If you are new to trading, please review our training material concerning the trading on a Forex market. Our tutorial on forex trading contains general rules, tips and guidelines for a new trader.
Here, you can find the following information:
- Introduction to Currency Trading
- What is Forex Trading?
- Understanding basic terms and concepts of Forex trading
- Risks and benefits at Forex
- Forex Market Participants
- Fundamental Analysis & Fundamentals Trading Strategies
- Technical Analysis & Technical Indicators
Introduction to Currency Trading
Presentation to currency trading must contain a bit of history.
Creation of gold standard of monetary system was an important phase in the history of the currency market. States attached an amount of their currency to be equal to an ounce of gold; the changing price of gold between two currencies became the first standardized means of currency exchange in history.
The gold standard broke down in World War I because the major European powers did not have enough gold to exchange for all the currency that the governments were printing off at the time in order to complete large military projects. The gold standard began a new between the wars, but it was dropped again by the start of WWII. Gold never lost its spot as the ultimate form of monetary value.
1944 saw the implementation of the Bretton Woods System which led to the formation of fixed exchange rates resulting in the U.S. dollar replacing the gold standard as the reserve currency. Thus, the U.S. dollar became the only currency that would be backed by gold. 1971 marked the end of this system when U.S. declared that it would no longer exchange gold for U.S. dollars that were held in foreign reserves. This led to the almost global acceptance of floating foreign exchange rates in 1976 effectively producing the current foreign currency exchange. It became electronically traded only in the mid-1990s.
What is Forex trading?
The term “Forex” is short for foreign exchange market, which is the “place” where different currencies are exchanged in a continuous fashion by millions of people all over the world.
It isn’t difficult to conceptualize about Forex trading. Tourists who travel from one country to another must exchange currencies in order to pay for a local product or service. A pack of Euros would be totally useless to an Italian tourist wishing to visit the Sydney in Australia because it is not the locally accepted currency. The tourist would have to exchange his Euros for the local currency, Australian dollars, at the existing exchange rate that day.
Even without knowing much about Forex trading, residents of one country exchange currencies with another country each time they purchase a foreign product. For example, someone living in the U.S. who wants to buy a nice bottle of French wine may pay for it in dollars but the wine has already been paid for in Euros. Somewhere along the line, either the wine producer or the American importer had to have exchanged the equivalent value of U.S. dollars (USD) into Euros. This is all about Forex trading.
Unlike the New York Stock Exchange or other stock markets, there is no central marketplace for foreign exchange. Rather, currency trading is conducted electronically over-the-counter (OTC), which means that all transactions occur via computer networks between traders around the world, rather than on one centralized exchange. The market is open 24 hours a day, five and a half days a week.
Another thing about Forex trading: The need to exchange currencies is the primary reason why the Forex market is the largest, most liquid financial market in the world. It outperforms other markets including the stock market, with an average traded value of around U.S. 4 billion per day. Being aware of the magnitude of Forex trading should be enough of an introduction to Forex trading to motivate the eager investor to plunk down his money and start to trade.
Traders can make a lot of money by trading on the Forex market. The more a trader knows about Forex trading, the more successful he will be. It’s really a very simple concept.
Understanding basic terms and concepts of Forex trading
Forex trading is done in currency pairs. The four major currency pairs include USD/EUR (U.S. dollar against the Euro), USD/JPY (U.S. dollar against the Japanese Yen), USD/GBP (U.S. dollar against Britain’s pound) and USD/CHF (U.S. dollar against the Swiss Franc). Other currency pairs such as USD/AUD (U.S. Dollar against Australian dollar), USD/CAD (US dollar against Canadian dollar) and USD/NZD (U.S. dollar against New Zealand dollar) are considered main commodity pairs.
The exchange rate of world currencies is not fixed and it is always changing or fluctuating. Exchange rate is the purchasing power currency compared with another currency.
For example, the exchange rate for 1 US dollar = 0.8018 Euro
Take note that exchange rates generally carry four decimal points. The smallest percentage point in the Forex market is called Pip (percentage in point).
Using the USD/EUR currency pair and the exchange rate above, a $200 will be able to buy 160.3592 Euros. If the dollar weakens and the exchange rate becomes 1 US dollar= .7500, the 160.3592 in your possession will be able to purchase USD 213.8123. You gain more than $13 based on the transaction.
Expert forex traders based their transactions-based charts. They use charting to make decision particularly to determine the price movements over time before trading. The candlestick chart is commonly used by traders because it is simple and it provides a detailed information about the price movements on a particular time.
