Liquidity
Liquidity is a term used to describe how quickly and easily an asset or security may be converted into cash. From real estate holdings to shares of corporate stock, degrees of liquidity vary significantly in relation to a broad spectrum of factors. Public interest, supply/demand levels, and macroeconomic cycle are a few broader issues that determine an asset’s relative liquidity.
Aside from applications in the marketplace, liquidity is also a valuable consideration in both personal and corporate finance. It is frequently used in reference to whether or not an entity is able to meet any financial obligations. Ratio analysis is a common way of measuring financial liquidity, and it’s an integral aspect of balance sheet and income statement analysis.
Market Liquidity
Currency, commodity and equity products exhibit varying degrees of liquidity due to any number of fundamental factors. Time of day, news cycle and institutional participation all contribute to the number of buyers and sellers actively engaging the market of a security.
Liquid markets are frequently targeted by forex, futures and equities traders. These venues afford participants three key advantages:
- Tight Bid/Ask Spreads: Trading liquid markets is more affordable due to consistently tight bid/ask spreads.
- Limited Slippage: The probability of having an order filled at a desirable price increases in a liquid market.
- Pricing Volatility: Enhanced participation rates typically lead to fluctuations in pricing, thus creating trading opportunities.
In practice, high degrees of market liquidity promote trade-related efficiency. Given this consideration, many strategies are designed specifically to engage those markets that exhibit consistently strong participation. The following are two indicators used to identify the markets/products most likely to facilitate efficient trade:
- Open Interest: Open interest is the number of outstanding shares or contracts in the market of a security at a specific point in time. This indicator is used to project future participation levels and quantify the activity present in a market.
- Traded Volumes: Traded volumes are the number of shares, lots or contracts that have changed hands for a given period. For instance, the forex boasts a tremendous daily traded volume in the trillions of pounds, which ensures robust market liquidity.
The general rule of thumb relating liquidity to volume and open interest is as follows: the greater the volume and open interest, the more liquid the market.
Perhaps the most important aspect of liquidity is how it impacts value. In the event that an asset or security is not readily exchangeable for cash, it is deemed illiquid and loses value. This can have dire consequences for the asset holder (seller) as any compensation received in an exchange is not likely to equal the asset’s full value. Illiquid assets or markets are not ideal for active traders, as efficiency is compromised due to wide bid/ask spreads and high degrees of slippage stemming from limited participation.
Measuring Liquidity: Ratio Analysis
While open interest and traded volumes are used to determine a market’s liquidity, ratios are frequently used as measurements for individuals and companies. These metrics relate assets and cash to liabilities, creating a picture of solvency or insolvency. Ratios play an integral role in fundamental analysis, especially as it pertains to the trade of equity products.
The following are three commonly used financial liquidity ratios:
- Current Ratio: (Current Assets)/(Current Liabilities)
- Acid-Test Ratio: (Cash + Accounts Receivable+Cash Equivalents)/(Current Liabilities)
- Cash Ratio: (Cash + Cash Equivalents)/(Current Liabilities)
The consequences for a company or individual being deemed illiquid can be substantial. In both cases, credit worthiness is negatively impacted. In the case of corporate stocks, share prices can plummet due to insolvency. For individuals, securing loans or lines of credit becomes exponentially more difficult.
Summary
Liquidity is a key element of both active trading and finance. In the marketplace, it promotes efficient trade and is vital to the success of a broad spectrum of strategies. As it pertains to traditional financial theory, it is the ability of an entity to meet its obligations. In either case, high degrees of liquidity are viewed as being positive characteristics, promoting efficiency and solvency.
What Is A Currency Union?
A currency union is a group of countries, municipalities, or regions that share a monetary standard. Typically, currency unions feature either common banknotes and coinage or a peg to an external monetary unit. By taking such measures, members are able to promote pricing stability and actively manage exchange rate volatilities within the context of a defined framework.
Also referred to as monetary unions, currency unions furnish participants with several distinct advantages and disadvantages:
- Advantages: Currency union members enjoy reduced transaction costs and foreign exchange risk pertaining to both commerce and travel. Also, interest rates for participants become aligned, which works to stabilise borrowing and lending functions.
- Disadvantages: Union members lose autonomy in regards to domestic monetary policy. If faced with unique inflationary or deflationary pressures, a union member is unable to act unilaterally to mitigate negative impacts.
While constituents of a currency union share a monetary standard, the allegiance falls short of a comprehensive economic union. Concessions pertaining to trade and commerce are not made, which preserves the cohesion of the local economy.
History Of Currency Unions
Currency unions have a long and storied history of bringing relative stability to fragmented nations or geographic regions. From war-torn areas to emerging economies, nations often seek membership to monetary unions in an attempt to restore economic order.
An early example of a currency union was the German Zollverein of the 19th century. The Zollverein was initiated in North Germany in 1818, with only specific coinage being universally recognised. Over time, the union expanded to include members from around the Germanic region. In the years following the end of the Franco-Prussian war in 1871, the Reichsmark became the common currency among Germany’s member states.
Another case of a currency union developing was the Latin Monetary Union of 1865. The Latin union was a bimetallic system based upon the scalable trade of gold and silver. Participants included France, Italy, Belgium and Switzerland. The Latin union was short-lived, disbanding in 1867 when delegates from member nations voted to shift to an exclusively gold-based system.
Although not a formal currency union, the Bretton Woods Accords standardised the global monetary system. During the aftermath of post-WWII, Bretton Woods effectively placed the world on a currency peg to the United States dollar (USD). Through forming the World Bank Group (WBG) and International Monetary Fund (IMF), Bretton Woods promoted a system of currency convertibility. International transactions were denominated in U.S. dollars, with the USD’s value fixed to gold at US$35 per ounce. Forty-four nations signed on to the Bretton Woods system, with the agreement ceasing in 1971 with the United States’ abandonment of the gold standard.
Modern Examples Of Currency Unions
As of this writing (December 2019), there are several prominent examples of currency unions in operation. Most notably is the adoption of the (EUR) by 19 of 28 European Union (EU) countries. Also, the British pound sterling (GBP) is used abroad in the Pitcairn Islands, South Georgia and the South Sandwich Islands. The GBP serves as a peg for many currencies such as the Gibraltar pound, Falklands pound and Guernsey pound.
In addition to the EUR and GBP, several nations use the USD as a domestic currency or peg. Egypt, Hong Kong and Saudi Arabia are a few independent countries that prefer to limit exchange rate volatilities to those experienced by the USD. Puerto Rico, Ecuador, El Salvador, American Samoa and Guam are a few areas that implement the USD as their premier form of money.
Money Supply
The money supply is the amount of currency available to consumers and businesses to make payments as well as money held in checking and savings accounts. The money supply is made up of different components.
In the U.S., the “monetary base” is the sum of currency in circulation plus banks’ reserve balances held at the Federal Reserve. There are two types of “M” used when speaking about money supply:
- M1: This includes the most liquid forms of money, including cash held by the public plus deposits available for immediate withdrawal—i.e., checking and debit accounts—held at depository institutions such as commercial banks and credit unions.
- M2: This includes M1 plus less liquid sources of cash, such as savings deposits, small-denomination time deposits (less than US$100,000), and money held in money market mutual funds.
The Fed publishes monthly money supply data in its Aggregate Reserves of Depository Institutions and the Monetary Base and Money Stock Measures.[1] The money supply and the monetary base are linked by reserves, namely cash held in bank vaults and bank deposit balances held at regional Federal Reserve banks.
Central Bank Control Over The Monetary Base
According to Daniel Thornton, economist emeritus at the Federal Reserve Bank of St. Louis, the Fed has “complete” control over the size of the monetary base but not the overall money supply. “One major reason for this is banks can choose to hold the additional base money (i.e., deposit balances with the Federal Reserve banks) supplied by the Fed as excess reserves,” Thornton writes.
