6, in a section thatcovers risk management, the full meaning and nuances of using stoplosses will be discussed.Stop losses are exactly what they appear to be. They actually “stop losses.” A stop loss is a form of pending order that canbe attached to any open order or position, whether that trade wasoriginally a market order or an entry order.A stop loss closes an open trade when that trade reaches a predetermined level of loss. It is the price point at which a trader nolonger wishes to be involved in the trade because of the desire tolimit losses to a manageable level.When using technical analysis (which will be discussed in greatdetail in Chapter 3), a trader will employ a stop loss to get out of alosing trade once that trade no longer makes sense from a technicalprice perspective.For example, if a currency pair’s price breaks out above a critical resistance line, and a technical trader then buys the pair in hopesof profiting on a continued price climb, a sensible location for atechnical stop loss would be right below the line from where pricebroke out. This is because if price subsequently retreats back belowthe line, it is no longer considered a valid breakout trade and thetrade no longer makes sense. Stop losses are an incredibly useful toolfor predetermining trade risk and limiting catastrophic trading losses.
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The close cousin to the simple stop loss is the trailing stoploss. Whereas a stop loss is, by definition, a static order to close atrade at a predetermined loss level, a trailing stop loss is a dynamicorder to close a trade at progressively better prices. The primarypurpose of a trailing stop loss order is to limit losses while automatically locking in gains. A trailing stop loss accomplishes this by systematically moving the stop loss as the price moves in favor of theposition.For example, a trader buys the EUR/USD pair. The trader thenwishes not only to limit losses if price goes against this long position, but also to lock-in gains if price favors the position. To accomplish this, the trader would set-up a trailing stop loss. If the stop-lossis set to trail the market price by 20 pips (the concept of pips willbe described shortly), it will actually follow the price dynamically byan increment of 20 pips as the market moves, but only if the marketmoves in a favorable direction.The key concept to remember is that the trailing stop will onlymove one way—in favor of the trader’s position. If price movesagainst the trader’s position, the trailing stop will not move. And ifprice moves against the trader’s position by more than the predetermined trailing stop increment, the trade will automatically be closedby the trailing stop. If this occurs after a long price run in favor ofthe trader’s position, substantial profits will have been gained whilehaving dynamically limited losses from the outset.Trailing stop losses are often key components of professional riskmanagement strategies, and can be used to great advantage by thetypical foreign exchange trader.
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Exit with Caution
P rofit Limits — When You ’re in the MoneyAnother important type of exit order is the profit limit. Profit limitscan be considered the direct opposite of stop losses. The purpose ofa profit limit order is to close an open trade automatically at a predetermined, profitable price level so that the trader may realize thoseprofits into the trading account.A profit limit order is set up much like a trader would set up astop loss order, only in the opposite direction.Profit limits are set primarily with the intention of realizing andsecuring profits before price reverses and erases those profits. Whenforeign exchange traders set entry orders, they will often also setboth stop losses and profit limits so that there is a contingency forany direction price may take within a given trade.
E xit with CautionThe last type of trade exit to be discussed here is the manual exit,or manual close. This consists of simply closing an open trade at thecurrent market price, much like a trader would open a trade atthe current market price with a market order.Relying on manual exits instead of preset exits can be a dangerous practice for beginners. Much like traders who over rely on market orders may be prone to opening positions haphazardly becauseof emotions like greed or fear, traders using manual exits may fallinto the same type of trap.Mental stops—which means a trader has an “intention” to manually close out a losing trade at some point of financial pain, but
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does not actually set the stop loss—fall into the category of manualexits. For obvious reasons, mental stops can potentially be dangerous,especially if the trader does not actually have the necessary disciplineto close the losing trade and avoid a catastrophic loss.On the profit end of the spectrum, manual exits can also bepotentially disadvantageous. If a strict profit limit that conforms toa properly planned risk:reward ratio is not set (risk:reward is discussed further in Chapter 6, which covers risk management), tradersare often tempted prematurely to close winning positions manually.In other words, with manual exits, fearful beginners will often closetheir trades too early and with too small a profit to become consistently successful traders.
