Forex trading

Getting Started In Forex

2007-09-30T08:26:00.000-07:00

The forex (FX) market has many similarities to the equity markets; however, there are some key differences. This article will show you those differences and help you get started in forex trading.

Choosing a Broker
There are many forex brokers to choose from, just as in any other market. Here are some things to look for:
Low Spreads - The spread, calculated in "pips", is the difference between the price at which a currency can be purchased and the price at which it can be sold at any given point in time. Forex brokers don't charge a commission, so this difference is how they make money. In comparing brokers, you will find that the difference in spreads in forex is as great as the difference in commissions in the stock arena.
Bottom line: Lower spreads save you money!

Quality Institution - Unlike equity brokers, forex brokers are usually tied to large banks or lending institutions because of the large amounts of capital required (leverage they need to provide). Also, forex brokers should be registered with the Futures Commission Merchant (FCM) and regulated by the Commodity Futures Trading Commission (CFTC). You can find this and other financial information and statistics about a forex brokerage on its website or on the website of its parent company.
Bottom line: Make sure your broker is backed by a reliable institution!

Extensive Tools and Research - Forex brokers offer many different trading platforms for their clients - just like brokers in other markets. These trading platforms often feature real-time charts, technical analysis tools, real-time news and data, and even support for trading systems. Before committing to any broker, be sure to request free trials to test different trading platforms. Brokers usually also provide technical and fundamental commentaries, economic calendars and other research.
Bottom line: Find a broker who will give you what you need to succeed!

Wide Range of Leverage Options
- Leverage is necessary in forex because the price deviations (the sources of profit) are merely fractions of a cent. Leverage, expressed as a ratio between total capital available to actual capital, is the amount of money a broker will lend you for trading. For example, a ratio of 100:1 means your broker would lend you $100 for every $1 of actual capital. Many brokerages offer as much as 250:1. Remember, lower leverage means lower risk of a margin call, but also lower bang for your buck (and vice-versa).
Bottom line: If you have limited capital, make sure your broker offers high leverage. If capital is not a problem, any broker with a wide variety of leverage options should do. A variety of options lets you vary the amount of risk you are willing to take. For example, less leverage (and therefore less risk) may be preferable for highly volatile (exotic) currency pairs.

Account Types
- Many brokers offer two or more types of accounts. The smallest account is known as a mini account and requires you to trade with a minimum of, say, $250, offering a high amount of leverage (which you need in order to make money with so little initial capital). The standard account lets you trade at a variety of different leverages, but it requires a minimum initial capital of $2,000. Finally, premium accounts, which often require significant amounts of capital, let you use different amounts of leverage and often offer additional tools and services.
Bottom line: Make sure the broker you choose has the right leverage, tools, and services relative to your amount of capital.

Things To Avoid
Sniping or Hunting - Sniping and hunting - or prematurely buying or selling near preset points - are shady acts committed by brokers to increase profits. Obviously, no broker admits to committing these acts, but a notion that a broker has practiced sniping or hunting is commonly believed to be true. Unfortunately, the only way to determine which brokers do this and which brokers don't is to talk to fellow traders. There is no blacklist or organization that reports such activity.
Bottom line: Talk to others in person or visit online discussion forums to find out who is an honest broker.

Strict Margin Rules
- When you are trading with borrowed money, your broker has a say in how much risk you take. As such, your broker can buy or sell at its discretion, which can be a bad thing for you. Let's say you have a margin account, and your position takes a dive before rebounding to all-time highs. Well, even if you have enough cash to cover, some brokers will liquidate your position on a margin call at that low. This action on their part can cost you dearly.
Bottom line: Again, talk to others in person or visit online discussion forums to find out who the honest brokers are.
Signing up for a forex account is much the same as getting an equity account. The only major difference is that, for forex accounts, you are required to sign a margin agreement. This agreement states that you are trading with borrowed money, and, as such, the brokerage has the right to interfere with your trades to protect its interests. Once you sign up, simply fund your account, and you'll be ready to trade!