The main way the Fed controls the monetary base is through its open market operations (OMOs), in which it buys and sells securities for its own account with banks and other large institutions. If the Fed wants to increase the monetary base, for example, it buys securities. The proceeds from the sale are deposited in the buyer’s account at the Fed, which adds to the bank’s reserves and increases the monetary base. Conversely, if the Fed wants to reduce the monetary base, it sells securities, thus decreasing the bank’s balance at the Fed.
Waning Importance Of The Money Supply
“Over time,” according to the Fed, the money supply has lost some of its importance as a guide to conduct monetary policy. Previously, the Fed says, the size of the money supply “exhibited fairly close relationships with important economic variables” such as economic growth and inflation. “Over recent decades,” however, those relationships “have been quite unstable.”
While the Federal Open Market Committee, the Fed’s monetary policymaking body, still takes money supply data into consideration while conducting monetary policy, it only uses it as “part of a wide array of financial and economic data.”
Summary
The money supply is the amount of cash available to consumers and businesses to make payments as well as money held in checking and savings accounts. There are different components to the money supply, but there’s only one that the Federal Reserve has “complete” control over, the monetary base.
The Fed can control the base’s size by buying securities from banks, which gives the banks more money, while selling securities has the opposite effect. Although the Fed still considers the size of the money supply in conducting monetary policy, it no longer has the strong correlation with economic growth and inflation that it once did.
Monetary Policy
Monetary policy is the decisions and actions taken by a central bank to achieve its goals, which usually consist of promoting economic growth, job creation and low inflation and interest rates. In the U.S., for example, the Federal Reserve is guided in its monetary policy by its mandate from Congress, which is to promote “maximum employment, stable prices, and moderate long-term interest rates.”[1] Most central banks around the world, such as the European Central Bank, the Bank of England and the Bank of Japan, largely have the same priorities.
The main mechanism available to central banks for executing monetary policy is influencing the level of interest rates—i.e., the cost of money—and the amount of money available to lend to businesses and consumers.
- An “easy” or “accommodative” monetary policy means the central bank is keeping interest rates low and trying to make more money available in order to encourage economic activity.
- However, if the central bank deems that the economy is growing too fast, which can create hyperinflation, it “tightens” monetary policy by raising rates and restricting the flow of money available for lending.
Central banks execute monetary policy through a variety of pronouncements of their intentions as well as actions in the marketplace to implement those goals.
In the U.S., for example, the Federal Open Market Committee (FOMC) is the Fed’s monetary policymaking unit. It sets the federal funds rate, its benchmark interest rate, which is the interest rate banks pay to borrow and lend money to each other overnight that they hold on deposit at the Fed. This rate has a profound effect on the general level of interest rates for businesses, consumers and governmental entities throughout the economy, both short- and long-term.
The FOMC is composed of 12 members. These are the seven members of the Fed’s Board of Governors and five of the 12 presidents of the regional Federal Reserve banks, one of whom is the president of the Federal Reserve Bank of New York, and vice chairman of the committee and a permanent member. The chairman of the Fed is also the chairman of the FOMC. The presidents of the other regional Fed banks take turns filling the remaining four voting seats.
Implementing Monetary Policy
In addition to these public pronouncements, the Fed has three tools to implement its monetary policy: open market operations, the discount rate, and reserve requirements. The FOMC is responsible for open market operations, while the Fed board of governors is responsible for the other two functions.
Open market operations (OMOs), which are conducted through the New York Fed, include the purchase and sale of securities by the Fed in the open market. There are two types of OMOs: temporary and permanent.
The Discount Rate And Reserve Requirements
In addition to the fed funds rate, the Fed sets the discount rate. This is the interest rate commercial banks and other depository institutions pay to borrow from the Fed’s regional banks, which banks use as a backup source of liquidity. By lowering the discount rate, the Fed makes it cheaper to borrow, thus encouraging lending and spending by consumers and businesses. Raising the discount rate should have the opposite effect by making borrowing more expensive.
The Money Supply
The Fed also has some level of control over the amount of money circulating in the economy, which can also impact interest rates. An abundant supply of money generally equates with low interest rates, while a tighter supply would make it more expensive to borrow.
Summary
Monetary policy is the means by which central banks try to achieve their goals, which usually consist of promoting economic growth, job creation and low inflation and interest rates. They do this through a combination of raising and lowering interest rates and open market operations, buying and selling securities to increase or decrease the amount of money available for lending. An “easier” or “accommodative” monetary policy consists of low interest rates and abundant money for lending, while a “tighter” or “restrictive” policy means higher rates and less money for lending in order to choke off inflation.
Learn Forex: Bollinger Bands
The main purpose of Bollinger Bands® is to help traders determine whether assets are reasonably priced, and whether prices in the market are stable or may be moving toward different levels. This information can be potentially helpful for investors because it can determine the following: whether they are paying a fair price for the asset, whether it is too costly, or whether it is a bargain purchase that could result in profit in the future.
Bollinger Bands® are not recommended as an exclusive method for understanding price movements. However, they are considered an effective tool for analysing price movements among several other tools. Those include basic trend analysis and indicators such as stochastics, moving average convergence and divergence, wave patterns and price gaps.
Bollinger Bands® were developed by John Bollinger in 1983, and they’re a system under a registered trademark.
The upper and lower band lines are based on a standard deviation of the price from the moving average. Standard deviation is a mathematical measurement for how spread out a group of numbers is on average. In the case of Bollinger Bands®, the numbers involved are prices.
On most analysis systems, traders can change the periods, and thus the standard deviation, used in the calculation of the bands according to their preferences for trading time horizons.
The region between the upper and lower bands is often referred to as an “envelope.”
Using Bollinger Bands®
A price trend that remains narrow and in the direction of either the upper or lower band line is considered to be a strong trend.
Analysts pay particular attention to when prices are trending near the upper or lower bands. Prices that are near the upper band are considered to be “overbought,” and good prospects for selling. Similarly, prices that are near the lower band are considered to be “oversold,” and good prospects for buying.
Signals: Trading Tops And Bottoms
The Bollinger analysis system uses visual patterns to determine when the market has reached a high or low price. Some of the main “signals” for price trends are patterns that come in the shapes of the letters “W” for market price bottoms and “M” for tops. When a price of a given asset reaches a low on the chart, chartists look for repetition of that low at the second bottom on a “W” shape for confirmation that the price will not likely go lower.
The middle price peak before the second downward trend on the “W” pattern is understood to be the “breakout” point. If the price rebounds above this point following the second low of the “W” shape, then the price is understood to have broken out of the downward trend and initiated a trend on a new upward movement.
The same type of analysis holds for determining the top of a price trend, only in an inverted manner. If an upward movement falls from a peak, analysts look for a second repetition of the peak in an “M” shape. When the price falls to below the middle “breakout” point in a second downward movement on the “M” shape, the price is determined to be on a new downward trend.
The fact that a price breaks beyond the upper or lower Bollinger Band® is not necessarily considered a “signal” of a possible new price movement. Analysts note that prices can frequently trend along the lines and break out on occasion When this occurs, the movement is called a “tag,” and it is considered to indicate that a price is at a high or low within a shorter term price trend. However, it has been seen that frequently when a price breaks the upper or lower band, it will fall back within the band toward the mid-line.
Volatility Trends
Bollinger Bands® are also used for examining the potential volatility of the market. In particular, when the band “envelope” narrows significantly, it is considered to be a sign that volatility will soon increase. This can be helpful in cueing investors that buying or selling opportunities may be approaching.
Other Indicators
In addition to using Bollinger Bands® as a tool on their own, they are frequently used with other indicators such as momentum, volume, sentiment, open interest and inter-market data.
RSI
One particularly popular indicator for use with the Bollinger Bands® is the Relative Strength Index (RSI), a “momentum oscillator” developed by J. Welles Wilder Jr. The RSI is used to compare upward movements in closing prices to downward movements over a selected period of time. Like other charting techniques, this index can be used to find signals that could determine bull market trends, bear market trends, trend reversals and large price corrections.
Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. GWT will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.
Learn Forex: Pivot Points
Pivot points are technical indicators that can prove helpful to investors, giving them one more tool for assessing the market. Trend, range and breakout traders can all harness pivot points points, using them to determine when to enter and exit positions.
