Fully Franked Issue 02 2011
Content
SECOND EDITION | 28th March 2011
2011 EDITION 02 | 28th March 2011
Volatility upping excitement in recent trading
Dear reader,
CONTENTS
Dollar Matters ........................................................... 2 Wayne Mcdonell The Dos and Don'ts of Investing and Trading ....... 5 Peter Ip On Japan and its path to recovery........................... 6 Justin Zuo Weighing in on simple and complex strategies ... 8 Martin Lotfizadeh
The past few weeks haven’t disappointed in giving us a full taste of the risk-reward rollercoaster driven by investor sentiments. On March the 15 the ASX 200 fell by an exceptional 2.1 percent which seemed rather like a plus than a minus when compared with the more than 10 percent and 5 percent slumps in the Nikkei and European markets respectively. Since then, equity markets have recovered strongly, oil has yet again spiked, our beloved dollar has returned to above parity - the bulls seem to be back in the game. Nevertheless we are left wondering what the chaos in Libya and the devastation in Japan represent for the Australian economy and its corporate outlook. In this issue we provide you with some commentary that can hopefully aid you in answering that all-important question. We have also assembled some useful advice from experienced traders on starting out and persevering as a successful trader or investor.
Proudly sponsored by:
th
As always, our thanks go to Nhi-Y Pham, publications director at UNIT Central for her enormous help in compiling articles and liaising with our affiliated chapters at UNSW and UMacq. Remember, volatility is far from scary in itself- it’s how you react that matters.
Justin Zuo Editor
EVENT: MACQUARIE is bringing WARRANTS WEBINAR UPCOMING EVENT: UNITTRADING Geoff Wilson, founder and principal of Wilson st th WHEN: Wednesday 1 September, 12:30pm-1:30pm. Asset Management to Sydney University on Wednesday 30 March. Geoff has over WHERE: Melbourne, but the Australian securities market 30 years of experience init’s viewable online. Register here. and will be giving a talk on WHY: Warrants can be risky and complicated, but also offer unique stock selection and techniques involved in rating companies. Visit our Facebook page benefits Learn how to use them wisely via this webinar More info here! for details.
Remember to keep an eye out for event updates on our website www.usydunit.com.au.
NEED A BITE-SIZE NEWSFEED AND MARKET UPDATES? S?
Only student-relevant world news, tutorials and career information. From value investing to quant trading, we’ve got you covered. Find our Twitter feed at http://twitter.com/USydUNIT
All information provided in this publication is subject to the Disclaimer on page 10.
INTEREST RATE
[email protected]
4.75%
WEBSITES
www.usydunit.com.au www.unitaustralia.com
SECOND EDITION | 28th March 2011
Dollar Matters
Wayne McDonell provides analysis of the currency market: supply and demand.
To be a truly successful currency trader one must understand global money flow well. Healthy economies tend to attract investment. As a result, their currencies are in high demand. In such situations, the classic supply and demand equation dictates that the value of the currency rises. The goal of a currency trader is to conduct analysis on economies around the world to identify healthy and weak currencies in order to trade them against each other. Therefore it is useful to look at global money flow and to break it down, using both macroeconomics and microeconomics. Macroeconomics Why is a currency in high demand? Let’s use Australia as an example. One of the country’s great strengths is its natural resources. Australia produces gold, diamonds, wheat, beef, iron ore, coal, and fabulous wines, all of which are in high demand by expanding economies such as China. In fact, China purchased 21 per cent of all Australia’s exports in 2009. However, the Chinese cannot spend their currency within Australia. They must first buy the Australian dollar. The more goods and services foreign economies purchase from Australia, the higher the
demand for the local currency (AUD) becomes. This is true for long-term investments as well. An international corporation might wish to build a factory; or a foreign institution might wish to buy a government bond; or perhaps a billionaire in Malaysia would like to invest in the Australian Stock Exchange. These three examples, like a plethora of other possibilities, would all create demand for the Aussie dollar. Let’s not forget central banking policy. All this demand for Australian resources creates a flow of money from around the world into the local economy. Farmers, ranchers, miners, and bankers all benefit financially. They, in turn, spend their money within the local economy: bigger houses, faster cars, and fancier watches. Suddenly a 30-foot boat doesn’t seem adequate, so hordes of successful Aussies begin to buy 42-foot yachts, which drives up prices for the yachts. This is classic inflation, the evil nemesis of the Reserve Bank of Australia. How does a central banker deal with the threat of inflation? Central bankers have many tools available to them, of which the most visible is the interest rate. In an effort to curb spending, a central banker often increases
the cost of borrowing money. If you don’t have the cash or can’t afford the higher borrowing cost, you will have no boat to float and thus demand for yachts dwindles. Central bankers increase the cost of borrowing money by raising interest rates and raising the yield curve. This strategy also encourages saving, further reducing spending and alleviating inflationary pressures. Raising the cost of money and enticing a higher savings rate is effective only within the local economy. A 10 per cent mortgage rate could indeed slow the housing boom and a 7 per cent savings account interest rate may be effective in changing the spending habits of Australian citizens. But the unintended consequence of the higher interest rate is foreign investment. Global money flow is also affected greatly by interest rates. It’s not just China’s desperate need for clean coal, but the world’s desperate need for a high rate of return for a low-risk investment. Higher interest rates, relative to the interest rates of other mature economies, will create a carry trade. Savvy investors, such as hedge funds, seek to borrow cheap money and invest it in a safe
