When trading the news, there are three questions that we need to ask ourselves before every trade: Is the news important? Is the surprise large enough? And is the surprise in line with the market’s sentiment?
1. Is the news important?
The first task at hand is to figure out what matters and what doesn’t. The top three pieces of potentially market-moving economic data for any country, which are the employment reports, retail sales, and manufacturing and service sector activity data, also known as the ISM or PMI reports. In addition to these, the Gross Domestic Product (GDP) releases and the inflation reports (consumer and producer prices) are also tradable. What is not tradable are reports like the Beige Book because there is no concrete number for comparison, data is released weekly, and any Japanese or Swiss economic reports are almost always overshadowed by the general sentiment in the market.
If you are having a tough time figuring out if the data is tradable or not, most Forex sites will list the impact that each piece of data may have on the currency. High-impact events are the ones that we want to trade.
2. Is the surprise large enough?
The second question is the trickiest of the three because it is subject to interpretation, but the good thing is that the market will usually do the interpretation for you. As a rule of thumb, if the number is greater or less than the forecast by more than 5 percent, it is considered a big surprise, but sometimes a 2 percent surprise is enough to elicit a big reaction in the currency.
So what should you do? Just wait and see how the market responds to the release. If the currency pair barely budges, then most likely, the surprise is not that significant. If the currency pair immediately shoots higher or falls like a rock, there is a good chance that the market was surprised. The key is to wait five minutes before getting into the trade to make sure that the currency responds the way that it is supposed to. In other words, a positive surprise should drive the currency pair higher and a negative surprise should drive it lower.
3. Is the surprise in line with the market’s sentiment?
The third question is important because sometimes the economic data is something that we would normally expect to elicit a big reaction, but for whatever reasons the rally fizzles quickly or traders simply don’t care.
This typically occurs when something else is overshadowing the data and driving the general sentiment in the Forex market. It could be anything from the risk appetite to U.S. data or concerns about problems in Europe. If the economic data surprise or “fundamentals” is in line with the prevailing sentiment in the market, it is a stronger trade. In other words, if the market wants to buy dollars and retail sales are strong, it normally gives Forex traders an even better reason to send the greenback higher. However, if the market is worried about the outlook of the U.S. economy because the Federal Reserve is warning that there will be more trouble to come, then good data may not do much for the dollar because it would be looked at with skepticism.
Quantifying the prevailing sentiment in the market can be difficult, but moving averages can help because they measure the current trend in the market by averaging a certain number of past prices. If the data is good and the currency pair is trading above the 50-period moving average on a 5-minute chart (or the data causes the currency to break above the moving average), then there is a better chance that sentiment and fundamentals will support the trade. However, if the data is good and the currency pair is trading well below the 50-period moving average, then it suggests that the prevailing sentiment does not support the economic surprise. In this case, we will not take the trade because we want to have as many key variables aligned in our favor as possible.
To summarize, we only want to trade economic data that is important, with surprises that are large enough to trigger a reaction in the currency, and only if the economic data is in line with the general sentiment in the market. With these guidelines in hand, let me show you how fast and furious news trading works.