A Complete Forex Trading Guide
Forex trading involves significant risk, and learning takes time. This course will get you started and give you a better understanding of the fundamentals of currency trading. Our educational material will guide you through the jungle of pips, lots and chart patterns and aspires to introduce you to the markets.
Our main purpose is to hasten the learning process by supplying you the most useful information in the simplest manner possible. With the power you’ll gain by the knowledge in these pages, you’ll be more prepared to meet the markets.
How to Read a Currency Quote
Forex trading is a form of commodity trading. In the commodity market traders buy and sell assets like oil or gold in exchange for currencies. In the Forex (currency trading) market the assets bought and sold are currencies themselves. As a result, unlike in the commodity, each currency’s value is determined relative to another. For example, when the currency trader buys an ounce of gold, he must pay for it with the US dollar, which creates a quote in which the price of the metal is defined in terms of a currency which is another asset class. But when the forex trader buys or sells the Euro, he must pay for it with another currency (Australian dollar, Swiss Franc, etc) in which case the quote created has the same asset class on both sides. The result of this is that it is impossible to speak of absolute value in the forex market because it is possible to value the Euro in dollars, Francs, or Yen, each being a valid choice as a value indicator. In the case of stocks, or commodities, the value can only be indicated in USD; therefore it is possible to speak of an absolute value.
How to Read and Understand a Currency Quote
Upon downloading and opening the software of your chosen Forex broker, the first concept that you will encounter is the Forex price quote. The quote is simply the record of a previous transaction in which a currency pair changed hands. When two financial actors exchange currencies, the price at which the transaction occurred is called a quote. Let’s see this with an example.
In the above quote, the currency on the left side is the currency which was bought by us, while the one on the right is the one that we sold to finance our purchase. The number signifies the value at which the currencies were exchanged. Or to put it in a short and simple mathematical form, when we bought 1 Euro, the value of one Euro was equal to 1.35 USD, and we had to pay that much to buy the currency.
Upon executing the trade, we are now long the Euro, and short the dollar (we bought the Euro, and sold the dollar.), in either words, we have an open position. The principle of profit in currency trading is the same as in all other kinds of trading activity: to buy cheap, and to sell expensive is our purpose. Consequently, we will wait for the value of the Euro to rise above 1.35, to for instance, 1.38, where we will be able to close our position by selling the Euro and buying back the dollars, and making a profit. Since our base currency is the dollar, our profit will also be measured in dollars.
Let’s solidify this with an example:
We buy 1,000 EUR for 1,350 USD, with the quote at 1.35. We wait until the quote is at 1.38, when we close our position by selling our 1,000 Euro at 1,380 USD. Since our initial trade was worth 1,350 USD, the difference between 1,380 and 1,350, that is, 30 dollars, becomes our profit.
What are Forex Pips, Lots, Margin and Leverage
Knowing and understanding the proper terminology within the forex market is essential in becoming a successful trader. In this article we discuss and define what pips, lots, margin and leverage are. We also provide examples of each for easier comprehension.
Pips and Lots
Currency traders quote the value of a currency pair, and trade sizes, in pips and lots. A pip is usually the smallest amount by which the value of a currency pair can change, although these days some brokers offer fractional pip quotes too. In example, when the value of the EUR/USD pair goes up by one tick (i.e. pip) the quote will move from 1.2345, to 1.2346, and the size of the movement is just one pip. An important guideline for the beginning trader is to measure success or loss in an account by pips instead of the actual dollar value. A one pip gain in a $10 account, is equal, in terms of the trader’s skill, to a 1 pip gain in a $1,000 account, although the actual dollar amount is very different.
The smallest size in currency trading for professional traders is called a lot. For USD-based pairs, the lot size is 100,000. In other words, when you enter a trade with your margin account, the smallest amount that you can buy or sell is 100K, regardless of the size of your margin.
Margin and Leverage
Another important concept in currency trading is the twin phenomenon of margin and leverage. This is a concept that carries a high degree of risk, but since forex prices move very slowly (in terms of the actual change in value), the vast majority of traders leverage their accounts when engaging in short-term trading.
When you open a forex account, the broker will request that you deposit a small sum, known as margin, as insurance against the losses that your account may suffer. With this small sum, you’re able to control a much larger amount, enabling greater gains, but also greater losses than you would be able to achieve with your deposit. It’s easier to understand margin and leverage in the context of a borrowing process. The lots that you can trade are borrowed from your broker, who requires a margin deposit as an insurance against losses. The ratio between the funds borrowed by you, and the margin that you deposit as insurance is called leverage. Thus, if you set a leverage ratio of 100:1, enabling the trade of 1,000,000 USD with just 10,000 USD in deposit, but eventually trade just 100,000, the actual leverage that you would be using is 10:1. Note that leverage over 50:1 for majors and 20:1 for minors is not available to traders in the U.S.
In order to understand how to manage your account you must gain a good understanding of leverage. Failure to pay proper attention to leverage and margin may result in a margin call and the broker may liquidate your position in order to ensure that your losses do not reach a level where your margin deposit is insufficient to cover them. Increasing leverage = increases risk.
Forex Order Types – Mechanics of Online Forex Trading
After examining the basic concepts, let’s briefly discuss how a trade is opened, and look at a few basic ways of controlling risk and managing our funds.
While most trading software is straightforward with order entries and the opening or closing of a position, the beginner may be bit confused by terms like stop-loss, trailing stop, or take profit orders, at least a basic understanding of which is crucial for a properly managed account.
A market order instructs the broker to buy or sell a currency at the current market price. As such, neither the trader, nor the broker has any control over where the trade is executed. The only commitment that the broker makes is that the order will be executed as soon as possible, which is usually instantly. Let us note here that in times of market turmoil, spreads can widen greatly, and the price at which a market order is executed can be shocking to the inexperienced trader. Consequently, it is a good idea to avoid market orders at such periods.
By contrast, a limit order instructs the broker to execute a trade only when a particular price value is reached. No action will be taken until the price quote is reached, regardless of the length of time. The disadvantage of the limit order is that the market may never move in the desired direction, and the trade may never be executed as a result. On the other hand, the limit order facilitates better planning, reduces arbitrariness in trading decisions, and eliminates the dangers associated with sudden price spikes to the greatest extent possible.
