AFXMarkets - stocks & trading
Depending on who you ask, there are varying definitions of what constitutes a successful forex trader and investor. Some believe that a professional trader is employed to trade, perhaps at a bank, broker or investment company.
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Where to Begin Trading And Investing
In many cases, those employed to trade at an investment firm are only responsible for placing trades under specific conditions that the company clearly defines. Other sources may consider a professional trader as someone highly skilled and consistently profitable; others will define a professional as someone whose full-time job and primary source of income will come from trading the forex market.
A profession is a paid occupation that involves specific skills and knowledge that can take years to be acquired. Being professional is associated with knowledge and skills required to undertake the profession. Anyone can become a successful trader without necessarily being a professional.
Like any skilled profession, becoming a full-time or part-time forex trader will require you to master the financial markets. In the sections that follow, we shall explore what becoming a successful forex trader entails.
Risk Management
Risk management is a cornerstone principle of investing. Many inexperienced traders focus exclusively on making a profit, whereas an experienced trader will see two critical objectives; achieve profits and limit losses.
If you cannot control your losses carefully, it really doesn’t matter how much money you make, because eventually, you will lose it. Successful traders pay a lot of attention towards their risk to reward ratios and position sizes.
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How To Analyse Markets
Before you can place a forex trade, you need to have a prediction and experienced traders but a lot of emphasis towards this part of trading. Without a specific plan of attack, you are simply gambling on whether you will make money, or not. Luck should never be a component of your decision-making criteria.
When placing a forex trade, you need to predict more than just whether the market will go up or down. Traders use different types of analysis to design what is known as trade setups. A trade setup predicts which direction the market will head, at what price the order should be opened, and the target to exit the position. When opening a trade, you need to decide where to place a take-profit, which is where the trade has succeeded, and the position should be closed profitably. You also need to decide at which point the trade has failed and should be closed to prevent any additional losses.
Traders use a variety of techniques to define precisely when to open and close positions. The categories of market analysis used by most forex traders are technical, fundamental and sentiment analysis. Each type of analysis can be combined to draw actionable conclusions about a specific financial market or security.
Technical Analysis
The centrepiece of every trading platform is a chart. The charts display historical price data of a particular security. Charts can display information in different formats; the most common chart type used by forex traders is a candlestick chart. Each candle reflects a variable period determined by adjustable settings, and the candle depicts the high & low and open & close price of the instrument.
Besides price information, other attributes can provide valuable information about the past and potentially future behaviour of a financial market. Technical analysis indicators can show information about changes in trading volume and how quickly prices have moved over a period of time.
Traders have dozens of technical analysis indicators at their disposal. The popular MetaTrader 4 platform has 30 technical analysis indicators, and the AFXMarkets trading platform offers 48 indicators.
Successful forex traders have a carefully curated toolbox of preferred technical indicators and tools. Indicators can be used to confirm the direction of a trend, indicate when a trend might stop, start and change direction.
Fundamental Analysis
Fundamental analysis is a way to assess the fundamental value of a security. Fundamental analysis is a widespread technique used to evaluate what things are worth. For example, a chocolate bar doesn’t cost €0.70 because it €0.35 to make it and the manufacturer would like to double their money. Nope. It costs €0.70 because it is comparable with all the other chocolate bars in the market and is aligned with what consumers expect it should cost.
What things cost are usually related to what people are prepared to pay for them, rather than the underlying costs of producing the product.
Successful traders study numerous macroeconomic indicators. Factors that influence the value of a currency pair or a commodity could be job market statistics, manufacturing output, trade balances, retail sales figures, GDP changes, elections, wars, interest rate decisions and central bank policies.
Sentiment Analysis
Sentiment analysis observes the actions of the market. Sources of sentiment analysis can be from different forex trading platforms that show the ratio of traders who are committed to the market going up with buy positions or are committed to the market going down by holding short positions.
Another source of sentiment analysis could be looking at the futures and options markets. For example, suppose there are many short futures or options contracts open. In that case, it could indicate that speculators expect the price of an asset to depreciate and intend to make a profit from the downside. However, it could mean the opposite too. Some traders may interpret that same situation as a corporation which physically holds the asset expecting the price to increase, but temporarily hedges some of the exposure.
Successful traders always take sentiment analysis with a grain of salt because of how subjective this form of analysis can be.
Risk to Reward
Just like in every business, risk and loss are ingrained. For example, let’s consider a restaurant. The restaurant serves twenty dishes and has enough ingredients to prepare twenty portions of each dish every day. The restaurant serves 100 customers per day. This means the restaurant has enough ingredients to prepare 400 meals but will only sell 100. Therefore, the restaurant ensures it makes a profit of at least 1:4 cost-to-reward on every meal sold. The additional revenue offsets the losses.
