USD/JPY Forex Trading Strategy

USD/JPY Forex Trading Strategy

This article will cover the following

  • Overview of the US economy
  • Overview of Japan’s economy
  • Properties of the USD/JPY cross
  • Average spread, volatility, correlation to other pairs
  • Trading strategies
  • and more

According to the Triennial Central Bank Survey by the Bank for International Settlements (BIS), the currency composition of global Forex trading has been notably shifted during the period 2010-2013. The US dollar remains the world’s major reserve currency, which stood on one side of 87% of all trades in the Forex market as of April 2013. Among other major currencies, the Japanese yen saw the most considerable surge in trading activity, or 63% since the survey conducted in 2010. The yen has significantly increased its share in global currency trading to 23% as of April 2013, which ranked it 3rd (following the US dollar and the euro). At the same time, USD/JPY accounted for 18.3% of the total turnover in April 2013, boosting its positions from a 14.3-percent share in 2010, which ranked the pair 2nd (following the EUR/USD cross).

Economy of the United States and major economic indicators

us flagThe 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”.

Economy of Japan and major economic indicators

japan flagJapan is the third largest economy in the world with a nominal GDP of 4.9 trillion USD in 2013, according to the International Monetary Fund, while in terms of purchasing power parity it is the fourth largest economy (with a GDP of 4.7 trillion USD in 2013).

The country is the third largest automobile manufacturer worldwide, with annualized production of 9.9 million vehicles in 2012. Japan was the largest car manufacturer in 2000, but its market share dropped recently, because of the intense competition by countries such as South Korea and China. The nation’s electronics industry is the largest in the world, despite that Japanese companies have recently been faced with fierce competition by producers from South Korea and Taiwan.

At present Japanese highly diversified manufacturing industry has focused mainly on high-tech and precision products, such as Hybrid vehicles, optical instruments and robotics, with the sector accounting for 18% of the GDP in 2012 and 24% of the GDP in 2013.

Japan is the largest creditor nation in the world for a 22nd consecutive year as of 2013, running a considerable net international investment surplus. Japan is also the second largest sovereign state in the world by global private financial assets, payable in currency, stocks and bonds in 2013 (13.991 billion EUR, following the United States).

As the country is in possession of insufficient natural resources to support its expanding economy and huge population, its exported goods are engineering-oriented and research and development-led, while its imports consist mainly of raw materials and petroleum.

Economic indicators

Here we provide a list of macroeconomic indicators, which tend to cause the largest influence on Japan’s yen on the global markets.

– Gross Domestic Product

– Current Account

– Tankan survey

– Industrial Production

– Machine Orders

– Employment

More details on these indicators you can find in our article “Profile of Japan’s yen“.

Specific features of USD/JPY

up-arrowAfter over 30 years of unprecedented economic growth, at one point during the 1980s, there was conjecture that Japan’s yen would join the US dollar as one of the global reserve currencies. However, the prolonged economic decline, that followed, has put an end to this supposition. In the early 1990s the bullish sentiment in Japan’s stock and real estate markets came to an end, which triggered a sudden economic slowdown and over two decades of deflationary processes. During this period the Japanese government has been seeking to revitalize economy and return GDP growth to the formerly seen robust rates. Despite that this objective has not been accomplished completely, Japan has claimed its place among the most powerful countries economically in the world.

Japan is considered as a proxy for Asian economic strength, having the second largest GDP on the continent. As Japanese capital markets are the most developed, in the past the country was the primary destination for foreign capital. Also, due to intense trade flows between Japan and other Asian countries, any economic or political disturbances in Japan have their immediate reflection upon other Asian economies. At the same time, any disturbances in any of Japan’s Asian partners can influence Japanese economy and respectively, the exchange rate of the USD/JPY pair.

Yen crosses show a tendency to become quite active near the end of Japan’s fiscal year (March 31st), as export-oriented companies repatriate their assets, denominated in US dollars. This, to a large extent, matters to banking institutions, as they have to reestablish their balance sheets in order to meet requirements, imposed by the Financial Services Authority (FSA). Banks are obligated to mark to market their security positions.

USD/JPY usually features tight bid-ask spreads and high liquidity, which makes it a suitable instrument to trade for beginners. The pair is traded in massive volumes during the Asian session.

