Winning in Today’s FOREX Market

Account Minimums

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Micro-accounts now start at $1—but realistically you need $300 to $400 even to trade 1k lots in FOREX mini-accounts (10k lots) are $1,000 to $3,000 and standard accounts (100k lots) typically begin at $5,000. ECNs tend to have higher minimums. This is a far cry from the days in the commodity futures markets where $5,000 was considered a mini-account and $25,000 was the standard. In FOREX the ability to set your own lot sizes and leverage make smaller accounts justifiable. Account size, leverage, and lot size should all work in harmony and be consistent; your broker-dealer monitors such parameters carefully in an effort to protect both parties.

The new NFA minimum margin requirements may impact minimum account sizes.

TIP: Your grubstake should be at least the equivalent of 30 trade losses and initial margin for a single trade. If you risk $50 per trade (50 pips on a mini-lot), you should have a $1,600 account. How much you risk per trade is determined by money-management parameters.

Order Backup

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Does your broker offer the capability to phone an order if their trader platform goes down or your Internet drops? Be sure that telephone order backup is available, although lines will be swamped if it is a system-wide outage and not your own Internet connection. If you open a mini- or micro-account, ask your broker to let you test a telephone order so that you know it exists and have the process down pat for when and if you need it. Keep in mind that brokers do not expect their platforms to go down often, and when they do, their backup systems tend to be overwhelmed.

TIP: Keep one secondary account with enough funding to cover whatever you expect your maximum exposure to be when trading. Be sure it is on a different FCM and data feed than your primary account.

Margin Requirements

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Because a trader can open an account from $1 to $1,000,000 and trade any size lot, margins and leverage are something of a misnomer in FOREX.

Broker-dealers allow you to set your own fixed maximum leverage— typically from 10:1 to 100:1. Dealers are mostly concerned that you do not hold open positions in excess of your account balance. If you do—or even come close—you will get a margin call, and you will be expected to meet it immediately. A broker may even liquidate part or all of your position(s) without informing you.

The lower the margin requirement, the higher the leverage factor. Profits and losses are magnified as the leverage is increased.

In reality today margin calls in FOREX are rare. Brokers are able to electronically monitor all parameters based on your account size, trading activity, and experience. If you attempt to enter an order outside of those parameters it will not execute. Big Broker is watching you!

Simple money-management rules—that you implement—are the key to avoiding margin calls and overtrading. In Chapter 16, “Money Management Simplified,” I offer the Campaign Trade Method for novices.

I recommend these basic four ideas to new traders: (1) never commit more than one-half of your account balance to open positions, (2) never trade more than two market pairs concurrently, (3) never commit more than 25 percent of your capital to a single position, and (4) never trade over 50:1 leverage. Begin your trading career at 20:1 and work up in increments of 10:1 as you are successful, and start with a demo account, move to a micro-account then to a miniaccount before committing your full grubstake. Experienced traders often modulate these parameters according to how confident they are of a trade. But that requires experience to make it an effective tool. New traders should keep the number of money-management parameters simple and to a bare minimum.

Orders (Traders use a wide variety of different orders for entry)

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Traders use a wide variety of different orders for entry, stop protection, and exit (price objectives). Our advice: Keep it simple. Thoroughly understand what an order does and how it works before using it. Many exotic order types add a level of complexity to the trading process that beginners normally do not need. Some orders also offer an extra license to the broker-dealer to manage their book; ergo, they generally love them and encourage them. Functionality of orders may differ slightly from market makers to ECNs.

You should be able to do everything you want with three types of orders: Market or Instant Execution, Stop, and Limits. Remember, speculative hedging is now prohibited for NFA member broker-dealers. You cannot simultaneously buy and sell the same currency pair.

I offer more detail on order placement and management in Chapter 9, “Making the Trade.”

Data Feed

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Application Programming Interface (API) is your broker-dealer’s price data stream from its liquidity providers—usually banks—made available for custom programming. What sources it is composed of is usually difficult if not impossible to ascertain. No two are identical. Market makers use a composite of sources—that may even include its own micro-ECN. But given the enormous liquidity of the market, they do not usually vary a great deal. The exception is when market makers requote.

Most brokers offer their API as a separate service. A trader would use the API to drive third-party software or his or her own software program. On the flip side, third-party vendors offer their services using various dealers’ API. It can be confusing. If you use a third-party program for trading or even just for your charts, be sure it has a one-to-one or close correspondence with your brokerdealer data stream. Rolling your own integration is strictly for experienced programmer gurus. New traders should probably avoid third-party integration, also.

APIs are becoming less and less important as the integrated trading platforms now offer robust scripting languages. NinjaTrader’s NinjaScript is a subset of C# with many additional functions, objects, and libraries specifically designed for trading system development.

Historical Data

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If you want to look at charts from months and years gone by, you will need historical data. Some brokers offer it in their trading platform, some as a separate service, and some not at all. For comprehensive historical data, you may wish to consider one of the data vendors in Chapter 13, “The FOREX Marketplace.” Historical data is available online, for download or on a CD. The vendor www.disktrading.com is a good value.

Both the MetaTrader and NinjaTrader platforms offer excellent tools for integrating historical data—and it is an easy task to import additional data, as needed.

The site www.disktrading.com offers historical data preformatted for all the major platforms—a big time saver!

Historical data is the inexpensive approach for developing and testing trading methods, systems, and theories. See the section Market Environments (ME) in Chapter 18, “Improving Your Trading Skills,” for approaches to effectively testing trading methods and systems.

Platform Stability and Backbone

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As we have mentioned above, trading platforms are enormously complex software programs. Real-time delivery of information is also a daunting task. Put those factors together and it is a minor miracle they work as well as they do. But . . . things happen. One of the biggest brokers had their trading platform crash for almost 24 hours in February 2007. Platform stability has improved enormously in the past few years.

