FOREX trading strategies

From CEOpedia | Management online

The foreign exchange markets, or forex (or FX), are where currencies are traded. With an average daily turnover of approximately $2 trillion - a value which is many times the total amount of the volume traded in the US stock market - it is the largest and fastest-growing financial market in the world. There is no central exchange or hub where orders are processed in the forex market, which instead consists of a global, connected network of currency buyers and sellers (Cheng, 2010). The forex is open 24 hours a day in the weekdays (Gallo, 2014). It opens on Sunday at 5 p.m. local time in New York City, and it closes on Fridays at 5 p.m to then resume trading again 48 hours later to begin a new week. This capability is called OTC, Over The Counter (Gallo, 2014).

The major currencies exchanged in the forex are reported in the list below (Gallo, 2014):

  • USD (U.S. Dollar)
  • EUR (Euro)
  • GBP (British Pound)
  • YEN (Japanese Yen)
  • CHF (Swiss Franc)

These currencies form together the most popular 10 trading pairs. They then become 24 if one includes the other following currencies: CAD (Canadian Dollar), NZD (New Zealand Dollar) and AUS (Australian Dollar). Moreover, depending on the broker an investor operates on, more Forex pairs are included, as there are more currencies available. For example: the Singapore Dollar SGD, the Hong Kong Dollar HKD and the Danish Krone DKK (Gallo, 2014).

Trading Strategies

In trading, there are two basic approaches for the study of the currency market: fundamental analysis and technical analysis. The fundamental analysis focuses on the "why", and so what causes the price fluctuation (for instance: social and political news, economic, and other connected information), while the technical analysis is focused especially on the price fluctuation. Conclusions may differ if basic and technical evaluations are used in parallel (Brtka, 2011).

Technical analysis, which uses charts and technical indicators to estimate future price development, is the study of market dynamics. Mathematical computations based on the present price, prior prices, and/or volumes generate technical indicators. The values of such indicators are used to predict likely price changes (Brtka, 2011). The three following axioms form the foundation of technical analysis:

  • market movement considers everything
  • the prices move with the trend
  • the history repeats itself

Three premises form the foundation of technical analysis. The first holds that any aspect that affects price, regardless of whether it is economic, political, or psychological, has been considered and is shown in the price chart. Every variation in pricing is the result of external variables changing. The second premise is that the price fluctuation is a result of a trend. The third premise is that past successful models would likely continue to be so in the future. This fact is based on human psychology, which hasn't evolved all that much over time (Brtka, 2011).

Beside the analysis of the FOREX market, there are some strategies that can be used to trade and are reported below.

Market Sentiment

The most significant aspect that influences the currency market is market sentiment, which is basically what the majority of the market thinks or feels like regarding the current market situation (Cheng, 2010). When forming opinions in the forex market, there are three basic categories of sentiment:

  1. bullish - positive sentiment, upward price movement
  2. bearish - negative sentiment, downward price movement
  3. confused

These sentiments are influenced by many factors such as: interest rates, economic growth and geopolitical risks. Basing on these factors, the broker should understand in what way to open its position (long or short) and, with the aid of the technical analysis, understand when to open the position (Cheng, 2010).

Trend Riding

Regardless of the time period you are using to view the market, forex tends to have quite trending markets; trends frequently develop on hourly, daily, or weekly charts (Cheng, 2010). In terms of temporal measurement, there are primarily three different sorts of trends (Cheng, 2010):

Types of trend
primary (long-term) long period of time - between 2 years and 8 months
intermediate (medium-term) range between 1 and 8 months
short-term range between few days and 2 months

Moreover, the currency trading pair can take three different trend directions:

The idea behind this strategy is simple, as it focuses on riding the current trend. Therefore, basing on the 3 types of trend one can see in the charts and its direction, a broker should follow the current trend (Cheng, 2010).

Carry Trade

Large financial institutions including hedge funds, pension funds, and banks all strongly favor the carry trade strategy as a way to trade the world's FX market. The potential for generating interest is a special feature that traders of all sizes may benefit from, which is what makes carry trades so intriguing (Cheng, 2010). A carry trade is a "long-term fundamental trading strategy" that entails selling one currency with a low interest rate and using other personal funds to purchase another currency with a higher interest rate in the anticipation that the higher-interest currency will appreciate in value relative to the lower-interest currency (Cheng, 2010).

Carry traders who hold these positions overnight are paid interest on the currency they have a long position open in, and are required to pay interest on the currency they have an open position but in short. The intriguing feature of this technique is that it allows the broker to profit from the spread or divergence in interest rates, which, when leveraged, can amount to a sizable sum (Cheng, 2010). To give an example of currencies with different interest rates:

  • high interest rates: CAD, NZD, GBP, AUD.
  • low interest rates: JPY, CHF.

Automatic Trading

Automatic trading software programs make the process of trading on foreign exchange market faster than doing it manually as they automatically monitor numerous parameters, moreover, they are capable of making decisions in real time. Using such software trading ways of investing is key to minimize the influence of emotions, especially while taking the decision to open or not a position. It also takes away all the possible mistakes that could be done due to low concentration on the market at the moment of the decision (Brtka, 2011). Real-time information, software, and modern technology do not guarantee profitable trading outcomes. Technology speeds up the trading process and increases information availability, but finding the right strategy to use the information at hand and to make the right judgments is still essential for effective trading outcomes (Brtka, 2011).

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Author: Claudio Mameli