T rade Size — Lots and Lots of LotsWhether entering or exiting a currency trade, how much of a givencurrency is actually being bought or sold? The answer lies in the lot.The closest equivalent to a lot in the financial markets is the contract, which is standard futures trading terminology. Lots, much likethe role of contracts in the futures markets, are the standardized unitsof trade that are bought and sold in the foreign exchange market.There are several types of lots available to trade that are classifiedaccording to size. Standard, mini, and micro (or super-mini) are generally the main terms used by retail forex brokers and traders to describethe different tradable lot sizes. A standard lot is sized at 100,000 currencyunits, while a mini lot is 10,000 units, and a micro lot is 1,000 units.These lot sizes are defined in generic unit terms because the specific currency represented by the units depends on which currency
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Leveraging Margin and Leverage
pair is traded. For example, if a standard lot of EUR/USD is traded, itwould be 100,000 euros. In contrast, if it was a standard lot of AUD/JPY, the lot size would be 100,000 Australian dollars.It is vitally important that a trader chooses a lot size that isappropriate to that trader’s account size and risk tolerance. The lotsize chosen by the trader affects virtually all other aspects of trading.This includes the margin required to enter and keep open a giventrade; the monetary value per pip movement in price; the amountpaid in spread costs; and the amount of interest paid or received. Allof these topics will be described next within this chapter.
L everaging Margin and LeverageThe concepts of margin and leverage are extremely important.Margin is the actual amount of trading equity in a trader’s accountthat is available to use for controlling currency positions. Leverage isthe multiplier by which a trader can magnify the financial controlling power of margin.Because of the high leverage common in foreign exchange trading, a trader is able to trade a large lot amount like $100,000 withonly a small fraction of this amount in trading account margin.Common leverage ratios currently offered by foreign exchangebrokers range from 50:1 on the low side all the way up to 400:1 onthe high side. The sheer magnitude of this level of leverage, evenon the low side, far eclipses the amount of leverage available in otherfinancial trading markets.In practical terms, what this means to the foreign exchangetrader is that a standard lot of $100,000, for example, can be
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traded in the USD/CHF currency pair with only $250 in trading account margin. This is assuming that the maximum leverage of 400:1 is utilized. In other words, for every $1 that a traderhas invested in a forex account, that trader can control a whopping$400 in a currency trade. In this particular example, the $250 in thetrader’s trading account can control a trade of $100,000, using 400:1leverage.Of course, like many good things in life, the massive amountof leverage offered in foreign exchange trading can be viewed asthe proverbial double-edged sword. The fact that a small amount ofmoney controls a large amount of money in forex trading can certainly serve to magnify profit potential. But on the flip side of thecoin, the amount of risk inherent in highly leveraged trading likethis is equally magnified.Therefore, it is advisable to use caution when trading with thesubstantial leverage common in forex trading. Highly leveraged trading is aggressive trading that is characterized by both high risk andhigh potential reward.
M argin Call — Insufficient FundsThe risk that is assumed when trading aggressively in currencies isprimarily confined to the dreaded margin call. But contrary to thepopular opinion that a margin call represents the worst-case scenario for a trader, this is far from the truth. The worst case could befar worse.A margin call is actually a safeguard to protect the trader fromlosing 100%, or even more, of the money in a trading account.