What backbone is a prospective broker-dealer using—Windows, Java, Web-based, or Flash? Windows is the most stable, and Java is cross-platform if you are using a Mac computer. At one time Java platforms had a bad habit of crashing under heavy loads but that seems for the most part to have been remedied. If you use Java do not install the latest Sun update without getting the okay from your broker-dealer. Updates are supposed to be downwardly compatible, but there is a lot going on in a real-time trading platform. Having owned a web conferencing business, author Archer has been leery of Java, but it has improved a great deal recently.

Flash platforms are available, but they do not have the years of development behind them that Windows and Java platforms do. Flash platforms have potential, once developers in FOREX get a handle on the immense Macromedia tool set.

The Internet is not perfect. You should not trade online unless you have a high-speed Internet connection. A backup connection from a different vendor is a good idea if you are a serious trader. Cable is more reliable than DSL in most locations. Some brokers offer their platforms on multiple backbones and even recommend specific browsers for their Windows-based venues. Traders should also invest in a reliable battery backup power supply for their computer.

Once you are trading with substantial amounts of money and taking larger positions, consider opening a small secondary account with a different brokerdealer in a different country on a different backbone. Should your primary broker go incommunicado and you need to execute a trade, you have an out. In your due diligence process, after you have sampled four or five mini-accounts and select a primary broker you may consider leaving a mini-account open as a hedge.

Trading platform stability has improved enormously in the past few years, but you must still be prepared for the occasional interruption of service.

The Trader’s Desktop

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How easy is it to place and monitor your orders? View your charts and technical indicators? Most retail dealers do a great job of this but layout and organization vary. Those factors can be important depending on how you trade, especially if you trade frequently. Can that information be easily backed up or saved? Almost all broker-dealers and integrated platform vendors have this process down pat; much of your decision is a matter of personal style. (See Figure 7.2.)

FIGURE 7.2 Trading Platform Source: www.ninjatrader.com

Trading Tools

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Traders are fascinated by charts, numbers, and indicators, and most brokerdealers are happy to accommodate them. Downloading a demo account will give you a good idea of the toolset available. In a few instances the demo does not offer the entire palette so you need a mini-account to see and test drive everything. Not sure? Ask the broker.

Most platforms offer integrated charting and technical studies capability. For those platforms that do not, you need to access a third-party vendor. We recommend an integrated platform for the novice.

Unless you have a unique trading tool, the days of needing to access a broker’s platform for order entry and a separate platform for market analysis are coming to an end. Today’s platforms do all the integration for you.

Most of the popular indicators are available—moving averages, stochastics, relative strength, oscillators, Bollinger bands, and many others. (See Figure 7.1).

FIGURE 7.1 Technical Indicators Source: www.ninjatrader.com

Bar charts with a variety of settings for time frames and units are offered. The new MetaTrader-5 platform has 21 preset time frames and if that is not sufficient, you can custom configure more—as many as you like with NinjaTrader. Be sure the dealer has what you need; integrated charting capability is a must, especially for the new trader. Swing charts, candlesticks, and point and figure charts are also available.

Most platforms offer a palette by which you can customize the look and feel of charts. The size, scale, and coloring of charts can make a big difference to your interpretation of them. As an experiment, take a single pair with the same time scale and unit and make a half-dozen or so charts with different parameters. My advice to the beginner is to keep all charts in the same size and color scheme. Trading is an extremely delicate process, and even small differences matter.

It is best if you have some idea of what you want before beginning your due diligence. Some primary considerations: colors, sizing/scaling, time frames, vertical and horizontal scrolling, printing. As an old-time trader, the author still likes to print charts for analysis.

TIP: Do not let the plethora of indicators and charts overwhelm you. I recommend that you initially work with bar charts, moving averages, and an oscillator. Learn them one at a time. Once comfortable, pick an Indicator of the Week to add to your platform and study.

Platform Capabilities

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Perhaps most critical to the trader is a broker-dealer’s platform capabilities. Due diligence, vis-à-vis your needs, will take some time and effort on your part. Here is what to look for in several categories. Learn everything possible before making a trade. Demo accounts are ideal for this purpose. Many brokers now offer one of several standard trading platforms from independent vendors. The three most popular platforms are NinjaTrader, MetaTrader, and eSignal. If you find a platform you like you will want to endeavor to trade only with brokers offering that platform. The trend today is clearly toward everything under one roof—quotes, charts, indicators, order-entry, and programming.

FCM or IB?

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A Futures Clearing Merchant (FCM) is a full, licensed broker-dealer who has met the current $20 million NFA capital requirement.

An IB (Introducing Broker) is an independent who routes trades and uses the trading platform and clearing services of a larger FCM (Futures Clearing Merchant) broker-dealer. IBs now must also meet a modest capital requirement but they are still essentially a coattail on the FCM.

The rationale for using an IB is that they may offer a higher level of customer care or value-add services you want and cannot get from the brokerdealer. An example of a value-add IB is HawaiiFOREX (GFTFOREX), which offers a structured educational program currently based on the work of Joe DiNapoli; www.atcbrokers.com (FXCM) with a variety of platforms. Service can also be a legitimate reason to prefer an IB over its own FCM as in the instance of www.tradeviewforex.com (IKONGM) although in this particular case the FCM also offers excellent customer care. Of course, everyone in the chain wants to get fed although markups are generally quite small.

