Here’s all you need to know about the world’s largest financial market
Forex is one heck of a market.
In fact, it’s THE biggest financial market in the world.
According to the Bank for International Settlements, foreign-exchange trading has increased to an average of $5.3 trillion a day. To put it another way, that’s about $220 billion per hour.
That’s a whole lotta moo-lah.
If you’re reading this article, it probably means you’re curious about the foreign exchange market. And we’re gonna cover a lot of ground from a high-level perspective.
My goal with this post is to provide a general overview of forex and help you become familiar with the basic concepts.
So, if you’re ready to learn, buckle up, and let’s dive in.
History of Forex
The very first forex transactions took place back in the time of the Babylonians. Even back then, different currencies existed and there was a need for a reliable way to convert one currency to the other.
In those days, they used a rudimentary method known as the “Barter System”. Due to its inherent limitations, a more accepted medium of exchange needed to be established.
Gold became an accepted medium of exchange around 700 BC when Lydian merchants produced the first gold coins. However, their coins were only 63% gold. The other 37% was composed of a silver mixture called electrum.
Before the first World War, most central banks backed their currency with gold. However, this had serious limitations. As a nation’s economy strengthens, every dollar that gets spent from importing diminishes their money supply, and thus, their gold reserves.
In July of 1944, in the midst of World War II, 730 representatives from the 44 Allied Nations came together at the Mt. Washington Hotel in Bretton, New Hampshire, USA for the United Nations Monetary and Financial Conference.
The Bretton Woods agreement marked the first time that a comprehensive monetary system was established between nation-states. The USD was fixed at $35.00 per ounce of gold and the other main currencies were fixed to the dollar.
The system came under increasing pressure in the 1960’s due to economies moving in different directions. A number of realignments took place to keep it alive but it eventually collapsed in the 1970’s following the then-president Nixon’s suspension of converting currency into gold in August 1971.
In the 1990’s, banks and small companies created online networks that produced automated quotes. This was made possible through the widespread adoption of the internet and allowed for instantaneous trading.
Advancing technology and regulation created a new category of brokers that allowed private individuals to trade forex for the first time.
Which brings us to the present day.
Forex Market Hierarchy
To better understand the foreign exchange market, we can look at it as a hierarchy of different entities.
Here’s an illustration courtesy of BabyPips:
At the very top is the interbank market. This is composed of the largest banks in the world and some smaller companies. They trade directly with each other or electronically through the EBS BrokerTec or the Reuters Dealing 3000-Spot Matching. They are both electronic brokers used to match buyers and sellers of various currency pairs.
The competition between these two companies (EBS BrokerTec and Reuters) is similar to McDonald’s and Burger King. Both companies offer most currency pairs but some are more liquid on one compared to the other.
After the interbank market, there are the hedge funds, corporations, retail market makers, and retail ECNs. These institutions have to do their trading via commercial banks because they do not have tight relationships with the interbank market.
Because of this, their rates are slightly higher and more expensive than those who participate in the interbank market.
At the bottom of the ladder are the retail traders. Retail trading only became possible recently thanks to the advent of the internet, electronic trading, and retail brokers.
Forex Market Players
Now that we have an understanding of the general structure of the forex market, we’re going to learn about the main players within it.
Since forex is a decentralized market, there isn’t a fixed exchange rate for any given currency. Because of this, the largest banks in the world determine the exchange rate.
These large banks are known collectively as the interbank market. They are responsible for a massive amount of foreign exchange transactions each trading day for their customers and themselves.
These “super banks” include the likes of Citi, JPMorgan, Barclays, Deutsche Bank, and others.
Governments and Central Banks
Governments and central banks, such as the European Central Bank, the Bank of England, and the Federal Reserve, are regularly involved in the foreign exchange market.
Like businesses, national governments participate in the forex market for their own operations, international trade payments, and handling their foreign exchange reserves.
Central banks affect the forex market when they adjust interest rates to control inflation.
Sometimes, they will start massive buy or sell operations if they think that the currency is priced too high or too low.
Large Commercial Companies
Companies take part in the foreign exchange market for their business transactions.
For example, Apple must exchange its United States Dollars for Japanese yen when purchasing electronic parts from Japan.
As we mentioned previously in the hierarchy, these institutions use commercial banks for their foreign exchange transactions. Mergers and acquisitions (M&A) also create fluctuations in the currency exchange rate.
Investment & Hedge Funds
Hedge funds are a major contributor to the forex market due to their high liquidity and their aggressive strategies.
They design and execute trades based on a macroeconomic analysis that reviews the challenges affecting the country and its currency.
The forex brokers are the firms that provide retail traders a platform to execute buy and sell transactions for foreign exchange currencies.
