Forex Trading

What is Forex and  Forex market participants:

The forex market is the largest, most liquid market in the world, with average traded values that can be trillions of dollars per day. It includes all of the currencies in the world and currencies are traded worldwide among the major financial centers of London, New York, Tokyo, Zürich, Frankfurt, Hong Kong, Singapore, Paris and Sydney. Mathematically, there are 27 different currency pairs that can be traded but about 18 currency pairs that are most often quoted by forex market makers because of their overall liquidity.

Currency pairs: 

Currencies are traded in pairs. In general, eight of the most traded currencies are the U.S. dollar (USD), the euro (EUR), the Japanese yen (JPY), the British pound (GBP), the Australian dollar (AUD), the Canadian dollar (CAD),  the Swiss franc (CHF), and the New Zealand dollar (NZD).

There is no centralized market for forex transactions and transactions can be done for spot or forward delivery. A spot exchange rate is the price to exchange one currency for another for immediate delivery. The spot rates represent the prices buyers pay in one currency to purchase a second currency. Spot for most currencies is two business days; the major exception is the U.S. dollar versus the Canadian dollar, which settles on the next business day. The spot market can be very volatile and the U.S. dollar is the most actively traded currency. The most common pairs are the dollar versus the euro, Japanese yen, British pound and Swiss franc. Trading pairs that do not include the dollar are referred to as crosses. The most common crosses are the euro versus the pound and yen. A forward trade is any trade that settles further in the future than spot. Like with a spot, the price is set on the transaction date but money is exchanged on the maturity date.

Any person, firm or country may participate in this market that allows the exchange of one currency for another or the conversion of one currency into another currency. The most influential participants involved in the forex market are the central banks and federal governments. Other big participants involved with forex transactions are banks and international businesses. One way that banks make money on the forex market is by exchanging currency at a higher price than they paid to obtain it.

Forex trading hours:

The forex market is open 24 hours a day, five days a week and there is no central marketplace. The best time to trade is when the market is the most active and therefore has the biggest volume of trades.

Forex trading time:

  • New York opens at 8:00 am to 5:00 pm EST (EDT)
  • Tokyo opens at 7:00 pm to 4:00 am EST (EDT)
  • Sydney opens at 5:00 pm to 2:00 am EST (EDT)
  • London opens at 3:00 am to 12:00 noon EST (EDT)

 

Inter market trading:

The Intermarket relationships are very important in Forex trading because, by understanding the different correlations, you’ll be able to take advantage of them to capitalize gains and hedge positions. Traders should not use intermarket relationships just to capitalize gains but also to hedge positions. Diversifying and managing risk are strategies that perform better over the long run. The higher the correlation, the stronger the relation between two assets, here are some examples :

 

  • Oil and CAD, NOK – Oil correlates positively with CAD and NOK because Canada and Norway are two major oil producers. As oil is priced in US dollars, oil exports have a major impact on the foreign exchange earnings in Canada. When oil prices increase, the amount of US dollars earned by Canada through exports will be higher, and therefore the supply of US dollars will be high relative to the supply of Canadian dollars. This results in an increase in the value of the CAD against USD. The same situation is with NOK but if you want to take advantage of a change in oil’s price, the best currency to look for should be the Canadian dollar. The positive correlation between oil and CAD/USD was about 80% over the past 10 years.

 

    • Gold and USD (inverse relation) –  when one rises, the other decreases. An increase in USD makes gold more expensive, which, according to microeconomics, reduces demand for the commodity. As the commodity’s price is in US dollars, a rise in the dollar makes it more expensive for non-US investors to buy gold. This doesn’t have to be always like that but according to analysts nearly 50% of the changes in gold prices are due to movements of the US dollar

 

