When you are first getting introduced to the world of forex trading, things can seem a bit overwhelming. There is so much information available online, but very little of it is aimed at beginners who may not be familiar with the terms and concepts they refer to. In this article we will cover the basics of forex trading, explain the most important terminology, and tell you how you can get started trading forex for yourself.
To start off, let’s define some terms. Forex stands for “Foreign exchange” and is the name often used for this market where traders can buy one currency by paying with another currency. Other names used for this is the “FX market” or the “currency market.”
A pip, often referred to as “point in price”, is simply the smallest price move that is possible in a given currency, also known as a basis point. Forex traders often talk about their gains and losses in terms of pips instead of percentages or monetary values.
Long/short are confusing terms that often get tossed around by forex traders as well as other traders. To put it simply, long means that you are buying an asset and will make a profit if that asset goes up in price. Short, on the other hand, means that you are trying to make a profit from declining prices. The way it works is that you sell an asset that is borrowed from another market participant. After the price has dropped, you can then buy back the asset in the market for a lower price than you sold it for, and thus make a profit.
Stop-loss is the level a trader decides on where he would like to exit his trade if it is not working out for him. In other words, it is the maximum loss the trader is willing to take on one particular trade. Alternatively, a stop-loss order can be used to secure a profit on a profitable trade in case the market turns.
Leverage is the practice of taking a larger position in the market than your trading account size would otherwise allow. Basically you are borrowing money from your broker in order to boost your buying power in the market. Leverage offered in the forex market is often in the range of 200-400:1
Spread, also known as bid-ask spread, is the difference between the buying and selling price of an asset in the market. The broker will offer you to buy a currency at a slightly higher price than they will let you sell that currency. This is where brokers make most of their money, and it is important to compare spreads when choosing a forex broker.
Since the forex market works by participants buying one currency with another currency, the price of a currency must always be quoted in another currency. For example, when you see that EUR/USD is trading at 1.20, it means that you need 1.20 US dollar to buy 1 euro.
The worlds largest market
The forex market is known as the largest of the world’s financial markets. Approximately $5 trillion changes hands in the forex market every day, far surpassing the global stock markets and commodities markets.
It is important to understand that the trading activity that retail traders (traders like you and me) account for is just a small, but rapidly growing, share of the total activity in the forex market.
Fundamental or Technical Analysis
When you are deciding to become a trader, you also need to decide on what type of trader you want to be. Broadly speaking, there are three types of traders; fundamental traders, technical traders, or a combination of the two.
Fundamentals take into account news, valuation, interest rates, etc. when trying to determine what price a currency pair “should” be trading at.
Technicals, on the other hand, focus strictly on what the price of the currency pair is doing. Technical traders study and analyze price charts to try to determine the future direction of the price.
Majors and Minors
Forex traders often talk about majors and minors when referring to currencies. Majors is a list of the most actively traded currency pairs in the world, and it consists of these pairs:
- EUR/USD: The euro and the US dollar.
- USD/JPY: The US dollar and the Japanese yen.
- GBP/USD: The British pound and the US dollar.
- USD/CHF: The US dollar and the Swiss franc.
Forex majors often have the lowest spreads in the forex market and they are also among the most liquid instruments you can trade in the financial markets.
Forex minors is a list of the next most actively traded currencies. This list includes currencies such as the British pound (GBP), Canadian dollar (CAD, aka “Loonie”), Australian dollar (AUD, aka “Aussie”), and New Zealand dollar (NZD, aka “Kiwi”).
Lastly, there are the exotic currency pairs. These include the remaining currencies from European countries outside the Eurozone (NOK, SEK, DKK) and smaller yet important Asian currencies like the Singapore dollar (SGD) and Hong Kong dollar (HKD). The exotics have less trading activity and the spreads are usually higher than for the majors and minors.
Benefits of Forex Trading vs. Stock Trading
A benefit of trading in the forex market rather than the stock market is that the forex market is trading 24 hours a day, from Monday morning in Australia until Friday evening in North America. The great thing about the market being open 24 hours is that there are no overnight “gaps” like you can find in the stock market.
A gap simply means that the market opens at another price in the morning than it closed the night before. For traders, gaps are considered a big risk, since the trader cannot control what is happening with his trade while the market is closed.
