00%instead of 100%.). The structure of currency pairs as they are tradedin the foreign exchange market will be discussed in Chapter 2,which covers basic trading mechanics.Because of the fact that only a few currencies form most of theactivity in the foreign exchange market, which means that thesecurrencies are the most liquid and active, it is usually recommendedfor beginning traders to concentrate initially just on the majorcurrencies. This avoids confusion and promotes focus in trading.When matched together into predetermined currency pairings(as will be described further in Chapter 2), these currencies make upthe four “majors.” These majors are all U.S. dollar-based and include,first and foremost, the EUR/USD (euro against U.S. dollar). Thiskey currency pair is considered not only the most actively tradedcurrency pair available, but also the most actively traded financialinstrument in the world.Following behind EUR/USD are USD/JPY (U.S. dollar againstJapanese yen), and GBP/USD (British pound against U.S. dollar).
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Playing in the Majors
Finally, USD/CHF (U.S. dollar against Swiss franc) has even lessliquidity because of the progressively diminishing market activity ofthe Swiss franc over the years, but it is still considered one of themajors. AUD/USD (Australian dollar against U.S. dollar) and USD/CAD (U.S. dollar against Canadian dollar) are next in line in terms oftrading activity, but are not generally considered among the majors.
IN THE REAL WORLD
Currency TerminologyAs in other businesses and industries, foreign exchange tradinghas evolved its own vernacular over time. To outsiders, some ofthe terminology used by professional forex traders may seem abit peculiar. But it has become virtually a language unto itself forthose that deal with currencies on a daily basis. Here are someof the most common examples of currency terminology:Currency or Currency Pair
Common Terminology
GBP (British Pound)
Sterling
CAD (Canadian Dollar)
Loonie
USD (U.S. Dollar)
Greenback
AUD (Australian Dollar)
Aussie
NZD (New Zealand Dollar)
Kiwi
EUR/USD (Euro/U.S. Dollar)
Euro
GBP/USD (British Pound/U.S. Dollar)
Cable
USD/JPY (U.S. Dollar/Japanese Yen)
Dollar-Yen
USD/CHF (U.S. Dollar/Swiss Franc)
Dollar-Swiss or Swissy
USD/CAD (U.S. Dollar/Canadian Dollar)
Dollar-Canada
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Unlike stock trading, where there are countless possible securitiesto choose from, foreign exchange trading is much simpler and morestraightforward in terms of selecting trades. Sticking to the majors—asmany foreign exchange participants are wisely apt to do—allows traders to focus their efforts in an efficient manner rather than dispersetheir attention among a multitude of different securities. In a timemarked by progressively increasing information overload, a limited setof trading options can certainly be seen as a significant benefit.
L everaged to the HiltAnother feature of foreign exchange trading that differentiates itfrom other financial markets is the astronomical levels of leveragethat are commonplace in the forex world. The specifics of utilizing this leverage will be discussed in Chapter 2. For now, though, itshould be known that many foreign exchange brokers will offer upto 400:1 leverage on the average retail trading account. This meansthat $1 in a trader’s forex account can control up to $400 in a currency trade. The implications of this are mind-boggling. No othermajor financial market offers even close to this kind of leverage.As will be discussed further in Chapter 2, however, this can beboth a very positive feature as well as a very negative one. By definition, leverage is a type of financial magnification. While it is truethat high leverage magnifies profits, it will also magnify losses equally.Oftentimes, it is this high level of leverage that summarily wipes outotherwise healthy trading accounts. Used with a great deal of caution,however, high leverage of the magnitude found in forex trading canoffer tremendous possibilities to the upside as well as to the downside.
