A-BEGINNERS-GUIDE-TO-FOREIGN-EXCHANGE-TRADING

F O R E I G N

E X C H A N G E

T R A D I N G

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Followed by the credit market – think Treasury bills,

notes and bonds – foreign exchange is by far the

largest financial market in the world.

To give you an idea how gargantuan this market is,

trading in FX markets reached $6.6 trillion per day in

April 2019, up from $5.1 trillion three years earlier[1].

Across the spectrum, a number of accessible foreign

exchange (often referred to as forex or FX) trading

products are available. The most active is spot FX,

which is traded over the counter (OTC).

The over-the-counter market, also known as the ‘cash’

or ‘spot’ market, is a place where instruments are

exchanged for cash and delivered forthwith, or on the

spot. Unlike the stock market, the spot market has no

physical central exchange – trade takes place through

brokers offering retail investor accounts.

Catering to a number of market participants, the forex

market operates 24 hours a day five days a week,

beginning in Wellington, New Zealand, on Sunday and

wrapping up in New York Friday afternoon.

A key point to also keep in mind is daily trading volume

generally increases amid London and New York hours,

particularly when the two market sessions overlap.

Market Participants


Source: https://www.euromoney.com/article/b18bzd2g51lqkn/fx-survey-2018-overall-results

The main players involved in the FX market, aside from

governments and central banks that perhaps have the

largest influence, are commercial banks. Collectively,

the five largest banking institutions control more than

40% of the total trade volume, with JPMorgan Chase

capturing the lion’s share at 12.13%.

In many countries, the central bank’s mandate is to

manage a nation’s currency, money supply and interest

rates. Autonomy from government is in place to ensure

short-term political events avoid interfering with

achieving this objective. The US Federal Reserve (more

commonly known as ‘the Fed’) is such an example.

After commercial banks, smaller banks, multi-national

corporations, large hedge funds and some of the retail

market makers enter the fold.

Financial Instruments

in the FX Space

The forex market includes a number of currency pairs

– that is two currencies paired along with one another.

At IC Markets you’re able to trade up to 65 currency

pairs.


The EUR/USD, the GBP/USD, the AUD/USD and the

USD/JPY are considered major currency pairs. Note

major markets all include the US dollar.

Major currency pairs are the most actively traded

markets, with the EUR/USD taking the lion’s share of

volume.

The ‘base currency’ is the initial currency, which always

represents a value of 1 unit. The EUR, GBP, AUD and

USD (highlighted in bold) are base currencies. The

‘quote currency’, or ‘counter currency’, is the second

currency – the US dollar and Japanese yen

(underscored). The quoted amount is the quantity of

quote currency it takes to equal 1 unit of the base

currency.

Minor currency pairs, the EUR/GBP, EUR/AUD and

GBP/JPY, on the other hand, capture a smaller market

share. Currency pairs not associated with the US dollar

are referred to as minor currencies, whereas exotic

currency pairs (best left for another article to avoid

confusion) include currencies associated with

emerging markets.

The Exchange Rate

An exchange rate is the value at which one country’s

currency can be exchanged for another.


When traders engage with the FX market from a

speculative standpoint, a ‘view’ or ‘bias’ is taken, either

in the form of a long position (a buy) or a short position

(a sell).

Should the EUR/USD, trading at a price of 1.07950,

advance to 1.07980 this indicates the euro advanced

against its US counterpart, increasing in value. Those

long the market will note a profit, while those short will

be at a loss. A decline to 1.07910, on the other hand,

translates to a loss for traders long the currency pair

and a gain for those short.

An important point to remember when executing a

trade in the foreign exchange market is:

Buying a currency pair involves buying the base

currency by selling the quote currency.

Selling a currency pair involves selling the base

currency by buying the quote currency.

Technical Jargon

Entering the world of foreign exchange trading is often

a daunting process, overloaded with a plethora of

technical jargon.

Technical analysis typically helps define WHEN to

trade. Assume you recognise the underlying

fundamentals are pointing to a rally in the British pound

vs. the US dollar, though the technical picture trades at

the underside of strong resistance (a level – a ceiling –

in the market price has had trouble breaking beyond),

this suggests buying the market is hazardous at this

point. Once the resistance is taken out, a buy trade

could then be taken as now both technical and

fundamental studies trend in unison.

Fundamental analysis helps answer the question WHY

a market is moving in a particular direction. For

example, is the currency pair rallying due to the

Federal Reserve expected to hike rates in the near

future, or is the move fuelled by a country’s political

stance. Knowing what may cause markets to move

helps pin down market direction.

Pip/Point

A pip – a common term in the business – serves as an

abbreviation for ‘point in percentage’ or ‘price interest

point’. It is the unit of measurement to express the

change in value between two currencies.

Using the EUR/USD exchange rate depicted above:

1.07950 – we can see in order to buy 1 Euro (remember

the base currency always represents 1 unit) it’ll cost

$1.07950. Assuming the market skips to $1.07960, price

has advanced one pip higher – that is a move from

.0795 to .0796, a .0001 price move.

The majority of forex pairs go out to 4 decimal places,

though there are some exceptions such as the

Japanese yen pairs that go out to two decimal places.

