GBP/USD Forex Trading Strategy

A look back in history

The British pound (also recognized by other names such as Sterling or Pound Sterling) is among the oldest currencies in circulation worldwide. For over a century the United Kingdom had the status of the largest global power. This was the nation with the largest economy in the world and the nation with a dominant presence in the international trade.

At that time its currency, the pound, had the status of the worlds reserve currency. After the first and the second World Wars, however, the United Kingdom plunged into a period of relative descent. Economy stagnated as a result of heavy government regulation and severe labor market conditions. It was during that period, when the United States emerged as the worlds economic superpower. Later, in the 1980s the UK economy managed to regain its vitality, while the country, and more precisely the capitol city of London, obtained the status of a global financial center. With local and expatriate bankers crowding into the city, the financial sector began to play a key role for overall economy.

Economy of the United Kingdom and major economic indicators

The United Kingdom is the sixth largest economy worldwide with a nominal GDP of USD 2.54 trillion in 2013 and also the eighth largest economy in terms of GDP measured by purchasing power parity (USD 2.39 trillion), according to the International Monetary Fund.

The nations economy is service-oriented, with services sector accounting for approximately 77.8% of the GDP as of the first quarter of 2014. The financial services industry added gross value of 116 363 million GBP to economy in 2011, according to the 2013 Blue Book report. The city of London is renowned as one of the three command centres of international economy alongside New York and Tokyo. London is a leading centre for industries such as banking (over 500 banks have their offices based in the city), insurance, foreign exchange and energy futures trading.

United Kingdom is among the largest producers and exporters of natural gas in the European Union. In Europe the United Kingdom is second largest oil and gas producer following Norway.

The case with adopting the euro

The United Kingdom refused to adopt the euro in June 2003. If the country had joined the European Monetary Union (EMU), this would have considerable consequences for the economy. Interest rates in the UK would need to be adjusted to the equivalent interest rate in the Euro zone.

As the UK policymakers are highly concerned with voter approval, in case the vote does not favor the adoption of the euro, an entry in the EMU is not very likely. There have been a number of opinions in favor and against the adoption of the single currency. More on the topic, you can read in our article “Profile of the United Kingdoms pound”.

Economic indicators

Here we provide a list of macroeconomic indicators, which tend to cause the largest influence on the British pound on the global markets.

– Bank of Englands monetary policy

– Employment change

– Gross Domestic Product (GDP)

– Industrial production

– Trade Balance

– Purchasing Managers Index (PMI)

– Retail Price Index (RPI)

More details on these indicators you can find in our article “Profile of the United Kingdoms pound”.

Economy of the United States and major economic indicators

The United States is the world’s largest economic power with a nominal Gross Domestic Product (GDP) at the amount of $16.8 trillion in 2013. It represents almost 25% of the global nominal GDP. It is also the world’s second-largest trading nation, following China.

The US economy is primarily service-oriented, as almost 80% of the GDP is produced by sectors such as real estate, transportation, financial services, other business services and health care.

The country is the second largest manufacturer in the world with an industrial production of $2.43 trillion during 2013, or larger than the output of Germany, France, India and Brazil combined. Major industries are petroleum, steel, automobile production, aerospace, construction and agricultural machinery, chemicals, electronics, telecommunications.

Moreover, as of 2013 the United States is the third-largest producer of oil (8 453 000 barrels per day, or 9.97% of the global total oil production) and the largest natural gas producer (66.5 billion cubic feet per day).

Taking into account the sheer size of the US economy and its pillars of strength, one can clearly understand the effect of economic data from those sectors on the US dollar, and in turn on the global Forex market. After all, the greenback stands on one side of 87% of all trades, according to the BIS.

Economic indicators

Here we provide a list of macroeconomic indicators, which tend to cause the largest influence on the United States dollar on the global markets.

– Non-farm payrolls

– Consumer Price Index

– Producer Price Index

– Trade Balance

– ISM Non-manufacturing

– ISM Manufacturing

– Federal Reserve Minutes

– Consumer Confidence (released by the Conference Board research group and Thomson Reuters/University of Michigan)

– Retail Sales

– Industrial Production

More details on these indicators you can find in our article “Profile of United States dollar”.

