Forces That Drive the Foreign Exchange Markets

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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.

Market Makers

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.

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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.

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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.