Forex Education

Foreign Exchange Definition

Foreign exchange (Forex) is the cross-country exchange of currencies and is, single handedly, the largest and most liquid financial market in the world. With an estimated $1.5 trillion in currencies traded in a single day, it eclipses the trading of other types of commodities. Unlike other commodity trading, Forex has no centralized exchange and is traded primarily through banks, brokers, dealers, financial institutions and private individuals. Due to this ability for financial institutions to trade Forex, the Forex market is open 24 hours, 5 days a week (closes Saturday morning).

Prior to the late 1990's, Forex trading was only the practice for institutional traders and even though retail traders had access to trade the Forex market, only recently has it become popular and more common for individuals to trade Forex for profit. Most of the world's different country currencies are free floating; meaning they retain an individual value and will appreciate and depreciate against other currencies. Currencies are always listed in pairs as they need another currency to benchmark against.

Reasons for Trading Forex

Trading Forex has many purposes and you'll be surprised of the many levels traded that impact you and you're not even be aware of it. For every purchase you make, the contents, ingredients, by-products, parts or materials may not necessarily be from a domestic source. It could have been bought internationally and as such the exchange of foreign currency would have had to be taken place.

From a financial perspective, some people may trade the Forex market for profit. By taking a cross currency pair, they may exchange currency to a foreign designation hoping for domestic currency values to depreciate, thus when you convert it back you will receive more than you initially started.

For international importer or exporter of goods and services, there are great opportunities by having access to the international market. However, with fluctuating international currency rates, payment can sometimes be difficult. Initially companies make a sale for an agreed price, then on the day of payment the agreed value is significantly less than agreed to, due to a currency fluctuation is known as 'foreign exchange risk'.

You will find all types of businesses, from large financial institutions to small retail freight forwarders will practice foreign exchange hedging. Simply put, these companies will put in place measure to ensure that their agreed payment value will represent the same value at the day of payment regardless of currency value fluctuations.

The Eight (8) Major Currencies

Internationally, there are eight (8) currencies that are traded more than other currencies. These are often referred to as 'Majors'. These currencies are as follows:

  1. USD - Unites States Dollar
  2. JPY - Japanese Yen
  3. GBP - British Pound
  4. CAD - Canadian Dollar
  5. EUR - European Currency Unit
  6. CHF - Switzerland Dollar
  7. AUD - Australian Dollar
  8. NZD - New Zealand Dollar.

Certain parts of the world have part of their Saturday to trade, as it's still Friday in other markets.
Financial institution in these countries may be dealing with the Forex market during their work hours, the Forex market is open and trading 24 hours, 5 days a week. For someone living in the East Coast of Australia, the market hours for the corresponding markets are outlined below:

  • New York session opens at 10:00pm and ends around 7:00am
  • Sydney session starts at 7:00am and ends around 4:00pm
  • Tokyo session begins at 9:00pm and ends around 6:00am
  • London opens at 5:00pm and ends around 2:00am.

What is a Currency Pair ?

Currency is always measured against another currency and they are referred to as currency pairs. Currency pairs are generally segregated into groups. These groups are known as Majors, Minors and Exotics. Major currency pairs are generally the most popular traded currency pairs.

Almost all currencies are free floated, meaning that they don't have a set representation of value to another currency and can rise and fall in value independently.

Some of currency pairs offered by LMFX available for trading are:

Major Pairs Minor Pairs Exotic Pairs
AUDUSD EURCHF USDSEK
USDCHF EURGBP USDDKK
GBPUSD EURJPY EURSEK
USDJPY GBPJPY EURNOK
EURUSD CFHJPY USDNOK
USDCAD GBPCHF USDMXN
NZDUSD EURAUD EURPLN
EURCAD USDPLN
AUDCAD EURCZK
AUDJPY USDCZK
CADJPY USDZAR

What is a Pip ?

A pip is a small measurement of change in the underlying currency. Generally, it is the forth (0.0001) decimal place of a currency price, except with the Japanese Yen, where they have no denomination for cents in their currency (in the Japanese Yen, the pip is the second decimal place). Shown below is an image representing an order window reflecting the price of the AUD/USD Currency Pair.

