Forex market is a market that never sleeps. It is one of the largest and fairest markets in the world operating across the globe. The dealings in the forex market can help one to earn a huge fortune provided one makes the right move. However, one might as well lose the same within no time. The trader has to constantly keep himself updated about the movements taking place in the market so that he ends up in a successful deal, for a host of factors have a great impact on the functioning of the market. Interested? Wanna be a currency trader? Read on to know more.
Global currency markets today offer unlimited opportunities for a trader to make money. Currency trading, quite often, appears easy, though deceptively. It makes a new entrant to the dealing room feel brilliant and invincible when he wins the bet though on the flip side it can tempt him to take wild risks. As against this, a matured dealer neither gets elated upon winning nor deflated on loss. Paradoxically, a good dealer does not aim at winning but to trade well. He strongly and, of course, rightly believes that if the trade is right, money automatically follows. In that context, trading becomes a fascinating intellectual pursuit that calls for hard work and constant honing-up of trading skills. To be on the right side of the market, a trader has to know the market, its dynamics, mechanics of trading decisions and risk management principles and that’s what the present paper shall deliberate upon.
Global Forex Markets
Foreign exchange market is an over the counter market in which currencies of different countries are bought and sold against each other. It is quite deep and highly liquid. It is the investors seeking the highest return on their funds who generate most of the currency trading. It is quite decentralized—participants like market makers, brokers, corporates and individual customers are physically separated. They communicate with each other via telephone, telex, computer network, etc. It is the commercial banks that offer such exchange conversion facility through their dealing rooms.
The cross-border capital movements have accelerated since the 1980s extending the market continuum through Asian, European and American time-zones. Forex market has thus become one of the largest in the world and a 24-hour continuous exchange that never closes. It is described as the “fairest market on earth”, for it is so large that no one player, not even a large government can completely control its direction. With the kind of technology at his command today, a trader can work from home or office at his chosen hours of work.
What Moves Currency Markets?
One of the most important factors influencing the returns from investing in a particular currency is the yield it offers relative to other currencies. Higher interest rates on a country’s currency will help to attract capital spurring its appreciation. Numerous other factors can also influence the demand for investments in a currency, such as, a rise in a country’s exports, its productivity or a resource discovery that may confer a competitive advantage on that country and attract investments. On the other hand, high levels of foreign debt can deter inflows of new funds, resulting in pressure on the currency to depreciate.
One may as well doubt the ability of the butterfly flapping its wings in Brazil setting off a tornado in Texas, but none can ignore the ability of innocuous minor happenings in the financial circles across the globe or statements made by financial power centers to generate turbulence in currency markets. It is essential for a trader to keep a constant vigil on some of the known important market movers such as:
- Global market movers—oil prices, G-7 Country decisions
- Movement in global stock markets—change in Dow Jones, Nikkei, Hang Seng, FTSE, DAX - 30 etc.
- Balance of payments—war and threat of war, dollar value etc.
- Business and industrial market movers—GNP, Industrial Production Index, Business Failures etc.
- Unemployment rates—status of labor force, total employment, seasonal adjustments, non-form pay-rolls etc.
- Consumer market movers—Consumer Price Index, Consumer Confidence Index, Personal Income, Auto Sales, Housing Status etc.
- Monitory and Financial Market Movers—Interest Rates (both Short-term and Long-Term), Yield Curve, Lombard Rate, Discount Rate, Base Rate Inflation and money supply, too much of money in circulation, open market operations of Central Bank, Taxation hikes, etc.
- People known as market movers (words of wisdom)—Statements made by people who enjoy tremendous political/financial power like, President of US, Fed Chairman, Chairman of ECB, Summit/Trade Talks etc.
Besides these well-established movers of the market, certain events such as internal troubles, coups, scandals, major oil discoveries, bandwagon effect are also known to influence market behavior. A trader has to keep his eyes and ears open for any happening in these sectors and factor that information into trading decisions.
How to Make Trading Decisions?
A trader basically enters the market to make profit but every deal need not necessarily result in profit, for the market can always move against one’s expectations. As “there is a tide in the affairs of men, which, taken at the flood level leads to the fortune”, there are trends in currency markets that need to be taken note of while making trading decisions else, “all the voyage of their life is bound in shallows and miseries.” This is feasible only through the dint of hard experience. Nevertheless, by following a few cardinal principles viz. trading with the trend, cutting the losses short, running profits longer and managing risk appropriately, a trader can safely sail through.
Trade with the Trend
To make money, a trader has to trade with the trend than against it. There are mainly three types of trades: Long trade, where market participants are actively buying a currency over a period expecting it to appreciate; short trades in which market participants are actively selling the currency over a period expecting it to depreciate and side ways trade where there is no trend for the currency moving up and down, of course within a specific range. Here, the simple logic is, when the trend is up, buy at support and if the trend is down, sell at resistance.