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asset that offers a higher return. The higher the differential of low cost and high return, the greater the flow of money from around the world: the greater the flow of money into Australia, the higher the demand for the Australian dollar. The likely outcome of this scenario is a higher valuation for the currency. As a currency trader, you would want to be in a long position versus a weaker economy’s currency. Microeconomics This is all fine and dandy after the fact, but how does a trader enter at the beginning of this global money-flow trend? It comes down to fundamental analysis. On a global scale, microeconomics is the study of a particular economy through trends in its economic reports. For example, when studying the United States and discerning the future value of the greenback, one should review reports that outline inflation, employment, housing, output, and so on. Within these economic reports, you should find trends and, more importantly, changes in trends. For example, fundamental analysis shows there is no inflation in the American economy. As long as this stays true, central banking policy is not likely to change at the Federal Reserve Bank. However, the economic fundamentals will change in time and thus central banking policy will eventually change as well. The only question is when. If you get the timing correct, you will likely be rewarded for a great macroeconomic trade based on sound microeconomics. In the United States the most important economic reports to watch are: Manufacturing ISM Industrial production Capacity utilization Durable goods Gross domestic product Employment Weekly jobless claims Nonfarm payrolls Unemployment rate Housing Building permits Housing starts New home sales Existing home sales Pending home sales Case Shiller index Inflation Consumer price index Producer price index Personal consumption expenditures Consumer Consumer confidence Personal income Personal spending Retail sales An economist or quantitative analyst would study each report. The analyst would look for a trend or a change in trend in each. They would also look for a trend or change in trend in each subcategory, and attempt to combine each report to come to a general conclusion as to the health of the economy. There are many questions one can ask. Do people have jobs? Do people feel confident in retaining their job? Are people spending money? Are factories in full production? Are inventories high or low? Is there inflation for factory owners? Will inflation be passed to consumers? Are consumers confident of the future? Will consumers make long-term investments, such as buying houses, vehicles, or stainlesssteel refrigerators? Much as a composer uses musical notation to create harmony and rhythm from various combinations of notes, an economist must make sense of the large sets of data to piece together the story of a local economy. A person who has a steady job is confident enough to make dayto-day and even frivolous purchases, thereby stimulating the economy. Factories and businesses will work to fulfil and replenish the needed inventories. This in turn keeps the employees of these businesses confident in the future of their jobs. They too spend their money and a positive cycle is created. Over time, inflation is created and interest rates are raised to try to
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contain the inflation sustainable levels. at true only when the rest of the world’s economies are in similar trouble. For example, at the beginning of 2009 the nonfarm payrolls report showed terrible employment statistics in the United States. At that time the US economy was losing 600,000 jobs each month, but the US dollar was extremely solid. This paradox was created by the fact that foreign investors, facing similar dire straits, sought the safety of government-backed treasuries. To purchase these treasuries a foreigner first had to purchase the US dollar; thus its value appreciated, based on high global demand. A few months later, the nonfarm payrolls employment report showed ‘less bad’ figures. This was the first sign that the worst was over and it was possibly an opportunity for foreign investors to cash out of their safe haven and return money to higherreturn assets. This was evident as stock indices around the world began to recover and the value of the US dollar began to decline. If you look at the weekly chart of the AUD/USD you will notice that at the worst part of the global financial meltdown the USD was at its strongest. Then, as the US nonfarm payrolls report because ‘less bad’, the US dollar began to weaken against the Australian dollar. This clearly shows how investors were no longer seeking the safety of US Treasuries after the economic crisis had hit bottom, but preferred the expanding economy Down Under for its opportunities to make money… and later to provide a higher yield. As you can see, even if safehaven currencies offer a paradox, a sound understanding of global money flow gives investors insight into how currency valuations change based on demand for those currencies. Demand for a currency may be high during a flight to safety, as in the case of the Swiss franc, while the global economy is contracting. However, during an expanding global economy, the Australian dollar may be in high demand for its higher relative interest rates. A savvy currency trader always has something to be bullish about. Be it greed or fear, there is always an opportunity to make money if you understand global money flow. Study the microeconomic data for each major economy around the world and develop a global macroeconomic map for strong and weak economies. You will likely be able to plot the path of money… this is your opportunity to make money from foreign currency arbitrage. Please visit http://www.fxbootcamp.com/yt e/micromacro-forex to watch a companion video about this topic.
It is a currency trader’s job to understand the cycle, to understand where in the cycle each economy around the world is, and to anticipate changes in the cycle. The economy is either expanding, contracting, or in a peak or valley between expansion and contraction. Expanding economies are often associated with appreciating currency values. Contracting economies are often associated with depreciating currency values. The exceptions to these rules are safe-haven economies such as the United States, Japan, and Switzerland. Safe-haven currencies It’s important to understand these exceptions. When the world is facing a global financial meltdown and fear is the defining factor for investing, parking money in a safe place is highly attractive. Safe havens often offer little or no return on investment beyond peace of mind. However a calm mind is often better than a messy portfolio. Safe havens include the treasuries of the first and second largest economies in the world. Traditionally they also include gold and the safety of Swiss bank accounts. Therefore gold, the US dollar, the Japanese yen, and the Swiss franc often appreciate, even in times when the economies of those countries are less than stable. It is important to note that this is
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the US National Futures Association and registered as a Commodities Trading Advisor. His book ‘Strategic and Tactical Forex Trading’ (Wiley Publishing) is a bestseller in the Foreign Exchange category of Amazon.com.
Wayne McDonell is the Chief Currency Coach of FxBootcamp. com, a live forex training organization. He is a member of
The Dos and Don’ts of Investing and Trading
Peter Ip explores what to and not to do as first time investors.
