What is Currency Trading?

When you're trading currencies your pitting one currency against another. So with something like EUR/USD, if you buy this pair you're betting that the Euro will rise against the US Dollar. If you sell this pair you're betting the opposite, that the US Dollar is going to rise against the Euro. With Forex there's no distinction between buying and selling, unlike the stock market where there is a tendency to buy and hold stocks.

The Market

The Forex markets are a 24 hour market. It starts in New Zealand, goes to the Asian session, the London session, the US session and then back again. From Friday night until Sunday night the market is closed. Liquidity is another important thing. With the stock market it does about $58 Billion a day. Major players can really move that market. With Forex it does about $4 Trillion a day. It's the closest thing we have to a perfect market. No big players can really move the price with the exception of central banks. If there's Japanese intervention or Swiss intervention then it can easily move the market a hundred points. But still in the scheme of things that's very minor.

Price Movements

One hundred points is a move of 1 cent in the price of the currency. Everything in Forex is measured in Pips. A pip is generally 1/100 of a cent. So in the case of EUR/USD if it's trading at 1.3546 and price goes up to 1.3556 then that represents a 10 pip move. Most brokers will display price out to a 1/10th of a pip (also called a pipette) or a total of 5 decimals. Some pairs, such as the Yen pairs, are displayed out to 3 decimals.

Leverage and Risk Management

One other interesting thing about Forex is the use of leverage. Since the Dodd-Frank legislation passed U.S. traders are limited to 50 to 1 leverage on a trade. (They are also pretty much forbidden from opening accounts overseas.) This means that with $10,000 you could potentially trade $500,000 worth of currency. Now if you do that you're a moron, but some use of leverage that is managed appropriately with risk management can be beneficial. I'll talk more about risk management in follow up posts because it's one of the most important things in trading yet it's often not discussed. The key is to know how much you're risking on each trade. A standard lot in Forex is $100,000 worth of currency. You can also trade mini lots ($10,000), and micro lots ($1,000). At a standard lot each pip movement is worth roughly $10 per pip. So if I set a stop loss in a trade of 30 pips then I'm risking $300 on that trade at a standard lot, or $30 on that trade with a mini.

Brokers

As "retail" traders we are not allowed to buy and sell directly with the central banks. Retail brokers are who we deal with. There are different kinds of brokers and different ways they do business. Most of the larger well known brokers are pretty reliable. Brokers tend to fall into two categories but these often get blurred. There are dealing desk brokers that are taking the other side of the trade from you and there are Electronic Communications Networks (ECN) brokers which are generally just batching up your trades and passing them on to the Interbank (central banks, partner banks, other brokers, etc...). Some folks don't like dealing desk brokers because in a sense the broker makes money if you lose. Brokers make their money mostly on the spread (the price difference between bid and ask).

Some brokers offer lower spreads but then charge a commission to make their money. If you search on the internet you'll find someone complaining about every one of them. A lot of the complaints can be distilled down to morons trying to blame the broker for their own bad decisions. Occasionally it's over an issue of slippage (fill price differences from your order price). Slippage can be a real problem in high market volitility situations. There are various ways to prevent slippage: trade when there is high liquidity, don't trade on banking holidays, don't trade 30 minutes prior to major news items such as Non-Farm Payroll announcements.

I don't want to make it all sound like it's not the brokers fault, because there have been NFA fines against brokerages over slippage and other nefarious trading practices.

No Central Exchange

Forex has no centralized exchange. It's all distributed. That means if I'm trading with FXDD and you're trading with Tradestation your data is always going to be a bit off from mine. Retail Forex trading is only a little over 10 years old. So it's a very infant market.

Some people have pushed for the creation of a centralized exchange. Personally I like the distributed nature of it. As a technical trader (mostly) all I can base my trades on is my data. As long as you are working with an ECN that has good liquidity, it shouldn't be a concern.