By calculating these points, investors can gather several helpful pieces of information. Technical analysts can use pivot points to not only determine levels of support and resistance, but also to gauge whether a market is bearish or bullish. In addition, these points can be especially helpful for determining stop-loss prices and profit targets.
At their most basic level, pivot points are areas where a security’s price trend might change. These technical indicators can help one obtain a better sense of how these financial instruments will behave in the short term, and investors frequently use pivot points for this specific purpose.
Calculating Pivot Points
To calculate pivot points, technical analysts harness the high, low and closing value of a security, and in some cases levels of support and resistance. These values can be from the last day, week or even month. The forex markets are open 24 hours a day, so calculations that involve a particular session will assume the session ends at 5 p.m. EST.
There are several methods for determining a pivot point, with the most basic one involving averaging the high, low and closing prices for the prior day. Another technique, called the five-point system, adds two support levels and two resistance levels to the aforementioned price levels.
Once a trader has identified the pivot point, he can then use this piece of information to calculate support and resistance levels. To determine the first levels of support and resistance, the trader can start with the pivot point and then measure the width between this point and either the high or low prices from the previous day.
To calculate the second level of support and resistance, the investor can utilise the full width between the prior session’s high and low prices.
Using Pivot Points
Once traders have identified pivot points, as well as their corresponding levels of support and resistance, they can harness this information. There are many uses of these data points, with some being more straightforward than others.
One basic application is that if a currency is trading above a pivot point derived from the previous day’s values, this situation helps show the bullish feelings of the global markets. In such a case, a forex trader looking to make use of trends might want to take a long position in the belief that he can capitalise on the sentiment of the market.
However, if a currency is trading below the prior session’s pivot point, an investor can take this as evidence of bearish sentiment. In cases like these, a trader may want to take a short position on the currency.
Range Trading
Range traders can potentially use pivot points, as well as their corresponding levels of support and resistance, to find better times to enter and exit trades. For these investors, pivot points can serve as reversal points. In addition, support levels can provide a good place to enter a buy order. Once a currency nears one of these levels, a range trader might find it a good time to take a long position.
In contrast, resistance levels can help give investors a good place to sell. When a currency approaches such a level, this might indicate an opportunity to close out a position and take profits.
Breakout Trading
Investors interested in breakout trading can also make use of pivot points. More specifically, these traders, who study charts in an attempt to identify instances where a security will experience a significant price fluctuation in a short time frame, can use pivot points to gauge when breakouts are genuine.
If used effectively, pivot points can potentially be a valuable tool for traders. If investors take the time to learn about these points, they may find they have one more tool for evaluating the market and determining when to enter and exit positions.
Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. FXCM will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.
What Is Momentum Trading?
Momentum trading is a technique in which traders buy and sell according to the strength of recent price trends. Price momentum is similar to momentum in physics, where mass multiplied by velocity determines the likelihood that an object will continue on its path. In financial markets, however, momentum is determined by other factors like trading volume and rate of price changes. Momentum traders bet that an asset price that is moving strongly in a given direction will continue to move in that direction until the trend loses strength.
Where Did Momentum Trading Start?
The practice of momentum trading has been around for centuries. As early as the late 1700s, famed British economist and investor David Ricardo was known to have used momentum-based strategies successfully in trading. He bought stocks with strong performing price trends, and then sold stocks whose prices were performing poorly. He characterised the method with the phrase: “Cut short your losses; let your profits run on.”
However, the concept was obscured and left dormant following the development and popularisation of value investing theory from the 1930s onward. Investors would focus more on the intrinsic, or “fundamental,” value of an asset, and less on the trajectory of the movement of its price.
Relative Momentum And Absolute Momentum
Momentum trading can be classified in two categories: Relative momentum and absolute momentum.
- Relative momentum strategy is where the performance of different securities within a particular asset class are compared against one another, and investors will favour buying strong performing securities and selling weak performing securities.
- Absolute momentum strategy is where the behaviour of the price of a security is compared against its previous performance in a historical time series.
How Is A Momentum Strategy Employed?
Momentum can be determined over longer periods of weeks or months, or within day-trading time frames of minutes or hours.
The first step traders customarily take is to determine the direction of the trend in which they want to trade. Using one of several momentum indicators available, they may then seek to establish an entry point to buy (or sell) the asset they are trading. They will also want to determine a profitable and reasonable exit point for their trade based on projected and previously observed levels of support and resistance within the market.
Additionally, they are recommended to set stop-loss orders above or below their trade entry point—depending on the direction of the trade. This is in order to safeguard against the possibility of an unexpected price-trend reversal and undesired losses.
Momentum Indicators
The momentum indicator is a common tool used for determining the momentum of a particular asset. They are graphic devices, often in the form of oscillators that can show how rapidly the price of a given asset is moving in a particular direction, in addition to whether the price movement is likely to continue on its trajectory.
The notion behind the tool is that as an asset is traded, the velocity of the price movement reaches a maximum when the entrance of new investors or money into a particular trade nears its peak. When there is less potential new investment available, the tendency after the peak is for the price trend to flatten or reverse direction.
The direction of momentum, in a simple manner, can be determined by subtracting a previous price from a current price. A positive result is a signal of positive momentum, while a negative result is a signal of a negative momentum.
Momentum tools typically appear as rate-of-change (ROC) indicators, which divide the momentum result by an earlier price. Multiplying this total by 100, traders can find a percentage ROC to plot highs and lows in trends on a chart. As the ROC approaches one of these extremes, there is an increasing chance the price trend will weaken and reverse directions.[6]
Here are a few of the technical indicator tools commonly used by traders to track momentum and get a feel for whether it’s a good time to enter or exit a trade within a trend.
- Moving averages: These can help identify overall price trends and momentum by smoothing what can appear to be erratic price movements on short-term charts into more easily readable visual trend lines. They’re calculated by adding the closing prices over a given number of periods and dividing the result by the number of periods considered. They can be simple moving averages, or exponential moving averages that give greater weight to more recent price action.
- Relative strength index (RSI): As the name suggests, it measures the strength of the current price movement over recent periods. The aim is to show the likelihood of whether the current trend is strong in comparison to previous performance.
- Stochastics: The stochastic oscillator compares the current price of an asset with its range over a defined period of time. When the trend lines in the oscillator reach oversold conditions—typically a reading of below twenty—they indicate an upward price momentum is at hand. And when they reach overbought conditions—typically a reading of above 80—they indicate that a downward price momentum is ahead.
- Moving average convergence divergence (MACD): This tool is an indicator that compares fast- and slow-moving exponential moving price average trend lines on a chart against a signal line. This reveals both price momentum and possible price trend reversal points. When the lines are farther apart, momentum is considered to be strong, and when they are converging, momentum is slowing and price is likely moving toward a reversal.
- Commodity channel index (CCI): This momentum indicator compares the “typical price” of an asset (or average of high, low and closing prices) against its simple moving average and mean deviation of the typical price. Like stochastics and other oscillators, its aim is showing overbought and oversold conditions. Readings above 100 indicate overbought conditions, and readings below 100 indicate oversold conditions.
- On balance volume (OBV): This momentum indicator compares trading volume to price. The principle behind it is that when trading volume rises significantly without a large change in price, it’s an indication of strong price momentum. And if volume decreases, it’s understood as a sign that momentum is diminishing.
- Stochastic momentum index (SMI): This tool is a refinement of the traditional stochastic indicator. It measures where the current close is in relation to the midpoint of a recent high-low range, providing a notion of price change in relation to the range of the price. Its aim is to provide an idea of a reversal point is nearby, or if the current trend is likely to continue.
- Average directional index (ADX): This simple oscillator tool aims solely at determining trend momentum. It plots the strength of a price trend on a graph between values of 0 and 100: values below 30 indicate sideways price action and an undefined trend, and values above 30 indicate a solid trend in a particular direction. As the value approaches 100, the momentum of the trend is understood to grow stronger.
