Of all the financial markets, the forex market is perhaps the least well understood, and yet it impacts us all every single day of our lives, in a myriad of different ways. Whatever we buy or sell, no matter how small or incidental, will in some way have been influenced by what we call the forex market, or more accurately foreign exchange.
Perhaps the simplest and most visual example is when we travel abroad. The first thing we do, either at the airport or before, is to change some of our own currency to that of the country where we are traveling. If we are in Europe and traveling to another European country, then this is less of a problem since the introduction of the so-called ‘single currency’, the euro. A German traveling to Italy has no such worries since both countries use the same currency. But once he or she travels to the UK or the USA for example, then euros need to be exchanged for US dollars.
This is the principle of the foreign exchange markets, and the small electronic boards that you see at international airports, are simply visual reminders that currency exchange rates affect us all. Whether we are traveling, buying products from overseas, using base commodities such as oil and petrol, or consuming imported foodstuffs, all are subject to and influenced by, foreign exchange rates between countries around the world.
Every country in the world has its own currency. It is the quoted exchange rate of one country’s currency against another, which is the simple principle on which the forex market is built.
Now, I make no apology by starting with the basics, as these are the building blocks of your knowledge, so let me begin by answering the five most asked questions in forex trading which are as follows:
- What is forex trading?
- Why do we have a forex market?
- Who are the main participants?
- How are prices derived?
- Where do I fit in?
What Is Forex Trading?
Forex trading is short for foreign exchange trading and, represents the market in which one country’s currency is quoted against that of another. It, therefore, provides the basis for anyone in the world, from governments, companies and private individuals to agree on a rate of exchange between one currency and another. Without these market rates being quoted, parties wanting to exchange their currency would be forced to agree on a rate for each transaction on an individual basis. In other words, there would be no agreed standard by which to set these rates.
An interesting feature of the forex market is that it has no centralized exchange, such as in stocks or futures. As a result, all trading is conducted over the counter (OTC), which simply means that it is not conducted in a regulated environment, and indeed is often referred to as ‘off exchange’ trading. The forex market allows businesses, investors and traders to take advantage of the change in currency rates by taking a view as to the likely future direction of one currency, relative to another. As a result, all currency rates are quoted in pairs, with one country quoted against another.
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With almost 200 countries and independent states in the world, each with their own currency, deciding on which currencies to trade and when can be a daunting task. In fact, the problem is far worse than this, since, in forex trading, each currency is then quoted against another, resulting in literally thousands of currency pairs covering all the possible combinations.
But don’t worry. Help is at hand, and in this chapter, we are going to focus on those currencies and currency pairs, which are the bedrock of the forex market.
Now at this point, I feel it is both appropriate and relevant to explain how the forex market has changed over the last few years. The catalyst for this was the financial turmoil, triggered in 2007 by the subprime mortgage crisis which sent world economies into a steep decline, and ultimately deep recession. Banks such as Lehman Brothers and Bear Sterns collapsed, as the true extent of the crisis, unfolded. In Europe, the situation was so severe that several countries came close to bankruptcy, only saved by the intervention of the European Central Bank.
What effect has all this had on the currency markets?
The simple answer is dramatic. This is not the book where I propose to cover this in detail. I have written other books on this subject, but I wanted to touch on it here, and the main drivers of change have been the central banks of the United States, Europe, Japan and other major economies around the world. What each of these has done in different ways, is to distort the currency markets, by effectively printing money using a process referred to as quantitative easing. You can think of this as increasing the amount of currency in the market, which helps to drive some much-needed inflation into ailing economies. It is a blunt instrument at best, with indeterminate results.
Secondly, the banks have been forced to lower interest rates too low, or ultra-low levels, in an attempt to stimulate growth in otherwise stagnant economies. This has led to what has been dubbed the ‘race to the bottom’. In other words, each country’s central bank deliberately attempting to maintain a low-interest rate, which in turn helps to protect its export market. This is particularly true of major exporters such as the US, Japan, and China. This sequence of events has distorted what was once a system of ‘free floating’ exchange rates and is a feature which is set to continue for years to come. It is a fact of life and one we have to live with as traders.
There is nothing we can do about the situation, except to recognize the fact that the foreign exchange markets have been drastically distorted by the events of the last few years. They will return to ‘normal’ within the next five to ten years, as the effects of the financial crisis start to wane, but for the time being, this is the situation and one that we have to accept. If you were starting your trading journey in the forex market ten years ago, then life would have been very different. I am not suggesting that it was ever easy, far from it, but the word I would use here would be ‘predictable’.
The financial crisis has removed that ‘predictability’ from the currency market in many different ways, and not least in the various attempts by central banks to both protect, and stimulate their own economies. This is what I meant in the last chapter when I referred to the paradox of the forex market. On the one hand, it is global, and yet on another, it is very local. Central banks will do anything and everything in their power to protect their own economy first. It is very much a case of ‘I’m all right Jack’. We see this every day, and interest rates and quantitative easing are all part of this distortion. Add in the politics of Europe and the major economies of the world, and it becomes a witch’s brew. Even the fundamental news has lost that predictable element.
And it’s not just in the currency markets themselves that these changes are having an effect. The bond markets have been the vehicle used by the central banks for currency creation, as they buy bonds in ever increasing quantities. At some point, this will cease, but as this is ‘new territory’ for the central banks, no one knows what the long-term effects will be, once these programs are tapered and cease. Least of all the banks themselves. All of this will play out in the next few years in the currency markets, and as forex traders, we have to be aware of these forces. The ‘predictability aspect’ of trading in currencies has gone. It will return, but not for many years, which is why volume becomes a key tool in our trading armory. It is one of the few indicators, which when combined with price, truly reveals what is happening as a currency moves higher or lower. Volume and price reveal the truth behind the move, which is why it is so powerful, and perhaps even more relevant today than ever before.
The above comments are not designed to frighten or worry you, they are simply a statement of fact. Things have changed and I would be doing you a huge disservice if I did not make this clear from the start. It’s something to be aware of, and accept, and as you will see later, these changes have also led to changes in the focus on which currency pairs to trade.