However, there is always a danger of a trader jumping at the wrong point on seeing an up-trend not knowing the exact support level and exiting at wrong resistance without making profit. It is sensible for an individual trader to trade and trend in the short term, which could be a week to fortnight, with of course, a clear understanding about the trend, the support and the resistance levels. Moving average indicator is a very good signal for a short-term trader. If the trend is up, the trader has to invariably be long and, if the trend is down one has to be short.
Long-term traders usually enter a position based on a confirmation of a long sustaining trend, may be for periods ranging from 6-9 months. These traders use various theories like the Dow theory and keep off from taking positions in choppy trading. They see at least three higher highs and three higher lows in the pattern to initiate a position. They mostly rely on weekly charts to spot the trend. On the other hand, intermediate traders spot the trend through the moving averages pattern during a period of 45-60 days.
To judge whether an indicator is a bona fide signal, one need to look for short- as well as long-term trend. When both are up, it is a good buy. When prices consolidate and create a shelf, it gives a signal for exit. There are traders who try to find out if there is a conspicuous pattern of consecutive higher highs and higher lows (up trend) or lower highs and lower lows (down-trend) on a weekly chart.
An intra-day trader, who does not trade for large profits nor is able to sustain huge losses, should never ever trade against the trend.
A decision to cut loss is the saddest event for a trader as it could trigger a huge hole in his profit or ability to trade further. As a trader learns the nuances of trading to make profits, he has to build-up the mental-frame to adjust to the realities of cutting a loss position too. One can decide upon stop-loss positions based on chart-based stops: On a long position, one has to leave the “stop” below the support level and on a short position it could be above a major resistance.
In the course of business, many deals end-up in profits, however small they may be. At times, a trader even after making ten deals in profit and one deal in loss, may end-up in a net loss position. This could be due to the fact that the trader had run the loss position for long. Hence, it is very essential to have small losses or cutting short losses, that too with speed. Conversely, small losses accumulated in a month could be wiped out by a single large profit (hence, learn to allow the profits to run till the trend reverses) enabling a trader to balance a portfolio to run in profit.
To be continuously losing small amounts and not making profits on deals tantamount to wrong interpretation of the market. It is wiser to build a portfolio and build currencies as a natural hedging mechanism to eliminate losses in one of the portfolios. It is always advisable to initiate a position at a support level/resistance level based on chart trends and devise a cut loss formula below or above the same in order to sustain in trading for longer periods. Of all the principles of trading, cutting losses should be observed very stringently.
To have a decent sleep after initiating a position and leaving the same attended to by a banker i.e. leaving overnight positions to correspondent, wherever possible, in the 24 hour market, the “stop” has to be fixed fairly based on the principles mentioned above. It is prudent not to wait for more than 30-40 points on a one million position. Again, it depends on the risk reward attitude one decides to adopt. Successful trading is a result of a combination of both risk and reward.
One could always be a winner if only one know when to strike a deal and when to exit to book profits, failing which one could lose the game. Entry point is the deciding factor in fixing the stop losses than anything else. Volatility stop means placing a stop based on the volatility trends. In conclusion, a dealer has to always remember and be guided by the mantra—“cut losses”, “cut losses”, “cut losses”.
Run Profits Long
As Will Rogers once said, “Even if you are on the right track, you will get run over if you just sit there”. A dealer should know how to book profits before reverse sets in. Here, speed is the essence. It’s like wrestling a gorilla: you rest when the gorilla wants to rest; you come out of a position when it is moving towards rest. Similarly, when one is on a winning position, it makes sense not to risk the portfolio further by initiating additional position/trading or pyramiding the position.
A trader should also realize that once he is out of a position and especially if there is a big move, it is difficult to initiate a position afresh as in a one way moving market it is difficult to get the right price. Systems like the trendsetter do give indications as when to book the profit, when the position is in profit and when not to be a short-but a long-term trader.
Long-term moving averages do indicate an exit signal where one has to take profit and hence this needs to be watched every day. This is called withholding taking of profits by fixing a “trailing-stop” on winning position by using say, chart points which help to indicate weekly reversals etc. It is often said that it is not thinking that makes big money but it is sitting (sitting on positions—but not at a loss).
In case one—“trailing stop” prematurely gets hit and the market rebounds, the re-entry point becomes very crucial. Suppose one had fixed one’s profit taking by giving a trailing stop of 200 bp over one’s position based on assessment and presume there is a deep trend reversal. This necessitates re-entry at the right time, that too more quickly. However, this strategy does not work in a ranging market but does work in a rallying market. It is here that one may have to see whether the RSI has reached an overbought or oversold level and fix up a tight trailing stop. The rules of reentry have to be less rigorous but stop loss on such positions could be tight. The trader has to reenter the position only if the indicators are still in alignment with the original view based on which the position was initiated.
