How can you can get started as a Forex trader and what are the limitations of day trading currencies to make money?
For decades, currency trading has been a popular way used by investment bankers and hedge funds to make money. It was not very popular among individual traders because of the expenses involved and the general lack of knowledge about the idea.
Today, things have changed and the forex industry has become popular among traders from around the world. In fact, investors exchange currencies worth more than $5.1 trillion every day. This article explains how you can get started as a forex trader and the limitations of using this strategy to make money.
Note, whenever you think of diving into an activity, it's good to ask yourself: does this activity add value? Activitities that do not add value are unlikely to make you happy in the long run. In the case of day trading the value added is not really visible.
How the forex market works
The currencies market is a large decentralized system that was created to facilitate international trade. This has become particularly important at a time when the amount of global trade has increased. For example, every year, the United States does trade worth more than $1.1 trillion with the European Union.
Because of this decentralized nature of the currencies market, the activities are usually concentrated within various centers. Among the most important are London, Shanghai, Tokyo, Hong Kong, Frankfurt, Chicago, and Toronto. This special characteristic makes it possible for the market to be open 24 hours a day for five days.
While there are hundreds of currencies around the world, the forex market tends to concentrate on a few, mostly convertible currencies.
The US dollar is the most important because of its role as the reserve currency of the world. More than 60% of the world’s trade is in US dollar. It is followed by the euro, Japanese yen, and the sterling respectively.
Types of Currency Pairs
In this market, currencies are usually quoted in pairs. This is because in a global transaction, traders exchange one currency pair with another. The most common currency pairs are EUR/USD, USD/JPY, GBP/USD, EUR/GBP, and USD/CAD. In this arrangement, the first currency is known as the base currency while the one on the right is known as the quote currency.
Currency pairs are not created equal. For this reason, different types of currency pairs have been developed. These are:
- Majors: These are currency pairs mostly from the G10 group of countries. Examples of these are EUR/USD, GBP/USD, USD/JPY, and USD/CAD.
- Minors: These are currency pairs from the G10 countries but those which does not have the USD. These pairs are not traded as much as the majors. Examples are AUD/NZD, EUR/CHF, and EUR/JPY.
- Exotics: These are currencies that combine one from the developed country with another from the emerging markets. The volumes of these pairs is relatively tiny. Examples are USD/HKD, USD/DKK, and USD/ZAR.
- Commodity Currencies: These are currencies that are deeply correlated with key commodities. For example, the Saudi Arabia riyal is increasingly correlated with the price of oil. Other commodity currencies are the Canadian dollar, Australian dollar, and Brazilian real.
Why Trade Currencies
There are a number of reasons why many traders and institutions trade currencies. Some of these reasons are:
- Liquidity: with more than $5 trillion worth of currencies traded every day, the currencies market is one of the most liquid. This means that you can enter and exit a trade within minutes. This liquidity is more in the majors and minor pairs.
- Open 24 hours a day: unlike the stock and bond market, the forex market is open 24 hours a day five days a week. This means that you can plan to be trading at any time.
- Leverage: most forex brokers provide leverage to traders. This leverage allows the traders to maximize their returns by using more money than they have invested.
- No commissions: most brokers don’t take a commission per trade. Instead, they make money from the spread of the bid and ask prices.
Impossible to corner the market: unlike in the stock market where sell-side analysts can manipulate the stocks, it is almost impossible for analysts to manipulate the currencies market.
Low barriers to entry: since the competition in the forex market is highly competitive, brokers have removed the barriers that existed before. For example, you can start trading with as little as $100.
What Moves Currencies?
To become a successful currencies trader, it is important for you to understand what moves the currency pairs. Broadly, like all financial assets, the main reason why currency prices move is the demand and supply dynamics. In forex, this demand is influenced by the health of the economy. The following are some of the most important things to watch:
- Employment data: a key determinant of the health of the economy is employment numbers. Ideally, investors tend to prefer countries with low unemployment rates, increasing participation rates, and growing wages.
