Advantages of Forex Trading
The foreign exchange market possesses many positive characteristics that make it very different from all other trading markets:
- Complete Market Access – Since the forex market is open and available for access 24 hours per day, there are no limitations on the time frames when trades can be placed. For most forex brokers, the only exceptions occur during the weekend periods and on major holidays.
- Low Fees/Commissions – The forex market is unregulated so brokerage commissions and fees will vary. The vast majority of the market’s forex brokers will make their money on the mark-up spread placed on each currency pair made available for trading. However, the high level of broker competition in the market helps keep these fees/commissions relatively low.
- Limited Rule Restrictions – The forex market is not subject to most of the strict regulations that characterize stock, options or futures markets. This means there are no governmental bodies controlling the daily activities in the global forex market and no restrictions are placed on short-selling activities in the same way that might be seen in stock markets.
- Attractive Leverage Opportunities – Leverage levels in the forex market are generally far greater than the allowances made in global stock markets. Some countries allow leverage levels of up to 500:1, which means traders can command a position size that is 500x larger than the original cash outlay.
Forex Market Characteristics
For investors, the forex market contains additional features that distinctly enhance its potential for trading profitability (when compared to other asset classes):
- Forex traders can profit from changes in the underlying market value of spot exchange rates (which occur almost constantly).
- Forex traders can profit from interest rate differentials that exist between various world currencies (which compound as long as positions are held).
Unlike stock trades, positions that are taken in the forex market have the potential to benefit from interest rate differentials. Specifically, this means traders can sell currencies with low interest rates as a way of funding purchases in currencies with high interest rates. These interest rate payments compound daily (at the close of each market session) and are guaranteed for as long as the interest rate differential remains constant. This forex strategy is widely known as the “carry trade.”
As an example, one carry trading strategy (which was even more popular before the global financial crisis of 2008) involved funding long trades in the British pound or Australian dollar using a short position in the Japanese yen. At the time, the GBP and AUD currencies were both characterized by high interest rate levels while the Bank of Japan was busy enforcing interest rate policy at near-zero levels for several decades.
Establishing long trades in currency pairs like GBP/JPY or AUD/JPY meant capturing high-yielding interest rollover at the close of every market session. Carry trades are still very popular in the forex markets, given their unique ability to guarantee returns outside of the base fluctuations seen in spot prices. For these reasons, most expert forex traders recommend factoring carry value into a long-term strategic approach to the currency market.
Factors Influencing Forex Prices
Of course, even carry trades are affected by the underlying changes in spot prices. So, it’s a good idea for forex traders to have a good understanding of what moves the currency markets. Classical economic factors like supply and demand are always critical as these forces largely influence the bullish/bearish sentiment that surrounds each currency. For example, if central banks or world businesses need to buy the Swiss franc at a faster pace, it’s value is likely to move higher against most world currencies. If there are too many francs circulating through the global financial system, the market value is likely to decline.
Supply and demand dynamics tend to be long-term in nature. However, many forex traders operate on time frames that are much shorter in length. In these cases, relevant price fluctuations are likely to be influenced by economic data reports, which often have the effect of influencing sentiment for days or weeks (rather than months or years). Fundamental analysis in the short-term is usually dictated by economic reports, which include:
- Market Economy Reports: GDP, Consumer Confidence, Monthly Home Sales, Retail Sales, Durable Goods
- Labor Market Trend Reports: Non-farm Payrolls, Monthly Jobs Additions
- Short-Term Labor Market Reports: Unemployment Rate (Monthly), Weekly Jobless Claims
- Manufacturing Reports: Purchasing Managers Index (PMI), ISM Surveys
- Inflation Reports: Consumer Price Index (CPI), Personal Consumption Expenditures (PCE)
- Import/Export Reports: Trade Balance
Of course, these economic reports don’t represent all of the fundamental influences watched by forex traders. Other important events like interest rate decisions by central banks, geopolitical tensions, or major technical moves make up additional factors that affect currency prices and are actively monitored by short-term forex traders.
Reading these economic reports and examining the public commentaries made by central bankers can aid in the process of fundamental analysis. Additionally, these practices can help forex traders attain a better understanding of what actually causes price trends to develop in the market. This is why it’s always a good idea to have economic calendars available, as they can help ensure important data reports are never missed.
Technical Chart Analysis
In addition to fundamental analysis, strategies based on technical chart analysis are critically important for most expert forex traders. Essentially, technical analysis of the forex markets can help traders to better understand trending price activity. Some of the common approaches technical analysis expert traders use in the forex markets include:
- Elliott Wave Theory
- Harmonic Patterns
- Fibonacci Retracement Analysis
- Pivot Points
- Ichimoku Analysis
- Indicators and Oscillators
- Parabolic SAR
- Trend Analysis
- Moving Averages
Expert forex traders will often combine multiple technical analysis techniques as a way of improving objectivity (and making more accurate price predictions before placing trades). There are many different examples of this which could be cited. Some of the most popular technical analysis combinations include the use of Fibonacci retracement studies along with analysis conducted using Elliott Wave Theory, or the use of indicator/oscillator readings in conjunction with Exponential Moving Averages (EMAs). The vast possibilities for alternative combinations are literally endless, so this creates an excellent trading environment for each person to develop their own trading style and unique approach to the forex market.
Developing Your Forex Strategy
The most successful forex traders are the people able to develop an approach to the market that can result in consistent profits over time. Of course, the long-term performance is always more important than winning or losing a few trades in succession. The key to achieving success in forex trading requires each person to devise a system that protects gains and limits losses in all market environments.
Some forex traders will focus on a particular technical indicator while others implement complex systems that combine technical analysis with fundamental analysis to achieve favorable long-term results. Since the forex market is (literally) the largest trading market in the world, the possibilities are essentially endless for all intents and purposes. Most forex experts will recommend backtesting any strategy using a demo trading account before putting real money at risk in live markets.
Trader Summary: Forex Trading Strategies
- The forex market is the world’s largest financial trading environment.
- The forex network is comprised of trading brokers, banks, and other financial institutions. Forex trading markets are open 24 hours a day, five days per week (trading is closed on weekends and major holidays).
- Under these conditions, currencies trade against one another as pairs (i.e. EUR/USD, GBP/JPY, AUD/CHF, etc.). Each currency pair is quoted in percentage points (or “pips”).
- Using a brokerage account, retail traders and buy/sell currencies and make a profit or loss from the results based on future changes in the price difference of each currency pair.
- Currency pairs fluctuate in value based on macroeconomic conditions and the relative strength/weakness of each country involved. Factors like GDP growth, exports, manufacturing, and interest rates are all used in the fundamental analysis of each respective currency.