Forex Explained

You, as a Forex Trader

Trading Forex can be an extremely rewarding experience, both personally and financially yet, as any experienced trader will tell you, it’s the small things that make big differences.

Such as that one extra tool that allowed you to find that great trade, the efficient execution by the broker which got you in & out at the right price, or the right risk-management tools that helped you avoid taking too big of a hit to your trading account on a trade that went the wrong way.

These are just a few of the many factors that come into play on each and every trade.

So when you start thinking about placing several trades per week or per day (or even per hour, for some people)- it’s easy to imagine how getting set up, in the right way, will have considerable impact on your success & profitability as a trader.

Yet, for anyone who’s still new to the business, the difficulty lies in trying to understand:

    • The market terminologies (which also varies between brokers)
    • Costs and risks
    • The various trading platforms and tools
    • Company stability and regulation
    • Service & support
    • Getting a good education

And so on and so on….

Quite simply- it’s hard to even know which questions to ask, let alone being able to gauge the accuracy of the answers, you simply don’t know what you don’t yet know.

The following Key Focus Areas are explained in order to dispel some myths about trading the FX markets and help you decide what’s important to you, in order to give you your best chance of having a long and successful trading career.

What kind of trader are you and what kind will you become?

Before thinking about the markets and brokers, you should take some time to think about how you actually want to trade.

Trading is very much a personal venture and therefore trading-styles can vary greatly. Ranging from the day-trader who spends several hours in front of his multiple monitors each day, looking for opportunities and trying to catch the most from every move, to the more passive trader who places a few trades every few weeks and simply reads his reports & checks his charts every now and then.

Of course, there is also everyone in-between. But, regardless of your intended trading style, you should take some time to think about the following key criteria:

    • How much time are you able to devote to the markets?
    • How much time are you willing to devote to the markets?
    • How technically proficient are you (do you get used to new software fairly easily)?
    • What will you base your trading decisions upon? Charting, news & research, both?

Trading according to your lifestyle and other commitments

One of the major benefits of trading is the flexibility of time that it affords. For this reason, just because you have a job, a spouse, children, hobbies or anything else that takes up your time doesn’t mean you can’t trade successfully. However it does mean that you have to pick a style of trading that you can manage as trading does take a clear & concentrated mind.

Fortunately, the FX market is open 24 hours per day (from early Monday to Saturday morning). Furthermore, the Australian evenings are usually better to trade than the days as the European session is a larger market and is active at these times.

Considering the costs

FX would quite easily be the most cost effective market to trade. Compared to other markets, the costs of getting in and out of trades and of holding trades really are very low.

For example; getting into an FX trade with a value of $10,000 could cost you as little as $1 or less, (depending on your broker) and you would only incur this cost on the way in, whereby a share trade could cost you $20 in plus $20 out.

In the FX market, this cost as well as profits and losses are usually measured in PIPs.

PIP stands for Price Interest Point and is a term that you’ll hear often in this business. Quite simply, it refers to the fourth decimal place in the exchange rate of two currencies (a currency pair).

Understanding FX price quotes

When you buy and sell FX, you’re buying and selling money- the only way to do that is with another kind of money. So, currencies are traded in pairs and, therefore, when you buy one currency- you simultaneously sell the other one in the pair.

Just as if you were to go to your bank to exchange your AUD for USD, you would then be selling the AUD while buying the USD. The exact reverse is also true (buy AUD, sell USD), meaning you can trade currencies in both upward and downward movements- a major advantage, in itself.

Many new traders tend to somewhat struggle in understand price quotes but, if you simply look at them in the same way as shares, it can be quite simple. For example:

If you saw the Google share-price at $492.50, what you’re actually seeing is the price of 1 Google share vs the US Dollar (GOOG/USD).

Therefore, if you saw the EUR/USD at 1.4500, what you’re seeing is that the price of 1 Euro Dollar is 1.4501 US Dollars.

Most importantly, while trading, you don’t need to worry about actually converting currencies as your broker will take care of all of that. A single Australian-Dollar trading account can be used to trade currency pairs from around the globe.

At the end of the day, it’s all about the PIPs in your pocket

At the time of writing this, the Australian Dollar was priced against the US Dollar (through one of our broker-partners) at 1.0578 / 1.0580.

As you can see- there are two prices. The higher is the price that you could buy at (known as the “Ask”), the lower is the price that could sell at (the “Bid”). The difference here is known as the “spread” and, in the case above, it is two PIPs.

What this means is that, if you bought in, you’d buy at 1.0580 and then if you sold out straight away- you’d sell at 1.0578. Your loss therefore, would just be these 2 PIPs.

In a practical example- this would cost you about $1.90 on a $10,000 currency trade.

The better trader is the one that makes the most PIPs, not the most money, and you should measure your results in PIPs as the size of your account will change over time.

So, while the dollar-value of a PIP can change with the size of your trading account, you’ll know you’re getting better if you’re making more PIPs.

Understanding volatility

The FX market is not more volatile than other markets. The opposite is a common misconception yet- most people simply confuse activity with volatility.

FX markets certainly are more active, however, this is a real positive for the trader as- without movements there, are no opportunities. However, in terms of the actual amount of movement (volatility), most FX markets will move considerably less than most other markets.

For example; a 2 or 3% move over 1 day would be a considerable move in a major currency pair, whereas prices in share markets will often move 5 or 10% or much more.

Furthermore, due to it’s size, the market is known to move (trend) stronger and more reliably in a particular direction- once it starts in that direction, meaning more consistent price action and therefore better opportunity for profit (assuming you correctly predict the trend).

Understanding leverage – making your money work harder

Using leverage could also be called gearing and simply means that; whatever the total value of your trade, you would only be required to put up a small percentage of that value as “margin” (like a deposit). Some FX brokers will offer you up to 500:1 leverage but, unless you’re an experienced and aggressive trader, 100:1 should be more than enough leverage for you.

