How Does Foreign Exchange Trading Work?
Daily FX Signals | Foreign exchange trading was once something that people only did when they needed foreign currency to use when traveling in other countries.
This involved exchanging some of their home country’s currency for another at a bank or foreign exchange broker, and they would receive their foreign currency at the current exchange rate offered by the bank or broker.1
These days, when you hear someone refer to foreign exchange trading or forex, they are usually referring to a type of investment trading that has now become common.2 Many people wonder how foreign currency trading, often shortened to forex trading, works because they’re interested in learning how to trade currencies for themselves.
The Forex Market for Beginners
It seems like something that most people would find easy, except, in this particular industry, there is a high rate of failure among new traders because there is quite a steep learning curve.
Even traders that are aware of that tend to start out with the attitude of “It happened to them, but it won’t happen to me.” In the end, an average of 77% of these traders walk away empty-handed, not quite sure what happened to them, or maybe even feeling a bit scammed.
Forex trading is not a scam; it’s just an industry that is primarily set up for insiders that understand it. The goal for new traders should be to survive long enough to understand the inner working of foreign exchange trading and become one of those insiders, and this will come with studying the market, understanding the terminology, and learning trading strategies.
Forex and Leverage
The number one thing that hangs most traders out to dry is the ability to use a trading feature called forex trading leverage. Using leverage allows traders to trade in the market using more money than what they have in their accounts.3
For example, if you were trading 2:1, you could have a $1,000 deposit in your brokerage account, and yet control and trade $2,000 of currency on the market. Many forex brokers offer as much as 50:1 leverage. This can be dangerous, as new traders tend to jump in and start trading with that 50:1 leverage immediately without being prepared for the consequences.
Most new traders, being optimistic, might say “but I could also double my account in just a matter of days.” While that is indeed true, watching your account fluctuate that seriously is very difficult to do.
Many traders assume that they will not be emotionally shaken by volatile price changes, however, the reality proves otherwise. When they experience the loss of money in real time they may act reflexively out of an irrational desire to quickly gain back what they have lost. This leads to rash judgement in which traders may take riskier trades which inevitably accelerates the losses.
The Market and Your Emotions
Assuming that you can manage not to fall into the leverage trap, the next big challenge is to get a handle on your emotions. The biggest thing that you’ll tackle is your emotion when trading forex. The forex market can behave like a roller coaster, and it takes a steel gut to cut your losses at the right time and not fall into the trap of holding trades too long.67 Forex trading should be a formula and a method that is enacted consistently and without emotion.
When traders become fearful because they have money in a trade and the market’s not moving their way, the professional sticks to her trading method and closes out her trade to limit her losses. The novice, on the other hand, stays in the trade, hoping the market will come back. This emotional response can cause novice traders to lose all of their money very quickly.
The availability of leverage will tempt you to use it, and if it works against you, your emotions will weigh on your decision making, and you will probably lose money. The best way to avoid all of this is to develop a trading plan that you can stick to, with methods and strategies you’ve tested and that result in profitable trades at least 50% of the time.
How to Plan an Effective Long-Term Forex Trading Strategy
One of the safest methods for forex trading is trading with the big picture in mind. The big forex picture takes into account all of the information available for a currency pair. Such big-picture information includes things like the interest rates in both countries, the functions of each country’s economy, and the current market environment for the trading pair.
Trading Forex | Tracking the progress of the commanding heights of the economy, also known as the fundamentals go along with the above idea. Fundamentals are things like employment, interest rates, CPI, and even politics. While trading the big picture, you need to know what the fundamentals are for the currencies involved.
Technical analysis can take many forms when you put it into practice. If you say technical analysis to one trader, they may think moving averages, while another market operator may think of MACD if you mention technical trading.
When trading the big picture, you are looking for technical aspects to support your trade. If you want to buy a currency pair, you don’t want it to be overbought technically. Your big picture trading should have some technical analysis that supports your decision. It helps with the timing and helps you avoid getting in at a bad time. You may have the right idea overall, but having technical analysis in your favor can reduce your risk.