To be able to become a successful trader, it is important to use simple charts, get educated by watching free videos regarding the fundamental concepts and technical analysis of forex trading and most importantly learn by practicing trading in the actual market using paper trade without risking money. By doing that, you would be able to actually experience trading, experiment, use investing strategies, create charting patterns and eventually apply what you learn to gain profit. It is also important to consider your trading style with time, meaning short-term traders spend time analysing the hourly, daily or weekly chart of price movements.
In terms of market analysis, Forex traders are closely watching the price changes, the quantity of trades (volume) over time. It is important to take note of the price patterns to determine buying opportunities and risks. It is also important for a person to understand the inherent risks, read the disclosures and warnings by the dealer before making a trade. Remember that Forex is a leverage product and there is a great chance that you will incur more losses because you can control large amount of currency with a small margin. For example, a 1:200 leverage means you will receive $200 in your account for every $1 you invested. If you invest $1000, you would be able to control $200,000 worth of currency trade. Money management is significant to succeed in Forex trading wherein you need to plan your risks, learn how to apply stop, losses and practice diversification in your trading practices.
Risks and benefits at Forex
It has already been explained how the world has impacted the Forex market and how certain movements in the market can affect the exchange rates. Given the liquidity of the market many investors have the ability to place large trades without affecting current exchange rates. These large positions are now available for Forex trading due to the requirements of the low margins that are used by most brokers in the industry. A good example is a trader who has control of over $100,000 who puts $1,000 up front while borrowing the remainder from a Forex broker. This type of leverage can have two effects. First other investors realize there are large sums to be made when seeing the small change in currency rates. However, there is also the risk of huge losses should the rates turn the other way. Despite the risks that the amount of leverage creates it still remains worth the risk to many spectators.
The foreign exchange market is truly open 24 hours a day 5 days a week. With good liquidity during the day hours of each country. For traders that work during the day it is only an optional market for them to trade in. Peak trading times occur at different times of the day throughout the world which eliminates the necessity of an opening and closing bell as with the traditional stock market. When one market closes in one time zone another opens in another time zone.
While the Forex market can be very exciting to many investors the risks can also be extremely high unlike traditional stock market trading. The extremely high leverage of the Forex market also means the risk factor is just as big and can result in huge losses. These losses can take a huge chunk out of your accounts in seconds. This is one thing new traders need to understand since in the Forex market there are large sums of money and a huge number of players. When new information is received it often results in quick twists and turns in the market.
Summing up all the above mentioned, we could say that it is critical for new traders to understand the risks that are involved in Forex trading before making their first trade. Traders, who have a desire to work on Forex market should have the basic knowledge of currency trading, which often mean the difference between profit and loss.
Forex Market Participants
The $4 trillion-dollar Forex market witnesses a lot of market participants. However, all of these participants have different motives. An understanding of these motives is required to predict their behaviour in the markets. Also, some of these participants have deeper pockets, better information and are more active than the others.
Forex dealers are amongst the biggest participants in the Forex market. They are also known as broker dealers. Most Forex dealers in the world are banks. It is for this reason that the market in which dealers interact with one another is also known as the interbank market. However, there are some notable non-bank financial institutions also that deal in foreign exchange.
These dealers participate in the Forex markets by providing bid-ask quotes for currency pairs at all times. All brokers do not participate in all currency pairs. Rather, they may specialize in a specific currency pair. Alternatively, a lot of dealers also use their own capital to conduct proprietary trading operations. When both these operations are combined, Forex dealers have a significant participation in the Forex market.
The Forex market is largely devoid of brokers. This is because a person need not deal with brokers necessarily. If they have sufficient knowledge, they can directly call the dealer and obtain a favourable rate. However, there are brokers in the Forex market. These brokers exist because they add value to their clients by helping them obtain the best quote. For instance, they may help their clients obtain the lowest buying price or the highest selling price by making available quotes from several dealers. Another major reason for using brokers is creating anonymity while trading. Many big investors and even Forex dealers use the services of brokers who act as henchmen for the trading operations of these big players.
There are many businesses which end up creating an asset or a liability priced in foreign currency in the regular course of their business. For instance, importers and exporters engaged in foreign trade may have open positions in several foreign currencies. They may therefore be impacted if there is a fluctuation in the value of foreign currency. As a result, to protect themselves against these losses, hedgers take opposite positions in the market. Therefore, if there is an unfavourable movement in their original position, it is offset by an opposite movement in their hedged positions. Their profits and losses and therefore nullified and they get stability in the operations of their business.
Speculators are a class of traders that have no genuine requirement for foreign currency. They only buy and sell these currencies with the hope of making a profit from it. The number of speculators increases a lot when the market sentiment is high and everyone seems to be making money in the Forex markets. Speculators usually do not maintain open positions in any currency for a very long time. Their positions are transient and are only meant to make a short-term profit.