The stop-loss order is a kind of safety mechanism that puts a ceiling over the losses that a misplaced trade can cause. By entering the stop-loss order, we’re specifying the maximum amount of unrealized losses that we are willing to tolerate, beyond which our confidence in the trade would not be maintained. Naturally, the stop-loss order should be set in the direction opposite to where we expect the price quote to move. The execution of a stop-loss order, as with the limit buy or sell orders, is automatic.
The trailing-stop order is a relatively uncommon order type. In this case, the stop-loss order is renewed automatically by the trading software at intervals specified by the trader. For instance, when we buy the EUR/USD pair at 1.3500, set our stop-loss order at 1.3400, and set the period of the trailing stop at 50 pips, the software will revise our stop-loss order higher at intervals of 50 points as the price moves and our account shows unrealized profits. When the price reaches 1.3550, our new stop-loss would be entered automatically at 1.345. When the price reaches 1.36, the new stop-loss would be at 1.35, ensuring a risk-free trade.
The take profit order specifies the price quote at which we would like our position to be closed, and profits to be realized.
Currency Pairs and Their Characteristics
Of course, we can’t trade currencies without knowing about them. There are a large number of currencies that traders can choose from for establishing their trades and portfolios, but most currency traders will concentrate on a few of the more widely traded, and liquid pairs such as the EUR/USD, GBP/JPY, or USD/CHF, which are all currencies of major powers. It is possible to divide currencies into many different groups based on the criteria chosen, but in general currency account position and interest rate policies of central banks are the most important values for classifying them.
If we try to divide currencies on the basis of financial soundness and economic policies, the following is one plausible categorization.
These are the currencies of nations which have a dominant role in global economic transactions. The European Union, Japan, the United States are the important powers the currencies of which fill the coffers of central banks around the world. Among those, the role of the Japanese Yen as a reserve currency has been diminishing since the 90’s, while that of the Euro has been increasing continuously since the launch of the currency. Among all those changes however, the US Dollar has remained as the one major currency that has the greatest preponderance over everything else in central bank currency allocations. With about two thirds of global forex reserves denominated in the dollar, the USD is the reserve currency of the world.
For traders, an important rule of thumb is that reserve currencies as a group tend to depreciate in times of boom, and to appreciate at times of economic trouble. This is a generalization; needless to say there is a degree of variation among the behavior of different currencies, but due to the financial structure of the global economy, economic activity usually leads to abundant supply of reserve currencies during robust economic growth.
Currencies such as the Australian and Canadian Dollars, the Brazilian Real, the South African Rand, or the Russian Ruble, which are the monetary units of commodity exporting nations, are called commodity currencies. There’s a great degree of diversity among commodity currencies in terms of trade balance or economic sophistication. However, due to the large currency inflows generated by proceeds from the sales of commodities, the value of these currencies is strongly dependent on the buoyancy of global commodity market.
Currencies of nations like Singapore, Japan, China, with large forex reserves accumulated through exports, are called exporter currencies. The value of these currencies is related strongly to the health of the global economy. As they depend on foreigners for economic buoyancy, any disturbance to the health of the global financial system can have outsized consequences for these nations. Nonetheless, due to their large forex reserves they are well-placed to withstand the impact of any economic shock better than most of their peers.
These may also belong to any of the other categories. High-risk currencies are the currencies of nations with high deficits (budget or trade), and high interest rates. Examples are Romanian Leu, currencies of Baltic nations, or Turkey. These currencies appreciate at times of boom, as capital from developed economies is directed to their assets, and depreciate during recessions and crises, as global capital discards risky assets.
Although the descriptions above may sound simple and brief, they already contain much of the basic concepts that are important for currency traders. The key to a successful trading career is carefully evaluating the widely available data, and establishing a disciplined and simple strategy which can be used to exploit the information for profit. How do we evaluate the data? What kind of tools do we use to make sense of the widely available and complicated information that we must sort out to generate trading signals? This is the subject of forex analysis, which we’ll discuss in the next chapter.
Fundamental Analysis vs Technical Analysis
In analyzing price action, forex traders make use of two main kinds of analysis. Those who concentrate on price action, and ignore most other factors choose to direct their efforts at perfecting their skills at technical analysis, while traders who prefer to study the economic events that cause the market action mostly focus their efforts in studying fundamental analysis. In this article we’ll take a brief look at both of these concepts, before moving onto examine them in greater detail in further lessons of our school.
Many traders combine the information provided by these two types of analysis to generate trading signals. Others concentrate on one aspect of analysis and exclude the other from their calculations, and it is fair to say that either approach can be valid depending on the circumstances. There are traders such as Martin Schwartz who acquired reputation and wealth by trading on the basis of technical analysis, along with those like Jim Rogers whose success was based on fundamental analysis almost exclusively. But while they would disagree on many subjects, both of these people would probably agree that emotional control and discipline are the most important aspects of a successful trading career, even before analytical prowess.
How Different are Fundamental and Technical Analysis?
We should note here, before going on with our discussion of the various aspects of the two analytical schools, that while the explanations of the fundamental and technical analyst on a phenomenon may differ from each other, the end result, and the trade recommendation can in many cases be the same.[nextpage]
To give an example of this, we may examine the classical case of a parabolic price graphic which would make both kinds of analysts cautious, but for different reasons. The technical analyst would look at his charts, notice the extreme values registered on the indicators, and would caution against joining a trend that is in danger of suffering a sharp reversal as the inevitable counter trend movement occurs. The fundamental analyst would look at the euphoria in news sources and analyst community, consider the declarations of government authorities and important personages, and would probably give the same warning. While the tools and indicators used by these two individuals are different, their actions often coincide with each other.
Fundamental and technical analysis are not exactly the same thing, and at least in the longer term, the predictive power of fundamental studies is almost certainly greater. Nonetheless, these two are akin to two different languages describing the same phenomenon, and at least on hindsight, they always show the same direction, and reach the same conclusions.
Let’s take a brief look at these two schools.
What is Fundamental Analysis?
Fundamental analysis is the discipline that tries to make sense of price movements in light of economic data and news flow. In comparison to technical studies, fundamental analysis has a larger selection of indicators. While many traders choose to focus on the news releases and indicators that appear to determine the day-to-day movements in the financial markets, fundamental analysis in fact studies many other aspects of economics including politics, financial law, social attitudes, in addition to the many other aspects of human life.
