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Did you know that the US dollar (USD) and the euro (EUR) are two of the most widely traded (liquid) currencies globally? According to the Bank for International Settlements (BIS) Triennial Central Bank Survey, the US dollar was on one side of 88% of all trades in April 2022, with the euro on one side of nearly 31% of all trades over the same period.
This makes the EUR/USD the most traded currency pair in the world.
The EUR/USD exchange rate is made up of a base currency (the first listed currency in a pair’s quotation and always represents 1 unit [the EUR]) and a quote currency, sometimes referred to as a term currency (this provides the value of the base currency in terms of the quote currency [the USD]).
Importantly, as a trader or investor in the foreign exchange space, the EUR/USD currency pair’s price movements are measured in what is referred to as pips. A pip, or price interest point, or 1/10,000th to the fourth decimal, is the smallest (whole) price movement a currency pair can make (whole because a currency pair also moves in points, which is 1/10th of a pip). Aside from the liquidity mentioned above, another key benefit of trading this currency pair is it can be traded around the clock, five days a week, unlike physical share dealing, which is restricted to exchange opening hours.
When trading the EUR/USD, you trade two major economies: the European Union and the United States.
The European Union (EU) is a single market of 27 countries, allowing the free movement of goods, services and labour. And out of those 27 countries, 20 have adopted the euro as their official currency: the euro area. Of note, the EU, the US and China are the three largest economies in the world, according to GDP (Gross Domestic Product). As you can see, the US economy remains the world’s powerhouse, the largest economy in the world according to GDP.
Source: The World Bank
Two prominent vehicles of analysis are used to assess current and future price movement on the EUR/USD: technical analysis and fundamental analysis. Many will also combine the two analytical techniques to form trading decisions.
Technical analysis involves the study of historical price action, volume studies, and implied volatility to define and identify trends across many different asset classes.
Trend-following strategies are a popular approach for many technical traders and investors in FX, which generally falls under the umbrella of position trading and swing trading (considered medium to longer-term trading styles). How one attempts to recognise and take advantage of trends will be trader-dependent.
A common approach, and one of the most basic, is to adopt the use of trendlines. These ascending and descending lines are applied to swing highs and lows to identify the underlying trend, with many trendlines requiring at least two points of contact before being considered valid. Their primary use is to identify the trend and a potential trend reversal. Once a trend is identified, the user may look to trade into the trend through corrections and pullbacks to the trendline (which often functions as support or resistance) or attempt to trade a trend change through a trendline break.
As shown in Figure 1, the daily chart of the EUR/USD, we have been in a downtrend since 2008. However, as demonstrated by the handful of trendline resistance breaks, the downside strength is slowing (thus, new trendline resistances are applied until they can no longer be logically useful to the trader). You may also note that a trendline support has been applied to the chart, but this will only be active if the price forms a fresh higher high (to be clear, this image has used longer-term swings here, and some traders may prefer to zoom further in on price action and use smaller swings to apply trendlines).
The bottom line is that a trendline can identify a trend, help trade into a trend, project trend weakness and potentially offer a setup to trade a trend reversal.
Source: TradingView
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While trendlines are widely popular, several ways of successfully trading the currency market are used. There is no one-size-fits-all here. For example, some traders look at momentum using momentum oscillators like the Relative Strength Index (RSI); some look at volatility and trade when volatility expands following a contraction: the Bollinger Bands are particularly useful for this. Many will also incorporate technical indicators and price action concepts to form confluence to generate an area of support and resistance.
The list is endless in how one can trade and, as underlined above, will be unique to that trader/investor. It entails exploring different approaches until one offers sufficient positive expectancy and fits with one’s personality.
Dollar Index
Traders and investors also often employ the use of the US Dollar Index, which is a geometrically average weighted value of the dollar against a basket of six major currencies, including the EUR (which controls about 57% of the overall index weight), the British pound (GBP) and the Japanese yen (JPY). Traders use this index to gauge the US dollar's strength (or weakness). For instance, breaching major support on the US Dollar Index can add weight to a bullish signal on the EUR/USD. This is primarily due to the inverse correlation between the Dollar Index and the EUR/USD.
It is largely all about the macroeconomic picture when trading the Forex market using Fundamental analysis: assessing the overall health of an economy through economic aggregates.
Things generally begin at the top with macroeconomics: the central banks—monetary policy and guidance. Central banks influence the supply and demand of their currencies. In the case of the EUR/USD, the focus is on the European Central Bank (ECB) and the US Federal Reserve (the Fed); the policy movements of these two central banks directly influence the currency pair.
If a central bank increases its interest rates, it aims to slow economic activity to discourage borrowing and spending. We saw this in 2022 as major global central banks, aside from the Bank of Japan (BoJ), embarked on global policy tightening to stem inflationary pressures. Peak inflation for the euro area reached 10.6% in October 2022 and, as of a recent release, inflation has slowed to 2.4% on a year-on-year basis (in the twelve months to November 2023). In the US, peak inflation hit 9.1% in June of 2022 and has since eased to 3.2% on a year-on-year basis as of October 2023.
With the help of central bank forward guidance—this is the communication from a central bank on the potential path of interest rates and bank projections regarding key indicators, like growth and inflation—some economic indicators become important to monitor. Macroeconomic statistics, therefore, play a vital role in the FX market. Major emphasis is placed on three main economic indicators: the GDP (Gross Domestic Product), inflation (the average price levels in an economy) and unemployment (the fraction of the labour force that is unemployed).
In terms of release schedules, approximately five key economic indicators are released each week. Of course, there could be more in some weeks. No single indicator can provide a clear picture of the economy’s health. At best, each indicator provides a ‘snapshot’ of current conditions. But when piecing the economic indicators together, you should get a clearer picture of how the economy is faring.
The key point to remember is the central bank informs market participants what economic indicators they are watching. So, for instance, if the central bank is paying close attention to inflation data and CPI shows deviation from the forecasted number, then volatility can be expected to increase across the respective currencies.
It is also important to note that the economic indicators create a short-term bias in the markets, but the central bank creates a long-term trend. Optimal trading opportunities tend to show themselves when economic numbers are in harmony with the longer-term bias. What this means is if the Fed is expected to increase rates in the near future to combat inflation, for example, an increase in inflation will likely underpin the USD and offer a trading opportunity as traders and investors will flock to the buck on the back of expectations of higher yield (increases the expectation of the Fed raising rates). And this is where technical analysis can come into play; you can use it to time your entries.
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