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Forex 101

Reprinted with permission from Interbank FX Back to Trading 101 Index

1. Introduction to Foreign Exchange Trading

Foreign Exchange is when you buy a particular currency from someone, for instance the British Pound (GBP). In order to buy this currency, you must sell them something in exchange, for instance you will pay for it with US Dollars (USD).

If you travel from the US to England you will need the local currency to pay for transportation, food, and so on. So when you get to the airport you go to the foreign exchange counter and give them your US Dollars and they give you the equivalent in British Pounds. In this example, you sold the USD and bought the GBP while the foreign exchange counter bought the USD and sold the GBP. The prices at which you buy and sell currencies at are known as the exchange rate. This rate or price fluctuates based on demand, political, and economic events surrounding each country.

This example illustrated how the Foreign Exchange market is used by world travelers, however, the market is also utilized by each country's central bank (i.e., America's Federal Reserve), investment and commercial banks, fund management firms (mutual funds and hedge funds), major corporations, and individual investors or speculators. Utilization by so many parties is why the Foreign Exchange market is the world's largest financial market, with a daily dollar volume exceeding $1.4 trillion ($1,400,000,000,000). This mind boggling volume is probably what led you to this site in the first place.

Now let's put the market's trading volume in perspective. Did you know that in all of 2003 the reported trading volume for the NYSE (New York Stock Exchange) was a mere $9.6 trillion and topped out at $10.2 trillion for all of 2002? The annual volume for the NYSE only equals 1 week's trading volume in the Foreign Exchange market. This is probably why so many fund managers and Fortune 500 companies invest heavily in this highly liquid market. Unlike other financial markets, the foreign exchange market operates 24 hours a day, 5.5 days a week (6:00 PM EST on Sunday until 4:00 PM on Friday EST) through an electronic network of banks, corporations and individual traders. Forex trading begins every day in Sydney, moves to Tokyo, followed by Europe and finally the Americas.


2. Foreign Exchange Prices

Foreign Exchange prices, or quotes, include a "Bid" and "Ask" similar to other financial products. "Bid" is the price at which the trader is able to "Sell" as currency pair. An easy way to remember this is that the "Bid price" or "Sell price" of a currency pair is always the lower price in a quote. "Ask" or sometimes referred to as "Offer" is then the price at which the traders is able to "Buy" a currency pair. In other words, Forex traders always buy at the high and sell at the low of a price quote. the difference between the Bid and Ask is called the "Spread" or "Pip Spread", which is the Trader�s cost of the transaction. There are no additional broker commissions involved in trading the Forex market, like there are in most other investments.

Reading a foreign exchange quote may seem a bit confusing at first. However, it�s really quite simple if you remember two things: 1) The first currency listed is the base Currency and 2) the value of the base currency is always 1 (one), meaning a quote of USD/JPY at 116.04 is the same as 1 US Dollar (USD) is equal to 116.04 Japanese Yen (JPY). When the US dollar is the base unit and a currency goes up, it means the dollar has appreciated and the other currency has weakened. Using the above USD/JPY example as a reference, if the USD/JPY increases from 116.04 to 117.51 for a total of 147 pips, the dollar is stronger because it will now buy more yen than before. There are four currency pairs that include the US dollar where it is not the base currency. These exceptions are the Australian dollar (AUD), the British Pound (GBP), the Euro (EUR), and the New Zealand dollar (NZD). A quote on the GBP/USD could be 1.7600, meaning that one British Pound equals 1.7600 US dollars. Just remember that if a price goes higher that increases the value of the base currency and a lowering price means the base currency is weakening.

Foreign exchange markets and prices are mainly influenced by international trade and investment flows. The Forex markets are also influenced, but to a lesser extent, by the same factors that influence the equity and bond markets: economic and political conditions especially interest rates, inflation, and political instability. Those factors usually have only a short-term impact, which makes Forex attractive. Currency trading offers investors another layer of diversification to their investment portfolio to protect against adverse movements in the equity and bond markets that heavily influence even their mutual funds.