Fundamental analysis aims to establish a cause and effect relationship between market movements and economic developments. In that sense, it is different from technical analysis which regards the price action as the beginning and end of trading. While technical analysts generally argue that the price action reflects all information available to the market, fundamental analysts seek to identify imbalances and “errors” in the market that may offer profit opportunities. Unlike the technical trader, the fundamental trader is always skeptical of the price action, and seeks alternative explanations to the “wisdom of the market” in evaluating price trends.
While this type of analysis has been proven to be efficient and reliable through the ages, there are a number of issues that we must keep in mind in order to avoid being too optimistic about the predictive powers of our approach. While fundamental analysis can and often does indeed warn us on possible errors in market attitudes to economic realities, there’s no indication that the correction will happen anytime soon. Similarly, bubbles and market extremes often cause analysts to rationalize the unhealthy positioning of the market, invalidating the healthy advantage of skepticism inherent in the fundamental approach.
Advantages of Fundamental Analysis
The greatest benefit derived from study of fundamental analysis is the ability to understand the causes that drive the market action. By understanding market dynamics, we can be confident in maintaining a position as long as the cause that triggered the trade exists. A thorough grasp of fundamental analysis also ensures that we do not lose our composure in the face of market volatility. Those who employ fundamental studies in gauging the price action are confident that they are on the tracks of the greatest geniuses of forex trading. All those who successfully made millions or billions in this business were users of fundamental analysis; and there is no reason to doubt that if we were to use the same methods we can achieve the similar, if not the same results with them.
What is Technical Analysis?
Unlike fundamental analysis, technical analysis is a relatively new discipline that is still being perfected by its practitioners. Still, years of continued use has made it an inseparable part of the traders arsenal: technical studies are probably the only tools used for determining entry or exit points, and in short term trading, technical analysis is probably the only analytical tool that has any predictive power.
Technical analysis is based on three important assumptions about market events. First, technical analysis posits that the prices discount all information available to the public. Secondly, it assumes that price movements are not random, and that technical tools can be used to establish the underlying currents behind the price action. Third, it claims that price trends tend to repeat themselves. In other words, past developments provide some guidance on the direction and magnitude of future price action. In consequence of these three assumptions, technical analysis regards the price action as the conscious activity of a mass of financial actors who act collectively as if they were one large sentient being with emotions and feelings. In other words, just like the case with a beehive, or an ant layer, the seemingly independent actions of individual traders are targeted toward achieving the most sensible and logical course for prices in general.
Naturally, if collective will of traders is rational and makes meaningful decisions, then the future choices of that body would depend on its past actions. And if such a logical coherence, and a train of reasoning between past and present exists, it would be possible to examine and understand the rules behind that train of reasoning, and consequently to follow it and to profit as a result.
And there lies the basis of technical analysis. Just as we deduce that a person who takes out keys from his pockets is intent on opening the door, we expect that a certain spike or collapse in prices, a period of trending activity, or consolidation must lead to their logical conclusion in the markets in breakouts, or successive highs or lows, the nature of which is determined by technical analysis.
Advantages of Technical Analysis
Technical analysis is simple and straightforward, with tools available to every one from the seasoned hedge fund manager, to the novice retail trader. In addition, technical tools are easier to interpret than fundamental indicators, the understanding of which usually requires a period of diligent study. Finally, since technical analysis focuses on the price action exclusively, the technical trader has only one needle in his compass: the price, on which any calculation about profits or losses must be based.
Technical studies have been refined and perfected over the years, and by using them we are making use of the heritage of thousands of experienced and knowledgeable traders who have contributed to the effort. By mastering the various aspects of technical trading, we can also minimize the role of guesswork and conjectures in analyzing the price action. While technical studies can give conflicting signals about the future, the error, if any, is on the part of the interpreter. By recognizing our flaws, we can better our analytical skills, and with better skills, wealth and success will be just a single blink away.
Both types of analysis are useful for examining market action. Your trading style, and attitude to trading will determine which kind of analysis you will find most beneficial. But before making that decision, it is a good idea to study the subject of analysis in slightly greater detail. In the next few sections, our subject will remain the various aspects of Forex analysis.
Forex Technical Analysis
In the previous chapter we took a look at the two kinds of analysis briefly, and discussed the various advantages and problems associated with making use of them. In this chapter we’ll examine technical analysis in greater detail.
If you’re dismayed by your inability to correctly interpret price movements in light of technical data, you may find the information in this article invaluable. If you’re a beginner, remember that each indicator has a particular configuration in which it generates the most reliable signals. Just like we cannot use a spade in a task better suited to a screwdriver, it is wrong to use the RSI for analyzing a trend which is better analyzed by a combination of moving averages.
Two important rules of technical analysis are to keep it simple, and to be strict and disciplined with money management and risk controls. Technical tools are not infallible, and their greatest use is in identifying and acting on the scenarios which offer the best risk/reward potential for the trader. In the absence of certainty, even the most capable technical trader will be in danger of seeing his account wiped out, if he doesn’t take the necessary steps for ensuring that he is properly controlling his risk allocation. Once those steps are taken, we are cleared to go on our journey to riches and prosperity.
Let’s take a look at the various tools used by the technical analyst in evaluating and understanding the price action.
Price action has no limits. The price of a currency pair can theoretically move anywhere between zero and infinite on the charts, and while in practice there is always an upper limit, it is extremely difficult to estimate where it should be. For example, based on today’s prices in EURUSD at around 1.35, we would regard 1.50 a very high price. But while this is true, how about 1.45, or 1.55? Since all those prices are “high” on an arbitrary definition, we would have great difficulty in placing a stop loss or take profit order anywhere on the charts. It is clear that we need to confine the price action into a more practical range within which we can interpret the developments more conveniently.
This lack of precision in defining a high or low price for a currency pair within a specific time frame is overcome by the usage of oscillators. There are a large number of oscillators developed through the past decades each of which depends on a different formula, but all of them aim at rearranging the price data mathematically in a way that will facilitate the designation of oversold or overbought levels. An oversold value indicates that the price is too low in comparison to where it has been in the past. Conversely, an overbought reading indicates that traders have driven the quote too high in their excitement. Both cases suggest that a contrarian trade may be profitable.
