the basics
an introduction
The purpose of this section is to provide a clear and simple description of the basic building blocks, tools and thinking underpinning our approach to trading foreign exchange (ForEx or FX). My hope is that it will be useful to those new to trading in particular and that it helps to interpret some of the necessary "jargon" on this website where it has been assumed the reader already has some understanding already. It is not intended to be a comprehensive course or even an expression of "best practice", just my sequential train of thought on the subject with all the fluff taken out. Experienced traders may therefore choose to skip this section, although I welcome comments and constructive observations for improvement or additions.
Here's what we cover - click on the bullet point to go straight to the topic or browse sequentially:
-
Price Charts - the foundation of trading with Technical Analysis
-
Mechanics of placing a trade - entries, exits and position sizing
Price charts - the foundation of Technical Analysis in Trading
As it is for many traders nowadays, "Technical Analysis" (TA) of price charts is at the heart of our trading methodology. The theory is that by studying graphs that chart the change in price of something (e.g the exchange rate of pounds sterling for Euros - denoted by the "symbol" EURGBP as shown here) over time, it is possible to predict, with a probability greater than 50%, how the exchange rate will change going forward in time. This enables a trader to make an informed decision as to where they can, e.g. "buy" at a (relatively) "low" rate and sell at a "higher"rate thus making a profit.
"Japanese Candlesticks" (or simply Candles) - the main component of a chart
There are several conventions for representing price variations graphically, e.g; High Low Open Close (HLOC), HLC or simple line graphs (we use the term "chart" in place of "graph") are alternatives used by some but the standard used here is the Japanese Candlestick Chart. I will not go into the history here but if interested, the seminal work on Japanese Candlesticks is a book called "Japanese Candlestick Charting Techniques by Nison. In the above chart of the Euro (EUR) versus the Pound (GBP), the chart is made up of green and red bars. Each of these bars or "candles" has a sold body and a "wick" at either end. In the chart above, each candle represents the change in exchange rate (price) between the Euro and the Pound over one day. The Green candles indicate that over the day, the rate ended higher than it opened and the red candles represent days when the net change over the day resulted in the price being lower than it opened. So in summary, green candles indicate "up" days and red candles indicate "down" days.
Anatomy of a Candle - "price action"
Now let's zoom in on just two candles to illustrate what they are telling us. This diagram shows the price action (i.e how price was changing) over two consecutive days. So each candle represents one day's worth of price action. On Day 1, the price opened as indicated and varied throughout the day, hitting highs and lows indicated by the two wicks at the top and bottom of the candle and closed higher than when it opened, as indicated. Hence the candle is coloured green. The Forex market is continuous, open 24 hours per day during the week (for all intents and purposes) so logically, on Day 2 the price opened at the same level as Day 1's close.
Day 2's price action varied similarly but this time it closed lower than it opened, hence it is coloured red. The "price action" that occurred during the days can also be charted using candles but with smaller time frames - i.e a day's candle will contain 24 x one hour candles and each hour candle would be made up of 12 five minute candles and so on.... This fractional representation provides us with, theoretically, infinite magnification on how price is changing over time and is the means by which "Multiple Time Frame" analysis is possible.
Candles within Candles - introducing Multple Time Frames
Following through from the above example, here now is a chart of the British Pound (GBP) in terms of the US Dollar (USD) - (GBPUSD). It too, is a "daily chart" meaning that, as with our previous example of EURGBP, the candles all illustrate the net price action over one day each. This is great if all you want to see is what's happening with price a day at a time but sometimes it us useful (and desirable) to see the detailed workings of price action during the day. As mentioned above we can do this by charting lower time frames. If we were particularly interested to know what the price did during the period from September 4th to September 6th (as marked out by the pink box here) we can "zoom in" to have look by having the chart redrawn in components of one hour at a time. Here below, is the chart redrawn with "hourly" (60 minute) candles.
