OVERLEVERAGING — THE RISKS OF FOREX LEVERAGE

We have already discussed what leverage is, and what it offers to the trader. Let us here take a look at the impact overleveraging can have on trader psychology.

As we mentioned above, the best trader is he who can detach himself from his emotions during his trading activity: one can have as much excitement and joy as he desires while enjoying the fruits of his achievements, but during trading itself, the heart should beat softly, and the brain should be in charge. Needless to say, a high-risk, all-or-nothing environment where any slight mistake can wipe out the trader's capital is not the environment that is conducive to creating such a mentality. Mistakes will inevitably happen during trading; neither man nor machine is capable of predicting every movement of the market precisely. To ensure that the mistakes that occur do not eliminate your capital, your self-esteem, and your chance of learning from your errors, do not over leverage.

High leverage works against the speculator by increasing the stakes and making the heart beat faster. No one jumps in his seat over the loss of a couple of dollars through which lessons are learned and mistakes recognized. But as potential losses increase, the beginner will have no time to focus on the lessons from his deficiencies, but instead will agonize over his stupidity at having risked so much money in a bet that didn't possess much chance of success anyway. And there begins the vicious spiral of fear, and losses which can eventually ruin a good man's livelihood.

But if the reader is afraid of the large holes that leverage can open in his pockets, he should also keep in mind that there's nothing related to the forex market per se that is dangerous and harmful. Forex is perhaps the safest of all market, since in general the prices move very slowly, and unlike in the stock market, the wipe-out of an unleveraged account is almost impossible: let us remember that nations do not go bankrupt, and currencies don't go to zero in general. But because many people see forex as a get-rich-quick scheme, and expect nonsensical levels of leverage to work for them, more people fail in this market than those who succeed.

To hopefully clarify this matter even further, and to let the incredulous reader reconsider his opinion, I'd like to remind him that the bankrupt Wall Street firms of 2008, like Bear Sterns, Lehman Brothers, Merril Lynch, had leverage ratios of at most 35 to 1, even in the worst cases. And there doesn't exist a person in the world today who doesn't, in hindsight, recognize how foolish and irresponsible it was to take that much risk. But if leverage in the thirties was bad enough for the giant Wall Street firms, with US government and international backing behind them to recapitalize them repeatedly before they went bankrupt, or were forced into gunshot marriages, how wise can it be for the "average Joe" to leverage his account in the fifty or even a hundred to 1? Given that the forex market is erratic, and unpredictable in the short run, how much wisdom can there be in overleveraging?

Remember, if you can't create great returns at low leverage, there's absolutely no reason to expect to do so on high leverage, and every reason to expect massive losses instead.

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TRADING PSYCHOLOGY

Human beings are emotional creatures. We love, we hate, we adore, worship and despise, we can be enthusiastic, and we can be cautious. The canvass of our lives is colored by the palette of emotions, and indeed it's impossible to define a human being without depicting his emotional reactions to life's various occasions.

To the better or worse however, the canvass of profit is colorless. Neither the blush of euphoria, nor the blues of depression have any bearing on the landscape of forex. The successful trader should attempt to banish the shades of pride from his heart when he succeeds, because the market is fickle, and quick to punish those who foolishly feel that they have "cracked the code of forex". But neither should the trader have any feelings of shame or sadness about his failures: failures pave the path of experience leading to success, and as long as he recognizes that he's not ready to embark on big risks, he can survive any calamity that the forex market throws on him by simply risking little, and employing low leverage.

And yet an enormous number of speculators have been unable to act by these simple principles. Desperation and excitement, greed and fear delude many people even after experimentation and study, and success in trading can elude even a genius like Sir Isaac Newton, if he's unwilling to fight his emotions, be deaf to the crowd, and follow the dictates of logic.

So we expect the trader to reason rather than feel, and to calculate rather than dream. We want to take emotions out of the deal, and we don't just want to remove those such as fear, apprehension, worry, anxiety from our trading experience, but also excitement, courage, euphoria, and the other so-called positive emotions, in order that we don't overestimate our skills and power and take more risk than we should take. How do we achieve that?

