Chapter 4

The Mechanics of Currency Trading

In This Chapter

Understanding currency pairs

Calculating profit and loss

Executing a trade

Using different types of orders

The currency market has its own set of market trading conventions and related lingo, just like any other financial market. If you’re new to currency trading, the mechanics and terminology may take some getting used to. But at the end of the day, you’ll see that most currency trade conventions are pretty straightforward.

Buying and Selling Simultaneously

The biggest mental hurdle facing newcomers to currencies, especially traders familiar with other markets, is getting their head around the idea that each currency trade consists of a simultaneous purchase and sale. In the stock market, for instance, if you buy 100 shares of Google, it’s pretty clear that you now own 100 shares and hope to see the price go up. When you want to exit that position, you simply sell what you bought earlier. Easy, right?

But in currencies, the purchase of one currency involves the simultaneous sale of another currency. This is the exchange in foreign exchange. To put it another way, if you’re looking for the dollar to go higher, the question is “Higher against what?” The answer has to be another currency. In relative terms, if the dollar goes up against another currency, it also means that the other currency has gone down against the dollar. To think of it in stock-market terms, when you buy a stock, you’re selling cash, and when you sell a stock, you’re buying cash.

Currencies come in pairs

To make matters easier, forex markets refer to trading currencies by pairs, with names that combine the two different currencies being traded against each other, or exchanged for one another. Additionally, forex markets have given most currency pairs nicknames or abbreviations, which reference the pair and not necessarily the individual currencies involved.

The U.S. dollar is the central currency against which other currencies are traded. In its most recent triennial survey of the global foreign exchange market in 2013, the Bank for International Settlements (BIS) found that the U.S. dollar was on one side of 87 percent of all reported forex market transactions, and the dollar’s position as the world’s dominant currency has remained virtually unchallenged for decades.

The U.S. dollar’s central role in the forex markets stems from a few basic factors:

• The U.S. economy is the largest national economy in the world.
• The U.S. dollar is the primary international reserve currency.
• The U.S. dollar is the medium of exchange for many cross-border transactions. For example, oil is priced in U.S. dollars. So even if you’re a Japanese oil importer buying crude from Saudi Arabia, you’re going to pay in U.S. dollars.
• The United States has the largest and most liquid financial markets in the world.
• The United States is a global military superpower, with a stable political system, even if we have seen a dysfunctional Congress in recent years!

Major currency pairs

The major currency pairs all involve the U.S. dollar on one side of the deal. The designations of the major currencies are expressed using International Standardization Organization (ISO) codes for each currency. Table 4-1 lists the most frequently traded currency pairs, what they’re called in conventional terms, and what nicknames the market has given them.

The Eurozone is made up of all the countries in the European Union that have adopted the euro as their currency. As of this printing, the Eurozone countries are Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain.

Currency names and nicknames can be confusing when you’re following the forex market or reading commentary and research. Be sure you understand whether the writer or analyst is referring to the individual currency or the currency pair.

• If a bank or a brokerage is putting out research suggesting that the Swiss franc will weaken in the future, the comment refers to the individual currency, in this case CHF, suggesting that USD/CHF will move higher (USD stronger/CHF weaker).
• If the comment suggests that Swissy is likely to weaken going forward, it’s referring to the currency pair and amounts to a forecast that USD/CHF will move lower (USD weaker/CHF stronger).

Major cross-currency pairs

Although the vast majority of currency trading takes place in the dollar pairs, cross-currency pairs serve as an alternative to always trading the U.S. dollar. A cross-currency pair, or cross or crosses for short, is any currency pair that does not include the U.S. dollar. Cross rates are derived from the respective USD pairs but are quoted independently and usually with a narrower spread than you could get by trading in the dollar pairs directly. (The spread refers to the difference between the bid and offer, or the price at which you can sell and buy and spreads are applied in most financial markets.)

Crosses enable traders to more directly target trades to specific individual currencies to take advantage of news or events. For example, your analysis may suggest that the Japanese yen has the worst prospects of all the major currencies going forward, based on interest rates or the economic outlook. To take advantage of this, you’d be looking to sell JPY, but against which other currency? You consider the USD, potentially buying USD/JPY (buying USD/selling JPY), but then you conclude that the USD’s prospects are not much better than the JPY’s. Further research on your part may point to another currency that has a much better outlook (such as high or rising interest rates or signs of a strengthening economy), say the Australian dollar (AUD). In this example, you would then be looking to buy the AUD/JPY cross (buying AUD/selling JPY) to target your view that AUD has the best prospects among major currencies and the JPY the worst.

Cross trades can be especially effective when major cross-border mergers and acquisitions (M&A) are announced. If a UK conglomerate is buying a Canadian utility company, the UK company is going to need to sell GBP and buy CAD to fund the purchase. The key to trading on M&A activity is to note the cash portion of the deal. If the deal is all stock, then you don’t need to exchange currencies to come up with the foreign cash.