No two traders are alike, and the landscape is constantly changing. Broker recommendations per se are risky business. That said, the author’s consensus opinion is that the new trader should open a demo account with one of the Big Three, an ECN, a market maker, and perhaps an IB to get a good look at the broker-dealer landscape. If your FOREX career blossoms—and we hope it does—move on to one of the larger ECN brokers. It is now possible to actually start with an ECN, but I still recommend testing the waters with a market maker in the mix. See Appendix A, “How the FOREX Game Is Played,” which discusses the current issues of importance to traders with respect to brokerdealer structure and practices.

All of this said, over the past five years things have gotten better, not worse, for the retail FOREX trader. What is true today may not be true tomorrow—one reason most traders hold accounts with multiple brokers.

Market Maker or ECN?

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Market maker or ECN is the single most critical distinction between FOREX broker-dealers. A market maker, or dealer, is always the counterparty to your trades; an ECN requires an actual counter order for execution. Given the liquidity of the FOREX markets a counter order is only a problem in a very fast or very slow market or if you place an extremely large order. An ECN cannot play many of the games that market makers do—in large part they do not need to because they have no book to balance. But ECN trading also requires a more accurate and delicate trading touch—an additional skill that the trader must acquire.

Regarding market makers: Some are good, even very good; many are awful. Keep in mind what “counterparty to your trade” means. Then remember that market makers hold all the cards—the data stream, the dealing desk, or control via their liquidity providers with an NDD (No Dealing Desk), the trading platform, and all the tools—requoting, pip spreads, trading rules, dealer intervention, accepting or canceling trades—all for the supposed purpose of maintaining an orderly market. National Futures Association (NFA) Compliance Rule 2-43 has minimized some of these factors—but not eliminated them by any means. Progress is being made but continued excesses will make them the dinosaurs of the industry.

ECNs have their own issues—the biggest one is that their platforms are more difficult to learn and use effectively. They are often bare bones and require integration of third-party charting and technical services. But they have much less leeway because they are functionally trade matchers. In fast or slow markets liquidity may actually be worse with an ECN because they do not have many of the orderly market tools at their disposal. But on balance, I feel that once you have gotten your feet wet in FOREX shop for an ECN. Several retail brokers are offering ECN trading to even mini-accounts. How they bundle 10k lots into a 250k bank lot without intervention I have not fully determined.

The core issue—and the reason the author predicted in the second edition that market makers would lose ground to ECNs—is that market makers manipulate the book to maintain order. This involves a number of activities such as requoting, dealer intervention, and setting pip spread—as and when they please. Market makers trade against their customers—it is why and how they are what they are. A profit for you may well be a loss for them. What would you do with a customer who cost you money on a consistent basis?

Market makers set, manipulate, or control pip spreads usually as legitimate operations of the market-making process; ECNs generally do not. Many trading platforms—both market maker and ECS—provide depth of market (DOM): the ability to see standing buy and sell orders, the quantities and prices bid and asked. This can be valuable information if you learn how to use it properly.

To complicate matters some firms that are obviously market makers now advertise a no dealing desk. The author is unsure how such a hybrid operates; in some instances it appears to be nothing more than semantics in an effort to shake the market-maker moniker. Lack of regulation makes knowing how a broker-dealer processes trades difficult if not impossible. The author queried five such brokers about this process and received no response from four of them and what can only be described as “mumbo-jumbo” from the other one. More and more brokers are attempting to distance themselves from the market-maker label, but whether they are actually making any significant changes to how they execute trades remains a question in many instances. You will hear the term liquidity provider from both ECNs and market makers. For a market maker it really has little meaning but it sounds good. It does not matter how many liquidity providers a broker-dealer has if it stops the feed to sniff and/or manipulate it before passing it through to the customer.

In reviewing the fine print of account forms you notice that even ECNs withhold the right to intervene as market makers. Yes, it is confusing! In FOREX, ultimately, “You pay your money and you take your pick.”

Demo Accounts

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Always start with a Demo Account! All retail FOREX brokers offer these accounts. This account allows you to preview most of the broker’s platform features and become familiar with how charting, indicators, order placement, and accounting are handled. Do one survey of demos to decide which brokers to take to the next level with a micro-account or mini-account. Typically a microaccount allows for trades of as little as 1,000 units; a mini-account, for 10,000 units. There may be some difference between the demo account and a real-time account, especially in the data-feed and order types; make an effort to find out what these are for each broker on which you do due diligence.

Broker-Dealer Due Diligence

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Retail brokers can be divided into market makers (dealers) and ECNs (Electronic Communications Networks). ECN is the way the true Interbank market operates. ECN brokers can have from one to a dozen liquidity providers. Market makers now also speak in terms of liquidity providers to avoid the stigma of the market-maker moniker. Each approach has advantages and disadvantages. Most retailers are still market makers, but more and more are venturing into the ECN world. The Big Three (see below) now offer a market-maker venue to small traders and an ECN venue for their larger and institutional clients. Market makers are going to be better at providing liquidity in slow or fast markets; ECNs are perceived as more legitimate in not engaging in activities market makers have at least been accused of—stop harvesting, ballooning spreads, and requoting. ECN platforms are somewhat more difficult to use and require more diligence on the part of the trader.

The beginner should first determine what tools he or she will need to trade. Of course, the more you study, the more you learn and the more you want. Your needs may change. Download and conduct due diligence on at least five of these broker-dealers’ demo platforms. Today, many brokers provide a variety of different platforms to even small traders. Use the checklist I provide to research their services in the categories noted and how they relate to your needs. Keep notes. I answer some of the questions for you; more can be found on their web sites, in their documents, and on the FOREX Internet review boards and forums.

