New to Forex
1. Introduction to Forex
The foreign exchange or 'Forex Market' is the world's largest financial market. It is a non-stop cash market where currencies of nations are being traded off-exchange through brokers.
It is estimated that, on average, $5.3 trillion is traded each day in the world Forex markets. The vast majority of Forex trading does not occur on any one centralized or organized exchange but through brokers on the interbank currency market. The interbank currency market is a twenty four hour market that follows the sun around the world. Opening in Australia and closing in the U.S. Whilst the market exists for organizations with exchange risk, speculators also participate in the Forex markets in an effort to profit from their expectations regarding shifts in exchange rates.
Who trades Forex
In the early part, the Forex market was used by institutional investors that transact large amount for commercial and investment purposes. Today however, importers and exporters, international portfolio managers, multinational corporations, speculators, day traders, long term holders and hedge funds all use the Forex market to pay for goods and services, transact in financial assets and speculate or to reduce the risk of currency movements by hedging their exposure or increasing their exposure through speculation.
In today's information superhighway the Forex market is no longer solely for the institutional investor. The last 10 years have seen an enormous increased of non-institutional traders accessing the Forex market and reaped the benefits of it.
The growth in the Forex market over the last decade has led to a number of advantages for the private investor. Trading material to educate the trader has become far more readily available. Support services via forums have become increasingly popular and in the event that you the private investor no longer wish to trade the account yourself, you have professional money managers that will take-over via managed accounts. In brief the main advantages for the private investor and the shorter term trader are:
24 hour trading, 5 days a week with 24 hour cover provided by the broker.
- ECN Trade provides 24 hours coverage for its clients
- Trading available from Sunday night through to Friday night.
An enormous liquid market.
- $5.3 trillion traded daily
- The Forex market is constantly moving providing volatility. It is this volatility that provides both long and short term traders the opportunity to profit from the Forex market.
Products that are traded
- With currently over thirty products being offered there are always opportunities in the market.
The ability to go long or sell short.
- You are not restricted to long positions only. If you believe that a currency pair is going down you could benefit with a short position.
2. Understanding Forex Prices
- The Spread
- The Pips
Forex prices are displayed in the form of a Bid/Ask spread. The spread is the difference between the Bid and the Ask. The Bid and Ask serve as the prices that similar to other financial products. The Bid is the price at which a trader is able to sell a currency pair. The Bid price or sell price of a currency pair is always the lower price in a quote. The Ask, also sometimes referred to as the "Offer", is the price at which traders are able to buy a currency pair.
The difference between the Bid and Ask is called the "Spread" and is effectively the cost of trade. There are typically no additional broker commissions involved in trading the Forex market, although we are witnessing a move towards commission based trading due to market execution.
Market increments are measured in 'Percentage in Point' or Pips for short. A pip is the last digit in the value of a currency pair (if you are trading from a 4 digit price feed); 1.3294, 115.13 etc. All Forex currency pairs, except for the Japanese Yen, measure the pip from the 4th decimal place.
Price Quotes: What do they mean?
Reading a Forex quote may seem a bit confusing at first. However, it's really quite simple if you are able to remember two things:
- The first currency listed is thebase currency
- The value of thebase currency is always 1 (one)
A quote of GBP at 1.5000 is to say that 1 Sterling Pound (GBP) = 1.5000 US Dollar (US). When the Sterling Pound is the base unit and a currency pair's price increases, comparatively the Sterling Pound has appreciated and the other currency in the pair (usually known as the quote currency) has weakened. Using the above GBPUSD example as a reference, if the GBP/USD increases, from 1.5000 to 1.5100 (100 pips), the GBP is stronger because it will now buy more USD than before.
There are four currency pairs involving the US dollar in which the US dollar is not the base currency. These exceptions are the Australian dollar (AUD), the British Pound (GBP), the Euro (EUR), and the New Zealand dollar (NZD). A quote on the GBP/USD of 1.7600 would mean that one British Pound is equal to 1.7600 US dollars. If the price of a currency pair increases the value of the base currency in comparison to the quote currency thus increases. Conversely, if the price of a currency pair decreases, such is to say that the value of the base currency in comparison to quote currency has weakened.
What Influences Price?
Forex markets and prices are mainly influenced by international trade and investment flows. It is also influenced, but to a lesser extent, by the same factors that influence the equity and bond markets: economic and political conditions, especially interest rates, inflation, and political stability, or as is often the case, political instability. Though economic factors do have long term effects, it is often the immediate reaction that causes daily price volatility, which makes Forex trading very attractive to intra-day traders.