Define a Basic Forex Strategy
Technical analysis and fundamental analysis are the two basic genres of strategy in the forex market - just like in the equity markets. But technical analysis is by far the most common strategy used by individual forex traders. Here is a brief overview of both forms of analysis and how they apply to forex:

Trade To Your Taste

2007-09-30T08:21:00.000-07:00

Do you like to fish, or do you prefer downhill skiing? How you answer that question may have a greater impact on your trading success than the most robust trading strategy you can devise. The FX market offers multiple avenues to trading success, but in order to take advantage of these opportunities, you must first understand your strengths and weaknesses. Most traders are taught that there is only one "proper way to trade". Nothing could be further from the truth. As an adult, you are highly unlikely to change your ways; markets, on the other hand, change all the time. Therefore, it is far easier to find a trading technique that is in sync with your personality than to try to conform to someone else's idea of a "proper trader".

Trading Strategies
So, why are fishing and downhill skiing so important? Believe it or not, this is a question about trend and counter-trend trading. Fishers trend, skiers fade. This is because fishing requires time, methodology and, most importantly, patience. Like trend traders, those who fish will cast their line many times before they get a bite. Downhill skiers, on the other hand, look for the quick thrill with a very specific goal - the end of the run. This psychological drive is similar to what drives faders - the quest for fast profits as currency prices make a quick retrace. Does fishing always lead to trend trading and skiing to counter-trending? Of course not. However, the activity you choose suggests a definite predilection for one style versus the other.

Timelines
The trend versus fade dynamic leads to the second important question that traders need to ask themselves. Are you more comfortable trading short-term or long-term time frames? Generally, traders who like to put on trend-based trades will work on longer timelines, if for no other reason than that trends in FX tend to develop over months rather than days. Faders who look for quick turns in market sentiment will usually operate on much shorter time frames.

Typically, the shortest effective time frame to trade the currency market is on the hourly charts with average risk/reward targets of at least 30 points, since the spread nature of the market means that trades that are any smaller are ineffective. For example, take the EUR/USD pair, which is the most liquid financial instrument in the world and typically trades 3 points wide on the bid/ask spread. A trader with a 10-point target and a 10-point stop would actually have to earn 13 points (10 points + 3 points of spread), but would be forced to stop out at only 7 points (10 points - 3 points of spread). After hundreds of trades, this negative skew in the risk/reward equation makes it very difficult to generate profits on such short time frames.

Type of Analysis
Once you have determined what time frame suits you best, the next question you must ask yourself is this: what type of analysis should you use to make proper trade selections? No issue creates more arguments on trading desks than the debate between fundamentalists and technicians.

Fundamentalists scoff at technicians' attempts to forecast future price movement by looking at the present price action on the charts. Hard core proponents of fundamental analysis consider technical analysis not much better than the ancient ritual of divining the future from the entrails of dead animals. News, economic reports and commentary from monetary officials are the primary tools of fundamentalists. Technicians, for their part, dismiss most fundamental data as woefully inconclusive and contradictory, believing instead that any material news will be reflected in the price action of the currency pair and will therefore provide objective clues to future direction.

Which camp has got it right? Neither one. Trading on technicals or fundamentals alone is a sucker's game, akin to wanting to box for the world championship title with one arm tied behind your back. Fundamentalists can talk all they want about the secular global demand for oil that will drive the price of crude to $100/bbl and will take the Canadian dollar to parity with the greenback, but if they choose to short USD/CAD at a grossly oversold level as momentum shows large divergence on the charts, then they will likely lose money on the trade - even if their analysis is ultimately correct. Conversely, a technician could short a major Fibonacci cluster to his heart's content, but if a piece of economic news surprises the market to the upside, his shorts will be run over like jungle shrubbery after an elephant stampede as traders try to cover their positions, ignoring various resistance levels.

Keep An Eye On Momentum

2007-09-30T08:17:00.000-07:00

One of the key tenets of technical analysis is that price frequently lies, but momentum generally speaks the truth. Just as professional poker players play the player and not the cards, professional traders trade momentum rather than price. In forex (FX), a robust momentum model can be an invaluable tool for trading, but traders often grapple with the question of what type of model to use. Here we look at how you can design a simple and effective momentum model in FX using the moving average convergence divergence (MACD) histogram.

Why Momentum?
First, we need to look at why momentum is so important to trading. A good way to understand the significance of momentum is to step outside of the financial markets altogether and look at an asset class that has experienced rising prices for a very long time - housing. House prices are measured in two ways: month-over-month increases and year-over-year increases. If house prices in New York were higher in November than in October, then we could safely conclude that demand for housing remained firm and further increases were likely. However, if prices in November suddenly declined from prices paid in October, especially after relentlessly rising for most of the year, then that might provide the first clue to a possible change of trend. Sure, house prices would most likely still be higher in a year-over-year comparison, lulling the general public into believing that the real estate market was still buoyant. However, real estate professionals, who are well aware that weakness in housing manifests itself far earlier in month-over-month figures than in year-over-year data, would be far more reluctant to buy under those conditions.

