3 Ways to Trade Forex News
Capital markets, in general, are unique from other markets for
goods and services. While I do believe the Forex is driven by supply and demand
for the respective currencies at play, often what really moves the markets is
anticipation of future supply and demand rather than actual supply and demand.
That realization comes to most traders at some point in their career. This
concept leads to the biggest question in the Forex: where do these estimates of
supply and demand come from?
Surely a comprehensive survey of every user of every currency is impossible.
However, there are ways to aggregate and access some information in one place.
This is the purpose of news and announcements. News comes from a variety of
sources–both commercial and governmental. In the Forex, an emphasis is placed
on the value of information or news from government sources. This is fine and is
certainly a location on which I place a lot of my own attention, but commercial
sources and general investor commentary can do a lot to improve your trading as
well.
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The purpose of this article is to provide some basic step-by-step methods you
can employ today to take advantage of forex news in the market. I have some
experiences that I will share to show how you can find some great trades and how
you can identify the duds before they become real bombs in your portfolio. The
examples I am using in this article are not the only possible trades available.
There are a variety of events each month that can be used to time a good trade.
It is useful to watch ongoing news stories that are currently dominating the
headlines and minds of investors to identify trading opportunities. The
significance of one piece of news over another will change over time. An easy
gauge to tell what is important and what can be minimized is the news coverage
itself. If one piece of information or speculation about that information is
dominating the scene, then it is clearly something you need to be aware of.
As we proceed through this article, I will share some rules that I have used in
the past to profit from news events. However, I think it is somewhat foolhardy
to rely completely on a set of rules established in the past. Adjusting your
price targets and stops to market volatility and your own risk tolerance is very
important. Similarly, while I consider myself a swing trader–willing to hold a
position for between 2-3 days and 2-3 weeks–there is a lot of room for good
day- or shorter-term traders and long-term traders as well. I will periodically
take some very short-term trades around a specific announcement, and I will
share those circumstances with you in this article. Understanding the news is
very important for every trader, especially those looking at the long-term play.
In my book, Profiting with Forex, I spend a great deal of time illustrating the
long-term effects of fundamental changes on the Forex.
Before we begin diving into specific strategies, it is important to accumulate
our arsenal of trading weapons. Two of the strategies I will be discussing rely
on the use of an outright long or short position. You could take this position
in either the spot Forex market, which most of you are probably using, or in the
exchange-listed currency futures market on the CME. The third strategy begins
diving into the world of options. For those of you familiar with equity options,
currency-futures and some spot Forex dealers offer similar instruments for
trading. Recently exotic, single-payment and binary options have also become
popular. I will refrain from going into too much detail here and instead just
pick one type as an example. Check them out on your own, and see how they work
for you.
Example #1
The first technique I have to share comes with a couple of tips. First, I have
found that news that involves the U.S. dollar usually has the biggest impact on
the market as a whole. I am sure most traders are already aware of this, but
with very few exceptions they tend to be the most closely watched by the
greatest number of participants. Each month there are some ï’hotï’ news
announcements, one of which is the unemployment report, which is released on the
first Friday of each month. The trick with this, however, is that the largest
moves are usually made when the numbers miss or beat expectations. But be
careful. The correction usually happens very quickly. I use an easy technique to
get me into the market before the move occurs with a generous stop and limit
order on the other two sides of the trade.
Source: Prophet.net
The chart above shows a graph of the EUR/USD pair during the labor announcement
of August 4, 2006. The numbers released showed that a substantially lower number
of new jobs had been created in the U.S. than had been anticipated. In this
case, the consensus estimate was around 150,000 new jobs and the actual number
came in around 113,000. That means that the U.S. economy was weaker than
expected, or at least the labor side of the economy was. This is not good news
for the U.S. dollar, and therefore we saw a move up in this pair. Another tip I
can share from my personal experience is that I have had the best success
trading U.S. economic news and announcements with the EUR/USD than any other
pair. I feel that it is a good proxy for the U.S. economy in general or at least
in very short time spans.
If we were to break this chart down into minutes or seconds following the
announcement, you would see how quickly it moved. Therefore, I would have had to
have lightning fingers on my buy button or a buddy on the dealing desk to have
taken advantage of the announcement once it was issued. I unfortunately have
neither. I did profit from this announcement, however, by anticipating the
marketï’s movement.
