What is Forex?
In this beginners guide to forex, we will look over what is forex, common currency pairs, and Forex is an amalgamation of the words “foreign” and “exchange”, and much more.
Forex is the trading of the currencies of various countries around the world on the open market. The Forex markets are open 24 hours a day, five days a week, starting at 5:00PM ET on Sunday, and closing at 5:00PM ET on Friday. Market Sessions There are three major trading sessions that occur each day the Forex markets are open. The first session, which beings at 5:00PM ET is the Asian session. While Asia technically begins at 5:00PM ET, it’s not until 7:00PM ET (the opening of the markets in Tokyo, Japan) that the Asian session really gets moving. The next major session gets underway at 3:00AM ET, which is when the markets in London open up, representing the full swing of the European markets. Finally, at 8:00AM ET, the New York markets open up and the final session – North America – gets underway. The North American markets remain open until 5:00PM ET, when Asia opens its doors once again. There is one final quasi market session that should be mentioned, the “Lony” session. “Lony” is another amalgamation of two words – this one of the words “London” and “New York” and represents the time (between 8:00AM ET and 12:00PM ET) when the biggest markets are both open. This is the time of the greatest volume and volatility in the average trading day.
This visual clearly demonstrates one of the key ADVANTAGES of trading forex, as compared to other asset classes. The market is truly 24-hours a day, 5-days a week, allowing unparalleled flexibility on the part of the trader. Full time job? No problem, trade before or after work. The markets are always ready when you are.
Forex Pairs
Forex traders trade currency pairs, which pits one currency against another – making Forex an exercise in relative strength. Each piece of the pair has a name – an individual currency is either the BASE currency, or the COUNTER or QUOTE currency – depending on the pair. For example, AUD is the base currency in AUD/USD (it comes first), but AUD is the quote currency in EUR/AUD (it comes second).
Reading a Forex Pair
Each pair tells you how much of the quote currency can be bought using 1 unit of the base currency. For example, if EUR/USD is trading at 1.2361 – that means that €1.00 will buy you $1.2361. If that number increases to 1.2381 – then the Euro has gained in strength against the dollar, and 1 Euro can now buy more dollars.
Types of Forex Pairs
There are three general groupings of forex pairs available to traders: the majors, the crosses, and the exotics. While each grouping has their advantages and disadvantages, most traders (especially new traders) are wise to stick with the majors and the crosses, and we won’t get into the exotics here.
The Majors
The most commonly traded currency pairs are known as “the majors”. The majors are generally considered to be the standard dollar and yen pairs – i.e. EUR/USD, GBP/USD, AUD/USD, NZD/USD, USD/CHF, USD/JPY, USD/CAD – plus the yen equivalents of these pairs. These pairs are the most often traded and analyzed pairs in the forex market.
Major Nicknames
Several of the majors also have commonly used nicknames that new forex traders should be aware of. NZD/USD is often referred to as the “Kiwi” in honor of the Kiwi bird found on New Zealand Dollar coins. Similarly, USD/CAD is known as the “loonie” in honor of the loon that graces the Canadian dollar coin (see left). GBP/USD is referred to as “cable”, in reference to the transatlantic cable that connects the two countries. Furthermore, some nicknames are used to refer to a currency generally, like “Aussie” is used to refer to AUD – e.g. “Aussie/Yen”.
The Crosses
The crosses – or cross currency pairs are formed when you combine parts of major pairs with each other. Common crosses include EUR/GBP, AUD/NZD, EUR/AUD, GBP/AUD, GBP/NZD, EUR/NZD, AUD/CAD, NZD/CAD, GBP/CAD, EUR/CAD, and EUR/CHF. The crosses often have a slightly larger spread, and greater volatility, but also offer some great trading opportunities for traders willing to put in the time necessary to understand them. They provide traders will a great deal of variety in their trading.
Carry, what is it and what does it Do?
“Carry” refers to the difference in interest rates between the two currencies in a currency pair, and is one of the major drivers in the foreign exchange market. Carry can be likened to a dividend, paid by a stock, but with two key differences. First, carry is paid daily, and second, carry can be negative – which means carry can actually cost you money, as well as make you money. Currently (and usually) commodity currencies like AUD and NZD have the highest interest rates, while funding currencies, like USD and JPY have the lowest. Therefore, buying AUD against USD and JPY yields a trader a positive carry, whereas selling AUD using USD and JPY yields a negative carry.