In reality, it would be much more complicated as labour, utilities and other expenses would need to be considered in the overall cost, but the principle remains the same; to make a sale, there is a cost and a risk.
Imagine if the restaurant had too many salmon fillets left and decided to lower the price to prevent losing money, meanwhile, there is only one steak left, so it decided to increase the cost to make more money. Doing so would not be an effective tactic and would result in a mess and most likely a loss. Risk management, as the name suggests, the practice of managing risk.
Much like how in the restaurant example, not every portion will be sold, not every forex trade you place will be profitable. Successful traders exercise a strict risk-to-reward policy to ensure that profitable trades will always offset the losses of the unprofitable ones. Therefore, traders follow something similar to a ratio of 1:4 risk-to-reward.
Position Sizing
The size of your position is directly correlated with the risk it presents. A larger position means a greater amount of exposure to the market, and small price movements can significantly impact profitability. See below an example of two positions, both are for the same instrument and have the same entry price, but the first is losing $1 while the second is losing $100.
Position 1
Position 2
Larger position sizes do not just affect profit and loss, but also margin consumption. If your positions are too big, you run the risk of missing other trading opportunities since all your available trading capital is allocated to maintaining just one position. Another even more critical reason is that larger positions in drawdown pose the risk of triggering margin-call or stop-out. Let’s consider a more advanced example that considers account balance margin too.
Position 1
Position 2
As you can see from the example above, by having a larger position, any pullback can have severe effects on a trading account. That is why experienced forex traders focus heavily on their position size by adopting rigid rules on how much they are prepared to risk for each trade. Some traders might, for example, impose a limit of not risking more than 2% of their account balance on each trade. Position #2 is in clear violation of this rule; however, position #1 is well within the parameters of a 2% risk allowance.
Trading Portfolio
Most online trading brokers (AFXMarkets included), offer dozens of currency pairs and hundreds of other financial instruments. Different instruments behave differently depending on the time of day, the week, or the season. Each instrument can have distinctive characteristics too.
For example, the characteristics of a stock market index like the S&P500 could keep trending up indefinitely. A currency pair like EUR/USD is likely to trade within a certain range unless some catastrophic macroeconomic situation destabilised either the euro or the dollar.
Some instruments may have wider spreads which can make some trading strategies unfeasible. For example, exotic European currencies like EUR/HUF, EUR/CZK have wider spreads than other currency pairs like EUR/USD and would therefore be harder to trade using a scalping strategy.
Some currency pairs have positive and negative Swap rates. A Swap rate is similar to an interest rate that you pay or collect when holding a position overnight. If a Swap rate is negative, you pay interest for boring a currency to hold the position overnight. If the rate is positive, you earn interest on the currency you are holding. Swap rates can vary significantly depending on the instrument, and it can affect your ability to trade profitably. If you plan on holding positions for a few days, Swaps can either take from or add to your profits.
An experienced trader will need to understand the unique characteristics of each financial instrument they trade. Many expert traders focus on trading a few specific products to become a specialist in those markets.
Trading Strategies
A forex trading strategy is a plan of attack for approaching the markets. A trading strategy encompasses all variables involved in making trading decisions. A robust strategy should define which forms of analysis should be used and how to interpret information. A strategy will also determine what instruments will be traded and when, how big orders should be and the risk-to-reward ratio that should be followed.
A trading strategy is crucial for maintaining consistency. Without consistency, there is no way to retrospectively analyse the performance and pinpoint areas which could be improved.
Successful traders maintain journals of their trades and try to understand why some trades failed and how others succeeded. Making changes to a strategy requires delicacy because one minor modification could throw everything off balance.
Trading Psychology
Trading forex and CFDs is a rollercoaster. The one thing that keeps the trading analysis, risk management, trading portfolio and overall strategy tied together is the ability to stick to follow a plan and not listen to your emotions.
Losing goes hand in hand with trading forex, and that is a feeling many traders struggle to overcome. Even when trading with minimal position sizes and losing a few dollars may be inconsequential to your finances, but the feeling of failure can be consuming. As opposed to having a robust and long term strategy, some traders fall victim to the disposition effect. The phenomenon leads traders to close profitable trades early, do they feel like they won, or rather didn’t lose. Meanwhile, they let losing trades run for too long because they do not accept they were wrong, and this results in a larger loss.
Without a comprehensive trading strategy and the commitment to follow it, your decisions will be governed by the hundreds of biases that pollute the human mind, all of which are prepared to sabotage us.
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