I want to emphasize, though, that I am willing to do this when the conditions of
a couple of rules have been met. First, I will only trade the direction that the
market has been trending on the daily charts previous to the announcement.
Second, I will only enter the order if just prior to the announcement the market
has been in a fairly tight range.
In the chart above you can see that the market had been trading in a fairly
tight range until 30 minutes prior to the announcement. Because the volatility
in that last 30 minutes was really concentrated in the last 5 minutes before the
announcement I had already placed my order and was not concerned. Call me
paranoid, but if I am seeing large moves the night or several hours before an
announcement, I get too nervous to take the trade. I suspect that either word
has leaked (unlikely) or that I will get whipsawed by wound-up traders just
following the actual news. That means that there are plenty of occasions that I
have spent a lot of time preparing for a trade that I cancel prior to launch.
The risk that I worry about the most is when the market is too volatile and
whips me out before I even have a chance to prove if I am right or not.
In the chart below, you can see the daily trend of the EUR/USD before the
announcement on the 4th. Clearly, the market was discounting the dollar and
already had a bullish bias on this pair before the trade. Thus my two setup
rules were satisfied, qualifying this as a legitimate opportunity.
Source: Prophet.net
Of course, there is more detail behind how I set these trades up. This is pretty
simple and is open to customization depending on the situation and your personal
preferences. I have placed another chart illustrating the setup with my trade
barriers in place below. There are some components of the potential trade that
are already in place before the announcement. I know that I am planning to trade
long based on the previous trend, and I am targeting 100 pips as upside
potential based on the average movement I have seen on this pair during previous
months. I like to maintain a pretty aggressive stop-loss-to-profit-target ratio
in my trading so a stop 25 pips below my entry is sufficient. Entering the trade
30 minutes before the announcement gives me plenty of room before the pair
breaks out of its range.
Source: Prophet.net
As you can imagine, the market does not always hit my limit just because I think
it should. If momentum begins to cool off and the market falls back into a
smaller channel again, I will elect to close the trade early. A few other news
announcements I recommend for this strategy include inflation data, FOMC meeting
announcements and trade numbers.
Example #2
International trade is another announcement that I like to trade. I like it
because it has growth and economic strength implications for the U.S., and it is
a very important metric for trade-centric economies, like that of Japan. In
fact, I generally concentrate on the USD/JPY pair when this announcement is due
since the reaction can be quite dramatic. It is possible to trade other
currencies that are trade dependent for economic health, but I prefer the USD/JPY
because of its liquidity.
To understand how this trade works, it is important to understand the
implications of trade balance. When an economy such as that of the U.S. is
importing more from exporting currencies, those goods must ultimately be paid
for in the local currency. In the example I am using here, that means Japanese
goods must be paid for in Japanese yen. If the U.S. is doing the importing, then
U.S. dollars must be sold to purchase Japanese yen. This shifts the supply and
demand balance toward a stronger Japanese yen and a weaker U.S. dollar. In this
case, that means that the USD/JPY exchange rate would decline in value.
Conversely, if the U.S. trade deficit narrows, that means demand for Japanese
yen could be declining and its value should drop relative to the U.S. dollar. If
that is the case, the USD/JPY exchange rate will rise toward a weaker Japanese
yen.
Like most U.S.-based economic announcements, trade is released an hour before
the equity markets open at 8:30 a.m. eastern. Like the labor announcement, I
need to set up my trade just prior to the announcement. I like to see the market
in a tight range or channel. I have pulled a trade example from August 10, 2006.
As you can see in the chart below, although the pair was declining in the hours
prior to the announcement, the range was pretty tight without a lot of
volatility whipping the market back and forth. This looks like a good setup and
you can see the spike in the market after the announcement that the deficit was
tightening occurred.
Source: Prophet.net
The fact that I setup my trade as a long position just prior to the announcement
was determined by the trend in the daily chart. The market had basically been in
an uptrend since May, and the most recent days during the week before also had a
bullish bias. This is not an exact science, but it helps immensely to put the
odds in your favor by using the tools you have at your disposal. You can also
see from the daily chart of the USD/JPY that its daily range was fairly tight.
