Trading the Forex Fundamentals

Strategies for Trading the Forex Fundamentals

There are several different strategies to trade the Forex Market. This analysis presents four (4) trading strategies based exclusively on fundamental analysis.

What is Forex Fundamental Analysis?

Forex fundamental analysis consists the interpretation of economic, strategic and political factors and aims to forecast the future exchange rate of a Forex pair. These factors may affect directly or indirectly the future demand and the supply of a currency pair.

How Fundamental Analysis can be combined with Technical Analysis

Most Forex traders are seeking opportunities in the currency market by using solely technical analysis tools (such is the MACD Histogram, Pivot Points, Support, and Resistance). Usually, they target profits of 50-200 pips per trade. The problem with this approach is the execution of tens of trades on a daily basis, a factor that increases significantly the trading cost. This analysis presents a different fundamental approach. This does not mean that technical analysis becomes useless, technical analysis will still be useful for determining entry and exit points.

◙ Using Fundamental Analysis to determine what to Buy and Technical Analysis to determine when to Buy

FOUR (4) STRATEGIES TO TRADE FOREX FUNDAMENTAL CONDITIONS

(1) TRADING THE LEADING MONETARY POLICIES OF CENTRAL BANKS

• Trading Style: Long-Trading, Carry Trading
• Time Horizon: 1 month to 6 months
• Capital Leverage: 1:1 to 20:1
• Capital Returns: 10%-200%
• Risk: Medium

Global currencies fluctuate in the long-run according to several fundamental factors (Growth, Inflation, Unemployment etc). All these fundamental factors are taken into consideration by the Central Banks which use an extensive arsenal of tools and techniques in order to control their domestic currencies. The key is always the implementation of the main monetary policy. The exchange rate of a currency pair is a very important factor influencing consumption, growth, and inflation and therefore Central Banks have a great incentive in order to control it. Central Banks can control their currencies mainly by altering the level of the interest rates. There are three main monetary strategies applied by Central Banks: 

Tip: Never Trade Against the Monetary Objectives of a Major Central Bank

 

Trading The Different Monetary Policies of Two Central Banks

It is easy for a Forex Trader to exploit opportunities using the above table. According to this approach, a Forex pair must combine two controversial monetary policies (one hard-currency policy and one flexible currency policy).

(i) Buy one currency that is the subject of a Hard Monetary Policy

(ii) Sell at the same time one currency that is the subject of a Flexible Monetary Policy

It is very easy to trade this situation and you don’t need to monitor your positions all the time, you just need time.

Example: The European Central Bank in December 2014 announced the beginning of a Flexible Monetary Policy while FED was expected to apply a Hard Monetary Policy in middle 2015. The result was that during the period from December 2014 to March 2015 EURUSD plunged about 20%. This is a huge move in less than 4 months. The trading profits achieved were extreme considering a normal capital leverage of 10:1.

Chart: EURSUD 2014-2015

(2) CARRY TRADING / INTEREST RATE DIFFERENTIAL

• Trading Style: Carry Trading
• Time Horizon: 3 months to 1 year
• Capital Leverage: 1:1 to 20:1
• Capital Returns: 10%-100%
• Risk: Low to Medium

Interest rates work as powerful magnets attracting foreign investors to the domestic bonds market, a process also knows as ‘the appetite for high yield’. One of the key features of Forex currencies is that they offer overnight interest rates. But when you are trading a Forex pair you buy one currency and you sell another at the same time, therefore your trade position becomes the subject of two different overnight rates:

(a) The Interest Rate of the currency you buy which works in favor of you

(b) The Interest Rate of the currency you sell which works against you

In other words, traders have a great incentive to buy currencies offering high-interest rates and at the same time to sell currencies offering lower interest rates. That is exactly the ‘job’ of a carry trader. Carry traders tend to buy high-yield currencies such is the Australian Dollar (AUD) and the New Zeeland Dollar (NZD) and at the same time to sell low-yield currencies, such is the Japanese Yen (JPY). Timing is very important here as you should prefer buying pairs that are moving in favorable long-term trends. To highlight the profit potential of this strategy just take a look at the following chart that consists the high-yield NZD against the low-yield JPY during two different long-term periods (2000-2006 and 2008-2014). Now consider that each and every day you were long to NZD and short to JPY you earned also an attractive overnight rate.

Chart: NZDJPY in Two Periods

Note: The Overnight or SWAP rate is credited each day in a trading account exactly at midnight (broker’s server time) except the weekends. On Wednesday the overnight rate is tripled (x3) in order to cover the two lost rates of Saturday and Sunday.

(3) TRADING NEW FUNDAMENTAL CONDITIONS -SWING TRADING

• Trading Style: Swing Trading
• Time Horizon: 1 day to 15 days
• Capital Leverage: 10:1 to 100:1
• Capital Returns: 30%-150%
• Risk: Medium to High

This trading style focuses on opportunities deriving from new fundamental conditions in the Forex Market. These new conditions include mainly economic and political changes but also other types of environmental changes. All factors are important as long as they play an important role to the demand and the supply of an exchange rate. For example, these new fundamental conditions may include a new growth outlook (economic) or the outcome of elections (political) or even technological changes (for example a new shale gas technology can directly affect the Crude Oil price and therefore the Canadian Dollar).

If you are trading these new fundamental conditions timing is everything. You can not afford to lose any time before entering the market. Most of the times you need to open a trade position within a few minutes after an important fundamental change have been announced. The use of technical analysis is also useful. If a new fundamental condition takes place in an already trending market the returns will be even greater. You can use many technical analysis tools in the M30, H1, H4 and D1 charts to define a trending market, for example:

(a) Seeking the existence of the simple rule ‘Price forms a Higher-High while previously has formed a Higher-Low’.

(b) Using the MACD Histogram

(c) Seeking Breakouts of important Support / Resistance Levels

This Swing Trading style has proved very profitable in the past but traders must always place their trades very carefully. The most important issue here is to apply the right rate of leverage and the right stop-loss level. Avoid high capital leverage and narrow stop-loss levels. Give some space to your stop-loss in order to avoid getting stopped-out.

(4) NEWS TRADING

• Trading Style: Intraday Trading
• Time Horizon: 1 minute to 1 hour
• Capital Leverage: 50:1 to 100:1
• Daily Capital Returns: 10%-50%
• Risk: Very High

News trading is a very popular intraday practice. News-traders are using an economic calendar to buy and to sell currencies according to the latest news and updates. News-trading can prove significantly more profitable than other forms of intraday trading. In any case, there are also a lot of important risks associated with this practice. Risks involving higher spreads during news releases, price manipulation by brokers and extreme volatility which may lead to stopped-out positions. The tip here is to control your capital leverage and to place the right stop-loss orders. News-traders need reliable ECN Forex Brokers with minimal slippage and of course state-of-the-art internet technology.

Economic releases include:

(i) Central Bank Decisions, Announcements, and General Comments

(ii) Government Announcements, Decisions and Comments

(iii) Bond Auction Results

(iv) Unexpected (Breaking) News

◙ Trading the Forex Fundamentals –Tips & Strategies

George Protonotarios for CarryTrader.com