Specific features of GBP/USD

GBP/USD, often referred to as the Cable by market players, is a vastly traded currency pair on the Forex market. Because it is that widely traded, GBP/USD is considered as one of the most liquid and cash rich pairs on the market. It also belongs to the group of the so called “major currency pairs”.

GBP/USD accounts for 85% of all of the currency cross rate trades, that occur at any moment in time. According to the current Bank for International Settlements (BIS) survey, the pair takes third position amid the most traded major currency pairs, as it comprises 14% share in the total daily trading volume.

GBP/USD usually demonstrates a wider price range compared to other major pairs. It is so, because this pair reacts more impulsively and tends to be highly unpredictable, which brings us to one exceptionally important feature – volatility. We shall take a closer look to it later in the article. Due to this wide price range, the pair is granted higher spread quotation by Forex brokers.

GBP/USD is able to provide a trader with a considerable amount of pips with one simple move, if compared to other majors such as USD/JPY, USD/CHF or EUR/USD. This feature makes the pair suitable for breakout trading, but however, one needs to be aware of the risks associated with this type of trading. It also requires a trader to place his/her stop-losses at a greater distance.

Last but not least, as GBP/USD tends to act impulsively and unpredictably, it leads to a great number of false signals and fake breakouts. It is the reason why this pair is not suitable to trade for beginners or traders with insufficient experience. Let us put it this way – it would be better, if a novice does not begin his/her Forex trading career by focusing on GBP/USD. On the other hand, as a trader amasses experience, studies the nuances of both currencies, their characteristics and their typical swings, which drive the pair up or down, as well as the way the pair reacts to political or economic news and events, GBP/USD may turn out to be quite a reliable instrument to trade.

Additional essential facts in regard to the British pound we provide in the article “Profile of the United Kingdoms pound”.

Midnight trading

After having back tested and analysed historical data randomly for GBP/USD, traders have come up with the conclusion that the midnight trading concept could be used to their advantage. It has proven to have a 1:1 risk-to-reward ratio. In addition, midnight trading of GBP/USD has proven to suit any trading system on the 15-minute charts. The midnight trading pattern needs to be based on the close of the first 15-minute bar on the GBP/USD chart past midnight based on GMT. If a trader makes an entry at the closing price of the first 15-minute bar past midnight, there is a greater probability that the pair will move in his/her favor than against him/her. Placing a stop order to buy 50 pips above the closing price and placing a stop order to sell 50 pips below the close will likewise appear to be a successful approach.

A possible entry would be, if a trader places a 20-pip stop-loss and a 20-pip limit order. Once one of the orders gains momentum, the trader needs to cancel the other order. As for the exit, the trader may place a 20-pip stop-loss and take profit at a distance of 20 pips.

Properties of the GBP/USD cross

Average spread

Depending on the Forex broker used, the spread can be fixed, floating, or both. For the purpose of this article, we have chosen the average spreads provided by 10 brokers, namely Saxo Bank, Dukascopy, Alpari UK, XM, Forex.com, FxPro, Markets.com, eToro, FXCM and Iron FX, and aggregated all the spread data provided to a single average spread, in the GBP/USD case – 2.07 pips.

Relative performance against other pairs

We conducted a series of calculations to gauge the performance of the GBP/USD pair relative to other crosses which include either the pound, or the US dollar over a certain period of time. For details about the calculation’s variables, visit the appendix.

Let us begin with Table 3, which visualizes the strength of the pound versus a number of currencies. On July 14th 2014 GBP/USD registered a prominent high at 1.7143. From this trading day until the end of the year we analyzed the performance of each currency pair in the table, using the high price on July 14th and the closing price on December 31st. We chose to present the performance of each pair as a gain/loss measured in pips and as a percentage. As can be seen from the table, the pound gained the most against the Norwegian Krone (or 9.288%) during the selected time span, while its worst performance was recorded versus the US dollar (a 9.147% depreciation).

On the basis of results in Table 3, we move on to rank each of the 9 currencies. Table 3.1 shows that the US dollar has been the strongest currency, followed by its Canadian counterpart, the UK pound was ranked 3rd, while the Norwegian krone has been the weakest currency.

