Fundamentals of Forex Trading

Forex trading involves the simultaneous buying of one currency and the selling of another. Forex traders are always trading pairs of currencies - this means they are always long one currency and short another. The U.S. dollar is the key currency in many of these pairs. Together with the U.S. dollar, six other major currencies account for more than 90% of all Forex transactions. These are the Japanese Yen (JPY), Euro (EUR), British Pound (GBP), Swiss Franc (CHF), Canadian Dollar (CAD) and the Australian Dollar (AUD). While there are other currencies traded on the Forex, for the most part, the Forex trader can concentrate on just six major currency pairs that have the most liquidity.

Currencies over TimeWhen currencies other than the U.S. dollar are traded against each other -- for example, the Japanese yen against the euro (JPY/EUR) these positions are known as cross-rates.

The first currency of a pair is the base currency: this is the main unit that traders buy or sell. The second currency is the secondary or counter currency against which they trade the base currency. The base currency has a value of 1.0 and the second currency is quoted as a number of units against the base currency. In the EUR/USD pair, you are looking at the number of dollars per one Euro, the base currency -- for example, 1.300 dollars for each euro. In the USD/JPY pair, you are looking at the number of yen per dollar, the base currency -- for example, 100 yen for each dollar -- except in futures.

Changes in currency values are quoted in terms of "price interest points" or "pips". Pips can also be called points and are similar to ticks in stocks or futures markets - the smallest increment of price movement. In most cases, a pip is a one point change in the fourth digit to the right of the decimal -- for example, a change from 1.2915 to 1.2916 for the Euro. The value of a pip depends on the size of the contract or lot being traded, and that depends on where Forex is traded.

Why Prices Move.

The underlying cause of a price movement in any market is the fundamentals -- those factors that affect the basic value of that market. For many markets, the focus is on supply and demand as free-market forces determine what is "expensive" or "cheap" depending on how much is available and how badly someone wants to buy or sell it.

Forex markets go far beyond basic supply and demand figures. Everything that affects the political and economic situation of the two nations involved in a Forex currency pair has some bearing on the value of the two currencies against each other. Forex traders have plenty of fundamentals to consider as they are bombarded by news broadcasts, government reports, newsletters, brokerage firm research, television analysts and many other sources.

Events and Reports that Affect Forex Markets

Knowing about the possibility of a potential adverse volatile movement as a result of some fundamental factors might, for instance, affect when to place a trade, what type of order to place or whether to trade at all that day.

Technical Analysis

MarketBoardMany traders today find the long list of fundamentals that affect Forex trading somewhat daunting. This is why many traders tend to prefer technical analysis - a study of price action that can be applied to any market. Technical analysis combines the influences of all the fundamentals affecting a market into one element, which is the current price. Rather than keeping up with all the various fundamentals, traders can focus on analyzing just one element - the price movements on a chart, knowing that the price synthesizes every factor known in the market at the present time -- at least, in the perception of traders. Thus, the price is the visible reflection of all underlying market forces affecting the market.

Technical indicators

In looking beyond basic chart patterns, many traders turn to technical indicators, which may be able to detect changes in market momentum or strength or weakness that are not obvious when looking at a price chart. Although these indicators can be back-tested and can be helpful in market analysis, they do share some general shortcomings:

I. Most are based on only one thing: past prices. As a result, they are all lagging indicators and not forward looking indicators.

II. Using several indicators together may improve traders' perspective, but because they are looking at basically the same thing, adding more indicators does not necessarily result in better analysis. In fact, it may lead to another technical analyst's catch phrase, "Paralysis by analysis" which may cause traders to "freeze" actually making it harder to make a trading decision.

III. It is easy to curve-fit or over-optimize the parameters of a technical indicator to the past price action. When traders examine historical price data, they may adjust the parameters to find those that performed best in the past, only to discover that they do not work quite so well in actual trading.

Technical Indicators can be broken down into two broad categories:

I. Momentum oscillators - spot market turns in the early stages and are typically based on a scale from 0 to 100. These indicators include Stochastics, %R, Relative Strength Index (RSI), Rate Of Change (ROC), and a number of others.

II. Trend-following indicators - detect the trend and the strength or weakness of the trend. These indicators include Moving Averages (MA), Moving Average Convergence Divergence (MACD), and Directional Movement Index (DMI) including the ADX indicator, which measures the trendiness of a market.

Problem with Technical Indicators

The momentum oscillators above evaluate how current prices compare to previous prices and provide clues about "overbought" or "oversold" conditions, which suggest a possible change in price direction. However, these oscillators are not very reliable in trending conditions, and they indicate signals which are often false. (They may still provide some good clues about future price direction, though, because of divergence -- that is, while prices may hit a new high or low, the indicator reading does not.)

Trend-following indicators on the other hand are relying on prices that have already occurred, meaning they are lagging in time and often give false signals in range-bound markets.

In addition, while the momentum oscillators lose their value in trending market conditions, trend-following indicators have the disadvantage of being subject to whipsaw moves when market conditions are choppy, with prices oscillating up and down.

Despite advances in technology, including more sophisticated software programs, technical analysis has remained much the same as it was years ago, and most traders using traditional approaches to trading are no more profitable than ever before. This is where the 4X-DAT™ can be found as an invaluable trading tool, as it takes most of the guesswork and emotion completely out of the trading game.