Forex Trading: Explained in Simple Terms
What is Forex? Forex is also called foreign exchange, FX or currency trading. It is a decentralized global market where all the world’s currencies trade with each other. The global foreign exchange market is the largest market in the world as measured by the daily turnover with more than US$7.5 trillion a day eclipsing the combined turnover of the world’s stock and bond markets.
How Currencies Are Traded: All currencies are assigned a three-letter code much like a stock’s ticker symbol. While there are more than 170 currencies worldwide, the U.S. dollar is involved in a vast majority of forex trading, so it’s especially helpful to know its (code: USD). The second most popular currency in the forex market is the euro, (code: EUR). Other major currencies, in order of popularity, are the Japanese yen (JPY), the British pound (GBP), the Australian dollar (AUD), the Canadian dollar (CAD), the Swiss franc (CHF) and the New Zealand dollar (NZD).
Three Ways to Trade Forex: Forex traders are attempting to buy currencies whose values they think will increase relative to other currencies or to get rid of currencies whose purchasing power they anticipate will decrease.
There are three different ways to trade forex, which will accommodate traders with varying goals:
The spot market: This is the primary forex market where those currency pairs are swapped and exchange rates are determined in real time, based on supply and demand.
The forward market: Instead of executing a trade now, forex traders can also enter into a binding (private) contract with another trader and lock in an exchange rate for an agreed upon amount of currency on a future date.
The futures market: Similarly, traders can opt for a standardized contract to buy or sell a predetermined amount of a currency at a specific exchange rate at a date in the future. This is done on an exchange rather than privately, like the forwards market.
Forex Terms to Know: Each market has its own language. These are words to know before engaging in forex trading:
Currency pair: All forex trades involve a currency pair like USD/PKR
Pip: Short for percentage in points, a pip refers to the smallest possible price change within a currency pair. Because forex prices are quoted out to at least four decimal places, a pip is equal to 0.0001.
Bid-ask spread: Exchange rates are determined by the maximum amount that buyers are willing to pay for a currency (the bid) and the minimum amount that sellers require to sell (the ask). The difference between these two amounts, and the value trades ultimately will get executed at, is the bid-ask spread.
Lot: Forex is traded by what’s known as a lot, or a standardized unit of currency. The typical lot size is 100,000 units of currency, though there are micro (1,000) and mini (10,000) lots available for trading, too.
Margin: Trading with leverage isn’t free, however. Traders must put down some money upfront as a deposit or what’s known as margin. Margin is the collateral that you’ll have to put down to open a leveraged trade.
Leverage: Leverage is a tool used by traders that enables them to control a large amount of capital by putting down a much smaller amount. Unlike traditional investing, where you must tie up the full value of your position, with leveraged trading you only must put up a smaller portion, known as margin. In the case of 50:1 leverage, for example, you can use $1 to control $50 of a position.
Bull market: A bull market is one in which prices increase for all currencies. Bull markets signify a market uptrend and are the result of optimistic news about the global economy.
Bear market: A bear market is one in which prices decline among currencies. Bear markets signify a market downtrend and are the result of depressing economic fundamentals or catastrophic events, such as a financial crisis or a natural disaster.
Contract for difference: A contract for difference (CFD) is a derivative that enables traders to speculate on price movements for currencies without owning the underlying asset. A trader betting that the price of a currency pair will increase will buy CFDs for that pair, while those who believe its price will decline will sell CFDs relating to that currency pair. The use of leverage in forex trading means that a CFD trade gone awry can lead to heavy losses.
What is long in forex trade? Whenever you purchase (buy) a currency pair, it is called going long. When a currency pair is long, the first currency is purchased (indicating, you are bullish) while the second is sold short (indicating, you are bearish). For example, if you are purchasing a EUR/PKR currency pair, you expect that the price of Euro will go high and the price of Pakistani rupees (PKR) will go down.
What is short in forex trade? When you go short on a forex, the first currency is sold while the second currency is bought. To go short on a currency means you sell it hoping that its prices will decline in future. In forex trade, whether you are making “long” (buying a currency pair) or “short” (selling a currency pair) trades, you are always long on one currency and short on another. Therefore, if you sell, or go short on USD/PKR, then you are long on PKR and short on USD. It means you expect the prices of PKR (Pakistani rupees) will rise and the price of the USD (US dollar) will fall.
Stop Losses: A stop-loss is an order placed in your trading terminal to sell a security when it reaches a specific price. The primary goal of a stop loss is to mitigate an investor’s loss on a position in a security (Equity, FX, etc.). It is commonly used with a long position but can be applied and is equally profitable for a short position. It comes very handy when you are not able to watch the position. Stop-losses in Forex are very important for many reasons. One of the main reasons that stands out is no one can predict the future of the forex market every time correctly. The future prices are unknown to the market and every trade entered is a risk. Forex traders can set stops at one fixed price with an expectation of allocating the stoploss and wait until the trade hits the stop or limit price.