The hourly chart here to the left is like taking a magnifying glass to the pink section of the daily chart (above) and shows how most of the price action - i.e the biggest change (move, if you like) happened over about 3 hours. One big green candle up followed by two smaller candles down. Outside of the context of the trading day in question, it is not possible to suggest a reason for this surge but whatever it was, it was due to a sudden imbalance between demand and supply of USD Dollars and Pounds sterling - meaning, for that brief one hour period represented by the green candle, the pound was buying more and more dollars until demand and supply stabilised again. This could have represented a trading opportunity to buy "low" and then sell "high" during the day, thus making a profit - which is of course our whole purpose. This is all a massive oversimplification but hopefully we now have an improved understanding of how multiple time frames are useful. Of course you can zoom out as well for the bigger picture, i.e daily charts scale out to weeks, and weeks to months...
Forex Currency Pairs - what we actually trade
Here is a list of some of the more popular (most frequently traded) currency pairs. They are called "pairs" because each one is made up of just two currencies expressing one in terms of the other. For example, the top line (NZD/USD...) in this table, shows the current (at time of writing) "exchange rate" between the New Zealand Dollar (NZD) and the US Dollar (USD). The currency represented by first 3 letter acronym (NZD in this case), is known as the "base" currency and the second (USD in this case) is known as the "quote" currency. Amongst this list we also have "CHF" for the Swiss Franc, "JPY" for the Japanese Yen, EUR for Euro, GPB Great British Pound and the AUD - Australian Dollar. There are many others! The numbers shown here indicate the exchange rate - i.e you can sell 1 NZD for 0.65332 USD or buy 1 NZD for 0,65352 USD. One will have experienced this difference in price of the same currency whether buying or selling, if one has ever used money changers at the airport (or the high street). This difference is known as the Spread.
"PIP"s - this stands for Point In Percentage and is what we in the FX world would consider a “point” for calculating profits and losses. You will see from the list here that currency pairs are quoted sometimes to 5 decimal places and sometimes to 3. The 5th and 3rd decimal places are rarely considered for the purpose of trading analysis so it can largely be ignored, therefore: for currency pairs displayed to 4 decimal places, one pip = 0.0001. Yen-based currency pairs are an exception and are displayed to only two decimal places (0.01). To be clear therefore, in our example the spread for the NZD/USD can be approximated to 5-2=3 pips. For the USD/JPY it will be 2-1= 1 pip and for the GBP/JPY it is 70-68=2 pips. Spreads tend to vary with time of day and volatility due, for example, to big economic announcements.
Introducing Spread Betting - our primary method of trading Forex
Spread betting is in effect a "financial derivative" that enables you to speculate on the change of the price of a financial market without actually owning the underlying asset. In other words, you don't have to buy a fortune's worth of US Dollars with your hard earned pounds sterling to profit from the purchase when (if!) they (hopefully!) increase in value. Instead, you predict whether the value will rise or fall and the degree to which you are right or wrong determines your profit or loss. So, when financial spread betting on currencies (Forex), the outcome you're speculating on is the direction in which the price of a currency pair will move - up or down. If it moves the way you predict, your profit will grow the further it goes. However, if the market moves against you, your loss will also increase as the price movement becomes greater. Spread betting is also not subject to tax so it is a particularly efficient way to grow your money... when you get it right!
Getting Started with Spread Betting - the bare minimums of what you will need to set up
You will need to set up a spread betting account - there are many spread betting companies out there, so, as with anything like this, you need to do a bit of research before choosing one. This website may be helpful https://www.money.co.uk/financial-spread-betting.htm. Things to look for are: lowest spread on the EURUSD and GBPUSD in particular and the lowest possible minimum stake size (e.g £0.50 per pip). When I first started (2004) I opened accounts with pretty much every major S/B player there was but over time I have gravitated to using just two (CMC and Igindex). This is purely because they were the ones I found most easy and convenient to use. There may be easier ones nowadays of course but it will be purely a matter of your personal choice.
Essential features - if starting out, the S/B platform you choose must (IMHO) have a "dummy account" facility so that you can try it out before putting money at risk. Unless you already have a stand alone charting package, the S/B platform must have a charting capability that displays prices in multiple time frames with live feeds to the actual FX rates. That's about it for essential features but it's all about ergonomics as far as I'm concerned, so just try some out and see which ones work, look and feel best for you.