The first time you put your own money into a company can be a daunting experience for many. What’s more, there are just so many things you hear everywhere about investing and trading that it’s hard to make sense of it all. Here are just a few “dos” and “don’ts” of trading to keep in mind next time you place in an order with your broker: DO keep well informed and up to date with the market. In the same way you *hopefully* revise before a test, you have to know your stuff about the economy and the company before putting your money into it. Placing orders without any prior research or knowledge is like buying lottery tickets: you might get lucky but the odds are stacked against you. You could start reading the finance section of the newspaper or doing your own research on the internet. You could also start attending trading and investing seminars to get a few tips from experts in the industry. Whatever you do, when it comes to your first trade you should be confident in knowing that you are making a
wise investment based on solid information. DON’T put all your money into a single investment. The saying “Don’t put your eggs in one basket” holds true in investing. The general rule for new investors is that you put in as much money in the share market as you can afford to lose. Good investors should always monitor the amount of money they have invested in the share market and keep a healthy reserve of cash just in case. Diversification is a boon to your portfolio as it helps to mitigate the risks unique to individual companies or industries. DO keep a log of all your share trades. Share trading is a learning experience. Often the best lessons come out of the most painful mistakes. By keeping a log of what you have done, you can learn from your mistakes and work on your trading technique. It is important not only to recognise what you are doing wrong...you have to know what you are doing right as well! Learning from others who trade and invest can sometimes be more
valuable than getting advice on what companies to invest in. Remember the saying: “Give a man a fish and you feed him for a day. Teach a man to fish and you feed him for a lifetime.” Keeping a log of what you have done also helps when it comes to organising documents you receive from the ASX (such as CHESS statements) and companies (dividends payments), especially when it comes to taxes. DON’T be emotional. There are often two emotions attributed to the share market: fear and greed. Fear is what causes investors to jettison out of good investments. Greed is what keeps their money in bad ones. There are numerous examples where investors have abandoned ship too early. There are also numerous examples where greed has kept investors in the share market, only for them to realise that things were just too good to be true (GFC anyone?). Often we let our emotions get the better of us. When it comes to trading and investing, keeping cool and rational is essential for consistent success. Often it is better to take your losses now
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rather than wait and hope that in the future, the stock will rebound. DO remember to factor in the cost of brokerage. Let’s take a simple example: On Monday, Company X has a share price of $1.00. You decide it’s a great investment and buy 1000 shares of Company X ie. you have invested $1000 in the company. On Tuesday you find out that the price of Company X’s shares is $1.03. Seeing a nice 3% return in a single day, you sell all your shares for $1030. That’s a nice $30 profit right? Not quite. Remember to trade on the market you MUST go through a broker and almost certainly there are brokerage fees which must be paid for each transaction. Say the brokerage fee is $15. That means when you bought into the company, you had to pay an additional $15 in brokerage. When you sold your shares the following day, $15 went to your brokers again. You’ve made no profit! DON’T get sucked into the hype. Everyone hears of the great investment stories from boastful investors. Remember that fishermen only tell their friends of the biggest fish they have caught: they never mention about the ones which got away or the ones which were too small. Behind every fantastic investment story is a painful one. Remember to keep on doing your research and be sceptical of the “This is a great company!” share advice from your peers. Hopefully that clears up a few things on what you should keep in mind before you make your first trade! Happy trading! Thanks to Peter Ip for his initial draft and the rest of the UNIT Team for their edits.
On Japan and its path to recovery
Justin Zuo suggests nine factors to look out for in the wake of the disasters
The Japanese earthquake, tsunami and continuing nuclear crisis will probably have as great an impact on Japanese society as the second world war. The impact of these events will be felt for years if not decades to come but below are a few immediate considerations that might impact on your investing decision. The consensus is in the tails. Over the past few years, investors have been buffeted by outlier events that have so dominated markets that tail events are becoming the consensus. Japan’s earthquake will probably reinforce perceptions that fear should
underpin any approach to financial markets. Japan will overcome the physical adversity. Japanese governments and policymakers have been much criticized for their tardy responses to economic conditions for nearly two decades. In their favour, the sources of their problems and the solutions were subject to some conjecture. The earthquake damage is likely to confront the government in a way that only compares with the rebuilding task after the second world war. There will be little debate about what needs to be done. The government and the
Bank of Japan have already moved to make funding available. Watch the liquidity roll in. Extrapolating the damage may be unwise. The pictures of destruction appearing on our television screens suggest a return to anything approaching normality will be decades in coming. These pictures are coming from the most severely affected prefectures and regions. Reports suggest that even the city of Sendai is largely intact despite being very near the areas of greatest destruction. The damaged areas account for only 7-8% of the country’s output.
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Japan’s major manufacturing areas have not been directly affected. There could be a rapprochement with China. China offered and Japan accepted assistance. This was unusual and might signify a thaw in relations. There are some silver linings in this especially bleak cloud. This may be one. Uranium is clean but only up to a point. In the normal course of events, nuclear power is cleaner than other forms of energy. The Fukushima explosions have highlighted how, at other times, nuclear power is a far more scary energy alternative. At a minimum, the positive consensus surrounding nuclear power and development of uranium mines will be reappraised. In the short term, greater recourse to natural gas and other fuel sources could be expected. Funding the reconstruction will pose problems for others. While Japanese debt has risen to 200% of GDP, nearly all has been held internally, removing the pressures faced by countries like the USA and Australia that must rely on foreigners having enough confidence to support a rising debt issuance. Self funding its debt has relied on Japanese households saving for their retirements. Now, many of those households will have to use their savings to restore their physical environs. The government may have to compete to fund reconstruction but the US may be the loser. The Japanese have also been funding the U.S. deficit. They might contribute less in the future. Japan’s future economic growth will be stronger. In the short term, plant closures and the loss of life will result in a contraction in output. As reconstruction gets underway, however, spending on physical infrastructure, housing, commercial properties, transport equipment and consumer durables will increase leading to stronger growth outcomes than would have otherwise been achieved. The mammoth rebuilding effort will require more raw materials. Mining and metal refining companies will benefit since more metal and industrial raw materials will be used in the next five years than would have been used if there had been no earthquake. Initially, nonJapanese producers of these materials may benefit most but, in the longer term, Japanese fabricators will probably meet the additional demand and recover some of their lost market share. Global supply chains will suffer disruption. Many major Japanese corporations such as Toshiba, Panasonic, Toyota and Nissan, among others, have already cut production even where they have not been directly affected. Exports will be lost. Inadequate supplies of products such as LCD screens and computer memory chips could see loss of Japanese market share but, more significantly, could result in rising prices or shortages in places apparently unconnected to Japanese industry as other manufacturers lose their input sources. The Japanese have a proverb which I have always liked: fall seven times, stand up eight. Let’s hope this tenacious people can recover quickly from the horrid devastation and rebuild their nation better and stronger. A version of this article first appeared in a blog co-founded by Justin Zuo. Visit http://thepitchbook.net/ for more commentary on current financial & economic affairs.
