What is Carry Trade?

What is Carry Trade?

Did you know there is a trading system that can make money if price stayed exactly the same for long periods of time?

Well there is and it’s one the most popular ways of making money by many of the biggest and baddest money manager mamajamas in the financial universe!

It’s called the “Carry Trade”.




A carry trade involves borrowing or selling a financial instrument with a low interest rate, then using it to purchase a financial instrument with a higher interest rate.

While you are paying the low interest rate on the financial instrument you borrowed/sold, you are collecting higher interest on the financial instrument you purchased. Thus your profit is the money you collect from the interest rate differential.

For example:

Let’s say you go to a bank and borrow $10,000. Their lending fee is 1% of the $10,000 every year.

With that borrowed money, you turn around and purchase a $10,000 bond that pays 5% a year.

What’s your profit?

Anyone?

You got it! It’s 4% a year! The difference between interest rates!

By now you’re probably thinking, “That doesn’t sound as exciting or profitable as catching swings in the market.”

However, when you apply it to the spot forex market, with its higher leverage and daily interest payments, sitting back and watching your account grow daily can get pretty sexy.

To give you an idea, a 3% interest rate differential becomes 60% annual interest a year on an account that is 20 times leveraged!

In this section, we will discuss how carry trades work, when they will work, and when they will NOT work.

We will also tackle risk aversion (WTH is that?!? Don’t worry, like we said, we’ll be talking more about it later).

How Do Carry Trades Work for Forex?

How Do Carry Trades Work for Forex?

In the forex market, currencies are traded in pairs (for example, if you buy USD/CHF, you are actually buying the U.S. dollar and selling Swiss francs at the same time). Just like the example in the previous, you pay interest on the currency position you sell, and collect interest on the currency position you buy.

What makes the carry trade special in the spot forex market is that interest payments happen every trading day based on your position. Technically, all positions are closed at the end of the day in the spot forex market. You just don’t see it happen if you hold a position to the next day.

Brokers close and reopen your position, and then they debit/credit you the overnight interest rate difference between the two currencies. This is the cost of “carrying” (also known as “rolling over”) a position to the next day.

The amount of leverage available from forex brokers has made the carry trade very popular in the spot forex market. Most forex trading is margin based, meaning you only have to put up a small amount of the position and you broker will put up the rest. Many brokers ask as little as 1% to 2% of a position. What a deal, eh?

Let’s take a look at a generic example to show how awesome this can be.

For this example we’ll take a look at Joe the Newbie Forex Trader.

It’s Joe’s birthday and his grandparents, being the sweet and generous people they are, give him $10,000. Schweeeet!

Instead of going out and blowing his birthday present on video games and posters of bubble gum pop stars, he decides to save it for a rainy day. Joe goes to the local bank to open up a savings account and the bank manager tells him, “Joe, your savings account will pay 1% a year on your account balance. Isn’t that fantastic?”

Joe pauses and thinks to himself, “At 1%, my $10,000 will earn me $100 in a year.”

“Man, that sucks!”

Joe, being the smart guy he is, has been studying BabyPips.com School of Pipsology and knows of a better way to invest his money.

So, Joe kindly responds to the bank manager, “Thank you sir, but I think I’ll invest my money somewhere else.”

Joe has been demo trading several systems (including the carry trade) for over a year, so he has a pretty good understanding of how forex trading works. He opens up a real account, deposits his $10,000 birthday gift, and puts his plan into action.

Joe finds a currency pair whose interest rate differential is +5% a year and he purchases $100,000 worth of that pair. Since his broker only requires a 1% deposit of the position, they hold $1,000 in margin (100:1 leverage). So, Joe now controls $100,000 worth of a currency pair that is receiving 5% a year in interest.

What will happen to Joe’s account if he does nothing for a year?

