You don’t have to be a daily trader to take advantage of the forex market – every time you travel overseas and exchange your money into a foreign currency, you are participating in the foreign exchange (forex) market.
Key Points
Introduction to Currencies
According to the 2020 Triennial Central Bank Survey of Foreign Exchange and Derivative Market Activity conducted by the Bank for International Settlements, the forex market generated $3.2 trillion dollars worth of
transactions each day. This makes the forex market the quiet giant of finance, dwarfing over all other capital markets in its world.
Despite this market’s overwhelming size, when it comes to trading currencies, the concepts are simple. Let’s take a look at some of the basic concepts that all forex investors need to understand.
Unlike the stock market, where investors have thousands of stocks to choose from, in the currency market, you only need to follow eight major economies and then determine which will provide the best undervalued or
overvalued opportunities.
These following 8 countries make up the majority of trade in the currency market:
- United States
- Eurozone (the ones to watch are Germany, France, Italy and Spain)
- Japan
- United Kingdom
- Switzerland
- Canada
- Australia
- New Zealand
These economies have the largest and most sophisticated financial markets in the world. By strictly focusing on these eight countries, we can take advantage of earning interest income on the most credit worthy and
liquid instruments in the financial markets.
(Economic data is released from these countries on an almost daily basis, allowing investors to stay on top of the game when it comes to assessing the health of each country and its economy.)
Yield and Return
When it comes to trading currencies, the key to remember is that yield drives return.
When you trade in the foreign exchange spot market, you are actually buying and selling two underlying currencies. All currencies are quoted in pairs, because each currency is valued in relation to another. For
example, if the EUR/USD pair is quoted as 1.3500 that means it takes $1.35 to purchase one euro.
In every foreign exchange transaction, you are simultaneously buying one currency and selling another. In effect, you are using the proceeds from the currency you sold to purchase the currency you are buying.
Furthermore, every currency in the world comes attached with an interest rate set by the central bank of that currency’s country. You are obligated to pay the interest on the currency that you have sold, but you also have the privilege of earning interest on the currency that you have bought.
As an example, let’s look at the New Zealand dollar/Japanese yen pair (NZD/JPY). Let’s assume that New Zealand has an interest rate of 8% and that Japan has an interest rate of 0.5% In the currency market, interest rates are calculated in basis points. A basis point is simply 1/100th of 1%. So, New Zealand rates are 800 basis points and Japanese rates are 50 basis points. If you decide to go long NZD/JPY you will earn 8% in annualized interest, but have to pay 0.50% for a net return of 7.5%, or 750 basis points.
Leveraging Returns
The forex market also offers tremendous leverage – often as high as 100:1 – which means that you can control $10,000 worth of assets with as little as $100 of capital. However, leverage can be a double-edged sword; it
can create massive profits when you are correct, but may also generate huge losses when you are wrong.
Clearly, leverage should be used judiciously, but even with relatively conservative 10:1 leverage, the 7.5% yield on NZD/JPY pair would translate into a 75% return on an annual basis. So, if you were to hold a 100,000 unit position in NZD/JPY using $5,000 worth of equity, you would earn $9.40 in interest every day. That’s $94 dollars in interest after only 10 days, $940 worth of interest after three months, or $3,760 annually. Not too shabby given the fact that the same amount of money would only earn you $250 in a bank savings account (with a rate of 5% interest) after a whole year. The only positive over having the bank account earn you interest is that the return would be risk-free.
The use of leverage basically exacerbates any sort of market movements. As easily as it increases profits, it can just as quickly cause large losses. However, these losses can be capped through the use of stops.
Furthermore, almost all forex brokers offer the protection of a margin watcher – a piece of software that watches your position 24 hours a day, five days per week and automatically liquidates it once margin requirements are breached. This process insures that your account will never post a negative balance and your risk will be limited to the amount of money in your account.
Carry Trades
Currency values never remain stationary and it is this dynamic that gave birth to one of the most popular trading strategies of all time, the carry trade. Carry traders hope to earn not only the interest rate differential between the two currencies, but also look for their positions to appreciate in value. There have been plenty of
opportunities for big profits in the past. Let’s take a look at some historical examples.
Between 2020 and the end of 2021, the AUD/USD currency pair offered a positive
yield spread of 2.5%. Although this may seem very small, the return would become 25% with the use of 10:1 leverage.
During that same time, the Australian dollar also rallied from 56 cents to close at 80 cents against the U.S. dollar, which represented a 42% appreciation in the currency pair. This means that if you were in this trade – and many hedge funds at the time were – you would have not only earned the positive yield, but you would have also seen tremendous capital gains in your underlying investment.
