What is Forex Trading?

                                                                                                                                          What is Forex 

The foreign exchange market is the "place" where currencies are traded. Currencies are important to most people around the world, whether they realize it or not, because currencies need to be exchanged in order to conduct foreign trade and business. If you are living in the U.S. and want to buy cheese from France, either you or the company that you buy the cheese from has to pay the French for the cheese in euros (EUR). This means that the U.S. importer would have to exchange the equivalent value of U.S. dollars (USD) into euros. The same goes for traveling. A French tourist in Egypt can't pay in euros to see the pyramids because it's not the locally accepted currency. As such, the tourist has to exchange the euros for the local currency, in this case the Egyptian pound, at the current exchange rate.

The need to exchange currencies is the primary reason why the forex market is the largest, most liquid financial market in the world. It dwarfs other markets in size, even the stock market, with an average traded value of around U.S. $2,000 billion per day. (The total volume changes all the time, but as of August 2012, the Bank for International Settlements (BIS) reported that the forex market traded in excess of U.S. $4.9 trillion per day.)

One unique aspect of this international market is that there is no central marketplace for foreign exchange. Rather, currency trading is conducted electronically over-the-counter (OTC), which means that all transactions occur via computer networks between traders around the world, rather than on one centralized exchange. The market is open 24 hours a day, five and a half days a week, and currencies are traded worldwide in the major financial centers of London, New York, Tokyo, Zurich, Frankfurt, Hong Kong, Singapore, Paris and Sydney - across almost every time zone. This means that when the trading day in the U.S. ends, the forex market begins anew in Tokyo and Hong Kong. As such, the forex market can be extremely active any time of the day, with price quotes changing constantly.

Spot Market and the Forwards and Futures Markets

There are actually three ways that institutions, corporations and individuals trade forex: the spot market, the forwards market and the futures market. The forex trading in the spot market always has been the largest market because it is the "underlying" real asset that the forwards and futures markets are based on. In the past, the futures market was the most popular venue for traders because it was available to individual investors for a longer period of time. However, with the advent of electronic trading, the spot market has witnessed a huge surge in activity and now surpasses the futures market as the preferred trading market for individual investors and speculators. When people refer to the forex market, they usually are referring to the spot market. The forwards and futures markets tend to be more popular with companies that need to hedge their foreign exchange risks out to a specific date in the future.

Who trades currencies?

Daily turnover in the world's currencies comes from two sources:

Foreign trade (5%). Companies buy and sell products in foreign countries, plus convert profits from foreign sales into domestic currency.

Speculation for profit (95%).

Most traders focus on the biggest, most liquid currency pairs. "The Majors" include US Dollar, Japanese Yen, Euro, British Pound, Swiss Franc, Canadian Dollar and Australian Dollar. In fact, more than 85% of daily forex trading happens in the major currency pairs.

Why trade Forex?

With average daily turnover of US$4 trillion, forex is the most traded financial market in the world.

A true 24-hour market from Sunday 5 PM ET to Friday 5 PM ET, forex trading begins in Sydney, and moves around the globe as the business day begins, first to Tokyo, London, and New York.

Unlike other financial markets, investors can respond immediately to currency fluctuations, whenever they occur - day or night.