Well, here are 3 possibilities. Let’s take a look at each one:
Currency position loses value. The currency pair Joe buys drops like a rock in value. If the loss brings the account down to the amount set aside for margin, then the position is closed and all that’s left in the account is the margin – $1000.
The pair ends up at the same exchange rate at the end of the year. In this case, Joe did not gain or lose any value on his position, but he collected 5% interest on the $100,000 position. That means on interest alone, Joe made $5,000 off of his $10,000 account. That’s a 50% gain! Sweet!
Currency position gains value. Joe’s pair shoots up like a rocket! So, not only does Joe collect at least $5000 in interest on his position, but he also takes home any gains! That would be a nice present to himself for his next birthday!

Because of 100:1 leverage, Joe has the potential to earn around 50% a year from his initial $10,000.

Here is an example of a currency pair that offers a 4.40% differential rate based on interest rates as of September 2010:




If you buy AUD/JPY and held it for a year, you earn a “positive carry” of 4.40%.


Of course, if you sell AUD/JPY, it works the opposite way:



If you sold AUD/JPY and held it for a year, you would earn a “negative carry” of 4.40%.

Again, this is a generic example of how the carry trade works.

Any questions on the concept? No? We knew you could catch on quick!

Now it’s time to move on to the most important part of this lesson: Carry Trade Risk.

To Carry or Not to Carry

To Carry or Not to Carry

When Do Carry Trades Work?

Carry trades work best when investors feel risky and optimistic enough to buy high-yielding currencies and sell lower yielding currencies.

It’s kinda like an optimist who sees the glass half full. While the current situation might not be ideal, he is hopeful that things will get better. The same goes for carry trade. Economic conditions may not be good, but the outlook of the buying currency does need to be positive.

If the outlook of a country’s economy looks as good as Angelina Jolie, then chances are that that country’s central bank will have to raise interest rates in order to control inflation.

This is good for carry trade because a higher interest rate means a bigger interest rate differential.

On the other hand, if a country’s economic prospects aren’t looking too good, then nobody will be prepared to take on the currency if they think the central bank will have to lower interest rates to help their economy.

To put it simply, carry trades work best when investors have low risk aversion.

Carry trades do not work well when risk aversion is high (i.e. selling higher-yielding currencies and buying back lower-yielding currencies). When risk aversion is high, investors are less likely to take risky ventures.

Let’s put this into perspective.

Let’s say economic conditions are tough, and the country is currently undergoing a recession. What do you think your next door neighbor would do with his money?

Your neighbor would probably choose a low-paying yet safe investment than put it somewhere else. It doesn’t matter if the return is low as long as the investment is a “sure thing.”

This makes sense because this allows your neighbor to have a fall back plan in the event that things go bad, e.g. he loses his job. In forex jargon, your neighbor is said to have a high level of risk aversion.

The psychology of big investors isn’t that much different from your next door neighbor. When economic conditions are uncertain, investors tend to put their investments in safe haven currencies that offer low interest rates like the U.S. dollar and the Japanese yen.

If you want a specific example, check out Forex Gump’s Piponomics article on how risk aversion led to the unwinding of carry trade.

This is the polar opposite of carry trade. This inflow of capital towards safe assets causes currencies with low interest to appreciate against those with high interest.

Carry Trade Criteria and Risk

Carry Trade Criteria and Risk

Carry Trade Criteria

It’s pretty simple to find a suitable pair to do a carry trade. Look for two things:
1- Find a high interest differential.
2- Find a pair that has been stable or in an uptrend in favor of the higher-yielding currency. This gives you the ability to stay in the trade AS LONG AS POSSIBLE and profit off the interest rate differential.

Pretty simple, huh? Let’s take a real life example of the carry trade in action:



This is a weekly chart of AUD/JPY. Up until recently, the Bank of Japan has maintained a “Zero Interest Rate Policy” (as of September 2010, the interest rate stands at 0.10%).

With the Reserve Bank of Australia touting one of the higher interest rates among the major currencies (currently at 4.50% as of this writing), many traders have flocked to this pair (one of the factors creating a nice little uptrend in the pair).

From the start of 2009 to early 2010, this pair moved from a price of 55.50 to 88.00 – that’s 3,250 pips!

If you couple that with interest payments from the interest rate differential of the two currencies, this pair has been a nice long term play for many investors and traders able to weather the volatile up and down movements of the currency market.

