Learn how forex market movements work

The foreign exchange market is the largest and most liquid market in the world with more than $7 trillion traded daily. This means that the foreign exchange market is a big enough market that even the stock markets pale in comparison.

Due to its enormity and its 24/5 operating hours, the foreign exchange market is a thrilling and sometimes daunting market to make transactions in. In order to succeed in this market, one must know all about the mechanics of the foreign exchange market’s movements.

How does the forex market react and what does it mean?

When the forex market moves that means that the value of currency pairs changes too. For example, when the EUR/USD pair rises from 1.1200 to 1.1250, it means the value of the euro against the U.S. dollar has changed. Such changes happen every day and are affected by a number of economic, political and psychological issues.

It is essential to grasp these movements because investors seek to capitalise on them with the hope of gaining profits. The purpose of forex trading is to buy or sell a currency pair when the base currency is set to increase or decrease in value.

How currencies are exchanged

Exchange rates are always conducted in pairs, and the rate is the value of the quote currency that is required for the purchase of one unit of the base currency. For instance:

The base currency is the EUR, while the quote currency is the USD.

If EUR/USD = 1.1250, this implies that 1 euro equals 1.1250 USD

Changes in these combinations are measured in pips, which is a unit of measure for currencies. For most currency pairs, a pip is equivalent to a value of 0.0001. Pips are fundamental in estimating losses or profits made within forex.

What drives volatility?

There are certain imperative key factors that determine how and why foreign exchange prices fluctuate. These can be classified under fundamental factors, technical factors and market sentiment.

1. Economic indicators

Economic indicators are statistics showing the state of the economy of a nation.

• Валовой внутренний продукт (ВВП): Reflects the total economic activity. High GDP always results in an appreciating currency.
• Employment Data: High employment means economic stability, thereby promoting more confidence in the currency among investors.
• Inflation Rates: Measured using indices such as the Consumer Price Index, inflation influences interest rate decisions, which are major factors in forex rate movements.
• Interest Rates: The interest rate is used by central banks to keep inflation under control. Higher interest rates are attractive to foreign investors, making the currency stronger.
• Just to clarify, when the Federal Reserve in the United States increases the interest rate, the value of the United States Dollar tends to appreciate when it is measured against other currencies due to the expected influx of investors looking for high returns.

2. Political and geopolitical events

There are also other factors that may influence forex markets and these include:

• Trade agreements or disputes
• Election Results and Political Stability
• Conflicts or wars impacting global supply chains

Political instability affecting a country can lead to depreciation of that country’s currency because of the search for safe havens.

3. Market sentiment

Market sentiment refers to market attitude or market mood with regard to a currency or market in general. Market sentiment is affected by market news and market reports.

Often, sentiment-based trades could be more volatile than fundamental-based trades, particularly when it comes to short-term trading.

4. Supply and demand dynamics

Just like in any other market environment, in foreign exchange, prices are determined by supply and demand. When there is high demand and limited supply of money in the market, the money’s value appreciates. Too much money in the market or insufficient demand results in reduced value.

5. Speculation

Hedge funds and retail speculators participate hugely in forex movements. They always try to make profits on account of day-to-day minor changes in the price of a currency; these developments result in the sudden sharp fluctuations, especially around news releases.

Types of forex market movements

Forex market movements can be divided into three main types:

1.Trend movements

A trend is a situation when a currency pair moves consistently in one direction for an extended period. Trends can:

• Uptrend: A series of higher highs and higher lows.
• Downtrend: A series of lower highs and lower lows.
• Sideways/Ranging: When price moves within a horizontal range.

Trends are crucial to a trader who follows or uses a trend-following approach, as he wants to ride with the market in the direction of momentum.

2.Volatility

Volatility reflects the extent to which the price of a currency has changed in a period. Highly volatile currencies can potentially alter their prices rapidly, offering great opportunities, as well as risks, for traders. Some of the factors driving volatility include economic announcements or unexpected political events.

Yet, risk management is necessary over these volatile markets, hence traders tend to use stop-loss orders and position sizing strategies.

3.Short-term vs long-term movements

• Short-term movement: It takes place within minutes, hours, or days. It is largely influenced by news, sentiment, and speculation.
• Long-term movements: These are movements that take more than several months, even years. The principle drivers are macroeconomic factors like trade balance, interest rates, and GDP growth.
• Effective traders will use both approaches. They will enter and exit trades based on shorter-term market activity while being mindful of the longer-term market trend.

How traders analyse forex movements

To forecast and react to foreign exchange market actions, traders may resort to технический анализ, фундаментальный анализ, or a combination of both.

1. Technical Analysis

Technical analysis requires analysing past prices so that future prices can be forecasted. Some of its main elements are:

Support and resistance levels show price levels around which the currency likes to turn back.

Moving Averages identify trends and possible reversal points.

Technical indicators and oscillators like the RSI, MACD, and Bollinger Bands calculate momentum and volatility.

Technical analysis is widely used by short-term traders who focus on taking advantage of small changes in the value of assets.

2. Fundamental Analysis

Fundamental analysis is concerned with economic, political, and social variables influencing foreign exchange rates.

• Interest rate decisions
• Reports on the economy and GDP growth
• Political events and central bank announcements

3. Sentiment Analysis

Sentiment analysis is essentially an attempt to assess the market mood through reports, news sentiment indicators or social media analysis.

By understanding whether traders are more likely to be bearish or bullish, traders can better understand what might be happening to the pricing of their investments.

Common patterns in forex movements

There are a number of key patterns and cycles that can be used by traders.

• Breakouts: Breakouts occur when the market price escapes from an established trading zone. Breakouts are known to result in fast market movement in the direction of the breakout.
• Reversals: An indication that the trend might reverse, thus starting the emergence of a new trend.
• It is important to recognise these patterns to enable effective entry and exit points.

Risk management practices

Although the foreign exchange market has high liquidity and fluctuations, risk management is crucial. Some of the methods used to manage risk are detailed below.

• Stop-loss orders: Close trades when a predetermined loss is reached.
• Position Sizing: This involves scaling the amount of a trade based on the value of the account and the risk profile of the trader
• Диверсификация: This is the technique involving the simultaneous use of more than one currency pair in order to mitigate risk
• Analysing market action enables market participants to set up stop loss levels and sizing in the market appropriately.

Being patient, disciplined and practising solid risk management will help keep you focused and allow you to keep trading in the long term.

Disclaimer: This information is not considered as investment advice or an investment recommendation, but instead a marketing communication. IronFX is not responsible for any data or information provided by third parties referenced, or hyperlinked, in this communication.