Forex systems and forex strategies
If you already understand the basics of forex trading, you are ready to develop your ownforex trading system. Most forex strategies attempt to predict a future exchange rate. If a trader expects a foreign currency to appreciate, he or she buys it and then resells it with a profit. This is called a “long trade”. If a trader anticipates a foreign currency to lose its value in the future, he or she would sell it now. This is called a “short trade”. Of course, financial markets are noisy and no one has been able to anticipate all the price movements perfectly. However, if the win/loss ratio is high enough to offset the inevitable occasional losses and the transaction costs (spread), a forex system is profitable. Assuming a low spread, the only thing you need to become a thriving trader is a forex strategy slightly more successful than simple tossing of a coin. Whenever you are consistently better in predicting the foreign exchange market's behavior than you would be by pure chance, your forex trading strategy is profitable.
Based on the employed forex system, the profit (and loss) can be realized anywhere between seconds and years. As I explain below, forex strategies also differ in how they predict the future exchange rate. But in general, almost all the forex systems may be roughly divided into those suitable for a ranging market and those suitable for a trending market.
Trend trading
The trend is the general direction of a financial market. A trader following a trend would buy a currency when it is trending upward and sell it when it goes down. Trending strategies assume that the present momentum will be kept for some time. The crucial part of profitable trend trading is to identify an entry point and an exit point. To identify when a trend starts, people often use technical indicators, such as Bollinger bands. After entering the market, they hold their position until the trend reverses.
Range trading
Range trading is suitable for the periods, in which an exchange rate oscillates in a clearly defined range, or a channel. A range trader sells a currency at the top of the range and buys it at the bottom of the range. This may be repeated many times, until the exchange rate leaves the range and starts trending. The basic assumption behind range trading is that whatever the actual direction of the market is, a price will eventually return to its origin.
Technical analysis
Forex strategies are mostly based either on fundamental or technical analysis. Technical analysis is much more popular among small forex traders, so let us start with it. Traders relying on technical analysis either visually examine forex charts or use mathematical modelsto estimate future price movements. Both approaches predict a future exchange rate based on the (recent) past values. A technical trader will enter and exit a trade if he or she sees a particular forex chart pattern or if a technical indicator achieves a certain value. The definitive book on technical analysis is Kirkpatrick and Dahlquist's Technical Analysis: The Complete Resource for Financial Market Technicians
. The most comprehensive description of chart patterns can be found in Bulkowski's Encyclopedia of Chart Patterns
. A book of similar scope and depth, but strictly focused on the foreign exchange market, is The Forex Chartist Companion: A Visual Approach to Technical Analysis
from Wiley Trading.Fundamental analysis
Fundamental analysis is usually used to identify long-term trends. Traders specialized in fundamental analysis believe that currencies are driven by economic and political fundamentals. They look at important economic indicators, such as interest rate, inflation, unemployment, FDI, and current account balance to evaluate long-term health of an economy. Some traders also trade short term on important economic news announcements (for example Non-farm Payrolls, PMI, and CPI). This is called trading news. The Trader's Guide to Key Economic Indicators
offers a concise and at the same time comprehensive description of main economic indicators. International economic indicators are described in great detail in Anne Dolganos Picker's International Economic Indicators and Central Banks
.Developing your own forex trading system
There are many ways to combine economic and technical indicators. Some traders analyze only one technical indicator (for example Bollinger bands) to keep things simple. But most traders enter a position only when several different signals simultaneously point in the same directions. An example would be a price breaking through both a Bollinger band and a trend line, combined with a signal from Parabolic SAR. It is often recommended to use fundamental analysis in order to identify a long-term trend and then to use technical analysis to determine a good entry point.
You can learn to build a profitable forex system from the top-rated forex books, written by accomplished traders or academics. A friendly yet comprehensive introduction into the area of forex strategies and forex systems is Raghee Horner's book ForeX Trading for Maximum Profit: The Best Kept Secret Off Wall Street
. If you prefer more practical treatment of the subject, Ed Ponsi offers a step-by-step guide in his Forex & Probabilities: Trading Strategies for Trending & Range-Bound Markets
. My personal favorite is The Encyclopedia of Trading Strategies
, which puts a great number of technical indicators under rigorous scientific testing.An alternative forex strategy: Carry trading
Carry trading is a forex strategy utilizing compound interest. Carry trading exploits an interest rate differential between two currencies. Let us say, the interest rate in Japan is set to 0.50% and in New Zealand to 7.5% (true in September 2008). A trader holding NZD/JPY for one year will theoretically get a yearly interest of 7%, which is more than an interest paid on saving accounts in American, European, and Japanese banks. I used the word “theoretically” because the real interest can be much higher. But, as you will see in a moment, a higher return goes hand in hand with increased risk.