- Step One: Decide on the amount of your initial trading capital. This should be money you can afford to lose, and not be borrowed or loaned.
- Step Two: Consider your family and financial commitments carefully and the time you may have available for trading. Think about the markets, the best times to trade and how this fits with your own personal work/life balance. If you have a job – keep it – your trading plan has to fit into your life, not the other way round. Look for the best fit, and adapt your trading approach accordingly.
- Step Three: Which approach are you going to take? Purely technical, purely fundamental, or a mixture of both. Explore them both. Read and digest arguments from both sides, then make your own mind up. Relational comes later, much later, as your experience grows.
- Step Four: Think about the advantages and disadvantages of various trading approaches. Your chosen approach may be dictated by your personal circumstances. If not, then consider the pros and cons of each, and in particular how each will suit you, your temperament and your personality. This is extremely important and needs careful thought and consideration. There is no right or wrong way to trade, just the way that suits you.
- Step Five: Set yourself realistic, simple and achievable targets, which should be non-financial. Do not set monetary targets. Trading success is about two things primarily – consistency and money management. If you can be consistent over an extended period, then the money will flow. Being consistent is about the number of pips you make in a week or a month, not about how much money. Twenty pips a week may not sound very much, but at $10 per pip it’s $200 and at $100 per pip it’s $2,000 per week.
Once you have a solid set of money management rules in place with your plan, then you are looking for consistency. From consistency comes money – it’s just a question of increasing your contract size on each trade.
- Step Six: Define your money management rule depending on the amount of trading capital. The minimum is 1% and the maximum is 5%. The rule you set is the maximum – you do not have to use it for each position!
- Step Seven: Based on your decision about your approach to the market, both in terms of timescales and technical, fundamental, or a combination, you now need to start thinking about how you are going to define an entrance to the market. What is the trigger? How do you decide? What are the rules? Are there any rules or are you going to be a purely discretionary trader? All of these things you will need to consider and seek guidance. Again, there is no right or wrong answer here. There are many, many ways. You may decide that a piece of software is the correct way to start, or perhaps using one of the many technical indicators which are freely available?
I will give you my own view later in the book, as this is a huge topic in its own right. Many traders like to define hard and fast rules in their trading plan. In other words, I will do A if B happens. This could be very simple, or complex, but in essence, it is a rule set that defines the entry. It will probably not surprise you to learn that this is not a route I advocate for many reasons, not least of which is that this is too prescribed. It verges on the mechanical, and the market is not a mechanical animal. If it were, then trading would be very easy.
If your entry is going to be discretionary, then that’s fine, but within your plan, you just need to try to define what the parameters are that signal an entry or what’s often called a ‘set up’ for your new position. What you will probably discover is that your entry decision will be based on a combination of elements, perhaps, as in my case, volume, price action and a simple indicator.
- Step Eight: Define your management and exit rules. This is another very grey area for novice traders, and I’m afraid one that non-traders write about a great deal, and sadly write a great deal of nonsense. Again, I am going to cover this in much greater detail when we start putting everything together, and the reason I include it here is simple. You do need to say within your trading plan how you are going to manage any position, and what your exit is based on – if it is purely discretionary then that’s fine and no problem at all.
Many trading books at this point will suggest a simple risk-reward relationship and once that has been met then you exit. This sounds very simple in theory, but that’s where it stops – in theory! The practical is very different. After all, why should the market give you 20 pips if you are prepared to risk 10? Or 30 pips, or whatever target you have in mind. The market does not work this way and never will, which is why you have to be discretional in your trading management and exit.
Let me explain with a simple example which combines the entry and the exit and uses the hammer candle, and the shooting star candle that we looked at in one of the early chapters.
Suppose your entry rule for a long position is a hammer candle and the associated exit rule is a shooting star. The opposite would be a shooting star for a short position as your entry trigger and a hammer candle for your exit rule. A very simple rule set, which can then be applied to your trading timeframe which might be a 5-minute chart, an hourly chart or a daily chart. That is your rule.
Do you follow this rule blindly and without thought of each position? Well possibly, but I doubt it very much.
What happens when your entry rule, a hammer, for example, is then followed on the next candle by a shooting star? Do you exit immediately? Probably not, and the reason, is simple. You have only just entered the position and your mindset is still in ‘hope’. You are hoping for a profit and not yet prepared to consider exiting at a loss after such a short space of time, which is one of the reasons these types of rules simply don’t work.
The corollary to this is that you might say, well I will adjust the rule to say after X bars. In other words, if my exit candle appears within 1 or 2 candles from my entry, then I will ignore it under my rules. Very soon, your rules become discretionary, or very complicated!
Let me give you another example which is a common rule that traders apply when trading in a market that has a physical exchange with an open and close – stocks for example or an index future. The rule here is generally something along the lines of: ‘never take a trade in the first ten minutes of the open’. This sounds very plausible. In other words, let the markets settle down before taking a position. But why 10 minutes, why not 9 or 11 or 15 minutes? And what happens when an opportunity appears after 9 minutes and your rule states that no position is to be taken before 10 minutes have elapsed. Do you wait? Do you take it? Is one minute important? This is what happens when you put these sorts of rules into a trading plan, which is why I have a problem with them, and I hope that you can start to see why!
I’m going to cover this in more detail later in the book for you, but this is perhaps the one area that is the most difficult for new traders. The only rules which are set in stone are your money management rules. Everything else is discretionary, they have to be. Traders who have trading plans which have no leeway will fail ultimately. The plan may work for a while, but market conditions then change, and the old rules no longer apply. It is rather like opening a shop and saying that today I want to make X. Well you may want to, but what if the weather is bad, the road is being dug up, it’s a Monday, or a shop close to you is having a sale? All these factors will play a part. Nothing stays the same day to day, and it’s the same with the markets. Every day is different, every day there are different forces at work, and to think that a mechanical plan will work consistently is somewhat naive.
