What moves the Forex Market?

Currency movements, as in any other market, are driven by two main forces: supply and demand.

Think for instance of the car selling business in a small village. At first there will be just a few car vendors. As the village grows, more and more people will need cars to satisfy their needs, pushing up the demand for cars. At this point the demand for cars is greater than the quantity supplied, pushing prices up. As people realize selling cars is such a great business opportunity, more people will be attracted the car business and will start selling cars. As this happens, more and more cars will be available, pushing up the supply of cars. At some point, the supply will be greater than the demand of cars. If car vendors don't lower their prices, they won’t be able to sell their cars, so they are forced to lower them.

The same goes for currencies, when a currency increases its value, the demand is greater than its supply. When a currency decreases its value, its supply is greater than its demand.

What factors influence the supply and demand of one currency?

The two main factors that influence the movements in one exchange rate are:

1. The capital flows

2. The trade flows

These two components constitute what economics call balance of payments. The main purpose of the balance of payments is to quantify the demand and supply for a currency of one country, over a period of time.

Balance of Payments = Capital Flows + Trade Flows

A negative balance of payments indicates that the capital leaving the country is greater than the capital entering the country (not much demand)

A positive balance of payments means that the capital entering the economy is greater than the capital leaving the economy (increasing demand of the domestic currency)

Theoretically, a balance of payments equal to zero indicates the right value of one currency.

Capital Flows

Capital flows is the net quantity of currency traded (bought or sold) through capital investments.

The capital flow can be divided into: physical flows and portfolio investments.

Physical Flows - They happen when foreign entities sell their local currency and buy foreign currency to make foreign direct investments (for joint ventures, acquisitions, etc.) When the volume of this kind of investment increases, it reflects the good shape and health of the economy where it is invested.

Portfolio investments - These are investments made on global markets, variable and fixed income market investments (Forex, stocks, T-bills, etc.) An example of portfolio investments is when a hedge fund in Japan invests in the US equity markets.

Trade Flows

Trade flows measure the net exports and imports of a given country. These two components (exports and imports) constitute what economists call the current account.

Countries that have a positive current account (exports greater than imports) are more likely to depreciate their currency; this way the consumer abroad will perceive the foreign currency to be cheaper (and can purchase more goods and services). A good example is Japan.

On the other hand, countries that have a negative current account (imports greater than exports) are more likely to appreciate their currency since they need to sell the local currency and buy foreign currency in order to purchase goods and services. United States is an example of a net importer country.

Purchasing Power Parity (PPP)

This theory states that exchange rates are determined by the relative prices of a similar basket of goods in different countries. In other words, the ratio of prices of a basket with similar goods of two countries should be similar to the exchange rate.

If a Personal Computer in Australia costs AU$1,500, and the same PC in United States costs US$1,200. According to the PPP, the exchange rate AUD/USD would be 1.2500 (1,500/1,200).

If the exchange rate was at 1.3000 (or above 1.2500) it states that in the long run it will decrease its value until 1.2500 is reached. On the other hand, if the exchange rate was at 1.0500 (or below 1.2500) the exchange rate in the long run will increase its value until 1.2500 is reached.

This example is just illustrative, in the real world it is not just one good, but a basket of goods.

The major weakness of this theory is that it assumes that there are no costs related to the trade of goods (tariffs, taxes, etc). Another weakness is that it does not consider other factors that might influence the exchange rate (i.e. interest rates etc)

Modern monetary theories include the capital markets to the PPP theory arguing that capital markets have less costs of trading.

Interest Rate Theory

This theory states that interest rates differentials neutralize the increase or decrease of any currency against another currency. Therefore there are no arbitrage opportunities.

For instance if the interest rate of Australia is 6.25% and the interest rate of United States is 3.5%, then the AUD should depreciate against the USD, so that there are no arbitrage opportunities.

There are also other theories that try to explain the value of a currency pair. But as with every theory, they are based on assumptions that may or may not be present in the real world.

