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Stocks & Commodities V. 25:10 (66-74): Interview: A Man Of Many Talents: Dan Gramza by Jayanthi Gopalakrishnan INTERVIEW

A Man Of Many Talents

Dan Gramza
Is there anything Dan Gramza hasnt done? Hes president of Gramza Capital Management and DMG Advisors, LLC. He is an author, trader, analyst, consultant to domestic and international clients, and an advisor to the St. Croix hedge funds. Gramza has also appeared on CNNs Moneyline program, Reuters TV, Bloomberg TV, ROB TV in Canada, and others. Wait, theres more! Hes developed and presented worldwide public and private courses for traders on candlestick analysis, Market Profile, technical analysis, options and options trading strategies, stock and futures industry fundamentals and operations, and Series 3 exam preparation. Hes presented courses to traders from over 36 exchanges, 400 institutions, and 35 countries. Hes also a teacher. Gramza is an instructor for the Chicago Mercantile Exchange Education Center, the Chicago Mercantile Exchange/DePaul University Certificate Program, The Chicago Board of Trade and the Chicago Stock Exchange. STOCKS & COMMODITIES Editor Jayanthi Gopalakrishnan (JG) and Staff Writer Bruce Faber (BF) spoke with Dan Gramza on August 8, 2007, via telephone.

an, how did you get interested in trading and technical analysis? It started when I was at the university. I found stock options very interesting. It was in the mid-1970s, not too long after they started trading, and I started following those. One thing led to another, and that was how I got introduced to the technical approach. JG: Lets focus on the forex markets. What affects the movements in the forex markets? From my perspective, the place to begin is to think about what you would want to see if you were going to invest in another country. Those are the things that also affect that currency. For example, the forex markets would be affected by economic trends, political stability, social changes and conditions, interest rates which have a huge impact on currencies inflation, and international trade. Is there a trade deficit? Are more items being imported than exported? You could look at the equivalent of the consumer price index for that country, or the cost of producing goods. You could look at the gross do-

mestic product, the measure of value of all the goods produced in that country. The fundamental trader focuses on how others will react to this information. If these fundamentals are positive or strong, the expectation is that other people will recognize that and enter the market. Those are some of the areas that will have an impact on currency prices. JG: What do the movements in these markets reflect? If you think about the change in the currency level itself, what does the movement in that currency actually reflect? It represents the change in value of one currency in terms of another. So any time there is a rate change, it means one currency is getting stronger and the other is getting weaker. Which currency is getting stronger, which weaker? In the forex or currency markets, all trades are done in pairs. The order of the currency in the pair will tell you which is getting stronger, or which is getting weaker. So a currency rate is the cost of the first currency expressed in terms of the second. Take the British pound vs. the US dollar. Since the British pound is the first variable we see there, it would be Copyright (c) Technical Analysis Inc.

If you think about the change in the currency level itself, what does the movement in that currency actually reflect?
the value of one British pound in terms of US dollars. If we say the rate is $2.00 it means the cost of one British pound per US dollars equals $2.00. So if I went to the bank to buy a British pound it would cost me $2.00. If we reverse that, US dollarsBritish pound, then that would mean a rate that would represent the value of one dollar, now in terms of British pounds. If it was a $2.00 rate, it would be a 0.5 rate for British pounds, which means one US dollar would buy half a British pound. JG: What else does it reflect? Lets take the euro. Say the euro rises from 1.3000 to $1.40. That would mean it would cost us 10 cents more to buy one euro. The euro has gotten stronger and the US dollar has gotten weaker. So we always have that inverse relationship. This change in value would also

