Trade Forex Fundamentally

This forex trading tutorial was written with the goal of letting you know what’s fundamentally driving price so you can make money trading forex by aligning yourself with these super powerful driving forces and making killer profits in the long run! Bear with me while we go over the basics here (even if you’re experienced there’s some gems here!).

Why is there a foreign exchange (“Forex”) market?

As long as we have importers and exporters doing business in other countries, we need a foreign exchange market. Different countries have different types of economies, production amounts, and laws and need a standard method for exchanging value. This is the reason why we have $2 trillion worth of currency crossing borders every 24 hours. As businesses grow or decline in different parts of the world, astute investors move their money from less attractive country investments to countries in which more attractive investments reside. Each time this occurs, an exchange of currency needs to happen at a rate that’s determined by the market’s perception of the value of one country with respect to another. The forex market is vast and consists of the cash market, the futures market, and derivatives used to protect against risk.

Who are the main players in the forex market and why is this important to me?

The forex market has several players, but they can essentially be grouped into one of three categories: commercial traders, speculators, and central banks. The commercial traders are the importers and exporters, ranging from small stores that trade international goods or large conglomerates that sell equipment overseas. They engage in the forex market to protect their cash flow from trading products overseas and investments. They usually do not have an interest in profiting from the forex market, but are just worried about exchange rates hurting their sales.

Speculators like to look at global economic trends and make an educated guess on where the market is going to be in the future. They are in the market for profit and are often taking the other side of the commercial traders’ trades.

Central banks monitor global financial activity and control the money supply in their country, often by changing interest rates. More often than not, they are not in the forex market to profit, but rather to make sure that there is sufficient growth in the economy, but not so much that inflation starts becoming an issue. They engage in the forex market by buying/selling foreign and domestic assets, otherwise known as intervention. By doing this they can control investment and business activity to achieve the happy medium referred to above.

What causes price to move in the forex market and how do I profit?

In the most simple sense, money flows to whatever offers the most attractive yield when times are good, and flows to whatever has the most safety in times of panic. So to sum it up, the driving forces of the forex market are yield and risk. You will want to align yourself to these powerful driving forces when selecting a direction to trade in so that you stand the best chance of making big profits.

For example, in 2008, the Reserve Bank of Australia set interest rates at 7.25%, which drove investors in countries like the U.S. and Japan where interest rates were relatively lower to invest in Australia. In the beginning of the year, AUD/USD and AUD/JPY increased in value significantly, whereas in the second half, those pairs plummeted in value because the onslaught of the credit crisis prompted money to flow into places that were perceived to be “safe” because of their lower interest rates (U.S. and Japan).

You will always want to keep in mind whether the market is in a “risk taking” (yield-seeking) or “risk adverse” mood. When the market is in the former mood, high interest rate currencies will do well. In the latter case, lower interest rate currencies will do better. The central banks recognize this and control interest rates to direct where money will flow. Do you see how the forex market depends heavily on interest rates? Do you see how businesses (“commercial traders”), investors (“speculators”), and central banks all tie in with each other now?

Let’s check out how interest rates actually work:

Forex Trading Education: "The Credit Cycle"

The credit cycle is basically a picture of the economy of a country. The amount of credit is going to determine the level of growth and inflation in a country, and thus its currency strength. Starting at the central bank at the bottom, we see that the central bank sets interest rates on money it lends to commercial banks, which lend to manufacturers and producers, who provide employment for people, who spend money on food and retail items. The central bank monitors the “health” of the economy by looking at growth or level of spending in each of the areas listed above, and speeds up or slows down the economy by changing the interest rate at which it lends credit to the banking system and businesses. The state of the economy and the yield of these interest rates then determine whether investors will put their money in that particular country, which will control the demand for currencies!

Do you see how the economy, interest rates, and the forex market all tie together now? Ok, you don’t have to be an economist to trade forex successfully, but you do need to be able to understand what’s going on so that you are able to put news events and price action into context and be able to say, “ah, this is good for the dollar” or “that’s going to destroy the Pound.” More on the specifics of this in the next few forex trading tutorial posts.