Arbitrageurs are traders that take advantage of the price discrepancy in different markets to make a profit. Arbitrageurs serve an important function in the foreign exchange market. It is their operations that ensure that a market as large, as decentralized and as diffused as the Forex market functions efficiently and provides uniform price quotations all over the world. Whenever arbitrageurs find a price discrepancy in the market, they start buying in one place and selling in another till the discrepancy disappears.
Central Banks of all countries participate in the Forex market to some extent. Most of the times, this participation is official. Although many times Central Banks do participate in the market by covert means. This is because every Central Bank has a target range within which they would like to see their currency fluctuate. If the currency falls out of the given range, Central Banks conduct open market operations to bring it back in range. Also, whenever the currency of a given nation is under speculative attack, Central Banks participate extensively in the market to defend their currency.
Retail Market Participants
Retail market participants include tourists, students and even patients who are travelling abroad. Then there are also a variety of small businesses that indulge in foreign trade. Most of the retail participants participate in the spot market whereas people with long term interests operate in the futures market. This is because these participants only buy/sell currency when they have a personal/professional requirement and dealing with foreign currencies is not a part of their regular business.
Fundamental analysis & fundamentals trading strategies
In the currency market, fundamental analysis looks to evaluate currencies, and their countries and use economic announcements to gain an idea of the currency's true value.
All of the news reports, economic data and political events that come out about a country are similar to news that comes out about a stock in that it is used by investors to gain an idea of value. This value changes over time due to many factors, including economic growth and financial strength. Fundamental traders look at all of this information to evaluate a country's currency.
Carry trade forex strategy
A carry trade forex strategy is the practice of buying currencies with high differential ratios. A differential ratio means that the interest rate of the currency you are buying is higher than that of the currency you are selling. The realized profit will be derived from the difference between the interest rates – the higher the differential, the greater the profits will be.
When selecting prospective targets for a carry trade, we must take into consideration the expected changes in interest rates of both currencies. In practice, a carry trade strategy functions best when the interest rate of the currency we are buying is expected to go up and the interest rate of the currency we are selling is expected to go down. In this way, we stand to optimize the profit potential of each specific trade.
When using a carry trade strategy, we make our profit from the differences in interest rates between two currencies. However, that doesn’t mean that the changes in price between the two currencies are irrelevant. For example, if we were to choose to invest in a currency because of a high-interest rate but the price of that currency dropped, the situation is not beneficial. When it comes time to close that trade, we might find that even though we profited from the interest rate a loss was taken on trade because of the difference in entry and exit prices.
Trading the News
The forex market is a 24-hour market and news can come in at anytime from anywhere in the world. Changes in the market based on economic news and data can hit any kind of trader wherever he might be and whichever currencies he chooses to trade. If you’re in Asia and like to trade the YEN, there’s news from Japan almost every day. If you like AUD or NZD then you have to watch for news out of Australia, New Zealand, and China. Same goes for EUR, GBP, and USD; you have to check the news during the morning and the afternoon if you live somewhere close to European time zones.
One of the first lessons for new traders is that when trading you should keep out of the market during major news releases. Nevertheless, we often find ourselves trading during the news and most of the time it’s not because of greed. Some like the adrenaline, some are addicted, but the majority of traders just like the profits. After all, we are in this business to make money and the risk is a necessary aspect of that.
Trading currencies always involves two currencies. When a trader plans to open a position both country’s upcoming news should be taken into consideration along with any other international news that could potentially affect the pair.
For example, if you decide to trade AUD/JPY, apart from evaluating possible outcome of the news out of Japan and Australia and the effect that it might have on the pair, you should consider important upcoming news from Europe, USA or elsewhere because that news may shock the financial markets. If there was really good economic data released from China, the pair would rally because it means that demand for Australian products is likely to increase. We could expect the opposite if there was really bad news from Europe; it would shock the global financial market and the traders would run for safe havens like YEN and CHF.
Below are the most important economic data and news and their effect on the country’s currency when the numbers beat expectations:
- Unemployment Rate
- Inflation (consumer and producer prices)
- Interest Rates
- Trade Balance
- Retail Sales
- Services and Manufacturing PMI
- Consumer and Business Sentiment
- Unemployment Claims
- Home Sales
So, before placing any trades on the market, the trader should carefully review the upcoming news feed, otherwise there is a chance that he/she may take the risk trader is not able to afford.