A market that is open 24/5, like the forex market is, opens up great opportunities for medium-term traders (swing traders) to for example take positions during the beginning of the week and exit those same positions before the week is over. That way, the trader takes no risk over the weekend when the market is closed.
Additionally, the forex market is much more liquid than most stocks, and it’s easy to find technical and fundamental analysis of this market everywhere on the Internet.
Choose a Forex Broker
Once you have decided to give forex trading a try, you need to choose a good broker that you trust with your money. This is the first, but still a critical step, on your way to become a successful trader. Pay particularly close attention to regulation, withdrawal policies, spreads, and trading platforms offered when choosing your broker. Fore more on this, read our earlier article on how to choose a forex broker.
Featured image from Pixabay.
Why I Switched to Momentum Investing
After sticking to various reversal trading strategies for a while now, I have started to look more into momentum and trend when it comes to investing in stocks specifically. Some people may find the idea of momentum a bit strange to begin with, and it is only after watching individual stocks, while also keeping an eye on the movements of the overall market, that you rally understand its meaning.
Seasoned stock investors, especially those that adhere to value investing, are often skeptical towards the idea of buying a stock that has already increased in price. It basically goes against their instincts of buying low and selling high. However, as people start to understand the mechanics of it, they tend to change their opinion.
Never catch a falling knife
An unwritten law in any market is that a trend tends to continue. Hence, if a stock has been moving up three straight months, it is more likely that it will continue to move up for a fourth month instead of turning down. A “cheap” stock can always become cheaper and an “expensive” stock can always become more expensive. These are well-known principles that explain the basics behind why momentum and trend trading works, and it is the idea behind old cliché’s like “never catch a falling knife” and “cut your losses, let your profits run.”
Over time, however, any financial asset has a tendency to revert to its mean. As such, when a trend has been overextended, a reversal in price can be expected to follow. This is the idea behind reversal trading. However, it is important to understand that it can take a while for this to happen, and you may very well get wiped out in the process.
The trend is your friend
The concept of buying stocks on their way up makes a lot of sense from this perspective, as you are then buying something that the market is starting to like, which is about to be valued higher. Trying to catch the falling knives is simply to risky from a risk:reward perspective, and in my opinion it should be avoided altogether. Why would you buy a stock that is falling when you instead can buy it at its way up?
Still, there are situations that arise in the grey areas, where a stock seems to have gone so low that it can do nothing but go up again. It may be tempting to give it a try, but remember that this is an extremely difficult thing to do, and the stock may just as well continue its steady decline. When the stock finally turns, there will still be plenty of time for you to jump on the bandwagon.
Mining companies, some companies within the maritime shipping industry, and the entire Japanese stock market are all examples of great bargains from a value standpoint, where the investor would sometimes have to wait for decades to earn his initial investment back. Don’t fall into this trap by picking stocks that are still falling and appear “cheap.” Don’t try to outsmart the market.
Combining momentum with value
In my opinion, a killer long-term strategy in the stock market is to combine sound value-investing principles with momentum. In other words, you should look for undervalued companies that have been badly beaten up for years, and that are just starting to turn. Oftentimes, this is where the greatest potential is and I believe it is one of the best ways to beat the index over the long term.
We can find two examples of how well value investing with momentum works in the US after the stock market crashes in the mid-70s and the 2008 financial crisis. Following these two events, only value investing yielded a clearly higher return than value combined with momentum.
However, if you were a value investor before the crash started, chances are you would get wiped out before the market finally turned. If, on the other hand, you were a value investor with momentum as one of your criteria for holding, you would automatically get rid of all the stocks that were in decline, and instead buy them again after the crash was over.
Because of this, momentum indicators like the MACD can be of great help when making these investment decisions. When combined with value-principles, you have a killer approach to long-term success in the stock market. I’m definitely looking more into crafting a robust investment strategy based on this for myself, and I will come back and share more specifics on potential strategies later.
Featured image from Pixabay.
Trading 101: Moving Averages and Moving Average Strategies
What are Moving Averages?
Moving Averages are among the most popular trend indicators in Technical Analysis. They provide a simple, yet powerful visualization of the ongoing trends in an asset. They are used for a wide variety of reasons, primarily for trend following and reversal strategies.