  • Gold-AUD & Gold-CHF – The correlation between gold and AUD is positive because Australia is one of the major exporters of gold and so, if the price of gold increases, Australian exports increase, contributing to the expansion the economy. The expansion of the economy contributes to an increase in foreign investment in Australia, which means the demand for Aussie dollars will increase. Gold and CHF also have a positive correlation. In times of uncertainty and selloff of currencies like the dollar, investors usually put their money into these assets. Besides having the same status as “safe-havens,” nearly 25% of Switzerland money is backed by gold reserves, the reason why CHF rises when gold appreciates.
  • Commodities and NZD – New Zealand Dollar benefits from the rise in general commodities prices because when prices of commodities rise, the exports (and, consequently, revenues) rise and the economy gets a boost, therefore increasing the value of NZD.
  • Bond Market – buying and selling of bonds have a great impact in the Forex market. Example – when the central bank is selling bonds, it’s withdrawing money out of the markets. This is why the domestic currency appreciates when interest rates are raised. The reduction of money in circulation makes each unit of the currency to be worth more.
  • Stock Market and Domestic Currency – there is a positive correlation between the stock market of a country and its currency because when the stock market is rising there is an increasing demand for the respective currency.

 

 

Pip and calculating value of pips:

  • Pip in the Forex market express the change in value between two currencies and is usually the last decimal place of a quotation.
  • For example, if EUR/USD moves from 1.1750 to 1.1749, that 0.0001 fall in value is one PIP. This is the usual situation how one PIP is calculated but some currency pairs like USD/JPY has two decimal places. Some Forex brokers quote currency pairs with five decimal places (fractional pips or pipettes). For example, if EUR/USD moves from 1.17543 to 1.17544, that .00001 move higher is a pipette.

 

How to place orders, chosing a broker, pips, various lots and sizes:

Trading on the Forex market is a very risky business and requires lots of practice and learning. Before making the first trade, you should try to become profitable on a demo account and continue to evaluate at regular intervals before funding the account or placing trades. The trader who makes money on a consistent basis generally uses trading plan with specific strategies. The trading strategies can be based on technical analysis (chart analysis) or fundamental analysis. In my opinion, every trader who wants to become profitable should use a combination of technical and fundamental analysis to make a trading decisions.

After you become profitable on the demo account you can open the “live” account with the real money. When choosing a Forex broker, always check history and reviews to make sure their performance is consistent.  Before choosing a broker, traders should eye broker spreads, trading platform and other important conditions. Steps to make your first trade include:

  • Opening the trading platform
  • Choose a currency pair and open a chart
  • Select a timeframe – Daily, weekly, 4hr, 1hr. For example, on 1 hour chart, each candlestick represents four hours of time.
  • Traders seek short-term price moves in order to profit and apply technical indicators to charts of various time frames in attempts to accurately forecast future price movements (support and resistance, moving averages, chart patterns, trendlines)
  • Place the order – after you find the position that could be a good opportunity you should place the order. Traders should always analyze the market from the “big picture” all the way down to the short-term or intra-day
  • Set the Stop Loss and Take Profit – Trading with a currency pairs is a very risky business and I would recommend every trader to always use “STOP LOSS” and “TAKE PROFIT” orders. Setting the stop loss will limit your losses if the market does not move in the preferred direction
  • Order Confirmation – you will get the ticket number that can be important if you want to call your broker about the trade
  • The waiting period – some advice says “turn off the screen and get away from the market” until the trade is closed. If the prices move up, it will be a profit for the “long” position and if the prices move down it will be a loss. For the “short” position is opposite situation
  • Trade Completion – the profit or loss is realized

Two ways to make money:

  1. Long Position:

The long position is made by the investor if he expects the currency to later rise in value. If that happens, he will be able to sell the currency he bought for a higher price than what he paid for it. In this case, the trader can benefit from a market that is on the rise.

  1. Short position:

A currency trading short position is maintained when a trader sells a currency in the expectation that it will depreciate in value. Contrary to common sense, for this trade the investor wants the currency to drop, and only then will he make a profit.

