Why you should trade currencies published by The Investors Chronicle -
By Scherzando Karasu
FOREX trading has a reputation for high-risk, exclusivity and was historically seen as the playground of banks, corporations, hedge funds and other citadels of capitalism, picture foreign-exchange traders and you probably imagine over-paid, over-excited young men in some giant dealing room, all shouting into multiple phones.These days though, you don't have to be a city-slicker to make great profits from the currency markets. With little more than an internet connection and small trading account, pretty much anyone can be a FOREX trader.
What is striking is its colossal and rapidly growing scale of the market. With over $2 trillion a day changing hands it is vastly bigger than stock, bond or commodities markets. With the rapid emergence of online trading platforms and sophisticated technology such as free charting software and real time news-feeds the market has been democratised to a new tier of retail traders who can buy and sell currencies with the click of a mouse.
What are FOREX's main characteristics then and why it has become such an attractive alternative asset group for the retail trader?
It is though probably wise to inject a little caveat-emptor here, as whilst a high degree of leverage allows traders to maximise profit potential, the potential for loss is equally large.
This ability may perhaps make many people shy away from FOREX believing it to be a high risk instrument, but this leverage can be customised to the individual traders own preference according to how aggressive or conservative you are the golden rule being of course; only trade with money you can afford to lose!
In terms of portfolio diversity FOREX plays can have a low correlation with other asset classes, such as equities, the general rule of thumb being that if adding any asset to your total portfolio that is not correlated with your other holdings you have lowered your risk. So not only can you boost your return but lower risk, if you select wisely.
What Makes a Winning Trader
Scherzando Karasu
There's no substitute for real-life experience in trading, so we asked a successful trader how he operates.
Great traders aren't born, but made. To find out what makes a winning trader, we asked Michael Hamilton, who's been making money from financial markets for more than two decades.
Michael was running a design business when he took up trading for a hobby. He quickly developed a passion for markets and sought guidance from some of the top traders in the UK and US. This helped him build his own approach to trading, which draws on both fundamental and technical analysis.
“I realised that fundamentals and technicals were most powerful if combined. So, I developed a system which uses market proxies, trend and cycle analysis to give me an incredible edge when trading. My golden rule is watch current price action and not time-lagged indicators.”
Following where institutional money is flowing is also at the heart to his approach. “I am sometimes contrarian because of it but I am often ahead of the market. If you know how to use market proxies and fundamentals, my system can help you see the big picture and trade with greater clarity and confidence.”
Here are some of the key lessons that Michael believes every trader needs to learn.
Follow the trend
The trend really is your friend. “Always watch the trend and use this to your advantage, as well as paying attention to how the fundamentals are moving and how they are affecting the market,” says Michael.
In order to do so, you need to study charts carefully and learn how prices move. As well as watching the price action unfold on graphs, Michael does back-testing of various trading set-ups to see how a particular trading strategy would have paid off in the past.
As a result of his approach, Michael has enjoyed some high-profile winners over the years. When gold surged through $1000 earlier this year - and commentators were predicting imminent massive gains - Michael ignored the hype and sold for a profit. He also got out of dotcom shares two months before the technology bubble burst in 2000 and liquidated most of his equity holdings hours ahead of the Black Wednesday crash in 1987.
All markets are linked
Just because you are a foreign exchange trader doesn't mean you can afford to ignore the stock, bond and commodity markets. Michael stresses that all financial markets are interlinked and you need to learn what sort of relationships exist between them.
His main focus is on the US dollar, which reflects the overall appetite for risk. In recent months, the dollar has tended to fall as stock markets and other risky assets have risen. A weak US dollar has long been associated with strong commodity prices, especially in oil, copper and gold.
It is worth keeping a close eye on gold, as it can give important messages about the outlook for inflation. Inflation is a critical issue for forex traders, as differences between countries' inflation levels have a strong bearing on interest rates and hence on exchange rates.
Understand economics
Economic factors are most influential over long periods. But releases of sensitive economic data can have an enormous impact on the day to day movements of markets.
“Currently, all eyes are on the trends in the monthly payroll figures that are due out of the US on Friday 2 October. If you have a situation where the dollar is the key proxy then the state of the US market is going to tell you what will happen amongst the major currency pairs and that is why my focus is currently on the US.”
Everything is cyclical
All asset classes move in cycles. This is equally true over shorter periods as it is over many decades. Although stocks have proved the best-performing asset class over the long run, there have been decades where commodities have done much better, such as the 1970s and the last few years.
A cycle starts at a trough, builds up to a peak and ends in a new trough, with the process repeating thereafter. The obvious way to try and play a cycle is by identifying potential peaks and troughs and joining the latest swing soon after it begins.
