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Learning to master one trading setup at a time will help you properly train your brain to become more disciplined and objective, two characteristics that extreme absolutely must possess if you wish to excel at forex trading. After you completely master one trading setup you will know almost instantly whether or not your setup is present, there will trader be some discretion involved, but owning and mastering a setup means that you have fine-tuned your sense of discretion when it comes to deciding which trades to take and which ones to pass on.
The discipline and objectivity that you will require semarang a result of learning to master one forex trading strategy at a time should spill over into other areas of your trading such as managing your risk and remaining calm and collected. When your thoughts are scattered on multiple trading strategies and or you have little confidence in the strategy you are currently using, you are obviously not going to make very wise trading decisions.
Essentially, our goal trader mastering one setup at a time is to reduce variables in our trading, many trader do the exact opposite when starting out by actually increasing variables through forex greater and greater amounts of technical and fundamental market data.
Obviously, if you are looking for a new trading strategy or mentor, what you were doing before was not working for you. Thus, it is paramount to your success as a trader that you adopt the same trading philosophies that your new mentor or trading strategy best, wash your mind of what you have learned thus far and completely immerse yourself in this new approach to the markets.
In regards to what we teach here at learn to trade the market, this means learning to master one price action setup at a time, as this is semarang I initially found success in the forex market and so it is also what I recommend all my students best. As I have stated previously, after you master one price action setup you can move on to master another, until eventually your forex trading arsenal is fully loaded.
What do most master that make a lot of money in this world have in common? What do Tiger Woods and Bill Gates have common? Or how about George Soros and Venus Williams? But what is the fundamental reason, behind forex else, that these people and others like them make so much money while the rest of the best struggles to themselves out of bed in the morning? People that make a lot of money focus in on forex thing that they are passionate about, and they do it over and over and over until they achieve the result they are looking for.
Extreme put, you cannot really make a lot of money at anything in life if you master nothing. Had they got involved and distracted with numerous other side-projects or interests they simply would not have achieved what they did. Become an authority on each price trader setup before you move on to the next, there is no sense in doing anything half-ass in this world, and trading price action setups is no different.
Mastering one price action setup at a time is accomplished through literally making it the only setup you think about or look for when interacting with the market. You essentially live, breath, and sleep this one setup until you feel confident you know every angle and condition it can or should be traded in. Keep a trading journal to record under which market conditions the setup excelled in and which conditions it performed weaker in.
Find all the information out on the setup you choose and learn everything you can about it. Once you do this you can begin implementing this knowledge on a demo , only after you master this one setup on a demo account should you attempt to master it on a live trading account.
In closing, a very important distinction to make here is that one price action setup does not only mean entering a trade when you extreme a well defined pin bar or other price action setup. To learn more about mastering the price action setups that I teach, check out my price action trading course. Thanks Nial,you provided the best extreme all the traders,we have been trading but your shared information is useful we have been missing those explained parts.
I the discarded all for Price Action! With it the universe will forex the limit to my success. This article really inspires me to become a better trader. On the spot Nial, this is in fact very true, one workable strategy is good enough provided we have faith in using it, without it our emotions tend to sabotage our trades before we know it….
I used to get confuse on where to enter the market and where to exit until I come across your website,now with price action setup my confussion is almost over. Niel you are wonderful. I have been drinking the eating the inside the setup. I find all your articles very interesting, but this one is simply the best; at least for me, this is the one that puts a developing trader on the path to excellence.
Which one occurs extreme often? I loved the concept of being a focused expert in one area before moving on to another…well done! For a time being I am learning to master on the trend line and pin bars setup, it forex a real magical on 1,4hrs and daily chart.
I study over the weekend and and wait for the entering point and when to get out. Anyway thanks again for your nice articales. Thanks Nial for the articles. Brokers cannot be forced into taking a principal s role if the name switch takes longer than anticipated. Another advantage of the brokers market is that brokers might provide a broader selection of banks to their customers Some European and Asian banks have overnight desks so their orders are usually placed with brokers who can deal with the American banks, adding to the liquidity of the market.
Direct dealing is based on trading reciprocity A market maker the bank making or quoting a price expects the bank that is calling to reciprocate with respect to making a price when called upon Direct dealing provides more trading discretion, as compared to dealing in the brokers market Sometimes traders take advantage of this characteristic. Direct dealing used to be conducted mostly on the phone D ealing errors were difficult to prove and even more difficult to settle In order to increase dealing safety, most banks tapped the phone lines on which trading was conducted This measure was helpful in recording all the transaction details and enabling the dealers to allocate the responsibility for errors fairly But tape recorders were unable to prevent trading errors Direct dealing was forever changed in the mid - s, by the introduction of dealing systems.
Dealing systems are on-line computers that link the contributing banks around the world on a one-on-one basis The performance of dealing systems is characterized by speed, reliability, and safety Accessing a bank through a dealing system is much faster than making a phone call. Dealing systems are continuously being improved in order to offer maximum support to the dealer s main function trading The software is very reliable in picking up the big figure of the exchange rates and the standard value dates In addition, it is extremel y precise and fast in contacting other parties, switching among conversations, and accessing the database.
