Fundamental Analysis – Forward Guidance for Binary Options Trading
The concept of Forward Guidance for binary options trading is a fairly recent development for the financial markets. It is basically the practice of central banks holding press conferences right after they have made a major announcement concerning a decision that they have taken with regard to monetary policies. The main objective of forward guidance is in order to provide the markets with better clarity as to the reasons the decisions taken by the central banks. The central banks hope that by understanding the motives of the central banks, the financial markets will be more stable and less prone to spikes of high volatility. And the most effective ways for central banks to communicate their message to the financial markets is through the use of press conferences.
U.S Federal Reserve
The U.S Federal Reserve was the first of the central banks to start holding press conferences. It held its first regular press conference in April 2011. A supporter of better communication with the financial markets, the U.S Federal Reserve Chairman Ben Bernanke started the ritual of what is now a regular 2 part press conference after every two to three Open Market Committee meeting.
The Bank of England
The U.S Federal Reserve is not the only central bank which has recently adopted the concept of forward guidance. When Mark Carney became the Governor of the Bank of England in 2013, he instituted major changes with the way the Central Bank communicates about its rate decisions by introducing the concept of forward guidance.
The Bank of England’s Monetary Policy Committee (MPC) has never been known to hold a press conference after setting the interest rate level. However, ever since the 2008 financial crisis and with the interest rate level still low after several years, the Bank of England moved the release of the inflation report to the same day as the announcement of the new interest rate decision to allow for a press conference. The idea behind this move was in order to communicate better to the financial markets as to what the MPC is aiming to achieve with its policy decisions. And with this move, the Bank of England started the ritual of having press conferences after the MPC has decided on the interest rate level.
The European Central Bank
Likewise, the European Central Bank (ECB) also conducts regular press conferences after its rates announcements in line with the concept of forward guidance. In addition to holding press conferences, the ECB goes one step further by publishing the minutes of the Governing Council meetings to let members of the public know what had been discussed in the meetings.
Effectiveness of Forward Guidance Concept
During the Q&A session of the press conferences, the members of the public can pose their questions to the central banks. And it is usually during the time that the markets can experience periods of high volatility especially when the answers given by the central banks is not what the market expects. So if the markets are spiking instead of being more stable, how effective is the concept of forward guidance?
While in the short term the markets do tend to react with high volatility, in the long run these press conferences held by the central banks do provide better clarity to the decisions undertaken by the central banks. To gauge the effectiveness of the concept of forward guidance, the ECB actually conducts a study on how the explanations of monetary policy decisions given out during these press conferences are construed by the markets. The results of the study were published in the ECB Working Paper #767.
It was noted in the study that these press conferences actually have a bigger impact on prices in the market than the initial announcement of the central bank’s decision. However, it was also noted in the study that the fundamental reason why these press conferences have a bigger impact is due to the forward looking perspective provided by them especially when there is ambiguity surrounding the central bank’s decision.
So what can we conclude about the effectiveness of the concept of forward guidance and the role it plays in identifying trading opportunities for binary options traders? In the short term because of the higher volatility experienced by the markets, the concept of forward guidance does result in more opportunities for those looking for short term gains. However for the longer term, you are better off basing your trading decisions on fundamental analysis since the whole point of the concept forward guidance is to provide future guidance to the markets through better dissemination of information to the markets.
Nevertheless, you also consider the market that you are trading in when trying to analyze the impact that a central bank’s press conference might have on the overall financial market. This is because central banks interest rate decisions have different impact on different asset classes. For example, interest rate decisions affect currencies differently from equities due to their inverse relationship. So while an interest rate decision might be bullish for currencies, it has the opposite effect on equities.
But we cannot deny the fact that central banks all over the whole are starting to embrace the concept of forward guidance. And given the fact that press conferences are an integral part of this concept, binary options traders should start learning to see how they can incorporate press conference trading as part of their short term and long term trading strategies.
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References and Further Reading:
- Forward Guidance at the Zero Lower Bound (Andrew J. Filardo, Boris Hofmann)
- The Power of Forward Guidance Revisited (McKay, Alisdair; Nakamura, Emi; Steinsson, Jón)
- How Effective is Central Bank Forward Guidance? (Clemens J.M. Kool, Daniel L. Thornton)
- Forward guidance and the ECB (Peter Praet)
- The Effects of the Federal Reserve’s Date-Based Forward Guidance (Matthew Raskin)