Retail Currency Trading – Retail Forex

When we invest in retail forex we have quite a few different possibilities and each one of them carries different risks. We can decide to invest trough our forex broker alone. We can trade completely manual, semi-automatic or fully automatic (set and forget). We can buy (subscribe to) trading signals. We can join a trading group that can be free or payable. The best chance to invest is through trading systems’ evaluators. You can also have your funds individually managed by a registered account manager. You can send your money to a forex fund, managed by registered account managers or by forex brokers. You can also give your money to somebody that claims (s)he or the group she works for have found a holly grail of forex investing and promise you 10% profits per month or more. Although the last is forbidden in the UK and USA there are still places where the practise is completely legal.

Trading On Your Own

If we decide to work on our own through retail forex broker we have the least risks, and they are many. Forex is the biggest market on earth. Forex is a zero-sum-game. For every win there is a loss. There is no growth like the one in stocks. Off-exchange foreign currency trading carries a high level of risk and may not be suitable for all customers. The only funds that should ever be used to speculate in foreign currency trading, or any type of highly speculative investment, are funds that represent risk capital; in other words, funds you can afford to lose without affecting your financial situation.

Forex dealers can set their own minimum account sizes, so you will have to ask the dealer how much money you must put up to begin trading.

Most dealers will also require you to have a certain amount of money in your account for each transaction. This security deposit, sometimes called margin, is a percentage of the transaction value and may be different for different currencies.

Keep in mind that a security deposit acts as a performance bond and is not a down payment or partial payment for the transaction. Let s use an example of a dealer requiring a 1% security deposit. The formula for calculating the security deposit is:

The current price of the base currency X transaction size X security deposit % = security deposit requirement given in quote currency

Looking at the Euro example, multiply the current price of the base currency ($1.2178) times the transaction size of 100,000 times 1%. Your security deposit would be $1,217.80.

$1.2178 X 100,000 X .01 = $1,217.80

Security deposits allow customers to control transactions with a value many times larger than the funds in their accounts. In the previous example, $1,217.80 would control $121,780 worth of Euros.

This ability to control a large amount of one currency using a very small percentage of its value is called leverage. In our example, the leverage is 100:1 because the security deposit controls Euros worth 100 times the amount of the deposit.

Since leverage allows you to control large amounts of currency for a very small amount, it magnifies the percentage amount of your profits and losses. A profit or loss of $1,217.80 on the euro transaction is 1% of the full price but is 100% of the 1% security deposit.

The higher the leverage, the more likely you are to lose your entire investment if exchange rates go down when you expect them to go up or go up when you expect them to go down. Leverage of 100:1 means that you will lose your security deposit when the currency loses or gains 1% of its value, and you will lose more than your security deposit if the currency loses or gains more than 1% of its value. If you want to keep the position open, you may have to deposit additional funds to maintain a 1% security deposit.

For example, assume you buy or sell a contract worth $100,000 and it moves against you by $2,000. No matter how much money you put up, your dollar loss will always be the same “$2,000″ but the percentage loss varies with the amount of leverage. At 100:4 leverage, you will have lost half of your investment. At 100:2 leverage, you will have lost your entire investment. And at 100:1 leverage, you will have lost twice your investment and owe the dealer $1,000.

You should check your Account Agreement with the dealer to see if the Agreement limits your losses. Some dealers guarantee that you will not lose more than you invest, which includes both the initial deposit and any subsequent deposits to keep the position open. Other dealers may charge you for losses that are greater than your investment.

A forex broker can trade against you. A forex broker can file for bankruptcy. Both cases are risky for your funds. There is no central authority that would exclude the risks of delivery.

We did not mention, that you have to know when to go long, when to go short (entry trade signals), how big a position to open (money management), when to close the trade (take profit, trailing stop, stop loss) and all the things needed to make money. We call the above risks “basic risks of retail forex”.

Trading Using Paid Trading Signals, Trading Software or a Group

The risk of trading on your own using paid trading signals and semi-automatic software are reduced because trading signals providers should know when to go long or short, how big a position to open and when to close out. Unless they are crooked or ignorant which is another risk you are taking. Semi-automatic trading software is probably better but you need to know how to set it up. If fully automatic trading software was profitable when created, market conditions have most likely changed since its creation or they will change in the near future. Then you will suffer a loss that can be a complete wipe out of your trading account.

