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Why is the Fed interest rate decision so important?
The question when the Federal Reserve is going to raise the interest rate for the first time in years has been dominating the markets for months.
Every word uttered by members of the Federal Open Market Committee (FOMC) - the branch of the Federal Reserve Board that determines the direction of U.S. monetary policy - is carefully disected in search of clues as to the timing of the first rate hike. Every new figure about the U.S. economy is immediately analyzed and explained as either improving or diminishing chances of a rate raise in the final months of 2015. Inflation, labor costs, employment, industrial production, export, they are all viewed in light of the approaching rate raise - the first in nine years - of the Federal Reserve.
But why exactly?
What is the ‘Fed rate’?
When economists, financial journalists, traders etc., are talking about ‘the’ Fed rate, they almost always mean the so-called Federal funds rate. This is the interest banks charge each other for short term loans from the balance they keep at the Federal Reserve, the so-called Federal funds.
U.S. banks are obligated by law to keep on hand about 10 percent of their outstanding liabilities, either in their vault or at the Federal Reserve. Since banks can’t do anything with these Federal funds, they always try to keep them at the legal minimum. Of course on a day-to-day basis some banks may need extra funds for a short-short-term investment. In such cases banks usually borrow from other banks whose Federal funds balance at that moment is a little more than required. The interest these banks charge each other for such a loan is the Federal funds rate.
Banks can also borrow directly from the Federal Reserve itself. The interest the Fed charges in that case is the so-called discount rate. The discount rate - which is sometimes confused with the Federal funds rate - is usually a little higher than the Federal funds rate, making the latter more popular with banks (no surprise there) and therefore more important.
Now, the Federal Reserve can’t directly set the Federal funds rate, banks do this amongst themselves. The average rate of all those short-term outstanding loans between banks is called the Federal funds effective rate, i.e., the effective rate banks charge each other. ‘The’ intereste rate decision of the Federal Reserve - the one that everybody is so fixated on - is the decision about the Federal funds target rate, i.e., the Federal funds effective rate the Federal Reserve would like to see.
But don’t let the fact that the Fed doesn’t have the power to set the rate directly trick you into thinking it can only hope and pray the banks follow their desired rate, because the Federal Reserve does in fact have a powerful weapon to get its way and have the effective rate move in the direction of the target rate, namely the buying or selling of government bonds on the open market (also known as Open Market Operations).
The mechanism works something like this: when the Fed wants to raise the interest, it sells U.S. treasuries on the open market. Buyers pay for those bonds with dollars, causing the Money Supply to shrink. When there is less money in circulation the cost of acquiring money - i.e., the interest rate - rises. Conversely, when the Fed wants to lower the interest rate, it buys U.S. Treasuries, thus increasing the Money Supply.
What happens when the Fed raises/lowers the interest rate?
Simply put: when the Federal Reserve raise the rate, money become becomes more expensive, when it lowers the rate, money becomes cheaper.
When the interest rate rises, money becomes more scarce and investing therefore more expensive, which can have a dampening effect on stock markets. The dollar will normally rise against other currencies when the Fed raises the rate, though part of that rise might have already been priced in by markets. A more expensive dollar has a dampening effect on U.S. export and a stimulating effecting on U.S. import, this because foreign products - priced in foreign currencies - will be relatively cheap in dollars, whereas American products - priced in dollars - become more expensive abroad.
What factors influence the Fed in its decision?
The monetary policy of the Federal Reserve is aimed at achieving full employment and guarding price stability.
In its regular policy statements, the Fed has said for a long time that more improvement was needed in the labor market, but in the July 2015 statement the FOMC hinted it was gearing up for a rate raise by saying that only “some” improvement was needed in the labor market. Obviously this makes the monthly U.S. employment figures - the so-called Non-Farm Payrolls - all the more important.
Aside from employment figures, the Fed will of course also take into account other macro-economic figures, such as the growth of the industrial production, consumer spending, the housing market etc, all figures that reveal important information about the state of the U.S. economy.
Impact on the Forex
As said, the effect of a rate hike is generally dollar positive. The last time the Fed raised the interest rate was 2006, so when it will decide to actually raise the Federal funds target rate, the effect on the forex will likely be sizable. Momentum will likely be on the side of the dollar bulls, not just on the day the decision is announced but also during the weeks that follow the decision.
Of course part of the rate raise will already be priced in, because investors and forex traders have been anticipating the rate hike for some time and taken this into account in their currency positions. It's important to realize there is no guarantee the dollar will actually rise, it could also be a matter of buying the rumor, sell the news, making for the paradoxical effect of a falling dollar after the Fed raises the rate.