"On a basic level, all I do is buy on confirmation of reversals at the low point, and sell on reversals in the high," says Michael. "Obviously, there's more to my trading that, but that is the essence of it."
Getting your head right
Trading requires a special mindset. According to Michael, developing the right mentality is more than half the battle when it comes to becoming a trader. But it doesn't happen easily.
“When I teach people to trade, I have to un-teach them what they may have been taught throughout life - that winning is not the imperative - that you have be able to accept losing as an integral part of trading. You have to unwire yourself from the psychology of always having to win.”
He accepts that there is a huge failure rate amongst retail traders and that many people will simply never make good traders.
“It will take anything between six months and two years to try and day-trade for a living, it takes that period of time to see enough set-ups and really learn to accept losses. The discipline of trading is absolute”.
Novice traders often pursue a losing position in a bid to break even. “You should always to stick to your trade-plan. If X or Y happens in the market and I lose, I simply stop trading. The more unemotional and systematic you are , the better a trader you will be.”
Managing risk
Even if your market calls are generally right, you can still end up losing money unless your risk and money management are correct.
“I never risk more than 2 per cent of my total account on any single trade," says Michael. "And I have a specific daily target for profit-and-loss at which point I will stop trading. I also maintain a minimum reward/risk ratio of 3 to 1."
"When I have a bad day, I then limit my trading. And if this happens more than once, I take a day off”.
Placing your first trade
Entering and exiting forex trades is easy enough but still needs planning
Scherzando Karasu
Placing a foreign exchange trade couldn't be simpler. In just a couple of clicks, you could be speculating on the Yen to rise against the Swiss Franc or on the South African Rand to fall against the Euro. All you need is a decent internet connection and as little as a few hundred dollars.
Picking what to trade
Having opened an account with a good forex broker - see our article on page xx for more on this - it's down to the business of selecting trades. All the many currency pairs on offer may seem a little bewildering at first. The best approach is to focus on just a few pairs and get to know them really well.
As a short-term trader, your main source of inspiration will be charts and news-flow. By looking at price-charts, you can spot trends in their early stages and try and ride them for as long as possible. Or, you can identify trends that are showing fatigue and speculate on their reversing.
Even if you mainly use charts for your research, you should also follow the news that drives prices. Interest-rate changes and economic releases - such as inflation and employment reports - frequently lead to significant moves in exchange rates. Learn the significance of these factors and ensure you know when the announcements are due. For more on keeping up to date with the markets, see page xx.
Plan your moves
Before you place a trade, you should have a clear idea of the price you want to get in at, your target price and your get-out price if things go against you. So, you might decide to buy sterling if it rises to $1.6001. You can either wait for it to hit that level and place your trade manually. Or, you can set up an order to buy automatically at that price.
Your charts tell you sterling is likely to reach at least $1.6312. Therefore, you place a "limit order" at that level, which will automatically close your trade at a profit if sterling fulfils your target. Remember, the forex market is open 24 hours a day, so you won’t necessarily be in front of your screen when the key moment arrives. You have to use orders, therefore.
As well as knowing where you'd take profits, you need to figure out the level at which you'd cut your losses if things went against you. At the same time, you feel that you would change your positive outlook on sterling if it dropped below $1.5896. You place a stop-loss order at that price, which will cut your losses if things go against you.
Deciding how much to risk
When you come to place a trade, you also need to decide the value of your position. Because forex is leveraged, you can control a position worth many times more than the funds you have in your account. For instance, you could easily take out a position worth $1 million even if you only have $10,000 in your account. This makes it easy to rack up super-sized profits, but also super-sized losses if you are not careful.
Especially when you are just starting out in trading, it is best to err on the side of caution when sizing your positions. Choose small total position sizes and place your stop order so as to keep your potential loss on each trade small. It is worth having a rule of never risking more than a certain percentage of your total funds on any single trade. If you only risk 5 per cent of your capital on each trade, you can survive a string losing positions.
Keep an eye on costs
Always be aware of how much your trades are costing you. One element is the spread, the difference the broker charges you to open and close trades. Using a broker that offers fixed spreads is one way to control this easily. You should also track financing charges, which is the interest cost charged on your position's value.
FOREX trading has a reputation for high-risk, exclusivity and was historically seen as the playground of banks, corporations, hedge funds and other citadels of capitalism, picture foreign-exchange traders and you probably imagine over-paid, over-excited young men in some giant dealing room, all shouting into multiple phones.These days though, you don't have to be a city-slicker to make great profits from the currency markets. With little more than an internet connection and small trading account, pretty much anyone can be a FOREX trader.