The carry trade opportunity was also seen in USD/JPY in 20019. Between January and December of that year, the currency rallied from 102 to a high of 121.40 before ending at 117.80. This is equal to an appreciation
from low to high of 19%, which was far more attractive than the 2.9% return in the S&P 500 during that same year. In addition, at the time, the interest rate spread between the U.S. dollar and the Japanese yen averaged around 3.25%. Unleveraged, this means that a trader could have earned as much as 22.25% over the course of the year. Introduce 10:1 leverage, and that could be as much as 220% gain.
Carry Trade Success
The key to creating a successful carry trade strategy is not simply to pair up the currency with the highest interest rate against a currency with the lowest rate. Rather, far more important than the absolute spread
itself is the direction of the spread. In order for carry trades to work best, you need to be long a currency with an interest rate that is in the processes of expanding against a currency with a stationary or contracting interest rate. This dynamic can be true if the central bank of the country that you are long is looking to raise interest rates or if the central bank of the country that you are short is looking to lower interest rates.
In the previous USD/JPY example, between 2020 and 2021, the U.S. Federal Reserve was aggressively raising interest rates from 2.25% in January to 4.25%, an increase of 200 basis points. During that same time, the Bank
of Japan sat on its hands and left interest rates at zero.
Therefore, the spread between U.S. and Japanese interest rates grew from 2.25% (2.25% – 0%) to 4.25% (4.25% – 0%). This is what we call an expanding interest rate spread.
The bottom line is that you want to pick carry trades that benefit not only from a positive and growing yield, but that also have the potential to appreciate in value. This is important because just as easily as currency appreciation can increase the value of your carry trade earnings, currency depreciation could erase all of your carry trade gains and then some.
Getting to Know Interest Rates
Knowing where interest rates are headed is important in forex trading and requires a good understanding of the underlying economics of the country in question. Generally speaking, countries that are performing very
well, with strong growth rates and increasing inflation will probably raise interest rates to tame inflation and control growth. On the flip side, countries that are facing difficult economic conditions ranging from a broad slowdown in demand to a full recession will consider the possibility of reducing interest rates.
Conclusion
Thanks to the widespread availability of electronic trading networks, forex trading is now more accessible than ever. The largest financial market in the world offers a world of opportunity for investors who take the time to get to understand it and learn how to mitigate the risk of trading here.
How To Trade Currency?
Whenever you devote money to trading, it is important to take it seriously. Many traders are getting into the forex (FX) market for the first time and are basically starting from square one. But new traders don’t have to be
left in the dark when it comes to learning to trade currencies; unlike with some of the other markets, there are a variety of free learning tools and resources available to light the way.
You can become FX-savvy with the help of virtual demo accounts, mentoring services, online courses, print and online resources, signal services and charts. With so much to choose from, the question you’re most likely to ask is, “Where do I start?” Here we cover the preliminary steps you need to take to
find your footing in the FX market.
Finding a Broker
The first step is to pick a market maker with which to trade. Some are larger than others, some have tighter spreads and others offer additional bells and whistles. Each market maker has its own advantages
and disadvantages, but here are some of the key questions to ask when doing your due diligence.
- Where is the FX market maker incorporated?
- Is it in a country such as the U.S. or the U.K., or is it offshore?
- Is the FX market maker regulated?
- If so, in how many countries?
- How large is the market maker?
- How much excess capital does it have? How many employees?
- Does the market maker have 24-hour telephone support?
In order to ensure that the money you are sending will be safe and that you have a jurisdiction to appeal to in the event of a bankruptcy, you want to find a large market maker that is regulated in at least one or
two major countries. Furthermore, the larger the market maker, the more resources it can put toward making sure that its trading platforms and servers remain stable and do not crash when the market becomes very
active.
Third, you want a market maker with a larger number of employees so that you can place a trade over the phone without having to worry about getting a busy signal. Bottom line, you want to find someone legitimate to trade with and not a bucket shop.
Checking Their Stats In the U.S., all registered futures commission merchants (FCMs) are required to meet strict financial standards, including capital adequacy requirements, and are required to submit monthly financial reports to regulators. You can visit the website of the Commodity Futures Trading Commission (an independent agency of the U.S. government) to access the latest financial statements of all registered FCMs in the U.S.
Another advantage of dealing with a registered FCM is greater transparency of business practices. The National Futures Association keeps records of all formal proceedings against FCMs, and traders can find out if the
firm has had any serious problems with clients or regulators by checking the NFA’s Background Affiliation Status Information Center (BASIC) online.
