At Maverick FX, we have thousands of people a month inquire about Forex trading with us. One of the most common questions we field is, “What is Forex trading and how does it work?”
What is Forex trading?
First, Forex is an abbreviation for “foreign exchange.” The definition of Forex, at its heart, it is exchanging one currency for another. Let’s say you fly out of JFK with dollars in your wallet and land in Heathrow. You still have dollars in your wallet, but those pesky Brits insist you pay for goods and services in British Pounds. In order for you to buy anything in Great Britain, one of the first stops you’re going to make is at one of those foreign currency exchange kiosks in the airport, where you will exchange your dollars for pounds.
Forex trading is doing the same thing, with different people, on a much larger scale, and for different purposes. Rather than exchanging dollars for pounds to go to a pub in London, in Forex trading, your purpose is either speculation or hedging.
Hedging v. Speculation in Forex Trading
Between the two purposes, speculation or hedging, hedging is largely the domain of business ventures. For example, let’s say while you’re in London, you represent a consortium of investors and close on a block of apartments for £10,000,000 and that generates a net income of £200,000 per year. You’ve got two types of risk in this situation: your general business risk in managing the block of apartments in London, but you also have currency risk. Your tenants pay their rent in British pounds, but unless you and your investors want to fly to London to use those pounds, you need to convert them into dollars to use in the United States.
Businesses like consistency; it helps them plan for the future. To achieve consistency, businesses try to remove as many variables as possible. Currency risk is a major variable. If the value of the pound compared to the dollar goes down (or the strength of the dollar compared to the pound increases) then the value of the apartment building and the value of the rent goes down as well.
As I write this (January 2019) the exchange rate for dollars to pounds is $1.2764 to £1.00. The apartment building generates £200,000 in net income per year, or £16,666.67 per month (or $21,273.34 per month). If you wanted to hedge out your currency risk and have a consistent income in US dollars every month, you would short £16,666.67, denominated in US dollars ($21,273.34). If the value of the pound rose compared to the dollar, you would make additional money on the rents, but you would lose a corresponding amount on your hedge. Conversely, if the value of the pound fell compared to the dollar, you would lose money on the rents but gain a corresponding amount on the hedge. That’s the definition of a hedge. The point is that from now until you took off the hedge, between the rents and the hedge, you will always generate $21,273.34 in income. You’ve removed your currency risk and created consistency. As you raise your rents, you would just increase the amount of your hedge.
Now, on to the real reason that most people look at Forex trading – speculation.
Online Forex Trading
Online trading is a great revolution (see our article: What is Proprietary Trading? for a more in-depth discussion). Online trading took what was once the domain of an exclusive club and democratized it. Online Forex trading opened up a world that was previously only the realm of inter-bank transfers and hedging vehicles for international businesses and gave the public a potential rocket ship for building wealth. But like rockets, an online Forex account in uneducated hands can blow up, leaving a fiery pyre of destruction in its wake.
The unfortunate fact is that most businesses offering Forex trading for beginners focus on getting a member of the public to open an account and then turn them loose create great wealth or (unfortunately more often) turn their accounts into blazing infernos.
Most companies that are offering online Forex trading entice people to open small Forex accounts, give them a Forex login and password to their new accounts, run them through a quick Forex trading tutorial, and then turn them loose with massive leverage, but no real training, coaching, mentoring, or supervision.
The Forex Market
The Forex Market can be difficult for beginning Forex traders to understand. For one, there is no centralized foreign currency exchange as there is, for say, stocks and the New York Stock Exchange. The Forex market is truly distributed, using Electronic Communications Networks (ECNs). Because the earth rotates and Forex transactions are inter-bank transactions, the Forex Market is open 23-½ hours a day, five days a week. The reason that there is a half hour gap is that there isn’t a lot in the middle of the Pacific Ocean. From closing time for US banks in Hawaii to the opening of banks in New Zealand is a half hour.
Since the Forex markets are live 23-½ hours a day, your Forex broker will allow you to trade all 23-½ hours the markets are open. This is great for insomniacs who are looking for something to do while they’re trying to fall asleep, but unless you’re trading a specific overseas event, the temptation to trade simply because you can is dangerous for a beginning Forex trader.
Forex Brokers and Trading Platforms
When reading Forex trading reviews, one thing becomes abundantly clear: the choice of your Forex broker is important. The best Forex trading platforms are high up the food chain and will get you the best bid/ask spreads and best execution. The lesser Forex trading platforms will either have wide bid/ask spreads or will even trade against you (with a bad spread).
This all boils down to the most important question: is Forex trading profitable? Done correctly, with proper training, support, mentoring, supervision, and capital, Forex trading can be very profitable. Those who master Forex trading gain an in-depth understanding of geo-economic events and how the world’s markets are intertwined.
Like trading any financial instrument, Forex trading takes education, support, and capital. The terminology and structure of Forex trading differs from everyday stock trading. Forex trading is pairs trading, where you are long one currency and short another currency at the same time. This can be difficult for beginning Forex traders to understand, especially if they are trading a currency pair (or currency cross) where one of the currencies is not their native currency.
While stocks are priced in dollars and cents, Forex pairs are priced in PIPs, which stand for Point in Percentage. Currency pairs rarely make the same percentage moves as stocks do in the short term, so they require more places after the decimal point to calculate price movement.