There are 2 main classifications of forex brokers: Dealing Desks and No Dealing Desks.
Dealing Desk Brokers
Dealing Desk brokers are commonly referred to as Market Makers. In a sense, they “literally” create a market for their clients because they often take the other side of the trade.
This might seem like a conflict of interest because they profit whenever the trader loses and lose whenever the trader wins. This is not the case because they provide both buy and sell orders to the client. They are indifferent to whatever the trader chooses.
Although you can’t see real interbank market rates with Dealing Desk brokers, their exchange rates are usually about the same or comparable due to the stiff competition among other brokers.
No Dealing Desk Brokers
Unlike Market Makers, No Dealing Desk brokers do not take the other side of their client’s trade. They simply link two parties together.
They make their money by either charging a small commission per trade or putting a markup by slightly increasing the spread.
No Dealing Desk Brokers are further subdivided into two categories: STP or ECN+STP.
STP stands for Straight Through Processing. Brokers that have an STP system route your market order to their liquidity providers who have access to the interbank market.
STP Brokers usually have many liquidity providers and each provider quotes its own bid-ask price.
Some STP brokers offer fixed spreads, but most of them offer variable spreads. We’ll talk more about spreads a bit later.
ECN (which stands for Electronic Communications Network) Brokers have all of the same qualities that an STP broker has. The only difference is that it allows its participants to interact with the orders of other participants in the ECN.
These participants could be banks, hedge funds, retail traders, even other brokers. You could say that participants trade against each other by offering the best bid-ask price.
ECN also allows their clients to see the “Depth of Market”. “Depth of Market” (or DOM for short) is a measure of the number of open buy or sell orders for a currency pair at different prices.
This is also referred to as the “order book” or “Level 2 Market Data”.
ECNs get compensated by charging a flat fee on each trade called a commission. This is the optimal choice because it is difficult to set a fixed markup due to the nature of the ECN itself.
Speculators are average people like you and me. We come in all different shapes and sizes. Some of us have a lot of money at our disposal, and others only have a couple of bucks.
When you combine all of us together, we make up close to 90% of the trading volume in the forex market. We might not be the big banks but we make our presence known.
Even if you’re just a beginner and you’re reading this, I want you to know that it’s possible to make lots of money in forex as a retail trader. It won’t happen overnight, but if you’re consistent, you’ll be able to join the ranks of profitable traders.
Non-Bank Foreign Exchange Companies
They’re also known as foreign exchange brokers or forex brokers. They’re not to be confused with the previous “forex brokers” mentioned.
These companies offer currency exchange and international payments for private individuals and companies.
Money Transfer Companies
Money Transfer Companies (also known as Remittance Companies) help arrange the transfer of money by a foreign worker to an individual in their home country.
More often than not, an exchange of currency takes place when transferring the money from one country to the next.
Remittance companies make up a significant portion of financial inflows to developing countries. In 2018, the World Bank reported that global remittance reached $618 billion.
The forex market is open 24 hours a day, from 5pm EST on Sunday until 4 pm EST on Friday. These hours are approximate because different businesses open at different times and the hours shift during certain periods of the year due to daylight savings time.
Even though it’s open around the clock, not all hours are created equal. To further illustrate this, we’ll go over the 3 main trading sessions of the forex market.
The Tokyo session opens at 12:00 AM GMT. They are first to see action when the forex market re-opens on Sunday. It’s also referred to as the Asian session because Tokyo is considered the financial capital of Asia.
According to BabyPips, Japan is the third-largest forex trading center in the world. Overall, about 21% of all forex transactions take place during this session.
In addition to Japan, other financial centers like Hong Kong, Singapore, and Sydney, are also active during this time.
The main market participants in Tokyo are large commercial exporters and the central bank. This is largely due to the fact that Japan is heavily export-dependent.
Usually, if there’s a big move in the preceding New York session, you’ll see the market consolidate during the Tokyo Session.
Thanks to its strategic location, London has always managed to be at the center of trade. The same is true with the forex market. In fact, they’re considered the forex capital of the world.
About 30% of all forex transactions take place during the London Session. Because of the large number of transactions that take place, the London trading session is the most volatile session.
Volatility tends to go down in the middle of the session as traders go off to lunch while waiting for the New York session to start.
Most trends that begin during the London Session will typically continue until the start of the New York session. Sometimes, the trend reverses at the end of the session as European traders may decide to lock in profits.
New York Session
The New York session begins at 8:00 AM EST as traders start rolling into the office. Even though there are other major financial centers in the United States like Charlotte, San Francisco, and Chicago, New York gets all of the attention of forex traders.
The session is extremely liquid in the morning as it overlaps with the London Session.
It’s important to note that about 85% of all trades involve the US dollar. So, whenever big economic news comes out that affects the U.S. dollar, it has the potential to move the market.
