What is foreign exchange? Introduction

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The foreign exchange market is undisputedly the world’s largest market place with the
average daily turnover in excess of US$4 Trillion. Operating 24 hours a day, 5 days a week
the foreign exchange market does not operate on a regulated exchange, therefore is
known as an OTC (over-the-counter) transaction. Most people at some point, either when
travel Iing or making an overseas purchase, would have in some way participated in the FX
market. However increasingly many are now turning to the FX market for the purposes of
speculation, dealing at prices formerly only available to financial institutions.

One of the prime advantages to trading foreign exchange is the sheer volume of market
participants, in turn creating liquidity which cannot be matched by any regulated exchange –
traded product or instrument. Like trading the share market, in theory the buying and selling
of currencies is extremely simple – buy low, sell high and vice versa; however in practice
learning the basics is essential before putting your hard earned cash on the line.

It’s worth noting trading currency by utilizing a broker is very different to
exchanging cash at your local money exchange. This guide is designed to give new or
prospective currency traders with the very basics of trading Forex.

Let’s start by exploring the two primary categories of currency pairs available.

Major Currencies or the ‚majors’ are usually deemed to be made up of six different
currency pairs from seven counterparts as detailed below – you will notice they all include a
currency relative to the value of the US Dollar.

Euro vs. US Dollar EUR/USO
US Dollar vs. Japanese Yen USD/JPY
British Pound vs. US Dollar GBP/USD
Australian Dollar vs. US Dollar AUD/USO
US Dollar vs. Canadian Dollar USO/CAD
US Dollar vs. Swiss Franc USD/CHF

These currencies are seen to be the most actively traded in the foreign exchange markets;
therefore often the most cost effective to trade given the spread between the buy and sell
price narrower than that of their less trade counterparts. You will also notice each currency is defined by a three letter abbreviation known as /SO Code (International Organization for
Standardization).

Minor Currencies o r the ‚minors’ generally consist of all other currency pairs and cross
currencies. For example, we could classify the Euro against the Aussie dollar (EUR/AUD) as
a minor currency or the New Zealand against the US Dollar (NZD/USD) can also be
classified as a minor currency. Under the band of minor currencies you will also hear the
term exotic currencies which may consist of irregular crosses such as the US Dollar against
Turkish lira (TRY) or the Polish zloty (PLN). Often exotic currencies can demand a higher
cost to trade, given the illiquid market conditions – quite simply, the less participants that
trade the currency, the greater the spread, therefore the cost. You can find some of the
minor currencies or ‚cross currencies’ examples on the next page.

Euro vs. Australian Dollar EUR/AUD
British pound vs. Japanese Yen GBP/JPY
Euro vs. Swiss Franc EUR/CHF
US dollar vs. New Zealand Dollar USD/NZD
Australian Dollar vs. Japanese Yen USO/CAD
British Pound vs. Swiss Franc GBP/CHF

 

THE COST OF DOING BUSINESS

Like trading in the share market, trading currencies also attracts a commission – however,
unlike share trading the commission does not come in the form of a monetary or dollar
amount per trade. Instead, most FX providers will have a ‚spread’ between the buy and sell
price.

The spread is the implied cost associated with trading the currency pair and highly
contingent to the currency pair, market volatility and of course market participants. The
bigger the spread, the greater the cost of doing the trade.

ITS ALL ABOUT THE PIPS!

When trading currency, a profit or loss is measured in pips. For example, one pip movement
when trading the AUD/USO pair is equal to a move from US$0.9850to US$0.9851. To
simplify, one Aussie dollar is equal to 98.51 US cents. On the INFINOX platform you will see the price of each currency will be expressed to the 5th decimal place. So if we look at
EUR/USO, one Euro is equal to US$1.3954. It’s important to understand the fifth decimal
place is not a pip, rather 1 tenth of a pip – or what the Meta trader 4 platform refer to as a
point. Let’s establish now what each pip is worth.

Contract Values a re used to express the amount of currency you would like to buy or sell.
One Standard contract denotes 100,000 of the base currency, and 10 per pip of the second
named currency (terms currency) .You can choose to do multiple standard contracts or
many providers such as INFINOX allow you to trade much smaller than a standard contract.
For example, a mini contract which is worth 10,000 of the base currency and 1 per pip of the
terms currency. An exception to these contract values need to be made when trading
Japanese Yen pairs where each pip fluctuation on a standard contract will equal JPY1000. It
is also imperative to understand which currency you are buying and which you are
selling.For example when buying ‚long’ the AUS/USO pair, you believe the first currency
value will appreciate against the second. Or you may have a bearish view of the Australian
currency, hence decide to sell or ‚short’ the Australian dollar against the USO dollar which
means you believe the first currency will depreciate against the second.