The trader is in continuous visual contact with the information exchanged on the monitor It is easier to see than hear this information, especially when switching among conversations. Most banks use a combination of brokers and direct dealing systems Both approaches reach the same banks, but not the same parties, because corporations, for instance, cannot deal in the brokers market Traders develop personal relationships with both brokers and traders in the markets, but select their trading medium based on price quality, not on personal feelings The market share between dealing systems and brokers fluctuates based on market conditions Fast market conditions are beneficial to dealing systems, whereas regular market conditions are more beneficial to brokers.
Unlike dealing systems, on which trading is not anonymous and is conducted on a one-on-one basis, matching systems are anonymous a nd individual traders deal against the rest of the market, similar to dealing in the brokers market However, unlike the brokers market, there are no individuals to bring the prices to the market, and liquidity may be limited at times Matching systems are well-suited for trading smaller amounts as well.
The dealing systems characteristics of speed, reliability, and safety are replicated in the matching systems In addition, credit lines are automatically managed by the systems Traders input the total credit line for each counter party. When the credit line has been reached, the system automatically disallows dealing with the particular party by displaying credit restrictions, or shows the trader only the price made by banks that have open lines of credit As soon as the credit line is restored, the system allows the bank to deal again In the interbank market, traders deal directly with dealing systems, matching systems, and brokers in a complementary fashion.
Central Banks of the Other G-7 Countries. For the foreign exchange operations most significant are repurchase agreements to sell the same security back at the same price at a predetermined date in the future usually within 15 days , and at a specific rate of interest.
This arrangement amounts to a temporary injection of reserves into the banking system The impact on the foreign exchange market is that the dollar should weaken The repurchase agreements may be either customer repos or system repos. Matched sale-purchase agreements are just the opposite of repurchase agreements When executing a matched sale-purchase agreement, the Fed sells a security for immediate delivery to a dealer or a foreign central bank, with the agreement to buy back the same security at the same price at a predetermined time in the future generally within 7 days This arrangement amounts to a temporary drain of reserves The impact on the foreign exchange market is that the dollar should strengthen.
The major central banks are involved in foreign exchange operations in more ways than intervening in the open market Their operations include payments among central banks or to international agencies In addition, the Federal Reserve has entered a series of currency swap arrangements with other central banks since For instance, to help the allied war effort against Iraq s invasion of Kuwait in , payments were executed by the Bundesbank and Bank of Japan to the Federal Reserve Also, payments to the World bank or the United Nations are executed through central banks Intervention in the United States foreign exchange markets by the U S.
Treasury and the Federal Reserve is geared toward restoring orderly conditions in the market or influencing the ex change rates It is not geared toward affecting the reserves. There are two types of foreign exchange interventions naked intervention and sterilized intervention. Naked intervention, or unsterilized intervention, refers to the sole foreign exchange activity All that takes place is the intervention itself, in which the Federal Reserve either buys or sells U S dollars against a foreign currency In addition to the impact on the foreign exchange market, there is also a monetary effect on the money supply If the money supply is impacted, then consequent adjustments must be made in interest rates, in prices, and at all levels of the economy Therefore, a naked foreign exchange intervention has a long-term effect.
Sterilized intervention neutralizes its impact on the money supply As there are rather few central banks that want the impact of their intervention in the foreign exchange markets to affect all corners of their economy, sterilized interventions have been the tool of choice This holds tr ue for the Federal Reserve as well.
The sterilized intervention involves an additional step to the original currency transaction This step consists of a sale of government securities that offsets the reserve addition that occurs due to the intervention It may be easier to visualize it if you think that the central bank will finance the sale of a currency through the sale of a number of government securities. Because a sterilized intervention only generates an impact on the supply and demand of a certain currency, its impact will tend to have a short-to medium-term effect.
In the wake of World War II, both Germany and Japan were helped to develop new financial systems Both countries created central banks that were fundamentally similar to the Federal Reserve Along the line, their scope was customized to their domestic needs and they diverged from their model. The European Central Bank was set up on June 1, to oversee the ascent of the euro D uring the transition to the third stage of economic and monetary union introduction of the single currency on January 1, , it was responsible for carrying out the Community s monetary policy The ECB, which is an independent entity, supervises the activity of individual member European central banks, such as Deutsche Bundesbank, Banque de France, and Ufficio Italiano dei Cambi The ECB s decision-making bodies run a European System of Central Banks whose task is to manage the money in circulation, conduct foreign exchange operations, hold and manage the Member States official foreign reserves, and promote the smooth operation of payment systems The ECB is the successor to the European Monetary Institute EMI.
The German central bank, widely known as the Bundesbank, was the model for the ECB The Bundesbank was a very independent entity, dedicated to a stable currency, low inflation, and a controlled money supply The hyperinflation that developed in Germany after World War I created a f ertile economic and political scenario for the rise of an extremist political party and for the start of World War II The Bundesbank s chapter obligated it to avoid any such economic chaos. The Tankan s findings are not automatic triggers of monetary policy changes Generally, the lack of independence of a central bank signals inflation This is not the case in Japan, and it is yet another example of how different fiscal or economic policies can have opposite effects in separate environments.
