Practice Makes Perfect

For most (forex) traders, the first few months of trading are going to be very expensive, not in terms of fees, but rather in terms of losses. That’s not necessarily because it will take you some time to master the markets (this, in fact, is impossible), but because it will take some time to master your own psychology and come to grips with your own limitations.

Fortunately, the majority of forex brokers now offer free demo accounts, and you can generally trade with them for as long as you’d like. Let’s be honest- most of us lack the discipline to spend a few months diligently trading with fake money in the same manner as we would if actual capital was on the line. Still, try to at least spend a few weeks trading with a practice account. This will not only help you to fine-tune your strategy, but also to help you gain a better understanding of the mechanics of trading forex. And even better, wait until you can consistently turn a profit on demo account trades before switching over to a real account!

Reading a Quote

The first time you open your (demo) account and attempt to make your first trade, you will be confronted with a series of decisions. The first step is choosing which currency pair you want to trade. When reading a quote, consider that the currency listed first is known as the base currency and the currency listed second is known as the counter currency or quote currency. In terms of trading, it is the base currency that you are buying relative to the counter currency. For example, EUR/USD = 1.36 signifies that one Euro is currently worth 1.36 US Dollars, and that by buying this pair, you would effectively be making a bet that the Euro will appreciate against the US Dollar. If you were to buy a USD/EUR lot, you would be making the opposite bet. If you can’t find the currency pair that you’d like to trade, you might be able to make a synthetic trade involving two currency pairs. For example, if your broker doesn’t offer EUR/JPY (this is highly likely, but for argument’s sake…) but does offer EUR/USD and USD/JPY, you can buy these two currency pairs simultaneously instead. The USD will cancel out, and triangular arbitrage guarantees your exposure to EUR/JPY.

When getting ready to make a trade (as opposed to merely obtaining a quote), you will be confronted with an additional piece of information: the bid/ask spread. In short, you must pay more to buy a currency pair than you would receive if you sold it, and this is how your broker makes money. Spreads will typically be quoted to 4 (sometimes 5) decimal places, or sometimes only the last two decimal places will be quoted. For example, EUR/USD = 1.36407/428 is equivalent to EUR/USD 1.36407/1.36428. Both indicate that to buy the EUR/USD you must pay 1.36428 (the ask price, which is listed second and is always higher), whereas if you were to sell the EUR/USD (either close out a position or go short), you would only receive 1.36407 (the bid price, which is listed first and is almost always lower).

There is plenty of other jargon that I could subject you to here, such as indirect and direct quotes, currency cross, etc, but frankly, it’s not worth learning, since it basically describes various permutations of the above.

Make a Trade!

You’ve selected the currency pair, and you’re ready to make your first trade. The only question is, what kind of order will you place?

By entering a market order, you are requesting (to your broker) that you want your order executed as quickly as possible at the price immediately available. Since quotes/spreads change very rapidly, this means that you could be filled at a price slightly higher (or lower) than you were expecting, though it will always adhere to the bid/ask.

With a limit order, in contrast, you stipulate exactly what price you are willing to pay or want to receive, and your broker will try to match this order with a market maker that will accept this price. The upside of this approach is that you have flexibility in choosing an acceptable price (even within the bid/ask spread) and you know exactly what price your order will be executed at, if it gets filled. The downside is that if the price is not acceptable to a market-maker, your order simply won’t get filled, and you will have to wait and/or adjust your price accordingly.

A stop order, meanwhile, can be used to prevent you from losing too much money if a position moves against you. This is known as a stop-loss order. Simply, key in a value that is below the current rate, and your position will be closed if the spot rate falls below this rate. A buy stop order works in reverse; if the spot rate moves above a value (perhaps a key resistance level) that you specify, then your buy order will execute. A Take-Profit order, then, can be used to close a position when the rate reaches a certain level.

In fact, a stop-loss and take-profit order can be used in tandem in the form of a One-Cancels-the-Other (OCO) order, such that if the rate falls above or below two distinct levels that you specify, the corresponding order will immediately be executed and the other will be cancelled. An IF DONE order, meanwhile, is constructed so that two orders will be executed one after the other. For example, if the price moves above a certain level, a buy-stop will be executed, and if it moves higher still, a take-profit order might be executed. In this way, you were able to execute two orders without even paying attention!

Many broker platforms support even more complicated orders, but these are only useful for sophisticated technical analysis, and it’s best to wait until you have a strong command of strategy before you utilize them.

Objectives, Strategy, and Backtesting

If you haven’t already, now is a good time to formally lay out your strategy and your objectives. For example, will you rely primarily on technical or fundamental analysis, and what will be your ideal time horizon? Will you rely on stop-loss orders, or will you monitor all of your positions constantly so that you can close them out manually? At what point will you take profits? Think about how much you’d like to earn per trade. What about per month? Don’t just say “a lot.” Consider that the more ambitious your goals are, the more time you will have to spend doing research, developing strategy, monitoring the markets, and simply trading.

Finally, before actually putting a strategy into practice, consider backtesting it. Simply put, backtesting involves applying a trading strategy to historical data. In other words, by checking the parameters that normally guide your trading approach against the way markets actually performed in the past, you can easily determine the stipulations/conditions that will make such parameters robust. Parameters include time period (hours, days, weeks, etc.), expected profit per trade (percentage, or number of pips), cumulative profit goal (i.e. 25% annual return) currency pair (USD/EUR, EUR/YEN, etc.) and comfort with risk (i.e. stop/loss). Stipulations, on the other hand, can be as simple or as complicated as you would like. For example, let’s say you want to buy whenever the currency pair breaches its 15-day moving average, and/or sell when the stochastic falls below a certain threshold. These kinds of stipulations can also be qualitative; let’s say, for example, you sell the Euro every time the European Central Bank lowers interest rates, or buy the Dollar every time the consumer confidence index records a rise.

The most robust strategies are profitable under a variety of market conditions, when profit goals are flexible. (For example, try adding or subtracting 5 pips to your expected profit per trade, and see if your strategy is still profitable). It is also important to remember that some strategies don’t lend themselves well to backtesting. Trendlines and other technical ‘patterns,’ for example, are often too circumstantial to be applied and tested generally. Backtesting also doesn’t account for market psychology. While it would be nice to devise a strategy that is profitable in a variety of conditions, sometimes it must be conceded that when market sentiment is especially (and often irrationally) bullish or bearish, one’s strategy may not apply.

As I indicated in the previous section, many broker platforms include built-in backtesting software. Otherwise, you might want to consider buying a software package.

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