Understanding The Forex Market

An important aspect in trading the Forex market is to understand what drives the market and equally critical, what doesn't. Regardless of whether they can be proven practically or theoretically, the following is a summary of my core beliefs about how the market moves and why so:

• The market may react to news and fundamentals, but that reaction is often short-lived and irrational (e.g. the news is positive but the market goes down, only to go up again later) and therefore do not usually indicate high quality swing or position trades. In other words, any quality trade that does occur in connection with a specific news event is likely to be predicted by a technical setup. This simply means that you need to pay attention to chart technicals in order to trade fundamentals.
  
• The market is also driven by crowd psychology - which contains news and fundamentals - and is revealed by way of fractals. A fractal is simply a chart pattern that may be found at all degrees of trend possessing the same basic form and function regardless of where it occurs. The only difference between a fractal found on the Weekly chart and one found on the 30m chart is the distance the market is likely to travel more on higher timeframes, less on lower.
  
• As a result of the above, my belief is that it is possible to trade profitably based primarily on technical analysis, supported only by a specifically 'contrarian' reading of fundamentals. For instance, being aware of how the Carry Trade was likely to be impacted by the Sub-Prime mortgage crisis of 2007 helped position informed traders to the short side of that market.

The reason these core beliefs are mentioned is not to say whether they are right or wrong, but rather to point out that as traders, we all hold beliefs about the market. These beliefs directly affect how we trade and why, so regardless of whether you agree with those listed above, the point is you should take the time to clearly document what your personal beliefs about the market are.

Perhaps you have reason to believe, for example, that news does drive the market. How is that belief going to affect your trading plan? How are you going to trade the news, what's your game plan? When you have the answers to those questions, write them down.

Also, it is important to note that certain markets tend to maintain a strong positive (or negative) correlation over time. To put it simply, we can characterize this as a dollar-versus-everything-else scenario. As more speculators enter the market (from the former Carry Trade, to oil, stocks and gold), the US dollar has tended to weaken. Conversely, as liquidity declines, the US Dollar has tended to strengthen.

According to some commentators, this reflects the fact that the global debt market is denominated primarily in US dollars, and as these debts are retired in a deflationary trend, demand for dollars accelerates; moreover, at a faster pace than would allow for the kind of price inflation many people expect when dollars are being printed and liquidity is being expanded.

The point here is that knowing how the dollar is faring in relation to stocks and other markets can give you a much clearer perspective as to which way a Forex major pair is likely to trend over time. In addition, it is important to be aware of certain long standing rule-of-thumb relationships, such as the fact that EUR/USD and the USDX (US Dollar index) are almost perfectly inverse of one another, due to the high weighting of the Euro within the basket of currencies comprising the USDX.

Specific correlation values among individual currency pairs are available through many online services or brokers such as Oanda. If you know with a high level of probability, for example, that EUR/USD is in a prolonged downtrend, and that EUR/USD has an extremely strong inverse correlation with USD/CHF (in excess of -0.95 over time), then the probability of success with a position trade to the long side on USD/CHF will tend to increase, regardless of the intraday picture for that pair.

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