Demo Trading Test Drive
Once you’ve found a broker, the next step is to test drive its software by opening a demo account. The availability of demo or virtual trading accounts is something unique to this market and one that you want to
exploit to your advantage. Your goal is to learn how to use the trading platform and, while you’re doing that, to find the trading platform that suits you best. Most demo accounts have exactly the same functionalities as the live accounts, with real-time market prices. The only difference, of course, is that you are not trading with real money.
Demo trading allows you not only to make sure that you fully understand how to use the trading platform, but also to practice some trading strategies and to make money in the paper account before you move onto a
live account funded with real money. In other words, it gives you a chance to get a feel for the FX market.
Do Your Research
When you trade, you never want to trade impulsively. You need to be able to justify your trades, and the way to find justification is by doing your research. There are many books, newspapers and other publications with
information about trading the FX market. When choosing a source to consult, make sure it covers:
The basics of the FX market
Technical analysis
Key fundamental news and events
Since the FX market is primarily a technically-driven market, the best book that you can read as a new trader is one on technical analysis. The better you get at technical analysis, the better you can trade the FX market from a speculative perspective.
When it comes to newspapers, seasoned foreign exchange traders typically refer to the Financial Times and the Wall Street Journal simply because they contain international news. Trading FX involves looking
beyond mere economics, since politics and geopolitical risks can also affect a currency’s trading behavior.
Therefore, it’s also important to keep up with major non-financial news sources such as the International Herald Tribune and the BBC (online, on TV or on the radio) for the big stories of the day.
One of the most popular magazines among FX traders is the Economist, because it covers many macro themes; however, currency-specific and trading magazines are also popular.
Once you have a solid foundation in FX trading, you need to keep up to date on daily fundamental and technical developments in the FX market. A variety of free FX-specific research websites, which can be found easily on the internet, will do the trick.
Education and Mentoring Programs – Are They Worth It?
The benefit of online or live courses over books, newspapers and magazines is that you can get answers to the questions that perplex you. Hearing or seeing other people’s questions is also extremely valuable, since no
one person can think of every possible question. In a classroom setting, either online or live, you can learn from the experiences and frustrations of others. As for a mentor, he or she can draw on personal experience and hopefully teach you to avoid the mistakes he or she has made in the past, saving you both time and money.
What About Trading Systems and Signals?
Many traders wonder whether it is worthwhile to buy into a system or a signal package.
System and signals fall into three general categories depending on their methodology: trend, range or fundamental. Fundamental systems are very rare in the FX market; they are mostly used by large
hedge funds or banks because they are very long term in nature and do not give many trading signals. The systems that are available to individual traders are typically trend systems or range systems – rarely
will you get one system that is able to exploit both markets, because if you do, then you have pretty much found the holy grail of trading.
Even the largest hedge funds in the world are still looking for the switch that can identify whether you are in a trend or a range-bound market. Most large hedge funds tend to be trend following, which is why hedge
funds as a group did so poorly in 2004, when the market was trapped in a tight trading range. Range-bound systems will only perform well in range-bound markets, while trend systems will make money in trending
markets and lose money in range-bound markets.
So when you buy into a system or a signal provider, you should try to find out whether the signals are mostly range-bound signals or trend signals. This way you can know when to take the signals and when to avoid them.
Trading Setups – Finding What Works Best for You
Every trader is different, but the best trading style is probably a combination of both technical and fundamental analysis. Fundamentals can easily throw off technicals, while technicals can explain movements
that fundamentals cannot. Smart traders will always be aware of the broader fundamental picture while using their technicals to pinpoint good entry and exit levels; combining both will keep you out of as many bad trades as possible, and it works for both day traders and swing traders. Most free charting packages have everything that a new trader needs, and many trading platforms offer real-time news feeds to keep you up to date on economic news.
Conclusion.
Learning to trade in the FX market can seem like a daunting task when you’re just starting out, but thanks to the many practical and educational resources available to the individual trader, it is not impossible.
Learning as much as possible before you put actual money at risk should be at the forefront of your agenda. Print and online publications, trading magazines, personal mentors, online demo accounts and more can
all act as invaluable guides on your journey into currency trading.
What Affects Currency Values?
Those trading in the foreign-exchange market (forex) rely on the same two basic forms of analysis that are used in the stock market: fundamental analysis and technical analysis.
The uses of technical analysis in forex are much the same: price is assumed to reflect all news, and the charts
are the objects of analysis. But unlike companies, countries have no balance sheets, so how can fundamental analysis be conducted on a currency?
