Interest rates are one of the key drivers of currency markets and include both a speculative and current affect on all currency pairs. The base interest rate is the amount that lenders of a currency can expect to receive as payment for their loan. These rates are set and manipulated by the largest banks that oversee and attempt to maintain the health of the economy through the adjustment of these rates, known as monetary policy. Whilst governments can change tax rates and other fiscal means to direct the economy, the central banks control the supply and demand of the national currency in order to achieve its economic goals. They january, for example, attempt to stimulate economic growth by decreasing the demand and thus devaluing the value of the currency in order to increase international sales of exports.

The real reason why base rates affect forex markets

Interest rates directly influence the demand for currencies in two ways. Firstly, they provide an actual demand for the currency in the knowledge that the worlds largest investors, such as countries and banks, will look for the highest rate of return on their investment with the lowest risk. Interest rates therefore determine how attractive a currency appears to these investors and by increasing or decreasing the base rate of interest this can be achieved. In the same way as holding money in a regular bank account these investors need to purchase the currency in order to gain the preferential interest rate. Therefore, raising the base rate even only very fractionally results in an increase in demand for that currency which is instantly reflected in the value between forex pairs.

The speculative influence of base rate changes

The second way in which interest rates operate is that they provide a speculative basis for many forex traders. Examples of how interest base rate speculation can influence the value of currency pairs are evident through the markets interest in key economic indicators. Events and news releases such as the non-farm payroll data, CPI levels and GDP figures all provide fundamental traders with a basis to speculate on future interest rate decisions by the central banks. This is due to the relationship between interest rates and inflation in every economy throughout the world. High inflation, created through strong employment and consumption figures, is often controlled directly by adjusting the cost of borrowing within an economy. High costs of borrowing, through increased interest rates, have the effect of “cooling” an economy by slowing consumption and at the same time making exports appear expensive to international buyers (the effect of increasing the strength of the currency).

Trading the announcement

Interest base rates are therefore one of the most important drivers of currency values. Fundamental traders will use this information to look for long-term trends in forex pairs whilst technical traders january trade the decision days themselves. Announcements by major central banks, such as the Federal Reserve or European Central Bank, on base rate changes have a similarly volatile effect on currencies as that of key indicators such as unemployment figures. One of the key differences in the release of interest rate decisions, however, is the fact that it is generally only interpreted as positive or negative rather than incorporating several different perspectives. Furthermore, the rationale for the change, as explained in the minutes of central bank meetings can be equally, if not more influential, than the event itself. This can also provide great opportunities for forex traders to interpret these correctly and take long or short positions on currencies.

Forex markets are intricately-woven reflections of the supply and demand for currencies around the world. Whilst currencies are always quoted in pairs, as an explanation of the relative value of one against the other, they are all interlinked in varying degrees to all other pair’s movements and value. The relationship between these currency pairs is known as their ‘correlation’, or the degree to which the movements of one pair affects the movements of another. Correlations can change over time, with some pairs becoming more or less correlated with one another; however, many currency pairs have a consistent correlation which is important for forex traders who can use these to manage the exposure of their trades and in order to hedge their positions.

Correlation tables

Understanding the degree to which currency pairs can be correlated removes counterproductive trading and the risk of two trades cancelling one another out. Correlation values are presented between -1 and +1 with a perfect correlation being +1 and no correlation being -1. These correlations are presented in a table which commonly provide the figures for one month and up to one year. It is important to remember that forex correlations are not necessarily fixed and are subject to fluctuations throughout the year and even on a daily basis. These changes underline the importance of checking currency correlations using longer term averages such as the yearly figure, in order to get a more comprehensive overview of the relationship between currency pairs.

Pairs that can be described as highly correlated, and therefore that move in unison, include the USD/GBP and GBP/JPY. The positive correlation between these pairs means that, when the USD/GBP rises or falls, it is very likely that the GBP/JPY will also follow this move. Entering opposing trades on both of these pairs, therefore, would be counterproductive as a long and short position on each of these would cancel one another out. Similarly, a currency pairs which have a high negative correlation, such as the EUR/USD and USD/CHF, will move in opposing directions most of the time. Taking a trade in the same direction on each of these pairs would therefore be likely to have the same negative effect of cancelling-out any gains.

