Last Updated on September 1, 2020 by Jason Wilson
The technical analysis that we have just studied will certainly enable you to multiply your possibilities for profits on the Forex. However, this analysis should be completed with a clear understanding of the different basic strategies.
In fact, it is primordial that before drawing any conclusions it is important to understand the economical environment in which a trade takes place. We can illustrate this aspect using the example of the Yen which underwent a major increase between February and March 2007. If we only refer to the technical analysis we can observe some excellent entry points with the pairs concerning the Yen at the beginning of March.
However this event should be seen in its economical context. In fact, the latter took place before the crisis and at this time the carry trade was still experiencing huge success. If we were to place this event in the current time it would constitute a real error of judgement to take a sell position on the Yen. In fact, this currency is actually experiencing great demand by numerous investors as well as financial establishments who, through this intermediary, wish to settle debts accumulated in the Yen before the crisis.
This reflection brings us to the conclusion that the analysis of a currency deemed as the counterpart reveals a certain importance when we take position on a trade. It is therefore necessary to know how to conduct an analysis. In fact, although many Forex traders quasi-systematically associate the Dollar with other currencies this choice is not always the best as it doesn’t enable the possibility of maximising opportunities for profits.
In this case, what is the best choice for the matching currency? Let us return to the example of the Yen, remembering that at that time the American economy was starting to slow down and the potential for a rise in the Dollar was fairly weak. At the same time the Pound Sterling seemed to be promising a much higher increase. Also, due to objectives fixed by the BoE, a continual rise in its interest rate was expected. It was therefore more judicious to place an investment on the GBP/JPY than on the USD/JPY.
This therefore brings us to the following conclusion: It is very profitable to make your choice concerning which currency pair to trade in accordance with the growth potential of the country concerned as well as the economical situation of that country. It is therefore primordial to remain well informed as to the different elements as whatever the exactitude of a technical analysis, it is of no use whatsoever if it is not studied within its economical context.
Let us now examine in detail some of the basic strategies that enable trading in a concrete manner.
Study of announcements and position
Once your strategy has been established, you should follow the announcements and their eventual consequences on the Forex market. In fact, as we have previously seen, the effects of announcements can have a real impact on the rates by greatly influencing the investors.
The announcements are consultable on a daily basis via the economic calendars or through dedicated newsletters. We will now examine reading and interpreting these calendars.
Firstly it is highly important to note that these economic calendars are quoted in GMT. This signifies that for European time you should add two hours in winter and one hour in summer.
The first column indicates the time at which the event is programmed to take place and the second refers to the countries concerned by this event.
The third column gives the title of the announcement, that is to say the event. Referring to the fourth column, this gives the period (here expressed in months) at which the event is announced.
The two items of information that interest us most here are indicated in the two columns situated at the top to the right. The consensus informs us of the figures awaited by the economists at the time indicated in the corresponding column. Finally, the last column indicates the preceding figure recorded. What should be noted here is that the more the preceding figure is similar to the awaited figure, the less the influence that the announcement will exert on the markets, the inverse also holds true.
However, it is just about impossible to analyse and compare these figures rapidly enough to make a correct decision. In fact, at the same time these figures are published the entire market reacts in accordance with the importance of the announced event. The major movements do in fact take place following an announcement. It is for this reason that certain traders prefer not to be holding a position at the time of an announcement to avoid a destabilisation due to the engendered effects.
At the time of an announcement, it is recommended either to take position before the beginning of the announcement in such a way as to be able to negotiate its effects over the whole period or wait in order to take position at the exact time that the announcement takes place. The latter requires a certain availability together with great attention and reactivity but allows you to take position immediately according to the observed occurring trend. Another technique consists of taking position at the time the first signs appear of a turn in the market once the announcement has been made. The taking of profits by investors often balances the speculative aspect engendered by such an announcement.
It is interesting to note that at the time of an announcement its effect on the currency rate is almost immediate with a tendency to continue throughout the day. If you decide to use this style of trading on announcements you should not use a strong leverage effect and should be careful to not take too many risks concerning your capital.
The Carry-trade strategy
The Carry Trade strategy consists of using the differences observed between the interest rates of different currencies for trading purposes. The Carry-Trade strategy is one of the most frequently used on the Forex market. It in fact amounts to completing an operation by purchasing a currency at a high interest rate and at the same time selling a currency at a low interest rate. The profit here is easily understood as it simply corresponds to the difference between the two rates of interest. Of course, this profit is only really interesting if you use the leverage effect. It is also necessary to possess all information concerning the different interest rates of the currencies concerned.