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The Players
T he PlayersKnowing and understanding who the primary players are within theforeign exchange market goes a long way in helping individual traders approach the market in an informed manner. In terms of market impact, the most influential group of participants in the forexmarket would have to be the major banks. From the perspective ofspeculative trading, these banks have a great deal of funds to throwaround, and the traders at many of these banks are responsible formoving astronomical amounts of money. Of course, banks also do alot of nonspeculative currency exchanges for clients, but the speculative activity is really what moves the currency markets in the mostdramatic manner. When there are big, sudden moves in currencyprices, more often than not the banks, as a collective entity, are behinda good portion of the move.Next in the hierarchy of speculative currency traders wouldhave to be the hedge funds and other investment firms. In recentyears, these entities, which often control a great deal of discretionaryclient equity, have progressively increased their speculative activitiesin foreign exchange. Because of the sheer enormity of the funds attheir disposal, some of these firms come close to rivaling the majorbanks in their power to influence the currency markets.Other participants in the foreign exchange market are not generally considered speculative players, and therefore may not be as influential in their trading activities as the participants described above.These include the central banks, which, as discussed earlier, are notconsidered speculative in their market activities. Rather, central banksget in the game primarily to further their economic policy agendas.
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Because of their vast importance in helping ultimately to determinecurrency value, however, central banks certainly have the potential toimpact currency prices with their attempts at currency manipulation.Companies wishing to convert their funds to a foreign currencyin order to purchase foreign goods or services are another example of nonspeculative market players. When their currency exchangeactivities are factored in collectively, these companies may help partially determine the course of international trade flow. Though thiscollective activity can certainly have some lasting impact on the currency markets, it is perhaps not influential enough to be of great significance to speculative foreign exchange traders.The last group of market participants in foreign exchange is, byfar, the smallest and least significant with regard to influence on themarket as a whole. This group consists most notably of people likeyou, the individual retail trader. Whether you have $100 or $100,000or even more to trade through your retail forex broker, none ofyour trading activity will likely ever move the currency markets inany appreciable way. That is not to say that you are at all unimportant. Rather, it just means that your trades, along with those of everyother individual forex trader combined, will probably never influence the direction of the vast foreign exchange market. This, again,goes back to the sheer size and liquidity of the market, as well asthe fact that its activity is so overwhelmingly dominated by wellheeled financial institutions whose funds dwarf those of individualretail traders.But while retail traders, via their brokers, will unlikely everinfluence the course of the foreign exchange market, they cancertainly learn how to trade it effectively and hopefully to extract
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What Moves the Forex Markets?
profit from it. That is precisely the goal for the rest of this book.From basic forex trading mechanics to common analytical methodsto specific trading strategies and risk management techniques, thisbook is intended to steer individual traders effectively through themaze that is foreign exchange trading.
W hat Moves the Forex Markets?In order to steer through this maze successfully, foreign exchangetraders should become familiar with the forces that drive this market. Although there are many traders who insist that market drivers,or causes of price fluctuations, are unimportant because everythingis already reflected in price action on the charts, it would be a gravemistake to ignore the fundamental roots of market movement.As will be discussed further in Chapter 4 on fundamental analysis,knowing what moves the forex market is integral to becoming aninformed, and therefore well-equipped, foreign exchange trader.The primary movers of currency exchange rates are all tied tothe basic forces of economics, as will be described in detail withinChapter 4. For now, though, a simplification of the cause of currency exchange rate movement can be said to relate directly to theprocess of international capital flow. This is simply the movement ofmoney from one currency to another. International capital flows, inturn, are caused by basic economic supply and demand factors.As will be expounded on in Chapter 4, supply and demand aredetermined by a number of different factors. Most notably, these factors include a country’s interest rates, inflation situation, GDP growth,employment, trade balance, and other barometers of economic
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health. If demand for a currency increases (and/or supply decreases)as a result of one or a combination of these factors, that currency’sexchange rate will generally increase in relation to other currencies. Conversely, if demand for a currency decreases (and/or supplyincreases) as a result of one or a combination of the factors above,that currency’s exchange rate will generally decrease in relation toother currencies. It is a simple concept, but one that is not so simpleto utilize in attempting to forecast market directions.Aside from the fundamental market drivers just described, technical factors are often overlooked or underestimated in their abilityto help move the forex markets. Although this will all be discussedin great detail in Chapter 3, a brief explanation here will help illustrate the point.Traders in many banks, hedge funds, and other potential marketmoving institutions will often use certain techniques of technicalanalysis to help them make trading decisions. These traders all haveaccess to the same price charts. Furthermore, these charts all showthe same patterns, key price levels, and technical phenomena, withperhaps just some minor differences due to variations in the traders’individual interpretations.This means that these influential players are generally all seeingthe same types of technical events on the charts, which will oftenprompt many of them to buy at a similar price level, as well as sell at asimilar price level. When a great deal of institutional money is on thesame side of the market at the same approximate price level, pricescan and will be influenced in one direction or another. In fact, thisphenomenon of collective trading activity by influential market players is considered one of the primary causes of support and resistance
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What to Expect from This Book
levels being respected so precisely in many instances. One of the mostsignificant concepts in foreign exchange trading, support/resistancewill be explored in much more detail in Chapter 3, which coverstechnical analysis.
