There might be instances that you will see the euro priced at 1.3832 and about nine days later, you will see that it is already 1.3296. (These price quotes are the high and low on October 25, 2013 to November 7, 2013.) A price change of 536 points is not unusual. Later, we’ll discuss what is normal and how we determine what is typical, but for now, you must realize that Forex prices can move extremely far and very quickly.
So what is behind the change? The correct reaction is that euro traders were altering their thoughts about the value of the euro or the value of the dollar. Actually, because no one knows or can even imagine what the true value of the euro or the dollar might be in the future, the euro trader is speculating on what others may believe about the true price of the euro or the dollar the next day. If a euro trader sells the euro today at 1.3832, it is because he believes that some piece of data or news unfavorable to the euro will cause others to be unwilling to pay as much for it as today’s price. If we talk about the future, we may refer to five minutes, three days or some weeks, however, the trader’s ability depends in attributing a probability to the market’s assessment of the facts or news. In other words, the euro trader somehow is reading their thoughts about possible demand for euros in the future.
This may sound silly, yet it accurately describes the process. The euro trader’s guess is made up of three parts.
Component One: The Chart
The euro has reached a point of being “overbought.” This term may refer to a majority of euro traders believing the euro should go higher (Buyers) and having already accumulated a huge position. The chart reader does not care whether the rest of the market is correct. He sees that in terms of the up-move that has already taken place, the other traders are overinvested in the bullish point of view.
If everyone has already purchased the euro and they are out of cash or credit to increase their holdings, there will be no one remaining to buy. As investors unload their positions, the price must decline in order for funds to be available to invest in new trades. When the market is overinvested or overbought, the chart reader can use any of numerous technical indicators to determine if it is overinvested or overbought. The relative strength index, or RSI, is the most often used indicator. Another one is the stochastic oscillator.
It is important to note that in Forex, we do not have volume figures like the volume available in equity trading. If we had volume, we could see that as the price is rising, volume is failing to keep pace proportionately. A divergence between rising prices and falling volume is a classic technique in equities to gauge when a security is becoming overbought. Alas, in Forex, we do not have volume as a tool.
Component Two: The Economics
The only reason to buy something is to use it or to sell it later for a higher price. While the Forex trader will not actually use euros in the sense of spending them on goods and services, he anticipates that others will want to use the euro’s purchasing power to buy stuff, not only socks and haircuts but also securities denominated in euros. Therefore, Forex traders follow the macroeconomics and news stories pertaining to the relative purchasing power of the euro vs. the dollar, including inflation (or deflation), wages increases, the robustness of the economy, and so on. At any one time, the market as a whole has a consensus view of which economies are growing and how fast, and which economies have immediate economic problems that the government and specifically the central bank should be addressing. As a rule, traders’ economic understanding is oversimplified and even crude, and usually boiled down to a catchy one or two-word descriptor, but it does not pay to be snobbish about the relative lack of sophistication of these views—they move markets.
Component Three: The News
The macroeconomics form the background against which traders judge news. The single most important piece of news is a change in interest rates or other stimulus/contraction by a central bank. A good example is the interest rate decision by the European Central bank (ECB) on November 7, 2013. Because inflation had fallen to a new low and there was fear of Japanese-style deflation, the consensus of Forex commentators was that the ECB would cut rates or impose negative rates on bank deposits to encourage banks to lend more. Accordingly, the euro was on a sharp falling trajectory. However, the ECB declined to cut rates and the euro reversed on the same day, rising nearly to the level it started eight days earlier.
You would be hard-pressed to say the euro reversed into an up-move because traders were thinking about purchasing power parity or other relative economic data — here the move was due to the ECB rate decision, made a little stronger because the market’s expectations were proved wrong.