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The Forex Trading Manual
The Rules-Based Approach to Making Money Trading Currencies
By Javier H. Paz
The McGraw-Hill Companies, Inc.Copyright © 2013Javier H. Paz
All rights reserved.
Similarities Between Driving and Trading
The forex driver analogy
The fear of driving under adverse weather conditions can have a paralyzing effect on new drivers. Picture a 15-year-old boy inside a car that is parked in front of his house, grasping the steering wheel with excitement. He is months away from getting his driver's license and being able to offer a ride home to cute and excitable girls. This happens to be an insecure teen, one who is prone to thoughts of remote risks. He now imagines himself driving on the freeway on a rainy day next to a semitrailer truck that is dumping copious amounts of water on his car's windshield. There is zero visibility at 60 miles per hour. His heart rate is accelerating; his eyes are fixed ahead. His grip on that steering wheel has suddenly gotten pretty tight.
To a lot more people than you might imagine, learning forex trading can be as scary as the thought of sharing the road with a water-gushing truck was to this boy. What could we tell our imaginary 15-year-old to stop him from hyperventilating? We can start by reminding him that those scenarios are everyday occurrences, but in very few instances do they actually lead to accidents. The key to keeping one's wits about one in that situation can be as simple as (1) gradually slowing down, (2) not making sudden lane changes, and (3) turning on the hazard lights.
Driving cars is an activity that most adults have adopted. Yet, nobody would say that being behind the wheel is always easy. Driving requires concentration and coordination. We concentrate on the road, on other vehicles, and on driving conditions. Like big computers, drivers are expected to calculate in real time the distance to the car in front of them, keep open the possibility that another driver might do something foolish, and so on.
As drivers, we are also required to maintain a delicate coordination among our eyes, our left hand on the wheel, our right hand on the stick, and our foot on the right pedal. Some people would argue that the reason we drive automatic cars is so that we can hold a phone to send that important text or Twitter update: "omg, I just crashed [??] [??]."
Learning to trade forex also requires concentration and coordination. You will learn to shut out life's distractions and the noise from news headlines and to focus on charts that will tell you whether or not to place a trade. You will also learn how to set the proper trade size, take-profit levels, and stop-loss levels.
Lack of patience is one of the biggest enemies that we will work on defeating. In fact, some of you are probably already wondering when I will get to "the good stuff." By design, I am starting this book with some mental conditioning before we jump to the technical chapters. For those of you who have watched The Karate Kid, this is a wax on, wax off, moment.
Forex driving school
This book will teach you how to become a proficient forex driver in what I believe is the proper sequence. Each chapter prepares you for the next lesson, so I strongly recommend that you read the book in order.
It's been a while since I was in driving school. One of the few things I remember about the experience was sitting in a driving simulator while my driving instructor, a guy in his fifties with a receding hairline who spoke with a soft, monotone voice, went through the lesson. In retrospect, I think each of the students in my class had faith that we could get through driving school relatively easily. After all, if those in the previous generation had gotten their driver's licenses this way, so could each of us. Likewise, I need you to keep this type of open mind on the idea that this book can be your driving school for trading forex.
Like driving school, learning forex will require reading and practicing over the course of several months. But even though it will take some time for you to master the material, I hope the knowledge you get will make it a fun, predictable, and profitable experience.
By the end of this book, you will be surprised at how much you have learned, and you will feel empowered to go out and try forex trading on a practice account. I encourage you to trade daily, for 20 to 30 minutes each time (or more, if possible).
Basic competency and expert handling
There is something to be said about managing our own expectations of what we can achieve as forex traders, both initially and over time. Many forex traders have quite high return expectations (see Figure 1-1).
Two of every five respondents in a 2010 Forex Datasource survey expected to earn a monthly profit of more than 10 percent. This figure is surprisingly high, considering that most traditional investments today have a hard time offering a 10 percent return per year. The 10 percent per month figure should also be taken with caution. With higher-than-average return comes higher-than-average risk of loss. Achieving that type of return is possible, but it is not as easy or quick as many traders initially expect. In Figure 1-2, a separate survey of global traders commissioned by CitiFX Pro (a Citibank unit) shows whether these high expectations of forex traders were achieved. About 27 percent of respondents lost money for the year, and a select 11 percent of traders reported an annual return of more than 100 percent; the majority of traders were somewhere in between.
So what should be your expected trading performance? This is a trick question. Setting a return target is secondary to becoming a proficient, disciplined trader.
When the State of Utah granted me a driver's license at age 16, it didn't expect me to be ready to race cars in Formula 1 events or to do crazy turns and jumps the way a Hollywood stunt driver would. My license was the last step in a process where I had shown a basic understanding of and proficiency at driving a car under normal conditions.
When the state grants driver's licenses, it has no certainty that all new drivers will be proficient drivers. Our society, from state agencies to insurance companies, has developed a fairly sophisticated system for educating, authorizing, and insuring drivers. It has also devised methods for removing, temporarily or permanently, drivers who are considered to be dangerous. Thus, it could be said that our society takes calculated risks on the driving population.