When trading semiautomatic you have a chance to set the parameters of your trading software to match market conditions. Although nothing and nobody can guarantee you profits on forex there is high probability that trading with correctly set semi-automatic software will put you in better position then trading fully automatic or completely manual.

Of course, your e-mail or phone can be out of order when you get important signal from your provider or your internet connection might fail when software tried to send orders to your retail forex trading platform. These are additional risks you are taking on if you trade like described above.

Trading groups are as good as their leaders are. Above mentioned risks with combined with the group leader’s style of trading and draw down tolerance can be added to the rest.

Trading Through Account or Fund Managers

If we give our funds to account manager we expect to profit from managers expertise. But again it depends on our contract. Account managers may be compensated for each trade they enter and as a part of profit they make. In the first case account managers can make huge profits even if we are even or take loss. The second case is much more favourable to investors. If they make money account managers make money. If they are taking a loss, account managers at least do not get paid for their “performance”.

Putting money in a fund will join the destiny of your investment with destiny of many others. Usually it looks like account management in first case. Fortunately, there is an easy way out. Withdraw the funds if fund performance is below par.

As long as account managers and fund managers are registered and your money is held by forex brokers, the funds are separate from the funds of broker or account or fund managers. They are held separately and all the accounts are audited. It is less likely that you lose your money through a staged bankruptcy or broker folding.

Trading Through Trading Systems’ Evaluators

If it is hard to measure real performance of individual forex account managers there are companies that rate participating trading systems through their performance. You can have your account traded automatically according to trading system or a mix of trading systems of your choice. I will mention Collective2 as being best in my opinion, compared to Tradingmatica, FX TradeLine or ZuluTrade. Additional risks are the scale of trades that make different money management procedures if your account is not the exact match of providers account and the risk of “ego trades”. Trading systems trade with hypothetical results. Although some of them trade real money, many just trade virtually. It is easy to lose demo account. It hurts much more if you lose real money. If you see a system with huge draw downs it usually means that it is trading with “funny money”. They are not to be completely trusted.

Throwing Your Money Trough a Window

The last possibility mentioned multiplies your risks immensely. If you give your money to somebody to invest in forex and promises you high return you can never be sure if your money went on forex or somewhere else. Is it funding illegal activity like drug trafficking or arms smuggling? Your government will confiscate it if it participated in illegal activity! Will the guy that you sent your money to be still around in six months? Who is auditing trading accounts? Is your money held separately from the companies funds? If the company goes bankrupt, are your funds separate? Is your contract enforceable in your country or it needs to be presented in some exotic jurisdiction? In a language you do not understand, under the law you are not familiar with?

There are profits to be made on forex, even on retail forex market. But every investor or speculator should be aware of inherent risks. Even issuers of the safest, mortgage backed securities sometimes do default. Forex has so many risks that you have to be prepared for the possibility of losing your entire investment at any time. Nobody likes losing but it is a part of the game. So invest in forex only the funds that won’t change your lifestyle if you lose them.

Patience means that we need to wait until trading signal fully forms or to check all the variables when adding to a position. A lot of times we have seen reversals if only five out of six required conditions were met. If you trade manually you should take great care to be consistent and thorough. Namely, as long as you are patient you stay on the sidelines and your portfolio is safe. Once you enter you lose control. Now you can only exit as market will allow.

If you are right and market moves your way, do move your stop loss on your entry point or a few pips better. You never know (and nobody else, for that matter) what can change the market sentiment in your cross to opposite direction. You do not want a winning trade to become loser again! It is adviseable (we did not say must, although we mean it) to have trading logbook. Information should include the reason (trading entry signal) for opening the trade,stop loss (why 23 and not 35 or 16), follow up strategy when your cross moves to positive territory (stop loss move, trailing stop, take profit, partial take profit, doubling a position etc….)

Gamblers should never gamble under influence or when emotionally disturbed. The same goes to forex traders. Forex is unforgiving. Each mistake costs money. Therefore, trader should have at least some help from a machine. A machine is 100% patient. Human is not. Human will unconsciously try to outsmart the market. Machine will not. Human will judge, machine will not.