Funding your spread betting account - "the Margin account" - This requires some pretty serious consideration in my view so I will give you my train of thought on it because I don't believe it is as binary simple as perhaps it is sometimes made out to be. Opening a spread betting account means you place a sum of money with your spread betting company (let's call them your "broker") and it is from this sum of money that you place - essentially - "bets". If your bet wins, the winnings go into your account, if you loose, the amount you loose is deducted from your account. You can see that the worst case is that, theoretically (we will get to the "stop loss" later) it is possible for you to loose all of the money in your account plus even more. Now, spread betting firms are businesses with an objective of making money, not loosing it so they are not going to let it happen that you owe them money - that's expensive. So what they do is require that you have a minimum amount of money in your account at all times, that is not at risk. If you let this happen - they will ask you for more money to be deposited. This is known as a "margin call" alternatively they will close out your trade(s).
Then there's regulation - (always very well meaning of course). Regulators require brokers to mandate minimised risk levels being taken by their clients (i.e you and me). This gives a copper bottom to the mechanics of the margin call. These are the bare mechanics of what is known as a spread betting "margin account". There is a lot more to it described under the terms of a broker's margin account, in very clinical and precise language on the broker's web site but I will summarise and simplify what it means for all practical purposes here.
Question: So how much should I deposit with my broker? Answer: "It depends". I mentioned that this section is a bit of a "train of thought" which will hopefully point to an answer which is right for you, so please bare with me. One very sensible and direct answer is "how much can you afford to loose?". This is a question you need to have a congruent answer to. Another is: "How serious am I?". You can open a spread betting account with less than £300. Think about that for a moment. Great right? I can afford that - one might be thinking.... Hmmm... OK, so here's how that plays out. The nature of this business (and we'll do some sums to objectivise this in a moment) in my experience, is that accounts with minimum sums in them run into margin calls almost immediately. This is not because of poor skills all the time but because it's very very difficult to predict a perfect entry to any trade. It's a game of approximations - like Golf . In fact almost (99.999%) every time your opening position will go into the red straight away before it comes back in your favour - if you've made a solid bet of course and sometimes it will go a long way against you (uncomfortable!) before it comes round. This gets you into margin call territory very easily - and you've done everything right! If you're OK with that, fine but consider where it takes you. Yes, you guessed it, you have to top up your account (minimum around £300) and this can become a never ending cycle whereby all you're doing is transferring money from your bank account into your broker's - unless you get incredibly lucky of course! So maybe one might now understand why you can open a S/B margin account with as little as £300? ... but don't think about that for too long :-) .... Let's do some sums:
Worked Example: So we have ascertained that we need to maintain sufficient funds in our account to cover deposit and running losses but how do we calculate that number – i.e. the “margin” required?
Here’s the kind of terminology that you will find on a S/B website:
Margin required = Exposure * Margin factor
Let’s use an example to translate this (and along therefore prove the appropriateness of the minimum levels of deposit for you).
Let’s say GBPUSD is at 1.2908 and we want to place a £5/pip bet – i.e. we want to make £5 for every pip that GBPUSD moves in the direction we expect it to move.
But do we have enough money in our account? (we will discuss direction – i.e. whether we BUY or SELL later in case you were wondering).
Exposure = Price * bet size. This is the total worth of the trade you are exposed to.
Price = 1.2908 or 12908 in pips
Bet size is the size of the trade – i.e. the number of pounds you want to risk per pip.
So, Exposure = Price * bet size = 12908 * £5 (= £64540)
The margin factor is the S/B’s assessment of the riskiness of GBPUSD. In this case we can find out from the S/B info pages that their margin (risk) factor for GBPUSD is 3.33%. It is possible that different Spread betting firms will have different margin factors with higher factors for currency pairs that they consider to be more risky - i.e. more thinly traded making them less predictable compared to a more liquid markets, like the GBPUSD. You’ll find these rates by looking at their website if you’re interested in such details but you don’t need to do this every time you place a trade. The platform will tell you if you’re trying to do something that breaks tolerances.
So, Margin required = 12908* £5 * 3.33% = £2149
And if we were less ambitious at £1/pip, the margin would be £429. So from this we can see that a £300 deposit with this spread bettor would not even allow you to place a £1/pip bet on the GBPUSD pair .. (spread betting isn’t all about FX, so in case you’re wondering, there will be other things you can use your £300 to practice on).