The goal of this book is to help you take calculated trading risks and become a proficient trader. With additional time, education, and dedication, a proficient trader becomes an expert trader.
The ranks of forex traders are growing
Aite Group estimates that the number of people who are interested in forex trading (those with live and practice trading accounts) grew to more than 28 million worldwide, with much of the growth taking place in Europe and Asia (see Figure 1-3).
People in Japan have taken on forex trading the most strongly. The Financial Futures Association of Japan reports that, as of March 2012, there are more than 3.9 million forex trading accounts in Japan. In an October 2009 article, the respected business journal Financial Times reported that Japanese forex traders included "everyone from housewives to full time workers who have given up their day jobs to focus on currency trading."
Growth of retail forex in the United States has been considerable, but it has been somewhat slower than in other parts of the world. There are clear signs that FX trading is growing in the United States as well, however. Each year, Inc. magazine recognizes the fastest-growing privately held firms in the United States. These companies typically show three-year revenue growth rates in excess of 100 percent. Every year from 2004 through 2011, Inc. recognized at least one U.S. forex trading firm in its prestigious list: FXCM (2004, 2005, 2006, 2010), Global Futures & Forex (2006, 2007, 2008), FX Solutions (2007, 2008), Gain Capital (2007, 2008, 2009), CMS Forex (2007, 2008, 2009), Interbank FX (2008, 2009), Forex Club (2010), and Boston Technologies (2011).
It is also interesting to observe that if the forex trading business depended on a good economy to thrive, we would not have seen these firms post record revenue growth during the 2007 to 2011 period.
Virtually all of this forex trading growth has taken place since 2005, although its roots date back to the late 1990s. What do traders find attractive in forex trading? One-third of the traders surveyed by CitiFX Pro believed that forex trading offers the best potential return in both up and down markets (see Figure 1-4). Stock and bond markets are acting in unpredictable ways associated with changing economic and political conditions.
The forex market has thrived regardless of whether the global economy was booming or was in the midst of a severe crisis. Forex trading is also attractive because people who trade it find it interesting and convenient to trade—it is open 24 hours per day for 5.5 days a week.
Important Terminology in Forex Trading
Let's move closer to trading and start to get technical. If you are already a trader, I recommend that you skim over my definitions of terms (like leverage, margin utilization, and so on) and make sure that your foundation of these trading terms is rock solid. If you are completely new to trading, then pay close attention.
The experience of driving a car is measured using some technical terms that may not be understood by those who do not drive. For example, if we asked a 12-year-old kid to define the meaning and use of mph, rpm, or psi, the kid would probably struggle a bit.
We measure travel speed and distance in miles per hour (mph). When we press the gas pedal, we measure rotational speed within the engine in terms of revolutions per minute (rpm). And we measure tire pressure in terms of pounds per square inch (psi). There are recommended numeric ranges for each of these measures.
In this chapter, we explain a few key concepts that will allow a new forex trader to appreciate what forex trading is all about. Very importantly, this is where we will cover how we measure trading profit and loss.
What is forex?
Forex is the name given to a very large market that involves buying one currency and selling another currency simultaneously. An exchange of currencies occurs anytime a person or entity in one country goes through the process of acquiring the currency of another country to
* Buy goods or services from a foreign company
* Hedge (protect) a foreign investment or trade receivable
* Buy foreign securities
* Borrow money from foreign investors
* Pay for meals and transportation while on a vacation abroad
* Speculate on changing foreign currency rates
Since the end of the Cold War era (approximately 1991), international trade and investment have increased at an extremely rapid pace. Money flowing within international money and capital markets is now measured in the hundreds of trillions of U.S. dollars. The daily trading volume of the forex market, as measured by the Bank for International Settlements and Aite Group, has risen from US$1.2 trillion per day in 2001 to approximately US$4.5 trillion in 2011.
Currency trading can be dated back thousands of years ago, originating in a need to exchange diverse commodities like grain, spices, and wine outside of a local or national region. However, it was only in the late 1990s that, through advances in trading technology and the Internet, individuals gained the ability to participate in this very large and fast-growing market. Although $4.5 trillion trades daily in forex markets, Aite Group estimates that more than US$350 billion per day changes hands in the retail part of the FX market.
In many markets, there are thousands of securities that someone could trade. Not so in forex markets, where the task of deciding what to trade is much simpler. Currency trading occurs in pairs, that is, currency pairs. There are seven currency pairs that people trade the most: EURUSD, GBPUSD, USDJPY, USDCHF, USDCAD, AUDUSD, and NZDUSD.
For example, EURUSD represents the value of one euro measured in U.S. dollars. If the current price of EURUSD is 1.3203, this means that for every euro, we get one dollar, 32 cents (or pennies), and three hundredths of a penny. When you go to a bank to exchange dollars for euros, you never get these hundredths of a penny (called pips), but when you trade forex, these pips matter a great deal.
Just to solidify the concept of currency pairs, let's do one more example. The USDJPY pair represents the value of one U.S. dollar measured in Japanese yen. If the current price of USDJPY is 89.95, this means that for every U.S. dollar, we should get 89 yen and 95 cents.
