Trading Central Bank Interventions When Currency Exchange Rates are Overvalued
Central banks often intervene in the forex markets to influence currency exchange rates and a currency trader can make profitable trades when these interventions occur. Why do central banks intervene in the markets? The main reason is to stabilize exchange rates when there is a sudden appreciation or depreciation that threatens a country’s economic growth. For example, if a currency has appreciated in value against other currencies such that its exports are now uncompetitive, the central bank may choose to intervene. In this case, the bank will usually sell its own currency on the markets.
One specific example of how a central bank intervened to devalue its currency and maintain currency exchange rates at competitive levels is the case of the Bank of Japan. The BoJ intervened between 2000 and 2003 to keep the value of the yen lower than the US dollar in order to keep Japan’s exports competitive and maintain its economic recovery. In October 2001, for example, the Bank sold nine trillion yen ($115 billion) when the USD/JPY reached 75.31. In November 2011, the Bank confirmed that it had conducted a ‘stealth’ intervention after the USD/JPY reached 75.35, selling some one trillion yen ($13.3 billion).
When a trader believes that an intervention is about to take place, they can profit from it by opening a position just before it happens and then closing it once the effects of the intervention have happened. In the case of the Bank of Japan interventions, this involves shorting the yen by selling it just before the intervention takes place, and then closing your position by buying it again once its effects have taken place. Trading an intervention can be risky, however, since the currency exchange rates can be very volatile and the trade could easily go against you.
If you are interested in trading interventions, here are some tips to help you determine when one might take place:
- If you know that past interventions have occurred when currency exchange rates have reached a certain level, then another one may happen when the rate starts to move towards that level again. However, this is not always true since the central bank may simply decide that an intervention is too costly or not necessary.
- Finance officials may give clues that they are about to intervene, and you can watch out for these. For example, when a Bank official threatens publicly to intervene in the markets, it may be a sign that one is actually due.
Once you believe an intervention is imminent, here are some tips on how to trade it profitably:
- Use minimal levels of margin: Although this may limit the amount of profit you enjoy, it also protects you from crippling losses if the trade should go against you.
- Always set take-profit and stop-loss orders in order to protect your capital: Take profits should be set at levels reached by past interventions while stop-losses should be placed such that there is enough room for a downside to occur before the intervention takes place.
- Gauge your profit targets based on the levels of past currency exchange rates that triggered interventions.
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