By Kathy Lien, Director of Currency Research
One of the most popular ways to trade forex is to trade economic data and news releases. Most people may have heard of the saying News Moves Markets. In the forex market this is particularly true because currencies are essentially confidence indicators for countries. Since forex is traded on a leveraged basis, the impact of news is magnified, making a small reaction turn into a large one. News releases provide fresh information on how an economy is performing and if the data surprise is large enough, the market’s reaction can last for a few minutes, hours and sometimes even days. Trading news through currencies can be exciting but also risky due to the volatility that can be triggered by the news event. Many forex traders love to trade news because of the potentially big reactions, but these same swings is what can also make news trading difficult.
Not all news releases are created equal. The key to trading news is knowing which releases matter and which don’t. For example, there is no point in positioning ahead of U.S. wholesale inventories report because this piece of data is not a game changer for the U.S. economy and almost never affects the U.S. dollar. The non-farm payrolls report on the other hand is a very big market mover because the degree of job growth directly affects consumer spending which is key to the viability of any economy. However the non-farm payrolls report is also traditionally the most market-moving piece of economic data for the U.S. dollar and the foreign exchange market in general. For this reason, it is better to avoid trading NFPs due to the volatility. The employment reports of other countries on the other hand are fair game. Many traders, particularly new ones will scratch their heads and wonder if they will be able to tell how impactful a particular news release will be. This comes with extensive experience but thankfully there are many experts out there who have do the work for you every day. A number of forex websites provide global economic calendars and rate the impact of each news events as High, Medium or Low. Generally speaking, the 3 most potentially market moving releases for currencies are the central bank’s rate decision, the employment report and retail sales.
The following chart shows how USD/CAD reacted to the Canadian employment report which was released at 7:00 AM ET. Job growth that month was surprisingly weak with employment growing by only 2.3k compared to a 21.7k rise the prior month. The Canadian dollar fell immediately after the release, driving USD/CAD sharply higher the moment the data came out. An hour later, USD/CAD was trading 30 pips higher. If not for the U.S. non-farm payrolls release at 8:30 AM ET, USD/CAD would have probably extended its rise further.
Economic releases can be traded either proactively or reactively. Trading proactively involves taking an educated guess on whether a piece of data will surprise to the upside or downside and placing the trade before the number is released. This is not as mind boggling as it first sounds and a Masters Degree in Economics is certainly not needed but oftentimes traders find it too challenging and opt to trade reactively, which involves placing a trade after the economic data is released. This removes the need to “guess” the economic data but can also remove any initially advantageous knee-jerk reactions.
When trading news proactively, I generally like to place my trade 20 minutes before the data is released. I find 20 minutes the sweet spot because it is close enough to the data release that the market is usually quietly anticipating the report. It is also far away enough from the release time that spreads usually remain stable. The key to trading news reactively on the other hand is to wait 5 minutes after the number is released before taking the trade. This is extremely important because first we want to make sure the market cares about the number. Second, we want to make sure that the reaction is logical, meaning that a good number is followed by a rally in the currency and a soft number is followed by a sell-off. You always want to avoid trades where the number is good and the currency pair sells off because something else could be going on. In other words, either the market doesn’t care about the release or there could be underlying weakness that is not immediately evident to new traders. We also don’t want to see the reaction reverse in the first 5 minutes because that also suggests that the data surprise was not material enough for the currency to hold its gains. When a data surprise is significant, the initial move will oftentimes see continuation, as in the USD/CAD chart above. The continuation may not be long, but it could be meaningful enough to generate some short profits. However, news trading is not the same as swing trading because it aims to trade an initial burst of activity rather than a long trend. This makes it important to be nimble with profits and tight with stops. For news trading, I am typically satisfied with a 25 to 30 pip move depending on the currency pair and news release.
In Chart #2, which is the same USD/CAD chart shown above entry points for proactive and reactive trading. In both cases, the trade would have been profitable but profits are never guaranteed particularly when trading news, which is why using stops is very important. In the case of USD/CAD, had we been greedier and decided to ride the trade through the non-farm payrolls report, it would have been a disaster.
Here are some tips to predicting economic data for anyone interested in proactive trading.
Tip: To Forecast Employment, Look at Employment Component of PMI Reports
The degree of job growth or lack thereof is very important to a country’s economic outlook. If the labor market is doing well and jobs are plentiful, it is usually synonymous with a strong and improving economy. If companies are laying off workers in size, then there is a good chance that the economy is weakening. Forecasting the potential surprise in the labor market is not as difficult as it may seem. Nearly every major country releases purchasing managers’ reports (PMI) for the service, manufacturing and construction sectors prior to the official employment report. In the U.S., it is called the ISM report. Within each of these reports is a subcomponent titled as employment. If the employment component of the 3 reports increased from the previous month, then there is also a good chance that the number of jobs created rose as well. However if the 3 reports show that the labor market has deteriorated, then there is a good chance that the official labor market report will show the same deterioration. A good jobs number is typically positive for the currency while a weak number will usually cause the currency to sell off. This information can usually be found through a simple Google news search using a clever combination of words.
Tip: To Forecast Retail Sales, Look at Confidence and Sales Component of PMI Services
The degree of consumer spending is just as important as the amount of job growth because it measures the contribution that consumers are making to the economy. If consumers are spending and retail sales are strong, then there is a good chance the economy is growing which is positive for the currency. If it is weak, then it is a cause for concern which usually translates into weakness for the currency. Forecasting the potential improvement or deterioration of retail sales is also not as difficult as one would expect. In Australia for example, most months, the performance of services index is released before retail sales and within the PSI report, there is a subcomponent titled sales. The PSI report is released by the Australian Industry Group which is an independent not for profit association and their results have a reasonably good correlation with the government’s figures.
Tip: Look at Producer Prices
A country’s consumer price report is also a tradable news release because keeping prices stable is a part of the mandate for many central banks. In fact, for the European Central Bank and the Bank of England, it is their top priority. Thankfully forecasting CPI is not as difficult as it seems. Producer prices, which measures inflation on a wholesale level is typically reported before consumer prices. If PPI accelerates quickly, there is a good chance that CPI will rise as well as producers pass their costs to consumers. If PPI falls, CPI has a good chance of declining.
Forecasting economic data is not easy but a Masters in Economics is not needed either – just some common sense. Try it for yourself, and if you still find it challenging, there is always reactive trading.
This article is sponsored by www.compareforexbrokers.com