Currencies are traded in the foreign exchange market (Forex) 24 hours a day, 7 days a week. This article deals with the advantages of currency trading, and provides some useful tips.
Forex is the largest and the most liquid financial market in the world, and the very size of the market tends to reduce the possibility of manipulation by a select group of people. Hence, the foreign exchange market is loosely regulated by the Commodity Futures Trading Commission (CFTC). Currency pairs are not traded in a centralized exchange, but are traded between agreeable buyers and sellers in the over-the-counter market (OTC).
Tips for Currency Trading
Using Leverage Wisely
Use of leverage is encouraged in the foreign exchange market since fluctuations in the price of a currency pair are typically fractions of a cent. The maximum leverage that can be employed by a trader is calculated using the following formula:
Maximum Leverage (Margin-Based Leverage) = Value of Transaction / Margin Requirement
For instance, if a person wants to control $100,000 worth of trade, he/she can borrow the sum from the broker by depositing a small initial margin. Say, the margin requirement is 2 percent of the total transaction value, the trader is expected to deposit $2000. Thus, the trader’s margin based leverage is 50:1. Using excessive leverage, especially when one is unsure about the direction of the market, can land one in deep trouble. Trading on margin is only advisable for people who have the capability of interpreting Forex signals or have reliable automatic trading robots.
Placing Stop and Limit Orders
Placing stop orders is useful from the perspective of limiting losses and taking advantage of the potential upside breakout. Placing a limit order allows people to enter a new position or to exit a current position at the specified or better price. A limit order may never be executed because the market price may quickly surpass the limit before the order can be executed. The term better is relative to the nature of the limit order that is placed.
A trader, who would like to sell a currency pair, places a limit sell order at a price above the current market price to book profits; while a trader, who would like to buy, sets a limit price below the current price. In the first case, the sell-stop order should be placed below the current market price to attempt to cap the loss on the position while in the second case a buy-stop order should be placed at a level above the current price. These are useful currency trading strategies.
Using Fundamental and Technical Analysis
Fundamental and Technical analysis are different, although both are necessary from the perspective of gauging currency movements. The former tries to determine fluctuations in the price of the currency by assessing factors that have a direct bearing on the value of the currency; while the latter relies on charts and graphs to effectively compare past trends and repetitive patterns to predict fluctuations in value. The charts, that are used in technical analysis, are Line Charts, Bar Charts and Candlestick Charts.
Line charts connect the opening and the closing price with a line while bar charts use vertical bars to indicate the range of the currency for a given time period. Candlestick charts give the opening price, the closing price, the highest price and the lowest price with the help of a vertical bar. If the closing price is less than the opening price, the vertical bar is colored.
Understanding Chart Indicators
Understanding leading and lagging indicators is critical from the perspective of being able to spot changes that may occur in the movement of currency pairs.
Leading indicators help a trader spot a change where the previous trend has run its course and the price is ready to change direction again. Lagging indicators provide an indication of the possible changes in trend once the change is clearly visible. The latter is meant to encourage people to move with the herd while the former is useful for a trader who is adept at spotting reversals before they occur.
Although, leading indicators seem like a potential gold mine, they have the tendency of misleading or giving wrong signals. Lagging indicators, on the other hand, rarely mislead. However, the downside is that a person may lose the opportunity to make a huge kill and may end up with a smaller chunk. The most common leading and lagging indicators are Oscillators and Momentum indicators respectively.
Stochastic, Parabolic Stop and Reversal (SAR) and Relative Strength Index (RSI) are examples of oscillators that used to determine overbought and oversold market conditions. For instance, in the case of Relative Strength Index (RSI), on a scale of 0 to 100, a value below 20 indicates an oversold market while a value above 80 indicates an overbought market. If a chart has been indicating oversold (or overbought) conditions, for a certain length of time, one can expect an increase (or decrease) in the price of the currency pair in future. The problem with the aforementioned leading indicators, is that they may provide conflicting signals. In such a situation it would be best to ignore the signal.
Momentum indicators are lagging indicators that generally give the right signal at the expense of delayed entry. People have to choose between leading and lagging indicators since the signals are generally conflicting.
Forex trading requires the ability to interpret a number of chart indicators needed for ensuring profitable trade. There are numerous signal systems that have been designed by professional money managers. These systems have been designed using past performance and trends to simulate results that may reflect the actual trading environment. Both mechanical and automated Forex currency trading systems are available in the market. The latter does not require the presence of a trader in order to execute trades while the former provides tips that are useful for executing trades.
Automatic trading robots ensure round the clock trades without any supervision and are thus effective in removing the human element from trading. Fully automatic trading robots can help one dispense with brokers who were previously required to manage accounts. However, one must remember that past performance is not indicative of future results. So, a robot that works well during back testing may not always yield the best results.
A good system should be constantly monitored in order to ensure improved and optimized trade. The trading account should require less investment and initially, one should be able to trade with a demo account. Forex robot systems should also have an inbuilt loss protection mechanism since these systems are not foolproof. These robots can be used by traders, brokers and institutional investors.
Advantages of Currency Trading
As mentioned earlier, Forex is the most liquid market in the world. Increased liquidity ensures that the trades gets executed at the desired price.
Ability to Use Leverage
Increased use of leverage is permitted, since price fluctuations are typically fractions of a cent. People are allowed to start trading with very little money in their account and are encouraged to control an extensive sum of money in lieu of an initial margin requirement.
The ability to employ leverage results in increased return on investment (ROI). Huge profits with a small up-front investment is one of the benefits of Forex trading. Moreover, traders are allowed to split their capital gains to their advantage since regardless of the time of executing the trade, 40 percent of the profits that accrue to the trader get taxed at the short term capital gains rate while the remaining 60 percent is taxed at the lower long-term capital gains rates.
People are allowed to place both buy-stop orders and sell-stop orders. The former allows the trader to buy the currency pair at a price that is set above the current market price. The buy-stop order is triggered when the market price touches or exceeds the buy-stop price. People place stop-orders when they would like to trade the potential upside breakout.
Similarly, sell-stop orders can be placed to sell the currency pair at a price that is set lower than the current price. The sell-stop order is triggered when the market price touches or falls below the sell-stop price. These sell-stop orders are placed by traders in order to limit their losses. These are also known as stop-loss orders.
Low/No Processing Fee
Many brokers do not charge extra fees for opening or closing a trading account, for phone trading, for inactive accounts or for changing stop or limit orders.
The absence of commission on Forex trades is another benefit. This is because the spread between the bid/ask price is the compensation for market makers.
Most businesses undertake currency hedging to prevent losses that accrue on account of unfavorable exchange rate movements. One must remember that, although an experienced Forex trader has the opportunity of reaping rich rewards, the chances of losing money, especially when one is overly leveraged, cannot be ruled out.