Investing Magazine

Many beginning FOREX traders are captivated by the allure of easy money.  FOREX websites offer ‘risk-free’ trading, ‘high returns’ ‘low investment’ – these claims have a grain of truth in them, but the reality of FOREX is a bit more complex.

There are two common mistakes that many beginner traders make – trading without a strategy and letting emotions rule their decisions.  After opening a FOREX account it may be tempting to dive right in and start trading.  Watching the movements of EUR/USD for example, you may feel that you are letting an opportunity pass you by if you don’t enter the market immediately.  You buy and watch the market move against you.  You panic and sell, only to see the market recover.

This kind of undisciplined approach to FOREX is guaranteed to lose you money.  FOREX traders need to have a rational trading strategy and not allow emotions to rule their trading decisions.

To make rational trading decisions the FOREX trader must be well-educated in market movements.  He must be able to apply technical studies to charts and plot out entry and exit points.  He must take advantage of the various types of orders to minimize his risk and maximize his profit.

The first step in becoming a successful FOREX trader is to understand the market and the forces behind it.  Who trades FOREX and why?  Who is successful and why are they successful?  This knowledge will allow you to identify successful trading strategies and use them as models for your own.

There are 5 major groups of investors who participate in FOREX – Governments, Banks, Corporations, Investment Funds, and traders.  Each group has varying objectives, but the one thing that all the groups (except traders) have in common is external control.  Every organization has rules and guidelines for trading currencies and can be held accountable for their trading decisions.  Individual traders, on the other hand, are accountable only to themselves.

This means that the trader who lacks rules and guidelines is playing a losing game.  Large organizations and educated traders approach the FOREX with strategies, and if you hope to succeed as a FOREX trader you must play by the same rules.

Money Management

Money management is part and parcel of any trading strategy.  Besides knowing which currencies to trade and recognizing entry and exit signals, the successful trader has to manage his resources and integrate money management into his trading plan.  Position size, margin, recent profits and losses, and contingency plans all need to be considered before entering the market.

There are various strategies for approaching money management.  Many of them rely on the calculation of core equity.  Core equity is your starting balance minus the money used in open positions.  If the starting balance is $10,000 and you have $1000 in open positions your core equity is $9000.

When entering a position try to limit risk to 1% to 3% of each trade.  This means that if you are trading a standard FOREX lot of $100,000 you should limit your risk to $1000 to $3000 – preferably $1000.  You do this by placing a stop loss order 100 pips (when 1 pip = $10) above or below your entry position. 

As your core equity rises or falls you can adjust the dollar amount of your risk.  With a starting balance of $10,000 and one open position your core equity is $9000.  If you wish to add a second open position, your core equity would fall to $8000 and you should limit your risk to $900.  Risk in a third position should be limited to $800.

By the same principal you can also raise your risk level as your core equity rises.  If you have been trading successfully and made a $5000 profit, your core equity is now $15,000.  You could raise your risk to $1500 per transaction.  Alternatively, you could risk more from the profit than from the original starting balance.  Some traders may risk up to 5% against their realized profits ($5,000 on a $100,000 lot) for greater profit potential.

There are many tools available to the FOREX trader for analyzing the market as well as for buying and selling currencies.  Software tools are a necessary part of FOREX because of its volume and volatility.  Software can be used to automate some of the trading procedures and safeguard against losses.

In order to make rational, successful trades, the FOREX trader needs information – lots of information.  Current exchange rates are the tip of the iceberg – the trader needs historical data as well as current information about political and economic conditions that could affect currency prices.  All this information is provided by many FOREX brokers on their web sites.

Successful FOREX trading relies on making accurate assessments of current political and economic conditions.  Being able to predict whether a currency will fall or rise against another currency allows the FOREX trader to profit from currency movements.

There are two basic trading methods for buying and selling currencies.  Reactive trading means the trader responds to changes in the political or economic climate.  Speculative trading means the trader makes buying decisions based on predictions on how the market will respond to current events.  While most FOREX trading is speculative, both types of trade require up-to-the-minute information and an analysis of current and historical conditions. 

Traders rely on both fundamental and technical analyses.  Fundamental analysis is based on news information about political conditions, economic policies, trade patterns, interest rates and unemployment rates.  Technical analysis relies on historical charting to identify trends and patterns over time.  Information needed for both types of analyses is available in real time on the Internet.  Most online brokers offer live news feeds and streaming rates for observing minute by minute changes in the market.

