How to trade FX?

How to Base Your Trading Decision

In addition to the large

portion of FX market activity, which is prompted by speculation,

arbitrage and professional trading, currencies are traded like any other

commodity. In a floating exchange rate environment, the exchange rate

responds to many factors, including the flow of capital, imports and

exports, and relative inflation rates.  You can start formulating views

on a particular currency from the information you get from the media.

Once involved in the FX market, you can ‘train’ your mind to ‘dissect’

this information in order to formulate a view. From there, many

approaches can be undertaken to base your investment decision.

How to trade FX
 
There are two main types of analysis that traders tend to use for making decisions. Technical analysis

is the study of past prices and patterns to determine future prices

movements; fundamental analysis is the study of the factors that drive

valuation, such as economic, political and business trends.  Both

fundamental and technical analysis

should be learned and understood in order to give you the best chance

to be successful in trading over the short and long term. Both of these

disciplines, in addition to a solid trading plan and money management

factors, are key factors which need to be examined.

Fundamental Analysis

Fundamental

analysis involves the study of economic indicators and government

policies to determine the intrinsic level of an exchange rate based on

prevailing supply and demand, and determine whether the currency is

undervalued or overvalued. Economic indicators used in this analysis

include interest rates,

inflation, a country’s balance of payments, monetary and fiscal

policies, and a government’s attitude towards intervention in currency

markets.

Specifically, a country’s current account, inflation rates and interest rates

are among the main fundamental factors which drive a currency. Many

traders use fundamental analysis to predict future price movements and

to help them in their trading decisions. Often, there can be

considerable immediate market impact when news and/or economic data is

released.

Some examples of fundamental analysis include:

1. Interest Rate Projections

Interest rate changes are one of the most important determinants of short-term movements in exchange rates.

Other things being equal, higher-interest rate currencies tend to

appreciate against lower-interest rate currencies. This is because

securities carrying a higher interest rate tend to attract more capital investment flows than securities with a lower interest rate.

2. Economic Statistics

The

market knows in advance when various statistics will be reported.

Economists put considerable effort into predicting the figures. When the

figure is released, dealers are ready to pounce. If the figure is

significantly different from what was expected, currencies can move

significantly in a short amount of time.  

3. Central Bank Intervention

Central

banks are prominent players in the currency markets. At certain times,

they enter the market with the intention of moving exchange rates in a

particular direction. Central bank intervention is most successful when

done on a concerted basis. For instance, if the US Federal Reserve, the

European Central Bank, the Bank of Japan, and the Bank of England are

all buying US dollars, it is unlikely that traders will take them on by

selling US dollars. Over the long-term, though, it’s difficult and

expensive for central banks to stand in the way of secular trends.

Technical Analysis

Technical analysis involves the study of price and other data over time, in order to try and predict future price movements. Technical analysis

techniques include studies such as traditional charting patterns,

moving averages, stochastics, point and figure charts, Elliot Wave

Theory, Fibonacci and Gann. Our articles on technical analysis contain more information about each of these theories.

 Technical indicators that are useful for foreign exchange trading include:

•    Moving averages
•    RSI
•    Fibonacci retracement
•    Stochastics
•    MACD
•    Momentum
•    Bollinger bands
•    Pivot point
•    Elliott Wave

A Three-Step Checklist Before Making That First FX Trade

1. Develop a Trading Plan

Due

to the emotional stress that is inherent in any speculative situation,

successful traders have a predetermined method of operation which

includes a set of rules by which they operate. It’s important to rigidly

adhere to these rules in order to protect you from yourself. Very often

your emotions will tell you to do something totally foreign or negative

to what your market trading plan should be. It is only by adhering to

your formula that you can resist the emotional temptations that are

constantly present in speculative markets. Following a trading plan can

also help you reduce stress, maintain objectivity and learn from your

mistakes.

Ask yourself:

>> Are you comfortable holding trades overnight?

>> When do you like to trade? Day or night?

>> How much do you risk per trade?

>> What is your profit target?

>> Where do you place your stop losses?

2. Develop a Risk Management System

The

most common mistake made by currency traders is not following a

systematic risk management plan. The high leverage and high volatility

nature of the currency markets can have an unusually strong influence on

a trader’s emotions. This emotional volatility can result in a lack of

objectivity and poor decision-making.

The aim, therefore, is to

devise a systematic approach and define in detail parameters of a risk

management system. Under such a system, profits, and in particular

losses, are defined and stop-loss orders are placed.

Ask yourself:

>> What is your strategy?

>> What is your risk versus reward for each trade?

>> Is your stop loss order placed at an appropriate level?

3. Know the Market and the Currencies You are Trading

In

foreign exchange trading, like anywhere else, there are winners and

losers. Successful traders shift the balance in their favour by

continually gaining knowledge about the Forex market, placing themselves

in the best possible situation to emerge successfully, and avoiding

marginal trades. Knowing the market characteristics and the currencies

you are trading can help shift the odds in your favour.

Ask yourself:

 >> What are the fundamental factors driving the currency?

>> When are key economic statistics released?

>> What are the underlying time zone characteristics?

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