What is forex?
Forex is a portmanteau formed from foreign exchange. It refers to the foreign exchange market and comprises all the different currencies issued by the countries of the world. Common currencies we are familiar with are the US dollar (USD), Euro (EUR), Japanese Yen (JPY), Australian Dollar (AUD) and New Zealand dollar (NZD) among many others.
The forex market exists so different currencies can be exchanged to pay for goods and services. For example, a US construction company buying cement from a China supplier will need to change their US dollar into Renminbi in order to pay for their goods. Alternatively, the Chinese supplier can accept US dollars from their US customer, but they will still need to exchange the US dollars for Renminbi in order to pay for their cost of production.
Large capital amount exchanges for international business are normally conducted with commercial banks who in turn balance their own accounts with each other in the interbank markets.
Smaller exchanges are conducted by local banks, money changers, financial firms or payment companies such as Paypal. When you wish to visit a foreign country, you will need to go to the money changer to exchange for foreign currencies.
2 sides to an exchange
All foreign exchange transactions will always involve both a buy and a sell. When a tourist goes to the money changer with his US dollars to try and get some Euros, he is effectively selling his US dollars to buy Euros. As such, all prices are quoted for a currency pair, instead of for a single currency. The quoted price for EUR/USD might be 1.2500 which means you will need 1.25 USD in order to exchange for 1 EUR.
What is forex trading?
Forex trading is the buying and selling of currency pairs for capital gains, interest gains and speculative gains.
Besides facilitating international trade, most foreign transactions are for speculative purposes. Forex prices go up and down just like any other assets, commodities or stocks and can thus be traded for speculative gains. This is the kind of activity we are interested in. if price never changes, no trading can take place, it will be a dead market!
Major currency pairs that are traded and priced with USD include, EURUSD, GBPUSD, USDJPY, AUDUSD, NZDUSD and USDCAD. Minor currency pairs with less volume are USDSGD, USDHKD for example.
Cross currency pairs are also traded and comprise of pairs that does not involve the USD in their price quotes such as GBP/JPY, EURSGD or AUDNZD for example.
Forex trading are predominantly conducted online using software and trading platforms provided by brokers and service providers. Most trading platforms are similar in construction with some special features or twists here and there. Standard components that can be found in all trading platforms include price quotes, charting and the plethora of trading tools and indicators, opened and closed trading orders and portfolio summary.
Price quotes/ bid and offer
2 prices are quoted at any moment in time for each currency pair. They are the bid and the ask or bid and offer or buy and sell. The difference between them is called the spread and this is what the brokers receive as their income for providing the trading and clearing services.
The bid is the price at which the market is willing to buy now, and the ask is the price that the market is willing to sell now. For example, if EURUSD is quoted at 1.2534/1.2536, you can buy immediately at a price of 1.2536 while you can sell your position immediately at the price of 1.2534. Note that if you execute a Buy and then Sell off immediately, you would have lost 2 pips. This is the spread that the broker collects!
Price charts are an important analysis tool that visually displays historical prices in a graphical manner. The price chart is plotted with prices on the Y axis in relation to time on the X axis. Common chart display types are Line charts, Bar charts and Candlestick charts. For bar charts and candlestick charts, 4 price datas are plotted for each time period. They are the opening price, highest price reached, lowest price reached and the closing price of that time period. On the other hand, only 1 price data is plotted at each time period on the line chart. Normally, closing price is plotted. Other chart types are tick chart, Heikin-Ashi, Renko chart and Point & Figures.
Indicators and analysis tools
In addition to past prices, analysis tools such as indicators are also plotted on price charts. Almost all values in indicators are calculated by using past prices as inputs and are thus backward looking to create a forward view or in short, using the past to forecast the future. Common indicators preloaded in trading platforms includes oscillators such as RSI, MACD, ADX and Stochastic Oscillators. They are called oscillators as their value moves in a fixed range, commonly from 0 to 100 and plotted on a separate section by itself. Another family of indicators are not bound in a fixed range and are commonly plotted together on the price chart. These include the moving averages, Fibonacci retracements & extensions, Ichimoko Kinko Hyo, parabolic SAR, pivot points, price channels, price envelops and trend lines.
Another popular technique of trading the markets is based on observing price action and price patterns. Simple trend lines may sometimes be used at the same time to provide clarity. Price patterns can consist of a single price bar such as, pin bars, dojis or morning stars or consist of multiple price bars such as head and shoulders, double tops and bottoms, triangles, pennants and flags, price gaps and more.
Types of trading orders
Common order types that traders can place on trading platforms are market orders, limit orders and contingent orders.
Market orders are sell or buy orders executed right now at market prices. They are filled immediately and will be met with slippages during volatile market environments, such as during major news events.
Limit orders are pending orders away from the current price that will be executed as market orders when price reaches that level. For example, EURUSD is trading at 1.2255 now and you wish to sell the pair at 1.2300 which is a resistance area you have identified. You will then proceed to enter a sell limit order at 1.2300. When price reaches that level, it will be executed as a market Sell at 1.2300. Note that if market activity is volatile at the time the price is reach, you will still be hit with slippage. A limit order does not guarantee a fixed price.