Your plan needs to reflect this and needs to be practical. If you are going to take your signals after a break out from congestion, then say so. If you are going to do this in conjunction with a technical indicator, then say so. What your plan will not say is precisely when you are going to act. Equally, if you are going to exit when the market moves into a congestion phase, then say so in your plan and you will then need to explain how that congestion is defined on your chart. At least you then have a basis, a framework around which to work, and not some hard and fast rule set which is unworkable, inflexible, and probably much too complicated.
Don’t worry, if this doesn’t make sense right now, it will be the end of the book, but remember, I will be teaching you what I believe is the correct approach – you may disagree! But I hope I can convince you.
- Step Nine: Then choose your broker with care – there are many good ones out there, but quite a few bad ones. Make sure you carry out due diligence before sending off your hard earned trading capital. I explain all about the good, the bad and the ugly of the trading world later in the book, as well as the various types of brokers and the questions to ask.
- Step Ten: Execute your first trade with the minimum contract size available. I do not believe that paper trading in a demo account teaches anything of value, other than perhaps how to use the trading platform. In many cases, the live and demo feeds are very different from one another, and any strategy you decide to test in a demo account simply will not work in a live account. Spreads may be very different and some orders may simply not be available. My advice is to go straight to a live account, but trade using a micro lot as a starting point as you get started. This will allow you to become familiar with the platform, with trading, with entering, managing and exiting positions, using the smallest financial risk possible.
When you have a live position, focus on the pips, not the dollar amount. This will help to reduce the trading emotions, which I will cover shortly in more detail.
Finally, keep a diary of your positions and why you opened them. This can be very simple but will help you to improve the insights gained when you look back at your trading history. Note down what you traded, and when, the entry trigger, and why you closed out, along with details of what happened next. This will then build into your own personal trading diary and also help to highlight possible problem areas. Perhaps you are being stopped out too often, in which case you may need to adjust your lot size and increase the pip loss per trade. Perhaps you are closing out too early and existing strong positions too early. Perhaps you are trading with a bias, always short or always long.
All these things and many more will be revealed in your trading diary. It does not have to be pretty and no one else will ever see it, but keep one you must. It is the diary of your trading journey and will help you enormously with your skills and knowledge develop.
Finally, your trading plan is a living thing. Don’t be afraid to make changes to it, to tailor it or adapt it, as your circumstances change and your knowledge grows. Nothing is cast in stone forever and provided you maintain your money management rules, everything else can be modified to reflect changes in your personal life.
When it comes to figuring out whether currencies are going to strengthen or weaken, there are two styles of analysis that you will want to pay attention to. The first of these is what’s known as “fundamental trading analysis”, which is based on such things as economic reports and news.
Starting Point A fundamental analysis is the best place to start, especially as you dip your toes in the trading waters. Before you do, though, you might want to consider how much you already know about the countries of the world and how they are governed. This is especially important in the countries whose currencies you plan to trade.
So, before you begin your daily analysis, make sure you create a clear mental picture of the countries you’ll be trading on. How is their government structured and what are its cash reserves and deficits like? Create this as a starting point and then move on to your daily look at how things are changing.
Economic Reports As a trader, you will want to stay updated on the economic reports coming out of not only the countries whose currencies you are directly trading but also from the countries who are involved in trade with those countries. As we mentioned earlier, for example, the situation in the United States can have a big impact on the price of oil coming out of Canada, so it’s going to affect the latter’s economy.
You can take stock of a country’s economy by looking at its inflation rate, employment rate, and economic growth rate. In the case of employment, as a general rule, the economy is improving if there are fewer people out of a job.
Be aware that there can also be seasonal impacts on this rate; for example, many businesses hire extra help for the holidays or for harvesting times. Conversely, you may see an uptick in layoffs when those events come to an end, which can skew the numbers. It’s also important to be aware that the raw numbers aren’t the only thing impacting the market: there is also the expectation of what those reports are going to show and the reaction of traders depending on whether it’s as good or bad as expected.
If, for example, Canada was expected to release incredibly low unemployment numbers and the report reflects low unemployment not quite at the level expected, it can actually weaken the currency. If it showed even lower numbers than expected, this might cause worries about interest rate upticks, which will affect stocks and also impact the currency.
Inflation has a marked effect because it can indicate what’s happening to the country’s economy – but it can also be affected by growth rate. If the economy is growing, it often means there is a demand for currency, which means the currency is valued more but can also mean that inflation is rising and weakening that currency. These factors are linked so strongly that it’s impossible to consider them separately.
Along with these reports, you should also pay attention to other aspects of the country’s economy, such as interest rates. Short-term rates tend to increase when the economy is strengthening and inflation is deemed likely to increase, while long-term rates are affected by investment in government bonds. It’s for this reason that currencies like the U.S. dollar are considered to be safe havens: their bond markets continue to do well even when less stable countries are suffering.
Supply and demand meanwhile play an important role: when it comes to international trade, prices change constantly based on how much of that commodity is available and how much is needed. The more people who want a good that’s in limited supply, the higher the price will rise. Movements in funds between currencies will reflect this fact and will also affect the demand for those currencies.
Finally, it’s important to be aware that most of the reports that have an influence on the Forex market are released at very specific times; the first Thursday of the month at 1 p.m. in your time zone, for instance. As you become more familiar with analysis, you’ll start to learn when these dates and times occur and you’ll come to expect them. This is incredibly important because the release of a report can have an instant impact on the market, so it should also be borne in mind when you initiate a trade.
For example, if you decide to initiate a trade on a Thursday evening but there’s a report scheduled for 8 a.m. the next morning, the third Fri-day of the week, you might find that the report itself pushes the pips in the opposite direction to which you were expecting, scuppering your strategy in the process.
A quick search on the internet will show you that there are a number of free calendars available, some of which can be personalized to your needs such that you’re only seeing the releases that will directly affect your trades and you’re seeing them in local time. You can use these to your advantage by simply taking a quick look before initiating a trade to check whether there are any releases scheduled that may change what happens to the currency you’re about to trade in.
