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The overall forex market generally trends more than the overall stock market.
Why? The equity market, which is really a market of many individual stocks, is
governed by the micro dynamics of particular companies. The forex market, on
the other hand, is driven by macroeconomic trends that can sometimes take years
to play out. These trends best manifest themselves through the major pairs and
the commodity block currencies. Here we take a look at these trends, examining
where and why they occur. Then we also look at what types of pairs offer the
best opportunities for range-bound trading. (Trade 10 of the most popular
currency pairs on our NEW forex trading simulator, FXtrader.)
The Majors
There are only four major currency pairs in forex, which makes it a quite easy
to follow the market. They are:
EUR/USD - euro / U.S. dollar
USD/JPY - U.S. dollar / Japanese yen
GBP/USD - British pound / U.S. dollar
USD/CHF - U.S. dollar / Swiss franc
It is understandable why the United States, the European Union and Japan would
have the most active and liquid currencies in the world, but why the United
Kingdom? After all, as of 2005, India has a larger GDP ($3.3 trillion vs. $1.7
trillion for the U.K.), while Russia's GDP ($1.4 trillion) and Brazil's GDP
($1.5 trillion) almost match U.K.'s total economic production. The explanation,
which applies to much of the forex market, is tradition. The U.K. was the first
economy in the world to develop sophisticated capital markets and at one time
it was the British pound, not the U.S. dollar, that served as the world's
reserve currency. Because of this legacy and because of London's primacy as the
center of global forex dealing, the pound is still considered one of the major
currencies of the world.
The Swiss franc, on the other hand, takes its place amongst the four majors
because of Switzerland's famed neutrality and fiscal prudence. At one time the
Swiss franc was 40% backed by gold, but to many traders in the forex market it
is still known as "liquid gold". In times of turmoil or economic stagflation,
traders turn to the Swiss franc as a safe-haven currency.
The largest major pair - in fact the single most liquid financial instrument in
the world - is the EUR/USD. This pair trades almost $1 trillion per day of
notional value from Tokyo to London to New York 24 hours a day, five days a
week. The two currencies represent the two largest economic entities in the
world: the U.S. with an annual GDP of $11 trillion and the Eurozone with a GDP
of about $10.5 trillion.
Although U.S. economic growth has been far better than that of the Eurozone
(3.1% vs.1.6%), the Eurozone economy generates net trade surpluses while the
U.S. runs chronic trade deficits. The superior balance-sheet position of the
Eurozone and the sheer size of the Eurozone economy has made the euro an
attractive alternative reserve currency to the dollar. As such, many central
banks including Russia, Brazil and South Korea have diversified some of their
reserves into euro. Clearly this diversification process has taken time as do
many of the events or shifts that affect the forex market. That is why one of
the key attributes of successful trend trading in forex is a longer-term
outlook.
Observing the Significance of the Long Term
To see the importance of this longer-term outlook, take a look at Figure 1 and
Figure 2, which both use a three-simple-moving-average (three-SMA) filter.
Figure 1: Charts the EUR/USD exchange rate from Mar 1 to May 15, 2005. Note
recent price action suggests choppiness and a possible start of a downtrend as
all three simple moving averages line up under one another.
Figure 2: Charts the EUR/USD exchange rate from Aug 2002 to Jun 2005. Every bar
corresponds to one week rather than one day (as in Figure 1). And in this
longer-term chart, a completely different view emerges - the uptrend remains
intact with every down move doing nothing more than providing the starting
point for new highs.
The three-SMA filter is a good way to gauge the strength of trend. The basic
premise of this filter is that if the short-term trend (seven-day SMA) and the
intermediate-term trend (20-day SMA) and the long-term trend (65-day SMA) are
all aligned in one direction, then the trend is strong.
Some traders may wonder why we use the 65 SMA. The truthful answer is that we
picked up this idea from John Carter, a futures trader and educator, as these
were the values he used. But the importance of the three-SMA filter not does
lie in the specific SMA values, but rather in the interplay of the short-,
intermediate- and long-term price trends provided by the SMAs. As long you use
reasonable proxies for each of these trends, the three-SMA filter will provide
valuable analysis.
Looking at the EUR/USD from two time perspectives, we can see how different the
trend signals can be. Figure 1 displays the daily price action for the months
of March, April and May 2005, which shows choppy movement with a clear bearish
bias. Figure 2, however, charts the weekly data for all of 2003, 2004 and 2005,
and paints a very different picture. According to Figure 2, EUR/USD remains in
a clear uptrend despite some very sharp corrections along the way.
Warren Buffett, the famous investor who is well known for making long-term
trend trades, has been heavily criticized for holding onto his massive long EUR
/USD position which has suffered some losses along the way. By looking at the
formation on Figure 2, however, it becomes much clearer why Buffet may have the
last laugh.
Commodity Block Currencies
The three most liquid commodity currencies in forex markets are USD/CAD, AUD/
USD and NZD/USD. The Canadian dollar is affectionately known as the "loonie",
the Australian dollar as the "Aussie" and the New Zealand Dollar as the "kiwi".
These three nations are tremendous exporters of commodities and often trend
very strongly in concert with the demand for each their primary export
commodity.
For instance, take a look at Figure 3, which shows the relationship between the
Canadian dollar and prices of crude oil. Canada is the largest exporter of oil
to U.S. and almost 10% of Canada's GDP comprises the energy exploration sector.
The USD/CAD trades inversely, so Canadian dollar strength creates a downtrend
in the pair.
Figure 3: This chart displaysthe relationship between the loonie and price of
crude oil. The Canadian economy is a very rich source of oil reserves. The
chart shows that as the price of oil increases, it becomes less expensive for a
person holding the Canadian dollar to purchase U.S.dollars.