3. Forex vs. Equities

For investors and speculators using the Internet as an investment tool will find that the Forex market offers several advantages over equities trading:

Foreign Exchange Trading Equities Trading
Leverage 200: 1* 2:1
Liquidity Daily Volume: $2 Trillion Limited Liquidity
Commissions No Commissions Commissions and Exchange Fees
Trading Hours 24 Hour Active Market 7 Hours with Limited After Hours
Trading Volume 1 week Forex volume is equal to all of 2003 reported volume of The New York Stock Exchange (NYSE)

* 200:1 is the entry leverage value. Since most brokerages will have margin calls set at different level, exact leverage may vary.

24-Hour Trading

Forex is a true 24 hour market, which offer a major advantage over equities trading. Investors are able to make trades around their family, business and social life. Whether that works out to be 8am, 2pm, or even 2am, no matter the time there will always be buyers and sellers actively trading foreign currencies. This flexibility in trading hours means traders are always able to respond to breaking news immediately.

After hours trading in equities has several limitations. In the US, for example, equities traders have access to ECNs (Electronic Communications Networks), also known as �matching systems�. These networks are established to provide a method for equities traders to buy and sell amongst each other. These networks do not offer as tight of spreads as normal market hours, most trades are not executed at a fair market price, and there is no guarantee that every trade will be executed.

Unmatched Liquidity

With a weekly volume equivalent to one year of NYSE (New York Stock Exchange) trading volume, there is not shortage of buyers and sellers in the Forex market. With the vast number of traders involved in the Forex market, the trading volume offers price stability and a consistency in fair market pricing.

Equity traders on the other hand are more susceptive to liquidity risk and are subject to potentially wider dealing spreads and larger price movements. Liquidity in the equities market is not match to the liquidity that the Forex market offers.

200:1 Leverage

This leveraging power enables traders to have a $50 margin controlling a $10,000 position or a 0.5% of the position value. The substantial leverage that is available to online Forex Traders can be a powerful money making tool. The need for such enhanced leverage capabilities is vital in the Forex market because of price stability and liquidity associated with the market. Such stability, liquidity and 24-hour access result in an average daily percentage movement of 1% on major currencies, compared to the volatility of the equities market that can easily have movements of 10% a day.

Lower Transaction Costs

The Forex market, in terms of commissions and transaction fees, is much more cost-effective than equities or even Futures. We offer some of the tightest currency pip spreads available to Forex traders without charging additional commissions or fees based on trades. There are also No additional fees for stops, limits or other orders that can be found in the equities market, which can range from $4.95 to $100 per order depending on your broker.

Profit Potential in Both Rising and Falling Markets

Bear in mind when you are trading the Forex markets, you are always buying one currency and selling another. Unless there is virtually not change in value between the two currencies, one will always be appreciating while the other is depreciating. Now the question is, which side are you investing in? Forex provides the ability to make money under any market conditions if you are positioned on the right side of the market. Equities traders may have a much more difficult time liquidating stocks when the market is moving against them.


4. Forex vs. Futures

Foreign Exchange Trading Futures Trading
Leverage 200: 1* 15:1
Liquidity Daily Volume: $2 Trillion Limited Liquidity
Commissions No Commissions Commissions and Exchange Fees
Trading Hours 24 Hour Active Market 7 Hours with Limited After Hours

* 200:1 is the entry leverage value. Since most brokerages will have margin calls set at different level, exact leverage may vary.

The benefits of spot Forex (cash market) over futures and more specifically currency futures trading are considerable. The dissimilarities between these investment vehicles range from philosophical - such as the history of each, their target audience, and their relevance in the modern Forex markets, to more tangible issues such as transactions fees, margin requirements, liquidity level, and the technical and educational support offered by providers of each service. A closer look at these differences are outlined below:

Higher Volume = Better Liquidity.

