Tactical trading considerations in EUR/USD

We’ve looked at the major trading attributes of EUR/USD and now its time to look at how those elements translate into real-life trading tactics. After all, that’s where the real money is made and lost.

Deciding whether it’s a U.S. dollar move or a euro move

As discussed in my previous post,  I mention that EUR/USD routinely acts as the primary vehicle for forex markets to express their view on the USD. At the same time, I also indicated that EUR/USD will also react to euro-centric news and data. So for traders approaching EUR/USD on any given day, it helps to understand whether the driving force at work is dollar-based or euro-based. Are they bearish on the USD, or are they bullish on the EUR? Or is it some combination of the two?

Having a sense of which currency is driving EUR/USD at any given moment is important so you can better adapt to incoming data and news. If it’s a EUR-based move higher, for instance, and surprisingly positive USD news or data is released later in the day, guess what? We’ve got countertrend information hitting the market, which could spark a reversal lower in EUR/USD (in favour of the dollar). By the same token, if that U.S. data comes out weaker than expected, it’s likely to spur further EUR/USD gains, because EUR-buying interest is now combined with USD-selling interest.

Being patient in EUR/USD

Also in my previous post,  we explore why EUR/USD can spend hours trading in relatively narrow ranges or testing technical levels. The key in such markets is to remain patient based on your directional view and your technical analysis. You should be able to identify short-term support that keeps an upside test alive or resistance that keeps a down-move going. If those levels fail, the move is ‘stalling at the minimum and may even be reversing.

Taking advantage of backing and filling

Because EUR/USD tends to retrace more of its short-term movements, you can usually enter a position in your desired direction by leaving an order to buy or sell at slightly better rates than current market prices may allow. If the post-08:30 ET U.S. data price action sees EUR/USD move lower, and you think getting short is the way to go, you can leave an offer slightly (roughly 5 to 10 pips) above the current market level and use it to get short, instead of reaching out and hitting the bid on a downtick.

If your order is executed, you’ve got your desired position at a better rate than if you went to market, and you’re probably in a better position rhythm-wise with the market (having sold on an up-tick). Alternatively, you can take advantage of routine backing and filling by dealing at the market by selling on up-ticks and buying on down-ticks.

Allowing for a margin of error on technical levels

When it comes to determining whether EUR/USP has broken a technical level, we like to use a 10- to l5-pip margin of error. Shorter-term traders may want to use a smaller margin of error.) Some very short-term traders and technical purist like to pinpoint an exact price level as support or resistance. If the market trades above or below their level, they’ll call it a break and that’s that. But the spot forex market rarely trades with such respect for technical levels to make such a clear and pinpointed distinction. And given the amount of interest in EUR/USD, it’s especially prone to hazy technical lines in the sand.

The key point to take away from this is that all sorts of interest emerge around technical levels, and it’s still going through the market even though the pinpointed level might have been breached. And this is where our margin of error comes in. Again, it’s not a hard and fast rule, but generally speaking, EUR/USD will have chewed through most of the market interest around a technical level within about 10 to 15 points beyond the level. 

Trading Behavior of EUR/USD)

The deep liquidity and tight trading spreads in EUR/USD make the pair ideal for both shorter-term and longer-term traders. The price action behavior in EUR/USD regularly exhibits a number of traits that traders should be aware of.

Trading tick by tick

In normal market conditions, EUR/USD tends to trade tick by tick, as opposed to other currency pairs, which routinely display sharper short-term price movements of several pips. In trading terms, if EUR/USD is trading at 1.2910/13, there are going to be traders looking to sell at 13, 14, and 15 and higher, while buyers are waiting to buy at 9, 8, 7 and lower.

In contrast, other less-liquid currency pairs, like GBP/USD and USD/CHF, typically fluctuate in a far jumpier fashion, which is reflected by the wider price spread in those pairs.

Fewer price jumps and smaller price gaps

The depth of liquidity in EUR/USD also reduces the number of price jumps or price gaps in short-term trading. A price jump refers to a quick movement in prices over a relatively small distance (roughly 10 to 20 pips) in the course of normal trading. A price gap means prices have instantaneously adjusted over a larger price distance, typically in response to a news event or data release.

Don’t get me wrong, price jumps/gaps do occur in EUR/USD, as anyone who has traded around data reports or other news events can attest. But price jumps/gaps in EUR/USD tend to be generated primarily by news/data releases and breaks of significant technical levels, events which can usually be identified in advance.

This is in contrast to other major currency pairs where short-term price gaps can develop from a one-off market flow, such as a portfolio manager selling a large amount of GBP/USD or a USD/CHF stop-loss order being triggered. When price gaps do occur in EUR/USD, they tend to be smaller relative to gaps in other pairs. 