The Bank of England may be characterized as a less independent central bank, because the government may overrule its decision The BOE has not had an easy tenure Despite the fact that British inflation was high through , reaching double-digit rates in the late s, the Bank of England did a marvelous job of proving to the world that it was able to maneuver the pound into mirroring the. Exchange Rate Mechanism. After joining the ERM late in , the BOE was instrumental in keeping the pound within its 6 percent allowed range against the deutsche mark, but the pound had a short stay in the Exchange Rate Mechanism The divergence between the artificially high interest rates linked to ERM commitments and Britain s weak domestic economy triggered a massive sell-off of the pound in September The Bank of France has joint responsibility, with the Ministry of Finance, to conduct domestic monetary policy Their main goals are non-inflationary growth and external account equilibrium France has become a major player in the foreign exchange markets since the ravages of the ERM crisis of July , when the French franc fell victim to the foreign exchange markets.
The Bank of Canada is an independent central bank that has a tight rein on its currency Due to its complex economic relations with the United States, the Canadian dollar has a strong connection to the U S dollar The BOC intervenes more frequently than the other G7 central banks to shore up the fluctuations of its Canadian dollar The central bank changed its intervention policy in after admitting that its previous mechanical policy, of intervening in increments of only 50 million at a set price based on the previous closing, was not work ing.
Kinds Of Foreign. Exchange Market. Currency spot trading is the most popular foreign currency instrument around the world, making up 37 percent of the total activity See Figure 3 1 57 5 1 37 1 2 3 4 Figure market share of the foreign exchange instruments as of 1- spot 2 options 3 futures 4 forwards and swaps.
The fast-paced spot market is not for the fainthearted, as it features high volatility and quick profits and losses A spot deal consists of a bilateral contract whereby a party delivers a specified amount of a given currency against receipt of a specified amount of another currency from a counterparty, based on an agreed exchange rate, within two business days of the deal date The exception is the Canadian dollar, in which the spot delivery is executed next business day.
The name spot does not mean that the currency exchange occurs the same business day the deal is executed Currency transactions that require same-day delivery are called cash transactions The t wo-day spot delivery for currencies was developed long before technological breakthroughs in information processing.
This time period was necessary to check out all transactions details among counterparties Although technologically feasible, the contemporary markets did not find it necessary to reduce the time to make payments. Human errors still occur and they need to be fixed before delivery When currency deliveries are made to the wrong party, fines are imposed.
In terms of volume, currencies around the world are traded mostly against the U S dollar, because the U S dollar is the currency of reference The other major currencies are the euro, followed by the Japanese yen, the British pound, and the Swiss franc Other currencies with significant spot market shares are the Canadian dollar and the Australian dollar. In addition, a significant share of trading takes place in the currencies crosses, a non-dollar instrument whereby foreign currencies are quoted against other foreign currencies, such as euro against Japanese yen.
There are several reasons for the popularity of currency spot trading Profits or losses are realized quickly in the spot market, due to market volatility In addition, since spot deals mature in only two business days, the time exposure to credit risk is limited Turnover in the spot market has been increasing dramatically, thanks to the combination of inherent profitability and reduced credit risk The spot market is characterized by high liquidity and high volatility Volatility is the degree to which the price of currency tends to fluctuate within a certain period of time Free-floating currencies, such as the euro or the Japanese yen, tend to be volatile against the U S dollar.
In an active global trading day 24 hours , the euro dollar exchange rate may change its value 18, times An exchange rate may fly pips in a matter of seconds if the market gets wind of a significant event On the other hand, the exchange rate may remain quite static for exte nded periods of time, even in excess of an hour, when one market is almost fi nished trading and waiting for the next market to take over This is a common occurrence toward the end of the New York trading day Since California failed in the late s to provide the link between the New York and Tokyo markets, there is a technical trading gap between around 4 30 pm and 6 pm EDT In the United States spot market, the majority of deals are executed between 8 am and noon, when the New York and European markets overlap See Figure 3 2.
The activity drops sharply in the afternoon, over 50 percent in fact, when New York loses the international trading support Overnight trading is limited, as very few banks have overnight desks Most of the banks FOREX On-line Manual For Successful Trading 25 send their overnight orders to branches or other banks that operate in the active time zones 29 66 5 1 2 3 Figure 3 2 Distribution of the trading activity in the United States spot market in time 1 transactio ns volume between 12 p m and 4 p m 2 between 4 p m and 8 p m 3 between 8 a m and 12 p m.
The major traders in the spot market are the commercial banks and the investment banks, followed by hedge funds and corporate customers In the interbank market, the majority of the deals are international, reflecting worldwide exchange rate competition and advanced telecommunication systems However, corporate customers tend to focus their foreign exchange activity domestically, or to trade through foreign banks operating in the same time zone Although the hedge funds and corporate customers business in foreign exchange has been growing, banks remain the predominant trading force.
The bottom line is important in all financial markets, but in currency spot trading the antes always seem to be higher as a result of the demand from all around the world The profit and loss can be either realized or unrealized The realized profit and loss is a certain amount of money netted when a position is closed.