In the previous section, we learned about the major trading sessions in the forex session. But now, we’re going to dive a little deeper into the behavior of the market itself.
The forex market is a bit like the weather. Some days, the markets are moving normally and other days, the markets are moving erratically.
If you’ve been trading for a while, you might’ve noticed that some trading days are a lot better than others. You could take two different days and trade the exact same way and end up with completely different results.
Why does that happen?
It happens because of the underlying conditions of the market, also known as the market environment.
As a forex trader, there are 6 main market environments to watch out for:
Bull normal — The market is moving in a predictable uptrend. We know that the market is moving in an uptrend if it is making higher highs and higher lows with each consecutive swing.
Bear normal — The market is moving in a predictable downtrend. In this scenario, the market is making lower highs and lower lows with each swing in the market.
Bull volatile — the market is moving in an uptrend but in a very sporadic fashion.
Bear volatile — the market is moving in a downtrend but in a very sporadic fashion.
Sideways normal — The market is moving up and down between two zones.
Sideways sporadic — The market is sporadically moving up and down between two zones.
Currency pairs are the financial instruments that are traded on the foreign exchange market. In other words, whenever you’re buying one currency, you’re selling the other.
The currency on the left is the base currency. The quote currency tells us how much it is worth against 1 unit of the base currency.
For example, if the exchange rate for the EURUSD is 1.50, it would read as 1 EUR is equal to 1.50 USD.
If we were to buy (or go “long”) the EURUSD, it means that we believe the Euro is strengthening against the US dollar. The opposite would be true if we were selling (or going short) on the EURUSD.
Currency pairs can be further subdivided into four distinct categories: majors, minors, exotics, and cryptocurrency.
Majors are currency pairs that contain the US dollar as either the base currency or quote currency.
They’re known for being extremely liquid and are among the most traded currency pairs in the forex market. The EURUSD is the most traded pair on the forex market with a daily trade volume of nearly 30% of the entire FX market.
Here are all of the majors:
- EUR/USD (Euro Zone/United States) aka “Fiber”
- USD/JPY (United States/Japan) aka “Ninja”
- GBP/USD (Great Britain/United States) aka “Cable”
- USD/CAD (United States/Canada) aka “Loonie”
- USD/CHF (United States/Switzerland) aka “Swissy”
- AUD/USD (Australia/United States) aka “Aussie”
- NZD/USD (New Zealand/United States) aka “Kiwi”
Minor currency pairs are also known as “crosses”. They do not contain the US dollar as either the base or the quote currency.
Back in the day, you had to convert a currency into US dollars before converting it to your desired currency. These days, brokers offer direct exchange rates which makes this unnecessary.
Here are a few examples of minor currency pairs:
- EUR/GBP (Euro Zone/Great Britain) aka “Chunnel”
- EUR/CHF (Euro Zone/Switzerland)
- EUR/CAD (Euro Zone/Canada)
- EUR/AUD (Euro Zone/Australia)
- EUR/NZD (Euro Zone/New Zealand)
Exotic currency pairs are made up of a major currency and a currency from an emerging or strong but smaller economy.
They tend to be less liquid due to the lack of trading volume and often have a higher spread cost.
Here are a few examples of exotic currency pairs:
- EUR/TRY (Euro Zone/Turkey)
- USD/SEK (Euro Zone/Swedish Krona)
- USD/HKD (United States/Hong Kong)
- USD/SGD (United States/Singapore)
Cryptocurrency pairs are made up of either one or two cryptocurrencies pitted against each other.
Like the exotics, they are not traded as frequently and the spread can be high due to the lack of liquidity.
Here are a few examples of cryptocurrency pairs:
- BTC/USD (Bitcoin/US Dollar)
- ETH/USD (Ethereum/US Dollar)
- DASH/BTC (Dash/Bitcoin)
- ETH/BTC (Ethereum/Bitcoin)
Most Tradable Currencies
The United Nations currently recognize 180 currencies worldwide. That’s a lot of currencies to choose from, especially if you’re just starting in the forex market.
Your best bet is to focus on the currencies that are traded the most. There, you will find the most opportunities and make the most money possible.
Here’s a list of the most traded currencies in forex:
- US Dollar (USD)
- European Euro (EUR)
- Japanese Yen (JPY)
- British Pound (GBP)
- Swiss Franc (CHF)
- Canadian Dollar (CAD)
- South African Rand (SAR)
Best Times To Trade
As we mentioned previously in the section on Trading Sessions, not all times are created equal. In order to maximize your results with forex trading, there are key times you should look out for.
Out of the 3 main sessions in forex, European session tends to be the busiest. If you can trade during that time, you stand a good chance at making profit.