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Weighing in on simple and complex strategies
Martin Lotfizadeh compares the benefits of simple vs. complex strategies – is simple better?
In a courtroom in California during the late eighties, a federal prosecutor overseeing the case of Barry Minkow, the mastermind behind the $100m ZZZZ Best Ponzi scheme, suggested that Minkow was talented and charismatic to the point that “he could have succeeded in a legitimate enterprise”. By 2009 the convicted 43-year-old former conman was back in the headlines for doing just that – his new firm had spent as much as US$300,000 to develop a system that could sift through a database of the degrees held by executives at public companies and identify potential red-flags. The software was developed for Minkow by a little-known technology company and worked by extracting the names and birthdates of executives from a database and sending them through to an organization that verified educational
credentials. When the system found inconsistencies in the data that could not be independently verified, a request of proof that a degree had been awarded was sent to the relevant university. If the information still could not be verified, an investigator was dispatched to the registrar’s office to be sure. Minkow would then proceed to buy put options in the targeted company, setting himself up to profit from the likely sell-off that would occur once his findings were made public. In one case, a 6.5% rout in a stock occurred after it surfaced that a key executive did not hold the two degrees that he claimed to have. Once the executive resigned, the price rebounded by 9% in the subsequent two trading sessions but not before Minkow had already profited from the initial sell off.
Minkow’s strategy is just a standout in an infinite number of creative and complex strategies that exist today, from high frequency trading (HFT) that exploit microstructure inefficiencies and often last for just milliseconds, to statistical arbitrage strategies, to the asset backed security disaster involving little understood repackaged mortgage securities, right through to an individual trader with half a dozen technical indicators on a chart. In markets which are increasingly complex, it’s understandable to see why they are matched with increasingly complex strategies. Conversely, it’s intuitive to dismiss extremely simple strategies such as support and resistance trading as something that has lost its effectiveness a long time ago. After all, if something truly as simple as buying and selling at support and resistance levels
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still worked, then there would be no Barry Minkows in the world with their elaborate résumé systems because they would all be labeling peaks and troughs on a chart instead. However for those patient and dedicated enough, simple strategies still do work. Back in 2006, as I learnt about the markets, the more complex my strategies became. A few years later I decided to combine my finance and programming background and go down the path of algorithmic trading. Although I still develop automatic trading systems today, most of my trading volume has long consisted of much simpler strategies. For instance, I don’t have any technical indicators on my chart, just a few lines I have drawn up earlier in the day. I also completely ignore the news or any any other fundamental factors, as my strategy is very short term, often in and out of the market within a few minutes. The only thing I am looking for is a confluence of important levels on a chart, such as big round numbers, floor pivots and recent price barriersturned-support and resistance. Once I have a confluence of some combination of these factors within a few points of each other, I place a buy-limit or sell-limit order around this price, anticipating price to bounce at this area. a futures contract found on the Eurex exchange, and the main market that I trade: Most reputable brokers require a minimum of $5,000-$10,000 in initial capital to open a futures account. Derivatives in general are also highly leveraged and risky instruments, so obviously you wouldn’t attempt to trade this market if you are just starting out. The point I am trying to make however, is that this is an example of a simple, common-sense based strategy that works – I have been trading it in more-or-less in its original form for the last few years. But if it’s so easy, why doesn’t everyone trade like this? Firstly, it’s not quite as simple as it looks – a fair amount of intuition stemming from experience is involved. I also look at things such as depth-ofmarket (DOM) and often need to employ a bit of common sense such as staying out during steep sell-offs or economic releases. The other reason that very few people are willing to trade this strategy is because of the fact that they will often find themselves waiting for two weeks at a time just to take five or six points (or ticks) out the market. To put that in perspective, the FESX can easily move 30 points or more within an hour. sure why this is the case. The absolute profit or loss of a five point move is a function of how many contracts are actually traded at a given price and not the number of points alone. For example, each point trading the European based FESX is worth €10 per contract. Clearly if you had traded 10 or 100 contracts, then each point would be worth €100 or €1000 respectively. This is limited only by the level of liquidity in the market, and if €100 per point for a five point trade is worth just 3 or 4 percent of your account, then this still falls under good money management, and would not be irresponsible. Therefore, the argument that you need to trade everyday in order to be a day trader is just plain wrong. Despite this, most traders that look for these small five point gains, known as scalpers, are typically in and out of the market several times a day and usually employ far more complex strategies to capture them. I am however perfectly content to wait for a long time, often up to two weeks, just to capture five points using this simple strategy as it translates to a lower risk-reward ratio and a higher win rate. Finally, I should point out that I don’t stare at a chart for 6 hours a day just to wait for a five point trade that only occurs once every other week. That would be ridiculous. Instead, I run my trading platform on separate, dedicated servers which issue email alerts once price is
Here is an example that I recently took on FESX, which is
The truth is, I don’t know anyone else that wants to wait a week or two just to capture five measly points. However, I’m not
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approaching an area that I had previously marked on the chart that afternoon (the German based Eurex market opens at 6pm AEST). The principles of simplicity and patience are still at the core of this strategy however, and for an individual trader with limited time and resources, you will likely discover, just like I did, that simple strategies can still be used in the markets. Martin Lotfizadeh recently completed a Bachelor of Commerce with a major in finance from Macquarie University. He has traded Eurex futures, FX and equities for several years and is now looking forward to beginning his career as a full-time trader.
DISCLAIMER The material in this report is produced as general information only and is not intended to be advice. Readers should not act on the basis of this information and must seek specific advice from a professional adviser before taking any action. No warranty or guarantee is given regarding the accuracy or reliability of this report. The authors expressly disclaim all and any liability to any person for any loss or damage arising as a result of this publication, whether whole or part of the contents of this publication. For permission to use this report, you must accept full responsibility for any action that you take. Note also that past results are not a reliable guide to future results. Future outcomes are unknown and investing can result in financial loss.