Oscillators fluctuate between a predefined upper and lower value, beyond which an oversold and overbought level is defined. As the price moves to the overbought level, the trader will contemplate a sell order. When the indicator signals an oversold price, the trader will consider placing a buy order. Oscillators are defined according to the price pattern where they function best. Some are used best in a trending market, while others are suited better to ranging or periodic markets. Examples of those that function best in a ranging environment are the RSI and Stochastics indicators. In contrast, the Williams oscillator and the MACD are thought to emit their most useful signals in a trending market.
Many experienced traders are skeptical of the validity of overbought and oversold readings on an oscillator even under the best of circumstances. It is important to remember that oscillators reduce the arbitrariness in defining what a high or low price is, but do not eliminate it altogether. For example, while an RSI reading at 80 is regarded as an overbought value, the price in many cases ignores this contention and keeps charging on, reaching 85-90, even 95 without looking back.
In order to avoid this problem, many make use of the concept of divergence/convergence between price and the indicator. As the divergence/convergence phenomenon is rarer in practice, greater significance is attached to its occurrence. A bearish divergence is the situation where the oscillator registers lower highs, while the price is making higher highs. In this case it is thought that the uptrend is running out of power. A bullish convergence occurs when successive lower lows of the price are coupled to successive higher lows of the oscillator. This is thought to signal that the downtrend is losing momentum. In both cases, a contrarian trade is advisable.
The RSI, Stochastics, Average True Range, Williams Oscillator, MACD, Force Index are a few of the indicators that are in common use among currency traders.
Moving Averages and Trend Indicators
Oscillators find the greatest use in ranging markets. But while ranges offer many profitable trades to those who like to concentrate on them, it is a fact that many of the greatest traders in history were trend followers. Trends can be overwhelmingly profitable for those who can capture them in time and possess the tools necessary for understanding and exploiting them. The fundamental analyst has his economic theory, his statistical tools, and analytical skills to depend on while studying trends, while the technical analyst makes use of certain indicators tailor-made for trend analysis.
Perhaps the most useful of all trend following indicators is the moving average. This indicator adds up the closing prices of a predefined period (like five minutes, two hundred hours, or ten days), and divides them by the moving average period, reaching at the indicator’s present value. The main reason of using the moving average is determining a mean value around which the price action fluctuates. The difference between an ordinary numerical average and a moving average is that the value of the moving average is constantly updated: as the price registers new highs or lows, the moving average also follows it, but at a slower pace.
There are two kinds of moving averages. The simple moving average (SMA) is the one that we have described in the previous paragraph where the prices of each period receive the same weighting in the calculation of the moving average. In other words, the price of five minutes ago is of the same value as the price of five days ago in determining the value of the moving average. The other kind, the exponential moving average, is a little different in that it gives the prices of the latest period a higher weighting, that is, the indicator is much more sensitive to price changes in the latest period than it is to the values registered weeks or months ago. The exponential moving average is not that useful when used in conjunction with the price action itself. Many traders choose to use the exponential moving average together with a simple moving average of about the same period, and interpret the crossover or divergence/convergence between those two trend indicators as entry or exit points.
Apart from the moving average, an important indicator favored by many technical analysts is the Bollinger Band. This indicator can be used, in combination with others, for predicting the breakdown of a range pattern, but it is also useful for determining entry or exit points in trading trends. During the course of a trend there are many periods where the trend calms down, and price settles into a consolidation pattern. The Bollinger bands are used to predict the end of these patterns, and to open positions as the consolidation phase concludes.
There are many other kinds of indicators which can be used in combination with others to generate trade signals for trend patterns. Once could even write his own indicator with a little bit of practice and understanding of market dynamics. The predictive power of the indicators, while valuable, are most fruitful when they are coupled to prudent money management methods which we’ll discuss a while later.
Both in trending and ranging markets, it is possible to break down the price action into various smaller scale patterns where the market consolidates and prepares the next phase of the movement. Similar to the concept of tension and resolution in both music and literature, prices move as tension is created during the consolidation phase, and resolution of the tension draws the market forward as the consolidation pattern breaks down.
There are many kinds of price patterns. During the development of a trend, triangles of all kinds are ubiquitous. In a range pattern, consolidations occur at the support and resistance levels of the price action, but the breakout fails to breach those levels. It is also possible to recognize many short-term range patterns developing during the course of a major trend: the successive legs of the trend follows the breakdown of those range patterns in succession.
Technical analysts divide price patterns into reversal patterns and continuation or consolidation patterns, but as we discussed shortly before, as branches of a main trend break down, reversal patterns can be found in the course of a trend too. A continuation or consolidation pattern (such as triangles) signals that the trend is ongoing, but is going through a phase of rearrangement, as market participants reevaluate their strategies, and readjust their positions. A reversal pattern signifies that the underlying price action is losing its power: the present dynamics behind the market action may soon be invalidated by market developments.
The use of price patterns in technical analysis is widespread, but it must be born in mind that in many cases the formations discussed by the technical analyst is obvious and actionable in hindsight only.[nextpage]
There are a vast number of tools available to the technical trader. While this richness can be useful for identifying and evaluating different scenarios, it can also be confusing for the novice and experienced trader alike. The power of technical analysis lies in the precise nature of its predictions, but there’s nothing precise about setting up the correct configuration of indicators which will generate the most useful predictions.
In spite of these facts, technical analysis is the most widespread method for the study of the market action. It is used by millions of traders all over the world, and consequently, its predictions possess a kind of power that is often thought to be unique to religions: as its dictates are confirmed by the collective behavior of vast numbers of technical traders, only the reckless will deny the value of technical studies.
Forex Fundamental Analysis
Throughout the ages, traders, producers and speculators have made use of fundamental analysis to understand and correctly interpret economic developments, and attempted to profit from them. Past or present, there has been no shortage of individuals who have used their understanding of supply and demand in the markets for acquiring great wealth. Until the beginning of the 20th Century, all the speculative wealth generated by speculative activity was created through the guidance of fundamental analysis. Like any theories or trading strategies, fundamental analysis require deep knowledge and understanding of its different components. There is always a risk invloved when trading the currency markets, regardless of the analysis method used.
