Longwood Currency Trading What is Foreign Currency Trading?
What is the FOREX Foreign Currency Market?
The website Investopedia gives the definition of the FOREX foreign currency market as:
Trading Foreign Currencies
Foreign Currency Trading, FOREX, involves two currencies, for example, the Euro (EUR) and the U.S. Dollar (USD). This currency pair is expressed as EUR/USD. It represents the rate at which one currency (the base currency, or EUR here) will be exchanged for another (the quote or counter currency, or USD here).
Note that the base currency is always 1 because this will compare 1 unit of that currency with the value of the other. Thus, in our example, if the value of EUR/USD is 1.3255, then 1 EUR will buy about $1.33 USD. In this case, the USD is weaker than the EUR by $.33 because 1 EUR will purchase $.33 more USD. If 1 EUR purchased 1 USD, that would be called parity, an even exchange rate.
Let's say you have a company based in the U.S. that buys pens from Europe. With the EUR/USD at 1.3255, it means that if the pen is selling for 1 EUR, you'll have to pay $1.33 for it. So, that's fine because you know you can turn that around and sell it here for $1.63 and make $.30. But what happens if EUR/USD goes to 1.5255? That means each pen will now cost you $1.53. Your profit is now only $.10 and that won't even cover your rent. You thus don't want the value of EUR/USD to go up, i.e. you don't want to see the EUR get 'stronger' because the pens will cost you more.
If the EUR goes up, it means that its comparison value to the dollar goes up, which means that the dollar is getting weaker. You don't want the dollar to get weaker, just like you might not want your stock to go down. Same thing. If you're afraid that your stock will go down, or if you're just looking at that stock and think that it's going to go down, what do you do? You sell your stock to protect it, or you short the stock, which means if it goes down you can buy it back for cheaper and realize a profit.
And so to protect yourself from the EUR getting stronger in relation to the USD getting weaker you would create some kind of currency hedging strategy to lock in your desired exchange rate of 1.3255. That's what you'd do as a hedger.
As a trader, you'd look at the price action and postulate as to if you thought the EUR was going to get stronger or weaker in relation to the USD. If you thought the EUR was going to continue to strengthen, you'd buy the EUR/USD pair at 1.3255; if you thought EUR was going to weaken, you'd sell EUR/USD at 1.3255.
There is no EUR/USD certificate like you would have a stock certificate. EUR/USD doesn't exist until one person comes into the market thinking the price will rise and offers to buy and another person feels the price is going to fall and sells to that buyer. One of them is going to be wrong. That's why FOREX is a zero sum game because you have two parties taking opposite sides of the transaction. And what is being bought and sold? Price. Just price.
Understanding Foreign Currency Pairs
The FOREX market consists of Currency Pairs. For example, the GBP/USD currency pair (the "pound-dollar") represents the ratio of the Great British Pound vs. the United States Dollar.
A value for this pair might be $1.4213 which says that 1 GBP (called the 'base currency') is worth $1.4213 USD, i.e. as an American you'd have to pay $1.42 USD to buy something a British citizen would only pay the equivalent of $1.00 USD for. That just means that it's going to cost an American $.42 more per dollar spent in Britain.
Though there are over a dozen actively traded currency pairs (and many more 'cross' and hybrid specialty pairs), there are only 6 'major' FOREX currency pairs: EUR/USD, USD/JPY, GBP/USD, USD/CHF, AUD/USD, and USD/CAD.
The majors are singled out because they represent the most active economies in the world. Their markets are huge in comparison to say an exotic pair like the EUR/TRY, which is the Euro vs. the Turkish Lira.
As a trader, you want markets that are huge and offer liquidity and low spreads, not small and highly volatile markets where there is huge risk. Those smaller markets exist, however, because of the trade relationships between those countries. In the EUR/TRY example, the pair exists because there is enough commerce flowing between those two countries that currency conversion needs to be seamless.
Advantages of the FOREX Foreign Currency Markets
There are many markets that can be traded: stocks, options, commodities, indexes, currencies, old tires, baseball cards, etc. So what would be the main reasons which would compel someone to trade the currency market over any of the others?
I'll only list the main reasons why you might favor trading currencies because you can find this information discussed in detail anywhere.
The FOREX market is open 24/5 vs all other markets which are only accessible during regular weekday exchange business hours. If you want, you can trade currencies in your pjs at 3:00am.
Currency prices are based on the conditions of whole economies rather then just a single stock, or individual commodity like orange juice or gold, or muni bonds for San Jose, CA. Because of this, no single entity or group can overtly influence or manipulate major currency pair price action for anything but the briefest of time frames.
Rarely will you find a price gap in a currency pair even as far down as the 15 minute time frame.
There are no lock limit move rules in the currency markets as there are, for example, in the futures and commodity markets.
You can sell or go short anytime in the currency markets. There are no up-tick rule restrictions as there are in the stock market, for example.
The currency markets dwarf all other markets as far as liquidity. For example, even in 2015 the whole NY Stock Exchange did $28 Billion Dollars of transactions a day, whereas the FOREX market did $6.6 TRILLION Dollars.
In the U.S. you can trade the currency markets with as much as 50:1 leverage (i.e. about $3,000 of margin will control 1 full lot of $100,000 of currency). Overseas, if you're foolish enough, you can find 200:1 leverage. Note that 50:1 leverage is equivalent to 2% margin. In stocks, the best offer you'll get is 50%. Even investment real estate is pretty much 30% down plus enormous closing costs. But try to sell that real estate by next week, even by next month, let alone right now....
How Money is Made Trading Currencies
Trading can make you a lot of money. A lot of money.
