Basic Forex Trading Strategies For Beginners
The concepts about the Forex market might be daunting because of its very complicated out of this world, non average terms being used, however, it is quite funny that most of us already have a first hand experience with the said market. The mere fact that every time we go to a currency exchange station to change our money into another currency is already a basic participation of the Forex market.
It is understandable that we get overwhelmed because of its encompassing entity to other capital markets but the concepts about trading currencies are let’s say, simple. Now, I would want to share to you the basic Forex Trading Strategies for Beginners out there.
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Forex Trading Strategy : 8 Majors
If you have an experience in trading in the stock market, you need to choose a stock out of thousands of stocks however in the currency market, you only need to be updated with the Economic data being released almost daily by the countries that belong to the 8 Majors. It will provide you the best undervalued or overvalued opportunities.
Here are the countries that make up the 8 Majors in the currency market:
- United States
- Eurozone (the ones to watch are Germany, France, Italy and Spain)
- United Kingdom
- New Zealand
The following countries belong to the most sophisticated financial markets in the world. It is strictly advised that following the 8 Majors is a way to take advantage of earning interest income on the most credit-worthy and liquid instruments in the market.
Forex Trading Strategy : Yield & Return
“Yield drives return” is a key to always remember.
A spot market is a commodities or securities market in which goods are sold for cash and delivered immediately. In dealing with foreign exchange spot market, you are actually buying and selling two paired currencies because each currency is valued in relation to another. For example, if the PHP/USD pair is quoted as 39.8500 that means it takes PHP 39.8500 to purchase one USD. Therefore, in every foreign exchange transaction, you are buying one currency and selling another. Furthermore, the country’s central bank places an interest on the currency, which means that you are obligated to pay the interest when the currency is sold however earning potentials are possible on the currencies that you have brought.
For example, let’s look at the New Zealand dollar/Japanese yen pair (NZD/JPY). Let’s assume that New Zealand has an interest rate of 8% and that Japan has an interest rate of 0.5% In the currency market, interest rates are calculated in basis points. A basis point is simply 1/100th of 1%. So, New Zealand rates are 800 basis points and Japanese rates are 50 basis points. If you decide to go long NZD/JPY you will earn 8% in annualized interest, but have to pay 0.5% for a net return of 7.5%, or 750 basis points. (Source: Investopedia)
Forex Trading Strategy : Leveraging Returns
Sometimes leveraging creates good profits but sometimes too, it generates huge losses. It can be a double-edged sword which comes with great risk and great opportunity. The Forex market offers tremendous leverage, as high as 100:1, which means that when you can control $10,000 worth of assets with a capital of $100.
Using the most conservative 10:1 leverage, the 7.5% yield on NZD/JPY would translate into a 75% return annually. Therefore, if you were to hold a 100,000 unit position in NZD/JPY using $5,000 worth of equity, you will have a daily interest of $9.40, which could be translated to a $3,760 annually. It is quite different when you would invest your money in a bank that will only give you a yield of $250 in return however the only edge it gives is assurance because it is much risk free compared to the Forex market.
Read more about Forex Trading Strategy Made Very Simple – Price Action
Forex Trading Strategy : Carry Trades
Since currency values is constantly dynamic, it paved way to one popular Forex trading strategy of all time, the carry trade. Carry traders look for positions to appreciate in value other than earn the interest rate differential between paired currencies. Here are some historical examples of carry trades:
Between 2003 and the end of 2004, the AUD/USD currency pair offered a positive yield spread of 2.5%. Although this may seem very small, the return would become 25% with the use of 10:1 leverage. During that same time, the Australian dollar also rallied from 56 cents to close at 80 cents against the U.S. dollar, which represented a 42% appreciation in the currency pair. This means that if you were in this trade – and many hedge funds at the time were – you would have not only earned the positive yield, but you would have also seen tremendous capital gains in your underlying investment. (Source: Investopedia)
Figure 1: Australian Dollar Composite (2003 – 2005)
The carry trade opportunity was also seen in USD/JPY in 2005. Between January and December of that year, the currency rallied from 102 to a high of 121.40 before ending at 117.80. This is equal to an appreciation from low to high of 19%, which was far more attractive than the 2.9% return in the S&P 500 during that same year. In addition, at the time, the interest rate spread between the U.S. dollar and the Japanese yen averaged around 3.25%. Unleveraged, this means that a trader could have earned as much as 22.25% over the course of the year. Introduce 10:1 leverage, and that could be as much as 220% gain. (Source: Investopedia)
Figure 2: Japan Yen Composite (2005)
Forex Trading Strategy : Carry Trade Success
It is not only pairing up two currencies with the highest interest rate against a currency with the lowest rate for the goal of earning but also look for paired currencies that have the potential to appreciate in value. Here is an example of a currency with an interest rate that is in the process of expanding against another currency.
In the previous USD/JPY example, between 2005 and 2006 the U.S. Federal Reserve was aggressively raising interest rates from 2.25% in January to 4.25%, an increase of 200 basis points. During that same time, the Bank of Japan sat on its hands and left interest rates at zero. Therefore, the spread between U.S. and Japanese interest rates grew from 2.25% (2.25% – 0%) to 4.25% (4.25% – 0%). This is what we call an expanding interest rate spread. (Source: Investopedia)
Forex Trading Strategy : Getting to know interest rates
It is compulsory to monitor the economic data being released by every country to be able to know the health of its economy, whether it is conditioned for investment. To know the underlying economics of the country is a way to know where interest rates are heading. In general, countries that have good economic condition, meaning strong growth rates and increasing inflation will likely increase interest rates to be able to control inflation and growth. On the other hand, countries in an economic crisis ranging from a broad slowdown in demand to a full recession will likely to reduce interest rates.
Bottomline is the abundant resources that are readily available and accessible are right at your finger tips. In the advent of technology, there are programs that are available for you to use in monitoring your position in trading. It is just a way on how you would exhaust such availability of these things. Happy Investing with the basic list of Forex trading strategies!
- 8 Basic Forex Market Concepts. Retrieved April 02, 2013. http://www.investopedia.com/articles/forex/08/forex-concepts.asp