The most actively traded crosses focus on the three major non-USD currencies (namely EUR, JPY, and GBP) and are referred to as euro crosses, yen crosses, and sterling crosses. The remaining currencies (CHF, AUD, CAD, and NZD) are also traded in cross pairs. Tables 4-2, 4-3, and 4-4 highlight the key cross pairs in the euro, yen, and sterling groupings, respectively, along with their market names. Table 4-5 lists other cross-currency pairs.

Table 4-2 Euro Crosses

Table 4-3 Yen Crosses

Table 4-4 Sterling Crosses

Table 4-5 Other Crosses

The long and the short of it

Forex markets use the same terms to express market positioning as most other financial markets do. But because currency trading involves simultaneous buying and selling, being clear on the terms helps — especially if you’re totally new to financial market trading.

Going long

No, we’re not talking about running out deep for a football pass. A long position, or simply a long, refers to a market position in which you’ve bought a security. In FX, it refers to having bought a currency pair. When you’re long, you’re looking for prices to move higher, so you can sell at a higher price than where you bought. When you want to close a long position, you have to sell what you bought. If you’re buying at multiple price levels, you’re adding to longs and getting longer.

Getting short

A short position, or simply a short, refers to a market position in which you’ve sold a security that you never owned. In the stock market, selling a stock short requires borrowing the stock (and paying a fee to the lending brokerage) so you can sell it. In forex markets, it means you’ve sold a currency pair, meaning you’ve sold the base currency and bought the counter currency. So you’re still making an exchange, just in the opposite order and according to currency-pair quoting terms. When you’ve sold a currency pair, it’s called going short or getting short and it means you’re looking for the pair’s price to move lower so you can buy it back at a profit. If you sell at various price levels, you’re adding to shorts and getting shorter.

In most other markets, short selling either comes with restrictions or is considered too risky for most individual traders. In currency trading, going short is as common as going long. “Selling high and buying low” is a standard currency trading strategy.

Currency pair rates reflect relative values between two currencies and not an absolute price of a single stock or commodity. Because currencies can fall or rise relative to each other, both in medium and long-term trends and minute-to-minute fluctuations, currency pair prices are as likely to be going down at any moment as they are up. To take advantage of such moves, forex traders routinely use short positions to exploit falling currency prices. Traders from other markets may feel uncomfortable with short selling, but it’s just something you have to get your head around.

Squaring up

If you have no position in the market, it’s called being square or flat. If you have an open position and you want to close it, it’s called squaring up. If you’re short, you need to buy to square up. If you’re long, you need to sell to go flat. The only time you have no market exposure or financial risk is when you’re square.

Profit and Loss

Profit and loss (P&L) is how traders measure success and failure. You don’t want to be looking at the forex market as some academic or thrill-seeking exercise. Real money is made and lost every minute of every day. If you’re going to trade currencies actively, you need to get up close and personal with P&L.

A clear understanding of how P&L works is especially critical to online margin trading, where your P&L directly affects the amount of margin you have to work with. (We introduce online margin trading in Chapter 2.) Changes in your margin balance will determine how much you can trade and for how long you can trade if prices move against you.

Margin balances and liquidations

As we mention in Chapter 2, one of the benefits of forex trading is that you can use leverage, which allows you to gain a large exposure to a financial market while only tying up a small amount of your capital. The initial capital that you have to post to your account in order to open a trade is called margin.

That initial margin deposit becomes your opening margin balance and is the basis on which all your subsequent trades are collateralized. Think of this as a bit like the collateral a bank will ask for if you apply for a loan. Unlike futures markets or margin-based equity trading, online forex brokerages do not issue margin calls (requests for more collateral to support open positions). Instead, they establish ratios of margin balances to open positions that must be maintained at all times.

If your account’s margin balance falls below the required ratio, even for just a few seconds, your broker probably has the right to close out your positions without any notice to you. In most cases, that only happens when an account has losing positions. If your broker liquidates your positions, that usually means your losses are locked in and your margin balance just got smaller.

Be sure you completely understand your broker’s margin requirements and liquidation policies. Requirements may differ depending on account size and whether you’re trading standard lot sizes (100,000 currency units), mini lot sizes (10,000 currency units), or micro lots (1,000 currency units). Some brokers’ liquidation policies allow for all positions to be liquidated if you fall below margin requirements. Others close out the biggest losing positions or portions of losing positions until the required ratio is satisfied again. You can find the details in the fine print of the account opening contract that you sign. Always read the fine print to be sure you understand your broker’s margin and trading policies.

Unrealized and realized profit and loss

Most online forex brokers provide real-time mark-to-market calculations showing your margin balance. Mark-to-market is the calculation that shows your unrealized P&L based on where you could close your open positions in the market at that instant. Depending on your broker’s trading platform, if you’re long, the calculation will typically be based on where you could sell at that moment. If you’re short, the price used will be where you can buy at that moment. Your margin balance is the sum of your initial margin deposit, your unrealized P&L, and your realized P&L.

Realized P&L is what you get when you close out a trade position, or a portion of a trade position. If you close out the full position and go flat, whatever you made or lost leaves the unrealized P&L calculation and goes into your margin balance. If you only close a portion of your open positions, only that part of the trade’s P&L is realized and goes into the margin balance. Your unrealized P&L will continue to fluctuate based on the remaining open positions and so will your total margin balance.

