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There are many ways to trade in the currency market. Here are 3 ways that take advantage of the key drivers of currency trading — fundamentals, technical, and market sentiment.
News. Economic news, political news, and commentary from monetary officials that is at odds with market expectations can all have a massive impact on price. Speculation is all about sentiment, and news can either reinforce that sentiment or completely turn it around.
One mistake that many novice traders make is assuming that all news is discounted in the price the moment it hits the computer screen. This is not true. The currency market is the largest, deepest, most liquid financial market in the world, trading more than $3 trillion of volume a day. In this market, it is impossible for prices to adjust instantly to major news surprises. When large players such as multi-national corporations or multi-billion dollar hedge funds react to the latest changes in the economic or political landscape, price can sometimes take days to fully adjust to the new reality.
By and large, currencies tend to develop very strong and persistent trends. Unlike stocks, which can be influenced by a myriad of unforeseen variables—from the state of the economy to the sudden change in management—currencies are primarily driven by larger macro-economic issues such as the country’s growth, unemployment rate, and interest rate policy. Therefore, like a large ship at sea, once they have established a direction, currencies tend to follow it.
However, it's not always straightforward to tell what that direction may be. On a day-to-day basis, economic and political news or speculative positioning can temporarily knock currencies off course, making trend trading more difficult than you may predict.
We have the benefit of technical analysis at our disposal to help us distinguish true trend from random noise. One of traders' favorite method to gauge trend is using Bollinger Bands. Bollinger Bands are one of the most popular technical indicators for traders in any financial market—stocks, bonds, or foreign exchange. In essence, Bollinger Bands measure deviation that help traders stay on the right side of the trend. Many traders use them primarily to determine overbought and oversold levels, selling when price touches the upper Bollinger Band and buying when it hits the lower Bollinger Band.
One of the most common trading strategies in the currency market is to try to pick tops and bottoms, but using traditional technical analysis can be frustratingly difficult. However, fading sentiment has proven to be a useful way to time tops and bottoms. Once a week, online brokerages lke FXCM publishes Speculative Sentiment Index, which measures the positioning of a subset of exceedingly speculative traders. This Index relies on traders who are always caught on the wrong side of the market and always trying to pick tops and bottoms at the wrong time. When they give up is the exact time when a turn usually occurs.
Here is a link to a sample of the Speculative Sentiment Index. The black line is the price of the EUR/USD while the bars represent the ratios of long to short positions. As a rule of thumb, when positioning is short, the contrarian signal is to buy EUR/USD in this case. When it is long, the signal is to sell the EUR/USD. When the ratio flips from short to long, expect a top relatively soon; and when it flips from long to short, expect a bottom.