FX Trading

A Guide to Trading Foreign Exchange

Alex Douglas, Larry Lovrencic, Peter Pontikis

• Publisher: Wiley
• Year: 2011
• ISBN:
  9780730376545
• Edition: 2
• Topic: Business
• Subtopic: Operazioni di cambio
• Index: Business

Your total plain-English guide to trading Forex

Open 24 hours a day, 5½ days per week, and trading nearly $4 trillion (US) per day, Forex is the biggest, fastest growing financial market in the world. Your complete A-to-Z guide, FX Trading gets you up to speed on everything you need to know to make a killing trading Forex. Starting with the basics of money management, analysis, and FX market trading mechanics, it swiftly advances into more advanced territory, discussing trading strategies and wealth management.

From quotations, pips and spreads to the pros and cons of using online brokers and websites to FX risk management, FX Trading is an indispensable tool of the trade for beginners and experienced Forex traders alike.

• Helps you to see past the media hype, while alerting you to common Forex trading mistakes and pitfalls and how to avoid them
• Filled with invaluable expert insights and proven strategies, backed by numerous examples, charts and checklists
• Updated to reflect the enormous growth in Forex trading and the new players involved, as well as the many changes wrought by the global financial crisis and the rapid evolution of electronic trading platforms

Chapter 1: Money management — an overview

The more things change, the more they stay the same.

There is no doubt that the environment in which we trade is evolving rapidly. Since the first edition of this book was published in 2005 we have seen the rise of high-frequency trading, the adoption of algorithmic trading robots by retail traders, an explosion in the use of social networking and a significant increase in both the number and quality of brokers catering to retail foreign exchange traders.

No matter how much the trading environment changes and technology advances, the ultimate goal remains the same: to make a profit.

Over the years, in various locations around the world, we have encountered dozens of trading experts who have shared their knowledge through seminars, conferences, workshops, books, software, websites and blogs. In all probability you have also encountered some of the same people. Many claim to have discovered or created a special secret or tool that has helped them achieve phenomenal trading success, while others have diligently studied the methods of successful traders of days gone by. Some are willing to share this information for a token fee, while others attempt to charge truly eye-popping amounts of money based on the promise of untold fortunes to be made. As you would expect, some are worth every cent and some are not (even some of the free ones!).

As we look back over the methods and techniques presented by these traders, analysts and commentators, one point has become startlingly clear — and it is not just that some techniques ‘work’ and others don’t. On the surface of it, all the market experts we have come across have different techniques for deciding when to enter and when to exit the market, but of those who have been demonstrably successful in the markets, there is one thing — and only one thing — that they all have in common: they all have a stringent method of money management and they all follow it unfailingly.

Although the journey taken by each trader is unique and will be influenced by changes in technology and the trading environment, the need for sound money management remains constant. To my mind, then, if there is a ‘Holy Grail’ in trading, money management must be it.

First things first: money management is by no means exclusive to the field of foreign exchange trading. It is used by traders in all markets. Those who are most diligent in its application tend to have the longest and most successful trading careers. At its core are the goals of protecting capital and maximising profits through appropriate trade selection, position sizing and exit strategies, with an overall focus on the discipline of adhering to the money management plan. Hence, money management is more about the process than the tactic to achieve the result; perhaps it could be described as the oyster shell that encases the growing pearl that is your trading methodology. Fingers crossed that with the discipline of iron-clad money management your wealth will grow steadily and surely for you to reap its eventual rewards.

But now we come to a considerable structural challenge for this book: we believe that the first chapter of any trading book should be on the topic of money management. However, beyond the briefest outline it is difficult to provide any kind of instruction or explanation of money management if the ground upon which it is set is yet to be explained or set out in detail. The overriding purpose of this book is to introduce you to the characteristics and jargon that are unique to the foreign exchange market, so it makes sense to leave the rest of this chapter until the end of the book. But in so doing, please do not let this lead you to believe it is any less important. Once more for the record: effective money management is absolutely crucial to your long-term trading success.