Stocks & Commodities V. 25:10 (66-74): Interview: A Man Of Many Talents: Dan Gramza by Jayanthi Gopalakrishnan

affect the cost of doing business between the countries represented by these two currencies. So it would now cost people who deal in US dollars more to buy goods that are priced in euros. For those using euros to buy goods priced in US dollars, it would mean the US dollar has become cheaper. In the US, people are not really used to thinking about currencies, but if we go to other countries they are used to thinking about the relationship of one currency to another. JG: Lets talk about some of those things like interest rates. Lets look at it from the view that the movements in the currency markets can also reflect the difference in interest rates between two countries. Say, for example, the interest rates in Japan are currently around 0.5%, and the interest rates in New Zealand are around 8%. If I could borrow yen in Japan at the rate of 0.5% and then convert to New Zealand dollars, and invest that at 8%, I could, theoretically, lock in a 7.5% interest rate differential. The challenge to that transaction is the rate of exchange in the currencies between these two countries. Heres the way to think about it. If other people recognize this difference in interest rates, think about what would happen to the New Zealand dollar. A lot more people would want to buy New Zealand dollars. That increasing demand would cause the New Zealand dollar to become more expensive, and stronger. For my trade that would mean I would get fewer yen when I convert my New Zealand dollars back to yen. That would mean that the interest rate differential I was trying to lock in would start to erode. One thing you could do to protect that transaction is to hedge a change in the currency rates. This is what a currency overlay manager does. That is what a carry trade is, taking advantage of the differences in interest rates between countries. The interest rate differential has a tremendous impact on the demand that countrys currency may have compared to another. BF: You mentioned the 7.5% differential. With transaction fees, it is probably not going to be quite that. At what

point in the differential does the carry trade no longer become profitable? When the change in the currency rates have eroded that interest rate differential. So if they have moved by 10% or 5% or whatever, it is going to knock out that rate differential. The concept you are referring to is interest rate parity. As the market recognizes this rate differential and if it was not hedged, that differential would be eroded by the change in currency rates. As that percentage change in currency rates increases, it is going to erode that differential to the point that there is nothing left. JG: And does this happen without any intervention? That is the theoretical side of it. Lets go back to the point that Bruce brings up, which I think was good, in that the differential is going to stay there to some extent. Bruce, you are also right that there are additional fees so we are not going to get a clean 7.5%. If we are going to do that type of trade, it is important that we take advantage of hedging techniques to maintain that exchange rate so we can preserve as much of that differential as possible. That is the job of these currency overlay managers that have become a growing aspect of the business. They have become more visible over the last few years than we have seen in the past. BF: So if it gets down to a 6.5% differential, would that get rid of something like 20% of the carry trade, or would it start a death knell that got rid of it completely? There is a lot of sensitivity now to this trade so it doesnt have to move that much before we see a dramatic impact. If a central bank changes an interest rate, and it is a popular currency as part of the carry trade, the market feels it instantly. We could see a dramatic drop in that currency and a dramatic rise in another as people get away from that rate differential they were trying to lock in before. It doesnt take a lot for the volatility to come into that marketplace for a carry trade. If you and I were doing that trade, we would want to be sensitive to the volatility as these carry trades Copyright (c) Technical Analysis Inc.

can be unwound. It doesnt take much to stimulate people to do that. It would not have to be an entire 7.5% change before people react to it. It could be a very small amount. If Japan increases its interest rates or New Zealand reduces theirs, it would have a tremendous impact on how people perceive that carry trade. If they decide to unwind it, there will be a lot of volatility in the market. JG: Speaking of volatility, which currency pairs are the most volatile? It varies. I would say there are seven currency pairs that are probably the most popular the euroUS dollar, the dollaryen, the cable, or British pound US dollar, the dollarSwiss, and then what they refer to as commodity pairs: the Aussie dollar, Canada, and New Zealand. If you are talking about volatility, and you look beyond the majors, there are other currencies such as the Thai baht, or the Indian rupee, which are considered exotic currencies. If volatility is your friend, you want as much volatility and movement as possible. Or maybe you want a little volatility or a steady as she goes kind of trade. Conditions vary based on political and social situations, and that can have an impact on what can change those interest rates and currencies. JG: The popular belief is that forex markets tend to trend well. Are there any specific technical chart patterns or indicators you prefer to use for the forex markets? I think its true that the currency markets have a tendency to trend well. Of course, it depends on the currency you are looking at and the political environment as well as other variables that have an impact. If you look at it from the point of view of technical approaches people would use in the currency market, it would probably fall into those price overlay and oscillator studies. That would be moving averages, or oscillators like moving average convergence/divergence (MACD). Personally, I like to look at candle charts and Market Profile.