Secondly, it’s also good to trade when two sessions overlap one another. The European session overlap with the New York session is a great example of this.
Some days of the week are also better to trade than others. In general, the middle of the week is highly preferable.
Lastly, news events also create great trading opportunities. This might not work for everyone because the market can be extra volatile during these times and it might not fit with your risk tolerance. We’ll talk more about news events a bit later.
If you’ve been watching the markets for a while, you might’ve noticed that as one currency pair goes up, another goes down.
In the financial world, correlation is the measure of how two currencies move in relation to one another.
Many financial websites provide currency correlation tables to show how closely currencies move in relation to one another. Unless you plan on trading one pair at a time, it’s important to pay attention to how currency pairs move another.
For instance, let’s say you decide you pick two currencies and you’re going long on both of them. Meanwhile, those two currency pairs are negatively correlated to one another.
This means that when one is going up, the other is going down, and vice-versa.
It’s very likely you’re going to lose at least one of them because you didn’t factor in how they’re correlated to one another.
Here’s a chart of how different currencies move in relation to one another:
There are 3 main types of forex charts: line charts, bar charts, and candlestick charts.
A line chart is a simple chart that draws a line from one closing price to the next.
When strung together, we get a feel of the general price movement for a currency pair over time.
Here’s an example of a line chart for the EURUSD.
Bar charts are a bit more complex than line charts. In addition to the close price, they also show the open, high and low. Thus, they’re also referred to as OHLC charts.
Open: The price that the bar opened at.
High: The highest price of that time period.
Low: The lowest price of that time period
Close: The price that the bar closed at.
Here’s an example of a bar chart for EURUSD
Candlestick charts are very similar to bar charts. They also show the open, high, low, and close of that particular session. In addition, they show the force of the current move.
Let’s take one bar and one candle and compare them side-by-side.
Both of them have the same open, high, low and close price but the candlestick bar reveals much more information about the psychology of the market.
We can see that although the market did close higher than it opened, it was met with strong resistance by the “bears” or the “sellers”.
The Japanese were the first to use candlesticks in trading and it became mainstream thanks to a man named Steve Nison.
You can utilize various candlestick patterns as part of your overall trading strategy, which is a whole subject in and of itself.
Here’s an example of a candlestick chart for EURUSD
Types of Analysis
When it comes to analyzing the foreign exchange market, there are three categories for you to choose from: fundamental analysis, technical analysis and sentiment analysis.
Each one of them has their unique strengths and it would be in your best interest to be familiar with all of them.
Fundamental analysis is considered by some to be the cornerstone of investing. It’s in a similar vein to the type of investing that Warren Buffett does, which made him billions of dollars.
For our purposes, we’ll be talking about fundamental analysis as it relates to forex trading.
We utilize fundamental analysis to examine the various economic, political, and social forces that may affect the supply and demand of a currency.
Economic indicators make up a large portion of the data that we use for fundamental analysis. Most traders pay attention to news events that affect the US Dollar because the dollar is the world’s reserve currency. With that being said, here are 3 forex news events to look out for:
- CPI (Consumer Price Index) — This index helps to determine whether consumers are paying more or less for the same goods. The Central bank closely monitors this and if the currency appears to be inflating, they will raise interest rates to counteract it.
- NFP (Non-Farm Payroll) — This report is used to gauge the strength of the economy. There is a very strong correlation between the report and the US Dollar, which means almost every forex trader is paying attention to this report when it comes out. The NFP report also represents 80% of the US workforce.
- FOMC Meeting (Federal Open Market Committee) — A committee within the Federal Reserve that meets periodically and makes key decisions about interest rates and the growth of the United States money supply.
Technical analysis takes a fundamentally different approach (no pun intended) compared to fundamental analysis. Instead of looking at all of the extrinsic factors that could be affecting a currency, we base our trading decisions solely on what the charts show us.
Charles Dow is credited with introducing technical analysis back in the 1800’s with his Dow Theory. Over time, technical analysis has evolved into dozens of indicators and chart patterns in order to predict price movement over time.
There are 2 basic assumptions within the Dow theory that form the basis of technical analysis:
- Markets are efficient with values representing factors that influence a security’s price.
- Market price movements are not purely random but move in identifiable patterns and trends that tend to repeat over time.
When we say that the market is “efficient”, we mean that the price at any given time reflects all publicly available information, and therefore represents the true value of a given currency.
The second assumption leads us to the belief that we can identify when the market trends and capitalize on it. If you become very proficient at technical analysis, you can make a handsome profit doing so.
We’ve all heard the old adage that history tends to repeat itself. When you apply this to forex trading, you’ll notice that the market tends to react around key areas of support or resistance, or as I like to call it, “critical areas” on the chart.