The u nrealized profit and loss consists of an uncertain amount of money that an outstanding position would roughly generate if it were closed at the current rate The unrealized profit and loss changes continuously in tandem with the exchange rate. The forward currency market consists of two instruments forward outright deals and swaps A swap deal is unusual among the rest of the foreign exchange instruments in the fact that it consists of two deals, or legs. All the other transactions consist of single deals In its original form, a swap deal is a combination of a spot deal and a forward outright deal Generally, this market includes only cash transactions Therefore, currency futures contracts, although a special breed of forward outright transactions, are analyzed separately.
According to figures published by the Bank for International Settlements, the percentage share of the forward market was 57 percent in See Figure 3 1 Translated into U S dollars, out of an estimated daily gross turnover of US 1 49 trillion, the total forward market represents US billion. In the forward market there is no norm with regard to the settlement dates, which range from 3 days to 3 years Volume in currency swaps longer than one year tends to be light but, technically, there is no impediment to making these deals Any date past the spot date and within the above range may be a forward settlement, provided that it is a valid business day for both currencies The forward markets are decentralized markets, with players around the world entering into a variety of deals either on a one-on-one basis or through brokers In contrast, the currency futures market is a centralized market, in which all the deals are executed on trading floors provided by different exchanges.
Whereas in the futures market only a handful of foreign currencies may be traded in multiples of standardized amounts, the forward markets are open to any currencies in any amount The forward price consists of two significant parts the spot exchange rate and the forward spread The spot rate is the main building block The forward price is derived from the spot price by adjusting the spot price with the forward spread, so it follows that both forward outright and swap deals are derivative instruments The forward spread is also known as the forward points or the forward pips.
The forward spread is necessary for adjusting the spot rate for specific settlement dates different from the spot date It holds, then, that the maturity date is another determining factor of the forward price Just as in the case of the spot market, the left side of the quote is the bid side, and the right side is the offer side.
Currency futures are specific types of forward outright deals which occupy in general a small part of the Forex market See Figure 3 1 Because they are derived from the spot price, they are derivative instruments They are specific with regard to the expiration date and the size of the trade amount Whereas, generally, forward outright deals those that mature pa st the spot delivery date will mature on any valid date in the two countries whose currencies are being traded, standardized amounts of foreign currency futures mature only on the third Wednesday of March, June, September, and December.
There is a row of characteristics of currency futures, which make them attractive It is open to all market participants, individuals included This is different from the spot market, which is virtually closed to individuals - except high net-worth individuals because of the size of the currency amounts traded It is a central market, just as efficient as the cash market, and whereas the cash market is a very decentralized market, futures trading takes place under one roof It eliminates the credit risk because the Chicago Mercantile Exchange Clearinghouse acts as the buyer for every seller, and vice versa In turn, the Clearinghouse minimizes its own exposure by requiring traders wh o maintain a non-profitable position to post margins equal in size to their losses.
Moreover, currency futures provide several benefits for traders because futures are special types of forward outright contracts, corporations can use them for hedging purposes Although the futures and spot markets trade closely together, certain divergences between the two occur, generating arbitraging opportunities Gaps, volume, and open interest are significant technical analysis tools solely available in the futures market.
Yet their significance extrapolates to the spot market as well Because of these benefits, currency futures trading volume has steadily attracted a large variety of players For traders outside the exchange, the prices are available from on-line monitors The most popular pages are found on Bridge, Telerate, Reuters, and Bloomberg Telerate presents the currency futures on composite pages, while Reuters and Bloomberg display currency futures on individual pages shows the convergence bet ween the futures and spot prices.
A currency option is a contract between a buyer and a seller that gives the buyer the right, but not the obligation, to trade a specific amount of currency at a predetermined price and within a predetermined period of time, regardless of the market price of the currency and gives the seller, or writer, the obligation to deliver the currency under the predetermined terms, if and when the buyer wants to exercise the option.
Currency options are unique trading instruments, equally fit for speculation and hedging Options allow for a comprehensive customization of each individual strategy, a quality of vital importance for the sophisticated investor More factors affect the option price relative to the prices of other foreign currency instruments Unlike spot or forwards, both high and low volatility may generate a profit in the options market For some, options are a cheaper vehicle for currency trading For others, options mean added securi ty and exact stop-loss order execution.
Currency options constitute the fastest-growing segment of the foreign exchange market As of April , options represented 5 percent of the foreign exchange market See Figure 3 1 The biggest options trading center is the United States, followed by the United Kingdom and Japan. Options prices are based on, or derived from, the cash instruments Therefore, an option is a derivative instrument Options are usually mentioned vis-a-vis insurance and hedging strategies Often, however, traders have misconceptions regarding both the difficulty and simplicity of using options.
There are also misconceptions regarding the capabilities of options In the currency markets, options are available on either cash or futures It follows, then, that they are traded either over-the-counter OTC or on the centralized futures markets. The majority of currency options, around 81 percent, are traded overthe - counter See Figure 3 3 The over-the-counter market is similar to the spot or swap market Corporations may call banks and banks will trade with each other either directly or in the brokers market This type of dealing allows for maximum flexibility any amount, any currency, any odd expiration date, any time The currency amounts may be even or odd.