In these two examples, the U.S. dollar appears in different positions within the pair. The first three letters of a currency pair represent the base currency, while the latter three letters represent the quote currency. It is a good idea to memorize the order of the currency pairs, because they follow conventions or common usages.
You would not say that your vehicle was traveling at 45 miles per "half an hour." Similarly, most forex traders would not quote the value of the U.S. dollar measured in euros, or USDEUR. It just isn't proper. Likewise, we would never quote yen measured in U.S. dollars, or JPYUSD. The most practical approach is to commit to memory the currency pairs in Table 2-1. The seven most common currency pairs are those that trade against the U.S. dollar—in other words, they all have "USD" in the currency pair.
There are also FX trading instruments called "cross-currency" pairs in which the U.S. dollar is not one of the two currencies in the pair. The most common of these "crosses" appear in Table 2-2.
Most of the Forex trading volume occurs in a few currency pairs, as shown in Table 2-3. Approximately 73 percent of all trading is done in the nine currency pairs listed in Table 2-3.
Pips: the basis of forex trading measurements
In the previous section, I mentioned that a pip (which stands for percentage in point) is one of the smallest measures of change in currency prices.
For example, when the price of EURUSD (the euro-dollar pair) moves from 1.3345 to 1.3346, we are talking about a 1-pip movement. Similarly, when the price of USDJPY (the dollar-yen pair) moves from 89.21 to 89.22, we are also talking about a 1-pip movement.
So what is the relevance of pips? Most forex traders measure their trading gains and losses in pips. The value of pips may vary depending on the (1) currency pair, (2) current price of the pair, and (3) type of trading account: standard account or mini account.
Many people start trading forex using so-called mini accounts, with a starting deposit of $250 to $2,500. For mini accounts, the pip value averages a little more than $1.00. Standard accounts have minimum deposits of $2,500 or higher, and the average pip value is a little more than $10.00. But it is important to note that not all currency pairs have the same pip value—see Table 2-4.
Table 2-4 shows the pip value (in U.S. dollars) for many currency pairs and crosses, based on December 30, 2011, prices. In practical terms, you want to become familiar with the pip value for the specific currency pairs that you would like to trade. Most people trade the euro against the dollar. Something interesting to note is that the EURUSD pip value is always $10 ($1 if you have a mini account). There are three other major currencies that have a never-changing pip value of $10 against the dollar: GBPUSD, AUDUSD, and NZDUSD.
The pip value for the yen, the Swiss franc, and the Canadian dollar will change over time, as will the pip value of currency crosses. To find the precise currency pip value at any given time, there are pip-value calculators on the Internet that you can use.
Please note that most pip values range between $9 and $12, but there is one pair, EURGBP, that has a pip value of $15.53 and possibly higher. What this means is that you need to be careful when you are setting your profit target and stop-loss levels in euro sterling. For a regular pair, setting a 20- or 30-pip profit target or stop-loss level will be around $200 to $300, but in EURGBP, a 20- to 30-pip target/stop-loss level represents $350 to $450.
Making money buying or selling
This section covers the simple mechanics of buying and selling currency contracts, which includes how money is made or lost trading currencies.
For a proficient forex trader, a basic task is to determine the currency price direction over a certain period: will the price of a currency pair go up or down? You also need to determine how much the currency price might go up or down, and possibly how long it might take to get to the target price.
For example, if you believe that the price of EURUSD will rise (the euro will go up and the dollar down), you would buy EURUSD and wait to see if the market confirms your expectation. So, let's say you buy one standard contract (also called one standard lot) of euro dollar at, say, 1.3240. Let's further say that the price on this contract rises to 1.3255, at which point you decide to close the trade. The resulting profit is +15 pips (1.3255 - 1.3240 = 0.0015). The dollar value for that 15-pip gain would be $150 (15 pips x $10 standard lot pip value x 1 standard lot). If you are trading 2 standard lots, then the same 15-pip gain represents a $300 gain (15 x $10 x 2).
Now let's consider what happens if you are wrong about the direction of the euro dollar. Let's say you buy three mini lots of EURUSD at 1.3240, and you decide to allow a maximum loss of 20 pips for the trade. This time, the dollar strengthens, and EURUSD drops 20 pips, triggering a loss for the trade. How much did you lose on this trade? The calculation would be
-20 pips x $1 mini lot pip value x 3 mini lots = -$60
In a different example, let's say that you believe the price of euro dollar will fall over the foreseeable future, so you sell EURUSD (sell euros and buy U.S. dollars). But wait a minute. You don't own euros in real life, so you ask yourself how it is that you can sell them if you don't already own them. Well, when trading forex, it is possible to make money if the price of a currency pair goes up or down, whether you own it in real life or not. When you trade forex, you are trading contracts, not crisp bills of domestic or foreign currency.
Excerpted from The Forex Trading Manual by Javier H. Paz. Copyright © 2013 by Javier H. Paz. Excerpted by permission of The McGraw-Hill Companies, Inc..
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