I like to send an e-mail question or two to sales to gather information but also to see if and how they respond. Ask to be contacted back by e-mail. Most sales reps will ignore your request and call you, a few will e-mail you, and many will not contact you at all or simply add you to an automated mailing list. Six years after writing the first pages of the first edition of Getting Started in Currency Trading, I continue to be amazed by the inability of many brokerdealers to answer an e-mail at all—much less in a timely manner!

Increasing capital requirements for retail broker-dealers will continue to shake up the retail FOREX industry. I also expect mergers between major players to continue and even a musical chairs effect is on the horizon as smaller firms jockey for position vis-à-vis increasingly onerous regulations. The entire marketmaking paradigm may be in a fast fade. Most traders now have multiple brokers—typically a primary and two secondary broker-dealers. Given the flux of the industry, this seems like a good idea.

Traders have vastly different experiences with brokers. Listed below are some that I would not fund with five cents but that receive wonderful reviews from others. Certainly study the reviews—but in the end, make your own call.

Use the Broker Due Diligence form to keep track of the brokers you review and or test. The reader can download this from the Getting Started section of www.goodmanworks.com.

TIP: The author has used 14 FOREX brokers in the past 10 years of trading. No broker is even close to perfect. Dealing with a FOREX broker—no matter how good they are—is part of the business of trading. Use at least one primary broker and two back-ups. Do not let poor communication from brokers distract you. Do not be surprised when a previously great broker turns mediocre for no apparent reason. Keep your eye on the ball.

A Guide to FOREX Brokers

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While regulation has indeed increased, it remains much less robust than it is in either the securities or commodity futures industries. FOREX has no central clearinghouse, making it a substantially different space from commodity futures or listed securities. Prospective traders need to understand the differences and ramifications when selecting a FOREX broker.

At last count I found more than 100 FOREX broker-dealers with online retail platforms. Although some of them are Introducing Brokers (IBs) for other companies, there remain many full Futures Clearing Merchants (FCM) brokers from which to choose.

One big improvement since the last edition: Several third-party trading platforms with a full complement of features are now offered by multiple brokers. Previously, moving brokers meant learning a new platform. But now, if you find a trading platform you like, you can have a wide selection of brokers to choose for your trading activities. The most popular platforms are discussed in Chapter 14, “Retail FX Platforms.”

Profit Threshold

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This is a little more complex, but important for money management over the longer term.

When you enter a trade you will also want to enter a stop-loss and a takeprofit order. Almost all traders seek a ratio higher than 1:1 between these two, with take-profit as the larger number for a profit/loss ratio. A 3:1 ratio means you risk one unit to make three units. For example, if your stop-loss (S/L) is 50 pips, your take profit (T/P) is 150 pips. Table 6.7 shows the basic Profit-Loss ratios for T/P and S/L pip values. Ninety percent of profit-loss ratios fall in the shaded area.

Once you make 10 trades you will know how many were winners and how many were losers. Over the long haul it is difficult to sustain more than 60 percent winners. Most traders are happy to get 40 percent winners. This can also be quoted as a ratio of winners/losers. For example, if out of 10 trades you have five winners and five losers, the ratio is 1:1. This is a relatively high ratio for winners/ losers but relatively low for profit/loss. Table 6.8 shows the basic Winners- Losers ratios.

TABLE 6.7 Profit-to-Loses Ratios

As you can intuitively see, the two are inversely correlated. To achieve a profit in the long term, the higher the profit/loss ratio, the lower the winner/loser ratio can be. Conversely, the lower the profit/loss ratio, the higher the winner/loser ratio must be to keep you in the black.

TIP: The higher your winners-to-losers ratio is, the lower your profit-loss ratio can be to meet the Profit Threshold. Conversely, the higher your profitloss ratio, the lower your winners-to-losers ratio can be to meet the Profit Threshold. Short-term traders—guerillas and scalpers—typically have high winners-to-losers ratios, but low profit-to-loss ratios. Long-term traders—day traders and position traders—typically have high profit-to-loss ratios, but low winners-to-losers ratios. There is more than one way to skin the FOREX cat.

TABLE 6.8 Winners-to-Losers Ratios

An example of this: If I hit three winners out of every 10 trades (seven losers) and achieve a 3:1 profit-to-loss ratio of $300/$100, I lost $700 but made $900 so I am okay. Table 6.9 shows the intersections of these two ratios as Positive, Negative, or Neutral (Profit Threshold). Chapter 16, “Money Management Simplified,” discusses the profit threshold in relation to the Campaign Trading Method.

TIP: Depending on your own selected T/P-S/L (Profit-Loss Ratio) you must know the Profit Threshold Winners-to-Losers Ratio. Where does the black end, the red begin? You do not want to cross that line; if possible, not even come close to it.

The light gray areas are losing and danger-zone combinations. The dark gray area of both high profit-to-loss and high winners-to-losers is difficult to maintain for any significant number of trades. Going there typically means the trader is using high leverage, investing most of his or her margin, and trading frequently. Such behavior is not sustainable over long periods of time.

For each trade you enter you must consider three factors: Leverage, Account Traded, and Required Margin. The information in Table 6.10 is also in Tables 6.7, 6.8, and 6.9 but is presented here for ready reference.

TABLE 6.9 Profit Threshold

TABLE 6.10 Leverage, Lot Size, Margin

For Futures Traders

Futures traders tend to think in dollars versus a commodity asset (silver, soybeans, pork bellies, etc.). The switch to co-relational values with ratios—one currency against another—can be a bit trying at first. The trick is to practice calculating profit and loss for fictitious trades. Again, use any of the online calculators available for practice. Change each parameter in turn and observe how it alters the others as well as the outcome. It may help to think of a currency pair as a spread.

