welcometoforex.pdf

The Forex Report – CORE CONCEPTS

JANUARY 2005

Welcome to Forex

By Scott Owens

Go to a dinner party and mention your

involvement with forex and you’re likely to get

a few baffled looks. Most people don’t have a

clue what forex is or how it works. Worst of

all, neither do most beginning forex traders.

Understanding what makes these markets tick

is a good step towards a successful trading

record.

ANALYSIS

• Get the answers to the most frequent questions about the foreign exchange

marketplace.

ACTION

• Learn more about the other forces that shape forex.

• Choose a few basic trading strategies to get started.

• Start trading, but don’t bet the farm.

RELATED MATERIAL

Test-drive FX Engines for free online at www.fxengines.com to see the power of

system building, system testing, and system automation.

FX Engines, Inc.

The world leader in

automated forex trading.

For more information and

a free account, visit:

ABOUT THIS REPORT

The Forex Report is a periodic publication that investigates advanced strategies

for superior trading performance in the foreign exchange markets. These

reports utilize advanced statistical and econometric modeling techniques to

create new insight into the trading strategy of the average trader. This Core

Concept Brief, Welcome to Forex, is intended for traders with all levels of forex

trading experience and technical analysis understanding.

www.fxengines.com

To learn more about The Forex Report or to register for delivery of all future

reports by email, including Case Studies & Data Briefs, please visit

www.fxengines.com.

The Forex Report January 2005

ANALYSIS

Forex is full of many concepts that are foreign to traders who have

previously specialized in stocks or commodities. Understanding these

aspects of forex is a key to making you more comfortable in this new

trading environment.

Q: What is forex?

A: Forex is the foreign exchange marketplace where currencies from

different countries are valued and exchanged. Most people only know

about forex to the extent that they have changed money going from one

country to another. When they did so, they unwittingly played a role in the

world’s biggest marketplace. Forex trades almost $2 trillion per day, a

total that exceeds all of the world’s biggest – and better known – markets.

Since currencies are valued differently, there is a market in place to set

those values. Where a market exists speculation inevitably follows. In this

case, the market is hyper-active. Banks sending deposits around the

world, corporations hedging their exposure to currency risk in different

countries, government banks forwarding national economic goals through

monetary policy, and massive investment funds playing the role of

speculator. Not long ago, that was the extent of the market. It was the

domain of the professional trader or banker.

The word “market” usually invokes the idea of a central market place like

the New York or London exchanges. This is not the case in forex. Instead,

forex functions through what is known as the “interbank” market.

Interbank is a fancy way of saying that banks trade with each other, absent

a central market place. This is one major reason why volume data is not

available for forex. It’s also the reason why retail investors and smaller

traders were left on the sideline for so long.

In the 90’s, a series of events unfolded that made forex available to retail

investors. Deregulation led many companies to form pools of liquidity

where retail investors could take advantage of the huge speculative

opportunity in forex. These dealers offered high leverage, low minimums,

and a new way to trade – 24/7.

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The Forex Report January 2005

Q: What are pairs and pips?

A: Each currency exists in the marketplace not on its own, but as a “cross”

between itself and another currency. This is practical, since when you

travel to Europe you want to exchange your money for Euros. If you have

US Dollars, you will be exchanging money at the rate set by EURUSD.

EURUSD is a “pair”. It also happens to be the most popular pair. Most

currencies are paired with EUR and USD, and to other currencies to a

lesser extent. The “four majors” are EURUSD (Euro/Dollar), USDJPY

(Dollar/Yen), GBPUSD (Pound/Dollar), and USDCHF (Dollar/Franc).

The bid-ask spread is usually lowest for the four majors, since their

volume is the highest. With high volume the dealer is usually assured of

having ample liquidity to meet your trading needs, so they charge you less

through the spread. For more obscure, less traded pairs, the spread will be

more, since dealers assume more risk in completing those transactions.

The spread itself is made up of pips. A pip is simply an incremental unit in

forex. In stocks, you call them ticks or points. That makes sense because

usually all stocks are quoted in the same currency. In forex, each currency

may have a different incremental unit. For example, a quote in EURUSD

might be 1.3240, versus a quote in USDJPY at 107.87. What is the

incremental unit? There is no common unit, so one was created, and it

was named a pip. A pip is always worth $10 if the pair ends in USD. If

not, you will need to refer to a pip calculator to get the value, since these

per pip values can vary, even within the same currency.