If you’ve got a winning position open, your unrealized P&L will be positive and your margin balance will increase. If the market is moving against your positions, your unrealized P&L will be negative and your margin balance will be reduced. FX prices are constantly changing, so your mark-to-market unrealized P&L and total margin balance will also be constantly changing.

Calculating profit and loss with pips

Profit-and-loss calculations are pretty straightforward in terms of math — it’s all based on position size and the number of pips you make or lose. A pip is the smallest increment of price fluctuation in currency prices. Pips can also be referred to as points; we use the two terms interchangeably.

We’re not sure where the term pip came from. Some say it’s an abbreviation for percentage in point, but it could also be the FX answer to bond traders’ bips, which refers to bps, or basis points (meaning 1/100 of 1 percent).

Even the venerable pip is in the process of being updated as electronic trading continues to advance. Just a couple paragraphs earlier, we tell you that the pip is the smallest increment of currency price fluctuations. Not so fast. The online market is rapidly advancing to decimalizing pips (trading in 1/10 pips) and half-pip prices have been the norm in certain currency pairs in the interbank market for many years.

But for now, to get a handle on P&L calculations you’re better off sticking with pips. Let’s look at a few currency pairs to get an idea of what a pip is. Most currency pairs are quoted using five digits. The placement of the decimal point depends on whether it’s a JPY currency pair — if it is, there are two digits behind the decimal point. For all other currency pairs, there are four digits behind the decimal point. In all cases, that last itty-bitty digit is the pip.

Here are some major currency pairs and crosses, with the pip underlined:

• EUR/USD: 1.3535
• USD/CHF: 0.9074
• USD/JPY: 101.43
• GBP/USD: 1.6142
• EUR/JPY: 138.01

Focus on the EUR/USD price first. Looking at EUR/USD, if the price moves from 1.3535 to 1.3555, it’s just gone up by 20 pips. If it goes from 1.3535 down to 1.3515, it’s just gone down by 20 pips. Pips provide an easy way to calculate the P&L. To turn that pip movement into a P&L calculation, all you need to know is the size of the position. For a 100,000 EUR/USD position, the 20-pip move equates to $200 (EUR 100,000 × 0.0020 = $200).

Whether the amounts are positive or negative depends on whether you were long or short for each move. If you were short for the move higher, that’s a – in front of the $200, if you were long, it’s a +. EUR/USD is easy to calculate, especially for USD-based traders, because the P&L accrues in dollars.

If you take USD/CHF, you’ve got another calculation to make before you can make sense of it. That’s because the P&L is going to be denominated in Swiss francs (CHF) because CHF is the counter currency. If USD/CHF drops from 0.9074 to 0.9040 and you’re short USD 100,000 for the move lower, you’ve just caught a 34-pip decline. That’s a profit worth CHF 340 (USD 100,000 × 0.0034 = CHF 340). Yeah, but how much is that in real money? To convert it into USD, you need to divide the CHF 340 by the USD/CHF rate. Use the closing rate of the trade (0.9032), because that’s where the market was last, and you get USD 376.43.

Factoring profit and loss into margin calculations

The good news is that online FX trading platforms calculate the P&L for you automatically, both unrealized while the trade is open and realized when the trade is closed. So why did we just drag you through the math of calculating P&L using pips? Because online brokerages will only start calculating your P&L for you after you enter a trade.

To structure your trade and manage your risk effectively (How big a position? How much margin to risk?), you’re going to need to calculate your P&L outcomes before you enter the trade. Understanding the P&L implications of a trade strategy you’re considering is critical to maintaining your margin balance and staying in control of your trading. This simple exercise can help prevent you from costly mistakes, like putting on a trade that’s too large, or putting stop-loss orders beyond prices where your account falls below the margin requirement. At the minimum, you need to calculate the price point at which your position will be liquidated when your margin balance falls below the required ratio. (We cover this subject more extensively in Chapter 13.)

Understanding Rollovers and Interest Rates

One market convention unique to currencies is rollovers. A rollover is a transaction where an open position from one value date (settlement date) is rolled over into the next value date. Rollovers represent the intersection of interest-rate markets and forex markets.

Currency is money, after all

Rollover rates are based on the difference in interest rates of the two currencies in the pair you’re trading. That’s because what you’re actually trading is good old-fashioned cash. That’s right: Currency is cold, hard cash with a fancy name. When you’re long a currency (cash), it’s like having a deposit in the bank. If you’re short a currency (cash), it’s like having borrowed a loan. Just as you would expect to earn interest on a bank deposit or pay interest on a loan, you should expect an interest gain/expense for holding a currency position over the change in value.

The catch in currency trading is that if you carry over an open position from one value date to the next, you have two bank accounts involved. Think of it as one account with a positive balance (the currency you’re long) and one with a negative balance (the currency you’re short). But because your accounts are in two different currencies, the two interest rates of the different countries will apply.