Why do we Care about Carry?
There are three major reasons why traders should care about carry. The first is that it adds up. While the amount of money added or subtracted from your account is generally small, holding a position with negative carry for a long period of time will eat into your profits, and must be taken into account when determining your trading plan.
The second reason traders care about carry is because carry helps determine the overall direction of the market. There are cases where the opposite is true, but on average, it indeed does dictate price action. When traders want to buy riskier assets they buy currencies with higher carry, meaning AUD benefits in a risk-on atmosphere, while USD and JPY suffer. The reverse is also true.
Thirdly, interest rates, like dividends dictate if a currency is going to perform well or not. A higher interest rate bodes well for currency performance because a higher carry makes the currency more desirable to traders.
What Affects Carry?
As stated above, carry is the result of different interest rates between currencies. These interest rates, in turn, are affected by a variety of fundamental economic data. Finally, interest rate expectations and economist sentiment also have an effect on carry trade.
Speculation/Expectations
If a market speculator thinks that one central bank will be more aggressive in raising rates than another central bank, the speculator will buy the currency of the more aggressive central bank relative to another in anticipation of a change in the key overnight interest rate. For example, if traders start anticipating that the Reserve Bank of Australia will raise their interest rates, the AUD/USD will start rallying, as will pairs like AUD/NZD – as long as the Reserve Bank of New Zealand is not expected to match the rate increase.
A good gauge of expectations are the BBA Libor (British Bankers Association, London Interbank Offered Rate), which is an average of interest rates outlooks by leading banks with durations ranging from intraday to yearly outlooks.
Another great gauge of expectations is the Credit Suisse overnight index swaps (OIS), which provide a percentage chance of a rate cut by central banks. For reference purposes, it is the difference between the LIBOR and OIS which allows participants to measure sentiment along with liquidity in the market place.
Sentiment
This is one area that is not often talked about but very important to understand. Investors will completely ignore carry and interest rates when market sentiment turns bearish.
One thing that people carry about more than carry trade is safety.
Some examples of fear being injected into the market include contagion (the spread of the European debt crisis), natural disasters, terrorism, or the collapse of major banks, as was seen in 2008.
When investors become fearful, they seek safety. Safety is found in low yielding currencies such as the U.S. dollar, also known as the greenback, and these low yielding investments become the preferred choice of investors.
All in all, interest rate expectations are essential to understanding not only the carry trade, but also understanding how price action is affected by speculation and/or sentiment. It is worth noting, however that while EUR/USD is the most popular pair to trade, currencies such as the Australian dollar are more attractive due to their interest rate appeal.
Fundamental Analysis
Fundamental analysis is the study of the strengths and weaknesses underlying the economy of a nation’s economy, and relating those findings to its currency. In very general, overbroad terms, positive economic data is good for a currency, because economic growth leads to increased interest rates, which leads to a better carry, and traders want to own high yielding currencies.
In addition to the interest rates that currently exist, traders are often focused on interest rate EXPECTATIONS – or where the interest rate will be after the next central bank meeting. These interest rate expectations are equally (or even more) important to determining the strength of a given currency as the current interest rate. These interest rate expectations are highly influenced by economic data releases. These data releases can and often do cause great market volatility, and extreme moves in price. It greatly behooves a trader to know when economic data is being released – please check out our “Key Economic Events”, available on the Sigmanomics.com homepage.
Do Fundamentals Really Matter?
There are a number of traders who believe that fundamental analysis is irrelevant, and that price (technical analysis) is the only relevant aspect to currency trading. Here at Sigmanomics; however, we believe that both technical and fundamental analyses are essentially for a trader to have success. Certainly fundamentals alone are not enough to ensure profitability – a trader also needs a good sense of timing, and a way to determine a profitable strategy and risk / reward ratio. Fundamental analysis alone cannot do it all. Fundamentals do, however, paint a broader picture, and allow traders to maximize their capital by specifically targeting setups that take advantage of fundamental strengths and weaknesses in the underlying global economy.
Key Economic Events
While there are dozens of different, important economic events, this page provides you with a brief introduction into arguably the three most important – employment, inflation, and Central Bank rate decisions.
