Using the Dollar Index

Another useful tool in fundamental analysis is using the U.S. dollar index or USDX for short. This keeps track of the dollar’s performance against a basket of currencies.

Included in this basket of currencies are the euro, yen, pound, Canadian dollar, Swedish krona, and Swiss franc. Aside from providing a general direction of dollar behavior, this also tracks the U.S. economy’s performance against a total of 22 economies, as the euro is a shared currency among 17 nations.

With that, the USDX could serve as a barometer for most U.S. dollar pairs and future dollar price action. Technical levels are generally respected by this index, with tests of support and resistance likely to hint of potential market turns.

The USDX is measured in points, usually until the third decimal place using a base of 100.000. This means that an 88.500 value reflects a 11.5% drop in the U.S. dollar’s value against the basket of currencies. A 105.675 reading shows a 5.675% increase in the dollar’s value relative to the other six currencies.

Analysts have begun looking at this index around the 1970s as leaders of the world’s biggest nations back then met in Washington to agree on a standard against which their currencies can float freely against. This means that the value of their currencies is relative to the U.S. dollar.

Other versions of the dollar index were constructed since then. Among these is the trade-weighted dollar index, which takes into consideration the trade values of goods from other economies. This was constructed by the Fed to monitor the competitiveness of U.S. products in the international scene. The weights are adjusted periodically but this index isn’t usually monitored by forex traders, as the basic USDX has been the norm for tracking the Greenback’s performance.

When it comes to predicting forex price moves, technical and fundamental analysis can also be applied on the dollar index to forecast future price action. Trends are monitored and leading or lagging indicators can be applied. Inflection points such as round numbers or retracement levels can also be indicative of potential market corrections or reversals. Chart patterns and Japanese candlestick formations are also useful in predicting USDX movement.

From there, the behavior of EUR/USD, USD/CHF, GBP/USD and other dollar pairs can be predicted. When the USDX is projected to bounce, it is reasonable to assume that EUR/USD could selloff or that USD/CHF could also rally. When the USDX is expected to drop, one can predict that GBP/USD would climb or that USD/JPY would weaken.

What’s important to keep in mind when using the USDX in predicting currency price moves is whether or not the U.S. dollar is a counter currency or base currency. For instance, the USDX is inversely correlated to EUR/USD’s moves because the U.S. dollar is the counter currency in this scenario.

Watching long-term trends in the dollar index is also useful in observing the Dollar Smile Theory. This is a phenomenon that helps swing traders predict whether the U.S. dollar can react to fundamentals or risk sentiment.

It has been observed that the dollar tends to act more of a safe-haven when global economic performance is very weak or in times of recession. During these cases, weak data tends to support the U.S. dollar’s rallies while strong data leads to a dollar selloff.

However, when the global economy is more or less stable, the U.S. dollar can be more sensitive to U.S. economic data. This means that weak U.S. reports lead to a dollar selloff while strong reports lead to a rally.

Taking Advantage of Carry Trade

With interest rates dictating the rate of return for holding assets denominated in the local currency, forex traders also pay special attention to interest rate differences when it comes to keeping their positions open for a long time. This is because the interest rate difference is carried on when a forex position is kept open overnight.

This practice is known as carry trade. When you are buying a currency that has a higher interest rate compared to the counter currency, you can take advantage of positive carry. In other words, you gain a small interest on your forex position if you keep it open until the next trading day and your broker will add that amount to your profits.

Conversely, when you are buying a currency that has a lower interest rate compared to the counter currency, you are losing from negative carry if you keep the trade open for days. You lose a small part of your forex position to the negative interest rate differential, which gets applied to your profits on the next trading day.

For instance, if the Reserve Bank of Australia offers 3.00% interest while the U.S. Fed offers only 0.25%, going long AUD/USD could give you a 2.75% additional return based on your position if you keep your trade open for a year. Shorting AUD/USD gives you a 2.75% loss on your profits if you hold on to your trade for a year. Overnight gains or losses are determined as a part of the annualized interest rate differential.

You’ve probably guessed that much longer-term positions have the potential of benefitting from purely positive carry. Even if you lose from the actual trade or if price doesn’t move at all, you can gain profits each day just by keeping the trade open for a really long time. On the other hand, negative carry can wind up eating a chunk of your profits even if you make small wins on the actual forex trade.

Carry trades can therefore maximize the profits on long-term trades, especially when risk is on. This can be determined by using the market sentiment analysis techniques discussed in the earlier section. When higher-yielders are likely to rally, a trader can benefit from long positions and from the positive rate differential.

