How to Trade Currencies
Currencies were traditionally the domain of businesses, institutional investors, and hedge funds, but online trading has now made it available to individual traders. Currency is the fastest moving and most liquid kind of trading. It far surpasses the speed and volume of equities. Currencies are traded on the ‘foreign exchange’ or forex.
The overall forex market sees average daily volumes of more than $3.2 trillion.48 This is four times more than all the equity and futures markets combined. About 20% of those trades come from businesses that need to move money from one currency to another to conduct international business. Speculative traders account for the remaining 80%.49
The forex market has incredibly flexible hours as different countries around the globe open and close. New York begins at 1pm GMT and closes at 10pm. But Sidney starts at 10pm GMT and then Tokyo opens at midnight. London opens at 8am GMT, just one hour before Tokyo closes and the cycle continues. Currency trading desks set their own hours, but many are open 24 hours a day 5 days a week, closing only for the weekend from Friday evening until Sunday evening.
The most active trading occurs when two markets overlap. For example, London and New York overlap for four hours between 1-4 pm GMT. At this time the USD, EUR, GBP are most actively traded. London and Tokyo only operate together for the last hour of Tokyo and the first of London trading. Trading strategy includes timing. Some traders choose the extra activity of multiple markets and the beginning and closing hours of the London or New York markets. Others prefer the calmer times.
In order to trade currencies, you need to know the terminology used. It’s a bit different than that used for equities. And some of the terms are used differently.
Ask: Also known as offer rate. This is the price you agree to buy the currency and the foreign currency agent agrees to sell it. In currency trading, this is not negotiable.
Base Currency: In a currency pair, the first currency is the base currency. So in the EUR/USD, the euro is the base currency as it is mentioned first. When you buy to open a trade, the base currency is the one you are selling or going ‘short’ If you are trading on margin, this is the currency you are borrowing against to buy the quote currency.
Bid: Also known as the buy rate. This is what you can sell your currency for. Your foreign currency exchanger will buy your currency at this price. Again, there is no negotiation because the spread is where the currency agents make their profit.
Carry Trading: Currency trading is designed to take advantage of the difference in interest rates between two currencies. Usually this is a longer term strategy. Even without price fluctuation, the trader can make money on the difference in interest rates.
Counter Currency: The second currency in a pair that is also called a quote currency because the price quoted is the amount one unit of the base currency can buy of the counter currency. When you buy to open the trade, this is the currency you are buying or going ‘long’.
Currency Pair: Currency trades are always shown as pairs: USD/GBP or EUR/JAP. When you buy to open a trade, you are selling the first and buying the second.
Exchange Rate: Also called the FX rate, or foreign exchange rate. This is listed as decimals out to the fourth place. This tells you exactly how much a unit of your base currency will buy of the counter currency. For example, in the GBP/USD pair, the exchange rate could be 1.2545.
Pip: Also called a point, is an abbreviation for ‘price interest point’. This is the smallest unit of trading and is usually .0001 or 1/100 of 1%. One exception is the Japanese yen which is only calculated out two decimal places. So in trading the yen, a pip is .01.
Rollover: The money your trade gains or loses when kept overnight. It is derived from the difference in the interest rates of the underlying countries and is typically listed as a rollover, overnight, or carry fee on your trading platform. As you increase your leverage, this amount increases as well. The rollover could be positive or negative depending on the pair you’re trading and if you are in a buy or sell position.
Spot Price: The current price for a currency pair.
Spread: The difference between the bid and ask price.
Currency pairs also have their own terminology. Currencies are traded most commonly in seven different pairs.
Major Pairs are any trading pairs that have the United States dollar (USD) on one side of the pair. Major pairs include any variation of these pairs regardless of which currency is the base currency. About 95% of all speculative trading occurs in these pairs:
Commodity Currencies come from countries that rely on commodities for much of their exports. These commodity currencies are also included in the majors:
Crosses are trades that do not involve the USD. Sometimes these are traded to take advantage of different interest rates in longer term carry trading. These might be:
Exotic currencies are traded with much smaller volumes and typically are more costly to trade but can sometimes see much larger swings. These involve currencies such as:
Currency trading is high-risk trading. Trade only with money you can afford to lose. It can be exciting and profitable, but it can also quickly wipe out your account. Be cautious of leverage that also increases your risks.
13.2 Getting Ready to Trade
Many beginning traders fail because they fail to plan. Trading on a hunch is no more than gambling. When you develop a strategy, you increase your chances for successful trades. Most professional traders say that each person must develop their own strategy. It’s helpful to look at how others trade, but your strategy will ultimately be uniquely your own.
Here are six factors that will go into your trading strategy.