Now, let’s find out what foreign exchange is …

Chapter 2: What is foreign exchange?

The abbreviations and words ‘FX’, ‘forex’ and ‘foreign exchange’ are all interchangeable terms used to describe the market in which the currency of one country is exchanged for that of another country. Foreign exchange transactions may be as simple as those encountered by a tourist when visiting a local money changer to conduct a physical exchange of one currency for another, or as complex as multi-legged option strategies executed between global investment banks over electronic trading platforms with multiple settlement dates in multiple currencies. Each transaction forms a part of the foreign exchange market.

An important concept to understand from the beginning is that, unlike the equities and futures markets, the foreign exchange market does not have a physical ‘exchange’ in which transactions are conducted. Nor is there a single electronic platform for the execution of FX trades. Foreign exchange is what is known as an ‘over-the-counter’ (OTC) market. In basic terms, this means that any two parties that come together and exchange currencies between one another on agreed terms are participating in the foreign exchange market. Unlike an ‘exchange-traded market’, like that which operates through the Australian Securities Exchange (ASX), with an OTC market there is no need for either party to report a trade to a central exchange, or for any other third party to ever know of the existence of the trade.

While it is possible for every foreign exchange transaction to have a unique set of characteristics agreed to by each party, for the sake of simplicity and efficiency certain market conventions have emerged that allow for trading to take place within a framework of standard rules and conditions. These FX market conventions cover issues such as quoting methodology, terminology, and settlement dates and procedures. Because foreign exchange trading follows these conventions, we can view trades executed via many different methods as all forming a part of the one market. Don’t worry, we’ll get to explanations of the different methods of FX trading over the next few chapters.

Market segments: wholesale, clients (of wholesale) and brokers

Chapter 5 covers the three main groups of players and forums for FX trading, but let’s have a quick look. Without doubt the biggest players in foreign exchange are the major international investment banks and fund managers. The activities of this section of the wholesale market drive the majority of moves in the market, influencing the levels at which one currency may be exchanged for another. Despite the OTC nature of the forex market, most trading that takes place around the world will be executed at prices that are very close to replicating those rates that are currently being used by these major players in what is known as the ‘inter-bank’ market. Any notable difference between the rates on the retail market and the inter-bank market would quickly be arbitraged out of existence (arbitrage is seeking to profit from price differences by buying or selling from one party for immediate resale or purchase to another). Traders would notice the difference and move to profit from the gap, buying in the underpriced market and selling in the overpriced market, quickly bringing the two back into line.

Importantly, the vast majority of transactions in the foreign exchange market take place between major institutional players in the inter-bank market. Corporations and small to mid-sized financial institutions generally use one of the major trading banks as their intermediary to the foreign exchange market. While some sophisticated and wealthy private traders are also able to participate in the forex market via an intermediary trading bank, it is becoming much more common for private retail traders to make use of the services of online margin FX providers as their bridge to the global foreign exchange market. (See chapter 6 for more on retail broking platforms through margin FX providers.)

Other than a small difference in the bid/ask spread and the amount of capital required, the key difference between participating in the forex market as a major trading bank in the inter-bank market and as a private trader using a margin FX provider is the nature of the counterparty. In the inter-bank market, the counterparty is the bank or institution on the other side of a deal. This counterparty may be different for each trade (though there are in-house limits and various rules that determine which counterparties may be traded with and how much may be traded with each of them). In contrast, a trader using an online margin FX provider will invariably have the same counterparty on each and every trade; namely, the margin FX provider that he or she has chosen to hold an account with. We will discuss the characteristics of the various market participants in a later chapter.

Why different sources quote different highs and lows

In the equities and futures markets there is rarely any dispute regarding the absolute high or low of trading activity on any particular day. It is a simple matter of checking the record of trades that have been registered with, or executed through, the exchange in question and determining the highest or lowest price achieved on the day. In such exchange-traded markets there is a single source of information, which is recorded by the relevant exchange and the ultimate high or low cannot really be disputed.

