Forex Mistake #61 – The Correlation between Economy and Currency

Why Misunderstanding the Correlation between Economy and Currency Can Get You Broke?

Not understanding what can move a currency can could get you broke and in a hurry. When you trade a currency, you are essentially expressing an opinion on a country’s economy, but very few of you will be aware of that. This can complicate the trading of currencies and helps ruin many new accounts. Not understanding relations between the underlying economy and its currency can cost you dearly. However, with a little bit of knowledge, trading Forex can be greatly improved.

 

Exotic Cocktail of Factors behind Price Movement

I can remember one of my biggest mistakes trading Forex. It was one of my first trades, and it involved the USD/ZAR pair. The South African Rand seemed exotic enough, and I had always prided myself on the idea of being “worldly” and “different.” After all, everyone traded the Euro, but it took a truly sophisticated trader to deal with the Rand. I was someone who watched the world news, and understood that South Africa was a developing nation that should continue to strengthen over time, especially now that Apartheid was history. The future looked bright, and it made sense that the currency should continue to show that. However, there were a few things that I didn’t understand going into this trade. The first thing was that it is an exotic pair, and because of that, it tends to move erratically. This is true with most exotic and thinly traded currency pairs, and this can be a real problem for those not psychologically prepared to deal with them. What I was learning is that liquidity does in fact matter. It has an effect on how price moves, especially when a large order is placed by a bank or institution. In an environment that is this thin, it is dangerous to have a large position on, which needless to say – I did. That being said, the trade immediately went against me. Looking back, I now understand that it was the market trying to teach me a lesson, and an expensive one. Almost right away, I was $100 down. Not a happy place in the span of about 3 minutes. The position was far too large, and I was essentially “stuck” at this point as I didn’t really know what to do. And I did the only reasonable thing a new trader can do in this position: I prayed that it would turn around!

 

Luckily, it did turn around, saving my account. I remember closing the trade as soon as I was 1 pip ahead. This trade was a real lesson for me, as I understood I almost made a massive mistake, and had no idea why or what I was trading. After all, why would the South African Rand go higher or lower? I was gambling at this point, as I had no idea what the actual “reasons” for the fluctuations in price tend to be in this market. The truth was I was trading blindly. As it turns out, the South African Rand will often move as a proxy on Africa in general, as it is the most common and popular currency to trade from that part of the world. Also, the gold market ends up driving the value of the Rand quite often, as South Africa is a major exporter of gold. (This makes sense, as if gold is in more demand, this will have more money crossing the border into South Africa to purchase more gold from the miners there. After all, they want to be paid in their local currency.) But when I opened my trade I wasn’t paying attention to all of that and it almost got me broke. I dodged that bullet but the only thing which protected me was luck, not skill.

 

Understanding what I do now, I would have approached this trade much, much differently. After all, the gold markets are fairly easy to follow, as there are plenty of charts online to watch, and many of those are relatively real time. Also, many brokers are now starting to offer gold prices as an informational service and beyond that, some will even allow spot gold trading. In other words, there is no reason whatsoever to not look at that potential driver of price in this case. If I would have been paying attention to the gold markets, I would have known that we were in the middle of a big pullback and that meant less demand for gold, and by extension, the Rand. However, until you understand the economy that you are trading, you will always be at a disadvantage in comparison to the professional trader.

 

The Underlying Conclusion

If you understand that there are often correlations with other markets and a particular currency, it can truly help you out. When it comes to currencies, you must pay attention to the fact that multiple forces will influence their movement. All these come together and generate trends or ranging movement, choppy price action or smooth travel. And keep in mind that there are 2 currencies in a pair and they are each influenced by their respective factors so pay attention to the underlying factors or pay the price of going broke.

 

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  • Arenoosh

    Nice try, but I totally disagree with your view Jack.

    1. “When you trade a currency, you are essentially expressing an opinion on a country’s economy…” – an intra-day trader does not give a shit on how an economy is doing. He is trading technical patterns and does not know (and no need to know) about macroeconomics as GDP, CPI, monetary policies and other things. If USD/ZAR is moving to the downside 500 pips in 5 minutes it does not mean that suddenly South Africa is doing better and the investors are buying ZAR now.
    2. “The first thing was that it is an exotic pair, and because of that, it tends to move erratically.” – that’s bullshit and a “sophisticated” trader would know that the exotic currencies are the best currencies to trade if you trade macroeconomics on long term. I can give you as many examples as you want but the best one (as also the most recent) is RUB.
    3. “The position was far too large, and I was essentially “stuck” at this point …” – that’s the real mistake here and not trading “exotics”
    4. “And I did the only reasonable thing a new trader can do in this position: I prayed that it would turn around!” – are you fucking kidding me? PRAY? A “sophisticated” trader would have placed a stop loss and moved on. Is not a shame to be wrong. Everyone is wrong several times in his life. The trick is to be right more times than you are wrong.
    5. “…the South African Rand will often move as a proxy on Africa in general…” – LOL
    6. “…the gold market ends up driving the value of the Rand quite often…” – this is the only real thing that you said in this joke.
    7. “… I would have known that we were in the middle of a big pullback and that meant less demand for gold, and by extension, the Rand….” – I don’t know when you took this USD/ZAR trade but in the past 12 months the ZAR rate action has nothing to do with the gold market but with the FED’s QE taper. South Africa is one of those EM that used cheap dollars (QE) to finance their deficits and since FED said that will start to taper their QE many EM are in trouble. Some of them managed to solve their problems and some other didn’t.
    8. If 100$ loss were caused by a “too large” position in USD/ZAR means that you were trading pennies. There is nothing wrong with trading pennies but it’s wrong to trade a currency pair with a large spread, using a large leverage and a large position.

    I hope you accept my critics! :)

    Reply
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