Of course, economic and political factors are changing the world daily. Interest rates and interest rate differentials between currencies may change as well, bringing popular carry trades (such as the yen carry trade) out of favor with investors.

Carry Trade Risk

Because you are a very smart trader, you already know what the first question you should ask before entering a trade is right?

“What is my risk?”

Correct! Before entering a trade you must ALWAYS assess your max risk and whether or not it is acceptable according to your risk management rules.

In the example at the start of the lesson with Joe the Newbie Forex Trader, his maximum risk would have been $9000. His position would be automatically closed out once his losses hit $9000.

Eh?

That doesn't sound very good, does it?

Remember, this is the worst possible scenario and Joe is a newbie, so he hasn’t fully appreciated the value of stop losses.

When doing a carry trade, you can still limit your losses like a regular directional trade.

For instance, if Joe decided that he wanted to limit his risk to $1000, he could set a stop order to close his position at whatever the price level would be for that $1000 loss. He would still keep any interest payments he received while holding onto the position.

Summary of Carry Trade

Summary: Carry Trade



While you are paying the low interest rate on the financial instrument you borrowed/sold, you are collecting higher interest on the financial instrument you purchased. Your profit is the money you collect from the interest rate differential.

This is another way to make money in the forex market without having to buy low and sell high, which can be pretty tough to do day after day.

Carry trades work best when investors feel like taking on risk. Current economic conditions need not be good, but the outlook does need to be positive.

If a country’s economic prospects aren't looking too good, then nobody will be prepared to take on the risk. To put it simply, carry trades work best when investors have low risk aversion.

Carry trades do not work well when risk aversion is high.

When risk aversion is high, investors are less likely to buy higher-yielding currencies or likely to reduce their positions in higher-yielding currencies.

When economic conditions are uncertain, investors tend to put their investments in safe haven currencies, which tend to offer low interest rates like the U.S. dollar and the Japanese yen.

It’s pretty simple to find a suitable pair to do a carry trade. Look for two things:
Find a high interest differential.
Find a pair that has been stable or in an uptrend in favor of the higher-yielding currency. This gives you the ability to stay in the trade AS LONG AS POSSIBLE and profit off the interest rate differential.

Always remember that economic and political factors are changing the world daily. Interest rates and interest rate differentials between currencies may change as well, bringing popular carry trades (such as the yen carry trade) out of favor with investors. So, when doing a carry trade, you should still limit your losses like a regular directional trade.

When properly applied, the carry trade can add significant income to your account, along with your directional trading strategies.

What is the Dollar Index?

What is the Dollar Index?

If you’ve traded stocks, you’re probably familiar with all the indices available such as the Dow Jones Industrial Average (DJIA), NASDAQ Composite Index, Russell 2000, S&P 500, Wilshire 5000, and the Nimbus 2001. Oh wait, that last one is actually Harry Potter’s broomstick.

Well if U.S. stocks have an index, the U.S. dollar can’t be outdone. For currency traders, we have the U.S. Dollar Index (USDX).

The U.S. Dollar Index consists of a geometric weighted average of a basket of foreign currencies against the dollar.

Say whutttt!?! Okay before you fall asleep after that super geeky definition, let’s break it down.

It’s very similar to how the stock indices work in that it provides a general indication of the value of a basket of securities. Of course, the “securities” we’re talking about here are other major world currencies.
The Basket

The U.S. Dollar Index consists of six foreign currencies. They are the:
- Euro (EUR)
- Yen (JPY)
- Pound (GBP)
- Canadian dollar (CAD)
- Krona (SEK)
- Franc (CHF)

Here’s a trick question. If the index is made up of 6 currencies, how many countries are included?

If you answered “6″, you’re wrong.

If you answered “22″, you’re a genius!

There are 22 countries total, because there are 17 members of the European Union that have adopted the euro as their sole currency, plus the other five countries (Japan, Great Britain, Canada, Sweden, and Switzerland) and their accompanying currencies.

