Lesson 4 – Understanding the Forex Market
In this lesson we’ll go through the fundamentals of understanding the forex market on a very high, overview level.
What makes the price move and why?
As forex is the largest and most liquid market in the world, it presents many chances for traders to make profitable trades every day. In essence, profit happens when you are able to sell a currency for higher than your what you bought it for, and vice versa if you are selling.
The key to making trading a successful venture is consistency.
Traders need a set of skills to routinely forecast market movements with higher than average accuracy and post winning trades while cutting losing trades as short as possible.
This boils down to one main skill, market understanding. If we know how and why the market moves, then we can more predictably forecast future price movements and eventually make more profitable trades.
The Basic Supply and Demand
Like any market or trade in the world, forex is at the mercy of simple supply and demand economics. The trade good is set by market participants and the price is set by the ‘invisible hand’ of supply and demand.
In forex, if there are more people in need of one currency than another, then that currency is in demand and the price will likely go up.
Equally, if there are more people selling that currency than there are buying, the the currency is not in demand and the price will likely go down.
Please note that this assumption is only so simplistic if we assume that the supply is constant.
Now a deeper dive into what demand is.
What is demand really?
Demand for a currency is broadly driven by the perceived outlook for the currency’s nation as a whole. This is clearly very complex and tought to break down specifically.
However, there are two main areas of focus.
The political situation in the country at the moment and what is likely to happen in the future.
And the general condition of the economy.
Generally speaking, if both of these factors are perceived to be positive, then demand will increase. If they are negative, then demand will fall. As mentioned, there are many small factors that come into play, and some currencies are more sensitive to political news (more often) than economic, or vice versa (less often).
As a very general rule, the most popular currencies with the highest trading volumes are more sensitive to the economics of their respective countries than their politics. This is due to the countries being much more politically stable and not too affected by their politics. Obviously this isn’t the case 100% of the time.
What causes currency prices to swing?
As mentioned, there are further small factors that definitely affect a currencies price. Here are the main areas:
Interest Rate Changes
One of the main factors affect the forex market is the interest rate set by the central banks. Specifically the eight most global central banks. When these banks change their interest rates, it can lead to very sudden and significant price changes.
Generally, central banks will raise their interest rates to reduce the inflation of their economy to reduce inflation of their currency.
And they will lower their interest rates to try to stimulate their economy.
The interest rate is the rate a countries regular banks can borrow money from the central bank at. If that rate is low, the banks are incentivized to borrow money from the bank and lend it to their customers (the regular population) at a lower rate.
If the interest rate is high, the opposite happens.
So, if the interest rate in one country is higher than another, then that usually generates demand in that currency. As holding the higher interest rate currency generates a higher return, just by holding that currency.
As mentioned, internal and international politics can be a huge factor in driving demand of a currency.
Some of the main factors influencing price is the consumer price index (CPI), current industry sales trends, quantitative easing (basically is the central bank printing money) , the gross domestic product (GDP) and employment rates.
These are the main, overview level indicators of a countries economy and stability.
However, on the day to day, the entities responsible for most small movements are the large investment banks, the international corporations and the retail investors like you and me. Sometimes, the news and economics might suggest the price moves in one direction but in reality it moves entirely in the opposite direction.
While this is more unlikely, it still does happen quite often on a smaller scale. Meaning that the market may rise when it is expected to fall due to market sentiment but then after a few hours or days more or less corrects itself to a more realistic price, once the big players in the marketplace seem to agree on their sentiment.
As we will go into depth into heavily in this course, there are many technical (graph and data based) indicators that present buy and sell signals that most traders will be reacting to. This creates many intraday trading opportunities for profitable trades, if you know what you are doing.
In these short, intraday instances, the political and economic landscape as mentioned earlier has much less effect of what is happening on a second by second, minute by minute basis.
The macroeconomics become less vital and it becomes more tactical to keep one on the fundamentals of the macroeconomics whilst focusing more on the market trends, support and resistance (both technical indicators) that can help determine the market sentiment and therefore future price movements.
Coming Up Next
As we move on in the course, we will go into much greater detail on each of these topics. We will be going in depth on technical analysis of a currency pair in part 4.