Following the example above, you can tag contingent orders together with your sell limit order. The most common contingent orders are stop loss and take profit orders. When your Sell order at 1.2300 is executed, you might want to protect your position with a 50 pip stop loss order and a 100 pip take profit order. These orders are inputted at the same time you create your limit order.
Portfolio summary, trading capital and margin
The portfolio summary section provides some figures to help you keep track of the equity levels in your trading account. Taking the Oanda FXTrade platform as an example, these numbers include your current Account Balance, Unrealised P&L, Realised P&L, Margin Used and the current Available Margin. Margin is the amount of goodwill deposit you have to utilize in order to open any trading position. Assuming your broker gave you a 100 time leverage facility for trading, it will mean that you need to use at least $1,000 as margin to open a $100,000 position.
Formulating a trading strategy.
A trading plan or trading strategy should be formulated before you begin trading with real money and not during trading hours. During trading hours, you should be concentrating on the task at hand, which is, executing trades according to the way your strategy dictates.
There are 3 main components in a trading strategy. They are entry rules, exit rules and risk management parameters.
Realistic trading time frames and trading hours
Other factors to consider in your trading plan include the timeframe that you are going to trade in and your trading hours. You have to be practical here and really have a good look at how you spend your waking hours. Some traders hold a day job and can only look at the markets and determine trade opportunities before and after work. So there is no point in trading a strategy that is profitable during the most active London hours when you will be at work at the time. Likewise, some traders attempt to do intraday trading by spotting trading opportunities on 1 min charts or lower when they do not have the patience and discipline to stare at the screen with great focus. Not to mention those with weak bladders will find it problematic to stay at their desk while a position is open and the market is volatile. Of course, these problems can easily be circumvented if your trading strategy can be automated and you know enough coding to implement it. This warrants an in depth study all on its own and I will be writing about it soon hopefully. Trading on a shorter time frame offers more trading opportunities at the cost of your free time and greater transaction costs.
Entry rules and exit rules.
Entry rules are simply the way you enter a trade. Take a moving average trading strategy as an example. Trades are taken when price CLOSE above the moving average line, and you enter a long/buy at the open of the next bar. When price closes BELOW the moving average line, you will EXIT your long trade and initiate a short/sell order at the open of the next bar. Most indicator based strategy will require entries on the open of the next bar. If you are trading on the hourly timeframe, a new bar appears at the start of each hour, that very first price of the hour is the OPEN price. Similarly, the last price traded in the previous hour was the CLOSE.
Popular indicators for entry includes SAR, high-low bar close and oscillators among others.
Traders trading based on support and resistance zones or trend lines frequently enter trades once price trades beyond the breakout point. Entering trades when price had closed beyond those levels are just a tradeoff between early entry (and so at a better price) versus more confirmation of a breakout.
More on exit rules.
As mentioned above, some strategies are under the “always-in” category, where exits will mean entering trades in the opposite direction. Likewise, the same indicators used for entering trades can be used as stop loss and exit points as well. A basic trend following strategy will be where one enter long trades when price closes above the previous 10 day high and short when price closes below the previous 10 day low. You can close the trades when price trades below a 20 period moving average for longs, and when price closes above the moving average for shorts. The parabolic SAR is a good trailing stop tool as well.
Risk management parameters.
Risk control is absolutely important and when improperly done can still render you broke even with a winning strategy. Unless you have a 100% win rate, you should never bet the farm or simply enter the largest trading size your margin allows you to take. Even with a trading strategy that wins 9 times out of 10, this might be the one trade that takes out your account. It also does not make sense to bet random amounts or vary your trading size on a whim, you will end up taking a small position on big wins and a large size trading size on big losers. Trading size should be determined both by your account size and the amount of market risk you are taking.
Position sizing can be done in a number of ways and one common way is using the ATR indicator developed by Wilders. This indicator is present in every trading platform, and if for any reason there is not, you can simply add up the high and low range of the past X periods and get the average (in the case of trying to mirror a 20 day ATR, you can find a close approximate figure by calculating the average range of the past 20 days.)
And now, an example to illustrate. Let’s say the ATR for EURUSD in the past 20 days is 110 pips. You get a signal to go long, you may decide to place a stop loss of 55 pips which is half ATR. You are willing to risk 1% of your account on any single trade. Based on an account size of $100,000, that is you are willing to lose a maximum of $1,000 on this trade which it goes against you by 55 pips. Your trading position size will be (1,000 / 0.0055 = 181,818) 181,818 units of EURUSD. This is close to 2 standard lots or 18 mini lots.
The ATR is one of the numerous tools you can use to size your position based on volatility. One of the key advantage is that you can normalise your risk across different asset groups based on their volatility. In short, the first step is always to determine your stop loss level and then calculate your position size accordingly.
This is a general overview of the major topics you will come across or need to know in the course of trading. You can use each new term as the starting point to gain more knowledge about forex trading. This is a never-ending road and there is always something new to learn. Knowledge and practice translates to profits! Good trading!
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