The trading of equities, futures, bonds or currencies requires proficiency in many unique skills and disciplines. When asked how to survive in the world of trading, legendary trader and billionaire fund manager Paul Tudor Jones answered succinctly, "You adapt, evolve, compete or die." Although a bit dramatic, Jones's quote is spot on. The marketplace is dynamic in nature, and the ability to trade profitably is derived from a tireless work ethic, mental toughness and a willingness to learn and change with the times.
The foreign exchange market, known as forex (FX), is an over-the-counter market where international currencies are bought and sold. With a daily traded volume near US$4 trillion, forex is the largest marketplace in the world. In comparison, for the entire month of March 2016, the New York Stock Exchange posted an aggregate traded volume of US$1.5 billion.
Forex participants are as diverse as the currencies they trade. Commercial banks, multinational corporations, central banking authorities and individual investors are active players in the market. Whether a country's central bank is actively managing inflationary concerns facing the national currency or an individual retail trader is looking to profit from an arbitrage situation, the goal of forex trading is to capitalise on exchange-rate fluctuations.
Trading forex varies a bit from trading stocks or futures, but the overall principles of profiting, or losing, from an actual trade are the same. Buy low and sell high; or in the case of shorting, sell high and buy low.
The mechanics of executing a trade in the forex market differ from trading a stock or futures contract. Forex currencies are traded in pairs, or pairings. When you buy a stock, you then own that individual stock; the value of the trade is dependent upon the behaviour of that stock's price alone. In contrast, the value of a forex trade is based upon the relation of one currency to another.
Currencies available for trade in the forex market are listed in pairs, with one currency being quoted in reference to another. For instance, the currency pairing of the euro to the United States dollar is represented by the expression "EUR/USD." The first currency listed in the pair is known as the "base currency." The value of the base currency is always one, and serves as the reference point for the exchange rate valuation. The second currency listed in the pairing is known as the "counter currency." For the EUR/USD pair, the base currency is EUR, and the counter currency is USD.
To simplify identification, each currency has been given an International Standards Organisation (ISO) code. In this case, the ISO codes are EUR for the euro and USD for the United States dollar.
The numeric value of EUR/USD represents how many US dollars one euro is currently worth. Say EUR/USD is valued at 1.1319. In this instance, €1 is worth US$1.13.
Similar to a "tick" in futures trading or a "point" in stock trading, a "pip" is the basic unit by which forex pricing fluctuations are measured. The term is an acronym for "percentage in point."
The EUR/USD valuation of 1.1319 is said to have moved one pip if value rises to 1.1320 or falls to 1.1318. Essentially, one pip is equal to 1/10,000th of one unit, and resides in the fourth decimal place. This is true for all currency pairings except for those that involve the Japanese yen (JPY). Its pips are denominated by 1/100th of one unit, and can be found in the second place to the right of the decimal point.
Commissions and fees charged for trade execution are a constant in trading atmospheres, as is having a "bid/ask spread" built into the pricing structure. The "bid/ask spread," or simply "spread," is one method by which forex dealers earn commissions from a trader's action in the market.
In terms of forex, a "bid" is the price at which another trader, broker or market maker is currently willing to buy a specific currency pair. The "ask" is the price at which another trader, broker or market maker is currently willing to sell the same currency pair. The "spread" is the difference between the "bid" and "ask" price. For example, a listing of EUR/USD dated April 28, 2016, was expressed as 1.13305/1.13308. The bid price for this quote was 1.13305, while the ask was 1.13308. Accordingly, the spread was .00003, or .3 pips. In the event that a trader wanted to instantly buy and sell EUR/USD, .3 pips is the price paid to the market.
The size of the bid/ask spread is dependent upon several factors. The specific forex dealer, trading volume and the currency pairing actively traded can affect the size of the bid/ask spread. In addition to the spread, it is not uncommon for other transactional fees to be passed on to the trader by the broker.
In terms of transaction costs and trader profitability, the lower the better. It is up to the individual trader to decide which spread and fee structure is most conducive to sustaining a profitable trading operation.
To execute a trade a trader must make decisions concerning the type of trade, entry order and amount of leverage to employ. Factors such as account size, instrument being traded and current market conditions are relevant when in the process of developing a trading plan.
Long Or Short?
The art of trading often boils down to one single question: Buy or sell? In trading forex, unless liquidity risk is high, opportunities to buy or sell a specific currency pair at any given time are generally readily available. A trader may desire to be "long" or "short," depending on market conditions.
A long position, or "going long," refers to the trader placing a buy order. For instance, if a trader likes the probability of EUR/USD rising in the future, then a buy order can be placed. After entry, the trader is said to be "long the EUR/USD." In a long position, profit is realised from the appreciation of the price and loss results if the price goes down. If the rate of EUR/USD moves from an entry of 1.1330 to a price of 1.1335, then a profit of five pips is recognised on the trade. If the rate of EUR/USD moves from an entry of 1.1330 to a price of 1.1325, then a loss of five pips is recognised on the trade.