But, like anything else, you have to know what you’re doing or you’ll lose instead of win. And you could potentially lose all the money you’ve allocated to your trading bank.
If you spend hours and hours planting a garden, and the rodents and deer eat it all up: would you give up? No. What would you do? You’d figure out how to keep that from happening, and you’d plant again. You plant until you understand how to deal with all the risks so that you can harvest your crops successfully. And each succeeding harvest becomes larger than the last because of that skill.
It’s the same with trading. You trade until you understand how to deal with all the risks so that you can harvest profits. And each succeeding series of profits becomes larger than the last because of that skill.
The Price Mechanics of a Currency Pair
A currency pair, such as EUR/USD (the Euro against the U.S. Dollar) is a ratio of the value of 1 EUR to the USD. Let’s say that this EUR/USD value is 1.0500. This means that 1 EUR will buy 1.0500 Dollars, and that means that the Dollar is weaker against the Euro by five cents.
We’re only used to looking at the hundreds place, i.e. that .05 cents. But in currency trading, moving from 1.05 to 1.06 is an enormous move. Currency traders generally talk in terms of pips with 1 pip being equal to just .0001, one-ten-thousandth of a cent. That seems pretty small, but that 1 pip move equates to $10 for the trader. So, the move from 1.0500 to 1.0600 is 100 pips and is a $1,000 move for the trader (on what's called a 'full lot' position; $3,000 if trading 3 full lots, for example, as it's all about scale).
To give you a sense for this sort of thing, a currency price may move 100 pips or so a day. But keep in mind that 100 pip move doesn’t necessarily mean 100 pips up from the start of the day to the end of the day. Sometimes it does, but more often than not, price will move all over the place for a total range of 100 pips but it might only close up 10 or 20 pips for the day, a $100 to $200 move.
How The Trader Makes Money
If you think the value of the EUR is going to increase over the Dollar, for example, then you’d buy or go long 1 lot EUR/USD. If the price goes up 1 pip from 1.0500 to just 1.0501, you make $10. If the price goes up 2 pips from 1.0500 to 1.0502, you make $20. Each of those moves of .0001 is called a pip, and each pip is worth $10. So, if EUR/USD moves from 1.0500 to 1.0510, that’s a 10 pip move and you make $100.
Correspondingly, if you think the value of the EUR is going to decrease over the Dollar, then you’d sell or go short 1 lot EUR/USD. If the price goes down 1 pip from 1.0500 to just 1.0499, you make $10. If the price goes down 2 pips from 1.0500 to 1.0498, you make $20. And if EUR/USD moves from 1.0500 to 1.0490, that’s a 10 pip move down, and you make $100.
You learn trading by first practicing in a free simulated account. After you feel that you have the hang of it, you can fund your live account with any amount of money you choose. If you have sufficient funds to trade in what's called "full lots" then each pip move is worth $10 per lot traded. A small 10 pip move then is worth $100; if you have the funds to trade 3 full lots, then that same small 10 pip move would give you a $300 profit.
A full lot represents $100,000 of currency, and requires you to have margin for many of the major currency pairs somewhere in the range of $6,000 to $8,000 in your account, though $10,000 is the safe and recommended amount. However, with only $1,000 of margin you can trade what's called a mini lot where each pip move is worth $1.00. And though I wouldn't recommend it, you can even trade micro lots with as little as $100 where each pip move is $0.10, ten-cents.
To give you an example of how powerful this leverage is, for seasoned traders with accounts large enough to trade 10 full lots, each pip then becomes worth $100 instead of just $10 for 1 lot. Now, with those 10 lots, that small 10 pip move becomes worth $1,000.
For the same work and same investment of your time, though you make an equivalent percentage gain, you make ten times the actual dollars. This is why the possibilities of how much you could earn become unlimited.
Of course, the question now is: How often does a 10 pip move occur in these markets? In most of the major currency pairs, 10 pip moves can happen about every 30 minutes. That's a lot of opportunity to make money for those who know how to trade.
Earning Potential For the Successful Trader
The grim reality of trading the FOREX markets is that brokerage statistics show what the industry refers to as the "90/90/90 trader": 90% of folks who take up trading lose 90% of their money in 90 days. I did. Only took me 3 months to lose 75% of my account; another 3 to lose most of the rest. I attribute that almost entirely to not having a mentor to keep me from doing stupid shit.
Now, some of that 90% keep reloading their accounts and failing until they either get it, or they throw a flag on the field and get carried off on their shield. I actually didn’t need to reload my account because I had enough left to trade multiple mini lot positions at $1 per pip instead of the $10 per pip I had been trading. It was a long, long climb back.
Though the statistics show that about 90% of traders fail, you need to know that most business fail within 2 years, and most folks who go into real estate, or insurance type sales positions fail within 2 years. There are a host of other examples.
The fact is that failure in trading isn’t the fault of the market, or in the act of trading itself, but rather it’s the individual who fails either to learn the rules or to stick through the hard times to learn what rules do work. It takes a shorter time frame to fail in trading than it does in other endeavors mainly because of a trader's incorrect use of the leverage available in the FOREX markets.
Of course, the converse to all of that is the enormous success traders in the winning 10% have. FOREX trading is different from regular business operations because it’s what’s called a Zero Sum Game, i.e., for every winner there is a loser.
What that means for the successful trader is that their winnings come at the expense of all the other trader’s losing trades. For example, 10 traders each have $10,000 accounts, $100,000. 9 of them lose 90% of their account, $9,000, for a total of $81,000 for the winning trader. Every 90 days....