Stocks & Commodities V. 25:10 (66-74): Interview: A Man Of Many Talents: Dan Gramza by Jayanthi Gopalakrishnan INTERVIEW

JG: What do you look for in candlesticks? I look at them a bit differently based on my first impression when I was on the floor. I think they are a reference we can use to measure buying and selling forces that are coming into the market. If you look at the basic characteristics of a candle, like in the diagram in Figure 1, if the closing price is higher than the opening price, the box is green. That box is the body of the candles and represents the buying force coming into the market. If the closing price is lower than the opening price, then that box, or body, is red. I feel that represents selling order flow coming into the market. I say a green body represents buying because buyers are competing against each other and that drives prices higher. I have a laptop on my desk. If I told you I would sell it to you for $30 and it was worth $3,000, you would probably be interested in buying it at $30. If there were 50 other people in this room, they would be interested in buying the laptop too. You would see competition. In electronic markets we dont see that competition on the screen, but we do on the floor of an exchange. We would all be brokers raising our hands trying to buy. We have order flow coming into the market, which means we start competing against each other, driving those prices higher. On the red side, the sellers are offering the market at lower and lower prices, and moving it down because they are trying to find buyers to take the other side of their trade. Here in Chicago, our housing market has gotten a lot softer recently. The homes I see that were going for $50,000 more than asking price, just a year ago, arent today. Now we see houses being offered at lower and lower prices. That is what you and I see reflected in the red candles. The little line on the top, the shadow, represents the difference between the high price and the body itself. It represents selling coming into the market at higher prices. The line we see on the bottom, where the low price doesnt match the body of the candle, represents buyers coming in at lower prices. The size of the body and the shadows are clues we can use to deter-

mine whether there are buying or selling order flows coming into a market. JG: Its slightly different than the traditional approach. With the traditional approach and there is nothing wrong with that we would be talking about candle patterns. Personally, I think there is a level beyond that, which helps me gain insight in what the market may be revealing. JG: You also use Market Profile, which is a charting type used mostly in the futures markets. Is that how you use it? I do use it with the futures markets and many other markets as well cash, stocks, and options. Most people think of it as a daytrading tool. I found it works tremendously well in the currency markets. I have also used it in different markets around the world. What I find interesting about it is that it is another summary of the footprints of the traders entering a market. If you think about any chart, it is a summary of the feelings of the traders who come to that marketplace. It is a record of human behavior. Market Profile is a tool that gives us another perspective of how people feel about the markets. We normally think about a market as something that traded 100,000 shares or a million shares today. A profile can show us how those share volumes were distributed at different price levels. This is reflected in a bell-curve shape that is typically formed with a Market Profile display format. It is a tool that gives us an idea of when and how something happens in the market was it a strong move or a weak move? It gives us an idea of the collective behavior we are seeing coming into a market. Say that for the last three days or last three weeks, we have seen buying behavior coming into the market. Suppose we see buying extremes, buying range extensions, and all of a sudden the market is going higher, but on selling extremes and selling range extensions. This gives us a clue that buyers may be unwrapping their positions. It would be the same as seeing a green candle with no shadow on the top, then Copyright (c) Technical Analysis Inc.

seeing shadows on the top and smaller bodies. Shadows on the highs would mean sellers are entering the market and the small bodies would mean a lost momentum, a lack of commitment. It implies sellers are coming in at higher prices. You may see that kind of behavior in both tools. This makes us think we should be cautious. If we are long or are looking for a place to sell, then we may see that opportunity about to begin. JG: So you use Market Profile in the currency markets and the cash market? Yes, I do. When I look at a typical Market Profile for a currency, the first thing I think of is what it represents. It represents 24 hours of trading. I look at this in two ways: as a 24-hour composite profile, and then I break the composite profile apart into smaller profiles representing different time zones. That means we can now see what comes to us if we are in the US. We can see what is coming to us from Europe, or how Asia reacted to the US market that day. Did it get weaker? Did it get stronger? Did it use references that we see in the profile? Is Europe getting stronger or weaker? What is typical behavior? For example, on February 27, 2007, when the markets came off a bit, we saw that during the Asia session, the emini S&P was unusually quiet going into the European session. We could see it in the candle charts, we could see it in the Market Profile if we broke it down into time zones. We also saw unusual behavior in Europe. It dropped about 20 or 25 points, if I recall. It typically moves about 10 to 15 points. So we saw unusual behavior coming into that session. You would see the same thing reflected in currencies. So you want to know what is typical for a particular time zone. Is there something unusual in terms of behavior? What I find interesting is that the market usually stops to take a breath. If Europe moves 15 points in the eminis, often at the beginning of the US session there will be sideways movement and a breather before another move occurs. In the currency markets, they are different, because they can maintain that momentum.