Interested in writing for Fully Franked? Contact the editor, attaching your CV: [email protected]
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2011 EDITION 02 | 28th March 2011
Volatility upping excitement in recent trading
Dear reader,
CONTENTS
Dollar Matters ........................................................... 2 Wayne Mcdonell The Dos and Don'ts of Investing and Trading ....... 5 Peter Ip On Japan and its path to recovery........................... 6 Justin Zuo Weighing in on simple and complex strategies ... 8 Martin Lotfizadeh
The past few weeks haven’t disappointed in giving us a full taste of the risk-reward rollercoaster driven by investor sentiments. On March the 15 the ASX 200 fell by an exceptional 2.1 percent which seemed rather like a plus than a minus when compared with the more than 10 percent and 5 percent slumps in the Nikkei and European markets respectively. Since then, equity markets have recovered strongly, oil has yet again spiked, our beloved dollar has returned to above parity - the bulls seem to be back in the game. Nevertheless we are left wondering what the chaos in Libya and the devastation in Japan represent for the Australian economy and its corporate outlook. In this issue we provide you with some commentary that can hopefully aid you in answering that all-important question. We have also assembled some useful advice from experienced traders on starting out and persevering as a successful trader or investor.
Proudly sponsored by:
th
As always, our thanks go to Nhi-Y Pham, publications director at UNIT Central for her enormous help in compiling articles and liaising with our affiliated chapters at UNSW and UMacq. Remember, volatility is far from scary in itself- it’s how you react that matters.
Justin Zuo Editor
EVENT: MACQUARIE is bringing WARRANTS WEBINAR UPCOMING EVENT: UNITTRADING Geoff Wilson, founder and principal of Wilson st th WHEN: Wednesday 1 September, 12:30pm-1:30pm. Asset Management to Sydney University on Wednesday 30 March. Geoff has over WHERE: Melbourne, but the Australian securities market 30 years of experience init’s viewable online. Register here. and will be giving a talk on WHY: Warrants can be risky and complicated, but also offer unique stock selection and techniques involved in rating companies. Visit our Facebook page benefits Learn how to use them wisely via this webinar More info here! for details.
Remember to keep an eye out for event updates on our website www.usydunit.com.au.
NEED A BITE-SIZE NEWSFEED AND MARKET UPDATES? S?
Only student-relevant world news, tutorials and career information. From value investing to quant trading, we’ve got you covered. Find our Twitter feed at http://twitter.com/USydUNIT
All information provided in this publication is subject to the Disclaimer on page 10.
INTEREST RATE
[email protected]
4.75%
WEBSITES
www.usydunit.com.au www.unitaustralia.com
SECOND EDITION | 28th March 2011
Dollar Matters
Wayne McDonell provides analysis of the currency market: supply and demand.
To be a truly successful currency trader one must understand global money flow well. Healthy economies tend to attract investment. As a result, their currencies are in high demand. In such situations, the classic supply and demand equation dictates that the value of the currency rises. The goal of a currency trader is to conduct analysis on economies around the world to identify healthy and weak currencies in order to trade them against each other. Therefore it is useful to look at global money flow and to break it down, using both macroeconomics and microeconomics. Macroeconomics Why is a currency in high demand? Let’s use Australia as an example. One of the country’s great strengths is its natural resources. Australia produces gold, diamonds, wheat, beef, iron ore, coal, and fabulous wines, all of which are in high demand by expanding economies such as China. In fact, China purchased 21 per cent of all Australia’s exports in 2009. However, the Chinese cannot spend their currency within Australia. They must first buy the Australian dollar. The more goods and services foreign economies purchase from Australia, the higher the
demand for the local currency (AUD) becomes. This is true for long-term investments as well. An international corporation might wish to build a factory; or a foreign institution might wish to buy a government bond; or perhaps a billionaire in Malaysia would like to invest in the Australian Stock Exchange. These three examples, like a plethora of other possibilities, would all create demand for the Aussie dollar. Let’s not forget central banking policy. All this demand for Australian resources creates a flow of money from around the world into the local economy. Farmers, ranchers, miners, and bankers all benefit financially. They, in turn, spend their money within the local economy: bigger houses, faster cars, and fancier watches. Suddenly a 30-foot boat doesn’t seem adequate, so hordes of successful Aussies begin to buy 42-foot yachts, which drives up prices for the yachts. This is classic inflation, the evil nemesis of the Reserve Bank of Australia. How does a central banker deal with the threat of inflation? Central bankers have many tools available to them, of which the most visible is the interest rate. In an effort to curb spending, a central banker often increases
the cost of borrowing money. If you don’t have the cash or can’t afford the higher borrowing cost, you will have no boat to float and thus demand for yachts dwindles. Central bankers increase the cost of borrowing money by raising interest rates and raising the yield curve. This strategy also encourages saving, further reducing spending and alleviating inflationary pressures. Raising the cost of money and enticing a higher savings rate is effective only within the local economy. A 10 per cent mortgage rate could indeed slow the housing boom and a 7 per cent savings account interest rate may be effective in changing the spending habits of Australian citizens. But the unintended consequence of the higher interest rate is foreign investment. Global money flow is also affected greatly by interest rates. It’s not just China’s desperate need for clean coal, but the world’s desperate need for a high rate of return for a low-risk investment. Higher interest rates, relative to the interest rates of other mature economies, will create a carry trade. Savvy investors, such as hedge funds, seek to borrow cheap money and invest it in a safe
