Forex on fundamentals
If you want to trade FX, people recommend trading on technical indicators. However, as much fundamentals (looking at the relative value of the currency instead of the trend) in currency markets have a bad reputation, I still think with study you can make Forex trades a profitable investment strategy in the long run based on fundamental analysis. The take away from this post is find the natural fx rate between two currencies and than analysis the relative strength of the two economies.
How often do you trade foreign currency? I do every day, but not for profit. I live in Krakow, Poland. I transact business in both Polish zloty and US dollars every day, as well as Euro and other currencies from time to time. I watch the FX rates almost daily and watch both Polish and US business news. I have a pretty good pulse on economics in both countries.
My currency rule of thumb – equilibrium price
Because I use these currencies daily I have grown familiar with the way they behave. Much like I know my neighbors. Their behavior most of the time is predictable. I watch my neighbors take out the trash on certain mornings and know when they will come home from work. I know that in the summer months they get home earlier. Few surprises. This is the same way I see currencies. I can tell their habits.
Develop a currency rule of thumb
Over the years I have developed a rule of thumb. I have a general feel that when the Polish zloty is trading 3 to 1 to the dollar or higher it is under valued. When it is below 2.5 to 1 it is over valued. The natural equilibrium rate being a little less than 3 to 1.
When the dollar is strong I use my American bank account to transact business. When European currencies are strong I use my European bank account to buy stuff.
Now, that is the extent I play currencies today. It is a very basic fundamental approach. However, since I am on the ground in a foreign land, I have a pretty good idea of other fundamental factors, or at least as good as the experts, maybe better.
Experts are often wrong
For example, when top economists were calling for the Polish economy to go in crisis, I disagreed. My economist friends were sending me reports from around the world about the Polish economy and I told them the guys who writes these reports are wrong. In fact, this economy was the only one that did not yet fall. So often the experts are wrong.
When considering currency fundamentals
I look at the interest rates compared in the two countries.
For example, at this time, the US is pursuing a lose money policy. Poland, on the other hand, has a tight money policy.
In addition the US growth is weak while Polish is strong. However, there are other factors. For example, the currency here is highly correlated with the Euro currency which is underwater. Also the dollar is a symbol of trust, like gold so even if beaten it often comes back, especially with changes in the politics in the USA.
Getting to know a currencies fundamentals are a lot like getting to know your neighbors.
Conclusion on trading FX on fundamentals
Even though FX trading works better using technical tools, you can trade exchanges on fundamentals. The way you do this is:
- Choose two currencies you are familiar with for some reason, get to know them like an old friend.
- Determine what is the historic equilibrium point. This is not just some historic statistic but generally a narrow trading range it likes to settle in. This is the natural fx rate. Not a lifetime rate, but a 3 to 5 year rate.
- Develop a theory why the money market is away from this equilibrium point for some reason. Consider things like interest rates and the overall strength of the economy based on macro economic indicators and personal knowledge of what businessmen on the ground are saying.
- Be patient. Trading on fundamentals is a long term form of speculation. It is not like trading on technical indicators like moving averages. If you choose to trade on technical indicators understand it is a very violate market that often has sudden turning points. This is why a fundamental strategy with a natural rate can make sense. But in the end, I am slightly skeptical about currency trading as generally it is a zero sum game at best.