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A Must Read For Forex Traders: How to Unpack Risk Sentiment Profiles

Authored by Ivan Delgado Egea, Head of Market Research at Global Prime Forex.

Our market research is also available via Tradingview .

Find out why Global Prime is the highest rated broker at Forex Peace Army.

Would you like to experience first-hand interaction with other like-minded traders and the author? Join our discord room , a place for all to hang out and get to know each other while trading the markets.

In this tutorial, I will explore the different risk profiles that can be at play in the forex market. If you trade risk-sensitive currencies such as the Japanese yen or the Swiss franc, what I am about to explain should be at the very top of your list. You really have to see it as your own little bible to trade JPY or CHF.

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Currency Moves: Function Of Fundamentals & Risk

While moves in the currency market can be influenced by a web of complex factors, ultimately though, these myriads of elements, in its simplest form, boil down to understanding two key drivers:

1. The anticipation of higher or lower interest rates by Central Banks, which creates a divergence in monetary policies as in the current case of the Federal Reserve and the European Central Bank as an example.

2. The other element to complete the equation has to do with risk sentiment. In other words, are we trading an environment conducive for a reshuffling of portfolio strategies into riskier-currencies? Or does fear, uncertainty, and doubt rule the behavior of market participants with safe havens to benefit?

Why Understanding Risk Sentiment Is Cardinal?

Failure to deconstruct the proper trading environment can lead to unnecessary loses just because you didn’t have the knowledge to distill and interpret the right market conditions at play. The fact that financial markets have become so intertwined and dynamic makes it essential to stay constantly in tune with market conditions and adapt to new environments.

The root cause that leads to many aspiring traders to perpetually be jumping from one strategy to another in a constant vicious cycle comes, at its core, from the inability of the system to adapt to the market context. On a rainy day, if you don’t use an umbrella, you’ll get wet, right? In the forex market, one can apply this metaphor by playing long risky currencies (AUD, NZD, CAD) while risk-averse conditions (rainy day) are present. You’ll probably get wet.

This guide focuses on the deconstruction of these different types of risk sentiment scenarios or weather conditions as the analogy goes. It includes a prop model that will assist you to constantly gauge the context that you are trading so that you can significantly reduce the downside risks (wet days) while embracing the days the market offers sunny conditions (profits).

Risk On/Risk Off Currencies & The Heavyweights

Firstly, to get to grips with the proper interpretation of risk sentiment, one has to make the distinction between the currencies linked to ‘risk on’ or risk appetite and the ones that we must associate to ‘risk off’ or risk aversion.

Out of the top eight currencies in the forex market, we can essentially break them down into two main groups as shown below:

  • Risk-off currencies: USD, JPY, CHF
  • Risk-on currencies: AUD, NZD, CAD, EUR, GBP

We can then further distill these currencies into sub-groups. AUD, NZD, CAD are referred to as commodity currencies, while the EUR, GBP, CHF form part of the European bloc. This distinction is important, especially as the lay of the forex land stands in 2020, as it will help us understand market dynamics.

It’s now time to bring to the forefront and incorporate four financial instruments that should always be at the epicenter as the absolute heavyweights to illuminate our path and act as barometers of risk. These include the S&P 500, the US 30-yr bond yield, the DXY index, and to a lesser extent Gold*. The ebbs and flows in these asset classes, when properly interpreted, will open floodgates to a tsunami of fresh knowledge and provide the tools you need to determine what type of risk profile is dominant.

*During 2020, Gold has become a function of USD performance in the majority of cases. As it stands, it has temporarily outlived the same degree of usefulness it used to have to monitor risk.

The RWI Index: A Formula To Follow Risk Flows

Since I am aware that it can be quite daunting to be monitoring the gyrations of up to four different instruments, here is a tip for you. I will provide you with a formula that has become the most intuitive way and my all-time favorite tool to capture the ever-evolving intraday risk sentiment.

On Tradingview, you must replicate the following calculation:

SPXUSD/value SP500 + US30Y/value US30Y — DXY/value DXY

As of Sept 18th, the calculation reads ES1!/2892+US30Y/3.15-DXY/94.42. Note, to keep the accuracy of the index, you must update the values of the denominator at the start of each trading day.

