Introduction to Foreign Exchange

What is Foreign Exchange?

The foreign exchange market is undisputedly the worlds largest market place with the average daily turnover in excess of US$4 Trillion. Operating 24 hours a day, 5 days a week the foreign exchange market does not operate on a regulated exchange, therefore is known as an OTC (over-the-counter) transaction. Most people at some point either when travelling or making an overseas purchase would have in some way participated in the FX market, however increasingly many are now turning to the FX market for the purposes of speculation, dealing at prices formerly only available to financial institutions. One of the prime advantages to trading foreign exchange is the sheer volume of market participants, in turn creating liquidity which cannot be matched by any regulated exchange-traded product or instrument. Like trading the share market, in theory the buying and selling of currencies is extremely simple buy low, sell high and vicar versa; however in practice learning the basics is essential before putting your hard earned cash on the line. Its worth noting trading currency when utilizing a broker such as GO Markets is very different to exchanging cash at your local money exchange. This guide is designed to give new or prospective currency traders with the very basics of trading Forex. Lets start by exploring the two primary categories of currency pairs available; Major Currencies or the majors are usually deemed to be made up of six different currency pairs from seven counterparts as detailed below you will notice they all include a currency relative to the value of the US Dollar. Euro vs. US Dollar US Dollar vs. Japanese Yen British pound vs. US Dollar Australian Dollar vs. US Dollar US Dollar vs. Canadian Dollar US Dollar vs. Swiss Franc EUR/USD USD/JPY GBP/USD AUD/USD USD/CAD USD/CHF

These currencies are seen to be the most actively traded in the foreign exchange markets; therefore often the most cost effective to trade given the spread between the buy and sell price narrower than that of their less trade counterparts. You will also notice each currency is

Introduction to Foreign Exchange

defined by a three letter abbreviation known as ISO Code (International Organization for Standardization) Minor Currencies or the minors generally consist of all other currency pairs and cross currencies. For example, we could classify the Euro against the Aussie dollar (EUR/AUD) as a minor currency or the New Zealand against the US Dollar (NZD/USD) can also be classified as a minor currency. Under the band of minor currencies you will also hear the term exotic currencies which may consist of irregular crosses such as the US Dollar against Turkish lira (TRY) or the Polish zloty (PLN). Often exotic currencies can demand a higher cost to trade, given the illiquid market conditions quite simply, the less participants that trade the currency, the greater the spread, therefore the cost. Below is an example of some of the minor currencies or cross currencies. Euro vs. Australian Dollar British pound vs. Japanese Yen Euro vs. Swiss Franc US dollar vs. New Zealand Dollar Australian Dollar vs. Japanese Yen British Pound vs. Swiss Franc EUR/AUD GBP/JPY EUR/CHF USD/NZD AUD/JPY GBP/CHF

The cost of doing business

Like trading in the share market, trading currencies also attracts a commission however, unlike share trading the commission does not come in the form of a monetary or dollar amount per trade. Instead, most FX providers will have a spread between the buy and sell price. The spread is the implied cost associated with trading the currency pair and highly contingent to the currency pair, market volatility and of course market participants. The bigger the spread, the greater the cost of doing the trade.

Its all about the pips!

When trading currency a profit or loss is measured in pips. For example, one pip movement when trading the AUD/USD pair is equal to a move from US$.9850 to US$.9851. To simplify, one Aussie dollar is equal to 98.51 US cents. On the GO Markets platform you will see the price of each currency will be expressed to the 5th decimal place. So if we look at EUR/USD, one Euro is equal to US$1.39545 Its important to understand the fifth decimal place is not a pip, rather

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Introduction to Foreign Exchange

1 tenth of a pip - or what the Meta trader 4 platform refer to as a point. Lets establish now what each pip is worth. Contract Values are used to express the amount of currency you would like to buy or sell. One Standard contract denotes 100,000 of the base currency, and 10 per pip of the second named currency (terms currency). You can choose to do multiple standard contracts or many providers such as GO Markets allow you to trade much smaller than a standard contract. For example, a mini contract which is worth 10,000 of the base currency and 1 per pip of the terms currency. An exception to these contract values need to be made when trading Japanese Yen pairs where each pip fluctuation on a standard contract will equal JPY1000. It is also imperative to understand which currency you are buying and which you are selling. For example when buying long the AUS/USD pair, you believe the first currency value will appreciate against the second. Or you may have a bearish view of the Australian currency, hence decide to sell or short the Australian dollar against the USD dollar which means you believe the first currency will depreciate against the second.

