Handbook On Forex Trading

Handbook On

FOREX TRADING An Easy Guide To Profitable Currency Trading Nicholas Tan

First Published May 2007 Reprinted June 2008 Reprinted June 2009 Published and distributed by: Rank Books Blk 1002 Toa Payoh Ind Pk #07-1423 Singapore 319074 Tel: 65-62508180 Fax: 65-62506191 Website: www.rankbooks.com Email: admin@rankbooks.com ISBN 978-981-05-7936-4 Cover Design and Typeset: Nathania Fransiska Susilo All Rights Reserved. No part of this publication may be reproduced or copied in any form or by any means - graphic, electronic or mechanical, including photocopying, recording, taping or information retrieval systems - without written permission of Rank Books.

ii

Conditions of Sale: This book is sold subject to the condition that it shall not, by way of trade or otherwise, be lent, resold, hired out or otherwise circulated without the publisher’s prior consent in any form of binding or cover other than that in which it is published and without a similar condition including this condition being imposed on the subsequent purchaser.

While every reasonable care is taken to ensure the accuracy of information printed, no responsibility can be accepted for any loss or inconvenience caused by any error or omission. The ideas, suggestions, general principles, examples and other information presented here are for reference and educational purposes only. This book is not in anyway intended to give investment advice or recommendations to trade. The author or publisher shall have no liability for any loss or expense whatsoever relating to investment decisions made by the reader.

Acknowledgement: Special thanks to OANDA Corporation for granting the publisher the right to reproduce the charts which appeared in this book.

Dedication

This book is dedicated to all my students, past and present, who have given me the confidence and inspiration to write this handbook.

iii

About the Author Nicholas Tan has more than 13 years of experience in the treasury departments of major banks. Armed with a degree in business administration from the National University of Singapore in 1989, he started as an assistant dealer. Working his way up to Vice President, he made millions for the banks he worked for. Since 2002, Nicholas has been trading his own account and has coached numerous individuals on forex trading. With five years of personal trading and 13 years trading for banks in Singapore, Nicholas has a wealth of experience and knowledge in forex trading.

iv

Preface The forex market may be the biggest market in the world, but not many people know of it or even trade it as compared to the stock market. Forex trading is an exciting alternative to the stock market. This market was once confined to banks and high net worth individuals but with the advent of the internet and broadband, retail forex trading is now within the reach of many individuals. With a deposit of less than US$3000, which enables you to trade an amount of US$200,000, and online brokers providing 100 times leverage on the margin deposit in many cases, forex trading has become the playground of many small time retail players.

The aim of this book, Handbook on Forex Trading, is to provide you with the knowledge and skills while guiding you through forex trading. You will learn how the forex market works, the basics of charting, how to trade, and when the best time to trade is. By explaining to you the FX terms and basics involved and guiding you through opening an online trading account, teaching you various useful chart patterns and technical indicators and infusing you with money management and trading discipline, this book is an invaluable help in shortening your learning curve and giving you a jumpstart on your road to forex trading.

This book will cover the following and more: 1. Introduction to the forex market This will give you an understanding of what forex is, as

well as the main players involved in this forex market. To get you started in FX trading, you will be introduced to FX basics and terms, as well as the fundamentals and news that move forex rates.

2. How to understand basic chart patterns and technical indicators Condensed into three chapters in this section is heaps of information on chart patterns and candlestick patterns useful for forex trading. An additional chapter will guide you on the technical indicators the majority of FX traders use.

3. When the best time to trade is In this section, you will put your new knowledge into a practical plan. You will learn to combine chart patterns with technical indicators to eke out synergies. You will learn about the various currency pair characteristics and

vi

when is the best time to trade these currency pairs.

4. Getting started in forex trading Here’s where you can get help and tips on choosing and opening an online forex trading account, be it a standard account or a mini account. In another section, you will learn to use the various types of forex orders.

Free sources of information and their websites will be provided to get you started as well.

5. How to manage risk and increase your profit Learn how to increase your winning percentage in forex trading and about the importance of discipline in forex trading.

Filled with real charts and proven trading techniques, this practical handbook will show you how to trade profitably.

Master these techniques of trading and enjoy the great rewards that await you in the forex market!.

Contents

Chapter 1 Introduction to Foreign Exchange

1

Chapter 2 Understanding FX Basics

13

Chapter 3 What Moves FX Rates?