Profit and Loss

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Table 6.3 allows you to see your profit or loss in dollars for various pip amounts and lot sizes. A micro-lot is 1,000 (1k) Units; a mini-lot is 10,000 (10k) Units; a standard lot is 100,000 (100k) Units; a bank lot is 250,000 (250k) Units. Some of these have been rounded off to make easier reading; they are close enough to serve the purpose for a quick in-trade status check.

Margin

Margin-per-trade is the amount of dollars you must put into play to control a larger amount of currency pair. Margin is a bit of a misnomer in FOREX. If you open a trade on a 100,000 lot of EURUSD and the broker requires $2,000 to accept the trade, your margin is $2,000. Brokers do set maximum margins. If you have multiple open positions your margin is the sum total of all of them; this is your aggregate margin. See Table 6.4.

TABLE 6.3 Profit and Loss

TABLE 6.4 Margins

TABLE 6.5 Leverage

Leverage Leverage is margin-per-trade quoted as a ratio. In the above example, leverage is 50:1 (100,000/2,000). The higher the ratio, the higher your profit (or loss) potential.

As you can see in Table 6.3, on a 100,000 lot a pip is worth $10. With leverage at 50:1 if prices go for (or against) you by 200 pips, you have made (or lost) your entire margin of $2,000, a 100 percent profit (or loss). See Table 6.5 for profit or loss in dollars of margin against different leverage ratios.

The Bid-Ask Spread

FOREX prices are always quoted in the form of Bid-Ask-Last Trade. If you are a potential buyer, the Ask is the price someone will sell to you. If you are a potential seller, the Bid is what someone is willing to buy from you. You Buy the Ask and Sell the Bid in FOREX.

Market-maker brokers add their transaction costs to this bid-ask spread. By knowing how many pips are in the spread you are able to calculate your costs for the trade, exclusive of any other factors such as slippage, commissions, or rollover costs. Typically only ECNs charge commissions and, therefore, their bid-ask spreads are tighter. Bid-ask spreads typically range from 0 pips to 10 pips in most pairs but can balloon much higher during fast markets and slow markets, as well as before, during, and after news releases. The information in Table 6.6 is given for the purpose of calculating the dollar value of the bid-ask spread and, if you trade with a market maker, the majority of your cost to trade that currency pair.

Pips

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A pip is the smallest price increment that any currency pair can move in either direction. In the FOREX markets, profits are calculated in terms of pips first, then dollars second. See Tables 6.1 and 6.2. The conversion of pips to dollars may be considered the base FOREX calculation. Calculate that against your lot size and you are halfway home already.

Approximate USD values for a one-pip move per contract in the major currency pairs are shown in Table 6.2, per 100,000 units of the base currency. TIP: On a typical day, actively traded currency pairs like EUR/USD and USD/JPY may fluctuate 100 pips or more. Table 6.2 is based on a margin requirement of 100 percent (leverage = 1:1). To calculate actual profit (or loss) in leveraged positions, multiply the pip value per 100k times the leverage ratio (margin percentage divided by 100).

Note that the EUR/GBP cross rate pair in Table 6.2 uses multiplication with the USD spot price instead of division. This is because the USD is the quote (second) currency in the spot conversion pair.

TABLE 6.1 Single Pip Values

TABLE 6.2 Full Lot Pip Values

Trading Tables

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FOREX is truly a numbers game with pips, dollars, lot size, stop-loss, takeprofit, leverage, margin, profit and loss, transaction costs, and more to know. Separately they are not difficult to understand but the interrelationships involving various mathematical formulas, ratios, decimals, and fractions can be difficult to master. For example, the pip amount of your take-profit divided by the pip amount of your stop-loss is the profit-to-loss ratio. It, in turn, is closely related to the ratio of winners to losers over a fixed number of trades. The new trader has a big plate, as is, even before considering these myriad mathematical mechanizations.

All of the mechanics are important and worth knowing. But I have found over years of mentoring new traders that they are best learned by practice. Your broker’s trading platform and/or tools on their web site should allow you to calculate most of these values. Simply using your demo account diligently can, over time, make most of these clear to you. As you calculate the values make an effort to see the relationship between each of the numbers, essentially reverseengineering them.

TIP: All calculations involve two or more factors. Change only one of them at a time, up and down, and see how they affect the others. Excellent calculation tools are available on www.goforex.net, www.forexcalc.com, and www.oanda.com.

For those who have a penchant for math, I have included most of the key calculations with examples in Appendix G. For those who do not, I offer Trading Tables. These are the key calculations and ratios you should know for getting started. Most of them are related to converting pips to dollars, profit and loss, and money management. In Chapter 16, “Money Management Simplified,” you learn how to put these tables to good use. You can use these computer-side as you trade. All of them are available for download from the Getting Started section of www.goodmanworks.com.

For the Trading Tables, pip values have been rounded off slightly in some cases to make them easier for the student to use.

Quote Convention

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Exchange rates in the FOREX market are expressed using the following format:

Base Currency/Quote Currency Bid/Ask

Examples can be found in Table 5.1.
Normally only the final two digits of the bid price are shown. If the ask price is more than 100 pips above the bid price, then three digits will be displayed to the right of the slash mark (that is, EUR/CZK 32.5420/780). This only occurs when the quote currency is a weak monetary unit.

TABLE 5.1 Examples of Quote Convention

Market Maker and ECN

Retail brokers are of two types, although some gray areas, terms such as liquidity provider and No Dealing Desk (NDD), have appeared recently.

A market maker is the counterparty to each transaction. In effect, they are acting as their own mini-exchange. At one end market makers are tapped into the Interbank market—often indirectly—and at the other end are the retail customers. What goes on in-between could be a book unto itself.

An Electronic Communications Network (ECN) broker is simply a matchmaker. They also have liquidity providers at one end—usually banks, sometimes other ECNs—and clients at the other. An ECN simply matches orders.