But whatever else, if the Federal Reserve indeed raises the rate in September - or a couple of months after that - it will be the first of the big central banks that makes a big step towards normalisation of its monetary policy, after years of ultra-low interest rates. That fact alone will likely have a big impact on the forex, despite all preparation and anticipation by forex actors.
The 6 simple secrets of successful forex trading
The system discussed here is not the holy grail of forex trading. There is no such thing. How to become a profitable forex trader has far more to do with mindset than with a specific trading strategy. In fact, no forex trading strategy can be profitable if a trader has the wrong mindset.
The GRABIT© System that I developed will optimize your trading mindset, so that it's better geared towards trading profitably. The system consists of 6 simple principles, who's first letters form the word GRABIT.
Is it hard to follow this system? No. That is to say, is it hard to quit smoking? Those of you who have smoked before - or still are smoking - will probably say that it is indeed (very) hard. But if that was your answer, ask yourself what is so hard about not lighting up another cigaret?
Ok, let's look at the 6 principles of the GRABIT system.
Goals
This really is the kind of principle that should play a role in every major endeavor you undertake. When you set out on a new path, it helps to set clear, definable goals to guide you. If you set no goals at all, or vague goals, you don't have anything to benchmark against. Clear goals help you stay the course on the road to success.
Realism
This second principle goes hand in hand with the first. Many beginning traders do set goals, only they're not very realistic. Setting the goal of making $10,000 annual profit with a trading capital of $500 is very enthusiastic, ambitious and optimistic - all very likable qualities - but such mission impossibles are best left to Hollywood. And since failing to reach a goal is very demotivating, there's really no reason to set goals that are ridiculously hard to achieve.
To make sure you set realistic trading goals, you should answer the following questions for yourself:
• How much money can you invest? Your financial goal is partially based on the amount you have available for trading.
• How much time can you devote to studying? The more time you can spend on expanding your knowledge, the more trading strategies you can explore and master. Learning about different trading strategies and techniques will increase the chance of finding a strategy that really suits you.
• How much time can you devote to trading? Answering this question will help you cross out a number of trading strategies. For instance, If you have a full time job which allows for only about an hour of trading each day, you don't have to bother with intraday trading.
Analyze
Every successful trader will tell you that the most challenging aspect of trading is keeping your emotions out. It's hard to stay in trades that have a lot of unrealized profit, just as it is hard to close a trade that is moving against you. It's hard to keep believing in a trading system that hasn't delivered for some time, and very easy to start doubting everything you do.
You have to do everything you can to limit the temptation of making emotional decisions, and of the most important steps you can take to that end is to find out what kind of trader you are. What kind of trading personality do you have? Are you impulsive, (relatively) good at taking a loss? Are you patient, disciplined, do you believe the natural direction of a given stock is up?
In my book 'Forex for Ambitious Beginners' I go deeper into the process of self-assessment for traders and also list a number of questions that will help you gauge your own trading personality. If you already have the book, I strongly suggest you spend time on the chapter about self-assessment.
Build
You should build your own trading system, rather than plucking one from the internet. I know it's very tempting to simply copy the trading system of some (supposedly) successful trader, and it might very well be a very profitable strategy but the fact that it works for them, doesn't mean it will work for you.
The best thing to do is to take note of those strategies and let other traders tell you what works for them, to see which parts really resonate with you. Borrow bits and pieces from other people's trading strategies, but only to mold them into a strategy that is customized to your trading personality, financial circumstances and time schedule.
If you are a hobby trader and just want to stay in the market without losing too much, you don't have to spend years building your system, but if you are committed, if you are serious, if you want to achieve financial freedom, than it might take you years before you have build and fine-tuned a successful trading system of your own.
Do you think that's a little long? How about if you were starting a business and someone told you it might take you three to four years before it'd become a successful business. Would you find that very odd? Because if you do, you better not start a business. Trading on the financial markets for a living, to become financially independent, is a business too. It will very likely take you a couple of years before you master trading profitably consistently. (and don't let anyone tell you differently).
So, find a trading strategy that fits your (trading) personality. Formulate a set-up, an exit strategy and determine the right money management, and you're on your way.
Impassionate
Interesting thing about the word 'impassionate' is that it has two opposite meanings. On the one hand it means being passionate about something, and on the other hand it means to be dispassionate. As a trader you need both those meanings to become successful.
Be passionate about trading
Look, if you're only in it for the money and don't care at all for charts, price development, financial news, or how different tradable instruments correlate with each other, in other words if you don't like the game , you probably won't last very long as a trader. In the beginning you might struggle, and there will definitely be difficult periods, so if you don't have any passion for the activity itself, for trading as such, it will be very hard to get through those difficult periods.
