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Currently existing Foreign Exchange market (or Forex) is undoubtedly the largest and most sophisticated market in the history of mankind. Daily volumeof trades on Forex may reach 4-5 trillion dollars per day, which is greater that daily capacity of all other markets combined. This is a spot market, which means that the deals are being conducted instantly and practically without delay. There is, however a possibility to postpone the execution of such deals, but it is a technical procedure and has nothing to do with traditional derivatives or deferred payment options. The list of main participants of the market includes banks, investment institutions as well as private speculators of various kinds. The latter are being percieved as the participants who provide liquidity to the market, or in simpler terms, primary serve as cannon fodder, providing the necessary momentum and volatility at the expense of their own assets.
The concept of Forex
There are several perceptions of the market per se. For major players – so called market-makers – Forex is a convenient instrument for currency trading with relatively narrow trends and speedy execution. Investment companies use Forex for hedging their portfolios and minimizing possible losses. There is, however, a different perception of themarket. Certain speculators, both corporate and private, consider Forex a sort of treasury from the Arabian Nights, which can bring them quick and easy money overnight. This approach leads to hasty and uninformed decisions which lead to the retention rate of no more than 10% among new entrants to the market after the first 12 months. This is the greed which provides the grease for the mechanism of the system. This situation remind me of thesaying of Jack London concerning the roulette – it is a mathematical system by itself, and if we assume that it may be logically assessed by another mathematical system, we would have to assume that two objects may exist in the same place at the same time, which is not possible. The extent of chaos and unpredictability om the marketis extremely high, and no method of technical or fundamental analysis provides a universal solution to the problem. Nevertheless the memory of George Soros who once earned 700 million dollars overnight on Forex in 1990-ies still preserves, despite the fact that he lost most of his fortune on the market in the following years.
Underlying principles of Forex
Anyway, watching the market and trying to detect and analyze the underlying mechanisms and techniques are extremely interesting. It is worth an effort, as the market demonstrates the principles of work of technical analysis aswell as numerous psychological tricks.
It is commonly percieved that Forex market never sleeps and is open 24/7. It is not completely correct. First of all, there is no trading between 18.00 West coast time on Friday and 08.00 Tokyo time on Monday. Secondly, the market hours of various nations overlap, but not entirely. The highest degree of trading activity is when European and US markets are both open. There is also ahigh volume of trades during the overlap of Japanese and Australian markets. Thisfact shouldbetaken into account intheanalysis of specific currency pairs.
Major currency pairs
AUD/USD – Australian dollar traded against theUS dollar. AUD is a regional currency, and this pretty much defines the trading pattern. It would betempting to say that the trendsare symmetrical to EUR/USD, butit is not entirely so. As USD is clearly a stronger currency here, market fluctuations here mostly depend on its performance and macroeconomic data from the USA.
EUR/GBP – this pair enjoys a higher degreeof liquidity due to higher volume of trades. The markets of UK and continental Europe (primarily – Frankfurt and Paris) practically overlap. However, it shouldbe also kept in mind that neither of these currencies is comparableto USD interms of influence on the global economy, therefore the volume of trades is still relatively low. Main market events which influence the pair is macroeconomic data and forecasts from theUK and Germany.
EUR/USD – is the largest and undoubtedly the most important currency pair traded on the market. It is also true that due to the greatest volume of trades on Forex, this pair is themost volatile one and suffers greatly from various large-scale speculations. Data from both EU and USA have a great impacton the exchange rate.
USD/CAD – in this pairUSD is traded against Canadian dollar, also quite stable, but regional currency. The exchange rate is less volatile than in the previous case and reflects economic performance of the USA as well as the paradigm of relations between the two countries.
USD/JPY – this is the second most traded currency pair among this list. The Japanese economy is oversaturated and tends to react negatively to further stagnation. Performance of the American economy and especially respective macroeconomic forecasting has a strong impact on the trend.
Technical analysis
There are two commonly accepted forms of analysis on the Forex market- technical and fundamental. The first represents analysis of specific technical indicators, the latter puts stress on global or regional political and economic events and their subsequent impact on themarket. Let’s have a closer look at the main areas of technical analysis.
This form of analysis is currently used on othermarketsas well. The usage of technical analysis is based on theassumption that itis possible to predict further price changes due to its previous performance. There are three major areas of indicators which are being used within the field of technical analysis: moving averages, stochastic indicators and oscillators.
Moving averages are being superimposed on the trading graphs and aregood for reflecting the general trend. The value of the moving average is being calculated taking into account price value within the past several bars of a time frame (usually from 3 to 500). The greater the number is, the more smoothed the average appears to be. This method, however, has very serious limitations,which areespecially visible on theForex market. The price change here depends on a number of very fast deals, and the trend may change entirely within 1-2 minutes. The moving average issimply unable to reflect such change in a timely manner andtherefore produces false signals to traders. In other words, properly smoothed moving averages are capable to providing accurate information concerning previous trends and liberate the trader from “white noise” of the market, yet it may be counterproductive andeven dangerous to try to use it for price prediction.
The second group of indicators within technical analysis is represented by stochastic indicators. Such indicators (e.g. MACD and Awesome Indicator) demonstrate the momentum of the market, or the potential of price to continue further movement within the set trend or a change of such. Some of them are based on the data retrieved from values of convergence and divergence of moving averageseither ofdifferent nature or of various calculation periods. These indicators are alsorelatively slow in terms of timely reaction to short-term and unexpected price changesandshould be treated with care.