Transaction Cost

The critical characteristic of the bid-ask spread is that it is also the transaction cost for a round-turn trade. Round-turn means both a buy (or sell) trade and an offsetting sell (or buy) trade of the same size in the same currency pair. In the case of the EUR/USD rate as seen earlier in Table 5.1, the transaction cost is three pips. The formula for calculating the transaction cost is:

Transaction Cost = Ask Price - Bid Price

In FOREX you buy the ask and sell the bid. You offset a trade by closing the trade, not executing the opposite action—buy if you are short, sell if you are long.

Market-maker brokers add their profit into the spread. Electronic Communication Network brokers (ECNs) charge a small commission per lot.

Rollover

Rollover is the process where the settlement of an open trade is rolled forward to another value date. The cost of this process is based on the interest rate differential of the two currencies. Rollover cost is not significant for the short-term trader but impacts cost for the long-term trader who might hold a position for several days. If you intend to do long-term trading, be sure to shop rollover costs among several broker-dealers.

Summary

Trading currencies on margin lets you increase your buying power. If you have $2,000 cash in a margin account that allows 100:1 leverage, you could purchase up to $200,000 worth of currency because you only have to post 1 percent of the purchase price as collateral. Another way of saying this is that you have $200,000 in buying power.

With more buying power, you can increase your total return on investment with less cash outlay. To be sure, trading on margin magnifies your profits and your losses.

A detailed description on how to calculate profit and loss of leveraged trades occurs in Appendix G, “FOREX Calculation Scenarios.”

Bid Price Ask Price

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Bid Price

The bid is the price at which the market is prepared to buy a specific currency pair in the FOREX market. At this price, the trader can sell the base currency. It is shown on the left side of the quotation. For example, in the quote USD/CHF 1.4527/32, the bid price is 1.4527, meaning that you can sell one U.S. Dollar for 1.4527 Swiss Francs.

Ask Price

The ask is the price at which the market is prepared to sell a specific currency pair in the FOREX market. At this price, the trader can buy the base currency. It is shown on the right side of the quotation. For example, in the quote USD/CHF 1.4527/32, the ask price is 1.4532, meaning that you can buy one U.S. Dollar for 1.4532 Swiss Francs. The ask price is also called the offer price.

Bid-Ask Spread

The spread is the difference between the bid and ask price. The “big figure quote” is the dealer expression referring to the first few digits of an exchange rate. These digits are often omitted in dealer quotes. For example, a USD/JPY rate might be 117.30/117.35, but would be quoted verbally without the first three digits as “30/35.” You buy the ask and sell the bid.

TIP: Be sure you know to what accuracy your broker provides currency quotes. Many now quote in fractional (1⁄10) pips. This may be referred to as “Four Digit Pricing” and “Five Digit Pricing.”

Margin

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When an investor opens a new margin account with a FOREX broker, he or she must deposit a minimum amount of monies with that broker. This minimum varies from broker to broker and can be as low as $100 to as high as $100,000.

Each time the trader executes a new trade, a certain percentage of the account balance in the margin account will be earmarked as the initial margin requirement for the new trade based on the underlying currency pair, its current price, and the number of units traded (called a lot). The lot size always refers to the base currency. An even lot is usually a quantity of 100,000 units, but most brokers permit investors to trade in odd lots (fractions of 100,000 units). A mini-lot is 10,000 units and a micro-lot is generally considered to be 1,000 units. A standard lot is 100,000 and a bank lot is 250,000 units.

For U.S. retail FOREX traders the minimum margin has been set by the NFA to 1 percent (100:1 leverage) for major currency pairs and 4 percent (25:1 leverage) for exotics.

Leverage

Leverage is the ratio of the amount used in a transaction to the required security deposit (margin). It is the ability to control large dollar amounts of a security with a comparatively small amount of capital. Leveraging varies dramatically with different brokers, ranging from 10:1 to 400:1. Leverage is frequently referred to as gearing. Typical ranges for trading are 50:1 to 100:1. The formula for calculating leverage is:

Leverage = 100/Margin Percent

The most typical leverage used by traders in retail FOREX is 50:1 to 100:1. Some brokers offer up to 400:1. A new trader should start with very low leverage, perhaps 20:1 and certainly no higher than 50:1.

To some extent FOREX traders set their own leverage insofar as they determine the lot size to trade. But your broker-dealer will set a maximum.

Margin Calls

Nearly all FOREX brokers monitor your account balance continuously. If your balance falls below 4 percent of the open margin requirement, they will issue the first margin call warning, usually by an online popup message on the screen and/or an e-mail notification. If your account balance drops below 3 percent of the margin requirement for your open positions, they will issue a second margin warning. At 2 percent, they will liquidate all your open trades and notify you of your current account balance. These percentages may vary from broker to broker. You may not even be able to execute a trade that exceeds certain capital and risk parameters. Brokers today are able to closely watch customer accounts to prevent them from getting to the point of requiring a margin call. You can be assured that as a new customer your account will be initially monitored with higher precision until the broker has a sense of how you trade.

The FOREX Lexicon

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As in any worthwhile endeavor, each industry tends to create its own unique terminology. The FOREX market is no different. You, the novice trader, must thoroughly comprehend certain terms before making your first trade. As your eighth-grade English teacher taught you in vocabulary class—to use them is to know them.

Currency Pairs

Every FOREX trade involves the simultaneous buying of one currency and the selling of another currency. These two currencies are always referred to as the currency pair in a trade.

