The Basics of Forex Trading

Everyone is familiar with foreign exchange when it comes to buying holiday money. We know that when you sell it back, you get a worse rate and we know that the day after we buy our holiday money, we could have got a better rate! In other words, there is a difference between the buying and selling rate, and the exchange rate varies from day to day. If we can buy cheap and wait for the price to rise, profits can be made (if we can clear the difference between the buy and the sell price). For example, today the bank is selling 1.85 dollars to the pound and buying them back at 1.95 to the pound. So, their margin is a huge 5.4%. That means we’d have to wait for an enormous 6% change to make any profit – that would take a while! If I look at the rates offered by my Forex trading software, it is 1.9632 and 1.9636 respectively, which is a much nicer 0.02% or 300 times better.

At the bank, the rate usually changes once or twice a day. In the Forex market, it changes every few seconds. Clearly, it is very easy to catch a fraction of a percent change in price and take a profit. Conversely, it is also very easy for the market to move against us by a fraction of a percent and give us a loss. Losing money is always easier than making it!

With Forex trading, we don’t have to actually buy and sell the currency; it is a paper transaction only. It must be clear that we would have to purchase tens of thousands of dollars worth to make a profit on a quarter percent movement. Trading allows us to buy at so much per ‘point’, a point being usually 0.0001 of a dollar. This means we can have the profit (or loss) on ten thousand times the point value. In other words, if we trade at 10 pounds or dollars a point, we are effectively buying or selling 100,000 pounds or dollars worth – serious money. £100 a point gives us a million pounds worth of currency. We can be big time players! Traditional brokers trade in ‘contracts’ or ‘mini contracts’ which is more limiting and less suitable for the beginner. A mini contract of 0.1 generally equates to $1 a pip.

Since we can buy or sell with equal ease, whether a particular currency rises or falls makes no difference to our percentage profit. This is an important new concept. In trading, you can sell before you buy! The same applies to any ‘futures’ market where we are basically speculating on the future condition of that market. You can sell futures of shares, commodities (gold, orange juice, lead) or currency pairs (pound against dollar, euro against yen) before you buy to close the trade. In this way, we can make money from falling markets just the same as rising markets. In effect, we are selling to our broker with a promise to buy it back later (when we close the trade).

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So, if we think the exchange rate on any currency pair (eg. euro against the dollar or EUR/USD) will fall, we sell to open the trade. This will be for so much per pip (smallest numerical price change), for example $5 a pip. If the price is quoted as 1.5482/84 that means that we can buy the euro against the dollar for 1.5484 or sell it for 1.5482 - the 2 pips difference going in the broker's pocket. That means the instant we open a trade, we are $10 down (2 pips spread X our $5 a pip). To close the trade we do the opposite for the same value per pip. In other words, if we buy to open the trade, we sell to close it and vice versa. Most trading platforms have a simple 'close trade' button which does it all for you.

We should always limit our risk by placing a 'stop' when we open the trade - for example 20 pips against us. For example, if we buy at 1.5484, our stop would be at 1.5464 and will close the trade automatically for $100 loss (20 X $5). In the other direction, we place a 'take profit' or a limit order, say for 30 pips. So we place our limit at 1.5514 to give us $150 profit. Ideally, we must have a broker or spread bet company that opens and closes trades at the price shown with a simple click of the mouse. The price we see should be the price we get! This is particularly important if we want to manually close the trade rather than wait for our stop or limit to be hit.

Many people like to compare futures trading with gambling and there are indeed many similarities. However, there are a couple of vital differences. The first is that with any kind of gambling, the statistics say we will lose in the long run – the odds are deliberately stacked against us in favour of the house or bookmaker. The second is that with all gambling, the bet is placed and we have no choice but to wait for the outcome.

With Forex trading, the odds are 50:50, less the very small broker’s margin. When we enter a trade (place the bet) we have the choice of exiting any time we wish from one second later to weeks or months later. Imagine a horse race where you could place a bet and click a button at any stage to close your bet. Perhaps, after a hundred metres, your horse is in third place and you have the choice of getting out for 5% profit rather than risk a complete loss. You wait and ten seconds later, it’s in second place and you are offered 25% profit. Maybe just before the finishing post he is contesting fourth place and gaining but you are offered a certain 2% - what do you do and when? Worse, halfway round it’s in sixth place and you can take a 50% loss, and so on. This is the trader’s dilemma and is the reason why most people make a loss!

Experience teaches us that most of our trades would make a profit if only we had the guts to hold on – sometimes for days! Practice demonstrates that we don’t have the nerve and would rather take a small loss. The most important thing to master in trading is the emotional aspect and to train ourselves to go against our natural inclinations. We are programmed to quit quickly when we have a small profit, yet stand like a rabbit in headlights as our losses increase - to the point where our emotions cause us to quit with a bigger loss than that small win.

This is where any sensible system can be a huge advantage if it tells us when to open and close trades. By sticking to a set of rules, we can override our motions and trade like a robot! This is incredibly hard to do with real money (as opposed to demo trading with play money) and we all have our weaknesses. Mine is closing trades too early. It is my nature to pocket 10 certain pips rather than hang on for the more sensible 30 pips profit.

So, not only do we need an effective method that tells us when to open and close a trade, we need some serious coaching on how to master our natural reactions to the stresses of seeing our losses and our excitement at seeing our profits. Unfortunately, waiting to take money from us are thousands of bullshitters who only make money from selling their feeble trading (and gambling) systems and signals services. Not from actual trading. It's a minefield!

The fact is that, much of the time, the market is quite unpredictable and moves are random. Traders quite commonly have half a dozen indicators in an attempt to get a clear trade signal - up or down. If only it were so simple! Often, when it does work it is just luck and any longish run of luck will be perceived as a result of having a good system or the skill of the trader. Failed trades then become seen as bad luck. Newcomers always want a precise set of rules to follow but, quite obviously, no such set of rules exist. There can be a general set of rules and some sort of indicator but, in the end, the trader must develop some skill, exercise discretion and use good money management.

The wonderful thing about trading is that it is scaleable. Start trading with peanut money and prove you can make a profit, and then you can increase your stake up to really serious money. Being British, I trade in pounds sterling. My ‘broker’ allows a minimum of £1 a point, which only requires a minimum of around £50 capital to place a trade and a sensible minimum working fund of £300. This should make you at least £20 to £50 a week. The maximum is £100 a point (some have almost no limit), which requires £25,000 capital and should make you a several thousand pounds a week. If you trade using one of the excellent spread betting companies, this is legally tax free all for a few hours work!

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