You can also use them to remind yourself when those reports are looming – you can be among the first to check them when they release and can make trading decisions accordingly. For instance, you might find yourself closing trades, tightening stops or delaying a decision to initiate a trade.
News and Media On a daily basis, you’ll find news stories that have an impact on your Forex trading decisions. It’s easy enough to root out stories that talk about government finances, the economy and large deals made by giant corporations, but you’ll want to develop a filter as you sort through all that information.
Don’t forget that “experts” can often be biased and stories may also reflect the hopes of the individual telling them or the government they represent. Thus the news can be remarkably helpful in developing your understanding of the world economic stage, but it’s also important to remain skeptical of what’s being said and find yourself as many sources as you are able to comfortably absorb in a day in order to verify, double check and ensure you’re getting a clear picture.
International Events While not technically a “source”, it’s worth mentioning international events in this chapter because of the immense influence they can have on your trading success.
Take a quick look at the headlines in the world’s newspapers today and you’ll see that huge event happen all the time. As a general rule, anything that causes fear and uncertainty is going to have a significant impact on the Forex market – and on your own individual trades, too. You can’t see most of them coming, but you can prepare.
These massive events can include natural disasters such as earthquakes and hurricanes; conflict from wars or terrorism events; and human-created disasters such as the meltdown of a nuclear reactor.
It’s not uncommon for a country to shut down its markets when massive events happen for the simple reason that panic can often lead to a crash. It’s a way to ensure that cooler heads prevail before disaster strikes the financial markets.
When the market is shut, there’s nothing you can do about your trades – they are frozen for the duration and your orders will not be fulfilled. The best way to avoid this from having a severe effect on your capital is to make sure you always leave stop-loss orders to automatically protect your position even when you can’t do so yourself.
If the market makers can be considered as the `micro’ manipulators working at the pip level and above, the central banks are at the other end of the scale, at the macro level. They are the `big picture’ market manipulators, and as such operate in a number of ways.
The mandate for most central banks around the world is very simple. It is to create a stable economic environment which encourages growth, creates prosperity for the people of the country, and where inflation is kept low. All of this is generally achieved with one simple mechanism – interest rates. As well as being responsible for monetary policy, central banks are, of course, responsible for the currency of the country in every respect.
Whilst most central banks are considered to be independent of their government, it would be naive to think that they are not fully aware of the views, ideas, and policies of each administration as they come and go, and also of the effect that monetary policy may have within the framework of government policy. Most governors and presidents of the central bank are ‘called to account’ by their lords and masters, the government, generally on a regular basis through monthly meetings and public hearings.
The game changer in terms of the role of central banks, and certainly for those currencies mentioned in the previous chapter, was the financial crisis which enveloped the world in 2007/2008. Up to this point, one of the primary forces to drive the foreign exchange markets was interest rates, for one simple reason. Return on investment. If assets in one currency are offering a better return on investments than assets in another currency, then investors and speculators would seek out the higher-yielding currency, either in terms of the currency itself, or to invest in assets denominated in that currency such as bonds and equities.
It was the interest rate differential that was the number one focus, and when interest rate changes were announced by the central bank, the markets paid attention and moved as a result. And this is what I was referring to in my introduction when I described this ‘loss of predictability’. Interest rate differentials, which were once considered the ‘arbiter’ of exchange rates, no longer apply. The rulebook has been thrown out of the window, and the ‘old rules’ no longer apply.
Since the financial crisis, interest rates around the world have fallen sharply, as central banks desperately tried to stimulate their economies. These have fallen to such an extent that interest rate differentials are now almost completely eroded. The US at 0.25% is now on a par with Japan at 0.1%, with the UK at 0.5% and Europe at 0.75%. Canada is at 1%, New Zealand at 2.5% and Australia at 3%. Switzer-land languishes at 0%. As a result, investors and speculators around the world have been searching out currencies with higher yielding interest rates in the Far East, Latin America, and India.
No doubt in the future, interest rate differentials will return and become the primary force they once were, but not for many years, as the financial crisis has also led to a global economic collapse, plunging most economies deep into recession. The problem for the central banks, and particularly for those with strong export markets, has been to ensure that these markets were protected, by keeping interest rates low for as long as possible, which they have all continued to do, either covertly or overtly. Whilst rising interest rates generally signal growth and a strong economy, they also attract inflows of money, hunting out the higher yields I mentioned above. It is a double-edged sword for many central banks around the world, and one they have to manage carefully, which many of them do, by direct intervention. The Bank of Japan and Swiss National Bank are classic examples, but other central banks also intervene directly when the home currency becomes too strong, and begins to threaten its competitiveness in world markets.
The simple message that has become very clear over the last few years is this. Each central bank in every country is now only interested in one thing – preservation of its economy and protection of its markets. Until the current crises end, interest rates will continue to remain relatively insignificant – but they will return to their dominant position in due course.
Next, and as the counterbalance to the above, many central banks embarked on various programs of ‘quantitative easing’ or QE for short.
All this means in simple terms is printing money, or adding money to the system if you like, and they do this by buying bonds. However, you don’t need to understand how they do this just that they do! What is happening here is that a central bank is simply increasing the amount of money in circulation, which should, in theory, weaken the currency, since there is more of it in circulation! But has this happened so far? The short answer is yes, and no. The US dollar did indeed weaken when the first program was introduced but has since recovered. The Japanese have been trying this approach for years, with little success, and only recently have they made some progress following a change in government. The Swiss have tried and each time the exercise was a failure.
All of this is played out in the currency markets which increasingly have become a battleground for these leviathans of the major economies. The term currency wars are appropriate and have become the norm and the backdrop for forex trading. At this point, you may be wondering why I am explaining all this in a book entitled Torex for Beginners’ and the answer is this. I believe it is important that you have an understanding of the big picture. Many traders come to this market with little or no knowledge of the forces that drive it. I believe that to succeed, you need, at the very least, to have some idea of the many and varied forces which play out in the world of foreign exchange.