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Margin Call—Insufficient Funds
To owe additional funds to a broker is actually the worst-case scenario, and this uncomfortable situation is largely avoidable becauseof the existence of the margin call.Unlike in the world of traditional stock trading, a margin callin foreign exchange trading is not actually a physical call from thebroker to add additional funds to the margin account when equityis running low. In forex, if a trader no longer has enough equity inthe trading account to keep the open position(s) viable, the trading platform software automatically closes out all open positions andimmediately realizes all losses at the prevailing market rates.Although this may seem a bit cold-hearted, there are good reasons for automated margin calls in foreign exchange trading. Pricescan move extremely fast in the forex market, and because of thehigh leverage involved, every price move is magnified. Therefore,when a trader’s equity runs low, the account can become depletedquickly and there is usually not enough time to call for more funds.As a safeguard measure, the forex margin call closes all open positions to help ensure that the trader does not lose the entire account,or worse.So when exactly is a margin call triggered? This depends entirelyon the number and size of the lot(s) traded, the leverage chosen,and the equity in the account. But generally speaking, a margin callis triggered when a trading account no longer has sufficient equityavailable to maintain the required margin for the positions that arecurrently open.For example, suppose a trader has $2500 in a trading account,and leverage of 100:1 with a standard lot size of 100,000 units pertrade have been chosen as the settings for this account. If this trader
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wishes to buy one lot (or GBP£100,000) of the GBP/USD pair,USD$1970 in margin is required to be put up, as per the exchangerate at the time of this writing. This is because £1000 is needed tocontrol £100,000 at 100:1 leverage. But since the trading accountis denominated in U.S. dollars, this £1000 needs to be convertedinto the U.S. dollar equivalent (which, at the current exchange rate,comes out to around $1970).Each minimum price movement, or pip (explained in thenext section), is worth exactly USD$10 in this scenario. If weassume that this trader does not place any stop losses and the market goes against the position, every price movement against theposition will bring down the account equity by $10. So, onceagain, if the trader has an initial $2500 in a trading account andthe margin required to keep the trade open is $1970, the accountwill experience a margin call and the position will automaticallybe closed once equity dips below $1970, which is $530 below theinitial account equity. At $10 per pip, this constitutes a potentialpip loss of around 53 pips (minus the spread) before margin call isreached.The obvious problem with the example just given is that thetrader entered into an inordinately large trade for the amount offunds in the trading account, and the trader also failed to use a stoploss. Of course, margin calls and even more horrible doomsday scenarios can easily be avoided just by using some good old-fashionedtrading prudence. This includes using stop losses and only entering trades that are sized appropriately in proportion to the size ofthe trading account. This will be discussed further in the sectioncovering risk and money management in Chapter 6.
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P i p s — T h e C u r r e n c y o f C u r r e n c y Tr a d i n g
P ips — The Currency of Currency TradingUp to this point, pips have been lightly touched upon but not properly defined. An extremely important concept in foreign exchangetrading, a pip is simply the smallest unit of price movement in theexchange rate of a currency pair. Pip can stand for “percentage inpoint” or “price interest point.” But regardless of the exact acronym definition, its practical meaning is clear. Traders trade foreignexchange in order to earn pips. Earned pips are the reward for agood trade, while lost pips are the punishment for a bad trade.Loosely akin to the “tick” found in other financial markets, a pipmost often refers to the smallest change in the fourth decimal placeof most major currencies. This would be the equivalent of 1/100th ofone percent, or one basis point. The notable exception to this wouldbe currency pairs denominated in Japanese yen, or JPY, in which apip would constitute the smallest change in the second decimal place.So, for the vast majority of currency pairs like EUR/USD orGBP/CHF or AUD/NZD, the exchange rate format would looklike x.xxxx, where a change of 0.0001 would constitute a pip movement. On the other hand, for the handful of currency pairs featuring the yen, like USD/JPY or GBP/JPY, the exchange rate formatwould look like xxx.xx, where a change of 000.01 would constitutea pip movement.Calculating the exact value of each pip for the currency pairand lot size traded is the job of the broker’s trading platform, whichshould include some kind of pip calculator created expressly for thispurpose. In its absence, however, here is a simple calculation:Value Per Pip = [Lot Size] ⫻ [Number of Lots] ⫻ [Pip Size]