The forex market has two features that make it suitable for carry trading. The first one is thecompound interest. The rollover interest (a daily fraction of those 7% paid on NZD/JPY) is usually added to a forex trading account every day. Therefore, you will get interest not only on your initial investment, but also on all the previously gained interest. Let say you are holding a long position in NZD/JPY worth $1,000. 7% of $1,000 is equal to a yearly profit of $70. With a daily rollover interest, you would get $72.50 instead.
That sounds nice, but also quite negligible unless you invest a large amount of money. Here enters the effect of leverage. With a leverage of 200:1 (offered for example by Easy Forex), your initial capital of $1,000 gives you control over $200,000 automatically borrowed from the forex broker. Now, the compound interest becomes interesting: In one year, your account would raise from $1,000 to $14,500. On the other hand, high leverage would also expose you to the risk arising from adverse exchange rate movements.
Since carry trading is reputedly the most popular forex strategy of big hedge funds, huge long position drive high-yielding currencies up. By consequence, the gap between high- and low-yielding currencies (for example between NZD and JPY) widens for most of the year. As a result, carry traders gain not only interest, but they can also profit from holding a constantly rising currency. Of course, neither this forex strategy is risk-proof. There are periods of thecarry trade unwinding, when high-yielding currencies lose their value for speculative reasons. To protect their investment during these violent periods, a carry trader usually does not use all the available leverage. Some carry traders also employ sophisticated methods of money management or grid trading.
Forex books recommended for beginners
These top rated forex trading books give basic understanding of the currency markets and teach novice traders to identify trading opportunities. Most of them include a practical step-by-step guide to forex trading and lots of real-world examples. You can access more advanced forex books through the links on the left side of the page. All the books featured at the Forex Learning Site are shipped from Amazon. Although you can buy them conveniently on our website, your checkout will be finalized on Amazon's secure servers.
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| Currency Trading For Dummies by Mark Galant | A Foreign Exchange Primer by Shani Shamah | Foreign Exchange: A Practical Guide to the ... by Tim Weithers $48.98 |
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| Mastering Foreign Exchange and Money Market... by Element Books Ltd. | The Forex Trading Course: A Self-Study Guid... by Abe Cofnas $40.29 | The 10 Essentials of Forex Trading: The Rul... by Jared Martinez $18.66 |
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| Profiting With Forex: The Most Effective T... by John Jagerson $29.37 | Trading in the Global Currency Markets, 3rd... by Cornelius Luca $44.54 | The Complete Guide to Currency Trading &... by Jamaine Burrell $24.95 |
How to choose the best forex broker?
This is a question that you should ask well before making the first forex trade. Most newbies end up paying exorbitantly high fees for clumsy services to a forex broker with the biggest and shiniest banners. Professional traders take forex trading seriously, just as any other business. And since a forex broker is their principal business partner, they make their choice very carefully. This free tutorial will explain you the criteria used by professional traders in evaluating different online forex brokers. It will then guide you in making your informed choice. While reading the tutorial, write down a list of the criteria that are important for you. Try to build an imaginary offer from the ideal, best forex broker. When you are done, find the closest match in our fully interactive comparison of forex brokers.
A regulated forex broker is safer
There are hundreds of online forex brokers and many of them are in fact scams cheating on their clients. To avoid unnecessary problems, it is better to entrust money with a regulated forex broker. Regulated forex brokers are under supervision of a trustworthy regulatory authority. The strictest broker regulations exist in Northern America, Europe, Australia, and Japan. So, before depositing any money on your forex trading account, check whether your broker is registered with at least one of the following agencies:
Australia: ASIC, AFSL
Canada: CIPF, OSC, BCSC
Denmark: Danish FSA
Germany: BaFin
Hong Kong: SFC
Japan: FFAJ
Spain: CNMV
Sweden: FI
Switzerland: ARIF, FDF, GSCGI
United Kingdom: FSA
United States: NFA, CFTC
Some forex trading brokers are even regulated in several jurisdictions at the same time. For example, Easy Forex is regulated by NFA, CFTC, CySEC, ASIC, and AFSL. But this is an exception and most online forex brokers are regulated only in their home country. Obviously, more oversight brings also more safety for your money. You can easily filter our list of forex brokers to include only the ones that are regulated.