All this information can help you decide which currencies to buy.  More tools are available to help you minimize your risk and maximize your profits.

The Risk Probability Calculator (RPC) can be used to identify trades that have more potential gain than potential loss.  The RPC can also help you target exit points to end the trade.

Pivot Points can be used to predict movements of currency prices.  They are calculated as an average of the currencies high, low and closing prices.  Pivot Point Calculators tell you whether prices fall in the normal trading range or extreme trading ranges.

Pip value calculators are used to tell you the value of each pip (smallest currency unit) according to various sized lots.  Pip calculators can tell you the actual profit or loss that will result from movements in the FOREX.

Once a trader has decided which currency pair to trade, he logs on to his online account provided by his broker.  The desired currency pair is entered and the current exchange rate appears on the screen.  The amount of the trade is entered (how much currency you wish to buy).  Some brokers may give you the option of specifying the amount you wish to risk.  This automatically enters a ‘stop loss rate’ into your order.

After the details of the trade are entered, you will be taken to a confirmation screen where you can accept the current price on screen.  You may be given the option of ‘freezing’ the quoted price, meaning the price of your transaction is exactly what you see on screen without any slippage.  Accept the rate and your deal is running.

Just as you can enter a ‘stop loss rate’ to automatically sell the currency if it falls below a certain rate, you can enter a ‘take profit rate’ to automatically sell the currency when it reaches a certain level.  If you don’t enter a ‘take profit rate’ you need to monitor the movement of the currency to decide when to close the deal and take either your profits or your losses.

To be a successful FOREX trader you need a trading strategy.  There is no one set strategy that is good for all traders; rather, each trader needs to develop his or her individual approach to the FOREX.  Some traders rely solely on technical analysis while others prefer fundamental analysis, but many successful FOREX traders use a combination of both to get a broad overview of the market and for plotting entry and exit points.

Technical analysis relies on one key concept: Prices move by trends.  The common saying in FOREX is ‘The trend is your friend.’  Market movements have identifiable patterns that have been studied over many years and a thorough understanding of these trends and how they can be read forms the basis of a good trading strategy.

There are many analytical tools available to understand market movements.  The beginner FOREX trader is well advised to study each one separately for getting a working knowledge of their concepts and application.  Once one has been understood, keep on using it while studying others.  Each tool tends to reinforce the others.

Support and resistance levels are used in many FOREX trading strategies.  ‘Support’ refers to the price level that is repeatedly seen as the bottom – when the price reaches this level it tends to rise.  Resistance levels are upper prices that the currency rarely trades beyond.  Support and resistance levels contain price movements for a period of time. 

When currency prices break through support or resistance levels, the prices are expected to continue in that direction.  For example, if the price rises above the previous resistance level, it is seen as bullish – the price should continue to rise.
 
To find support and resistance levels, price charts need to be analyzed for unbroken support and resistance levels.  Charts can be analyzed in any time frame; however longer time frames establish more important support/resistance levels.  Traders can use support/resistance levels to determine when to enter or exit a transaction.

Moving averages are another common tool in FOREX trading strategies.  The simple moving average (SMA) shows the average price in a given period of time over a specified period of time.  Moving averages serve to eliminate short term price fluctuations giving a clearer picture of price movements.  FOREX traders can plot a SMA to determine when prices have a tendency to rise or fall.  If prices cross above the SMA they have a tendency to keep on rising.  Conversely, prices below the SMA have a tendency to continue their downward motion.

These are two examples of trading strategies that can be used individually or in combination.  In practice, the FOREX trader should have a repertoire of trading tools to examine market conditions and to support the findings of one study or another.  If several indicators show that the market is moving in a particular direction the trader can act with more assurance than when relying on a single indicator.

Similarly, fundamental analysis can be used to reinforce technical findings, or vice versa.  Ideally, the FOREX trader will take several indicators into account when plotting a trading strategy.

Every trading strategy should provide clear guidelines about when to enter a trade, what to expect in terms of market movement, when to exit a trade, and how much loss can be accepted in case the deal moves against the trader.  Following these simple guidelines and learning about technical analysis can help you become a successful FOREX trader.

Almost every online FOREX broker has a software package for their clients to make transactions and get information about market prices.  Due to the relative maturity of online trading there is a consensus among FOREX brokers about what clients need in terms of software tools.  There are two main classes of FOREX software – web based and client based.