The fourth decimal place is circled red to show which decimal the pip is in reference to. If the price 0.84693 moves to 0.84683 then there was a 1 pip movement. Please note that the fifth decimal represents 1/10th of a pip.

A pip is a good reference measure to how much a trader can make based on the volume of their trades. For example, if a trader purchases a full contract the value of potential return and risk is $10 profit or loss (of the second named currency in a pair) per pip movement. You can follow the table below as a reference to potential risk or return:

Trading Volume U.S. Dollars/Pip
1 $10
0.1 $1
0.01 $0.10

Quite often, the annotation used to measure how well a trader is doing is to mention how many 'pips' they have gained in a set time period.

What is Bid & Ask and Spread ?

With currency quotes, they are always represented with a Bid offer and an Ask offer. This denotes the price difference between buying and selling.

If you BUY, you are buying at the ASK price. if you SELL, you are selling at the BID price. Shown below is a list of currency pairs all showing a Bid and Ask offers.

Remember, if you opened a BUY position and you wish to close it, you are essentially selling it back, therefore the price you will be closing the position at is the BID price and vice versa.

The spread is the pip difference between the BID and ASK. If you were to look at the above image and referred to the AUD/USD then you will notice the BID as 0.84767 and the ASK as 0.84786.

This is a spread of 1.9 pips. 0.84786 - 0.84767 = 0.00019 0.00019 = 1.9 pips

What is Leverage and How much do I need to trade ?

Leverage is the amount that you are borrowing based on the deposit in your account. Default leverage is set at 100:1, meaning that for every $1 you have in your account, you have a buying power of $100. If you have $1,000 in your account, you have buying power of $100,000.

Something to remember is a full contract is $100,000 of the base currency. So if you were looking to trade a Full Lot of the EUR/USD, then you would need the equivalent of EUR$100,000 in your account to trade this.

If you wanted to trade a full contact and you had a leverage of 500:1, then you could take this position with only $200 in your account ($200 x 500 = $100,000). High leverage can help you take larger positions based on smaller capital in your account, but it is not without its pit falls. Larger positions result in larger dollar movements per pip and as such can wipe out smaller capital amounts in a short period of time.

How do I read charts ?

If you can't read the charts, then you won't make sense of any of the data, from which to form your strategy.

Charts can be placed in to three different categories:

  • Line Bar Charts
  • Bar Charts and
  • Candlestick Charts.

1. Line Bar Charts

The easiest to read of the charts is the Line Bar Chart. It simply shows a line graph of time vs. price.

2. Bar Charts

The next chart to decipher is the Bar Chart. Bar charts not only show price, but also show the open price per period, the close price at the end of the period and the high and low of that period. Each vertical line represents one time period. The period is selected by you to represent 1 minute, 5 minutes, 15 minutes, 30 minutes, 1 hour, 4 hours, a day, a week or a month.
Let's take a closer look at one of these bars.

3. Candlestick Charts

Candlestick charts are similar to bar chart but with additional information of each bar being hollow or colored. This is done to allow a trader to easily visualize a period bar to have moved in a positive or negative direction from its entry price.

As shown in the image below, the hollow bars are bars that have moved up. Colored or filled bars are bars that have gone down. The lines that you see above each bar represent the high and lows.

How do I interpret charts ?

Now you know what line charts, bar charts and candlestick charts look like, how do you interpret them?

Firstly, you have to understand that these individual bars or candlesticks only represent one time frame. Have a look at the following image to see that each bar represents one hour.

The x-axis represents a time interval and the y-axis represents the currency pair price.

Each single bar represents the high and low of that one-hour period, the entry price and the exit price (B) at the end of the hour. Each bar can be represented in all sizes and lengths.

- Longer bars indicate there were big differences between the high and low.
Short bars indicate not much movement in the market.

What are Shadows ?