If possible, get an ECN forex broker
There are two basic types of forex brokers. Interbank forex brokers (or ECN) offer the lowest transaction costs (spread) and are extremely reliable. They never trade against their clients and they do not have any capacity to do that. Unfortunately, this royal treatment is not for everyone. ECN brokers generally accept only clients with large accounts. For example,Dukascopy, an interbank broker from Switzerland, only recently lowered its required minimum deposit from 50,000 USD to 1,000 USD.
The so-called Market makers (MM), on the other hand, accept almost anyone. Accordingly, their spread (cost of each trade) is higher. While choosing a market maker, it is usually more advantageous to find one with no dealing desk (NDD). Forex brokers without a dealing desk will execute your orders instantly and at the price that you clicked on. In contrast, market makers with a dealing desk can change the price at which you are entering a trade. This is called “to requote”. According to broker reviews in various fora, some market makers reputedly do requote from time to time and such a new price is rarely at the trader's advantage. Dishonest MM forex brokers may also enter trades against you or manipulate the price itself by sending you artificial “spikes”. Of course, there are also many honest MM brokers, who do not resort to this kind of behavior. You should always read reviews and browse relevant discussion fora to check the reputation of the broker you plan to trade with. Or, if you want to avoid any risk, trade only with a genuine ECN or NDD broker, such asDukascopy or InstaForex.
The best forex brokers have low spread
The spread is the difference between the sell quote and the buy quote (or the bid and ask price) at any given point in time. It is calculated in pips, which is basically the last decimal point of the price. So, with a spread of 1 pip, you would pay $0.0001 for every dollar traded. Most online forex brokers make money from spread and do not charge any other visible commission. The smallest spread available to small retail traders is currently offered byDukascopy. Their spread on major currency pairs often drops to zero, plus a minuscule commission of 0.018 pip. For comparison, many of the so-called “no-commission” brokers would charge you a spread of 6 pips on the same currency pair. High spread can completely kill your strategy if you specialize in scalping or day trading.
A forex broker may offer either a fixed or a variable spread. In general, a fixed spread is a bit higher on average, but it remains constant regardless of the trading conditions. A variable spread is generally lower for most of the time, but it may widen considerably during important economic news announcements or at night. You should choose a broker with a fixed spread if you want to trade news or will be active in the periods with low volatility (such as after 5pm EST). eToro offers a very low fixed spread of 2 pips on all majors. If you prefer a variable spread, Dukascopy has the lowest one. You can find more forex brokers with variable or fixed spreads in our database.
You want a forex broker with sufficient leverage
Leverage is a ratio between the total capital available for your trading and the actual capital that you have on your trading account. For example, a ratio of 100:1 means that your broker would lend you $100 for every $1 of your actual capital. Therefore, you would command $100,000 with an account of $1,000.
High leverage increases both your potential profit and your potential loss. For example, if you use your $1,000 to buy USD/CHF and the exchange rate goes up from 1.1000 to 1.1100, your profit would be $10. Had you used the 1:100 leverage instead (investing $100,000 automatically borrowed from your broker), your return from the same trade, with the same starting capital, would have been $1,000. Of course, the same logic also applies to your losses and high leverage can exacerbate them. Use it with caution.
If you have limited capital, you will need high leverage to earn any substantial profits. But, again, do not forget about the risk that comes with high leverage. Leverage offered by online forex brokers starts at 50:1 and may be sometimes as high as 500:1 (LiteForex) or even 1000:1 (InstaForex). If your broker offers a really high leverage, you do not have to use it all and all the time. Your real leverage needs will depend on a particular forex strategy.
Familiarize yourself with different forex trading account types
Online forex brokers usually offer several types of trading accounts. Sometimes, they differentiate between a “mini” account and a “standard” account. The former requires a low starting capital, but often provides a user with a limited trading platform or worse spreads. Standard, fully-functional accounts require deposits over a certain threshold, for example $1,000. Before you send out any forex investment, always read the trading conditions related to the account you are opening.