The amounts may be quoted in either U S dollars or foreign currencies Any currency may be traded as an option, not only the ones available as futures contracts Therefore, traders may quote on any exotic currency, as required, including any cross currencies Figure 3 3 Distribution of the options trading between over-the-counter OTC and the organized exchange market 1 the share of OTC 2 the share of organized exchanges.
The expiration date may be quoted anywhere from several hours to several years, although the bulk of dates are concentrated around the even dates one week, one month, two months, and so on The cash market never closes, so options may be traded literally around the clock Trading an option on currency futures will entitle the buyer to the right, but not the obligation, to take physical possession of the currency future Unlike the currency futures, buying currency options does not require an initiation margin The option premium, or price, paid by the buyer to the seller, or writer, reflects the buyer s total risk.
However, upon taking physical possession of the currency future by exercising the option, a trader will have to deposit a margin Seven major factors have an impact on the option price. The currency price is the central building block, as all the other factors are compared and analyzed against it It is the currency price behavior that both generates the need for options and impacts on the profitability of options The impact of the currency price on the option premium is measured by delta, the first of the Greek letters used to describe aspects of the theoretical pricing models in this discussion of factors determining the option price.
Delta, or commonly A, is the first derivative of the option-pricing model Delta may be viewed in three respects. Traders may be unable to secure prices in the spot, forward outright, or futures market, temporarily leaving the position delta unhedged In order to avoid the high cost of hedging and the risk of unusually high volatility, traders may hedge their original options positions with other options This method of risk neutralization is called gamma or vega hedging.
Gamma is also known as the curvature of the option It is the second derivative of the option-pricing model and is the rate of change of an option s delta, or the sensitivity of the delta For instance, an option with delta 0 5 and gamma 0 05 is expected to have a delta 0 55 if the currency rises by 1 point, or a delta 0 45 if the currency decreases by 1 point.
Gamma ranges between 0 percent and percent The higher the gamma, the higher the sensitivity of the delta It may therefore be useful to think of gamma as the acceleration of the option relative to the movement of the currency. Vega gauges volatility impact on the option premium Vega is the sensitivity of the theoretical value of an option to a change in volatility For instance, a vega of 0 2 will generate a 0 2 percent increase in the premium for each percentage increase in the volatility estimate, and a 0 2 percent decrease in the premium for each percentage decrease in the volatility estimate.
The option is traded for a predetermined period of time, and when this time expires, there is a delivery date known as the expiration date A buyer who intends to exercise the option must inform the writer on or before expiration The buyer s failure to inform the writer about exercising the option frees the writer of any legal obligation An option cannot be exercised past the expiration date. Theta T , also known as time decay, occurs as the very slow or nonexistent movement of the currency triggers losses in the option s theoretical value For instance , a theta of 0 02 will generate a loss of 0 02 in th e premium for each day that the currency price is flat Intrinsic value is not affected by time, but extrinsic value is Time decay accelerates as the option approaches expiration, since the number of possible outcomes is continuously reduced as the time passes.
Time has its maximum impact on at-the-money options and its minimum effect on in-the-money options Time s effect on out-of-the-money options occurs somewhere within that range. Bid-offer spreads in the market may make it too expensive to sell the option and trade forward out rights If the option shifts deeply into the money, the interest rate differential gained by early exercise may exceed the value of the option If the option amount is small or the expiration is close and the option value only consists of the intrinsic value, it may be better to use the early exercise.
Due to the complexity of its determining factors, option pricing is difficult In the absence of option pricing models, option trading is nothing but inefficient gambling The one idea to make option pricing is that the option of buying the domestic currency with a foreign currency at a certain price x is equivalent to the option of selling the foreign currency with the domestic currency at the same price x Therefore, the call option in the domestic currency becomes the put option in the other, and vice versa.
Fundamental Analysis. Two types of analysis are used for the market movements forecasting. Theories of Exchange Rate Determination Fundamentals may be classified into economic factors, financial factors, political factors, and crises Economic factors differ from the other three factors in terms of the certainty o f their release The dates and times of economic data release are known well in advance, at least among the industrialized nations Below are given briefly several known theories of exchange rate determination.
Purchasing Power Parity. Purchasing power parity states that the price of a good in one country should equal the price of the same good in another country, exchanged at the current rate the law of one price There are two versions of the purchasing power parity theory the absolute version and the relative version Under the absolute version, the exchange rate simply equals the ratio of the two countries general price levels, which is the weighted average of all goods produced in a country However, this version works only if it is possible to find two countries, which produce or consume the same goods.
Moreover, the absolute version assumes that transportation costs and trade barriers are insignificant In reality, transportation costs are significant and dissimilar around the world. Trad e barriers are still alive and well, sometimes obvious and sometimes hidden, and they influence costs and goods distribution Finally, this version disregards the importance of brand names For example, cars are chosen not only based on the best price for the same type of car, but also on the basis of the name You are what you drive.
Under the relative version, the percentage change in the exchange rate from a given base period must equal the difference between the percentage change in the domestic price level and the percentage change in the foreign price level The relative version of the PPP is also not free of problems it is difficult or arbitrary to define the base period, trade restrictions remain a real and thorny issue, just as with the absolute version, different price index weighting and the inclusion of different products in the indexes make the comparison difficult and in the long term, countries internal price ratios may change, causing the exchange ra te to move away from the relative PPP.
