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Recently, the Great Britain Pound/ U.S. Dollar currency pair (GBP/USD) neared a significant milestone – the point at which the value of one British Pound would be equal to two U.S. Dollars. In Forex trading, we express this exchange rate as 2.0000.
As the currency pair approached the figure, the rally sputtered and GBP/USD pulled back
(see figure 1). This comes as no surprise because of the huge psychological significance of the "2 handle".
Figure 1: GBP/USD backs away from a key psychological level
Source: FXtrek IntelliChart™. Copyright 2001-2006 FXtrek.com, Inc.
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Not only is 2.0000 a huge round number, which can often act as support or resistance in many forms of trading, but it also matches the highest point reached by the pair since 1992. GBP/USD last flirted with the 2.0000 just before a massive collapse in the British Pound sent the GBP/USD pair tumbling – and made at least one prominent currency trader a billionaire.
Why did this happen? The U.K. was attempting to participate in the Exchange Rate Mechanism (ERM). The ERM was an attempt to achieve economic stability in Europe, as a prelude to the introduction of the Euro. Stability would be achieved by limiting the fluctuations among currencies, and the U.K. government agreed to keep the British Pound within a narrow range vs. the German Deutschmark. With Germany raising interest rates, the Pound struggled to keep up, and the Bank of England was forced to prop up the currency by buying British Pounds.
Speculators such as George Soros determined that the Bank of England would be unable to support the Pound indefinitely, and shorted the currency heavily. On Wednesday, September 16, 1992, in order to give currency traders an incentive to buy British Pounds and thereby support the currency, the Bank of England raised interest rates from 10% to 12% - and promised a further rate increase to an astronomical 15%. The gambit failed as traders continued to short massive quantities of GBP/USD, causing the UK government to cease its attempts to prop up the Pound.
The currency responded by plunging nearly 4500 pips over the next two months, making shorts wealthy overnight at the expense of the Bank of England. More than 14 years later, the GBP/USD pair still has not regained all of the ground lost since the 'Black Wednesday' fiasco
(see figure 2).
Figure 2: GBP/USD last approached the '2 handle' on Black Wednesday in 1992
Source: FXtrek IntelliChart™. Copyright 2001-2006 FXtrek.com, Inc.
FAQ's – Frequently Asked Questions
What do you mean when you refer to the "exchange rate"?
At some point, most of us have travelled from our home country to foreign land. When we do this, we must exchange our currency for the currency of the country we are visiting. For instance, when I travel from the United States to Canada, I need to exchange my U.S. dollars for Canadian dollars. Please note that there are two currencies involved in this transaction (the currency 'pair'), but only one exchange rate (the 'price').
Most of us have performed a similar transaction at some point in time. The rate at which this exchange is made fluctuates constantly, and currency traders attempt to profit from these fluctuations.
When reading the exchange rate, it is helpful to think of the first member of the currency pair as 'one'. For example, In the Euro/ U.S. Dollar currency pair (EUR/USD), the first member of the pair is the Euro. A quote of 1.3000 is understood to mean that 'one' Euro is worth approximately $1.30.
In mid-October, the pair traded at about 1.2500. At this point, one Euro (the first member of the pair) was equal to 1.2500 U.S. Dollars – or about $1.25 per Euro. After rallying in November and early December, EUR/USD traded at about 1.3100, or approximately $1.31 per Euro
(see figure 3).
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Figure 3: EUR/USD climbs from 1.2500 to 1.3100 in late 2006
Source: FXtrek IntelliChart™. Copyright 2001-2006 FXtrek.com, Inc.
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How do we account for the random factor, which causes the market to go in unexpected directions, in developing a winning strategy?
Thank you for your question. There is always a random factor in all forms of trading, whether it is stocks, futures, or forex. Traders often refer to this random activity as "noise". If we could eliminate this random activity, trading would be much easier. Unfortunately, there is no way to completely eliminate noise, but it can be dealt with by working in longer time frames. This is because random activity may be concentrated in a very short time frame, meaning that the trader may simply be trying to trade random activity on a one-minute chart for example. Noise is distributed more evenly over longer time frames, making it less of a factor and less of a concern.
I would like to know how and when set the stop-loss
Most strategies have a specific stop-loss technique already built in to remove any confusion. I generally use two different types of stops, volatility and support/resistance. Other types of stops can be used in special situations. It's important to learn the proper time to use each type of stop. Also, these techniques are not mutually exclusive; they can be used in combination to create superior stops.
I'd also like to add that I'm not a big fan of automatic trailing stops. I think they can be useful in some situations but ideally I would like to trail my stop manually so that I can be sure that my stop is not sitting in an area where it will be vulnerable. I prefer to trail the stop using subsequent support or resistance levels to move the stop higher or lower.
When a trade is placed and quickly becomes profitable, what steps should I take to protect my profit without exiting the trade too soon?
If a trade quickly moves strongly in your favor, there is a good chance that it will continue to move in your favor. This is because there is aggressive buying or selling that is pushing the price in your favored direction. Although we do not have comprehensive volume figures on the forex market, we can make a reasonable assumption that when the market is moving quickly, there is either a higher level of volume and/or aggression on the part of the market participants.
A possible exception may occur if the move is based on the release of economic data or some other fundamental event. Often these rapid moves retrace just as quickly, so in this situation extra care is warranted.
Naturally, we want to protect ourselves but at the same time we want our winning trade to have a chance to become a significant winner. In order to do this we will trail the stop manually. In other words, assuming that we are long our stop is most likely located beneath some level of support. As the exchange rate rises, we will raise our stop so that it is beneath a subsequent level of support, one that creates less risk or eliminates the risk altogether. A good trading plan includes all of the details for the proper time to raise a stop, the proper time to take a partial profit, the proper time to exit, and as many other details as possible.
Until next week – happy trading!
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