The difference between the interest rates in the two countries is called the interest-rate differential. The larger the interest-rate differential, the larger the impact from rollovers. The narrower the interest-rate differential, the smaller the effect from rollovers. You can find relevant interest-rate levels of the major currencies from any number of financial-market websites, but www.marketwatch.com and www.fxstreet.com have especially good resources. Look for the base or benchmark lending rates in each country.

Rollover rates have a bigger impact on you, depending on the size of your position. They have a bigger impact on someone trading in the millions than they do on someone trading in the tens. However, regardless of your size, it’s still handy to know how a rollover affects you.

So how do interest rates get turned into currency rates? After all, interest rates are in percent and currency rates are, well, not in percent. The answer is that deposit rates yield actual cash returns, which are netted, producing a net cash return. That net cash return is then divided by the position size, which gives you the currency pips, which is rollover rate.

The following calculation illustrates how this works. We’ve simplified matters by using just one interest rate for each currency. In the real world, each currency would have a slightly different interest rate depending on whether you’re borrowing or lending (depositing).

• Position: Long EUR/USD 100,000 at 1.3000 (long EUR/short USD 130,000)
• EUR interest rate: 3.50 percent per annum → 1 day = 0.035 × (1 ÷ 365) = 0.009589 percent
• Euro deposit earns: 100,000 × 0.00009589 = EUR +9.59
• USD interest rate: 5.25 percent per annum → 1 day = 0.0525 × (1 ÷ 365) = 0.01438 percent
• USD loan costs: 130,000 × 0.0001438 = USD –18.70
• Because EUR/USD pips are denominated in USD, convert the EUR to USD: EUR 9.59 × 1.3000 = USD 12.47.
• Net the USD amounts 12.47–18.70 = USD –6.23 ÷ 100,000 = 0.0000623
• On a long EUR 100,000 position, the rollover costs 0.0000623, or –0.623 pips.

Value dates and trade settlement

When we talk about currency trading, we’re implicitly referring to trading the spot forex market. A spot market is one that’s trading for immediate delivery of whatever security is being traded. But in the real world, immediate means a few business days, to allow banks and financial firms time to settle a trade (make payment, deliver/receive a security).

In forex markets, spot refers to trade settlement in two business days, which is called the value date. That time is needed to allow for trade processing across global time zones and for currency payments to be wired around the world.

The forex market operates on a 24-hour trade date basis beginning at 5 p.m. eastern time (ET) and ending the next day at 5 p.m. ET. So if it’s a Monday, spot currencies are trading for value on Wednesday (assuming no holidays). At 5 p.m. ET on Monday, the trade date becomes Tuesday and the value date is shifted to Thursday. If you have an open position on Monday at 5 p.m. ET closing, your position will be rolled over to the next value date, in this case from Wednesday to Thursday, or a one-day rollover.

If you close your position the next day (Tuesday) and finish the trade date square, there are no rollovers because you have no position. The same is true if you never carry a position through the daily 5 p.m. ET close.

On Wednesday trade dates, spot currencies are normally trading for a Friday value date. At 5 p.m. ET on Wednesday, the value date changes from Friday to Monday, a weekend rollover. In rollover calculations, that’s a three-day rollover (Saturday, Sunday, and Monday), which means the rollover costs/gains are going to be three times as much as any other day.

The one exception to the two-day spot convention in FX are trades in USD/CAD. And that’s because the main financial centers in the United States and Canada share the same time zone, so communications and wire transfers can be made more quickly. USD/CAD trades settle in one business day. The weekend rollover for USD/CAD takes place on Thursday after the 5 p.m. ET close, when the value date shifts from Friday to Monday. This only applies to USD/CAD and not to other pairs involving CAD, such as CAD/JPY or EUR/CAD.

Market holidays and value dates

Value dates are based on individual currency pairs to account for banking holidays in respective countries. Rollover periods can be longer if there is a banking holiday in one of the countries whose currency is part of the trade. For example, if it’s Wednesday and you’re trading GBP/USD, the normal spot value date would be Friday. But if there’s a banking holiday in the United Kingdom on Friday, UK banks are not open to settle the trade. So the value date is shifted to the next valid banking day common to the United Kingdom and the United States, typically the following Monday. In this case, the weekend rollover would take place at the close on Tuesday at 5 p.m. ET, when the value date would change from Thursday to Monday, skipping Friday’s holiday. That’s a four-day rollover (Friday, Saturday, Sunday, and Monday).

So what happens at the change in value date at Wednesday’s 5 p.m. ET close? No rollovers in GBP/USD, that’s what. Because the value date for trades made on Wednesday is already Monday, no rollover is needed because trades made on Thursday are also for value on Monday. That’s called a double value date, meaning two trade dates (Wednesday and Thursday) are settling for the same value date (Monday).

A few times each year (mostly around Christmas, New Year’s, and Golden Week spring holidays in Japan) when multiple banking holidays in various countries coincide over several days, rollover periods can be as long as seven or eight days. So you may earn or pay rollovers of seven or eight times normal on one day, but then not face any rollovers for the rest of the holiday period.