To combat the market makers we have an answer, and it’s called VPA. The central banks, on the other hand, are a law unto themselves and are becoming an increasingly dominant force in their own right. A decade or so ago, it was their monetary policy and interest rate decisions that were the focus. Now for us as forex traders, it is the extent to which a central bank is likely to intervene, coupled with programs to maintain low-interest rates and a weak currency to boot. In other words, decisions designed to keep their political lords and masters happy.
Finally, of course, central banks not only `manage’ free-floating currencies such as those outlined in the last chapter, either overtly or covertly, but also in those currencies which are pegged, often to the US dollar.
These types of arrangements range from fixed pegs, where the currency is managed in a range, or informal ‘dirty float’ regimes and others, where the currency is allowed to float free and with no public statement on when or where intervention is likely to occur. Each central bank takes its own very different approach.
Some are straightforward, and what you see is what you get. Examples here would be Australia, Canada, and New Zealand whilst others are highly political, such as the ECB in Europe. The Bank of Japan and Swiss National Bank are openly interventionist and protectionist. Away from the major currency pairs, some central banks are happy to see strength in their currency, such as the Bank of Mexico which is seen as non-interventionist, whilst Brazil’s central bank is perceived as the complete opposite.
Therefore, in summary.
First, be aware that the framework of the forex market is very different for the reasons I have outlined above. The old forces which once drove the markets have changed dramatically in the last few years. Normal service will be resumed, but not for some years – at least 5 or more in my opinion, with economies unlikely to recover much before 2015. At that point, we may start to see interest rates becoming the focus once again, but until then, the above conditions will prevail for the foreseeable future.
Which leads me neatly into the final group of forces which drive the markets, and these are back to the micro level, and here it’s the economies and economic data.
Boil any financial market down to its basic components, and you will find that there are only two forces which drive price action, day in day out. Fear and greed in equal measure. These two emotions manifest themselves in the simple mechanism of risk and return. The higher the return, then the greater the risk. The lower the return, the lower the risk.
This is what creates the constant flow of money, into one asset and out of another. It is why the US dollar and the Japanese yen see money flow into the currency when the markets are nervous, and out again when speculators and investors are prepared to take on more risk.
The question now is, do the forex markets work on this simple principle? And the answer is both yes, and no. You see the forex markets are unique. They sit at the heart of all the other major markets, and it may sound a rather obvious statement to make, but the forex market is about money. It is where money flows when assets in other markets such as stocks, bonds, and equities are being bought and sold and converted into cash. It is also the market that underpins economies and whose currencies are held in reserves by the central banks around the world. It is the market where governments and banks try to control and manage their economies. Finally, it is also one of the most manipulated markets on a variety of levels, simply because there is so much money to be made. So, let’s start there, and then move on to the central banks and finally take a brief look at economic data, which will then take us neatly into the next chapter.
As I explained in the introduction, the forex market is effectively managed and controlled by a handful of extremely powerful and increasingly profitable banks. There is no central exchange as with other markets, and as a result, this cartel of banks effectively runs the market. They are the source of the wholesale pricing which is then distributed through a spider’s web of brokers, dealers, resellers, and finally out to us as traders at the end of the line. They are ‘making a market’ which is why they are referred to as market makers.
Regulation, of course, does apply, but not at this level. The banks themselves are regulated to make sure that their banking practices are fair and ethical, and that they are holding sufficient reserves, but other than that, regulation of the forex market does not exist in this context.
Now the question you may be asking at this stage is, how do they do this and why is it not self-evident to everyone?
To answer the first part of the question, they do this using the media, and indeed whilst writing this chapter we had a perfect example yesterday. The Twitter account of the news service Associated Press was hacked and a tweet released suggesting there had been two explosions at the White House, and that the President had been injured. The forex markets reacted suddenly and violently, with immediate flows into the Japanese yen and the US dollar. As soon as this news was in the public domain the market makers would have reacted quickly, moving prices fast and with three objectives in mind.
- Frighten traders into closing existing positions
- Take traders out of the market by triggering stop orders
- Trap new traders into weak positions on the wrong side of the market
A move such as this would have netted these banks 100’s of millions of dollars, pounds or whichever currency you prefer to choose!
But don’t worry if all this sounds a little complicated. You don’t need to understand why or how they do this just simply that they do. The market makers will use every piece of news, no matter how small to move the market around to suit their own objectives. In this case, it was a very short and sudden move, and the move out of both the yen and the US dollar was just as fast and volatile as they move in, once it was confirmed that the news had all been a hoax, and prompted by hackers.
We will look at the news in a little more detail at the end of this chapter, as we start to explore what we call the fundamental approach to trading. But the forex markets, just like all financial markets, are bombarded with news and comment throughout the day, from politicians, central banks, and government officials along with all the economic data which is released every day, coupled with natural disasters and world events. When you think about this logically it is really very simple, and given the same circumstances, you would do the same.
At this stage let me say two things.
If you are starting to worry and perhaps think that forex trading is not for you, stop worrying now. And second, the reason that I am explaining this here, is that I believe that it is an aspect of the forex markets that you need to be aware of before you start trading. Many traders start trading currencies with very little idea of who they are trading against, or how manipulated the market is, by various groups. The market makers are one group. The central banks are another, and then finally there are the forex brokers. All have their own agendas, and all manipulate the markets in different ways. Whilst the market makers are perhaps the most pervasive, ironically they are the easiest to see, as we have one powerful tool in our armory with the MT4 platform, and that’s volume. And better still, just like the platform itself, it’s free.
Whilst the market makers can manipulate prices and move market prices as news in the media ebbs and flows, there is one activity that they cannot hide which is volume. You can think of volume as an activity, it is much the same. If we see strong volume (activity) in a price move higher or lower, then we know that the move is genuine. In other words, the market makers are joining the move themselves, which is our signal to enter the market. It re-allies is this straightforward, and when we look at volume and price together, this reveals not only the strength of any move higher or lower, but also shows when and where the market makers are buying or selling themselves. This is the power of VPA or volume price analysis, which I explain later – so there is no need to be alarmed by the market makers or their activities. They are there and manipulate the markets to meet their own objectives, but we can see them at work very clearly through the prism of volume and price.