- Building block: In this technique, traders divide an existing chart into equal periods, separated in blocks. The blocks are then color-coded according to whether they indicate an upward trend or a downward trend; for example, green for upward and red for downward. A third color, yellow, could be used to indicate a sideways trend. If the chart shows two consecutive blocks with the same color, then it indicates that there is momentum in a given direction.
Risks To Momentum Trading
Like any style of trading, momentum trading is subject to risks. It’s been found to be successful when prices follow on a trend, but on occasion momentum traders can be caught off guard when trends go into unexpected reversals. Traders should remember that:
Summary
Momentum is a key concept that has proven valuable for determining the likelihood of a profitable trade. Measurements of momentum can be used in the short and long term, making them useful in all types of trading strategies. Several technical trading tools are available to reveal the strength of trends and whether a trade on a particular asset may be a good bet.
However, traders should be forewarned that momentum projections are customarily calculated using measurements of past price trends. Actual momentum and price can change at any moment based on events that weren’t factored into the original calculations. Because of this, it’s important to take preventative measures, such as setting stop-losses, to safeguard against unforeseen price reversals in even the most probable momentum scenarios.
Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. FXCM will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.
International Monetary Fund (IMF)
Since its creation during the post-Great Depression era, the International Monetary Fund (IMF) has been a prominent figure in global finance. With the objective of promoting global currency and economic stability, it influences financial governance worldwide.
Creation At Bretton Woods
In July 1944, delegates from 44 countries met at the United Nations Monetary and Financial Conference in Bretton Woods, New Hampshire. They investigated the pressing issues of the day, such as exchange rate stability and exploding international debt. At Bretton Woods, the concept of the IMF was developed as a solution to these challenges and then introduced to the world.
Since then, the IMF has been a prominent figure in crisis resolution and global economic management. From the end of the Bretton Woods System in 1971 to the Global Financial Crisis of 2008, the IMF has influenced the policies of countries around the globe.
The IMF’s Form And Function
The IMF is an international organisation that aspires to promote financial stability, economic growth and cooperation among its members. Headquartered in Washington D.C., it is made up of 189 member countries.
The policy-making body of the IMF is the Board of Governors, which is commissioned with ensuring the structure and function of the IMF remains uncompromised. It is made up of one representative and alternate from each member country.
The self-stated mission of the IMF is multi-fold and is as follows:
In an attempt to address issues such as global poverty and sustainable economic growth, the IMF performs several core functions on a routine basis:
The primary objective served by each of these functions is crisis aversion. By monitoring, advising and extending credit, the IMF aspires to reduce systemic risks facing member nations while promoting broad-based economic health.
IMF: Membership And Quotas
The IMF has extended membership to countries in every geographic locale. Whether a nation has a developing economy or is an established economic superpower, it may seek membership.
In order to gain and maintain acceptance by the IMF, a country must satisfy the following ongoing requirements:
In respect of their SDR qualifications, larger countries receive larger quotas while smaller members are allocated smaller quotas in the much the same fashion. The IMF uses quotas to determine benefits and obligations designated for member nations. This is accomplished in several ways:
The IMF quota system is designed to ensure that member countries are treated fairly and receive any assistance that may be needed. In this fashion, an economic superpower such as the U.S. or U.K. is able to secure ample resources in a similar manner as those in smaller, developing nations.
Summary
Since its inception, the IMF has been an integral part of the global monetary and financial system. Through monitoring, extending credit and educating member nations, the IMF has built a truly international body representing 189 of the 195 officially recognised countries.
However, the IMF is also a controversial figure. High-profile partnerships with member nations such as Iceland and Greece have prompted voracious debate over the role of international lending in contemporary finance. Concerns pertaining to the negative impacts of globalisation, as well as nation building, are frequently cited by critics. In addition, widespread criticisms of the quota and SDR system have been prevalent over the course of its history.
In spite of its detractors, the IMF is a viable entity. Given the levels of membership and resources, it is poised to remain at the forefront of global finance for decades to come.
What Is An Interest Rate?
An interest rate is the percentage of the principal loan that borrows pay to lenders for borrowing assets.
An interest rate is basically the cost for leasing cash, goods or assets like automobiles. Depending on the risk associated with the borrower, the interest rate could be low or high. Interest rates are often use to control economic activities, such as inflation and unemployment. Central banks lower the interest rate level when investment and consumption is desired, and raise to avoid economic bubbles. In the forex market, some traders use a strategy that involves selling currencies with low interest rates and buy currencies with high interest rates.
What is Opec?
OPEC stands for the Organisation of the Petroleum Exporting Countries, which is a cartel of some of the largest oil-producing nations in the world. In its early years, OPEC was able to a large degree dictate the world price of oil, making it a major political and economic player.
However, over the past several decades, the group has lost a lot of its market and political power due to the following issues:
- The instability of some of its members
- Internal bickering (sometimes including war) among its members over pricing policies and other differences
- Falling market share as other non-OPEC countries have ramped up their own production
- Conservation efforts around the world to reduce dependency on foreign non-renewable fossil fuels
OPEC was created in September 1960 at the Baghdad Conference in Iraq. The five founding members were Iran, Iraq, Kuwait, Saudi Arabia and Venezuela.[1]
They were subsequently joined by Qatar (1961), Libya (1962), the United Arab Emirates (1967), Algeria (1969), Nigeria (1971), Angola (2007) and Equatorial Guinea (2017). Ecuador, which joined in 1973, suspended its membership in December 1992 then rejoined in 2007. Gabon, which joined in 1975, quit 20 years later but then rejoined in 2016. Indonesia, which joined in 1962, suspended its membership in January 2009, reactivated it in January 2016, but then suspended its membership once again later that same year. As a result, the group had 14 members as of April 2018.[2]
According to its Statute, “any country with a substantial net export of crude petroleum, which has fundamentally similar interests to those of Member Countries, may become a Full Member of the organisation, if accepted by a majority of three-fourths of Full Members, including the concurring votes of all Founder Members.”[2]
OPEC’s Mission
The group’s mission “is to coordinate and unify the petroleum policies of its Member Countries and ensure the stabilisation of oil markets in order to secure an efficient, economic and regular supply of petroleum to consumers, a steady income to producers and a fair return on capital for those investing in the petroleum industry.”[3]
Although no European countries are members of OPEC, the group’s headquarters are in Vienna, where it moved in 1965 after spending its first five years in Geneva.[1]
According to OPEC, the group’s members hold 81.5% of the world’s proven crude oil reserves (i.e., petroleum in the ground) as of 2016, or an estimated 1.2 trillion barrels.[4] The lion’s share of that, or about two-thirds of OPEC’s total proven reserves, is in the Middle East.
Among individual countries:
- Venezuela holds the largest amount at 302 billion barrels, or about a quarter of OPEC’s share
- Saudi Arabia is next with 266 billion barrels (or 22%)
- Iran holds 157 billion barrels (13%)
- Iraq holds 149 billion barrels (12%) [4]
Many of the world’s biggest oil producers have never belonged to OPEC, including Canada, China, Mexico, Norway, Oman, Russia, and the U.S. Many of them have responded to OPEC’s attempts to control world oil prices by exploring for and pumping more oil themselves and achieving greater market share and energy independence, which has greatly diminished OPEC’s power.[5]
Oil Power
As described on its website, OPEC was founded “at a time of transition in the international economic and political landscape, with extensive decolonisation and the birth of many new independent states in the developing world.”[1] The world oil market was then dominated by the so-called Seven Sisters, which are the large, Western-based, privately-owned multinational companies such as Royal Dutch Shell and Exxon.
In 1968, OPEC adopted a “Declaratory Statement of Petroleum Policy in Member Countries” that “emphasized the inalienable right of all countries to exercise permanent sovereignty over their natural resources in the interest of their national development.”[1]
In other words, OPEC members wanted to have greater say in how their oil wealth was exploited and keep more of the proceeds for themselves. It did not take long for OPEC to start flexing its muscles.