I hope this Train of thought was useful and has helped you answer the question about how much money you need to deposit - if you need to discuss it in more detail please do drop me a note via the contact page.
The mechanics of placing a trade - entries, exits, position sizing
Example - Here is a 60 minute chart of the EURGBP. Let us assume that we have looked at this chart and decided that there is a high probability, profitable trading opportunity should the price, currently at 0.8923 in green, return to the level marked in orange at 0.8942 where we anticipate it will turn around and fall back to the yellow level at 0.8903. So our profit opportunity is the difference between the Orange and Yellow lines ie - 0.8942 - 0.8903 = 0.0039 = 39 pips.
Ok so now to the fun stuff! You've got your spread betting platform set up, you've decided how much money you're going to put into this. Maybe you've experimented with the platform a bit and you've started looking at some charts. (I'd strongly recommend you "paper trade" with a demo account first before putting your money on the line by the way!) This section is NOT intended as a course on Technical Analysis - there are lots of good (and awful) books on that subject (and I'll be pleased to provide some pointers if that's what you'd like) but as a beginners guide to using a spread betting platform to enter and exit trades.
Sizing the order and controlling risk - So, what we need to do is to place an order on the spread betting platform to SELL EURGBP at 0.8942 and BUY back at 0.8903 - i.e at a lower price than you sold, hence profiting by the difference of 39 pips in this case. But how do we make money on this? How many pounds per pip do I put into this? Obviously the more the better! but what happens if it goes wrong - i.e you sell at 0.8942 but instead of it turning round as we "expect" it to, it carries on up. It could go on for ever and each pip turns into an incremental pip of loss, rather than a pip of profit. So there has to be a point in our setup on the chart where we decide that our hypothesis is wrong and interestingly, the answer to the question of sizing pounds/pip comes from the anticipation of the trade resulting in a loss. Here's how it works.
How to use the "Stop Loss" to determine your position size - on the chart you'll see a red line at 0.8958. From a pretty standard (and therefore, rather unsophisticated - Ed) technical analysis point of view, this level is the level beyond which we might expect the price to not be turning back towards our yellow target and therefore, beyond which "there be dragons" and we don't want to go there - we want to be out, accept we were wrong and move to the next trade. We call this red line our Stop Loss level. It is the level beyond which we, quite literally stop any further losses - remember we're already in a loosing position by now so it's only limiting our loss not eradicating it completely.
Calculating the trade risk and Pounds per PIP - First, it's worth stating a philosophical point that trading successfully, is as much about controlling risk of loss as it is about making a profit. So let's address that by returning to the question of the size of your account. Let's say you have put £1000 into your spread betting account. The question is - how much are you prepared to loose on a trade? Difficult, so guidelines are useful. Standard thinking is that we risk between 1% and 3% of our account on a trade. Let's say we are relatively cautions about this one, (for whatever reason) so we only want to risk 2% on this trade. So the maximum we are prepared to loose is 2% of £1000 = £20. We want to make sure whatever happens, we're not going to loose more than £20 on this trade. This means that each pip between your entry at 0.8942 and the level at which you'd bail out at 0.8958 if the market spurns your cunning plan, will be costing you the quotient of: £20 / (0.8958-0.8942) = £1.25
Hey presto, we have our pounds per pip at £1.25, for this order. We also have the reward to risk ratio - i.e how much we are willing to to risk (£20) to make 39 x £1.25 = £48.75: 48.75/20 = 2.4. This of course can all be contained within a spreadsheet for repeatability and for record keeping.
Placing the order - the scenario we have described here would require a "limit order" with a stop loss and target built in. Most spread betting platforms provide for this type of conditional (oftern called "bracketed")order. In our example we would express our order in English as follows:
"should the price of EURGBP get to 0.8942, sell at £1.25 per pip. If the price goes to 0.8958 Buy at £1.25 (to exit for a loss) otherwise Buy at £1.25 when the price gets to 0.8903 for a profit"
In spread betting speak this would be:
Limit order SELL @ £1.25 at 0.8942
Stop Loss 0.8958
Take profit Limit 0.8903
It takes a while to get used to the different kinds of orders but this diagram provides some illustrations of the other types. The permutations and combinations and dynamics of the different orders and how one would use them (and we haven't even mentioned the good old "market order") are too many to describe here - and it would get boring anyway because it's so repetitive. May be a section in a future e-book? If you would like further insight on how to place orders, please contact me.