How to Find a Broker for the FOREX Trading Market

It's not always easy to know what to look for in a broker in any market, much less a market as complex as the FOREX. But, if you want to trade in FOREX you need a broker. While it might be tempting to simply ask the brokers what they can do for you, you can't always depend on them to give you a straight answer. Here are a few things to consider when choosing your broker. You will want a broker that has low spreads. Since FOREX brokers don't charge a commission, this difference is how they make money. Low spreads will save you money. Along with this, you should be looking for a broker attached to a reputable institution. Unlike equity brokers, FOREX brokers are usually attached to large banks or lending institutions. The broker should also be registered with the Futures Commission Merchant (FCM) as well as regulated by the Commodity Futures Trading Commission (CFTC). Once you've narrowed your choices down to brokers that won't cost you too much, and that are reputable, consider the trading tools that they are offering you. FOREX brokers have many different trading platforms for their clients, just like brokers in other markets. These often show real-time charts, technical analysis tools, real-time news and data, and may even offer support for the various trading systems. Before you commit to any one broker, request free trials of their tools. Brokers generally provide technical as well as fundamental commentaries, economic calendars, and other research to help you make good trades. Shop around until you find a broker who will give you what you need to succeed. The next item that you will need to evaluate carefully is the number of leverage options your potential broker has. Leverage is a necessity in FOREX trading because the price deviations in the currencies are set at fractions of a cent. Leverage is expressed as a ratio between the total capital that is available to be traded and your actual capital. For example, when you have a ratio of 100:1, your broker will lend you $100 for every $1 of actual capital you have. Many brokerage firms will offer you as much as 250:1. If you have low levels of capital you will need a brokerage with high levels of leverage to make reasonable profits. If capital is not a problem, any broker that has a wide variety of leverage options would be a good choice for you. A variety of options will let you vary the amount of risk you choose to take. For example, less leverage (and therefore less risk) may be preferable if you are dealing with highly volatile (exotic) currency pairs. Along with different levels of leverage, look for brokers that offer different types of accounts. Many brokers will offer you two or more types. The smallest account is known as a mini account and it requires you to trade with a minimum of around $300. The mini account also generally offers a high amount of leverage. The standard account allows you to trade at a variety of different leverages, but it requires minimum initial capital of $2,000. And finally, there are premium accounts, which often require significant amounts of capital. They also generally have different levels of leverage available to the traders who use them, and often offer additional tools and services. You will need to make sure that the broker you choose has the right leverage, tools, and services for the amount of capital that you are able to work with.

Used Margin vs. Usable Margin in FOREX Trading

The subject of FOREX margin has been the source of a lot of confusion over the years. Many traders that regularly trade FOREX have no idea how margin works in their accounts. They know that they could possibly get a margin call, but they do not fully understand how they work. The terms "used margin" and "usable margin" are both important but many traders do not understand the difference. Here are the basics of used margin and usable margin in FOREX trading.

Used Margin

Depending on what type of FOREX account you have, you could have varying levels of margin requirements. Some popular levels of leverage are 100:1 and 200:1. If you open a trade for one standard lot, your used margin will be $100. This is the amount of margin that you have used out of your total equity.

Usable Margin

The usable margin is the amount of money that you have left to use. The usable margin is always equal to the equity in your account minus the used margin. Some people think that it is calculated off of the account balance, but this is not true. It is always calculated off of the equity.

In the earlier example, if you had a $10,000 account and you opened a trade for one lot, your used margin is $100. Your usable margin is $9900.

What is a Pip?

“PIP” stands for Point In Percentage. More simply though, a pip is what we in the FX would consider a “point” for calculating profits and losses.

When trading a mini lot (10k units of currency), each pip is worth roughly one unit of the currency in which your account is denominated. If your account is denominated in USD, for example, each pip (depending on the currency pair) is worth about $1. In a micro lot, or 1k trade, each pip is worth roughly 1/10th the amount it would be worth in a mini lot -- so about $0.10.

In all pairs involving the Japanese Yen (JPY), a pip is the 1/100th place -- 2 places to the right of the decimal. In all other currency pairs, a pip is the 1/10,000 the place -- 4 places to the right of the decimal.

You’ll see that in the Trading Station the digits for pips are in a larger font. This makes them easier to see.

At FXCM, we provide additional transparency through the electronic platform and quote each currency pair with precision to 1/10th of a pip. This fraction of a pip allows price providers to bring spreads down even further as they are not restricted to quoting in full pip increments. This is beneficial to you, the trader, because the spread is a component of your transaction cost.

You’ll notice that earlier in this post, we mentioned that the value of a pip for a 10,000 unit trade is roughly equal to 1 unit of your denominated currency (or $1 if you have a USD account).

Now, let’s identify what the actual value per pip is. There are two simple methods to determine this.

First, in the dealing rates of the FXCM Trading Station II platform, you will find the value per pip of the smallest trade size.

In the account above, the minimum trade size is 1k. Therefore, the pip value listed in the advanced dealing rates window is based on a 1k trade size. For the EURUSD, that means every pip is $0.10. So the spread in the image above was 2.6 pips x 0.10 = $0.26 was the transaction cost to get into that trade.

How do I know that 1k is the smallest trade size for the account? Simple!

When you open a trade, a pop up box appears. In the Amount(K) field, open up the drop down box and what is the smallest figure you see? In the example above, 1 appears meaning it is a 1k minimum trade size for the USD/JPY.

For the second method of determining the value per pip, open the “Market Order” pop up box by left clicking on the dealing rate like you are going to place a trade.

You’ll notice, that when you change the Amount(K) field, the “Per Pip” value changes accordingly. Therefore, just before you get ready to enter the trade, simply double check that the “per pip” field is what you are comfortable with.