The only way of achieving this aim, and successfully managing our psychological responses during trading is understanding what we do, and doing what we understand.

Once the trader is aware that his success is not a gift from angels, and his failure is not bad luck, or karma, but the logical consequence of wrong choices and indiscipline, there will be little cause for any emotional ruin, or gratification. Success in the market should be as simple as a good meal enjoyed after hard work. And failure should be as harmless as the bite of a mosquito, because risking more in a highly leveraged trade will never grant anyone success: it is always possible to begin with small sums, gain confidence while scaling-in, and even those small sums will translate to great profits in time. And if they do not, what would make us think that adding to the account or changing leverage will change our fortunes?

And I'd like to repeat here once more in response to the many online get-rich-quick schemes that proliferate: success in the forex market, and in fact in all financial markets, is not dependent on knowledge of some secret formula, or some magic indicator, or a prodigious intellect: all that is needed is discipline and study. To study the causes of economical events, and understanding them, thereafter devising, or adopting a clear and uncomplicated technical method, and adhering to that with principle and discipline is all that is necessary for success. But it must be remembered that nothing more and nothing less will do either. And the trader should get rid of all dreams of overnight riches without labor: who knows, maybe overnight riches will be possible for some individuals, but even then not without hard work and reflection.

Let us examine two major problems that cause traders to lose their wits, and turn the forex market into some kind of Russian roulette where it is impossible to maintain calm during trade decisions: the problem of undercapitalization and overleveraging.

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UNDERCAPITALIZATION

Undercapitalization is closely related to leverage, since, contrary to what many people believe, higher leverage actually increases risk-capital requirements. While the broker allows the client to control higher amounts through less initial capital through high leverage, because price swings are amplified in the process, the trader has to increase his capital that he deposits with the broker in order to survive periods of high volatility (in other words, wide price fluctuations).

Leverage increases the amount of loss or gain that a trader must experience. When the account is registering a positive unrealized return, leverage, and price fluctuations will not cause much problem since they're absorbed by the unrealized profit. When the account is in the red, however, undercapitalization becomes a problem, because even if the price eventually moves in the direction that the trader anticipated when opening the position, the amount of risk capital (in other words, margin) may not be enough to absorb the temporary fluctuations in the meantime.

What use is a successful prediction of market direction if you will never be able to survive the inevitable price fluctuations in between? What use is a complete and well-thought analysis if your capital allocation doesn't allow that analysis to bear its fruit?

Leverage amplifies volatility, and thus increases the initial deposit that must be maintained. But we had said that leverage allows the trader to control large sums through lesser initial deposits. What is the whole point of this circular game? So we reach back at what we argued at the opening of this section: Overleverage is wrong, and must not be used except in very unusual circumstances

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FOREX MONEY MANAGEMENT

FOREX (FOReign EXchange market) is the international currency trading market, where money is sold and bought freely. In its present condition FOREX was launched in the 1970s, when free floating currencies were adopted by most countries, and only the participants of the market determine the price of one currency against the other proceeding from supply and demand.

As far as freedom from any external control and free competition are concerned, FOREX is a perfect market. It is also the financial market with the highest liquidity. According to various assessments, the daily turnover of the market constitutes from 1 to 2 trillion US dollars a day. Transactions are conducted all over the world via internet 24 hours a day from 00:00 GMT on Monday to 10:00 pm GMT on Friday.

While other traders make complicated mathematical analysis or guess what to do, you don't have to be a financial expert to trade forex and achieve success like professionals do!

All you need is a Forex Automoney - the web service which will give you a detailed information about "what" and "how" to trade.

Now, all you have to do to make a trading profit, is to click one button (for example "Buy") and a moment later the other button ("Sell"). If the price of the chosen currency pair rises in the meanwhile, you can have a trading profit, and with the help of leverage, earn as much as 400 times more than the actual increase in the currency pair's price.

This way, with the tiny effort of a few clicks a day, traders can earn thousands or even dozens of thousand dollars per day

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MARGIN TRADING AND LEVERAGE ACCOUNTS

It’s very important that the trader gain a good grasp of these two concepts before engaging in any deals, because leverage and margin determine the lifespan of any trading account in a far more decisive manner than either technical or fundamental analysis.