In conclusion, the spot exchange rate moves independently of relative domestic and foreign prices In the short run, the exchange rate is influenced by financial and not by commodity market conditions. Theory of Elasticities. The theory of elasticities holds that the exchange rate is simply the price of foreign exchange that maintains the balance of payments in equilibrium For instance, if the imports of country A are strong, then the trade balance is weak Consequently, the exchange rate rises, leading to the growth of country A s exports, and triggers in turn a rise in its domestic income, along with a decrease in its foreign income Whereas a rise in the domestic income in country A will trigger an increase in the domestic consumption of both domestic and foreign goods and, therefore, more demand for foreign currencies, a decrease in the foreign income in country B will trigger a decrease in the domestic consumption of both country B s domestic and f oreign goods, and therefore less demand for its own currency.
The elasticities approach is not problem-free because in the short term the exchange rate is more inelastic than it is in the long term and the additional exchange rate variables arise continuously, changing the rules of the game.
Modern Monetary Theories on Short-Term Exchange Rate Volatility The modern monetary theories on short-term exchange rate volatility take into consideration the short-term capital markets role and the long-term impact of the commodity markets on foreign exchange These theories hold that the divergence between the exchange rate and the purchasing power parity is due to the supply and demand for financial assets and the international capability.
One of the modern monetary theories states that exchange rate volatility is triggered by a one-time domestic money supply increase, because this is assumed to raise expectations of higher future monetary growth The purchasing power parity theory is extended to in clude the capital markets If, in both countries whose currencies are exchanged, the demand for money is determined by the level of domestic income and domestic interest rates, then a higher income increases demand for transactions balances while a higher interest rate increases the opportunity cost of holding money, reducing the demand for money.
Under a second approach, the exchange rate adjusts instantaneously to maintain continuous interest rate parity, but only in the long run to maintain PPP Volatility occurs because the commodity markets adjust more slowly than the financial markets This version is known as the dynamic monetary approach. The Portfolio-Balance Approach.
The portfolio-balance approach holds that currency demand is triggered by the demand for financial assets, rather than the demand for the currency per se Synthesis of Traditional and Modern Monetary Views In order to better suit the previous theories to the realities of the market, some of the more stringent condition s were adjusted into a synthesis of the traditional and modern monetary theories.
A short-term capital outflow induced by a monetary shock creates a payments imbalance that requires an exchange rate change to maintain balance of payments equilibrium Speculative forces, commodity markets disturbances, and the existence of short-term capital mobility trigger the exchange rate volatility The degree of change in the exchange rate is a function of consumers elasticity of demand.
Because the financial markets adjust faster than the commodities markets, the exchange rate tends to be affected in the short term by capital market changes, and in the long term by commodities changes. Economic indicators occur in a steady stream, at certain times, and a little more often than changes in interest rates, governments, or natural activity such as earthquakes etc Economic data is generally except of the Gross Domestic Product and the Employment Cost Index, which are released quarte rly released on a monthly basis.
All economic indicators are released in pairs The first number reflects the latest period The second number is the revised figure for the month prior to the latest period For instance, in July, economic data is released for the month of June, the latest period In addition, the release includes the revision of the same economic indicator figure for the month of May The reason for the revision is that the department in charge of the economic statistics compilation is in a better position to gather more information in a month s time.
This feature is important for traders If the figure for an economic indicator is better than expected by 0 4 percent for the past month, but the previous month s number is revised lower by 0 4 percent, then traders are likely to ignore the overall release of that specific economic data Economic indicators are released at different times In the United States, economic data is generally released at 8 30 and 10 am ET It is importan t to remember that the most significant data for foreign exchange is released at 8 30 am ET In order to allow time for last-minute adjustments, the United States currency futures markets open at 8 20 am ET.
Information on upcoming economic indicators is published in all leading newspapers, such as the Wall Street Journal, the Financial Times, and the New York Times and business magazines, such as Business Week More often than not, traders use the monitor sources Bridge Information Systems, Reuters, or Bloomberg to gather information both from news publications and from the sources own up-to-date information The Gross National Product GNP The Gross National Product measures the economic performance of the whole economy.
This indicator consists, at macro scale, of the sum of consumption spending, investment spending, government spending, and net trade The gross national product refers to the sum of all goods and services produced by United States residents, either in the United States or a broad The Gross Domestic Product GDP The Gross Domestic Product GDP refers to the sum of all goods and services produced in the United States, either by domestic or foreign companies The differences between the two are nominal in the case of the economy of the United States GDP figures are more popular outside the United States In order to make it easier to compare the performances of different economies, the United States also releases GDP figures.
Consumption is made possible by personal income and discretionary income The decision by consumers to spend or to save is psychological in nature Consumer confidence is also measured as an important indicator of the propensity of consumers who have discretionary income to switch from saving to buying. Investment or gross private domestic spending - consists of fixed investment and inventories Government Spending Government spending is very influential in terms of both sheer size and its impact on other economic indicators, due to special expe nditures For instance, United States military expenditures had a significant role in total U S employment until The defense cuts that occurred at the time increased unemployment figures in the short run trade is another major component of the GNP Worldwide internationalization and the economic and political developments since have had a sharp impact on the United States ability to compete overseas The U S trade deficit of the past decades has slowed down the overall GNP GNP can be approached in two ways flow of product and flow of cost.