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asset that offers a higher return. The higher the differential of low cost and high return, the greater the flow of money from around the world: the greater the flow of money into Australia, the higher the demand for the Australian dollar. The likely outcome of this scenario is a higher valuation for the currency. As a currency trader, you would want to be in a long position versus a weaker economy’s currency. Microeconomics This is all fine and dandy after the fact, but how does a trader enter at the beginning of this global money-flow trend? It comes down to fundamental analysis. On a global scale, microeconomics is the study of a particular economy through trends in its economic reports. For example, when studying the United States and discerning the future value of the greenback, one should review reports that outline inflation, employment, housing, output, and so on. Within these economic reports, you should find trends and, more importantly, changes in trends. For example, fundamental analysis shows there is no inflation in the American economy. As long as this stays true, central banking policy is not likely to change at the Federal Reserve Bank. However, the economic fundamentals will change in time and thus central banking policy will eventually change as well. The only question is when. If you get the timing correct, you will likely be rewarded for a great macroeconomic trade based on sound microeconomics. In the United States the most important economic reports to watch are: Manufacturing ISM Industrial production Capacity utilization Durable goods Gross domestic product Employment Weekly jobless claims Nonfarm payrolls Unemployment rate Housing Building permits Housing starts New home sales Existing home sales Pending home sales Case Shiller index Inflation Consumer price index Producer price index Personal consumption expenditures Consumer Consumer confidence Personal income Personal spending Retail sales An economist or quantitative analyst would study each report. The analyst would look for a trend or a change in trend in each. They would also look for a trend or change in trend in each subcategory, and attempt to combine each report to come to a general conclusion as to the health of the economy. There are many questions one can ask. Do people have jobs? Do people feel confident in retaining their job? Are people spending money? Are factories in full production? Are inventories high or low? Is there inflation for factory owners? Will inflation be passed to consumers? Are consumers confident of the future? Will consumers make long-term investments, such as buying houses, vehicles, or stainlesssteel refrigerators? Much as a composer uses musical notation to create harmony and rhythm from various combinations of notes, an economist must make sense of the large sets of data to piece together the story of a local economy. A person who has a steady job is confident enough to make dayto-day and even frivolous purchases, thereby stimulating the economy. Factories and businesses will work to fulfil and replenish the needed inventories. This in turn keeps the employees of these businesses confident in the future of their jobs. They too spend their money and a positive cycle is created. Over time, inflation is created and interest rates are raised to try to
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contain the inflation sustainable levels. at true only when the rest of the world’s economies are in similar trouble. For example, at the beginning of 2009 the nonfarm payrolls report showed terrible employment statistics in the United States. At that time the US economy was losing 600,000 jobs each month, but the US dollar was extremely solid. This paradox was created by the fact that foreign investors, facing similar dire straits, sought the safety of government-backed treasuries. To purchase these treasuries a foreigner first had to purchase the US dollar; thus its value appreciated, based on high global demand. A few months later, the nonfarm payrolls employment report showed ‘less bad’ figures. This was the first sign that the worst was over and it was possibly an opportunity for foreign investors to cash out of their safe haven and return money to higherreturn assets. This was evident as stock indices around the world began to recover and the value of the US dollar began to decline. If you look at the weekly chart of the AUD/USD you will notice that at the worst part of the global financial meltdown the USD was at its strongest. Then, as the US nonfarm payrolls report because ‘less bad’, the US dollar began to weaken against the Australian dollar. This clearly shows how investors were no longer seeking the safety of US Treasuries after the economic crisis had hit bottom, but preferred the expanding economy Down Under for its opportunities to make money… and later to provide a higher yield. As you can see, even if safehaven currencies offer a paradox, a sound understanding of global money flow gives investors insight into how currency valuations change based on demand for those currencies. Demand for a currency may be high during a flight to safety, as in the case of the Swiss franc, while the global economy is contracting. However, during an expanding global economy, the Australian dollar may be in high demand for its higher relative interest rates. A savvy currency trader always has something to be bullish about. Be it greed or fear, there is always an opportunity to make money if you understand global money flow. Study the microeconomic data for each major economy around the world and develop a global macroeconomic map for strong and weak economies. You will likely be able to plot the path of money… this is your opportunity to make money from foreign currency arbitrage. Please visit http://www.fxbootcamp.com/yt e/micromacro-forex to watch a companion video about this topic.
It is a currency trader’s job to understand the cycle, to understand where in the cycle each economy around the world is, and to anticipate changes in the cycle. The economy is either expanding, contracting, or in a peak or valley between expansion and contraction. Expanding economies are often associated with appreciating currency values. Contracting economies are often associated with depreciating currency values. The exceptions to these rules are safe-haven economies such as the United States, Japan, and Switzerland. Safe-haven currencies It’s important to understand these exceptions. When the world is facing a global financial meltdown and fear is the defining factor for investing, parking money in a safe place is highly attractive. Safe havens often offer little or no return on investment beyond peace of mind. However a calm mind is often better than a messy portfolio. Safe havens include the treasuries of the first and second largest economies in the world. Traditionally they also include gold and the safety of Swiss bank accounts. Therefore gold, the US dollar, the Japanese yen, and the Swiss franc often appreciate, even in times when the economies of those countries are less than stable. It is important to note that this is
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the US National Futures Association and registered as a Commodities Trading Advisor. His book ‘Strategic and Tactical Forex Trading’ (Wiley Publishing) is a bestseller in the Foreign Exchange category of Amazon.com.
Wayne McDonell is the Chief Currency Coach of FxBootcamp. com, a live forex training organization. He is a member of
The Dos and Don’ts of Investing and Trading
Peter Ip explores what to and not to do as first time investors.