23

Chapter 4 Basics of Charting

35

Chapter 5 Chart Patterns

49

Chapter 6 Using Technical Indicators in FX Trading

77

Chapter 7 Putting It All Together

101

Chapter 8 When Is the Best Time to Trade?

113

Chapter 9 Choosing an Online Broker

135

Chapter 10 Money Management

149

vii

viii

INTRODUCTION TO FOREIGN EXCHANGE

chapter

01

introduction to foreign exchange

HANDBOOK ON FOREX TRADING

inside this chapter:

- What is forex?

- The FX marketplace - Main players in the FX market - What are the attractions of trading FX? - Is FX suitable for you?

INTRODUCTION TO FOREIGN EXCHANGE

chapter 01

introduction to foreign exchange

What is Forex?

Foreign Exchange, or FX as it is commonly referred to, involves the simultaneous buying of one currency and the selling of another. Currencies are traded in pairs, for example US Dollar/Japanese Yen (USD/JPY). When you buy US dollars, you are selling Japanese Yen in exchange for the US dollars. You can buy your currency from the moneychangers or go to the banks. This is the FX marketplace you are familiar with. For the majority of us, our knowledge of FX extends only to changing currency when we need it or when we want to go to another country. By changing currency, you are playing a part in this market. However, FX is much more than this, and it is a huge marketplace of which we only know a fraction. Hopefully, by the end of this book, you will know enough of FX to trade in it.

HANDBOOK ON FOREX TRADING

The FX Marketplace At the core of the FX market, there is a network of banks, which trade against one another. This is known as the interbank market. This interbank market accounts for the bulk of daily FX volume, which amounts to US$3.2 trillion daily. The banks trade directly among themselves through a network of dealing stations. Each bank has a unique code through which other banks can make contact and connect directly with to carry out their trades. They can conduct their trading through an electronic broker called the Electronic Broking System (EBS). Banks will conduct their buying and selling by placing their buy orders and sell orders in the electronic broking system, where buy and sell orders of the same

price are matched. If prices cannot be matched, they will be put in the queue. Prices will remain in the queue till they are matched or withdrawn.

Bank A

Bank D

EBS

Bank B

Bank C Hedge Fund B

Online Broker

Money Changer

Retail Trader A

Retail Trader B

Retail Trader C

Fig 1.1 The FX marketplace and its participants.

Hedge Fund A

INTRODUCTION TO FOREIGN EXCHANGE In the interbank market, this buying and selling of currency continues 24 hours a day from Monday to Friday. In a week, starting from Monday, the market will open with Australia and move on to Asia, when Tokyo, Hong Kong, and Singapore come in. When Europe comes in, activities will move over to Europe as Asia calls it a day.

New York will join in when it opens, and when New York officially closes at 5 p.m. New York time, it is the end of a day in foreign exchange. After the close of New York, it is back to Australia again to start another day cycle.

This continues till New York closes on Friday evening at 5 p.m. This will end a week in FX. If we were to convert all these into Singapore time, the FX market would have started at 6 a.m. Singapore time on Monday, with trading continuing through till 6 a.m. of Saturday morning. When there is daylight savings in Europe and USA, the hours will be from Singapore 5 a.m. on Monday morning to 5 a.m. of Saturday morning. Daylight savings starts in March and ends in October.

Day 1

Day 2

SINGAPORE TIME 0500

0700

0900

1100

1300

1500

1700

1900

2100

2300

0100

Sydney/Aust Tokyo/HK/Singapore Europe/London New York Fig 1.2 A daily cycle in the FX.

0300

0500

0700

HANDBOOK ON FOREX TRADING This goes on for 363 days a year. There are only two holidays a year for the FX market. They are New Year’s Day and Christmas Day. For these two holidays, the majority of trading centres in the world are closed so there is no trading. At other times, when there is a holiday in one country, it may not be the case with another country. FX trading in the world will continue as usual with other trading centres. If there is a public holiday in Tokyo, there is still the FX market in Hong Kong and Singapore to make up the numbers. Just in case you might wonder, if the United States is closed for a holiday, Canadian centres like Montreal and Toronto will still be opened to trade. Liquidity, of course, would be lower without Uncle Sam.

Main Players in the FX Market Banks and Central Banks The main players in this big FX market are the banks.

Banks employ many traders to trade on the banks’ proprietary accounts. These proprietary traders trade currency to generate profit for the bank. Banks also act on their customers’ orders to buy one currency against another for commercial and trading purposes.

