First Principles of Forex Trading
The true currency of life is time, not money, and we’ve all got a limited stock of that.
—Robert Harris (1957–Present)
British novelist
Critical Concepts
As a day trader, you want to be in a position to take advantage of all different types of securities, including the forex market. However, there is a misconception that trading forex is easy and can only make you money.
Here is an example to show how difficult it is to trade forex. Assume that you live in South Africa and you want to travel to the United States. You have ZAR100,000 and you need to covert them to U.S. dollars.
Your choices are:
• A straight conversion: ZAR to U.S. dollars.
• Or, if you believe that you can get more U.S. dollars for your ZAR by converting between countries’ exchange rates, that is to see if you can beat the market.
Here is the answer. You cannot beat the market.
Strategy 1: Direct Change of ZAR to U.S. Dollars
• Stats as at June 23, 2017.
• 1 ZAR = 0.0773881 USD
• Therefore, ZAR100,000 = US$7,738.81
Strategy 2: Attempt to Beat the Market
• Stats as at June 23, 2017.
• The trader attempts to convert his ZAR to the Indonesian Rupiah, then to the Australian dollar, then to the Brazilian Real, and finally, to the U.S. dollar.
• This is what happens:
ZAR100,000 to Indonesian Rupiah = 103,003,294.09 IDR.
Indonesian Rupiah 103,003,294.09 to Australian dollar = 10,229.271712 A$.
Australian dollar 10,229.271712 to Brazilian Real = 25,807.973886 BRL.
Brazilian Real 25,807.973886 to U.S. dollars = 7,736.6216583cUSD.
The difference between the two strategies is virtually nonexistent. You cannot beat the market using the forex ratios on the same day. If you hold positions over a few days, then you increase the risk of the currency going against you, but also raise the potential of profits.
Let us take a look at some important basic concepts for traders, who wish to trade forex.
Major Currencies
The advice from all professional traders is to start by only trading the top eight liquid and most-traded currencies, before you venture into the lesser-known currencies. These following eight currencies make up the majority of daily global currency trade:
• Australia
• Canada
• China
• Eurozone and the United Kingdom
• Japan
• Switzerland
• United States
These countries release economic data every day, making it easier to trade currencies.
Yield and Return
The most important concept to fully understand when you trade currencies is that yield drives return. In essence, every currency is affected by that country’s interest rate, which, in turn, is affected by supply and demand. If you sell a currency, you must pay the interest on the currency, but if you buy a currency, then you are earning interest on the currency.
Example
• The South African Rand (ZAR) versus U.S. dollar.
• Assume:
South Africa = interest rate of 8 percent or 800 basis points.
United States = interest rate of 0.5 percent or 50 basis points.
• Going long ZAR/USD, you will earn 8 percent in annualized interest, but 0.5 percent has to be paid.
• The net return = 7.5 percent, or 750 basis points.
Phenomenal Leveraging Options
High-risk traders love forex, which gives them one of the highest leverages on offer on any exchange. While futures markets offer leverage rates between 5 and 25 times, forex markets offer leverages as high as 100:1; which means that you can control 10,000 dollars worth of assets with as little as 100 dollars of capital.
As stated before, it can create massive profits quickly when your trades are successful, but can also result in massive losses when your trades are wrong. However, these losses can be minimized if you use stop losses.
Pair-up the currency with the highest interest rate against a currency with the lowest rate.
Ensure that you have a long currency position with an interest rate that is in the processes of increasing, and a short currency position with a slow or declining interest rate.
The strategy is called an expanding interest rate spread.
Ensure that the preceding has the potential to appreciate in value.
Defining a PIP
A PIP is simply defined as the smallest price move that a given exchange rate can make between two paired currencies. In today’s trading world, major currency pairs are priced to four decimal places; thus, the smallest change is that of the last decimal point, that is 1 percent, or one basis point. A PIP varies depending on how a given currency pair is traded. The value of one PIP can have sharply different values depending on the currency pair and pricing.
Part IV, Chapter 15, commences your journey into day trading in the global markets.