Lesson 9: Money and Risk Management.

The Forex market is very volatile which means despite doing the right thing, you can still stack up a quite few losses before you make good. Most profitable traders lose approx 60% of the time but still make a good return, but only because they know how to manage money. Firstly divide your capital into 100 even lots, to ensure your maximum loss on any one trade will only be 1% of your account. This also aids you emotionally as it allows you to be wrong quite a few times without having a major effect on your capital. To figure out what 1% of your account is, divide your capital by 100. So if our account was £500 our Max Risk per trade/bet would be £5 (£500 / 100 = 5). In each trade our risk is the point difference between our Entry and Stop price, we call this the “Stop Size”. If our entry price on a EURUSD trade was 1.30000 and our stop was 1.29990  our Stop Size would be 10 points (1.30000 - 1.29990 = 0.0010). We need to ensure that our Stop Size (entry price - stop price) does not exceed our max risk per trade (1% of our capital), or we will have lost more than 1% of our account on 1 bet/trade. To do this we divide Max risk per trade (1% of our capital) by our Stop size (Entry - Stop price), to get our Bet Size. In this case £5 (1% of our capital) / 10 (stop size) = £0.5 (bet size). A lot of traders spend their time counting pips, thinking that they've had a marvellous day if they make 100 points. But of course it all depends on what you were risking! if you only risked 50 pips that would be fine (a RRR of 1:2), doubling your money for a return 2%. But if you risked 200 pips (a RRR of 1: 0.5), it’s crap as you’re only getting half your risk back, a 0.5% return. As you can see measuring risk is far more important than measuring any other unit.

Lesson 8: Spread Betting Entry, Exit and RRR

Once you have identified an opportunity, you will want to place your bet. Let's say you want to go long (buy) the EURUSD. To go long hit the “buy/ask” button (to short = sell, hit the "sell/bid" button) on your platform, you will then be asked to specify the bet size. Bet size = how much do you want to bet per pip (the last digit on the right of the quote). Some firms allow you to bet as little as 10p a point, this means that every point is worth 10p, so a 10 point move would equal £1 (10x10=100p). If desired (you should) you can also place a stop loss order, an area where you would wish to close your bet should it go against (an insurance policy if you will) and a take profit order, representing a level of profit you would be happy with. In these orders you are asked to type in the exact price at which you would want to sell. Here's an example, we buy the EURUSD at 1.30000, we place our stop at 1.29990 (-10pips) and a take profit order at 1.30020 (+20pips). You can see we are are basically trying to double our money. We call this a risk reward ratio of 1:2, because we are risking 1 (10pips) to get 2 (20pips) back. A RRR of 1:2 is genuinely accepted as the absolute minimum a trader should accept. Throughout your trade you are able to update your stop and take profit levels (however you rarely change your take profit area). This is fab as it means we can lock in gains reducing our RRR. For example when our trade moves in our favour by 10 pips it has not yet hit our profit target but we could move our stop loss to our entry price, essentially making our risk 0,  (If we bought and sold at 1.30000 we would register no loss or gain) so our RRR would be 0:2. When you move your stop, it is called a trailing stop. When trailing a stop we have to give price a little wiggle room because the collective market agreement of what something is worth fluctuates a fair bit! ;) So to avoid being stopped out too early we have to keep our stop loss wide.

Lesson 7: What Forex Market to Trade? Forex Spot, Futures, Options and Spread Betting

Forex Spot is the most traded market in the world with a daily turnover of around 1.5 trillion dollars! Spot basically translates to "now". So if you were to trade it, you would be buying or selling a pair at the price it is right now and would own the currency you were buying (although not physically, this would be completely impractical, it's all electronic). Futures are very different. When trading any future you are not actually buying the base product (currency in our case), you are buying a contract. This contractual agreement is a little like asking someone to reserve a sofa you like for 3 months at a set price, you put a deposit down but contractually you must (are obligated) pay for it at the end of the 3 months. The idea is that if you think the price of the sofa (currency) will go up, you buy the contract (guaranteeing a set price for 3 months). If you’re right the price of the sofa will have gone up in value and you profit from the difference by selling on the contract or the sofa. Options are very similar to futures with the exception that you are not obligated to buy the “sofa” at the end of the 3 months (in this circumstance you just lose your “deposit”) also the contracts can vary in length. When spread betting one can trade just like the spot, future or options market but you never actually own the currency or contract, instead you place a bet with a financial bookmakers (a “Corals” for finance). The bets you place with them unlike a regular bookie, are open, meaning you can alter them just like a trade (you can add to, reduce or close your bet whenever you want). The major benefit to spread betting is that all winnings are tax free (because it is gambling). There’s no right or wrong method, just choose what suits your needs. If you only have limited funds it might be best to spread bet (but always with a stop, otherwise your losses are limitless!), as the minimum deposit and trade sizes are considerably smaller than other types of accounts.

