Forex Trading
Understanding Forex Orders
One thing that you must understand about orders is that when you buy or sell short,
you are simply exchanging 1 currency for another. For instance, consider the Euro/dollar
currency pair, which is expressed as EUR/USD. (Short tutorial: Currency Quotes) EUR is the base currency
and USD is the quote currency. Since this is the most actively traded currency
pair, most brokers allow you to trade it. When you buy EUR/USD, you are exchanging
Euros for United States dollars, and when you sell this pair, you are doing the
opposite—exchanging dollars for Euros. Note that buying EUR/USD is the same as selling
USD/EUR, and vice versa. (You do not have to worry about having Euros in your account
to buy dollars—the broker will take care of this for you automatically.)
Buy EUR/USD ≡ Sell USD/EUR ≡ Exchange Euros for Dollars
Sell EUR/USD ≡ Buy USD/EUR ≡ Exchange Dollars for Euros
If you initiate a transaction by buying, then you are going long in the quote
currency and short on the base currency. If you initiate an order by selling the
currency, then you are going short the quote currency and long on the base
currency. Therefore, perforce, if you are long in 1 currency, you must be short
in the other.
To close a position, you must reverse the transaction that opened your position:
selling the currency you bought, or buying the currency you sold short.
Order Types
Most, if not all, brokers provide for basic order types that are similar to orders
for stocks.
Market Orders
The most common order is the market order, which is to buy or sell at market.
Actually, what this means is that you are buying the quote currency at the brokers
ask price or you are selling short at the brokers bid price, which
is always lower than the ask price. This is how most brokers make their money, and
why they do not need to charge commissions. The spread is the difference
between the bid and ask prices. In most cases, the most actively traded pairs will
have the smallest spreads, and less actively traded currency pairs will have larger
spreads. Spreads also increase when there is increased volatility in the market,
even for frequently traded currency pairs.
As soon as you buy or sell short, the spread is immediately subtracted from your
equity, because if you immediately closed the transaction even before there are
any price changes, then you will lose the amount of the spread.
The problem with the over the counter (OTC) market is that
there is no market price that is the same for all brokers, because there is no central
exchange where bid/ask prices can be compared. Most brokers average the quotes from
several large banks, but these quotes can differ depending on the bank. The forex
dealer then widens the spread for their own profit. This is the "market price"
that your broker quotes. This is true even for those brokerages that are advertising
a no-dealing desk, where your quote, supposedly, is seen directly by the
participating banks. However, the forex dealer is still widening the spread, for
that is how brokers make their profits.
Another problem with market orders is that some dealers may give a trader a very
unfavorable price that could be 10 pips or more removed from what the trader could
see using the broker's software, and then see the price go right back to where
it was. Sometimes, the broker will even requote the price, giving you a different
price from what you thought you bought it at. This doesn't happen often, but
if it does, you should find another broker.
Entry Limit Orders
An entry limit order is an order for a currency pair that is away from your
broker’s bid/ask price. In other words, your limit order to buy is not your broker’s
ask price, or your order to sell is not your broker’s bid price.
Your order does not compete with any other orders. Only your broker sees your order—no
one else. So there is little point in trying to place an order inside the spread,
where the transaction price—either a buy or a sell—is between the bid/ask price.
Many trading platforms do not even allow such an order to be entered, but even if
they did, the broker probably won’t complete the transaction unless the market moves
enough in the direction of your order.
There are some forex brokers who are advertising a no dealing desk, where
your order is shown to some banks that are in the broker’s network, and, in these
cases, the trading platform does allow you to place an entry limit order inside
the spread, but even this is not really effective, because only a few big banks
see your order, and if it is a small order, they probably won’t have much interest.
This is in contrast to an American stock exchange, where the best bid/ask prices
from all participants is displayed in the system, allowing just about anybody to
see those stock prices.
Closing Limit Order
There is another type of limit order that closes a transaction—the closing limit
order—and, often, it is listed simply as a limit order by the trading platform,
but this is an order to close a transaction that has already been initiated. If
the initial transaction was a buy, then the closing limit order will be a sell,
and vice versa. It is not necessary to specify whether to buy or sell, since this
will be determined by the initial transaction. It is only necessary to specify the
price.
Closing limit orders are set to take profits, so if the quote currency was purchased,
then the limit order will be higher than the purchase price; if the quote currency
was sold, then the limit order will be less than the sale price. If the broker’s
relevant bid or ask price never reaches your limit order, then no transaction will
be triggered, and your position will remain open until you change the limit price
or change it to a market order.
Stop-Loss Orders
It is very difficult to predict currency prices or monitor a 24-hour market, and
so brokers offer the stop-loss order type as a way for traders to prevent
major losses by being able to set a limit at an unfavorable price to close an open
position before the losses become too great. Because stop-loss orders are placed
to prevent more losses, they are set on the other side of the limit order to take
profits. Thus, a stop-loss order for a purchase transaction to sell is set below
the purchase price, and a stop-loss order to buy for a short transaction is set
above the sell price.
Because of the spread, a stop-loss order for a purchase transaction must be placed
below the dealer’s bid quote, which is lower than your purchase price at the time
of the transaction. In fact, it should be placed low enough so that the random walk
of market prices will not trigger your stop-loss order before your limit order.
Many traders try to avoid this by not setting a stop-loss order, but this is a mistake.
The market could move counter to your expectations for a long time or by a large
amount, resulting in very large losses, which are magnified by whatever leverage
you are using.
Since currency prices are so unpredictable, it is wise, and most trading platforms
allow it, to set both limit and stop-loss orders with the initial order, whether
it be a market or an entry limit order.
FX Trading Platform
The way to actually trade with most forex brokers is over the Internet using their
software—the trading platform. The mechanics of trading and what currency
pairs you may trade is determined by the software. In addition to trades, the software
usually provides other information about your account, such as your balance, how
much margin you have used, and how much you have left. It shows all open positions
along with any stops or limits for those orders, and any entry limit orders to initiate
a transaction. The software may also have windows for news and messages, and may
provide a chat service so that you can get help.
The best way to learn the software is to use it to manage a practice account, where
the broker allows you to trade using real market data, but without using real money.
Good software should prevent you from making at least some mistakes, such as accidently
entering a buy price that is higher than the market price, for instance, with similar
constraints in setting limit and stop orders. Otherwise, mistyping something, or
misusing the software can be a costly mistake.
Conclusion
In the stock market, you can set time limits on orders, such as good till canceled
(GTC), or day orders, which are good for the day. However, because
the forex market is a 24-hour market from Sunday afternoon until Friday afternoon,
most orders placed with brokers are GTC orders.
Before you start trading with real money, you should practice with a practice account
first. This is the best way to ensure that you not only understand the trading platform,
but also understand forex transactions. Otherwise, you could end up with large losses.
You should also trade long enough to see how well you do. Don’t jump into it just
because you did so well with a practice account in your 1st week. You
were probably just lucky. Although forex is very popular nowadays, and there is
a great deal of advertising promoting it, the fact is, it is very difficult to make
money trading currency—unless you’re a broker!