Let me give you a very simple example from everyday life of the power of volume and price. Consider an auction on eBay.
An item is posted for sale, and immediately attracts buyers, pushing the price higher, more bidders join the auction, and as more bids are received the item moves higher very quickly, and finally sells at a very high price. This is a genuine move higher since the price action has been pushed higher by the volume of bidding. This is the simple principle of price and volume. The volume has validated the price move higher.
But take another example, this time from a more traditional auction, where the auctioneer is selling a piece which is of poor quality, and with few bidders in the room. The auction starts and there are no bids for the item. In an attempt to spark some interest, the auctioneer pretends to take some bids (this is called taking bids ‘off the wall’) which are simply fake. This attracts a few bids and the price moves higher slowly, and finally, the auction ends. In this case, the price has moved higher, but on very low volume. Is the price move higher gen-
urine? No, simply because there was no activity (volume) as the price moved higher. In other words, this was a fake move by the auctioneer. This is the simple principle that reveals the activities of the market makers.
I mentioned at the start of this chapter that one of the issues that we face as traders in the forex market, is the problem of knowing which currency is driving the pair. When the GBP/USD is rising, is its strength and buying in the pound which is the dominant force, or is it selling and weakness in the US dollar? This problem is compounded by the fact that a currency can be bought or sold against a myriad of other currencies making it extremely difficult to identify where this buying or selling is taking place. A bank that wants to sell euros and buy US dollars, for example, can do so directly, simply by selling the EUR/USD. However, in order to hide their activities from other large institutions, and also avoid moving the market against their own trading, this transaction may be executed using a second or even third currency.
Rather than go from A to B, the bank will get to B via C. If we go back to the above example of selling euros and buying US dollars, this can be achieved by selling euros and buying pounds in the EUR/GBP and then selling pounds to buy US dollars in the GBP/USD. The result is the same – the route is very different. There are, of course, additional costs of execution, but the benefit to the bank is that large transactions can be hidden in this way, well away from the prying eyes of competitive institutions. The Interbank market makers do this, day in and day out.
For single instrument traders in commodities stocks or bonds, this is not an issue, since all the buying and selling is executed through limited channels, either in the cash or futures markets. For foreign exchange traders, life is not that simple, as the alternative options to buy or sell are almost limitless. This is where the currency matrix comes to our aid.
The currency matrix is a very simple concept, yet very powerful, and the easiest way to explain it is with some examples.
Many forex traders, even more, experienced ones, only ever look at one chart when trading, a huge mistake in my view. As you will see in the next chapter, using multiple timeframes is an important feature of my approach to trading, and I hope will become important to you too. The currency matrix uses multiple charts in a different way. In this case, we use the same timeframe, but different currency pairs.
Suppose we are considering taking a position in the EUR/GBP. The pair is moving higher, and we want to establish whether this is euro strength or pound weakness. If this pair were a major, then life would be a little easier as we have the US dollar index as our starting point, but here things are more complex.
We turn instead to our currency matrix for the euro, which is six charts of the principle euro pairs. In this case, we would have the following in our matrix, all in the same time frame which would be relative to our strategy:
Suppose in all these pairs the euro was also rising. What conclusion can we draw from our matrix? Well, in simple terms, the euro is the driving force, as it is rising across all the other currency pairs. In this case, the other pairs are confirming this picture by virtue of the fact that the euro is rising against all these currencies as well, and not just against the UK pound. In other words, the euro is the driving force of the move higher.
The matrix will also tell you something else as well.
If one or more of the pairs is not rising in line with the others, then perhaps the move is lacking some momentum, and therefore unlikely to develop further. After all, if the market is buying euros across all the other pairs, this is a strong signal that the euro is being bought everywhere, and other currencies are being sold.
Finally, the currency matrix also reveals another facet. It reveals the best currency pair to trade. If you are trading euro strength, it will be instantly self-evident from the matrix, which of the euro pairs offers the best trading opportunities based on your analysis. The move higher in the EUR/GBP may be sluggish compared to a move higher in the EUR/JPY or the EUR/CAD. You may see a strong breakout in one pair, which offers a lower risk opportunity than in another, where perhaps the price action is running into a support or resistance area, or the volume is signaling weakness.
In other words, having a currency matrix reveals the complete picture of forex market behavior. The currency matrix is there to tell you what is going on ‘behind the scenes’, and not simply what you see in a single chart. What in effect you are doing in creating this simple matrix, is to ‘see’ the money flow for a particular currency, where the real buying and selling is taking place, and in doing so, reducing the risk on your trading position, which is something we are going to look at in detail in the next chapter. Trading is all about risk, and anything you can do, to help you gauge the risk of the trade and reduce it accordingly is immensely powerful.
In case you are still a little confused, let me give you another example for a Yen matrix. In this case, we would have the following:
Once again you would set this up with these charts using the same timeframe, and the timeframe would depend on your trading strategy. If your approach was short-term or scalping then these would be anywhere between a few minutes and a few hours. For longer-term trading, you might have these on the daily timeframe.
Finally, whilst mentioning multiple charts, the above currency matrix is not the same as trading using multiple timeframes. This is the next stage. The first step is to undertake our initial analysis, perhaps using a currency strength indicator, which is invaluable in revealing in-dividual currency strength and weakness. Step two is to then consider our currency matrix, for the ‘inside view’ on overall strength or weakness in our currency. Finally, in step three we arrive at our multiple charts (generally three) where we have our selected currency pair but viewed in different timeframes.
The currency matrix is immensely powerful and very simple, and I am always amazed that more forex traders don’t validate currency strength and weakness in this way. To me, it just makes sense. If you are trading in the majors, they have a US dollar matrix, and this will also confirm the price movements in the US dollar index. Here, one will validate the other. We also have a yen index, so again, you can have this running in parallel with your yen matrix.
One of the hardest things to do when trading is to quantify the risk on the position before you take it in the market.
Now we move from the major currency pairs to the cross currency pairs, and this essentially means any pair which does not have the US dollar. Many books at this stage might suggest that as a novice trader you stick to the majors and avoid the cross currency pairs. I do not subscribe to this view for several reasons.