Mind - the psychology of trading
In a way, it seems like a huge oversight (to me) to have got this far on a page about the "basics" of trading without even mentioning the subject of how you manage your state of mind whist doing it (or how it will "manage you" if you don't! - and who are "you" anyway? there's a thought and "who" is thinking that?... ). It might give the impression that if you practice all the mechanics of trading with precision and rationale, then money just gushes out of the machine automatically. And (disappointingly although not unsurprisingly) this is an impression that is largely left hanging in the air with every interaction one has in conversation, presentation, webinar, reading, etc ... about trading. There are some huge misconceptions there. First, the market is NOT rational - it is not a machine. It is one gigantic organism made up of people, hundreds of thousands of them, all with their own lives, hopes, dreams, fears, tendency to euphoria
emotions and so on and it is impossible to rationalise that. Our western approach tends to be to try and analyse everything in fact. Turning things into numbers, makes us feel in control and safe. "If you cannot measure it, it doesn't exist" I've heard it said, so many times but that only placates those who are not comfortable with uncertainty. Unfortunately, as traders, I'm afraid that's all we have, so not a particularly useful approach (IMHO of course) and to paraphrase the Tao (the ancient Chinese really said it best) we cannot understand running water by catching it in a bucket (I love that thought!) ...
To the point: as with any pursuit of excellence, trading successfully is at most, 10% mechanics but it's 90% in the little grey cells. (ask any accomplish Golfer, Tennis Player, Musician ...) Get the mechanics right of course, but your mechanics will never be a match for a market that doesn't know (or care) anything about you. Now introduce Money - the acquisition of it, the spending of it, the accumulation of it, the lack of it and so on, is loaded with emotion - (oh really? .. thanks for that Mark! - ... must right that down) ... I thank you. But recognise it! You loose a £10 note and you feel angry, with yourself or someone else, for a while. Someone persuades (or cheats) you into buying something that you don't need or is just plain rubbish. Or let's say that brown envelope from Her Majesty's Revenue & Customs lands on your door mat (oh joy!) with it's customary earth shattering thud - you open it, peer inside... It's a cheque! you overpaid your tax and there's refund! How many emotions in that little episode? So many emotions, chemicals rushing around your nervous system in chaos - good chaos, bad chaos - mechanise that! Write that into a system. And it's all around money. You will have them all whilst trading, many to extremes. And unless you're descended from Vulcan heritage, they will get in your way. I cannot teach you how to manage this - there are people much better qualified than I am to even write about it but what I can say is.... experience is the best way to cope. Like driving. When you've experienced the market run through your carefully planed trades for days on end and see weeks worth of gains chewed up in a morning! you've seen it before - you can cope. When you get that blue bird winner that you didn't really plan (or "deserve") you will cope. Experience is (practically) Everything. You need to get to a stage where "you've seen it before" and for that, there is NO substitute for screen time. Here are some great books that I'd strongly recommend you read:
-
Market Mind Games by Denise Schull
-
Trading in the Zone by Mark Douglas
-
High Performance Trading by Steve Ward
-
TraderMind, also by Steve Ward
-
The Tao Jones Averages: A Guide to Whole-Brained Investing, by Bennett Goodspeed
Having a Daily Routine - building trading into your daily schedule
Ok so by now we have an idea of the how and the why of trading Forex, so this is about the "when"? When do we actually do all of this? I have written a fairly comprehensive and detailed description of my daily schedule on my Blue Note - "A day in the life" so please go ahead and read that to get an idea of how my daily routine is shaped. As FX traders we can trade any time, 24 hours a day, Monday through Friday, (although there are caveats to that as I explain in my aforementioned blue note). Essentially you need to carve out some good quality time for quiet, focused contemplative staring at your computer screen, every day ideally and quite frankly - please use the "you too can trade 20 minutes a day... blah blah" flyers as door stops or coffee mats - they are nonsense. Practice makes perfect as with any pursuit of excellence, so it needs to become an essential, habitual part of your day - like going to the gym, or hitting 50 balls on the range if you're a golfer, or scales if you're a musician. This bit cannot be put asside. You have to get down and "do it"! But what do you do?