Governments and their central banks also buy and sell currency to hold as reserves. For example, when one central bank decides to reduce their US dollar holding and wants to increase their Japanese yen holding, the central bank will sell US dollars against the Japanese yen.

INTRODUCTION TO FOREIGN EXCHANGE In this way, the central bank increases its holding of yen and reduces its US dollar holding. They might want to do this if they think the US dollar will weaken. What they are trying to do is to protect the country’s reserves.

Another reason why central banks are active in the FX market is to moderate the strength or weakness of their country’s currency. The Monetary Authority of Singapore (MAS), which is the central bank of Singapore, tries to intervene in the FX market when they think the Singapore dollar movement is excessive. Similarly, the People’s Bank of China will try to sell the yuan when the yuan appreciates too much against the US dollar.

Investment Funds and Hedge Funds In the FX market, there are hedge funds speculating in currency value. They will buy or sell a currency if they think it will appreciate or depreciate in value over time. One of the most famous of this hedge funds is the Quantum fund, whose major shareholder is George Soros. Mr Soros made his name in the 1990s, with the most famous example being his bet against the Bank of England. He made a cool USD two billion out of speculating on the Sterling pound depreciation. Most big hedge funds will, to a certain extent, speculate in currency. FX is the biggest market in the world in terms of volume turnover. The FX market is able to accommodate their large trading size, which may not be possible in the equity market or futures market.

HANDBOOK ON FOREX TRADING Companies Companies have a part to play in the FX market. Let’s consider the example of Singapore Airlines: SIA will need to pay for the cost of purchasing Boeing airplanes. SIA would have to buy US dollars from a bank to pay for their airplane purchase unless Boeing agrees to accept payment in Singapore dollars. But if Boeing were to accept payment in Singapore dollars, they will still need to convert the money to US dollars. Boeing will need to pay their US workers in US dollars. Similarly, an exporter in Singapore will receive their payment either in US dollars or Singapore dollars. If they were to receive their payment in US dollars, they will need to convert it to Singapore dollars.

Retail Trader Not least of all, there is the small retail trader, who is out to make some money from FX trading. Not too long ago, FX was out of access to the small retail trader. It was the arena of the banks and other big participants.

However, with the rise of the Internet and fast and cheap broadband, the scenario has changed. The small retail player is now able to participate in this FX market without handicap compared to the big players. Brokers are able to provide this continuous price feed to small retail players at a low and affordable cost. Brokers have gone online with their own trading platforms. These sophisticated online trading platforms are able to offer quick access to prices and information. This has brought

INTRODUCTION TO FOREIGN EXCHANGE FX trading to the small retail trader in the late 1990s.

The number of brokers has mushroomed in recent years. As a result of this, costs have decreased for the small retail FX trader. Today, most online brokers offer commission free trading for their clients. The spread has also narrowed to two to three pips for the major currency while in the past it used to be five to seven pips. There is no better time to get started in FX trading. (more explanation of pips in page 19).

What are the Attractions of Trading FX? There are many reasons for you to get hooked on FX trading.

1.

The market is open 24 hours a day. As the market is opened 24 hours a day, you will be able to find a time window to trade. When you are free, after all your work has been done, you can switch on the computer, login to your online trading platform and start trading. It could be in the evening for the busy office worker. From 8 p.m. to 11 p.m. there will be opportunities to make some money. Unlike the stock market, when the office worker would have to juggle his office duty and watch the stock prices during office hours, FX allows him to watch and trade the market without distraction during his free time. For a housewife out to make some extra income, FX is another alternative besides the stock market when their children are in school.

HANDBOOK ON FOREX TRADING 2.

The daily volume for the FX market totals USD 1.7 trillion a day. That is more than the volume of NYSE, NASDAQ, and the London equity market combined.

There is no reason for you to worry about a lack of liquidity.

3.

Unlike stocks, the four major currency pairs account for a substantial amount (70%) of the FX volume. You just have to concentrate on the four major currency pairs. Time spent on analysis will be confined to the four major currency pairs. You do not have to waste time analysing countless companies.

10

4.

There is a good daily range to keep you happy as well. The usual daily range for Euro/USD is close to 100 pips. Only on a few days a month will the daily range be less than 100 pips. Even when the daily range falls below 100 pips, it will have at least 80 pips.

5.

