Currency Trading – Day 2: Three Easy Ways to Trade Currencies
Lesson 2: Three Easy Ways to Trade
Currencies
No two people are alike. We all have different tastes,
styles, and temperaments. Fortunately, when it comes to
trading, we don’t have to limit ourselves to a single
strategy. There are many ways to trade the currency
market, and in this report, we have focused on 3 specific
styles that take advantage of the key drivers of currency
trading—fundamentals, technicals, and market sentiment.
News Moves Markets
What moves currency markets? 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 of the common mistakes that many novice traders
make is assuming that all news is discounted in the price
the moment it hits the computer screen. Not so at all. The
currency market is enormous. In fact, it 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.
Following the flow is what reactive trading is all about.
There’s no need to guess the result beforehand, which is
often difficult for traders without a strong economic
background. Instead, we sit and observe. If the piece of
economic data is considerably worse or better than the
forecast, then a good reactive opportunity may present
itself. There is, however, one key rule that we follow in all
reactive trades: We are either right or we are out. If the
price has not reacted as expected to a given piece of
news and has in fact retraced all the way to pre-news
levels—why be in the trade? The market has clearly
decided that the news does not matter enough, so we
take a small loss and move on. In those cases when we
are right, however, we try to milk our profits for as much
as we can.
Each week, our Trading the News report teaches you
exactly how to trade reactively. We pick the most market
moving data of the week and give you clear entry and exit
levels (Sample Report).
Stay With a Trend
Trade with the trend is an old maxim that has helped
many traders earn millions of dollars in the currency
market (conversely, they can also lose millions of dollars).
Generally, currencies tend to develop very strong and
persistent trends. Unlike stocks, which can be impacted
by a myriad of unforeseen variables—from the overall
state of the economy to the sudden surprising resignation
of a key executive—currencies are primarily driven by
larger macro-economic issues such as the country’s
growth 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 clear 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 think. Fortunately, we have the benefit of technical
analysis at our disposal to help us distinguish true trend
from random noise. One of our favorite ways to gauge
trend is through Bollinger Bands. Bollinger Bands are one
of the most popular technical indicators for traders in any
financial market—stocks, bonds, or foreign exchange.
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.
We, however, have a unique way of using Bollinger
Bands to create dynamic price channels that help us to
stay on the right side of the trend. At the core, Bollinger
Bands measure deviation. This is the reason why they
can be very helpful in diagnosing trend. By generating two
sets of Bollinger Bands—one set using the parameter of
“1 standard deviation” and the other using the typical
setting of “2 standard deviation”—we can look at price
from a fresh perspective. In the chart below, we see that
whenever price channels between the upper Bollinger
Bands +1 SD and +2 SD away from mean, the trend is
up; therefore, we can define that channel as the “buy
zone.” Conversely, if price channels within Bollinger
Bands -1 SD and -2 SD, it is in the “sell zone.” Anywhere
in between is what we call “no man’s land.”
One of the other great advantages of Bollinger Bands is
that they adapt dynamically to price expanding and
contracting as volatility increases and decreases.
Therefore, the Bands naturally widen and narrow in sync
with price action, creating a very accurate trending
envelope.
Fading Sentiment
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,
FXCM publishes the 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
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