The Oil Weapon
Throughout the 1960s, the world price of oil was largely stable, if decreasing slightly year by year. But things changed in 1973, when the cartel lowered production and raised oil prices by 70%, and then by an additional 130% following the outbreak of the Yom Kippur War. The goal was to punish countries, notably the U.S. and the Netherlands, for supporting Israel in its war with Egypt. From 1973 to 1980, the price of oil skyrocketed, which also increased the political and economic power of OPEC and its member nations.[6]
By the end of the 1970s, the price of oil had jumped from about US$20 a barrel (adjusted for inflation) before the embargo to more than US$120.[7]
Internal Squabbling and War
During the next decade, oil prices plunged back to where they were before the oil embargo. There were, however, varying moments of volatility.
In 1979, for example, the Shah of Iran was toppled by Islamic revolutionaries, who then held 52 Americans captive for more than a year. This created a short-lived runup in oil prices, and was followed by a nearly decade-long war between Iran and Iraq. Given that they’re two of OPEC’s founding members, the squabble led to interrupted supplies from the Middle East.[6]
However, that gap was quickly filled by new oil discoveries and exploration from non-OPEC sources, chiefly North Sea oil from Norway and the U.K. and Alaskan oil from the U.S. Eventually, this created a glut of oil in world markets and a plunging price. The decade largely ended OPEC’s presumed ability to control the market.[6]
Compared to the previous two decades, oil prices were relatively stable in the 1990s expect for a short-lived spike in prices following Iraq’s invasion of Kuwait, in which one OPEC member invaded another by force. But prices stabilised following the U.S.-led intervention to drive Iraq out of Kuwait.[6]
OPEC’s ability to control oil prices since its heyday in the 1970s has diminished largely due to the rest of the world becoming less dependent on OPEC-generated oil, owing to a variety of factors including new sources of petroleum and conservation efforts. OPEC has tried to control the price of oil by increasing or decreasing production, but the organisation has often had difficulty with controlling the behaviour of its member nations.
For example, severe economic conditions at various times in Iran, Iraq, Libya and Venezuela in have often led those countries, among others, to cheat on their production quotas. The belief was that it was in their own national interest to sell as much oil as possible to generate revenue, even if that went against OPEC policy to limit their production. As a result, OPEC’s effectiveness as a genuine cartel is not what it used to be.[8]
That’s largely because its market share has fallen. According to the U.S. Energy Information Administration, four of the top six oil producers in the world are non-OPEC countries with Russia as number one, the U.S. in third, and China and Canada fifth and sixth, respectively. Saudi Arabia is number two and Iraq is number four.[9]
Summary
The Organisation of the Petroleum Exporting Countries was created in 1960 by some of the world ‘s largest oil-producing nations in order to safeguard their oil wealth and better manage the price and market for crude oil. The cartel’s member countries control more than 80% of the world’s proven oil reserves.
The group reached the height of its market power in the 1970s as it withheld oil from the market and raised prices during the Yom Kippur War. Since then the group has lost a lot of its market influence as other countries have found new sources of oil or cut back on oil usage, while internal disagreements among its members has hurt the group’s ability to control production and prices.
What is The G20?
In a similar vein as the International Monetary Fund (IMF) and World Bank, the Group of 20 (G20) is an international financial authority. However, instead of engaging in lending or the provision of financial assistance to member nations, the G20 is a consortium tasked with addressing the premier global economic challenges of the day.
Composition And Mission
The G20 is made up of the world’s economic superpowers, financial leaders and developing nations. As a whole, G20 members represent every continent (except Antarctica), two-thirds of the world’s population and 85% of global economic output. The G20 is officially made up of 19 member nations, the European Union (EU) and permanent guest country Spain. Below is a list of the individual member nations by region:
- Africa: South Africa
- Asia: China, India, Indonesia, Japan, South Korea
- Americas: Argentina, Brazil, Canada, Mexico, United States
- Europe: France*, Germany*, Italy*, Russia, United Kingdom*, EU members
- Middle East: Saudi Arabia, Turkey
- Oceania: Australia
*Featured EU economies, with the United Kingdom scheduled to depart in March 2019
While the G20 has no permanent headquarters or physical residence, its bodies convene on a regional basis throughout the year. Serving as a non-partisan and independent think tank, the G20’s formal mission statement is as follows:[2]
- “Act as a facilitator and mediator for expert discourse, with focus on innovation-driven communication.”
- “Initiate and coordinate communication between governments, business, academia and youth, in an effort to create a sustainable win-win situation for all involved.”
History
The creation of the G20 dates back to the late 1990s and a decision to expand the existing Group of Seven (G7). Citing a need to “broaden the dialogue on key economic and financial policy issues” while “promoting co-operation and achieve sustainable global economic growth for all,”[3] acting G7 ministers sought to extend the reach of group. The result was the inclusion of the world’s most influential economies, both advanced and emerging.
One of the inspirations behind the G20’s foundation was the framework put forth by the Bretton Woods Accords. In December 1999, acting G7 heads summoned “counterparts from a number of systemically important countries from regions around the world” to Berlin, Germany.[4] Their task was to engage challenges facing the international economic and financial environment, and the invitees included leading global powers and developing nations. In addition, the meeting in Berlin featured representatives from several Bretton Woods holdovers such as the IMF and World Bank.
One of the G20’s founding principles was to recognise the growing importance of developing nations and foster full integration of the global economy. These objectives were outlined in the G20’s mandate:[3]
- Help shape the international agenda
- Debate economic and financial issues that lack consensus opinion
- Prevent and resolve international financial crises
- Strengthen financial systems through transparency
Over the roughly two decades of its existence, the G20 has made special accommodation in times of extraordinary trials.
- Following the terrorist attacks in the U.S. on 11 September 2001, an emergency meeting of G20 members was held in Ottawa, Canada. At the conference, an unprecedented set of controls was put forth to cease the international financing of terrorist activities. In the years that followed, the guidelines were adopted by all members of the G20. [5]
- During the height of the Global Economic Crisis of 2008-10, the G20 took action by holding a special meeting in the spring of 2009. Following the collapse of lending giant Lehman Brothers, real questions surrounded the future viability of the global economy. At the spring summit in London, United Kingdom, then-U.K Prime Minister Gordon Brown negotiated a deal that called for a US$1.1 trillion stimulus package to be injected into the global economy.[6] This stimulus is credited with staving off a world-wide depressionary cycle, as well as being the first step in rectifying the “too big too fail” problem facing commercial banking institutions.
While the accomplishments of the G20 are often lauded as being a calming influence in the world of finance, they do not come without criticism. Detractors deem efforts as being “exclusive,” arguing that the G20 has strengthened the power of corporations, ignored climate change, turned a blind eye to social injustice and been tolerant of authoritarian regimes.[7] These claims have been put forth periodically by leading opposition bodies such as Greenpeace and Oxfam Germany. Subsequently, organised protests are commonplace for the annual Leaders’ Summit, with one of the largest in history occurring in 2017 at Hamburg, Germany.
Form And Function
Over the course of each calendar year, the G20 carries out an extensive agenda. More than 50 regional conferences of member representatives, known as “sherpas,” are held to address any pressing issues stemming from global finance. The focus of these meetings is categorised as adhering to one of two “tracks”:
- Finance Track: The finance classification includes all meetings involving G20 finance ministers, central bank authorities and affiliates. The issues they tackle are rooted in finance and economics, and topics such as monetary policy, exchange rate volatility, financial regulation and infrastructure development are frequently discussed.
- Sherpa Track: Each member nation’s representative, or “sherpa,” is commissioned with addressing broader societal matters. Politics, trade, energy and gender equality are a few of the subjects regularly scrutinised by working groups at scheduled sherpa functions.
Each year, a select member nation is given the opportunity to act as president of the G20. To ensure a seamless execution of the annual agenda, the acting presidency works in tandem with the previous and succeeding administrations. This collective is referred to as the “troika.”
Upon the year’s work being completed, the annual Leaders’ Summit is held to issue the G20’s joint declaration. The troika works together to ensure the consistency of the Leaders’ Summit and to promote the official agenda of the meeting.