When accessing the types of bars or candlesticks, 'shadows' is the term given for the portion of the bar or candlesticks where they have reached a high or low, but have not ended the period at the high or low. You will be able to see the shadows of each bar or candlestick where there were highs or lows for that period. In the image below, the shadows are circled.

What is Support ?

By being able to see the shadows, it gives an indication that the market at that time period may have reached a high, but the market retracted and closed at a lower point. This may show that when the underlying asset (the currency pair) reached a certain point where there was resistance by other market participants in offering a higher price than the high shown. On the other side, it can be said that there was support in pushing the price in the other direction if you see several shadows in one direction, i.e. several consecutive bars or candlesticks with shadows in one direction.

As you can see in the image above, in the filled candlesticks, there are a lot of consecutive shadows going downward. This shows that there are many market participants seeking a lower price.

It shows support for a downward trend for this particular case, however many counter tails in the opposite direction can set up a reversal so care is needed in thinking whether lower tails always equal lower prices.

What is Resistance ?

In the following image, you will see that the bars reach a certain high, but seem to struggle to beat a price mark.

The horizontal line indicates that there is an imaginary level where market participants feel that they should not push the currency past. This is known as resistance.

What are Trend Lines ?

Trend lines are lines that are usually drawn on charts to determine a direction the market is moving. A person sitting in front of a chart will physically draw a line from one point to another point to determine the general direction the market is moving.

The two 'x' points, which the line is following, are the low point of two time periods over a distinct time span. The two points are 36 periods apart (the gap between periods can be any number and not necessarily 36 periods), the trend line was drawn from the two low points at the 'x'. The line is a very clear up-ward trend. Trend lines are useful with trending strategies. Trend lines are useful to help determine current market direction. (To have a confirmed trend support or resistance you need two points to make it a line.)

What are Channel Lines ?

Channel lines are drawn to show the general direction taking in to consideration also any bar 'shadows' containing support and resistance.

Drawing channels clearly show the channels that trading generally trades between. This is particularly useful when using the 'ranging strategy' and also for assessing opportunities for 'break out strategies'

Trading Strategies

Having placed some random trades, you would have figured out that when you place an order to buy or sell, you could potentially earn or lose money. The theory is quite simple, pick the right direction and you will make money. The important question is 'how do I pick the right direction?'

Strategies are a systematic and planned course of action based on existing information you know of the market. There are a multitude of strategies for Forex trading. A lot are available to learn for free by doing an Internet search, books available and people that will teach these strategies for a fee. Around the world, professional traders and recreational traders alike will always hold at least one trading strategy to heart and will attribute their success in trading to following that one or many trading strategies. The following section covers some popular strategies that are used by many traders.


The Trending Strategy

The trending strategy is to follow the market in the direction that it is clearly following over an extended period of time. Currency pairs often take either 'bullish' (up) or 'bearish' (down) trend.

By following the trend of a particular currency pair, you are banking on the fact that the currency continues its existing direction and you are taking in a profit by following the market direction. This strategy is by far the most popular strategy method for trading currency.

Trends can be long or they can be short, meaning that there are short-term trends and there are long-term trends. An example would be that during a 6-month period, there was a bullish trend for the AUD/USD, however, in between this 6-month period there were 2 short periods where it took a bearish trend. The following is a graphical representation of the example.

If you held a buy position from the start of the 6 months to the end, you would be well in profit. Be careful when you look for your trends. Sometimes when you look at a chart and it shows a very clear trend, if you were to expand your chart to include more data it could very well show you the opposite. As such, if you are looking for trends make sure you view the time frames of all charts.


The Ranging Strategy

The Ranging Strategy occurs when a currency is trading between a set upper and lower limit and seems to constantly bounce up and down between the high and low limit. Traders take the opportunity to sell when it is at the upper limit and to buy when it is at the lower limit. Represented in the image below, you will see a sideway trend. This marks the opportunity for people who follow a ranging strategy.


