Victor Darleguy
Forex: A global financial market for currency trading
Introduction
The year 1971 marked a decisive turning point in the history of global finance. The Bretton Woods Agreement, which had established an international monetary system based on the gold standard, came to an end, paving the way for the creation of the Forex market as we know it today. Also known as the foreign exchange market, Forex is a global financial market where currency trading is conducted 24 hours a day, 5 days a week by investors such as banks and pension funds. With several trillion dollars exchanged daily, Forex is the largest financial market in the world.
Currency trading has become a major issue in the global economy due to its role in managing currency risks for businesses and investors. Additionally, it provides investors with the opportunity to make significant profits by speculating on fluctuations in exchange rates, contributing to global financial stability by enabling efficient capital allocation between countries.
However, Forex is a highly complex market that requires a deep understanding of the global economy, factors that influence exchange rates, as well as technical and fundamental analysis skills. With the advent of new technologies, currency trading has undergone a true revolution that has changed practices, particularly with the introduction of trading robots that have changed the way strategies are built.
In this article, we will first present some fundamental principles of currency trading and the main influencing factors. Secondly, we will give a brief overview of analysis techniques for trading currencies. Finally, we will discuss the evolution of currency trading technologies.
Development
To invest in the Forex market, it is important to understand the fundamental principles of currency quotes. Forex quotes represent the exchange rate between two currencies and can be viewed on real-time trading platforms.
Currency pairs are composed of two currencies, the first being called the “base currency” and the second the “counter currency”. For example, in the EUR/USD pair, the euro is the base currency, and the US dollar is the counter currency. The currency quote is generally presented in the form of an exchange rate between the two currencies, as in the following example: EUR/USD 1.1232/1.1237. The first part of the quote indicates the buying rate of the currency pair (called the “bid price”), while the second part indicates the selling rate (called the “ask price”).
It is important to understand that the exchange rate of a currency pair is influenced by many factors, such as the economic health of the issuing countries, central bank monetary policies, geopolitical events, and many others. Therefore, it is essential to follow economic and political news to understand exchange rate fluctuations.
Since 1976, the US Dollar has dominated the foreign exchange market, accounting for nearly 85% of daily transactions. The dollar is widely traded due to its role as a reference currency in the international monetary system, its position as the world’s leading reserve currency, and the fact that many commodities are priced in dollars. However, the floating exchange rate system (i.e., the Forex) has experienced currency crises due to speculation orchestrated by hedge funds, which has forced central banks to intervene to stabilize currency rates.
The upcoming prospects for the Forex will consist of the emergence of new currencies within the floating exchange rate system. The currencies of major emerging countries, such as China’s Renminbi Yuan, Brazil’s Real, and India’s Rupee, are not yet integral parts of the Forex market, but they are expected to gradually integrate into the market as they develop economically.
But what are the main factors that influence currencies in the Forex market? There are many factors that can impact currency rates, but here are some of the most important:
Firstly, economic data such as GDP, interest rates, inflation, unemployment, retail sales, and trade balances are key indicators that can affect currency rates. For example, a growing economy with moderate inflation can strengthen a currency, while a recessionary economy with high unemployment can weaken a currency.
Secondly, monetary policy and decisions made by central banks regarding interest rates can influence exchange rates. A central bank that raises interest rates can strengthen a currency, while a central bank that lowers interest rates can weaken a currency.
Thirdly, geopolitical events such as tensions and conflicts between countries can impact currency rates. Therefore, elections, wars, natural disasters, and trade negotiations can all have an impact on currency rates.
Finally, investor speculation is another important factor that can influence currency rates. Investors may buy or sell a currency based on their perception of the economy, monetary policy, and geopolitical events.
All these influencing factors are examples of data that can be used to fuel analysis techniques to make decisions and trade currencies. Among these are technical analysis techniques that focus on studying charts and historical price data to detect price patterns, trends, and trading signals. On the other hand, there are fundamental analysis techniques that focus on studying underlying economic and financial factors that influence the foreign exchange market, such as interest rates, economic growth, inflation, monetary policy, and geopolitical events. Let’s present some examples…
Within technical analysis, trend is considered one of the most important concepts. The goal of all technical analysis tools is to help identify the direction in which the market is moving. The meaning of Forex trend doesn’t differ much from its general sense, it simply represents the direction in which the market is moving. However, the foreign exchange market doesn’t follow a straight line, but rather a series of zigzags resembling waves with clear peaks and troughs, commonly known as highs and lows.
Figure 1: Forex Trend
There are several indicators that can help track the trend, including moving averages. There are several types of moving averages, including simple, exponential, linear weighted, and smoothed moving averages, which use different mathematical functions.
The simple moving average (SMA) is the most popular type. It represents the average prices over a given period.
Exponential and linear weighted moving averages use a higher coefficient for more recent prices, which can provide faster signals. However, they can provide lagging information, so caution is advised!
The smoothed moving average is based on the simple moving average and allows for smoothing out price fluctuations for a better understanding of the trend.
Technical indicators are also widely used in Forex technical analysis. These are mainly mathematical formulas based on the price and volume of a financial asset. They are used to confirm market trends, the quality of chart patterns, and to help traders identify buy and sell signals. Indicators can be used alone to form buy and sell signals, or in combination with other indicators, charts, and price movements. However, not all indicators are used by traders. Among the most important indicators for analysts are indicators such as moving averages, Bollinger bands, stochastic oscillators, RSI, and MACD.
Fundamental analysis is another method used by traders to predict currency price movements. This method involves analyzing economic and political factors such as interest rates, economic reports, geopolitical events, and monetary policies. One of the challenges faced by fundamental analysis is how to interpret changes to economic data and official speeches. For example, when a country’s economic data improves and exceeds expectations, the national currency increases. Conversely, if economic data is worse than expected, the national currency decreases. When trading currency pairs involving two currencies, fundamental analysis allows you to compare the economies of these two countries. Depending on the strength of each currency, one of them will increase compared to the other.
Finally, trading strategies based on market sentiment can also be mentioned. Market sentiment refers to the general attitude of investors towards the financial market or a specific security. Understanding investor opinions is crucial for making good decisions, as it can offer valuable insight to achieve a particular goal. Traders have their own opinions on the market, which are reflected directly in their transactions, thereby contributing to the overall market sentiment. It is important to note that the market is complex and made up of several individuals, whose positions effectively reflect market sentiment. However, traders cannot influence the market to their advantage. Therefore, if a trader thinks that CAD will increase and others do not share this opinion, they cannot do anything to change it.
In conclusion, currency trading technologies have undergone significant evolution in recent decades, from manual and limited exchange to global real-time electronic exchange. Technological advancements have allowed for increased automation of trading operations, reducing the time required to execute transactions and improving the overall efficiency of the trading process. Engineers play a key role in this evolution, being responsible for the design and development of these technologies, and ensuring that they are secure, reliable, and compliant with regulations. To do this, engineers work closely with traders to understand their needs and develop solutions that meet their requirements. Artificial Intelligence (AI) and Machine Learning technologies have begun to play an increasingly important role in data analysis and optimization of trading strategies. However, the human aspect of trading remains crucial, as traders must be able to interpret data and make informed decisions based on their experience and judgment.
References
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Business Times. (2022). Ukraine war : What explains the calm in global stock markets? https://www.businesstimes.com.sg/opinion/ukraine-war-what-explains-the-calm-in-global-stock-markets
Reuters. (2022). S&P Global says Russia-Ukraine insurance losses could reach $35 billion. https://www.reuters.com/business/finance/sp-global-says-russia-ukraine-insurance-losses-could-reach-35-billion-2022-03-31/