Major and Minor Currencies

The seven most frequently traded currencies (USD, EUR, JPY, GBP, CHF, CAD, and AUD) are called the major currencies. All other currencies are referred to as minor currencies. The most frequently traded minors are the New Zealand Dollar (NZD), the South African Rand (ZAR), and the Singapore Dollar (SGD). After that, the frequency is difficult to ascertain because of perpetually.

Cross Currency

A cross currency is any pair in which neither currency is the U.S. Dollar. These pairs may exhibit erratic price behavior since the trader has, in effect, initiated two USD trades. For example, initiating a long (buy) EUR/GBP trade is equivalent to buying a EUR/USD currency pair and selling a GBP/USD. Cross currency pairs frequently carry a higher transaction cost. The three most frequently traded cross rates are EUR/JPY, GBP/EUR, and GBP/JPY.

Exotic Currency

An exotic is a currency pair in which one currency is the USD and the other is a currency from a smaller country such as the Polish Zloty. There are approximately 25 exotics that can be traded by the retail FOREX participant. Liquidity—the ability to buy and sell without substantial pip spread increases; a willing buyer or seller is always available at or near the last price—is not good. Whereas a EUR/USD pair may be traded at two pips at almost any time, the EURTRY may balloon to 30 pips or more during the Asian session. changing trade agreements in the international arena.

Base Currency

The base currency is the first currency in any currency pair. It shows how much the base currency is worth as measured against the second currency. For example, if the USD/CHF rate equals 1.6215, then one USD is worth CHF 1.6215. In the FOREX markets, the U.S. Dollar is normally considered the base currency for quotes, meaning that quotes are expressed as a unit of $1 USD per the other currency quoted in the pair. The exceptions are: the British Pound, the Euro, and the Australian Dollar. If you go long the EUR/USD, you are buying the EUR.

Quote Currency

The quote currency is the second currency in any currency pair. This is frequently called the pip currency and any unrealized profit or loss is expressed in this currency. If you go short the EUR/USD, you are buying the USD.

Pips

A pip is the smallest unit of price for any foreign currency. Nearly all currency pairs consist of five significant digits and most pairs have the decimal point immediately after the first digit, that is, EUR/USD equals 1.2812. In this instance, a single pip equals the smallest change in the fourth decimal place, that is, 0.0001. Therefore, if the quote currency in any pair is USD, then one pip always equals 1⁄100 of a cent.

One notable exception is the USD/JPY pair where a pip equals $0.01 (one U.S. Dollar equals approximately 107.19 Japanese Yen). Pips are sometimes called points.

Ticks

Just as a pip is the smallest price movement (the y-axis), a tick is the smallest interval of time (the x-axis) that occurs between two trades. When trading the most active currency pairs (such as EUR/USD or USD/JPY) during peak trading periods, multiple ticks may (and will) occur within the span of one second. When trading a low-activity minor cross pair (such as the Mexican Peso and the Singapore Dollar), a tick may only occur once every two or three hours.

Ticks, therefore, do not occur at uniform intervals of time. Fortunately, most historical data vendors will group sequences of streaming data and calculate the open, high, low, and close over regular time intervals (1-minute, 5- minute, 30-minute, 1-hour, daily, and so forth). See Figure 5.1. Pips are a function of price; ticks are a function of time. Any location on a chart is effectively a Cartesian coordinate of Price, read vertically from bottom to top and Time, read horizontally from left to right.

FIGURE 5.1 Pip-Tick Relationship

NFA Compliance Rule 2-43

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The regulation that has dropped on the industry like a bomb is NFA Compliance Rule 2-43. Although 2-43 addresses many issues, the two most important are Anti-Hedging and FIFO.

Anti-Hedging Anti-hedging has been the most controversial new regulation. It has, in many ways, turned the retail FOREX business on its head—at least for the moment. Traders are prohibited from entering and brokers are prohibited from accepting orders that would place a trader on both sides (buy and sell) of any currency pair. Traders use speculative hedging for a wide

range of trading and money management functions, including the popular news trading technique and multiple time-frame systems.

FIFO (First In First Out) Related to anti-hedging, FIFO changes the manner in which open orders are ledgered and closed. Orders entered first must be closed first. Again, this substantially upsets the applecart for many traders, especially those who are short-term traders, those who tier in positions, and those

Price Adjustments Brokers are prohibited from canceling customer orders except under certain conditions. Price adjustments to filled orders may only be made for specific, limited reasons. This part of Rule 2-43, while unpopular with brokers, is generally accepted as positive by traders.

Capital Requirements for Retail FOREX Broker-Dealers Broker-dealers in retail FOREX must meet higher and higher capital requirements. As predicted in the first edition and began in the second edition, mergers are now common in retail FOREX. Small firms, both good ones and bad ones, are getting shut out. who use automated trading systems.

The CFTC Reauthorization Act of 2008 increases the adjusted net capital requirement for certain counterparty FCMs to $20 million. This requirement was phased in; it is a quantum leap from the previous $5 million. A counterparty FCM is generally considered to be a market maker—a broker-dealer who trades as counterparty to their customers. The author predicts the entire counterparty paradigm will be revisited by the CFTC and NFA soon. Introducing Brokers (IB) who coattail on an FCMs capital base are now also required to meet minimal capital requirements of their own.

Recently, a small broker-dealer with good customer support was shut out by this regulation and, as I write, is looking for a new FCM sponsor. I can hear the conversation with a prospective FCM’s CEO: “Sir, we offer our customers terrific customer service. It is the touchstone of our business model.” “Go away, kid.” Regulations often have unintended consequences.

Registration of FOREX Money Managers The NFA has proposed to the
CFTC that every FOREX money manager must register as a Commodity
Trading Advisor (CTA) in the same manner and with the same process as
those who manage money in commodity futures.