There would be occasions when a trader pulls out of profits based on a false break-out or in a quiet, calm and illiquid market when some trader dumps sufficient volumes to pull down the price. One has to survive this onslaught or one may not survive a long-term move.
It makes business sense for a short term trader to take profit by fixing aggressive trailing stops during the first few days of the move and then get back into the position to catch the long-term move of the movement. It is always an advantage for a trader to stay focused on a single currency that he watched and meditated upon most than dabbling around many.
A trader on his entry into the dealing room should first know the closing price of the previous day, watch the chart signals and based on this, re-fix his trailing stops or initiate further position, for it is a small percentage of the total trades done that runs into profits to sustain the major losses. Of course, it does not mean that the trader has to wait for such windfalls without early shutting out of loss making positions. A trader has to allow the profits to run longer based on the volatility trends/chart pattern. He has to initiate a base position and as the market starts rallying, should gradually move the “stop” below the major support areas or below a Fibonacci pull back. A trailing stop could also be fixing of a limit on the profit making itself. Some of the traders, in fact, believe in having profit target, which is as crucial as a predetermined stop loss point.
A matured trader won’t mind stepping out of his position and for that matter stop trading, if the day was found to be wrong where decisions are turning against him, for after all not all days are bad.
Manage Risk Properly
The ultimate deciding authority for a winner or loser is the risk management. A dealer has to decide which are the markets to be traded, the number of markets and exposures that one can trade and how to diversify the portfolio. The management should decide as to how much of the capital could be exposed to the risk with what level of diversification. Senior management should establish, enforce and regularly review a risk management framework, clearly specifying authorities, limits and polices. The risk management procedure should be fully approved by the Board of Directors and senior management should be made accountable for its implementation.
A separate system for independent monitoring to ensure compliance with the risk management framework should be in place. There must be complete segregation of duties between the front, middle and back office activities. Regular internal audits independent of trading and risk management functions should be carried out to ensure early identification of internal control and weaknesses, if any.
Professionalism of the highest standard should reflect in every operation of the dealing room. A priority to minimize deal input cycles, errors and down time should be in force. There should be a regular review of internal processes to identify and rectify weaknesses, disjoints and failures.
There should be appropriate system for timely documentation, processing and reporting. A technology policy to plan systematically for adequate systems support should be in place. A fully tested contingency site ready for back-up should be available.
A functional department should mark trading positions to market on a daily basis, independent of trading. The frequency of position valuation should be increased where justified by market volatility, volume and the institution’s own risk profile. Valuations should be verified against independent sources wherever possible. There should be a robust process for evaluating any off-market transactions. The risk measuring methodology used should be based on generally accepted statistical practices and approved confidence levels. Market models should be validated before implementation.
Risk positions should be regularly evaluated under stress scenarios. Volatility measures should be continually updated. The importance of market liquidity conditions should be considered before entering into transactions. The potential costs of unwinding up of positions, especially in illiquid markets should be assessed. A liquidity contingency plan for implementing in crisis situations should be in place for both on-and-off balance sheet instruments.
Returns should always be measured against market and other risks and against risk weighted capital with a corresponding measure on regulatory capital taken into account.
There should always be rational diversification of trading and customer activities to reduce risk. The highest standard of conduct with clients should be promoted. No trader should knowingly conduct business with clients involved in business activities known to be illegal or inconsistent with generally accepted standards of ethical or social behavior in the community.
Proper documentation for all transactions and counter parties should be in place. Prior to entering a transaction, the dealer should ensure that customers and counter parties have the legal and regulatory authority to transact. The terms of contracts must be legally sound and enforceable. Confirmation of all transactions should be dispatched on time and tracked for compliance.
How to Be a Successful Trader?
A dealer has to examine his trading motives and accordingly design a method that matches his personality. He should realize that he is responsible for the trades he undertakes. He needs to be independent and confident of his acts. He should accept that losing is a part of the game and should be open to new ideas/opinions. He should be patient and not worry about looking stupid should a deal turn out to be a losing bet. He should learn to be disloyal else he cannot cut losses in time. Lastly, a dealer should believe that there is more to life than trading.
A dealer’s quote must possess three major qualities: one, fast reply to the request for the quote; two, narrow spread and three, willingness to deal a reasonable amount at the quoted rate. In any case, a dealer should never ever resort to loading losses incurred elsewhere into the merchant quotes.
It is based on one’s view on price movement that a dealer should take a bullish/bearish or conservative/aggressive posture. Here it makes sense to remember that even the best traders are known to lose 60% of the time and make money 40% time only. They should set clear goals beforehand under money management—position of the size, stop losses, reward risk and tactics of trading.
Importantly, they should cultivate their own way of dealing with success or adversity: Grass grows in inches but dies in feet.