But in the OTC world of foreign exchange trading there are many different methods by which trades may be executed, including through traditional voice brokers (which have now been almost entirely replaced by electronic brokers), direct party-to-party deals, and online FX trading facilitators. Although the levels of the exchange rates used by participants in each of these areas will be very close to one another, they will not necessarily move in 100 per cent lock-step.

For example, if a trader using the EBS platform (an electronic broking platform for the inter-bank market) is desperate to buy EUR/USD, they may choose to pay slightly more than participants using the other trading methods. As a result, EBS may report a slightly higher high for EUR/USD than is seen elsewhere. No central authority has the final word on the absolute high or low of the market, so a situation will often exist where different platforms or brokers quote different levels for the highs and lows.

The existence of different trading platforms and brokers and the different supply and demand profiles of their individual clients at any particular point in time will not only affect absolute highs and lows, it will also result in slight differences in the bid and offer quotes. As mentioned, these variations will only ever be small because the foreign exchange market is extremely efficient and transparent, and any significant difference will be arbitraged out of existence very quickly.

Volume of data

Because of the lack of a central authority to collect data on each and every trade, it is impossible for anybody to acquire accurate figures for volume, or the exact number and value of FX transactions that take place each day. Traders can certainly tell reasonably well whether the market is busy or quiet (especially if they sit on an inter-bank trading desk), and those who have access to the tightly controlled data of the major electronic trading platforms will also have a good idea of the broad level of activity in the market, but there is no single authoritative agency that brings all this information together in one place. Nor is there likely to be — the companies that control the major trading platforms would be very reluctant to give out such information.

Although we lack day-to-day volume data for the foreign exchange market, a major international survey is conducted every three years by the Bank for International Settlements (BIS). This is an international body charged with the promotion of cooperation between the central banks and monetary authorities of the world with an aim of achieving monetary and financial stability. A central bank is a nation’s principal monetary authority, responsible for monetary policy (interest rates) and stability of the financial system. Where required, this is the body that will intervene in the markets to influence the exchange rate of its currency. In Australia, the central bank is the Reserve Bank of Australia. The results of the BIS survey are published in the Triennial Central Bank Survey, which is on its website www.bis.org.

The results of the latest survey, conducted in April 2010 and published in December 2010, show that average daily turnover in the traditional (inter-bank) market was estimated at US$3981 billion (US$3.981 trillion), up significantly from a daily average of US$3210 billion in April 2007.

By comparison, data from the World Federation of Exchanges www.world-exchanges.org suggests that during May 2011, average daily turnover of all of the world’s 52 associated equity exchanges combined (that is, the Australian Securities Exchange, Tokyo Stock Exchange, New York Stock Exchange, London Stock Exchange, and the many other exchanges) was in the vicinity of approximately US$241 billion. These figures for both the equities markets and foreign exchange markets fluctuate from day to day, depending on current events in each market, but in broad terms we can say that the foreign exchange market is roughly 10 times larger than the equities market, as shown in figure 2.1. By any measure, then, the FX market is the biggest market on earth by a very long way.

Figure 2.1: average daily turnover comparison

Brief history of the FX market

Merchants and travellers who trekked along the Silk Road through Asia selling and transporting their precious wares and traders in ancient Babylonian marketplaces may not have a great deal of relevance to your life today, but they were among the earliest participants in the foreign exchange markets. Any time that these border-hopping, business-savvy people wanted to exchange the currency unit of one country or region for that of another, the two parties involved in the transaction would have to settle on an acceptable rate of exchange in order for the transaction to take place. By doing so, traders from the Far East were able to trade successfully with traders from Mediterranean countries and vice versa. The ability to conduct foreign exchange transactions has always been of great significance in facilitating international trade. And in the absence of a common currency the world over, this situation is just as true today as it was hundreds of years ago.

In modern-day markets, most of the major currencies of the world are allowed to float relatively freely, with a myriad market forces that affect supply and demand determining the rates at which one currency may be exchanged for...