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While online forex trading might seem like a newfangled way of playing around with
currencies, it has actually been around for a very long time. This article will
enlighten you about the world of the forex trader as we trace its history and in
the end get to know the various tools that a forex trader might need in order to
survive such a technologically advanced world of finance.
History of Forex Trading
Forex traders can thank our ancestors for setting the foundation of currency trading.
Since the time of the Babylonians, there existed a need to find a way to exchange
currencies – thus, the use of paper notes and receipts was born. In a lot of cultures
during those times, economic exchanges were done by exchanging one item for another,
which was called the Barter System. From this practice there came out a trend in
the kind of goods that were generally accepted as mediums of exchange. Usually they
put a lot of value on teeth, feathers and stones, but as time went on metals such
as gold and silver became more accepted means of payments from which the value of
other items could be compared to. This trend spread like wildfire, all the
way from Africa to Asia.
For the sake of uniformity and stability, metal was converted into minted coins
and the introduction of paper money as a form of governmental IOU’s sprang out during
the Middle Ages. After much persuasion, it became the worldwide standard and has
surpassed the test of time, seeing as to how we ourselves use such a system in our
era or modernity.
In recent times, the foreign exchange market found a way to take action in another
realm other than central banks and different government institutions. Because of
the World Wide Web, we saw a significant boom in the dot com industry as tied to
finance and currency exchanges. One can truly say that forex traders have found
for themselves a much better playground, as the foreign exchange market is now the
biggest financial market in the world. To give you a bit of information regarding
the impressive digits that are evidence of such a statement, daily trades by forex
traders in the foreign exchange market goes up as high as 1.9 trillion dollars.
On an average, more than 1,200 billion US dollars are traded every day. Which is
why becoming a forex trader is in fact a very action-packed career.
Understanding Your Nature…
If one is to become a forex trader and foray into the exciting world of the currency
market, essential tools are necessary for the player to survive. There are a lot of
forex traders out there – mostly average and hitting so-so profits, and most traders
will lose, but there are a token few who have gone through their trials and tribulations
and have honed their skills to truly call themselves “Forex Traders”. For this forex
trader, tools of the trade are very important.
Because of its volume and volatility (magnified due to leverage), software tools
are a must for forex traders. It works to automate most trading procedures and safeguards
you against some losses. But before we get ahead of ourselves, we have to first
understand who or what is a forex trader? Forex Trader is by definition some one
who is trading in currencies, and not investing in it. One must understand the difference
between trading and investing and for that matter a trader and an investor, and
then identify the best approach for themselves.
Generally speaking, an investor seeks long term gains through stock picking based
on fundamentals, while a trader seeks short term gains based on short term technical
movements and momentum in the markets. Both are viable approaches to making gains
in the capital markets, however remaining consistent with the strategy is the key
to success. I would like to highlight some of the main characteristics of a trader
vs. an investor which will help you better identify yourself and your style and
approach.
Short Term vs. Long Term
There is no doubt that markets have direction both in short term and long term,
and as long as there is direction there are opportunities to make money. The question
is which term does one choose to work on- the short term or the long term? The answer
is very simple: an investor by definition has a long term outlook thus has to take
a “big picture” view of the markets, with a minimum of 2-3 years objective. A trader
pays more attention to the short term markets, and sees the market as what it can
produce in a span of time starting from 3 weeks and going down to only a few minutes.
Once the objective is set then remaining consistent with the approach is what pays
off in the end.
Fundamental vs. Technical
While fundamental analysis is the study of companies’ core value, and its inherent
growth extrapolated from balance sheets, the technical analysis is merely the study
of patterns in market movements and market participants psyche depicted on charts.
Fundamentals have diminishing value in the short term market- shorter the term,
lesser the importance of fundamentals, diminishing to a point where at certain time
spans fundamental analysis has no value. Seemingly irrational behavior of market
participants overrides the fundamentals, with over selling and over buying, over
liquidity and under liquidity, over exuberance and under exuberance. However in
the long term the opposite generally holds true, the fundamentals take over and
the prices stay close to the true value of a company. So it becomes important for
the investor to keep that in perspective without getting shaken in and out of their
holding due to short term market movements.
As an investor, these short term movements can be opportunities for entry and exit
but only if the markets have reached some extreme irrational levels, where investors’
long term (2-3 year) target prices have been met, or where the markets are deeply
discounted from the book value, especially if the fundamental basis has not changed.
In any other circumstances an investor should remain unaffected by market fluctuations
doing absolutely nothing and riding through the short term waves. An investor should
be married to the stock (as they say) through thick and thin, though sickness and
in health, because he is a believer in the company, its product, its people and
its potential. A trader on the other hand is only concerned with the current market
and where it could be in the short term, given liquidity and trend. His objective
is just the opposite of an investor- he is not married to any stock, always looking
for short term opportunities to get in and out quickly and make quick profits. A
trader uses technical analysis on charts to seek out short term patterns in the
market place and takes advantage of that, never staying with a stock for too long
and always seeking new opportunities.