Stocks & Commodities V. 25:10 (66-74): Interview: A Man Of Many Talents: Dan Gramza by Jayanthi Gopalakrishnan
High Selling shadow

For example, I was just thinking of a yen trade. Asian markets were consolidating after the US session, and then the European markets took off. In that particular occasion, the momentum that started in Europe carried through to the US session and also bled over into the next Asian session. When I look at a profile, I think about it in terms of what that shape shows me, and how it reflects different time zones. In Figure 2, we see the traditional Market Profile with all the letters. Each column of letters represents a half-hour range of trading. What we see is this bell-shaped curve action. Where we dont see much time, we typically dont see much volume, and vice versa. The histogram we see next to Market Profile is volume. These profiles represent 24-hour yen futures markets and the volume associated with those differing time zones. We use time and volume as a reference. On that first profile on September 13 in Figure 2, at the top we see the market slowing down when it opened, represented by the white arrow on the left side of the profile, below the high-volume prices on the histogram of the previous session. We would determine some potential resistance levels if the market were to move higher. The bulge on the volume histogram would be the first level we would probably look at. In this case, it did seem to slow down. Even in the following session, on September 14, when that market opened up youll notice the bottom of that session held against the high-volume price levels from September 13. When it moved up away, it stopped at the high-volume prices of September 12. We saw resistance on the top with those references, and support on the bottom, as well as on September 15. It also used those highvolume prices on September 13 and 14. On September 15 when the market tried to go up, it didnt make it, but you saw potential resistance in the highvolume prices of the 14th. So not only do we have these references but we could ask ourselves, When does this market typically put in these highs and lows? Was it an unusual time of day we saw this kind of action? Since we have letters as

our guide, it is easy to identify the time of day when certain behaviors typically occur. It is an interesting tool to gain some insight in terms of how the market may be unfolding. That is how I would use it.

Close Buying body Selling body Open Buying shadow Low

Open

Close

JG: I also wanted to talk about the differences between the cash mar- FIGURE 1: CANDLE CONSTRUCTION kets and the futures markets in the currencies. Are there any major differ- traders investing in the cash currency ences between the two? market, they are typically making a There are some differences. First, I transaction with the market maker. In am not saying one market is good and the foreign currencycash markets there the other is bad. What I am saying is are a multitude of market makers around there are differences. If a trader is mak- the world that a trader could make a ing a decision about trading the cur- transaction with. If we have a multidealer rency markets, they should be aware of market when it comes to the cash curthese differences. Then they should de- rency market, how do they get paid? cide what is appropriate. The currency Say that the dealer now goes back to the markets are the most liquid financial bank and says, If I make a transaction markets in the world, about $1.9 trillion with you in this currency, how much do I a day. The next survey from BIS, which have to pay to buy or sell? What is the should be released in September, is ex- difference between the bid between the pected to indicate that it is a $2.5 trillion bid and the offer, or the spread? They industry. It is an amazing market; there may have to pay two pips percentage in is nothing else like it. But before talking points. A pip represents the smallest inabout the differences, I would like to crement of trade in the cash currency market, which is usually 0.0001. In the talk about the interbank market. The interbank market is the cash futures markets, it is called a tick. If they market, where large institutions trans- are paying two pips to put that spread on act currency business. It is where they or take it off, they will widen the spread to are buying and selling currencies among three or four pips for their customer. So they can now take that trade from themselves. I remember reading an article in The Wall Street Journal Euro- the customer, turn around and sell it to pean edition in February 2006. It men- the bank and make one or two pips in that tioned that 73% of the forex volume is trade. That would be a typical way that a done through 10 banks. It mentioned cash market maker would get paid. names like Deutsche Bank, U BS , CitiGroup, HSBC. These banks under- JG: What happens in the futures market? The customer pays a commission plus stand the creditworthiness of their counterpart. They create transactions among exchange fees and other fees involved themselves. That is the interbank mar- with the transaction. You want to comket. A lot of retail traders think they pare that to what you are going to be trade in the interbank market when they paying on the interbank market. Lets trade cash currencies, but they do not. say we were doing a $100,000 transaction in the interbank market. If we are They trade with another layer. After the interbank market we move paying three pips for that trade, the difdown to forex dealers, also called mar- ference between the bid and offer to buy ket makers. They will make a market, or and sell it would be $30. In the futures in another way, they are willing to take markets you could probably buy and sell the other side of a trade from traders that futures contract between $5 and $10. who would not be able to trade in the So there can be a difference in cost. Another difference you want to be interbank market. They may have transactions with a major bank, or with a sensitive to is that when you are trading smaller bank. When it comes to retail in the futures market, for example, it is