The Breakout Strategy

The Breakout Strategy is the break out of a sideways trend. Usually, momentum is greatest on breakout points. A lot of traders take advantage of the breakout strategy when sideways moving prices break the upper or lower limits.

Below represents a few breakouts following some periods of sideways tending.


News Release Trading Strategy

News traders trade off economic news release. The Forex market is particularly reactive to economic news, in particular, interest rate news from the G8 countries, as well as unemployment news for each corresponding country.

News traders will have to bear in mind that the Forex market movements have already taken in to consideration existing and expected economic news. The sharp movements you see due to economic news are corrections due to unexpected news, either better than expected or worse than expected.

Another consideration to take to heart for potential news traders is that during negative sentiment news reports, currency movements generally head towards lower yielding and perceived 'safer' currencies; USD and JPY in particular.

A good grasp of economics is generally recommended for traders wishing to start news releasing trading.

An economic news calendar is highly recommended. Forex Economic calendars show the release date for important economic news such as 'non-farm payroll', GDP figures and interest rate news.

Below is an example of what an economic calendar shows:


source: forexfactory.com

The Right Trading Psychology

Besides learning the mechanics of Forex Trading and creating a Trading Strategy, for a trader to be successful, the correct trading psychology has to be cultivated.<br>This is as huge subject that needs extensive studying and time so this is by no means a complete source. It is designed to get the trader to start thinking along the correct lines.

Below is a list of 4 elements which constitute the correct trading psychology:

1. Take Complete Responsibility

For the successful trader knows every action he takes, every decision he makes he ,and only he, is responsible for that action. You will never meet a successful trader who is looking to blame someone else, or something else for the consequences of his results. It just will not happen. You see, when you accept 100%, no questions asked responsibility for all your actions you close the door to 'excuses' behind you. When something goes wrong instead of looking for someone else to shoulder the blame, you will accept responsibility, note it down and vow never to repeat it again. Simply, you are willing to accept you are going to make mistakes, but more importantly, you are going to learn and never repeat those mistakes. A vital component of any winning trader.

2. Have a System that fits you

Every successful trader, has a system that fits them. Some are long term, some mechanical, some intuitive, day traders, scalpers, arbitrage, value and momentum. The system its self is not the important factor. What is? Is that the system fits their unique personality Too many traders try to copy the latest hot fad in trading. Right now that would be day trading. But that style of trading will not suite every-one. To be a successful day trader you have to love the short term up and downs of the market during the day and being in contact with quotes for hours at a time. Yes, there are a number of traders making very good incomes from day trading, but there's many more who lose their shirts within a couple of months and don't even find out whether day trading is suited to their temperament. It's a little like choosing a career. I remember reading a book some time ago about the world's best managers. And one characteristic the author emphasized with all these top achievers was their LOVE for their chosen careers. Most of them said they couldn't believe they were getting paid to do something they loved so much. It's no different in trading You will only be a top trader if you trade a system which you simply love to trade. You wouldn't swap that way of trading for anything. And the profits you make, well that's just icing on the cake. How do you find a system you are happy with? You have to work backwards by first finding your objectives.

3. Plan a trade and trade the plan

Without doubt, no trader will last long if he doesn't plan every trade. But there is absolutely no point in making a plan for a trade if you are not disciplined enough to follow it. A plan should cater for every eventuality. As Richard Dennis (Turtles fame) Said 'Don't worry about where the prices are going. Worry about what you are going to do when they get there.' Think about what is being said here. Once you put your money down on a trade you cannot control the prices. So stop worrying about what could happen and concentrate on you trigger points and what you will do when these points are violated. By doing this your trading stops being emotional and now becomes very systematic and stress free.

4. Work hard at learning how to trade properly and keep working

This is no different from any other trade. Would you expect to become a brain surgeon after attending a week-end seminar and reading a few books? Yet, why do so many people expect to become a Market Wizard within such a short period of time? If you ever have the privilege to ask questions to a successful trader you'll realize just how much effort, time, determination and lost money it took until they arrived at where they are. Being a Consistent forex market winner is no different from being a top lawyer, doctor or a businessman