All FOREX software needs to provide up-to-the-second market information.  The fast moving pace of the FOREX demands real-time data delivery for making decisions about when to enter and exit the market.  FOREX dealers claim their software performs well with a minimum of delay, but in fact there can be a number of factors that could delay data transmission.

Internet connection speed and distance from the broker’s servers are the two main factors that can slow down data transmission.  FOREX traders should have a reasonably modern computer and a high speed Internet connection to take full advantage of the FOREX software offered by their broker.  It may also pay to choose a broker in the same area as you live.  Traders in Bangkok who deal with brokers in Ohio may experience delays – especially during volatile market conditions.

Web Based or Client Based?

Web based software is on the broker’s website – you don’t have to install any software on your computer.  Client based software requires you to download and install the software package used by your broker.  Which is better?  More and more brokers are offering web based client software for reasons of convenience, safety and reliability.  Web based software allows you to log on to your account from any computer – you can make trades from any location that has an Internet connection.  Client based software, on the other hand, restricts you to making trades from just one computer.

Besides the convenience, web based software offers greater security.  Data is secured with high-strength encryption making it impossible for outside parties to access during transmission.  Client based software is also secured during transmission but there are more possibilities for data loss from the trader’s computer.  Viruses and hackers may be able to access valuable financial data stored in a home or office computer.

Features

FOREX software needs to access real-time quotes and offer a means to enter and exit the market.  Even the most basic packages offer these functions.  Current quotes can be seen for most currency pairs and the software allows you to buy or sell at market prices or enter and exit the market using stops or limits.  Ideally, trading software should have integrated charting functions with a variety of viewing functions.

Basic software packages should be offered free of charge, but many brokers also have more advanced packages available for a monthly fee.  Some of the features you could expect to see in advanced software include the ability to trade directly from the chart and full analytical functions.

Technology

The backbone of FOREX software is a series of data servers that allow you to connect to your broker’s web site and make transactions.  Servers operated by the FOREX broker need to be reliable and secure for maintaining data integrity and assuring accurate transaction processing.  Servers are subject to power outages and natural disasters, so to ensure maximum uptime, the broker should operate at least two sets of servers in separate locations.  Brokers should also offer regular data backups to guarantee the integrity of their customer’s financial data in case of server failure.

One of the disadvantages of FOREX trading is the time investment needed to monitor the markets for advantageous entry and exit points.  It’s possible to sit in front of a computer monitor for hours watching the markets.

Of course, you can use automated orders such as limits and stops.  These allow you to walk away from your computer with the knowledge that your losses will be kept to a minimum, but by doing so, you may miss out on potential profits because your limit order kicks in too soon.

If you don’t have the time to watch your computer monitor and still wish to achieve as much profit as possible, consider signing up for a FOREX signal service.  These services monitor and analyze the market for you and send their findings directly to your computer desktop, email, or SMS on your cell phone or pager.

Companies that offer FOREX signals do so on a paid basis, so you have to sign up and pay a monthly or yearly fee.  Some brokers may offer this service as an extra which integrates into their trading software.  You can receive signals as a popup on your screen or by any of the other methods described above.

There are usually a limited number of currency pairs that are available for FOREX signals.  Most services offer signals on EUR/USD, USD/JPY, GBP/USD, USD/CHF, but specialized services may offer other currency pairs.

FOREX signals are primarily based on technical analysis of market conditions.  Most companies use a combination of indicators to identify main trends and entry and exit points.  The results are sent to subscribers who have the option of acting on them or passing.  Some services will even execute the trade for you.

Using a variety of technical studies, various types of signals can be derived from currency charts.  The SMA (Simple Moving Average) indicates buy signals when currency prices rise above the average line.  Sell signals occur when the price falls below the moving average line.

MACD (Moving Average Convergence Divergence) studies have a signal line that is used to generate a buy signal (above the line) or a sell signal (below the line).

Volume indicators are used to determine market interest.  High volume (especially near the bottom of the market) can indicate the start of a new trend while low volume indicates investor uncertainty. 

Bollinger Bands indicate potential changes in the market.  Sharp price changes tend to occur when the bands tighten while prices that touch one band tend to go all the way to the other band.

Other indicators like volatility and momentum can be used to reinforce signals provided by other sources.  Taken together they form a relatively reliable source of information about how the market is behaving.

Are signals a sure thing?  Of course not, otherwise we would all be millionaires.  Signals can give you good advice about which currencies to trade, but no signal service will guarantee their information is 100% accurate.  Reputable services will show you their track record, however, and let you see for yourself how they have done in the past.

