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If a stock price has been rising, but volume is declining, it may signal that the market is overbought. Or if a declining stock suddenly reversed on high volume, it means the market sentiment may have changed from bearish to bullish. Unfortunately, since the foreign exchange market is traded over-the-counter, it doesn't have a centralized market. This means that the volume of each currency traded cannot be easily measured.
Without any tools to measure volume, how can a trader measure market sentiment?! This is where the Commitment of Traders report comes in! Because the COT measures the net long and short positions taken by speculative traders and commercial traders, it is a great resource to gauge how heavily these market players are positioned in the market. Later on, we'll let you meet these market players.
These are the hedgers, large speculators, and retail traders. Just like players in a team sport, each group has its unique characteristics and roles. By watching the behavior of these players, you'll be able to foresee incoming changes in market sentiment. You're probably asking yourself, "Why the heck do I need to use data from the FX futures market? Activity in the futures market doesn't involve me. So what's the closest thing we can get our hands on to see the state of the market and how the big players are moving their money?
Yep, you got it The Commitment of Traders report from the futures market. Step 3: It may seem a little intimidating at first because it looks like a big giant gobbled-up block of text but with a little bit of effort, you can find exactly what you're looking for. To find the British Pound Sterling, or GBP, for example, just search up "Pound Sterling" and you'll be taken directly to a section that looks something like this: Yowza! What the heck is this?! We'll explain each category below. For the most part, these are traders who looking to trade for speculative gains.
In other words, these are traders just like you who are in it for the Benjamins! If you want to access all available historical data, you can view it here. You can see a lot of things in the report but you don't have to memorize all of it. As a budding trader, you'll only be focusing on answering the basic question: "Wat da dilly on da market yo?! These players could be categorized into three basic groups: 1.
Commercial traders Hedgers 2. Non-commercial traders Large Speculators 3. Retail traders Small Speculators Don't Skip the Commercial - The Hedgers Hedgers or commercial traders are those who want to protect themselves against unexpected price movements. Agricultural producers or farmers who want to hedge minimize their risk in changing commodity prices are part of this group. Banks or corporations who are looking to protect themselves against sudden price changes in currencies or other assets are also considered commercial traders.
A key characteristic of hedgers is that they are most bullish at market bottoms and most bearish at market tops. What the hedgehog does this mean? Here's a real life example to illustrate: There is a virus outbreak in the U. Zombies run amok doing malicious things like grabbing strangers' iPhones to download fart apps. It's total mayhem as people become disoriented and helpless without their beloved iPhones. This must be stopped now before the nation crumbles into oblivion!
Guns and bullets apparently don't work on the zombies. The only way to exterminate them is by chopping their heads off. Apple sees a "market need" and decides to build a private Samurai army to protect vulnerable iPhone users. It needs to import samurai swords from Japan. Steve Jobs contacts a Japanese samurai swordsmith who demands to be paid in Japanese yen when he finishes the swords after three months.
In order to protect itself, or rather, hedge against currency risk, the firm buys JPY futures. In It to Win It - The Large Speculators In contrast to hedgers, who are not interested in making profits from trading activities, speculators are in it for the money and have no interest in owning the underlying asset!
Many speculators are known as hardcore trend followers since they buy when the market is on an uptrend and sell when the market is on a downtrend. They keep adding to their position until the price movement reverses.
Large speculators are also big players in the futures market since they hold huge accounts. As a result, their trading activities can cause the market to move dramatically. They usually follow moving averages and hold their positions until the trend changes. Cannon fodders - The Small Speculators Small speculators, on the other hand, own smaller retail accounts.
These comprise of hedge funds and individual traders. They are known to be anti-trend and are usually on the wrong side of the market. Because of that, they are typically less successful than hedgers and commercial traders.
However, when they do follow the trend, they tend to be highly concentrated at market tops or bottoms. The question you may be asking now is this: How the heck do you turn all that "big giant gobbled-up block of text" into a sentiment-based indicator that will help you grab some pips?!
One way to use the COT report in your trading is to find extreme net long or net short positions. Finding these positions may signal that a market reversal is just around the corner because if everyone is long a currency, who is left to buy? No one. And if everyone is short a currency, who is left to sell?