Like all forms of analysis, technical analysis is subject to misjudgments or biases, which can throw off appropriate investing decisions.
Advanced Forex Trading Techniques
Forex (FX) trading can be as simple or as complicated as you want it to be. In the beginning forex trading seems like it is simple. Forex is a marketplace for trading in currencies. Traders will use these trades to speculate and hedge for profit as well as for commerce and other purposes. The FX market is the largest, most traded exchange in the world and is used by individual traders, financial institutions, broker, and institutional investors.
It may seem like your only job as a trader is to pick the direction of a currency pair and collect your profit. However, forex trading takes time, patience, and experience. You will need a combination of fundamental and technical analysis skills and an understanding of the factors that move the currencies traded on the foreign exchange marketplace. Or, maybe you are hoping to find a precise forex trading system on the internet. If only it were that simple.
Hedging Forex Signals
Hedging is a way to reduce risk by taking both sides of a trade at once. If your broker allows it, an easy way to hedge is just to initiate a long and a short position on the same pair. Advanced traders sometimes use two different pairs to make one hedge, but that can get very complicated.
For example, say you decide that you want to go short on the U.S. dollar and the Swiss franc (USD/CHF) because you see it sitting at the top of a recent price range. You decide to initiate your short. After setting up your short, you start thinking that the USD/CHF is looking a little strong, and you think that it might break upward and make your short an expensive one.
To do an advanced balancing act, you start looking at other USD pairs. You find that the euro to dollar pair (EUR/USD) tends to move inversely—opposite—to the USD/CHF. To complete your forex hedge, you go short on EUR/USD. The USD ends up breaking resistance and moves strongly against the CHF. Your short EUR trade becomes a winner, and your USD/CHF trade is a loser, but your risk is limited because they almost even out.
Position trading is trading based on your overall exposure to a currency pair. Your position is your average price for a currency pair. For example, you might make a short trade on EUR/USD at 1.40. If the pair is ultimately trending lower but happens to retrace up, and you take another short at say 1.42, your average position would be 1.41. Once the EUR/USD drops back below 1.41, you will be back in overall profit.
Trading Forex Options
A forex option is an agreement to purchase a currency pair at a predetermined price at a specified future date. For example, say you are long the EUR/USD at 1.40, and you feel that there is a chance that it will fall to 1.38 in overnight trading. Not wanting to risk a deeper reaction, you decide to put a stop at 1.3750, setting up a potential loss of 250 pips.
250 pips sound really painful, so you decide to use a forex option to lessen the pain. You purchase an option for the overnight hours with a strike price of 1.3750. If the EUR/USD goes up and never touches 1.3750 overnight, you would lose the premium that you paid for your currency option.
If the EUR/USD falls and touches your option and your stop loss, you would receive the profit from your option, depending on how much of a premium you paid, and you would realize the loss of your long trade on the EUR/USD. The options profit would make up for some of that loss on your currency trade.
Market: Scalping is making a very short-term trade for a few pips usually using high leverage. Scalping typically is best done in conjunction with a news release and supportive technical conditions. The trade can last anywhere from a few seconds to a few hours. Many beginning forex traders start with scalping, but it does not take long to figure out how much you can lose if you do not have any idea what you are doing. In general, scaling is a risky strategy that does not pay well in comparison it’s a risk. If you are going to make scalping trades, it is best to do them in conjunction with your overall trading position, not as a primary method of trading.
Advanced forex trading is about seeing all your options when you make a trade. Aside from using masterful risk management and extreme caution, advanced trading can be an alternate way to make profits and control losses. Advanced trading techniques are just about using the behavior of the market to your advantage. Learning to use advanced techniques properly is what will give you the edge that will make you stand apart from the average trader.
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How Does Foreign Exchange Trading Work?