It’s obvious that 22 countries make up a small portion of the world but many other currencies follow the U.S. Dollar index very closely. This makes the USDX a pretty good tool for measuring the U.S. dollar’s global strength.
USDX Components

Now that we know what the basket of currencies is composed of, let’s get back to that “geometric weighted average” part. Because not every country is the same size, it’s only fair that each is given appropriate weights when calculating the U.S. dollar index. Check out the current weights:



With its 17 countries, euros make up a big chunk of the U.S. Dollar Index. The next highest is the Japanese yen, which would make sense since Japan has one of the biggest economy in the world. The other four make up less than 30 percent of the USDX.

Here’s something interesting: When the euro falls, which way does the U.S Dollar Index move?

The euro makes up such a huge portion of the U.S. Dollar Index, we might as well call this index the “Anti-Euro Index”. Because the USDX is so heavily influenced by the euro, people have looked for a more “balanced” dollar index. More on that later though. First, let’s go to the charts!

How to Read the Dollar Index

Just like any currency pair, the USDX even has its own chart. Holler at the U.S. Dollar Index:

First, notice that the index is calculated 24 hours a day, five days a week. Also, the USDX measures the dollar’s general value relative to a base of 100.000. Huh?!?

Okay. For example, the current reading says 86.212. This means that the dollar has fallen 13.79% since the start of the index. (86.212 – 100.000).

If the reading was 120.650, it means the dollar’s value has risen 20.65% since the start of the index. (120.650 – 100.00)

The start of the index is March 1973. This is when the world’s biggest nations met in Washington D.C. and all agreed to allow their currencies to float freely against each. The start of the index is also known as the “base period”.

The U.S. Dollar Index Formula

This is strictly for the grown and geeky. Here is the formula to calculating USDX:

USDX = 50.14348112 × EUR/USD^(-0.576) × USD/JPY^(0.136) × GBP/USD^(-0.119) × USD/CAD^(0.091) × USD/SEK^(0.042) × USD/CHF^(0.036)

Got that? Good! Now you can get a wedgie from the school bully.

We’re kidding!

Queen Cleopiptra usually includes the U.S. dollar index in her Chartology articles so if you’re planning to watch USDX, you should also find out what our resident chartologist has to say.

Trade-Weighted Dollar Index

Trade-Weighted Dollar Index

There is also another kind of dollar index used by the Federal Reserve. It is called the “trade-weighted U.S. dollar index”.

The Fed wanted to create an index that could more accurately reflect the dollar’s value against foreign currencies based on how competitive U.S. goods are compared to goods from other countries. It was formed in 1998 in order to keep up-to-date with U.S. trade.

Currencies and Weights

Here is the current weighting (in percentage) of the index:

Country	Weight (%)
Euro zone	17.66
China	17.33
Canada	15.22
Mexico	9.72
Japan	8.71
United Kingdom	4.32
Korea	3.50
Taiwan	2.37
Singapore	2.02
Brazil	1.95
Malaysia	1.87
Hong Kong	1.75
India	1.61
Switzerland	1.42
Thailand	1.40
Australia	1.20
Russia	1.17
Israel	1.12
Sweden	1.00
Indonesia	0.92
Saudi Arabia	0.82
Chile	0.82
Philippines	0.65
Colombia	0.50
Argentina	0.48
Venezuela	0.47
Total	100

*Weights as of May 2009

The main difference between the USDX and the trade-weighted dollar index is the basket of currencies used and their relative weights.

The trade weighted index includes countries from all over the world, including some developing countries. Given how global trade is developing, this index is probably a better reflection of the dollar’s value across the globe.

The weights are based on annual trade data.

Weights for the broad index can be found at http://www.federalreserve.gov/releases/H10/Weights.

If you’d like to see historical data, check out http://www.federalreserve.gov/releases/h10/Summary/

Using the USDX for Forex

Using the USDX for Forex

I bet you’re wondering, “How do I use this thing in my trading arsenal?” Well, hold your trigger finger and you’ll soon find out! We all know that most of the widely traded currency pairs include the U.S. dollar. If you don’t know, some that include the U.S. dollar are EUR/USD, GBP/USD, USD/CHF, USD/JPY, and USD/CAD.