Be dispassionate when trading
You've carefully build a trading system that fits your trading personality, that has a solid set-up, exit strategy and money management. One of the main reasons you have a trading system is to keep you from making emotional decisions. So, now that you're in the market it's time to let your system do its work.
Therefore, when the position is open you are dispassionate. Your system is running the trade and you don't care either way whether or not the trade goes one way or the other. The system does not provide you with a 100% wins - no system can - but you've set it up so that it is profitable on the whole, and now you have to let it do it's work.
That doesn't mean you can never change your system, it means you have to trust your system as long as you're in a trade.
Trust
You have to trust your trading system. You have to trust your set-up, you have to trust your money management and you have to trust your exit strategy. If you don't, you're likely to change your system before it has had a chance to prove itself.
Let's look at an example. Say you have a system that provides 50% winners and 50% losers. A winning trade will make you 10 (pips, dollars, gold bars, doesn't matter) a losing trade will cost you 7. That means that in the long term, executing 100 trades will turn an average net profit of 50x3 = 150. So your Expected Value is 1,5 per trade.
That doesn't mean you will make 150 profit every time you execute 100 trades. A random sample of 100 trades could easily show 80 winners and 20 losers, or the other way around. But in the long run you will turn that average net profit of 1,5 per trade. That is, if you stick to the system.
If you don't trust your system, you'll switch too soon to another system and you'll never find out whether or not that system (or any other trading system) works or not. Of course you can backtest your system, and doing so will help you fine-tune it before going live, but many traders still have difficulty following a system even after it has proven itself in a solid backtest. As soon as they start trading with real money, doubt creeps in after only a couple of losing trades, and then the tweaking, changing, distrusting begins. Before long, many traders have switched to a new system entirely, after which the process repeats itself.
Of course you can tweak your system - and you should - but do it sparingly, and mindfully. You've spend time building the system, tracking the system, evaluating your system. Only when you find a leak over a longer period of time should you adjust the system.
If you don't trust the system while you're in a trade, you'll become impatient. Impatience makes you exit too soon - afraid that profits will dissipate - or too late, because you don't want to take a loss.
Once you're in the trade and for as long you're in the trade, you have to trust the system.
In short
The GRABIT system consists of six principles you have to follow to become a successful trader.
Goals - Set clear, definable goals.
Realism - Make sure the goals you set are realistic.
Analyze - Find out what kind of trading personality you have.
Build - Build your own trading system, one that suits your trading personality.
Impassionate - Be passionate about trading, impassionate when trading.
Trust - Trust your system when you're in a trade, don't be impatient.
Following these principles won't guarantee success as a trader, nothing can, but you'll have a lot more chance to be successful if you do.
Want to learn more about successful forex trading? Check out Forex for Ambitious Beginners
Biggest Forex Beginner Mistakes - No Exit Strategy
Many of the best forex trading tips have little to do with following a specific trading strategy. They are common sense approaches that are often neglected by forex beginners, possibly because they were tempted by self-appointed forex experts to follow this or that 'great forex money making strategy'.
It's a bit like popping pills and/or following complex diets invented by self-appointed diet experts in order to lose weight. As simple as it might sound, you only need to do two things if you want to lose weight: 1) eat less 2) exercise more. Of course it can be quite a challenge to lose 20 pounds simply by eating less and exercising more, but that's another story. The point is that everyone knows what's best, the problem lies in doing what's best.
The internet is chocablock with can't-lose-make-a-million-today! forex strategies that absolutely, super-duper guarantee the pips will come rolling in if you follow the advice to the letter. But most of these strategies are about when to enter the market, not about when to get out. And it's the getting out that's the most important.
One of the most important rules to follow when trading the forex is to always have an exit strategy. Study after study shows that traders - whether in the stock market, futures market or forex - tend to sell winners to soon, and hold on to losers for too long. It makes sense, we are emotional beings and we know it.
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A solid exit strategy can help you guard against this. Determine when you should go out of the market before you open the position, then lock in that exit when you enter the market. This exit might be a specific price goal or something like a trailing stop, as long as you set it up in advance.
Example I specific profit target and stop loss
Let's say you want to go short the USD/CAD after studying the fundamentals and the 1 day forex chart for the USD/CAD.
You decide you will get in if the USD/CAD reaches 1.0132. You will use the resistance around 1.0220 as your stop loss, meaning the trade will automatically be closed if the currency pair reaches that price.
