Forex trading for dummies, part II

Market analysis for Forex beginners

Introduction

In Forex for dummies Part I, you learnt what the Forex market is and why anyone should be involved in trading the financial markets at all. Part two of this guide continues to focus on currency trading for dummies, with a specific emphasis on how to trade the Forex market. It expands on the different types of analysis there are, and explores how traders can apply them.

However, before we move on to that, let us briefly recap on the reasons why we would want to learn about financial trading.

In a highly capitalised environment, most people are merely spectators of the economic realities that unfold in front of them. This passive stance makes little sense, considering how significant a factor money is our lives.

These people have no control over their financial realities, with no way to escape them. Until recently, only a few of them had any way to profit from these realities. This has changed in the last decade - and the Foreign exchange market has been at the heart of that change. A knowledge and understanding of the financial markets empowers a person to exercise their basic economic freedom. They can speculate on price movements and take responsibility for their financial future.

Consider Wayne Gretzky's infamous quote: "You lose at 100% of the markets you do not trade."

Market analysis for Forex dummies

Fundamental analysis can be thought of as a methodology that follows a broad group of news and data points. They in turn reflect the macroeconomic situation of the countries that are major players in the Forex market.

Fundamental traders research economic reports and pay specific attention to interest rate levels, changes in monetary policy, international trade volumes, and international investment flows. Fundamental analysis also involves reviewing events that do not affect the market directly, but affect it in one way or another. They include natural disasters, man-made disasters, war, technological advancements and political events.

For example, a tsunami in Japan that tragically killed 15,000 people and caused approximately $2 billion in damages on May 11 2011, also caused the Japanese yen to rally 600 pips against the US dollar in the four days that followed. On March 17, the G7 committee implemented a contingency funding plan that returned the Japanese yen to its original trend in the following week.

Another example would be a breakthrough in oil drilling that made shale oil financially feasible to extract - and, by extension, promised an increased oil supply, helping to push oil prices down 50% in the last five months of 2014.

In short, fundamentalists analyse the current value of an asset, as well as the forecasted value of that asset. They try to rationalise how it might be influenced by current and future macroeconomic events.

Technical analysis is a methodology that uses price charts as its primary source of data. Identifying key levels and trend-lines, while using statistical probability to support trading decisions is, broadly speaking, the way that technical traders operate.

Technicians, as opposed to fundamentalists, are not concerned about the theoretical value of an asset, or economic events that might tilt that value. What they care about is the statistical data displayed on their charts.

When it comes to trading the currency market, most traders use a hybrid approach to plan their trades. Historically, these two schools of thought criticise the opposing approach.

Fundamental analysis claims that it only makes sense to research the factors that influence supply and demand, thus anticipating the likely direction of future price movements. They also claim that what has happened in the past is of little help in forecasting the future. On the other hand, technical analysts claim there is a lot of uncertainty when analysing fundamental forces. They argue that it makes sense to analyse the exact data that has already been reflected in the price of the asset.

It is true that factors such as interest rates, relative growth rates, and market sentiment are more likely to determine the big-picture direction of currency rates. But in the shorter run, currencies rarely move in a straight line, which means that there are plenty of short-term price fluctuations to take advantage of. In that domain, macroeconomics just does not apply.

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Trading styles

If you are into long-term trading, you will most probably find the fundamental school of analysis appealing. On the other hand, if you start learning about fundamentals first, it will lead you to long-term trading, rather than short-term.

Similarly, if trading is your only occupation, or you have a home-based job that allows you to be near your trading station at all times, you will have lots of time to devote to market analysis and trading. This may tempt you into frequent short-term trading, making technical analysis your primary tool.

This calls for a disclaimer here, as it is the short-term and technical-based style that is most popular among trading Forex dummies. However, technical analysis misuse, combined with over-trading, can lead to actions that wipe out trading accounts within hours.