Here’s an example to better illustrate what I mean:
You’ll notice that whenever the market “touches” the red line on top, it tends to trend downward. We’ve seen it happen multiple times and it’s likely that it will happen again in the future.
Traders that use technical analysis also make use of indicators when it comes to forming their trading ideas. Simply put, an indicator is anything that can be used to predict future financial or economical movements.
To date, there are probably dozens, if not hundreds of indicators you can choose from. I could write an entire post on just indicators alone.
In the interest of time, I’ll tell you about the 4 most important indicators you need in your arsenal, inspired by Troy Segal’s article on Investopedia:
- Trend-Following Tool — When it comes to trading, you’ll make the most profit by trading with the trend than against it. In other words, if you see the market is going up, you should be looking for a buy or go “long” on the market. If the market is going down, you should be looking for a “sell” or “shorting” the market.
- Trend-Confirmation Tool — This tool is used in conjunction with the previous tool to provide you with a double-confirmation of the current trend. If the trend-following tool and the trend-confirmation tool both agree with one another, then you have a much better chance of being on the right side of the market.
- Overbought/Oversold Tool — This tool helps with determining if a currency pair has been trading above or below its true market value. You can either wait for the trend to re-establish itself or when the market does a temporary pullback to lower (or higher) price levels, depending on how the currency pair was originally moving.
- Profit-Taking Tool — As the name implies, this tool is used to determine when to take profit on a winning trade. An example of a profit-taking tool would be the Bollinger Bands. If you’re currently going long on the market, you might consider getting out of a trade once the price reaches the upper band. If you’re in a “short” trade, you might consider getting out of it once price reaches the lower band.
Here’s a quick example of what the Bollinger Bands look like:
The red and green lines on the chart represent the upper and lower bands respectively. Bollinger Bands are calculated using the standard deviation of price-data changes over a specific period, and and then adds and subtracts it from the average closing price over that same time frame, to create the trading “bands.”
Previously, we mentioned that one of the basic assumptions of technical analysis is that the price of an asset reflects all publicly available information. If that were true, then the market should be 100% predictable.
If you’ve been trading for any length of time, then you’ve probably realized that isn’t the case. This is where sentiment analysis comes into play.
Just about every trader has a bias about where they think the market is heading. Some of them might think that the price of an asset is going up, and other people are thinking the exact opposite.
Each trader’s thoughts and opinions combined together forms the overall sentiment of the market, regardless of what information is available. Even if you feel strongly about a currency pair moving in a given direction, you can’t move the markets.
For example, if you feel that the market is going up while most traders believe the market is going down, then you’re going to be swimming against the tide if you decide to take a “long” position in the market.
SSI is the primary tool that is used for gauging market sentiment in forex. It helps to reveal trader position and tells us if more traders are going long or going short. Go to dailyfx.com/sentiment to see the market sentiment for different currency pairs.
Types of Traders
If you plan on trading actively, then you need to know what kind of trader you are. Choosing the wrong style of trading can do serious damage to your trading account and will make trading a lot harder than it needs to be.
There are probably thousands, if not millions of traders that are actively trading the market. Out of that, each one of them falls into one of four general categories of traders: day traders, swing traders, position traders, and scalpers.
Day Traders are perhaps the most well-known type of active traders. As the name implies, day trading involves buying and selling currency pairs within the same day.
Positions are closed out the same day they are taken and no trades are held overnight. Traditionally, this style of trading was done by professional traders like market makers or specialists. Thanks to electronic trading, this style of trading became available to novice traders as well.
Swing traders employ a longer-term trading style compared to day traders. Their goal is to identify swings within a medium-term trend and enter the market only when there’s a high probability of winning.
They tend to have larger profit targets compared to day traders and require larger stop losses to allow for movement in the market.
Note: A Stop loss is an order to sell a currency pair at a given price. This is used to limit the amount of losses one can potentially make.
There may be times when you’re in a trade and it’s going against you. It’s important to keep your emotions under control and trust in the analysis you did beforehand.
This style of trading is ideal for those who don’t have a lot of time to commit but have enough free time to stay up-to-date with what’s happening in the global economy.
Position traders hold their trades the longest compared to everyone mentioned so far. They can have trades that last anywhere from a few months to a few years.
Due to the long holding periods used by position traders, they place a greater emphasis on the fundamentals of a currency. If you’re considering this style of trading, then it’s important you have a good grasp on how the economic data affects the currencies you’re trading and their future outlook.
Like swing trading, position traders use large stop losses to give the market room to breathe. It’s also important that you have enough trading capital to withstand the drawdown periods.
Note: Drawdown is the difference between the balance of your account and the net balance of your account. Net balance factors in all trades that are currently in profit or at a loss. Once your net balance falls below your actual balance, you have drawdown.
