Finding Your Edge In The Market Part 4

Trading Like The Big Boys

The average retail forex trader has little understanding of what truly drives the FX Market. By discovering what drives the investment decisions of large banking and financial institutions, you can not only further refine your understanding of this marketplace, but you can also begin to place trades, knowing what is driving the market. The birth of this understanding in the mind of a trader will foster a psychological atmosphere of confidence and confidence is one of the most powerful attributes a trader can have. A learned, confident trader will often be a profitable, successful trader.

 

Interest Rates are the fundamental key driver of the FX Market. Without a doubt, this is what drives every currency pair over the long term. In order to understand this in basic terms, let’s use a hypothetical story. Let’s pretend you are an investor, which you are, and your financial advisor presents you with 2 investment opportunities. In the first opportunity, you are going to receive 5% interest on your money for the year. In the second opportunity, you are going to receive 1.5% interest on your money for the year. Let’s assume the risk on both investments is virtually equal. Which investment opportunity are you going to choose? Of course, you are going to choose the opportunity that yields you 5% interest! Why? Because above all things, what do investors want to do with their money? Make more money!!!

This is why interest rates drive the FX Market. Each currency has an interest rate that its Central Bank sets every 2 months. This benchmark interest rate dictates interest rates throughout the entire economy of that country. For example, when the Federal Reserve (Central Bank of USA) increases its benchmark interest rate, then that decision will have a trickle down effect in the entire economy. Banks will increase interest rates on mortgages, car dealerships will increase interest rates on car loans, etc etc. The reason Central Banks raise and lower interest rates is a topic that is beyond the scope of this article. Instead, we want to know why interest rates drive the market and how we can profit from it as traders.

Large banking and financial institutions will generally invest in currencies that yield higher rates of interest. By tracking what currencies have high interest rates, and which currencies are expected to be raising interest rates, you can determine which currencies will most likely appreciate over the long term. By tracking which currencies have low interest rates, and which currencies are expected to be lowering interest rates, you can determine which currencies will most likely depreciate over the long term. Let’s take a quick look at a chart to see this in action.

Trade like the Big Institutional Traders

This chart depicts the rapid growth of the Aussie Dollar versus the US Dollar over a 7 year period as the Reserve Bank of Australia held rates between 5-7% while the Federal Reserve kept interest rates very low ranging from 1-3%. Investors seeking yield bought the AUD/USD during this time. The move yielded over 5,000 pips.

 
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