Read an Excerpt
By David Borman
McGraw-Hill EducationCopyright © 2014 The McGraw-Hill Companies, Inc.
All rights reserved.
Introduction to Forex
In this chapter you will learn the following:
What it means when people say they trade Forex
The basics of Forex Leverage
The basics of the Forex Pair
The best times to trade Forex
The history of Forex Trading
When people say they trade Forex, which means buying and selling money in the worldwide Foreign Exchange market, what they are saying is that they trade money. It is as simple as that: Forex traders buy and sell different types of money. After all of the strategizing, technical analytics, and fundamental analysis, the basic Forex trade is betting that one country's currency will be worth more than another country's currency at some point in the future. You as a Forex trader might use a mathematically based diversification theory to minimize the risk of your Forex trading account. You might wait until a technical indicator such as a 200 day/50 day moving average cross signals you to "go long" the Euro and short the U.S. dollar. You might study the Bank of England's website http://www.bankofengland.co.uk/ and discover that the UK's economy is shaky, leading you to "short" the Great British pound against the Swiss franc.
Either way, you are placing an educated bet that one currency will be worth more of another currency at the end of the holding period. How is this done? Currencies are traded in pairs. In the case of the Euro/U.S. dollar pair, a Forex trader has the choice to bet that the U.S. dollar will get stronger in relation to the Euro, or that the Euro will get stronger in relationship to the U.S. dollar. If you were the Forex trader and you thought that the Euro was going to get stronger against the U.S. dollar, you would "go long" or "buy" the Euro/U.S. dollar pair. What this means is that you are simultaneously betting that the Euro will go up, at the same time betting that the U.S. dollar will go down. Extending this out further, a long Euro/U.S. dollar trade is in reality a long Euro/short U.S. dollar trade.
How Is Money Made on a Forex Trade?
In order to see how money is made on a currency trade you first have to understand what is going on behind the scenes in a trade. If you thought the Euro was going to get stronger against the U.S. dollar, we have seen that you would go long the Euro and short the U.S. dollar. In reality, what happens is that by shorting the U.S. dollar, you are in effect "borrowing" U.S. dollars and using the money to "buy" Euros. When this is done, you then have an IOU to your Forex broker for the amount you shorted. This IOU is denominated in U.S. dollars. When the Euro gets stronger than the U.S. dollar, you would then close out the trade, take the Euros, and use the money to settle out the IOU from when you "borrowed" U.S. dollars. Since the Euro got stronger, you would be able to use less Euros to satisfy the U.S. dollar IOU and pocket the difference as a profit. This works due to the exchange rates of the two currencies having changed (see Figure 1-1). At the beginning of the trade, you would have one exchange rate, and at the end of the trade you would have another.
In this book, Forex Demystified, you will be lead along the sometimes twisting, turning path of Forex trading, or trading the different currencies of different countries. You will learn all of the key ideas behind what makes Forex trading one of the most exciting financial products to trade. You will also learn one of the key elements in any type of trading or investing: how to spot trades that have a good chance of becoming profitable. In order to do this, you will be shown where to look for long-term signals to a good trade, such as how to read between the lines of central bank websites. You will also be shown how to use basic charting techniques—also known as technical analysis—to help you determine the best price level to enter into and exit out of a trade.
In addition to learning how to seek out and spot good trading ideas, you will be shown the fundamentals of how to actually handle the software that comes with your own Forex trading account. You will learn the advantages and risks of the huge amounts of leverage (sometimes called gearing by Forex traders) that Forex trading is known for, and what creates the potential to squeeze out profits from the smallest moves in the market.
You will also learn how to match your trading activities with your risk appetite, available time, established portfolio, and lastly, your long- or short-term investment objectives. You will learn how to build a grouping of Forex positions that are designed to last six months to two years, and have Forex effectively act as an alternative asset class that has returns that are uncorrelated to your traditional assets such as stocks, bonds, and mutual funds. You can also use your Forex trading skills to earn quick profits; using your Forex trading endeavors as a form of second job—a hobby that produces income.
What It Means to Trade Currencies
Trading Forex, or the concept of trading currency pairs, can best be described as making money from the difference of the money of two different countries. Other ways that Forex trading can be described are: (1) using very high amounts of leverage to benefit from the price differentials of one currency as it moves in value against another, or (2) a method of placing bets where the trades are made in currency pairs in a 24-hour market of overlapping trading time zones.
Trading currencies is like trading stocks, ETFs (Exchange Traded Funds) or mutual funds. A trade is made on a trading software platform with the hopes that it will create a capital gain. Forex traders make capital gains when they can accurately predict the direction of the movement of one currency against another. Forex trading is simple: one currency gets strong, the other gets weak.