This equation will result in what I refer to as an intraday risk-weighted index (RWI) with an initial score of 1 and a constant fluctuation in value. Note, I use two versions, this one that is best suited for intraday trading, while the second version is a more macro calculation with up to 9 instruments to monitor, accounting for emerging markets, junk bonds in the US, etc. I will probably dedicate an entire tutorial to explain the large version.

What I’ve done is to put together a cheat sheet so that I can make it more visually intuitive and eye candy for you. Find the table below:

You can also watch a video I’ve put together:

Extra Insights: General Rules to Keep In Mind

It’s important to note that in 4 out of the 6 risk scenarios, with the exception of an environment driven by broad-based USD weakness or strength, the RWI will be guiding us with accuracy as a barometer for risk. The way you want to read the RWI is based on its evolving structure and what type of scenario has caused the break into new highs or lows. Then it’s just a matter of matching up that scenario with the most advantageous direction to trade as long as you can find a price that is appealing enough for you to engage as a trader.

The ones that I call extreme ‘risk on’ or ‘risk off’ are the most straightforward, and it involves a surge or decline in both the S&P500 and the US 30-yr bond yield. When these moves occur, independently of the DXY performance, it actually fulfills one of the general rules about risk sentiment, that is, a move in the same direction by the S&P500 and the US30-yr bond yield, either up or down, will result in either ‘risk on’ or ‘risk off’ conditions.

The second and fourth scenario in the table above is what I refer to as ‘solid’ ‘risk on’ or ‘risk off’. In this type of directional move, the S&P500 detaches from the overall positive or negative risk but the fact that both the USD and the US 30-yr bond (not the yield) move in the same direction, communicates that the market is still very much on its toes ready for any risk eventuality.

As I explain in the table, only when a USD-led move develops — 5th and 6th scenarios — , we must resort to the cues provided by the S&P 500*. However, this scenario tends to be tricky to trade at times, as fundamental-led factors may then play a role for a currency to have a temporary disconnect.

*Note, if you trade through Europe, you still can keep the S&P500, but I recommend replacing it with the DAX30 as the leading indicator.

As an example: If we have USD weakness across the board yet the S&P 500 rises, it argues for friendly risk conditions, which may suggest the prospects to buy let’s say GBP/JPY. However, we may find ourselves in a situation where negative fundamental news is having an impact in the sterling, keeping the pair pressured. Therefore, aside from all the scenarios and its respective descriptions, one must always factor in individual currency criteria at play. Knowing your currencies’ fundamentals is vitally important.

Remember, the differentiation of risk scenarios will yield the most benefits when trading the yen or Swiss franc crosses as the currencies most linked to risk. My personal preference is the Japanese yen, as the Swiss franc can at times behave a bit more erratically, playing catch up to the Euro. In my experience, the RWI tends to be best suited if you stick to trading pairs such as the AUD/JPY, USD/JPY, CAD/JPY, NZD/JPY, EUR/JPY, GBPJPY.

At the end of the day, the crux of the matter is to find exploitable divergences that occur between the structure of the RWI and the pricing of the pair.

Remember, if you want to find out how I personally strategize my approach to trading divergences in correlated instruments, you can refer to my guide on trading correlated assets.

Let’s not leave any stone unturned. Allow me to show the strong correlation the RWI has against yen crosses. In the majority of times, the correlation is strikingly high as the chart below illustrates (1h chart on a 30-period).

The times when the correlation breaks down, more often than not, has to do with a USD-driven scenario. When this happens, it tends to debunk the usefulness of the RWI direction and one must look for clues via the S&P500.

Practical Examples: Divergence Between RWI & JPY

Next, we will take a glimpse at a few examples as an exercise to demonstrate the edge one can gain if combining the RWI and a risk-sensitive pair.

Below you can find the RWI, its respective instruments, and in a thick blue line the AUD/JPY as a proxy for risk. Upon closer inspection, you will notice the run-up was on an extreme ‘risk on’ environment. Meanwhile, the topping formation that led to the breakout of the RWI structure came as the S&P500 and the US30yr bond yield both got hammered while the DXY stayed under pressure, which would fit into our 6th scenario of USD weakness. Therefore, the moment the S&P500 cracked support, it was then a matter of finding attractive levels to engage in AUDJPY shorts (white arrows).