Fundamental analysis is the study of the causes of price developments, as determined by the supply and demand dynamics of economic activity. To be sure, markets are independent of underlying economic dynamics in the short term. The speculative enthusiasm of major market actors does not allow short term price developments to reflect the underlying trends of economic activity. On the other hand, since all speculative activity is eventually dependent on the availability of money, and as the availability of money is determined directly by fundamental economic factors, fundamental analysis is the best guide to understanding and predicting market developments in the long term. To give an example, regardless of the immediate reaction of the markets to an interest rate decision, the effects of the decision will be powerful in the course of years, the understanding of which is facilitated by the use of fundamental studies.
The fundamental analyst does not necessarily analyze the price action, although market movements must be inevitably be taken into account when studying economics. Economic events and government authorities do indeed react to market developments, and in many cases these reactions can be of momentous significance for both economic events and price action.
How does the analyst perform his study? There’s no single approach to this matter among traders. The vast majority of traders focuses on the short term market responses to fundamental data releases, and call the buy or sell signals generated by those reactions fundamental analysis. However, this approach is just another form of technical trading, since the interpretation and short term value of each news release is only dependent on the market’s internal dynamics. For instance, if the market reacts to a particular unemployment number by driving the value of a currency pair up, and the trader decides to buy that currency pair on the basis that the release is favorable to that currency pair, he certainly is not basing his decision on fundamental analysis. There’s no justification for the belief that the market’s short-term reaction to a piece of data is a guide to the meaning of that data. In that sense, the trader who completely ignores the purported fundamental causes behind market movements, and bases his actions on the technical aspect of trading alone is far more sensible than one who tries to incorporate fundamental explanations into his short-term trading decisions for the simple reason that there’s no fundamental explanation for short term market movements.
Fundamental analysis is concerned with all aspects of economic activity. Consequently, the statistical releases that shake the markets in the short term are just a small part of the analytical tools which are at the disposal of the fundamental trader. Indeed, it is often the case that news releases, statistical data are just backward-looking indicators with limited predictive value for the long term.
Social and Political Analysis
Under this heading a large number of concepts, including economic regulation, geopolitical tensions, economic habits of a nation, and many other aspects indirectly related to economic functions are analyzed.
Traders with just a little bit of experience will admit readily that the currency rates are strongly responsive to changes in the political environment of a nation. In addition, it is well known that the regulatory structure of a country can be very influential on its economic dynamism, which would be reflected on GDP values, and eventually on currency rates. But beyond these basic concepts, social and political analysis of a nation’s character can be very helpful in predicting the economic reactions of currency to all economic events at the global scale.
In example, many people were expecting the EU economy to perform much better than the American one in the aftermath of the 2008 collapse in economic activity, as the European consumer had a much smaller debt burden, and was affected by the collapse of the real estate bubble to a lesser extent. But those who defended this proposal were neglecting to perform the social analysis on the mentality and habits of the European consumer. Eventually, when the impact of the crisis was felt by Europeans, the reduction in spending was much more severe than initially expected due to the conservative mindset of the European consumer.
There are many cases where a raw analysis of the data, without accounting for the various different characteristics of nations, can lead to mistakes and errors on a grand scale. It is therefore important that we incorporate these characteristics into our analysis of interest rate changes or global shocks. On the other hand, the differences in national characteristics are not a result of genetics, and they are not irreversible; they merely reflect the divergent economic paths taken by nations, the varying regulatory mechanisms, and demographic trends which can all change in time.
It is self-evident that fundamental analysis will include economic analysis as per the definition of the term. This is the aspect of fundamental analysis which focuses on indicators, statistical releases and economic news to derive the data that can signal profitable trades to us. There are a very large number of releases that many traders keep track of, and many of those have an important impact on the short-term direction of the markets. But the kind of data that can allow us to make predictions and form conjectures on future price movements is more limited in nature. The GDP data, for instance, is carefully followed by market participants and its release results in volatility and excitement among market participants. However, since it’s backward looking, in many cases its value for understanding future developments is less than the inventory component of the release.
Let’s review a few of the major indicators used by the forex trader for generating signals.
The gross domestic product of a nation is the data that provides us the clearest and most straightforward snapshot of the economic situation of a nation. The GDP number includes everything that is produced inside the borders of a nation, and as such, it is the best indicator of overall economic activity in a county. One drawback associated with this data is the fact that it is backward looking. All the information contained in it relates to a previous quarter, and the number itself is usually calculated on the basis of information that is already available to the market. Many analysts use the available data to create their own estimates of the GDP number, and the market evaluates the actual release based on how much it diverges from the analyst consensus as surveyed by news channels and other media sources.
Interest rate decisions of central banks have long been the most important drivers of currency trends. In general, when central banks are moving in one or the other direction decisively, markets react in a similarly strong fashion and establish strong trends in currency pairs. Conversely, when central banks and government authorities are unclear about the future, and their own policies, volatility rises, and sometimes it is even possible that directionality in the markets disappears.
Interest rates are important because they define the cost of the cheapest borrowing available to anyone in an economy. As the Central Bank is the sole authority controlling the money supply at the lowest level, traders are very attentive to the decisions and declarations of these institutions. And the importance of interest rates is not limited to money supply either. In a healthy economy where money demand is in tune with growth, stimulatory or contractionary policies of central banks have great importance for determining unemployment, industrial production, trade deficits, and many other statistics.
Finally, since interest rates determine the attractiveness of a currency for speculators and investors all over the world, interest rates are powerful determinants of currency flows to a nation, which, by virtue of supply and demand dynamics, determines the value of a currency against its peers.
The PPI (the producer price index) measures the pipeline price pressures at the producer level. Producers increase or reduce prices in response to many dynamics including import and labor costs, but consumer demands are less relevant to their pricing choices, unless there’s a general slack in demand. Thus there’s often a large gap between the PPI and the CPI, depending on the overall economic conditions of a nation.
The release of the PPI is rarely a market moving event unless the numbers are too surprising and unexpected. Otherwise, most traders focus on the close relative of this statistic, the CPI, and only use the PPI data as a kind of preliminary release of the consumer price index. Nonetheless, especially the gap between the CPI and the PPI can be very useful for analyzing economic trends.