Fundamental Analysis

There are basically two ways to approach the markets: technical and fundamental analysis.

Technical Analysis: studies the past behavior of price of any given instrument as an attempt to forecast its future behavior. 

Fundamental Analysis: the focus of which is to study the economic, social and political forces that drive the supply and demand of currencies.

Which one is the best approach?

There has been an ongoing debate on which approach is better. Sometimes technicals nail it down, but for some others the fundamentals do it. The truth is, there is no clear answer to this question. And I would say that the answer lies within each one of us. That is, use the one that fits you, the one that works better for you.

If you are a short term trader, you will probably prefer the technical approach, since it concentrates on price behavior. On the other hand, fundamental changes take longer to be visible in the charts so it will be better to adopt a fundamental approach.

Today, many traders and investors use both approaches, so they can have a clearer picture of any given situation.

In this lesson we will go through Fundamental Analysis.

The topics covered in this section are:

1- What Moves the Forex Market: We will try to explain what makes currency pairs fluctuate; we will see several theories about how currency pairs are valued.

2- Fundamentals by Country: A list of the important news announcements for each country (majors), how important they are to the market, effects they produce on some currency pairs etc.

3- Other Economic Indicators: In this section we will review other (not so important) economic indicators that under some circumstances can have a larger than usual impact to the Forex market.

4-Other Fundamental Factors that Influence the FX Market: We will explain the role of political and social crisis, and the statements of important people in the FX Market.

5- Gold and Oil and their Relationship to the Forex Market: Getting to know how each of these two commodities are related to the Forex market can help you make better decisions.

6- Common Practices Used by Fundamentalists: We will mention some practices used fairly often by fundamental traders.

7- Some Thought on News and Event Trading: “Trading the news” has become a very popular style of trading in the last few years; we will analyze its advantages and disadvantages.

Price Action Forex Trading Strategies

• My core trading philosophy
My personal trading style is completely focused on “reading” the price movement of the market in its “natural” form, or in other words: “Price Action Trading Analysis’”. I don’t use any indicators or confusing systems; I simply trade from a naked price chart.
I have an arsenal of powerful price action patterns that I look for within the structure of the market. For example, if a market is in an uptrend, I will be looking for price to retrace to a support level within the uptrend, this is what I consider a “value” area, and I will then watch patiently for one of my price action signals to confirm a trade entry. Whilst the majority of my trades are following the trend of the market, I will occasionally take a counter-trend trade setup or a range-bound market trade.
Regardless of what direction I am trading, the main thing I am looking for is “obvious” price patterns forming at “key” levels in the market. When I see one of my trade setups has formed at a key level in the market, I consider this a green-light confirmation signal for me to enter a trade. Given that there are only a ‘few’ good signals each week, I spend a lot of time just waiting patiently for a trading opportunity. I wrote a very popular article last year on the concept of being a patient trader waiting to ambush trading opportunities, you can read that article here: “Trading Like A Sniper “.
In summary, my trading approach is largely built on finding multiple pieces of “evidence” that work together to confirm an entry into the market. Professional traders call this “trading with confluence”. In regards to my price action trading strategies, trading with confluence means looking for multiple factors on the chart that support the case for entering on a price action signal that has formed.
Overall, my trading strategy might appear quite simple, and frankly it is, but as I said before; simple is better in Forex trading. I’ll be honest with you guys, must unprofitable or beginner traders are attracted to overly-complex trading methods and this is usually what leads to their eventual failure. As a trader who has “been around the block” a few times, I know what has worked for me in the markets, and I feel it’s my job to convey that information to other traders. Thus, my main priority as a trading mentor is to teach my students how to trade with a simple forex trading strategy.

