Last weekend I recently struck up a conversation with a friend of my wife’s whom I had never met before and, as is often the case, it didn’t take long before we moved into discussing what each one did for a job. Given my day to day conversations with forex traders, one can falsely come to the conclusion that everyone knows how to trade the forex markets. However, after 5-10 minutes of passionately explaining my job as a forex trader, I could see the confused glaze running over this poor strangers eyes. It got me to thinking that many people don’t fully understand how forex trading works and so I’m going to take today’s blog as an opportunity to explain, in very high level and simple/Lehman’s terms, how forex markets are traded. This coming through the eyes of a forex trader of over 10 years but aimed at the audience of non forex traders with little to no knowledge. I hope it helps those who are looking to become more familiar with our wonderful currency trading world 🙂
Whilst most people I speak to (outside of the forex trading bubble/world) have a good understanding of the foreign exchange markets in general (exchanging money to go on holiday etc…), many were completely baffled by how they are physically traded online. So if you have no idea about how professional traders are able to profit from the forex markets, this blog post is for you. A jargon free article in Lehman’s terms that everyone can understand and finally somewhere I can easily direct people to when inevitably I encounter more confused conversations about my job in the future!
Now before we begin, its important to highlight that you are probably already a forex trader in some shape or form. For example, if you have ever been on holiday and had to exchange one currency into another, then you would have traded currencies against one another (albeit not with the main aim of making a profit from the transaction) Sadly this isn’t going to help much in terms of understanding how forex markets are traded by financial market participants. So let’s get into the detail of explaining how they operate and how we trade them with the primary objective of making a profit.
This is the component of foreign exchange that you are likely to understand; that one currency is converted into another. So two currencies have to be involved for the ‘exchange’ to take place. Unlike when you buy a stock, whereby you are purchasing shares in one single company, in the currency markets you are always using one currency to buy or sell another. For example I could use £1 to buy $1.30. This is where the confusion for many arises and so I want you to STOP thinking about conversion’s right now. It will just waste precious brain energy. Thankfully the latest and greatest trading software does the heavy ‘exchange’ lifting automatically so we as currency traders don’t have to. So just forget about this right here and instead focus primarily on what we discuss below.
So just like apple shares will have a price of say $400 (for example), that is constantly moving up and down in value as financial market participants trade it, currency pairs (such as the GBPUSD pair) will also have a single exchange rate/price (NOTE that for all currency pairs we trade, we use 4 decimal places unless the pair includes the Japanese Yen/JPY of which it will be just 2 decimal places). For example the GBP/USD exchange rate may have an exchange rate/price of 1.3000 (which is also constantly changing as it is traded up and down in value). So that means for every £1, we are able to access $1.3000 in exchange. This 1.3000 exchange rate number is the price we, as forex traders, are most interested in as its the fluctuations in this price (both up and down) that we look to take advantage of.
So in simple terms forex traders treat a currency ‘pair’ as a single asset ‘price’. Just like a stock trader would do so when looking at the price of say, Google. We have used the example of the GBPUSD currency pair throughout the blog so let’s stick with this for simplicity. We noted that the pair was trading at 1.3000 (again just using this as an example price/rate and not the current rate/price) and that we are now interested in where the price is likely to move in the future. As professional forex traders we are simply speculators on the direction of a currency pair. Well before considering a live/real trade, and considering putting our trading capital to work, we are constantly asking ourselves is the GBPUSD price more likely to move higher or lower in the future? Only when we have a strong belief that the price is likely to rise or fall, will we pull the trigger on a trade. If we have no clarity on this, we will simply sit on the sidelines and wait or consider an opportunity on another currency pair where the directional bias is clear.
Again notice the similarities of this to stock trading. Stock traders will make a speculation about whether the price of a stock will move higher or lower in the future and we as currency traders will do exactly the same but using the price/exchange rate of a currency pair. Traders will profit if they get their speculation correct and lose out if they don’t. But how do professional forex traders make this speculation, with confidence and a high probability of success?
Hopefully by now you are starting to ask yourself what are some the things that professional forex traders use in order to help them with determining this all important ‘direction’ of a currency pair. If so, great, as your mind is now starting to move to the stage of ‘analysis’ whereby we look to observe a number of factors that can help us determine, with confidence and a high probability of success (but of course never with a complete guarantee of success), the likely direction a currency pair is likely to move i.e. rise or fall in value from its current level. Now the area of ‘analysis’ is one far too detailed to go into in this blog but in very simple terms traders will use a variety of tools which come under the banners of either ‘fundamental analysis’ (using economic events to determine a currency pairs likely future value), technical analysis (using technical chart tools to determine a currency pairs likely future value) or combining both.
Personally we use both but fundamental analysis is always our starting point and ALWAYS at the core of every trade we take. Certain economic events have a huge impact on the value of a currency, and thus the direction of a currency pair, and so they are an essential part of our analysis both on shorter (minutes/hours) and longer term time-frames (days/weeks). These events really help us with giving us an ‘edge’ in terms of knowing, which a high probability, where currency prices are likely to head in the future. We then blend technical analysis on top of the fundamentals to assist with the timing into and out of trades which, as we have discussed, is the critical element in being able to generate a profit.