In Table 1, which reflects the strength of the US dollar against a number of currencies, we have conducted similar calculations, this time on the basis of the EUR/USD cross. EUR/USD registered a prominent high on May 8th 2014 at 1.3993, respectively this has been a prominent low for the US dollar against the euro. In the case with EUR/USD we inverted the result, so that it represents the change from the US dollar’s point of view (which means that the figure would actually represent the USD/EUR’s movement). The same is valid for GBP/USD, NZD/USD and AUD/USD. For each pair in the table we used the low price on May 8th and the closing price on December 31st. The US dollar gained the most against the Russian ruble, showed almost no change against its Hong Kong counterpart and lost ground against the Chinese yuan only.

On the basis of results in Table 1, we move on to rank each of the 22 currencies. As can be seen from Table 1.1, the Chinese yuan has been the strongest currency, followed by the US dollar, the pound has been ranked 8th, the euro – 14th, while the ruble has been the worst performer among this particular list of currencies. The sterling has lost 8.018% against the dollar, the euro has plunged 13.521%, while the ruble has depreciated by 70.913% during the examined period.

Correlations to other pairs

The term “correlation” refers to the connection between two assets and how they move in relation to each other. As a key component of advanced portfolio management, correlation is crucial for achieving maximized risk-adjusted return. Ranging between -1 and +1, a correlation close to the upper limit means that the two currencies are moving in almost perfect consonance, allowing for almost no diversification, and vice versa. A correlation of 0, which in the world of finance practically does not exist, means that movement of the two assets is completely random.

Below you can see two tables, which present those currency pairs that demonstrated the strongest positive correlations relative to GBP/USD and those crosses, showing the strongest negative correlations. The statistics are derived from daily market data, encompassing 300 periods (trading days), or approximately the whole year 2014.

Volatility

The term “volatility” in Forex refers to the fluctuations a currency pair exhibits during trading. These fluctuations directly impact the amount of risk a trader is subjected to, but also affect his/her return. A higher volatility means that the currency pair could potentially perform a sudden and drastic move in either direction over a short period of time.

In contrast, low volatility implies that the exchange rate does not have the potential for wide fluctuations and instead moves at a steady pace over a longer period of time. Lower volatility carries less risk for market participants, but it is also much harder to profit from, especially by shorter-term traders such as scalpers and day traders.

For the purpose of this article, we have selected to display historic volatility calculated over the last 52 weeks, or the period between January 1st 2014 and December 31st 2014. In order to measure historic volatility of each currency pair on our list, we use two methods similar to the Average True Range:

Intraday Volatility (%) = {(Intraday High – Intraday Low) / Intraday Low}%

and

Daily Volatility (%) = {(Current Daily High – Previous Daily Low) / Previous Daily Low}%.

Below are the results in regard to GBP/USD during the examined period.

As can be seen from the table, GBP/USD showed an average intraday volatility of 0.479% during the past 52 weeks, while the pairs average day-to-day volatility was 0.461%. During the examined period the pair tended to show a lower volatility in comparison with other majors such as NZD/USD, for instance. Table 4 in the appendix presents generalized data regarding the average annual volatility, shown by the seven major pairs in 2014.

At the beginning of the year the pair tended to have the most significant daily volatility. In late January and early February the cross showed daily moves of over 110 pips. As the year progressed, the daily volatility decreased, as in May and June the pair showed daily moves of under 100 pips. The lowest daily volatility (about 85 pips) was registered in late August.

Within a trading day the highest volatility was registered between 8:00 and 9:00 GMT (25-30 pips per hour). The pair continued to be more active until 15:00-16:00 GMT, when a drop to under 15 pips per hour was observed. The lowest volatility during the trading day was recorded between 3:00 and 4:00 GMT and between 22:00 and 23:00 GMT (under 10 pips per hour).

Within a trading week the pair tended to show the highest volatility on Wednesday (about 100 pips) and the lowest volatility on Monday (about 80 pips).

Carry trade

Carry trades are one of the most popular trading strategies used in the Forex market. When performing a carry trade, a trader typically sells a currency with a relatively low interest rate, while purchasing a higher-yielding one. The objective is to profit from the difference in interest rates, which can be substantial, especially when taking into account leverage. To learn more about carry trades, please read our article “Using Carry Trades to Maximize Profit”.

At present, the GBP/USD pair could be used in carry trades, but they would not be that profitable. Bank of England has maintained its benchmark interest rate (repo rate) at the current record low level of 0.50% since its policy meeting, held on March 5th 2009. There have been several indications that the first rate hike may occur in the spring of 2015.