The last value on the quotation: $1.07950 is called a

‘pipette’, which equals 1/10 of a pip. If the EUR/USD

moves to $1.07952, a 2-pipette advance has been

observed.

Bid/Ask Price

The Bid price is the price traders execute a short

(sell) position.

The Ask (or ‘offer’) is the price used to enter into a

long (buy) position.

Below is a standard order window available on MT4/5

platforms. The GBP/USD forex pair is trading at

1.2873/1.2874 (the smaller values: 7 and 2 are, ‘pipettes’,

as highlighted above). This means the market has an

Ask/offer price of 1.2874 and a Bid price of 1.2873.

Traders can, therefore, buy the GBP against the US

dollar at 1.2874 (the Ask) and sell the GBP at 1.2873 (the

Bid).


Spread

The difference between the Bid/Ask is called the

‘spread’ – another common term you’ll hear often,

which basically represents brokerage service costs.

The GBP/USD forex pair above shows the spread or

‘cost’ to purchase 1 unit of GBP using IC Markets is half

a pip, or five pipettes (1.28742 [the Ask] – 1.28737 [the

Bid]). The broader the spread the more expensive it is

to trade. Liquid and frequently traded major currency

pairs routinely offer small bid/ask spreads, while the

more erratic, less traded pairs, typically boast larger

bid/ask spreads (the exotics and some minor currency

pairs).

Leverage

Leverage is the ability to control large sums of capital

using very little of your own funds. Leverage, however,

is a double-edged sword and can be considered high

risk if not controlled.

Risk of excessive leverage has the potential to enlarge

your profits or losses by the same magnitude.

Helpful Tips to Get Started

Think long term. Don’t fall victim to the ‘I want to be a

millionaire next month’ camp. While gaining access to

the retail forex marketplace takes less than a few

clicks, trading has proven particularly tough for

beginner traders, often entering the market with

unrealistic expectations. This business, despite what

some gurus claim, is not a get-rich-quick-scheme. And,

unless treated as a business, your trading career will

likely be a short-lived one.

Journal your progress. Learn from your mistakes. This

is crucial. Without a journal, the learning curve will

likely be a long process that may end up with you

throwing in the towel.

Winning trades. Despite hearing of traders winning 80%

of the time, while there are some that do, you don’t

have to win 80% of your trades to profit. You don’t even

need to win 50% of the time. If you were presented a

trading method that won only four trades out of ten,

this is unlikely to gain much interest. Yet, what if it

stated on those winning trades the average gain was

two times your risk (risk: $200)? On each winning trade

we record a $400 gain. Multiply this by four ($1600).

Taking out the six losses ($200 * 6 $1200) and we’re left

with a profit of $400 from these ten trades, minus

transaction costs. Therefore, learn to accept losses as

they’re part of the business.

Position sizing. While this is an article for beginners, it

is necessary to touch on how a trader sizes

(calculates) positions. This is important. As traders,

before anything else, we are effectively risk

managers. Get this part wrong, and it can empty your

account.

To calculate a position’s risk, you need the following

data: account equity, pip value, the stop-loss pip

distance and the percentage of your account equity

you’re willing to risk. Standard lots, mini lots and

micro lots are what we use to calculate a trading

position. 1 standard lot equates to 100,000 units of

the base currency – that’s the first currency in a

currency pair (EUR/USD), a mini lot represents 10,000

units and a micro lot comes in at 1,000 units. A

standard lot equals $10 per pip, a mini lot equates to

$1 per pip and a micro lot represents $0.10 per pip.

These signify pip values for currency pairs with the

US dollar as their quote currency.

By way of example, trader A has an account balance

of $10,000. On average he risks about 25 points each

trade on the EUR/USD pair. In this case, the account

denomination is the same as the quote currency.

Trader A has also chosen to risk 2% of his account

equity per trade.

Firstly, we’ll need to calculate the dollar risk amount:

$10,000 * 0.02 = $200.

With this in mind, we can divide the amount of

equity risked by the stop-loss distance in pips:

$200/25 = $8 per pip. The trader then must locate

the pip value of the EUR/USD to size the position,

which we know from above.

Using a 1 standard lot places the trader at a higher

risk bracket of $250 ($10 per pip * 25 pip stop loss =

$250). Given this, we can simply size the position

using 8 mini lots since they equate to a $1 pip

movement ($1 per pip [1 mini lot] * 8 = $8 per pip *

25 pips = $200). There are additional steps involved

when your account currency is different from the

quote currency, but this may be best suited for

another article.

Risk parameters. Keep risk parameters to within a

1-2% risk bracket. While it may be tempting to risk

more, this is a dangerous play.

Don’t overtrade. Focus on only a few pairs to begin

with.

Trade using a demo account first. This will allow one

to become familiar with the platform’s features and

test strategies. However, while a demo account is

beneficial for the learning process, to trade the

markets successfully you must appreciate the

psychological demands trading imposes which is

only felt using a live account. Therefore, once

comfortable with the trading platform features and a

strategy, trading a small live account could be the

next step forward. With IC markets, you can open an

account with as little as $200.

[1] https://www.bis.org/statistics/rpfx19_fx.pdf


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