What is Forex Trading?

Whether you are a Forex novice or a current investor in another equities or derivatives market the aim of this article is help you to understand the world of foreign currency trading – in doing so we have addressed the answers to the most frequently asked questions that we receive from people like yourself who are entering the market for the first time. Although Forex (often referred to as FX) is the largest financial market in the world it is relatively unfamiliar to most retail traders and investors. In fact, until the advent of the internet FX was primarily the domain of central banks, large financial institutions, multinational corporations and hedge funds.

But times have changed and individual investors are hungry for information on this fascinating and lucrative market. In 2018 retail traders, i.e. you and me, make up the largest participants in the currency market, however, the vast volume and liquidity still come from financial institutions. Unlike stocks, futures or options, FX trading does not take place on a regulated exchange. It is traded electronically through FX dealers who provide software and the necessary trading platform for retail investors such as yourself.

This platform is linked to your personal trading account that you open with the dealer. So effectively the dealer does nothing more than facilitates your access to the FX market. Essentially, trading in the largest, most liquid market in the world is open to anyone!

At first glance, this opportunity might seem bewildering to investors who are used to the structured exchanges such as the ASX or NYSE but the end result is really very simple.

So, when you trade Forex are you buying anything physical? The short answer is “no”. The retail FX market is purely a speculative market. No physical exchange of currencies ever takes place. All trades exist simply as computer entries and are netted out depending on market price. For dollar-denominated accounts, all profits or losses are calculated in dollars and recorded as such on the trader’s account.

The primary reason the FX market exists is to facilitate the exchange of one currency into another for multi-national corporations that need to trade currencies continually (for example, for payroll, payment for costs of goods and services from foreign vendors, and merger and acquisition activity).

However, these day-to-day corporate needs comprise only about 20% of the market volume. 80% of trades in the currency market are speculative in nature. They are put on by large financial institutions, multibillion-dollar hedge funds and retail traders who want to express their opinions on the economic and geopolitical events of the day.

Because currencies always trade in pairs, when a trader makes a trade he or she is always long one currency and short the other. For example, if a trader sells some EUR/USD, they would, in essence, have exchanged Euros for US dollars and would now be “short” Euros and “long” US dollars.

What is a “pip” you ask? Pip stands for “percentage in point” and is the smallest increment of trade in FX. In the FX market, prices are quoted to the fourth decimal
point, or in the case of JPY crosses 2 decimal points. For example, if a bar of soap in the supermarket was priced at $1.20, in the FX market the same bar of soap would be quoted at 1.2000. The last decimal place is the pip – sometimes referenced as the point.

Investors who trade stocks, futures or options typically use a broker, who acts as an agent in the transaction. The broker takes the order to an exchange and attempts to execute it as per the customer’s instructions. For providing this service, the broker is paid a commission when the customer buys and sells the tradable instrument.

Forex Trading

The FX market does not generally have commissions. Instead, they make their income from taking what is called a spread. You will place the trade and once the price clears the cost of the markup or spread, there are no additional fees or commissions. Every single penny gain is pure profit to the investor and you only pay the dealer once on entry. The spread or mark up you pay is incremental to the value per pip you trade. Let’s assume you trade the lowest volume per pip possible which, with most brokers, is a micro lot of $1000 which on an AUD v USD trade would be equivalent to 10c per pip. The spread with most brokers would be approximately 1.5 so the brokerage earned by the broker on your $1000 volume trade would be just 15c.

You can credit and redeem funds on your account when you wish. You will get daily statements sent to you via email if you have traded that day along with an end of month statement.

If you live in Australia or New Zealand you will be required to pay tax in accordance with what entity the account is set up in. You can trade as an individual, company name, family trust and in Australia a self-managed super fund. When you will pay the tax will depend on the entity that operates your account, however, for most, it will be at the end of the financial year.

In FX, investors use leverage to profit from the fluctuations in exchange rates between two different countries. The leverage that is achievable in the FX market is one of the highest that investors can obtain.

Brokers will generally offer leverage of 100:1, which means the margin required to maintain the trade is 1% of the trade volume. Leverage essentially means that you are able to use a smaller amount of capital than the value of the trade. For example, with a leverage of 100:1, you would be able to trade a volume of one hundred times the size of the initial capital you put into the account.

Of course, when you use risk profiles of 2% risk on trading capital per trade you are not using the full leverage available and nor should any trader. If you were, however, and you are trading 100,000 AUD v USD (which is generally a standard lot size of 1.00 on most platforms and equates to approximately $10 per pip), the margin requirement in your account will be $1000 AUD. The margin requirement is the amount of money you would need in the account to be able to place a trade.

If the account balance dropped below the margin requirements, you would get a margin call, and likely be closed out of the trade by the dealer. However, again when using institutional risk profiles and correct stop loss positions in the market, margin calls should not be part of any clients trading experience. For example, if you had $1100 in your account, you could place an order of 1 standard lot on the AUD v USD. This would put your initial margin at $1000. If the trade went into a loss, and your account balance dropped to $990, you could be closed out of the trade.

