Don't be afraid to dip your toe in the volatile forex waters

David Jones
OVER recent years one market type more than any other seems to have grabbed the attention of spread betting clients &ndash; foreign exchange. At the beginning of 2009, as equity markets continued to plumb the depths and were shunned by investors, our spread betting firm saw forex overtake equities in monthly trading volume. <br /><br />Of course the rally in equities since March has brought the stock pickers back, but forex remains as popular as ever. I think there are a few reasons for this, but the main attraction is the sheers volatility of forex. Ultimately, most traders need a market to move in one direction or the other to make money, and forex is seldom dull. For example, in September the pound-dollar pair moved in a near 1,000 point range and daily moves of 100-plus points are not rare. <br /><br />Volatility is a double-edged sword &ndash; it offers the opportunity of quick significant profits, but hand in hand with that goes the risk of much bigger losses than those in quieter markets. Many people, when they have explored the market, can feel fearful. They feel that that there is a &ldquo;special&rdquo; approach to these markets which should be different to others. <br /><br />This is plainly cobblers. Forex is the same as every other market &ndash; it goes up, it goes down and, very occasionally, it goes sideways. Another reason for the appeal of this particular asset is that many people feel that the trends in forex tend to be somewhat more durable than other markets &ndash; there is no reason why some of the simple approaches used in asset classes such as equities, commodities and indices cannot be applied to forex.<br /><br />One simple approach to identify trends is to look for breakouts. I make no apologies for mentioning this tried and tested technique. In common with all trading strategies it does not work all the time &ndash; unfortunately, there is no Holy Grail. But it can help identify when a particular currency pair is experiencing a change in sentiment. <br /><br />The principle behind the approach is sound enough &ndash; a level that has previously been a problem for the market, either on the way up or on the way down, is broken through. You see this over all sorts of time frames, both during the day and the longer-term. To illustrate the technique we can look at the euro/pound exchange rate during the summer.<br /><br /><strong>STEEP DECLINE</strong><br />After a steep decline from March, the euro/pound stabilised in the second half in June and strengthened into July. But this rally ran out of steam just ahead of the 0.8660 area and the exchange rate dipped back into August. Let&rsquo;s just look at the psychology going on here. Markets do not move up and down by magic &ndash; they are driven by the actions of buyers and sellers. The strength ran out of steam at 0.8660 &ndash; so this was an area where the sellers overcame the buyers, the market view was that it had got too high and the euro/pound dropped back.<br /><br />This left a line in the sand for anyone watching the market &ndash; a level where sentiment changed. Some people view these zones as important and will pay attention when the market returns here to see how it reacts. Towards the middle of August, the euro/pound strengthened again but dropped back before eventually moving back up and breaking through this level. <br /><br />If a market breaks through a level that has been a problem in the past, it can be a sign that things have changed. During the previous month, the euro/pound ran into selling around the 0.8660 area and dropped back &ndash; this time around the buyers still seems to have the upper hand suggesting sentiment has changed. Every journey starts with a single step, and breaks like this can signify a new trend is about to start.<br /><br />This break was the start of a new trend &ndash; and it has proved to be an impressive one. Over the next six weeks the euro/pound moved 600 points higher. While unfortunately this sort of breakout will not automatically lead to such moves, many traders do view them as some of the most basic buy or sell signals, and they can be a useful part of a trading strategy. <br /><br />David Jones is Chief Market Strategist at IG Index. See him at The World MoneyShow on 31 October at 3:30, where he will give a talk called Forex: Currency Spread Betting Explained.