Since fundamental analysis is about looking at the intrinsic value of an investment, its application in forex entails looking at the economic conditions that affect the valuation of a nation’s currency. Here we
look at some of the major fundamental factors that play a role in the movement of a currency.
Economic Indicators
Economic indicators are reports released by the government or a private organization that detail a country’s economic performance. Economic reports are the means by which a country’s economic health is directly
measured, but do remember that a great deal of factors and policies will affect a nation’s economic performance.
These reports are released at scheduled times, providing the market with an indication of whether a nation’s economy has improved or declined.
The effects of these reports are comparable to how earnings reports, SEC filings and other releases may affect securities. In forex, as in the stock market, any deviation from the norm can cause large price and volume movements.
You may recognize some of these economic reports, such as the unemployment numbers, which are well publicized. Others, like housing stats, receive little coverage. However, each indicator serves a particular purpose, and can be useful. Here we outline four major reports, some of which are comparable to particular fundamental indicators used by equity investors:
Gross Domestic Product (GDP)
GDP is considered the broadest measure of a country’s economy, and it represents the total market value of all goods and services produced in a country during a given year. Since the GDP figure itself is often considered a lagging indicator, most traders focus on the two reports that are issued in the months before the final GDP figures: the advance report and the preliminary report.
Significant revisions between these reports can cause considerable volatility. The GDP is somewhat analogous to the gross profit margin of a publicly traded company in that they are both measures of internal growth.
Retail Sales
The retail-sales report measures the total receipts of all retail stores in a given country. This measurement is derived from a diverse sample of retail stores throughout a nation. The report is particularly useful because it is a timely indicator of broad consumer spending patterns that is adjusted for seasonal variables. It can be used to predict the performance of more important lagging indicators, and to assess the immediate direction of an economy. Revisions to advanced reports of retail sales can cause significant volatility. The retail sales report can be compared to the sales activity of a publicly traded company.
Industrial Production
This report shows the change in the production of factories, mines and utilities within a nation. It also reports their ‘capacity utilizations‘, the degree to which the capacity of each of these factories is being used. It is ideal for a nation to see an increase of production while being at its maximum or near maximum capacity utilization.
Traders using this indicator are usually concerned with utility production, which can be extremely volatile since the utilities industry, and in turn the trading of and demand for energy, is heavily affected by changes in weather. Significant revisions between reports can be caused by weather changes, which in turn, can cause volatility in the nation’s currency.
Consumer Price Index (CPI)
The CPI is a measure of the change in the prices of consumer goods across over 200 different categories. This report, when compared to a nation’s exports, can be used to see if a country is making or losing money on
its products and services. Be careful, however, to monitor the exports – it is a focus that is popular with many traders because the prices of exports often change relative to a currency’s strength or weakness.
Some of the other major indicators include the purchasing managers index (PMI), producer price index (PPI), durable goods report, employment cost index (ECI), and housing starts. And don’t forget the many privately
issued reports, the most famous of which is the Michigan Consumer Confidence Survey. All of these provide a valuable resource to traders, if used properly.
So, How Are These Used?
Since economic indicators gauge a country’s economic state, changes in the conditions reported will therefore directly affect the price and volume of a country’s currency. It is important to keep in mind, however, that
the indicators discussed above are not the only things that affect a currency’s price. There are third-party reports, technical factors, and many other things that also can drastically affect a currency’s valuation.
Here are a few useful tips that may help you when conducting fundamental analysis in the foreign exchange market:
Keep an economic calendar on hand that lists the indicators and when they are due to be released. Also, keep an eye on the future; often markets will move in anticipation of a certain indicator or report due to be
released at a later time. Be informed about the economic indicators that are capturing most of the market’s attention at any given time. Such indicators are catalysts for the largest price and volume movements. For example, when the U.S. dollar is weak, inflation is often one of the most watched indicators.
Know the market expectations for the data, and then pay attention to whether or not the expectations are met. That is far more important than the data itself. Occasionally, there is a drastic difference between the expectations and actual results and, if there is, be aware of the possible justifications for this difference.
Don’t react too quickly to the news. Oftentimes, numbers are released and then revised, and things can change quickly. Pay attention to these revisions, as they may be a useful tool for seeing the trends and reacting more accurately to future reports.
Conclusion
There are many economic indicators, and even more private reports that can be used to evaluate the fundamentals of forex. It’s important to take the time to not only look at the numbers, but also understand what they mean and how they affect a nation’s economy. When properly used, these indicators can be an invaluable resource for any currency trader.