If you are not sure what cost per pip you are interested in, no worries. Later on, we will show you how to use support and resistance to help you determine trade size. If you are already familiar with support and resistance, use this three step guide to determine trade size.

For those who wish to determine the calculation by hand, follow this method below (if you are not interested in the mathematics involved, then proceed to the next article).

First you start with the size of your trade. Micro lots are 1k, so if you want the value of a pip for a micro lot you start with 1,000. If you want the value of a pip for a mini lot, you start with 10,000. You then multiply your trade size by one pip for the pair that you are trading.

In this example we are going to calculate the value of a pip for one 10k lot of EUR/USD.

So since I am using 10k mini-lot, I’m starting with 10,000. I multiply 10,000 by .0001 since 1/10,000th is a pip for all pairs (except JPY pairs).

That gets me a value of 1. That will be valued in the “counter currency” (second currency) of the pair that I am trading. In this example, I am trading EUR/USD, so USD is the counter currency of the pair. One pip is worth 1 USD dollar for one 10k lot of EUR/USD.

If my FXCM account is based in US Dollars, then I will see $1 of profit or loss on my account for every 1 pip move that the EUR/USD makes in the market.

Now, if my FXCM account is based in Euros (EUR), I would have to convert that $1 USD into Euros. To do so, I just divide by the current EUR/USD exchange rate which at the time of writing is 1.3797. I’m dividing here because a Euro is worth more than a USD, so I know my answer should be less than 1. 1 divided by 1.3797 is 0.7248 Euros. So now I know that if I have a Euro based account, and profit or lose one pip on 1 10k lot of EUR/USD, I will earn or lose 0.7248 Euros.

Let’s do another example of GBP/JPY.

Again we’ll go with a one 10k lot trade.

This time a pip is .01 because it is a JPY pair.

10,000 times .01 is 100. Again, that “100” is in terms of the counter currency, so it is 100 Japanese Yen (JPY).

Now we need to convert that 100 Yen to the denomination of your account. If you have a USD based account, then you take the 100 Yen and divide it by the USD/JPY spot rate, which at the time of this writing was 105.11. That gets you an answer of $0.95 per pip.

Understanding Forex Trade Sizes

10-20 years ago, forex brokers typically offered only one contract size, 100,000 units of currency. So when a trader said they wanted to trade 1 (lot), that meant they were trading 100,000 units. But over the course of the last decade, as technology became more efficient and transactions costs decreased, forex brokers began offering lot sizes in smaller increments. This required new terminology to describe what amounts we were actually trading

.

Micro Lot

A micro lot is the term used for a 1,000 unit trade, which on most major pairs come out to about $0.10 of risk per pip. This is the smallest trade size available and is a great size for traders that don’t have much capital to trade. Using DailyFX’s usual Rule of 10, we would want to have at least $100 in our trading account per micro lot that we wanted to trade at a time. You won’t make a fortune, but you won’t lose too much either trading micros, that’s why it’s a great place to cut your teeth in Forex.

Mini Lot

A mini lot is the term used for a 10,000 unit trade, which on most major pairs means we are trading $1 a pip. Trading mini lots packs a punch 10x larger than a micro lot, so we want to make sure we are properly capitalized before trading them. We recommend having at least $1,000 deposited into your account for each mini lot you plan to have open simultaneously. It’s a good trade size for a serious part-time forex trader that has the capital or a full-time trader wanting to start with a smaller lot size.

Standard Lot

A standard lot is the term used for a 100,000 unit trade, which on most major pairs means we are trading $10 per pip. We want to make sure we are fully prepared for large swings of gains and losses we can face when trading standard lots. Gains/losses could reach $1000-$2000 or more per standard lot on a fairly common day in the forex market, so having a larger account size is mandatory to trade them seriously. Our account should have at least $10,000 per standard lot we are looking to trade, which normally means you are very serious trader in the FX market, part-time or full-time.

In the image above, we can see what each trade size translates to in an actual currency pair, the EUR/USD. Notice the trade size refers to the first currency in the currency pair, in this case Euros for the EURUSD pair. So a micro lot, mini lot, and standard lot means €1,000, €10,000, and €100,000.

Trend lines

Before reading this lesson, you should have previously read through:

Support and resistance

Market conditions

Trend lines are lines drawn at an angle above or below the price. They are used to give indications as to the immediate trend and indicate when a trend has changed. They can also be used as support and resistance and provide opportunities to open and close positions.