Position traders have a general sense of where the market is heading but do not try to predict any particular price level. They tend to jump into a trade once a trend has established itself and look for an exit once they see a break in the trend.
There are some traders that enjoy fast-pace action and will hold onto a trade from a few seconds to a few minutes at most. If that sounds like your cup of tea, then you might be a scalper.
The goal of scalpers is to get as many small wins as possible throughout the busiest times of the day. This requires intense focus and quick thinking.
This style of trading is best suited for those who can spend several hours of undivided attention on the charts.
Now that you have an idea of what kind of trader you want to be, it’s time to think about what kind of strategy you want to use for trading.
Having a reliable and predictable strategy is key to making consistent profits within the market. You might need to try a few before you know for sure what strategy you want to stick with.
Price Action Trading
Traders that use price action trading based their decision solely on the movement of the currency pair throughout time. They forego many of the standard indicators and use a combination of raw market data such as volume, chart patterns, and price movement to validate (or invalidate) a potential trading opportunity. Besides forex, price action trading works in any market and in all timeframes.
When Steve Nison introduced Japanese Candlesticks in his 1991 book, “Japanese Candlestick Charting Techniques”, price action trading took on a whole new look and color. Prior to that, most traders were still using line charts and bar charts.
In his book and subsequent seminars, he showed how candlesticks can be used to gauge the psychology of the market, and are fully compatible with Western tools.
Price action trading is one of the fastest methodologies for sizing up the market and can be used with just about any trading software.
There’s an old saying that goes, “The trend is your friend”. In other words, once you establish that the market is heading in a particular direction, it’s safe to assume that it will keep in heading in that direction for a while.
As the name implies, trend trading can only be used if the market is trending. It won’t work if you’re in a ranging market.
Note: A ranging market is where the price is stuck between two price levels and keeps going up and down between the two.
Trend trading took center stage in the 1980s when Richard Dennis and Bill Eckhardt, 2 successful traders in their own right, recruited a group of traders known as the Turtle Traders, and taught them a trend trading strategy that made them over $100 million in profit.
The 2 most common indicators used by trend traders are moving averages and momentum indicators.
Moving averages “smooth” price data by showing a single flowing line. The line represents the average price over a specific period of time.
For example, if you have a 20-period Moving Average, then the line represents the average price over the last 20 candles. Depending on what time frame you’re looking at, each candle can represent a single minute, a single month or anything in between.
Moving averages are used to determine the general direction of the trend, or if the market is even trending at all. For instance, if the moving average is horizontal, then you’re most likely in a ranging market. If the moving average is pointing upwards or downwards, then you’re in a uptrend or downtrend, respectively.
Crossovers are another great way to use moving average. In this case, you have 2 moving average and you wait for one to cross the other to either buy or sell the currency pair.
For instance, let’s say you’ve plotted the 50-period and the 200-period moving average on your chart. When the 50 crosses the 200, you look for an opportunity to buy. On the other hand, if the 200 crosses the 50, you look for an opportunity to sell.
Moving averages can also act as dynamic support and resistance levels.
Here’s a quick example:
As you can see, whenever the price touches the moving average, it tends to “bounce” off and continue its trend.
Momentum indicators help us identify the strength of the price movement. The 3 most common momentum indicators are the Relative Strength Index (RSI), the Stochastic Oscillator and the Moving Average Convergence Divergence (MACD).
The RSI and the Stochastic are both oscillators, meaning that they move in a bounded range, usually between 0 and 100.
Momentum indicators help to identify whether a market is overbought or oversold. In either case, we want to see whether or not the market has enough momentum to keep going in the same direction.
Countertrend trading is a strategy that anticipates and capitalizes on the reversal of a prevailing trend. As we all know, what comes up, must go down, and vice-versa.
It’s a medium-term strategy in which a position is held from weeks to month, depending on how long the retracement lasts.
Note: Retracement is a temporary reversal in the movement of a currency pair
As we mentioned previously, “the trend is your friend”, but there are valid reasons for going against it. The most common purposes for countertrend trading include pure profit, diversification, and risk management.
Countertrend trading can be used in any timeframe, but it’s preferable to use in shorter time frames because long-term trends can take a long time to reverse.
Range Trading is a strategy whereby a trader identifies overbought and oversold areas (or support and resistance areas) and buys at the oversold area (support) and sells at the overbought area (resistance).
Ranges often form after a long-term trending move. Day traders frequently use trading ranges of the first half hour of a trading session as a reference point for their intraday strategies.
Trading ranges capitalizes on the tendency of market prices to revert to the mean. Traders use moving average lines to determine whether the price is moving towards or away from its average price. Whenever the price moves significantly above or below its moving average price, there’s a good chance that the price will return, in part, towards its average price.