Influential factors

Factors which influence the relationship between currency pairs can include geopolitical changes, commodity price fluctuations and, importantly, convergence and divergence of monetary policy. As interest rates and speculation surrounding these is a major driver of currency movements, these can potentially influence the correlation between pairs with similar or opposing interest rate forecasts.

The benefits of trading using currency correlations

Correlations can also benefit forex traders by allowing them to spread their risk over highly correlated currency pairs. Rather than entering a position on just one currency pair, a portfolio can be diversified between highly correlated pairs in order to lower the risk associated with over-exposure. This is most effective when currency pairs are highly, but not perfectly, correlated. An example january be a long position on both the EUR/USD and AUD/USD which have a generally high correlation. The trade here would assume a devaluing of the USD but by spreading the risk between the two pairs. The difference in monetary policies between the Australian and European Central Banks would also help protect the trade against the rise of the US dollar as they are unlikely to be affected equally and one january therefore absorb some of the negative impact of the rise.

Furthermore, those pairs with a strong negative correlation can be used to hedge against one another. Due to the fact that the number of points movement for the two currencies are unlikely to be equal, traders can take advantage of this by taking opposing positions in order to offset any losses should the trade fail to be profitable. Although this will result in lower profits, the use of negatively correlated pairs to insure losses are limited is a good example of the benefit of understanding currency correlations.

Many forex traders use chart patterns and formations to accurately predict the future direction of price. The most popular patterns occur across all timeframes and form a central part of technical analysis. These chart formations are considered reliable, not only because they have historically performed as anticipated when they have occurred, but also because of the number of traders who are watching for these patterns. Chart formations january take several hours, days or weeks to form but their outcome can be verified by looking at previous examples which have provided good trading opportunities. The two types of chart formation, reversal and continuation, are helpful to all traders learning how to read the forex markets.

The double top and bottom

This is one of the most highly recognisable and popular reversal chart formations. The double top and double bottom form when price attempts, twice, to push higher or lower. The result is that an M or W pattern forms and this represents the end of a trend. Traders normally wait for this pattern to be confirmed when price pushes up or down beyond the first pullback, showing that it is not simply a short-term correction but a complete reversal of the trend. Double bottom and double top chart formations can be seen on all timeframes and they are made even more reliable if the second top or bottom fails to reach the price level of the previous top or bottom.

Head and shoulder

This is another very recognisable and frequently-traded reversal chart formation. The pattern is formed when price rises before pulling back, creating the left “shoulder”, and then pushes higher to create the “head”. In the most obvious head and shoulders patterns the price will then fall to the level of the first neckline before trying once again to rise in order to create the right hand shoulder. Forex traders will wait for the right shoulder to complete before price is expected to fall aggressively beyond this. This is one of the favoured patterns for technical traders due to the high probability of success but also the speed at which price often falls off the right shoulder.

Flags and pennants

Flags and pennants form a good indication that price is going to continue in the direction of the trend after a consolidation period. These are particularly important for traders who use the trend to hold long and short positions as they provide reassurance that price will continue to move in their favour once the consolidation is complete. In order to be considered reliable, these chart formations should be found during a trend when a previously sharp rise or fall in price has occurred. These patterns are usually followed by a breakout beyond the resistance line formed by the pattern.

Channels

Channels are used by most technical traders to define the inner and outer boundaries of the current price trend. They can be found on price charts using both an upper and a lower trend line and these become support and resistance levels from which trades can be places. As a continuation pattern, channels can be either bullish or bearish, depending on their slops. Once the trend begins to falter, traders typically wait for the price to confirm a breakout of the channel before looking for reversal or corrective trades.

Rectangles

Breakout traders enjoy identifying rectangular chart patterns that represents price trapped within a range to form a rectangle. These patterns are particularly powerful on the 1 hour and higher timeframes as price tests the upper and lower support and resistance of the rectangle and eventually breaks out. Traders will typically wait for confirmation of the breakout and enter the trade with a high probability that the trend will continue in the direction of the breakout.

Breakouts occur when price has been range-bound for a period of time as bulls and bears battle to dictate the direction of the trend. Breakouts can either represent a continuation of the trend, after a period of consolidation which results in the formation of a rectangle chart pattern or at the end of a move higher or lower as a reversal. They can be seen on most timeframes and often result in price moving sharply higher or lower as either bulls or bears finally get the upper-hand. The general rule of breakout trading is that the longer the period of consolidation the more powerful the breakout is likely to be. Having said this, forex traders need to be wary of the potential for “false breakouts” which leave traders trapped on a break which quickly reverses and moves in the opposite direction.