What is striking is its colossal and rapidly growing scale of the market. With over $2 trillion a day changing hands it is vastly bigger than stock, bond or commodities markets. With the rapid emergence of online trading platforms and sophisticated technology such as free charting software and real time news-feeds the market has been democratised to a new tier of retail traders who can buy and sell currencies with the click of a mouse.
What are FOREX's main characteristics then and why it has become such an attractive alternative asset group for the retail trader?
- Firstly its size and unparalleled liquidity, traders need never concern themselves with this again, especially when it comes to trading any of the major currencies such as USD, GBP, EUR and CHF.
- There is always a trading opportunity somewhere as currency is a 24 hour global market, following the sun five and a half days a week. As Tokyo closes London is opening for business.
- You have the miraculous ability to go short or long at any time. Currencies are always traded in pairs so you can be bullish in one and bearish in another shorting or longing a currency pair anytime without restrictions. This gives a tremendous advantage and flexibility as traders are able to profit from both up and down trends at anytime.With stocks, bonds and commodities they can all fall together, not so with currencies. A zero-sum-game, as one currencies loss is another’s gain. This simultaneous act of buying and selling is the most important aspect of FOREX.
- Leverage many retail FOREX brokers offer a sizeable leverageto customers of up to 400 times and the Forex market indisputably offers the highest amount of leverage compared to other markets, so small movements can result in big profits, and let’s face it who doesn’t like trading on other people’s money?
- Volatility is another attractive feature of this market, the benefit being that the more a currency pair moves that day, the greater the chance that profits can be made intra-day. A broad spectrum of volatility means that there is something to suit everyone from the aggressive to the risk averse there is a currency pair for you.
It is though probably wise to inject a little caveat-emptor here, as whilst a high degree of leverage allows traders to maximise profit potential, the potential for loss is equally large.
This ability may perhaps make many people shy away from FOREX believing it to be a high risk instrument, but this leverage can be customised to the individual traders own preference according to how aggressive or conservative you are the golden rule being of course; only trade with money you can afford to lose!
In terms of portfolio diversity FOREX plays can have a low correlation with other asset classes, such as equities, the general rule of thumb being that if adding any asset to your total portfolio that is not correlated with your other holdings you have lowered your risk. So not only can you boost your return but lower risk, if you select wisely.
What Makes a Winning Trader
Scherzando Karasu
There's no substitute for real-life experience in trading, so we asked a successful trader how he operates.
Great traders aren't born, but made. To find out what makes a winning trader, we asked Michael Hamilton, who's been making money from financial markets for more than two decades.
Michael was running a design business when he took up trading for a hobby. He quickly developed a passion for markets and sought guidance from some of the top traders in the UK and US. This helped him build his own approach to trading, which draws on both fundamental and technical analysis.
“I realised that fundamentals and technicals were most powerful if combined. So, I developed a system which uses market proxies, trend and cycle analysis to give me an incredible edge when trading. My golden rule is watch current price action and not time-lagged indicators.”
Following where institutional money is flowing is also at the heart to his approach. “I am sometimes contrarian because of it but I am often ahead of the market. If you know how to use market proxies and fundamentals, my system can help you see the big picture and trade with greater clarity and confidence.”
Here are some of the key lessons that Michael believes every trader needs to learn.
Follow the trend
The trend really is your friend. “Always watch the trend and use this to your advantage, as well as paying attention to how the fundamentals are moving and how they are affecting the market,” says Michael.
In order to do so, you need to study charts carefully and learn how prices move. As well as watching the price action unfold on graphs, Michael does back-testing of various trading set-ups to see how a particular trading strategy would have paid off in the past.
As a result of his approach, Michael has enjoyed some high-profile winners over the years. When gold surged through $1000 earlier this year - and commentators were predicting imminent massive gains - Michael ignored the hype and sold for a profit. He also got out of dotcom shares two months before the technology bubble burst in 2000 and liquidated most of his equity holdings hours ahead of the Black Wednesday crash in 1987.
All markets are linked
Just because you are a foreign exchange trader doesn't mean you can afford to ignore the stock, bond and commodity markets. Michael stresses that all financial markets are interlinked and you need to learn what sort of relationships exist between them.
His main focus is on the US dollar, which reflects the overall appetite for risk. In recent months, the dollar has tended to fall as stock markets and other risky assets have risen. A weak US dollar has long been associated with strong commodity prices, especially in oil, copper and gold.
It is worth keeping a close eye on gold, as it can give important messages about the outlook for inflation. Inflation is a critical issue for forex traders, as differences between countries' inflation levels have a strong bearing on interest rates and hence on exchange rates.
Understand economics
Economic factors are most influential over long periods. But releases of sensitive economic data can have an enormous impact on the day to day movements of markets.
“Currently, all eyes are on the trends in the monthly payroll figures that are due out of the US on Friday 2 October. If you have a situation where the dollar is the key proxy then the state of the US market is going to tell you what will happen amongst the major currency pairs and that is why my focus is currently on the US.”