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The result of this equation will be denominated in the quotecurrency (the second currency in the pair). No currency conversionis needed for U.S. dollar-denominated trading accounts if the quotecurrency is already USD. To obtain the dollar value per pip if thequote currency is anything other than USD, however, the result mustbe converted to dollars using the current exchange rate between thequote currency and the U.S. dollar. Here are a few examples:Example 1: Pip value for 1 standard lot of USD/JPY = 100,000[Lot Size] ⫻ 1 [Number of Lots] ⫻ 000.01 [Pip Size] = ¥1000(quote currency in Japanese yen)Dollar pip value = ¥1000 ÷ 101.00 [current USD/JPY exchangerate] = $9.90/pipExample 2: Pip value for 1 standard lot of EUR/GBP = 100,000[Lot Size] ⫻ 1 [Number of Lots] ⫻ 0.0001 [Pip Size] ⫽ £10(quote currency in British pounds)Dollar pip value ⫽ £10 ⫻ 1.9750 [current GBP/USD exchangerate] = $ 19.75/pipExample 3: Dollar pip value for 1 standard lot of EUR/USD ⫽100,000 [Lot Size] ⫻ 1 [Number of Lots] ⫻ 0.0001 [Pip Size] ⫽$10/pip (quote currency already in U.S. dollars)This may all seem very confusing at first to the beginning trader,but again, most forex trading platforms come well-equipped witha pip calculator that provides all pip values. If this calculator is notoffered, it helps to keep in mind that all currency pairs ending inUSD (as the quote currency) will be $10/pip for a standard lot,
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Spreading the Wealth—Spreads or Commissions
$1/pip for a mini lot, and $0.10/pip for a micro lot. This includesheavily traded pairs like EUR/USD, GBP/USD, and AUD/USD.For other key pairs like USD/JPY, USD/CHF, and USD/CAD,their exchange rates as of this writing conveniently place their pipvalues in the same approximate vicinity as the pairs ending in USD.For a standard lot, these pairs are currently at $9.87/pip, $9.99/pip,and $9.80/pip, respectively.Finally, it should be kept in mind that while the lot size, amountof lots traded and specific currency pair traded will certainly affectpip value, the leverage chosen by the trader, whether it is 50:1, 400:1or somewhere in between, has absolutely no bearing whatsoever onpip value.
S preading the Wealth — Spreads orCommissions?Closely related to pip value is the much-discussed topic of spreads.Futures and equities traders have been accustomed to paying commissions to their brokers on each and every trade, pretty much sincethe beginning of time. Within the past decade or so, retail foreignexchange brokers began emerging with their promises of nocommissions.Most recipients of this still-enduring marketing message eventually come to realize that the broker must somehow make money, ifnot through the “commissions” label. The moniker for forex brokerrevenue is therefore known as the spread.A spread is simply the difference in pips between the bid price(exchange rate at which a trader can sell a currency pair) and the
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ask price (exchange rate at which a trader can buy a currency pair).Often, one may view an exchange rate quoted much like the following: 1.5850/53. This type of quote provides first the bid priceand then the ask price as a variation of the bid. In this case, the twoprices are separated by three pips.These pips represent the spread, which is essentially the paymentmade to the broker for services rendered, in lieu of commissions.With most forex brokers, the spread is manifested immediately ontrade entry. That is, once a trade is entered, whether it is a buy orsell, the open position immediately displays a running loss equivalent to the magnitude of the spread.The spread deficit then needs to be overcome by favorable pricemovement before the trader can break even and have the opportunity to profit off the position. It should be made clear that thisspread is charged only once on an entire trade cycle, from the openof the position to the close. Spreads are never charged twice on asingle round-turn trade.Most spreads on the major currency pairs, including EUR/USD,USD/JPY, GBP/USD, and USD/CHF, are usually in the vicinity oftwo to five pips wide. Looking back to the previous section on pipvalues, we can easily extrapolate the spread cost per trade.For example, if trading one mini lot of EUR/USD, which mayhave a spread of 3 pips with a certain broker, the spread value forthis trade would be USD $3.00 (as each pip on a EUR/USD minilot is worth USD $1.00). This would constitute the primary transaction cost incurred for making the trade.Generally speaking, spreads can either be variable or fixed. Manyof the variable-spread brokers will advertise their tight spreads that
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Interest—Giving and Receiving
