Although trading foreign currency is widely seen as requiring a series of overly risky gambles in a dubious market, it really doesn’t have to be that way. Foreign currency trading can be an effective channel for building wealth, offering the prospect of good risk-adjusted returns, even at the retail level. In order to make it work, though, you need to take a few preparatory steps to avoid disaster.
Be properly capitalized. It is important to trade only with money that you can afford to lose, otherwise the psychological stress of the inevitable losing streaks will be impossible to bear. Risk per trade should be a function of account size, and if account equity is too small, it will be impossible to implement correct position sizing. As a general rule, a minimum initial deposit of $5,000 is required to trade effectively in a systematic way, although many brokers will accept much less. You can also get a better deal on fees and commissions when you deposit larger amounts.
Choose a good Forex broker. First of all, make sure your money is safe, and that your deposit is covered by a government-backed insurance scheme. Secondly, make sure your broker is well-regulated and has a reputation to protect. Once you have cleared those hurdles, you can take a closer look at suitable Forex brokers by opening demo accounts with them to see if the platforms, execution and other conditions are acceptable to you.
Be aware of the costs of trading. Every broker charges spreads and/or commissions. Take a close look; there are sites which show the live spreads of a range of brokers which you can monitor for free. When you are planning your trading strategy, make sure you take these costs into account. One thing that is often overlooked are overnight charges: brokers charge an extra commission for keeping a trade open overnight New York time, which is one reason why long-term investing can be difficult. All these issues must be factored in when you are testing trading strategies, too.
Understand the statistical basis of Forex price movements. It is amazing how many people risk thousands of hard-earned dollars without any investigation of the market’s statistical tendencies. For example, people buy and hold stocks because they know that the stock market has a tendency to rise over time. However far too many Forex traders would be surprised to learn that currency rates tend to move more at certain times of the day, or that the most profitable trends have in recent years required about three months to get started. It is not very hard to investigate: you only need a working knowledge of excel and historical price data which can be downloaded from several sources for free.
Build a system with a real edge. You might be tempted to get started by making your own discretionary trades based upon your own technical and/or fundamental analysis. However, unless you have a lot of experience, you are very likely to do worse than if you follow a more mechanical strategy based upon a well-researched “edge” such as trend following and momentum trading. Any strategy should be kept as simple as possible and not “curve fitted” or otherwise optimized to fit historical data. Strategies should be thoroughly back tested over several years, and then tested against a fair amount of “out of sample” data. Factors you are likely to experience in real trading, such as slippage, mistakes and trader fatigue should be priced in too.
Be Flexible. While this seems contradictory, there are times when rules should be bent or broken. In fact, a really successful trading methodology might be based upon you deciding whether to accept or reject “signals” from the trading strategy you have designed. This takes experience and must not be used as an excuse to allow fear or greed to dictate your actions, though.
Finally, you might now be thinking about designing a trading robot to automate a trading strategy, to save time and effort as well as potential for human error. While this could be useful, bear in mind that any bugs in the coding could lead to you checking your account one day to find out it has been emptied by a thousand losing trades. Additionally, many standard trading platforms allow your broker to “read” any live robot, seeing exactly where its trade entry and exit prices are, which theoretically would allow an unscrupulous broker to adjust the price feed you are receiving to their advantage in some cases.
It is possible to use Forex as a diversified wealth-building activity uncorrelated to stock trading. Before you take the step of trading Forex, make sure you get fully prepared, or you are likely to learn some expensive lessons about the foreign exchange market.