Part 3 - Mechanics of Online Trading

After examining the basic concepts, let’s briefly discuss how a trade is opened, and look at a few basic ways of controlling risk and managing our funds.

While most trading software is straightforward with order entries and the opening or closing of a position, the beginner may be bit confused by terms like stop-loss, trailing stop, or take profit orders, at least a basic understanding of which is crucial for a properly managed account.

A market order instructs the broker to buy or sell a currency at the current market price. As such, neither the trader, nor the broker has any control over where the trade is executed. The only commitment that the broker makes is that the order will be executed as soon as possible, which is usually instantly. Let us note here that in times of market turmoil, spreads can widen greatly, and the price at which a market order is executed can be shocking to the inexperienced trader. Consequently, it is a good idea to avoid market orders at such periods.

By contrast, a limit order instructs the broker to execute a trade only when a particular price value is reached. No action will be taken until the price quote is reached, regardless of the length of time. The disadvantage of the limit order is that the market may never move in the desired direction, and the trade may never be executed as a result. On the other hand, the limit order facilitates better planning, reduces arbitrariness in trading decisions, and eliminates the dangers associated with sudden price spikes to the greatest extent possible.

The stop-loss order is a kind of safety mechanism that puts a ceiling over the losses that a misplaced trade can cause. By entering the stop-loss order, we’re specifying the maximum amount of unrealized losses that we are willing to tolerate, beyond which our confidence in the trade would not be maintained. Naturally, the stop-loss order should be set in the direction opposite to where we expect the price quote to move. The execution of a stop-loss order, as with the limit buy or sell orders, is automatic.

The trailing-stop order is a relatively uncommon order type. In this case, the stop-loss order is renewed automatically by the trading software at intervals specified by the trader. For instance, when we buy the EUR/USD pair at 1.3500, set our stop-loss order at 1.3400, and set the period of the trailing stop at 50 pips, the software will revise our stop-loss order higher at intervals of 50 points as the price moves and our account shows unrealized profits. When the price reaches 1.3550, our new stop-loss would be entered automatically at 1.345. When the price reaches 1.36, the new stop-loss would be at 1.35, ensuring a risk-free trade.

The take profit order specifies the price quote at which we would like our position to be closed, and profits to be realized.

Part 4 - Currency Pairs and Their Characteristics

Of course, we can’t trade currencies without knowing about them. There are a large number of currencies that traders can choose from for establishing their trades and portfolios, but most currency traders will concentrate on a few of the more widely traded, and liquid pairs such as the EUR/USD, GBP/JPY, or USD/CHF, which are all currencies of major powers. It is possible to divide currencies into many different groups based on the criteria chosen, but in general currency account position and interest rate policies of central banks are the most important values for classifying them.

f we try to divide currencies on the basis of financial soundness and economic policies, the following is one plausible categorization.

Reserve Currencies

These are the currencies of nations which have a dominant role in global economic transactions. The European Union, Japan, the United States are the important powers the currencies of which fill the coffers of central banks around the world. Among those, the role of the Japanese Yen as a reserve currency has been diminishing since the 90’s, while that of the Euro has been increasing continuously since the launch of the currency. Among all those changes however, the US Dollar has remained as the one major currency that has the greatest preponderance over everything else in central bank currency allocations. With about two thirds of global forex reserves denominated in the dollar, the USD is the reserve currency of the world.

For traders, an important rule of thumb is that reserve currencies as a group tend to depreciate in times of boom, and to appreciate at times of economic trouble. This is a generalization; needless to say there is a degree of variation among the behavior of different currencies, but due to the financial structure of the global economy, economic activity usually leads to abundant supply of reserve currencies during robust economic growth.

Commodity Currencies

Currencies such as the Australian and Canadian Dollars, the Brazilian Real, the South African Rand, or the Russian Ruble, which are the monetary units of commodity exporting nations, are called commodity currencies. There’s a great degree of diversity among commodity currencies in terms of trade balance or economic sophistication. However, due to the large currency inflows generated by proceeds from the sales of commodities, the value of these currencies is strongly dependent on the buoyancy of global commodity market.

Exporter Currencies

Currencies of nations like Singapore, Japan, China, with large forex reserves accumulated through exports, are called exporter currencies. The value of these currencies is related strongly to the health of the global economy. As they depend on foreigners for economic buoyancy, any disturbance to the health of the global financial system can have outsized consequences for these nations. Nonetheless, due to their large forex reserves they are well-placed to withstand the impact of any economic shock better than most of their peers.

High-risk currencies

These may also belong to any of the other categories. High-risk currencies are the currencies of nations with high deficits (budget or trade), and high interest rates. Examples are Romanian Leu, currencies of Baltic nations, or Turkey. These currencies appreciate at times of boom, as capital from developed economies is directed to their assets, and depreciate during recessions and crises, as global capital discards risky assets.

Conclusion

Although the descriptions above may sound simple and brief, they already contain much of the basic concepts that are important for currency traders. The key to a successful trading career is carefully evaluating the widely available data, and establishing a disciplined and simple strategy which can be used to exploit the information for profit. How do we evaluate the data? What kind of tools do we use to make sense of the widely available and complicated information that we must sort out to generate trading signals? This is the subject of forex analysis, which we’ll discuss in the next chapter.

Next, part 5 >> Fundamental Analysis vs Technical Analysis >>

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