What's that? Pretty quiet Yeah, that's right. NO ONE. One analogy to keep in mind is to imagine driving down a road and hitting a dead end. What happens if you hit that dead end? You can't keep going since there's no more road ahead. The only thing to do is to turn back. Let's take a look at what happened mid-way through Soon after, investors started to buy back EUR futures. Over the next year, the net value of EUR futures position gradually turned positive.
In early October , EUR futures net long positions hit an extreme of 51, before reversing. Holy Guacamole! Just by using the COT as an indicator, you could have caught two crazy moves from October to January and November to March The first was in mid-September This would have resulted in almost a 2,pip gain in a matter of a few months!
With those two moves, using just the COT report as a market sentiment reversal indicator, you could have grabbed a total of 3, pips. Pretty nifty, eh? Picking Tops and Bottoms As you would've guessed, ideal places to go long and short are those times when sentiment is at an extreme.
If you noticed from the previous example, the speculators green line and commercials blue line gave opposite signals. While hedgers buy when the market is bottoming, speculators sell as the price moves down. As a result, speculative positioning indicates trend direction while commercial positioning could signal reversals. If hedgers keep increasing their long positions while speculators increase their short positions, a market bottom could be in sight.
If hedgers keep adding more short positions while speculators keep adding more long positions, a market top could occur. Of course, it's difficult to determine the exact point where a sentiment extreme will occur so it might be best to do nothing until signs of an actual reversal are seen. We could say that speculators, because they follow the trend, catch most of the move BUT are wrong on turning points. Until a sentiment extreme occurs, it would be best to go with the speculators.
The basic rule is this: every market top or bottom is accompanied by a sentiment extreme, but not every sentiment extreme results in a market top or bottom. Using the COT report can be quite useful as a tool in spotting potential reversals in the market.
There's one problem though, we cannot simply look at the absolute figures printed on the COT report and say, "Aha, it looks like the market has hit an extreme I will short and buy myself 10,, pairs of socks. What may have been an extreme level five years ago may no longer be an extreme level this year.
How do you deal with this problem? What you want to do is create an index that will help you gauge whether the markets are at extreme levels. Below is a step-by-step process on how to create this index. Decide how long of a period we want to cover. The more values we input into the index, the less sentiment extreme signals we will receive, but the more reliable it will be.
Having less input values will result in more signals, although it might lead to more false positives. Calculate the difference between the positions of large speculators and commercial traders for each week. This would result in a positive figure. On the other hand, if large speculators are extremely short, that would mean that commercial traders are extremely long and this would result in a negative figure.
Rank these results in ascending order, from most negative to most positive. Assign a value of to the largest number and 0 to the smallest figure. And now we have a COT indicator! This is very similar to the RSI and stochastic indicators that we've discussed in earlier lessons.
Once we have assigned values to each of the calculated differences, we should be alerted whenever new data inputted into the index shows an extreme - 0 or This would indicate that the difference between the positions of the two groups is largest, and that a reversal may be imminent.
Remember, we are interested in knowing whether the trend is going to continue or if it is going to end. If the COT report reveals that the markets are at extreme levels, it would help pinpoint those tops and bottoms that we all love so much. We dug around the forums and found this little gold nugget for you. Apparently you can download the COT indicator if you're trading on an MT4 platform and you can find the link in our COT data to indicator forum thread!
Recall that not every sentiment extreme results in a market top or bottom so we'll need a more accurate indicator. Calculating the percentage of speculative positions that are long or short would be a better gauge to see whether the market is topping or bottoming out. Going through the COT reports released on the week ending August 22, , speculators were net short 28, contracts.
On March 20, , they were net short 23, contracts. From this information alone, you would say that there is a higher probability of a market bottom in August since there were more speculators that were short in that period. But hold on a minute there You didn't think it would be THAT easy right? A closer look would show that 66, contracts were short while 38, contracts were long.