The first time you put your own money into a company can be a daunting experience for many. What’s more, there are just so many things you hear everywhere about investing and trading that it’s hard to make sense of it all. Here are just a few “dos” and “don’ts” of trading to keep in mind next time you place in an order with your broker: DO keep well informed and up to date with the market. In the same way you *hopefully* revise before a test, you have to know your stuff about the economy and the company before putting your money into it. Placing orders without any prior research or knowledge is like buying lottery tickets: you might get lucky but the odds are stacked against you. You could start reading the finance section of the newspaper or doing your own research on the internet. You could also start attending trading and investing seminars to get a few tips from experts in the industry. Whatever you do, when it comes to your first trade you should be confident in knowing that you are making a
wise investment based on solid information. DON’T put all your money into a single investment. The saying “Don’t put your eggs in one basket” holds true in investing. The general rule for new investors is that you put in as much money in the share market as you can afford to lose. Good investors should always monitor the amount of money they have invested in the share market and keep a healthy reserve of cash just in case. Diversification is a boon to your portfolio as it helps to mitigate the risks unique to individual companies or industries. DO keep a log of all your share trades. Share trading is a learning experience. Often the best lessons come out of the most painful mistakes. By keeping a log of what you have done, you can learn from your mistakes and work on your trading technique. It is important not only to recognise what you are doing wrong...you have to know what you are doing right as well! Learning from others who trade and invest can sometimes be more
valuable than getting advice on what companies to invest in. Remember the saying: “Give a man a fish and you feed him for a day. Teach a man to fish and you feed him for a lifetime.” Keeping a log of what you have done also helps when it comes to organising documents you receive from the ASX (such as CHESS statements) and companies (dividends payments), especially when it comes to taxes. DON’T be emotional. There are often two emotions attributed to the share market: fear and greed. Fear is what causes investors to jettison out of good investments. Greed is what keeps their money in bad ones. There are numerous examples where investors have abandoned ship too early. There are also numerous examples where greed has kept investors in the share market, only for them to realise that things were just too good to be true (GFC anyone?). Often we let our emotions get the better of us. When it comes to trading and investing, keeping cool and rational is essential for consistent success. Often it is better to take your losses now
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rather than wait and hope that in the future, the stock will rebound. DO remember to factor in the cost of brokerage. Let’s take a simple example: On Monday, Company X has a share price of $1.00. You decide it’s a great investment and buy 1000 shares of Company X ie. you have invested $1000 in the company. On Tuesday you find out that the price of Company X’s shares is $1.03. Seeing a nice 3% return in a single day, you sell all your shares for $1030. That’s a nice $30 profit right? Not quite. Remember to trade on the market you MUST go through a broker and almost certainly there are brokerage fees which must be paid for each transaction. Say the brokerage fee is $15. That means when you bought into the company, you had to pay an additional $15 in brokerage. When you sold your shares the following day, $15 went to your brokers again. You’ve made no profit! DON’T get sucked into the hype. Everyone hears of the great investment stories from boastful investors. Remember that fishermen only tell their friends of the biggest fish they have caught: they never mention about the ones which got away or the ones which were too small. Behind every fantastic investment story is a painful one. Remember to keep on doing your research and be sceptical of the “This is a great company!” share advice from your peers. Hopefully that clears up a few things on what you should keep in mind before you make your first trade! Happy trading! Thanks to Peter Ip for his initial draft and the rest of the UNIT Team for their edits.
On Japan and its path to recovery
Justin Zuo suggests nine factors to look out for in the wake of the disasters
The Japanese earthquake, tsunami and continuing nuclear crisis will probably have as great an impact on Japanese society as the second world war. The impact of these events will be felt for years if not decades to come but below are a few immediate considerations that might impact on your investing decision. The consensus is in the tails. Over the past few years, investors have been buffeted by outlier events that have so dominated markets that tail events are becoming the consensus. Japan’s earthquake will probably reinforce perceptions that fear should
underpin any approach to financial markets. Japan will overcome the physical adversity. Japanese governments and policymakers have been much criticized for their tardy responses to economic conditions for nearly two decades. In their favour, the sources of their problems and the solutions were subject to some conjecture. The earthquake damage is likely to confront the government in a way that only compares with the rebuilding task after the second world war. There will be little debate about what needs to be done. The government and the
Bank of Japan have already moved to make funding available. Watch the liquidity roll in. Extrapolating the damage may be unwise. The pictures of destruction appearing on our television screens suggest a return to anything approaching normality will be decades in coming. These pictures are coming from the most severely affected prefectures and regions. Reports suggest that even the city of Sendai is largely intact despite being very near the areas of greatest destruction. The damaged areas account for only 7-8% of the country’s output.
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Japan’s major manufacturing areas have not been directly affected. There could be a rapprochement with China. China offered and Japan accepted assistance. This was unusual and might signify a thaw in relations. There are some silver linings in this especially bleak cloud. This may be one. Uranium is clean but only up to a point. In the normal course of events, nuclear power is cleaner than other forms of energy. The Fukushima explosions have highlighted how, at other times, nuclear power is a far more scary energy alternative. At a minimum, the positive consensus surrounding nuclear power and development of uranium mines will be reappraised. In the short term, greater recourse to natural gas and other fuel sources could be expected. Funding the reconstruction will pose problems for others. While Japanese debt has risen to 200% of GDP, nearly all has been held internally, removing the pressures faced by countries like the USA and Australia that must rely on foreigners having enough confidence to support a rising debt issuance. Self funding its debt has relied on Japanese households saving for their retirements. Now, many of those households will have to use their savings to restore their physical environs. The government may have to compete to fund reconstruction but the US may be the loser. The Japanese have also been funding the U.S. deficit. They might contribute less in the future. Japan’s future economic growth will be stronger. In the short term, plant closures and the loss of life will result in a contraction in output. As reconstruction gets underway, however, spending on physical infrastructure, housing, commercial properties, transport equipment and consumer durables will increase leading to stronger growth outcomes than would have otherwise been achieved. The mammoth rebuilding effort will require more raw materials. Mining and metal refining companies will benefit since more metal and industrial raw materials will be used in the next five years than would have been used if there had been no earthquake. Initially, nonJapanese producers of these materials may benefit most but, in the longer term, Japanese fabricators will probably meet the additional demand and recover some of their lost market share. Global supply chains will suffer disruption. Many major Japanese corporations such as Toshiba, Panasonic, Toyota and Nissan, among others, have already cut production even where they have not been directly affected. Exports will be lost. Inadequate supplies of products such as LCD screens and computer memory chips could see loss of Japanese market share but, more significantly, could result in rising prices or shortages in places apparently unconnected to Japanese industry as other manufacturers lose their input sources. The Japanese have a proverb which I have always liked: fall seven times, stand up eight. Let’s hope this tenacious people can recover quickly from the horrid devastation and rebuild their nation better and stronger. A version of this article first appeared in a blog co-founded by Justin Zuo. Visit http://thepitchbook.net/ for more commentary on current financial & economic affairs.