Major Eight Currencies and Dominant Pairs
Next, not all currency pairs have enough liquidity to trade consistently. Just because you can trade the Egyptian Pound to the Mexican Peso doesn’t mean that you should, unless it is for a bona fide hedging of currency risk in a business venture.
If you’re going to trade Forex for speculation, you should stick to the eight major currencies and the crosses they make. The eight major currencies in Forex trading are:
- US Dollar (USD)
- British Pound (GBP)
- Eurodollar (EUR)
- Canadian Dollar (CAD)
- Australian Dollar (AUD)
- New Zealand Dollar (NZD)
- Japanese Yen (JPY)
- Swiss Franc (CHF)
These eight currencies provide the most liquidity and the tightest spreads in trading, allowing you to concentrate on the trade itself and risk management rather than worrying about whether you got a good fill on your order.
Even limiting your Forex trading to the eight majors, you still need to refine your trading even further to ensure that you’re trading the dominant pair in the currency cross. For example, if you were trying to put on the hedge for the London apartment building we discussed earlier, hedging pounds for dollars, you would short the GBP/USD cross. The USD/GBP cross is the exact opposite and you would need to go long that cross to get the same hedge, but GBP/USD cross trades far more than the USD/GBP cross.
The dominant Forex pairs are listed in the following chart.
|Yen Crosses||Pound Crosses||Euro Crosses||Dollar Crosses|
|NZDJPY||CADCHF||New Zealand Cross||AUDUSD|
Technical Trading and Forex
The typical time horizon to trade Forex is intra-day to several days, but rarely longer than a week. Because the time horizon is so short, most speculative Forex trading is completely technical. Learning technical analysis is a key to Forex trading.
Forex trading can also be event-driven, but even in conjunction with the fundamental reaction to the event, there is still an underpinning of technical analysis required to trade Forex.
Anyone who wants to learn to trade Forex will absolutely need to learn technical analysis and proper order entry.
At Maverick FX, we teach our proprietary traders the T.E.S.T. system, which stands for Target, Entry, Stop, and Timeframe.
Whether you are entering a position long or short, the procedures are the same. TARGET is a reasonable expectation of where a position could go, based on previous technical movement of the currency pair. ENTRY is the point at which your order was filled, whether it be a from a market order, limit order, or stop order. STOP is a protective stop-loss order to limit risk. This, too, is based on a reasonable expectation of at which point a trade would be proven broken, again based on sound technical analysis. TIMEFRAME is simply the timeframe you anticipate holding the position until your TARGET price is reached. This could be an hour, several hours, a day, or several days. The timeframe helps determine what a reasonable price movement for both TARGET and STOP would be as well. A currency pair that you could reasonably expect to move 40 pips in an hour may take a week to make a 400 pip movement.
Leverage and Risk Management
The leverage in Forex trading is massive. In the US, as a result of Dodd-Frank, leverage on Forex trading is limited to 50:1, so depositing $2,000 in a Forex account means that you can trade a full lot position of $100,000. Before Dodd-Frank and currently in other countries, the leverage is even higher, often 100:1 or even greater.
This leverage is great when a trade is going your way, but it is the kiss of death when the trade is not going your way.
A common mistake among beginning Forex traders is to trade for dollars rather than trading for pips. At first, this sounds counterintuitive because any movement of any amount of pips in a position will have a direct correlation to the profit and loss on the position. By concentrating on trading for pips, traders are able to concentrate on the technical aspects of the trade itself, entering the trade correctly, taking profits when the trade has run its course, and stopping the trade out for a small, manageable loss when the trade goes against them.
This type of risk management relates directly to position-sizing. For example, let’s say a trader is looking at a technical setup that is approaching an ideal entry point. The trade will be proven wrong if it goes against the trader a total of 40 pips, but there is also a reasonable expectation that the trade could be profitable for a total of 120 pips. The trader calculates the position size for that specific position based on those metrics.
Concurrently, let’s say there is a second trade in a different currency pair that is also approaching an ideal entry point, but this pair is more volatile and needs 80 pips to be proven to be broken, but also has the opportunity to generate 250 pips in profit. The position size for this trade would be half the size of the trade that only needs 40 pips in potential risk.
If the trader put the same dollar amount into each trade, the risk in the second trade is actually twice the risk of the first trade. Trading this way provides no consistency in risk management and actually makes long-term profitability more difficult for the new trader.
The Next Step to Trading Forex
Forex trading is a great way to create wealth, but the inherent leverage in Forex makes ill-educated or unprepared trading a recipe for disaster. If you want to know more about trading foreign currencies, there are many books that treat the subject with the respect it deserves. You can tell which ones are worth reading by the amount of time they devote to risk management and position sizing rather than the mechanics of trading.
If you are serious about trading Forex as a consistent source of income and a way to build wealth, we recommend exploring proprietary trading firms that specialize in Forex Trading. The training program should be robust and support should be extensive and continuous. At Maverick FX, the firm’s in-house training program has over 100 hours of structured training, with subject matter expert support available at all levels and into live trading. The firm should provide supervision to its traders and have a dedicated Risk Manager to guide traders through rough times.
In the end, with proper risk management, trading Forex is an exciting and fulfilling market to learn and trade.Darren Fischer is the CEO of the proprietary trading firm Maverick Trading. Maverick Trading has two divisions. It’s Forex division, Maverick FX has been in operation since 2009 and accepts beginner and professional Forex traders from around the world.