W hat to Expect from This BookThe core of this book begins with in-depth descriptions of basic foreignexchange trading mechanics in Chapter 2. This includes all of the terminology and explanations necessary to get started in foreign exchangetrading. From the structure of a currency pair to the intricacies of margin and leverage as they pertain to forex trading, Chapter 2 will gettrue beginners up and running quickly. The chapter is also directed atexperienced traders coming from other financial markets, serving as athorough discourse on the unique intricacies of trading currencies.Following the chapter on basic trading mechanics is Chapter 3,which is a comprehensive discussion of technical analysis as it isapplied to foreign exchange trading. The tools of technical analysis are perhaps the most tangible and accessible trading tools available to the individual foreign exchange trader. Software programsused specifically for charting prices in the foreign exchange market abound, and they provide the most popular way for most currency traders to make trading decisions. From free-hand trendlinesto mathematically derived chart indicators to complex pattern formations, the primary tools of technical analysis, as they are used totrade forex market movement, will be the sole focus of Chapter 3.Next is Chapter 4, which is devoted exclusively to fundamental analysis as it applies to foreign exchange trading. This important
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discipline can best be described as the study of factors that drivecurrency exchange rate movement. From interest rates to inflationto economic growth and much more, the fundamental conceptsdescribed in Chapter 4 provide an essential foundation of knowledge for forex traders who wish to understand what really makesthe foreign exchange markets tick.Moving on to Chapter 5, this is where the knowledge gainedin previous chapters can be put to practical use. Chapter 5 is allabout foreign exchange trading methods and strategies, or the waysin which top currency traders tackle the markets on a daily basis.Included in this chapter are sections on strategic trading based ontrends, breakouts, chart patterns, news, interest carry, divergences,multiple timeframes, and much more. The methods and strategiescontained in this chapter provide traders with practical ideas thatcan be used almost immediately to trade forex.Finally, Chapter 6 closes the book with some extremely important elements of trading. This chapter is found at the end of the bookbecause it introduces perhaps the most advanced concepts in thebook, and not because its contents are any less important than othersubjects. On the contrary, concepts like risk and money management,trading discipline, and the optimal trader’s psychology, are often considered by experienced traders to be among the most importantcomponents of a successful trading career. Since many beginningtraders instead believe that finding the best trade entry point is themost crucial aspect of good trading, it is especially imperative thatthese novice traders pay particularly close attention to Chapter 6.As a whole, this book should serve as a solid introduction andguide to the fascinating world of foreign exchange trading. Much
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Chapter Summary
more can be said about the minute intricacies of how this market works. But in order to learn how it really works, the very bestteacher beyond this book on the essentials is a lot of hands-on experience. Nothing beats getting your hands dirty by getting in thereand actually practicing. Fortunately, this is extremely easy in today’sretail currency trading environment. Virtually every reputable forexbroker offers free practice account demos of their trading platforms,complete with real-time prices, charting software, and newsfeedservices. With these convenient resources at every prospective forextrader’s fingertips, there is absolutely no excuse not to get out thereand start trading currencies with play money in a practice account.