The G20 Leaders Summit
A key function of the G20 is the annual Leaders Summit where heads of state, central bankers and various civil and business leaders are invited to share ideas regarding global economic health. It is held over a two-day period and is the culmination of the year’s work. Following the Leaders Summit, the G20 issues a formal statement regarding its official recommendations crafted throughout the year.
The inaugural Leaders Summit was held in 2008 in Washington D.C., United States. Since that time, the periodic meeting has been held in various international locales:
Year | Location |
2008 | Washington D.C., United States |
2009 | London, United Kingdom |
2009 | Pittsburgh, United States |
2010 | Toronto, Canada |
2010 | Seoul, Korea |
2011 | Cannes, France |
2012 | Los Cabos, Mexico |
2013 | St. Petersburg, Russia |
2014 | Brisbane, Australia |
2015 | Antalya, Turkey |
2016 | Hangzhou, China |
2017 | Hamburg, Germany |
The 2018 Leaders Summit was held from 30 November to 1 December in Buenos Aires, Argentina, and more than 5,000 delegates participated in more than 100 meetings focused on industry and finance.
Future venues are announced ahead of time, in a similar fashion to those of the Olympic Games. G20 Member nations rotate the honor of entertaining the Leaders’ Summit, and host cities are nominated by leadership of the president nation. For 2019, Japan was nominated to host the summit, and in 2020 the duty falls to Saudi Arabia.[12]
The annual G20 Leaders’ Summit is attended by the most powerful heads of state and business in the world. Often, news breaking from the conference enhances the pricing volatility in equities, futures and currency markets.
Summary
While not an official regulatory body, the G20 has formidable power when it comes to international finance. Its agenda often leads to reform, defining the path of the global economic and monetary systems. In times of prosperity or crisis, the G20 is viewed as a pillar of the world’s financial community and a premier decision making body.
Risk Management
In the realm of active trading, risk management is a discipline essential to sustaining profitability. If the issue of risk is not thoroughly addressed before entering the marketplace, unexpected volatilities can wreak havoc upon the trading account. It is imperative that risk is put into the proper context each and every time an order is placed at market.
Depending upon the type of trading and market being engaged, your approach to risk management may vary. However, there are four basic actions that can be extremely useful in limiting risk exposure:
- Adherence to a comprehensive trading plan
- Use of protective stops and profit targets
- Aligning risk to reward
- Prudently utilising leverage
No matter if you’re trading futures, forex or stocks, the number-one reason a majority of traders are forced to leave the market is untimely capital loss. Through taking an aggressive stance toward risk management, the odds of blowing out the trading account fall dramatically.
Developing A Comprehensive Trading Plan
The contemporary marketplace is a fast-paced environment with seemingly infinite possibilities. If you’re not adhering to a strategic framework while interacting within its bounds, the potential for catastrophe becomes very real.
A robust trading plan addresses several elements essential to conducting operations in a regimented manner. The following questions must be answered thoroughly while in the process of building a rules-based approach to the markets:
- Strategy: Is the adopted methodology rooted in technical or fundamental analysis? Is a swing, day, or intraday time frame most desirable? Is the strategy automated or discretionary?
- Ideal Market(s): Which products offer optimal levels of liquidity and volatility for the selected strategy?
- Money Management Parameters: Given the available capital resources, which safeguards are necessary to protect the account balance? What kind of trade management parameters are best suited for success?
Engaging the markets via a detailed trading plan limits many of the risks involved when you’re simply “shooting from the hip.” Individuals can build a statistically verifiable track record and trade consistently according to a structured approach. In turn, bad habits rooted in emotion, such as overtrading and reckless money management, may be reduced or eliminated.
Developing and following a suitable plan is the first step in eliminating many of the unnecessary risks associated with active trading. It must be easily understood and followed routinely in order to be effective. A comprehensive trading plan ensures the trader has the best possible chance of achieving replicable results.
Protective Stops And Profit Targets
Protective stops and profit targets are integral parts of almost any risk management approach. When used consistently and within the context of a comprehensive trading plan, stop losses and profit targets ensure that downside risk is limited while acceptable returns are locked in.
A protective stop or stop-loss is an order placed at market that runs contradictory to the direction of an open position. Protective stops are placed at a price level above active short positions (buy orders) and below open long positions (sell orders). Upon price reversing to the location of the stop loss, the open position is automatically liquidated or closed-out.
Stop-losses are one of the most valuable tools implemented by active traders to limit potential liabilities. They may be placed at market using any number of strategies. Protective stops are typically utilised in concert with an appropriate risk/reward ratio, technical indicator or predetermined monetary value.
Profit targets are applied to lock-in or guarantee that a gain is realised from a beneficial move in pricing. Profit targets are executed in a similar fashion as stop-losses. A limit, stop-limit or stop-market order is placed at market in opposition to the open position—sells for longs and buys for shorts.
Profit target and stop-loss order locations are largely subjective, but they’re commonly defined by using various aspects of technical analysis including support and resistance levels. The primary difference between the two is that profit targets are placed ahead of price, not behind it. When the designated price point is hit, the resting order is triggered locking in a gain.
Profit targets and stop-losses play a key role in risk management. While the stop-loss limits a trade’s ultimate downside, the profit target ensures that gains are realised and not given back in the wake of negative price action.
Balancing Risk And Reward, Understanding The Impact Of Leverage
The business of active traders is to frequently interact with a market, putting capital in harm’s way to achieve financial gain. To accomplish this task consistently and avoid abnormal account drawdowns, risk must be properly aligned with reward.
A risk vs reward ratio is a tool used to quantify the potential return and risk exposure facing a specific trade. It may be defined in terms of currency, pips, or ticks. The setting of profit targets and stop losses are key elements in developing a risk vs reward ratio.
For example, the following long trade in the EUR/USD illustrates the relationship between stop-loss/profit target location and risk vs reward:
- Trader A decides to go long in the EUR/USD from 1.1800
- The stop-loss is placed below a relevant 50-period Simple Moving Average at 1.1775.
- Utilising a Fibonacci Expansion, Trader A expects strong bullish price action toward resistance and places the profit target at 1.1850.
- The risk vs reward for this trade is 25:50 or 1:2.
In the above example, the use of financial leverage is held constant. While it is true that the maximum loss on the trade is 25 pips, an optimal pip value must be found. This is easily accomplished by calculating a percentage of the account balance suitable to be risked on the trade.
Concrete guidelines for implementing leverage must be included in the trading plan. In the event that an abnormally large position is taken, undue risk is assumed and a loss may be devastating. The degree of leverage placed on a single trade is best quantified in terms of available capital. Adhering to a static percentage, such as 3% of the trading account balance, is a good way of ensuring that adequate risk controls are in place.
It is important to remember that increasing the position size or degree of leverage adds to a trade’s risk exponentially. In simplest terms, the greater the leverage, the greater the risk.
Summary
By far, haphazard risk management practices are the number-one cause of new traders leaving the market prematurely. Through sticking to a comprehensive trading plan, using protective stops/profit targets, understanding leverage and the concept of risk vs reward, you can effectively limit the amount of risk exposure on a trade-by-trade basis.
Leverage
Leverage is the ability to control a large quantity of an asset with a relatively small initial capital outlay.
A real-world example of financial leverage is the purchase of a home using a fractional downpayment and a larger financed balance. While the homebuyer is technically bound by the eventual payoff of the mortgage, only a much smaller down payment is required to secure the deal.
As a result, the new homeowner has taken a long position in the local real estate market, effectively controlling an asset that is worth much more than the initial cash investment.
Effective Leverage
Effective leverage is the amount of equity being used in relation to the aggregate value of an open position. Using the home purchase example, assuming a 20% down payment and a £330,000 sale price, effective leverage is calculated as follows:
Effective Leverage = Total Position Size / Account Equity
- Effective Leverage = (£330,000/(.20 * £330,000)) = 5
The effective leverage of the home purchase is an illustration of the amount of equity used to control the value of the entire investment, in this case a ratio of 5:1.