It is certainly true that the spreads on the major pairs will be tighter than in the cross currency pairs, and this is generally the reason cited for trading these in preference to the cross pairs. However, this aside, there are many reasons for considering these pairs, even as a novice, provided you understand the characteristics of each, and accept some basic principles, such as wider spreads and a little less liquidity, which can make some of them more volatile.
However, against this, I would suggest the following argument.
It is a fact of life in the foreign exchange markets that 2007 changed the market, and the old values and methodologies have been swept aside as a result. Prior to these events, currency markets, broadly speaking, were ‘free floating’, where exchange rates were left to find their own levels, based on fundamentals, money flow, risk, supply, and demand? In other words, a free market economy if you like, where simple market forces dictated the ultimate exchange rates. This was the principle on which the gold standards of the early 19 70’s were abandoned. Just like any other market, the principle was to allow market forces to dictate market prices, rather than to impose ‘artificial’ pegs, such as the gold standard.
Until 2007, this was the case – then came the financial meltdown, and the game changed. No longer were exchange rates left to find their free-market level, but manipulation, both covertly and overtly became the defining standard. And the reasons are very simple – self-preservation, as central banks around the world, battled to maintain their fragile economies, particularly those with strong export markets, and the so-called ‘race to the bottom’ began. This was simply a process of implementing ultra-low interest rates to protect exports. In addition, many banks began printing money (referred to as quantitative easing) by buying bonds, to stimulate inflation in stagnant economies, creating yet another artificial component in the currency markets.
One of the principal exponents of this policy has been the US Federal Reserve, which has systematically continued to print money, ever since, creating a false market for the currency of the first reserve.
This is what I mean when I say a ‘game changer’. The world of foreign exchange has changed, not forever, as ‘normal’ market conditions will return in the next 5 to 10 years, but for the present and foreseeable future, this is a very different market. No longer are interest rates dictated by economic forces, they are dictated by self-preservation. Equally, supply and demand of currencies are no longer left to the market. It is the remit of the central bank to protect the economy – self-preservation again.
In such a world, the cross currency pairs offer an alternative, away from the artificial world of the US dollar. Whilst I would be the first to admit that they have some disadvantages, on balance, these are outweighed by the advantages, even if you are just starting out on your forex trading journey.
Let’s take look at some of the pairs I would suggest as possible starting points, and those to consider as alternatives to the major currency pairs.
The EUR/GBP is one of the less volatile cross currency pairs and represents the economic dynamic between Europe and the UK. Whilst the euro is politically sensitive as a major, particularly against the US dollar, as a cross pair against the British pound, the characteristics change, with the pair returning to ‘old school’ price behavior based on economic and technical forces. In some respects, the euro adopts the characteristics of the pound, and away from the influence of the US dollar, becomes more measured and predictable as a result. This is not an ‘exciting’ pair to trade, but then trading is about consistency, and not about the adrenaline rush!
This is a nice pair to trade as a novice. The price action is steady, and for intraday medium term trading, there are always plenty of opportunities, particularly based on the fundamental news releases in both Europe and the UK during these trading sessions. The pair does trend longer term, but in recent times has been rangebound so a shorter term or intraday is my suggestion here.
This is another pair in the same vein as the EUR/GBP. In this case, it’s the euro matched with the Swiss franc. This is a pair for longer-term trading, as it can become becalmed for long periods of time, and move in a very narrow range. But as always patience is a virtue and for longer-term traders, any breakout from these congestion phases is usually rewarded with a nice trend.
This is an interesting pair for several reasons. First, the Swiss franc has increasingly been seen as a safe haven currency over the last few years. Switzerland is seen as safe in every respect and with a stable economy and renowned banking system underpinned by gold, the Swiss franc has strengthened accordingly. The net result of this has been that the Swiss National Bank has intervened on several occasions to prevent the currency strengthening further, and it does so in the full knowledge of the ECB. The recent flood has been in the 1.2000 regions, but as the financial crisis begins to subside, then we may see the
Swiss franc weakens as money flows out from the pair and back into higher risk assets in due course.
Now we move to some of the more volatile currency pairs, and there are several to choose from here, all based on the Japanese yen. The Aussie dollar, however, is always the starting point, as it is an excellent barometer of risk in the currency market. If the AUD/JPY is rising then the Australian dollar is being bought and the Japanese yen is being sold.
This reveals two things. As I mentioned earlier, the Aussie dollar is closely associated with commodities, therefore the currency is a measure of risk buying or selling since commodities are seen as risk assets in general terms. Equally, and on the opposite side of the currency, selling or buying of the yen is also a measure of risk flow. Selling the yen implies investors and speculators ready to take on more risk, both in the carry trade and elsewhere, whilst buying of the yen implies the opposite.
The AUD/JPY, therefore, tends to provide a barometer of risk appetite across all the financial markets. As with all these relationships, they can and do change over time, and indeed the Australian dollar is another currency which is seen as a ‘safe haven’ largely as a result of the economic stability of the Australian economy in the last few years. However, this has to be counterbalanced by its close association with commodities and in particular China, and any slowdown in economic growth here will be reflected firmly in the Aussie dollar and the Aussie yen pair.
This is an interesting pair as it has a relatively close correlation to the price of oil. Canada is a major exporter, and the Japanese are major importers. If oil prices are rising, at the same time as the yen is being weakened by ‘risk on’ or politics, then the pair will move quickly. The weekly oil inventories release on the economic calendar will also play a part here, with any build in reserves, bad for the price of oil, and any draw, generally good. So, there are several influences, but as always with the yen crosses, if you get the direction right, then your account will start to build very quickly. Conversely, get it wrong and this is where your money management and risk management will really pay dividends.
There are many other cross currency pairs, with a variety of spreads and relationships. The ones I have outlined above are the starting point and some of the more liquid that are traded in this group.
The fundamental motion of the Forex market is somewhat different to other types of trading markets. To put it poetically, Forex follows the sun as it travels around the globe, with particular markets opening and closing according to time zones.