On the other hand, there were just 8, long contracts and 32, short contracts in March. What does this mean? There is a higher chance that a bottom will occur when As you can see on the chart below, the bottom in fact did not occur around August , when the Canadian dollar was worth roughly around 94 U. The Canadian dollar continued to fall over the next few months.
Then what happened? It started to steadily rise! A market bottom? Yep, you got it. Before we start betting the farm based on our analysis of the COT report, remember that those were just specific cases of when the COT report signalled a perfect market reversal. The best thing to do would be to back test and look at reasons why a reversal took place.
Was the economy booming? Or was it in the middle of a recession? Remember, the COT report measures the sentiment of traders during a specific period of time. Like every other tool in your toolbox, using the COT report as an indicator does not always correlate to market reversals. So take the time to study this report and get your own feel of what works and what doesn't.
Also, before we bring this lesson to an end, always keep in mind that market prices aren't driven by solely COT reports, stochastic, Fibonacci levels, etc. The markets are driven by the millions of people reacting to economic analysis, fundamental reports, politics, Godzilla attacks, UFO sightings, Lady Gaga concerts - life in general! It is how you use these tools that will help you be prepared to what lies ahead. In conclusion Trading the News Extra!
Reading up on the news reports may just reel you in a handful of pips! Lessons in Trading the News 1. Importance of News Like how things are in the world of Star Wars, there is always fundamental force behind each movement in the market. Why Trade the News Trading the news is a double-edged sword. Sure, you can earn a lot of money by doing it but you also stand to lose a lot in times of increased volatility!
Which News Reports are Trade-Worthy? The most-watched news reports are from the U. Can you guess why? Directional Bias vs. Non-Directional Bias "Buy the rumor, sell the news. Trading with a Directional Bias Let's take a look at an example on deciding whether to go long or short before a report is released. What do you do next if you want to let the market decide which side to take? Summary: Trading the News You could get burned a couple of times by trading the news so practice, practice, practice!
It will be very rewarding once you get the hand of it. Importance of News It's not enough to only know technical analysis when you trade. It's just as important to know what makes the market move. Just like in the great Star Wars world, behind the trend lines, double tops, and head and shoulder patterns, there is a fundamental force behind these movements. This force is called the news!
To understand the importance of the news, imagine this scenario purely fictional of course! Let's say, on your nightly news, there is a report that the biggest software company that you have stock with just filed bankruptcy. What's the first thing you would do? How would your perception of this company change? How do you think other people's perceptions of this company would change? The obvious reaction would be that you would immediately sell off your shares. In fact, this is probably what just about everyone else who had any stake in that company would do.
The fact is that news affects the way we perceive and act on our trading decisions. It's no different when it comes to trading currencies. There is, however, a distinct difference with how news is handled in the stock market and the forex market. Let's go back to our example above and imagine that you heard that same report of the big software company filing bankruptcy, but let's say you heard the report a day before it was actually announced in the news.
Naturally you would sell off all your shares, and as a result of you hearing the news a day earlier, you would make save more money than everyone else who heard it on their nightly news. Sounds good for you right? Martha Stewart did it and now she has a nice mug-shot to go along with her magazine covers. In the stock market, when you hear news before everyone else it is illegal. The earlier you hear or see the news, the better it is for your trading, and there is absolutely no penalty for it!
Add on some technology and the power of instant communication, and what you have is the latest and greatest or not so greatest news at the tip of your fingers. This is great Big traders, small traders, husky traders, or skinny traders all have to depend on the same news to make the market move because if there wasn't any news, the market would hardly move at all! The news is important to the Forex market because it's the news that makes it move.
Regardless of the technicals, news is the fuel that keeps the market going! Why Trade the News The simple answer to that question is "To make more money! When news comes out, especially important news that everyone is watching, you can almost expect to see some major movement. Your goal as a trader is to get on the right side of the move, but the fact that you know the market will most likely move somewhere makes it an opportunity definitely worth looking at.
Dangers of trading the news As with any trading strategy, there are always possible dangers that you should be aware of. Here are some of those dangers: Because the market is very volatile during important news events, many dealers widen the spread during these times.