C hapter Summar yIn this introduction to Essentials of Foreign Exchange Trading, a briefhistory and description of the development of the foreign exchangemarket was touched upon. After the collapse of the Bretton WoodsAgreements, which essentially fixed exchange rates, speculative currency trading was able to develop in an extremely rapid manner.Fast forward to the past decade or so, and this developmentbecame even more rapid with the help of the Internet and technology enhancements. Modern-day spot forex trading via retail electronic platforms has opened up new opportunities for legions ofindividual traders.Characteristics inherent in the foreign exchange market that differentiate it from other financial markets include the fact that it isthe most heavily traded market in the world, by far. This ensures thatits liquidity is second to none. Another differentiating characteristic
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is that forex is open 24 hours a day (except weekends), as the markettravels seamlessly around the globe with the changing time zones.Other notable distinguishing features include the fact that there areonly a handful of tradable currencies to worry about, as opposedto countless stocks and options, as well as the fact that forex offersextremely high leverage levels (currently up to 400:1).The key speculative players in the foreign exchange marketinclude the major commercial and investment banks, as well as thelarger hedge funds. The lowest rung on the totem pole of influentialparticipants consists of individual retail traders. Although there maybe a great deal of enthusiasm in this group, individual traders aregenerally unable to move the forex markets in any appreciable way.The primary drivers of foreign exchange price movement includekey fundamental factors like interest rates, GDP, employment, andinflation, which all help affect the basic economic supply and demandsituation for each currency. Besides the fundamentals, technical factors can also contribute significantly to exchange rate movement.Finally, the rest of the chapters in this book were introduced. Inits entirety, this book serves as an essential guide to foreign exchangetrading, as the title suggests. But nothing could ever take the place ofhands-on, practical experience. Forex traders are fortunate to havetheir pick of free demo practice accounts provided by forex brokers. These accounts generally differ from real accounts only by thekind of money traded (play money versus real money). Therefore, itis incumbent upon the serious student of forex to practice diligentlywith these demo accounts, as no better method exists of gaininginvaluable experience and self-directed education at no cost.
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CHAPTER 2
Basic ForeignExchange TradingMechanicsAfter reading this chapter, you will beable to:●
Appreciate the unique structure of currency pairs.
●
Place foreign exchange trades using any type of tradeorder.
●
Understand the mechanics behind stop losses and profitlimits.
●
Recognize how lot size, leverage, and margin can affectyour trading.
●
Identify the potential transaction costs involved in forextrading, including spreads and interest.
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A natomy of a Currency PairThe foreign exchange market is traded in a very unique way whencompared with other major financial markets like stocks or futures.Unlike these more traditional markets, foreign exchange trading isaccomplished using the relative value of the underlying instrument,rather than the absolute value.More specifically, currencies are traded in pairs. When forextraders talk about trading the U.S. dollar, for example, they are reallytalking about trading the U.S. dollar’s relative value against anothercurrency. This other currency could be the euro, the British pound,the Japanese yen, or even the Thai baht, among many others. Thefirst currency in a currency pair is called the “base” currency, whilethe second currency is called the “quote” (or “counter”) currency.It cannot be emphasized enough how important it is to keep inmind that there are two integral, opposing components of a tradedcurrency pair, instead of the single component prevalent in trading stocks or futures. When forex traders initiate market positions,it is imperative that they take into consideration the relative valueof both currencies. This means that a trader should not just considerwhether a currency will go up or down in value. Rather, the tradermust always take into account whether the currency’s value will goup or down in comparison with another currency.For example, one of the most commonly traded currency pairsis the USD/JPY, which can be described in longhand as the U.S.dollar against the Japanese yen. If traders maintain the view thatthe value of the U.S. dollar will rise in relation to the Japanese yen,they will buy the USD/JPY pair. Conversely, if they think that the
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Anatomy of a Currency Pair