Nevertheless, many forex trading brokers do not make the distinction between standard and mini accounts at all. For example, FxOpen lets you open a “micro account” with as little as $1 and you pay the same spread as you would pay with a standard account. Marketiva has only one type of forex trading account and it is up to you whether you deposit $100,000 or $1. If your resources are limited, choose a broker that does not discriminate against small traders.
If you plan to trade small, you should also know that many forex brokers require a prohibitively high minimum trade size. They often use 1 lot (100,000 units of the base currency) as the smallest trading volume. That means that you would need to buy at least 100,000 USD while trading USD/JPY, for instance. With a leverage of 200:1, you would have to risk at least $500 of your capital to be able to trade 1 lot of USD. Fortunately, online forex brokers are becoming more and more flexible and they often offer also mini lots or micro lots. Using our previous example, 1 mini lot would be equal to 10,000 USD and you would risk only $50 with a standard leverage of 200:1. 1 micro lot would be equal to $1,000 and you would risk $5. Some forex brokers go even further. For example, FxOpen lets you trade 100 units of the basic currency and Marketiva has no limits at all.
Play around with a demo account
A demo account allows you to test your trading strategy in real time, on the broker's trading platform, but with virtual money. Demo trades can reveal weaknesses of your strategy. They can also help you discover any problems with the broker's trading platform. At the same time, you do not bear any risk. It is essential to use a free practice account before you trade for real. However, demo trading might sometimes differ from live trading because of the non-existing slippage (difference in price between the time you place an order and the time it is executed) in demo accounts. In addition, your own psychology becomes much more significant when you trade live.
Choose a forex trading platform with the features you will need
Forex trading platforms usually feature real-time forex charts, technical analysis tools, and real-time economic news. What you should be interested in besides user-friendliness are functions related to trading itself.
Some forex trading platforms allow you to trade only major currencies (such as EUR/USD), but others also include crosses (such as AUD/JPY), exotic pairs (such as USD/INR), gold, silver, and oil. Although many forex traders specialize only in few pairs, availability of additional financial instruments naturally brings more trading opportunities. Moreover, some exotic currencies have a very high interest rate, making them very interesting for carry trading. Gold offers wonderful trading opportunities during political crises. Some currencies, metals, and oil also exhibit correlations that can be exploited by a savvy trader. As a novice trader, you may simply want to experiment with different currencies and commodities to find the ones that fit your mental profile. Either way, a greater number of currency pairs is always welcome. Easy Forex offers the largest variety of trading instruments, 182 currency pairs and precious metals.
An important feature of advanced forex trading platforms is hedging. It allows you to hold both short and long orders at the same time. Hedging is often used to decrease risk and it is also required by many sophisticated trading strategies (such as numerous flavors of grid trading). A trader pays for this risk reduction by higher transaction costs. However, not every forex broker will allow you to hedge. You can find the forex brokers, who offer hedging in ourdetailed comparison of forex brokers.
Other useful yet rare feature is a trailing stop. It allows you to ride a trend without a fear that you would lose money in case of a sudden reversal. Trailing stops provide the easiest way to lock in your profit (or limit loss), but, again, they are not always included in forex trading platforms.
If your trading strategy is based on technical analysis, you may want to automate its execution at some point in the future. The biggest advantage of automated forex trading is that a trader does not need to stare at the monitor the whole day, waiting for a trading signal. You will also never miss a trading opportunity while you are sleeping, eating, or on a vacation. The computer will trade for you. Automated forex trading is an integral part of several forex trading platforms, including the popular MetaTrader 4.
Some forex brokers also provide mobile trading. With a cell phone, a trader can check or execute orders from any place. This gives more independence and flexibility. Mobile trading is more and more widespread among forex brokers.
The best forex broker should combine hedging, trailing stops, automated trading, and mobile trading. FxOpen, LiteForex, and Nord FX are some of the online forex brokers that offer all of these services. You can find even more such forex brokers in our interactive forex broker comparison.