This increases trading costs and could hurt your bottom line. You could also get "locked out" which means that your trade could be executed at the right time but may not show up in your trading station for a few minutes. Obviously this is bad for you because you won't be able to make any adjustments if the trade moves against you! Imagine thinking you didn't get triggered, so you try to enter at market You'd be risking twice as much now!
You could also experience slippage. Slippage occurs when you wish to enter the market at a certain price, but due to the extreme volatility during these events, you actually get filled at a far different price. Big market moves made by news events often don't move in one direction. Often times the market may start off flying in one direction, only to be whipsawed back in the other direction.
Trying to find the right direction can sometimes be a headache! Profitable as it may be, trading the news isn't as easy as beating Pipcrawler at Call of Duty. It will take tons of practice, practice and you guessed it In the following lessons, we'll give you some tips on how to trade news reports.
Before we even look at strategies for trading news events, we have to look at which news events are even worth trading. Remember that we are trading the news because of its ability to increase volatility in the short term, so naturally we would like to only trade news that has the best market moving potential.
While the markets react to most economic news from various countries, the biggest movers and most watched news comes from the U. The reason is that the U. Dollar is the world's reserve currency. This means that the U. With that said, let's take a look at some of the most volatile news for the U. In addition to inflation reports and central bank talks, you should also pay attention to geo- political news such as war, natural disasters, political unrest, and elections.
Although these may not have as big an impact as the other news, it's still worth paying attention to them. When our economic guru Forex Gump is in a good mood, he usually releases a Piponomics article on upcoming news reports that you can play and with trade strategies to boot! There are times where sentiment in the equity markets will be the precursor to major moves in the forex market.
Now that we know which news events make the most moves, our next step is to determine which currency pairs are worth trading. Because news can bring increased volatility in the forex market and more trading opportunities , it is important that we trade currencies that are liquid. Liquid currency pairs give us a reassurance that our orders will be executed smoothly and without any "hiccups".
These are all major currency pairs! Remember, because they have the most liquidity, majors pairs usually have the tightest spreads. Since spreads widen when news reports come out, it makes sense to stick with those pairs that have the tightest spreads to begin with. Now that we know which news events and currency pairs to trade, let's take a look at some approaches to trading the news.
Non-Directional Bias There are two main ways to trade the news: a Having a directional bias b Having a non-directional bias Directional Bias Having directional bias means that you expect the market to move a certain direction once the news report is released. When looking for a trade opportunity in a certain direction, it is good to know what it is about news reports that cause the market to move. Consensus vs. Actual Several days or even weeks before a news report comes out, there are analysts that will come up with some kind of forecast on what numbers will be released.
As we talked about in a previous lesson, this number will be different among various analysts, but in general there will be a common number that a majority of them agree on. This number is called a consensus. When a news report is released, the number that is given is called the actual number. For example, let's say that the U. Imagine that last month the unemployment rate was at 8.
With a consensus at 9. So with this anticipation, big market players aren't going to wait until the report is actually released to start acting on taking a position. They will go ahead and start selling off their dollars for other currencies before the actual number is released. Now let's say that the actual unemployment rate is released and as expected, it reports 9. As a retail trader, you see this and think "Okay, this is bad news for the U. It's time to short the dollar!
Now let's revisit this example, but this time, imagine that the actual report released an unemployment rate of 8. The market players thought the unemployment rate would rise to 9. What you would see on your charts would be a huge dollar rally across the board because the big market players didn't expect this to happen. Now that the report is released and it says something totally different from what they had anticipated, they are all trying to adjust their positions as fast as possible.
This would also happen if the actual report released an unemployment rate of The only difference would be that instead of the dollar rallying, it would drop like a rock! Since the market consensus was 9. Keeping track of the market consensus and the actual numbers, you can better gauge which news reports will actually cause the market to move and in what direction. Non-directional bias A more common news trading strategy is the non-directional bias approach.
This method disregards a directional bias and simply plays on the fact that a big news report will create a big move. It doesn't matter which way it moves We just want to be there when it does! What this means is that once the market moves in either direction, you have a plan in place to enter that trade. You don't have any bias as to whether price will go up or down, hence the name non-directional bias. Trading with a Directional Bias Let's go back to our example of the U.