Copyright (c) Technical Analysis Inc.

Stocks & Commodities V. 25:10 (66-74): Interview: A Man Of Many Talents: Dan Gramza by Jayanthi Gopalakrishnan INTERVIEW

not a multidealer market. You have one central marketplace. All the transactions will occur within the specific exchange. When I make a trade there I dont have to worry about another market maker offering a better price. It is going to be a transparent market. I know what the offer is. I know what the bid is. Actually, on the CME website there is something interesting. They call it an equivalence page where they take the futures and put them in cash terms. You can compare them. You can go to that page and look at the size of the spreads between the bid and offer on the futures side. It is free and it gives you a way to compare the spreads and size of the futures to the cash market. Yet another difference is that the interbank market is worldwide. Bank to bank, they understand the creditworthiness of the people they transact with. It really is a handshake deal, only electronically. The retail trader needs to thoroughly check the financial condition of the cash market maker. This cash market is not regulated, so they are going to have to be sensitive to that fact as well. The futures market, because it is a US futures market, comes under the federal regulation of the CFTC and it is highly regulated. There are certain safeguards put into place. For example, that means we could arbitrate a dispute with our broker very easily. In a cash market it may be a little more difficult. It is also important to understand who your dealer is. In the futures market, behind every trade is the CME clearinghouse. If we are talking about currencies traded on that exchange, their clearinghouse stands behind every trade. If you and I did a transaction, and I go bankrupt, it doesnt affect your transaction. The CME clearinghouse has been in business for more than 100 years and havent had a default. In the cash market I have the integrity of the party I am dealing with. I need to understand their creditworthiness in that sense. So there are some differences between the two, but I should also say both markets are highly liquid. In every market, during the day, there are times when the market is more liquid than at others. They both virtually trade 24 hours

a day. I should say the cash market does trade 24 hours a day, except for weekends. The futures market does stop. It stops before Asia starts to trade, and the US is winding down. It stops a few minutes a day to make sure all systems are working properly. But it basically is a 24-hour market. One of the last characteristics we should look at is the difference between having a segregated account and not having one. A segregated account, which all futures accounts in the US are, means that your money is held separate from everything else. If you and I have an account at the same firm, and I blow my account out, it does not affect your account. Those monies are segregated. In addition, the broker cannot pay bills out of their customers accounts. That is something else you want to take into consideration when you are evaluating whether you want to trade cash currencies or trade futures. JG: It seems to me the forex market is so dominated by the central banks, or just big banks. Is the retail trader at a huge disadvantage because of that? They have a good chance of having a level playing field. My path crosses these institutions that deal in the interbank market. They are faced with the challenges just like a retail trader or private trader is faced with in terms of making a decision about a market. The bottom line is, Do I buy? Do I sell? Do I keep it? Do I spread it? Do I hedge it? Those are all things that go through their minds. Those issues, and the way they decide, do not differ much. The other thing is that if you and I trade futures on the GLOBEX platform, the platform the CME uses for futures trading for forex, say I buy one contract and right behind me comes an order to buy 10,000 contracts. Most people will think the 10,000-contract order will probably get filled first. But it doesnt work that way. With the GLOBEX technology, I would get filled first. They dont have an edge in terms of jumping ahead of us because of their size. I think technology really has leveled that playing field. Something else too, that you brought up, is the idea of central banks. On the Copyright (c) Technical Analysis Inc.