Margin trading is trading with borrowed funds, and is closely related to leveraging. The broker allows the trader to control a far greater amount of money in the market in exchange for a small deposit of funds, with the understanding that the sum borrowed must be returned in exact amount, with any losses or profits returned to the account of client (the trader).

The amount that the client can control is determined by a number called the leverage ratio, and even the occasional observer can notice this number being proclaimed loudly by brokers in the advertisements that they scatter everywhere online. It’s not that difficult to grasp what the leverage ratio does: it simply multiplies the trader’s potential losses and gains in the market by the specified amount. For instance at a leverage ratio of 1/100, the client (you) will be able to control 100,000 USD which makes a standard lot, for a deposit of a mere 1,000 USD, and every single pip gain or loss will be multiplied a hundred times. To put this in a better perspective, you need a movement of just 1% in the price quote before your account is doubled — or wiped out.

One will often come across notices on broker websites making the claim that leverage is a double-edged sword; that you can both lose and gain massively depending on what you do. But high leverage, for sure, is a sword with only one edge, and we will discuss why it is so later.

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MAJOR CURRENCIES AND CURRENCY TYPES

There are a lot of nations in the world and consequently a large number of currencies to choose from when trading. The currencies of Brazil, Russia, China, the Eurozone, Turkey, Japan, South Africa and Canada are popular with large and small traders, for different reasons. What the market values most in a trade can change depending on government policies and the global economic environment. For example, during the flowery days of the carry trade, many traders would simply long (buy) the currency offering the highest interest rate, and short (sell) the one offering the lowest interest rate, with little consideration given to the underlying economic soundness. Such a strategy is less likely to be profitable in today’s chaotic environment with interest rates racing lower across the globe, and fundamental economic strength is once again the major concern in deciding on currency allocations.

In order to simplify the matter, let us group the currencies into four types and examine each of them briefly:

Reserve Currencies
There’s really only one true reserve currency in the world with dominance of about two-thirds of central bank accounts, and it is the US dollar, the currency of international trade. But there are also others, such as the Swiss Franc, Japanese Yen and to a greater extent, the Euro, which play the same role, and as such are of higher quality and offer greater safety in times of trouble.

Commodity Currencies
These are currencies of nations with a heavy dependence on commodity exports, such as the Canadian and Australian dollars or the Brazilian real, and their performance is closely related to the performance of the global commodity markets.

Exporter Currencies
These are currencies of the likes of Singapore, Malaysia, Taiwan, or China — although it’s difficult to trade the Ren Min Bi (RMB) due to capital controls — with healthy external trade surpluses. These nations often have a high private and corporate savings ratio, and are better placed to survive periods of financial difficulties as they have little need for external borrowing. As exporters, they will most often choose to keep their currencies priced lower against competitors to keep their products more competitive in the global markets.

High risk, high deficit, high yield currencies
In analogy with the bond market, one could also term these currencies junk currencies, in that the economies are usually dependent on external financing, with greatest domestic activity concentrated in real estate, finance, and tourism-related industries. Many emerging markets are members of this group, but there are also other, relatively advanced nations such as (alas!) the UK, or Iceland, which nowadays can be considered to belong to this category. Further examples would be Turkey, Romania and Hungary — as a group, they have suffered the worst of the troubles of 2008.

What use is this categorization to the trader?

It's mainly for those who want some diversification in their currency portfolios, in accordance with the ancient wisdom of not putting all eggs in the same basket. The above categories suggest that good diversification cannot be achieved by, for example, allocating long positions to both the Turkish lira, and the Romanian leu in the same account, as both of these currencies share the junk status. Nor can the trader claim to diversify his positions by buying the Brazilian real, and selling both the Swiss franc and the Japanese yen to fund the purchase. Both the franc and the yen are exporter currencies, and they are likely to make similar moves in response to financial developments. Forex brokers and websites sometimes offer correlation charts (which depict the price relationship between currency pairs during a specific time period), and the interested reader can learn more on this subject by studying them. But in general, positions in different currencies in a single category are likely to react like a single position of a single currency to market events; the trader should always keep this in mind when managing his account.