Earlier, we gave examples of what could happen if the report came in light with expectations, or slightly better. Let's say there was a surprising drop. What effect could this have on the dollar? One thing that could happen is that the dollar falls.
Isn't the dollar supposed to rise if the unemployment rate is dropping? There could be a couple reasons why the dollar could still fall even though there are more people with jobs. The first reason could be that the long-term and overall trend of the U. Remember that there are several fundamental factors that play into an economy's strength or weakness. Although the unemployment rate dropped, it might not be a big enough catalyst for the big traders to start changing their perception of the dollar.
The second reason could be the reason for the unemployment rate drop. Perhaps it's right after Thanksgiving during the holiday rush. During this time, many companies normally hire seasonal employees to keep up with the influx of Christmas shoppers. This increase in jobs may cause a short term drop in the unemployment rate, but it's not at all indicative of the long term outlook on the U.
A better way to get a more accurate measure of the unemployment situation would be to look at the number from last year and compare it to this year. This would allow you to see if the job market actually improved or not. The important thing to remember is to always take a step back and look at the overall picture before making any quick decisions. Now that you have that information in your head, it's time to see how we can trade the news with a directional bias.
Let's stick with our unemployment rate example to keep it simple. By looking at what has been happening in the past, you can prepare yourself for what might happen in the future. Imagine that the unemployment rate has been steadily increasing. You could now say with some confidence that jobs are decreasing and that there is a good possibility the unemployment rate will continue to rise. Since you are expecting the unemployment rate to rise, you can now start preparing to go short on the dollar.
Take note of the high and low that is made. This will become your breakout points. Since you have a bearish outlook on the dollar, you would pay particular attention to the lower breakout point of that range. You are expecting the dollar to drop so a reasonable strategy would be to set an entry point a few pips below that level.
You could then set a stop just at the upper breakout point and set your limit for the same amount of pips as the breakout point range. One of two things could happen at this point. If the unemployment rate drops then the dollar could rise. No harm no foul! Or if the news is as you expected and the unemployment rate rises, the dollar could drop assuming the entire fundamental outlook on the dollar is already bearish.
This is good for you because you already set up a trade that was bearish on the dollar and now all you have to do is watch your trade unfold. Later on, you see that your target gets hit. You just grabbed yourself a handful of pips!
The key to having a directional bias is that you must truly understand the concepts behind the news report that you plan to trade. If you don't understand what effect it can have on particular currencies, then you might get caught up in some bad setups. Luckily for you, we've got Pip Diddy and Forex Gump to help explain what effect each report can have on the forex market. Earlier in this lesson we discussed the biggest moving news reports.
Ideally you would want to only trade those reports because there is a high probability the market will make a big move after their release. The next thing you should do is take a look at the range at least 20 minutes before the actual news release. The high of that range will be your upper breakout point, and the low of that range will be your lower breakout point. Note that the smaller the range is the more likely it is you will see a big move from the news report.
The breakout points will be your entry levels. This is where you want to set your orders. Your stops should be placed approximately 20 pips below and above the breakout points, and your initial targets should be about the same as the range of the breakout levels. This is known as a straddle trade - you are looking to play both sides of the trades, whichever trade it moves. Now that you're prepared to enter the market in either direction, all you have to do is wait for the news to come out.
Sometimes you may get triggered in one direction only to find that you get stopped out because the price quickly reverses in the other direction. However, your other entry will get triggered and if that trade wins, you should recoup your initial losses and come out with a small profit. A best case scenario would be that only one of your trades gets triggered and the price continues to move in your favor so that you don't incur any losses.
Either way, if done correctly you should still end up positive for the day. One thing that makes a non-directional bias approach attractive is that it eliminates any emotions - you just want to profit when the move happens. This allows you take advantage of more trading opportunities, because you will be triggered either way. There are many more strategies for trading the news, but the concepts mentioned in this lesson should always be part of your routine whenever you are working out an approach to taking advantage of news report movements.