Applying rollovers

Rollover transactions are usually carried out automatically by your forex broker if you hold an open position past the change in value date.

Rollovers are applied to your open position by two offsetting trades that result in the same open position. Some online forex brokers apply the rollover rates by adjusting the average rate of your open position. Other forex brokers apply rollover rates by applying the rollover credit or debit directly to your margin balance. In terms of the math, it’s six of one, half a dozen of the other.

Here’s an example of how the rollover of an open position would work under each model:

• Position: Long 100,000 AUD/JPY at a rate of 90.15 for a value date of January 10
• At 5 p.m. ET, the rollover takes place and the following rollover trades hit your account. (Remember: This is done automatically by most online brokers.)
• You sell 100,000 AUD/JPY at 90.22 for a value date of January 10. (This trade closes the open position for the same value date.)
• You buy 100,000 AUD/JPY at 90.206 for a value date of January 11. (This trade reopens the same position for the new value date.)
• The difference in the rates represents the rollover points. (90.22 – 90.206 = 0.014, which is expressed as 1.4 points.)
• If the rollover is applied to your average rate on the open position, your new average rate on the position is 90.136. (Here’s the math: 90.15 – 0.014 = 90.136.) Because you’re now long from a lower average price, you earned money on the rollover.
• If the rollover is applied directly to your margin balance, the rollover points are multiplied by the position size (100,000 × 0.014 = JPY 1,400 earned) and converted into USD (JPY 1,400 ÷ 116.00 [the USD/JPY rate] = $12.07) and added to your margin balance.

Here’s what you need to remember about rollovers:

• Rollovers are applied to open positions after the 5 p.m. ET change in value date, or trade settlement date.
• Rollovers are not applied if you don’t carry a position over the change in value date. So if you’re square at the close of each trading day, you’ll never have to worry about rollovers.
• Rollovers reflect the interest rate return or cost of holding an open position.
• Rollovers represent the difference in interest rates between the two currencies in your open position, but they’re applied in currency-rate terms.
• Rollovers constitute net interest earned or paid by you, depending on the direction of your position.
• Rollovers can earn you money if you’re long the currency with the higher interest rate and short the currency with the lower interest rate.
• Rollovers will cost you money if you’re short the currency with the higher interest rate and long the currency with the lower interest rates.
• Rollovers can have spreads applied to them by some forex brokers, which can reduce any interest earned by your position.
• Rollover costs/credits are based on position size — the larger the position, the larger the cost or gain to you.
• Rollovers should be considered a cost of doing business and rarely influence overall trading decisions.

If you’re going to be trading a relatively large account with an online forex broker (say, over $25,000 in margin deposited), you’ll probably be able to negotiate a tighter rollover spread with your broker. This will enable you to capture more of the gains if you’re positioned the right way, or to reduce your cost of carry if you’re not.

Understanding Currency Prices

Now we’re getting down to the brass tacks of actually making trades in the forex market. Before we get ahead of ourselves, though, it’s critical to understand exactly how currency prices work and what they mean to you as a trader. Earlier in this chapter, we show you that buying means “buying the currency pair” and selling means “selling the currency pair.”

Here, we look at how online brokerages display currency prices and what they mean for trade and order execution. Keep in mind that different online forex brokers use different formats to display prices on their trading platforms. A thorough picture of what the prices mean will allow you to navigate different brokers’ platforms and know what you’re looking at.

Bids and offers

When you’re in front of your screen and looking at an online forex broker’s trading platform, you’ll see two prices for each currency pair. The price on the left-hand side is called the bid and the price on the right-hand side is called the offer (some call this the ask). Some brokers display the prices above and below each other, with the bid on the bottom and the offer on top. The easy way to tell the difference is that the bid price will always be lower than the offer price.

The price quotation of each bid and offer you see will have two components: the big figure and the dealing price. The big figure refers to the first three digits of the overall currency rate and is usually shown in a smaller font size or even in shadow. The dealing price refers to the last two digits of the overall currency price and is brightly displayed in a larger font size.

For example, in Figure 4-1 the full EUR/USD price quotation is 1.40225/1.40246. The 1.40 is the big figure and is there to show you the full price level (or big figure) that the market is currently trading at. The 225/246 portion of the price is the bid/offer dealing price.

Spreads

A spread is the difference between the bid price and the offer price. Most online forex brokers utilize spread-based trading platforms for individual traders. In one sense, you can look at the spread as the commission that the online brokers charge for executing your trades. So even if they say they’re commission free, they may be earning the difference when one trader sells at the bid price and another trader buys at the offer price. Another way to look at the spread is that it’s the compensation the broker receives for being the market-maker and providing a regular two-way market.

Spreads will vary from broker to broker and by currency pairs at each broker as well. Generally, the more liquid the currency pair, the narrower the spread; the less liquid the currency pair, the wider the spread. This is especially the case for some of the less-traded crosses.