- Manufacturing and industrial production: investors prefer countries with growing production in the manufacturing and industrial sector. These numbers are important indicators of internal and external demand.
- Inflation: market participants prefer countries with stable inflation rates. When inflation is growing too fast, capital tends to flee, leading to higher rates of inflation. The most common measures of inflation are: consumer price index (CPI), producer price index (PPI), retail sales, and consumer confidence.
- Trade data: participants prefer countries with increasing exports and imports. This data shows that the productivity of the country is increasing.
- Confidence: traders prefer countries where there is increasing consumer and business confidence.
- Interest rates: all the data mentioned above help to determine whether the central bank will tighten or loosen the monetary policy of a country. Higher interest rates or expectations of higher interest rates leads to more demand of the local currency because of the yield it attracts.
Technical indicators of Forex trading
The six determinants mentioned above are known as the fundamentals. In addition, there are the technical factors that help to move the currencies. There are four main types of technical indicators that are followed closely. These are:
- Trend indicators: these are indicators that help determine whether there is a trend in a currency pair. They also help identify when divergences are emerging. Examples of these indicators are moving averages, Bollinger Bands, Average Directional Index (ADX), and Standard Deviation among others.
- Oscillators: these indicators help to identify when there are extremes in the market. Broadly, they help identify the overbought and oversold levels. Examples are: Relative Strength Index (RSI), Relative Vigor Index (RVI), and Stochastics among others.
- Volumes: these indicators help to determine whether the trend is supported by the volume. Examples of these are: accumulation and distribution, money flow index, and on-balance volume.
- Custom indicators: these are indicators that are created to incorporate the concepts of the three categories of the indicators. Examples are fractals, alligators, and market facilitation index.
How to start trading forex
Like in all types of market, the first step is to try and learn about the industry. There are many books about forex that you can find online. Some of the most common books you can read are: Come into my trading room by Alexander Elder, Trading for a living by Thomas Karr, and Millionaire Traders by Kathy Lien.
Second, you need to select a forex broker. In the United States, the forex trading industry is a highly regulated one and only a few regulated brokers. Before you create an account with a broker, you need to ensure that is is regulated by the SEC. Some of the brokers that operate in the country are Interactive Brokers, IG, Forex, Oanda among others. In the past, a number of brokers like ITG and IronBrokers have been fined by the SEC for marketing to US customers.
Forex day trading strategies
Third, you need to create a trading strategy. Broadly, there are a number of strategies you can use in the forex market industry. Examples are:
- Algorithmic trading: this is where you use algorithms and expert advisors to buy and sell pairs.
- Scalping: this is where you open and close trades within a few minutes.
- Hedging: this is a pairs trading strategy, where you open two trades simultaneously with the goal of profiting from the spread of the profit and loss of the two.
- Swing trading: this is where you open trades and leave them open for a few days.
- Long-term trading: in this, you open trades and leave them open for weeks.
- Price action trading: this is a strategy that involves buying or shorting pairs based on the recent price action.
- Trend following: this is a strategy where traders follow the existing trend and exit when a divergence starts to happen.
As you develop your trading strategy, you should use the demo accounts provided by the brokers to test the performance of the strategy. If you're looking for some courses, there are plenty tutorials on Youtube for technical analysis as well as professional courses on Udemy.
Finally, you should deposit your funds and start trading. Initially, you should use a small lot size and small leverages to prevent the size of your losses.
But Should You Trade Currencies?
While many people and institutions have made a lot of money in the forex market, the fact is that it is a very risky industry. In fact, more than 80% of all traders who start their careers in forex lose money. Think about that. You are most likely to loose money, on top of spending a lot of time looking at screens, in stress.
Speculating vs Investing
Therefore, don't look at this as more than gambling. And do not get sunk into spending entire days and nights trading. Instead of this gambling we think there are way better opportunities. First of all, keep in mind the difference between investing and speculating. We can only endorse investing really:
- Invest in index funds
- Invest in Bitcoin, meaning buy and hold for at least a couple of years