It is assumed the CFTC will oblige, but final regulations, at the time of this writing, have not been passed or implemented. Nonetheless, most retail FOREX broker-dealers are now requiring that money managers who work with their customers must go ahead and register as a CTA. It is possible that FOREX money managers who have been in business for a certain number of years might be grandfathered—but no one is counting on this. It is likely that exemptions from registration similar to those for commodity futures CTAs will stand. The most important of those are: (1) your primary business is not that of a CTA and you do not hold yourself out to the public as a CTA, and (2) you manage fewer than 15 accounts.

To provide for the new registration requirements a separate test has been created, the Series 34 examination. FOREX CTAs will be required to pass the Commodity Futures Series 3 examination as a prerequisite. Again, at the time of this writing, final rules have not been released.

As mentioned earlier, many brokers—including the majors—are affiliating with overseas broker-dealers who are not obligated to comply with NFA and CFTC regulations. One broker told me that two of their best money managers will leave if they are required to register as a CTA. File this one also in the unintended consequences folder. As a former CTA I can attest that regulation is an expensive proposition. If you manage $20 million per year, $100,000 to meet all the requirements to sustain an audit is doable. If you manage $2 million, it makes no sense at all.

TIP: This bears some watching because it involves a small loophole through which a few brokers are driving large trucks. One suspects that the CFTC and NFA will become interested soon.

Another area continuing to receive regulatory attention is graciously called a “harmonization issue” by the industry.

Suitability/Know-Your-Customer Requirements This is NFA Compliance Rule 2-30. This basically requires broker-dealers to determine suitability to trade retail FOREX on a customer-by-customer basis, not, as in the old days, with a simple acknowledgment on the account form, “You understand the risk of FOREX trading.” But there is still little specific guidance and enforcement by the NFA. One may expect that to change soon.

Some brokers still allow a customer to deposit and withdraw funds with services such as PayPal and eGold. One strongly suspects Know-Thy-Customer will bring those methods to a close in the not-too-distant future. FOREX brokers now typically do withdrawals in kind: If you made a wire deposit, your withdrawal will be sent by wire.

Margin Requirements In late 2009 the NFA also mandated minimum margin requirements for retail FOREX positions: 1 percent for any pair containing one or both of what the NFA labels as “majors”—USD, GBP, CHF, CAD, JPY, EUR, AUD, NZD, SOK, NOK, DKK. All others now require a 4 percent margin. This means that for U.S. traders the maximum leverage is 100:1 and 25:1, respectively.

Many U.S. broker-dealers have already established overseas offices to stem the tide of customers leaving in droves because of Rule 2-43 and the new margin requirements. Few will want to trade exotic currency pairs at 25:1 leverage.

Foreign Regulation

Many foreign countries also regulate retail FOREX, though typically not at the level of the NFA and CFTC in the United States. The United Kingdom’s Financial Services Authority (FSA) bears the most similarity to the NFA and CFTC.

Regulation Future

Only time will tell if the current pace of regulation will continue, or if it will slow down, allowing participants to digest what they currently have on their plate. But, clearly, the regulatory cat is out of the bag in retail FOREX. Regulation Future bears watching by all players in the retail FOREX space. As we go to press there are rumors that some factions in the CFTC want to force retail FOREX into an exchange environment similar to commodity futures. As mentioned above, the market-making paradigm may be on the chopping block soon. We shall see.

Summary

The FOREX forums are a good place to find updated regulatory information as well as traders’ (and sometimes brokers’) take on them. Both the CFTC web site, (www.cftc.gov) and the NFA web site (www.nfa.futures.org) are worth a peek on a monthly basis. For those who wish to dig deeper, I recommend www.forexlawblog.com. As the Madoff case demonstrates, regulations sometimes miss the forest for the trees; security is truly in your hands and knowledge is still king.

Fraud is always fraud, irrespective of specific industry regulations. I recommend FOREX traders keep copies of everything as well as screenshots of relevant web pages and communication logs.

Regulation Present

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Government regulation often is an all-or-nothing effort. For the first 10 years of retail FOREX the CFTC and NFA did little. To be sure, part of the reason was that it took time to get a handle on this loose, freewheeling, and widely disseminated business.

In 2008 and 2009 these agencies poured out new regulations at a ferocious pace—usually without requesting much in the way of feedback from market participants. When I discussed the proposed Compliance Rule 2-43 with an NFA representative at a FOREX trade show in August 2008, I was assured it would be slow in coming and there would be a substantial comment period. Not so. To some extent the economic meltdown of 2008 encouraged this fast-track mode.

The new NFA Compliance Rule 2-43 has wrought havoc on brokers as well as traders. The latest regulations concerning hedging, order placement (First In First Out; FIFO), and money manager registration has sent U.S.-based brokers scurrying to find overseas affiliates that are beyond the reach of the NFA and CFTC. One incentive for brokers: Traders do not like the new regulations either and many are moving their accounts and their money overseas. To that extent, the regulation’s purpose of protecting U.S. citizens who trade FOREX may be partially counterproductive.

In late 2009 brokers found that they had to quickly make major changes to their trading platforms to accommodate the new FIFO and hedging regulations. The sense in the industry was that regulations were made without regard to what was involved in making them work. For example, one of the major independent trading platforms planning to release an updated version in the summer of 2009 was sent “back to the drawing board” at the last minute to implement the necessary code into their software. The situation for most of the summer and fall of 2009 could only be considered as chaotic.

The government often carries a hatchet and meat cleaver when a scalpel and carving knife would have done the job. Nonetheless, those who complain that regulations are typically reactive cannot fault the proactive work of these agencies recently.

TIP: No government, no agency, no regulation can prevent fraud completely. The best protection for traders is knowledge, education, and a firm understanding of what caveat emptor means and implies.