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The appeal of trading currencies over other asset classes includes excellent market liquidity and 24-hour markets for five days a week. But it’s key for traders to understand the product and market and ensure they have a stringent risk and money management strategy in place.
Currency trading is a relative game, whereby you are playing one currency against another. If you feel the Australian dollar will appreciate against the US dollar (for example, you think the AUD/USD exchange rate will go from $0.7100 to $0.7200) you buy the pair. That’s known as ‘going long’. The directional bias is expressed through the first named currency (in this case AUD), but your profit and loss is derived in the second named pair (in this case USD).
The role of technical analysis in FX trading
Technical analysis has a large role to play in FX trading, and should be considered as a risk management tool even if trading is based on fundamental analysis. It is an integral part of identifying trends, momentum, risk/reward and entry and exit points. There’s also the study of price action, which many confuse with technical analysis. This involves the likes of candle stick analysis and the visualisation of supply and demand, which of course are at the very heart of trading.
Essentially a chart is a road map of supply and demand, amalgamating the activity of every single market participant at any given time. Markets are highly effective aggregators of news and therefore charts can show how markets view current issues such as politics, potential monetary policy changes by a central bank, the underlying economy or overall sentiment at a macro level. Of course positioning and other capital flows also play a big part in short-term moves.
Understand the key players in forex markets
There are many players in the FX market at any one time. Exporters, leveraged funds, macro-focused funds, real money accounts (insurance and life funds), retail traders and reserves managers (who transact on behalf of central banks) are the key players. This diverse range of participants ultimately means there are many opinions and varying thought processes in the market, all with different time frames and tolerance to risk. A great way to rationalise this flow and bring it all together is through price action and technical analysis.
Using one’s gut feeling to form a trading view can often prove wrong, so let price guide you. It’s perfectly OK to be wrong, just as long as you don’t stay wrong and this is where discipline plays a big part. Successful traders will let profits run and cut their losses as soon as they can. Emotion is the number one reason traders lose money. Some traders will target a higher win/loss ratio, in which case they will not have to worry so much about letting profits run as far, but importantly there isn’t really one right or wrong strategy as long as the maths provides an edge.
Fundamentally, the forex markets take time to truly comprehend and harness, and truth-be-told even the most seasoned traders are always learning. Currencies are essentially driven by global capital flows and the perception of the value of money. However, there is so much more that goes into a currency valuation, or what many will label a ‘fair value’.
This so-called ‘fair value’ in the FX market is highly subjective and there really is no universally recognised text book equation which we can adhere to. Compare this to equities, where the textbook ‘fair value’ is calculated as the ‘net discounted cash flow of future earnings’, while in the bond market this is the ‘net discounted cash flow of future interest payments and principal’. In theory this makes FX trading all the more interesting, but it also highlights just how important risk and money management are.
What drives a currency?
Each currency will have external influences they are more sensitive to, and what drives the Australian dollar, for example, will often be different from that of the British pound, Japanese yen, US dollar or the euro. Timeframe is important and the different influences change over a short, medium and longer-term perspective:
- Short-term considerations: risk appetite, volatility, moves in commodity prices, interest rate pricing and positioning
- Medium-term considerations: current account surplus/deficit, fiscal policy, political risk, bond yield spreads (or differentials) and relative economic growth
- Longer-term considerations: purchasing power parity, net foreign assets and terms of trade.
Of these, the single most important variable trader is volatility. Volatility directly affects risk and money management, whereby range expansion will generally mean placing a stop further from entry and taking position sizing down. Increased volatility will often see demand for currencies of countries whose economies run a current account surplus, such as the Japanese yen, euro or Swiss franc. These nations are global net creditors and in times of stress, funds will repatriate to their currencies.
In times of lower volatility, tighter price ranges and heightened risk appetite, then traders will tend to buy currencies where yields in their bond market are higher - the Australian and New Zealand dollars and many emerging market currencies for example. This is known as the ‘carry trade’ and traders will fund this position by borrowing (funding) in a lower yielding currency.
There are many other trading strategies used by currency traders. This may all sound daunting, but traders need to find a strategy and trading plan that is right for their individual circumstance. Find a plan that provides an edge, whether that is trading currencies using fundamentals, technicals or a combination of both.