Executing a Trade

It’s trigger-pulling time, pardner. In this section, we assume you’ve signed up for a practice account at an online forex broker and you’re ready to start executing some practice trades. Getting a feel for executing deals now, before you’re ready to commit any real money to a trade, will be very helpful. (See Chapters 2 and 11 for more on using a practice account.)

There are two main ways of executing trades in the FX market: live trades and orders. If you’re an adrenaline junkie, don’t focus only on the “Trading online” section — the “Orders” section gives you plenty of juice to keep you going, too.

Trading online

Live dealing is how you access the market to buy or sell at current market rates. Knowing exactly what you want to do is important, because when you make a live deal, it’s a done deal. If you make a mistake, you’ll have to make another trade to correct your erroneous trade, and that is very likely going to cost you real money.

There are a few different avenues to get to the market depending on how your broker is set up. In the following sections, we cover all the bases.

Clicking and dealing

Most forex brokers provide live streaming prices that you can deal on with a simple click of your computer mouse. On those platforms, to execute a trade:

1. Specify the amount of the trade you want to make.
2. Click the Buy or Sell button to execute the trade you want.

   The forex trading platform will respond back, usually within a second or two, to let you know whether the trade went through:

   • If the trade went through, you’ll see the trade and your new position appear in your platform’s list of trades.
   • If the trade failed because of a price change, you need to start again from the top.
   • If the trade failed because the trade was too large based on your margin, you need to reduce the size of the trade.

   When the trade goes through, you have a position in the market and you’ll see your unrealized P&L begin updating according to market price fluctuations.

Click-and-deal platforms usually have a number of shortcuts to enable more rapid trading. Some of these are for more advanced or active traders, so be sure you know what they are before you engage them. Here are the parameters that you can usually set up in advance:

• Preset trade amounts: These are so you don’t have to specify the amount each time you make a deal.
• Automatic stop-loss orders at a predetermined distance from the trade-entry price: These automatic stop-loss functions can be turned on or off, and you define the number of pips away for the stop loss. These functions are good for providing fail-safe stop-loss protection until you can enter a more detailed order for your trade strategy. Remember: You never know when a headline will roil the market, and you don’t want to get caught with your pants down.
• Close buttons: These will appear next to all open positions. By clicking them, you’ll automatically square up (close) the open position you’ve selected (assuming the position size is within the maximum per-trade deal size).

Some online brokers advertise narrower trading spreads as a way to attract traders. If your click-and-deal trade attempts frequently fail, and the platform then asks if you’d like to make the trade at a worse price, you’re probably being re-quoted. Re-quoting is when brokers offer you a worse price to make your trade, meaning you end up paying a larger spread than you bargained for.

Phone dealing

Placing live trades over the phone is available from most online forex brokers (although it’s probably the least popular form of trading). You need to find out from your broker whether it offers this service and exactly what its procedures are before you can be ready to use it.

The capability to make trades over the phone is critical if you’re frequently trading while away from your computer or tablet or in cases of technological disruptions. At the minimum, you need to have the dealing phone number in your contact list and a reliable phone connection in case something goes wrong with your Internet connection. If your dog chews through your mouse cable or your kid spills a sippy cup of juice on your tablet, you’ll need a fallback plan to protect your market exposure. (We discuss more such risk considerations in Chapter 13.)

To place a trade over the phone, you’ll need to:

1. Call the telephone number at your broker for placing a trade.
2. When you’re connected to a representative, identify yourself by name and give your trading account number.

   Be ready to provide whatever account password is needed. (Knowing what’s required before you call to place the trade is a good idea.)

   Know what your position is. If you’re not sure, your broker will be able to give you this info, but be prepared for time delays.

3. Ask what the current price is for the currency pair you’re trading. The broker’s representative will quote you a two-way bid/offer price, such as “EUR/USD is trading at 1.3213/15.”
4. If you don’t want the price, say, “No, thank you.”
5. If you want the price, specify exactly what trade you would like to make.

   Don’t just say “Close my position” or “Square me up.” Note the direction (buy or sell), the amount (don’t use lots — use the real amounts), and the currency pair. For example, “I would like to sell 140,000 EUR/USD.”

   The broker should then say, “Done” or “That’s agreed.”

6. Confirm with your broker exactly what trade you just made.

   For example, say, “To confirm, I just sold 140,000 EUR/USD at 1.3213.”

   Be sure the broker confirms the trade. You can double-check that the trade was correct by asking the broker to input the trade and update your position.

7. Get the name of the broker’s representative you just made the trade with in case you have to call back.

Orders

Currency traders use orders to catch market movements when they’re not in front of their screens. Remember: The forex market is open 24 hours a day. A market move is just as likely to happen while you’re asleep or in the shower as it is while you’re watching your screen. If you’re not a full-time trader, then you’ve probably got a full-time job that requires your attention when you’re at work — at least your boss hopes she has your attention. Orders are how you can act in the market without being there.