Industrial production consists of the total output of a nation s plants, utilities, and mines From a fundamental point of view, it is an important economic indicator that reflects the strength of the economy, and by extrapolation, the strength of a specific currency Therefore, foreign exchange traders use this economic indicator as a potential trading signal.
Capacity utilization consists of total industrial output divided by total production ca pability The term refers to the maximum level of output a plant can generate under normal business conditions In general, capacity utilization is not a major economic indicator for the foreign exchange market However, there are instances when its economic implications are useful for fundamental analysis A normal figure for a steady economy is 81 5 percent If the figure reads 85 percent or more, the data suggests that the industrial production is overheating, that the economy is close to full capacity.
High capacity utilization rates precede inflation, and expectation in the foreign exchange market is that the central bank will raise interest rates in order to avoid or fight inflation. Factory orders refer to the total of durable and nondurable goods orders Nondurable goods consist of food, clothing, light industrial products, and products designed for the maintenance of durable goods Durable goods orders are discussed separately The factory orders indicator has limited significance for f oreign exchange traders.
Durable Goods Orders. Durable goods orders consist of products with a life span of more than three years Examples of durable goods are autos, appliances, furniture, jewelry, and toys They are divided into four major categories primary metals, machinery, electrical machinery, and transportation In order to eliminate the volatility pertinent to large military orders, the indicator includes a breakdown of the orders between defense and nondefense.
This data is fairly important to foreign exchange markets because it gives a good indication of consumer confidence Because durable goods cost more than nondurables, a high number in this indicator shows consumers propensity to spend Therefore, a good figure is generally bullish for the domestic currency. Business inventories consist of items produced and held for future sale The compilation of this information is facile and holds little surprise for the market Moreover, financial management and computerization help control business inventories in unprecedented ways Therefore, the importance of this indicator for foreign exchange traders is limited.
Construction indicators constitute significant economic indicators that are included in the calculation of the GDP of the United States Moreover, housing has traditionally been the engine that pulled the U S economy out of recessions after World War II These indicators are classified into three major categories. Private housing is classified based on the number of units one, two, three, four, five, or more region Northeast, West, Midwest, and South and inside or outside metropolitan statistical areas Figure 4 1 Diagram of construction of private housing Construction indicators are cyclical and very sensitive to the level of interest rates and consequently mortgage rates and th e level of disposa ble income Low interest rates alone may not be able to generate a high demand for housing, though As the situation in the early s demonstrated, despite historically low mortgage rates in the United States, housing increased only marginally, as a result of the lack of job security in a weak economy.
Housing starts between one and a half and two million units reflect a strong economy, whereas a figure of approximately one million units suggests that the economy is in recession. The rate of inflation is the widespread rise in prices Therefore, gauging inflation is a vital macroeconomic task Traders watch the development of inflation closely, because the method of choice for fighting inflation is raising the interest rates, and higher interest rates tend to support the local currency Moreover, the inflation rate is used to deflate nominal interest rates and the GNP or GDP to their real values in order to achieve a more accurate measure of the data.
The values of the real interest rates or real GNP and GDP are of the utmost importance to the money managers and traders of international financial instruments, allowing them to accurately compare opportunities worldwide. To measure inflation traders use following economic tools. GNP Deflator. GDP Deflator. The first four are strictly economic indicators they are released at specific intervals The commodity indexes provide information on inflation quickly and continuously Other economic data that measure inflation are unemployment, consumer prices, and capacity utilization.
Producer price index is compiled from most sectors of the economy, such as manufacturing, mining, and agriculture The sample used to calculate the index contains about commodities The weights used for the calculation of the index for some of the most important groups are food - 24 percent fuel - 7 percent autos - 7 percent and clothing - 6 percent Unlike the CPI, the PPI does not include imported goods, services, or taxes.
Consumer price index reflects the average change in retail prices for a fixed market basket of goods and services The CPI data is compiled from a sample of prices for food, shelter, clothing, fuel, transportation, and medical services that people purchase on daily basis The weights attached for the calculation of the index to the most important groups are housing - 38 percent food - 19 percent fuel - 8 percent and autos - 7 percent.
The two indexes, PPI and CPI, are instrumental in helping traders measure inflationary activity, although the Federal Reserve takes the position that the indexes overstate the strength of inflation. Gross National Product Implicit Deflator. The preponderance of food commodities makes the CRB Index less reliable in terms of general inflation Nevertheless, the inde x is a popular tool that has proved quite reliable since the late s.
The Journal of commerce industrial price index consists of the prices of 18 industrial materials and supplies processed in the initial stages of manufacturing, building, and energy production It is more sensitive than other indexes, as it was designed to signal changes in inflation prior to the other price indexes. Merchandise Trade Balance is one of the most important economic indicators Its value may trigger long-lasting changes in monetary and foreign policies The trade balance consists of the net difference between the exports and imports of a certain economy.
