Investing on FOREX and other OTC markets - introduction
To earn money on FOREX, commodity or the equity market, a trader should either buy an asset and sell it higher or sell it and then buy back lower. This however, is not that simple. The key to a successful transaction is to know when the price is relatively low or high, and then - is it going to fall or to rise? In order to achieve that, traders basically use two types of investment analysis:
- Fundamental analysis - method of predicting exchange rate movement on the basis of economic and political data and factors, that influence supply and demand of currencies, commodities or equities and other markets.
- Technical analysis - method of predicting exchange rate movement and future market trends on the basis of charts, oscillators and other indicators constructed from historic exchange rates and turnover data.
In practice investors usually apply both investing techniques, combining methods and relying on their own investment experience.
Fundamental analysis
Introduction
Fundamental analysis of the FOREX market can be based upon analysis of political and macroeconomic environment of the relevant countries, trend identification and its impact on the supply and demand for the given currency. In order to achieve this aim it is advisable to follow the main political, economical and social processes and macroeconomic indicators related to the state of the economy of relevant countries.
Macroeconomic data publication of is one of the most important events "fundamentalists" closely watch. Publicized by news agencies accordingly to specified calendar agenda, along with forecast for a given indicator. If the actual value is equal to the prior prognosis, there should be no reaction on the market. However, if there is a significant difference, the market is likely to respond nervously, according to the impact the publication has on the underlying economy, rewarding traders that correctly predicted the value of the indicator.
One of the characteristics of the FOREX market is its sharp reaction to macroeconomic data publications and thus discounting of future information. An investor has to decide - is the data predicted by him already discounted by the market or not. Publishing of commonly expected data will not have any major impact on the market, as it is almost certainly already discounted by the currency exchange rate. Information is interesting only when it is not known to the public.
One of the most important factors in fundamental analysis is the monetary policy carried out by central banks. Interest rates, open market operations and central banks interventions influence the situation on the market and are closely watched by financial analysts.
Natural and man made disasters like terrorist attacks, wars and catastrophes may have a significant impact on the currency market. During a crisis investors come back to safe currencies like: American Dollar, Swiss Frank or Euro.
Statements by government officials, central bank presidents, or other officials related to international or monetary policy should also be followed closely. Stability of the political environment improves the economy, attracting foreign direct investments and demand for local currency, whereas an unstable political situation may result in a massive withdrawal of invested assets and an increase in foreign currencies prices.
Economic indicators
The most important macroeconomic indicators are:
GDP (Gross Domestic Product) – measures summary value of goods and services generated in a relevant country. All economic activity is taken into consideration while calculating the index, regardless of nationality of the owner of any given production factor. The level of GDP can be calculated in actual prices, asserting actual market production value, as well as in static prices, allowing estimation of the dynamics in the economic growth rate.
Financial markets analyze carefully changes in GDP published each quarter. Higher then expected economic growth rate can contribute to strengthening the local currency on the international market.
CPI (Consumer Price Index) – reflects the price of consumer goods adjusted by seasonal factor. Investors tend to avoid currencies with increasing inflation. The rise of the CPI index leads to an increase in interest rates, that results in a lowering of bond prices, nominated in a given currency. Panic amongst foreign investors selling the bonds with the perspective of an interest rate rise may result in increased supply and weakening of the currency.
PPI (Production Price Index) – the dynamics of changes in the prices of goods offered by farmers and manufacturers. Financial markets follow changes in final goods prices, published monthly. As a result of seasonal food prices and high instability of energy prices the PPI index may be subjected to frequent revisions. Large increase in PPI together with high inflation expectations can negatively affect market sentiment towards the currency.
Industrial Production – specifies momentum of aggregated growth of the physical level of economic production. High dynamics of the indicator signifies the good condition of an economy and can positively influence the sentiment towards the local currency. Low dynamics of industrial production reflects an unhealthy condition in the local economy.
Trade balance – compares the value of exported and imported goods and services. The difference between the value of export and import for the given country represents the trade balance. Its positive value - advantage of export over import illustrates the status of economic capacity of a country. High competitiveness of economy can interest investors in local currency.