FOREX signals cost anywhere from $50 to $200 a month.  It’s up to the individual trader to decide if the cost is worth it.  Don’t think that signals can take the place of trader education – they are advice, and if you don’t have the knowledge to analyze the advice, you should go back to the books before using a signal service.

Despite the claims you may see on some FOREX web sites, FOREX is not risk-free.  You are trading with substantial sums of money and there is always a possibility that trades will go against you.  There are several trading tools, however, that can minimize your risk, and with caution, and above all education, the FOREX trader can learn how to trade profitably and while minimizing losses.

Scams

FOREX scams were fairly common a few years ago.  The industry has cleaned up considerably since then, but you still need to exercise caution when signing up with a FOREX broker.  Do some background checking – reputable FOREX brokers will be associated with large financial institutions like banks or insurance companies and they will be registered with the proper government agencies.  In the United States brokers should be registered with the Commodities Futures Trading Commission (CFTC) or a member of the National Futures Association (NFA).  You can also check with your local Consumer Protection Bureau and the Better Business Bureau.

Risks

Assuming you are dealing with a reputable broker, there are still risks to FOREX trading.  Transactions are subject to unexpected rate changes, volatile markets and political events.

Exchange Rate Risk – refers to the fluctuations in currency prices over a trading period.  Prices can fall rapidly resulting in substantial losses unless stop loss orders are used when trading FOREX.  Stop loss orders specify that the open position should be closed if currency prices pass a predetermined level.  Stop loss orders can be used in conjunction with limit orders to automate FOREX trading – limit orders specify an open position should be closed at a specified profit target.

Interest Rate Risk – can result from discrepancies between the interest rates in the two countries represented by the currency pair in a FOREX quote.  This discrepancy can result in variations from the expected profit or loss of a particular FOREX transaction.

Credit Risk – is the possibility that one party in a FOREX transaction may not honor their debt when the deal is closed.  This may happen when a bank or financial institution declares insolvency.  Credit risk is minimized by dealing on regulated exchanges which require members to be monitored for credit worthiness.

Country Risk – is associated with governments that may become involved in foreign exchange markets by limiting the flow of currency.  There is more country risk associated with ‘exotic’ currencies than with major currencies that allow the free trading of their currency.

Limiting Risk

FOREX trading can be risky, but there are ways to limit risk and financial exposure.  Every FOREX trader should have a trading strategy – knowing when to enter and exit the market and what kind of movements to expect.  Developing strategies requires education – the key to limiting FOREX risk.  At all times follow the basic rule: Do not place money in the FOREX that you cannot afford to lose.

Every FOREX trader needs to know at least the basics about technical analysis and how to read financial charts.  He should study chart movements and indicators and understand how charts are interpreted.  There is a vast amount of information on FOREX trading available both on the Internet and in print.  If you want to be successful at FOREX, know what you are doing.

Even the most knowledgeable traders, however, can’t predict with absolute certainty how the market will behave.  For this reason, every FOREX transaction should take advantage of available tools designed to minimize loss.  Stop-loss orders are the most common ways of minimizing risk when placing an entry order.  A stop-loss order contains instructions to exit your position if the currency price reaches a certain point.  If you take a long position (expecting the price to rise) you would place a stop loss order below current market price.  If you take a short position (expecting the price to fall) you would place a stop loss order above current market price.

As an example, if you take a short position on USD/CDN it means you expect the US dollar to fall against the Canadian dollar.  The quote is USD/CDN 1.2138/43 – you can sell US$1 for 1.2138 CDN dollars or sell 1.2143 CDN dollars for US$1.

You place an order like this:

    Sell USD:    1 standard lot USD/CDN @ 1.2138 = $121,380 CDN
    Pip Value:    1 pip = $10
    Stop-Loss:    1.2148
    Margin:    $1,000 (1%)

You are selling US$100,000 and buying CDN$121,380.  Your stop loss order will be executed if the dollar goes above 1.2148, in which case you will lose $100.

However, USD/CDN falls to 1.2118/23.  You can now sell $1 US for 1.2118 CDN or sell 1.2123 CDN for $1 US.

Because you entered the transaction by selling US dollars (buying short), you must now buy back US dollars and sell CDN dollars to realize your profit.

You buy back US$100,000 at the current USD/CDN rate of 1.2123 for a cost of 121,223 CDN.  Since you originally sold them for CDN$121,380 you made a profit of $157 Canadian dollars or US$129.51 (157 divided by the current exchange rate of 1.2123).