The daily currency futures volume on the Chicago Mercantile Exchange (CME) is a mere 1% of what Forex market investors experience every day. This unmatched volume and liquidity is one of many advantages that the Forex markets have over currency futures.

Tighter Bid/Offer Spreads.

Forex offers mostly 2-5 pip spreads versus a possible 8 pip spread in the currency futures market.

Higher Leverage - Lower Margin Requirements.

Forex offers up to 400:1 leverage with as low as 0.25% margin, compared to a typical currency futures leverage of 15:1

Easy to Read Price Quotes.

Currency futures quotes are inversions of the cash price. For example, if the cash price for USD/CHF is 1.7100/1.7105, the futures equivalent is .5894/ .5897 (a format only familiar to future's traders).

Currency futures' prices also have the added complication a forward Forex component that takes into account a time factor that is not necessary in the Forex Market.

Commission FREE Trading.

While currency futures have the added baggage of trading commissions, exchange fees and clearing fees, the Forex market has eliminated such expenses to the investor. These fees can add up quickly and seriously erode potential trading profits.



5. Understanding Currency Pairs

Most currency transactions involve the "Majors" consisting of the British Pound (GBP), Euro (EUR), Japanese Yen (JPY), Swiss Franc (CHF) and the US Dollar (USD). Many traders are beginning to add the Canadian Dollar (CAD) and the Australian Dollar (AUD) to this category as well. Currency pairs that do not include the US dollar are referred to as Cross Currency Pairs. Cross Currency trading can open a completely new aspect of the Forex market. Some cross currencies move very slow and trend very well, ideal for beginning traders. Other cross currency pairs move very fast and are extremely volatile with daily average movements exceeding 150 pips. Many of these cross currencies also offer greater return potential with enhanced interest (also referred to as swap, rollover interest or carry forward interest) that can be paid on open positions. To learn more about swap go to our frequently asked questions (FAQs) section of our website.



6. Understanding Margin

Margin is borrowing money from your brokerage house for the purpose of purchasing additional currency pair positions or lots. How much money you can borrow depends upon how much marginable equity you have in the account and the leverage level that you have chosen your account to be set at. This leverage level may be modified at anytime. The below table illustrates how much equity is placed on margin per lot traded.

Leverage Level Marginable % of lot size Margin per Standard Lot Margin per Mini Lot Margin per Micro Mini Lot
1:1* 100% $100,000 $10,000 $1,000
5:1* 20% $20,000 $2,000 $200
10:1* 10% $10,000 $1,000 $100
25:1* 4% $4,000 $400 $40
50:1* 2% $2,000 $200 $20
100:1* 1% $1,000 $100 $10
200:1* 0.5% N/A $50 $5

* 200:1 is the entry leverage value. Since most brokerages will have margin calls set at different level, exact leverage may vary.

Default leverage levels for new accounts are set at 200:1 for Mini accounts and 100:1 for Standard accounts.

Trading Forex on margin lets you increase your buying power. Here's a simplified example: If you have $10,000 cash in a margin account that allows 100:1 leverage, you could purchase a maximum of $1,000,000 worth of currency because you only have to post 1% of the purchase price as collateral. Another way of saying this is that you have a maximum of $1,000,000 in buying power.

Benefits of Margin

With more buying power, you can potentially increase your total return on investment with less cash outlay. Trading on margin should be used wisely as it magnifies both your profits AND your losses.

Margin Benefits Example:

You have a $10,000 account balance; you decide that the US Dollar (USD) is undervalued valued against the Euro (EUR). The current bid/ask price for EUR/USD is 1.2348/1.2350 (meaning you can buy $1 USD for 1.2350 EUR or sell $1 USD for 1.2348 EUR. You sell EUR (buy dollars) by selling 1 standard lot or sell 100,000 EUR and buy $123,480 USD. With your leverage at 100:1 or 1%, your initial margin deposit for this trade is $1,000, leaving your account balance at $9,000. As anticipated, EUR/USD drops 48 pips to 1.2298/1.2300. To close out the position you buy 1 lot or 100,000 EUR and sell $123,000 USD.