There are 3 main things you need to find time to do, every day and we have covered them here on this page (and on my blog) if you've read it from the top:
-
Scanning the major currency pairs for new trading opportunities - you need to set up a watch list of the crosses (e.g the one detailed above in the section about currency pairs) and examine them one at a time, for trading setups. As you start you may want to focus on just one or two pairs. The best ones, I'd suggest would be GBPUSD and EURUSD because they are both highly liquid (lots of people are trading them in huge volumes so they move well) and the spreads are usually quite narrow. I have given one example of a setup above (and describe my method in my blog) but I certainly do not want you to see that as a full course on scanning for good trade setups. It's huge subject and a book by itself so no room here (I may get rounds to it one day). In the mean time, please contact me if you'd like to learn more about what I look for and how I go about things.
-
Placing new orders and / or opening new positions - we went through this in the "mechanics" section above
-
Managing existing positions - again another huge topic but an example might be tightening "trailing stops". A trailing Stop is a technique for locking in profit that a trade has already yielded by moving what was your original Stop Loss somewhere "in front of" your entry level.
When's the best time to trade? - 24 hours but not ...
The foreign exchange market is a global market operating across a number of time zones. Time zones of particular interest are: Australasia, Asia, Europe (mainland and UK) and the USA. FX is not traded on a regulated exchange like stocks and commodities but is made up of a network of "financial institutions" and "retail trading brokers" which each have their own individual hours of operation. Since most participants trade between the hours of 8:00 a.m. and 4:00 p.m. in their local time zones, these times are used as the market open and close times, respectively. This table shows how the hours of trading overlap through a 24 hour period:
The figures in the table above represent a 24 hour clock GMT - eg FX market for central europe officially opens at 06.00 GMT and closes at 14.00 GMT
As individual retail traders we do not have enough weight to significantly influence the momentum which drives the direction of the FX market but we can be ready to jump into the slip stream of those who do - i.e the aforementioned institutions. With reference to the table above therefore, here are some ideas as to good (and conversely, less good) times to trade:
-
Concentrate your trading activity during the trading hours for the three largest Market Centres: London, New York and Tokyo because most market activity will occur when one or more of these three markets is "open".
-
Some of the most active market times will occur when two or more Market Centres are open at the same time. The above table indicates when these times are.
-
The most active time frame by the number of active participants is the 12.00 - 14.00 window because Frankfurt, London and New York are all active during that time.
-
Conversely, we can expect the period from 20.00 - 22.00 to be a lot less active as none of the major markets are open during that time frame hence it is not a good time for us retail traders to be active (spend time with family, friends, etc).
A note from experience as to When's a good time? With regards to time of day, I find first thing in the morning from about 6.30 onward (see my "Day in the life .. Blue Note) as a good time to start hunting for trades. So if you can spare an hour (or ideally more) at the start of the day - and then through the day if you can and at the end too through until about 7pm. As per the above after about 7pm UK time, the market gets thin and choppy as Europe packs up for the day and it's not so good to be actively trading - ie actually taking new positions. I fully understand that spending all day in front of the screen for some/many may be impossible for various very good reasons. Good news is that it's not absolutely necessary as you start (or ever actually) but what I would say is that you need to get your hours up - somehow. Experience is not to be found in a system and you need the experience, just to gather and internalise on all the little tricks and games that are being played out, if you're serious about succeeding as a retail trader that is. It's a bit like driving - anticipation when, or if, that car in front is going to pull out or is it a fake ... loads of metaphors come to mind.
What else? - stuff we haven't covered.
The intention of this page is to give some insight into how I see the very basic aspects of trading and to be honest there are a ton of things I have not covered because it would take a book to give it full coverage and there are loads of those out there. So, we've barely touched the surface on; how to find good trading opportunities, good TA, support, resistance, moving averages, candle shapes that tell you certain things are happening, the mysteries of Fibonacci and so so on. If, however, you are enjoying my website and would like to dig into this some more, please contact me and / or suggest topics you'd like to see more on. Thanks and Good Trading/Luck/Fortune ...
Page under construction … watch this space for new material which is being created daily!