraged bull financial ETF and its evil twin the 3 times leveraged bear financial ETF, both products of Direxion Shares.  These creations have taken over the investment world.  Created just last year, already they are trading hundreds of millions of shares a day, putting them near or at the top of some very elite company.

A look at the prospectus of these funds,  if the average investor goes that far, starts to bring some questions about, namely "seeks daily investment results, before fees and expenses, of 300% of the price performance of the Russell 1000® Financial Services Index" Hrmmm, before fees and expenses.   Curiosity around the mechanics of the 3x leverage, kept me digging into these ETFs.  If you are so keen you can download the daily holdings, and most of it is pretty dull.  The majority of the list is just vanilla shares in companies included in the index, although there appears to be a lot less than the index itself contains.  Now, the magic of leverage comes from the largest holding in the fund: RUSSELL 1000 FINANCIAL INDEX SWAP.  By value, this instrument makes up 66% of the holdings.

The RUSSELL 1000 Financial Index Swap is a Total Return Swap and Direxion is pretty hush about the party (parties?) they are negotiating these swaps with.  The ticket is that although these swaps give you tremendous exposure to their underlying without making you pony up the dough, they are no where near free; usually they reside a percentage point or two above the interbank rate.  That cost, the cost of the swap, is what will gradually eat away at the value of these ETFs.

Ignorance will lead you to believe that since FAZ is bearish and FAS is bullish they should move inversely to each other.  They do to an extent, but it is not truly the case.  If you compare holding shares of FAS, and shares of FAZ assuming you bought at the open of the month, and sold at the close, you'd see returns like:

Now, nobody in their right mind would hold these funds for a whole day, let a lone a whole month, and this timescale does demonstrate the erosion of capital that is happening.  Sure the upsides are multiplied, but the downsides are magnified even more, all because the swap that is underlying the fund is eating away at the value.  If investors were rational, and you had access to enough capital you could just short equal values of each fund and wait for that overnight rate + premium to eat away at the value.   Investors are not rational, however, and as these funds become more and more popular, more and more capital is made available to the manager to buy more swaps (and marketing).

With this knowledge in hand, why are these funds so popular?  They are liquid, the spread is tight, and the leverage appeals to the greedy part of the human mind.  If you are on the right side of the market, you can pull in 10 or more percent in a single day.  These funds do this crazy dance, day after day.  The average true range of FAS over the last 14 trading sessions is $1.51.  With today's close of $7.85 the average range the fund's price moves is almost 20% of it's current price.  That is a lot of volatility.  Take a look at the option premium charts:

FAS - Put Premiums (click for larger)

FAS - Call Premiums (click for larger)

If you can magically get the price half way between the bid and the ask, you could sell a straddle at $8 for about $2.85, or the $7 straddle instead for a credit of about $2.90.  That is a boat load of premium, because it is also a boat load of risk.  Option strategies laid ontop of a financial instrument based on return swaps.  Only disciplined traders who can execute within seconds of a movement should attempt to tread these waters, if you have a chance of being trapped in a meeting, or are not glued to your terminal, you'd be safer using proven strategies on a simpler financial index

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