Q: How do you trade forex?

A: There are two major methods for trading forex: fundamental and

technical.

Fundamental analysis relies upon a broad and near-expert understanding

of multi-national macroeconomic statistics and events.

Fundamental traders believe that the value of a pair is determined by the

underlying health of the two nations involved in the pair. A high value for

GBPUSD, for example, would suggest a better economic outlook in Britain

vis-à-vis the United States. Global events like news, catastrophes, politics

or economic shocks all play a role in determining price.

Technical analysis is based on the mathematical analysis of price, and of

many variables which all derive from price. Technical traders believe that

technical indicators include fundamental analysis and also provide

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The Forex Report January 2005

repeatable, tradable patterns. Technical traders use charts to determine

support and resistance, draw trend lines, or analyze measures like moving

averages, etc.

Whichever camp you belong to determines your trading approach. A

fundamental trader may take the Warren Buffet approach and buy-and-

hold a pair, expecting long term returns. A technical trader may play long

term as well, but usually day trades. Some fundamental traders trade on

news, which may just be certain days of the month.

Q: What is leverage?

A: Since dealers have ultimate control over accounts and trades, they are

willing to loan money to the trader. That’s called margin – basically a loan

from the dealer to the trader, but based on the trader’s equity. Normally if

the trader wants to trade EURUSD he would need $100K, but not if the

dealer offers margin. Margin is another word for leverage, with a little

difference in concept.

Some dealers will allow you to trade a full standard contract with just

$500 in margin available. That means the user has to have at least $500

(or really $500 + spread) in their account to trade. If at any time their

account balance equals or drops below their margin requirement, the

dealer will liquidate all of their positions. That’s called a Margin Call. So if

you traded 5 contracts with $4,000 in your account, you would be using

$2500 in margin. If the trade went against you $1500, you would be taken

out.

When you traded the one contract with $500 in margin, you controlled

$100,000. That’s leverage. It’s 200:1 in this case (leverage = $100,000

divided by $ per contract as a % of total equity). In this example, you

would only be employing 200:1 leverage if your account equity was $500.

Most dealers have scaling margin which allows smaller accounts to use

something like 200:1 and bigger accounts to use 50:1, or 10:1. If you had

$20K in your account and played 40 contracts, that would be 200:1

leverage. $100K with 10 contracts is 10:1.

Leverage is one of the biggest reasons people trade forex, but it’s also one

of the biggest reasons people lose money. Be careful to manage your

leverage position when trading, especially when starting out.

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The Forex Report January 2005

Q: What tools do I need when starting out?

A: First, common sense and good judgment! Dealers make it very easy for

new traders to come in and make money, but many of those same features

make it possible to lose money very quickly. Use the demo system to start,

and then be sure to begin with one mini contract (controls $10,000, not

$100,000 like the standard contract).

Beyond that, you will need a trading platform, charts, and/or a news

service. Joining a trading community with forums is also a great way to

learn.

Most dealers will provide a trading platform. Some offer an automated

platform on their own, and others offer an automated platform through a

third party. FX Engines offers its automated trading platform with many

features for beginning traders, and routes all trades through FXCM, the

world’s largest dealer. Other automated trading platforms may be

different.

Charts are sometimes offered through the trading platform, as is news. If

not, check one of the many forex forums online to get a sense for what

people think are good chart and news subscriptions, then give those a try.

Q: What’s the most important element in trading forex?

A: Discipline. That’s easy to say and much easier to practice in other

markets. Forex makes it tougher because it’s always open, and big moves

are always happening. It’s one of the reasons why an automated system is

so valuable in forex.

Even if you forego automation, you need to develop a script for trading

that you can always follow. Consistency is the key, and your ability to stay

consistent will surely be challenged.

Learn all you can, build a system, and practice trading before you risk a

dollar. The early losses that come from a rush to trading can damage

confidence, and that can be difficult to repair. The markets are going

nowhere – if you take the time to learn and then consistently apply your

knowledge to this huge market your rewards will surely follow.

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