What does this mean? If you trade any of these pairs, the USDX can be the next best thing to sliced bread (or hamburger on a bun… or chocolate ice cream).

If you don’t, the USDX will still give you an idea of the relative strength of the U.S. dollar around the world. In fact, when the market outlook for the U.S. dollar is unclear, more often times than not, the USDX provides a better picture.

In the wide world of forex, the USDX can be used as an indicator of the U.S. dollar’s strength. Because the USDX is comprised of more than 50% by the euro zone, EUR/USD is quite inversely related. Check it:



Next, take a look at a chart of EUR/USD.



It’s like a mirror image! If one goes up, the other most likely goes down. Will you look at that? It seems like the trend lines almost inversely match up perfectly. This could be a big help to those big on trading EUR/USD.

Some of our trader friends in the forums monitor the USDX as an indicator for EUR/USD. Hang out with them if you wanna learn more about using this index.

If the USDX makes significant movements, you can almost surely expect currency traders to react to the movement accordingly. Both the USDX and spot currency traders react to each other. Breakouts in spot USD pairs will almost certainly move the USDX in similar breakout fashion.

To sum it all up, currency traders use the USDX as a key indicator for the direction of the USD.

Always keep in mind the position of the USD in the pair you are trading.

For example, if the USDX is strengthening and rising, and you are trading EUR/USD, a strong USD will show a downtrend on the EUR/USD chart. If you are trading a pair in which the USD is the based currency, such as the USD/CHF, a rise in the USDX will most likely show a rise in USD/CHF charts like the one shown below.



Here are two little tips you should always remember:

If USD is the base currency (USD/XXX), then the USDX and the currency pair should move the same direction.

If USD is the quote currency (XXX/USD), then the USDX and the currency pair should move in opposite directions.

The Dollar Smile Theory

The Dollar Smile Theory

Ever wonder why the dollar strengthens both in times of tough luck and when the economy is booming like a Jay-Z remix? Well, so does everybody else. In fact, this really smart dude over at Morgan Stanley came up with a theory to explain this phenomenon.

Stephen Jen, a former currency strategist and economist, came up with a theory and named it the “Dollar Smile Theory.” His theory depicts three main scenarios directing the behavior of the U.S. dollar. Here’s a simple illustration:


Scenario 1: The first part of the smile shows the U.S. dollar benefiting from risk aversion, which causes investors to flee to “safe-haven” currencies like the dollar and the yen. Since investors think that the global economic situation is shaky, they are hesitant to pursue risky assets and would rather buy up the less risky U.S. dollar regardless of the condition of the U.S. economy.

Scenario 2: Dollar drops to new low. The bottom part of the smile reflects the lackluster performance of the Greenback as the U.S. economy grapples with weak fundamentals.

The possibility of interest rate cuts also weighs the U.S. dollar down.

This leads to the market shying away from the dollar. The motto for USD becomes “Sell! Sell! Sell!”

Scenario 3: Dollar appreciates due to economic growth. Lastly, a smile begins to form as the U.S. economy sees the light at the end of the tunnel. As optimism picks up and signs of economic recovery appear, sentiment towards the dollar begins to pick up. In other words, the greenback begins to appreciate as the U.S. economy enjoys stronger GDP growth and expectations of interest rate hikes increase.

This theory appears to have been in play when the 2007 financial crisis began. Remember when the dollar got a huge boost at the peak of the global recession? That’s phase 1.

When the market eventually bottomed out in March 2009, investors suddenly switched back to the higher yielding currencies, making the dollar the winner of the “Worst Currency” award for 2009.


So will the Dollar Smile Theory hold true?

Only time will tell.

In any case, this is an important theory to keep in mind. Remember, all economies are cyclical.

The key part is determining which part of the cycle the economy is in.

