A Brief History of Forex
Up until World War I, currencies were pegged to precious metals, such as gold and silver. But the system collapsed and was replaced by the Bretton Woods agreement after the Second World War. That agreement resulted in the creation of three international organizations to facilitate economic activity across the globe. They were the International Monetary Fund (IMF), General Agreement on Tariffs and Trade (GATT), and the International Bank for Reconstruction and Development (IBRD). The new system also replaced gold with the US dollar as peg for international currencies. The US government promised to back up dollar supplies with equivalent gold reserves.
But the Bretton Woods system became redundant in 1971, when US president Richard Nixon announced “temporary” suspension of the dollar’s convertibility into gold. Currencies are now free to choose their own peg and their value is determined by supply and demand in international markets
What Is the Forex Market?
Forex Market is an exciting place. The one good thing about entering into the forex market is that you can trade anytime as per your convenience.
The forex market is enormous in size and is the largest market with millions of participants. Hundreds of thousands of individuals, money exchangers, to banks, to hedge fund managers everybody participates in the forex market. The foreign exchange market is not dominated by a single market exchange, but a global network of computers and brokers from around the world.
The US dollar is by far the most traded currency, making up close to 85 percent of all trades. Second is the euro, which is part of 39 percent of all currency trades, and third is the Japanese yen at 19 percent. (Note: these figures do not total 100 percent because there are two sides to every FX transaction).
If you are living in the U.S. and want to buy cheese from France, either you or the company that you buy the cheese from has to pay the French for the cheese in euros (EUR). This means that the U.S. importer would have to exchange the equivalent value of U.S. dollars (USD) into euros. The same goes for traveling. A French tourist in Egypt can’t pay in euros to see the pyramids because it’s not the locally accepted currency. As such, the tourist has to exchange the euros for the local currency, in this case the Egyptian pound, at the current exchange rate. One unique aspect of this international market is that there is no central marketplace for foreign exchange. Rather, currency trading is conducted electronically over-the-counter (OTC), which means that all transactions occur via computer networks between traders around the world, rather than on one centralized exchange. The market is open 24 hours a day, five and a half days a week.
Core Liquidity Provider
What Is a Core Liquidity Provider?
A core liquidity provider is a financial institution that acts as a middleman in the securities markets. The providers buy large volumes of securities from the companies that issue them and then distribute them in batches to financial institutions who then make them available directly to retail investors. The term core liquidity provider describes the function of these firms: They may simultaneously buy and sell shares of a security with the goal of ensuring that it is always available on-demand. A core liquidity provider is also known as a market maker.
Understanding the Core Liquidity Provider
Ideally, the core liquidity provider brings greater price stability to the markets, enabling securities to be distributed on-demand to both retail and institutional investors. Without their participation, the liquidity or availability of any given security would not be guaranteed and the ability of buyers and sellers to buy or sell it at any given time would be diminished.
They quite literally make a market for an asset by offering their holdings for sale at any given time while simultaneously buying more of them. This pushes the volume of sales higher. But it also allows investors to buy shares whenever they want to without having to wait for another investor to decide to sell.
Their activities underpin some routine practices in the market, such as hedging. In the commodities markets, for instance, farmers and food processing companies invest regularly to protect their businesses against declines or increases in future crop prices.
A key characteristic of core liquidity providers is that they continually provide liquidity in all market conditions, not just when they find it advantageous to buy or sell a security. Unlike traders, their business model is not dependant on securities prices.
A bank, financial institution, or trading firm may be a core liquidity provider. The different business models and capabilities of these liquidity providers allow them to serve the market in different ways.
Their Role in IPOs
Perhaps the best-known core liquidity providers are the institutions that underwrite initial public offerings (IPOs). When a company goes public on a stock exchange, it selects an underwriter to manage the process. The underwriter buys the stock directly from the company and then resells it in large batches to large financial institutions, which then make the shares available directly to their clients.
Currency futures are a trading instrument in which the underlying asset is a currency exchange rate, such as the euro to US Dollar exchange rate, or the British Pound to US Dollar exchange rate. Currency futures are essentially the same as all other futures markets (index and commodity futures markets) and are traded in the same manner.