Currency trading can offer investors another layer of diversification. Trading currencies can be viewed as a means to protect against adverse movements in the equity and bond markets, movements that of course also impact mutual funds. You should bear in mind that trading in the off-exchange foreign currency market is one of the riskiest forms of trading and you should only invest a small portion of your risk capital in this market.
3. Understanding Currency Pairs
- The Majors
- Currency Pairs
- The SWAP
Most currency transactions involve the "Majors", consisting of the British Pound (GBP), Euro (EUR), Japanese Yen (JPY), Swiss Franc (CHF) and the US Dollar (USD). Whilst these are the key five currencies, the Canadian Dollar (CAD) and the Australian Dollar (AUD) are starting to be considered as additional 'major' currencies.
Currencies in Pairs
The logic for currency pairing, is that if we had a single currency alone, we would have no means to measure its relative value. By pairing two currencies against each other a fluctuating value can be established for one versus the other.
Currency Pairs that do not include the US dollar are commonly referred to as Cross Currency Pairs. Cross Currency trading can open a completely new aspect of the Forex market to speculators. Some cross currencies move very slowly and trend very well. Other cross currency pairs move very quickly and are extremely volatile with daily average movements exceeding 100 pips
When we execute a Forex transaction, we essentially borrow one currency and lend another. This borrowing and lending is like any other banking transaction and therefore is subject to interest rates calculation. This interest rate differential is referred to as the SWAP rate in the currency markets. The Swap is a credit or debit as a result of daily interest rates differential. When traders hold positions overnight, they are either credited or debited with interest rate benefit or cost based on the rates and the currency they are holding at the time.
4. Introduction to Margin
- What is FX Margin
- Working Example of Margin
- Free Margin and Used Margin
What is FX Margin?
The Forex market offers its participants the potential to trade on margin. The ability to trade on margin is one of the attractive - but at the same time risky- features of forex trading. Essentially trading on margin allows the forex trader to trade on borrowed funds. The degree to which the trader can borrow will depend on the broker they are using and the leverage or gearing they offer.
In the Forex market the term margin is the amount of money required to open a leveraged position, or a contract in the market.
Without leverage a trader placing a standard lot trade in the market would need to post the full contract value of $100,000 in order to have his or her trade executed. Leverage allows a trader to place the same $100,000 contract for an amount of margin (determined by the set level of leverage). For example, an account at 1:30 leverage would require around $3,333 of margin to place a $100,000 trade.
By offering leverage to the trader, the brokerage is essentially allowing the trader to open a contractual position with considerably less initial capital outlay. Without leverage, a trader placing a standard lot trade in the market would need to post the full contract value of $100,000. With a leverage of 1:30, the trader can in fact open the position with an initial leverage of USD $3,333.
Trading Forex on margin should be used wisely as it magnifies both your potential profits and potential losses. Remember, the higher the leverage, the higher the risk.
Forex traders are subject to the margin rules set by their chosen brokers. In order to protect themselves and their traders, brokers in the Forex market set margin requirements and levels at which traders are subject to margin calls. A margin call would occur when a trader is utilizing too much of their available margin. Spread across too many losing trades, an over margined account can give a broker the right to close a trader's open positions. Every trader should be clear on the parameters of their own account, i.e. at what level are they subject to a margin call. Be sure to read the client agreement in the account application when opening a live account.
Traders should monitor margin balance on a regular basis and use stop-loss orders to limit downside risk. However, due to the extreme volatility that can be found in the Forex market, stop-loss orders are not always an effective measure in limited downside risk. There is still the possibility of losing all, or more, of your original investment.
Every trader should know what level of risk they wish to take. Whilst the attraction of taking on a big position to receive increased profits is quite clear, it should also be noted that a slight movement in the market will result in a much higher loss in an overly leveraged account.
Traders always have the option of applying a lower level of leverage to an account or transaction. Doing so may help manage risk, but bear in mind that a lower level of leverage. will mean that a larger margin deposit will be required in order to control the same size contracts.
Working Example of Margin
To calculate the margin required to execute 1 mini lots of USD/CAD (10,000 USD) at 1:30 leverage in a $500 mini account, simply divide the deal size by the leverage amount e.g. (10,000 / 30 = 333). Therefore, $333 margin will be required to place this trade, leaving an additional $167 marginable balance in the trading account.
Most Forex trading software platforms automatically calculate FX margin requirements and check available funds before allowing a trader to enter a new position.