The consumer price index is one of the most important fundamental indicators, measuring price pressures at the consumer level. Since consumers are the end users of all products and services in an economy, price pressures on consumer goods must eventually be reflected on wages which leads to inflation. Central Banks are very attentive to the CPI and base their interest rate decisions on the changes in the underlying CPI trend. For some central banks, the CPI is the single most important indicator for determining policy rates.
As the importance of interest rates in determining the value of currencies against one another is well-known, the CPI is one of the most closely watched indicators in the currency market. An unexpected number has the potential to change market perceptions about a currency’s future value drastically. Nonetheless, CPI is just the snapshot of price pressures as of the day it is released, and it is predictive power is limited.
The commitment of traders (COT) report is released by the Chicago Board of Trade each week reflecting the commitment of various small and large speculators in the US commodity futures market. The report categorizes traders according to their purpose: non-commercial traders are financial firms and speculators whose main purpose is to profit from price swings, with no real interest in buying or using the underlying commodity. Commercial firms are those that use the commodity bought for purposes other than speculation.
The COT report’s main use for currency traders is as a volume indicator. Since there’s no central authority for the currency exchange market, traders turn to the COT report for gauging the depth of the market with respect to any currency pair. There are many other uses of the COT report including for predicting market reversals, but those lie beyond the scope of this introductory article.
The information contained in these statistical releases is not very helpful when it is used by itself alone. Since the purpose is to gain an understanding of economic developments, and to establish a framework within which we can evaluate price trends, we must combine the data with our own insight. Without that additional angle provided by study and analysis, raw data has very little use for explaining the economic facts behind price developments.
If you choose to use the data for short-term trading, fundamental news releases must still be coupled with some kind of secondary information in order to allow the successful implementation of a trading strategy. It is well known that immediate market responses to fundamental releases are erratic and unpredictable. As a result, unless the news release is very surprising, it is not a good idea to formulate short term strategies purely on the basis of news releases. Indeed, fundamental analysis is perhaps the worst tool for trading markets in the short term.
Forex Trading Psychology: The Four Demons of Trading Psychology
We’ll conclude the basic lessons of our school with a brief study of trading psychology and its effect on the profits or losses of Forex traders.
It is rare to see a brilliant academic do very well in trading. While there are many scholars with degrees and honors from the most prestigious universities of the nation, there are not that many of them who have achieved exceptional success in trading Forex. Suffice it to say at this point that the board of directors of LTCM included Myron Scholes and Robert C. Merton, two Nobel Prize winners, whose contributions to economic theory are among the most valuable in the past century. Nonetheless, even their analytical skills were not enough to save that firm from a spectacular collapse, as greed and euphoria overrode the dictates of reason, and leverage amplified the impact of false calculations.
It is clear that a lack of knowledge or expertise wasn’t the cause of LTCM’s demise. Instead, too much confidence, enthusiasm, a lax attitude to risk controls were the main culprits behind the firm’s demise, and it is possible to tie these factors to emotional faults with ease. To understand these emotional problems, and trader psychology, we’ll introduce you to the four Forex demons in this text whose lies and deception ruin the careers of many beginners. The harm done by them is far greater than anything caused by faulty analysis or neglect of important information. While the results of one simple mistake can be readily corrected in time, the damage done by these beings is chronicle.
But let us remind you that the rewards of a successful battle with these troublesome beings can be unlimited. The trader who masters the psychological aspect of trading has walked two thirds of the way to riches, and all the rest is just a matter of patience and study, before the inevitable outcome of wealth and prosperity is attained.
The greed demon is the number one enemy of forex traders. This demon has a long and spiky tongue which constantly whispers to our ears that the opportunities in the market are going away unless we act quickly to profit from them. Its feet are on fire: it screams “faster, faster” to the trader, stressing him, causing him to lose focus. It has an empty belly, is emaciated, weak and hungry, because none of his exhortations for speed and greed lead to the slightest profit in the end.[nextpage]
It is perhaps natural that the vast majority of Forex traders are money-oriented, profit seeking individuals who attach great importance to financial success. It is also true that without a strong drive for making money, no trader will be able to withstand the pressures of trading the Forex market. In moderate amounts the drive to achieve monetary gain, and focus on financial success are healthy and necessary. But these healthy impulses become unhealthy when they direct our trading decisions: the greed demon needs to know his place, and he must not interfere in trading practices which must be formulated by logic alone.
How to avoid the wrong choices forced on us by greed? The first step for conquering greed is ensuring a disciplined approach to trading which minimizes the role of impulse in our trading decisions. By formulating a trading strategy in the beginning, and remaining loyal to this throughout the course of a trade, we can ensure that greed has nothing to do but bow down in silence as we study the markets and make our decisions based on reason and analysis alone.
Success can be achieved by a refined trading method, and its disciplined application. Emotions thrive where uncertainty and fear are rampant. To avoid such a situation, we’ll ensure that our responses to market developments are calculated and based on the principles established by our diligent study of them. Since our motivation alone, or desire for profits will not ensure that we actually acquire those profits, there’s nothing to be gained from listening to the teachings of the greed demon.
This fiend has a fearsome sight, and a sharp voice, bellowing, growling all the time, trying to intimidate us into indecision in everything that we do.
Fear has the opposite role of greed in our trading decisions. Instead of inspiring us to trade like a machine gun, opening and closing positions with the speed of lightning, fear convinces us that nothing that we do will be profitable in the long term, regardless of the power of our analysis, and the amount of study and consideration gone into perfecting our method. In this case, a fearful trader will be unable to wait for the realization of a profitable position, and he will be unwilling to act on the basis of rational expectations. In addition, the fearful trader will be unable to realize losses that result from mistaken assumptions, and the red ink in his account will keep spreading everywhere as a result. The result is usually ruin: as fear leads to more and more irrational decisions, and few trades are profitable, a few long-held losing trades will eventually wipe out the account.
It is necessary to distinguish between conservatism and fearfulness. Being conservative in our trading decisions is surely a healthy and sensible practice. A conservative trader is skeptical about everything he hears, but is still willing and able to act when his study confirms a profitable risk/reward prospect for a particular scenario. The fearful trader, on the other hand, is incredulous of not only the opinions of others, but everything that his analysis tells him too. He doesn’t know what to do, where to look, which trade to take and which to avoid, because all are the same to him. As he doesn’t trust his own logic, he has no tools with which he can understand or evaluate market developments. The end result is something akin to panicky gambling, with deleterious results being the inevitable outcome.
