Nenad & Chris Reveal Inner Mechanism of the Financial Markets

October 26, 2018

14 min read

Dear Traders,

Via our Elite CurrenSea website, Nenad and I are share with you a large part of the knowledge that we have learned over the years. In this article we reveal some deeper thoughts about how the market ticks.

Forex traders are often enough most interested in the trading signals and trading systems but we encourage you not to skip any of our articles. It is perhaps tempting to immediately read about our strategies without diving into the finer details of the approach itself. But the very best way to understand the entire logic and methods is to read all of our material.

Why and What Drives Price?

The first aspect we need to address is what makes the financial markets tick?

We need to understand what drives the financial markets and what causes market volatility to make the price movements as we see them. Every trader is going to have a different answer and that’s okay.

You don’t need to fully subscribe to our view of the market to be able to use our methods. But we are going to explain our thoughts and ideas in detail because we use those concepts as building blocks for our strategies.
By providing you with a full overview, you can judge for yourself whether our approach offers suitable methods for you, because it is vital that your chosen method and your trading psychology match. What works for us, does not always work for all other traders.
The best way to find out is to trade and test it for a few months with a minimum of 40-50 setups before any conclusion can be made regarding the trading strategy and its execution.

Keep in mind that every approach always has a learning curve and giving up too soon will undermine any attempt to become successful. That said, if you have been trying an approach for a while but without any success, then switching or changing methods is eventually acceptable and needed. For instance, you might decide to remove the Fibonacci tool from your tool box because it does not help you with finding targets. All of that is perfectly acceptable after sufficient testing.

So, how does price move?

The answer will vary depending on which financial instruments you are analysing and also probably which expert you ask. In the world of Forex, there are a wide range of political, economic, and financial factors pulling and pushing the supply and demand of each currency, which impact the price movement of each currency pair.

Our Prism for Analysing

Nenad and I have our own prism for analysing this. We think that these factors do have a long-term impact on the price movement of each currency pair. That said, it is very difficult or even impossible for individual traders to analyse all of these factors. Some fundamental aspects are more important than others, but which how do you weigh them? What is cause and effect? How will the dynamics and correlations change in the future?

It could be doable if you work with an entire research department such as the big banks do. Or perhaps it’s different if you have an entire IT department creating self learning algorithms that can measure, detect and analyse all of the shifts and changes that are taking place. As a single retail trader or small hedge fund, however, assessing all fundamental factors could seem like carrying water to the sea.

Although a trader could try to analyse all of these factors, Nenad and I subscribe to the fact that all information is impacting price right here and right now.

The core principle for us is this:

Analysing price action is the shortcut to understanding the financial markets.
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Rather than focusing on the cause, we choose to focus on the effect which is price. As explained above, analysing what impacts price has multiple problems and challenges. But by analysing past and current price, traders can simply analyse the total outcome of all these effects on price, rather trying to weigh the net effect of each aspect within an ever increasing interconnected world.

Although we do not use fundamental analysis for our SWAT and CAMMACD trading purposes such as intraday, intra-week and swing trading, we do believe that fundamentals guide price in the long run. So we will share our views on how we analyse the long-term fundamentals. For us, it has little practical application in our day-to-day trading, although sometimes it is useful for our swing trades at major turning points.

Here is our simplified method for evaluating fundamentals in the long run. The supply and demand of each currency is impacted by a long list of items but in essence here are the main factors:

The demand for a currency is determined by reward received for buying the currency.
The supply is determined by the chance of a currency losing its appeal and value via the risk of default and level of inflation.

This is of course valid for free floating currencies, not for currencies with strong intervention by their own or any central bank.

Supply and Demand

What factors impact supply and demand?

The list of factors is endless long and consists of dozens of data points such as GDP growth, GDP revisions, housing starts, retail sales figures, unemployment figures, consumer figures, production levels but there are many more that are not mentioned here. But in our view there is a straightforward formulate that can be used, it’s called reward to risk:

A currency which offers more reward and less risk will see increased demand and decreased supply.
A currency which offers less reward and more risk will see decreased demand and increased supply.

What is vital for demand?

