Basics of Forex Trading – Part 1 – FX…
The average daily trading volume of the forex market now exceeds 5 trillion U.S. Dollars, making it the most liquid market in the world. Liquidity refers to how easy it is for market participants to open and close positions without affecting the price of the underlying asset. The concept of liquidity also works hand-in-hand with volatility, which measures the speed and velocity of changing buy and sell prices. The majority of forex traders love volatile markets because they provide greater opportunities to profit, especially with short-term strategies like scalping and day trading.
Forex Trading Risks
Most forex traders lose money over time. Lack of preparation, bad leveraging, weak skill sets, and emotional fatigue all take their toll, triggering losses that eventually force the trader to ‘wash out’, leaving the forex game to the next participant. The profitable minority learn how to overcome these headwinds, often spending hours building skillsets, doing research, and testing new systems and strategies.
In addition, banks around the world seek to manage sovereign and credit risk through bid and ask prices on the interbank quoting system, triggering frequent supply and demand disruptions unrelated to market-moving events or economic releases. These pose a major risk for the typical newcomer who grows complacent between scheduled market movers, failing to place stop losses, or taking too much short-term exposure for their experience level.
Ironically, the new trader’s biggest risk comes from the broker they choose. The vast interbank system is a hodgepodge of ‘regulated brokers’, offering unbiased market access, and ‘unregulated brokers’ who take advantage of customers’ lack of sophistication. These companies are easy to spot because most are domiciled (headquartered) in off-shore tax havens, rather than in the U.S., U.K., E.U., or Australia, which heavily regulate currency trading.
Unregulated brokers do the most damage when they operate a ‘dealing desk’ that takes the other side of a customer’s position and manipulate price through ‘requoting’ to trigger stops and force unexpected losses, especially in the off-hours when most active traders are asleep. It can also be difficult to get your money back when you choose to close an account at an unregulated broker.
Key Forex Trading Terms
Currency Pair: Currency pairs consist of two currencies, the base currency on the left (top) and the quoted currency on the right (bottom). EUR/USD is an example of a currency pair. When buying this pair, the trader buys the Euro and sells the U.S. Dollar. Alternatively, when selling this pair, the trader sells the Euro and buys the U.S. Dollar.
Major Pairs: Currency pairs can be sub-divided into major, cross, minor, and exotic pairs. Major pairs include the U.S. Dollar as the base or counter-currency, coupled with one of seven major currencies: EUR, CAD, GBP, CHF, JPY, AUD, and NZD. New traders focus on major pairs because they’re highly liquid and carry lower transaction costs through tighter spreads, limiting slippage.
Cross Pairs: Cross pairs consist of any two major currencies, except the U.S. Dollar. Unlike major pairs, cross pairs have higher transaction costs, higher volatility, and lower liquidity, increasing potential slippage. Examples of cross pairs include EUR/GBP, EUR/CHF, and AUD/NZD.
Exchange Rate: Exchange rate shows the price of a base currency, expressed in terms of a counter-currency (quoted currency). For example, if the EUR/USD exchange rate is 1.2500, €1.00 will cost $1.25. A rising exchange rate indicates the base currency is appreciating against the counter-currency while a falling exchange rate indicates the base currency is depreciating against the counter-currency.
Bid/Ask: Currency pairs have two exchange rates: the bid price and the ask price. The bid price identifies the current price that market participants can sell (short), while the ask price identifies the current price that market participants can buy. The bid price is always lower than the ask price and the difference between the two is called the spread.
Spread: The difference between the bid price and ask price. The spread marks one type of transaction cost for a trade and a profit source for the broker. This cost can greatly reduce profits or increase losses when engaged in high frequency trading strategies, like scalping.
Pip: Pip refers to ‘percentage in point’, or the smallest increment that a currency pair can rise or fall in price. One pip is equal to the fourth decimal of most currency pairs. For example, if the EUR/USD ask price is quoted at 1.2542 and rallies to 1.2548, the change is equal to six pips.
Hedge: A hedge marks a forex transaction intended to offset or protect another position from positive or negative exchange rate risk. Traders, investors, and institutions apply hedging techniques to enhance profits, limit losses, or protect investments.
Margin: Brokers lend money up to a multiple of account capital, called margin, so traders can take leveraged positions. Borrowed funds incur transaction costs through overnight lending rates. For example, a 30: 1 margin allows exposure up to 30 times higher than account capital. Leveraged positions need to build profits in excess of borrowing costs or they lose money.
Leverage: Leverage allows traders to take positions in excess of account capital through broker margin lending. Taking substantial leverage is risky for new forex traders but an appropriate and required strategy for experienced forex traders.
Major Order Types
The forex trader opens a position through a buy or sell order, specifying whether to take the position ‘at the market’, or at a specified price. A market order will execute immediately at the current ask price for a buy, or current bid price for a sell. Both orders can incur slippage when prices are moving quickly, triggering trade executions at much higher or lower price levels.
A limit order can be used in place of a market order, specifying the price at which a) the limit order turns into a market order or b) the exact price of the entry. The order will be filled when price is hit with the first technique, potentially incurring slippage, but price can ‘skip over’ an order with the second technique and never get filled. Similar limit order types, including stop and stop loss orders, are used to open, manage, and close outstanding positions.
- Buy Stop: open a long position at the price higher than the current price or close a short position at the price lower than the current price.
- Sell Stop: open a short position at the price lower than the current price or close a long position at the price higher than the current price.
- Buy Limit: open a long position at the price lower than the current price or close a short position at the price higher than the current price.
- Sell Limit: open a short position at the price higher than the current price or close a long position at the price lower than the current price.
The forex market has grown hugely popular with new traders and has never been easier to access. Learning the basics of forex trading isn’t overly complicated but choosing the right way to trade requires self-examination, with a realistic view of personality traits, available time, long-term goals, and current income. It’s a rewarding endeavor that benefits from dedication, patience, emotional control, and a willingness to build multiple skillsets and strategies over time.