Futures based upon currencies are similar to the actual currency markets (often known as Forex), but there are some significant differences. For example, currency futures are traded via exchanges, such as the CME (Chicago Mercantile Exchange); currency markets are traded via currency brokers and are therefore not as regulated as currency futures.
There are some day traders who prefer the currency markets while others prefer currency futures. If you are considering trading in the currency futures, you should understand what they are based on, how transactions work, what margins are, and know some of the popular futures.
Currency Futures Background
Currency futures are based on the exchange rates of two different currencies. For example, the euro and the dollar (EUR/USD) is a pair of currencies that have an exchange rate. The controlling currency is the first currency listed in the pair—in this case, it is the euro price that futures traders are concerned with. Traders buy a contract worth a set amount, and the value of the contract goes up or down with the value of the euro.
Currency futures only trade in one contract size, so traders must trade in multiples of that. As an example, buying a Euro FX contract means the trader is effectively holding $125,000 worth of euros.
Currency futures do not suffer from some of the problems that currency markets suffer from, such as currency brokers trading against their clients, and non-centralized pricing. On the flip side, forex trading is much more flexible, allowing traders access to high leverage and trading in very specific position sizes.
Since markets move in ticks, each tick is worth a certain amount of money for each type of investment and market. The Euro FX market moves in tick sizes of .00005 dollars per euro, or price movements of $6.25 ($125,000 X .0005). In other words, you purchase one Euro FX contract for $125,000, and the value then moves up or down a certain number of ticks per day. If the change in price for the day was $.0051 per euro, you would have made $637.50.
In the forex market, a trader can trade in multiples of $1000, which allows them to fine-tune their position size to a much greater degree. One market isn’t better than another, but one may suit a trader (and their account size) better than the other.
Settlement, Delivery, and Profits
Currency futures are based on the exchange rate of a currency pair and are settled in cash in the underlying currency. For example, the EUR futures market is based upon the euro to dollar exchange rate and has the euro as its underlying currency.
Settlement and delivery occurs when a EUR/USD futures contract expires—the holder receives delivery of $125,000 worth of euros in cash to their brokerage account.
Note that this only happens when the contract expires. Day traders do not usually hold futures contracts until they expire. Therefore, they should not be involved in the settlement, and will not receive delivery of the underlying currency.
anyone who is trading currency futures for speculation and profit, reap rewards based on the price difference between purchase and sale price. With futures, you can also sell first and then buy later, collecting a profit if the price drops.
To determine the profit made on a currency pair, you first calculate the expiration amount and the tick values for the entry and exit amount.
For example, assume a trader buys a Euro FX contract at 1.2525 and then sells it at 1.2545. That is a 20 tick profit, and each tick in that contract is worth $12.50. Therefore, the profit is $12.50 x 20, multiplied by the number of contracts the trader had bought.
Margins on Futures
Currency futures margin should not be confused with margin/leverage as it applies to stocks or the underlying currency market.
With currency futures (or any futures contract), margin refers to how much the trader must have in their account to open a one contract trade. To trade a Euro FX contract, a broker may require the trader have at least $2,310 to $3,000 in their account, as margins vary by currency broker (although the minimum is set by the exchange).
This margin is designed to hold a position overnight. If day trading, brokers usually provide preferential margin, often only requiring a $500 balance be maintained in the account while holding the position.
The margin is not a cost. Think of it as money that is held by the broker to offset any losses you may incur on a trade. Once the trade is closed, you will be able to use those margined funds again.
Popular Currency Futures
Many of the most popular futures markets that are based upon currencies are offered by the CME (Chicago Mercantile Exchange), including the following :
Many other currency pairs are also offered for trading via a futures contract.
Some Final Words
Currency futures are a regulated and centralized way to participate in currency market movements. Currency futures move in increments called ticks, and each tick of movement has a value. The number of ticks made or lost on a trade determines the loss/profit of the trade. To open a currency futures trade, the trader must have a set minimum amount of capital in their account, called the margin.
You have been told that you need to create a strategy; you cannot trade without it, however, once you have made your trading strategy, how do you know if it is any good? How do you measure whether it is a good strategy or not? Of course, you can look at whether it is profitable or not but there are plenty of other things that you can look at to work out whether the strategy is a good one or not, most of those reasons will be personal to you.