Forex Trading – Types of Market Analysis: There are three types of analysis used for the market movements forecasting:
Fundamental Analysis: Fundamental analysis is analyzing the currency price forming, basic economical and other factors influencing the exchange rate of foreign currency. It is an analysis of economic and political information with the hope of predicting future currency price movements. Fundamental analysis helps in forecasting future prices of various foreign currencies. The forecasting of prices is based on several key economic factors and indicators that determine the strength of a country’s economy. The factors may also include various geopolitical aspects that may impact the price movement of a currency pair.
Key factors influencing fundamental analysis
Interest Rates: The interest rates set by the central bank is one of the most important factors in deciding the price movement of currency pairs. A high interest rate increases the attractiveness of a country’s currency and attracts forex investors to buy.
GDP Growth: It is one of the first indicators used to gauge the health of an economy. It represents economic production and growth, or the size of the economy. Measuring GDP can be complicated, but there are two basic ways to measure it.
One measurement is the income approach. This approach adds up what everyone earned in a year, including gross profits for non-incorporated and incorporated firms, taxes less any subsidies and total compensation to employees.
The other approach is the expenditure method. This method adds up what everyone spent in a year, including total consumption, government spending, net exports and investments. The results of these two measurements should be roughly the same. However, the expenditure method is the more common approach because it includes consumer spending, which accounts for the majority of a country’s GDP.
Employment Rate: The number of jobs created or lost in a month is an indicator of economic health and can significantly impact the securities markets. When more businesses are hiring, it suggests that businesses are performing well. More hiring can also lead to predictions that more people will have more money to spend since more of them are employed. If unemployment rates rise unexpectedly or decline less than expected, that can sometimes be associated with a drop in stock prices as it may suggest that employers cannot afford to hire as many people. Remember, how an economic indicator comes in relative to expectations is very important.
Industrial Production: A high industrial growth in any country signifies a robust country economy. A country with robust economy encourages forex traders to invest in the country’s forex currency.
Consumer Price Index (CPI): The CPI is one of the most popular measures of inflation and deflation. CPI is used in calculating the retail inflation in the economy by tracking the changes in prices of most used goods and services. The items that are considered in Consumer Price Index are goods related to food, clothing, transportation, housing, electronics, apparels, education, medicine, etc.
Producer Price Index (PPI): PPI is a coincident indicator that tracks price changes in almost all goods-producing sectors, including mining, manufacturing, agriculture, forestry and fishing. PPI also tracks price changes for an increasing portion of the non-goods-producing sectors of the economy. The report measures prices for finished goods, intermediate goods and crude goods.
Retail Sales: A country’s retail sales data gives an accurate picture of how people are spending and the health of its economy at the lowest level. A strong retail sales figure shows that the domestic economy of a country is in strong shape; it points towards positive growth rates in the future.
Technical Analysis: Technical analysis helps in the prediction of future market movements based on the information obtained from the past. There are different kinds of charts that help as tools for technical analysis. These charts represent the price movements of currencies over a certain period preceding the exchange deal, as well as technical indicators. The technical indicators are obtained through mathematical processing of averaged and other characteristics of price movements. Technical Analysis (TA) is based on the concept that a person can look at historical price movements (for example currency) and determine the current trading conditions and potential price movement.
Speculative Analysis: Apart from mini and micro analysis of data, this is the analysis of the mindsets and sentiments of traders and investors. Speculation is a trading activity that involves engaging in a risky financial transaction, in the expectation of making enormous profits, from fluctuations in the market value of financial assets. In speculation, there is a high risk of losing maximum or all initial outlay, but it is offset by the probability of significant profit. Although, the risk taken by speculators is properly analyzed and calculated.
Characteristics of a Successful Trader?
Have patience – don’t trade if you don’t have to. You should wait for a set-up according to your trading plan and system. Have Discipline to follow your rules.
Mark Douglas, in his book, ‘Trading in the Zone’, says that most investors believe they know what is going to happen next. This causes traders to put too much weight on the outcome of the current trade, while not assessing their performance as “a probability game” that they are playing over time. This manifests itself in investors getting too high and too low and causes them to react emotionally, with excessive fear or greed after a series of losses or wins.
All traders will encounter fear at some stage, no matter whether you are a professional or a novice trader, this seems inevitable, and to succeed and fight fear, traders will have to work through this positively. Two of the greatest fears that a trader will encounter can be, Fear of Loss and Fear of Letting a profit turn into a loss.