Margin Requirement
When placing a trade you do not need the full position value, rather, a smaller amount of funds often referred to as margin. This is simply the amount of collateral or funds required to hold your position. For example, if you buy one contract of the AUD/USD pair which has a notional value of AUD 100,000, you will only need a very small percentage of the value to make the trade. This concept is often referred to as leverage where you use a smaller amount of cash to control a larger valued asset. The margin requirement or leverage rate your forex broker may set will depend on a number of factors but you will find outside of the US the leverage rate of 100:1 or 1 per cent of your position value is common place. GO Markets allows leverage of up to 500:1. So this means to buy one contract of the AUD/USD pair you may only need AUD 200 as a margin requirement. Importantly, you will also need to be able to maintain any running losses; therefore, a buffer is prudent to ensure you are not prematurely taken out the market by means of a margin call. As you can imagine, leverage can work both for and against a trader, so it is important to consider the risks associated before taking the plunge and you can also choose to reduce the amount of leverage your account provides.

Swap | Rollover Rates

When you buy or sell a currency, a swap or rollover fee may be paid or received on a daily basis. This is simply the interest owed/paid to maintain your position, and the amount of which will

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Introduction to Foreign Exchange

depend on the relative interest rate yield of each currency. You are essentially using the currency you have sold to fund the currency you have bought. To get a little technical, you now need to look at the relative yields of each countries interest rate to gauge an understanding on if you are going to receive or indeed pay interest on a daily basis. If you decided to buy one contract of the AUD/USD pair at 9800 US, this means you are borrowing US dollars to fund your AUD 100,000 position. This is a particularly good pair to use as an example given the large interest rate yield differential. Lets use benchmark interest rates as at November 2010 for each currency to get a general understanding if we are due to pay or receive interest. The overnight cash rate set by the Reserve Bank of Australia is currently 4.75%, therefore you would expect AUD 100,000 dollars to earn at least at least 4.75% PA. On the other hand you are borrowing US dollars, given the Federal Reserve are attempting to stimulate US economy interest rates are near zero, therefore, theoretically the cost of borrowing is a lot cheaper. In essence, you are borrowing at rock bottom rates to fund a higher yielding asset hence interest should be paid to you. So to ascertain if you are due to pay or receive interest or swap on a currency simply, compare the interest rates of each country and check if you are buying or selling the currency with a higher yielding interest rate. You will also need to take into account swap calculations are not as simply as two interest rate differentials, often funding costs can be greater than that of the underlying interest rate.

Market analysis - fundamental vs. technical

Yes, it is an age old argument in equity markets and the FX market is certainly not immune to the same debate. However we are increasingly seeing traders opt for a combination of both as technical analysts acknowledge the important part market fundamentals play in price activity of a currency and vice versa. For example, price reaction to economic indicators such as Non-farm payroll data from the United States or an interest rate decision has the propensity to shift market sentiment thus resetting price action on a currency pair. Likewise, fundamental traders acknowledge the importance of technical mile stones such as past price activity which shows particular areas of support and resistance, or whether a currency is overpriced relative to the past trading activity. Technical signals can also bode well for a short term trader looking to take advantage any perceived anomaly in price activity or follow a basic trend. On the other hand, a fundamentalist can use a currency to take a longer term view of the relative economic health of each country. Whatever the case, youre always

GO Markets Pty Ltd | Level 16 | 114 William Street | Melbourne | VIC 3000 Free Phone: 1800 88 55 71 | Phone: +61 3 9670 3055 | info@gomarketsaus.com

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Introduction to Foreign Exchange

going to have staunch supporters of particular methods and if youve got more winning trades than losing youre on the right track. The below AUD/USD chart demonstrates how a news event can impact on price action, showing a steep ascent after the RBA increased benchmark interest rates by 25 bps to 4.75 per cent, the first increase in six months. With an overwhelming market majority expecting rates to remain on hold, the ensuing minutes saw the Aussie take a 1 US cent leap.

RBA Interest rate decision 2nd November 2010 - Subsequent minutes of the decision saw the Aussie dollar take a 1 US cent leap.