Experienced currency traders also routinely use orders to:

• Implement a trade strategy from entry to exit
• Capture sharp, short-term price fluctuations
• Limit risk in volatile or uncertain markets
• Preserve trading capital from unwanted losses
• Maintain trading discipline
• Protect profits and minimize losses

We can’t stress enough the importance of using orders in currency trading. forex markets can be notoriously volatile and difficult to predict. Using orders will help you capitalize on short-term market movements, as well as limit the impact of any adverse price moves. A disciplined use of orders will also help you to quantify the risk you’re taking and, with any luck, give you peace of mind in your trading. Bottom line: If you don’t use orders, you probably don’t have a well-thought-out trading strategy — and that’s a recipe for pain.

Types of orders

In this section, we introduce you to all the types of orders available in the forex market. Bear in mind that not all order types are available at all online brokers. So add order types to your list of questions to ask your prospective forex broker. (For more in-depth information, we look at tactical considerations for placing orders in Chapter 13 and offer practical tips for entering orders in Chapter 14.)

Take-profit orders

Don’t you just love that name? There’s an old market saying that goes, “You can’t go broke taking profit.” You’ll use take-profit orders to lock in gains when you have an open position in the market. If you’re short USD/JPY at 107.20, your take-profit order will be to buy back the position and be placed somewhere below that price, say at 106.80 for instance. If you’re long GBP/USD at 1.6640, your take-profit order will be to sell the position somewhere higher, maybe 1.6675.

Partial take-profit orders are take-profit orders that only close a portion of your open position. Let’s say you bought 200,000 EUR/USD at 1.2950 expecting it to move higher — and it does. But to take some money off the table and lock in some gains, you decide to sell half the position (100,000 EUR/USD) at 1.3000 and to allow the market to see how high it wants to go with the rest. Or you can place two partial take-profit orders to close the whole position at two different levels.

Limit orders

Technically speaking, a take-profit order is a type of limit order. The key difference is that take-profit orders close or reduce open positions and limit orders open new positions or add to existing positions in the same direction.

A limit order is any order that triggers a trade at more favorable levels than the current market price. Think “Buy low, sell high.” If the limit order is to buy, it must be entered at a price below the current market price. If the limit order is to sell, it must be placed at a price higher than the current market price.

Stop-loss orders

Boo! Sound’s bad doesn’t it? Actually, stop-loss orders are critical to trading survival. The traditional stop-loss order does just that: It stops losses by closing out an open position that is losing money. You’ll use stop-loss orders to limit your losses if the market moves against your position. If you don’t, you’re leaving it up to the market, and that’s always a dangerous proposition.

Stop-loss orders are on the other side of the current price from take-profit orders, but in the same direction (in terms of buying or selling). If you’re long, your stop-loss order will be to sell, but at a lower price than the current market price. If you’re short, your stop-loss order will be to buy, but at a higher price than the current market.

Trailing stop-loss orders

A trailing stop is a beautiful little tool, especially when you’ve got a winning trade going. You may have heard that one of the keys to successful trading is to cut losing positions quickly, and let winning positions run. A trailing stop-loss order allows you to do just that. The idea is that when you have a winning trade on, you wait for the market to stage a reversal and take you out, instead of trying to pick the right level to exit on your own.

A trailing stop-loss order is a stop-loss order that you set at a fixed number of pips from your entry rate. The trailing stop adjusts the order rate as the market price moves, but only in the direction of your trade. For example, if you’re long EUR/CHF at 1.2350 and you set the trailing stop at 30 pips, the stop will initially become active at 1.2320 (1.5750 – 30 pips).

If the EUR/CHF price moves higher to 1.2360, the stop adjusts higher, pip for pip, with the price and will then be active at 1.2330. The trailing stop will continue to adjust higher as long as the market continues to move higher. When the market puts in a top, your trailing stop will be 30 pips (or whatever distance you specify) below that top, wherever it may be.

If the market ever goes down by 30 pips, as in this example, your stop will be triggered and your position closed. So in this case, if you’re long at 1.2350 and you set a 30-pip trailing stop, it will initially become active at 1.2320. If the market never ticks up and goes straight down, you’ll be stopped out at 1.2320. If the price first rises to 1.2375 and then declines by 60 points, your trailing stop will have risen to 1.2345 (1.2375 – 30 pips) and that’s where you’ll be stopped out.

Pretty cool, huh? The only catch is that not every online trading platform offers trailing stops. If you find a platform you like and it doesn’t offer trailing stops, you can mimic a trailing stop by frequently manually changing the rate on your regular stop-loss order. But this is an imperfect solution unless you can monitor your position constantly.

One-cancels-the-other orders

A one-cancels-the-other order (more commonly referred to as an OCO order) is a stop-loss order paired with a take-profit order. It’s the ultimate insurance policy for any open position. Your position will stay open until one of the order levels is reached by the market and closes your position. When one order level is reached and triggered, the other order automatically cancels.

Let’s say you’re short USD/JPY at 101.00. You think if it goes up beyond 101.50, it’s going to keep going higher, so that’s where you decide to place your stop-loss buying order. At the same time, you believe that USD/JPY has downside potential to 100.25, so that’s where you set your take-profit buying order. You now have two orders bracketing the market and your risk is clearly defined.

