The Simple Truth about Trading FOREX

General Information About Trading Forex

Many people have a vague idea about what the FOREX is and know that it has to do with trading and finances and that you can make or lose a lot of money in a blink. All of that is true. You can leverage a million dollars with just ten grand in the FOREX market and double your ten thousand in a few minutes on a volatile day (or lose ten grand in a few minutes!) I’ve been trading commodities and currencies now since the 90s and still often feel like a beginner. It’s actually fairly simple to make money trading, but it isn’t easy. In a nutshell, to make money, you need to stick to a system that has been proven to work. So what’s so hard about that? The problem is that emotions get in the way: Fear and greed. Emotions make traders second guess themselves, risk too much, make last second decisions… basically, emotions prompt traders to abandon their systems in the heat of the moment. So to make money trading, you have to either master your emotions, or have the self-discipline to follow your system no matter what.

What is the FOREX?

FOREX stands for Foreign Exchange and refers to the international foreign exchange currency market. Currencies are paired up, such as USD/CAD. If you think that the US dollar will rise against the Canadian Dollar, then you buy this pair. If you expect the reverse, you sell it. The FOREX is the biggest money market in the world, far bigger than the commodities market (coffee, cotton, oil, treasury bonds etc.) or all of the world’s stock markets combined. The main currencies in this market are the USD (United States dollar), EUR (European dollar, or Euro), and the JPY (Japanese Yen). Other currencies include CAD (Canadian dollars), GBP (British pound), AUS (Australian dollar) and so on. These currencies are all on the open international markets and “float” based on the supply and demand of traders (which include governments, massive trading funds, and small time players like myself).

What Moves the Market?

Basically, supply and demand for the currencies moves the prices. Most of the volume is in the market with the big three (USD, EUR, JPY) and the movement of these currencies causes movement among the lesser traded currencies. So why do prices move? News is the biggest factor for small movements, or market hiccups. Interest rates are hugely influential for both long term and short term movement. Also, the general economic state of a country will strongly affect the currency. These are all market fundamentals. In practice though, most independent traders are technical traders, meaning that they study charts and use different approaches to analyzing the chart to find patterns that serve as entry and exit points in the market. Market fundamentals are difficult to time and may already be factored into the price through market speculation before the actual news announcement is official. An example of this that you might recognize in mainstream news might be that you will hear of a large company having financial problems and the stock continues to plummet. But once the news is official that they have filed for bankruptcy, the stock starts to climb again. This implies that the most investors pulled out of stock earlier, and once the news of the bankruptcy was finalized, some speculators jumped into the market to take advantage of what they believe to be the bottom of the price.

Common Mistakes

Trading with money that you can’t afford to lose is one of the most common errors. If you need to pay your mortgage or your debts based on a steady income from trading currencies, then you are setting yourself up for failure. Trading is not the kind of business where the effort you put in is directly proportional to the money that you make. It is not dependent your sales ability, your past success in business or in life, the number of degrees you have accumulated, how much you listen and study financial news feeds. It is not even dependant on how long you are in a market. Everything depends on where you enter and exit the market, not when. Volatility is the factor that affect whether a trade takes you minutes or months. It is best to trade with money that you can afford to lose, but to do your best to protect yourself from losing that money. Risk is inherent in every trade. If your stops are too close to the market action, you will get stopped out very often. But if your stops are far away, you may save some trades and get out profitably, however you may also sit for weeks in the red on a trade if it moves against your direction and waffles. That way, it may tie up your capital and your attention and energy for some time.

Picking tops and bottoms is one the biggest mistake that most trades make, and that’s saying a lot since there are so many ways that you can make mistakes in trading. Emotionally, traders love the idea of buying the bottom of the market or selling the top (you can make money in either direction in FOREX and commodity trading), but if you think about it, how often does a major reversal happen in a market? Once a year? Twice? Some markets trend in one direction for decades. Yes it’s true that markets go up and down like waves, but they also build or trend in one direction like the tide. It takes a lot of energy to change the direction of a trending market. It’s a very exciting (but also very dangerous) place to be in the market. It is much safer to go with the trend that to go against it. There will always be lots of systems out there promising that after decades of research this particular trader has perfected top and bottom picking, and out of the goodness of their heart, they will gladly sell you their 90+% winning strategy that has made them millions of dollars over the years. The truth is, big traders never sell you the system that they use themselves. They just create a system by doing some retroactive historical chart analysis and use their reputation to sell it. Past patterns are not necessarily indicative of future patterns. As the global economy changes, so do trading patterns.

Another common and critical mistake is to risk too much. This is a side effect of greed. People want to make money fast in trading, and they enjoy the excitement of taking the risk. But if you risk more than 2% of your account on each trade, you may find yourself broke in a hurry. If you risk 2% of your account or less on each trade, you are trading “small” and are less likely to get emotionally wrapped up in the outcome, therefore can remain more objective and more likely to stick to your plan.

A third major mistake is trading too soon. Once you have a system, whether you have developed it yourself or have purchase it, you should test it with a demo account for at least three months, and preferable 6-12. This sounds like a lot of time to spend on the sidelines, but trust me, if your system does not make money in your demo account over that length of time, that means you would have lost those real dollars. If it makes money, great. You will have more faith and discipline when you are trading real dollars with it and are less likely to let emotions run the show. In other words, you would be gaining valuable experience.

