Trade Forex On Herd Instinct

"Herd instinct" in the investing lexicon refers to the tendency of traders to blindly follow an established investment trend or pattern. Such traders are typically adherents of the well-known investment axiom "the trend is your friend." This principle is likely to provide better returns in forex trading than in equities trading for a couple of reasons.

Firstly, forex trading is arguably driven by technical analysis to a greater extent than stock trading, given that fundamental analysis plays a much bigger part in the latter than it does in the former. Secondly, while the forex market is the world's most liquid financial market with estimated daily turnover exceeding $4 trillion in 2010, just six currency pairs – USD/euro, USD/yen, USD/sterling, USD/Australian dollar, USD/Swiss franc and USD/Canadian dollar – accounted for two thirds of this trading volume. (Conversely, blue-chip stocks on the major global equity exchanges collectively number in the thousands).

These currencies are avidly watched by legions of currency traders around the world, and the same technical levels are monitored around-the-clock by these traders for buy and sell signals. Once a key technical gives way, other traders jump in and reinforce the initial trend, thus exacerbating the herd effect.

Using Herd Instinct in Forex
The guiding principle for using the herd instinct profitably in the forex market is a simple one – base your trades on the majority view and established trends in global markets. Being a contrarian may enable you to reap rewards in the stock market – assuming that you are astute enough to time the markets effectively – but it can be a recipe for disaster in the forex market, where a currency can defy fundamentals for so long and drift so far that it can test the resolve of the biggest and best traders.

The decline of the Japanese yen in 2013 is a prime example of the herd instinct at work. In April 2013, the Bank of Japan (BOJ) announced that it would buy government bonds and double the country's monetary base by 2014. The BOJ embarked on this unprecedented degree of monetary stimulus to foster growth and break the deflationary spiral that had plagued the Japanese economy for two decades. As a result, the short JPY/long USD trade was one of the most popular forex trades in the first half of 2013.

While traders were already shorting the yen going into 2013 on account of Japan's aging population and massive government debt, the yen's descent picked up steam as traders and speculators grew increasingly confident that the Bank of Japan would continue to ease monetary policy. By the first week of May 2013, the yen was the biggest decliner of the major currencies for the year, with a 12.4% fall versus the U.S. dollar. With forex traders rushing to put on short JPY positions, the currency looked set to break the 100 barrier, at which point the herd instinct would have added to its downward momentum.

The short JPY/long USD trade had in fact superseded the short EUR/long USD trade by 2013 as the "go to" trade for trend followers, as the attention of currency bears shifted to the Japanese currency following the euro's rebound since mid-2012 from a low of around 1.20. This sentiment shift could be gauged by the performance of the two currencies versus the greenback in the one-year period ending May 7, 2013; while the euro had gained 0.2%, the yen was down 19.3%.

The herd instinct was also evident in the strength of the U.S. dollar against most major currencies by May 2013, with the greenback on the ascent against 13 of the 16 most widely-traded currencies. The unexpected strength of the U.S. dollar at that time was largely attributed to the rebounding U.S. economy, which had driven the Dow Jones Industrial Average and S&P 500 indexes to record highs, attracting further capital inflows in a virtuous circle.

Common Herd Instinct Forex Trades
Currency action over the years indicates that the following trades are the most common "herd instinct" ones. These are only suggestions, and if you intend to trade these currencies, it is strongly recommended that you conduct your own research and due diligence.

Read GFT’s free guide> Forex trading – 10 Tips.

As China is the world's biggest importer of numerous commodities, when the Chinese economy is growing strongly, currencies of commodity exporters such as Canada and Australia benefit. In the first decade of this millennium, as commodity demand soared due to the Chinese boom, the AUD and CAD surged 37% against the U.S. dollar. Therefore, consider going long CAD and AUD versus the greenback when the Chinese economy is expanding rapidly.

The AUD and CAD tend to do well when the global economy is growing strongly and demand for risk appetite is strong. Conversely, when fears abound about slow global growth and risk appetite shrinks, these commodity currencies decline and safe-haven currencies such as USD and Swiss franc (CHF) rise. At such times, popular herd instinct trades are short CAD or AUD and long USD or CHF.

While the Japanese yen had lost substantial ground by spring of 2013, it has tended to trade in a direction opposite to that of global risk appetite because of its popularity as a funding currency for "carry trades*." The carry trade strategy can be disastrous when risk appetite vanishes and panicked speculators rush to close their positions, because of the double whammy arising from the fire-sale of risky assets and the spike in the yen exchange rate due to demand for the currency to repay carry loans. More than $1 trillion had been invested in the yen carry trade by 2007, but as the global economy unraveled in 2008, the currency rose 20% versus the greenback that year.