Of course carry works negatively when risk is off. Not only do higher-yielders sell off, but also holding on to a short position with these currencies could reduce your profit potential.

Understanding Market Sentiment

Briefly introduced in the earlier sections is the concept of market sentiment, which involves gauging whether traders are in the mood to take on more risk in their portfolios or not. This is relevant in the forex market because higher-yielding currencies or those with central banks offering higher interest rates tend to benefit during risk-on market environments while lower-yielding currencies or those with central banks giving lower interest rates enjoy stronger demand when risk is off.

Risk-on or periods of market risk appetite refer to those instances when traders are more confident about global economic performance and prospects that they are in pursuit of higher yields, which generally carry a greater amount of risk.

On the flip side, risk-off or periods of market risk aversion include those times when traders are pessimistic about global economic performance and prospects, causing them to be more cautious and in favor of lower-yielding safe-haven assets.

As of this writing, the major economies that offer higher interest rates are Australia, New Zealand, and Canada. Aside from the fact that commodity currencies are also sensitive to global economic performance, the Australian dollar, New Zealand dollar, and Canadian dollar also enjoy significantly higher interest rate differentials from other major currencies, such as the U.S. dollar or Japanese yen. With that, the comdolls tend to rally when risk is on while the Greenback and yen benefit from risk aversion.

Lower interest rates don’t guarantee safe-haven status though, as the euro is a prime example of a currency with a low interest rate that isn’t considered as a flight-to-safety option. Even though the European Central Bank already offers low interest rates, the likelihood is that further easing measures or interest rate cuts can be implemented, thereby giving the possibility of lower returns on euro holdings.

Aside from looking at equity performance or monitoring global economic trends, another way to gauge market sentiment is to look at the Commitments of Traders Report as released by the CFTC or Commodity Futures Trading Commission. This weekly report indicates how many commercial and non-commercial traders are long or short the major currency pairs.

With this strategy, traders usually focus on extreme short or extreme long positions in order to pick market tops or bottoms. When traders are extremely short on a currency, there is no one left to sell, which means that the market will eventually turn. When traders are extremely long on a currency, there is no one left to buy, which means that price could eventually fall.

To get these figures, you simply have to visit the CFTC webpage and look for the COT report then view the short format. Just look for the currency you are interested in to see the current positioning of traders. It also helps to compare to the previous week’s report to see if more short or long positions were added. Sudden shifts in positioning could also be a sign of a market reversal.

Correlations in Other Financial Markets

Aside from watching economic data releases or keeping track of central bank policy biases, monitoring other financial markets can also be helpful in predicting forex price moves. To be specific, there are currencies that move in tandem with asset prices or precious metals while others are negatively correlated to other financial markets.

For one, the Australian dollar has been observed to have a positive correlation with gold prices. This is probably because Australia is the third-largest gold producer in the world and any increases in the precious metal’s value is bound to be positive for the Land Down Under’s export revenues. This then translates to better growth prospects, which boost the Aussie’s value.

Another interesting financial market correlation with forex is that of U.S. dollar and gold. Unlike the Australian dollar, the U.S. dollar has an inverse correlation to the precious metal’s price. After all, gold is usually treated as a hedge to U.S. inflation.

Aside from that, traders tend to park their money in gold if risk appetite is strong. This takes place when global economic performance is strong and traders are more confident in pursuing riskier assets. In that case, the lower-yielding and safe-haven U.S. dollar gets dumped in favor of gold. On the other hand, when risk aversion is in play, traders buy up the U.S. dollar and let go of their gold positions.

More often than not, the Swiss franc also has a positive correlation with gold, as most of the country’s reserves are linked to gold.

When it comes to other commodities and currencies, it has also been observed that crude oil and the Canadian dollar have a positive correlation. This is because Canada is one of the top oil producers in the world, with roughly $2 million worth of barrels per day. The U.S. economy is its top oil buyer, which means that rising fuel demand from the global economy can drive the Canadian dollar higher.

Aside from commodity prices, bond prices also tend to have a correlation with forex market price action. Simply put, a bond is an IOU issued by an entity to its bondholders. Bond prices and yields that are monitored by traders are usually government debt securities.

What’s particularly tricky about this type of financial instrument and its correlation to currency trading is that bond yields instead of prices are usually monitored. Bond yields refer to the rate of return when one buys government bonds and these are inversely correlated to bond prices.