Lesson 6: Currency Quotes

Currencies are abbreviated to a 3 letter code, EUR = Euro, USD = US Dollar, JPY = Japanese Yen, CHF = Swiss Franc, GBP = GB Pound. In any transaction there are always two commodities, so currencies must be put into pairs. In stocks we sell money to buy stock while companies sell stock to buy money. So in FX we must sell Money to buy Money and vis versa. The most common pairs are the EURUSD, GBPUSD, USDJPY and the USDCHF, aka the "majors". Please note they cannot be reversed ie USDEUR. Generally the currency with the higher IR comes first, with exception of the EUR which always comes first. When reading a quote, ie  "EURUSD 1.30025" we call the EUR the 1st currency, the USD the 2nd currency and the number represents how many 2nd currency (USD) the 1st currency (EUR) can buy. In this case 1 EUR can buy 1.30025 USD. If we buy the EURUSD we would be buying EUR (1st currency) and selling/"borrowing" USDs (2nd Currency). If we sell the the EURUSD we would be selling /"borrowing" EUR's (1st currency) and buying USD (2nd currency), this applies across all pairs. There are 5 decimal places after the 1 in 1.30025 as the FX market is so leveraged (tiny movements = big gains). When we buy or sell our profit/loss is calculated by the last number on the right of the quote, in this case the 5. We call this the pip, (we’re trading in thousandth of a penny increments!) sometimes the 2nd or 3rd number on the right is used as the pip depending on the pair, but don’t worry we’re always told which it is in the order entry screen. Finally when you view a pair there are always 2 prices, the “bid/sell” price (lower) and “ask/buy” price (higher), the difference between them is called the spread and is how brokers make their money. They match a buyer paying 1.30027 with a seller selling at 1.30025 to make a 2 pip profit. On the majors spreads of anything up to 2-3 pips are acceptable.

Lesson 5: Trading the Carry Trade (A Long Term Strategy)

As you've probably guessed we’re going to work our trading ideas from the carry trade and safe haven plays. Let’s do a brief recap here so you don’t need to re-read all the lessons to date. The Carry Trade: Okay so a Central Bank spends it's time either trying to stimulate a flagging economy (lowering IR, lowering Reserve Requirements and buying Debt), or containing a booming economy (raising IR and Reserve Requirements). This makes our life very easy for spotting potential Carry Trades... If we hear that a central bank is flooding it's economy with money and lowering IR, we know it's a great time to borrow money from it cheaply. While if we hear that a central bank is struggling to contain an inflationary economy (raising IR / Reserve Requirements) we know it's a great time to deposit money with them, and that's just what we do! We're almost a reverse Robin Hood, we borrow from the poor, and deposit with the rich. Very rarely one of the 3 “mega economies” (US, EU, Asia) goes into recession (2 consecutive negative quarters of growth/GDP). Our objectives must change from one of capital growth to capital preservation, so we buy the safe haven currencies (US Dollar, Japanese Yen or the Swiss Franc) until the problem “mega economy” has returned to growth (positive GDP). Our strategy can be summed up as “Money always flows to the highest IR except in times of global fear, when it seeks safety”.

Lesson 4: Safe Havens

Okay sometimes, very rarely the Carry Trade doesn't work. Why? Because of “global fear” (recession). In times of global fear, investors objectives change from one purely of capital growth (greed) to that of capital preservation (fear). So instead of buying risky currencies offering high returns, they buy safe havens with no regard to whether they offer any return or not. Its important not to confuse “global fear” with just fear. This is because in all potential carry trades the country with the lower IR will most likely be suffering/recovering from a recession, so feeling some fear. While the country with the higher IR will naturally be experiencing growth, so some positive emotion. IMO The best way to identify “global fear” is to divide the world into 3 mega economies of. 1. US Economy, 2. EU Economy (when added up has a GDP roughly the size of the US) 3. Asian Economy (China+Australia+Japan again equal a GDP roughly that of the US). If any one of these 3 mega economies (US, EU, Asia) falls into recession you want to start trading the safe havens until it has returned to growth(a recession is defined as 2 consecutive negative quarters of growth/GDP), because it affects the entire world as they rely on each other for imports and exports. On a global level this means slower growth everywhere... In the currency market our safe havens are the US Dollar, as it’s the biggest single economy, the reserve currency of the world and is how we price oil. The Swiss Franc, a relic of the cold war when the Swiss Franc offered some safety because of it’s neutrality. And the Japanese Yen, being based in the East it’s economy is thought to be  far enough removed for it not to be too heavily affected by economic problems in the West. Although one can poke some holes in the theory behind the safe havens they work because of 2 reason 1. traders and investors have little other option and 2. The Crowd effect, the desire to follow that which others are doing.

Lesson 3: How a Central Bank Makes its Decision

So a Central Bank’s objectives are to  maintain 1. High Employment, 2. Steady Growth and 3. Low Inflation. So obviously it needs a way to measure each of these areas. To measure employment it uses the monthly/yearly unemployment figures. In the US they are confusingly called NFP’s (non farm payrolls) which records all those employed, but not at a farm, so the entire service sector of the US (80% of its economy!). Thankfully the rest of us manage to call them unemployment figures. To measure growth they view the monthly/yearly GDP figures (gross domestic product), which is the gross income from a country's goods and services. Finally to measure inflation it uses the monthly/yearly CPI figures (consumer price index), which is an index that records price increases/decreases from a set basket of consumer products. Are there other ways to measure these figures? Absolutely, dozens but none are as respected as the ones mentioned. Do you really need to know this stuff? Well, you don’t need to be a mechanic to drive a car, but it’s not a bad idea to know how to fill up your radiator fluid. Having said that, it’s important to remember that you’re a trader not a central banker. Some will swear you should monitor these figures religiously but I would argue that they’re non of our business. We don’t trade employment, growth, or inflation figures, We trade money. The only thing that can affect the supply of money is it’s central bank, so ultimately I only follow their decisions. CPI can go up warning of inflation and possible IR hikes but until the central bank does something, the supply of money hasn’t changed. The decision is always based on the 3 objectives of the central bank, never one factor. This is why predicting what a central bank may do should be avoided.