Summary of Trading the News

Summary: Trading the News



There you have it! Now you know how to trade the news! Just keep these things in mind when trading:
When you have a directional bias, you are expecting price to move a certain direction, and you’ve got your orders in already.
It is always good to understand the underlying reasons why the market moves in a certain direction when news is released.
When you have a non-directional bias, you don’t care which way price heads. You just want to get triggered.
Setups for the non-directional bias are also called straddle trades.

That’s pretty much it…

Is it really that easy???

HECK NO!!!

You’ll have to practice and trade many different reports before you get a feel of which news reports will make the market move, how much of a surprise is needed for the market to move, and which reports to avoid trading.

Like in any other trading method, your success depends on your preparation.

This will take time and practice. Do your homework and study the economic indicators to understand why they are important.

Remember, nothing worth having comes easy, so stick with it and you’ll find that trading news report will be very rewarding once you get the hang of it!

Letting the Market Decide Which Direction to Take

Letting the Market Decide Which Direction to Take



The first thing to consider is which news reports to trade. Earlier in this lesson we discussed the biggest moving news reports. Ideally you would want to only trade those reports because there is a high probability the market will make a big move after their release.

The next thing you should do is take a look at the range at least 20 minutes before the actual news release. The high of that range will be your upper breakout point, and the low of that range will be your lower breakout point. Note that the smaller the range is the more likely it is you will see a big move from the news report.

The breakout points will be your entry levels. This is where you want to set your orders. Your stops should be placed approximately 20 pips below and above the breakout points, and your initial targets should be about the same as the range of the breakout levels. This is known as a straddle trade – you are looking to play both sides of the trades, whichever trade it moves.



Now that you’re prepared to enter the market in either direction, all you have to do is wait for the news to come out. Sometimes you may get triggered in one direction only to find that you get stopped out because the price quickly reverses in the other direction. However, your other entry will get triggered and if that trade wins, you should recoup your initial losses and come out with a small profit.

A best case scenario would be that only one of your trades gets triggered and the price continues to move in your favor so that you don’t incur any losses. Either way, if done correctly you should still end up positive for the day.

One thing that makes a non-directional bias approach attractive is that it eliminates any emotions – you just want to profit when the move happens. This allows you take advantage of more trading opportunities, because you will be triggered either way.

There are many more strategies for trading the news, but the concepts mentioned in this lesson should always be part of your routine whenever you are working out an approach to taking advantage of news report movements.

Trading with a Directional Bias

Trading with a Directional Bias


Let’s go back to our example of the U.S. unemployment rate report. Earlier, we gave examples of what could happen if the report came in light with expectations, or slightly better. Let’s say there was a surprising drop. What effect could this have on the dollar? One thing that could happen is that the dollar falls. What??? Isn’t the dollar supposed to rise if the unemployment rate is dropping?

There could be a couple reasons why the dollar could still fall even though there are more people with jobs.

The first reason could be that the long-term and overall trend of the U.S. economy is still in a downward spiral. Remember that there are several fundamental factors that play into an economy’s strength or weakness. Although the unemployment rate dropped, it might not be a big enough catalyst for the big traders to start changing their perception of the dollar.

The second reason could be the reason for the unemployment rate drop. Perhaps it’s right after Thanksgiving during the holiday rush. During this time, many companies normally hire seasonal employees to keep up with the influx of Christmas shoppers. This increase in jobs may cause a short term drop in the unemployment rate, but it’s not at all indicative of the long term outlook on the U.S. economy.

A better way to get a more accurate measure of the unemployment situation would be to look at the number from last year and compare it to this year. This would allow you to see if the job market actually improved or not.

The important thing to remember is to always take a step back and look at the overall picture before making any quick decisions.

Now that you have that information in your head, it’s time to see how we can trade the news with a directional bias.

Let’s stick with our unemployment rate example to keep it simple. The first thing you would want to do before the report comes out is take a look at the trend of the unemployment rate to see if it has been increasing or decreasing. By looking at what has been happening in the past, you can prepare yourself for what might happen in the future.

Imagine that the unemployment rate has been steadily increasing. Six months ago it was at 1% and last month it topped out at 3%. You could now say with some confidence that jobs are decreasing and that there is a good possibility the unemployment rate will continue to rise.