* Let us take a simple example
We know that the New Zealand Dollar offers an interest rate of 3.5% whereas the interest rate of the Yen is at 0.1%. By purchasing the NZD and selling the JPY we obtain a profit corresponding to the difference between these two rates, that is to say 3.4%. This profit can be made every day by the carry trader. There again, the benefits of using a leverage effect here can be easily understood given the small amount of revenue that is represented by such an operation.
There is a simple calculation that enables you to evaluate the long term profits for a carry trade. You simply need to multiply the difference by the number of days and divide by 360.
The difference between the two interest rates expressed in pips is called the “swap” in an exchange. It can easily be found on the different trading platforms. This swap in an exchange is indicated by a loan operation combined with a deposit operation. The loan is accomplished here using the currency that offers the higher interest rate and the opposite for the deposit operation. This swap is applied on a daily basis on the position held.
Caution! The real impact of these exchange ‘swaps’ on a position is not observed except for those currencies offering a major difference in interest rates although it is applied in a regular manner on all the currency pairs. The currency exchange ‘swaps’ are also called ‘roll-overs’.
At the end of each day’s trading, each position is said to be ‘rolled over’ to another trading date. This ‘roll-over’ consists of closing a position and re-opening it with the modified difference between the closing rate and the opening rate. It is precisely this difference that is expressed by the exchange ‘swap’.
To summarise, the carry trade comes down to identifying an interesting entry point on a currency pair that shows a strong difference between the interest rates and keep the position for as long as possible. This choice of entry point is extremely sensitive as it determines the direction in which you position yourself on the market. In fact, far from being a perfect position for a trader, this carry trade strategy, like all other strategies offers both limits and risks. The risk of change can in fact rapidly become an obstacle to your forecasts.
Despite the risk of abrupt movements, the carry trade remains one of the most efficient methods for making profits over the long term.
The reason for diversifying investments
The fact of investing the total sum of your capital on one sole currency can pay off handsomely if you are lucky. This technique is however very risky as if you lose, you lose all your investment without registering any profit in any part. To trade well on the Forex one of the rules to respect is that of caution so keeping risks to a minimum. It is therefore essential to not place all on one currency but on the contrary to diversify your trades in order to register profits that can recompense any eventual losses.
The notion to take into consideration when diversifying your investments is that of the ratio profit/risk. By analysing at the same time both the potentials for the profitability of your financial operations and the risks that you are incurring, you will implement a strategy of diversification.
The Forex is actually the ideal market for applying this strategy and spreading your risks. Contrary to the stock market, on which it is necessary to find buyers in order to offset any recession suffered by the stock markets, here it is easy to inverse a position by selling on one hand and buying on the other. The high liquidity of the Forex contributes to this strategy by offering the possibility to sell or buy at any time of the day.
The main objective of diversification is here to cover the risks undergone on one of your positions using an opposite position. You therefore have full control of your investments and it is easier to master your real risks from the moment where you pay particular attention to the risks you take. The orders are there to help you master these risks without requiring too much diligence. Remember that whatever happens, your orders will be completed at the rates you have set.
Due to the leverage effect that we explained earlier, you can either decide to take a chance on making major profits but at the risk of losing a lot too, or keep your risks to a minimum and rely on your strategy and money management to make lesser profits.
The ideal position is therefore to trade on 3 or 4 pairs simultaneously in order to limit your risks to the maximum, even if this signifies that your profits will be a little smaller. However, do make sure you carefully choose the pairs you invest in.
Certain trading platforms offer their clients tools that indicate in real time the client’s exposure to different currencies. This information, coupled with your intuition and technical analysis will enable you to reduce or increase your exposure.
As we detailed earlier, a currency should never be considered alone but rather in correlation with another. This is exactly the reason for diversification. To benefit from the different trading methods it is not enough simply to analyse one currency compared to another but rather one pair of currencies compared to another with one of the currencies being common to both. Very often, these pairs move in parallel as they are both vulnerable to the same economic susceptibilities. This is therefore the ideal method of identifying opportunities while at the same time diminishing your risks on certain investments. You can therefore evaluate more precisely your exposition to one or several currencies.
When you trade on the Forex, it is preferable to compile your portfolio with trades relative to currency pairs that move in opposite ways. The more marked this effect, the more you will cover your investments. Of course, this method will proportionately lessen your opportunities for profits. Use the correlation rate to determine the direction in which the different pairs are moving. The more the rate approaches the value of -100 the more the rate has a tendency to move in the other direction, and the same with the opposite.
As the Forex is a dynamic market, these correlation rates vary over time. It is therefore necessary to update your data on a regular basis.