Initial sell $123,480 USD
Offset buy $123,000 USD
USD Profit $480 USD

Return on Investment (ROI) for this trade would be calculated as follows:


Initial Account Balance $10,000
Initial Investment or Margin Used $1,000
USD Profit $480
ROI on Margin Used 48%
ROI on Total Account 4.8%

Managing a Margin Account

Trading on margin can be a profitable investment strategy, but it's important that you take the time to understand the risks.

You should make sure you fully understand how your margin account works. Be sure to read the margin agreement in the account application when opening a live account. Click on our live help to talk to a customer service representative if you have any questions.

The positions in your account could be partially or totally liquidated should the available margin ("Free Margin") in your account falls to the predetermined threshold of 50% margin level.

You should monitor your margin balance on a regular basis and utilize stop-loss orders to limit downside risk.

Calculating Your Margin Capability

The maximum available margin is 1% (100:1 leverage) for standard accounts and 0.5% (200:1) mini accounts. Traders always have the option of employing a lower degree of leverage. For more information on lowering the leverage level on your account, please contact a customer service representative. Keep in mind that the lower the leverage used requires a larger amount of margin capital for the trade.

Margin = (Contract size / Leverage)

The minimum margin requirement is approximately $50 per lot in a mini account. The requirements for leverage may vary with account size or market conditions, and may be changed from time to time at the sole discretion of Interbank FX, please refer to your trading agreement for details.

If maximum leverage is employed, traders must maintain the minimum margin requirement on their open positions at all times. It is the customer's responsibility to monitor his/her margin account balance. Interbank FX has the right to liquidate any or all open positions whenever a trader's minimum margin requirement is not maintained. This is an important risk management feature designed to strictly limit trading losses in your account.

Margin Example:

You have $500 in a mini account. To calculate the margin required to execute 4 mini lots of USD/JPY (40,000 USD) at 200 leverage, simply divide the deal size by the leverage amount e.g. (40,000 / 200 = 200). You post $200 margin for this trade, leaving an additional $300 marginable balance in your account.

The trading platform automatically calculates margin requirements and checks available funds before allowing you to successfully enter a new position. If you do not have adequate funds available to enter a new position, you will receive an "Not Enough Money" message when attempting to place the trade.

If the means that if your Equity drops to 50% of your Margin amount then your account will receive a "Margin Call" to close out one or more open positions. To avoid liquidation of your positions, do not use your entire account balance as margin for open positions. Instead, leave enough funds in your account to withstand a market movement against your open positions. We suggest you always use stop loss orders to limit your downside risk.

Please contact our customer service reps should you wish at any time to use a lower degree of leverage or adjust the margin settings in your account.


7. Understanding Fundamental Analysis

Fundamental analysis is the study of the core underlying elements that influence the economy of a particular currency. This method of study attempts to predict price action and market trends by analyzing economic indicators, government policy and societal factors. Imagine financial markets as a large clock, the gears inside this clock that move the hands, or drive the clock would be these "fundamentals". Although you can look at the clock and know what time it is, only by looking at the fundamentals can you truly understand how it became the time it is now. By knowing this, you might better understand the movement of time and be better able to predict what time it will be in the future. As a Forex investor you can better understand why the market is where it is today and where it might be tomorrow (or at a future point) based on studying these fundamentals.

Keep in mind that Fundamental analysis is a very effective resource to forecast economic conditions, but not exact currency prices. For example, you might get a clear understanding of the health of the US economy by studying an economist�s forecast of an upcoming Employment Cost Index (ECI), but how does that translate into entry and exit points? You need to develop a method that you use to decipher this raw data into usable entry and exit points based on your personal unique trading strategy. These methods are known as forecasting models. Forecasting models are like fingerprints - unique to every trader. Every trader may look at the exact same data, yet conclude completely different scenarios on how the market will react. It is important to analyze the fundamentals and apply your findings to your model.