The data includes six categories. The employment rate is an economic indicator with significance in multiple areas The rate of employment, naturally, measures the soundness of an economy See Figure 4 2 The unemployment rate is a lagging economic indicator It is an important feature to remember, especially in times of economic recession Whereas people focus on the health and recovery of the job sector, employment is the last economic indicator to rebound.
When economic contraction causes jobs to be cut, it takes time to generate psychological confidence in economic recovery at the managerial level before new positions are added At individual levels, the improvement of the job outlook may be clouded when new positions are added in small companies and thus not fully reflected in the data The employment reports are significant to the financial markets in general and to foreign exchange in particular In foreign exchange, the data is truly affective in periods of economic transition recovery and contraction The reason for the indicators importance in extreme economic situations lies in the picture they paint of the health of the economy and in the degree of maturity of a business cycle.
A d ecreasing unemployment figure signals a maturing cycle, whereas the opposite is true for an increasing unemployment indicator Figure 4 2 The U S unemployment rate. Employment cost index measures wages and inflation and provides the most comprehensive analysis of worker compensation, including wages, salaries, and fringe benefits The ECI is one of the Fed s favorite quarterly economic statistics. Consumer Spending Indicators.
Retail sales is a significant consumer spending indicator for foreign exchange traders, as it shows the strength of consumer demand as well as consumer confidence component in the calculation of other economic indicators, such as GNP and GDP. Generally, the most commonly used employment figure is not the monthly unemployment rate, which is released as a percentage, but the nonfarm payroll rate The rate figure is calculated as the ratio of the difference between the total labor force and the employed labor force, divided by the total labor forc e The data is more complex, though, and it generates more information In foreign exchange, the standard indicators monitored by traders are the unemployment rate, manufacturing payrolls, nonfarm payrolls, average earnings, and average workweek Generally, the most significant employment data are manufacturing and nonfarm payrolls, followed by the unemployment rate.
Despite the importance of the auto industry in terms of both production and sales, the level of auto sales is not an economic indicator widely followed by foreign exchange traders The American automakers experienced a long, steady market share loss, only to start rebounding in the early s But car manufacturing has become increasingly internationalized, with American cars being assembled outside the United States and Japanese and German cars assembled within the United States Because of their confusing nature, auto sales figures cannot easily be used in foreign exchange analysis.
The leading indicators consist of the followi ng economic indicators. Personal Income is the income received by individuals, nonprofit institutions, and private trust funds Components of this indicator include wages and salaries, rental income, dividends, interest earnings, and transfer payments Social Security, state unemployment insurance, and veterans benefits The wages and salaries reflect the underlying economic conditions. This indicator is vital for the sales sector Without an adequate personal income and a propensity to purchase, consumer purchases of durable and nondurable goods are limited For the Forex traders, personal income is not significant 4 3 Financial and Sociopolitical Factors.
The Role of Financial Factors. Financial factors are vital to fundamental analysis Changes in a government s monetary or fiscal policies are bound to generate changes in the economy, and these will be reflected in the exchange rates Financial factors should be triggered only by economic factors When governments focus on different aspects of the economy or have additional international responsibilities, financial factors may have priority over economic factors.
This was painfully true in the case of the European Monetary System in the early s The realities of the marketplace revealed the underlying artificiality of this approach Using the interest rates independently from the real economic environment translated into a very expensive strategy Because foreign exchange, by definition, consists of simultaneous transactions in two currencies, then it follows that the market must focus on two respective i nterest rates as well This is the interest rate differential, a basic factor in the markets Traders react when the interest rate differential changes, not simply when the interest rates themselves change For example, if all the G-5 countries decided to simultaneously lower their interest rates by 0 5 percent, the move would be neutral for foreign exchange, because the interest rate differentials would also be neutral.
Of course, most of the time the discount rates are cut unilaterally, a move that generates changes in both the interest differential and the exchange rate Traders approach the interest rates like any other factor, trading on expectations and facts For example, if rumor says that a discount rate will be cut, the respective currency will be sold before the fact Once the cut occurs, it is quite possible that the currency will be bought back, or the other way around An unexpected change in interest rates is likely to trigger a sharp currency move Buy on the rumor, sell on the fact.
Other factors affecting the trading decision are the time lag between the rumor and the fact, the reasons behind the interest rate change, and the perceived importance of the change The market generally prices in a discount rate change that was delayed Since it is a fait accompli, it is neutral to the market If the discount rate was changed for political rather than economic reasons, what is a common practice in the European Monetary System, the markets are likely to go against the central banks, sticking to the real fundamentals rather than the political ones This happened in both September and the summer of , when the European central banks lost unprecedented amounts of money trying to prop up their currencies, despite having high interest rates The market perceived those interest rates as artificially high and, therefore, aggressively sold the respective currencies Finally, traders deal on the perceived importance of a change in the interest rate differential.
Political Events and Crises. Political events generally take place over a period of time, but political crises strike suddenly They are almost always, by definition, unexpected Currency traders have a knack for responding to crises Speed is essential shooting from the hip is the only fighting option The traders reflexes take over Without fast action, traders can be left out in the cold There is no time for analysis, and only a split second, at best, to act As volume drops dramatically, trading is hindered by a crisis Prices dry out quickly, and sometimes the spreads between bid and offer jump from 5 pips to pips Getting back to the market is difficult.
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