To avoid the disastrous effects of fear, we must train ourselves to understand that there’s nothing random about a successful trading career. We must be convinced that we are in control of our choices; we must have a clear plan to which we adhere with iron will, impervious to the illogical emotional extremes of the crowd. All that is only possible by a logical, calm approach to trading, which can only be gained by patient study. Another good way of avoiding fearful trading decisions is ensuring that we do not over leverage our account, and risking only so much that when the account is wiped out, we can laugh at the outcome, and go on and seek our fortunes in another aspect of life.
The queen of Forex demons, Euphoria, is a creature that promises unlimited wealth, and delivers unlimited misery and destitution. Euphoria works hard to ensure that wherever we look, we see nothing but wonderful prospects for limitless profits. It is as if the trader has somehow been blessed with the Midas Touch, with success being the natural consequence of his routine behavior.
Under normal circumstances, euphoria has little relevance for most traders, because most are aware that success in Forex trading is not child’s play. While magnificent profits in a short time are sometimes possible, such gains are usually the result of a period of study and practice during which the false promises of euphoria are proven repeatedly to be meaningless. In the case of the beginner, who doesn’t possess this background of hard work and study, euphoria may result from a string of profitable trades, as the trader comes gradually to believe that his understanding of the markets is impeccable, his analysis, flawless.
The key here is the knowledge that the first condition for performing a flawless analysis is beginning with the assumption that no analysis is flawless. Consequently, the successful analyst or trader is always skeptical about the value of his explanations, although he doesn’t hesitate to act on them because he bases his work on logic alone. The profit potential of the next trade taken is independent of how profitable the previous one was. Consequently, there’s no sense in getting excited about a string of profits: the next trade may or may not be profitable, depending on how diligent our study of the market was.
Thus, the best way of avoiding euphoria is by understanding that a string of wins or losses does not impact the outcome of the next trade that we will make. The success or failure of the next trade is only dependant on how capable we are of excluding emotions from our study of the markets, and in that knowledge lies the alpha and omega of a successful trading strategy.
Panic is the opposite of euphoria. In a panicky situation, the trader sees nothing but losses in the market, with no possibility of concluding a profitable trade. This is an exceptionally strange way of thinking in the forex market, since by definition; the loss of someone must be another person’s gain. When a trader is losing large sums on a long currency trade, another trader is possibly making large profits on a short trade on the same pair. This fact by itself should have helped traders to be more realistic in response to bouts of panic in the forex market, but experience shows that this is not the case.
So what are the causes of the panic that leads a forex trader to wrong choices? Obviously, periods of market volatility are the most common catalysts of a panic response. As price fluctuations increase in depth and frequency, the value of predictions diminishes greatly. This results in a loss of confidence in our trading choices, and if the period lasts long enough, the inevitable emotional outcome is panic in most cases.
A panicking trader will commit all kinds of errors. He will close a profitable position in expectation that it will reverse quickly, and will register losses soon. He will be unable to perform a logical analysis of his situation, and will instead become the victim of mental illusions on “potential” scenarios. The ultimate arbiter of a trade’s success or failure is of course the market, but for the panicky trader, all kinds of imaginary benchmarks, unreal expectations constitute the major criteria for the advisability, and ultimate profitability of a trade.
The impact of panic is greatly amplified by leverage, and the damage caused by it is intensified by tight stops.
To deal with the problems associated with trading psychology, we must minimize the role of emotions in our trade decisions. To minimize the role of emotions, we must understand that success or failure are not related to luck, but are the logical consequences of our own choices. We discussed before that it is almost impossible to have an unleveraged account wiped out as the consequence of a single trade. If the trader succeeds in realizing an empty account as a result of a string of losing trades, it’s hard to speak of luck or chance as being the causes of the disaster. Leverage is entirely in the control of the account owner; he can set it at any value provided that he can live with the consequences. Leverage amplifies the profit/loss potential of a trade, but it also intensifies the emotional aspect of trading too. Eventually, this intensification of emotional pressures may prove to be the most dangerous and negative impact of leverage.[nextpage]
The best way of dealing with emotional problems is acquiring a logical approach to trading. The best way of acquiring that attitude is understanding the market mechanisms, and the forces that direct economic activity. In this website, we have attempted to give you a basic understanding of those factors upon which you can build your own edifice of knowledge to improve your own potential for success in the Forex market.
Choosing the Right Forex Broker
Before choosing a broker, we hope you have you studied the previous articles in our Forex school and concluded that you’re qualified to trade forex on a preliminary basis? Do you possess the determination and moral courage necessary to recognize and overcome emotional problems inherent in Forex trading? Do you possess the drive and the intelligent focus necessary to concentrate all your energies on the one goal of success in whatever endeavor you take?
If you possess the drive, focus, and perseverance necessary for concluding any activity successfully, forex is your ground. Armed with the necessary knowledge, and almost immune to the tricks and lies of fraudsters through the information that we provide in this website, you are ready to step to the next phase of your trading activity. After acquiring the background information, the first step of trading Forex must be the opening of an account with an online broker.
There are a large number of Forex brokers in the retail Forex market these days, each touting its services as the best in the entire market. It can be a daunting task to sort out between them seeking those that are best suited to your needs, however, as usual; we have worked to simplify your task by reviewing some of the most reliable brokers in the market. Here we would like to explain the importance of the various criteria according to which you can screen the brokers we have reviewed, and make your choices. Due to the vast diversity of options, it is not possible to speak of a broker who is perfect for all kinds of traders. Instead, you should carefully consider your own expectations from trading, and compare that with what is offered by the broker, and choose the one that is best suited to your needs.
Here we’ll examine the criteria in order of importance.
What is the point of opening a Forex account if the funds we deposit will be unsafe with the broker, or worse yet, will be stolen and misappropriated? What is the logic of studying analysis and currency fundamentals if the profits that we make are pilfered by shameless crooks, or squandered by irresponsible individuals who cannot even manage themselves decently?
Thus, the first necessity for the right broker must be the safe and reliable track record of the firm. On the other hand, it is clear that the retail trader possesses neither the tools, the time, nor the expertise for determining which of the brokers are reliable, and which are not. Fortunately, the regulatory authorities in this country and in other financial centers of the world do their best for screening and weeding out the unreliable ones among the many decent firms. Our best course is to ensure that the broker we choose is a member of NFA, and is registered with CFTC in the US, and with other relevant authorities in other parts of the world.