Summary: Trading the News There you have it! Now you know how to trade the news! You just want to get triggered. That's pretty much it Is it really that easy??? You'll have to practice and trade many different reports before you get a feel of which news reports will make the market move, how much of a surprise is needed for the market to move, and which reports to avoid trading.
Like in any other trading method, your success depends on your preparation. This will take time and practice. Do your homework and study the economic indicators to understand why they are important. Remember, nothing worth having comes easy, so stick with it and you'll find that trading news report will be very rewarding once you get the hang of it! Carry Trade Did you know that you can actually still make money in forex without doing anything?
You just have to keep your fingers crossed that price stays the same for a long period of time. Lessons in Carry Trade 1. What is Carry Trade? Carry trades involve buying higher-yielding currencies and selling lower-yielding ones. Seems too good to be true? Oh, but carry trades are true! Check out how they work in real life in the forex market! To Carry or Not to Carry Carry trades work well when risk aversion is low. Carry Trade Criteria and Risk There are only two things to consider when you pick a pair to do a carry trade, but that simplicity doesn't make it any less easy.
Summary: Carry Trade Simply put, carry trades can work by making moolah out of the interest rate differentials of two currencies. Did you know there is a trading system that can make money if price stayed exactly the same for long periods of time? Well there is and it's one the most popular ways of making money by many of the biggest and baddest money manager mamajamas in the financial universe!
It's called the "Carry Trade". A carry trade involves borrowing or selling a financial instrument with a low interest rate, then using it to purchase a financial instrument with a higher interest rate. Thus your profit is the money you collect from the interest rate differential. What's your profit? You got it! The difference between interest rates! By now you're probably thinking, "That doesn't sound as exciting or profitable as catching swings in the market.
In this section, we will discuss how carry trades work, when they will work, and when they will NOT work. We will also tackle risk aversion WTH is that?!? Don't worry, like we said, we'll be talking more about it later. Just like the example in the previous, you pay interest on the currency position you sell, and collect interest on the currency position you buy.
What makes the carry trade special in the spot forex market is that interest payments happen every trading day based on your position. Technically, all positions are closed at the end of the day in the spot forex market.
You just don't see it happen if you hold a position to the next day. This is the cost of "carrying" also known as "rolling over" a position to the next day. The amount of leverage available from forex brokers has made the carry trade very popular in the spot forex market. What a deal, eh? Let's take a look at a generic example to show how awesome this can be. For this example we'll take a look at Joe the Newbie Forex Trader. Instead of going out and blowing his birthday present on video games and posters of bubble gum pop stars, he decides to save it for a rainy day.
Isn't that fantastic? So, Joe kindly responds to the bank manager, "Thank you sir, but I think I'll invest my money somewhere else. What will happen to Joe's account if he does nothing for a year? Well, here are 3 possibilities. Let's take a look at each one: 1.
Currency position loses value. The currency pair Joe buys drops like a rock in value. The pair ends up at the same exchange rate at the end of the year. Currency position gains value. Joe's pair shoots up like a rocket! That would be a nice present to himself for his next birthday! Here is an example of a currency pair that offers a 4.
Again, this is a generic example of how the carry trade works. Any questions on the concept? We knew you could catch on quick! Now it's time to move on to the most important part of this lesson: Carry Trade Risk. Carry trades work best when investors feel risky and optimistic enough to buy high-yielding currencies and sell lower yielding currencies.
It's kinda like an optimist who sees the glass half full. While the current situation might not be ideal, he is hopeful that things will get better. The same goes for carry trade. Economic conditions may not be good, but the outlook of the buying currency does need to be positive. If the outlook of a country's economy looks as good as Angelina Jolie, then chances are that that country's central bank will have to raise interest rates in order to control inflation.
This is good for carry trade because a higher interest rate means a bigger interest rate differential. On the other hand, if a country's economic prospects aren't looking too good, then nobody will be prepared to take on the currency if they think the central bank will have to lower interest rates to help their economy. To put it simply, carry trades work best when investors have low risk aversion.