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FOREX ANALYSIS — ANALYZING THE FOREX MARKET

So we know what the forex market is, and we know what we want to do with it: We want to make money. How do we make money? That’s where we must understand forex analysis.

Forex analysis is the tool with which people aim to make sense of the seemingly random developments in a typical day’s price action. Without analysis, all we’d have is a massive list of price quotes that's updated on our screens every single second, and there would be no way of making any sense of it.

As with every other event in nature, developments in the currency market manifest themselves through cause and effect which are analyzed through the two branches of forex analysis: fundamental and technical. One problem people often have when studying forex analysis is failing to understand that price action is the result of a series of events that are independent of the price action itself. In other words: prices do not cause prices. The study of those economic and political factors which cause price movements is called fundamental analysis. Prices do, however, create patterns (such as head and shoulders, triangles, double tops or bottoms, etc.), the study of which is the subject of technical analysis.

What causes prices to move in a particular direction? Obviously this is the most important question that one must have answered in order to make a profit in currency trading. Major geopolitical and economic events undoubtedly create the powerful, long lasting undercurrents in the forex market. But, there are factors such as daily trade flows, cross-border mergers, currency options expiration-related activity, and other psychological factors which distort the underlying picture for those who are not very familiar with currency trading.

But let’s first briefly examine the two types of analysis that we just mentioned, before returning to the subject of the previous paragraph.

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FOREX FUNDAMENT KNOWLEDGE

As we mentioned before, prices do not cause prices. The reasons that lie behind price movements in the forex market are the subject of fundamental analysis, and those familiar with trading stocks should have little trouble in becoming familiar with fundamental analysis of currencies. Just as stock traders measure the health of a publicly-traded company by examining its balance sheet, indebtedness and cash flow statistics, the forex trader decides on the soundness of a nation’s economy by considering such things as central bank interest rate differentials (which is the difference between the borrowing costs as decided by the central banks of different countries), trade surplus or deficits, along with employment trends, productivity, and a number of other factors.


Fundamental analysis states the causes of major price movements in a straightforward and clear manner. For instance, because of the ease of borrowing and the resultant abundance of global liquidity in recent years, the interest rate differential between two nations’ central banks has been the most important indicator in determining price trends in the forex market. While this is unlikely to remain so in today’s difficult environment, interest rates will remain one of the most important drivers of currency market trends for as long as financial actors are free to move capital across national borders.


Fundamental analysis attempts to discover and predict the causes of forex trends, and in doing so it uses a number of indicators to present a comprehensive picture of global finance. But beyond the indicators themselves, what really causes a currency pair to move in a particular direction? Are currency movements really decided by statistics and news flow only?


This question brings us to another definition of fundamental analysis: Fundamental analysis attempts to predict money flows into and out of a particular currency. Statistics are significant only as far as the markets regard them as a basis for directing cross-border money flows. A nation can have very low unemployment, a high current account surplus, excellent productivity rates, and very good statistics in general, and its currency can still do poorly against others — if, despite all those advantages, there’s a greater supply of it with respect to total demand. In other words, no indicator, no statistic or standard is enough to magically appreciate a currency versus another, if the general economic environment (i.e. the financial markets in general), is unwilling to make use of the advantages that a sound and healthy economy provides.


Later we will return and take a deeper look at fundamental analysis.

The strength of fundamental analysis lies in its ties with economic events at the root level. It is relatively straightforward about its descriptions, and its rules and principles are often simple and easy to understand. And, the fact that fundamental causes decide the major trends in forex markets is indisputable. The trader possesses a very reliable tool in this kind of analysis. The problem with fundamental analysis, on the other hand, is twofold: it’s very poor as a timing indicator; and markets do not always react to its dictates in a rational manner. What must be remembered when the market value of a currency is a lot different from its fundamental value, is that the market would not have tolerated an irrational quote if some people somewhere were not making a great profit from that irrationality. It is therefore imperative that the analyst identify the abnormality, examine the causes of it, and formulate a strategy to exploit the discrepancy.


