Investing and trading the currency markets requires an understanding of the securities, knowledge of how they trade, a strategy and a risk management plan.
When you develop your trading plan, which combines your strategy and your risk management techniques they should conform to your trading personality.
There are several popular types of analysis that is used to determine the future direction of a currency pair including both fundamental and technical analysis.
The securities that are used to trade the currency markets are currency pairs. As opposed to a stock or bond, a currency pair is the relative value of one currency to another. For example, the USD/JPY currency pair is the exchange rate and describes how many yen is needed to purchase $1.
The interbank market is the most liquid arena for currency trading. Here the largest banks and investment funds exchange currency with one another.
Interbank dealers will make prices for central banks, hedge funds, and corporate treasurers. The interbank market is a physically delivered market where traders take delivery of currencies. The most widely traded rate is referred to as the spot rate which is the exchange rate where you would receive the currency you purchased and deliver the currency you sold in two business days.
Most currency trading on the retail level is non-deliverable, where the broker charges you an interest rate fee for rolling your currency pair to a future date. The rate you receive is the forward rate. This rate is calculated by adding the interest rate differential between the two currencies countries to the spot rate. So, if the interest rate in the U.S. is higher than the interest rate in Japan, you receive interest for holding the U.S. dollar and you pay away interest when you are long the yen.
Each currency pair is quoted differential and it is important to understand what you are buying and what you are selling. Your broker will generally show you the currency pair in the order that it is quoted. For example, the EUR/USD currency pair is quoted where the exchange rate reflects the number of dollars need to purchase 1 euro. Usually the first currency quoted in a pair is the base currency and the second is the counter currency. In the case of the USD/JPY it’s how many yen need to purchase $1.
When a dealer quotes a price, they will create a spread, which is referred to as the bid/offer spread. The dealer is willing to purchase the currency pair on the bid and sell the currency pair on the offer. If you see a quote for EUR/USD of 1.0600/1.0605, this means that the dealer will purchase the EUR/USD at 1.0600 and sell it at 1.0605. While each broker is different, generally dealers and brokers will not charge a commission. There charge comes in the bid/offer spread they use to quote a price. In theory, the dealer believes they can purchase the currency pair on the bid, and sell it to another client on the offer, capturing the spread.
Trading in the forex space is around the clock, and many currency pairs are liquid all the time. The most liquid currency pairs that provide opportunities to trade are major currency pairs. These are currency pairs that are quoted versus the U.S. dollar and include the yen, the British Pounds, the Euro, the Australian dollar, the Canadian dollar and the Swiss Franc.
Currency pairs that are traded against the dollar from developed nations that are not majors are called minor currency pairs. For example, the Swedish Krone is a minor currency pair. Additionally, there are cross currency pairs. When the U.S. dollar is not included in the exchange rate, the pair is referred to as a cross. So, the EUR/JPY is a cross currency pair. There are also emerging market currency pairs.
Once you get a handle on how the market is traded, you need to determine the trading style and strategy you plan to use to generate income. While some investors appreciate a relative value style of trading where there is a constant return to the mean when a currency is knocked down, other like momentum trading. To find your style think about the way you like to trade other products or even purchase apparel. Are you a bargain hunter where you are always trying to find the lowest price, or are you an impulse buyer, looking for momentum?
Types of Analysis
Fundamental analysis focuses on the macro events that alter a currency pair. Since the interest rate differential makes up the forward rate of a currency pair, many analysts study monetary policy, economic data, and political uncertainty to evaluate an exchange rate.
The fundamental analysis used by currency traders is a relative value analysis where there is a focus on how valuable one currency is relative to another. There may be many times where the Euro appreciates versus the dollar but losses value again the yen. Generally, when an economy is performing well and growing their interest rates and asset values are climbing making the value of the currency stronger.
To track potential economic events, most currency traders use a financial calendar which tells you what to expect in the next day, week or month. Traders often focus on specific economic releases such as an employment report, or inflation. These economic data points can move both the currency and interest rate markets.
Monetary policy is very important to the value of a currency. Market participants will price in an expected change in monetary policy to a currency pair before a central bank releases its decision. If the decision was not priced in there will be a move immediately to adjust to the new information.
Political risk plays a significant role in the value of a currency pair. If traders believe there will be uncertainty, they will sell or short a currency, looking some type of adverse move to occur.
What is Technical Analysis
Technical analysis is the study of human psychology, which is represented in the form of price action. If you believe that all available information is incorporated into the price of a security, then analyzing prices can help you determine how future information can alter the current price.
Technical analysis gives you a visual representation of the historical landscape, and allow you to view any patterns that have existed. Although past exchange rates do not guarantee future movements, the patterns that occur, will likely happen again if the information is similar.
The current exchange rate of a currency pair represents current sentiment. As new data becomes available, you might change your view. For example, the EUR/USD before the U.S. Presidential Election priced in a Clinton victory. Once information became available that Trump had won, people changed their view.
There are several techniques that can be used to measure past price and how the past relates to the future. One of the easiest to understand is support and resistance levels.
Support and Resistance
When you follow prices, you attempt to find levels where prices congregate. During a trading day, you will find spots were equilibrium has been reached, but when this changes and prices move, they usually slice through either support or resistance. You can use a daily low or high as short term resistance, or a weekly or monthly low or high. Many technicians use trend lines.
Trend lines connect points. The more points that are connected, the stronger the support or resistance created by a trend line. Trend lines can be horizontal, upward sloping or downward sloping. When a trend line forms resistance, the most common trend line is a downward sloping trend line. Moreover, when a trend line forms support, and upward sloping line is the most popular trend line to use. When the slope of a trend line is broken, the market is on the move. The breakout or breakdown, which follows a close above or below a trend line changes market sentiment, as the equilibrium is broken.
A moving average is the average of a security over a specific period and is often used as a level that is considered support or resistance. Moving averages tell you were prices were on average, and are calculated by dropping the last date in the average when a new date is added. For example, a 5-day moving average is calculated by averaging the last 5-days and on day 6, you would drop day one.
Bollinger bands combine moving averages, and the standard deviations of the security, to define a distribution of the security over a period that you choose. This means that the study, which was introduced by John Bollinger, encapsulated 95% of all the history over the period you chose and shows you and upward band, known as the Bollinger band high, and a lower band, known as the Bollinger band low.
The default setting for Bollinger bands is the 20-days and 2-standard deviations. Most of the time, the Bollinger band describes the range of movement, which is mean reverting when a security is rangebound. In this situation, a currency pair will likely revert to the mean after hitting a Bollinger high or Bollinger low. When a security breaks out, momentum will take it above the Bollinger band high or below the Bollinger band low, and the security may not mean revert.
Relative Strength index
Another very useful tool which is helpful in determining the future movement of a security is the relative strength index. This is a momentum oscillator that measures overbought and oversold levels. The oscillator looks at the change in the price of a security and measures that change relative to the change over the past 14-days, which is the default. RSI index levels above 70 are considered overbought, while RSI index levels below 30 are considered oversold.
Trading the currency markets requires an understanding of the securities, knowledge on how they trade, a strategy and a risk management plan. When you develop your trading plan, you should make sure that you only bet what you can afford to lose. There are several popular types of analysis that is used to determine the future direction of a currency pair including both fundamental and technical analysis.
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David Becker is a New York-based finance writer and capital markets analysis. With more than 25 years of experience in derivatives trading and risk analysis. David runs a consulting business that focuses on investment evaluation and personal finance. David has been published in the high profile online and print media. He holds a B.A. in economics