Carry trades do not work well when risk aversion is high i. When risk aversion is high, investors are less likely to take risky ventures. Let's put this into perspective. Let's say economic conditions are tough, and the country is currently undergoing a recession. What do you think your next door neighbor would do with his money? Your neighbor would probably choose a low-paying yet safe investment than put it somewhere else. It doesn't matter if the return is low as long as the investment is a "sure thing.
In forex jargon, your neighbor is said to have a high level of risk aversion. The psychology of big investors isn't that much different from your next door neighbor. When economic conditions are uncertain, investors tend to put their investments in safe haven currencies that offer low interest rates like the U.
If you want a specific example, check out Forex Gump's Piponomics article on how risk aversion led to the unwinding of carry trade. This is the polar opposite of carry trade. This inflow of capital towards safe assets causes currencies with low interest to appreciate against those with high interest. Find a high interest differential. Find a pair that has been stable or in an uptrend in favor of the higher-yielding currency.
Pretty simple, huh? With the Reserve Bank of Australia touting one of the higher interest rates among the major currencies currently at 4. From the start of to early , this pair moved from a price of If you couple that with interest payments from the interest rate differential of the two currencies, this pair has been a nice long term play for many investors and traders able to weather the volatile up and down movements of the currency market. Of course, economic and political factors are changing the world daily.
Interest rates and interest rate differentials between currencies may change as well, bringing popular carry trades such as the yen carry trade out of favor with investors. Carry Trade Risk Because you are a very smart trader, you already know what the first question you should ask before entering a trade is right? Before entering a trade you must ALWAYS assess your max risk and whether or not it is acceptable according to your risk management rules.
That doesn't sound very good, does it? Remember, this is the worst possible scenario and Joe is a newbie, so he hasn't fully appreciated the value of stop losses. When doing a carry trade, you can still limit your losses like a regular directional trade. He would still keep any interest payments he received while holding onto the position.
Your profit is the money you collect from the interest rate differential. This is another way to make money in the forex market without having to buy low and sell high, which can be pretty tough to do day after day. Carry trades work best when investors feel like taking on risk. Current economic conditions need not be good, but the outlook does need to be positive. If a country's economic prospects aren't looking too good, then nobody will be prepared to take on the risk.
Carry trades do not work well when risk aversion is high. When risk aversion is high, investors are less likely to buy higher-yielding currencies or likely to reduce their positions in higher-yielding currencies. When economic conditions are uncertain, investors tend to put their investments in safe haven currencies, which tend to offer low interest rates like the U. It's pretty simple to find a suitable pair to do a carry trade. Look for two things: 1. Always remember that economic and political factors are changing the world daily.
So, when doing a carry trade, you should still limit your losses like a regular directional trade. When properly applied, the carry trade can add significant income to your account, along with your directional trading strategies. The U. Dollar Index If U. Read up on the dollar index and learn how you can use it in your trading! Lessons in The U. Dollar Index 1.
What is the Dollar Index? The dollar index is made up of six foreign currencies and includes 21 countries. Trade-Weighted Dollar Index The Fed wanted to measure the dollar's value more accurately so they came up with the Trade-weighted dollar index.
How is it different from the U. The Dollar Smile Theory Have you ever wondered why the dollar rallies in the good times and in the bad? You're about to find out why. Oh wait, that last one is actually Harry Potter's broomstick. Well if U. For currency traders, we have the U. Dollar Index consists of a geometric weighted average of a basket of foreign currencies against the dollar. Say whutttt!?! Okay before you fall asleep after that super geeky definition, let's break it down.
It's very similar to how the stock indices work in that it provides a general indication of the value of a basket of securities. Of course, the "securities" we're talking about here are other major world currencies. The Basket The U.
Dollar Index consists of six foreign currencies. If the index is made up of 6 currencies, how many countries are included? If you answered "6", you're wrong. If you answered "21", you're a genius! There are 21 countries total, because there are 16 members of the European Union that have adopted the euro as their sole currency, plus the other five countries Japan, Great Britain, Canada, Sweden, and Switzerland and their accompanying currencies. It's obvious that 21 countries make up a small portion of the world but many other currencies follow the U.
Dollar index very closely. USDX Components Now that we know what the basket of currencies is composed of, let's get back to that "geometric weighted average" part. Because not every country is the same size, it's only fair that each is given appropriate weights when calculating the U.