In comparison, long-term trading involves more modesty in trading volume, since average daily volatility is more severe than smaller time frames. This is why smaller trading volumes are used to minimise risk.

Currencies are traded around the clock and you have to be mindful of which session you are trading, as well as the daily peaks and troughs in liquidity. Just because the market is always open, doesn't mean it's always a good time to trade. Actually, it means exactly the opposite.

Long-term trading works more like investment, but can be more psychologically challenging to a trader. This is despite it being 'safer' due to the prolonged periods of a trade having a negative P&L.

Warren Buffett once said to a room full of students: "When you are buying stock, you are buying a small piece of a business." Playing with this idea, one can almost say that buying a currency is like buying a small piece of a country's economy. Thus, currencies of stable, predictable economies that will most likely retain their relative competitive edge will always make a potentially profitable asset to buy over the long run. Just as the currencies of relatively weak economies make a potentially profitable asset to sell.

In financial trading, a timely entry, patience, and a timely exit is the best formula for success.

Practically speaking, there are three major ways of how to trade Forex for dummies.

Short-term, high frequency trading

This group of traders is often called scalpers. Their exposure to the market is minimal. Their trades yield from one to five pips, rarely stay open for more than 15 minutes, and are never left unattended. Here are a few tips for Forex dummies who find this type of trading appealing:

  • Trade only the most liquid pairs and only at appropriate trading sessions - i.e. when the market is most liquid for the currency pairs of your interest. Tight spreads are a key factor in scalping. Trading during other sessions can leave you with far fewer and less predictable short-term price movements to take advantage of.
  • Focus. The amount of pairs you can keep track of simultaneously is very limited because your eye and brain can only process so much at one time. Start by trading one pair and train. If that works out for you - add more charts. If that works as well - add more screens. Make sure nothing distracts you.
  • Make sure your broker offers one-click-trading. Dealing with re-quotes strips precious seconds off of your advantage.
  • Pre-set your trading volume and make other preparations for yourself. Write down your targets. Assuming that your average trade only brings you two to five pips, consider in advance how much drawdown you can withstand. Mentally prepare for closing some trades with a loss. This can be very hard psychologically, but very good economically.
  • In short-term trading, avoid simultaneously opening trades on 'related' currency pairs to avoid excessive exposure to any one currency. For example on pairs like EUR/USD and GBP/USD. Neither twin buys, nor twin sells, nor even opposing trades will make sense here.
  • Be extra cautious when trading around the news. This is the time when market logic may not apply to the price. Even if you accurately predict the direction of the coming move, the shear speculating force can push the market in the opposite direction five to 30 minutes prior to the actual data being published. Not to mention that sudden spikes in volatility can cause gaps. Lastly, the 100-200 pips market fluctuations are simply inconsistent with risk management techniques used in scalping.

Medium-term, directional trading for dummies

Medium-term traders, also known as intraday traders, use the style of momentum trading, or swing trading. Unlike scalpers, they try to anticipate the overall market direction and catch a substantial move. The question they ask is: "Where will the price be within the next few hours?". These traders hunt for a specific amount of pips and care little for how long (within a day) their trades stay open. This trading style demands a broader perspective, greater analytical effort, and a lot of patience, when compared to scalping.

Here are the two mutually complementary examples of medium-term trading methodologies:

  • View traders mostly rely on the outcomes of their fundamental analysis to predict the future directions of price movements. These are caused by such items as interest rate expectations, economic growth trends, overall market sentiment. View traders also keep track of technical levels as part of an overall trading strategy.
  • Technical traders base their trading decisions on chart patterns, trend lines and momentum studies. This discipline involves watching for and following key breakout levels. When a price breaks through a major support level, this means that it has the momentum to fall further. Similarly, breaking through a key resistance level, indicates there may be enough momentum for a further gain. Technical medium-term traders also keep track of fundamental events, knowing that those are the catalysts for many breaks outs above or below key levels.