Since you are expecting the unemployment rate to rise, you can now start preparing to go short on the dollar. Particularly, you feel like you could short USD/JPY.

Just before the unemployment rate is about to be announced, you could look at the price movement of USD/JPY at least 20 minutes prior and find the range of movement. Take note of the high and low that is made. This will become your breakout points.

*Note: The smaller the range the larger tendency there is for a volatile move.

Since you have a bearish outlook on the dollar, you would pay particular attention to the lower breakout point of that range. You are expecting the dollar to drop so a reasonable strategy would be to set an entry point a few pips below that level.



You could then set a stop just at the upper breakout point and set your limit for the same amount of pips as the breakout point range.


One of two things could happen at this point. If the unemployment rate drops then the dollar could rise. This would cause USD/JPY to rise and your trade would most likely not trigger. No harm no foul! Or if the news is as you expected and the unemployment rate rises, the dollar could drop (assuming the entire fundamental outlook on the dollar is already bearish).

This is good for you because you already set up a trade that was bearish on the dollar and now all you have to do is watch your trade unfold.


Later on, you see that your target gets hit. You just grabbed yourself a handful of pips! Booyeah!

The key to having a directional bias is that you must truly understand the concepts behind the news report that you plan to trade. If you don’t understand what effect it can have on particular currencies, then you might get caught up in some bad setups. Luckily for you, we've got Pip Diddy and Forex Gump to help explain what effect each report can have on the forex market.

Directional Bias vs. Non-Directional Bias

Directional Bias vs. Non-Directional Bias
There are two main ways to trade the news:
a) Having a directional bias
b) Having a non-directional bias

Directional Bias

Having directional bias means that you expect the market to move a certain direction once the news report is released. When looking for a trade opportunity in a certain direction, it is good to know what it is about news reports that cause the market to move.

Consensus vs. Actual

Several days or even weeks before a news report comes out, there are analysts that will come up with some kind of forecast on what numbers will be released. As we talked about in a previous lesson, this number will be different among various analysts, but in general there will be a common number that a majority of them agree on. This number is called aconsensus.

When a news report is released, the number that is given is called the actual number.
“Buy the rumors, sell on the news”

This is a common phrase used in the forex market because often times it seems that when a news report is released, the movement doesn’t match what the report would lead you to believe.

For example, let’s say that the U.S. unemployment rate is expected to increase. Imagine that last month the unemployment rate was at 8.8% and the consensus for this upcoming report is 9.0%.

With a consensus at 9.0%, it means that all the big market players are anticipating a weaker U.S. economy, and as a result, a weaker Dollar.

So with this anticipation, big market players aren’t going to wait until the report is actually released to start acting on taking a position. They will go ahead and start selling off their dollars for other currencies before the actual number is released.

Now let’s say that the actual unemployment rate is released and as expected, it reports 9.0%.

As a retail trader, you see this and think “Okay, this is bad news for the U.S. It’s time to short the dollar!”

However, when you go to your trading platform to start selling the dollar, you see that the markets aren’t exactly moving in the direction you thought it would. This is because the big players have already adjusted their positions way before the news report even came out and may now be taking profits after the run up to the news event.

Now let’s revisit this example, but this time, imagine that the actual report released an unemployment rate of 8.0%. The market players thought the unemployment rate would rise to 9.0% because of the consensus, but instead the report showed that the rate actually decreased, showing strength for the dollar.

What you would see on your charts would be a huge dollar rally across the board because the big market players didn’t expect this to happen. Now that the report is released and it says something totally different from what they had anticipated, they are all trying to adjust their positions as fast as possible.

This would also happen if the actual report released an unemployment rate of 10.0%. The only difference would be that instead of the dollar rallying, it would drop like a rock! Since the market consensus was 9.0% but the actual report showed a bigger 10.0% unemployment rate, the big players would sell off more of their dollars because the U.S. looks a lot weaker now than when the forecasts were first released.

Keeping track of the market consensus and the actual numbers, you can better gauge which news reports will actually cause the market to move and in what direction.