Although Australia does not have many oil reserves, the country is a very rich
source of precious metals and is the second-largest exporter of gold in the
world. In Figure 4 we can see the relationship between the Australian dollar
and gold.
Figure 4: This chart looks at the relationship between the Aussie and gold
prices (in U.S. dollars). Note how a rally in gold from Dec 2002 to Nov 2004
coincided with a very strong uptrend in the Australian dollar.
Crosses Are Best for Range
In contrast to the majors and commodity block currencies, both of which offer
traders the strongest and longest trending opportunities, currency crosses
present the best range-bound trades. In forex, crosses are defined as currency
pairs that do not have the USD as part of the pairing. The EUR/CHF is one such
cross, and it has been known to be perhaps the best range-bound pair to trade.
One of the reasons is of course that there is very little difference between
the growth rates of Switzerland and the European Union. Both regions run
current-account surpluses and adhere to fiscally conservative policies.
One strategy for range traders is to determine the parameters of the range for
the pair, divide these parameters by a median line and simply buy below the
median and sell above it. The parameters of the range is determined by the high
and low between which the prices fluctuate over a give period. For example in
EUR/CHF, range traders could, for the period between May 2004 to Apr 2005,
establish 1.5550 as the top and 1.5050 as the bottom of the range with 1.5300
median line demarcating the buy and sell zones. (See Figure 5 below).
Figure 5: This charts the EUR/CHF (from May 2004 to Apr 2005), with 1.5550 as
the top and 1.5050 as the bottom of the range, and 1.5300 as the median line.
One range-trading strategy involves selling above the median and buying below
the median.
Remember range traders are agnostic about direction (for more on this, see
Trading Trend or Range?). They simply want to sell relatively overbought
conditions and buy relatively oversold conditions.
Cross currencies are so attractive for the range-bound strategy because they
represent currency pairs from culturally and economically similar countries;
imbalances between these currencies therefore often return to equilibrium. It
is hard to fathom, for instance, that Switzerland would go into a depression
while the rest of Europe merrily expands. The same sort of tendency toward
equilibrium, however, cannot be said for stocks of similar nature. It is quite
easy to imagine how, say, General Motors could file for bankruptcy even while
Ford and Chrysler continue to do business. Because currencies represent
macroeconomic forces they are not as susceptible to risks that occur on the
micro level - as individual company stocks are. Currencies are therefore much
safer to range trade.
Nevertheless, risk is present in all speculation, and traders should never
range trade any pair without a stop loss. A reasonable strategy is to employ a
stop at half the amplitude of the total range. In the case of the EUR/CHF range
we defined in Figure 5, the stop would be at 250 pips above the high and 250
below the low. In other words if this pair reached 1.5800 or 1.4800, the trader
should stop him- or herself out of the trade because the range would most
likely have been broken.
Interest Rates - the Final Piece of the Puzzle
While EUR/CHF has a relatively tight range of 500 pips over the year shown in
Figure 5, a pair like GBP/JPY has a far larger range at 1800 pips, which is
shown in Figure 6. Interest rates are the reason there's a difference.
The interest rate differential between two countries affects the trading range
of their currency pairs. For the period represented in Figure 5, Switzerland
has an interest rate of 75 basis points (bps) and Eurozone rates are 200 bps,
creating a differential of only 125 bps. However, for the period represented in
Figure 6, however, the interest rates in the U.K are at 475 bps while in Japan
- which is gripped by deflation - rates are 0 bps, making a whopping 475 bps
differential between the two countries. The rule of thumb in forex is the
larger the interest rate differential, the more volatile the pair.
Figure 6: This charts the GBP/JPY (from Dec 2003 to Nov 2004). Notice the range
in this pair is almost 1800 pips!
To further demonstrate the relationship between trading ranges and interest
rates, the following is a table of various crosses, their interest rate
differentials and the maximum pip movement from high to low over the period
from May 2004 to May 2005.
Currency Pair Central Bank Rates (in basis points) Interest Rate Spread (in
basis points) 12-Month TradingRange (in pips)
AUD/JPY AUD - 550 / JPY - 0 550 1000
GBP/JPY GBP - 475 / JPY - 0 475 1600
GBP/CHF GBP - 475 / CHF - 75 400 1950
EUR/GBP EUR - 200 / GBP - 475 275 550
EUR/JPY EUR - 200 / JPY - 0 200 1150
EUR/CHF EUR - 200 / CHF - 75 125 603
CHF/JPY CHF - 75 / JPY - 0 75 650
While the relationship is not perfect, it is certainly substantial. Note how
pairs with wider interest rate spreads typically trade in larger ranges.
Therefore, when contemplating range trading strategies in forex, traders must
be keenly aware of rate differentials and adjust for volatility accordingly.
Failure to take interest rate differential into account could turn potentially
profitable range ideas into losing propositions.
The forex market is incredibly flexible, accommodating both trend and range
traders, but as with success in any enterprise, proper knowledge is key.
by Boris Schlossberg
Boris Schlossberg is the director of currency research at GFT. He is a weekly
contributor to CNBC's "Squawk Box" and a regular commentator for Bloomberg
radio and television. His daily currency research is widely quoted by Reuters,
Dow Jones and Agence France Presse newswires and appears in numerous newspapers
worldwide. Schlossberg has written for publications like SFO Magazine, Active
Trader and Technical Analysis of Stocks and Commodities. He is also the author
of "Technical Analysis of the Currency Market" and the co-author of
"Millionaire Traders" with Kathy Lien.