As long as the market trades between 100.26 and 101.49, your position will remain open. If 100.25 is reached first, your take profit will trigger and you’ll buy back at a profit. If 101.50 is hit first, then your position is stopped out at a loss.

OCO orders are highly recommended for every open position.

Contingent orders

A contingent order is a fancy term for combining several types of orders to create a complete currency trade strategy. You’ll use contingent orders to put on a trade while you’re asleep, or otherwise indisposed, knowing that you’re contingent order has all the bases covered and your risks are defined. Contingent orders are also referred to as if/then orders. If/then orders require the If order to be done first, and then the second part of the order becomes active, so they’re sometimes called If done/then orders.

Let’s look at a trade idea and see how a contingent order works. Say NZD/USD has been trading in a range between 0.6700 and 0.6800 and is currently sitting in the middle at 0.6750/54. You think it’s going to go higher, but you don’t want to jump in at the middle of the range and risk watching it go down before it goes up. So you use a contingent order to implement your strategy, even if you’re not watching the market.

Because you’re ultimately looking to buy on a dip toward 0.6700 to get long, you would place an if/then limit order to buy at 0.6710, the if part of the order. The contingent, or then, part of the order only becomes active if the if part is triggered and you enter a position.

The then part consists of either a stop-loss order or a take-profit order, or both in the form of an OCO order.

Continuing with this example, your contingent order may be to place a stop-loss order below 0.6700, in case the range breaks and you’re wrong. So you may place your stop-loss order at 0.6690 to sell what you bought in the if part. This type of contingent order is called an if/then stop loss. You may opt for only an if/then stop-loss order if you want to limit your downside risk, but let your upside gains run.

If you think the upside is limited to the range highs at 0.6800, you may want to add a contingent take-profit order at 0.6790 to sell what you bought at 0.6710, in addition to your stop-loss order. Now if your position is opened at 0.6710, you have an OCO order to stop sell at 0.6690 or take profit at 0.6790. Now you have a complete trade strategy with defined risk parameters.

If the market continues to trade in the range, it may drop from the level you saw (0.6750/55) before you went to bed. If it hits 0.6710, then your long position is established and your OCO orders are activated. If the range holds and the price moves back up to the range highs, your take profit at 0.6790 might be triggered. If the range fails to hold, your stop-loss order will limit your losses and close out your trade for you.

Be careful about using if/then orders with only a contingent take-profit order. Not using a stop loss to protect your downside is always very risky. At the minimum, always use an if/then stop loss to limit your risks.

If you use an if/then OCO order and the market behaves as you expect, you could awaken to find that you bought at 0.6710 and took profit (sold) at 0.6790, all while you slumbered through the night. Or you could awaken to find that your if order to buy was done, but the market has not yet hit either your stop-loss or take-profit levels. But at least your open position is protected by the activated OCO order. Worst-case scenario in this example: You wake up and find that your if limit order was filled and your stop was triggered on a break through the bottom of the range, giving you a loss. The key is that you effectively managed your risk.

Spreads and orders in online currency trading

Now that we’ve covered the different order types, we think it’s important for you to be aware of how online trading platforms typically handle traders’ orders. We spent some time earlier in this chapter discussing forex market spreads and the role of the market-maker. There was a good reason for that: Online forex brokers accept your orders according to their trading policies, which are spelled out in detail in the fine print in the contract you’ll have to sign to open up an online trading account. Make sure you read that section to be absolutely certain what your broker’s order execution policies are.

The key feature of most brokers’ order policies is that your orders will be executed based on the price spread of the trading platform. That means that your limit order to buy will only be filled if the trading platform’s offer price reaches your buy rate. A limit order to sell will only be triggered if the trading platform’s bid price reaches your sell rate.

In practical terms, let’s say you have an order to buy EUR/USD at 1.2855 and the broker’s EUR/USD spread is 3 pips. Your buy order will only be filled if the platform’s price deals 1.2852/55. If the lowest price is 1.2853/56, no cigar, because the broker’s lowest offer of 56 never reached your buying rate of 55. The same thing happens with limit orders to sell.

Stop-loss execution policies are slightly different than in equity trading because most online forex brokers guarantee that your stop-loss order will be executed at the order rate. To be able to guarantee that, brokers rely on the spread.

• Stop-loss orders to sell are triggered if the broker’s bid price reaches your stop-loss order rate. In concrete terms, if your stop-loss order to sell is at 1.2820 and the broker’s lowest price quote is 1.2820/23, your stop will be filled at 1.2820.
• Stop-loss orders to buy are triggered if the platform’s offer price reaches your stop-loss rate. If your stop order to buy is at 1.2875 and the broker’s high quote is 1.2872/75, your stop will be filled at 1.2875.

The benefit of this practice is that some firms will guarantee against slippage on your stop-loss orders in normal trading conditions. (Rarely, if ever, will a broker guarantee stop losses around the release of economic reports.) The downside is that your order will likely be triggered earlier than stop-loss orders in other markets, so you’ll need to add in some extra cushion when placing them on your forex platform.

We explore in more detail the nuances and strategies of trading with orders in Chapter 13.