Technical Analysis & Technical Indicators
Technical analysis is a method of predicting price movements and future market trends by studying charts of past market action. Technical analysis is concerned with what has actually happened in the market, rather than what should happen and takes into account the price of instruments and the volume of trading, and creates charts from that data to use as the primary tool. It is also the art of recognizing repetitive shapes and patterns within those price structures represented by charts. One major advantage of technical analysis is that experienced analysts can follow many markets and market instruments simultaneously.
Technical analysis is built on three essential principles:
1. Market action discounts everything! This means that the actual price is a reflection of everything that is known to the market that could affect it, for example, supply and demand, political factors and market sentiment. However, the pure technical analyst is only concerned with price movements, not with the reasons for any changes.
2. Prices move in trends. Technical analysis is used to identify patterns of market behaviour that have long been recognized as significant. For many given patterns there is a high probability that they will produce the expected results. Also, there are recognized patterns that repeat themselves on a consistent basis.
3. History repeats itself. Forex chart patterns have been recognized and categorized for over 100 years and the manner in which many patterns are repeated leads to the conclusion that human psychology changes little over time.
Forex charts are based on market action involving price. There are five categories in Forex technical analysis theory:
- Indicators (oscillators, e.g.: Relative Strength Index (RSI)
- Number theory (Fibonacci numbers, Gann numbers)
- Waves (Elliott wave theory)
- Gaps (high-low, open-closing)
- Trends (following moving average).
Relative Strength Index (RSI)
The RSI measures the ratio of up-moves to down-moves and normalizes the calculation so that the index is expressed in a range of 0-100. If the RSI is 70 or greater, then the instrument is assumed to be overbought (a situation in which prices have risen more than market expectations). An RSI of 30 or less is taken as a signal that the instrument may be oversold (a situation in which prices have fallen more than the market expectations).
This is used to indicate overbought/oversold conditions on a scale of 0-100%. The indicator is based on the observation that in a strong up trend, period closing prices tend to concentrate in the higher part of the period's range. Conversely, as prices fall in a strong downtrend, closing prices tend to be near to the extreme low of the period range. Stochastic calculations produce two lines, %K and %D that are used to indicate overbought/oversold areas of a chart. Divergence between the stochastic lines and the price action of the underlying instrument gives a powerful trading signal.
Moving Average Convergence Divergence (MACD)
This indicator involves plotting two momentum lines. The MACD line is the difference between two exponential moving averages and the signal or trigger line, which is an exponential moving average of the difference. If the MACD and trigger lines cross, then this is taken as a signal that a change in the trend is likely.
Fibonacci numbers: The Fibonacci number sequence (1,1,2,3,5,8,13,21,34...) is constructed by adding the first two numbers to arrive at the third. The ratio of any number to the next larger number is 62%, which is a popular Fibonacci retracement number. The inverse of 62%, which is 38%, is also used as a Fibonacci retracement number.
W.D. Gann was a stock and a commodity trader working in the '50s who reputedly made over $50 million in the markets. He made his fortune using methods that he developed for trading instruments based on relationships between price movement and time, known as time/price equivalents. There is no easy explanation for Gann's methods, but in essence he used angles in charts to determine support and resistance areas and predict the times of future trend changes. He also used lines in charts to predict support and resistance areas.
Elliott wave theory: The Elliott wave theory is an approach to market analysis that is based on repetitive wave patterns and the Fibonacci number sequence. An ideal Elliott wave patterns shows a five-wave advance followed by a three-wave decline.
Gaps are spaces left on the bar chart where no trading has taken place. An up gap is formed when the lowest price on a trading day is higher than the highest high of the previous day. A down gap is formed when the highest price of the day is lower than the lowest price of the prior day. An up gap is usually a sign of market strength, while a down gap is a sign of market weakness. A breakaway gap is a price gap that forms on the completion of an important price pattern. It usually signals the beginning of an important price move. A runaway gap is a price gap that usually occurs around the mid-point of an important market trend. For that reason, it is also called a measuring gap. An exhaustion gap is a price gap that occurs at the end of an important trend and signals that the trend is ending.
A trend refers to the direction of prices. Rising peaks and troughs constitute an uptrend; falling peaks and troughs constitute a downtrend that determines the steepness of the current trend. The breaking of a trend line usually signals a trend reversal. Horizontal peaks and troughs characterize a trading range. Moving averages are used to smooth price information in order to confirm trends and support and resistance levels. They are also useful in deciding on a trading strategy, particularly in futures trading or a market with a strong up or down trend.
So, summing up all the above mentioned, we could say that unlike the fundamental analyst, the technical analyst is not much concerned with any of the "bigger picture" factors affecting the market, but concentrates on the activity of that instrument's market.