- Time of Day: You will want to develop a consistent time to trade. Currency markets have patterns based on the time and the markets that are open. Trading is more active when two large markets, like London and New York, are open at the same time. Decide if you want the fast movements of this time or the slower movements of mid-market times. When both the US and British markets are open, the trades move more pips and the spread is smaller.50
- Technical Analysis: Some traders depend almost entirely on charts and chart patterns to map out currency swings. They look for historical cycles. Others use very little technical analysis, perhaps just enough to find support and resistance lines to guide them on when to enter and exit the trade. Focusing on chart patterns alone lets traders enter multiple currency markets as the patterns may be similar across many charts.
- Fundamental Analysis: In currencies this means looking into the ‘health’ and financial well-being of the country behind the currency. They check employment numbers, debt, consumer spending, import/export, government reports, and other resources. All these give traders indications to help them determine if a currency is strengthening or weakening against another currency.
- Interest Rates: This can be one of the biggest movers of currency. Often the Federal Reserve or central bank will give us helpful hints to prepare the market for interest rate changes. This helps the market factor them in more gradually. But some countries are willing to shock the market. However, sometimes a country will signal that there will be no changes expected in interest rates… and then, BANG! Change the interest rates to shock the market.
Each night a trader keeps the trade open they incur a rollover or a carry rate. This can be positive or negative depending on the difference in interest between the currency pair. The central banks set the interest as a way to heat up or cool down the economy. Carry trading is a kind of currency trading that takes advantage of the short-term interest rate difference. A trader goes long in a currency rate with high interest and finances it with the sale of a currency with low interest.
For example, in 2005 the New Zealand economy was roaring, but the Japanese economy was stagnant. Traders who traded the NZD/JPY earned 7.25% annual return. Traders harvested 725 pips, or basis points, in yields or carry charges alone, regardless of how the currency moved. However, as the currency interest rates start to equalise, traders may rush for the door causing a drop in the selling currency price.
- News Events: Currency traders keep an ear tuned to the latest news events. Government reports, politics, even a presidential tweet can twitch the market. On 15 January 2015, the Swiss National Bank (SNB) suddenly decoupled the Swiss franc from the euro. It caused the Swiss franc (CHF) to rally 23% in a matter of moments. It bankrupted several currency trading firms and rocked the financial world. This is why the news is so vital to traders. And it reminds traders how speculative and risky trading can be. Even with a stop loss order, the price may drop so quickly you will not be filled at your requested price, but at something lower.
In currency markets, there is no such thing as ‘insider trading’. Any news is legal news. Hear a tip from your golf buddy who works in the central bank? You are free to use it. Traders who focus on news and fundamentals more often stick to a few currency pairs so they can keep up with all the information.
- Enter and Exit Plans: Your strategy will also include when you will enter a trade and when you will leave it. Currency trading is high-risk trading. You can and will lose money sometimes. But you may protect your assets with carefully formulated stop loss and limit order settings.
Many traders recommend you set your stop loss with enough room to stay in the trade in minor fluctuations, but not to risk too much capital. Some advise you to place the upside limit with a greater spread than the downside. So if you set your stop loss at 30 pips, you may want to set your limit order to sell at a profit at 90 pips. This way your winning trades will give you three times as much as your losing trades. Trades like this let you absorb three losses for every one win and still come out ahead.
Of course, if you set your limit order too high, it may never be reached before the market turns. This is where your support and resistance lines guide you to the best entry and exit positions.
You may also find an online forex risk/rewards calculator very handy. You put in your buy price the stop you set, and profit target and it will give you the risk/reward ratio.
13.3 How to Make a Trade
While each trading platform is different, walking you through the process of making a trade can be useful. By now you know all trading involves risk. Only risk capital you are prepared to lose and that past performance does not guarantee future results.
You go to the chart and check your support and resistance. You want to buy just after support and sell just before resistance. So you set up your trade and set your stops. This chart has three places where you could have entered the trade at support and exited near resistance.
You decide to enter a buy position at 1.0052. You decide to set your stop loss at the resistance line of 1.0043. Support is at 1.0075, but you decide to set it a little under support at 1.0070 to grab profits if it turns before the top. That gives you an upside of 20 pips and a downside of 7 pips minus the spread. You’ve checked the fee schedule and know the spread is 3 pips.
You click the plus or minus tab, or just click on the amount and change it to the amount of money you want to trade. You choose your leverage rate. As you click on the leverage tab, it will give you the different amounts of leverage you can use, from no leverage (1x) from no leverage (1x) up to as high as 400x on some currencies, which is an incredibly high risk. As you put in your amount and leverage, your preset stops and limits will update automatically.