Trading the foreign exchange market profitably is hard but also can be rewarding. There are no guaranteed proven methods to assist investors but many successful traders adopt a simple disciplined approach and stick to the important rules of trading. These rules may seem easy to follow but in practice emotions when trading can run high. Remember to run your trading account like you would your own business, keep rational and by following the rules below hopefully you will keep profitable.

GO Markets Pty Ltd | Level 16 | 114 William Street | Melbourne | VIC 3000 Free Phone: 1800 88 55 71 | Phone: +61 3 9670 3055 | info@gomarketsaus.com

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Introduction to Foreign Exchange

The Golden Rules of Trading

There are a number of important rules to follow when you are trading in Forex, or any other market. Every strategy will involve different objectives and methods, but there are some key points to consider:

Have specific goals and objectives

Few things are more important to your trading success than having set (i.e. written) goals and objectives for what you are aiming to achieve. It is amazing how often we hit our targets, meet our objectives, and reach our goals only when we articulate them and write them down. For any business to be successful it must have measurable objectives that are actually achievable. In trading (obviously) the primary objective is to make money, but it is important to have other objectives that are not purely cash-related.

Be consistent and disciplined

In order to realize the full potential of your trading systems it is critical that you take every trading entry, adjust every stop, and close out every trade as and when your system says you should do. This takes extreme confidence in your trading systems, good robust reliable technology, and the mental discipline to stick to your trading plan whatever happens (assuming it is complete). An underlying assumption about being consistent and disciplined is that you have a pre-defined plan for every situation you may face in your trading, so that you know how you are defining what being consistent is. Your plan needs to include at least the following items:

All your trading rules for entering, adding to, and exiting positions What you will do if your trading computer, internet connection, broker, power, telephone etc. fails? What you will do if you are unable to trade?

GO Markets Pty Ltd | Level 16 | 114 William Street | Melbourne | VIC 3000 Free Phone: 1800 88 55 71 | Phone: +61 3 9670 3055 | info@gomarketsaus.com

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What you will do if you lose X% of your account? What you will do if all the markets are closed and you can't exit your positions?

Unless you write the answers down to all these issues, you cannot be consistent and disciplined in your approach to trading and if you lose money you will not know whether it is because you didn't follow your plan, because your plan is incomplete, because your systems do not work, or simply because you are going through a losing period.

Let profits run

This simple rule is the key to being a successful trader. It is three simple words that are very hard to actually implement. When we get a profitable trade our natural fear of losing the unrealised gains kicks in and we truly want to close it out now and take the money. Most trading consists of long periods of small winners and losers followed by a few huge winners that make the difference between overall profitability and simply breaking even or losing due to trading costs(commissions, spread, and slippage). The key to letting winning trades run is to have trailing stops that are outside the average daily range of the market so that they are not tight enough to get stopped out during 'normal' trading. This means being prepared to give up a significant portion of a winning trade's open profit and is the thing that makes this so hard to implement. Consider adding to clear winning trades if capital reserve allows and avoid stops that are too tight.

Cut losses short

This is the sister rule to the previous one, and is usually just as difficult to implement (although it is very easy to define). In the same way that profitability comes from a few large winning trades, capital preservation comes from avoiding the few large losers that the market will toss your way each year. Setting a maximum loss point before you enter the trade so you know before-hand approximately how much you are risking on this particular position is relatively straightforward. You simply need to have an exit price that says to you 'this trade is a loser and I will exit before it gets any bigger'. Due to gaps at the open, or limit moves in futures we can never be 100% certain that we can get out with our maximum loss, but simply having the rules, and always sticking to it will save us from the nasty trades that just keep on going and going against our position until we have lost more than many winning trades can make back. If you have a losing position that is at your maximum loss point, just get out. Do not hope that it will turn around. Why risk any more money on this losing trade, when you could simply close it out (accept the loss) and move on. This will leave you in a much better place financially and

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Introduction to Foreign Exchange

mentally, than holding the position and hoping it will go back your way. Even if it did do this, the mental energy and negative feelings from holding the losing position are not worth it. Always stick to your rules and exit a position if it hits your stop point.

