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What Drives the Foreign Exchange Markets and How to Decide When to Open Forex Trades
Foreign exchange markets are not the same as other financial assets traded commonly. The difference is the size of the market and the number of transactions (known as liquidity). In other markets such as share markets individual trades can influence which way the market will move. With a market with a size of trillions of dollars like the forex market even massive trades are just a drop in the ocean.
This article will explain what controls the forex market and will touch on how traders can predict where markets will go. There are no certainties with trading. Trades need to be opened when there is a high probability that the market will move in a certain distance either up or down. This article provides an insight into selecting which currencies to trade and when to make a trade.
So what moves the forex market?
Almost anything can move the foreign exchange market. A country's exchange rate can be seen as a good guide to their economic fortunes. So the factors that effect the economy also effect the relative value of it's currency. Some factors are much more important than others and should take priority. Here are the ones to 'look out' for.
The money supply
Central banks control the money supply using interest rates and other factors. Generally speaking if the supply of money increases the value of the currency falls and if the money supply decreases the value of the currency increases. This follows established principles of supply and demand. Interest rates are an important factor controlling money supply. Increasing interest rates reduces the supply of money into the economy and decreasing interest rates increases the supply of money.
A central bank sets the base lending rate for organizations who want to borrow money. Think banks, investment houses, and other financial institutions. Base lending rates end up effecting the man on the street through mortgages and unsecured loans, not to mention the price companies can set for goods and services. In simple terms if a country offers a higher interest rate than another country, demand for the currency will be stronger when compared to the other country's currency. When an established position changes, such as the dominance of one country's currency over another, the markets move which creates an opportunity to trade. See the example below.
The 'carry trade' so called because money is borrowed in a low interest rate currency to 'carry' a trade in buying a currency with a higher interest rate. The difference in interest rates between the two currencies is pocketed by the traders. Traditionally the Japanese Yen has been used for this purpose which has fueled demand for higher interest rate currencies. If interests changes these carry trades can unwind and produce large moves in the market. This serves as a good example of markets that can produce big moves when interest rates move.
What is quantative easing?
Quantative easing (QE) is a type of monetary policy that is used vary rarely and is not used in normal circumstances. Recent history has shown that QE is used when interest rates are near zero and no longer stimulate the economy. Effectively QE is printing money (but not literally) and can be done slightly differently depending on the country. The effect is to add zeros to the amount of money in the economy. Increasing the amount of money without producing any extra value is a very strong factor that will decrease a currencies value.
Employment data
The number of people employed in an country is a key indicator to the health of the economy. Importantly it also gives and indication of where inflation will be headed in the future. Inflation of course is one of the main drivers for interest rates. The most important employment data is the US non-farm payrolls data. It shows the number of people hired and fired each month. If employment is rising it can indicate that the economy is improving and increases the chance that rates will go up and vice versa if unemployment is rising.
Watch out for dates when key economic data like US non-farm payroll is released. If there isn't any other news that has more bearing on currency value this information can move the markets. This is the case especially if data 'surprises' the markets because it is different from what was predicted.
GDP data
Gross domestic product or GDP is a measure of a country's wealth. Simply put it is the market value of good and services provided by the country. The most useful measure of GDP for currency traders is the GDP growth rate. Measured year on year is shows if the country's growth is ticking up or going down.
Trade data
Countries generally fall into to camps. Net importers (they buy more goods and services than they sell) or net exports (the sell more goods and services than they buy). Factors that shift the relative strength of imports and exports are factors that effect the strength of currencies. If the demand for goods that a country produces increases other countries need to buy their currency in order to buy those goods. As such the value of the producing country's currency increases.
All these factors effect one another. When traders study these economic factors it is called fundamental analysis. Fundamental analysis is good to indicate which currencies are worth trading. The best currencies to trades are those where it is possible to predict that there will be a long term shift in values. Currencies are always traded in pairs as an exchange rate is produced by one currency compared to another. Popular currencies pairs are the US Dollar traded against various other currencies such as the Japanese Yen, the Euro and the UK Pound. Other popular currency pairs include various combination of these.
The exact timing of trades as well as clues to which currency pairs to trade is revealed by technical analysis. Technical analysis involves studying price charts of currency pairs.
When to enter trades
The trend is your friend. A common saying, but is 'rings' true with currency trading. It take something very big to change a long term trend. If a trend is entrenched then it increases the probability that profitable moves will be in the direction of the trend. Currency pairs with strong trends are good to trade. If something big does happen, viz the economic facts described above, there will be large moves within the trends trading range. The trend may even reverse which can produce great opportunities to trade.
Here are the things that should be considered when doing technical analysis. Identify if the trend is up or down. Trends can be primary; over years; secondary; over months; or tertiary over days or minutes. The type of trend can be used to decide the length of the trade. Secondary and tertiary trends will produce big moves and trading opportunities.
Look at the trending or trading range. This is the upper-most and lower-most price points for a specific amount of time. Upper most points are called resistance and lower most price points are called support. On a chart draw a line through as many points of resistance and support as possible. This forms the price range. The longer a currency pair trades in a price range the stronger it is. If the trader expects economic factors to changes there is a high probability that the currency pair will move out of the trading range to the upside or down side. A trade should be set just above or below the trading range to profit from this move.
Look at charting patterns. Price charts tend to follow patterns. Similar loosely defined price patterns tend to repeat themselves (some what of a self fulfilling prophecy that helps traders make profitable trades). If the fundamental data confirms a moves either up or down a high probability trade can be opened based on expected a price pattern to complete itself. Price patterns can form over years, months, weeks, days or minutes, and all can be traded.
Add moving averages to charts of currencies pairs. A moving average can help decide when to open a trade an when to close a trade.
Consider learning more advanced technical analysis techniques such as Elliot Wave analysis or fibonacci series. Some of the most successful traders advocate the easy approach and tend not to rely on complicated technical analysis. Instead they use easy to understand indicators like trends, trading ranges and moving averages. If one indicator is backed up by another and economic information reinforces the charts high probability trades can be opened. Spread trading is a type of trading that can be used to trade forex markets. A good spread betting guide will explain spread betting and how to decide when to open and exit trades. In addition to spread betting trading options contracts is also a popular way to access foreign exchange markets.
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