U.S. dollar will fall in relation to the Japanese yen, they will sell theUSD/JPY pair.Logically, by the same token, if traders believe that the yen willrise in relation to the dollar, they will sell USD/JPY. And if theythink the yen will fall against the dollar, they will buy USD/JPY. Atfirst this may appear confusing. But if one considers currency pairsas a coupling of polar opposites, it becomes a lot easier to grasp withsome time and experience.As a point of reference, the top tier of currency pairs are the four“majors,” which consist of the most traded, and therefore most liquid,U.S. dollar-based pairs. These are EUR/USD (euro against U.S. dollar),USD/JPY (U.S. dollar against Japanese yen), GBP/USD (British poundagainst U.S. dollar), and USD/CHF (U.S. dollar against Swiss franc).Then, there are the “semi-major” pairs, which also contain theU.S. dollar but are not traded as actively as the majors. These includeUSD/CAD (U.S. dollar against Canadian dollar) and AUD/USD(Australian dollar against U.S. dollar).After these, there are the many significant “crosses” which, bydefinition, do not contain the U.S. dollar. Crosses include EUR/GBP (euro against British pound), AUD/NZD (Australian dollaragainst New Zealand dollar), CAD/JPY (Canadian dollar againstJapanese yen), GBP/CHF (British pound against Swiss franc), andEUR/JPY (euro against Japanese yen), among others.And finally, the exotics, which are thinly traded on the globalforex market compared to the more popular majors and crosses,round out the currency pair list. These pairs include such currenciesas the Hungarian forint (HUF), the Malaysian ringgit (MYR), andthe South African rand (ZAR), among numerous others.
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G oing Long and Selling ShortThe fact that currencies are traded in pairs differentiates the foreignexchange market from other financial markets in important ways,one of which is the concept of long and short.In trading equities, for example, a “long” entry is simply theprocess of buying shares in a specific security in the hope that it willgo up in value. Conversely, a “short” entry is to sell shares beforeactually owning them. This is with the understanding that the sharesmust be bought back or “covered” at a later date, hopefully for aprofit if the stock goes down. Consequently, if traders believe thata stock will go up, they will enter the trade “long.” If, on the otherhand, they think it will go down in price, they will sell “short.”The foreign exchange market, in contrast, treats long andshort in a significantly different manner. To be long EUR/USD, forexample, is to simultaneously buy euro and sell dollar. To be shortEUR/USD, on the other hand, is to simultaneously sell euro andbuy dollar. So whether one is long or short any given currency pair,one is always long one of the currencies in the pair, and short theother.This concept may seem foreign to traders used to dealing withstocks and/or futures, but it essentially means that no matter whatposition a trader takes in the currency markets, that trader is alwaysboth bullish (financially optimistic) on one currency while simultaneously bearish (financially pessimistic) on another.Now that the structure of currency pairs has been established,the all-important topics of order type and trade placement can bediscussed.
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Going Long and Selling Short
EXECUTIVE INSIGHT
Robert R. Prechter Jr.Robert R. Prechter Jr., CMT, famed publisher of The Elliott WaveTheorist since 1979, is founder/president of Elliott Wave International (elliottwave.com) and executive director of the SocionomicsInstitute. Legendary for his market timing and trading acumen utilizing Elliott Wave principles, Prechter has won numerous major accolades from the media and financial community over an illustrious,decades-long career. He has authored many books, several of whichwere instrumental in bringing Ralph Nelson Elliott’s groundbreakingElliott Wave Principle into the forefront of financial market analysis.Prechter states:“Currencies help us understand a fundamental aspectof markets. They make clear that all markets are simplyratios.”“Stock indexes are expressions of share values interms of some currency. For example, the Dow JonesIndustrial Average is the ratio of an average of 30 Dowstocks relative to dollars. But one could just as wellexpress the ratio as its inverse, showing the value ofa dollar in terms of 30 Dow stocks. Then, instead ofwatching the Dow go up and down, investors wouldbe watching the dollar go up and down in terms of a certain group of 30 stocks. They would be talking about howtheir dollars are doing instead of how their stocks aredoing.”“Many people have difficulty understanding the simple fact that markets are ratios. Thankfully, currencymarkets illustrate the matter clearly. A U.S. investor canobserve the dollar going up and down by watching thedollar/euro ratio. A European can watch the euro go up