Never add to a losing trade

This is certainly a rule thats hard to follow, especially is we have a strong view of the trajectory of a particular currency. Trades are split into winners and losers, and if a trade is a loser, the chances of it turning right around and becoming a winner are too small to risk more money on. If indeed it is a winner disguised as a loser, why not wait until it shows it's true colors (and becomes a winner) before you add to it. If you do this you will notice that nearly always the trade ends up hitting your stop loss and does not look back. Sometimes the trade turns around before it hits your stop and becomes a winner and you can count yourself very fortunate. Sometimes the trade hits your stop loss and then turns around and becomes a winner and you can count yourself unlucky. Whatever the result, it is never worth adding to a loser, hoping that it will become a winner. The odds of success are just too low to risk more capital in addition to the initial risk.

Don't take too much risk

One of the most devastating mistakes any trader can make is risking too much of their capital on a single trade. One thing is certain in trading and that is if you lose all your capital you are out of the game. Why risk so much you could be prevented from continuing? There is a saying in poker than going all-in (risking all your chips) works every time but once. This is true of trading. If you risk all your account on every trade it only takes one loser to wipe you out (and no trading method is 100% accurate), so you will be out of the game at some point - it is only a question of time. By its very nature FX trading involves leverage, your provider may require less than 1% initial margin to cover a position, but its wise to leave some slack on your account to avoid immediate margin calls if the trade goes against you. If you are worried about the size of a trade then it is too big and you should reduce the size immediately. Remember that longevity is the key to making money by trading - slowly over a long time with minimal risk, is always preferable to rapidly with too much risk.

GO Markets Pty Ltd | Level 16 | 114 William Street | Melbourne | VIC 3000 Free Phone: 1800 88 55 71 | Phone: +61 3 9670 3055 | info@gomarketsaus.com

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Only trade positive expectancy systems
If you have a positive expectancy trading system, the only factors that determine how much money you will make per year are the number of trades the system generates, how much capital you allocate to the system, and how accurately you implement the trading signals. If you do not know whether your trading system is positive expectancy then why are you trading it? Expectancy is calculated using the profit or loss on each trade (net of trading implementation costs) divided by the initial risk (using your stop loss) and then taking the average of this number of a series of trades. Systems that have positive expectancy will make money on average and those with negative expectancy will lose money. Successful traders only trade systems where the odds of success are in their favor (i.e. the system is positive expectancy) so they know that making money is the result of accurately implementing the system and not just pure luck.

Be educated
In order to compete at the highest level in the trading business and be one of the few truly successful participants you must be well-educated about what you are doing. This does not mean having a degree from a well-respected university - the market doesn't care where you were educated. Being well-educated means that you have thoroughly researched and tested your trading ideas and know why your trading system worked in the past and is continuing to work now. It means understanding all the technology and applications that your system needs to perform accurately. It means understanding your goal and objectives and how trading will achieve these. It means understanding yourself and how your personality affects your results. It means understanding the markets and instruments you trade. In order to succeed you really need to become an expert in your own trading business to understand how it all fits together, when it is broken, and how it can be improved. As with all worthwhile endeavors, this takes commitment, hard work, dedication, and more hard work.

GO Markets Pty Ltd | Level 16 | 114 William Street | Melbourne | VIC 3000 Free Phone: 1800 88 55 71 | Phone: +61 3 9670 3055 | info@gomarketsaus.com

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Don't trade scared money
No one ever made any money trading when they had to do it to pay the mortgage at the end of the month. Having a requirement to make X dollars per month or you will be financially in trouble is the best way to completely mess-up all trading discipline, rules, objectives and can quickly go awry. Trading is about taking a reasonable risk in order to achieve a good reward. The markets and how and when they give up their profits is not under your control. Do not trade if you need the money to pay bills. Do not trade if your business and personal expenses are not covered by another income stream or cash reserve. This will only lead to additional unmanageable stress and be very detrimental to your trading performance.

Take a break
The last rule may not seem obvious, but always take a trading holiday. This could mean a 2 week beach break or simply avoiding the markets for a few days to take a breather. The market will still be there on your return and you should be recharged from the break.

Summary
We have covered the rules that we believe should never be broken in trading. If you work on never breaking them, your trading style should improve dramatically.

Good luck and happy trading!

GO Markets Pty Ltd | Level 16 | 114 William Street | Melbourne | VIC 3000 Free Phone: 1800 88 55 71 | Phone: +61 3 9670 3055 | info@gomarketsaus.com

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