Bond yields usually serve as an indicator of local stock market strength. When stock prices are rising, bond yields are also rising while bond prices are falling. On the other hand, when stock prices are falling, bond yields are also dropping while bond prices are rising. In relation to the forex market, the local currency tends to move in tandem with bond yields.

Fixed income securities also show correlations with the forex market, more often than not. Economies that offer higher returns on their fixed income securities tend to have a stronger local currency while those that offer lower returns on their fixed income securities usually have a weaker local currency.

Economic Releases You Can Trade

The forex economic calendar is one of the most useful tools for traders, especially those who incorporate fundamental analysis in determining their currency biases. A typical forex calendar lists the upcoming data releases and indicates whether those could have a strong or low impact on the currency involved. These also post the previous period’s data results to provide the trader with a point of comparison in gauging if improvements were made, along with the market consensus.

Simply put, a stronger than expected release or one that marks a considerable improvement from the previous period’s data could lead to a rally for the currency since these could eventually translate to tighter monetary policy. On the other hand, a weaker than expected release or one that is lower compared to the previous period’s data could lead to a selloff for the currency since these could result to easier monetary policy.

Not all economic reports listed on the forex calendar are ideal to trade though, as some could simply generate small price reactions or serve as bigger picture indicators rather than resulting to significant short-term moves. The larger reports, such as the GDP and CPI, tend to large and prolonged price movements since these provide more or less an idea of how the economy is faring from a bird’s eye view.

In particular, the GDP or gross domestic product provides a neat number that sums up how the economy fared and this is usually reported on a quarterly basis. As such, it is one of the clearest gauges of economic growth, as a positive GDP reading would mean that the economy expanded over the period while weak GDP reading would signal contraction. Consecutive quarters of economic contraction would then constitute a recession, which turns out to be very bearish for that country’s currency.

The CPI or consumer price index measures changes in price levels and this is usually reported on a monthly basis. It is also closely linked to monetary policy since the central bank’s mandate is to maintain price stability. When prices keep climbing, the central bank has to employ its monetary policy tools in order to prevent inflation from surging out of control. Conversely, when prices keep dropping, the central bank also has to make monetary policy adjustments in order to stoke inflationary pressures and prevent a deflationary cycle from occurring.

On the other hand, data such as producer prices or wholesale sales don’t generally result to significant price moves for the currency involved. Instead, these could serve as underlying data when one is trying to predict how larger reports such as core CPI or consumer spending might turn out.

Retail sales, manufacturing production, or trade balance releases tend to have varying levels of impact depending on the currency involved. Trade-dependent exporting economies, such as Australia and New Zealand, have currencies that are more sensitive to trade balance data. Meanwhile, economies that are heavily reliant on the consumer sector have currencies that react to retail sales and household spending reports.

Monetary Policy and Central Banks

Monetary policy and interest rate expectations play a central role in fundamental analysis, as these determine the rate of return for holding a country’s assets and therefore the demand for its currency. As mentioned in the previous section, central banks’ decisions carry a major influence in this regard.

Of course these decisions are based on a number of economic factors, including overall growth, inflation, consumer spending and confidence, and trade activity among many others. These data can be found in economic databases online and fresh releases can be tracked using an economic calendar.

Generally speaking, consistent economic improvements and expectations of strong performance could lead a central bank to tighten monetary policy. This involves decreasing the amount of money in circulation, which then causes the value of the currency to go up, or increasing interest rates. These tools are employed in order to prevent the economy from overheating or inflation from spiking out of control.

When traders see consecutive improvements in economic data, interest rate hike expectations tend to build up and push the value of the currency higher even before the actual monetary policy decision is announced.

On the other hand, consecutive declines in economic performance could convince a central bank to ease monetary policy. They can either increase the amount of money in circulation, which then causes the value of the currency to drop, or by decreasing interest rates. Both of these moves are designed to encourage lending and spending, which eventually translate to stronger economic performance.

When traders see a prolonged weakness in economic data, interest rate cut expectations grow and push the value of the currency lower even before the actual policy decision is made.

Central banks can also intervene in the foreign exchange market, as the Swiss National Bank has been notorious for doing. These are very rare occasions when the central bank thinks that the currency is overvalued and is starting to take its toll on the country’s export industry. After all, a higher currency value means that exports are relatively more expensive in the international market, which could then hurt demand. A central bank can conduct currency intervention by selling a large amount of its local currency in order to drive its value down.