Free Margin and Used Margin
In the above example we had a $500 account. In order to open the position above we were required to have initial margin of $333. This is referred to as used margin. The remaining $167 is known as the free margin. All things being equal, the free margin is always available to trade upon.
5. Contract Sizes
Understanding contract sizes
- Each standard lot traded in the Forex market is a 100,000 (of the base currency) contract. In other words, when trading one lot in a standard account, a trader is essentially placing a $100,000 trade in the market. Without leverage, many investors would not be able to afford such a transaction. Leverage of 1:30 would allow a trader to place the same one lot ($100,000) trade by posting around $3,333 in margin.
- Many retail Forex brokers also offer the ability to trade mini lots. Mini lots essentially allow the trader to trade one tenth of a standard lot. Trading in this size is often referred to as trading a mini lot. Mini lot contracts are $10,000 (of the base currency). A trade of one mini lot would be a $10,000 trade. Trading with 1:30 leverage would mean that $333 of margin would control a $10,000 contract.
6. Majors and Currency Pairs Revisited
- Currency Acronyms
- Major Forex Currency Pairs
Since foreign currencies are quoted in terms of value of one currency against another, a Forex currency pair consists of an acronym for both currencies, separated by a slash "/". The acronyms used were established in 1947 and we have listed a few below:
- GBP = Great British Pound
- EUR = Euro
- CHF = Swiss Franc
- USD = United States Dollar
- CAD = Canadian Dollar
- JPY = Japanese Yen
- AUD = Australian Dollar
- NZD = New Zealand Dollar
Currencies are always traded in pairs, for example EUR/USD, USD/JPY. Every position requires the buying of one currency and selling of another. When someone says they are "buying the EUR/USD", they are buying Euros and selling Dollars.
There are many other Forex currency pairs available to trade, such as the Danish Krone, Mexican Peso, and Russian Ruble. However, these currency pairs are generally traded less, and are not considered major currencies.
Major Forex Currency Pairs
Some Forex currency pairs are traded more heavily than others. The currency pairs that have the most volume consist of the "majors". It is widely agreed that the following 6 pairs are considered the majors:
For example, let's assume a Forex trader buys 1 standard lot of GBP/USD. The current exchange rate is 1.9615. Essentially this trader is buying 100,000 Pound in exchange for $196,150. Again, for example's sake, assume the Forex market rate rose 15 PIPs to 1.9630 and the trader liquidates the position. The same 100,000 Pound is now worth $196,300, the trader realizing a $150 profit.
Nicknames are sometimes used for currency pairs. Here is a list of Forex currency pairs and commonly used nicknames for each:
- GBP - Pound, Cable, or Sterling
- EUR - Euro
- CHF - Swissy, or Franc
- USD - Greenback
- CAD - Loonie
- AUD - Aussie
- NZD - Kiwi
- JPY - Yen
7. Understanding Risk
- What is Risk
- The Risk: Reward Ratio
In order to trade successfully you must fully understand the risks involved. Each trader will approach the market slightly differently, underlying the fact that there is no right or wrong way to trade the market. Instead each trader must know the risk that they can comfortably take on.
Establishing the type of trader you are is very important. Are you a systematic trader or do you prefer being in the market during periods of volatility. Are you looking to be constantly involved or are you looking to smooth out the short term noise to capitalise on long term gains.
What is Risk?
Risk is "The variability of returns from an investment or the chance that an investment's actual return will be different than expected. This includes the possibility of losing some or all of the original investment. It is usually measured using the historical returns or average returns for a specific investment. The greater the variability of an investment (i.e. fluctuation in price or interest), the greater the risk."
The volatility we see in daily prices, combined with the leverage available in the off-exchange retail foreign currency (or Forex) market compared to other financial instruments- like stocks- is the reason why Forex is categorized as highly risky. As investors are generally averse to risk, investments with greater inherent risk must promise higher expected yields to warrant taking on additional risk. Others add that higher risk means a greater opportunity for high returns or a higher potential for loss. However, a higher potential for return doesn't always mean that it must have a higher degree of risk.
What risks do you face trading currencies?
There are two basic classifications of risk:
- Systematic Risk - also sometimes called market risk, or aggregate risk,, is the risk associated with overall aggregate market returns. Systematic risk is a risk of security that cannot be reduced through diversification.
- Unsystematic Risk - Sometimes referred to as "specific risk". An example is economic news that affects a specific country or region. Diversification across multiple non-related currency pairs is the only way to truly protect the portfolio from unsystematic risk.