 

                                                                                    Technical indicators and  oscillators

Indicators represent a statistical approach to technical analysis as opposed to a subjective approach. By looking at money flow, trends, volatility, and momentum, they provide a secondary measure to actual price movements and help traders confirm the quality of chart patterns or form their own buy or sell signals. Oscillators are the most common type of technical indicator and are generally bound within a range. For example, an oscillator may have a low of 0 and a high of 100 where zero represents oversold conditions and 100 represents overbought conditions. Technical indicators and oscillators will give you a better chance of making good trading decisions when you use the right tool at the right time. Each chart indicator/oscillator has its imperfections. This is why forex traders combine many different indicators to “screen” each other.

                                                                               Technical and fundamental analysis:

Technical and fundamental analysis are the most important tools when it comes to analyzing the Forex market and currencies. Investors and the long-term traders are generally more focused on the fundamental analysis while short-term traders usually trade according to technical analysis in order to profit from short-term price moves instead of waiting to profit from long-term price movements. In my opinion, every trader or investor who wants to become profitable should use a combination of technical and fundamental analysis to make decisions. Fundamental analysis helps you to figure out the real market value while technical analysis helps you to find a better entry or exit position by predicting price movement.

Technical Analysis

The most common tools in the technical analysis are trend lines, moving averages, support and resistance levels, chart patterns, Fibonacci and MACD indicator. Trend lines, support and resistance levels are essential for technical traders and can be used to determine good places to buy or sell. As more and more traders look for certain chart patterns, the more likely that these patterns will manifest themselves in the markets (flags, rectangles, head and shoulders pattern, cup with the handle..). The trader who makes money on a consistent basis generally follow a written trading plan. Every trading plan uses personal trading styles and goals like specifications for trade entries and exits, trade filters and triggers, money management, account size, risk level, timeframes, order types, and other important information. One of the biggest mistakes that new traders often make is to change trading plan at the first sign of trouble. My recommendation for all traders is once you are comfortable with a particular trading plan, remain faithful to that trading plan and always use “stop loss” and “take profit” orders.

The most common tools for entry and exit scenarios include support and resistance, trend lines, moving averages, Fibonacci, MACD indicator, chart patterns. Popular chart indicators and oscillators in the technical analysis are also: Bollinger Bands, parabolic SAR, Stochastic Indicator, Relative Strength Index (RSI), Average Directional Index (ADX).

 

Moving average convergence divergence (MACD):

Moving average convergence divergence (MACD) is a trend-following momentum indicator that shows the relationship between two moving averages of prices. The MACD is calculated by subtracting the 26-day exponential moving average (EMA) from the 12-day EMA. A nine-day EMA of the MACD, called the “signal line”, is then plotted on top of the MACD, functioning as a trigger for buy and sell signals. MACD is used to identify moving averages that are indicating a new trend, whether it’s bullish or bearish. The default setting for most charting software is “12, 26, 9” as the MACD parameters. Because there are two moving averages with different “speeds”, the faster one will obviously be quicker to react to price movement than the slower one. When a new trend occurs, the fast line will react first and eventually cross the slower line. When this “crossover” occurs, and the fast line starts to “diverge” or move away from the slower line, it often indicates that a new trend has formed. Since the MACD is based on moving averages, it is inherently a lagging indicator. As a metric of price trends, the MACD is less useful for pairs that are not trending. MACD loses money in a sideways market and if we can do something to identify that the market is so, then we can get the MACD to ignore trade signals until it appears to be trending again. The use of Bollinger Bands can help identify sideways markets it seems. If the price has moved outside the Bollinger bands, then it is likely that a trend is starting. The bands contract when the market is slow and expand when the market moves.

Example: MACD indicator on $eurusd 60min/hourly chart

                                                                                             

   

MACD AND PRICE DIVERGENCE:  Divergence happens when price goes in one way and the indicator goes in the opposite way.  When the MACD tops/bottoms are in the opposite direction from the prices tops/bottoms,we have a divergence. In other works, when a price is making higher  highs and higher lows and MACD is making lower highs and lower lows, a trend reversal is generated. Macd divergence is one of the reliable signal used by technical traders. we can have bullish or bearish divergences.