Speculators who had borrowed yen to invest in AUD (which is equivalent to a long AUD/short JPY position) had the mortification of seeing the AUD plunge by a staggering 49% against the JPY in a one-year period, from October 2007 to October 2008. The bottom line is that the yen can often be exceptionally volatile, and before determining your entry into a currency carry trade based on the yen (such as long CAD/short JPY or even long EUR/short JPY), make sure you have planned your exit as well.

The Canadian dollar has a close positive correlation with crude oil prices because of Canada's status as a leading oil exporter. On the other hand, Japan is the world's biggest oil importer, making its economy vulnerable to high crude oil prices. If crude oil spikes, say because of a sudden conflict in the Middle East, consider long CAD/short JPY.

Global macroeconomic risk from 2010 to 2012 had centered on Europe and a potential break-up of the euro-area. While these fears have dissipated substantially from mid-2012 onward, an increase in eurozone concerns precipitated by another debt crisis in one or more of the most highly indebted nations could lead to a surge in short EUR/long USD or short EUR/long CHF positions.

Herd Instinct Tips
Inexperienced forex traders should note these "herd instinct" tips:

• Beware of a stale trend or a long-lived one, since it may be in danger of imminent reversal. Currency trends can reverse quite sharply, and being on the wrong end of a trend reversal can lead to catastrophic losses. By the same token, unless you're George Soros, don't be a currency contrarian.

• While playing a trend, plot your exit strategy in advance. Staying in a herd can provide safety in numbers, as long as you don't get crushed when the herd stampedes for the exits.
  
• Stop losses are very critical, since the inordinately high degree of leverage in retail forex can lead to financial ruin if strict trading discipline is not implemented.
  
• Don't forget that being long one currency means you are short the other. Short positions seem to warrant closer monitoring by traders, and this approach may help avoid the complacency that can turn a profitable position into a losing one.
  
• Adding to a losing position is not advisable, since "averaging down" is seldom a viable trading strategy in forex.

The Bottom Line
The herd instinct can help you profitably trade established trends in forex; but use caution and commonsense within the herd – use stop losses, avoid complacency and plan your exit strategy. As innumerable traders have discovered to their cost, the trend is your friend, but only until it comes to an end.

* In yen carry trades, speculators borrow the yen at near-zero interest rates, sell it for U.S. dollars and plough the proceeds into higher-yielding (and riskier) assets such as equities, other currencies or commodities. Steady yen depreciation is a prerequisite for such carry trades to be successful, because a smaller amount of foreign currency is required to repay the initial yen loan.

Posted  May 09 2013 Source : http://www.investopedia.com

Disclaimer…The subject matters expressed above is based purely on technical analysis and personal opinions of the writer. it is not a solicitation to buy or sell.

Currency Exchange: Floating Rate Vs. Fixed Rate

Did you know that the foreign exchange market (also known as FX or forex) is the largest market in the world? In fact, more than $3 trillion is traded in the currency markets on a daily basis, as of 2009. This article is certainly not a primer for currency trading, but it will help you understand exchange rates and fluctuation.

What Is an Exchange Rate?
An exchange rate is the rate at which one currency can be exchanged for another. In other words, it is the value of another country's currency compared to that of your own. If you are traveling to another country, you need to "buy" the local currency. Just like the price of any asset, the exchange rate is the price at which you can buy that currency. If you are traveling to Egypt, for example, and the exchange rate for U.S. dollars is 1:5.5 Egyptian pounds, this means that for every U.S. dollar, you can buy five and a half Egyptian pounds. Theoretically, identical assets should sell at the same price in different countries, because the exchange rate must maintain the inherent value of one currency against the other.

Fixed Exchange Rates
There are two ways the price of a currency can be determined against another. A fixed, or pegged, rate is a rate the government (central bank) sets and maintains as the official exchange rate. A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the yen or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged.

SEE: What Are Central Banks? and Get To Know The Major Central Banks

If, for example, it is determined that the value of a single unit of local currency is equal to US$3, the central bank will have to ensure that it can supply the market with those dollars. In order to maintain the rate, the central bank must keep a high level of foreign reserves. This is a reserved amount of foreign currency held by the central bank that it can use to release (or absorb) extra funds into (or out of) the market. This ensures an appropriate money supply, appropriate fluctuations in the market (inflation/deflation) and ultimately, the exchange rate. The central bank can also adjust the official exchange rate when necessary.