The active trade of currencies, futures or equities function in a similar manner to a home purchase. However, the use of liquid cash as the primary means of settlement emphasizes the concept of effective leverage. As an illustration of its impact upon a forex trade, take the following scenarios:
- Trader A has an account balance of £10,000 and decides to short 20 standard lots of the EUR/USD:
- Effective leverage= (20 * £100,000)/£10,000 = 200:1
- Trader B decides to short 20 mini lots of EUR/USD, using the same £10,000 account balance:
- Effective leverage= (20 * £10,000)/£10,000 = 20:1
The effective leverage of Trader A’s account is 200:1, while Trader B’s is 20:1. The difference in leverage greatly increases the value of each pip, which in-turn magnifies the impact of short-term volatility. While Trader A stands to realise a profit 10 times greater than Trader B from a positive move, a negative move is detrimental 10 fold.
Fortunately, there are constraints placed on position sizing and the degree by which leverage may be implemented in the markets of futures, currencies and equities. Margin and maximum leverage requirements address the terms by which traders and investors are able to access credit within the marketplace:
- Margin: Margin trading takes place when a buyer or seller places a percentage of an underlying asset’s value down and borrows the balance from a broker. For instance, if an energy futures trader is interested in purchasing 1 contract of WTI crude oil (1,000 barrels) at a price of £50 per barrel, the contract is worth £50,000. In order to facilitate the trade, a broker will require a specified percentage of the contract’s value to remain in the client’s trading account. The balance insures the broker from taking a loss on the trade, placing the financial responsibility of the open position solely on the trader.
- Maximum leverage: Maximum leverage is the largest customer position size allowable. For instance, in forex, common maximum leverage ratios range from 100:1 to 200:1. It is up to the individual to learn what the maximum leverage constraints are and how they will be applied to the trading account.
Summary
While it’s true that leverage is a necessary component for the facilitation of trade, understanding how it works and its impact upon risk capital is an essential part of interacting within the marketplace. The inability to balance risk with reward, or to properly implement leverage can pose a challenge individual’s longevity within the marketplace.
Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. GWT will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.
What Are Currency Carry Trades?
A currency carry trade is a method some investors use in an effort to meet their financial objectives. The basic idea behind this strategy is selling a currency with a low interest rate and then using the resulting funds to buy a currency with a higher interest rate. By harnessing this approach, an investor can try to capture the difference in interest rates, or interest-rate differential.
Carry Trades
Currency Carry Trades
Now that you have a better idea of how carry trades work, let’s explore how this concept can be applied to currencies. For starters, you could borrow a currency, such as the Japanese yen, for a very low interest rate. After doing so, you could convert the yen to the U.S. dollar and use the greenback to buy U.S. Treasuries.
As long as these U.S. Treasuries provide higher yields than their Japanese counterparts, the aforementioned transaction produces a positive carry, meaning a positive return. Lower yields would cause a loss.
For example, if you borrow ¥10,000 from a Japanese bank at 0.25%, convert it to the U.S. dollar and then use the resulting money to buy bonds that pay 2%, you stand to turn a profit of 1.75% as long as the exchange rate remains constant. Should the exchange rates change, you could sustain a loss which could exceed your deposited funds.
In the event you decide to use leverage, these returns, or losses, can increase substantially. By harnessing 10:1 leverage in the aforementioned situation, you can generate returns of 17.5%. However, using this much leverage when setting up currency carry trades can produce equally sharp losses which may exceed your deposited funds.
Keep in mind that currency carry trades do not always generate a return, and that unexpected changes in interest rates can generate losses. If you use the aforementioned strategy of borrowing the yen, converting it to the greenback and buying U.S. Treasuries, you could experience a loss should the yields on these bonds fall below the interest rate paid to borrow Japan’s currency.
If you borrowed ¥10,000 at 2% and then bought U.S. Treasuries yielding 0.25% with the resulting dollars, you would incur a loss of 1.75% as long as the exchange rate stayed constant. This loss would be amplified if you had harnessed leverage to amplify returns. For example, 10:1 leverage would make the aforementioned loss rise to 17.5%.
While this consequence might seem modest, carry currency trades can produce far greater losses. For example, a person could borrow $10,000 at 1%, convert that money to the pound and then use the funds to purchase 10-year U.K. government bonds that pay a 1.2% yield. As long as the exchange rate remains constant, the investor would make a 0.2% profit.
However, if the yield on the U.K. government bond suddenly plunged to 0.5%, this would result in the person suffering a 0.5% loss. Should the person use 10:1 leverage, the loss would increase to 5%.
Interest Rate Determinants
Currency carry traders may benefit from researching the factors that affect interest rates. For those looking to learn more about interest rates, here are some variables that are widely credited for influencing their fluctuations:
Supply And Demand: At the most fundamental level, interest rates are a function of the supply of and demand for capital. If investors and financial institutions have a high willingness to lend money to would-be borrowers, this will result in a high supply of capital. However, if these lenders are reluctant, the situation will be the exact opposite.
As for demand, aspiring homeowners, budding entrepreneurs and those seeking consumer credit (such as automobile loans) can help produce high demand for capital. However, if they are hesitant to take on debt, this desire for credit could be far lower.
Inflation: Inflation can play an important role in interest rates by impacting how much financial institutions get paid back relative to how much they lend out. If prices rise very quickly, this development could easily reduce the purchasing power of the amount that lenders get paid back by borrowers.
Alternatively, if the price level rises very slowly, lenders face less risk that the money repaid by borrowers will have weakened buying power. As a result, they may have greater incentive to loan out money at lower rates than they would in the event of higher inflation.
Exchange Rate Fluctuations
Investors may also trade by selling currencies in nations where they believe the central bank will cut benchmark rates or buy currencies in countries where they think the central bank will hike these rates.
As central bank policy decisions often hinge around business conditions, some traders are sure to stay abreast of the latest macroeconomic events.
Summary
The currency carry trade technique is widely used, as the broader foreign exchange markets frequently providers with opportunities to benefit from interest-rate differentials. However, those thinking about using such approaches should keep in mind that risk is inherent to investment. Interest-rate differentials can also generate losses. If you are considering currency carry trades, be sure to conduct substantial due diligence and/or consult an independent financial adviser.
Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. GWT will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.
What Is Scalping?
In the financial marketplaces of the world, there are numerous different styles and trading methodologies employed with the goal of achieving profitability. One of the most prominent forms of trading used by both retail and institutional traders alike is known as “scalping.” Scalping is a trade management strategy in which the trader elects to take small profits quickly as they become available within the marketplace.
Often referred to as “picking up pennies in front of a steam roller”, scalping focuses on identifying fluctuations in price during the extreme short-term. Essentially, this trading philosophy is based on the idea that taking small profits repeatedly limits risk and creates an advantage for the trader.
The viability of scalping as a trading approach depends on several contributing factors and inputs:
- Low transaction costs: Commissions and fees need to be minimised in order to facilitate a high-volume approach to trading in a given financial market.
- Efficient market entry and exit: Adequate computer hardware and software technology is required to minimise latency-related slippage and interact within the marketplace efficiently. Slippage on entry and exit can play a major role in the overall profitability of a scalping approach and is magnified when the realised profit per trade is small.
- High volume trade identification: A major part of the scalping methodology is to repeat small profits over and over. It is crucial that the adopted trade recognition philosophy is able to produce a high volume of possible trades.
- High market liquidity: The ability to enter and exit the market quickly and efficiently is dependent upon the number of potential buyers and sellers available at the trader’s desired price. Markets that exhibit a high degree of liquidity, in addition to tight bid/ask spreads, are prime candidates for scalping.
There are several common methods of scalping in which short-term traders attempt to secure market share. Strategies aimed at capturing the bid/ask spread are prevalent in forex scalping, while increased leverage with the objective of harvesting minute moves in price are commonplace in the futures and equities markets.
Advantages Of Scalping
Perhaps the single largest advantage attributed to a trading approach based on scalping methodology is the limited market exposure afforded to the trader. At its core, scalping is an ultra-short-term trading strategy; therefore, the trader (and the equity in the trading account) is only vulnerable to short-term market volatilities. Typically, the short trade durations insulate the trader from greater systemic risks present in the marketplace, and limit the potential liability of each trade.
