đ EDU 3 of 20: Here is What Moves the Forex Market đ
EDU 3 of 20: What Moves the Forex Market?
Hello traders! First of all, I wish you a merry Christmas and a happy holiday season.
Now that markets are closed and liquidity is thin, we have got some time to learn more about what it takes to become a successful Forex trader. In the last educational post (2 of 20), we have covered why you shouldnât rely only on technical analysis in your trading. Thatâs the most common mistake that new traders make! They follow only charts, and trade when they see a trendline breakout, triangle breakout, MA crossover, or any other signal that wonât return consistent profits over the long run.
Professional traders in banks and other large market participants donât trade with technical analysis! We do use technical levels to find appropriate entry and exit levels, but we will never enter into a trade because of a simple trendline breakout! Thatâs why institutional traders make millions in the markets, and the average retail trader loses 90% of its capital within 90 days of trading.
My mission is to teach you how to trade like a professional trader. So, what are my credentials to claim this? I am a full-time profitable trader and follow the markets since 2008, I worked in the trading department and have first-hand experience, and my passion for the markets helped me to gain academic degrees in financial markets (MSc in fundamental analysis of currency markets.)
So, what moves the Forex market? What causes the EUR/USD pair, for example, to move from 1.15 to 1.20? Here are the main determinants in the short-term, medium-term, and long-term.
Short-term determinants:
1. Trend-following behavior and herding effect: Market participants tend to buy into uptrends and sell into downtrends, which accelerates the original moves and causes the trend to continue.
2. Investor sentiment: When investors are bullish on a currency, they tend to buy. When they are bearish, they tend to sell. There are ways to measure investor sentiment in the market, and weâll cover this later in our educational series (hint: We use the futures and options markets to measure investor sentiment)
3. Risk appetite: When investors are willing to take on risk (risk-on), they tend to buy riskier high-yielding assets, such as stocks and high-beta currencies like the AUD and NZD. When they are risk-averse, they tend to park their capital in safe-havens (âFlight to Qualityâ) such as bonds, gold, the JPY and the CHF. If you can measure the current risk appetite, this can help you identify great day trading opportunities.
4. Market positioning: Certain groups of market participants take longer to change their positions, while others are quicker in rebalancing their portfolios. When large players show a tendency to buy a certain currency, we can expect higher prices for the currency in the future. Real money (like pension funds) are less price-sensitive, while smart money (like hedge funds) are more price-sensitive and quicker in identifying new market trends.
Medium-term determinants:
1. Real interest rate differentials: Currencies follow interest rates, and Forex traders are basically interest rate traders. The real interest rate differential between two countries tends to be a leading indicator of future exchange rate movements. The real interest rate represents the nominal interest rate minus the current inflation rate.
We follow the real interest rate differential of 10-year government bonds of respective countries (like between the UK and the US for the GBP/USD pair) to get a hint of where the currency pair is heading to.
2. Monetary and fiscal policy: Changes in monetary and fiscal policy can create strong and long-lasting trends in the Forex market. Usually, a tighter monetary policy will put buying pressure in a currency, while looser monetary policy will exert selling pressure in the currency. Tighter fiscal policy is usually bearish for a currency, while looser fiscal policy (i.e. more public investments) is usually bullish for a currency (at least until more fiscal spending starts to negatively impact a countryâs budget deficit, which is then bearish for a currency!)
3. Trends in the current account: Countries that run a current account surplus (i.e. they export more than they import) often see their currency appreciate (rise in value) because of capital inflows and higher foreign demand for their currency.
A typical example for this is Japan in the 80s and 90s (When the US imported Toyotas, they had to buy Japanese yens to pay for them). Countries that have a current account deficit (i.e. they import more than they export) see capital outflows, which then lead to currency depreciation (fall in value).
Long-term determinants:
1. Purchasing Power Parity (PPP): The PPP is a macro-economic principle that says that different currencies need to have the same purchasing power over time. Letâs say a Porsche costs 100,000 pounds in the UK, and 120,000 USDs in the US. If the current GBP/USD rate is 1.40, a buyer from the UK could exchange 100,000 pounds to 140,000 USDs and buy the Porsche in the US for 120,000 USDs.
Over time, this demand for US dollars will cause the GBP/USD exchange rate to fall towards 1.20, which is the Real Exchange Rate according to the PPP. Of course, the buyer has to take into account import taxes and shipping costs to the UK, as well as the time required to complete the purchase and import the car. We also have to make the assumption that Porsches are the same and have the same built quality in the UK and the US. It can take years until a currency pair finally moves towards its PPP equilibrium level.
Fun fact: The Economist magazine has created the Bic Mac Index, which compares the prices of a McDonaldâs Big Mac in different countries to calculate the PPP exchange rate for different currencies.
2. Terms of Trade: Terms of Trade for a country measures the trends in prices for imports and exports. For example, when oil rises, oil exporting countries will experience a positive trend in their Terms of Trade and likely see their currencies rise in value (take Canada for example.) On the other side, countries that rely on cheap oil will likely see their currencies fall in value when the price of oil rises (India for example.)
In the upcoming educational posts, we'll combine the most important currency determinants into an effective framework used by professional traders: The FIST analysis.
The stuff I deliver here for free is world-class trading education! There isn't anything like this on the world wide web, and you'll learn a full and profitable trading framework (analysis + execution + risk management) used by professional traders!
We are still developing your "Analyst brain", and will then move on to your "Trader brain" (execution) and "Manager brain" (risk and money management) in this fully free 20-part Educational Series!
Upcoming post: Introduction to FIST Trading
Don't forget to FOLLOW and LIKE to receive new posts! Also, if you have any questions, let me know in the comment section below.