Check out the current weights: With its 16 countries, euros make up a big chunk of the U. Dollar Index. The next highest is the Japanese yen, which would make sense since Japan has one of the biggest economy in the world. The other four make up less than 30 percent of the USDX. Here's something interesting: When the euro falls, which way does the U. S Dollar Index move? The euro makes up such a huge portion of the U. Dollar Index, we might as well call this index the "Anti-Euro Index".
Because the USDX is so heavily influenced by the euro, people have looked for a more "balanced" dollar index. More on that later though. First, let's go to the charts! Holler at the U. Dollar Index: First, notice that the index is calculated 24 hours a day, five days a week. Also, the USDX measures the dollar's general value relative to a base of For example, the current reading says This means that the dollar has fallen If the reading was This is when the world's biggest nations met in Washington D.
The start of the index is also known as the "base period". Dollar Index Formula This is strictly for the grown and geeky. Now you can get a wedgie from the school bully. We're kidding! Queen Cleopiptra usually includes the U. It is called the "trade- weighted U. The Fed wanted to create an index that could more accurately reflect the dollar's value against foreign currencies based on how competitive U.
It was formed in in order to keep up-to-date with U. The trade weighted index includes countries from all over the world, including some developing countries. Given how global trade is developing, this index is probably a better reflection of the dollar's value across the globe. The weights are based on annual trade data. We all know that most of the widely traded currency pairs include the U.
If you don't know, some that include the U. If you trade any of these pairs, the USDX can be the next best thing to sliced bread or hamburger on a bun In fact, when the market outlook for the U. It's like a mirror image! If one goes up, the other most likely goes down. Will you look at that? It seems like the trend lines almost inversely match up perfectly.
Hang out with them if you wanna learn more about using this index. If the USDX makes significant movements, you can almost surely expect currency traders to react to the movement accordingly. Both the USDX and spot currency traders react to each other. Always keep in mind the position of the USD in the pair you are trading.
The Dollar Smile Theory Ever wonder why the dollar strengthens both in times of tough luck and when the economy is booming like a Jay-Z remix? Well, so does everybody else. In fact, this really smart dude over at Morgan Stanley came up with a theory to explain this phenomenon. Stephen Jen, a former currency strategist and economist, came up with a theory and named it the "Dollar Smile Theory. Here's a simple illustration: Scenario 1: Dollar appreciates due to risk aversion.
The first part of the smile shows the U. Since investors think that the global economic situation is shaky, they are hesitant to pursue risky assets and would rather buy up the less risky U. Scenario 2: Dollar drops to new low.
The bottom part of the smile reflects the lackluster performance of the Greenback as the U. The possibility of interest rate cuts also weighs the U. This leads to the market shying away from the dollar. The motto for USD becomes "Sell! Lastly, a smile begins to form as the U. As optimism picks up and signs of economic recovery appear, sentiment towards the dollar begins to pick up.
In other words, the greenback begins to appreciate as the U. This theory appears to have been in play when the financial crisis began. Remember when the dollar got a huge boost at the peak of the global recession? That's phase 1. When the market eventually bottomed out in March , investors suddenly switched back to the higher yielding currencies, making the dollar the winner of the "Worst Currency" award for So will the Dollar Smile Theory hold true? Only time will tell. In any case, this is an important theory to keep in mind.
Remember, all economies are cyclical. The key part is determining which part of the cycle the economy is in. For example, we know that an unexpected change of communication from the Federal Reserve is going to affect all markets but fundamental analysis allows us to understand to what degree.
Macro and micro considerations are interpreted differently by different types of investors and traders. A forex trader would be more interested in interest rate pricing and which upcoming events could impact this pricing structure, and then how that would influence the currency.
Of course, other factors such as government bond yield differentials, current account and relative terms of trade dynamics, not to mention positioning are all important considerations too. Even the staunchest of technical traders can use fundamental analysis with good results. We encourage our clients to learn as much as they can about both analysis and pair this with a set of indicators and tools to help support and simplify their trading strategies.
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