Fundamentals for each currency might include, but not limited to; interest rates, central bank policy, political figures/events, unemployment/employment reports, and Gross Domestic Product (GDP). These economic indicators are snippets of financial and economic data published by various agencies of the government or private sectors for each country. These statistics, which are made public on a regularly scheduled basis, help market observers monitor the pulse of the economy. Therefore, almost everyone in the financial markets religiously follows them. With so many people poised to react to the same information, economic indicators in general have tremendous potential to generate volume and to move prices in the markets. While on the surface it might seem that an advanced degree in economics would come in handy to analyze and then trade on the glut of information contained in these economic indicators, a few simple guidelines are all that is necessary to track, organize and make trading decisions based on the data.


8. Understanding Technical Analysis

Technical analysis is concerned with what has actually happened in the market, rather than what should happen. A technical analyst will study the price and volume movements and from that data create charts (derived from the actions of the market players) to use as his primary tool. The technical analyst is not much concerned with any of the "bigger picture" factors affecting the market, as is the fundamental analyst, but concentrates on the activity of that instrument's market.

Technical analysis is based on three underlying principles:

1. Market Action Governs Everything - This means that the actual price is a reflection of everything that is known to the market that could affect it, for example, supply and demand, political factors and market sentiment. The pure technical analyst is only concerned with price movements, not with the reasons for any changes.

2. Prices Move In Trends - Technical analysis is used to identify patterns of market behavior that have long been recognized as significant. For many given patterns, there is a high probability that they will produce the expected results.

3. History Repeats Itself - Chart patterns have been recognized and categorized for over 100 years and the manner in which many patterns are repeated leads to the conclusion that human psychology changes little with time.

No two technical traders are the same. There are too many technical indicators to analyze the market and just as many ways to use each. Many traders overlay several technical indicators as they feel that this is the best way to analyze and confirm market movements. There is not a single strategy or concept that is foolproof. Most strategies are effective under certain market conditions. Knowing which strategy to employ during which circumstances is what makes an experienced trader successful.


9. Learning Your Risk Tolerance

The secret to successful investing is learning your own style, or in other words trading method(s) that work for you. There is no correct approach that everyone should learn. However, every trader needs to assess how much risk they can comfortably handle. It is the single most important investment issue for long-term success in the Forex market.

Are you able to stomach the risk when the markets are moving up or down as fast as your nervous heartbeat? Do you carefully consider the various risks that are associated with each trade you make? The fact is, many people either don't have a clue how or don't feel they need to protect themselves from unnecessary risk. In most cases they don't even understand all the types of risk their investing is exposed to. We will be reviewing the various types of risk and proper risk management to maximize your personal performance, including:

  • What is Risk?
  • The Different Types of Risk
  • The Risk/Return Balance
  • Diversifying Your Trading
What is Risk?

Whether it is investing, driving, flying, swimming, or just walking down the street, everyone exposes themselves to risk. Your personality and lifestyle play a big role on how much risk you are comfortable with. For most investors, risk simply means "losing money." But if your investment choices leave you having troubles sleeping at night you are probably taking on too much risk. The dictionary's definition of risk is "The variability of returns from an investment or the chance that an investment's actual return will be different than expected. This includes the possibility of losing some or all of the original investment. It is usually measured using the historical returns or average returns for a specific investment. The greater the variability of an investment (i.e. fluctuation in price or interest), the greater the risk." The enhanced daily price movements and the leverage available in the Forex market compared to other financial instruments like stocks is the reason the Forex market is categorized as a "high risk investment vehicle". As investors are generally averse to risk, investments with greater inherent risk must promise higher expected yields to warrant taking on the risk. Others add that higher risk means a greater opportunity for high returns or a higher potential for loss. However a higher potential for return doesn't always mean that it must have a higher degree of risk. This is why identifying and adhering to a strict trading strategy is so important to the overall performance. Learn more about use of proper money management to minimize your risk exposure. Do you have a hard time giving money back to the market when you feel that you have worked so hard for every penny of profit? If so, you would find yourself amongst the "risk adverse" category of investors. On the other hand, super active day traders feel most comfortable making dozens of trades per day and are considered "risk loving". When investing in currencies, stocks, bonds, commodities, futures or any investment instrument there is a lot more risk than most investors think. Learn more about the different types of risk that effect your Forex trading.