In real estate, month-over-month figures provide a measure of rate of change, which is what the study of momentum is all about. Much like their counterparts in the real estate market, professionals in the financial markets will keep a closer eye on momentum than they do on price to ascertain the true direction of a move.

Trading On News Releases

2007-09-30T08:16:00.000-07:00

One of the great advantages of trading currencies is that the forex market is open 24 hours a day (from 5pm EST on Sunday until 4pm EST Friday). Economic data tends to be one of the most important catalysts for short-term movements in any market, but this is particularly true in the currency market, which responds not only to U.S. economic news, but also to news from around the world. With at least eight major currencies available for trading at most currency brokers and more than 17 derivatives of them, there is always some piece of economic data slated for release that traders can use to inform the positions they take. Generally, no less than seven pieces of data are released daily from the eight major currencies or countries that are most closely followed. So for those who choose to trade news, there are plenty of opportunities. Here we look at which economic news releases are released when, which are most relevant to forex (FX) traders, and how traders can act on this market-moving data.

Which Currencies Should Be Your Focus?
The following are the eight major currencies:

1. U.S. dollar (USD)
2. Euro (EUR)
3. British pound (GBP)
4. Japanese yen (JPY)
5. Swiss franc (CHF)
6. Canadian dollar (CAD)
7. Australian dollar (AUD)
8. New Zealand dollar (NZD)

This is just a sample of some of the more liquid derivatives based on the currencies above:

1. EUR/USD
2. USD/JPY
3. AUD/USD
4. GBP/JPY
5. EUR/CHF
6. CHF/JPY

As you can see from these lists, the currencies that we can easily trade span the entire globe. This means that you can handpick the currencies and economic releases to which you pay particular attention. But, as a general rule, since the U.S. dollar is on the "other side" of 90% of all currency trades, U.S. economic releases tend to have the most pronounced impact on the market.

Trading news is harder than it may sound. Not only is the reported consensus figure important, but so are the whisper number and the revisions. Also, some releases are more important than others; this can be measured in terms of both the significance of the country releasing the data and the importance of the release in relation to the other pieces of data being released at the same time.

Mergers And Acquisitions - Another Tool For Traders

2007-09-30T08:14:00.000-07:00

One of the most important things you will learn when trading the currency market is that the world is interconnected. The stock, bond, commodity and currency markets all have a hand in each other's business. There is no rule written in stone about which market has a leading or lagging effect on another. Rather, any one of the markets can lead or lag the other markets. In the article Bond Spreads: A Leading Indicator For Forex, we looked at how movements in the bond market can be used to trade in the forex (FX) market. Here we will focus on how the stock market can impact the currency market and how traders can use this information to identify trading opportunities.

How Are the Two Connected?
The equity market can impact the currency market in many different ways. For example, if a strong stock market rally happens in the U.S., with the Dow and the Nasdaq registering impressive gains, we are likely to see a large influx of foreign money into the U.S., as international investors rush in to join the party. This influx of money would be very positive for the U.S. dollar, because in order to participate in the equity market rally, foreign investors would have to sell their own domestic currency and purchase U.S. dollars. The opposite also holds true: if the stock market in the U.S. is doing poorly, foreign investors will most likely rush to sell their U.S. equity holdings and then reconvert the U.S. dollars into their domestic currency - which would have a substantially negative impact on the greenback. This logic can be applied to all the other currencies and equity markets around the world. It is also the most basic usage of equity market flows to trade FX.

We attempt to take equity flows one step further by looking at how currency traders can use merger and acquisition (M&A) news to trade FX. In basic terms, mergers and acquisitions are a combination of two or more companies, or the acquisition of a part of a corporation for which some payment is given in compensation. This payment can be in stock, cash or a combination of the two. (For an in-depth look at M&As, see our tutorial The Basics Of Mergers And Acquisitions.) Professional FX traders will generally focus on large cross-border M&A activities greater than US$1 billion. The key is for traders to look primarily at cross-border flows rather than every large M&A transaction. Why is this important? Because a cross-border M&A transaction is a transaction in which the target company and the acquiring company are from different countries: this means that, in order to make the deal complete, there must be some sort of currency transaction. If the deal involves no cash, a simple payment to the bankers for conducting the deal may be all we're looking at, but if the deal does involve cash, the significance and potential impact of the transaction is far greater.