As a side note, since both techniques to some extent involve trend following, it is important to mention that according to some estimates, markets only trend around one third of the time. The rest of their activity is ranging - bouncing up and down within a confined price corridor. With this in mind, medium-term traders combine the two schools of analysis, using fundamental research to hint at the direction, while using technical analysis to confirm the move.

Long-term, low frequency trading

Long-term trading is also called positional trading and is mostly reserved for institutional traders at a professional level. Long-term traders can easily hold their positions open for weeks, months and potentially even years.

Retail traders can also exercise positional trading. However, it will require that no more than 5-10% of their margin be used in such trades.

This is a long-term way of making money from Forex trading, but it is used by institutions for a reason. Professional traders are not sprinters. Their profitability may be low, but it is consistent.

There is a particular type of long-term trading strategy that works best for low-volatility markets. It specialises in buying currencies with high interest rates and selling those with low interest rates (just like JPY/NZD from our swap example a few paragraphs back). The strategy aims to make money by accumulating swaps, in addition to capturing any potential price movements in a favourable direction.

Trading plan

One common feature among all successful traders is not technical analysis skills or macroeconomic education. It is discipline.

Trading discipline is best expressed through a trading plan - and sticking to it even when emotions are high.

Trading plans vary greatly in their content - but usually, the more thorough they are, the better. Knowing the exact market conditions for entering and exiting trades, along with the reasonable trading volume per trade, are just a few of the key areas that a trading plan of a Forex dummy must detail.

A trading plan can be hard to follow, but unless it is followed, there will be no way for a trader to systematically analyse past trades. Meaning there will be no way to improve trading performance.

Trading without a plan and just on instinct is outright dangerous for a Forex dummy.

Being profitable in Forex trading is in theory relatively simple, once you have learned how to identify a trend and developed the patience to follow it. The challenge is in increasing one's profitability, which requires perpetual analysis of your past trades.

Money management

A fresh flock of currency trading dummies might think that money management is all about calculating margins, P&L and proper use of leverage. Yes, it is. However, the real money management starts much earlier than that. It starts with knowing what kind of money you should invest.

When it comes to money - and this can not be stressed enough - trading capital has to be risk capital. In other words, you should never trade with money that you can't afford to lose.

They say that the worst thing that can happen to a new trader is a successful first trade. The line between confidence and criminal self-confidence is very thin when trading Forex on a leveraged account. Every broker has an example of a client that has risked too much and lost it all in a matter of minutes.

'Revenge trading' is a term from a trader's psychology guide that cites an unfortunate example of what investing non-risk capital can lead to.

Let's say you have invested money you can't afford to lose, but you start with a losing streak. Not your fault. It can happen to the best of us. Perhaps, it has even happened with you. Only this time, you get anxious. One bad trade after another decimates your balance. Anxiety levels grow. Against all common sense, you increase the volume of your next trade, planning to cover all the loses with one swift trade - only that trade happens to be losing too. You are way in the red, but do not close with a loss. You are hoping that the market will turn around - and it doesn't. A margin call comes and you are out. The money is gone and probably so is your desire to ever trade the financial markets again.

By definition, risk capital is money that will not materially affect your standard of living if lost. Borrowed money is no good for trading. Neither are your kid's college funds, your life savings, or even the smallest amount of money that you cannot afford to lose - even of it just $10.

When you determine how much risk capital you have available for trading, you'll have a better idea about what account size you can trade and what position size you can handle. Most online trading platforms offer generous leverage ratios that allow you to control a larger position with less margin.

But here comes another disclaimer. Just because the high leverage is available doesn't mean you have to fully utilise it. Be aware of how fast it can leave you with nothing and don't let it happen.

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Conclusion

This wraps up the guide on trading currency pairs for dummies. Continue your education by researching further on the topics presented in this guide. Practice market analysis, develop the according trading strategies, write a trading plan, and implement them first on a Forex dummy account. Once you're making profits consistently, try your hand at a live account. You can find more useful tips in our Forex trading for beginners article.