In the following example, the RWI broke its bullish structure by creating lower lows as the horizontal orange line is penetrated. Here is the key: The move in the RWI occurs amid USD strength (higher DXY & US 30-yr bond yield), therefore the SP500 will be our ‘lead’. Notice how the break of the structure in the RWI is a function of a sudden drop in the SP500? That’s the trigger to sell the AUD/JPY at the level one may consider being attractive enough.

I personally tend to wait for retests of highs/lows but it doesn’t have to be the case. One can use the RWI to serve you as confirmation to engage in trend trading JPY crosses if you find the index moving in tandem with the pair.

Practice, Practice And More Practice

By now, you’ve probably developed a fairly solid grasp about how the RWI can be an essential tool to incorporate as part of your trading arsenal. Now it’s just a matter of constant practice to perfect your craft and up your game to a whole new level. Don’t forget, nobody likes getting wet on rainy days after all!

Additional Articles By The Author

Admiral Markets Group consists of the following firms:

Admiral Markets Cyprus Ltd

Admiral Markets Pty Ltd

Admiral Markets UK Ltd

Reading books is, of course, extremely beneficial to you. You will always benefit from continuing education, self development, and a bit of light entertainment from time to time.

As a new trader, acquiring the proper knowledge by reading the best Forex books available is arguably one of the most critical aspects of becoming a successful trader. Forex trading books can provide the foundation upon which you can build successful trading strategies, and be able to understand how to select good quality stocks and Forex pairs, while at the same time successfully managing and minimizing risks. Reading should be a top priority for you as a trader.

So where should you begin? It’s all well and good typing ‘what is the best book for candlestick charting?’ into google in a bid to find the right book quickly, but perhaps it is better to have a range of Forex trading books first, together with, a few beginners books, to make sure you’re giving yourself a well rounded knowledge of Forex in general.

So without further ado, here is our list of the best recommended Forex trading books you must read in 2020!

10. “Reminiscences of a Stock Operator” by Edwin Lefevre

Edwin Lefevre’s book focuses on Larry Livingston, who represents a thinly veiled depiction of Jesse Livermore – one of the most famous traders of all time. Readers can follow Mr Livingston on a trading journey that leads through various instances of him being financially broke, and then recovering to amass a fortune each time. Each recovery therein, gives him new strength and a will to finally understand the market’s behaviour.

This veiled biography of Livermore recounts his real-life fame for making and then losing several multi million-dollar fortunes while short selling during the stock market crashes of 1907 and 1929.

9. “The Disciplined Trader” by Mark Douglas

Mark Douglas stresses the importance of a proper trading psychology in his book ‘The disciplined trader’. He discusses how emotions are always the enemy of a trader, and how, even a trader who has limited knowledge of the technical and fundamental understanding of trading, but who has good psychological control, can ultimately be on the winning side.

The author is not ashamed to admit that he has lost almost everything he owned because of his bad trading decisions. That experience led him to a rigorous self-examination, where he discovered that emotions, especially fear, had made him trade with losses.

8. “The Candlestick Course” by Steve Nison

Steve Nison is famous for introducing Japanese candlestick charting to westerners. His first book ‘ Beyond Candlesticks’ showed some advanced techniques of candlestick charting. However, this book summarises candlesticks more generally – making it ideal for new and experienced traders. This price action Forex book should be a perfect choice for learning how to identify which candlesticks to use with a system for successful entries and exits. Traders who have studied all the candlestick patterns presented in this book should have an edge in trading. A must read for all prospective traders.

7. ”How to Start a Trading Business With $500” by Heiken Ashi Trader

Written by a Heiken Ashi trader, many traders begin their business with very little capital. This book gives a realistic way to become a full time trader with limited capital, providing a guidance plan to begin a trading business with capital as low as $500. The core of successful trading is money management, and this book explains how to do so, as well as, how to become a disciplined trader. The book also includes topics such as:

  • Implementing good trading habits
  • Communication skills with your Broker
  • Maximisation of returns from limited capital
  • How to become a Professional Trader
  • Trading activities for a Hedge Fund

6. “Currency Forecasting” by Michael Rosenberg

“Currency Forecasting” is one the best books on Forex trading. Michael Rosenberg, an analyst of Merrill Lynch, wrote the book, and for a long time analysts and traders have referred to this book as it aligns fundamental and technical analyses in a concise matter to help with trading in the Forex markets. Rosenberg has been able to link monetary dynamics with currency market moves; as a guide for traders to predict Currency Forecasts. Currency Forecasting is a classic among Forex technical analysis books, and should definitely be on your bookshelf!.