The Different Types of Risk

There are two basic classifications of risk: Systematic Risk - A risk that influences a large number of currency pairs. Examples of systematic risk are global political events, natural disasters, or war. Unsystematic Risk - Sometimes referred to as "specific risk". It's risk that affects a very small number of currencies and currency pairs. An example is economic news that affects a specific country or region, such as a sudden strike by employees or a change in the Canadian interest rate. Diversification across multiple non-related currency pairs is the only way to truly protect yourself from unsystematic risk. Learn more about diversification in currency trading.

Now that we've determined the two main classifications of risk lets take a closer look at more specific types of risk.

Default Risk - This is the risk that the company with whom you have your Forex trading account will be unable to pay out investor's account balance when a withdrawal request is submitted. Many Forex traders remember the incident of Refco in the fall of 2005. Unfortunately Refco, one of the world's largest investment firms with brokerage arms within commodities, futures and foreign exchange filed for bankruptcy protection and each of the brokerages were auctioned off to competitors or former subsidiaries. Unfortunately their clients were unable to withdraw their profits nor initial capital until the brokerages were sold off. As of yet the dust has not settled and it is still too early to tell if all former customers received complete compensation. Choosing a suitable, stable broker is more than choosing the biggest.

Country Risk � This refers to the risk that a country won't be able to honor its financial commitments. When a country defaults it can harm the performance of all other financial instruments in that country as well as other countries it has relations with. Country risk applies to stocks, bonds, mutual funds, options, futures and most importantly the currency that are issued within a particular country. This type of risk is most often seen in emerging markets or countries that have a severe deficit.

Foreign Exchange Risk � When investing in foreign currencies you must consider that the currency exchange rate fluctuations of closely linked countries can drastically move the price of the primary currency as well. For example, economic and political events directly tied to the British Pound (GBP) have an effect on the Euro's trading (i.e. the EUR/USD might have similar reaction as GBP/USD even though they are both separate currencies and are not in the same currency pair). Knowing what countries effect the currency pairs you trade is vital to your long-term success.

Interest Rate Risk - A rise or decline in interest rates during the term a trade is open will affect the amount of interest you might pay per day until the trade is closed. Open trades at rollover are assessed either an interest charge or interest gain depending upon the direction of the open trade and the interest rate levels of the corresponding countries. If you sell the currency with the higher interest rate you will be charged daily interest at the time of rollover based on your broker's rollover/interest policy. For more specifics on understanding your interest risk, please consult your broker for complete details of their policy including time of rollover, interest price (also called swap) and account requirements to receive interest paid to your account. Learn more about trading strategies that capitalize on interest paid by reviewing "carry trading strategies"

Political/Economic Risk - This represents the risk that a country's economic or political events will cause immediate and drastic changes in the currency prices associated with that country. Another example of this risk is government intervention that we typically see with Japan and the need to maintain low currency prices to bolster their exports.

Market Risk - This is the most familiar and by some the only risk they think about. Market risk is the day to day fluctuations in a currency pair's price. Also referred to as volatility. Volatility is not so much a cause but an effect of certain market forces. Volatility is a measure of risk because it refers to the behavior, or "temperament," of your investment rather than the reason for this behavior. Because market movement is the reason why people can make money, volatility is essential for returns, and the more unstable the currency pair the more chance it can go dramatically either way.