How Can This Information Be Used?

M&A Deals à Average 1% Appreciation in Target's Currency
Every $1 Billion à 0.5% Positive Impact on Target's Currency
In a study conducted in 2000 by Francis Breedon and Francesca Fornasari of Lehman Brothers entitled "FX impact of cross-border M&A", it was found that, on average, large M&A deals cause the domestic currency of the target corporation to appreciate by 1% relative to the acquirer's. For every $1-billion deal, the currency of the target corporation increased in value by 0.5%. More specifically, the report found that in the period immediately after the deal is announced, there is generally a strong upward movement in the target corporation's domestic currency (relative to the acquirer's currency). Fifty days after the announcement, the target currency is then, on average, 1% stronger. However, the study found that this currency impact tends to peak at approximately 5%.

According to our observation, since the market is predominantly an expectations market, we generally see a large portion of the move that can be attributed to M&A activity occur within the first week of the announcement.

Trading The MACD Divergence

2007-09-30T08:11:00.000-07:00

Moving average convergence divergence (MACD), invented in 1979 by Gerald Appel, is one of the most popular technical indicators in trading. MACD is appreciated by traders the world over for its simplicity and flexibility because it can be used either as a trend or momentum indicator.

Trading divergence is a popular way to use MACD histogram (which we explain below), but, unfortunately, the divergence trade is not very accurate - it fails more than it succeeds. To explore what may be a more logical method of trading MACD divergence, we look at using the MACD histogram for both trade-entry and trade-exit signals (instead of only entry), and how currency traders are uniquely positioned to take advantage of such a strategy.

MACD: An Overview
The concept behind MACD is fairly straightforward. Essentially it calculates the difference between an instrument's 26-day and 12-day exponential moving average (EMA). Of the two moving averages that make up MACD, the 12-day EMA is obviously the faster and the 26-day is the slower. In the calculation of their value, both moving averages use the closing prices of whatever period is measured. On the MACD chart, a 9-day EMA of MACD itself is plotted as well, and it acts as a trigger for buy and sell decisions. MACD generates a bullish signal when it moves above its own 9-day EMA, and it sends a sell sign when it moves below its 9-day EMA.

Trading Trend Or Range?

2007-09-30T08:07:00.000-07:00

Whether trading stocks, futures, options or FX, traders confront the single most important question: to trade trend or range? And they answer this question by assessing the price environment; doing so accurately greatly enhances a trader's chance of success. Trend or range are two distinct price properties requiring almost diametrically opposed mindsets and money-management techniques. Fortunately, the FX market is uniquely suited to accommodate both styles, providing trend and range traders with opportunities for profit. Since trend trading is far more popular, let's first examine how trend traders can benefit from FX.

Trend
What is trend? The simplest identifiers of trend direction are higher lows in an uptrend and lower highs in a downtrend. Some define trend as a deviation from a range as indicated by Bollinger Band "bands" (see Using Bollinger Band "Bands" to Trade Trend in FX). For others, a trend occurs when prices are contained by an upward or downward sloping 20-period simple moving average (SMA).

Regardless of how one defines it, the goal of trend trading is the same - join the move early and hold the position until the trend reverses. The basic mindset of trend trader is "I am right or I am out?" The implied bet all trend traders make is that price will continue in its present direction. If it doesn't there is little reason to hold onto the trade. Therefore, trend traders typically trade with tight stops and often make many probative forays into the market in order to make the right entry.

By nature, trend trading generates far more losing trades than winning trades and requires rigorous risk control. The usual rule of thumb is that trend traders should never risk more than 1.5-2.5% of their capital on any given trade. On a 10,000-unit (10K) account trading 100K standard lots, that means stops as small as 15-25 pips behind the entry price. Clearly, in order to practice such a method, a trader must have confidence that the market traded will be highly liquid.

Of course the FX market is the most liquid market in the world. With US$1.6 trillion of average daily turnover, the currency market dwarfs the stock and bond markets in size. Furthermore, the FX market trades 24 hours a day five days a week, eliminating much of the gap risk found in exchange-based markets. Certainly gaps sometimes happen in FX, but not nearly as frequently as they occur in stock or bond markets, so slippage is far less of a problem.