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5. “Japanese Candlestick Charting Techniques” by Steve Nison

“Japanese Candlestick Charting Techniques” is popular with traders who want to learn about candlestick charts, and how they can be used with other technical tools for technical market analyses. Candlestick charting is used by a range of traders in many markets, ranging from Forex, futures, equities, commodities, or anywhere else that technical analysis can be applied to a market. Authored by Steve Nison, who has years of research study and trading in markets, this makes it a good read for traders who are learning Forex trading strategies.

4. “How to Make a Living Trading Foreign Exchange” by Courtney Smith

Courtney Smith outlines the Forex markets and how to trade on them in his book, “How to Make a Living Trading Foreign Exchange”. Smith’s book details trading strategies for making money on Forex markets, including six key ways to help traders earn a steady income. Smith’s rejection rule includes a strategy aimed to double the profit generated from a basic channel breakout system. Smith’s book on Forex trading also includes risk management aspects to help with the psychological aspects of trading.

3. “Forex Trading: The Basics Explained in Simple Terms” by Jim Brown

Very suitable for beginner traders, this book covers essential elements of Forex trading, including:

  1. Strategies for Entries
  2. Strategies for Exits
  3. Money Management
  4. Trading Psychology
  5. Basic Trading System

With the basic trading system that is included in the book you can build your own trading strategy. If you are approaching Forex trading as a beginner, and would like to have a Forex strategy book that covers the basics in a very clear manner, go and grab it now!

2. “Trading in the Zone” by Mark Douglas

Author Mark Douglas is a trader, trading coach, and has been a industry consultant since 1982. Mark Douglas professes a “thinking strategy” to be the major feature of being a successful trader. Douglas discusses five elements which might help traders become consistent winners in the market.

‘Trading In The Zone’ aims to expose the “people factor” in commodity price action, and the lack of consistency in stock selection. It recommends simple exercises for traders to think in a probabilistic way in order to develop a winner’s mindset. This publication is littered with examples to help traders have a better understanding of their decisions.

This Mark Douglas classic has had a huge impact on trading and charting styles for many traders. Douglas explains the common dangers of trading and different terms of probabilities. Thinking in terms of odds and probabilities, instead of right or wrong, will help you to understand the market structure better than the average trader. Douglas explains this concept well by saying that “to manage risk and allocate capital more efficiently, traders need to be aware of the catalysts, such as earnings, the fundamentals, and the price action of supply and demand”.

1. “Momentum, Direction and Divergence” by William Blau

This book by William Blau is an ideal read for all new and prospective traders. Blau perfectly yet simply describes how most popular oscillators work, including the RSI, Stochastic, and MACD. By reading this book, you may discover very effective and unique ways to measure trend and momentum through MACD as well as divergence. Mr. William has provided the inspiration for all MACD traders, and various trading methods which have inspired traders with new ways of identifying MACD divergence. This Forex trading education book has been the top choice in many lists for top Forex books in 2020.

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Honourable Mention: “Technical Analysis For Dummies” by Barbara Rockefeller

Barbara Rockefeller is a foreign exchange veteran, and one of the pioneers in technical analysis. She has been the author of six books, where this one is actually a must read for disparate types of traders. ‘Technical Analysis For Dummies’ is an absolute classic trading book. The third edition of the book was published in 2020, and provides readers with new insights and an updated look at unique formulas and key indicators. In her book you can learn:

  1. How to determine the markets’ performance
  2. How to spot proper investments
  3. Where to look for the markets’ turning points
  4. How to improve your profits and portfolio performance

When you finish reading, it is always best to actually verify what you have learnt in practise. Theorycraft is one thing, but actually making money in the markets is a totally different beast. Through applying what you have learnt by combining some of the best Forex books to read in the market, together with, the practical knowledge you can receive with our Zero to Hero and Forex 101 online courses, you should be well on your way to potentially achieving financial freedom.

If you are patient and willing to put the time into your education, it may be a lot less work than you think. Taking the time to prepare and thoroughly research every educational option, as well as, setting realistic goals will help you find the right solutions for successful trading.

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.

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