Understanding Central banks and how they conduct themselves in the Forex market is one of the most important concepts that a Forex trader needs to know about for effective trading. In this Wiki, we will explore How to Trade with Central Banks including Central Bank statements.
This Wiki is part of our Fundamental and Sentiment Trading Strategies Wiki. Be sure to check that out HERE.
How to Trade with Central Banks
The big traders in the Forex market are all trading around the Central Banks of individual countries. The market will react every time a central bank takes action by implementing a policy or mandate or even when they say something in or out of tune from their normal rhetoric. It could be as simple as a member speaking more hawkish or dovish than they normally do.
If a central bank has recently changed its tone, just the mere mention of something such as inflation, could completely change the overall trend of that currency.
The primary role of the central bank is to control the money supply for the country in which it sits and maintain economic order. To do this the central bank will have targets which usually revolve around inflation and growth, both of which are usually around 2%.
Central Banks will typically offer forward guidance to the markets for 2 reasons:
- To prevent unnecessary market crashes or panics about what the bank might do, which is caused by speculation in the market.
- To ensure that their actions and policies have a desired effect. For example, if they are deliberately trying to weaken their currency then they will make it explicitly clear to the market and outline how they intend to do this, followed by expressing their determination to do this no matter what happens.
The key rule of central bank tools is that everything revolves around interest rates. A large part of the time all the markets are thinking is "How will this new information impact interest rates?" The answer to that question is what drives prices up or down.
Process for monitoring central banks:
- Follow the news feeds and look out for articles written right after any major central bank statements that give an insight into how the markets are reacting to this information, and how you might best trade it.
- Central banks release all of their policy actions and plans via specially planned statements. You will find when these statements will be released on the economic calendar weeks in advance, so you will need to be noting the dates and then monitor all related news articles to get an idea of what traders are expecting and how analysts expect these events to move the currencies.
- Place your trades in line with expectations and existing market reactions. Do not become scared out of your positions by the short term volatility. Closely monitor the fundamental situation and make sure that your expectations and previous reasons for entering any positions are still valid on a session-by-session basis.
How to Trade Central Bank Statements
Trading central bank statements can produce large price moves in the market and be extremely profitable if you know how to catch the move.
There are 2 main ways to trade a central bank statement:
1. Analyse the market expectations and position yourself before the event:
By entering before the statement you have a much higher profit potential but the risk is higher if it does not play out as expected. The key is to have a very firm expectation regarding the upcoming statement. If there is a firm reason to think that the central bank will announce some type of action with regard to its monetary policy or if they change their tone of language then this will almost certainly move the market if it happens.
2. Wait for the central bank to confirm the market's expectations and then trade the aftermath
This is where you look to trade the pullback after the news rather than getting in before the event. The key to this strategy is to be patient and wait for price to pullback to an attractive level.
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