Tag: Forex Theories

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Forex Market

Purchasing Power Parity Theory

Traders, who operate in the foreign exchange market, read such news every day as: “the consolidation of the dollar led to the fall in the price of gold” or “the price of the euro backed the price of oil”. Although this news is usually published after an event, the relationship between the goods market and […]

Traders, who operate in the foreign exchange market, read such news every day as: “the consolidation of the dollar led to the fall in the price of gold” or “the price of the euro backed the price of oil”. Although this news is usually published after an event, the relationship between the goods market and […]

Traders, who operate in the foreign exchange market, read such news every day as: “the consolidation of the dollar led to the fall in the price of gold” or “the price of the euro backed the price of oil”. Although this news is usually published after an event, the relationship between the goods market and the foreign exchange market is felt independently whether we trade in the foreign exchange market or have nothing to do with it.

Theoretically, inflation serves as a correlation between the value of money and the prices of goods, and in this case, the currency does not matter (whether dollars, euros, rubles, British pounds, or Indian rupees). If a week ago the price of gasoline cost 40 rubles per liter and now it is 50 rubles, this means that the ruble in a week was lowered by 25% and the gasoline, on the contrary, increased in price. If gold cost $ 30 per gram in June 2009 and in June 2019 was $ 43, this shows that in 10 years the value of gold in US dollars increased 43% and the dollar, the other way around, fell in price.

Correlation between the goods market and the foreign exchange market. How does it work? They are simple and easy to understand (and also applicable to trading) examples of how money and goods are related and why the correlation between the goods market and the foreign exchange market is a fundamental rule that determines the price of a currency. Let’s try to decipher this theory.

Purchasing Power Parity Theory

Purchasing power parity theory states that the cost of goods in one country should not exceed the cost of goods in another country more than the price of the transport of goods between the two countries. The price of transportation also includes the profit margin of the trader and the change of the standards of one country by the standards of the other. It is also theoretically assumed that there are no artificial trade barriers.

When most of Europe and Asia, back in 1944, were in ruins, a conference was held at the Bretton Woods spa where, for the next twenty-five years, the fate of all the world’s currencies was determined, among which the United States was chosen as the international reference currency. The currencies of other countries were beginning to be traded in dollars, the same dollar was convertible into gold and the troy ounce was worth $ 35. That agreement at that time seemed fair, as the US had 70% of all world reserves and, thanks to the Second World War, it had an international advantage.

The Bretton Woods monetary system existed until 1971 when United States President Richard Nixon unilaterally terminated the agreement, and on 16 March 1973, the treaty is known as the “Jamaica agreement” was signed, which formed the Forex currency market. According to the “Jamaica agreement”, exchange rates would be set in the market on the basis of supply and demand. Since then and to this day the dollar is the main reserve currency, occupies a leading position in the calculation of energy, goods, and gold, and is the main currency used in many financial instruments.

At present, the US dollar position is well described with the word “petrodollar”, and the main volumes of trade in goods, including oil and gold, take place on US exchanges such as NYMEX, COMEX, CME, and ICE. The United States leads in the trade of oil, gold, grains, and many other goods, and the quotations of productive resources are valued in US dollars: gold/dollar (GOLD/$), oil/dollar (WTI/$), corn/dollar (Corn/$), wheat/dollar (Wheat/$), coffee/dollar (Coffee/$), etc.

For the determination of the value of the market of goods or a group of goods there are different indices of raw materials. The best known among them are: Thomson Reuters/CoreCommodity CRB Index (CRY) and Deutsche Bank Commodity Index, which are calculated based on parameters of futures traded on the exchanges indicated above. The exception is for aluminum and nickel prices, which are based on quotations from the London Metal Exchange, calculated in US dollars. Gold prices are also valued in US dollars.

The quotations of foreign currencies are also translated through the value of the dollar: pound/dollar (GBP/USD), euro/dollar (EUR/USD), dollar/ruble (USD/RUB), dollar/franc (USD/CHF), dollar/yen (USD/JPY), etc.

The best known of these is the US dollar index (USDX) measured in relation to the value of a basket of six currencies: the euro (57.6%), the Japanese yen (13.6%), the pound sterling (11.9%), the Canadian dollar (9.1%), the Swiss franc (3.6%) and the Swedish krona (4.2%). The index began in 1971 with a base of 100, and values since then are relative to this base. Therefore, the current rate of index 97 indicates that the exchange rate of the US dollar, relative to the basket of previous currencies, represents 97% of the level of 1971. ¡ A completely insignificant change in 48 years!. But the reality is that it hasn’t always been like this, and in recent years the index has changed considerably from the level of 70 percent in 2009 to the level of 128 percent in 1985.