Another upside is the ability for a trader to profit from rotational or slow markets. While it is true that the most liquid and volatile markets are the primary target of many scalping operations, trading with the goal of capitalising on small market moves can prove to be profitable in stationary markets.
Often, trend or momentum-based trading methodologies struggle when faced with markets stuck in a consolidation or rotational phase. In these market states, fluctuations in price are limited, with the movements in price itself not being robust enough to reach required profit targets. Scalping eliminates the need for a directional market move to realise a profit, because small fluctuations in price are enough to achieve profitability and sustain a scalping approach.
Disadvantages To Scalping
Drawbacks to employing a trading approach based on scalping are numerous and closely related to trader discipline and psychology.
The very nature of scalping is to take small profits quickly in order to limit risk and create a consistent flow of revenue. However, in the pursuit of small profits, the scalper foregoes potentially lucrative trending markets in addition to large and directional pricing moves. In turn, it is possible for a trader to repeatedly “miss out” on trends and generous profits while adhering to the scalping trading plan. Over time, the fear of missing out on these moves can test trader discipline, lead to overtrading, and take a psychological toll on the trader thereby inhibiting performance.
Another drawback to employing a scalping approach is the increased use of leverage. To realise an acceptable profit on a given trade, scalpers often employ large amounts of leverage to boost profit. Trading for small numbers of ticks, pips or points often goes hand in hand with adding several contracts, lots or shares to the trade. Leverage acts as a double-edged sword. In the event a trade is not an immediate success, the potential liability is increased exponentially.
Summary
Scalping remains one of the most popular trading methods in the current electronic marketplace. Independent retail traders and institutional investors employ various scalping strategies in pursuit of sustained, long-term profitability. As long as the risks are clearly defined and accepted, and the proper inputs are in place, scalping can potentially provide value and opportunity to nearly any trading operation.
As always, risk is inherent to investment, so forex traders can benefit from conducting their due diligence and/or consulting independent financial advisors before participating in range trading or other strategies.
Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. FXCM will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.
Position Trading
The active trading of securities offers individuals many ways of engaging the marketplace. Scalping, swing trading and long-term capital investment are all valid methods of pursuing profit through the buying and selling financial instruments. Falling somewhere on the spectrum between swing trading and long-term investment is the discipline of position trading.
Position trading is a strategy where traders and investors aspire to capitalise on strong pricing trends through entering and remaining present in a market for an extensive term. A position trade is a commitment of both time and money, with the intention of realising a sizable gain from the sustained growth of an open position’s value.
Elements Of A Position Trade
In contrast to day trading, position trading is an intermediate to long-term approach to the marketplace. The typical duration of this type of trade is measured in weeks, months and years. Instead of implementing an intraday perspective using seconds, minutes and hours, decisions are made referencing daily, weekly, monthly and yearly timeframes.
Successful trading is dependent upon many factors, with each style having unique elements crucial to its effectiveness. In position trading, there are a few aspects of function that are essential to the viability of the approach:
- Market Entry: In any trading strategy, entering the market in a controlled, consistent and structured manner is a critical part of achieving sustainable profitability. Because of the extended duration of a position trade, market entry decisions are predominately made according to fundamental analysis. While technical analysis may be used to refine an entry point, accounting for the importance of macroeconomic factors is a major part of identifying a product’s long-term growth potential.
- Trade Management: Actively managing an open position in the marketplace can be a daunting task. Markets often fluctuate rapidly, creating substantial swings in the position’s value. A management plan that defines when and how to exit a trade is crucial to physically realising a profit or taking an appropriate loss. Many strategies are available to manage trades, including trailing stops, break-even scenarios and scaling out of a position.
- Money Management: Identification of assumed risk and potential reward can be the most important aspect of a trade’s viability. Position trades are to remain active in the market for a relatively long time, so the potential payoff from taking a higher degree of systemic risk must be considerable. There is no steadfast rule in how large of a profit must be aspired to, but a 1:3 risk vs reward ratio is a common target.
It is important to remember that the primary goal of position trading is to capitalise on a strong trend. Identifying opportunities with adequate risk vs reward ratios, in addition to entering and exiting a market efficiently, are imperative to the success of the approach.
Advantages To Position Trading
While the optimal duration of a position trade depends upon several factors unique to each specific product, holding an open position in any market affords traders and investors several inherent advantages:
- Trend Capitalisation: Taking a position in a market for an extended period of time enables the trader to catch robust trends created by evolving market fundamentals. For instance, an announcement by the European Central Bank (ECB) regarding the future of monetary policy for the European Union (EU) may cause a precipitous rise or fall in the value of the euro (EUR). A trader that is long or short the EUR/USD at the time of the announcement may have the opportunity to gain from an ensuing trend in the EUR/USD market.
- Mitigate “Noise“: “Noise” is a term used to describe short-term volatilities unrelated to the overriding market direction. Noise can wreak havoc upon short-term trading approaches, frequently stopping out winning trades prematurely. Position trading greatly reduces the impact of noise, because trade management parameters associated with larger timeframes are able to withstand pressure created by short-term volatilities.
- Limited Maintenance: In comparison to intraday trading styles, position trading is a relatively hands-off approach. After the due diligence related to market entry has been completed, and a trade management strategy is in place, the only task that is left is to periodically monitor the situation. The time allocation necessary for position trading is limited, much less than a day trading or scalping methodology.
The advantages of position trading appeal to a wide array of individuals. People who do not have the time necessary to trade on an intraday basis find position trading a great way of engaging the financial markets. In addition, many traders prefer to make infrequent decisions and avoid getting caught up in the periodic turbulence intraday trading often provides.
Disadvantages To Position Trading
While the logic behind the implementation of a position trading strategy is alluring to some, there are several unique disadvantages. As stated earlier, taking a position for a considerable period of time is a commitment. Getting “cold feet” and making an unplanned, early exit from the trade may serve to compromise the integrity of the entire strategy.
Listed below are several drawbacks to the practice of position trading:
- Exposure: While it is true that holding an open position in a market for a longer period does increase the chances of catching a trend, being exposed to the market itself is inherently risky. Systemic risk is the danger of a sector or entire market undergoing a severe correction. Remaining active in a market for long periods of time increases the chances of experiencing heightened degrees of volatility related to systemic risk.
- Consider the example of the ECB making a monetary policy announcement regarding interest rates facing the EU. If the announcement is unprecedented or a major shock to the currency markets, then a dramatic restructuring of market-related fundamentals is possible. The valuations of not only the EUR/USD may be thrown into chaos, but the entire currency market.
- Account Liquidity: Taking and holding a position requires a trader or investor to allocate capital for a substantial period of time. The initial capital outlay—the money required to facilitate the transaction (including margin requirements)—is effectively off the table until the position is closed out. This can lead to sustaining noticeable “opportunity cost,” where the trader or investor is unable to pursue other opportunities because sufficient risk capital is not available.
- Lack Of Compounding: Position trading is conducted on an infrequent basis. Gains from each trade are realised upon the position’s close, which can be weeks, months or years from the date of market entry. Accordingly, those profits cannot be reinvested back into the market until the position trade is closed out. This severely limits the ability to compound returns in a timely manner.
The disadvantages to position trading are worth consideration. Tying up risk capital for an extended period can come with great opportunity cost, both in terms of missed trades and the inability to compound returns. In addition, the psychological impact on the trader can be extensive as position value fluctuates, or as an unforeseen development shakes up the marketplace as a whole.
Summary
As with seemingly everything in the financial arena, the strategy of position trading comes with upsides and downsides. Many individuals find the possibility of realising sizable gains through catching a trend attractive, while others are leery of being exposed to the possibility of a widespread financial collapse.
The decision of how to engage the markets lies within the individual. While position trading is a great fit for some, it can be a detriment to others. The responsibility for selecting an optimal trading methodology also lies with each aspiring trader or investor. If the appropriate time, capital and personality is present, then a strategy of position trading may be ideal.
Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. GWT will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.