Unlike Singapore stocks, where short selling is prohibited, in FX there is equal opportunity in both long and short. There is no restriction on short selling. You can short a currency pair and hold it for as long as you want so long as your margin is able to support it.

INTRODUCTION TO FOREIGN EXCHANGE 6.

Small capital with great leverage is provided. Most FX trading platforms provide great leverage for you to trade currency. Most platforms need you to put up only a 2% margin deposit. That is as good as 50 times leverage. Many brokers will provide 100 times leverage. At this ratio, you only need a margin of USD 1,000 to short USD 100,000 against the Japanese yen.

7.

When using online trading platforms, your trade execution is almost instantaneous. Once you submit your buy or sell market order, the platform will report back to you in a second or two on your order execution. Your broker’s platform is likely to provide news information and charting as well. You do not need to incur additional monetary cost to subscribe to news and charting software. By just putting up a margin deposit with your broker, you will be ready to start trading.

Is Forex Suitable for You? Unlike the stock market, forex has higher risks to the new investor. To a new forex investor, the product itself is new. His knowledge of forex is next to nothing. Little is reported in the newspapers daily except when there is a major event.

11

HANDBOOK ON FOREX TRADING There are few or no rumours in the market for the trader to depend on. Even if there are any rumours, the forex market would be very fast to factor in these rumours.

Passed down rumours would not be fast enough for those further down the line to profit from it. Real trading skill is needed. Charting skill and knowledge would come in handy.

The forex rate movement is fast and at time furious and as a result, stress level is higher than that in the stock market. It is certainly not for the faint-hearted. As forex trading involves leverage, profits and losses are magnified. One would have to be disciplined to control losses and not let losses ruined his financial standing.

12

UNDERSTANDING FX BASICS

chapter

02

understanding FX basics

13

HANDBOOK ON FOREX TRADING

inside this chapter: 14

- The spot FX market - Transaction and settlement date - Rollover - Currency pairs - Reference and quote currency - Pips - Bid and offer - Spread - Profit and loss

UNDERSTANDING FX BASICS

chapter 02

understanding FX basics

The Spot FX Market When we trade the FX, it is usually the spot market that we are involved in. The rate that we see changing almost every second on our broker’s online trading platform is the spot price. It is also referred to as the cash rate.

Transaction Day and Settlement Date When we purchase or sell a currency pair at the rate we see and trade, there is an exchange date or settlement date. The day you trade is the transaction day. The day of settlement is two trading days after the transaction day. Taking the example of the USD/JPY, if we purchase USD/JPY on 3 Jan 2007 (Wed), the settlement will be on the 5 Jan 2007 (Fri), which is two trading days later.

Saturday and Sunday are not trading days, so if the

15

HANDBOOK ON FOREX TRADING transaction date is on a Friday, the settlement date will be on a Tuesday.

Rollover After your transaction, if you do not close or square your position on that same day, but instead choose to close your position one day later, there will be a different settlement date. Your opening position’s settlement date would not be the same as your closing position settlement date. Your broker will roll over your opening position settlement date to the next day so that both your opening and closing position settlement date is the same. You will either have to pay interest or earn interest 16

depending on your position. If you bought a currency that pays a higher interest rate than the currency you sold, you will earn interest. If you are holding a currency that has a lower interest than the one you sold, you will have to pay interest.

Currency Pairs The four majors Currencies always trade in pairs. You buy one currency and sell the other currency in the pair. There are many pairs of currencies, but these pairs are the most highly traded. (See Table 2.1). These four majors alone account for 70% of the USD 1.7 trillion daily volume.

UNDERSTANDING FX BASICS The Four Major Currency Pairs

Symbols

1. Euro Currency/US Dollar

EUR/USD

2. Great Britain Pound/US Dollar

GBP/USD

3. US Dollar/Swiss Francs

USD/CHF

4. US Dollar/ Japanese Yen

USD/JPY

Table 2.1 Highly traded currency pairs.

Other currency pairs Besides the four majors, there are many other currency pairs. They are sometimes referred to as the minor currency pairs. Here are some examples: Asian Currency

Symbols

1. Australian Dollar/US Dollar

AUD/USD

2. US Dollar/Singapore Dollar

USD/SGD

3. US Dollar/Korean Won

USD/KWR

4. US Dollar/China Yuan

USD/CNY*

* Some brokers use CNY, while some brokers use RMB

Others

Symbols

1. US Dollar/South African Rand

USD/ZAR

2. US Dollar/Mexico Peso

USD/MXN

3. US Dollar/Swedish Krona

USD/SEK

Table 2.2 Minor currency pairs.