And last but not least, to make the task even easier for you, we have reviewed some of what we believe to be the best and most reliable firms in the market. All that you need to do is to go and check out the relevant section.
Unavoidably, the second most important variable in our equation for comparing brokers is the initial deposit requirement. Many traders prefer to begin their careers by risking very small amounts which leads them to seek the broker offering the lowest initial deposit requirement naturally. This reasoning certainly has its merits; however, the initial deposit requirement should in fact be one of the last considerations in choosing the best broker for you, unless you really have a very small amount of capital that you want to risk for Forex trading.
A serious broker offering excellent services may choose to keep the initial deposit requirement relatively high (around $500, for example) in order to ensure that the clients are serious about their trading practices. In addition, forex is usually so volatile that a less than optimally capitalized account is highly likely to be wiped out during the ordinary fluctuations in the market. We have already discussed the difficulties associated with undercapitalization, and those who have read that article should have little trouble in understanding the reasons behind our deemphasizing the importance of initial deposit requirements.
It is self-evident that a beginning trader should only risk the amount that he can comfortably afford to lose. In that sense, the initial deposit requirement of the broker should never be more than what we can afford. On the other hand, beginning our career with a pittance like $10-50, and trading at 10:1 leverage cannot be considered a wise choice. Trading with such small sums is similar to trading in a demo account, and the emotional lessons gained will probably be of little value.
Spreads are extremely important for Forex traders, seasoned, or novice. Since the broker usually receives the compensation for its services by widening the bid-ask spread beyond the quoted values in the wholesale inter bank market, a wide bid-ask spread represents a larger amount of money leaving your pockets, and entering those of the broker’s. You pay this fee regardless of the profit or loss you make with your trade: so there’s always good sense in ensuring that you choose the broker which offers one of the more competitive spreads in the market. Sometimes it may be advisable to open an account with a broker that charges slightly higher spreads in exchange for the safety offered by its long history and track record. But even in that case, a spread beyond three for the EURUSD pair, for example, is not a very good idea.
Deposits and Withdrawals
It is not a good idea to trade Forex if you cannot withdraw your earnings with ease. Conversely, the broker must facilitate your termination of the account in case that you’re not entirely satisfied with the services offered, regardless of the reasons. This should be non-negotiable: since the broker is only the custodian of your funds, there’s no justification for any unreasonable delays or excuses when you make the request to withdraw your funds.
Similarly, you, as the client, should have no headaches at all when depositing funds with the broker. Come to think of it: if the broker is not even capable of ensuring that your deposit process is smooth, how likely is he to guarantee a painless and satisfactory trading experience for you?
Margin requirement and leverage ratios are the second most important aspect that must be considered during the choice of the broker. For the beginner, the lower the leverage the better. Since higher leverage is only advisable for traders with a proven track record of profits and success, the beginner should be uninterested in the maximum leverage offered by a broker. Instead, since he must be allowed to get used to leverage on a step-by-step basis, the minimum leverage available is far more useful as a criterion.
For an experienced trader, evaluating the value of a high leverage options can be a bit more different. Since, by definition, successful traders use highly divergent techniques in their trades, there is no general rule for determining the optimal leverage ratio for a seasoned trader. However, for traders who plan to hold a position for long term, 10-to-1 may well be the highest sensible value.
In short, beginners should choose brokers that offer the lowest minimum leverage option, and the greatest customizability. With such a setup, it is possible to increase leverage gradually, in tandem with our improving and developing skills.
In online Forex trading, almost all activity is conducted through the trading software. Indeed, for a safe trading experience, this is also a must: in order to ensure that the broker doesn’t temper with your trades, and misquote currency prices to you, you should always seek those offers which allow the greatest automation, and reduce human interference to the lowest level possible. This is only possible with a successfully implemented trading platform.
What should you look for when choosing the trading platform? Does it offer a wide array of charting tools and technical indicators for evaluating the price action? What about financial news? Is the interface clean and uncluttered? Since you may spend a long time looking at the graphics and examining charts, is the appearance of the platform physically pleasing and relaxing?
Are the servers of the broker reliable? Do you have connection problems in the middle of something important while using the demo account? How wide are the spreads during market volatility and news releases? Is slippage and misquoting a problem? Can you customize the platform to suit your trading needs and language requirements? Does the platform receive frequent updates and bug fixes?
These are the most basic issues related to the trading platform. Needless to say, an advanced, easy-to-use, and uncomplicated trading platform can make the task of the beginner a lot easier. But even the seasoned traders will find that using a well-crafted, well-maintained Forex software can greatly reduce the element of stress during trading.
Software is prone to generating errors. This has always been the case, and will remain so for the foreseeable future. When there are problems with the trading software, or delays, or issues with deposits and withdrawals, you will need to seek the aid of the customer service.
A friendly, patient, and helpful customer service can be profit multiplier if used correctly. In those cases where the customer service is run by individuals with trading experience and understanding of economics and analysis, you can even hasten the learning process by asking questions.
Before opening your account, it is perhaps a good idea to read our reviews on customer service of various brokers to receive a preliminary impression of how competent the people are. While we cannot just pick a broker because its customer service department is professional, success in this department is certainly a promising sign for overall competence.
Some brokers offer a large number of account packages. Others choose to offer one package with many customization options. In general, the number of account packages is not very important, provided that the broker offers a highly customizable main offer with adjustable leverage and margin requirements suitable to the needs of clients from different backgrounds and experience levels.
Finally, it is a good idea to choose a broker that offers the widest array of tradable currencies. In evaluating the currency pairs offered, you should try to make sure that different currency pairs of different classifications are available, instead of concentrating on just the number of the total offers. For example, if a broker offers three pairs of major economic powers, three pairs of emerging nations with floating currencies, three of fixed or pegged currencies, and three rare pairs (like the Saudi Riyal, or the Chinese Yuan), the offer is much better than that of a firm which offers 12 pairs all of which belong to major, developed economies.
Such details are especially important for the experienced trader, but the beginner can focus on the more important, basic aspects of the broker’s package before worrying about the intricacies of the various currency pairs on offer.