Everything is cyclical
All asset classes move in cycles. This is equally true over shorter periods as it is over many decades. Although stocks have proved the best-performing asset class over the long run, there have been decades where commodities have done much better, such as the 1970s and the last few years.
A cycle starts at a trough, builds up to a peak and ends in a new trough, with the process repeating thereafter. The obvious way to try and play a cycle is by identifying potential peaks and troughs and joining the latest swing soon after it begins.
"On a basic level, all I do is buy on confirmation of reversals at the low point, and sell on reversals in the high," says Michael. "Obviously, there's more to my trading that, but that is the essence of it."
Getting your head right
Trading requires a special mindset. According to Michael, developing the right mentality is more than half the battle when it comes to becoming a trader. But it doesn't happen easily.
“When I teach people to trade, I have to un-teach them what they may have been taught throughout life - that winning is not the imperative - that you have be able to accept losing as an integral part of trading. You have to unwire yourself from the psychology of always having to win.”
He accepts that there is a huge failure rate amongst retail traders and that many people will simply never make good traders.
“It will take anything between six months and two years to try and day-trade for a living, it takes that period of time to see enough set-ups and really learn to accept losses. The discipline of trading is absolute”.
Novice traders often pursue a losing position in a bid to break even. “You should always to stick to your trade-plan. If X or Y happens in the market and I lose, I simply stop trading. The more unemotional and systematic you are , the better a trader you will be.”
Managing risk
Even if your market calls are generally right, you can still end up losing money unless your risk and money management are correct.
“I never risk more than 2 per cent of my total account on any single trade," says Michael. "And I have a specific daily target for profit-and-loss at which point I will stop trading. I also maintain a minimum reward/risk ratio of 3 to 1."
"When I have a bad day, I then limit my trading. And if this happens more than once, I take a day off”.
Placing your first trade
Entering and exiting forex trades is easy enough but still needs planning
Scherzando Karasu
Placing a foreign exchange trade couldn't be simpler. In just a couple of clicks, you could be speculating on the Yen to rise against the Swiss Franc or on the South African Rand to fall against the Euro. All you need is a decent internet connection and as little as a few hundred dollars.
Picking what to trade
Having opened an account with a good forex broker - see our article on page xx for more on this - it's down to the business of selecting trades. All the many currency pairs on offer may seem a little bewildering at first. The best approach is to focus on just a few pairs and get to know them really well.
As a short-term trader, your main source of inspiration will be charts and news-flow. By looking at price-charts, you can spot trends in their early stages and try and ride them for as long as possible. Or, you can identify trends that are showing fatigue and speculate on their reversing.
Even if you mainly use charts for your research, you should also follow the news that drives prices. Interest-rate changes and economic releases - such as inflation and employment reports - frequently lead to significant moves in exchange rates. Learn the significance of these factors and ensure you know when the announcements are due. For more on keeping up to date with the markets, see page xx.
Plan your moves
Before you place a trade, you should have a clear idea of the price you want to get in at, your target price and your get-out price if things go against you. So, you might decide to buy sterling if it rises to $1.6001. You can either wait for it to hit that level and place your trade manually. Or, you can set up an order to buy automatically at that price.
Your charts tell you sterling is likely to reach at least $1.6312. Therefore, you place a "limit order" at that level, which will automatically close your trade at a profit if sterling fulfils your target. Remember, the forex market is open 24 hours a day, so you won’t necessarily be in front of your screen when the key moment arrives. You have to use orders, therefore.
As well as knowing where you'd take profits, you need to figure out the level at which you'd cut your losses if things went against you. At the same time, you feel that you would change your positive outlook on sterling if it dropped below $1.5896. You place a stop-loss order at that price, which will cut your losses if things go against you.
Deciding how much to risk
When you come to place a trade, you also need to decide the value of your position. Because forex is leveraged, you can control a position worth many times more than the funds you have in your account. For instance, you could easily take out a position worth $1 million even if you only have $10,000 in your account. This makes it easy to rack up super-sized profits, but also super-sized losses if you are not careful.
Especially when you are just starting out in trading, it is best to err on the side of caution when sizing your positions. Choose small total position sizes and place your stop order so as to keep your potential loss on each trade small. It is worth having a rule of never risking more than a certain percentage of your total funds on any single trade. If you only risk 5 per cent of your capital on each trade, you can survive a string losing positions.
Keep an eye on costs
Always be aware of how much your trades are costing you. One element is the spread, the difference the broker charges you to open and close trades. Using a broker that offers fixed spreads is one way to control this easily. You should also track financing charges, which is the interest cost charged on your position's value.
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