Do we say “oil,” but do we really mean “dollar”?

As we have already mentioned, the US dollar is used in goods and currencies; the exception is inverse currency pairs, but it is only a mathematical casuistry for the ease of quotation of these currencies. It is very logical to think that at the moment when the dollar rises, the exchange rate of goods decreases, and vice versa, the depreciation of the dollar leads to the rise of currencies and goods markets.

Between July 2014 and July 2017, oil and the dollar correlated with each other with a coefficient of -0.75, that is, they were inversely correlated. Thus, at that time the linear correlation between EUR/USD pair and Brent-type oil in certain periods of time can reach the coefficient of 0.9, that is, it can be very high.

In the preceding paragraph, I purposely emphasized the phrase “in certain periods of time”. The ability to detect periods, in which one or the other factor impacts on quotes, depends on the competition between traders and the level of his training. In this case, there are no clear examples and schemes, everyone has to take this path on their own. But what we do have to warn about is the effects of oil prices on foreign exchange rates increases over time, when the difference in interest rates is small, as in the years 2014-2017, and decreases, when interest rate potential increases, as in the years 2018-2019.

Analysing the correlation between the prices of goods, oil, and the foreign exchange market, it should be noted that the study of the correlation between these assets has a low efficiency. It is better that traders, who ultimately decide to study the issue on their own, focus on monitoring quotes by oscillators, for example, the stochastic indicator or RSI that allows absolute values to be left by the percentage change of some assets compared to others.

We live in the era of hydrocarbons, and oil and its derivatives are the main product whose price affects all other sectors of the economy, which is reflected in the indices. Energy carriers account for 33% of the composition of the Thomson Reuters/CoreCommodity CRB index, regardless of natural gas. As a major part of the Deutsche Bank’s commodity index, petroleum products, and oil amount to 50 percent.

In this way, the change in the price of oil leads to changes in the entire market of goods, from which some dependencies can be deduced: the decline of the dollar leads to the growth of the price of oil and foreign currencies; and vice versa, the rise of the US Dollar contributes to the depreciation of the price of oil and foreign currencies.

It is impossible to predict the beginning and the end of this correlation. For example, the price of the euro may fall, causing the rise of the US dollar, which in turn will contribute to the fall in the price of oil; or if the price of oil begins to rise, the price of the dollar begins to fall, which in turn causes the growth of the euro.

Purchasing Power Parity Assumptions

Purchasing power parity theory takes into account a world in which there is no single reserve currency, assuming many world trade points, which is not in keeping with the current situation. However, the crisis of the world’s dollar-based currency and the trade wars that have been unleashed as a result of Donald Trump’s presidency have forced the governments of major emerging power centers to try to find a gradual replacement of the US dollar as a universal equivalent value.

Thus, for example, in the calculations of Asian goods, the Chinese yuan has already left the Japanese yen behind and is gradually displacing the US dollar from trade. At the St Petersburg Economic Forum in early June, China and Russia agreed to eliminate the US dollar from reciprocal payments and arrangements; Iran and Turkey take the same path.

The tendency to renounce the dollar is barely growing, but it already seems impossible to stop it. The more trade tariffs the US applies, the more the dollar will shift in financial calculations and the faster the US currency will lose its position as the dominant global currency. Trade wars will inevitably lead to the fragmentation of the world economy in several monetary and customs zones, where the theory of purchasing power parity will be in force in a forceful manner, avoiding the intermediate link that is the US dollar. Of course, there is no one who knows for sure when it will happen, but there is no doubt that one day it will happen.

Purchasing power parity theory, like interest rate parity theory, is the fundamental basis of the currency market. In turn, the study of the relationship between the goods market and the foreign exchange market is an important element in the “authentic” fundamental analysis, unlike the studies of different “relevant” economic indicators or informative, which are very often difficult for private traders to analyse due to a lack of their knowledge and resources. However, knowing how it works and thinking nimbly, we will always find a way to apply the basic rules of the currency market to make a profit, even in complicated situations. He who seeks finds!