prevail during quiet markets, but then widen the spreads considerably and without notice during the faster, more volatile markets.These faster markets usually occur around relatively frequent economic news announcements. Widened spreads during trading canpotentially wreak havoc on open and/or pending positions. Thiscould potentially include missed or prematurely triggered tradeentries, stop losses, profit limits, or even margin calls.Fixed-spread brokers, on the other hand, usually offer spreadsthat are slightly wider, but then actually keep those spreads fixedat a constant level, regardless of market conditions. This offers theclearly significant advantages of increased price certainty and fewersurprises. If a trader plans on ever buying and/or selling currenciesduring any type of fast market, it may perhaps be in the trader’s bestinterest to choose a fixed-spread broker.As for whether spreads or commissions are better, the jury is stillout. As mentioned earlier, spreads and commissions both effectivelyrepresent a transactional payment by a customer for services offeredby a broker. Assuming the amount is comparable, there is little difference beyond their labels. As of this writing, the vast majority offorex brokers continue to use the spread model, and this situationappears unlikely to change significantly within the near-term, foreseeable future.
I nterest — Giving and ReceivingThough spreads are certainly the primary transactional cost in foreignexchange trading, there can also be a secondary cost that dependsupon the currency pair traded, direction of the trade, and length of
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time the position is held. Interestingly enough, this potential secondary cost can either be avoided altogether or even turned into a highyielding positive. In foreign exchange trading, this phenomenon isknown variously as “swap,” “cost of carry,” or simply “interest.”There is actually an entire trading strategy called carry tradingthat is based on earning highly leveraged, high-yield interest returnsthrough holding strategic currency positions. This method willbe discussed in-depth in Chapter 5, which covers specific tradingstrategies.For now, though, a simple example will help illustrate the concept of interest in foreign exchange trading. At the time of this writing, the Reserve Bank of Australia shows a relatively high centralbank interest rate for the Australian dollar at 7.25%. The Bank ofJapan, on the other hand, has kept the rate on the yen very low at0.50%. The differential between these two rates (6.75%) is where thepotential opportunity, as well as the potential cost, resides.As described towards the beginning of this chapter in the section“Going Long and Selling Short,” if a trader buys the AUD/JPY pair,that trader is essentially buying the Australian dollar (with the currently high interest rate) while simultaneously selling the Japaneseyen (with the currently low interest rate). The net effect is that theposition would earn the high rate while paying the low rate. Thiscreates a net-positive interest yield for the trader that is approximately based on the rate differential between the two currencies. Inthis AUD/JPY example, the yield is based on the current 6.75% differential (minus an interest spread cost).Conversely, if the trader sells the AUD/JPY pair, that trader isessentially selling the Australian dollar while simultaneously buying
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Interest—Giving and Receiving
the yen. The net effect is that the position would earn the low rate(JPY) while paying the high rate (AUD). This creates a net-negativeinterest deficit for the trader that is approximately based uponthe rate differential between the two currencies. In this AUD/JPYexample, the deficit is based upon the current 6.75% differential(plus an interest spread cost).Usually, traders would hardly get excited about the prospect ofearning or paying seemingly insignificant sums due to interest, especially within the fast-paced, volatile world of currency trading.But an extremely key point here that does often succeed inexciting traders is that the interest earned or paid is based on theleveraged amount traded, and not just upon the trader’s fractionalmargin amount. In other words, to use the same AUD/JPY example, differential-based interest is actually earned or paid on the leveraged A$100,000 in the standard lot (100:1) trade, and not just onthe A$1000 that the trader puts up in margin to make the trade.This can have enormous implications for traders who routinely holdtheir positions open, as the potential profit or loss every day due tointerest alone can be very substantial.Whether the trader pays or earns the interest, it is calculateddaily according to the leveraged net interest rate differential of thetrader’s open position(s), taking into account the inevitable interest rate spread cost. With most foreign exchange brokers, the dailyamount paid or charged to the trader (depending on the directionof the position(s), long or short) is added to or subtracted from thetrader’s account each day when open positions get “rolled over” (asdescribed in Chapter 1). This process generally occurs at the sametime every trading day, and is usually at the end of each business day,
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but the specific time varies among the different foreign exchangebrokers.Whether a trader seeks to avoid interest charges, gain interestpayments, or neither, it is extremely important to be aware of howinterest may affect all foreign exchange positions.