An example of using 100:1 leverage (approximate figures):

    1. Your account size is $5000.
    2. You decide to take a trade of $10,000 of the Aussie Dollar vs the US Dollar (AUD/USD).
    3. Due to the 100:1 leverage (or 1% margin requirement), $100 of your account would be placed to take this trade.
    4. The other $9,900 is being provided by your broker and you would then control a $10,000 trade.
    5. If the AUD/USD exchange rate then moves in your favour by 5%, you’d then control a $10,500 trade and you could exit at a profit of $500, leaving you with an account balance of $5,500 (minus the $1.95 entry/exit cost of the spread).

Note: If the exchange rate moved against you by 5% and you had no risk management measures in place, your account balance would be reduced to $4500.

The first step to profitable trading, in any market, is managing your risk. Everyone knows that there is money to be made from trading yet, what holds most people back is the fear of “losing the house” due to a couple of bad trades.

Acknowledging that there are inherent risks in trading is absolutely crucial to your success however, it’s just as important to understand what those risks actually are, so that you neither overestimate nor underestimate them. Most importantly- you must understand that a good trader always trades within strictly controlled risk levels.

Higher available leverage does not equal higher risk, necessarily…

Many have likened leverage to driving a race-car, but just because you have a top-speed of 300kmh- doesn’t mean that you’d try to reach it on your way down to the supermarket…

Therefore, just because you could take a trade at 500:1 on an FX trade, whereby you may only be able to use 5:1 (or none at all) on other markets, does not make FX trading more risky- as long as you can avoid the temptation to over-leverage.

The most important aspects of leverage to focus upon:

The size of your account, compared to the total size of your all of your open trades.

For example; if you had an account-size of $5000 and you had an open trade of $10,000 you would then be leveraging your account at 2:1. If you took a $5000 trade then you wouldn’t be leveraging your account at all- regardless of whether your actual margin requirement is $100 or $20 (or any other amount).

Don’t worry about margin too much, as many tend to, unless you’re being reckless- you’ll have more available leverage than you should need. Above all- you can and must control your risk.

All brokers will provide you with a range of risk-management tools (such as orders to automatically get you out if the trade goes against you- Stop Loss orders). But, the most important thing to understand is that, once again, you control your risk.

In fact, since you can’t control any of the factors that move prices up and down- your risk is one of the only things that you can control. So, regardless of whether you want to start with an account-size of $1000 or $100,000 – you should only ever risk an amount that you’re comfortable with.

I.e.- if you only want to risk $50 on the trade then only risk $50, regardless of whether your account balance is, for example, $100 or $100,000 (most brokers will offer benefits to higher-deposit accounts).

Quite simply, as long as you do control your risk- there’s no reason to be afraid to at least make a start.

Tools of the trade

With recent advances, trading using advanced technology is now relatively simple. All FX brokers now offer trading software with access to live-streaming-prices, live news & research, comprehensive charting capabilities as well as detailed account-reporting capabilities.

While some brokers provide a trading platform that they’ve developed in-house, others offer third-party platforms (Meta Trader 4 being by far the most common).

Some brokers offer their clients a choice of which trading software to use. If you will need to trade from any PC, or from a company PC which you can’t install software on then it’s a good idea to consider a web-based trading platform.

While the trading universe is full of every latest gadget under the sun; the truth is that it is more than possible to, at the very least, get off on the right foot with just the basics- while spending hardly anything (if anything at all) on trading-tools.

You don’t have to be an economics major to trade FX

Even those that actually do trade economic news announcements are usually basing those trades on how the market will actually react to the news, without needing an in-depth understanding of what the economic news announcement really is.

Most traders (including news-traders) simply base their trading decisions on technical analysis (charting) therefore, once you have a foundational understanding of FX, it’s essentially the same as trading any market.

You will become educated, one way or another, there’s no way around it…

Most brokers offer education that’s designed to help you get started in trading, especially in how to place orders and open charts and the like (please note: the level of education & support can vary greatly between brokers). Although, in order to learn effective risk management principles, develop a method of picking trades and all of the other crucial elements of your all-important trading-plan, you simply must face one of two choices; either get yourself an education… or let the market do it for you.

The latter, for reasons of time, money & personal stress is simply not an attractive option. To the inexperienced, markets inevitably prove that, although getting started can be easy; developing a strategy that fits your time-schedule, level of risk tolerance & achieves desirable results can take years. Unfortunately, most just don’t make it at all…

You don’t need to pay an arm & a leg for good education

In addition to the free education provided by brokers (some), there are several excellent books- all of which can offer an excellent, low-cost form of education. For FX education, we also recommend you register as an IU Member (which is completely free), at least as a good way to get started.

Getting off on the right foot: Where to go from here…

    1. Decide how you plan to trade, thinking about what your trading goals are. In other words; why are you getting into this business? As a hobby? For some extra income? To replace your income? To build capital for your retirement? And, very importantly- how much time you’ll have to do so.
    2. Understand the risks involved in trading, particularly in leveraged products, and that you must trade them with proper risk management and the discipline to not get carried away. Avoid emotions completely- both greed and fear.
    3. Decide how much capital that you’d like to open your account with- remembering that some brokers will offer benefits to larger account holders, and most importantly- this doesn’t need to affect how much you risk on each trade.
    4. Think about which tools you’ll need, remembering that if you’re still somewhat new, there may not be much point in spending a great deal on a tool that you won’t be using if or when your trading style changes.
    5. Remember that education is not just crucial- it’s unavoidable, think about how you’ll learn about all of the crucial elements that will make up your trading plan.
    6. Open an account with a quality broker that will suit your trading style & goals.