Trading EUR/USD | How to trade the Euro-Dollar
As it represents the world's two largest economies, it's no surprise that the EUR/USD is the world's most traded currency pair. But while high volatility and significant trading volume attract traders from everywhere, generating profits is no small feat.
The euro and the US dollar represent the world's 2 biggest trading and economic blocks. This is because many multinational companies operate in Europe and the United States, with offices on both continents, and need to permanently hedge against currency risk. These companies are therefore still involved in EUR/USD and USD/EUR trades.Also, as it is also the most liquid currency pair in the world, EUR/USD offers low spreads between bid and ask prices as well as consistent liquidity for investors who want to buy it or sell it.
The EUR/USD's popularity is due to several reasons: the large number of market participants and the constantly available financial and economic data. Traders are able to constantly review and reformulate their opinions and positions, and perpetual activity allows for high levels of volatility, which leads to great opportunities for traders to make a profit.
This combination of volatility and liquidity makes the EUR/USD pair a great place for new forex traders to begin their exploration of the financial markets. However, they should keep in mind that a good understanding of risk management is essential for investing in foreign currencies.
Benefits of trading the EUR/USD pair
As it's the most popular major currency pair, the EUR/USD is often highlighted on trading platforms. But why do so many day traders chose to trade this pair?
- Prevalence - These are the two most popular reserve currencies. Their size results in the publication of an abundance of financial data on the pair. It also makes them relatively easy to follow.
- Liquidity - The EUR/USD boasts constant liquidity, as well as low spreads between bid and ask prices.
- Volume - The large number of active traders and trading in the market ensure relatively high levels of volatility. All of this can lead to greater profit potential.
- Availability of resources - In a way, it is now easier to make short and long term forecasts. You have access to historical charts, candlesticks and monthly charts, as well as customisable indicators. Performing an overbought/oversold analysis via the RSI indicator is simpler, for example. In addition, you have active online trading communities (visit our forum section!). It features an almost daily EUR/USD forecast here.
Risks
Despite the above benefits, there are also a few disadvantages:
- Volatility - High levels of volatility in the EUR/USD can cause winning positions to turn into losers, fast. No amount of 20-year historical data and charts can prepare you for how quickly prices can swing.
- Leverage - It is true that trading on margin can increase your potential profit. However, it can also magnify losses. Therefore, if you are using leverage, you must strive to make accurate predictions.
- Automated competition - Unfortunately, even with quality forecasts and live quotes, the competition is now fierce. You are faced with an increasing number of trading algorithms. You have to manually analyse and react to a bull market with your interactive chart. However, robots automatically enter and exit positions as soon as certain criteria are met.
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Factors that influence the EUR/USD's price movements
Economic growth
The main factor influencing the direction of the EUR/USD is the relative strength of the two economies. When the US's economy grows faster, the dollar will strengthen against the euro, while if the EU's economy grows faster, the euro will be stronger versus the US dollar.
Interest rates are also a good indicator of economic strength. For example, the dollar typically strengthens when US interest rates are higher than those of major European economies.
Political events
Instability, as we saw with the Brexit referendum, can influence the direction of currencies. But it is not just major elections that play a role, events like the SNB's abandonment of the minimum floor on the EUR/CHF pair have also had an impact on exchange rates.
The challenge is to keep an eye on the eurozone's many countries. You must therefore keep abreast of the latest political and economic news.
Compared to most of the world's major currencies, the euro is a relatively new currency, which only appeared on the scene in 1999. The result is discrepancies between the governments of the various countries of the euro area in matters of opinion and monetary policy, and when these divergences appear to pose a potential threat to the future stability of the euro area, it is almost certain that the US dollar will be stronger than the euro. This means that when an investor wants to trade the EUR/USD pair, he should pay close attention to any new policies of European countries which could suggest instability in the EU economy.
Monetary policy
There is also a correlation between the monetary policy implemented by a relevant central bank and the EUR/USD's relationship. We saw this during the global financial crisis of 2007, which was one of the biggest declines in the history of the euro versus the dollar.