Now that we've determined the two main classifications of risk let's take a closer look at more specific types of risk.
This refers to the risk that a country won't be able to honour its financial commitments. When a country defaults, it can harm the performance of all other financial instruments in that country as well as other countries, it has relations with. Country risk applies to stocks, bonds, mutual funds, options, futures and most importantly the currency that is issued within a particular country. This type of risk is most often seen in emerging markets or countries that have a severe deficit.
When investing in foreign currencies you must consider that the currency exchange rate fluctuations of closely linked countries, can drastically move the price of the primary currency as well. For example, economic and political events directly tied to the British Pound (GBP) have an effect on the Euro's trading (i.e. the EUR/USD might have similar reaction as GBP/USD even though they are both separate currencies and are not in the same currency pair). Knowing what countries effect the currency pairs you trade is vital to your long-term success.
Interest Rate Risk
A rise or decline in interest rates during the term a trade is open, will affect the amount of interest you might pay per day until the trade is closed. Open trades at rollover are assessed either an interest charge or interest gain depending upon the direction of the open trade and the interest rate levels of the corresponding countries. If you sell the currency with the higher interest rate you will be charged daily interest at the time of rollover based on your broker's rollover/interest policy. For more specifics on understanding your interest risk, please consult your broker for complete details of their policy including time of rollover, interest price (also called swap) and account requirements to receive interest paid to your account.
This represents the risk that a country's economic or political events will cause immediate and drastic changes in the currency prices associated with that country. Another example of this risk is government intervention that we typically see with Japan and the need to maintain low currency prices to bolster their exports.
This is the most familiar of the risks we have discussed, and according to some, really the main risk to consider. Market risk is the day to day fluctuations in a currency pair's price; also referred to as volatility. Volatility is not so much a cause but an effect of certain market forces. Volatility is a measure of risk because it refers to the behaviour, or "temperament," of your investment rather than the reason for this behaviour. Because market movement is the reason why people can make money, volatility is essential for returns, and the more unstable the currency pair, the higher the chance it can go dramatically either way.
This is a particular risk that many traders don't think much about. However, with the majority of individual Forex traders executing trades online, we are all technology reliant. Are you protected against technology failure? Do you have an alternative internet service? Do you have back-up computers that you could use if your primary trading computer crashes?
As you can see, there are several types of risk that a smart investor should consider and pay careful attention to in their trading.
The Risk Reward Balance
The risk/return balance could easily be called the iron stomach test. Deciding what amount of risk you can take on while allowing yourself to walk away from your computer without worrying and to get sound rest at night while you have long-term trades open is a trader's foremost important decision. The risk/return balance is the balance a trader must decide on between the lowest possible risk for the highest possible return. Remember to keep in mind that low levels of uncertainty (low risk) are associated with low potential returns and high levels of uncertainty (high risk) are associated with high potential returns. Trading is all about risk and probabilities. Understanding the inner functions of your Forex trading strategy(s) and proper placement of entry and exit orders will assist in limiting your risk exposure while maximizing your profit potential.
What about how much of your account to place on each trade, or in other words the number of lots per trade? How much of your account have you lost in a single trade? Was it too much to swallow? If so, you might not have utilized proper risk management and over leveraged your trade. Establishing the right level of leverage and corresponding margin requirements are a big part of managing risk.
There is Not One Correct Risk Level
Just as there is no single favorite food for everyone, there is no right risk level for everyone. Only you can determine what level of risk is right for you. You need to find the right balance between the amount of risk you think you are willing to take, and the amount of risk you can actually stomach. All too often investors think they are willing to take risk, but when the worst happens, they find out they aren't.
You will likely lose money during this learning process, but if this loss helps you achieve this level of understanding then you can financially afford the loss. It is important to identify in advance the amount you are willing to "pay" for this education. This financial and emotional tuition is a valuable trading resource and something most experienced investors have paid through the process of trial and error.
Different individuals will have different tolerances for risk. Tolerance is not static; it will change along with your skills and knowledge. As you become more experienced, tolerance to risk may increase. Don't let this fool you into not adhering to and thinking about proper money management practices.
We all hear diversification is the best policy for an overall investment portfolio. This is also true amongst our currency focused investments as well. To be well diversified, we should master the use of multiple trading strategies and multiple currency pairs to equalize our overall return. Some trading strategies boast 80% accuracy in specific market conditions. However, a full-time trader must utilize more than this single strategy as many times there are long periods of time when the trading conditions are not met, such intervals can last anywhere from a few days to several months. What good is a single strategy that can yield profits for only a small portion of the year? Diversification may be the answer.