Non-Farm Payrolls and Employment Data
One of the largest economic data movers in the global financial markets, employment data, but more specifically Non-farm Payrolls serves as a guage of employment in the public and private sector along with the unemployment rate.
Consumer Price Index (Inflation)
Central Bank Decisions
One of the mostly watched central bank interest rate decision is the Federal Open Market Committee (FOMC). The focus of the FOMC are price stability and to promote employment. As the latter is necessary for economic expansion, it is also worth noting the dual mandate which combines a lower combating of consumer prices.
How does this impact the currency market? Higher yields translates into a stronger greenback relative to its counterpart, with the opposite also holding true.
Technical Analysis
Now that we’ve mentioned technical analysis, it’s time to explain exactly what that is. Technical analysis is the study of price charts, in an attempt to forecast where price is headed next. There are dozens of different ways to do technical analysis, but we’ll cover a few basics here, to get you started. First, a note about timeframes: Forex traders use a number of different timeframes for trading – the most common of which being the daily, four hourly, hourly, and 15 minute time frames. These timeframes refer to what period of time each bar, line, or candlestick represents. For example, a new bar appears every hour on an hourly chart.
Forex Chart Types
There are several different types of charts used by forex traders, but the three most popular are the bar chart, the line chart, and the candlestick chart.
The Line Chart
A line chart is a very simple chart that traces the price action using a simple line. The line color shows whether the price increased or decreased during the time period of the line – red for down, blue or green for up. The line chart is the simplest possible chart, and does not provide a lot of additional information. It is not often used by traders, who prefer either the bar chart, or more commonly, the Japanese candlestick chart.
The Bar Chart
The bar chart is a slightly more complicated and more informative type of chart used by forex traders. Bar charts provide more information than line charts, and give a much better indication of the price action within a given time period. In order to demonstrate what additional information is provided by a bar chart, we must take a closer look at the bars that comprise the chart.
Here are two red bars that demonstrate the elements of the bar chart. First, the color of the bar alerts a
trader as to whether price is below or above the close of the previous bar. Second, each bar contains two lines perpendicular to the stem of the bar, the line on the left side of the stem shows the level at which the bar opened, while the line on the right side of the stem shows where the bar closed. The stem shows the entire range of prices covered within the time period of the bar. This allows traders to get a better idea of price action within the bar, which offers bar charts a distinct advantage over line charts. Traders can use this additional information to their advantage. Despite the undeniable advantage bar charts enjoy over their line counterparts, bar charts are still not the favorite tool of forex traders. The final charting option we’re going to discuss provides all the same information as a bar chart, but in an easier to read and understand format. The final charting option is the Japanese Candlestick chart.
So what is technical analysis? We just covered the different types of charts you can use when performing technical analysis, what exactly do you do with these charts? As mentioned above, there are dozens of different ways and methods to perform technical analysis, but we’ll run through the very basics here: trend-lines and horizontal support and resistance. These two techniques lay the groundwork for all other technical analysis, and should be an integral component of any trader’s technical strategy.
Trend-lines
There is a saying in the forex world that “the trend is your friend” – meaning that trading with the trend, or in the direction of the trend is the best way to have winning trades, and to make money. Determining the trend, therefore, is a powerful tool for traders. Trend-lines are the best way to determine the trend. They can serve as resistance, as seen above – you can see where price came up to touch the trend-line, then fall back off it – or trend-lines can be used as support, as seen below, where price stays above the line.
There are two ways to use trend-lines – buy or sell with the hope that the line will continue to support / resist price, or wait until the line breaks, the sell a break to the downside, or buy a break to the upside. Either is a valid strategy, and either offers a trader a well defined risk / reward ratio – an essential element of trading success.
Horizontal Support and Resistance
While trend-lines offer a more dynamic support and resistance, meaning the levels move up and down with the line, horizontal support and resistance levels stay constant. These areas of support and resistance form when price tests a particular level, and finds itself rejected off the level. The rejection could be a result of a number of different factors – both technical and fundamental – but the point of this introduction is to show you the value of these levels, and demonstrate what they look like.
These two charts show the value of horizontal support and resistance. Price tested the same level many times, offering an opportunity to buy against the support, or sell against the resistance. When the key support levels finally broke, another great trading opportunity occurred – with price falling extensively over the following candles. These examples illustrate the two different ways to use horizontal support and resistance, and the value in doing so.
