The ABCs of Forex Trading

What is Forex trading?

Speculative Forex trading is an exciting world with fortunes lost and gained daily, it isn’t for the faint hearted. So what makes forex trading such an exciting endeavor? Forex trading and forex market is as simple as it is complex. Simple in the way how anybody from any part of the world with internet access and a few hundred dollars can trade it; and complex in the way how innumerable factors affect the daily movement of the global currencies. Needless to say if you don’t know what you are doing you can easily get hurt. In fact even seasoned professionals can and do routinely lose money in Forex trading. But what keeps millions of traders, small and large, coming back? It is the simplistic nature of speculative Forex trading in a market place that offers a level playing field for small and large traders alike. You can certainly apply the saying “it takes a couple of weeks to understand but a lifetime to master” in Forex trading.

In Forex trading, you buy and sell currencies-buying the stronger currency against the weak and vice versa. There is no restriction in the order of your transaction, meaning you can sell a currency pair first and buy it later, commonly known as “shorting” (if you think the market will move down before it goes up). Understanding the basics of Forex trading is a must before you venture into the world of currency trading.

Currency Pairing

First, it is best to understand that currency trading in the Forex market is always done in currency pairs. For that matter any time you exchange one thing for another you are dealing in “pairs”. For instance when you buy anything from your local grocer you are exchanging money for the goods and services, and each is valued in relative unit terms to the other (example $1.00 = 1 Orange, so Orange/$ exchange rate is $1.00). So if the Euro is paired with the US Dollar it is coded as EUR/USD or simply how much 1 Euro cost in Dollar. Normally, as far as quoting conventions are concerned, the currency representing greater value, or economic strength historically is used as the “base” currency (or the currency on the left), whose value is given in terms of the “counter currency” (or the currency on the right). As an example, a EUR/USD 1.1100 only means that 1 Euro is equivalent to 1.1100 US Dollar. To buy 1 Euro, you will need 1.1100 US Dollar. Note that the currency rate is normally quoted out to four decimal places (0.0001), with the exception of Japanese YEN and other currencies whose relative values are much smaller, in which case they are quoted out to only two decimal (00.01). The last digit of the quoted currency is known as a “Pip” which is the lowest number by which the currency value moves up or down. This is the standard format in Forex trading.

Basic Practices in Forex Trading

To start in Forex trading, you will need to open an account with an online Forex trading broker. If you have ever traded on margins, forex market offers one of the highest levels of leverage in the financial market place. If you are not familiar with leverage, it is simply a way to amplify your purchasing power. Forex trading firms usually give 1:100 leverage for traders. This means that if you have $1000 dollars in your account, you can trade dollars worth $100,000.

Once you have an account you can simply start your Forex trading by defining your view. You identify based on technical and or fundamental analysis which currency you feel is the strongest and which is the weakest, then you simply buy the strongest against the weakest currency. For instance, if you think that US dollar is weak because of various news and chart patterns that you have observed, and Euro is strongest among other currencies as it has been gaining across the board, you would simply look to buy EUR/USD and wait for it to appreciate. However markets can and do reverse all the time so there is no guarantee that you will profit. The point is to make sure that you understand the basic market dynamics before you make decisions to buy and sell and that will give you the best chance of succeeding.

The spread is another factor that you have to consider, and it is the difference between the buying and the selling price at any give moment. Market makers generally always give you a two way quote, (one price to buy and another to sell). The difference between the buying price or the “Ask” and the selling price or the “Bid” is known as the spread. In Forex trading the spreads importance depends on your trading strategy. If you are a high frequency trader, and trade multiple times in day for short periods of time (also known as a “Daytrading”) then you should look to trade on the narrowest spreads possible, as wide spreads will have a greater impact on your overall profitability. On the other hand if you don’t trade frequently but take positions and keep them for days before exiting then narrow spreads should not be of any real concern.

Forex Trading Strategy

Forex Trading strategies can basically fall into two categories as mentioned above- short term trading (Daytrading high frequency trading,) or mid to long term trading (swing trading, days to weeks)); and if you take positions for longer periods of time then that falls in the category of investing and not trading. Leverage, like the spread, plays an important role depending upon your trading strategy. For day trading, and high frequency trading high leverage is more preferable, whilst for swing trading and as you extend more into investment zone then low to no leverage should be employed. Why? Because as a short term trader, you want to maximize your profits by capturing small movements in the market place. Leverage amplifies market movements, hence your portfolio movements, but in short term trading, you don’t leave your positions open long enough and are more intone with market movement tick by tick, so you are actively managing the risk that is inherent with high leverage. Long term trading does not usually require actively viewing the market tick by tick, hence using high leverage can be fatal for a portfolio as you may not be aware of any sudden sharp movements that along with high leverage can wipe out your portfolio. So in Forex trading it helps to identify your strategy along with the proper levels of leverage and spreads, which will ensure safety of your funds and continued success.

The Rollovers

Spot deals are the most common practice in Forex trading. Due dates of spot deals are two days after the transaction. It means that delivery of what you buy or sell should be done within two working days. However, in the world of speculative forex trading, majority of traders do not take delivery of any currency but instead “roll” their positions forward on the delivery date. This service is normally done by the market maker and does not require you as retail traders to take any action. If the position is left open at the close of Forex trading floor, it will be automatically rolled over to the next transaction date to avoid delivery of the currency. This is to allow the position to be opened and speculate further on the Forex trading market.

Along with rollover comes an interest charge that is either paid to you or charged on your account at the time of rollover (which usually takes place around 5 Pm US Eastern Time). Rollover calculation of interest is based on the current or prevailing interest rates of currencies involved in Forex trading. If you bought a currency and it has a higher overnight interest rate than the paired currency, you will gain interest from the rollover. However, if you sell a currency with a higher overnight interest rate, then you will lose from the rollover and the interest charges will be made against your Forex trading account.

Aside from knowing the basics of Forex trading, it is also best to analyze the market in order to determine the direction the general direction. There are two ways to analyze the Forex trading market. You can use fundamental analysis or technical analysis.

Fundamental analysis vs Technical analysis in Forex trading

These two approaches can be used simultaneously but proponents of the two schools of thought are always in disagreement on what should be the best analytical tool to predict the movement of the Forex trading market. This technical analysis vs. fundamental analysis dichotomy has been the subject of much debate and produced papers and counter-papers. It is better to know the basics of both analytical methods in order for you to choose which one is appropriate for your needs in Forex trading.

Fundamental analysis delves into the intrinsic value of the currency. The intrinsic value is usually the economic fundamentals underlying in the given currency. In countries, the economic fundamentals are the prevailing interest rates, the economic growth rate, the ability to pay foreign obligations, the movement of the currency, and the existing stability of political leadership. If one or many of the mentioned fundamentals suffer a crisis, the fundamental analyst will definitely predict a downslide in the intrinsic value of that country’s currency in Forex trading.

Technical analysis for Forex trading, on the other hand, does not care about economic fundamentals. Analysts using this method rely mainly on statistical probability. They analyze the history and past movements of currencies and predict statistically future movements in the Forex trading floors. It is purely based on mathematical assumptions, which in some way can be pretty accurate. Technical analysis believes that the fundamental of the currency is always reflected on the Forex trading floor at any given moment. The fundamentals essentially are embedded in it. So, there is no need to analyze the economic fundamentals. Instead, the work would be easier if you can make calculations based on past history of the Forex trading floors, its price movements and fluctuations.

Generally speaking, fundamentals impact the overall market direction in the long run while the technical analysis and patterns help determine short term movement in the overall trend.