During this period, there was an unusual separation between the policy of the US Federal Reserve (Fed) and that of the ECB in particular.
The Fed sought to aggressively stimulate the US economy early on, with quantitative easing measures. The ECB, on the other hand, delayed quantitative easing measures. The US bought sovereign bonds as a stimulus measure for years before the ECB followed suit.
The two institutions also had somewhat different priorities. While the Fed aimed to increase employment and stabilise prices, the ECB was primarily concerned with price stability.
As a result, most articles on the forex market focused on the Fed's actions, while the ECB was largely ignored. Add to this that many Member States were dealing with crushing debt and people quickly began to question the longevity and effectiveness of a universal monetary policy.
Unsurprisingly, all of this led to some strange fluctuations in the EUR/USD. Today, therefore, many traders focus on central bank policy projections and expectations to build their EUR/USD trading strategies.
Correlations between currencies
While you can focus your trading efforts on the specific EUR/USD pair, there are some correlations with other currencies that you should consider. You'll notice that certain currencies appear in many pairs. This is because all currencies are related to each other. None of them trade completely independently of the others.
Their relationships are known as positive and negative correlations:
- Negative Correlation - Negative correlation is when currency pairs react in the opposite direction. The most popular pairs are USD/CHF, USD/JPY and USD/CAD. Here, the base currency is the US dollar. This means that they move in the opposite direction of the major pairs mentioned below, where the US dollar acts as a counterweight.
- Positive Correlation - Positive correlation is when the pairs react in relation to each other. The three most popular pairs, GBP/USD, AUD/USD and EUR/USD, are all positively correlated. This is a result of the dollar being the counterparty currency. Thus, any change in the USD will have an impact on all pairs.
Application
A EUR/USD trader can use this knowledge to better understand the implications of certain pair movements. Let's look at an example: the British pound versus the US dollar. When you trade this pair, to some extent you are also trading the euro against the British pound.
Unfortunately, it's not that simple. Economic factors and market speculation can cause correlations between currencies to change. A negative correlation can become positive and vice versa.
History
24 years ago, before today's mini-futures, the currency markets were different. It was the German deutschmark against the US dollar and the French franc against the US dollar that dominated the scene.
However, 1 January 1999 set the stage for the history of the foreign exchange market. But the road to the euro had been laid out decades before.
There were two earlier versions of the euro, both of which were internal units of account for the EC (European Community) members. These were:
- The European unit of account
- The "ecu" (European Currency Unit)
These weren't actual currencies, though. They were groups of specific community currencies, designed to help stabilise European exchange rates. Together they helped form the single currency we now know.
The currencies in the ECU section had a somewhat different composition than those that would form the euro. But the ecu played a key role in the euro's historic exchange rate. The value of 1 euro was set at the value of 1 ecu when it was created on 1 January 1999. The initial EUR/USD exchange rate was therefore 1.1686.
Despite this, the euro was not to become a physical currency until 2002. However, the 1999 launch brought together all the currencies of the eurozone, including:
- The German deutschmark
- The French franc
- The Spanish peseta
- The Italian lira
This is when they stopped having separate, floating exchange rates. They were lumped together, forming today's euro.
Historical EUR/USD data and sentiment from that time show that many expected the euro to rob the dollar of its unofficial title as the world's reserve currency. However, this has yet to occur.
Key dates
Those who track the EUR/USD nowadays are better able to predict its price movements, taking into account previous events. Some of the most important ones are:
- 18 September 2007 - The FED cut funds rates by 50 basis points. As a result, the euro strengthened against the USD.
- 16 December 2008 - The FED cuts rates to near zero. Again, the euro strengthens against the USD.
- 19 October 2009 - The new Greek government changes its latest deficit forecast, which goes from 6.7% of GDP to 12.7%. This had the effect of weakening the euro versus the dollar.
- 1 June 2011 - Moody's downgraded Greece's debt by seven notches to junk. This had the effect of further weakening the euro against the dollar.
- 18 December 2013 - The FED declares that the "tapering" of stimulus measures will begin in January 2014. The euro continues to weaken against the dollar in February 2014.