Think about how you want to fund your forex trading account
Most forex accounts are denominated in USD. But if you live in the Eurozone, you would probably prefer a forex broker offering accounts in Euro. Many brokers allow you to deposit and withdraw money in your local currency. For example, Easy Forex not only offers accounts in USD, EUR, JPY, and GBP, but also in ILS, PLN, SGD, and other "exotic" currencies. When you are actively trading, your money (including profits) will sit in your account for some time. If you expect your currency to depreciate in a long run, you may want to hold your account in a different currency. In last few years, American traders have lost a lot of money not because of bad trades, but simply by cashing their profits in American dollars.
Another question is whether you prefer to make your initial deposit by a credit card, bank wireor PayPal. Some forex brokers (for example Easy Forex) would accept any of them, but this is rather an exception. Most brokers also offer deposits and withdrawals in e-currencies or other alternative payments. For example, FxOpen accepts C-Gold, cashU, China Union Pay, Moneybookers, Perfect Money, WebMoney in addition to standard bank wires. Probably the easiest way to withdraw money from your forex trading account is to a debit card. A dedicated debit card is provided by InstaForex and few other forex brokers.
How to find an online forex broker meeting your criteria?
After you decide which conditions are important for you, you can compare forex brokers in our database. Just specify your criteria and the interactive page will return a list of those brokers who match them. There is no single best forex broker out there. But we will help you find the one that suits your needs the best.
Friday, 13 July 2012
What is Forex?
Who can trade forex?
The traditional participants in the foreign exchange market are central banks, commercial banks, and hedge funds. However, the development of the Internet has opened the forex market also to a great variety of small retail traders, from Russian finance students to Japanese housewives to American retirees. Basically, anyone with a computer, an Internet connection, and a starting capital of $1 can start trading forex. Currencies are traded through a broker. You can learn more aboutdifferences between forex brokers in another free tutorial.
When and where are currencies traded?
Forex is open 24 hours a day, 5.5 days a week. It is up to you when you want to trade – full-time from 9 to 5, part-time after work, or once a day, before going to bed.
Unlike a stock market, the foreign exchange market has no physical location. It is rather a decentralized electronic network of banks and forex brokers.
Which currencies can be traded?
Forex currency symbols consist of three letters. For example, USD stands for the US dollar, EUR for the Euro, and JPY for the Japanese Yen. Some currencies are also known under nicknames:
American dollar (USD) = Greenback
British pound (GBP) = Cable or Sterling
Swiss franc (CHF) = Swissy
Canadian dollar (CAD) = Loonie
Australian dollar (AUD) = Aussie
New Zealand dollar (NZD) = Kiwi
The most popular currency pairs include the so-called majors (EUR/USD, USD/JPY, GBP/USD, USD/CHF) and commodity pairs (USD/CAD, AUD/USD, NZD/USD). Any other combination of these currencies (for example EUR/GBP or AUD/JPY) is called a currency cross. Many forex brokers also offer exotic currencies, such as HKD, TRY, and ZAR.
What is a quote?
The quote records the value of one currency in terms of another currency. The currency on the left side of a currency pair is called the base currency and the currency on the right is called the counter currency. A quote indicates how much worth one unit of the base currency is in terms of the counter currency. For example, EUR/USD quoted at 1.5102 means that 1 Euro can be purchased for 1.5102 American dollars.
What is a pip?
Pip stands for “percentage in point” and it represents the smallest change in price that a currency pair can make. In other words, it is the last decimal point of the quote. If the EUR/USD moves from 1.5230 to 1.5432, it rises by 2 pips. Most currency exchange quotes have four digits after the decimal place; only the Japanese yen is quoted out to two decimal places. So, USD/JPY would move by two pips for example from 108.11 to 108.13.
What is a long trade? What is a short trade?
If you expect the base currency to appreciate, you want to buy it and then sell it back at a higher price. In the forex jargon, buying a currency is called “taking a long position” or simply “going long”.
If the base currency is expected to depreciate, you can sell it now and buy it back later, at a lower price. Selling a currency is called “taking a short position”, “going short” or “shorting”.
What is the spread?
Currency quotes are expressed in two prices, a bid price (buy) and an ask price (sell). For example, an online forex broker will show the quote of the Euro as something like 1.5102/1.5105. You can buy the base currency (enter a long trade) at the bid price (1.5102 in our example). You can sell the base currency (enter a short trade) at the ask price (1.5105). The difference between the bid and the ask price is called the spread. The spread is in fact a hidden commission paid to a broker. So, if the bid price of EUR/USD is 1.5102 and the ask price 1.5105, you automatically pay the spread of 3 pips from every trade to your broker.