Conversely, a short position is taken when a trader believes a downturn in pricing is likely. Instead of placing a buy order on the EUR/USD, the trader places a sell order and is "short the EUR/USD." In a short position, profit is realised from depreciation of the exchange rate. Loss occurs if the price appreciates. If the rate of EUR/USD moves downward from an entry of 1.1335 to 1.1330, a profit of five pips on the trade is recognised. If the rate of EUR/USD moves upward from an entry of 1.1335 to 1.1340, a loss of five pips on the trade is recognised.
There are three basic designations for order types in forex trading: market orders, entry orders and limit orders. Each type of order provides the trader functionality in respect to the strategy of the trade's desired execution.
- Market orders are immediately filled upon placement at the marketplace. When a trader places a trade using a market order, the order is filled at the best available market price. Essentially, the trader is immediately buying or selling into the market. In volatile market conditions, using market orders for a trade's entry into the marketplace can be risky. Substantial slippage can be realised, with the filled order price varying greatly from the initial market order price.
- Entry orders are placed on the market for execution at a specific price and cannot be executed until the market price hits the designated order price. For instance, if a trader desires a long position in EUR/USD from 1.1330, and EUR/USD is currently trading 1.1325, the entry order remains in queue at the market until EUR/USD trades 1.1330. If EUR/USD does not trade 1.1330, then the entry order is not filled and the trade is not elected. Entry orders are ideal for traders who want to reduce slippage and desire a specific entry point.
- Limit orders come in two varieties: profit targets and stop losses. A profit target is a limit order that is used to harvest profits. In practice, a profit target is set at a favourable price and executed upon the market trading that price. Conversely, stop-loss orders are used to limit the liability of a trade. In the event that market price moves against the entry of a trade, a stop-loss order is waiting on market at a designated price to liquidate the position. The implementation of a stop-loss order is crucial to the protection of a trading account's equity.
Lot Size: Applying Leverage
In forex trading, leverage, or trade size, is measured in "lots." A "lot" is the smallest possible trade size that can be made on a customer account.
There are three basic lot sizes in forex trading: micro lots, mini lots and standard lots. Each lot size represents a different amount of leverage to place upon the funds in a trading account.
- A micro lot is the smallest lot value. One micro lot represents 1,000 units of capital in the trading account. In the case of an account funded by USD and the desired trade involves a USD-based pair, a trade size of one micro lot applies a small amount of leverage to the trade. For the trade, each pip is equal to US$0.10.
- A mini lot represents 10,000 units of capital in the trading account. Given an identical scenario as above, a trade of one mini lot on a USD-based pair yields a pip value of US$1. The leverage placed on the trade is 10 times that of the micro lot.
- A standard lot is the largest lot size. One standard lot increases leverage tenfold over one mini lot, accounting for 100,000 units of capital. Assuming a USD account and trade denomination, a trade size of one standard lot renders a US$10 pip value.
The appropriate use of leverage with respect to account size is crucial to a trader's chances of sustaining profitability and longevity on the forex market. A good rule of thumb regarding the use of leverage is the use less than 10-to-1 leverage.
Leverage is a double-edged sword as it can dramatically amplify your profits and can also just as dramatically amplify your losses. Trading foreign exchange with any level of leverage is high risk and may not be suitable for all investors as losses can exceed deposited funds.
Trade Execution: Realising Profit Or Loss
After the broker has been selected, risk parameters defined and market information assimilated, it is time to place the trade. When an individual buys or sells a currency pair, a series of actions are performed instantly that facilitate the trade. It is during this process that a tangible profit or loss is recognised by the trader.
For example, a trader wishes to open a long position of one mini lot at market in EUR/USD. A limit order is set for the profit target at 100 pips, and a stop loss is placed at -50 pips. The EUR/USD market is currently trading 1.1330.
Upon the market order for one mini lot (units of 10,000) at 1.1330 being filled, the following sequence of actions takes place:
- The trader purchases euros and simultaneously sells dollars.
- The forex broker issues the trader a loan on margin for US$11,330, and converts the funds into €10,000.
- According to the chosen leverage of one mini lot, one pip is now equal to US$1 of the trader's account value.
- In the event that the trade is profitable, and the profit target of +100 pips is hit at 1.1430, the euros are sold and the margin loan of US$11,330 is paid back. The remaining 100 pips are a realised profit to the trading account of US$100.
- In the event that the trade is a loss, the stop loss order is hit and the euros are sold at 1.1280. The proceeds of US$11,280 are allocated to the repayment of the US$11,330 margin loan. The result of the trade is -50 pips and a loss to the trading account of US$50.
- Slippage is already factored into the realised profit or loss. Commissions and fees need to be factored in separately.
Each step of the trade execution process is an integral part of trading currency pairings. Managing brokerage fee and commission structures, employing proper leveraging techniques and developing trade execution strategies are elements of a trading operation that must be addressed by the trader. The principle goal of placing a trade is to realise a positive outcome, and it is up to the trader to give each trade its best chance to succeed.
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