Categories
Forex Psychology

Why Conspiracy Theories in Forex Might Only be Half-Truths

A conspiracy is definitely one of the terms that arise a lot of pros and cons among people, depending on the way of their thinking and using their common sense and healthy logic and presumptions. The majority of the crowd get into the endless world of conspiracy theories once they start getting older and being disappointed with society, limited by life responsibilities, and faced with their own failures. By blaming someone else behind the curtain, the one who we actually cannot affect and who is pulling the triggers is one of the paths to enter the wide world of conspiracy theories. These people believe that there is always something suspicious going on behind the scene in every single fragment of their life, without actually being able to prove most of their beliefs. 

A conspiracy is definitely one of the terms that arise a lot of pros and cons among people, depending on the way of their thinking and using their common sense and healthy logic and presumptions. The majority of the crowd get into the endless world of conspiracy theories once they start getting older and being disappointed with society, limited by life responsibilities, and faced with their own failures. By blaming someone else behind the curtain, the one who we actually cannot affect and who is pulling the triggers is one of the paths to enter the wide world of conspiracy theories. These people believe that there is always something suspicious going on behind the scene in every single fragment of their life, without actually being able to prove most of their beliefs. 

A conspiracy is definitely one of the terms that arise a lot of pros and cons among people, depending on the way of their thinking and using their common sense and healthy logic and presumptions. The majority of the crowd get into the endless world of conspiracy theories once they start getting older and being disappointed with society, limited by life responsibilities, and faced with their own failures. By blaming someone else behind the curtain, the one who we actually cannot affect and who is pulling the triggers is one of the paths to enter the wide world of conspiracy theories. These people believe that there is always something suspicious going on behind the scene in every single fragment of their life, without actually being able to prove most of their beliefs. 

On the other hand, many individuals among us completely deny the existence of any conspiracy and these are usually people that buy everything being served to them via media, commercials, press, celebrities’ statements, etc and not having developed their critical thinking or use of logic in their mindset. They even use the term “conspiracy theory” in a pejorative sense, dismissing the possibility to consider other side arguments. 

None of these two aspects can actually be either proved or denied totally, but one thing stands for sure – conspiracies do exist, at least in a form of financial scandals, political affairs, or related fields where power and money play main roles. The games with big money are controlled by people having big money, influence, and power and that is the only certain conclusion proofed by nowadays so many times. Large funds and institutions are usually connected with placing news on the market, which hence provokes adequate moves on the market. 

And let’s remind ourselves for the moment that these moves are made, for instance, through the Bloomberg terminals. The abovementioned terminals belong to partnership Bloomberg L.P., which is 88 percent owned by Michal Bloomberg, the US Democratic party member, and a former mayor of New York City. The entity, together with its subsidiaries makes about USD 10 billion of revenue annually, providing necessary information to the people doing business in finance all over the world through its Bloomberg terminals. Over 320,000 people pay the subscription for use of this software and this is not the only company he possesses through its subsidiaries Bloomberg news and television as well.

It is not therefore hard to assume that someone with that much influence and money imperia would be capable to affect the market and place the news of his own interest, especially considering the fact that M. Bloomberg belongs to the Democratic party, lacking, however, to have the Trump’s charisma, speech and in general capacity to beat him on the Presidential elections. On the other hand, he would be probably capable to set the stock market circumstances and trade trends in the favour of his party, simply because he is in a position to control these factors. It would not be hard to imagine that he could easily start the recession or another financial crash, not him personally of course but by using that great influence he has. But this is something that is yet to be seen. 

On the other side, the US Democratic party itself has used the allegation of another conspiracy theory-surprisingly-through Bloomberg news, as a weapon against Trump’s administration. They alleged that the so-called QAnon internet movement, being supporters of Donald Trump and part of his voting body could potentially become very dangerous or even an inspiration for domestic terrorism acts. Although it remains unknown who is actually Q, the allegations described him as a -positioned governmental officer, supporting Donald Trump and having access to very confidential peace of information related to US national security, nuclear weapons. The QAnon movement originates actually from a connection with another conspiracy theory in the past – during the US Presidential elections campaign back in 2016.

As we can remember, Trump’s opponent and the democratic candidate was Hillary Clinton. The affair that occurred at that time was so-called PizzaGate, and it pertained to the sex trafficking involving children around pizza restaurant in Washington. The conspiracy theory was relating the leading democratic politicians to this affair and Hillary Clinton among them as well. It is, however, difficult to prove how massive is the crowd that supports this theory, especially because they seem to get their support mainly via the internet and online.