We never have any guarantee’s of success when trading (no trader does) but we look to stack the probabilities of success in our favour so that, over time, our profits are more frequent AND generally larger than our losses. We are playing a probabilities game here. We never toss a coin and play a 50:50 chance (that would be gambling). We do extensive fundamental and technical analysis to attain the highest probability of success from a trade and only then will we execute a trade. This is what separates professional trading from gambling. Using the UK Brexit 2016 referendum result as a great example, we saw this huge economic event send the GBP crashing lower against the USD thus bringing the GBPUSD exchange rate down from 1.5000 (before the event) to 1.2000 in a matter of weeks. Having a heavily fundamental analysis approach to our trading we were prepared for this event well in advance. Our analysis drew a clear conclusion that if the UK voted to leave the European Union (which is what they did), that this would likely send the price of GBPUSD sharply lower. With this clarity and understanding we were then able to confidently take advantage of this movement lower in the GBPUSD by selling the currency pair for a nice profit as you can see in the videos below. These types of big economic events are not just a one off random phenomenon. They are happening all the time and provide a consistent stream of highly probable trading opportunities to profit from most months.
Now you may be a little confused about how you physically execute a trade on a currency pair so let’s clear this up quickly now. When executing a trade in the forex markets you can do 1 of 2 things. You can either buy or sell that currency pair. Buying a currency pair means that you believe, based on your analysis, that the price of said currency pair is likely to RISE from its current value. If this happens then you profit. If it doesn’t then you will take a loss. For example if you BUY GBPUSD at 1.3000 and it subsequently rises to 1.3050 then it has risen in price and done as you predicted/speculated. You will profit as a result, in this example by +50 points or ‘pips’ (pips being the common word used in the forex world for points). As part of your trade you will have attributed a certain monetary amount i.e. £1 per point/pip. If this was the case then you would have made a £50 profit i.e. +50 pips x £1 per pip = £50. Money/risk management is a little more detailed than this example but it should give you a general idea on how you profit when you get the directional movement of a currency correct.
When you are selling a currency pair its just the opposite scenario. You are, based on your expect analysis (fundamental, technical or both), expecting that the price of that currency pair will eventually FALL from its current value. So if the current value of GBPUSD is 1.3000 and you SELL the currency pair then you are predicting/speculating that it will FALL from its current value. If this happens then you profit. If it doesn’t then you will take a loss. For example if you SELL GBPUSD at 1.3000 and it subsequently falls to 1.2950 then it has fallen in price and done as you predicted/speculated. You will profit as a result, in this example by +50 points or pips. As part of your trade you will have attributed a certain monetary amount i.e. £1 per point/pip. If this was the case then you would have made a £50 profit i.e. +50 pips x £1 per pip = £50.
Irrelevant of whether you are buying or selling a currency pair, you are just speculating on direction. If you get the direction correct you will profit. You will take a loss if you don’t (see below for more detail on this).
It’s vitally important, that having just talked about how traders profit from movements in the price of a currency pair, to make you aware that we also take a number of losses along the way too. How do these materialise? Well simply put, its when you get your prediction on a currency wrong. If you predict that a currency is likely to head higher in time, and therefore buy that currency at a certain price, but it then goes in the other direction i.e. the price goes down from the current price, then your prediction was proven to be incorrect. Vice versa if you make a prediction to sell and the price heads higher.
To illustrate using the same examples as before, if you BUY GBPUSD at 1.3000 and it subsequently falls to 1.2950 then it has fallen in price and done the OPPOSITE to what you predicted/speculated. You will take a loss as a result, in this example by -50 points or pips. As part of your trade you will have attributed a certain monetary amount i.e. £1 per point/pip. If this was the case then you would have made a £50 LOSS i.e. -50 pips x £1 per pip = -£50.
Conversely if you SELL GBPUSD at 1.3000 and it subsequently rises to 1.3050 then it has risen in price and done the OPPOSITE to what you predicted/speculated. You will take a loss as a result, in this example by -50 points or pips. As part of your trade you will have attributed a certain monetary amount i.e. £1 per point/pip. If this was the case then you would have made a £50 LOSS i.e. -50 pips x £1 per pip = -£50.
The comforting thing about the approach of professional forex traders is that we can always pre-determine and pre-set our max loss and profit. We can place an automatic instruction with our trading broker (who we make live trades through) to get us out of a trade at a certain monetary loss i.e. if your trade reaches a loss of -£50 then your trade will be closed automatically at this point. The same goes for profits although as a professional trader its more advantageous to let profits run a little longer whilst losses are taken quickly and without hesitation. This approach will be another factor in why the top +20% of traders are able to make a consistent profit overtime. Losses will happen, that’s a given. They are inevitable at the times when we get our analysis wrong. But if the majority of your trades are profitable, and the profits are generally larger than the losses, then its a recipe for long term success. As already mentioned there is much more to risk/money management but this gives a good summary of the approach most successful long term traders take. Let profits breathe so that they can realise their potential but cut losses sharply or at a maximum pre-determined level/amount so that they never spiral out of control.
The forex markets are an asset class like any other (stocks, commodities etc…). Forex pairs come with a constantly evolving price/exchange rate and as forex traders we look to speculate on where this price is likely to go in the future when our professional analysis gives us a high probability of success. We then profit when we get this prediction right, we take a loss when we don’t. There is of course much more to it all than what we have discussed in this article but we hope that it has given you a better understanding of how things work in the world of forex trading and a strong foundation from which to build.
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