ISM – index takes into account five factors: new orders, production, deliveries, stockpiles and employment. A value greater then 50% indicates the development of production and the whole economy. Reading 45%-50% indicates stagnation of industrial production, and an index value below 40% signifies stagnation in production and the entire economy.
Financial markets place great importance in ISM on account of its decisive influence on Federal Reserve’s monetary policy.
Current Account – includes all capital flow in and out of the country. Positive current account balance indicates that capital is flowing into the country, which may strengthen the demand for the local currency.
Unemployment rate – the level of unemployment is one of the most important indicators representing the condition of the economy. The published level of unemployment includes natural - voluntary unemployment as well as real unemployment – resulting from unsuitable qualifications of the workforce to the market requirement, lack of demand.. The steady rise in unemployment indicates an aggravation in the economic situation of the country, and negatively impacts financial markets, leading to a weakening of the given currency.
University of Michigan Consumer Sentiment Index – published monthly, represents an important indicator of consumers’ sentiment and perspective of future economic growth in the USA. Its value is influenced by the assessment of the current situation and anticipation of the future economic condition. The survey is carried out by phone among 700 households. Consumer expenditures represent one of the most significant factors, having an impact on the level of Gross Domestic Product. Positive Index data - surpassing expectations of the market - may influence the demand for the US dollar.
IFO Business Sentiment – developed by Munich Institute of Economics represents sentiment of German industrial entrepreneurs. The survey is carried out among 7000 business entities. Financial market analysts regard the Index as an important indicator for the state of the economy in the whole Euro zone. Growing IFO Index may signify a healthy economic condition and stimulate the rise of the euro.
Durable Goods Orders – measures the value of orders for durable goods (amortization above 3 years). The Index is fairly volatile and subject to frequent revisions; nevertheless the publications can have a considerable impact on financial markets, resulting in significant currency price changes.
New Home Sales - stands for the number of houses sold and for sale. Changes in dynamics represent the condition of the American real estate market. High dynamics is characteristic for a boom period, while low dynamics indicates a potential stagnation of the economy.
Housing Starts and Building Permits – published monthly, represents relative increment in building investments and building permits on the US real estate market. The Index is influenced by the level of mortgage interest rates. Prosperity in the real estate market characterizes a boom economy.
Conference Board Consumer Confidence – similar to the Michigan Index. As the sentiment of consumers reflects the state of the economy – optimism during a boom period, pessimism during a recession. Good sentiments of American consumers signify higher demand, higher business sector income and a potential demand for the US dollar.
Non-farm Payrolls – reflects the condition of the US economy. Ongoing increases in employment represents improvement of the economic climate, a boost in household income and in long-term value of enterprises. High Index values may result in increased demand for the US dollar.
Psychological aspects of investing
One of the most important factors for success on the FOREX, commodities and equity markets is investor's psychological ability to take the financial risk and act under pressure. All the traders operating on OTC derivatives markets should have a selective thinking ability, capability of accepting the loss and avoiding market pressure.
Ability of selective thinking - the separation of the trader's own considerations and market forecasts from currently possessed market position. Thinking about market through currently owned position is most often wishful thinking and has nothing to do with actual market situation. Most often traders that do not have any real position achieve very good results, however when real money is considered, they are not capable of achieving analogical results.
Second problem of OTC derivatives traders is a lack of acceptance for a certain level of loss. Most often traders. while they close the position, satisfy themselves with small profits, however when a position generates a loss, they find it difficult to close it, as they imagine that soon the situation will change for the better. This behavior may lead to unlimited risk and exposure and excessive financial losses, that could have been otherwise avoided. It is the trader's psychology that tells him to believe up to the end in a positive transaction conclusion, ignoring basic money management principles.
Ability to avoid market settings pressure relies on the skill to make trading decisions without consideration for the market environment. Traders should be able to select from the surrounding information "noise" only the essential news and not give in to pressure from the environment.