A breakout is an event where the market breaks through a level of resistance to an unprecedented price. They have the potential to be very profitable and can result in quick gains for savvy traders.
Breakouts usually occur in market conditions where an upward movement is expected. For example, if the market is currently in a range and is moving towards its upper boundary, traders will start preparing for a price breakout to capitalize on potential gains.
Breakouts will sometimes occur after a high-impact news event, but these are much harder to predict.
Traders will look for chart patterns such as triangles and flags that suggests resistance limits near completion, which further increases the likelihood of a strong upward movement.
Here’s an example of a triangle formation and a breakout that followed:
A carry trade is a strategy where a high-yielding currency funds the trade of a low-yielding currency. The goal of the trader is to capture the difference between the two rates, which can be substantial, depending on the amount of leverage used.
Carry trades work when the central bank is increasing interest rates or plans to increase them. When the central bank is raising interest rates, the world notices and typically many traders pile into the same carry trade, which pushes the value of the currency pair higher.
In general, carry trades are better suited for investors as opposed to traders because it is a long-term strategy. Carry traders will hold their positions for months, if not years, at a time. The point of this strategy is to get paid while you wait, so waiting is a good thing.
Pivot Point Trading
Pivot points are precalculated price levels based on the previous day’s trading activity. They are used to determine potential areas where market sentiment might shift.
It was originally developed by floor traders in the commodities market to determine potential turning points and proved itself to be useful in the forex market. They are now commonly used in conjunction with support and resistance levels to confirm trends and minimize risk.
Because so many traders are looking at the pivot points, they tend to become self-fulfilling prophecies.
Traders that use range-bound strategies use pivot points to identify reversal points.
Traders that use breakout strategies use pivot points as key levels to be broken in order to classify a market move as a legitimate breakout.
In order to trade on the forex market, you have to place an order. There are 3 types of orders you can place: Market Execution, Limit Order, and Stop Order.
Market Execution orders is the fastest and most reliable way to get into the market, as long as there’s adequate liquidity.
Note: Liquidity is the ability to purchase or sell an asset without causing a drastic change in the price.
The only downside is that Market Execution orders don’t allow for any precision in order entry, which could present costly slippage. Slippage refers to the difference between the expected price of a trade and the price at which the trade is executed.
The forex market is one of the most liquid markets in the world, so slippage is rarely an issue if you’re trading liquid assets like the majors.
Limit orders gets their name because they set a limit on the price you’re willing to buy or sell an asset. Unlike market execution, which gets filled in at the next available price, limit orders are pending orders which don’t get filled until the market has reached your predefined price.
For example, you place a buy limit on EURUSD for 1.5. In plain English, you are telling your broker not to fill you in until the market has reached 1.5. Not only that, you will not pay more than 1.50.
If you were to place a sell limit order, it would be the exact opposite. You will sell when the market reaches 1.50, but you will not sell for less than that.
When you’re placing a buy limit order, you must buy below the current market. When you’re placing a sell limit order, you must sell above the current market.
Stop orders (also called a stop-loss order or stop market order) are pending orders that become market orders only after the market has crossed a specified price level. They work in the opposite direction of limit orders.
Whereas a buy limit order requires buying below the market price, a buy stop order requires buying above the market. Similarly, a sell stop order is placed below the market as opposed to sell limit orders, which are placed above the market.
Stop orders are used more often than limit orders because they are filled more consistently. Keep in mind that a market order guarantees a fill, not a price. They’re also preferred because they help reduce the pressure of monitoring a trade from day-to-day. You can “set it and forget it”.
When trading currencies, you are quoted two prices side-by-side. One of them is the bid price and the other is the “ask” price. The bid price is always the lower price of the two.
The “bid” is the price that your broker is willing to sell a currency.
The “ask” is the price that your broker is willing to buy a currency.
The difference between the “bid” and “ask” is called the spread. The “spread” is the profit that your broker makes for each buy and sell transaction on their platform. The wider the spread, the more expensive it is for you to trade.
Spread is more relevant to traders who trade frequently, like day traders and scalpers. It becomes less important when trading on higher time frames or if you hold your trades long-term like swing traders and position traders.
In the past, currencies were traded in large quantities known as “lots”. A lot is equivalent to 100,000 units of a base currency. Previously, we mentioned that the base currency is the first currency appearing in a currency pair.
Change in currency value relative to one another is measured in pips. It represents a very small percentage of a unit of currency’s value. In U.S. dollar-related currency pairs, a pip is equal to about $0.0001. Because this is such a small change in value, we need to trade large amounts of a particular currency to see any significant profits or losses.
In addition to standard lots, there are also mini lots, micro lots, and nano lots available that are 10,000 units, 1,000 units, and 100 units, respectively. Smaller lot sizes became possible because of online brokers and the increased competition between them.