Dual And Multiple Exchange Rates

2007-09-30T08:06:00.000-07:00

When faced with a sudden shock to its economy, a country can opt to implement a dual or multiple foreign-exchange rate system.With this type of system, a country has more than one rate at which its currencies are exchanged. So, unlike a fixed or floating system (to learn more about these, see Floating And Fixed Exchange Rates), the dual and multiple systems consist of different rates, fixed and floating, that are used for the same currency during the same period of time.

In a dual exchange rate system, there are both fixed and floating exchange rates in the market. The fixed rate is only applied to certain segments of the market, such as "essential" imports and exports and/or current account transactions. In the meantime, the price of capital account transactions is determined by a market driven exchange rate (so as not to hinder transactions in this market, which are crucial to providing foreign reserves for a country).

In a multiple exchange rate system, the concept is the same, except the market is divided into many different segments, each with its own foreign exchange rate, whether fixed or floating. Thus, importers of certain goods "essential" to an economy may have a preferential exchange rate while importers of "non-essential" or luxury goods may have a discouraging exchange rate. Capital account transactions could, again, be left to the floating exchange rate.

Why More Than One?
A multiple system is usually transitional in nature and is used as a means to alleviate excess pressure on foreign reserves when a shock hits an economy and causes investors to panic and pull out. It is also a way to subdue local inflation and importers' demand on foreign currency. Most of all, in times of economic turmoil, it is a mechanism by which governments can quickly implement control over foreign currency transactions. Such a system can buy some extra time for the governments in their attempts to fix the inherent problem in their balance of payments. This extra time is particularly important for fixed currency regimes, which may be forced to completely devalue their currency and turn to foreign institutions for help.

How Does It Work?
Instead of depleting precious foreign reserves, the government diverts the heavy demand for foreign currency to the free-floating exchange rate market. Changes in the free floating rate will reflect demand and supply.

The use of multiple exchange rates has been seen as an implicit means of imposing tariffs or taxes. For example, a low exchange rate applied to food imports functions like a subsidy, while the high exchange rate on luxury imports works to "tax" people importing goods which, in a time of crisis, are perceived as non-essential. On a similar note, a higher exchange rate in a specific export industry can function as a tax on profits.

Floating And Fixed Exchange Rates

2007-09-30T08:01:00.000-07:00

What Is an Exchange Rate?
An exchange rate is the rate at which one currency can be exchanged for another. In other words, it is the value of another country's currency compared to that of your own. If you are traveling to another country, you need to "buy" the local currency. Just like the price of any asset, the exchange rate is the price at which you can buy that currency. If you are traveling to Egypt, for example, and the exchange rate for USD 1.00 is EGP 5.50, this means that for every U.S. dollar, you can buy five and a half Egyptian pounds. Theoretically, identical assets should sell at the same price in different countries, because the exchange rate must maintain the inherent value of one currency against the other.

Fixed
There are two ways the price of a currency can be determined against another. A fixed, or pegged, rate is a rate the government (central bank) sets and maintains as the official exchange rate. A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the yen, or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged.

If, for example, it is determined that the value of a single unit of local currency is equal to USD 3.00, the central bank will have to ensure that it can supply the market with those dollars. In order to maintain the rate, the central bank must keep a high level of foreign reserves. This is a reserved amount of foreign currency held by the central bank which it can use to release (or absorb) extra funds into (or out of) the market. This ensures an appropriate money supply, appropriate fluctuations in the market (inflation/deflation), and ultimately, the exchange rate. The central bank can also adjust the official exchange rate when necessary.

Floating
Unlike the fixed rate, a floating exchange rate is determined by the private market through supply and demand. A floating rate is often termed "self-correcting", as any differences in supply and demand will automatically be corrected in the market. Take a look at this simplified model: if demand for a currency is low, its value will decrease, thus making imported goods more expensive and thus stimulating demand for local goods and services. This in turn will generate more jobs, and hence an auto-correction would occur in the market. A floating exchange rate is constantly changing.

In reality, no currency is wholly fixed or floating. In a fixed regime, market pressures can also influence changes in the exchange rate. Sometimes, when a local currency does reflect its true value against its pegged currency, a "black market" which is more reflective of actual supply and demand may develop. A central bank will often then be forced to revalue or devalue the official rate so that the rate is in line with the unofficial one, thereby halting the activity of the black market.

In a floating regime, the central bank may also intervene when it is necessary to ensure stability and to avoid inflation; however, it is less often that the central bank of a floating regime will interfere.