Individual countries open at individual times, with the day, starting in New Zealand as its citizens wake up for the day, followed by Sydney and then Tokyo and Hong Kong. As the hours move on, more markets open as those countries wake up for the day and then begin to close as the day ends across the globe.
- The Asian Session opens first with Tokyo opening at 8 p.m. Eastern Standard Time and includes currencies from countries such as Australia, Japan, and New Zealand. It’s generally regarded to be the quietest of all the sessions in terms of how much trading goes on.
- The European Session opens next, with London opening at 3 a.m. Eastern Standard time. This session, obviously, includes all the countries on the European continent. It is the busiest of all the sessions because London is the financial capital of the world.
- The U.S. Session opens last, with New York opening at 8 a.m. Eastern Standard Time. This, too, is a busy session because it can often involve announcement and news that will have a large effect on the dollar.
The three sessions overlap, so you’ll find that there are some hours of the day in which two are running at once. Understanding which of the three main markets you’ll be dealing with requires first figuring out at what time of day you are free to trade on a regular basis (i.e. when you are not working, sleeping or fulfilling other responsibilities) and which markets are open at that time. If you have your eye on a particular session or market, on the other hand, you will need to adapt your schedule to suit.
The best times to trade are, of course, the times when there are overlaps because this is when the most volume of trade is taking place, more liquidity is available and there is more volatility. Perhaps the best time of all is at around 1 p.m. Greenwich Mean Time, which is when the UK and European markets are trading and the New York market is just opening. For two hours, these major markets will all be trading together.
A key piece of insight for a Forex trader is that all things are not equal to the hours of the day. A currency that is trading heavily during the Asian Session will not necessarily be trading heavily during the U.S. session. In fact, it will probably not be trading that much at all, because the corporations and governments who deal in international trade are snoozing on their pillows.
Which currencies become your trading bread and butter will, therefore, depend on where you are in the world and how your daily schedule tends to look. To become a successful trader may mean making concessions to the markets in terms of your own time. In other words, though it might be most convenient for you to do your trading in a couple of hours after you get home from work, that might not be a time when sessions are overlapping and the markets you want to trade in are awake and working.
As an example, let’s assume that you are able to be active during the London session. During this time, there is a wide range of trading going on, with around two-fifths of the trades concentrating on the pairing of the Euro and U.S. dollar and just under a quarter on the British pound paired with the U.S. dollar. Only a fifth of the trades involve the Japanese yen -down considerably from during the Toyko session, in which it took up three-quarters of the trading.
Clearly, where you are and when you are trading is important – and you’re going to need to think locally. Wherever the focus of the market is at any particular time during the day is also going to be where the focus of the trading is centered. It might be a poetic way of putting it, but Forex trading really is all about where the sun is shining – and who it’s shining on.
You will, therefore, need to study your options and decide what time of day for you is going to complement your trading the best. More markets open means more active trading and therefore more liquidity on the currencies involved in those markets.
For most beginners, the most complicated aspect of Forex trading is not the volatility of the markets, but understanding how currency trading actually takes place and how to dip your oar into its waters.
The common mistake is to assume that it’s a simple form of trading because it’s top level – you’re not dealing in what money can buy, you’re dealing in the money itself. However, the market does not actually work with individual currencies.
Instead, it works with what is known as “currency pairs”. While there are only around 180 currencies in the world, these can be paired in literally thousands of different ways because, as we’re about to find out, it matters which order they are paired in and therefore whether you are dealing with GBP/USD or USD/GBP.
For instance, you might be working with the British pound and the U.S. dollar, a pair referred to as GBP/USD. You could be working with the New Zealand dollar and the U.S. dollar together, which would be referred to as NZD/ USD.
Along with the pairings is the meaning associated with their order. It does, indeed, a matter which currency is listed first in a pair and which is listed second.
The first currency listed in the pairing is the “base currency”. It always represents a total of one and therefore is the stable base on which a trade is found. The base currency is used to figure out the answer to, “One of these equals X amount of that”. In other words, if GBP is the base currency, one British pound is equal to X yen, X Canadian dollars and so on.
The second currency listed in the pairing is the “quote currency”, and this is the one that alters to reflect the relationship between the two currencies in the pairing. The higher it is, the most of that second currency you will receive if you trade it with some of the base currency. For instance, if one GBP equals 1.4 USD, then for every British pound you trade you will receive $1.40 in American dollars.
This is where the jargon starts to get complicated. When you trade on the Forex market, you will either “bid” or “offer/ask”.
- To bid means that you are selling the base currency on the left side of the pairing in exchange for the quote currency on the right-hand side of the pair. In other words, you are buying the base currency and selling the quote currency.
- To offer/ask, you will buy the base currency on the left of the pair in exchange for selling the quote currency on the right-hand side of the pair. In other words, you are selling the base currency and buying the quote currency.
It’s absolutely crucial to memorize the difference between bids and ask because what you’ll get out of a trade depends entirely on the relationship between the two currencies. Get it the wrong way round and you’ll make a loss where you thought you were making a profit.
You will also need to know that the Forex market specifically deals with how the value of the two currencies in a pair are changing. If the value of one is increasing, however, it doesn’t necessarily mean that the other is decreasing. Though the two are paired in the trade, they are not solely going to be influenced by each other – you are simply removing two small cogs from the giant machine and holding them up against each other at a particular moment in time. What’s happening in the rest of the machine (and, indeed, what’s happening to that cog itself) is also going to influence its value.
The speed at which the two currencies are changing is also not always going to match. Just because the U.S. dollar is increasing fast in value doesn’t mean the Canadian dollar is increasing at the same rate. This is where knowledge of the currency market comes into play. Simply looking at the pairing isn’t going to tell you much about how it’s going to look later in the day when certain markets close. You will need to look at the overall trend of the individual currencies to figure that out.
Obviously, the clearest trades are going to happen when one currency is weakening against the other, allowing you to buy or sell the weak currency at a great price. However, you can also make a profit when both are strengthening, if they are doing so at different speeds.