Leverage - the double edge sword
Leveraging simply is a tool that can enhance both the gains and the losses in a
portfolio. The amount of safe leverage is a function of time and liquidity, among
other factors. Long term investors use the least amount of leverage, since they
want to remain in a position where they can ride out short term market fluctuation,
and having high leverage can put their portfolios at unnecessary risk. As the time
frames get shorter the magnitude of price change reduces. For example it’s conceivable
to see a US$ 100 stock over a period of 1 year to move 15-50 points, but in a matter
of one day the magnitude is much smaller, perhaps a few points at most. In currency
market both the long term and short term market movement are even less volatile.
With smaller magnitude of price change the leverage can be safely increased accordingly
till you have a very short time frame where price changes are minute and leverage
is maximized. Given its nature, high leverage can be safely used only by short term
traders who are more responsive to market movements. They maximize their profits
through leverage and don’t leave their holdings exposed long enough to uncertain
market factors that can create adverse market conditions.
Investors Market vs. Traders Market
A place to invest vs. a place to trade- in principle the equity market is designed
for individuals and institutions to invest, and share in the growth and earnings
of companies. In keeping with the principle, generally the equity markets do not
and should not encourage trading but focus more towards investment (buy and hold).
The rules and regulations should be such that encourage stable appreciation, reduce
volatility and encourage buy side and long only approach. The traders in the equity
market do have a function by providing liquidity when investors want to exit, if
and when they want to, but for all intense purpose equity market is not the
primary place for traders. In many instances by default due to lack of transparency
or access to other markets, traders become participants in the equity market which
are generally more transparent in their regions and can be accessed readily. Investors
generally want a market where opportunities and potentials of the underlying instruments
are easily quantifiable. With abundance of fundamental stats and limited unknowns,
equity market is an easy place for investors to extrapolate and quantify long term
opportunities. Additionally, access to leveraging as such should be very limited
in the equities market. Generally, investors want a place where there is limited
volatility, limited to no utilization of leveraging (which increases volatility),
greater transparency and decent liquidity. Also, commission costs are not as big
a factor for investors since they are not trading frequently.
In contrast traders who are short term opportunists (speculators), want a place
where they can maximize their gains without any limitation in the long or the short
side of the market. The traders want the maximum leverage they can get for the lowest
cost and for the shortest period of time. Traders want the most liquid markets so
they can easily get in and out of their large leveraged positions with the lowest
impact cost. Traders don’t need the fundamental data but would rather trade a market
where most people are using technical analysis to make decisions (so patterns are
more distinct). By far the best most suitable market for traders is the FOREX, where
95% of the daily volume is speculative. A market that trades almost over US$ 2 Trillion
per day, more than all major equity exchanges combined, where it’s as easy to offload
a billion dollars as it is a few hundred thousand in a major equities exchange.
A market that offers up to 200 times leverage for speculators at no additional cost
and where commission are normally waived off for self traders, and spreads go into
thousandth of a point. Traders want market access from any part of the world and
at all times of the day so they can react quickly to any patterns or market movements,
and not leave their leveraged position exposed overnight to uncertain events. FOREX
being traded 24 hours of the day with about the same amount of liquidity allows
traders the perfect place to exit and enter when they want. They can go short as
easily as they can go long without any limitations, and seek opportunities on both
sides of the market. Simply stated stock market is an investors market while FOREX
is a traders market.
Given the above, asset management can successfully choose to take a pure investor
style or a trader style approach to the market, or any blend in between in the spectrum
where the two approaches are at opposite ends. The caveat is that once the approach
is chosen, asset management should be consistent at every level; otherwise they
are at risk of under performing. The table below illustrates this point, where consistency
at any gradient of the spectrum will ensure high probability of success. For example
long term investors using low to no leverage and good fundamental basis for investment
will certainly win over a period of time. However, if long term investors start
using leverage, it magnifies the movements in their portfolios which becomes more
sensitive to volatility and puts the investments at unnecessary risk. Since a long
term investor is not actively adjusting or managing the portfolio, this becomes
an undesirable feature. Likewise a trader, whose outlook is very short term, will
not perform if there is no market volatility. Plus, since short term market movements
are relatively small combined with the fact that active traders are more in tune
with the market direction, they can use leverage safely to enhance minute movements
and maximize their profits. Without leverage active trading would not be as successful.
Moving from one end of the spectrum to the other requires corresponding adjustment
of the variables (such as leverage, time frame etc) to optimum levels, as illustrated
in table 1 below, in order to maintain low risk profile and overall profitability.
What is suggested here is nothing new as currently successful participants can be
found in every gradient in the spectrum of market approach. If Warren Buffet stands
at one end as a primary example of a long term buy and hold investor, who is known
for picking growth and value stocks, then on the other end stands equally successful
Societe Generale model which is arguably one of the largest most active inter-bank
participants, with trading teams scattered globally trading the FX market at a micro
level, buying and selling for few seconds to minutes. James Simons is another example,
who is one of the richest and most successful hedge fund managers ever. His most
successful funds use short term signals based on proprietary algorithms which generate
signals, sometimes for micro seconds.
So ask yourself this simple question, do I want to trade or do I want to invest?
If the answer is trade then look no further Forex market is best suited for you!
If you are looking to invest, then the stock market is the better option for you.
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