This means that my target is a little smaller than it was on the EUR/USD in the
previous example.
Source: Prophet.net
In this case I used a 50-pip limit, or profit target, against a 15-pip stop
loss. This still maintains a nice risk-to-reward ratio while allowing enough
room for the market to shake out a little if needed.
As you can imagine, it is not uncommon to be wrong more times than you are right
with any trading technique. It is therefore necessary to make sure that it is
possible to be more right when you are right than wrong when you are wrong. I
know many traders who talk about systems that are right 80 percent or more of
the time, but the one time they are wrong, they wind up wiping out yearsï’ worth
of profits. If you ask me, I think it is healthier for my portfolio and my
stress levels to take trades that have more balance between what I have at risk
versus what I stand to gain if I am a winner.
Source: Prophet.net
Example #3
In this last example I have prepared, I need to introduce you to a special kind
of option called a barrier option. This type of trading instrument is also known
as a binary option, and is part of a group of options known as single-payment
options. In order to use a barrier option, you have to decide on three things.
The first is how far the currency pair is expected to go one direction or the
other. The second is to know how long it will take to get there. And the third
question you must answer is whether the currency will stay at or beyond your
target for a certain length of time. That sounds complex, so letï’s look at an
example before we go on to a specific trade strategy.
I have an image of the EUR/USD exchange rate from the last half of July 2006 to
the beginning of August 2006 below. If I thought that the market was likely to
move a lot and I wanted to speculate to the downside, I could buy a barrier
option that said that the market will close below 1.2500 at the end of seven
days. If the rate does close below that level, I will be paid a certain amount.
I will have to pay for the option, but I will stand to gain a lot more than I
paid if I am right. If I am wrong, I will lose the total amount I invested in
the option. Every time I explain this to new traders, they invariably say that
it sounds like gambling. That would be true if the expected return was less than
zero. But how many of us willingly trade for a negative expected return? In this
real-life example, the option would cost me $1,500 for a potential payoff of
$10,000.
Source: Prophet.net
One of the benefits of options is that I donï’t have to use a stop loss because
no matter how high this rate rises, I have already invested as much as I can
lose. Another benefit is that I donï’t have to worry about timing my exit. As
long as the exchange rate closes below my barrier, I will be paid at the end of
the contract. One final benefit is that it is possible, using options, to
straddle (or strangle) the market by placing a barrier option on the upside and
the downside. That means that you donï’t have to be right about the direction of
the market, you just have to be right about the potential for a big move. That
makes this trade pretty simple and ideal for a news event. One helpful hint for
new options traders is that you may have to plan a little farther in advance of
this trade than you do on the others.
Recently I wrote an article about rising oil prices and its effects on Forex
crosses involving oil-producing and oil-consuming countries. The example I used
was the AUD/JPY. In this case, I was confident that the market would rise from
support near 87.50 toward 89.00 or 90.00 within the short term. A purchase of an
option on August 1, 2006 with a barrier at 89.00 and expiration at 10:00 am on
August 14, 2006 cost $3,200 for a potential $10,000 payout. The benefit of not
having to maintain a stop loss more than made up for the cost of the option and
the lower risk-to-reward ratio.
Source: Prophet.net
In this example, I was speculating on an ongoing bit of news, rising oil prices,
instead of a specific announcement. I used similar rules in that I traded with
the trend. But because I was not pinned to a specific time and date, I could be
a little more flexible with my entry timing. I liked the fact that this pair was
at support and was still within a very strong uptrend.
Conclusion
Trading the news is important as an effective method for finding new trading
opportunities and to become more aware of the fundamental forces at work in your
portfolio. The opportunities presented are some of my favorite trades, but they
are not the only reason to be aware of your surroundings. I am convinced that
the Forex favors the well informed, and these methods can add a few more solid
trades to your arsenal every month.
John Jagerson is a Forex writer and active trader. His
book,
Profiting With Forex, published by McGraw Hill, is available nationwide.
This author also develops Forex education courses for
INVESTools.com.
You can find more how-to and educational articles to improve your investing
and trading each day on TradingMarkets.com.