In earlier days before mass computing and kid’s addiction to video gaming, there was nothing to a lad like outdoor activities. A favourite among kids and adults alike was community events comprised of school fairs and dances. To the consternation of many a parent and the police (district constable) the elusive three cards man and his crony was always in-tow enticing and devouring the gullible with his pick.
In keeping with the times, technology has re-branded the old trick; “currency pairs” (two cards) has replaced three cards, and FX Broker the con-man. The brokerage houses offer free-trading accounts to convince the public how easy it is to pick winning trades, that is, until real money is invested in a live account. For no matter how long a position is observed with simulations, the game changes when your cash gets on the line. Statistically, foreign exchange trading improves the odds in favour of the trader to 1 in 2 from 1 in 3; if it is that easy the average trader should therefore break-even.
Picking the pairs
Recently, everything has been about the US dollar, and most currencies either rises or falls together against the dollar, excepting of course the British pound. So no matter what the fundamentals indicate, in the short-term it is sentiments that drive currencies.
A critical factor to consider in selecting currency pairs is the source of earning of individual countries, for example resources, tourism, manufacturing etc. Currencies with similar income source tend to move together.
The main currency pairs include the US dollar, Euro, Swiss Franc, British pound, and Japanese yen.
At the secondary level there are cross (mixed) currency pairs, that is, pairs excluding the US dollar, example Euro and British pound pair.
At the third level there is cross currency triangulation, which provides the opportunity to profit from arbitrage in the main currency pairs. The second component of this is interest rate arbitrage where sophisticated traders borrow in low yielding currencies, sell that currency and buy higher yielding currency to earn higher interest rate.
Types of trade
It is important to decide at the outset what factor (s) the trade will be based on:
This factor will determine on the duration of the trade and what risk management techniques are utilized. Trading on fundamentals are medium to long-term trades, while technical trading are short-term and should employ strong risk management like setting stop loss orders at inception.
Hedging of risk
There is no certainty of outcome in foreign exchange trading therefore it is advisable to hedge (by income source) a position by taking a lesser trade in the opposite direction. Say a person trading on fundamentals believe that the Canadian dollar will strengthen against the US dollar within the next 6 months. Because of the uncertainty about the exact time it will happen the trader sold 2 contracts on the USD/CAD but to reduce the risk and benefit from any adverse movement against his fundamental position, a good hedge would be to sell 1 contract in AUD/USD as both the Canadian and Australian dollars are petro-currencies and tend to move in the same direction compared to the US dollar.
Deck is stacked
There are two ways that I will mention that indicates how the deck is stacked against a trader:
- Stop loss orders- the FX Brokers use sophisticated computer software that can identify and group the stop loss orders of traders. It is suspected that the brokers introduce artificial volatility that triggers the stop orders and shake out of marginal traders.
- Opposite trades offsets- individual orders in the same currency pairs are cumulative, they are not treated as individual identifiable contracts if they are not in the same direction.
Rules of trade
The most important rule in foreign exchange trading is to use a maximum of 5% of available margin on the sum of all initial trades.
The second and equally important and related rule is to take profit and wait out losses. Never be too eager to reenter a trade because it was profitable, or to average down by adding to a losing position. All the factors that went into deciding on an entry point remains, so don’t let your emotions cloud your judgment.