It should be personal
A good strategy needs to be personal to you, it needs to have been created in a way that suits you and the best way for that to happen is for you to create it yourself. This way you know the ins and outs and exactly how it works, if the markets suddenly decide to change, you need to have that understanding of the strategy in order to adapt. If you were to take a strategy from someone else, then you do not have a full understanding, as soon as the markets change you will be stuck, not knowing how to adapt it. So creating it from scratch is paramount and will help to really make that strategy your own.
It needs to be specific
The trading strategy that you need has to be quite specific; it should be focusing on specific things rather than being too broad. If a strategy focuses on just one or two currency pairs, this way the strategy will be able to more easily be adapted to the changing markets or if there is a dramatic event in the markets. If a strategy is trying to cover all bases and all currencies then it will struggle, each currency behaves in different ways and so there cannot be a group of settings that can cover them all, this will only result in there being issues when things go wrong or if the settings do not match the characteristics of one of the pairs.
Opening lots of trades
A good strategy will be able to pick its trades well; it will use very specific criteria before opening one up. What you do not want is a strategy that is opening tens of trades when only one is needed, some strategies do this to increase the volume being traded or the entry requirements are so loose that it allows for lots of trades. This is also sort of related to the precious points of being specific, if it is relevant to too many pairs then it may open too many at a time. When we look at trading, we are looking at quality and not quantity.
A good strategy will have its risk management built into it. This will include things like the stop losses, the take profits, and the percentage of the account to risk on each trade, and just simple methods of keeping your account safe. A bad strategy will unfortunately not include some of these things that can make them far riskier and dangerous; if a strategy does not have any risk management attached to it then we would suggest looking for a different one to use.
Can it cope with change?
A good strategy will need to be able to adapt to the changing markets, they will always be changing, on a day-to-day basis and on a larger scale over the months and years. If your strategy is not able to handle any of those changes due to it being too rigid and requiring very specific requirements without the ability to alter them, then it would be considered a bad strategy. You need to be able to make adaptations or the strategy will only lead to eventual losses.
So that is a non-exhaustive list of things that could cause a strategy to be either good or bad, there are of course a lot of other things too, but these are some of them.
Futures markets serve two primary purposes. The first is price discovery. Futures markets provide a central market place where buyers and sellers from all over the world can interact to determine prices. The second purpose is to transfer price risk. Futures give buyers and sellers of commodities the opportunity to establish prices for future delivery. This price risk transfer process is called hedging.
Differences Between Spot and Futures Markets
Managing Counterparty Risk – Futures Markets
Counterparty is the process where there is a buyer and seller for each transaction. Since futures trades settle in the future, the last thing you want is to have no one on the other side of the trade.
Futures exchanges utilize two types of risk mitigation techniques to reduce the risk of this occurring: (1) performance bonds and (2) maintenance margin.
To begin placing trades, you need a performance bond or initial margin. This essentially is the cash in your account to cover trade obligations.
This maintenance requirement is the minimum amount of cash to cover all open positions.
The maintenance will differ based on your type of position (long/short), the specific requirement of the security you are trading and if you are holding the position overnight.
To touch upon more advanced methods used by the exchanges, let’s dive into when things go your way quickly and when you lose your shirt.
Price Moves Sharply Against You
If a trade moves significantly against you, the difference is made up by deducting this amount from your maintenance margin.
When the maintenance margin falls below the initial margin, you are issued a margin call and required to fund your account to avoid liquidation.
This request to fulfill your obligations can come in the form of an automated email or a phone call if you have a sizable position.
Managing Counterparty Risk – Spot Markets
Margin in the spot market is an upfront fee with the broker and is not related to counterparty risk.
Is Counterparty Risk a Big Deal?
According to research conducted by the IMF, counterparty risk is largely dependent on the creditworthiness of the institution and its supporting casts of banks and broker dealers.
If you think managing counterparty risk is not a concern, think back to the mortgage crisis.
Essentially a lot of notes came due and there wasn’t money on the other side of the trade to complete the transaction for credit default swaps.
I think we all know how that played out.
Spot Market Settlement Period
For some spot markets, the allowable settlement time period is two working days.
While this is contradictory to the term “spot”, two working days are for the transfer of cash from the buyer to the seller.
However, in most cases, spot market prices settle near real-time.
This is most common with spot Forex markets where transactions are sent electronically and settle immediately.