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EXECUTIVE INSIGHT (CONTINUED)and down by watching the euro/dollar ratio. Each of thesetwo investors—if he hasn’t thought about the matter—might have a different psychological orientation to hislocal expression of the ratio. But that doesn’t change thefact—obvious in this instance—that both investors arelooking at exactly the same information. ‘Up’ and ‘down’have no real referent.”“Most stock investors are married to the idea that upis good and down is bad. There is some basis for truthin this feeling, because a downtrend in the stock market indicates a trend toward more negative social mood,which in turn has negative results in social action. But interms of investment success, the direction is irrelevant,and feelings of ‘good’ and ‘bad’ only get in the way ofsuccessful decision-making.”“A currency investor has an advantage over a stockinvestor, because he should be far less married tofeelings of whether a certain direction for a ratio is‘good’ or ‘bad.’ In the currency trader’s world, there is noqualitative difference between the numerator and thedenominator. On one side of the ratio is one currency,and on the other side is another. There is not even properly an ‘up’ or a ‘down’ direction. Every move is bothdirections, depending on how you express the ratio.The point is that a currency investor should be able toapproach his craft with less psychological baggage thana stock investor carries and therefore with more objectivity and a better chance of success. This difference makesit easier for a currency analyst to see that his job is not to‘hope’ or ‘fear’ but just to get the trends right. If all investors could learn that lesson, they would be better off.”
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E n t r y o r d e r s — Wa i t i n g u n t i l t h e P r i c e I s R i g h t
M arket Orders — On the SpotDepending on the specific strategy or type of trading preferred,foreign exchange traders often rely heavily upon market orders. Amarket order simply means that a trader wishes to enter a currencyposition at the present moment, whether it is an order to buy (long)or sell (short) a specific currency pair.The main functionality that differentiates this type of order fromothers is the fact that a market order is executed at the current market price, as opposed to a future price level.Market orders are primarily used by traders who are physicallyat their trading stations watching the market, waiting for either aspecific technical chart setup or a fundamental news announcement.Once one of these trading opportunities presents itself, the trader isthen able to establish a virtually instant market position through theuse of a well-placed market order.
E ntry Orders — Waiting until the Price Is RightIn contrast to the immediate nature of market orders, entry orders arepending positions whose purpose is to trigger when a certain pricelevel is reached. These types of orders can be set to execute well aheadof time, and will only be executed if the specified price is reached.There are two primary types of entry orders—stop entries andlimit entries. In the retail foreign exchange market, the functionaldiscrepancy between these two entry order types is largely semantic,and many brokers simply blur the differences by calling them bothlimit orders. But for those forex brokers that keep the delineation
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intact, traders simply need to learn and remember the definitions,which are as follows:Buy stop—an entry order to buy at a price above the current price.Buy limit—an entry order to buy at a price below the current price.Sell stop—an entry order to sell at a price below the current price.Sell limit—an entry order to sell at a price above the current price.Unlike market orders, entry orders are primarily used by traderswho are unable or unwilling to be watching real-time prices andwaiting for trade opportunities at their trading stations. With entryorders, complete orders can be entered ahead of time that encompass the full trading lifecycle, including both the trade entry as wellas the stop loss and profit target exits. These trade exits will be discussed in more detail in the next section.Entry orders may also be used as a tool for enforcing order entrydiscipline. Traders placing market orders at the current price areoften prone to entering orders “on the fly,” as a result of counterproductive emotions like greed and fear. In contrast, the mechanismof entry orders encourages traders to enter trades only if their specific, predetermined price level and entry rules are met. Disciplineis a tremendously vital factor in successful trading that will be discussed further in Chapter 6.
S topping Losses with Stop Losses andTrailing StopsWhereas market orders and entry orders are trade entries, stop losses,trailing stops, and profit limits (described in the next section) are
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S t o p p i n g L o s s e s w i t h S t o p L o s s e s a n d Tr a i l i n g S t o p s
trade exits. While many beginning traders concentrate almost exclusively on entries, most intermediate and advanced traders eventually come to realize that exits are at least as important, and some sayeven more important, than getting the entries right.In this section, only the basic mechanics of stop losses and trailing stops will be touched upon. Later, in Chapter