Go in and click on them to set the limits you’ve chosen. You can choose a dollar amount, or you can choose a percentage. If you decide you are only willing to take a 5% loss, you will set your stop loss at 95%. If the value of your trade drops below 95%, it will trigger the sale. On the other side, you may preset a 10% profit point. Simply type in the rate ‘1.10’ and the platform will convert that to a dollar amount that takes into account your leverage.
Then simply click the open trade button. When you trade with preset exit points, you take the emotion out of the trade. You let the market make its little swings without panic. You’ve chosen the maximum loss you’re willing to risk against the hoped for gains. Either the trade will trigger a win or a loss. You are free to focus on your next trade.
13.4 Controlling Risk
Because much of the profit in currency trading is made in pips which are only .0001 unit (dollar, pound, euro), it’s easy to want to magnify those profits by using large amounts of leverage. After all, if you trade $5000 and make a 20 pip profit, it might total only about $10. But if you leverage it by 10x, that’s $100 and if you leverage it by 100x, that’s $1000. Now you’re making money.
The downside is that you run the real risk of losing money as well. That $5000 trade could equally cost you 2% to 20% of your equity. What are some ways to reduce risk while increasing the chances for profits?
- Start trading with lower leverage and work up as you master your strategy
- Eliminate emotion from the trade by setting exit points, both stop loss and take profit orders.
- Use discipline in your trading. Create your strategy and trust it. Many traders bail out of a trade too soon and lose out. Others let their losses mount up in the hope things will change for the better. Stick to your plan.
- Don’t get married to your trade. It is not a reflection of your intelligence. It’s a trade. Exit it when you planned. Be very cautious about adjusting the stops.
- Use expendable money. You will feel less emotion when you don’t bet the farm and you trade with money you can afford to lose.
- Visualise the full amount. You may only be trading with $500. But if you have leveraged it to $5000 or $50,000, think and feel like you are controlling the entire amount. This is real money. While you may only have $500 invested, you are accountable for the full amount.
- Make sure your trading platform is regulated by a major oversight authority. This way you are assured of greater transparency.
13.5 Tips for Currency Trading
As you begin currency trading, remember these basic methods to help you toward more profitable trading. Currency trading always involves risks. You can feel more confident as you take it step-by-step.
- Understand how and why currency moves. Spend time seeing the correlation between interest rates, news events, the fundamentals and technical analysis, and how your chosen currency moves. The best traders are always learning.
- Start with one trading pair. Spend time just trading one pair. Learn to see the patterns and thoroughly understand the news surrounding it. Which reports make the currency move? Your depth of knowledge in one currency pair and the skills you develop are more likely to help you see patterns and entry points you might miss if you dilute your focus.
- Keep a diary of your trades. Why did you enter the trade? Write down the date and time you entered the trade. Record your entry points and exit points, both stop loss and limit order. Record the results. Why did you exit? Did you follow your strategy? Jot down notes and reminders of things you learned from this trade.
- Set your limit order so you have more upside gain than you will lose if you are stopped out. That way, even if you only succeed 50% of the time, you will still be ahead. Don’t be unrealistic about the upside gains.
- Technical analysis may reinforce the trade or be a self-fulfilling prophecy. Every trader sees the same charts you look at. They are setting the same support and resistance lines. When they begin to react to the market, it creates a volume of traders all acting in the same pattern.
- You won’t make money on every trade. You’re going to lose some. Accept it with ease. The less emotional you can be about both wins and losses, the more control you will have in your trading.
- Choose a reputable trading platform. Look for one that is easy to use, trades the markets that you want to trade, and has reasonable transaction costs. An active community of investors on the forums can help answer questions and guide your trading decisions. Traders who allow you to follow them can jumpstart your trading.
Currency trading can be exciting and profitable. It offers tremendous liquidity and flexible trading hours. The higher leverage offered by different brokers allows you to make quicker profits than most other markets while being mindful of the risks. Know the risks and don’t trade money you can’t afford to lose. When you look at successful currency traders on eToro you will see the capital they put at risk in balance with the earnings they gain.
This is a marketing communication and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to buy or sell, any financial instruments. This material has been prepared without having regard to any particular investment objectives or financial situation, and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past performance of a financial instrument, index or a packaged investment product are not, and should not be taken as, a reliable indicator of future results. eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this publication, which has been prepared utilizing publicly-available information.
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48‘Trading Basics You Should Know’, XE https://www.xe.com/currencytrading/basics.php
49Schlossberg, Boris ‘Top 7 Questions About Currency Trading Answered’, Investopedia 3 May 2017 http://www.investopedia.com/articles/forex/06/sevenfxfaqs.asp
50Mitchell, Cory, ‘Best Time to Day Trade the GBP/USD Forex Pair’, the balance 14 Oct 2016 https://www.thebalance.com/best-time-to-day-trade-the-gbp-usd-forex-pair-1031020