Diversifying your investment is not the most popular of investment topics. In fact many people believe diversifying dilutes trading profits. But most investment professionals agree that while it does not guarantee against a loss, diversification is the most important component to helping you reach your long-term financial goals while minimizing your risk. But, remember that no matter how much diversification you do, it can never reduce risk down to zero.
A Well Defined Portfolio
What do you need to have a well diversified portfolio? Three aspects to ensure the best diversification:
- Your portfolio should be spread among many different trading strategies
- Your trades should vary in risk and time held. Picking different trade opportunities with different potential rates of return will help the gains offset losses of other trades. Keep in mind that this doesn't mean blindly placing trades all across the spectrum!
- Your currency pairs should vary by region and crosses, minimizing unsystematic risk to small groups of countries
Another question people always ask is how many currency pairs they should trade to reduce the risk of their portfolio. One portfolio theory for stocks tells us that after 10-12 diversified stocks you are very close to optimal diversification. However, in the currency market this doesn't mean buying 12 currency pairs will give you optimal diversification, instead, it has been recommended to trade currencies of different regions and importance levels (i.e. majors, crosses and more exotic currencies).
8. Approaches to Trading the Market
- Technical Analysis
- Support and resistance
- Moving averages
- Fundamental Analysis
Technical analysis is the method of evaluating traded products by analysing statistics generated by market activity, such as past prices and volume. Technical analysts believe that the price contains all known information and therefore technical analysts do not attempt to measure a security's intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity.
With wonderful sounding names such as Elliot Wave Theory, Candlestick Charts, Moving Average Convergence Divergence or Bollinger Bands they all have the common aspect of presenting us with a visual approach to market analysis.
In the section we introduce you to a handful of methods that are currently applied to the market.
Support and resistance
Support is the price level at which demand is thought to be strong enough to prevent prices from declining further. Support levels are below the current price, though it is not uncommon for prices to dip below support briefly signalling a false breakout. With a support level broken, the market will move lower indicating that the sellers have overwhelmed the buyers. Once a support level has been broken, another support level will be established at a lower level and the tendency is that support level that was breached, will now become a resistance level.
Resistance is the price level at which demand is thought to be strong enough to prevent prices from rising further. Resistance levels are usually above the current price. A clear break above the resistance level signals that the buyers are in control. In this instance there are fewer sellers and the price tendency is to move further up. Once a resistance level has been broken, another resistance level will be established at a higher level and as with the support level, when the resistance level is breached, this will now become the new support level.
Moving averages are very popular tools used by technical traders to measure momentum. They are usually the first tool that technical analysts are introduced to as they are simple to apply and are building blocks to more complicated moving average theories. The main purpose of these averages is to smooth price data so traders can be in a better position to gauge the likelihood that a current trend will continue. Moving averages are commonly used to predict areas of support and resistance and are also used in conjunction with other indicators to help give more accurate entry and exit signals. There are different types of averages that vary in popularity but, regardless of how they are calculated, they are all interpreted in the same manner.
We have simple moving averages, weighted moving averages and exponential moving averages.
A very simple theory is the moving average crossover. This is where you combine two moving averages with differing time frames. Where they cross will indicate the entry and exit points to a trader.
Fundamental analysis is the study of the core underlying elements that influence and impact on the underlying price of a security or a country's economic well being. This method of study attempts to predict price action and market trends by analysing economic indicators, government policy and other factors. Whilst fundamental analysis may help you forecast an underlying real value for a stock or share, when it comes to fundamental analysis for the foreign exchange markets, the analysis is carried out to forecast economic conditions and underlying direction. Therefore for the currency markets, fundamental analysis is not an exact science to predict price. For example, you might get a clear understanding of the health an economy by studying an economists forecast of an upcoming economic release but that will not give you entry and exit points, simply price direction.
Fundamental analysis and the resulting figures will involve interest rates, central bank policy, political figures or events, employment reports; whether seasonal or unemployment figures, gross domestic product (GDP), etc. These economic indicators are snippets of financial and economic data published by various agencies of the government or private sectors for each country. These statistics, which are made public on a regularly scheduled basis, help traders monitor the health of the economy.
Fundamental analysts broadly label economic data and news releases into three categories. The release is either there to reflect the current state of the economy which is referred to as a coincident indicator, is alternatively known as a leading indicator as the release will look to predict future conditions or is finally known as a lagging indicator.