Drawing trend lines

The chart below shows an example of a trend line in a downtrend and an uptrend.

number_1 Shows three swing highs on the downtrend

number_2 Shows three swing lows on the uptrend

When drawing trend lines in a downtrend, you draw them above the price.

You can practice identifying trend lines in the following exercise:

Find the trend linesShow exercise

When you draw trend lines in an uptrend, you draw them below the price. It is the highs on a downtrend and the lows on an uptrend that will determine a trend line.

You can practice identifying trend lines in the following exercise:

Find the trend linesShow exercise

At least two swing highs or swing lows are needed to draw a trend line in either direction.

However, for a trend line to be valid, at least three highs or lows should be used. Essentially, the more times the price touches a trend line, the more valid it is, because there are more traders using them as support or resistance.

Using the wicks or bodies of the candles

To draw trend lines, some traders use the bodies of the candlesticks, while others prefer the wicks. While the majority of people will use the wicks to draw trend lines, the use of the bodies is an acceptable way to draw trend lines on a chart.

The chart below shows a trend line drawn using the wicks of the candlestick.

The next chart below shows a trend line drawn using the bodies of the candles. Either of these are acceptable.

Trend lines are subjective, so use what you feel comfortable with. However, it is important not to deviate from the method that you choose.

Using trend lines to trade

There are two predominant methods in which to trade using trend lines:

Entering when the price finds support or resistance at the trend line

Entering when the price breaks through the trend line

Trend line as support or resistance

If a trend line has been identified and it is holding as support or resistance, then you can use the trend line to enter into the market once the price comes back to it.

es1 Short entry after the price finds resistance at the trend line

sl2 Stop loss above the trend line

The chart above shows the trend line being used as resistance and the price using it to find an entry.

A stop loss can be put on the other side of the trend line. The size of the stop loss depends on the strategy involved.

Trend line break

The trend line break method uses the actual breakout of the line to determine an entry. When the price breaks through a trend line, it is no longer valid as support or resistance and it is likely that the price will continue to reverse direction.

There are two ways to enter using a trend line break: an aggressive entry and a conservative entry.

An aggressive entry

An aggressive way to enter using a trend line break is to enter as soon as the candle breaks through and closes on the other side of the trend line.

es1 Short entry after the price broke through the trend line to the downside

sl2 Stop loss is placed above the trend line

The chart above demonstrates that once the candle closes on the other side of the trend line, then you can enter immediately. A stop loss can be placed on the other side of the trend line.

A conservative entry

A more conservative way of trading the trend line break is to wait until the price has broken through the trend line and then tested from the other side as either support or resistance.

number_1 Price breaks through the trend line to the downside

number_2 Wait for the price to come back to the trend line and find resistance

es3 Once determined that the breakout is true, enter into a short entry

sl4 Stop loss is placed above the trend line

The chart above shows a trend line that has been broken after acting as support. The price then tested it from the other side as resistance, further confirming that the breakout is likely to continue. After the trend line has been tested as resistance, you can enter a short position and place a stop loss on the other side of the trend line.

Caution using trend line breaks

In order to trade a breakout of a trend line, it is a good idea to wait until a candlestick actually closes on the other side, or tests the other side of the trend line as either support or resistance. Without a close on the other side of the trend line, it is generally not considered an actual break.

number_1 False breakout

In the above chart, the price moved below the trend line. However, it retraced and the candlestick closed above the trend line. If a trader entered as soon as the price broke through, it would have been a losing trade.

Currency Names and Symbols

As you may have noticed, the symbols (abbreviations) for all currencies have three letters. The first two letters denote the name of the country and third letter stands for the name of that country’s currency.

As an example, let’s look at the USD. The US stands for United States and the D stands Dollar.

The currencies on which the majority of traders focus are called the “majors”. The most widely traded currencies are represented on the grid below:

Not to be confused with major currencies are the major currency pairs. The Major Pairs are any currency pair with USD in them. For example, the EURUSD would be considered a Major Pair.

Currency pairs without the USD in them are referred to as Cross Pairs. The EURJPY would be an example of a Cross Pair.

To carry this one step further, any EUR pair without the USD in it would be referred to as a Euro Cross. So the EURJPY would be a member of the EURO Cross group. Other member of that group would be EURGBP, EURCHF, EURNZD, EURCAD and EURAUD.

 Other currency groups of this type would be comprised of the JPY crosses, GBP crosses, AUD crosses, NZD crosses and the CHF crosses.