MARGIN REQUIREMENT

When placing a trade you do not need the full position value, rather, a smaller amount of
funds often referred to as ‚margin.’ This is simply the amount of collateral or funds required
to hold your position. For example, if you buy one contract of the AUD/USD pair which has
a notional value of AUD 100,000,you will only need a very small percentage of the value to
make the trade. This concept is often referred to as „leverage” where you use a smaller
amount of cash to control a larger valued asset. The margin requirement or leverage rate
your forex broker may set will depend on a number of factors – but you will find outside of
the US the leverage rate of 100:1 or 1 per cent of your position value is common place.
INFINOX allows leverage of up to 500:l. So this means to buy one contract of the AUD/USD
pair you may only need AUD 200 as a margin requirement. Importantly, you will also need
to be able to maintain any running losses; therefore, a buffer is prudent to ensure you are
not prematurely taken out the market by means of a margin call. As you can imagine,
leverage can work both for and against a trader, so it is important to consider the risks
associated before taking the plunge and you can also choose to reduce the amount of
leverage your account provides.

SWAP I ROLLOVER RATES

When you buy or sell a currency, a swap or rollover fee may be paid or received on a daily
basis. This is simply the interest owed/paid to maintain your position, and the amount of
which will depend on the relative interest rate yield of each currency. You are essentially
using the currency you have sold to fund the currency you have bought.

To get a little more technical, you now need to look at the relative yields of each countries
interest rate to gauge an understanding on if you are going to receive or indeed pay
interest on a daily basis. If you decided to buy one contract of the AUD/USD pair at 9800
US, this means you are borrowing US dollars to fund your AUD 100,000 position. This is a
particularly good pair to use as an example given the large interest rate yield differential.

Let’s use benchmark interest rates as at November 2010 for each currency to get a general
understanding if we are due to pay or receive interest. The overnight cash rate set by the
Reserve Bank of Australia is currently 4.75%, therefore you would expect AUD 100,000
dollars to earn at least 4.75% PA. On the other hand, you are borrowing US dollars, given
the Federal Reserve are attempting to stimulate US economy interest rates are near
zero,therefore, theoretically the cost of borrowing is a lot cheaper. In essence, you are
borrowing at rock bottom rates to fund a higher yielding asset – hence interest should be
paid to you. So to ascertain if you are due to pay or receive interest or swap on a currency
simply, compare the interest rates of each country and check if you are buying or selling the
currency with a higher yielding interest rate. You will also need to take into account swap
calculations are not as simply as two interest rate differentials, often funding costs can be
greater than that of the underlying interest rate.

MARKET ANALYSIS – FUNDAMENTAL VS. TECHNICAL

Yes, it is an age old argument in equity markets and the FX market is certainly not immune
to the same debate. However we are increasingly seeing traders opt for a combination of
both as technical analysts acknowledge the important part market fundamentals play in
price activity of a currency and vice versa. For example, price reaction to economic
indicators such as Non-farm payroll data from the United States or an interest rate decision
has the propensity to shift market sentiment thus resetting price action on a currency pair.

Likewise, fundamental traders acknowledge the importance of technical mile stones such
as past price activity which shows particular areas of support and resistance, or whether a currency is overpriced relative to the past trading activity. Technica I signals can also bode
well for a short term trader looking to take advantage any perceived anomaly in price
activity or follow a basic trend. On the other hand, a fundamentalist can use a currency to
take a longer term view of the relative economic health of each country. Whatever the case,
you’re always going to have staunch supporters of particular methods and if you’ve got
more winning trades than losing you’re on the right track.

Trading the foreign exchange market profitably is hard but also can be rewarding. There
are no guaranteed proven methods to assist investors but many successful traders adopt a
simple disciplined approach and stick to the important rules of trading. These rules may
seem easy to follow but in practice emotions when trading can run high. Remember to run
your trading account like you would your own business, keep rational and by following the
rules below hopefully you will keep profitable.

THE GOLDEN RULES OF TRADING

Have specific goals and objectives

Lets profits run

The key to letting winning trades run is to have trailing stops that are outside the average
daily range of the market so that they are not tight enough to get stopped out during
‚normal’ trading. This means being prepared to give up a significant portion of a winning
trade’s open profit and this is the thing that makes this so hard to implement. Consider
adding to clear winning trades if capital reserve allows and avoid stops that are too tight.

Cut losses short

This is the sister rule to the previous one, and is usually just as difficult to implement
(although it is very easy to define). In the same way that profitability comes from a few large
winning trades, capital preservation comes from avoiding the few large losers that the
market will toss your way each year. Setting a maximum loss point before you enter the trade so you know before-hand approximately how much you are risking on this particular
position is relatively straightforward. You simply need to have an exit price that says to you
‚this trade is a loser and Iwill exit before it gets any bigger’. Due to gaps at the open, or limit
moves in futures we can never be 100% certain that we can get out with our maximum loss,
but simply having the rules, and always sticking to it will save us from the nasty trades that
just keep on going and going against our position until we have lost more than many
winning trades can make back.