This other common mistake I mentioned before is to let emotions control your trading. The corollary of this is that you do not follow your system. For example, if you have waited patiently for six weeks for an entry point, and you enter the market one Friday morning and are stopped out within an hour, you will be sorely tempted to “get back in” and give it another try. You will likely convince yourself that your timing was a bit early and now that things are settling a bit, you have a second chance to jump back in. What is really happening is that you were disappointed and you want payback. If your system doesn’t say that you have a new entry point, then follow your system and don’t enter! It would be wise to never have more than one trade a day, especially if you are a position trader (a trader who trades for a few days to weeks or more).

Another common mistake when it comes to trading is the idea that you are going to make a killing on a single trade and retire off of it. Yes, it has been done before, but the odds of this working are quite dismal, and so are the risks. This is similar to the idea of someone who decides one day that he/she will be a movie producer and with their first film, make such a tremendous blockbuster that it will be a top ten grossing film of all time, and retire off of that. Trading can be simple, but that doesn't mean that there isn't a lot to learn, and without mastering the fundamentals, you are basically depending on dumb luck. Luck never lasts in the world of trading. You have to be good at it to make money year after year.

At the opposite extreme are traders who think that they can spend a few minutes a day and make money hand over fist, day in, day out. Although many system sellers claim that this is exactly what you can do using their systems, this is also not a realistic approach to trading. Ideally, you should trade with the intention of eventually making it your career. Dabbling with trading invites financial disaster. There is a lot to learn when it comes to trading, and if you do not spend some time at some point or other watching every market tick and noticing your psychological response to it, how will you cope under pressure when you have big money on the line?

Another error is using too many indicators. There are literally dozens of tools and indicators you can use to analyze the market, but more is not necessarily better. The more indicators you rely on, the later your entry signal will likely trigger because you are waiting for so many different signals to be in agreement. In such cases, the naked eye would likely easily enough notice which way the market is trending because the trend is already clearly underway. And if this is the case, where do you put your protective stop? It is likely that if you're stop is place properly, it is so far from the current market price (because it is above a recent high if you are selling, or below a recent low if you are buying) that you are risking too much in the trade.

A final error that I will point out is poor money management. This is because many traders treat the career like a trip to Las Vegas rather than as a business. Yes, it's true that there are many similarities between high stakes gambling and trading. But just as there are a small percentage of professional gamblers who can make money consistently, there also exists a small percentage of professional traders who can make money consistently. In both cases, they manage their money properly, meaning that they control their risk properly. They know when to get in, get out, and how much they can afford to risk. Professional gamblers and traders are in it for the long haul, so protecting their capital is paramount if they want to live to trade another day. The other 95+% of losing traders and gamblers out there and doing it for the thrill and the possibility of fast money rather taking good care of their potential golden goose.

Recommendations

Chose a System that Works for You

Find or develop a system that works (i.e. is profitable over time and fits your emotional and financial, psychological and lifestyle profile). Your system should work for you. If you have to work a fulltime job, don’t pick a system that requires you to watch the market 24 hours a day. If you only have $1000 to trade with, don’t pick a system that requires a 50K bankroll or one that requires you to make multiple trades each day. Be sure to test your system for several months to see if it works for you and if you can stick to it.

Find a Mentor

If you can find a trader who is willing to let you what how he/she trades that would be invaluable. Trading is a business that is all about experience. Both good and bad experiences provide valuable lessons. Also, there are many “little things” about trading that are abstract to learn from a book, but are easy and intuitive once someone shows it to you.

Practice Make’s Perfect

Start with a demo account and work with it until you are consistently or relatively profitable. Demo accounts tend to be limited to 30 days, so if your system requires longer positions than that, keep meticulous records and “roll over” your demo trades when you sign up for an additional free demo account. This way, you can track your trading over months and get to practice record keeping of your trades.

Start Small

Even though many a book or source will tell you to start with an account of 20-50K, you can definitely start with much less (as little as $600US, but I recommend at least a few thousand) and trade mini-contracts of $10,000 (which can be leveraged from just 0.5% of that, or $500US to control a contract of that size). There is no official “commission” in FOREX, but you do have to pay a spread for each trade to the dealer’s desk usually ranging from $20-75 for a full ($100,000) contract. The nice thing about mini-contracts is that the pip spread is proportionately smaller (although potentially less liquid), so would typically be between $2-7.50/contract per trade. Due to less liquidity, it is safer to stick with the more liquid markets such as EUR/JPY, EUR/USD, USD/JPY. But even these markets can be relatively illiquid if the market volatility is very low.

Starting small is a great way to develop some experience and work out the kinks in your system.

Start Simple

Just stick to one trade at a time initially. You may have multiple contracts in that one trade eventually, but that is still a single trade. Trading multiple positions in multiple markets is asking for trouble, particularly if you are taking on too much risk and find yourself in a position of having to liquidate positions to meet a margin call.

Stay In Business

Your priority when starting off should be to NOT LOSE MONEY while gaining experience. This will keep you in business. If you're primary objective is to make lots of money, you will likely risk too much and decimate your account while you are learning how things work. So keep it small and simple, and practice with demo accounts first until you are consitently profitable with them. 

There is lots more information here:

http://www.forextrading.com/articles/HowToTrade.aspx

There is quite a lot of information out there on FOREX basics, but also a lot that isn’t said or explained adequately. If you would like to know more or know specific things about trading that you aren’t easily able to find on the Internet, let me know and I’ll do my best to address it.

Best of luck!

RKW