Futures Market Settlement Period
In the futures markets, the underlying asset has a specific settlement date in the future.
If you are long a futures contract, you agree to buy that contract on a specific date down the road.
Conversely, if you are short, you have entered an agreement to sell the contract on a future date.
As you can see in the below table of the S&P E-mini contract, there are different expiration dates for each contract.
If you elect to not deliver the contracts on the specified date, you will need to roll your contracts to another out month.
Stocks do not rollover and you can hold them as long as the company is active on the respective exchange.
Therein lies the key difference between the two instruments – the element of time.
Traders use the futures market as a hedge against spot markets.
Why not the other way around?
Well, your ability to leverage is far greater in the futures market. Therefore you can purchase a few contracts, but able to hedge against a sizable spot market position.
This allows you to prevent any catastrophic move against you that could blow up your account, without risking a lot of your capital.
For example, if you had short exposure to the XAU/USD as depicted above, you could buy futures contracts to hedge against rising prices.
History of Commodities Trading in the US
Although the futures markets today are made up of interest rates derivatives, Treasuries, and stock index futures; futures markets were originally known for trading commodities.
In the U.S. grains were one of the first commodities to trade in the early 1800’s and began as a forward contract.
In 1848, the Chicago Board of Trade (CBOT) exchange was formed where farmers and merchants could buy and sell commodities for cash.
The buying and selling process eventually evolved into contracts.
For nearly 100 years, agricultural products were the most commonly traded futures contracts, which slowly expanded to include other commodities such as soybeans in 1936 and cotton futures in 1940.
Precious metals began trading in the 1960’s and currency futures began to appear in the 70’s after the Bretton Woods agreement, where the U.S. dollar was depegged from gold.
The simplest answer is that the forex is open for trading all the time, but that the specific hours it opens and closes at any given location depending upon where you are in the world. The base reference time for all opening and closing times worldwide is Greenwich Mean Time, commonly abbreviated GMT. Many websites devoted to clarifying forex business hours describe the opening and closing times with three or four significant examples, usually
Here’s Where Things Begin to Get Complicated
One source of confusion for new forex traders has to do with how the various websites choose to present the open and closing time data.
In all cases, to make a meaningful description of trading hours worldwide, the opening and closing times at each location worldwide need to be presented with a common base reference time. In this article, for instance, the data is referenced to GMT. In other articles with a United States orientation, however, the common base reference time often used is Eastern Standard Time. It isn’t wrong, but it’s a little confusing for readers who don’t distinguish between GMT and EST –something few persons other than forex traders and airline personnel need to deal with on a regular basis.
Another possible source of confusion is that GMT is always just that, summer, winter and fall. Eastern time, however, comes in two flavors: Eastern Standard Time (EST) and Eastern Daylight Time. Since the agreed-upon reference time worldwide is actually GMT, which has no Greenwich Mean Daylight Savings Time, this means that a New York trader who chooses to reference Eastern time rather than GMT, must keep in mind that during Daylight Savings Time in New York, the trading hours shift by an hour because the GMT reference time, needless to say, does not shift.
Eight Hours a Day or 24?
The first section of this article notes that at each location the forex is open for eight hours. It is true. But other websites on the subject of forex trading hours note that the forex is open “24 hours a day.” It is also true or at least “true-ish.”
The explanation isn’t complicated, but at first, it may seem a little strange and requires a two-part explanation. First, remember that if it’s midnight in New York when the New York forex market is closed, it’s also the middle of the trading day somewhere in Tokyo, for instance. Also, keep in mind that forex is a worldwide market that is entirely virtual. There’s no trading pit anywhere. When you enter a midnight forex trade on your laptop in New York, the trade is executed in Tokyo or in another of the several trading centers worldwide that are open when you initiate the trade.
So, yes, at any given trading center, it’s an eight hour day. But that really doesn’t matter, because somewhere in the world trading centers are open. You can trade anytime you want, although you should also note that, you will get the narrowest spreads — the broker’s profit margin — when the maximum number of trading centers are open or, more precisely, when the trading volume for your currency trade is greatest.
Five Days or Seven?
Still another source of confusion has to do with how many days a week the forex is open. Some websites may declare without further explanation that the forex is always “open 24 hours a day” and others, probably the majority, note that the forex market is open “five days a week.”
