Many questions arise about fundamental analysis and its effect on the Forex Markets. Many traders try to utilize data or news events to trade and others find it utterly useless. Here, we analyze the effect of fundamentals on the market and why we think there is a better way to trade.
Forex trading is based on currency pairs, long one currency and short the other currency. As an example, EUR/USD (Euro/US Dollar) means that you are long EUR and short USD. Initially, data or news events released on one of the countries or currency can change its economic model via its economic unit change, and then make a significant difference in the price of that currency. EUR and USD are two different currencies and as such, there are different news events or data that affect the price of this pair.
Let us talk about data or news events and their effect on a pair mathematically. Referring to probability theory, there are 4 different outcomes for the pair during a news events or data announcement:
1- EUR Bullish, USD Bearish
2- EUR Bullish, USD Bullish
3- EUR Bearish, USD Bullish
4- EUR Bearish, USD Bearish
Some traders try to predict market direction as either bullish or bearish (however we believe it is not correct) by interpreting data or news events hoping to establish a new position or keeping an existing pair open. Forex trading as discussed earlier, is long one currency and short the other, consequently, data or news will impact the pairs in one of the aforementioned 4 options. In other words, only a change in one of the currencies is not sufficient for a protracted move.
As an example, assume a trader is long EUR/USD. If the EUR is stronger against the USD then the price will go up and produce a profit. However, only option 1 of the 4 options above guarantee the traders’ expectation. In other words, the trader has only a 25% chance to be correct in judging the data’s impact on the price.
Additionally, a trader needs accurate information to calculate the proper risk/reward to enter a trade. Therefore, even if they can estimate the direction, it will be useless because they cannot measure the data or the news impact on the market. Even if a trader can determine the direction (bullish or bearish) of a currency and calculate its impact on the currency via fundamentals, the result in the pair could be significantly different than calculated, thus giving the trader conflicting results.
The second issue revolves around the difference between data and scheduled or unscheduled news events that can cause very different market reactions. News has an instantaneous impact; however data represents a specific period in the past. For example, a GDP quarterly report from the US represents at least a month lag in its’ release. In other words, not only does it need a quarter for GDP calculation, but it’s also released a month after the quarter end. The sooner the data for comprehensive monthly economic reports are released the better, however, the Forex market, with its extreme volatility, can create another problem for the trader. Therefore, it seems that predicting a market trend using just data or news events can be very tricky and highly unpredictable.
Thirdly, some instantaneous events come as a complete shock to the market. As an example, the Brexit vote in the UK in June 2016 created an unpredictable move in the market that contradicted all of the known data. So instantaneous news can disrupt the current market trend.
The Fourth issue is the perceived political effect on the market. For example, in September of 2017, the Bank of Canada interest rate increase was unexpected by many analysts, however, the government decided to do it anyway. Therefore, sometimes a political move can have a dramatic effect on the market causing a counter trend move.
Last and the most important is the unpredictability of the market. As mentioned before, many factors affect what is predictable or measurable. It stands to reason then that trading according to trend prediction is a huge mistake. Therefore, if news events or data announcements can be viewed as market “surprises”, a trader who wants to be cautious, may not want to trade during these announcements. However, we believe market strategy should be flexible to any market action and suitable technical strategy can cover it. Now, let us talk about our strategy.
We trade “price action.” Why? Because price is the only true indicator of where a market is going. It’s the only point in the universe where you know if you are right or wrong. We spent a lot of money developing our algo that tells us where the inflection prices are; the exact points from where the market will move.
One of the beauties of inflection point trading is that you can enter the market with a minimum of risk. Our algo is able to do it with between 5 and 15 pips of risk. And this is for swing and long-term trades. Do you realize what this does to your risk/reward ratio? Since our average winning swing trade nets us 250-500 pips and our average long-term trade about 500-1,000, we only have to be right about one out of 5 or 6 times. Traders using wider stops have to be right a lot more often, perhaps 70% of the time and that’s not easy to do.
There’s also a positive psychological element to taking minimum risks when entering a trade; your losses are small and you NEVER hold losers. After all, why would you hold a trade when it was moving away from your inflection point? Similarly, price action trading will keep you in your winners. If price was above your inflection point, why would you get out?
Another aspect to our style concerns money management. Our algo is programmed to take quick partial profits and put break even stops on the contracts we keep. This allows you to be playing with the market’s money, an ideal situation.
So often a market will jump in your favor and then crash below your entry point making you a loser. And then a trade becomes an investment…the worst possible scenario. And so the magic is, enter your swing and long-term trades with minimum risk, take partial profits quickly and hold the rest with your stops at breakeven; a winning formula.
Another step has to do with what types of charts you are looking at. If you are interested in swing and long-term trades there’s no reason to look at charts below dailies and weeklies. You are not going to find an 800 pip move on a 1-hour chart. Leave the small charts (5 minutes, etc:) to the day traders. They are more interested in buying small dips and selling small rallies than they are in the big moves. They are going to frustrate you on occasion with their activity because they basically prevent movement during the day unless they are overwhelmed by major news.
Also, you don’t want to be in the business of picking tops and bottoms. It is a useless occupation. Get in the habit of buying strength and selling weakness or another way of saying it is “go with the trend.”
You also want to buy the strongest in any group and sell the weakest. How do you know which is weakest and which is strongest? Just measure them both against the same thing: an industry measure or another currency or index.
One last note. It’s a known fact that basketball teams who press on defense hate to be pressed themselves. Similarly, the markets love to reverse quickly and make everybody a loser but hate to be reversed on themselves.
You can learn how to reverse your position on a dime and take advantage of the fast and powerful moves that come from everybody being wrong and scrambling to get out.
Failed formations (like head and shoulders) or failed technicals (like Fibonacci retracements) are two of the many good places to do this.
In summary, don’t trade your opinion, don’t guess, don’t hold losers, stay in your winners. Just trade price action. Prices tell you exactly where you are right or wrong.
Authors: Afshin Bakhtiari, Jeff Wecker, Stephen Kruse