H edging — Two Sides of the Same CoinThe final topic for this chapter on basic foreign exchange tradingmechanics may not be quite as basic as the other topics in this chapter.Hedging is a rather specialized trading function that not every traderutilizes. In fact, most foreign exchange brokers do not even offer it ontheir trading platforms. But if available, hedging can be a useful toolfor those traders who have specific strategies for employing it.To hedge is to be long and short in the same currency pair atthe same time. For example, if a trader buys one lot of USD/JPYand sells one lot of USD/JPY at the same time, that trader can besaid to be in a perfectly hedged trading situation that is completelyprofit/loss-neutral. In other words, any price movement in the currency pair—up, down, or sideways—would not exert the least bit ofinfluence on a hedged trade.So why, then, would a trader utilize a trading functionality thatmimics not taking a position at all? Some traders have developedstrategies—especially those geared toward exploiting news-drivenprice spikes—that involve the strategic use of hedging. For themajority of traders that do not employ hedging, though, it is sufficient at least to be aware that hedging exists, and that it can potentially be used for protecting a one-sided currency position.
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Chapter Summary
Those brokers that do not offer hedging simply close the original one-sided position if an opposite position in the same currencypair is initiated. For the hedging brokers, however, opposite positions in the same currency pair are treated as two open positionsthat effectively cancel out each other’s running profit/loss.One final note about hedging is that since two exactly opposing positions are profit/loss-neutral, and therefore create essentiallya riskless trading scenario, brokers that offer hedging usually requiremargin on only one side of the hedge. The other, opposing side isa margin-free trade. This means that none of the trader’s tradingequity needs to be used to open and sustain the second leg of ahedge.
C hapter Summar ySince currencies are always traded in pairs, their value is determinedby the market on a relative basis rather than an absolute basis. Inforex trading, one currency can only have value if it is comparedand contrasted to another currency. Because of this fact that forex isall about trading one against another, both going long (buying) andselling short (selling) always involve betting on one currency whilesimultaneously betting against another. So being long EUR/USDmeans buying EUR while selling USD, and being short EUR/USD means selling EUR while buying USD.There are a few methods for entering into forex trades. A market order opens a trade at the current market price. An entry orderplaces an order to open a trade if price reaches a certain level predetermined by the trader. Similar to the way trades are entered, they
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can also be exited. This can be accomplished through manually closing the trade, which is the exiting equivalent of the market orderentry, or through predetermined stop losses and profit limits.Factors that affect trading significantly include lot size and leverage. Lot size is the actual amount that is being traded, while leverageis the degree to which a trader’s financial power can be magnified inorder to control more in a trade with less capital.A margin call is a safety measure that occurs when a trader nolonger possesses enough equity in the trading account to supportopen position(s). In this event, all open positions are automaticallyclosed at the prevailing market rates, thereby preventing even furthercatastrophic account losses.Pips are the smallest unit of currency movement, and they serveas the primary measure of profit or loss in currency trades. Spreads,which are the main transaction cost incurred by traders when trading with the vast majority of forex brokers, are measured in pips.A spread is simply the difference between the price at which a currency pair is bought and the price at which it is sold. This difference,which varies with each broker, is automatically deducted once fromeach round-turn trade (open and