Simply put moving averages are connected points calculated for every day (or whatever the timeframe is). The calculation itself is simple; you take a given number of previous days and calculate their average. Of course, you don’t have to do the calculations yourself. All basic charting software and trading platforms do the math for you and plot the moving average (or up to dozens of averages for that matter) on the chart of the asset.
How to Interpret Moving Averages?
Trading 101: Trading Forex Swing Reversals
It’s easy to get distracted by the plethora of trading strategies recommended online, where each new strategy you read about appear to promise more than the previous one. This is indeed a dangerous path to go down, and it will lead you nowhere in trading.
Stop Looking For New Strategies
Most traders who are struggling with being consistent should stop looking for new strategies right away. If you find yourself constantly blaming your strategy for your losses and hunting for new strategies online, it’s time to simply pick one and stick with it for some time.
More likely than not, it is your implementation and execution of the strategy that is causing your problems, not the strategy itself. This is especially true for strategies that involve some degree of discretion, and are not purely mechanical.
Execution is Key
Instead of switching strategy, I recommend taking a closer look at how you are executing your trades. Check your trading journal and go back and take a look at the charts. Did you really follow your trading plan, or was there some part of the trade you should have executed differently that would have improved your result?
Remember, reviewing your trades and your own performance is just as important as making new trades if you want to last as a consistently profitable trader.
Reversal Trading Strategy
In this article I will share one strategy that you can choose to stick with, optimize, and refine to fit your own style. It is not a 100% mechanical strategy, and thus involves some degree of discretion from the trader, including an understanding of how to use supply and demand zones.
Once you understand the concept of supply and demand zones, you will know that these are areas on the chart where price tends to consolidate before it “decides” on the next move. It may happen as a reversal in the opposite direction of the previous trend, a continued consolidation, or a spike through the supply/demand zone in the direction of the trend.
For this trading strategy we are looking for potential reversals into the opposite direction of the previous trend. In the chart below, I have indicated the cluster zones that we call supply/demand zones.
To me, this is a chart that now looks “top heavy” and ripe for a sell-off at least down to the support zone in the 0.90 area and perhaps all the way down to the previous swing low at 0.60.
Wait For Confirmation
However, unless the market gives us any sort of confirmation about our short bias, we are not going to do anything except observing the price action. What we are looking for specifically would be a strong breakdown below the current resistance zone before we enter our short order.
Personally, I never enter before I see a red candle that breaks and closes below the 20 period simple moving average (SMA) line in a strong way. The 20 SMA in particular often works as a dynamic support line for the price, and a break through this line often gives trend followers an indication that the trend is broken, and that it’s time for them to get out of their trade.
By waiting for the strong break below the 20 SMA, the market has confirmed for us that the dynamic between buyers and sellers is changing. The bears are in control, and we can expect lots of stop-loss orders that are placed just below the resistance zone to be triggered, and thus reinforcing the sell-off.
Let’s take a look to see what actually happened in this case:
Indeed, we did see a strong break below the 20 SMA with several consecutive red candles. In this case, the market continued to fall for the next few months.
Reversal Trading Strategy Rules
Although this is a fairly discretionary strategy that requires you to make a judgment call on the overall market conditions, there are a few general guidelines that can help you spot the right setups:
- Look for a strong previous trend in the chart, either up or down.
- Highlight consolidation areas where the price is hovering around the 20 SMA, including all support/resistance zones above/below the current price.
- Wait for price to break away from the support/resistance zone in a strong way and the candle to close on the other side of the 20 SMA.
- Finally, enter your order if risk:reward is satisfactory and there are no obvious support/resistance zones nearby.
The first point is a very important condition for this strategy, as it is what makes it possible to get a strong reversal in the price. Without a strong previous trend, the reversal may be weak and not worth our effort as traders.
If you have previously been a trend trader, the concept of reversal trading may be a bit more difficult to get used to. However, as trend traders, we know how sharp the reversal often is when our dear trend ends. It can be violent and explosive to watch, and it hurts trend followers’ returns badly. As such, why not give the other side of the trade a chance and see if you can be more successful this way?
Featured image from Flickr.
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