Forex Trading Library

How to Trade a Recession

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Recessions are inevitable. It’s not a matter of if there will be a recession, it’s a matter of when.

The longer we go without one, the more likely the next recession is just around the corner. A savvy forex trader will want to get ahead of the circumstance and be ready for when it happens. They’ll also already know how to deal with it.

The problem with recessions, though, is that they are nearly impossible to predict. After all, if we could predict them, then everyone would trade so as to avoid a recession, and then they wouldn’t happen.

So, we have to be constantly on the lookout for potential signs of where and when a recession might happen. That way, we can figure out what to do.

They’re All the Same, but Different

Economic growth cycles follow a pattern.

There is about a 7-9 year growth cycle, followed by a short contraction of maybe six months to at most a couple of years (barring unwise fiscal and monetary policy). The contraction period often has the same cause, but it presents itself differently each time.

For example, in the 2008 financial crisis, there was an excess of mortgage-backed securities (MBS), to oversimplify the situation to a comic degree. The prior financial crisis in 2001 followed the tech bubble, where there was too much investment in tech stocks.

From a very simplified and practical perspective, recessions happen as a consequence of excess inventory in something. This leads to a correction that has a domino effect throughout the economy.

Chaos is a Ladder

When the recession starts, few people know the cause. Some think they do, but they don’t, which leads to worse investment decisions.

There is no sure-fire way to deal with economic chaos. However, there is an order to the madness that follows a bursting bubble. And, from that, we can get some potential trading guidelines.

As the recession sets in, investors get frightened and very risk-averse. This is bad for stocks, especially the more speculative ones.

On the other hand, risk aversion leads to people holding more liquid assets and tends to support currencies. While many invest in gold, safe-haven currencies are also just as likely to jump. A recession is not exactly a bad time to be a forex trader.

Nerves of Steel

Recessions drive out speculators as it becomes increasingly hard to make a quick buck since major investors move out of riskier assets and try to maintain liquidity.

This is also when people who manage to have liquidity come in to seize underpriced assets, such as commodities, stocks, and bonds.

Despite lower liquidity, volatility tends to increase. Keeping an eye on the VIX would help when trading forex during a recession. Risk and money management are increasingly important as margins become shorter. This allows you to stay in shape to take advantage of the also inevitable recovery.

Even after the “Great Recession” of 2008, the market recovered its losses in less than two years. Many traders were able to get in on the bottom thanks to keeping their risk profiles in line with the circumstances.

The bottom line is that recessions offer a lot of opportunities because people didn’t manage their risk ahead of time. Liquidity, the ability to buy underpriced assets, is the key to trading forex in a recession.

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