17

HANDBOOK ON FOREX TRADING Cross currency pairs Cross currency pairs are currency pairs that do not involve the USD. Some examples are: Euro Cross Currency Pairs

Symbols

1. Euro Currency/Japanese Yen

EUR/JPY

2. Euro Currency/Swiss Francs

EUR/CHF

3. Euro Currency/Great Britain Pound

EUR/GBP

Other Cross Currency Pairs

Symbols

1. Malaysian Ringgit/Singapore Dollar

MYR/SGD

2. Singapore Dollar/Thai Baht

SGD/THB

3. Australian Dollar/NZ Dollar

AUD/NZD

4. Great Britain Pound/Japanese Yen

GBP/JPY

Table 2.3 Cross currency pairs.

18

Reference and Quote Currency reference currency

quote currency

USD/JPY 119.68/70 Sell USD

68

bid price Fig 2.1 USD/JPY example.

70

Buy USD

ask price

UNDERSTANDING FX BASICS In the example on the USD/JPY, the USD is called the reference currency while the JPY is called the quoted currency. The reference currency is the first of the two currencies while the quoted currency is the second currency of the pair. Profit or loss is always in the quoted currency. The transaction amount is usually denominated in the reference currency. Example: USD 100,000/ Japanese Yen 11,970,000. The transaction amount is USD 100,000. Profit and loss would be in Yen amount.

Pips The smallest movement is one pip. In EUR/USD terms, one pip is equivalent to 0.0001. In most currency pairs, it is the fourth decimal placing. However, in USD/JPY, one pip is equivalent to 0.01. For Yen related currency pairs, one pip is the second decimal placing.

Bid and Offer Your online broker will quote you a price. E.g. 119.68/70.

When you want to buy USD/JPY, you will have to buy at the asking price or the ask price. This would be 119.70.

When you want to sell, it will be at the bid or buying price. This would be 119.68.

19

HANDBOOK ON FOREX TRADING

Spread The difference between the bid and ask price is the spread. In the above example 119.68/70, the spread would be two pips. The spread is the price you pay to your online broker. Most online brokers do not charge any commission on FX trading. Instead, they earn their money from the spread when you trade. Thus, when choosing any online broker, it would be an important consideration to look at the spread. The narrower the spread, the more you would save and also the faster for you to breakeven on your trade.

Profit and Loss 20

Unrealized/Realized Profit and Loss If your position is still open and losing money, it is considered as unrealized loss. If your position is making money, it is considered as an unrealized profit.

Once you close your position, there will be a profit or loss; this is called the realized profit or loss.

Using the EUR/USD as an example: Buy EUR/USD @ 1.3101 Buy EUR 10,000 Sell USD 13,101 Sell EUR/USD @ 1.3102 Sell EUR 10,000

Buy USD 13,102

Difference

USD 1 Profit

0

UNDERSTANDING FX BASICS When you are trading on a size of EUR 10,000, the profit and loss for every pip would be USD 1. If you are trading on a size of EUR 100,000, every movement in pip would cost you USD 10.

Below is another example on the USD/JPY: Buy USD/JPY @ 118.01

Buy USD 10,000 JPY 1,180,100

Sell USD/JPY @ 118.02

Sell USD 10,000

JPY 1,180,200

Difference

0

JPY 100 Profit

In the above two examples, I have used the difference of one pip to illustrate what one pip would mean to your bottom line; your profit and loss. However, in trading, due to the spread quoted and earned by the online broker, you would need more than one pip to make a profit. If your online broker quotes you a spread of two pips for EUR/USD, you would only make a profit if the EUR/USD were to advance more than two pips.

In fact every time you enter into a position, you will notice that you are making a loss on your entry position. This is due to the spread. The trading software will calculate your profit and loss in real time. Assuming you close the position immediately and the rate remains unchanged, you would lose two pips when you sell out. If you refer back to the section on spread, when the spread of USD/ JPY is two pips, 119.68/70, you need to buy at 119.70. If

21

HANDBOOK ON FOREX TRADING you want to sell immediately, assuming that USD/JPY rate remains unchanged, you would have to sell at 119.68. That is why you always start your position with an unrealized loss. That unrealized loss is equivalent to the spread of the currency pair. In this case, the unrealized loss would be two pips.

22