When trading equities, stocks move either up or down, with most market participants taking a bullish stance (meaning they set their trades to make money when the stock gains in value). When you are trading currencies, you not only have to decide what currency will go up, but you will have to decide what currency that currency will get stronger against. In other words, not only will one currency go either up or down in price, it will do so at different rates against different currencies (called the counter currencies). While this may seem to make the process of deciding which Forex trades to place a difficult one, any complexity is greatly outweighed by the simplicity of the relatively small number of currency pairs to trade: Equity traders have thousands of stocks to trade, Forex traders only have somewhere between 20 and 50 currency combinations to worry about. This makes the process of trading Forex easier than picking stocks, as it is quite possible to become an expert in and trade only three, four, or five currency pairs day in and day out.
The most heavily traded currency pair is the Euro/U.S. dollar pair. With this pair, traders will bet if the Euro will get stronger or weaker against the U.S. dollar. In this pair, the Euro is the first of the quote called "EUR." The U.S. dollar is quoted as "USD." This quoting system is used for all currency pairs, with examples being Great British pound/Euro as GBP/EUR, US dollar/Swedish Krona as USD/SEK, and the Australian dollar/Japanese yen as AUD/JPY. In the example of EUR/USD, if a trader thought that the U.S. dollar was set to lose value against the Euro in the next few days, he would set up a trade by selling USD and buying EUR. This is exactly what is done when a trade is made in the currency markets. By the way, the easiest way to look up a current market quote of a currency pair is to list the two currencies followed by a "= X". In the case of a live Euro/U.S. dollar quote you would enter "EURUSD = X" in the "symbol lookup" screen of Yahoo Finance, Google Finance, Marketwatch.com, etc. Here is the link to the Euro/U.S. dollar quote on Yahoo Finance: http://finance.yahoo.com/q?s=EURUSD=X. Figure 1-2 shows an Australian dollar/U.S. dollar pair chart showing the huge gain of the AUD over the USD indicated by the large upward bar of the chart.
Using Leverage and Gearing While Trading Forex
To break it down even further, a trader has a cash balance in his Forex brokerage account. He uses this cash balance for "gearing" or "leverage" to increase the buying power of his account from 10 to 50 times, and in some cases up to 500 times the amount in the account. Keep in mind that the actual multi-day movement in the EUR/USD pair may be in the neighborhood of 0.50%–1.25% in either direction, up or down, with either the Euro getting stronger against the U.S. dollar or the U.S. dollar getting stronger against the Euro. This means that if a Forex trader had a long EUR/USD trade on the books, and the Euro moved 1.0% stronger against the U.S. dollar (which is common in overnight trading) and the Forex trader had his Forex account set to trade at a 50:1 margin, the gains on the trade would be the 1.0% multiplied times 50. To put it another way, the gains that the Forex trader would experience would be 50% on this one trade. This serves as a very good example of the potential for return in the Forex market. Minimal percentage movements in the exchange rates between currency pairs can lead to maximum profits for your Forex account. It is clear that where a stock market trader can earn 1%, 3%, 5%, or even 10% per trade, the Forex trader can earn 30%–50% or more per trade.
With the right amount of risk management, diversification, and money management, a Forex trader can earn these large gains on a consistent basis. Another thing to keep in mind is that the currency markets are the deepest and most widely traded markets in the world, with hundreds of thousands of trades being placed 24 hours per day, 6 days per week. This means that a bet placed on a currency such as the Euro, dollar, yen, or even less-traded currencies such as the Swedish krona, will definitely move either up or down almost as soon as the trade is placed. The longer your trade will be on the books, or the longer your Forex trade is "live," the greater the chance for bigger and bigger movements. As an example, a one-hour long trade might move slightly, a few hundredths of a percent, and earn you just enough to pay for that night's pizza.
On the other hand, a larger move of 0.1%–1% or more would be expected for an overnight trade. With proper risk management, conservative position sizes, and automated profit taking, gains being in the neighborhood of 15%–20% of a Forex trader's total account balance can become the norm. It is not unusual to place a trade at dinner time and wake up the next morning to find that you have made so much overnight that you start to consider Forex trading full time! After a while you will discover trading opportunities come in two forms: good and really good. While it is not uncommon for Forex traders to be full-time professionals at mutual fund houses, banks, and hedge funds, it can be your goal to earn enough profits from Forex trading to make the payment on a new car, help pay your rent, or just simply add to your household's income.
With the right risk management, you can set up your trades so that they are able to withstand bad news. This allows you to have a Forex portfolio that is "impact resistant" to bad calls or mistakes, or just simply provides you the insulation to sit and wait out an unrealized loss until a reversal brings the trade into the profit range.