Testimonies by central bank officials also tend to influence forex market price action as these contain clues on what their next monetary policy moves might be. This is why central bankers’ speeches are also marked on the economic calendar, usually as a top-tier event when it’s the central bank head speaking.

Minutes of policy meetings also carry weight in price action, as these also provide hints on how the other members of the board think the economy is faring and whether monetary policy adjustments are needed or not. Traders usually monitor when there is a change in bias and start pricing in potential policy tightening or easing ahead of time.

Using Multiple Time Frame Analysis

While using a combination of technical indicators can help confirm price movements and filter out false signals, most traders opt to conduct multiple time frame analysis for additional confirmation. This method simply involves looking at the same currency pair across various time frames, from the short term 15-minute to the long-term daily or weekly charts. The reason behind this approach is that some trends are more visible on longer-term time frames. Meanwhile, some reversal signals or potential entry levels might be clearer on shorter-term time frames. With that, it helps to have both a bird’s eye view of price action then to zoom in to determine exact entry or exit levels for a trade.

In this example, the daily time frame of the currency pair is showing a very clear trend but it can be difficult to determine precise entry points for a long trade simply based on this chart.

Zooming in to the 1-hour time frame of the same currency pair can be helpful in pinpointing possible Fibonacci retracement levels or breakouts of nearby inflection points, which would confirm that the ongoing trend will continue. There are no definite rules that state which time frames you should look at, as you have to determine this based on your trading style or what works for you. If you are a swing trader, you might be more comfortable looking at the daily chart and the 4-hour chart. If you’re a scalp trader, you might want to watch the 1-hour chart then zoom in to the 15-minute time frame. Some traders find price action longer-term time frames too slow and they’d rather take quick moves with tight stops based on short-term time frames. Other traders are not too comfortable about fast price movements on minute charts so they’d rather trade the long-term charts and hold on to their trades for days or weeks. Of course there are a few advantages and disadvantages to favoring certain time frames. For instance, the advantage of sticking to longer-term charts is that it allows the trader to maintain his bias without having to check intraday charts every now and then. The disadvantage, however, is that this approach generates fewer trade signals. On the other hand, the advantage of looking at shorter-term time frames is that the trader is able to spot several trade opportunities very often. However, transaction costs for these trades could pile up and eat part of the profits. This also requires the trader to be flexible and able to change biases quickly. Another factor to consider, apart from one’s trading style, when it comes to deciding which time frames to trade is capital. Trading shorter-term charts usually requires lower margin while longer-term trades may require a bigger account to avoid getting a margin call.

How to Trade Divergences

As you’ve learned in the previous sections, technical indicators and price action tend to move in tandem. For instance, when stochastic starts heading lower from the overbought zone, the corresponding currency pair usually sells off. On the other hand, stochastic climbing out of the oversold area indicates that the currency pair could rally. There are instances, however, when technical indicators and price action seem to be showing different results. Traders refer to these scenarios as divergences. Divergences take place when indicators make different highs or different lows. To be specific, higher highs in price and lower highs for the technical indicator constitute a trading divergence. So does lower highs in price and higher highs for the technical indicator. Meanwhile, lower lows in price and higher lows for the technical indicator or higher lows in price and lower lows in the indicator are also divergences.

These may be a challenge to remember at first so it might be easier to group these trading divergences into two main categories: regular and hidden. A regular divergence suggests a reversal in price action. In an uptrend, price usually makes higher highs but once the technical indicator shows lower highs, it could mean that the trend is about to turn.

In a downtrend, price usually makes lower lows but once the technical indicator draws higher lows, it might be a sign that the trend is almost over.

A hidden divergence indicates that the current trend is likely to resume. In an uptrend, price usually makes higher lows but when the technical indicator starts making lower lows in a pullback, it could be a sign that the correction is over and that the previous trend could resume

In a downtrend, price tends to make lower highs but once the technical indicator draws higher highs in a retracement, it could be a signal that the pullback is over and that the previous downtrend could carry on.

Divergences tend to work better in longer-term time frames than in shorter-term ones, as trends are more visible on those charts. Aside from that, there are also some requirements that must be fulfilled before trading a valid divergence. For one, successive highs and lows must be connected. You must also make sure that the highs or lows on the price are vertically aligned with the highs or lows in the technical indicator.

Of course there are some instances when divergence fails and you simply have to be prepared with a good risk management strategy in these cases. To lessen the odds of this happening to you though, you might want to consider a multiple time frame analysis, as discussed in the next section.