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Weighing in on simple and complex strategies
Martin Lotfizadeh compares the benefits of simple vs. complex strategies – is simple better?
In a courtroom in California during the late eighties, a federal prosecutor overseeing the case of Barry Minkow, the mastermind behind the $100m ZZZZ Best Ponzi scheme, suggested that Minkow was talented and charismatic to the point that “he could have succeeded in a legitimate enterprise”. By 2009 the convicted 43-year-old former conman was back in the headlines for doing just that – his new firm had spent as much as US$300,000 to develop a system that could sift through a database of the degrees held by executives at public companies and identify potential red-flags. The software was developed for Minkow by a little-known technology company and worked by extracting the names and birthdates of executives from a database and sending them through to an organization that verified educational
credentials. When the system found inconsistencies in the data that could not be independently verified, a request of proof that a degree had been awarded was sent to the relevant university. If the information still could not be verified, an investigator was dispatched to the registrar’s office to be sure. Minkow would then proceed to buy put options in the targeted company, setting himself up to profit from the likely sell-off that would occur once his findings were made public. In one case, a 6.5% rout in a stock occurred after it surfaced that a key executive did not hold the two degrees that he claimed to have. Once the executive resigned, the price rebounded by 9% in the subsequent two trading sessions but not before Minkow had already profited from the initial sell off.
Minkow’s strategy is just a standout in an infinite number of creative and complex strategies that exist today, from high frequency trading (HFT) that exploit microstructure inefficiencies and often last for just milliseconds, to statistical arbitrage strategies, to the asset backed security disaster involving little understood repackaged mortgage securities, right through to an individual trader with half a dozen technical indicators on a chart. In markets which are increasingly complex, it’s understandable to see why they are matched with increasingly complex strategies. Conversely, it’s intuitive to dismiss extremely simple strategies such as support and resistance trading as something that has lost its effectiveness a long time ago. After all, if something truly as simple as buying and selling at support and resistance levels
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still worked, then there would be no Barry Minkows in the world with their elaborate résumé systems because they would all be labeling peaks and troughs on a chart instead. However for those patient and dedicated enough, simple strategies still do work. Back in 2006, as I learnt about the markets, the more complex my strategies became. A few years later I decided to combine my finance and programming background and go down the path of algorithmic trading. Although I still develop automatic trading systems today, most of my trading volume has long consisted of much simpler strategies. For instance, I don’t have any technical indicators on my chart, just a few lines I have drawn up earlier in the day. I also completely ignore the news or any any other fundamental factors, as my strategy is very short term, often in and out of the market within a few minutes. The only thing I am looking for is a confluence of important levels on a chart, such as big round numbers, floor pivots and recent price barriersturned-support and resistance. Once I have a confluence of some combination of these factors within a few points of each other, I place a buy-limit or sell-limit order around this price, anticipating price to bounce at this area. a futures contract found on the Eurex exchange, and the main market that I trade: Most reputable brokers require a minimum of $5,000-$10,000 in initial capital to open a futures account. Derivatives in general are also highly leveraged and risky instruments, so obviously you wouldn’t attempt to trade this market if you are just starting out. The point I am trying to make however, is that this is an example of a simple, common-sense based strategy that works – I have been trading it in more-or-less in its original form for the last few years. But if it’s so easy, why doesn’t everyone trade like this? Firstly, it’s not quite as simple as it looks – a fair amount of intuition stemming from experience is involved. I also look at things such as depth-ofmarket (DOM) and often need to employ a bit of common sense such as staying out during steep sell-offs or economic releases. The other reason that very few people are willing to trade this strategy is because of the fact that they will often find themselves waiting for two weeks at a time just to take five or six points (or ticks) out the market. To put that in perspective, the FESX can easily move 30 points or more within an hour. sure why this is the case. The absolute profit or loss of a five point move is a function of how many contracts are actually traded at a given price and not the number of points alone. For example, each point trading the European based FESX is worth €10 per contract. Clearly if you had traded 10 or 100 contracts, then each point would be worth €100 or €1000 respectively. This is limited only by the level of liquidity in the market, and if €100 per point for a five point trade is worth just 3 or 4 percent of your account, then this still falls under good money management, and would not be irresponsible. Therefore, the argument that you need to trade everyday in order to be a day trader is just plain wrong. Despite this, most traders that look for these small five point gains, known as scalpers, are typically in and out of the market several times a day and usually employ far more complex strategies to capture them. I am however perfectly content to wait for a long time, often up to two weeks, just to capture five points using this simple strategy as it translates to a lower risk-reward ratio and a higher win rate. Finally, I should point out that I don’t stare at a chart for 6 hours a day just to wait for a five point trade that only occurs once every other week. That would be ridiculous. Instead, I run my trading platform on separate, dedicated servers which issue email alerts once price is
Here is an example that I recently took on FESX, which is
The truth is, I don’t know anyone else that wants to wait a week or two just to capture five measly points. However, I’m not
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approaching an area that I had previously marked on the chart that afternoon (the German based Eurex market opens at 6pm AEST). The principles of simplicity and patience are still at the core of this strategy however, and for an individual trader with limited time and resources, you will likely discover, just like I did, that simple strategies can still be used in the markets. Martin Lotfizadeh recently completed a Bachelor of Commerce with a major in finance from Macquarie University. He has traded Eurex futures, FX and equities for several years and is now looking forward to beginning his career as a full-time trader.
DISCLAIMER The material in this report is produced as general information only and is not intended to be advice. Readers should not act on the basis of this information and must seek specific advice from a professional adviser before taking any action. No warranty or guarantee is given regarding the accuracy or reliability of this report. The authors expressly disclaim all and any liability to any person for any loss or damage arising as a result of this publication, whether whole or part of the contents of this publication. For permission to use this report, you must accept full responsibility for any action that you take. Note also that past results are not a reliable guide to future results. Future outcomes are unknown and investing can result in financial loss.
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