Forex trading has several features that make it very different from carrying out transactions in other markets. The volume of currencies traded is extremely high at approximately $3 - 5 trillion per day. The market is open 24 hours, permitting trades to be made at any time of the day or night.
Earlier, the market was the exclusive preserve of banks, hedge funds and other institutional traders but with the advent of online platforms, forex trading has gained wider appeal and individuals operating from the comfort of their homes are a common phenomenon.
As forex trading has proliferated, speculators make up 95% of the total number of traders. Banks comprise the remaining 5%, but account for 92% of all forex volumes. Banks play a crucial and leading role in this market but it is practically impossible for any single bank to influence rates as volumes are exceedingly high.
Another unique feature of the forex market is that there are no commissions involved. Forex firms are dealers and not brokers. They assume market risk by serving as a counterparty to the investor’s trade. Instead of commission they make their money through the bid-ask spread.
How the Forex Market Works
Each forex transaction involves a currency pair where one currency is purchased and another is sold. It is for this reason that forex quotes are always made as a combination of two currencies. A sample forex quote for the U.S. dollar (USD) and Japanese yen (JPY) would be USD/JPY = 119.50. In this example the U.S. dollar is the base currency and the Japanese yen is the quote or counter currency.
If you expect the U.S dollar’s value to go up you would buy the base currency and sell the quote currency i.e. you would buy U.S. dollars and sell Japanese yen. When buying the base currency, the ask price is the price at which the dealer is willing to sell the base currency in exchange for the quote currency. Conversely, if you are selling the base currency, the bid price is the price the dealer is willing to pay to buy the base currency from you.
Forex trading hinges on the fact that daily currency movements are usually very small. Most currency pairs, on average move no more than 1% per day. It is for this reason that traders rely on leverage to increase their potential returns.
For example, to trade $200,000 worth of currency you may be required to pay a 1% margin. Hence by putting up only $2,000 you could trade in an amount of $200,000. This translates into a leverage of 100:1, but is not as high as it sounds because currencies do on fluctuate much.
Basic Rules to Follow When Trading
The most important factor to keep in mind is that you should follow a disciplined approach and cut your losses at the rate which you had determined at the time of making the trade. This is easier said than done as the self-control required to book a loss is not an easy trait to develop. But experienced traders know that making profits is as much about knowing when to exit from a transaction as selecting the right trade in the first place.
It is also essential to decide and set the risk that you are willing to take on a single trade. This may vary from around 1% to as much as 5% of your portfolio on a given trading day. Once you reach this limit it is vital that you stop trading for the day even if you feel that the next opportunity is the one which will give you a great return.
If you lose control for even a moment and indulge in a hasty trade that is not part of your overall strategy, you risk losing a substantial or even a major portion of your investment because of a moment’s indiscretion.
A common mistake made by novice traders is to concentrate most of their energy, time and effort on looking for buying opportunities and paying little attention to their exit from a position which has deteriorated. Remember there may be two exits for the trade you make.
The first is the stop loss you set when you make the trade. It is not enough to decide on a figure mentally and hope to remember it at the time when your trade goes against you. You must write it down so that there is no chance of misinterpretation. You must also have a profit target and stick to it regardless of how you anticipate the market to move once it has been achieved.
What you can do is to sell a portion of your positon when your profit target is achieved and set your second stop loss for the remaining amount so that you break even in the transaction. The strategy you adopt is entirely dependent upon your risk appetite but the fundamental issue is to practise self-restraint and stay with your plan regardless of the movement in the market.
Adopt a Winning Approach
Forex trading can prove to be a lucrative activity if it is approached in the correct manner and if the pre-decided strategy is executed deliberately and methodically. A trader will need to be dispassionate about both successful and unsuccessful trades. Forex trading is definitely not a get rich quick opportunity and those who expect to make very high returns should remember that the risk they will incur will be in the same proportion.
The most important qualities that a successful forex trader has are discipline and self-restraint. A measured implementation of your trading strategy with the ability to exit in time from unsuccessful trades will set the stage for a profitable forex trading venture. On the other hand, a hasty approach, even if it yields profits initially, will lead to losses in the long run.
The forex trader who has never made a loss does not exist. But the ones who stay the course and follow a focussed approach to trading are bound to succeed.