Backing and filling

When prices move rapidly in one direction, they tend to reach a short-term stopping point when opposite interest enters the market. For instance, let’s say EUR/USD just traded higher from 1.2910/13 to 1.2922/25 in relatively orderly fashion, tick by tick over two minutes, meaning no price gaps. When the price move higher pauses, short-term traders who were long for the quick 12-pip move higher will look to exit and sell.

As selling interest begins to enter the market and prices stop rising, other not-so-fast longs will also start hitting bids (selling), pushing prices lower. From the other side, traders who missed the quick run up, or who were not as long as they wanted to be, will enter their buying interest in the market. Other buyers, sensing selling interest, may wait and place their buying interest at slightly lower levels. This back-and-forth consolidation after a short-term price movement is referred to as backing and filling. The price backs up and fills the short-term movement, though it can happen in both up and down price movements.

When it comes to EUR/USD price action, backing and filling is quite common and tends to be more substantial than in most currency pairs, meaning a greater amount of the directional move is retracecl. Look at figure below to get a visual idea of what backing and filling looks like. When EUR/USD is not backing and filling the way you would expect, it means the directional move is stronger and with greater interest behind it.

Figure: A one minute EUR/USD chart showing periods of backing and filling price action after short-term directional moves. Backing and filling occurs in price declines, too.

Prolonged tests of technical levels

When it comes to trading around technical support and resistance levels, EUR/USD can try the patience of even the most disciplined traders. We say this because EUR/USD can spend tens of minutes (an eternity in forex markets) or even several hours undergoing tests of technical levels.

This goes back to the tremendous amount of interest and liquidity that defines the EUR/USD market. All those viewpoints come together in the form of market interest (bids and offers) when technical levels come into play. The result is a tremendous amount of market interest that has to be absorbed at technical levels, which can take time.

Looking at GBP/USD) and USD/CHF as leading indicators

Given the tremendous two-way interest in EUR/USD, it can be very difficult to gauge whether a test of a technical level is going to lead to breakout or a rejection. To get an idea of whether a test of a technical level in EUR/USD is going to lead to a break, professional EUR/USD traders always keep an eye on GBP/USD and USD/CHF, as they tend to be leading indicators for the bigger EUR/USD and dollar moves in general.

If GBP/USD and USD/CHF are aggressively testing (trading at or through the technical level with very little pullback) similar technical levels to EUR/USD (for example, daily highs or equivalent trend-line resistance), then EUR/USD is likely to test that same level. If GBP/USD and USD/CHF break through their technical levels, the chances of EUR/USD following suit increases. By the same token, if GBP/USD and USD/CHF are not aggressively testing the key technical level, EUR/USD is likely to see its similar technical level hold.

GBP/USD and USD/CHF lead times can be anywhere from a few seconds or minutes to several hours and even days. Just make sure you’re looking at the equivalent technical levels in each pair.

The vast majority of trading volume takes place in the major currency pairs: EUR/USD, USD/JPY, GBP/USD, and USD/CHF. These currency pairs account for about two-thirds of daily trading volume in the market and are the most watched barometers of the overall forex market. When you hear about the dollar rising or falling, it’s usually referring to the dollar against these other currencies.

Even though these four pairs are routinely grouped together as the major currency pairs, each currency pair represents an individual economic and political relationship. We will look at the fundamental drivers of each currency pair to see what moves them. We will also look at the market's quoting conventions and what they mean for margin-based trading.

Although it’s important to understand why a currency rate moves, I think it’s also essential to have an understanding of how different pairs’ rates move. Most currency trading is very short-term in nature, typically from a few minutes to a few days. This makes understanding a currency pair’s price action (how a currency pair‘s price moves in the very short term) a key component of any trading strategy. 

The Big Dollar: EUR/USD

EUR/USD is by far the most actively traded currency pair in the global forex market. Everyone and his brother, sister, and cousin trades EUR/USD. This will come as no surprise to anyone who has traded in the forex market, because if you have, more likely than not you traded EUR/USD at some point.

 The same goes for the big banks. Every major trading desk has at least one and probably several, EUR/USD traders. This is in contrast to less liquid currency pairs such as GBP/USD or AUD/USD, for which trading desks may not have a dedicated trader. All those EUR/USD traders add up to vast amounts of market interest, which increases overall trading liquidity.

Trading fundamentals of EUR/USD

EUR/USD is the currency pair that pits the U.S dollar against the single currency of the Eurozone, the euro. The Eurozone refers to a grouping of countries in the European Union (EU) that in 1999 retired their own national currencies and adopted a unified single currency. In one fell swoop, at midnight on January 1, 1999, the Deutsche mark, Italian lira, French franc, and nine other European currencies disappeared and the euro came into being.