From measuring the previous moves of the currency pair you gather that if the downtrend continues, the price will probably fall about 200 pips before retracement sets in again. So you set your profit target at 0.9940.
Example II trailing stop
Same situation, but instead of a fixed stop loss and profit target, you decide to use a trailing stop. This is a stop that - in case of a short position, like here - is set at a percentage level above market price. The trailing stop price is adjusted as the price fluctuates. It allows you to let the trade remain open when it goes your way - because there is no fixed profit target - while still cutting your losses at the same time.
It's really not that hard to formulate an exit strategy every time you open a position. It is simply a matter of answering the question 'when do I think the trade should be closed' before you actually open the trade. Because as soon as the trade is opened, real-time losses or winnings might (and often will) cloud your judgement.
If you're a forex beginner, now is the time to ram home the habits that almost all successful forex traders use. And one of the most important habits is having an exit strategy for every forex position you open.
You can find more about forex exit strategies in the book Forex for Ambitious Beginners.
Biggest forex beginner mistakes - no trading plan
Entering the forex without a trading plan is nothing short of suicide and yet it's one of the most common mistakes forex beginners make. It's like starting a business by renting office space and hiring staff but not having any sense of the market, the competition or even what kind of product you are going to sell.
If you're wondering why 90 percent of forex beginners lose money trading currencies, this is the reason: because they don't have any trading plan whatsoever.
All successful forex traders use a trading plan and many of them will tell you that they treat trading as a business. They have a clear and realistic vision on what they want to achieve, a trading strategy that fits their personality and circumstances, an exit strategy as well as an entry strategy. They also take time to evaluate and adjust their plan while they're out of the market.
The thing is, for most forex traders the problem isn't in developing a trading plan, it's in following it. There is an old saying among traders: 'Plan your trade and trade your plan'. It's the second part of that saying that's the most important. Think about it: if you have a great plan but you're not following it, what good will it do you? Then again, if you have a shitty plan that you follow to the letter, you could at least improve it through evaluation.
How to build a great trading plan
So what does a good trading plan look like? Well, first of all you have to take your own personality and circumstances into account. For instance, a good trading plan has realistic goals, and to arrive at them you need to take into account how much trading capital you have at your disposal and how much time you can set aside for trading and learning about trading.
Self-assessment
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"Simply a Must Read for Every Serious Forex Beginner" Available at Amazon Now also for Kindle
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Not every trading strategy is suitable for every trader. Some strategies yield a high percentage of small winning trades, others a low percentage of big winners. For some strategies you only have to set-up new positions about once a week, others are meant for intense intra-day trading. This is why Forex for Ambitious Beginners has a section on self-assessment, to help you determine what kind of trading personality you have.
Self-assessment will help you find the trading strategy that's right for you, so that you can create working set-ups. A set-up is basically a collection of conditions that have to be met before a trade is opened and closed. For example, if you think trend trading suits you best, you could create a set-up for trading the AUD/JPY.
Exit strategy
Remember that one of the most important parts of your trading plan is your exit strategy. Setting (and keeping) a stop loss and profit target is often what makes the difference between being a successful forex trader and a losing one, so be sure to spend time on this.
Evaluation
Another important part of your trading plan is evalution. You can't expect your trading plan to be perfect from the get go, in fact you can't expect it to be perfect ever. You need to regularly evaluate it, in order to find and deal with leaks and weak spots, to improve your Expected Value.
Record keeping
So keep records of your trading. For a single position, you could note things like: what currency pair, what was the set-up, entry, exit, profit. Forex brokers usually keep a history of your trades as well, but the more information you write down about a trade, the more information you have to tweak your trading plan later on.
To sum up
For many forex beginners trading is an emotional business, but it shouldn't be. You shouldn't enter the market on a whim or follow a strategy because your friend says it did wonders for him; you shouldn't keep a position open because you can't bear to take the loss or trade with money you can't really miss because you are trying to reach a goal that isn't realistic to begin with.
Find out what kind of trading personality you have, factor in your personal circumstances and build a trading plan around that. Then keep to that plan while you're trading and evaluate it regularly when you're out of the market, continuously improving upon it. That's how you go from struggling forex beginner to successful forex professional.
You can find more about creating a forex trading plan in the book Forex for Ambitious Beginners.
5 Forex Beginner Tips That Will Save You Money
The 5 forex trading tips listed below are mentioned throughout this book. That's because even though they can't guarantee success ― nothing ever can, otherwise everybody would be successful ― they can save you a lot of money. Experience shows that many beginning forex traders bleed money mainly because they fail to follow the next five principles:
Forex Beginner Tip 1. Money Management
Rule number 1 for every forex trader is to survive. Every trader has losing trades, but when you go broke you can put yourself in a position where you can no longer have winning trades. Therefore, before everytying else you have to make sure you stay in the game.