We DO NOT recommend trading in this manner but an explanation of this may be helpful to understand what can occur if traders use the full leverage made available. Standard lot trading is done on 100,000 units of currency (1.00 or $10 per pip) however, our clients can trade micro and mini lots. Effectively from 0.10 cents per pip and up.

Although the ability to earn significant profits by using leverage is substantial, leverage can also work against investors who use it poorly. For example, if the currency underlying one of your trades moves in the opposite direction of what you believed would happen, leverage will greatly amplify the potential losses IF you were using a high-risk profile on trades and no stop loss.

To avoid such experiences, we recommend our clients only risk 1% of their entire trading capital on any one trade.

What value per pip you may trade will be determined by three main factors:

  1. The amount of capital in your trading account.
  2. The % of this capital you are prepared to risk on the trade.
  3. The size of stop loss target in pips.

It is imperative that all investors in the FX Markets use a risk calculator that automatically works out what volume to trade depending on the size of the stop loss and % risk they wish to apply.

Prior to entering any trade, any professional trader knows what he is prepared to risk and what he desires in reward. More on reward later.

No matter what the account size, professional traders conserve loss by managing risk as the No.1 priority. As your account grows so should the value per pip you trade. And the opposite if your account is being drawn down. If you are in multiple positions at once your overall risk exposure on your capital should not exceed a maximum 3.0%. So, therefore, you may elect to be in 3 positions each risking 1% of your trading account.

Remember capital preservation is KING!!

So what about the reward you may ask? If I’m risking 1%, or in the example, we showed $100 what should my potential reward be? You should aim for 2% or greater. Or using the previous example $200 or greater. This, in trading terms, is a risk to reward ratio.

Some of the biggest losers in the currency market do not understand risk and reward and how critical it is within any trading business. No matter if their account is growing or decreasing they often trade the same value, have no risk mitigation and no real idea where their reward should be.

Many successful traders have win/loss ratios of less than 60%. Their account grows because they understand the power of taking out of the market far more than they are prepared to give back. If the probability of a trade cannot deliver you more than double what you are prepared to risk, it is unwise to take the trade.

And what about if you use a risk to reward ratio of 1:3 you may ask? Well, you do that math and you tell me who the most profitable ones are.

How come one trader achieved a larger ROI % over others? Regrettably, many traders are looking for nothing but the golden goose of trade set ups that delivers them a winning trade more than 80% of the time. Let me tell you right here and right now…they don’t exist!

The trade set up is only one part of the puzzle. Risk mitigation and understanding risk and reward is critical and are big parts of any profitable traders trading plan. Fail to adopt these principles and you will likely join the long list of struggling or unprofitable people trading FX.

Let me say that if you genuinely believe you can make money, and potentially a lot of it without risk, making additional income on top of what you do right now is probably never going to happen.

You cannot make money without risk, however, what you can do is identify, understand and learn to manage that risk professionally.

Let me take you outside FX for just a minute. Every private and commercial business you drive past today and tomorrow has degrees of risk. Some more than others. You even have risk as an employee. They have staff, stock, rent, advertising, equipment and often much more. Is the success of many of these businesses always just about the product and the customer? No of course not. It’s a combination of them all and those that manage those risks the best are often the ones that stay operating, year in, year out.

Well, FX trading is no different. Is it all about the trade set up? No, it’s about managing your trading business in the same ways that successful private and commercial business do. Knowing how to manage risk comes first.

Is going to bed at night knowing you have a trade running risking no more than 1% of your trading account, knowing you took the trade using a risk to reward greater than 1:1 going to keep you up at night? I would certainly hope not.

So the next time you have someone say to you “oh that FX stuff is all too risky”, you can justifiably say “yes making money can be if you don’t know what you are doing. But I’m far more informed now… thank you”.

Oh, and by the way, we are talking about a truly recession-proof business. Currencies don’t go to zero. One is either rising and the other falling. You buy a currency and it goes up – you can make money. If you sell it and it goes down, you can do exactly the same. Most investors cringe in times of economic uncertainty. FX traders revel in these times due to the opportunity of trading “long” (buying) or going “short” (selling).

Fundamental vs Technical Trading

Technical analysis is based on forecasting the future using past price movements – it is also known as price action.

Fundamental analysis, on the other hand, incorporates economic and political news to determine the future value of the currency pair. We have often seen fundamental factors rapidly shift the technical outlook, or technical factors explain a price move that fundamentals cannot.

The real key, however, is to understand the benefit of each style and to know when to use each discipline. Fundamentals are good at dictating the broad themes in the market, while technical analysis is useful for identifying specific entry and exit levels.

We firmly believe in firstly having an overall sentiment on a currency direction based on fundamental factors, i.e. we may feel over the next 3 months the GBP will for economic reasons move lower. So in effect, we will only look for selling opportunities on the GBP during this time.

If we do sell, it may be because of a technical indicator of price on the chart. Sadly purely technical traders will often have what they believe as the greatest technical set up in the world, enter the position and then get taken out for a loss due to economic reasons that they had no idea was coming.