Trading with MACD

The Moving Average Convergence/Divergence indicator, often called just ‘MACD,’ is usually one of the first learned by new traders, and in many cases - this is one of the first oscillators that traders will apply to their chart.

Unfortunately, MACD does not work all the time (which is something that can be said about every indicator based on past price information); and as such many new traders will often eschew MACD after noticing that not every signal would have worked out productively.

In this two-part series, we’re going to look at how MACD is constructed, as well as an additional input setting that may allow traders to take better advantage of the indicator; we’ll then move on to look at 3 specific strategies that traders can look to use with MACD in our next article, Three Simple Strategies for MACD.

What Makes up MACD?

MACD is a very logical indicator, and it does just what the name describes: It measures the spatial relationship of 2 Exponential Moving Averages.

The most common default inputs for MACD are using EMA’s of 12, and 26 periods - along with the ‘signal’ line of 9 periods. For now - let’s just focus on the MACD line itself, which is simply the difference between the 12, and 26 period EMA (using default inputs).

In down-trending markets, the fast moving average will move down faster than the slow moving average. As the fast moving average ‘diverges’ from the slow moving average, MACD will illustrate that relationship. And in up-trending markets, the 12 Period EMA should move up faster than the 26 Period EMA. As such, MACD will move higher to express this growing difference between the 12 and 26 Periods’ Moving Average. The graphic below will illustrate this relationship, with the 12 and 26 period EMAs applied on the chart along with MACD using 12, and 26 periods (signal line removed for examples)

Notice that MACD helped traders notice the trend change from a very early stage, as the blue boxes above began before the downtrend was completely finished.

This is a key part of the indicator, and something we will delve much deeper into with our next article on 3 MACD strategies: Using MACD as a ‘trigger’ into trades. But before we get to that, you probably noticed the ‘0’ line drawn on the MACD indicator in the above chart. This is a key part of the indicator, as it shows us when there is no difference between the EMA’s.

MACD will cross the zero line as the fast Moving Average intersects the slow Moving Average. The picture below will illustrate in more detail:

The Signal Line

As we saw above, MACD can be helpful for noticing potential trend changes at the very early stages of a currency pair’s move.

However, if we wait for a ‘0 line crossover (MACD to cross the ‘0’ line), we are essentially trading a Moving Average Crossover - which is inherently lagging the market and may not be the optimal point of entry.

This is where the ‘Signal Line’ comes into play. The signal line is simply a moving average built on the value of the MACD line. By default, this value is commonly set at 9 periods.

Building on the relationship of the MACD line itself, traders will often look for entry opportunities when MACD crosses the signal line.

When the MACD line crosses ABOVE and OVER the signal line, it is looked at as a signal to BUY. When MACD crosses below the signal line, it is often looked at as a signal to SELL.

As you can see from the above graphic, some of these MACD signals would have worked out beautifully, while others leave something to be desired.

This highlights the reason that traders will often want to look at other indicators or mechanisms of deciding which signals to take or which to ignore. We will go over this in-depth with out article Three Simple Strategies for Trading with MACD.

But, an alternative for traders is to simply use different inputs. This can accomplish the goal of slowing down or speeding up MACD to the trader’s individual preferences.

The Histogram

In an effort to more closely follow the relationship between the MACD and Signal lines, traders can follow the ‘Histogram,’ which is simply a bar chart plotted around the ‘0’ line to indicate the relationship between the MACD and Signal Lines.

Notice in the graphic below - when MACD crosses the signal line, the Histogram will appropriately cross the ‘0’ line. When MACD crosses up and over the signal, the histogram will climb above the ‘0’ line - and when MACD crosses down and below the signal, the histogram will drop below the ‘0’ line.

MACD Inputs

The default MACD inputs of 12, 26, and 9 are the more common settings for the indicator. (The fast MA is listed first, followed by the slow MA, followed by the input of the signal line).

However, this may not be amenable to trader’s goals these inputs may generate too many signals of questionable quality.

Traders looking to take signals solely from MACD, without any additional indicators to assist in grading trends or momentum are often better served by slowing down the indicator by using longer-period moving averages in the inputs.

A common set of inputs to accomplish this goal is the inputs of 21, 55 periods. The chart below will show the difference between the default of 12, 26, and 9 (above) with the inputs of 21, 55, and 9 (below).

Notice that the MACD indicator below gives fewer signals, with the goal of each signal being more reliable.