Tuesday, 22 May 2012

Short Term Fundamental Analysis

A. Event-Driven Trading
The Importance of News

  • Exchange rate fluctuations are highly correlated with news.
  • News that is unexpected tends to have a major impact on the market.
The most important aspect of interpreting news and its impact on the foreign exchange markets is the determination of the market's expectations for that news. In the financial world, this is commonly referred to as the "market discount mechanism". The correlation between currency markets and news is pretty clear. Expected news has little impact on exchange rates while unexpected news, especially when pertaining to potential changes in monetary policy, may have an immense impact. Short-term traders need to closely monitor financial publications like The Financial Times and The Wall Street Journal, as they are excellent gauges of current sentiment towards potential news events. Being aware of events and expectations allows traders to be fully prepared for, and profit from, the discounting of potential market moving events.

Event-Driven Trading

  • It is difficult to determine the effect of news on currency movements.
  • Traders need to avoid analyst bias and take special care when trading during economic releases.
Event-driven trading is a fundamental based methodology that attempts to exploit the volatility associated with economic releases and political announcements. Often times it is quite difficult to determine the effect of news on currency movements, and because of this traders need to avoid biased analysis and adopt a defensive posture during these events. Generally, as fundamental news becomes available, the market as a whole will assimilate the news and move the exchange rates to more appropriate levels as market perceptions adjust accordingly. The event driven trader seeks to profit from this ensuing shift in price. Timing of event driven trades is obviously a key factor to success as positions entered prematurely or belatedly can have significant adverse impacts on P&L. For this reason, profitable event-driven traders usually incorporate some form of technical analysis that helps to validate the merit of the fundamental catalyst.

A Common Error

  • News releases can lead to sharp volatility in FX, but this volatility can begin well in advance of the actual announcement.
  • Much of this volatility occurs in the days leading up to the announcement.
Economic releases can lead to sharp increases in volatility in the currency markets. This rise in volatility can begin days in advance of an announcement and end days later. The most common mistake made by most novice traders is to enter positions after a particular announcement hits the new wires in an attempt to profit from the perceived good or bad news. What they fail to realize is that if an economic release meets expectations, there will likely be no reaction to the news because it is already 'priced in' to the market. The reaction of the market is based on the market's expectations, not on whether the news was intrinsically good or bad.

Buy the Rumour, Sell the News
Rather than trade on the announcement itself, some participants prefer to trade on the rumors that circulate before its release.
Bank dealers and institutional traders often adhere to the old Wall Street adage of “buy the rumor, sell thenews”. Rumors of a positive report will typically begin to circulate among trading desks and hedge funds days before an expected release date. The institutions will then use this information to position themselves on the long side. When the news comes out as expected, they then sell their positions to a frantic public, profiting from the run-up to the announcement as opposed to guessing the reaction to it.

USD/JPY is a good example of an event driven trade where technicals and fundamentals were in clear alignment. Notice how the pair breaks the neckline of a bearish Head & Shoulders pattern the week before the crucial G-7 Meeting in Dubai.

B. Key Economic Terms
A number of economic terms are particularly relevant to the FX market. The following is a list of economic indicators that are released on a scheduled basis and are observed by traders and analysts. Analysts project their estimates for results of these economic statistics, and the market's reaction to this news is usually based on these estimates.

The unemployment rate is a measure of the strength of the labor market. One of the ways analysts gauge the strength of an economy is by the number of jobs created, and the percentage of workers unable to find jobs. Strong job creation is indicative of economic growth, as companies must increase their work force in order to meet demand.

CPI (Consumer Price Index)
The CPI is a key gauge of inflation, as it measures the price of a fixed basket of consumer goods. Higher prices are considered negative for an economy, but since central banks often respond to price inflation by raising interest rates, currencies sometimes respond positively to reports of higher inflation.

PPI (Producer Price Index)
The PPI is another gauge of inflation, but it differs from CPI as it measures inflation at the producer or wholesale level. Note that because food prices are seasonal and energy prices are frequently volatile, many analysts tend to focus on the core rate of inflation, which excludes food and energy prices. The PPI affects various markets in a similar respect to the CPI, because the prices producers receive ultimately affects the prices consumers pay.

GDP (Gross Domestic Product)
GDP measures the total production and consumption of goods and services, representing the total economic output of a nation. It is calculated by adding expenditures by households, businesses, governments and net foreign purchases.

Balance of Trade
The balance of trade measures the difference between the value of goods and services that a nation exports and the value of goods and services that it imports. A trade surplus results if the value of exported goods exceeds that of imported goods, whereas a trade deficit exists if imported goods exceed exported goods.

Manufacturing Indices (ISM, PMI)
Manufacturing indices measure manufacturing activity, usually in a particular region of the country. Since they are an indication as to whether the economy is expanding or contracting, FX participants place heavy emphasis on these figures.

Consumer Confidence (Michigan Index, Consumer Conference Board, etc.)
Consumer confidence is a measure of the level of confidence in economic performance. It is calculated via the results of a survey asking participants what they think of the economy relative to both the past and the future. These numbers can be a precursor to the level of future consumer spending.

Retail Sales
Retail sales is a measure of the total goods sold by a sampling of retail stores. It is used as a gauge of consumer activity and confidence as higher sales figures would indicate increased economic activity.

Industrial Production
Industrial production measures the change in the physical output of factories, mines, gas and electric utilities. A rise in the IP value signals economic growth. Note that unlike sales value, which incorporates both quantity and price, IP solely refers to the physical quantity of items produced.

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