The move to a single currency was the culmination of financial unification efforts by the founding members of the European Union. In adopting the single currency, the nations agreed to abide by fiscal policy constraints that limited the ratio of national budget deficits to gross domestic product (GDP), among other requirements. The nations also delegated monetary policy (setting interest rates) to the newly founded European Central Bank (ECB).

As of this printing, the countries that use the euro are: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Slovenia, and Spain. All together, the Eurozone constitutes a regional economic bloc roughly equal to the United States in both population and total GDP.

Trading EUR/USD by the numbers

Standard market convention is to quote EUR/USD in terms of the number of USD per EUR. For example, a EUR/USD rate of 1.3000 means that it takes $1.30

to buy €l.

EUR/USD trades inversely to the overall value of the USD, which means when EUR/USD goes up; the euro is getting stronger and the dollar weaker. When EUR/USD goes down, the euro is getting weaker and the dollar stronger. If you believed the U.S. dollar was going to move higher, you’d be looking to sell EUR/USD. If you thought the dollar was going to weaken, you'd be looking to buy EUR/USD.

EUR/USD has the euro as the base currency and the U.S. dollar as the secondary or counter currency. That means

• EUR/USD is traded in amounts denominated in euros. In online currency trading platforms, standard lot sizes are €100,000, and mini lot sizes are € 10,000.
• The pip value, or minimum price fluctuation, is denominated in USD.
• Profit and loss accrue in USD. For one standard lot position size, each pip is worth $10; for one mini lot position size, each pip is worth $1.
• Margin calculations in online trading platforms are typically based in USD. At a EUR/USD rate of 1.3000, to trade a one-lot position worth €l00, 000, it’ll take $1,300 in available margin (based on 100:1 leverage). That calculation will change over time, of course, based on the level of the EUR/USD exchange rate. A higher EUR/USD rate will require more USD in available margin collateral, and a lower EUR/USD rate will need less USD in margin.

Swimming in deep liquidity

Liquidity in EUR/USD is unmatched by other major currency pairs. This is most evident in the narrower trading spreads regularly available in EUR/USD.

Normal market spreads are typically around 2 to 3 pips versus 3 to 5 pips in other major currency pairs.

In terms of concrete numbers, EUR/USD accounted for 28 percent of global daily trading volume, according to the 2004 Bank for International Settlements (BIS) survey of the foreign exchange markets. That’s more than one and a half times the volume of the next most liquid currency pair (USD/JPY).

Liquidity in EUR/USD is based on a variety of fundamental sources, such as

• Global trade and asset allocation: The Eurozone constitutes the second largest economic bloc after the United States. Not only does this create tremendous commercial trade flows, but it also makes Eurozone financiall markets, and the euro, the destination for massive amounts of international investment flows. In April 2007, overall European stock-market valuations surpassed the value of U.S. equity markets for the first time ever.
• Central bank credibility: The ECB has established itself in the eyes of global investors as an effective institution in fighting inflation and maintaining currency stability.
• Enhanced status as a reserve currency: Central banks around the world hold foreign currency reserves to support their own currencies and improve market stability. The euro is increasing in importance as an alternative global reserve currency to the U.S. dollar.

The euro also serves as the primary foil to the U.S. dollar when it comes to speculating on the overall direction of the U.S dollar in response to U.S news or economic data. If weak U.S. economic data is reported, traders are typically going to sell the dollar, which begs the question, “Against what?" The euro is the first choice for many, simply because it's there. It also helps that it’s the most liquid alternative, allowing for easy entry and exit. ,

This is not to say that EUR/USD only reacts to U.S. economic data or news. On the contrary, Eurozone news and data can move EUR/USD as much as U.S data moves the pair. But the overall tendency still favors U.S data and news as the driving force of short-term price movements.

This situation is partly a function of geography and daily trading rhythms, because European data is released about four to eight hours before U.S economic reports are typically issued. On any given day, traders will respond to European news and data and adjust prices accordingly for several hours until U.S. data is released.

Watching the data reports

Country-specific economic reports, such as Dutch retail sales or Italian industrial production, are increasingly disregarded by the forex market in favor of Eurozone aggregate economic data. However, German and French national economic reports can still register with markets as they represent the two larges Eurozone economies. Here’s a list of the major European data reports and events to keep an eye on:

• European Central Bank (ECB) interest rate decisions and press conferences after ECB Central Council meetings: This is when the ECB president explains the ECB’s thinking and offers guidance on the future course of interest rates.
• Speeches by ECB officials and individual European finance ministers.
• EU-harmonized Consumer Price Index (CPI), as well as national CPI and Producer Price Index (PPI) reports
• EU Commission economic sector confidence indicators.
• Consumer and investor sentiment surveys separately issued by three private economic research firms known by their acronyms: Ifo, ZEW and GfK.
• Industrial production
• Retail sales
• Unemployment rate