To every trader we recommend a semi-automatic expert advisor. Semi-automatic means that trader checks daily fundamental and technical analysis results and setup entry conditions for an entry signal. Let then the machine monitor the market and enter a trade when all the conditions are fullfilled. When positions are open a human trader will make better decissions, so let her/him follow up. Yes, we firmly believe in semi-automatization.

Why we do not use trailing stops? We like trailing stop. It is very useful function for automatic trading. When we are not able to actively watch the market we would certainly let trailing stop to take us out in profit.

The only thing preventing us to use trailing stop in our daily trading is that we can not tell our computer in advance to watch all the variables we can, and to judge things accordingly.

As we described in Third Bite, it is far better to move stop loss manually, because curency trading is not a smooth ride. It jumps, dips, rises, tread water, wave, breaks resistance, or falls through support.

Trailing stop is just a predefined number of pips that cant take into account playing around support and resistance levels, sudden quick reversals etc. It is higly probable, that a cross will retrace after breaking through support forcefully but it is also much more probable that it will test former support as new resistance. We are much safer if we stay above resistance than below even if it only means 10 pips difference.

Trailing stop does not take into account these bumps in a road. It tends to close the trade prematurely. If we are able to monitor market movements on hourly bases, manual movement of stop loss makes far better strategy than trailing stop.

If, on the other hand, you are away then let the machine do it`s work and let it close the trade at trailing stop.

How we handle stop losses? When we decided our investment strategy we adopted 2% maximum risk per open trade. This means that, if everything goes wrong, our total loss in this trade wont exceed 2% of our portfolio size. If our portfolio is $10.000 our maximum exposure per trade is $200. In Jaypex we open four crosses for each trading signal. 2 lots of GBPUSD ($100 = 50 pip), 1 lot of USDCHF ($50 = ~60 pip), and 1 lot of CHFJPY (~60 pip). This sets maximum stop loss in pips. However, we need to work inside maximum exposures. So we need to consider checking ATR in combination with timeframe which we want to trade. The longer the timeframe the bigger the stop loss. The shorter the timeframe the bigger the noise.

The True Range is the distance from maximum of yesterday’s range to today’s range. We obtain it from three simple calculations; take the maximum of these numbers.

• The distance from today’s high to today’s low
• The distance from yesterday’s close to today’s high
• The distance from yesterday’s close to today’s low

The Average True Range is a moving average of the True Ranges (The shorter the range, the closer it reflects present).

Average True Range Technical Indicator (ATR) is an indicator that shows volatility of the market.

If 2xATR feets into maximum allowed it is good to start with. As we described in second bite, crosses tend to diverge and eventually one or two will hit the stop loss and go further without us on board. We can forget about them and take great care for the ones in positive territory.

After our cross breaks two resistance levels (if long) or supports (if short) we can do two things:

a) Move stop loss well into plus and wait

b) Double the position and move stop loss for all positions to new entry level (2 pips in positive)

In the example a) we have locked-in some profit and let the position run at the same pace, each 1 pip move bringing in 1 pip of profits. In the example b) we did not lock any profits, but we covered our exposure 100%. From this point further we play “on the house”. Not a penny of our money is at risk and every move for 1 pip in the right direction brings in 2 pips in profits.

Our experience taught us to alternate. First we start with a). If trend goes on our next move is b) and than a )  again and b) and so on as far as it goes.

Sometimes a strong overnight move or a gap over the weekend will allow us to do both, doubling and move deep into positive. When this happens never forget to thank for your luck.

When we are “in the money” we can make bold moves. Once we are closed out we have to forget all the good and wait for another opportunity. Don`t just do something, sit there! Patience comes next!

From strategically background talk straight to the point. When we pick EURJPY cross we actually don’t have to open EURJPY. We get much the same effect if we open EURUSD and at the same time USDJPY. If USD cancels out the result is clear. The sum of EURUSD and USDJPY will be almost the same as EURJPY with small short term deviations. This is the first step. If you look a little bit deeper, you will quickly realise that EURUSD is basically composed of EURGBP and GBPUSD, while USDJPY is a result of USDCHF and CHFJPY. This is the second step.

The third logical step in this strategy is after generating Buy to Open (BTO) signal in EURJPY cross to open long positions in EURGBP, GBPUSD, USDCHF, and CHFJPY.