Higher Leverage Amounts than Stock Trading
One of the key advantages of Forex trading is the ability of the Forex trader to use large amounts of leverage. Most currency trading brokerage accounts allow for the use of leverage or margin in the range of 10:1 to 50:1. Some Forex brokerage accounts are domiciled in locations where it is possible for the owner of the Forex account to preset her leverage or "margin" to very high levels such as 250:1, 500:1, or even 1,000:1. As an example, if the trader had a balance of $100 U.S. in her account, and she had her leverage set to 50:1, she could buy 100 × 50 = 5,000, or $5,000 U.S. of currency. She could then take this purchasing power and sell the currency that she thinks will go down (similar to "shorting the market," as is done in equity or derivatives trading accounts) and use the proceeds of the sale of the shorted currency, in this case the USD, to buy the currency that she thinks will go up in value. In this case, the trader would sell or short USD and buy or go long EUR. It sounds complex, but the ratios, dollar amount of sales, and buying power in EURs is all calculated within moments by the trader's trading software, which is called a trading platform.
The different instantaneous exchange rates of the two currencies determine how much she can buy of the second currency. If the trader uses $1,500 of her available purchasing power to sell short USD, she will have created $1,500 worth of buying power to buy or go long EUR. If the exchange rate in the world's currency markets at the instant she places the trade is $1.25 USD to 1.00 EUR she will exchange her $1,500 USD for 1,200 EUR (1,500/1.25 = 1,200).
The trader will make money in the trade when the price of the EUR rises higher than 1.00 EUR/1.25 USD. If the trader has predicted the market correctly, and if for example the world's currency markets, economies, stock markets, bond markets, and political news has changed in such a way that it has benefited the value of the Euro, and if that benefit has caused the value of the Euro to move to 1.35 EURs per USD, the trader will make money on the trade. Keep in mind that the gain in value of the long or bought currency can be very, very small and a trade can still be very, very profitable.
Deciding What Margin Amount to Use
Trading on margin or leverage is akin to trading with borrowed money. While it is true that when you trade with borrowed money in a normal brokerage account you may be responsible for paying back borrowed amounts or margined amounts that are equal to or even greater than the original borrowed (margined) amount, this is not the case with Forex.
When you set your margin to a certain level, you use the actual cash balance in your account to have a "buying power" that is a multiple of the margin level. If your margin is set to 20:1, you are able to buy 20 times the cash value of the account. Your preset margin amount (10:1, 50:1, 500:1, etc.) can determine how much value of currency you can trade. The thing to realize with higher levels of margin is that the percentage movements of the currency pairs will be amplified that much more. In other words, if you are trading at 50:1, you will experience the profit and loss (P&L) of your account moving at a rate that is 50 times the actual percentage movement of what currency pairs move daily. It is quite common for a currency pair such as the Australian dollar/U.S. dollar (AUD/USD) pair to move 0.75%–1.25% up and down from one trading day to the next. To put this into perspective, if your margin level was set to 50:1, the P&L of your trade would be moving 375%–625% of the cash value of the trade. While this percentage movement is good if your trade is gaining, it could also wipe out your entire account if you are in a losing trade due to the fact that your Forex brokerage firm might step in and make a forced margin call. A margin call is when your Forex losses are so great that your cash equity balance in your Forex account falls below a minimum.
Most of the time, your Forex equity can fall to very low levels before your Forex broker issues a margin call. If it happens, you will be required to close out your trades at a loss, or deposit more cash into the account to bring the cash equity balance back above the minimum level. If you fail to deposit the minimum cash, your Forex broker will force the close out all of your trades at an automatic loss. This is one of the disadvantages of high margin trading: rapid loss of account value and potential for total loss. Keep this in mind as you read further on about choosing how much of your total available margin to use with any position and at any one time.
Position Size Is Tied to Margin Levels
In order to prevent the chance for forced margin calls, professional Forex traders limit the size of each trade to a percentage of the total cash balance in the account. One of the best margin level/trade size ratios is to set your margin at 50:1 and then commit no more than one-third of your available margin to your entire open trades at any one time.
To put it simply, if you have a $250 USD cash balance, and you have your margin set at 50:1, you have a buying power of $250 USD × 50 = $12,500 worth of currency. This $12,500 is the maximum amount of usable margin value. While this is the maximum, most professional Forex traders will only use between 20% and 33.3% of this amount at any one time. This means that they will only have 20%–33.3% of their maximum purchasing power involved in all of their open trades. In this example, a professional trader would only commit $2,500 to $4,160 worth of his maximum margin ($12,500) to trading at any one time.
When this prescribed maximum level is adhered to, it can prevent accidental margin calls due to rapid swings in the percentage movements of the currency pairs that are being traded. This is due to the fact that the leftover available margin (80%–66.6%) can be used to absorb any swings of fortune, for example bad trades, in your account.
Excerpted from Forex DeMYSTiFieD by David Borman. Copyright © 2014 The McGraw-Hill Companies, Inc.. Excerpted by permission of McGraw-Hill Education.
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