The Psychology of Forex Trading(3)

 

• How to obtain and maintain an effective trading mindset
Obtaining and maintaining an effective Forex trading mindset is the result of doing a lot of things right, and it usually takes a conscious effort on the trader’s behalf to accomplish this. It’s not necessarily difficult to achieve, but if you want to develop an effective trading mindset, you have to accept certain facts about trading and then trade the market with these facts in mind…

You need to know what your trading strategy (trading edge) is and you need to master it. 
 You have to become a “sniper” in the market instead of a “machine gunner”, this involves knowing your trading strategy inside and out and having absolutely NO questions about what the market needs to look like before you risk your hard-earned money in it.

You need to always manage your risk properly.
  If you do not control your risk on EVERY single trade, you open the door for emotional trading to take hold of your mind, and I can promise you that once you start down the slippery slope of emotional Forex trading, it CAN be very hard to stop your slide, or even recognize that you are trading emotionally in the first place. You can largely eliminate the possibility of becoming an overly-emotional trader by only risking an amount of money per trade that you are 100% OK with losing. You should EXPECT TO LOSE on any given trade, that way you are always aware of the very real possibility of it actually happening.

You need to not over-trade. 
Most traders trade way too much. You need to know what your trading edge is with 100% certainty and then ONLY trade when it’s present. Once you start trading just because you “feel like it” or because you “sort of” see your trading edge…you kick off a roller coaster of emotional trading that can be very hard to stop. Don’t start over trading and you will likely not become an emotional Forex trader.

You need to become an organized trader.
  If there is something that is the “glue” that holds all of the points I’ve discussed in this part together, it is being an organized trader. By organized, I mean having a trading plan and a trading journal and actually using both of them consistently. You need to think of Forex trading like a business instead of like a trip to the casino. Be calm and calculating in all your interactions with the market and you should have no problem keeping the emotional trading demons at bay.

The Psychology of Forex Trading(2)

• What emotions should you watch for in yourself while trading?
To be a little bit more specific about “emotional” trading, let’s go over some of the most common emotional trading mistakes that traders make:

1-Greed – 
                       There’s an old saying that you may have heard regarding trading the markets, it goes something like this: “Bulls make money, bears make money, and pigs get slaughtered”. It basically means that if you are a greedy “pig” in the markets, you are almost certainly going to lose your money. Traders are greedy when they don’t take profits because they think a trade is going to go forever in their favor. Another thing that greedy traders do is add to a position simply because the market has moved in their favor, you can add to your trades if you do so for logical price action-based reasons, but doing so only because the market has moved in your favor a little bit, is usually an action born out of greed. Obviously, risking too much on a trade from the very start is a greedy thing to do too. The point here is that you need to be very careful of greed, because it can sneak up on you and quickly destroy your trading account.
2-Fear – 
                  Traders become fearful of entering the market usually when they are new to trading and have not yet mastered an effective trading strategy like price action trading (in which case they should not be trading real money yet anyways). Fear can also arise in a trader after they hit a series of losing trades or after suffering a loss larger than what they are emotionally capable of absorbing. To conquer fear of the market, you primarily have to make sure you are never risking more money than you are totally OK with losing on a trade. If you are totally OK with losing the amount of money you have at risk, there is nothing to fear. Fear can be a very limiting emotion to a trader because it can make them miss out on good trading opportunities.

3-Revenge – 
                           Traders experience a feeling of wanting “revenge” on the market when they suffer a losing trade that they were “sure” would work out. The key thing here is that there is no “sure” thing in trading…never. Also, if you have risked too much money on a trade (starting to see a theme here?), and you end up losing that money, there’s a good chance you are going to want to try and jump back in the market to make that money back….which usually just leads to another loss (and sometimes an even larger one) since you are just trading emotionally again.