Again, both statements are true enough if you put them in context. The apparent contradiction comes because just as a given trading center is open for eight hours and yet you can trade 24 hours a day, so it is also true that although any given trading center keeps a five day week, somewhere in the world, another trading center is open when that trading center is closed. It is the happy consequence of the way the day of the week shifts forward or back as you cross the international dateline.
In short, you can trade anytime you want. That’s the basic information you need. Also, as noted, you’ll get the best trading spreads when the volume is peaking — that is when the greatest number of major trading markets are open.
A pivot point calculator is used on a daily basis by many successful traders to pinpoint key support and resistance levels where they can expect price to react.
The formula for creating pivot points is based on 4 figures you need to obtain from your Forex charting software. You just need these values, which can be obtained by looking at yesterday’s candle on a daily chart:
The key figure in your pivot point calculator is the central pivot point. This value is obtained by adding the High, Low and Close figures together and dividing the total by 3. That’s it! You now have your central pivot point. This pivot point now gives you the basis for calculating the other levels such as R1, R2, S1, and S2.
As the distance between these levels can sometimes be quite significant, many traders also put mid-levels on their charts and refer to them as M1, M2, M3, and M4. They are positioned as follows:
The formulas for the other levels are:
S1: (Central Pivot Point x 2) minus the High
S2: Central Pivot Point minus (R1 minus S1)
R1: (Central Pivot Point x 2) minus the Low
R2: (Central Pivot Point minus S1) plus R1
Once these levels are calculated it is then easy to put the M levels in your pivot point calculator.
M1: S1 minus S2 divided by 2
M2: Central Pivot Point minus S1 divided by 2
M3: R1 minus Central Pivot Point divided by 2
M4: R2 minus R1 divided by 2
In the resource box below is a link to a spreadsheet that is setup for the six major currency pairs. use this pivot point calculator as part of my preparation for each day’s trading session. then just type them in to the appropriate cells on the spreadsheet and all the pivot points are automatically calculated for us. After this, insert horizontal lines to mark the main pivot levels on the 15 minute chart. This enables you to see the general area of price activity for the day.
Sometimes price will go way beyond the average range for the day and exceed R2 or S2. On the spreadsheet referenced below, additional pivot levels are calculated to give some guidance for such trading days.
In this article we will outline the most important terms, which are an integral part of the world of Forex trading.
What are the so-called currency pairs?
When a beginner is confronted for the first time with a platform for trading currencies, he/she will undoubtedly notice that each world nation currency trades in pairs with another. That is why they are known as currency pairs. Each of the pairs consists of one base currency and one counter currency (quote currency).
If we take, for example, GBP/USD pair, here the United Kingdoms pound (GBP) stands for the base currency and the United States dollar, also known as ”greenback”, stands for the counter currency.
In Forex trading, as in stock and commodity trading, one can notice one single price, announced for each currency pair. In the case of trading currency pairs, a trader purchases or sells the base currency in relation to the counter currency. In our example, we do not simply buy the British pound, we buy the pound with a specific amount of US dollars.
If GBP/USD pair currently trades at 1.6395, this means that 1.6395 units of the counter currency (USD) are currently needed to satisfy the trade for 1 unit of the base currency (GBP).
In case the US dollar gains strength, then it will be possible to say that a lesser amount of US dollars may purchase a greater amount of British pounds. However, because of the increased value of the US dollar and because it is denoted in relationship to the pound as a counter currency in the pair, GBP/USD pair tends to decrease. If it was previously trading at 1.6395, because of the strenghtening US dollar it is now trading at 1.6380, for instance, or a lesser number of units of US dollars now buys 1 unit of British pounds.
Another crucial moment, when trading currency pairs, is that a trader does not have to possess US dollars in order to purchase the GBP/USD pair. He/she may begin trading with euros and purchase GBP/USD, because his/her euros are converted into US dollars, which are then used to buy British pounds.
What is a pip?
In Forex trading, the movement in prices of currency pairs is measured in ”pips”. A pip is an acronym for the phrase “percentage in point”. This is the smallest price change, which a given exchange rate can make. Most major currency pairs are priced to four decimal places, so in this case, the smallest change is that of the last decimal point – for most pairs this is the equivalent of 1/100 of 1%, or one basis point.