- 14 July 2014 - ECB (European Central Bank) President Mario Draghi prepares the market for quantitative easing (QE). As a result, the euro weakens against the dollar.
- 22 January 2015 - The ECB introduces Quantitative Easing (ie. printing tons of money out of thin air) with full force. This leads to a weakening of the euro against the dollar.
Historical EUR/USD exchange rate data demonstrates the effect of central bank action on prices. Thus, those who analyse the Fed's actions may be better able to accurately predict the movements of the pair.
In addition to the factors highlighted in the above timeline, wars, elections, and production levels have all also influenced the pair in the past.
Other events
A number of other events also triggered significant volatility in the pair. The most important are as follows:
- Internet bubble - From 1997 to 2001, speculation rocked the EUR-USD relationship. It took years for the dust to settle and for stability to return.
- Real estate bubble - This bubble was considered one of the main factors of the 2007-2009 recession, which was extremely detrimental to the US economy.
- The European debt crisis - The impact of the European debt crisis is still felt today and has had a significant impact on the relationship between the two currencies.
It should be said that those who understand the past are often in a better position to predict future price movements.
Role of the US dollar
The US dollar has a very important, unique role in the world of international finance. As the world's most widely accepted reserve currency, the USD is used to settle the majority of international financial transactions, and central banks around the world hold a large portion of their foreign currency reserves in US dollars.
Many smaller countries choose to peg the value of their own currency to the USD. Some even use the dollar as their own currency instead of developing their own currency. The US dollar is also used to set the price of gold and many commodities, and is the currency of choice for OPEC oil transactions.
The combination of these factors contributes to making the USD the most important currency in the world. As the USD is also the most frequently traded global currency, the majority of foreign currencies trade against it more frequently than any other currency pair. With this in mind, any investor getting into forex trading should develop a solid understanding of the factors driving the US economy, and pay attention to the direction the dollar is heading.
The EUR/USD index you are looking at today will have been shaped to some degree by the unique role the US dollar has played over the years. These are just some of the reasons why it has become the most important currency in the world:
- Considered the world's reserve currency, it is used to settle most international transactions.
- Many small countries peg the value of their currency to the US dollar, while global banks hold a large portion of their currency reserves in US dollars.
- You will also notice that the live price of gold and other commodities is often set in US dollars.
- OPEC (Organisation of the Petroleum Exporting Countries) also transacts in US dollars.
- It is the most common currency among the most popular pairs, so as a budding forex trader, you need to have a solid understanding of what is driving the US economy to predict where the US dollar is going.
The euro and the EU's economy
Overall, the largest economic region in the world is the EU (European Union), as its GDP exceeds 14 trillion euros. As in the United States, the European economy is heavily service-oriented; however, manufacturing accounts for a larger proportion of Europe's GDP than that of the US.
When EU economic activity is strong, the euro generally becomes stronger, and when there is a slowdown in European economic activity, the euro generally weakens. The euro is unique in the currency market because while the US dollar represents the currency of a single country, the euro is a currency shared by 19 different EU countries. The different governments of the European Union sometimes disagree on the future direction of the Union or on its monetary policies. When these economic arguments arise, the euro generally weakens.
The countries that are currently part of the Eurozone are: Germany, Austria, Belgium, Cyprus, Spain, Estonia, Finland, France, Greece, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Portugal, Slovakia and Slovenia.
The history of the euro
The euro is a relatively recent currency, having been created only in 1995. To be able to adopt this currency, the Member States of the euro area must meet specific criteria, in particular a budget deficit below 3% of the GDP, a debt ratio below 60% of GDP, low inflation and interest rates close to the European average. It was in 1995 that the name "euro" was first adopted, and in 1999 it was first introduced in the form of banking services, electronic transfers and travelers checks, with a process of continued introduction within Member States which allowed existing currencies to be used legally until the introduction of the new euro coins and bills in 2002.