Because EURGBP and GBPUSD will tend to diverge as well as USDCHF and CHFJPY we have as our fourth logical step to enter breathable but tight stop loss on all the constituent crosses. With a little help from volatility (which at the times of crises abounds), we will have a strong divergence run in all crosses, two will be taken out at stop loss (and continue falling without us) and the other two will continue rising (with us on board). Soon we are able to move stop loss to zero position, which we define as entire trade without a loss.

Our fifth logical step in said strategy is the way we manage a stop loss.

This is not too much text but information contained herein may be revolutionary. Even if it looks a small bite chew on it until we explain how we manage a stop loss and why we did not find trailing stop to be satisfactory.

We maintain three parcelled cross trading strategies on Collective2: Artex, Jaypex and Montex. We’ll talk about them later.

Parcelled cross trading strategy is a forex trading strategy that evolved through the years of trying to follow thousands of qualified and non-qualified forex advisers. Some strategies tried were not suitable for our style of trading. I do not say that they were necessary bad. I am just saying that trading strategy needs to fit chief trader’s personality.

Some traders can bear huge draw downs before the market turns their way. I can’t. I can’t sleep if draw down exceeds my comfort zone which is tight since I wiped-out my entire forex trading account in 1997.

So as a rule, I don’t feel good trading without a stop loss. The first guiding principle of Parcelled cross forex trading strategy is to limit losses and draw downs as much as possible. We never risk more than 2% of portfolio value in one trade. One trade consists of four open positions. This way we can be wrong 5 times in a row and still keep the losses at manageable level. Without such money management one can lose entire investment account in one trade gone badly.

We are not too tight with stop losses as every currency pair needs to “breathe” before succumbing to a long term trend. When volatility is stronger than the trend we elect to stay on the sidelines. We do not take trades even if other indicators show an entry signal. We will have a chance to talk about the importance of patience later on in this series. We want in this place to express our contrairarian opinion to “Idiot-proof” trading strategies like Freedom Rocks.

In stable times Freedom Rocks strategy works well. Basically it consists of long opening of two correlated currency pairs like EURUSD and USDCHF for the long haul. Being inversely correlated and having positive interest rate differential usually one of the crosses will rise when the other is falling. When a cross comes to a top sell 1/10 of a position and at the same time when the other cross is at the bottom buy 1/10 of a position. Depending on the leverage you also multiply interest rate differential. You also make money each time you close a position.

In reality, this strategy depends on the behaviour of EURCHF cross. It works fine when EUR steadily rises against CHF as was the case from April of 2002 to July of 2007. If you traded the same strategy since July 2007 your account would have probably been erased. The wrong thing with described strategy is the omission of stop losses. Because in this strategy you play on crosses going astray and back, you can’t stop the one going down. You actually want it to, because you make money on swings.

But when EURCHF, which is a sum of EURUSD and USDCHF, starts going down, both your open long crosses start losing money. Apart from closing all the positions with a loss you have no remedy. You have no real measure when to close positions. There are no flawless “Idiot-proof” trading strategies. Whenever somebody introduces better “Idiot-proof” strategy somebody else makes a better idiot.

We are still at a stop loss discussion. No stop loss strategy may still be good for gamblers (Gambling trading style). You enter strong and have luck to double your investment in short time. You withdraw your initial investment and gamble with the rest again. Whenever you double your investment withdraw half and gamble some more with the “house money”. This may be good way to make money if it fits your personality. It is gambling, though, not investing.

Just to make sure that everybody is on the same song-sheet: A loss is realised. It moves no more. A draw down is unrealised, still in the open position that can be changed into plus if the market turns your way. Or make the loss bigger.

There is an easy way to avoid huge draw downs and exposure to loss without losing the upside potential. Your market analysis says to buy a cross with 30 pip stop loss. You opened this position. The market turns against you and stops you at minus 30 pips. Market falls 40 pips more before it turns your way. You wait the move to reach your stop loss point and enter the long position again. You did not miss the good thing that is moving up after falling. You escaped the bad thing, the draw down. Namely, if you didn’t exit at 30 pip stop loss, and in the meantime, when you are down 70 pips on your position, adverse information emerges. The market moves instantly 200 more pips against you and your entire investment account is at risk of erasure. You can succeed in making profit after humongous draw downs five or even ten times. Once you fail and all your investment is lost. I have seen many a trading systems reaching 20.000% or more in profit just to lose it all in a draw down, too big to handle.