If GBP/USD is currently trading at 1.6370 – the last number (0) is the pip. If the value of the pair increases from 1.6370 to 1.6371, then it has increased by 1 pip.
Traders in the Forex market usually measure their profits/losses in pips. If a trader purchases GBP/USD at 1.6370 and the value subsequently climbs to 1.6390, this means that the value has increased by 20 pips, while the trader obtains 20 pips of profit.
Some trading platforms break the value of currency pairs down even more, including a fifth number, which is called a pipette. For example, the platform will show the value of GBP/USD as 1.63708, or with a fifth number after the decimal.
It is useful to mention also, that Japanese pairs are showed in a slightly different way, with the pip being the second number behind the decimal, while the pipette – the third. If the value of USD/JPY pair is presented as 101.548, then the number 4 is the pip and the number 8 is the pipette.
The importance of spreads
In Forex trading the spread represents the fee (commission), which any broker will charge you every time you enter a trade.
Let us provide an example of what a spread is. If GBP/USD pair currently has a value of 1.6350 and you intend to buy this pair at this price, your broker will not sell it to you at 1.6350. The broker will submit you a quote slightly higher, for instance, 1.6352. In case you intend to sell this pair, then you will be given a quote slightly lower than 1.6350, say 1.6348, or the value at which your broker will purchase the pair.
As you can see there is a difference between the two quotes (1.6348 and 1.6352). The difference, at the amount of 4 pips, represents the spread. This is the difference between the price at which the broker is willing to buy from you and the price at which he is willing to sell to you. As the broker buys from you at a lower price and sell to you at a higher price, he makes a profit.
Many trading strategies and systems depend strongly on spreads, and most often a very high spread may render a trading system useless. If the trading system involves entering many positions in small periods, then it is highly recommendable that you find a broker offering low spreads.
The spread value is different for each currency. Volatile currency pairs commonly have a tighter spread, while crosses suffering low liquidity usually have a higher spread. This is one of the main reasons why the majority of traders prefer to trade pairs such as the EUR/USD, since its spread is relatively thin, which renders it especially suitable for scalpers who enter many position each day and need the lowest spreads possible.
Bid and Ask
Bid stands for the best possible price, at which a given instrument being traded at the present moment, can be purchased by a trader. In Forex trading world bid price refers to the highest price, which the broker is willing to pay in order to purchase the instrument from the trader.
Ask price stands for the best possible price, at which a given instrument being traded at the present moment, can be sold by a trader. In Forex trading world ask price refers to the lowest price, at which the broker is willing to sell the instrument to the trader.
Trading instruments (Assets)
By trading instruments or assets, we refer to the items that are being traded at the moment. If we are currently trading gold, then gold is the trading instrument. If we are currently trading a currency pair (USD/CAD, for example), then the currency pair is the trading instrument.
Opening and closing a position. Entry and exit
If a trader has purchased or sold a trading instrument, than he/she has opened a position in the market, or he/she has entered the market. If a trader has exited the market, then he/she has closed a position.
If a trader has decided to open a position by purchasing or selling a trading instrument in the market, then he/she has made an entry.
If a trader has decided to close a position in the market and register a profit or a loss, then he/she has made an exit from the market.
Stop loss and profit target
A stop loss is a term, used to point out how to exit the market in a situation, when a trade has gone away. Let us imagine a trader, which has opened a position buying an instrument in the market, but the trade develops in a wrong direction and he/she starts to lose money. If the position remains open and the price continues going in the opposite direction, it is possible the trader to lose most or all of its deposited funds in his/her trading account.
A stop loss order actually prevents the trader from suffering heavy losses. This order will automatically close the position, once a specific price has been reached. We shall examine the basic types of orders, which a trader can submit in order to start trading in the market later.
Profit target refers to the price, at which a trader is willing to exit the market and lock in the profit he/she has registered. This target is usually set by the trader before he/she decides to enter the market. In this case, before making an entry, if the trade develops as expected, the trader already knows how much he/she will profit from this trade.
Bear market versus Bull market
One of the most important things one needs to consider when investing in a certain market is whether prices are trending up or down. Sometimes however, the market may move with no distinct direction, or as many people refer to it “trade sideways”. Prices which fluctuate without any noticeable trend are very hard to predict and respectively difficult to profit from, which is why beginner traders are advised to avoid investing during such market movements.
When we have a distinctive trend however, the market can move in two possible directions – up or down, or as it is most often referred to – a bull or bear market.
A bull market is a financial market of any kind in which prices are rising or according to broad expectations will rise. The word “bull” used to describe such a market comes from the way bulls charge and thrust their horns from below into the air, whereas bears swipe their paws down toward the ground.
Bull markets are characterized by strong investor confidence, optimism and sentiment that the strong performance will continue. “Bullish” investors, lured to the market as momentum picks up, charge in and buy assets amid expectations that prices will continue to rise and they can later resell those assets at a higher price, profiting from the difference.
Likewise, the term “bear market” describes a time when stock prices have been falling as a whole. A bear market is dominated by widespread pessimism which causes a self-sustaining negative sentiment. As investors become more and more pessimistic amid expectations losses will extend, they continue to sell and fuel further sell-offs.
A “bearish” investor who wants to profit when prices are trending down will enter a short position, betting that prices will extend losses. “Shorting” however requires more practice to manage and isn’t suitable for inexperienced traders.
Types of Positions
There are two types of positions when trading on the markets – long and short. Taking a long position means you are buying an instrument with the intention to sell it later, after it has gained, and earn through the price difference. Other terms that are often used as synonyms are: long side trading, trading on the long side of the market, going long the market etc.
Taking a short position means you are betting that prices will drop and you are selling. Basically, when going into a short position, you borrow, for example stocks, from a broker and you sell them on the market. Later, you have the obligation to return what you have borrowed by buying it from the open market and you will profit, if prices have dropped. The idea is to sell something you have borrowed now for a certain amount of money and later refund the broker by buying the same thing at a lower price.
Let us have an example. An investor places an order, which is immediately executed, to sell short 100 shares of XYZ Corp. at $25.00 per share. The investor will receive a cash inflow of $2 500 from this transaction.
Now let us assume that two weeks later, the price has indeed dropped, and that the investor is able to buy back the shares (also known as covering a short position) for $20.00 per share. In this transaction, he will have to spend $2 000 to repurchase these shares. His profit on the trade will be $500 ($2 500 initial cash inflow minus an eventual $2 000 cash outflow). The other way to look at this is that he will have earned $5 per share on the trade, which will provide him with a profit of $500 ($5 gain multiplied by 100 shares).
Short-selling of currencies differs from “shorting” stocks
Beginner traders should pay attention to the fact that short selling a currency pair differs from short selling a stock. Within the pair, currencies are traded one against the other. If we choose to trade GBP/USD and enter a long position in this pair, then we are actually buying the British pound and selling (shorting) the US dollar. If we are to enter a short position in this pair, then we do the opposite – we are buying the US dollar and selling (shorting) the British pound. Now we are short selling GBP/USD pair.
The very first step most new traders will want to take from the get-go is to dive into the market, and immediately enter into their first Forex position as quickly as possible. Having understood the majority of basic terms and how to enter a position, a beginner trader should also be aware of the risk management aspect of their trading idea.
Proper risk management is imperative to any trading plan, and allows the trader to know exactly where he/she wishes to exit the market in the event that price turns against him/her. Thats why well focus on better understanding the Risk/Reward ratio.
The Risk/Reward ratio refers to the amount of profit an investor expects to gain on a position, relative to what he is risking in the event of a loss. Knowing this ratio can help traders manage risk by setting expectations for the outcome of a trade prior to entry. The key here is to find positive ratio for your strategy. This way he increases the margin of profit when he is right, relative to the amount he loses if was wrong.
Number one mistake
Understanding these ratios can actually help newbies avoid the number one mistake that traders make. After reviewing more than 12 million trades, analysts were able to calculate that while most trades are closed at a profit, losses still far exceeded profits due to traders risking more on losing positions than the amount gained from a winner. This statistic shows that most traders are using a negative Risk/Reward ratio which requires a much higher winning percentage to compensate for their losses.
An example to avoid this scenario is to use at minimum a 1:2 Risk/Reward ratio. This maximizes profits on winning trades, while limiting losses when a trade moves against you. For example, if the trader expects a trade will likely produce at least double the amount risked, this would be referred to as a 1:2 Risk/Reward Ratio. Many look for this ratio to be at least 1:3 before taking a position in the trade.
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