Interest rates. They offer a direct reward for buying a currency. Higher Interest rates relative to another currency can push demand for the first currency(with the higher rates). The USD is offering now almost 2+% interest rate whereas the EUR is at 0%. There is more reward for buying USD than for the EUR, which pushes up demand for the USD. Also higher expected interest rates can have a significant impact. Lower (expected) rates have the opposite effect.

But there are a long list of other factors. For instance, moderate levels of inflation for instance can indicate the potential for interest rates to rise as many central banks are committed to keep inflation levels at or around 2%. We will not dive into all of the factors but a booming economy or strong stock market can also offer reward for investors.

What impacts supply?

There are a dozens of factors but the most important ones in our eyes are these four:

Large government debt.
High levels of inflation.
Quantitative easing.
Risk of currency devaluation.

Point 1. A large government debt (in relationship to a country’s GDP) will burden the currency as investors might see an increase in the default risk, which is when the government fails to pay back what it owes. The risk of default is not gradual and investors usually don’t pay attention to it unless the debt really spirals out of control. This is why and when the currency suddenly and quickly loses value. Defaults seem to be rare but actually occur more than we think when we review the last decades and centuries.

Point 2. The other risks are inflation and quantitative easing (printing of money). Inflation erodes the value of the currency but is only noticeable when the inflation reaches high levels. Here is a summary:

A modest inflation rate of two per cent per year does not endanger the value of the currency and in fact promises above zero interest rates which is good for the return side of the equation (see above paragraph).
Low levels of inflation could be bad for the currency as the economy might be struggling to rebound and improve and interest rate gains seem unlikely.
Super high levels of inflation fully erode the value of savings and make the currency extremely undesirable.

Point 3. Although quantitative easing helps smooth out major recessions, there are potential disruptions it could cause in the future such as asset bubbles. It also means that more of the same currency is printed, which could lower the value of the currency.

Point 4. Devaluations are a direct hit for the value of the currency because the central bank or government is basically reducing the purchasing power of each currency unit. Direct devaluations used to be a regular tool for governments to become competitive, but their usage seems to be less frequent now.

Ultimately this balance of reward to risk ratio will determine the demand and supply for each currency. Each currency pair is basically a relative measurement between two currencies. For instance, one currency might not do so well but an even worse currency will still lose ground. The reward to risk ratio is in fact the long-term scorecard for each currency versus other currencies. Price shows that scorecard in the long run, which is why Nenad’s CAMMACD webinars are focused on technicals, indicators and price action.

What about news events?

Of course, news events do impact the charts. First of all, they have a certain degree of influence on the long-term balance of supply and demand. A good or bad consumer inflation figure will have make an interest rate increase or decrease a bit more or less likely. The data points offers the market a way to correct its vision to the current most accurate assessment.

Secondly, they have an immediate effect on the chart, which is noticeable on lower time frames such as the 1 minute, 5 minute, 15 minute, and 1 hour charts. Huge events can even impact the 4 hour and daily candle.

Nenad and I are no fans of news trading. Although there are plenty of traders that like to trade the news, it is vital to keep in mind that the strategies and trading based on news are more volatile and risky. We prefer setups based on clear technical analysis.

Our intra-day trading therefore avoids taking entries just before big news events, which is roughly 30 minutes before the news. In most cases we exit the setup five to ten minutes before a big news event, with the exception of two cases. The first is when the open setup has a large profit and the second is when the setup has been largely closed for a profit and only a small part remains open.

What is considered a “big” news event? We consider big news to be red tagged events on the economic calender of ….or any speech of a central bank president or even board member.

Swing traders on the 4 hour are not impacted by regular red tagged news events unless there is an interest rate decision on that trading day for that currency or when the market expects a FOMC (statements from US central bank) meeting minutes or NFP (Non-Farm Payroll) figures. The latter two events could cause to alter our trades but we make a decision case by case.

Conclusion

Fundamentals do guide the financial markets but mainly for the long-term. News events impact the very short-term (movements during some hours). However, fundamentals and news events are not able to explain the price movements in between the news events and long-term direction.

Price moves up and down alot in the Forex market, each and every day. But the fundamentals do not change much every hour and day… In our opinion, there must be something else that can explain price movement in the short and medium-term.

Luckily there is and it’s called: