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Forex Basics

How can I trade Forex?

It is now easier than ever before to get involved in trading the dynamic foreign exchange markets, with the internet providing traders with 24 hour access to advanced trading software. Working from your average PC or laptop it is possible to download a platform such as the MetaTrader 4 at no cost and begin trading forex at a moment’s notice.

But despite the availability of software and constant market access, there are several reasons why would-be traders should take the time to research the field thoroughly before committing any money. Some key questions include: what currencies should I be trading; how can I minimise trading risk; what broker do I use; and how long should I trade a demo account before taking the leap to real money?

How do I read forex ‘quotes’?

In order to be able to trade foreign currencies, it is vital that you understand the way pair prices are communicated. A forex quote will show you the current price of any given currency pair, with the quote itself consisting of three parts.

As you can see from the diagram the ‘symbol’ or ‘currency’ category represents the two currencies that are being traded. In this category, you will find the abbreviated versions of the currencies in the pair. The EUR/USD represents the euro (shared currency of euro zone nations) and dollar (United States currency). Some of the most common pairs – otherwise known as major pairs –include the EUR/USD, USD/JPY, GBP/USD and USD/CHF.

The first currency pair in a quote is called the ‘base’ currency; this is the currency being valued within the quote. The second half of the quote indicates which currency is being compared to the base. In a quote which reads EUR/USD 1.5536, the euro is the currency being valued per unit – and in this instance it would be worth $1.5536 per single euro.

The ‘ask’ price represents the price at which the market is currently willing to sell that particular currency. In other words, it is the price that a buyer must pay in order to buy up, for example, euros.

The ‘bid’ category represents the price at which other traders are willing to buy that particular currency. The difference between these two prices is known as the ‘bid-ask spread’, this spread will vary in size between various assets because of the difference in liquidity (the availability of the given asset).

Pips

A pip is the smallest measurement for a currency rate and it is usually found at the fourth decimal place in all the major currency pairs. It stands for Percentage In Point and is so called because it usually represents about 1/100th of a given currency quote. This can also be known as one basis point.

For example:
If the exchange rate for the GBP/CAD goes from 1.0384 to 1.0386, it will have gone up by TWO pips.

If the GBP/CAD went up from 1.0384 to 1.0484 - because of the positioning of the decimal place in a regular forex quote – it will have gained 100 pips.

There is one exception to the rule and that is the Japanese yen, which uses the second decimal. For example:
If the JPY/USD exchange rate went from 80.12 to 80.15 it will have gone up by THREE pips.

Spreads

Take a look again at the picture in the preceding example, for the EUR/USD, we have a ‘bid’ price of 1.5536 and an ask price of 1.5538; the difference between these two values is what is known as the spread. In this example, the spread is worth it is 0.0002 (or 2 pips).

The spread is important because it represents transaction costs for you the trader. Generally speaking, you want the smallest spreads possible so you pay less for your transactions.

Let's say you buy the EUR/USD at 1.5536 from your broker or, in other words, your broker sold you euros at 1.5536. Because your broker is an active market maker, they have the ability to then go and offset those euros by buying euros from someone else at 1.5532. The broker just made four pips from your trade. This would not be an unusual scenario and is how many brokers make their money.

Lots

A ‘lot’ is term used by forex traders to describe how much of a given currency they are trading.

A ‘micro lot’ is one thousand units of currency, meaning the smallest trade that you can place is 1000 units. If you placed an order of one lot – you would receive 1000 currency units, whereas if you placed an order for 10 lots, you would receive 10 000 lots. In the forex markets however, 1 standard lot tends to be equal to 100,000 units of the base currency.

More than one lot may be ordered as long as the order follows increments of the original lot size. It is always important to bear in mind the leverage working on your account because this can expose you to more risk than you may at first assume as a beginner.

The lot sizes listed above still don't represent the exact amount of transaction costs for trading forex. You would have to factor in the effects of leverage and margin in your own personal trading in order to get an accurate picture.

Leverages

In forex trading, leverage is the tool which allows traders to access a higher rate of purchasing power. A standard amount of leverage in the forex markets is 100:1. This means that for every dollar in your account, you receive $100 of purchasing power. Once you have, say, $1 500 in your account, you will have enough to purchase a standard lot – all thanks to leverage.

Leverage therefore, despite its bad reputation as a result of the credit crisis of 2008, is what allows retail traders to partake in the potentially lucrative forex markets. Obviously it is important to use leverage with respect, ensuring that you are fully aware of how much leverage is being applied to your account and what the repercussions are for you as the account holder.

Margin

The margin is the amount of money that a broker requires a trader to their account before he/she is able to make a forex transaction. If you are in the market to purchase a single standard lot of the EUR/GBP and you have an account which offers 100:1 leverage, you will still be required to have a certain amount of money – or margin – in your account in order to finance that transaction.

Let’s take an example:
If 1 x lot of EUR/USD stands at the typical 100,000 EUR and the exchange rate is 1.5536, you must multiply these two number together in the first instance.

Once you have this figure, you will need to multiply it by the leverage your account offers. At 100:1 leverage, you will be looking at 155, 360 USD x 0.01 in order to work out your margin. Thus, a broker would require you to have at least $1553.60 in your account as a margin for this transaction.

How much am I making/losing?

This is what it all comes down to for traders. It’s all very well knowing basic terms and providing the readies for a trade, but understanding whether you are making or losing money is one of the most important skills you can learn.

Let's carry on with our previous example of one lot of EUR/USD at 1.5536 with a leverage of 100:1. As soon as the pair moves to 1.5537, you have made $10. Every pip of EUR/USD movement within 1 single lot is equal to a $10 gain for the trader.

Don’t forget, if you have a smaller lot size, the amount of $ per pip movement will be reduced. The chart below provides a handy summary of how lot sizes have the potential to affect profitability. Choosing a smaller lot evidently size reduces the risk for beginners who are still keen to act cautiously, whereas larger lots carry greater risk but also the potential for greater profit.

Charts – how do I read them?

One of the most popular ways that forex traders choose to view the markets in action is through the charts of specific currency pairs. The charts below provide examples of the popular candlestick chart, in varying degrees of detail:

The chart to the left is a close-up of an individual candlestick, complete with descriptions of what the various parts of the candlestick indicate to traders.

The chart to the right is a candlestick chart of the daily EUR/USD currency pair and shows the day’s price high, low and close values for the EUR/USD pair.

As the day progresses, the corresponding day’s candlestick will move accordingly until the entire day’s price action has been consolidated into one candle.

The bottom of the chart or X-axis tracks the date, while the Y- axis marks out time. The most recent price on the chart above –and many others of its type – is represented by a horizontal grey line, which moves as the price itself moves.

Some traders use charts to predict future currency moves by analysing the past performance of given currency pair against a particular strategy or certain market conditions; this is known as technical analysis.

Price Movement

There is a limited supply of all the currencies in the world; price movement is the effect of the laws of supply and demand on the price of those currencies.

When an event occurs that increases the demand for dollars, the laws of supply and demand dictate that dollar bid price is sent higher. As investors flock to get their hands on dollars, people selling will recognise that demand is high and they will increase their asking price.

When the converse situation is true and either demand for the currency is low, there is an increase in the amount of sellers in the marketplace or there is an injection of liquidity into the market (thereby increasing supply) - the price per unit is prone to go down.

There are many reasons why investors make the decision to buy or sell currencies. Some of these might include a change in interest rates, gross domestic product, inflation rates, stock prices or the overall economic health of a nation. Investors are often keen to stay up to date with the latest world news in order to make decisions about the direction they think a currency will take, and therefore whether they wish to buy or sell.

Risk Management

Risk Management, (also known as money management) is probably the most important factor for any trader or investor. Risk management is what allows an individual to minimise their losses, allowing them to continue trading and leave with a profit. Without any money management, you are effectively gambling.

It is important to realise that every trader will at some point in their trading career lose money, it's the size of that loss that counts. A good rule of thumb is to never risk more than 2-5% of account equity on each trade they place. Another must is that you use a stop loss on every trade made. Under this scenario, it would take 20-50 trades before one goes completely broke.

The way to control your risk is through the quantity of lots you trade and not necessarily through the level of your stop loss.

For example, you believe that the EUR/USD is going to rise based on your fundamental and technical analysis of that market. What you should do next is find a place on the chart where you would want to stop out if your predictions proved wrong – so if you’re buying at 1.5000 then you may pick out a level of 1.4950 for your stop loss (a 50 pip stop loss). Now, you figure out what 2% of your account balance is. Let's say it is $5,000 X .02 = $100. You now know that you have $100 of capital to spread out across 50 pips, which means you have $2 to risk for each pip. $100/50 (pips of risk) = $2/pip. This is equal to a lot size of .2 (or 2 mini lots).

This is a suitable way to manage risk and is a process every trader should go through each time they look to place a trade.

Trading Strategy

Before you begin trading, you should have a well thought out trading plan that encompasses every aspect of your trading, including: type of analysis (technical vs fundamental); which indicators to use; what measurements are being used; how you plan to manage your risk; what quantity you will trade/risk and how you will be able to continuously execute your strategy regardless of the multiple emotional issues that may come to play.

This trading strategy should be tailored to you and your strengths. Just because one trader may be doing well with their strategy, does not mean it will work for you too.

To develop the actual strategy that will guide your trades, one must study the market consistently. Hours of analysis, reading, and demo trading will be needed in order to profitably trade the market. Ideally, you will be able to back test your strategy, however, to do this, you will need to either program your strategy or find someone to do it for you. Once you have found the right plan for you the next step is how you will manage your risk.

Risk management is what will keep you alive. All traders make losses and all traders go through draw downs. What is important is that the draw downs don't put you out of the game for good. You have to stick to and trust your strategy; you must trust that - even if you have a losing trade - you will bounce back and your strategy will continue to show long term profitability.

Trading is all about making (and losing) money. Forex is pretty much as raw as any profession can get and because of this your emotions will affect your ability to stick to your strategy. It is common to feel fear if you begin to lose money and, as a result, hold on to a losing trade in the hope that your position will turn around. You are also likely to feel greed as you begin to make money and hold on to a winning trade for too long. Trading is a very emotional profession and conquering your emotions and maintaining solid discipline above all is an absolute must.