Floating Exchange Rates
Unlike the fixed rate, a floating exchange rate is determined by the private market through supply and demand. A floating rate is often termed "self-correcting," as any differences in supply and demand will automatically be corrected in the market. Look at this simplified model: if demand for a currency is low, its value will decrease, thus making imported goods more expensive and stimulating demand for local goods and services. This in turn will generate more jobs, causing an auto-correction in the market. A floating exchange rate is constantly changing.

In reality, no currency is wholly fixed or floating. In a fixed regime, market pressures can also influence changes in the exchange rate. Sometimes, when a local currency reflects its true value against its pegged currency, a "black market” (which is more reflective of actual supply and demand) may develop. A central bank will often then be forced to revalue or devalue the official rate so that the rate is in line with the unofficial one, thereby halting the activity of the black market.

In a floating regime, the central bank may also intervene when it is necessary to ensure stability and to avoid inflation. However, it is less often that the central bank of a floating regime will interfere.

The World Once Pegged
Between 1870 and 1914, there was a global fixed exchange rate. Currencies were linked to gold, meaning that the value of a local currency was fixed at a set exchange rate to gold ounces. This was known as the gold standard. This allowed for unrestricted capital mobility as well as global stability in currencies and trade. However, with the start of World War I, the gold standard was abandoned.

SEE: The Gold Standard Revisited

At the end of World War II, the conference at Bretton Woods, an effort to generate global economic stability and increase global trade, established the basic rules and regulations governing international exchange. As such, an international monetary system, embodied in the International Monetary Fund (IMF), was established to promote foreign trade and to maintain the monetary stability of countries and therefore, that of the global economy.

SEE: What Is The International Monetary Fund?

It was agreed that currencies would once again be fixed, or pegged, but this time to the U.S. dollar, which in turn was pegged to gold at US$35 per ounce. What this meant, was that the value of a currency was directly linked with the value of the U.S. dollar. So, if you needed to buy Japanese yen, the value of the yen would be expressed in U.S. dollars, whose value in turn was determined in the value of gold. If a country needed to readjust the value of its currency, it could approach the IMF to adjust the pegged value of its currency. The peg was maintained until 1971, when the U.S. dollar could no longer hold the value of the pegged rate of US$35 per ounce of gold.

From then on, major governments adopted a floating system, and all attempts to move back to a global peg were eventually abandoned in 1985. Since then, no major economies have gone back to a peg, and the use of gold as a peg has been completely abandoned.

Why Peg?
The reasons to peg a currency are linked to stability. Especially in today's developing nations, a country may decide to peg its currency to create a stable atmosphere for foreign investment. With a peg, the investor will always know what his or her investment's value is, and therefore will not have to worry about daily fluctuations. A pegged currency can also help to lower inflation rates and generate demand, which results from greater confidence in the stability of the currency.

Fixed regimes, however, can often lead to severe financial crises, since a peg is difficult to maintain in the long run. This was seen in the Mexican (1995), Asian (1997) and Russian (1997) financial crises: an attempt to maintain a high value of the local currency to the peg resulted in the currencies eventually becoming overvalued. This meant that the governments could no longer meet the demands to convert the local currency into the foreign currency at the pegged rate. With speculation and panic, investors scrambled to get their money out and convert it into foreign currency before the local currency was devalued against the peg; foreign reserve supplies eventually became depleted. In Mexico's case, the government was forced to devalue the peso by 30%. In Thailand, the government eventually had to allow the currency to float, and by the end of 1997, the Thai bhat had lost 50% of its value as the market's demand and supply readjusted the value of the local currency.

SEE: What Causes A Currency Crisis?

Countries with pegs are often associated with having unsophisticated capital markets and weak regulating institutions. The peg is there to help create stability in such an environment. It takes a stronger system as well as a mature market to maintain a float. When a country is forced to devalue its currency, it is also required to proceed with some form of economic reform, like implementing greater transparency, in an effort to strengthen its financial institutions.

Some governments may choose to have a "floating," or "crawling" peg, whereby the government reassesses the value of the peg periodically and then changes the peg rate accordingly. Usually, this causes devaluation, but it is controlled to avoid market panic. This method is often used in the transition from a peg to a floating regime, and it allows the government to "save face" by not being forced to devalue in an uncontrollable crisis.

The Bottom Line
Although the peg has worked in creating global trade and monetary stability, it was used only at a time when all the major economies were a part of it. While a floating regime is not without its flaws, it has proven to be a more efficient means of determining the long-term value of a currency and creating equilibrium in the international market.

by Reem Heakal

Source :http://www.investopedia.com/
Read more:
http://www.investopedia.com/articles/03/020603.asp?partner=fxweekly3#ixzz1pXk8a5QV

Disclaimer…The subject matters expressed above is based purely on technical analysis and personal opinions of the writer. it is not a solicitation to buy or sell.