At the same time, the Federal Reserve Bank has kept its benchmark rate within the range of 0%-0.25% at the past 47 consecutive meetings. The Fed has committed to begin raising borrowing costs also in 2015, having already concluded its Quantitative Easing program. As long as this difference between interest rates in the United States and the United Kingdom is in place, GBP/USD may be used in carry trades. In the future such opportunities will depend on the pace, by which each of the two financial institutions raises borrowing costs and, of course, on the timing.

Let us provide an example. With the help of a standard carry trade calculator we can conclude that a long position in GBP/USD with a standard lot and a holding period of 30 days would earn us $20.55 in interest. The respective earnings would be $2.05, if we held 1 mini lot, and $0.21, if we held 1 micro lot. For the sake of comparison, if we went long the NZD/USD pair with the same amount and holding period, this would earn us $267.12. The respective earnings would be $26.71, if we held 1 mini lot, and $2.67, if we held 1 micro lot.

Trading strategies

Highest trading volumes and volatility can be expected during the European and the US trading sessions, and more particularly when key economic indicators are released. It is logical to expect that the most intense trading will occur at the release of economic reports such as the US non-farm payrolls and UK unemployment rate, US consumer sentiment and spending, US or UK manufacturing and non-manufacturing activity growth, US durable goods orders, US or UK consumer inflation, US or UK retail sales, US or UK balance of trade, US or UK industrial/manufacturing production and last but not least, policy decisions by the Federal Reserve or the Bank of England.

Trading the fundamentals

Trading the major economic releases and other events without the help of technical analysis is basically done using three general strategies – using a proactive, a reactive or a mixed approach. Proactive trading suggests entering a position ahead of the release of the data and basing your decision on analysts’ forecasts, while the reactive approach implies entering the market after the data is published. Logically, a mixed approach combines the previous two. To learn more about these styles of fundamental trading, read our articles “Trading the News – Proactive Approach“, “Trading the News – Reactive Approach” and “Trading the News – Combining the Proactive and the Reactive Approaches“.

Technical trading

Breakouts from a narrow range

Let us take a look at a simple trading strategy, that can be applied in the case with the GBP/USD pair. A breakout from a narrow range is referred to price movement from a period of low volatility to a period of high volatility. Imagine a case, when the price moves within quite a tight range and then another case, when the price range increases a few times the original “narrow” size. Forex traders constantly look for such tight ranges, because they indicate that a huge move may be on the horizon. They would trade the possible breakout in the direction of the underlying trend.

In case the daily trend is a bullish one, a trader would wait for a breakout from the ”upper bound of the range”, or above the narrow range bars high. In this case the trader would not take into account any bearish signals.

In case the daily trend is a bearish one, a trader would wait for a breakout from the ”lower bound of the range”, or below the narrow range bars low. In this case the trader would not take into account any bullish signals.

In case the daily trend is actually a trading range, a trader would expect breakouts from either side.

The narrow range breakout setup usually involves either a doji bar or a spinning top bar, as they have small bodies, reflecting the tight price range. A breakout above the upper wick of these bars signifies a signal to buy, while a breakout below the lower wick of these bars signifies a signal to sell.

On the 1-day chart of GBP/USD above we can see that the November 14th bar was actually a spinning top. Its high was at 1.6099, while its low was at 1.5987. The next bar, on November 15th, had a wide price range, which breached above the high of the spinning top bar.

If a trader prefers a more aggressive approach, he/she will look to buy the breakout above the high of the preceding bar. He/she will place a stop-loss at a distance 10 pips below the low of the current bar. The trader will set a profit target just below the new zone of resistance, or in the area around 1.6220.

If a trader prefers a more conservative approach, he/she will wait for the daily bar to close above the high of the preceding bar before making a long entry in the market. He/she will place a stop-loss at a distance 10 pips below the low of the current bar. The profit target will be set as with the previous case.

On the chart we can see the high and the low of the range bar, marked with green and red dotted lines. If the move on the next day is above the high, then it is a bullish one. If the move on the next day is below the low, then it is a bearish one. Because the daily trend was up, a trader would ignore bearish signals and look for bullish signals only. It is so, as they are in line with the major trend.