Trading pattern breakouts

There are a number of methods to trade breakouts and many of these agree that the breakout needs to be confirmed in order to avoid a “false breakout” situation. When the breakout setup shows a rectangle pattern, with both highs and lows forming horizontal support and resistance lines, traders will wait for either level to be broken. This will provide the entry either directly at the high of the breakout price bar or, as many forex traders prefer, after the first pull back following the breakout. The reason that traders should wait to trade following the breakout of the rectangle is to reconfirm that this is a genuine price movement and that the momentum exists in the market for the breakout to be successful.
Other pattern breakouts include triangles and flags/pennants which all trade within a range before breaking out as a continuation of a reversal of the trend. Sideways price ranges can also be viewed on higher timeframes as “inside bar” patterns using candlestick analysis. The formation of inside bars represents market indecision and consolidation and several inside bars can result in a powerful breakout move.

Support and resistance in breakout trading

Breakout trading is all about waiting for price to break through an area of support or resistance that has been re-tested several times. As with all breaks of support and resistance levels, once price has moved past these the support levels become resistance and vice versa. In breakout trading this also applies and the point at which price breaks out will often be re-tested after the breakout to test if it will become a new support or resistance level. Using this knowledge, some of the highest-probability trades are the combination of candlestick analysis on the retest of the breakout. Once the new support or resistance level has been confirmed then traders can buy or sell with confidence in the direction of the breakout.

False breakouts

When a breakout occurs with strong initial momentum, there is a high possibility that it could be a false breakout. Market makers know that such a push beyond the breakout level will trigger a high number of trades and a reversal will trap a large number of traders with losing positions. Being aware that these false breakouts are common, some traders choose to ‘fade’ the initial breakout for several pips profit. Although this is an advanced strategy for trading breakouts, the understanding that price frequently returns to retest the breakout area provides an opportunity to trade the pull-back from a strong break out. Additionally, trades can be taken once the breakout failure has been confirmed; this will often result in a complete reversal and moving out of the consolidation area in the opposite direction.

There are literally thousands of strategies and methods for trading forex and numerous trading signal providers to choose from. Depending on whether you want to trade mechanically, automatically or manually will influence your decision as to which january be best suited for your trading. Automated trading includes software robots which are designed to enter and exit positions without requiring the trader to actively execute the trade. Although these systems can be effective, many traders prefer a more manual approach to trading and do this either mechanically with the use of a forex signal service. Mechanical trading relies of the trader entering and exiting each position after their system or strategy provides them with the signals. Trading with a signal service is similar to this although the trader january not necessarily know of how or why the signals have been generated and essentially enters the trade ‘blind’ with only the entry and exit known.

Using a forex signal service

Although traders frequently are unaware of the system or method behind many forex signals services, this can be beneficial in preventing “analysis paralysis” and reduce the anxiety associated with such over-analysis. However, as a long-term solution to forex trading the use of a signals service is less sustainable and most traders prefer to learn and execute their own methods of trading without having to rely on such a service. In order to develop the skills to trade autonomously, forex traders need to recognise their own trading signals which will very much depend on the type of trader they are and their preferred trading style.

Confirming the trading signal

For all traders, the confirmation of a trading signal is essential to increase the probability of a profitable trade. This confirmation supports the initial trading signal and many successful forex traders will wait for several additional signals to provide confluence before entering a position. For technical traders, this can be in the form of indicators such as an oscillator at either of its extremes or showing divergence with the current price. For price-action traders who prefer not to use any indicators but instead to look for price to react near key areas of support and resistance they january rely on candlestick analysis as their primary trading signal. Although there are a number of effective ways to interpret trading signals, perhaps the most important factor in common with all of these is the requirement for at least one further reinforcing signal.

Timeframes are important for spotting forex signals

Forex trading signals occur on all timeframes but it is good to bear in mind that the lower timeframes, such as the 5 and 1 minute charts are likely to generate many more signals than the hourly or daily charts. Although the signals of any method are likely to be less on the larger timeframes it is for this reason that they can be considered more reliable. This reinforces the importance of filtering the multiple opportunities that january be seen on the lower timeframes so that only those with the highest probability of success are actively traded.