Oscilators,the third group of indicators, are based on the measurement and estimation of market volatility. They may be goodpredictors of the moment of entering or leaving the market, however they themselves do not predict the direction of the trend. The natureof Forex is such,that even with strong and positivesignals of indicators the trend may develop in a quite unpredictable manner.
Market events
Maket events by themselves cannot serve as trustworthy predictors of pricing trends,either. Let’s take the events of Wednesday, December 4th, 2013. There have been around 20 ofsuch events publishedwithin working hours – around 35% of which were concerning USD economy (Reports on new home sales, crude oil inventories etc.), another 35% went to the Euro zone (manufacturing indexes in Spain and Italy, Retail services quarterly report, revised quarterly GDP report etc.), the rest 30% were distributed among GBP, CAD and JPY. The nature of these events may signify their high importance, and it would be reasonableto assume that they had a strong andstraight-forward impact on the currency exchange rates. Their influence, however, was not so obvious. Strong events might have destabilized the market, yet the situation was similarto superposition of waves in a pond where several stones were thrown. Apart from time lag with reportingoftheevents (they became available to the investors on average within 5-7 minutes since they actually happened), they also tended to somewhat neutralize each other. On the other hand, oneshould not forget about possible bearish and bullish traps, which may be set on the market in order to cut off those traders who expect a linear market reaction on such events. Although it is very difficult to influence the market of such size and complexity, it is nevertheless theoretically possible for bulls and bears to speculate on expectations of others within proximity from important market events.
Behavioral aspects of Forex trade
The observations, provided above concerning the main postulates of technical analysis as well as market events, allow us to define the main psychological aspects of Forex trading and their respective false assumptions.
Illusion of control.
Many rookies fall for this. It seems obvious – there are hundreds of indicators and news programs, thementors showed a lot of graphs which demonstrate the possibility of successful trading based on the commonly accepted and utilized rules of thumb. In reality, however, this point of view if far from perfect.
The indicators fail, the market events do not lead to theexpected results, and it is extremely difficult to cope with pressure and stick to a certain specific market strategy. The feeling of control appears to be a bogus and may cost a lotof money.
Noise trading.
The noise on the market is inevitable. Each moment hundreds of deals are being completed, and it is quite understandable that some participant are trying to sell or buy outside of the general trend. These fluctuations of price may be considerable over a period of time, and it gives an impression of a trend change.
Then suddenly the price is back to the existing corridor, and the less fortunate traders are calculating their losses. Thereare some indicators (e.g. ZigZag) which allow to get rid of the noiseand be able to determine the trend. Such indicators, however, also provide a lot of false signals andtendto explain the past much better than the present.
Overreaction towards new information.
Some people would think that a major forthcoming market event will surely change the trend and increase volatility to a certain degree. As it was mentioned above, it does notnecessarily happen.
First of all, the event, although major for the bigger world, in general, may not be so important for Forex. Secondly, the market effects of various events may neutralize each other. Thirdly, bearish or bullish attempts may result in a complete different impact of the event on the market rather than expected.
Underreaction towards new information.
This is the oppositeto the fallacy described above, and it may lead to financial losses,as well. If one does not take into account the possible impact of the new information on the market, it may cost him.
For example, if a trader neglects the possible result of a certain event and does not close or at least modify his position, the trader may find soon enough that he is trading against the trend. This may result in the loss of money and orientation on the market.
Anchoring.
One of the most popular and logically understandable traps. For instance, if the market has been following a certain trend within the past few weeks, it may appear highly likely that it follows a specific pattern. It may be therefore assumed that the price will further change within a certain corridor, which may be used to hedging the risks or evenscalping the market.
It is natural for a human mind to look for patterns and try to identify them. That’s why traders are trying to convince themselves that the market is predictable, and that they can use some anchored values while essessing it. Reality proves them wrong far too often.
Major trading risks
It is obvious that there are certain outside risks that affect the market, although not always in a linear predictable manner. Such megarisks may include political risk (e.g. involvement of the USA in another war, victory of an unexpected candidate at presidential elections etc.), interest rate risk (unexpected and significant change of interest rates by governments) aswell as payment risk (a rare case for stable and economically developed countries which do not normally experience problems with debt payments). Such risks affect the market as a whole and may potentially lead to long-term change of trends, increase of volatility and overall unpredictability.
Conclusion
So, taking all af this information into account, we should ask themselves: How efficient is the Foreign Exchange market? On the one hand, it is the most deregulated market in the world. No government, no organization or international agreement seems to be powerful enough to control it. The prices for currencies are being formed solely on the basis of respective supply and demand. It is also true, however, that market participants may be influenced by certain macroeconomic and political events. Although it is highly doubtful that any particular financial institution has enough resources and motivation to dictate the trends in its favor, it is possible, nevertheless, that certain speculative bearish and bullish actions still occur. It is yet to be discovered whether the Foreign Exchange market is a chaos with elements of order, or a complex and logical mathematical model with a certain degree of unpredictability.
References:
- Foreign Exchange Simulation (2013). Oanda Corporation. Web. Retrieved from www.oanda.com
- Calendar of Market Events (2013). Forex Factory. Web. Retrieved from www.forexfactory.com