Does trading with one eye closed make a little more sense now? Make it your goal to understand what really drives currencies from professionals and you will be ahead of the pack!

Although some dealers offer exotic currencies the majority of traders, trade the most liquid currency pairs in the world, which are the four “majors”:

  • EUR/USD (euro/dollar)
  • USD/JPY (dollar/Japanese yen)
  • GBP/USD (British pound/dollar)
  • USD/CHF (dollar/Swiss franc)

and the commodity pairs:

  • AUD/USD (Australian dollar/dollar)
  • USD/CAD (dollar/Canadian dollar)

These currency pairs, along with their various cross combinations (such as EUR/JPY, GBP/JPY and EUR/GBP), account for more than 95% of all speculative trading in FX.

Protect your profits. Protect your profits.
Protect your profits.

There is nothing worse than watching your trade be up 75 pips one day, only to see it completely reverse the next, go back through your entry and take out your stop loss. If you haven’t already experienced this as a trader firsthand, consider yourself lucky – it’s a feeling most traders face more often than you can imagine and is a perfect example of poor trade management.

One of the cardinal rules of trading is to protect your profits and understanding techniques to manage positions professionally, ensuring you are at all times mitigating risk and managing reward.

Many traders will jump into a trade with their entire volume at once. You can employ techniques of scaling in and out of trades. Learn to enter with only half of your risk, but ultimately be rewarded with all of your desired volume.

There are ways to never let a winner turn into a loser. A basic method is to trail your risk (stop loss), which is essentially when price moves a certain distance in your favour, you mitigate your risk by moving the stop loss order to your entry price, or even inside your entry to lock in profit.

Half of Forex trading is about strategy, the other half is undoubtedly about management. Even if you have losing trades, you need to understand them and learn from your mistakes. No strategy is fool-proof and works all of the time. However, if the failure is in line with a strategy that has worked more often than it has failed for you in the past, then accept that loss and move on.

The key is to make your overall trading approach meaningful but to make any individual trade meaningless. You will learn to manage each trade like a professional.

You have no doubt now heard the phrase “Risk Profile”. Each professional trader has one as a major part of their trading business.

The 1% range is often recommended and used by disciplined traders. Losing only 1% per trade means that you would have to sustain 10 consecutive losing trades in a row to lose just 10% of your trading account.

Remember I spoke earlier about capital preservation, risk and reward. Sadly some of biggest losers in FX, trade in excess of 5% per trade, have a risk to reward of 1:1 or less and try to get it right 80% or more of the time. They generally dive in head first, usually losing their first account – and then they either give up, or they take a step back and do a little more research and open a demo account to practise. The art of trading is not about winning as much as it is about not losing.

By controlling your losses, much like a business that contains its costs, you can withstand the tough market environment and will be ready and able to take advantage of profitable opportunities once they appear.

Crawl, walk, jog, run and then sprint. There is one golden rule that you must follow if you are going to trade real money from day one…learn the platform first, then trade small position sizes first to prove your success. Don’t kid yourself and think you can just roll with an account of $50K and trade large positions. You will crash and burn.

Types of Forex Traders

Type of Trader Definition Good Points Bad Points
Short-term (scalper) A trader who looks to open and close a trade within minutes, often taking advantage of small price movements with a large amount of leverage. Quick realization of profits or losses due to the rapid-fire nature of this type of trading. Large capital and/or risk requirements due to the large amount of leverage needed to profit from such small movements. A heck of a lot of time spent in front of charts.
Medium-term A trader typically looking to hold positions for one or more days, often taking advantage of both economic and technical opportunities. Less time in front of charts. Price action is more consistent. You can use wider stop and take profit targets. Management of your trade is comfortable. Fewer opportunities because these types of trades take a little more time to come around.
Long Term A trader looking to hold positions for months or years, often basing decisions on long-term fundamental factors. More reliable long-run profits because this depends on reliable fundamental factors. Large capital requirements to cover volatile movements against any open position.

Trading is an art rather than a science. Therefore, no rule in trading is ever absolute except the one about always using stop losses!

Tips for new FX traders


Markets can – and will do anything…File this story about the blow up of Long Term Capital Management (LTCM) in your long term memory bank.

At one time, it was one of the most prestigious hedge funds in the world, whose partners included several Nobel Prize winners.

In 1998, LTCM went bankrupt, nearly bringing the global financial market to its knees when a series of complicated interest rate plays generated billions of dollars’ worth of losses in a matter of days.

Instead of accepting the fact that they were wrong, LTCM traders continued to double up on their positions, believing that the markets would eventually turn their way.

It took the Federal Reserve Bank of New York and a series of top-tier investment banks to step in and stem the tide of losses until the portfolio positions could be unwound without further damage.

In post-debacle interviews, most LTCM traders refused to acknowledge their mistakes, stating that the LTCM blow up was the result of extremely unusual circumstances unlikely to ever happen again.

 

If you would like to book a free 30-minute phone consultation to speak to one of our Senior Client Advisors regarding the relative client opportunities offered at LTG GoldRock and how you can follow along with our Professional traders each day in our live trading room please click here.