If fundamental analysis is a poor method for deciding on the timing of a trade, what will you, the trader, use to define your entry and exit points? Which method will allow you to decide when to take a profit or accept a loss? This question leads us to introduce the subject of technical analysis.

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INTRODUCTION TO THE FOREX MARKET

Many of us have been fascinated by the shiny, colorful world of currencies as children, and even those of us who have little interest in the forex market have engaged in some form of currency trading while traveling outside their homeland. And these days, one will easily find people discussing the advantages and weaknesses of the US dollar even in a casual gathering.

 The forex market is the currency market: it’s where the value of each currency is determined versus every other currency in the world. If you exchange one US dollar for its equivalent value in Euros, you’re already a part of the forex market, and are creating the quotes you see reported on TV screens every day. There’s no difference between the actions of a tourist at an exchange bureau, and the transactions of banks in the international market, apart from size and maturity

 terms.


In today’s integrated and specialized economies it’s rare to find all the components of any product produced inside one country’s borders, and so, international trade is a major creator of global forex volume. Deepening financial interactions across the globe through partnerships, buyouts of firms and international loans, along with ever complex tools of investment have been increasing the size of the forex market in recent years.

If global trade and finance were the body of world economy, the forex market would be the circulatory system; in other words, there doesn’t exist a deeper, more liquid market than that of currency trading. Almost every political or economical event of long-term significance is reflected in its workings, and understanding it results in a very good comprehension of finance and economics in general. Participating in such a vast and significant mechanism can be a rewarding and exciting experience for the individual investor. But while this is true, success during your interactions with the giants will require more than a bit of diligence and patient study.

The rewards can be immense: famous investors such as George Soros, Jim Rogers, large Wall Street firms such as Goldman Sachs, or banks like Citibank all make millions of dollars each year from trading in the forex market. In fact George Soros is notorious as being the man who broke the Bank of England: Through successful speculations, he was able to make 1 billion dollars in just about a week.

 

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LEARN ABOUT FOREX CURRENCY TRADING - STUDY YOUR OPTIONS

If you study finance or have a career in a finance related field, chances are you have had some interaction or knowledge of the foreign exchange trading market. The sheer volume of trades in the foreign exchange market makes it the single largest financial market in the world. This is not a market for the timid or occasional trader. This is a very competitive market with players from global financial giants, retail currency traders, and governments of most countries in the world. To stay competitive in this spirited market you need to learn about forex currency trading. Unfortunately, it's not as easy as it looks.

The huge amount of information resources available regarding foreign currency trading can be daunting. For people who are new to the field, it's extremely difficult sorting the good information from the bad. Before relying on forex information you've found, determine if the source of the material is reliable. You certainly don't want to bother with the sites that appear as search results simply due to search engine optimization. The major firms in the currency exchange industry provide on their sites a number of charts, graphs and other forms of analysis of foreign exchange information.

These are international monetary corporations which maintain their good reputations by providing correct data and explanations. As you start to learn about forex currency trading, you will want to make their sites your initial locations. If you are not just a student of finance curious about the foreign exchange market; and you foresee yourself earning a living trading forex, a structured course in foreign currency trading becomes inevitable. There are reputed financial institutions such as investment banks, stock exchanges etc. who have tied up with the leading universities and colleges in creating such structured courses in foreign exchange trading. It would be wise if you don't restrict yourself to these structured courses alone.

You can test yourself in order to obtain a certification in foreign exchange trading after you learn about forex currency trading. These certifications will also assist you in getting a job in financial institutions which specialize in currency trading. There are prerequisites that must be met before you are ready to learn about forex currency trading. You must be firmly grounded in the basic principles of economics and capital markets. If you are studying finance or are already working in the financial field, you must learn about forex currency trading to keep up with your competitors. Saying that is one thing, but it's much more difficult to actually do. The volume of data out there about this trade is enormous, and it can be confusing. To be certain of the credibility of forex information make sure that your information comes from a reputable source. If you foresee yourself earning a living trading forex, a structured course in foreign currency trading becomes inevitable. Financial institutions have tied up with universities and colleges to create structured courses in foreign exchange trading.

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