Non-directional bias

A more common news trading strategy is the non-directional bias approach. This method disregards a directional bias and simply plays on the fact that a big news report will create a big move. It doesn’t matter which way it moves… We just want to be there when it does!

What this means is that once the market moves in either direction, you have a plan in place to enter that trade. You don’t have any bias as to whether price will go up or down, hence the name non-directional bias.

Which News Reports are Trade-Worthy?

Which News Reports are Trade-Worthy?
Before we even look at strategies for trading news events, we have to look at which news events are even worth trading.

Remember that we are trading the news because of its ability to increase volatility in the short term, so naturally we would like to only trade news that has the best market moving potential.

While the markets react to most economic news from various countries, the biggest movers and most watched news comes from the U.S.

The reason is that the U.S. has the largest economy in the world and the U.S. Dollar is the world’s reserve currency. This means that the U.S. Dollar is a participant in about 90% of all Forex transactions, which makes U.S. news and data important to watch.

With that said, let’s take a look at some of the most volatile news for the U.S.



In addition to inflation reports and central bank talks, you should also pay attention to geo-political news such as war, natural disasters, political unrest, and elections. Although these may not have as big an impact as the other news, it’s still worth paying attention to them.

When our economic guru Forex Gump is in a good mood, he usually releases a Piponomics article on upcoming news reports that you can play and with trade strategies to boot! Check out some of his articles of this sort:

- Trade the News This Week

- 4 News Reports You Can Trade this Week

- Trade the U.S. Retail Sales Report With Me

- Make Pips with this Week’s Big Reports

Also, keep an eye on moves in the stock market. There are times where sentiment in the equity markets will be the precursor to major moves in the forex market.

Now that we know which news events make the most moves, our next step is to determine which currency pairs are worth trading.

Because news can bring increased volatility in the forex market (and more trading opportunities), it is important that we trade currencies that are liquid. Liquid currency pairs give us a reassurance that our orders will be executed smoothly and without any “hiccups”.
+ EUR/USD
+ GBP/USD
+ USD/JPY
+ USD/CHF
+ USD/CAD
+ AUD/USD

Did you notice anything here?

That’s right! These are all major currency pairs!

Remember, because they have the most liquidity, majors pairs usually have the tightest spreads. Since spreads widen when news reports come out, it makes sense to stick with those pairs that have the tightest spreads to begin with.

Now that we know which news events and currency pairs to trade, let’s take a look at some approaches to trading the news.

Why Trade the NEWS

Why Trade the News

The simple answer to that question is “To make more money!”

But in all seriousness, as we learned in the previous section, news is a very important part to the market because it has the potential to make it move!

When news comes out, especially important news that everyone is watching, you can almost expect to see some major movement. Your goal as a trader is to get on the right side of the move, but the fact that you know the market will most likely move somewhere makes it an opportunity definitely worth looking at.

Dangers of trading the news

As with any trading strategy, there are always possible dangers that you should be aware of.
Here are some of those dangers:

Because the market is very volatile during important news events, many dealers widen the spread during these times. This increases trading costs and could hurt your bottom line.

You could also get “locked out” which means that your trade could be executed at the right time but may not show up in your trading station for a few minutes. Obviously this is bad for you because you won’t be able to make any adjustments if the trade moves against you!

Imagine thinking you didn’t get triggered, so you try to enter at market… then you realize that your original ordered got triggered! You’d be risking twice as much now!

You could also experience slippage. Slippage occurs when you wish to enter the market at a certain price, but due to the extreme volatility during these events, you actually get filled at a far different price.

Big market moves made by news events often don’t move in one direction. Often times the market may start off flying in one direction, only to be whipsawed back in the other direction. Trying to find the right direction can sometimes be a headache!

Profitable as it may be, trading the news isn’t as easy as beating Pipcrawler at Call of Duty. It will take tons of practice, practice and you guessed it… more practice! Most importantly, you must ALWAYS have a plan in place. In the following lessons, we’ll give you some tips on how to trade news reports.