Many beginning and/or consistently losing traders focus exclusively on having a profitable trading strategy. But even though a good trading strategy is definitely important, using solid money management and having a rational, disciplined trading attitude will get you further at the end of the day.
Two rules of thumb for good money management are not to risk more than 3% of your trading capital per trade and making sure you have enough trading capital for at least 40 trades when you are a beginner.
Forex Beginner Tip 2. Always use a stop loss
The stop loss is perhaps the most powerful weapon in your arsenal as a forex trader, just as the most powerful weapon of the professional poker player is the fold (if that means anything to you). The stop loss allows you to predetermine your risk down to the pip, therefore ALWAYS use it!
There are really only advantages to putting in a stop loss. It forces you to think about when the trade you're about to put on would be considered a failure. After you've opened the position you might talk yourself into staying in a trade going bad, using all kinds of irrational excuses. But if you've set a stop loss before opening the trade (when you were still thinking rationally) you'll always have that shining beacon, reminding you that you'd be a weak, emotional idiot if you stayed in the trade after the stop loss is triggered.
Setting a stop loss also forces you to think about your profitable trades/losing trades ratio. Suppose you want to risk 50 pips to win 100 pips, that would mean you'd need a winning trade at least 33% of the time to break even. Does your trading strategy get you a profitable trade 33% of the time?
Another advantage of the stop loss is that you don't have to be afraid that one badly chosen trade will kill your whole account in case the trade goes bad and for some reason you're not in a position to close it manually. So remember to always put in a stop loss and never move it further away after opening the trade.
Forex Beginner Tip 3. Be realistic
Unless you are amazingly lucky you can't expect to close 80% of your trades profitably or turn a $500 trading capital into a $10,000 trading capital in six months. With those kind of expectations you're simply setting yourself up for disappointment, frustration and failure. (unless you're very, very lucky).
Try to look at things realistically right from the start. Determine an attainable percentage of winning trades considering your strategy and experience. Ask yourself how much time you can spend on trading and learning. When you have a clear view of your trading tools and conditions, you will find it much easier to work towards a profitable trading strategy.
For example, suppose you're a day trader with a trading strategy where you risk, on average, 15 pips to win 30. After doing about 200 trades, it turns out that 50% of your trades reached their profit target of 30 pips; the other 50% of the trades went sour and triggered your stop loss. So you've won 100 x 30 pips = 3,000 pips and lost 100 x 15 pips = 1,500 pips, for a gross revenue of 1.500 pips total. Gross revenue, because you still have to deduct the spread, i.e. the transaction cost you pay your broker, remember? Let's say the spread is 2 pips per position, meaning your 200 trades costed you 400 pips. Your net revenue then, was 1.100 pips over 200 trades, or 5.5 pips per trade.
Of course data on 200 trades isn't enough yet to be of statistical significance, but at least it would give you something to work with: on average, each trade nets you 5,5 pips.
Forex Beginner Tip 4. Interact with other traders
For beginning traders an often overlooked source of information is other traders. Of course, reading books about forex is important. Books can provide you with a solid basis in a short time, providing a foundation to build on.
Practicing is another important factor to get the hang of things quickly, but you'd be surprised to find out how often fellow traders can give you valuable feedback about your trading strategy, or about alternative ways for putting on a particular trade. You should therefore become part of an online forex community and consider starting a trading blog, so people can comment on your strategy.
Don't be embarrassed because you're a beginner; remember that we all started out as beginners at some point, and many of the traders you'll meet on online trading forums are also just starting out.
Forex Beginner Tip 5.Keep your emotions under control
This last trading tip is perhaps the most important one. As previously said, trading on the forex is exciting, fun and dynamic, but it's crucial not to get carried away because of this. Successful traders approach trading like a business, not a hobby.
You use your trading capital to make business decisions; some will make you money, others will cost money, it's that simple. But as soon as you lose sight of your rationality I promise you that the losses will stack up pretty quickly.
I'm talking about those moments that you do move your stop loss, because you just can't get yourself to take the hit. Or those moments that you decide to get in right now, even though your trading plan tells you to wait, because you're so scared to miss the trade, or perhaps you're just bored. Those moments that you're so mad that you lost 10 trades in a row that you start trading with triple your normal risk, taking positions in currency pairs you normally never trade in.
Those are the moments you lose in 30 minutes what it took you three weeks to build up.
from: Forex for Ambitious Beginners, Jelle Peters, Odyssea Publishing 2012