Examples of  bearish divergence:

$eurusd daily chart Price goes higher but macd indicator turned lower, we call it divergence.

 

                                    

Support and resistance are the most widely used concepts. 

SUPPORT/RESISTANCE, somewhere price has changed direction repeatedly. The only reason price moves in the market is because of the imbalance in the demand and supply zone!   Demand and supply zone can be seen as support resistance level. The continuous shift in the balance between supply and demand results in dynamic pricing and sometimes a volatile market. When supply exceeds the demand, prices start to fall; whereas when there is not enough supply to meet the demand, prices start to rise.

A support level is where buyers step in and become more aggressive, therefore keeping price from going lower.  In other words,  A  support level is a price level that works as a floor to stop the further fall of the stocks. As price declines towards support, selling pressure declines due to lower price, and buyers become more aggressive due to this lower price.  However, when price breaks below a support level, the broken support level can turn into resistance. Best support levels can be found at previous swing low levels, at uptrend lines and on moving averages etc.

A resistance level is where sellers step in and become more aggressive and, therefore, keep prices from going higher. Resistance level is the opposite of the support level.  As price rallies towards resistance, buying pressure declines due to higher prices, and selling pressure increases. Short sellers get aggressive at the resistance levels! Best resistance levels can be found in previous swing high levels, down trend lines and below moving average lines.

The more often price tests a level of resistance or support without breaking it, the stronger the area of resistance or support is. When the price passes through the resistance, that resistance could potentially become support.

 

 

 

 

Trend lines are also one of the most important tools in technical analysis, most traders don’t draw them correctly, all you have to do is locate two major tops or bottoms and connect them. It takes at least two tops or bottoms to draw a valid trend line but it takes three to confirm a trend line. A formal uptrend is when each successive peak and trough is higher than the ones found earlier in the trend.  A formal downtrend occurs when each successive peak and trough is lower than the ones found earlier in the trend. Range bound moves are normally looks like price is moving within a box. Trend lines can be used in all time frames daily, wkly 15 min,hourly etc. Image by traderbulletin

 

  • Example – on this EURUSD 60 min chart EUR/USD  is moving in the uptrend and as long the price is above the trend line there is no indication of the trend reversal. In this case trend line also represents support level and if the price falls to this line it would be a good entry for the traders. Trend lines can be used in all time frames daily, wkly 15 min,hourly etc. Higher time frames give better results.

 

Example of downtrend,resistance line can be possible short zones.

 

Multiple time frames using Trendlines

Trend lines are probably the most common form of technical analysis in Forex trading. Trend lines can be as accurate as any other method if drawn correctly. To draw trend lines properly, all you have to do is locate two major tops or bottoms and connect them. There are three types of trends: downtrend (lower highs), uptrend (higher lows) and sideways trends (ranging). It takes at least two tops or bottoms to draw a valid trend line but it takes three to confirm a trend line. Trend lines become stronger the more times they are tested. A formal uptrend is when each successive peak and trough is higher than the ones found earlier in the trend.  A formal downtrend occurs when each successive peak and trough is lower than the ones found earlier in the trend.

Multiple time frame analysis is very important in Forex trading because there are several time frames – the daily, the hourly, the 15-minute, 5-minute.. Different forex traders can have their different opinions on how a pair is trading and both can be completely correct, for example – EUR/USD is on a downtrend on the 4-hour chart but the same pair can be in the uptrend on 15 min chart. Every trader on FX market should trade a specific time frame that fits his own personality. My recommendation will be to open a DEMO account and trade using different time frames to see which fits your personality the best. New forex traders will want to get rich quick so they’ll start trading small time frames like the 1-minute or 5-minute charts. Then they end up getting frustrated when they trade because the time frame doesn’t fit their personality. On the other hand, some traders trade only daily, weekly, and monthly charts. Long-term traders will usually refer to daily and weekly charts. The weekly charts will establish the longer-term perspective and assist in placing entries in the shorter term daily. Short-term traders use hourly time frames and hold trades for several hours to a week. Intraday traders use minute charts such as 1-minute or 15-minute and they have more opportunities for trades. Shorter time frames allow you to make better use of margin and have tighter stop losses.