What is leverage?
Leverage is a ratio between the total capital available for trading and the actual capital that you have on your trading account. For example, a ratio of 100:1 means that a broker would lend you $100 for every $1 of your actual capital. Therefore, you can control $100,000 with an account of only $1,000.
High leverage maximizes both potential profits and potential losses. For example, if you use your $1,000 to buy USD/CHF and the exchange rate goes up by 100 pips from 1.1000 to 1.1100, your profit would be equal to $10. Had you used the 1:100 leverage instead, the return from the same trade, with the same starting capital, would have been $1,000. Of course, higher leverage also increases potential losses. Had the USD/CHF fallen by 100 pips, you would have lost all of your starting capital with the 100:1 leverage.
Although you technically borrow huge amounts of money from a forex broker, you can never lose more than the actual capital that you have in your trading account. If the account falls to below the minimum amount required to maintain an open position, you will receive a margin call and your positions will be automatically closed to prevent further losses.
Why to trade currencies?
Forex is a 24-hour market. This creates a great number of trading opportunities every day. It also allows to trade currencies part-time.
No big player controls the forex market. Because of the liquidity, no single bank or fund can influence the price at the expense of small retail traders, at least not for long.
The forex market cannot crash. Unlike stocks, currencies are valued relatively to each other. If one currency depreciates, another goes up.
You can profit from both rising and falling currencies. Even if you do not physically hold a particular currency, you can still sell it. You can go long or short, capturing all the price movements. But, of course, if the currency moves in the opposite direction to that you have predicted, you will lose money.
Low starting capital. Some online forex brokers let their clients trade with as little as $1. Thanks to high leverage, you can make substantial profits even with a small trading account.
Low transaction costs. Most forex brokers do not charge any commission. They are compensated by the spread that can be sometimes as low as 10 cents for every $10,000 traded.
Free tools. Most online forex brokers give away tons of free stuff. You can practice forex trading on a free demo account. You get access to free forex charts, free technical indicators, free economic news feeds... even to free professional market analyses.
Instant execution of trades. Under normal market conditions, trading orders are executed instantaneously. Many forex brokers also allow you to automate your trading strategy, using algorithmic trading.
Where is the catch?
Forex trading takes time to learn. If it was so easy, everyone would trade currencies instead of working. But, in reality, most new forex traders fail and quit. Successful forex trading requires a lot of knowledge. You can start with one of the forex books recommended for beginners to get the basic understanding of the foreign exchange market. Then you can move on to more advanced books on technical analysis, fundamental analysis, and money management. Do not expect to succeed in the largest financial market on Earth just because you have read some pdf file downloaded from your broker's website. In addition to reading, forex trading also involves a lot of experimenting. Traders constantly refine and retest their trading strategies. If you are a creative person, you will enjoy this aspect of forex trading a lot. If you just look for quick money without any work, forget about forex.
Forex trading requires great discipline. It is difficult to stick even with a time-tested strategy if the market suddenly goes in the opposite direction, cutting into your trading account. You can avoid the most common errors by learning from trading psychology books, but the serious test of your nerve comes only when you risk real money.
Forex trading will not give you a free lunch. If you start trading forex with an account of $100, you cannot expect to become a millionaire. Like in any economic activity, only a reasonably high investment can bring substantial profits - and even then losses are still possible. In general, professional forex traders rarely gain a higher return than 30-40% a year. Many new traders want to offset their small starting capital by using too much leverage. Although this may work for months or even for years, they risk to eventually blow up their overleveraged accounts. There is no free lunch. On the other hand, 30-40% is still much more than you would get from a saving account.
Beware of suspicious get-rich-quick schemes. You can google thousands of websites offering forex signals that will make you a millionaire in few weeks and without any education. Of course, they are all scams. Forex trading requires understanding of the market. Warren Buffett, the richest person in the world, never invests in what he does not understand. Why would you?
The next crucial step in learning to trade forex is to develop, adapt, and test a profitable forex strategy. If you want to learn how to do it, you can read our tutorial about forex systems and strategies.