Factors that influence the euro
There are many things that impact the value of the euro in the forex. These include:
- The minimum bid rate - This is set by the ECB, which publishes its interest rates decision every month. Decisions on eurozone interest rates are taken by the six members of the ECB's executive board and the central banks of the 19 eurozone countries.
- Employment figures - Employment data is essential to economic health, and the publication of consolidated employment figures for the eurozone, as well as figures for the main economies of the euro zone (Germany and France), can have a big impact on the value of the euro.
- GDP - The value of goods and services produced by members of the eurozone can change each year.
- Balance of trade - This is the difference between the value of exports and imports, with a surplus indicating an increase in exports, and a deficit indicating an increase in imports.
- Consumer price, producer price and retail sales indices - All of these indicators measure the inflationary pressure on an economy, and will impact both interest rates and monetary policies.
- Sentiment indicators - Sentiment surveys such as the German ZEW Economic Sentiment Survey give an indication of the overall perception of an economy's strength.
- International news - Political, economic and environmental news can have a significant impact on the exchange rate. Any sign of unrest, such as riots, for example, can cause the value of the euro to drop.
EUR/USD trading strategy
An effective EUR/USD strategy is more than just understanding how to use pip values and calculators to your advantage. Nor is it about having a "pulse" of the market's mood. It's about using a real-time chart to factor in tick data and to evaluate your options.
Timing
Once you understand how EUR/USD market forces interact, you need to define a strategy. The 5 minute, 30 minute, weekly and global charts can be useful, but knowing when to trade is just as important.
Part of the appeal of forex day trading is that you can buy/sell around the clock. While this is true, that doesn't mean you should. It's best to trade when the EUR/USD is active, with lots of volume and volatility.
For example, when London and Europe are open, pairs that feature the British pound and euro are more actively traded. If you are day trading EUR/USD, the volume charts show that the most active period is when London and New York are open. These markets are open between 8:00 and 22:00 (London time).
The danger is that if you trade at the wrong times, the cost of spreads and commissions can wipe out your profits. That's why many suggest only trading within a three to four hour window.
Ideal window
So when is the best time to trade the EUR/USD pair?
The ideal time is between 13:00 and 16:00 (London time). This three-hour window features an overlap of the opening hours of London and New York. The volumes in both markets means spreads are usually tightest during this time.
This is also the time when forex forums are most active where you'll see the biggest daily moves. All of these factors can give rise to the greatest profit potential. So while it may be tempting to respond to every buy or sell signal you see today, resisting may be a good idea.
Try not to let charts and market noise trick you into trading based on intraday 12-hour forecasts. Focus on what you know and make sure the volumes validate any potential new trade you make.
Buying and selling Breakouts/Breakdowns
Live EUR/USD charts and technical analysis are useful to be successful with this strategy. You'll find that the pair swings back and forth within "tunnels" for long periods of time. This creates clear trading ranges, which should lead to new trends, whether upward or downward.
Take your time during consolidation phases. The reward could be low risk trade entries when you spot key resistance and support levels eventually being broken, leading to a swift upward or downward move.
This technique relies on timing. If you enter the position too early, you may find that the range holds and a reversal is triggered. Enter too late and your risk increases as the position may trade above the new support or below the new resistance.
Tight range models
You will frequently see the pair climb or fall within a large tunnel and then fall dormant, creating narrow price range bars, resulting in minimal volatility. This also results in strong entry signals for price breakouts.
So enter your position in a narrow range setup and place a tight stop to avoid losses if a major reversal pops up.
The advantages of this method are that the narrow range pattern often predicts that price bars will rise on major price breakouts. Also, it is low risk because you can place stop-losses close to the entry price.
When it comes to EUR/USD day trading, different strategies work for different people. Some prefer to use pivot points or futures curves, while others focus on trading before/during/after news announcements. Whether you opt for chart investing or not, be patient, perfecting a strategy takes time.
Conclusion
Traders are always looking for the best possible return when choosing a currency pair to invest in. Choosing the EUR/USD pair gives you the best chance of making a profit, and the high liquidity of this particular market along with competitive spreads can have the effect of increasing your odds of making - rather than losing - money.
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