Demo Trading

The tools are starting to get really good. One great thing about Forex is that with any broker you can sign up for a demo account and start "paper" trading right away. Their value add is in the tools they provide, so it's pretty amazing what you can do for no commitment. As an example, you can go to Oanda, Dukascopy or Alpari today and sign up for a demo account, download a platform and start getting a feel for what it's like to trade the markets without risking any money. The demo platforms are exactly the same as the live platforms in terms of features. Data reliability and execution time of orders is not guaranteed to be the same, so it's always a good idea to take a new strategy live with very minimal exposure. Personally I'll trade in micro lots for a couple of weeks to be sure I'm seeing live what I saw in my own back testing.

Note that any reference to brokers in the above paragraphs does not represent and endorsement and they are not "introducing broker" links. I'm a trader, not a salesman. Do you own homework.

What Kind of Trader are You?

Different traders use different trading methodologies. There's fundamental traders which like to trade off longer time frames and base it on the overall fundamentals of the economies in play, and there are technical traders that simple trade off the technicals of the price.

A fundamental trader for instance might short EUR/GBP betting that the Eurozone countries are going to suffer ratings downgrades, due to lack of a sustainable plan to address the Greek debt crisis, and the British Pound is going to continue to strengthen.

A technical trader may just have a technical strategy that says if price reaches a prior point of support it's likely to bounce off of it and head higher. I think the best traders combine the two methodologies and consider both in a trade. Most of my trading is purely technical, but I don't ignore the fundamentals. If nothing else I don't trade on bank holidays for instance because of the low liquidity. Things like that.

For technical traders they tend to fall into two main camps, those that trade based on indicators and those that trade based on price action. This is not a hard defined rule, but I'm just trying to generalize things. Indicator traders tend to use things like Fibonacci levels, stochastics, exponential moving averages, etc... to build a trading strategy. Price action traders tend to look at support / resistance, candlestick patterns, and just general price movement between the bears and bulls.

Some traders like to go after small wins, such as a 10 pip move, and other traders like to have a trade open for several days and go after 100 - 300 pip moves. I'd caution about trying to scalp trade for very small pips because as a retail trader you would get eaten alive by execution speeds and the spread. When you carry a currency over a day there's interest to be paid, so some folks make sure they close their trades by end of day or in other cases end of week. In fact sometimes it's to be paid and sometimes it's to be received. There is a trading methodology that is just based on this interest called the Carry Trade. It's not such a good thing today since all economies are in the toilet but there was a time when it was a great way to trade. With the carry trade you would find a currency paying 6% interest and another that is paying .5% interest. You would sell the higher interest currency.The buyer of the currency would pay you that 6% over the .5% you'd pay out and you would make a relatively low risk 5.5%.

Automated Trading

The up and coming thing these days is automated trading. That's what I'm most interested in. I'll have a lot more to say about this in future posts. The tools are finally good enough that most brokers offer an API that you can code to. This means you can back test a strategy for about 10 years, fine tune it, and then automate it. If you balance a good strategy with good Risk Management you can live to trade another day.

Automated trading also takes a lot of the psychology out of it, which is huge. In my opinion psychology is the number one reason why most traders lose money. In fact it is said that 90% of Forex traders lose money. That's huge! Discretionary traders tend to not follow their rules. So although they may have developed a great strategy when they get into the trade the psychology eats them alive.

Final Thoughts

I could go on and on but I'm sure I'll have future posts on the subject. I will wrap it up with just one more item. You shouldn't be trading Forex with money you cannot afford to lose. That's critical. Because as much as you can back test and use risk management the high degree of leverage offered in Forex means price can work in your favor just as much as it can work against you.

Here's a couple of helpful resources to get you started in the right direction:

Baby Pips - excellent resource to get started. They make it fun and do a good responsible job of presenting the fundamental aspects of trading.

Review Pips - by the same folks that do Baby Pips. This is a review site by users of products and services they have used. Be careful about any review sites. Some "salesman" are clearly stuffing the ballot. I'd get the opinion of people you trust and combine it with reviews from multiple sites.

Market Wizards Books - very inspirational series of books by Jack D. Schwager that are interviews with traders that have done exceptional. These books help to understand the mindset of a succesful trader.