In my opinion, every trader should start with analyzing from the bigger picture and try to figure out major trend and support and resistance levels (from weekly to 15 min chart). It is very important to understand that trend, support and resistance levels have stronger power on the bigger time frame. When the market did stall or reverse on the 15-minute chart, it was often because it had hit support or resistance on a larger time frame. Most beginners look at only one-time frame, the problem is that a new trend, coming from another time frame, often hurts forex traders who don’t look at the big picture. The larger the time frame, the more likely an important support or resistance levels would hold.

Example – EUR/USD is moving in the uptrend on 4-hour chart and as long the price is above the trend line there is no indication of the trend reversal. In their most basic form, an uptrend line is drawn along the bottom of easily identifiable support areas (valleys). In this case trend line also represents support level and if the price falls to this line it would be a good entry for the traders. In the uptrend when they get a “bullish” confirmation candle on the trend line (support) they can open the position with stop-loss order below this support. First strong resistance could be 1.2900 and if the price reaches this level it would probably make a retrace. This resistance level represents exit level for short-term traders. It is very important to look at risk/reward ratio, short-term traders are looking at least 1:2 risk/reward ratio.

 

 

 

Conclusion on time frames– The largest time frame shows us the big picture of the pair we wanna trade. The smallest time frame shows the short term trend and helps us find really good entry and exit points (usually resistances on the bigger time frames).

 

RELATIVE STRENGTH INDEX(RSI):

Relative Strength Index – RSI calculates the strength of the stock trend and helps to predict their reversals.  Rising RSI line is considered  as bullish and falling RSI  is considered as bearish. RSI is similar to the stochastic in that it identifies overbought and oversold conditions in the market. It is also scaled from 0 to 100. Typically, readings below 30 indicate oversold, while readings over 70 indicate overbought. Therefore, if the RSI values stay near the middle (40-60) then that probably means it is a sideways market. RSI is not very effective on short times frames (under 4h).

Uses of RSI:

  1. Identify overbought stocks
  2. Identify oversold stocks
  3. Identify Trend reversal
  4. Can be used to find divergences
  5. Identify direction of trend.

In the picture below  (EUR/USD 15 min chart) I have marked entry and exit levels, when the market is overbought traders should think about exit and when the market is oversold traders should think about the entry. Higher time frames give give better results.

 

The Stochastic is chart analysis indicator, it measures momentum in that it tells you via the direction if price is closing closer to the highs or lows over a set period of time. Many traders consider it is an oversold/overbought indicator however that was not the original intention of the indicator. George Lane, the developer of the indicator, actually used it for stochastic  momentum and divergence – the divergence of the Stochastic when compared to price.  The Stochastic tells us when the market is overbought or oversold and is scaled from 0 to 100. Market is overbought when the lines are above 80, market is oversold when the Stochastic lines are below 20. However,  Stochastic  overbought and oversold levels works well  in  range bound trade set ups.  When a stock is in an uptrend oversold stochastic above 20 may be a buy signal  and trying to short the overbought levels above 80 level may not work.

In the picture below  (EUR/USD hourly chart) I have marked  overbought and oversold levels in stochastic. When back testing anything in trading, ensure you are seeing the whole picture and not just what you want to see. Stochastic indicator can sometimes give false signals as well ,it has to be used in conjunction of other indicators such as support,resistance,trendlines etc.

 

Divergence Trading With Slow Stochastic:

Price goes one way and the Stochastic goes another, divergence is usually the play traders look for. This was the original play that Lane was looking at when developing the Stochastic but like I keep saying, an indicator signal by itself is not always the smartest opportunity.

  1. If price makes lower low but Stochastic makes higher low, consider longs
  2. If price makes higher higher but Stochastic makes lower high, consider shorts

Stochastic  bullish bearish divergences: