Foreign exchange, more commonly known as forex, is the most traded market in the world. Well over $5 trillion of currency is traded in a single day, dwarfing the hundreds of billions traded on stock markets around the world. While the big banks and corporations make up the vast majority of daily forex trading, everyone else in the market is still trading trillions of dollars’ worth of forex each and every day.
There are only two drivers of forex: supply and demand. In turn, both of these are influenced by just one thing: sentiment. However, sentiment is moulded by an endless list of factors and the mood of investors is highly sensitive to the flood of news, data and other developments that happen around the world, particularly as the fast-moving forex market is open 24 hours a day.
Still, investors have more tools to aide their forex trading strategies than ever before, allowing them to implement a range of different methodologies and approaches to help them gain an edge in the market. But this has also made the forex market more competitive than ever.
We have a look at the various tools that investors can use when trading forex, as well as some different approaches that can be taken.
What approach should investors use to predict forex movements?
Before deciding what approach to take forex investors need to define the basics of their strategy, including what currency pairs to trade. The majority of trading volumes in the forex market are concentrated on major currency pairs, like EUR/USD, GBP/USD and USD/JPY, but some find opportunity by focusing on other, less popular pairs.
Read more about the most overlooked currency pairs
Another major factor that will influence what approach to take is the timeframe in which to trade. Many short-term forex traders will start afresh each day, closing out all of their positions before the end of the day (wherever they are) in order to avoid any drastic price movements that could occur overnight, known as day trading. Others look to hold positions over a slightly longer period, typically between two to 14 days, known as swing trading. Those in it for the longer term use the likes of position trading, which sees traders hold positions for months or even years while trying to refrain from reacting to any up or down price movements in the meanwhile.
Learn more about day trading and swing trading
Not all types of forex trading are proactive, whereby traders predict where they believe a certain currency to be heading, but reactive, responding to moves in price. This includes momentum trading, when traders believe a notable price movement up or down is the start of a longer-term trend, or range trading, when traders try to spot where the levels of support or resistance have occurred in the past with the expectation those levels will come round again. Range trading is mainly used for currencies that roam up and down in price but have no clear long-term trend.
Forex predictions: fundamental analysis vs technical analysis
In order to gain an insight into where the forex market is heading and to muster up a view on what currency pair to trade, two main types of analysis are used: fundamental and technical. Fundamental analysis involves evaluating the many external events and influences that impact the price of currencies such as the state of the economy and financial markets, as well as government and monetary policy. Technical analysis, on the other hand, concentrates solely on the price and predicting future movements in the forex market using patterns and trends identified from historical price charts and statistics.
In a nutshell, fundamental analysis aims to find a currency that is either over-or-undervalued by identifying what the true value based on the external factors that drive price movements. It centres on what impacts the price, but not the price itself. Technical analysis, on the other hand, is all about understanding supply and demand with the expectation that previous market patterns will be repeated, focusing only on the price and disregarding everything else as unquantifiable data.
Using fundamental analysis to predict forex movements
As the name suggests this is all about analysing the fundamentals of the market, considering all the factors that influence exchange rates - everything from monetary and government policy to the state of the labour and housing markets. The core belief behind fundamental analysis is that it can identify a currency that is mispriced and will eventually correct itself. This is part of the reason why fundamental analysis is generally better at predicting longer-term price movements, although it does have its uses for short-term strategies.
While the list is endless and some events can be unpredictable, such as natural disasters, there are a few key drivers to the price of currencies that should always be at the forefront of any fundamental analysis. These are:
- Economic growth: the state and performance of a country’s overall economy, centred on data like gross domestic product (GDP), which measures whether the economy is growing or shrinking, and at what rate. When an economy is improving it generally translates to a stronger currency as it attracts investors to their financial markets, whereby traders have to use local currency to buy stocks or other financial assets in the country
- Inflation: how fast the price of goods and services is rising affects monetary policy in a country, such as the likelihood of rising interest rates, which in turn weighs on exchange rates. The main measures of inflation to consider are the retail price index (RPI) and consumer price index (CPI)
- Interest rates: this has one of the biggest bearings on the forex market. Higher interest rates generally lead to a stronger currency as, again, it attracts investors to invest their money in savings accounts or other instruments to benefit from the higher savings rates on offer, increasing demand for local currency
- Trade and capital balances: with the forex market international by nature, changes in the amount of money or trade flowing in and out of a country will impact its currency. A currency of a country heavily reliant on exports will fall if those exports drop, for example. For capital, any signs that investors and traders are tacking their money out of the country could be a sign that sentiment is changing, or vice-versa if the flow of investment is growing
- Employment and wages: the level of employment can be correlated to the overall strength of an economy but the movement in wages is equally important. Although rising employment signals that an economy is strengthening, stagnate wages can suggest disposable incomes and the state of the public’s personal finances are not performing as well (or vice-versa)
- Geopolitics: in addition to the swathe of economic data, developments in the political world also weigh on the forex market. With currencies representative of their country, the exchange rate is swayed by government politics and international relations, shaken up by disturbances to the political status quo
Using an economic calendar to predict forex
Fortunately for forex traders there is an easy way to keep up with developments and prepare for the major events that move the price of currencies, the ones that are scheduled anyway. An economic calendar is crucial for anybody trading forex and a guide to the biggest economic and political events that are likely to have an effect, one way or another, on forex and other financial markets.