4-Euphoria – 
                                While feeling euphoric is usually a good thing, it can actually do a lot of damage to a trader’s account after he or she hits a big winner or a large string of winners. Traders can become overly-confident after winning a few trades in the market, for this reason most traders experience their biggest losing period’s right after they hit a bunch of winners in the market. It is extremely tempting to jump right back in the market after a “perfect” trade setup or after you hit 5 winning trades in a row…there’s a fine line between keeping your feet grounded in reality and thinking that everything you do in the markets will turn to gold.
Many traders enter into a tailspin of emotional trading and losing money after they hit a string of winners. The reason this happens is because they feel confident and euphoric and forget about the real danger of the market and that ANY TRADE CAN LOSE. The key to remember here is that trading is a long-term game of probabilities, if you have a high-probability trading edge, you will eventually make money over the long-term assuming you follow your trading edge with discipline. But, even if your edge is 70% successful over time, you could still hit 30 losing trades in a row out of 100….so keep this fact in mind and always remember you never know WHICH trade will be a loser and WHICH will be a winner.

The Psychology of Forex Trading(1)

The Psychology of Forex Trading

 

I have been a trader long enough to know a thing or two about how most people think while trading the market. You see, most people experience similar thinking patterns and emotions as they trade the markets, and we can learn many important things from the differences in the way losing traders think and the way winning traders think.
I would be lying to you if I said that success in the Forex markets depends entirely on the system or strategy you use, because it doesn’t, it actually depends mostly on your mindset and on how you think about and react to the markets. However, most Forex websites trying to sell some indicator or robot-based trading system won’t tell you this, because they want you to believe that you can make money in the markets simply by buying their trading product. I prefer to tell people the truth, and the truth is that having an effective and non-confusing trading strategy is very important, but it’s only one piece of the pie. The bigger portion of the pie is managing your trades correctly and managing your emotions correctly, if you do not do these two things you will never make money in the markets over the long-term.
• Why most traders lose money
You have probably heard that most people who attempt Forex trading end up losing money. There’s a good reason for this, and the reason is primarily that most people think about trading in the wrong light. Most people come into the markets with unrealistic expectations, such as thinking they are going to quit their jobs after a month of trading or thinking they are going to turn $1,000 into $100,000 in a few months. These unrealistic expectations work to foster an account-destroying trading mindset in most traders because they feel too much pressure or “need” to make money in the markets. When you begin trading with this “need” or pressure to make money, you enviably end up trading emotionally, which is the fastest way to lose your money.

How to Make a Forex Trading Plan (2)

Trading plans contain written guidelines of what a trader will do and look for as well as images of trade setups
Your trading plan should contain a written description of what you will do in the markets. This includes things like what your trading edge is, how you trade it, when you trade it, what time frames you trade (I prefer daily Forex chart trading), your strategy for risk management and profit taking, and your overall goals as a trader. You should also include images of your trading edge setups, so that you are constantly reminded of what an “ideal” setup looks like. Eventually, after you follow your written guidelines and “ideal” trade setup images long enough, you will burn them into your brain to the point of knowing exactly what you are looking for in the market, which will work to build your confidence as a trader.
• Trades planned in advance and ‘anticipated’ work best
One of the main reasons to create a Forex trading plan is because pre-planning your trades and pre-determining what you are looking for in the markets is the best way to profit over the long-run. You will never be more objective and calm then when you are NOT in the market, so if you can plan out all your trades when you are not in the markets, you will be totally uninfluenced by market variables when you are in a trade, and this will work to protect you from becoming an emotional Forex trader.
• Be patient and wait for the conditions of a plan to unfold – don’t force the issue
Patience is perhaps the most important virtue that a Forex trader can possess. When you are a patient trader it means you know what you are looking for in the markets and you wait for your trading edge to appear before you execute a trade. Trading in this manner eliminates many losing trades that are the result of trading emotionally…or without patience. A large part of trading, and perhaps the largest part, is simply waiting for an “ideal” price action setup or other trade setup to form in the market. Traders who don’t wait for an ideal setup to form, end up losing their money quickly because they negate their trading edge and are simply gambling instead. Make sure you stress the importance of patience in your trading plan, this way you will be reminded every time you read it why being a patient trader is so important to making money in the Forex market.