Happy holidays again!
Hello traders! First of all, I wish you a merry Christmas and a happy holiday season.
Now that markets are closed and liquidity is thin, we have got some time to learn more about what it takes to become a successful Forex trader. In the last educational post (2 of 20), we have covered why you shouldnât rely only on technical analysis in your trading. Thatâs the most common mistake that new traders make! They follow only charts, and trade when they see a trendline breakout, triangle breakout, MA crossover, or any other signal that wonât return consistent profits over the long run.
Professional traders in banks and other large market participants donât trade with technical analysis! We do use technical levels to find appropriate entry and exit levels, but we will never enter into a trade because of a simple trendline breakout! Thatâs why institutional traders make millions in the markets, and the average retail trader loses 90% of its capital within 90 days of trading.
My mission is to teach you how to trade like a professional trader. So, what are my credentials to claim this? I am a full-time profitable trader and follow the markets since 2008, I worked in the trading department and have first-hand experience, and my passion for the markets helped me to gain academic degrees in financial markets (MSc in fundamental analysis of currency markets.)
So, what moves the Forex market? What causes the EUR/USD pair, for example, to move from 1.15 to 1.20? Here are the main determinants in the short-term, medium-term, and long-term.
Short-term determinants:
1. Trend-following behavior and herding effect: Market participants tend to buy into uptrends and sell into downtrends, which accelerates the original moves and causes the trend to continue.
2. Investor sentiment: When investors are bullish on a currency, they tend to buy. When they are bearish, they tend to sell. There are ways to measure investor sentiment in the market, and weâll cover this later in our educational series (hint: We use the futures and options markets to measure investor sentiment)
3. Risk appetite: When investors are willing to take on risk (risk-on), they tend to buy riskier high-yielding assets, such as stocks and high-beta currencies like the AUD and NZD. When they are risk-averse, they tend to park their capital in safe-havens (âFlight to Qualityâ) such as bonds, gold, the JPY and the CHF. If you can measure the current risk appetite, this can help you identify great day trading opportunities.
4. Market positioning: Certain groups of market participants take longer to change their positions, while others are quicker in rebalancing their portfolios. When large players show a tendency to buy a certain currency, we can expect higher prices for the currency in the future. Real money (like pension funds) are less price-sensitive, while smart money (like hedge funds) are more price-sensitive and quicker in identifying new market trends.
Medium-term determinants:
1. Real interest rate differentials: Currencies follow interest rates, and Forex traders are basically interest rate traders. The real interest rate differential between two countries tends to be a leading indicator of future exchange rate movements. The real interest rate represents the nominal interest rate minus the current inflation rate.
We follow the real interest rate differential of 10-year government bonds of respective countries (like between the UK and the US for the GBP/USD pair) to get a hint of where the currency pair is heading to.
2. Monetary and fiscal policy: Changes in monetary and fiscal policy can create strong and long-lasting trends in the Forex market. Usually, a tighter monetary policy will put buying pressure in a currency, while looser monetary policy will exert selling pressure in the currency. Tighter fiscal policy is usually bearish for a currency, while looser fiscal policy (i.e. more public investments) is usually bullish for a currency (at least until more fiscal spending starts to negatively impact a countryâs budget deficit, which is then bearish for a currency!)
3. Trends in the current account: Countries that run a current account surplus (i.e. they export more than they import) often see their currency appreciate (rise in value) because of capital inflows and higher foreign demand for their currency.
A typical example for this is Japan in the 80s and 90s (When the US imported Toyotas, they had to buy Japanese yens to pay for them). Countries that have a current account deficit (i.e. they import more than they export) see capital outflows, which then lead to currency depreciation (fall in value).
Long-term determinants:
1. Purchasing Power Parity (PPP): The PPP is a macro-economic principle that says that different currencies need to have the same purchasing power over time. Letâs say a Porsche costs 100,000 pounds in the UK, and 120,000 USDs in the US. If the current GBP/USD rate is 1.40, a buyer from the UK could exchange 100,000 pounds to 140,000 USDs and buy the Porsche in the US for 120,000 USDs.
Over time, this demand for US dollars will cause the GBP/USD exchange rate to fall towards 1.20, which is the Real Exchange Rate according to the PPP. Of course, the buyer has to take into account import taxes and shipping costs to the UK, as well as the time required to complete the purchase and import the car. We also have to make the assumption that Porsches are the same and have the same built quality in the UK and the US. It can take years until a currency pair finally moves towards its PPP equilibrium level.
Fun fact: The Economist magazine has created the Bic Mac Index, which compares the prices of a McDonaldâs Big Mac in different countries to calculate the PPP exchange rate for different currencies.
2. Terms of Trade: Terms of Trade for a country measures the trends in prices for imports and exports. For example, when oil rises, oil exporting countries will experience a positive trend in their Terms of Trade and likely see their currencies rise in value (take Canada for example.) On the other side, countries that rely on cheap oil will likely see their currencies fall in value when the price of oil rises (India for example.)
In the upcoming educational posts, we'll combine the most important currency determinants into an effective framework used by professional traders: The FIST analysis.
The stuff I deliver here for free is world-class trading education! There isn't anything like this on the world wide web, and you'll learn a full and profitable trading framework (analysis + execution + risk management) used by professional traders!
We are still developing your "Analyst brain", and will then move on to your "Trader brain" (execution) and "Manager brain" (risk and money management) in this fully free 20-part Educational Series!
Upcoming post: Introduction to FIST Trading
Don't forget to FOLLOW and LIKE to receive new posts! Also, if you have any questions, let me know in the comment section below.
Happy holidays again!