Elliott Wave Analysis 101

A combination of repeating price patterns with Fibonacci analysis yields another branch of technical analysis known as Elliott Waves. This is named after its founder Ralph Nelson Elliott who analyzed 75 years’ worth of stock data before formulating and compiling his theories in a book entitled The Wave Principle. He discussed how price movements are not completely random and that markets traded in repeating cycles. He noted that the upward or downward swings in price action are a result of a collective market psychology, central to which are emotions of traders. In his book, he outlined ways in which traders can catch trends at ideal prices as he detailed methods of catching market corrections and continuations. One of the most basic wave patterns discussed in his book is the 5-3 pattern, wherein the first five waves are the impulse waves and the last three waves are corrective waves.

The first wave consists of the initial move upwards (or downwards in a downtrend) which is sparked by a sudden influx of buyers (or sellers), spurred to take long (or short) positions and causing the price to make a big rally (or selloff). The second wave occurs in the opposite direction of the first one as traders book profits off a key inflection point or start to believe that the asset or currency pair is already overvalued (or undervalued). This leads to a move lower (or higher) but not beyond the initial price before the first wave started. The third wave takes place when more buyers (or sellers) pay attention to the asset and see that it is moving in a strong trend. This pullback allows them to get in the trend at a relatively good price so they set their long (or short) orders and push the price up (or down). The fourth wave happens because traders once again think that the asset is becoming overvalued and that it may be time to book profits once again. The fifth and last wave occurs to extend the price rally to a point wherein it becomes extremely overvalued (or undervalued), before the trend starts to reverse. The first, third, or fifth impulse waves may have a chance of being extended, which means that they can be longer than the other two impulse waves. Again, this depends mostly on market psychology or sentiment. Apart from that, fundamental and technical factors may also combine for a stronger push in price action. What’s particularly interesting about Elliott Waves is that you can see these impulse and corrective waves occur in longer-term time frames and even as you zoom in to much shorter-term time frames, such as the 1-minute chart. Elliott has mentioned that there are roughly 21 wave patterns illustrating this phenomenon. These depend on the strength of the waves or the sharpness or shallowness of each pullback. These can be in the form of zig-zags, flat formations, or triangle patterns – all of which have the same general appearance as the 5-3 wave pattern. What’s important to note about these Elliott Waves are the three cardinal rules. First is that the third wave can never be the shortest impulse wave. Second is that the second wave can never go beyond the start of the first wave. Third is that the fourth wave can never cross into the same area as the first wave.

Basic Forex Chart Formations

Aside from technical indicators and Japanese candlestick patterns, another main component of technical analysis is chart formations. Remember that the concept behind technical analysis is that price patterns tend to repeat themselves, which means that these chart patterns more or less result to the same price behavior later on.

The sheer number of classic chart formations may seem intimidating and difficult to memorize at first but this comes with practice. More often than not, the names of the chart formations describe how the patterns look like on the charts.

For instance, the double top and double bottom patterns are one of the easiest ones to remember. A double top looks like two peaks in price action while the double bottom looks like two lows.

These are considered reversal signals, as a break beyond the neckline of the formation suggests the start of a new trend. To trade this, you can set a buy order above the neckline of a double bottom or set a sell order below the neckline of a double top.

Drawing necklines take practice but a good rule of thumb to remember is to simply connect the price turn in between the bottoms or the tops with a horizontal line.

A variation of the double top and double bottom is the triple top and triple bottom, which are also reversal signals. These are rare finds though but can be potent signals of a new trend.

A more complex reversal chart pattern is the head and shoulders. When it forms on top of an uptrend, it is a sign that a selloff might take place if price is able to break below the neckline.

Conversely, an inverse head and shoulders pattern forming at the bottom of a downtrend is a sign that price will turn and may move in an uptrend after breaking above the neckline.

Another group of chart patterns is the triangle formations. These can be descending, ascending, or symmetrical.

There is no hard and fast rule in saying whether these formations result to reversals or continuations. When price is consolidating tighter towards the rightmost tip of the triangle, it is a sign that a breakout may occur in either direction. Traders try to catch an up or down move by setting buy and sell orders outside the triangle.

Last but not least, another popular group of chart formations are the flags and pennants. These are typically treated as continuation patterns, as price simply consolidates for a short while inside a flag or pennant before resuming its ongoing trend.

There are other kinds of chart patterns such as wedges or cup and handle formations, which will be covered in a later section.