As a result of the above mentioned period of suppressed economic growth the Bank of Japan has been keeping its benchmark interest rate at very low levels in order to boost economic activity. Because borrowing costs in Japan have been low for a prolonged period of time, the yen has lured the attention of carry traders. In periods of low volatility in the global financial markets, traders consider the yen carry trade as an excellent opportunity to profit from. However, in times of high market volatility, yen carry trades tend to lose their popularity. A trader, interested in taking positions in USD/JPY, needs to research how popular the carry trade currently is among hedge funds and other large market players. When there is a boom in carry trades, the result is selling pressure and respectively, depreciation of the Japanese yen (appreciation of the USD/JPY pair). When yen carry trades lose their popularity, traders reverse their positions, thus, buying the Japanese currency. This buying pressure contributes to the appreciation of the yen and the depreciation of the USD/JPY cross, respectively.

Last but not least, shares of Japanese banking corporations are of certain interest to traders, operating in the Forex market. The reason for this is probably the fact that the severity of the economic crisis, experienced by the country, was very much related with non-performing loans of Japanese banks. Any prospects of default, released weaker earnings reports and other disappointing data by these banks may imply further deterioration of economic conditions. This way movements in shares of domestic banks may lead movements in the Japanese yen.

Properties of the USD/JPY 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 USD/JPY case – 1.52 pips.

Relative performance against other pairs

Muscles-iconWe conducted a series of calculations to gauge the performance of the USD/JPY pair relative to other crosses, which include the US dollar over a certain period of time. For details about the calculation’s variables, visit the appendix.

Let us look at Table 1, which reflects the strength of the US dollar against a number of currencies. 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 euro has been ranked 14th, the Japanese yen – 17th, while the ruble has been the worst performer among this particular list of currencies. The euro has lost 13.521% against the US dollar, the Japanese yen has plunged 18.005%, while the ruble has depreciated 70.913% during the examined period.

Correlations to other pairs

arrows_correlationThe 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 demonstrate the strongest positive correlations relative to USD/JPY 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.

Top 5 positive correlations
CAD/JPY 0.96
GBP/JPY 0.95
USD/DKK 0.93
USD/CHF 0.92
USD/SGD 0.92
Top 5 negative correlations
EUR/USD -0.92
GBP/USD -0.92
AUD/USD -0.88
NZD/USD -0.86
EUR/CHF -0.81

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 his 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 USD/JPY during the examined period.

Day High Low Intraday Vol. Daily Vol.
Dec 31, 2014 119.94 119.22 0.604% 0.926%
Dec 30, 2014 120.71 118.84 1.574% 0.474%
Jan 02, 2014 105.44 104.52 0.880% 0.247%
Jan 01, 2014 105.40 105.18 0.209% 0.544%
Average for the year 0.629% 0.671%

As can be seen from the table, USD/JPY showed an average intraday volatility of 0.629% during the past 52 weeks, while the pair’s average day-to-day volatility was 0.671%. 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 about 100-105 pips. As the year progressed, the daily volatility decreased, as in June and July the pair showed daily moves of about 65-70 pips. The lowest daily volatility (about 60-65 pips) was registered in late August.

Within a trading day the highest volatility was registered between 13:00 and 14:00 GMT (20-25 pips per hour). The lowest volatility during the trading day was recorded between 21:00 and 22:00 GMT (under 15 pips per hour). The pair showed a steady hourly volatility during the Asian session and especially between 0:00 and 6:00 GMT.

Within a trading week the pair tended to show the highest volatility on Wednesday (about 80-83 pips) and the lowest volatility on Monday (about 70 pips).

Carry trade

interest_rate_carry_trade_percentageCarry 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, USD/JPY is not a suitable pair to use in carry trades. Bank of Japan has maintained its benchmark rate at zero since October 2010.

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 Japan is in place, USD/JPY may be used in carry trades. In the future such opportunities will depend on the policies followed by the two financial institutions. In case there is a growing divergence between policies (more accommodation in Japan and further tightening in the United States), one can bet on carry trade opportunities.

Let us provide an example. With the help of a standard carry trade calculator we can conclude that if we were in a long position in USD/JPY with a standard lot and a holding period of 30 days, this would earn us $10.23 in interest. The respective earnings would be $1.02, if we held 1 mini lot, and $0.10, 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 Asian 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, US consumer sentiment and spending, US or Japanese manufacturing activity growth, US durable goods orders, US or Japanese consumer inflation, US or Japanese retail sales, US or Japanese balance of trade, US or Japanese industrial/manufacturing production, Japanese Machine Orders, and last but not least, policy decisions by the Federal Reserve or the Bank of Japan.

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

Let us take a look at a simple technical trading strategy, which features the Relative Strength Index, crosses between a shorter-period and a longer-period Exponential Moving Averages and price action setups. You can see an example here.