monthly chart in Figure 3, we have a CME candlestick chart of the euro, so it is euroUS dollar. When you look at a currency chart, cash or futures, it is a spread. In any spread you can think of the first variable getting stronger or weaker. This chart represents the weakness and strength of the euro. We see the market moving down on the left-hand side. All these red candles means the euro is getting weaker and the dollar is getting stronger. When we see it moving up to the right, with those green candles it implies the euro is getting stronger, and the dollar is getting weaker. Because we are looking at euroUS dollars, if you look over to the right, the numbers we see are in US dollars. Heres what happened. Lets start on the left-hand side with all the red candles moving down. It is the cost of one euro. If we look at the bottom of that last candle at the lowest low, that means the euro was trading at approximately 82.5 cents. As we move up to the top of this chart, we see the euro was trading at $1.30. When I go to the bank, I am not going to pay 82.5 cents. I will be paying $1.30. The euro has gotten stronger and more expensive. When it got down to 82.5 cents, back in 2000, I remember everyone was complaining about the US dollar being too strong. This level represents central bank intervention. The movement you see away from that, that large green candle that moved up, represents central bank intervention. Here is what I find fascinating. The central bank, to me, is nothing more than another trader. Now they dont bleed at the same price level that everybody else bleeds at, because they have this big chunk of money. However, their ability to maintain their influence is different than we would have seen 15 years ago. Fifteen years ago, if the central banks had intervened, the market would have reacted, and then it would have stayed at that level. Now, the central banks did intervene at 82.5 cents and as the prices moved to 95 cents, the market went right back down. The central banks intervened again, and the market moved right back down again, before it finally turned the corner and started moving up. The cen-

Stocks & Commodities V. 25:10 (66-74): Interview: A Man Of Many Talents: Dan Gramza by Jayanthi Gopalakrishnan INTERVIEW

FIGURE 2: THE MARKET PROFILE

be a barometer that we can look at to give us a feel for that currency. Canada is the ninth-largest producer of oil in the world. What is interesting is that 55% of the US consumption of oil supplies comes from North America. Our largest supplier is, starting in 2000, Canada. The second-largest supplier is Mexico. The third-largest supplier is Saudi Arabia. Then we get about 12% of our supply from South America, 15% from Africa, and about 3% from Europe and Asia. We only get about 15% from the Middle East. People think that supplies come in huge amounts from the Middle East. In the 1970s they did, but not today. Oil is one of Canadas major resources. The Canadian currency value can be sensitive to changing oil prices. I would suggest looking at it in terms of lead and lag. Sometimes what you will see is that as the commodity price changes, it may lead the currency price changes by a few weeks. You will see the same thing with stocks and futures. The futures markets have a tendency to sometimes lead individual stocks. That is really the potential we are seeing with these types of relationships. Thank you for your time, Dan.
Market Profile

FIGURE 3: CME EURO CONTINUATION

S&C

tral banks have tremendous influence, but it is not a long-term influence like we would have seen in the past. JG: Why is that? Because the market is such a large marketplace now that their influence is lessened. This trade gives us an idea of how the markets react to central bank intervention, and also a way to look at a chart from the point of view of the strength or weaknesses of a currency. JG: It has been said the currency markets can be gauged to commodities. How are the Australian dollar and gold related? There are three currencies commonly

considered highly correlated to commodities: the Australian dollar, the Canadian dollar, and the New Zealand dollar. The idea is that some countries are resource-oriented. If you look at Australia, they have tremendous resources, which is the significant part of their income. Its similar in Canada. New Zealand also has a lot of resources, and Australia is a consumer of New Zealands resources. Australia is the third-largest producer of gold in the world. When gold prices rise, the Australian dollar usually appreciates as well. If there is a currency with some degree of a relationship to a commodity or a resource, then that may Copyright (c) Technical Analysis Inc.

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