If you have a losing position that is at your maximum loss point,just get out. Do not hope
that it will turn around. Why risk any more money on this losing trade, when you could
simply close it out (accept the loss) and move on? This will leave you in a much better place
financially and mentally, than holding the position and hoping it will go back your way.Even
if it did do this, the mental energy and negative feelings from holding the losing position are
not worth it. Always stick to your rules and exit a position if it hits your stop point.

Never add to a losing trade

This is certainly a rule that’s hard to follow, especially ifwe have a strong view of the
trajectory of a particular currency. Trades are split into winners and losers, and if a trade is a
loser, the chances of it turning right around and becoming a winner are too small to risk
more money on.If indeed it is a winner disguised as a loser, why not wait until it shows it’s
true colours (and becomes a winner) before you add to it? If you do this you will notice that
nearly always the trade ends up hitting your stop loss and does not look back. Sometimes
the trade turns around before it hits your stop and becomes a winner and you can count
yourself very fortunate. Sometimes the trade hits your stop loss and then turns around and
becomes a winner and you can count yourself unlucky. Whatever the result, it is never
worth adding to a loser, hoping that it will become a winner. The odds of success are just
too low to risk more capital in addition to the initial risk.

Do not take too much risk

One of the most devastating mistakes any trader can make is risking too much of their
capital on a single trade. One thing is certain in trading and that is if you lose all your capital
you are out of the game. Why risk so much you could be prevented from continuing? There
is a saying in poker that going all-in (risking all your chips) works every time but once. This
is also true of trading. If you risk all your account on every trade it only takes one loser to
wipe you out (and no trading method is 100% accurate), so you will be out of the game at
some point and it is only a question of time.

By its very nature FX trading involves leverage, your provider may require less than 1%
initial margin to cover a position, but it’s wise to leave some slack on your account to avoid
immediate margin calls if the trade goes against you. If you are worried about the size of a
trade then it is too big and you should reduce the size immediately. Remember that
longevity is the key to making money by trading – slowly over a long time with minimal risk,
is always preferable to rapidly with too much risk.

Only trade positive expectancy systems

If you have a positive expectancy trading system, the only factors that determine how much
money you will make per year are the number of trades the system generates, how much
capital you allocate to the system, and how accurately you implement the trading signals. If you do not know whether your trading system is positive expectancy then why are you
trading it?

Expectancy is calculated using the profit or loss on each trade (net of trading
implementation costs) divided by the initia I risk (using your stop loss) and then taking the
average of this number of a series of trades. Systems that have positive expectancy will
make money on average and those with negative expectancy will lose money.

Successful traders only trade systems where the odds of success are in their favour (i.e. the
system is positive expectancy) so they know that making money is the result of accurately
implementing the system and not just pure luck.

Be educated

In order to compete at the highest level in the trading business and be one of the few truly
successful participants you must be well-educated about what you are doing. This does not
mean having a degree from a well-respected university – the market doesn’t care where you
were educated.

Being well-educated means that you have thoroughly researched and tested your trading
ideas and know why your trading system worked in the past and is continuing to work now.
It means understanding all the technology and applications that your system needs to
perform accurately. It also means understanding your goal and objectives and how trading
will help you to achieve these. It means understanding yourself and how your personality
affects your results. It means understanding the markets and instruments you trade.

In order to succeed you really need to become an expert in your own trading business to
understand how it all fits together, when it is broken, and how it can be improved. As with
all worthwhile endeavours, this takes commitment, hard work, dedication, and more hard
work.

Do not trade scared money

No one ever made any money trading when they had to do it to pay the mortgage at the
end of the month. Having a requirement to make X dollars per month or you will be
financially in trouble is the best way to completely mess-up all trading discipline, rules,
objectives and this can quickly go away.

Trading is about taking a reasonable risk in order to achieve a good reward. The markets
and how and when they give up their profits is not under your control. Do not trade if you
need the money to pay bills. Do not trade if your business and personal expenses are not
covered by another income stream or cash reserve. This will only lead to additional
unmanageable stress and can be very detrimental to your trading performance.

Take a break

The last rule may not seem obvious, but always take a trading holiday. This could mean a
2-weeks beach break or simply avoiding the markets for a few days to take a breather. The
market will still be there on your return and you should be recharged from the break.

Summary

We have covered the rules that we believe should never be broken in trading. If you work
on never breaking them, then your trading style should improve dramatically.