Leverage & Margin
In forex, leverage is the ratio between the trader’s funds to the size of the broker’s credit.
For example, if a company offers 100:1 leverage, that means for every dollar in the trader’s account, they have access to $100 in purchasing power.
Upon first glance, this seems like a pretty good deal. The more capital you have, the more profits you can make, right?
Yes but, if you’re on the wrong side of the market, then your losses can be substantial.
Margin is the “good faith deposit” that the trader puts up to maintain an open position. It’s usually expressed as a percentage of the full position.
Getting back to our original example, at 100:1 leverage, your margin requirement would be 1%.
On your broker platform, you might come across a term called used margin. This is the amount of funds that your broker has “locked up” to keep your positions open.
Although the money is still technically yours, you cannot get it back until you close all of your open positions or you get a margin call.
A margin call occurs when the amount of money in your account cannot cover your possible loss. This happens when your equity falls below your used margin.
For example, if your used margin reaches $900 and you only have $800 in your trading account, you would get a margin call.
There are 3 main types of accounts for you to choose from: standard, mini, and managed. The type of account you will choose depends on a number of factors, including risk tolerance, size of initial investment, and the amount of time you’ll dedicate to trading forex on a day-to-day basis.
Standard trading accounts are the most common type of trading accounts. This account allows you to trade standard lots of currency, each worth $100,000.
Because of margin and leverage, you don’t need to have $100,000 in your trading account. Depending on how much leverage you have, you can start with as little as $2,000.
Most brokers provide better service with this type of account, compared to the other two. And the gain potential is large with each pip being worth $10.
Mini accounts allows traders to trade mini lots. Many brokers who offer standard accounts will also offer mini accounts to attract new forex traders who are intimidated by the amount of capital required to trade standard lots.
They’re considered low-risk accounts which allows for new strategies to be tested without worrying about losing lots of money. Most mini accounts can be opened with as little as $250 to $500.
If you want to be completely “hands-off” with your trading, then you should consider getting a managed account. Unlike the previous two accounts, the buy and sell decisions are made by professionals, rather than yourself.
Generally speaking, there are two types of managed accounts:
- Pooled Funds — Money is put in a mutual fund with other investors. The profit is shared among the investors. The accounts are separated according to the risk tolerance of investors.
- Individual Accounts — A broker will handle each account individually, and make custom-tailored decisions for each individual investor.
Creating A Trade Plan
A wise man once said, “If you fail to plan, then you plan to fail.”
The same goes for trading. Without a trading plan, you’re more of a gambler than a trader.
Here are 5 questions to ask yourself when creating your trading plan:
- When will I be trading? (Which sessions? Days? Time?)
- What size account will I be trading?
- What type of trading will I be doing? (Day Trading? Swing Trading? Scalping?)
- What strategies will I be trading? (Trend? Countertrend? Breakout?)
- How will I monitor the performance of the trading? (Maximum Drawdown? Profit Factor?)
Proper risk management is one of the most vital skills you can learn as a trader. You could win 100 trades in a row and still lose everything if you don’t manage your risk properly.
One of the best ways to exercise proper risk management is by coming up with a trade plan, as we discussed in the previous section, and sticking to it.
Sun Tzu, a Chinese military general once said, “Every battle is won before it’s fought”.
Stop-Loss orders and Take-Profit orders present two ways in which you can plan ahead (and manage your risk) in your trading.
Stop-Loss orders are placed with your broker to sell once the currency pair reaches a certain price. They are designed to limit your loss on a position.
Take profits orders are a type of limit order that specifies the exact price to close out a trade at a guaranteed profit. When a take profit order is hit, the trade is closed at the current market value.
Here are a few more points about managing your risk properly:
- Determine your risk tolerance — How much of your total account are you willing to risk on each trade? 2%? 5%? 10%?
- Customize your lot size accordingly — Based on your risk tolerance, customize the number of lots that you will be trading per trade.
- Determine your timing — Make yourself available to place trades when the opportunity arises.
- Avoid weekend gaps — Don’t hold trades over the weekend, if you can help it. Gaps can run beyond your intended stop loss or take profit target.
- Watch the news — Certain news events can create abnormally large moves in the market. Unless you’re looking to take that strategic risk by placing a trade before the event, it is more risk-conscious to wait until after the event has passed. Check out forexfactory.com for upcoming news events affecting the forex market.
If you’ve made it to the end of this post, you should know have a solid grasp on the forex market. There’s a lot of moving pieces but I’ve covered the most important ones.
Now, it’s up to you to take what you’ve learned and build upon it. You’re not going to get rich overnight, but if you take the time to learn and build the skill, you’ll become a profitable trader in no time.
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