It is already more info here than bite size. We will cover more in our next post.

I considered myself to be an expert on equity markets when I started trading forex in 1997. I made money in stocks since early 1990’s. Yet I lost my entire first investment on forex. I traded longer term. I was hitting it big from the start. All the available leverage put me ahead 70% in just a few months. Without any info out, the market one day started to go against my bets. I added to a position, to lower entry point in an anticipation of market turn. Yeah right, market turned my way, as soon as a margin call wiped-out my entire balance.

I was stunned. My trading pride was badly hurt. I could afford to lose that money it just wasn’t good for my self-consciousness. So I stopped trading for a while and started reading. This way I actually analysed what went wrong. Basically I implemented Murphy’s Law (When all else fails read the Users Manual.).

I found an article describing the need of protecting your gains in leveraged investments. There was an anecdotal description there. You can gain 500% or even 1,000% trading in forex. You can lose no more than 100%. So gaining 500% on $10.000 investment makes it $60.000. Losing 100% on $60.000 brings account to zero. The moral of the story was to protect your gains and never risk too much. I made a rule to risk no more than 2% of my portfolio in one trade.

I am an economist by education and I know a lot about John Maynard Keynes. But it was years after my forex wipe-out when I found his famous saying: “Markets can behave irrational far longer than you can stay solvent.” That was a trigger to my next rule – don’t try to outsmart the market. Trade with the trend, not against it. If I think that market exaggerates I stay on the sidelines. I actually use this rule ever since in all markets. Even in Real Estate. I pay more in rising market. I sell in falling markets. Wherever I can use stop-loss, I use stop-loss (or some other strategy or combination of instruments to the same effect). Even my Home Insurance is a kind of stop-loss.

I tried that strategy and it works. I switched many trading strategies and styles of trading before I devised cross-majors strategies I use now with a success.

Also, when I first started trading forex I entered with an intention to make big profits. I tried to catch every upswing and every downswing. I overtraded, even if it paid-off at first. Than I picked a story telling that good swing traders catch 1 swing in 10. No one can catch every move. You have a choice to enter a trade or not. When you enter the trade you lose control. After you are in, the market will dictate moves and you can exit only as circumstances allow. My next rule is connected to the mind set. First I need to protect my portfolio; second goal is to make profit.

That is completely different mindset. I do not rush into every opportunity to make money with all the risks of loss associated with every open position. I wait until an opportunity that satisfies preset criteria arises. I limit my loss. I know what I will do whichever way the market turns.

There are more rules I try not to break in my trading, but these three are fundamental: Limit your risk, follow the trend and wait for the right opportunities. If used in every situation they will save you a lot of headaches.

Using stop-loss to limit my potential loss to 2% of my portfolio I can be wrong 5 times in a row and still not lose more than 10% of my portfolio. If I didn’t have stop-loss one big move against me could wipe-out my entire portfolio.

I am rarely wrong five times in a row but I have never been 100% right for more than a week.

Two years ago surfing I stumbled upon a website called Collective2, “Trading Systems Authority”. It took me some time to go through it but I am glad I did. Why? To make a long story short:

I used to invest some money in stocks and mutual funds, I tried commodities and options and I enjoyed trading currencies. My problem was, that I could not possibly study each trading market and segment particularities. It is just too huge for a humble human mind to know it all. I tried managed accounts, but all serious money managers required bigger amounts than I could afford.

In C2 I found more than 5000 trading systems, from commodities to stocks to options to currencies. All the systems are audited in real time and their performance scrutinized and analysed. Not all are good, but I was able to pick a few good ones. By good ones I mean systems that bring in more than 10% a month, consistently and with low exposure to loss. And I did not expose my money either. I was given free demo account to learn what to do and how. I started live trading only after I learned how to evaluate trading systems according to their past achievements and their trading style.

The beauty of these systems is a mixing capability. I usually pick 5-7 systems and give them different weights. For example, I give the first system 25%, the second system 20%, 15% to the third, and 10% to next four. If I do not like how they trade (I can check their open positions in real time through my free C2 account) I can easily switch one or more systems off, replace them by another or reinstate them afterwards again.

I do trade currencies successfully. With C2 I can trade all the markets successfully.