Let us, though, come back to the financial conspiracies, which seem to affect the trader’s daily life and certainly have a large impact on the common people’s loss of money, their capital, or retirements. Why are the crowd and the common trends usually the ones that we follow, without having a second thought that the result may not be so brilliant as it may seem in the beginning?

If we understand the control and the power on the forex market it may be easier to prevent the traps and find ourselves in a way better position. The so-called Big Banks are the ones controlling the fluctuance and the times of raises and falls on the stock market, controlling that way the prices going up and down. The Interbank, being the network of all banks present at the market, cca 45 of them, is consisted of a couple of major ones:

Deutsche Bank, Citi Bank, JP Morgan, HSBC, and some of the Chinese banks. As the banks are in constant need of liquidity, they need extra money to put it out there in a market. But their main advantage in relation to traders is that these banks are aware a priori where each order sits, in which direction it goes, does it have tendencies to go long or short on the market, and in which time frame. This is something that puts them in a position to control the market, and once they do, it becomes very hard to respond. Banks are also well connected to the people of great influence, and once they publish information, the major crowd is going one way, for example going long for a certain type of currency.

The banks then cut that trend and start going short and this is the point where people lose their money. Not always, though. In order to continue this game and to keep playing the traders must also win sometimes. But sometimes only, and this is the so-called “Black Jack theory”. It is a small win, with a strong psychological impact: makes one feels good, smart, and capable to do so much more. And this is the momentum where the majority of people, instead of taking their money and invest in something else, keep playing. And they usually lose in the end, but the game goes on. A good comparison with the forex market here would be a casino, that functions the same way.

How dangerous it is to follow the crowd may be shown on the example of the EUR/CHF crash back in 2015. That was the pure example of how can banks affect price going one way while traders are going the other way. At the aforementioned time, the Swiss National Bank had ordered a pegging of CHF to EUR, meaning that CHF will not drop below the EUR 1.2. Pegging is the way of controlling one country’s currency rate by fixing it to another, presumably more stable currency. As a result of this, the common thought of the majority of traders was to put long on EUR/CHF with the thought in their mind that CHF could only go up and not down. What happened next was that the above mentioned banks used their influence, power, and capital and persuaded the Swiss National Bank to remove that peg. And the swiss national currency went down, provoking one of the biggest financial crashes in a newer history. Not only traders had lost after this happened, but entire platforms and funds crashed and closed and it all happened in a time frame of one day. Afterward, the CHF started going up again slowly, but that was not enough to repair the damage.

The common people cannot compete with big banks, the banks will always be one step further, if not for anything else then because of the fact that they had the information prior to simple individual trading on the stock market. There is, however, a way that one can profit and make smaller benefits from time to time, by using the market moving in waves and by going out with a profit and investing again somewhere else at the right timing. This would be like turning the above-mentioned BlackJack theory in his own favor and there are tools in a market that can help with this.

One of the theories in trading against the crowd is the so-called contrarian trading approach and is worth mentioning in the context of what is being said so far. Contrarian trading is trading against the current market sentiment. The market sentiment is shown on some financial platforms that show the indicators in which direction traders are positioning all over the world, showing the percentage of traders going long and going short or whether the market signals are bullish or bearish. This is being used as some sort of a prediction, to anticipate prices direction in a market and make a proper move timely. 

Hence, trading against the current market sentiment would actually mean that if the present situation on a market shows that the majority of the investors are going short, the contrarian will go long and vice versa. Such a way of trading requires, of course, in-depth knowledge of the market circumstances, updated information, experience and follow up of the client sentiment indicators mentioned above. In that sense, one will be able to figure the exact entering and exiting points while trading, in conjunction with other indicators. Trends get to some point when they become exhausted and recognizing that moment is vital for contrarian trading-if the masses are going one way, contrarian will do the opposite but at the right timing. That is why some prior experience is needed here, in order to be able to recognize such moments.

To put a bottom line and pull out a conclusion here, it is important to say that we should not ignore conspiracy ideas and theories completely but to be able to determine their impact on money, power, influence because it all ends up for these motives. Should be aware of fake news, half-true news at certain moments and open up our minds and think of the reason why such information is placed to us right now, and how this affects the behavior of the investors, politicians, etc. Conspiracies had existed through numerous affairs and historical happenings in the US for many decades now, from JFK murder to the aliens and bunch of secret agents working together for evil purposes or whatsoever.

However, it is very important to sort out the information, and if we talk about market trading – to avoid following the masses.