Technology Risk � This is a particular risk that many traders don't think much about. However with the majority of individual Forex traders executing trades online, we are all technology reliant. Are you protected against technology failure? Do you have an alternative internet service? Do you have back-up computers that you could use if your primary trading computer breaks?

As you can see, there are several types of risk that a smart investor should consider and pay careful attention to in their trading. Deciding your potential return (target profit) while respecting risk is the age old decision that each investors must make.

The Risk/Reward Balance

The risk/return balance could easily be called the iron stomach test. Deciding what amount of risk you can take on while allowing yourself to walk away from your computer without worrying and to get sound rest at night while you have long-term trades open is a trader's foremost important decision. The risk/return balance is the balance a trader must decide on between the lowest possible risk for the highest possible return. Remember to keep in mind that low levels of uncertainty (low risk) are associated with low potential returns and high levels of uncertainty (high risk) are associated with high potential returns. Trading is all about risk and probabilities. Understanding the inner functions of your trading strategy(s) and proper placement of entry and exit orders will assist in limiting your risk exposure while maximizing your profit potential.

The following chart shows an example of the risk/return balance for trading, meaning the higher the desired return typically requires a higher degree of risk:



What about how much of your account to place on each trade, or in other words the number of lots per trade? How much of your account have you lost in a single trade? Was it to much to swallow? If so you might not have utilized proper risk management and over leveraged your trade. Establishing the right level of leverage and corresponding margin requirements are a big part of managing risk. How are you doing?

Learning Your Risk Tolerance

The secret to successful investing is learning your own style, or in other words trading method(s) that work for you. There is no correct approach that everyone should learn. However, every trader needs to assess how much risk they can comfortably handle. It is the single most important investment issue for long-term success in the Forex market.

No One Answer for Everyone

Just as there is no single favorite food for everyone, there is no right risk level for everyone. Only you can determine what level of risk is right for you. You need to find the right balance between the amount of risk you are willing to take, and the amount of risk you can actually take. All too often investors think they are willing to take risk, but when it happens, they find out they aren't. Surviving in the market long-term is the most important way to make the market work for you. To do that, you need to learn your own risk tolerance ability. This could mean that you loose money during this learning process, but if this loss helps you achieve this level of understanding then you can financially afford the loss. This financial and emotional tuition is a valuable trading resources and something most experienced investors have experienced and paid at one time or another.

In Conclusion

Different individuals will have different tolerances for risk. Tolerance is not static, it will change as your skills and knowledge does. As you become more experienced tolerance to risk may increase as your strategies or systems of trading have become more and more proven in your mind and wallet. But don't let this fool you into still adhering to and thinking about proper money management practices. Achieving the right median between risk and return will ensure that you achieve your financial goals while allowing you to get a good nights rest.


10. Diversification

We all hear diversification is the best policy for an overall investment portfolio. This is also true amongst our currency focused investments as well. We must master the use of multiple trading strategies and multiple currency pairs to equalize our overall return. There are many traders that utilize trading strategies that when trading conditions are met are 80% accurate. However a full-time trader must utilize more than this single strategy as many times there are long periods of time when the trading conditions are not met which can last from a few days to several months. What good is a single strategy that can yield profits only half the year. Diversification is the answer. The key to making a living from your trading profits is to master several strategies that together yield consistent profits month after month.

Diversifying your investment is not the most popular of investment topics. In fact many people believe diversifying dilutes trading profits. But most investment professionals agree that while it does not guarantee against a loss, diversification is the most important component to helping you reach your long-term financial goals while minimizing your risk. But, remember that no matter how much diversification you do, it can never reduce risk down to zero.

What do you need to have a well diversified portfolio? There are 3 main aspects to ensure the best diversification:

Your portfolio should be spread among many different trading strategies.

Your trades should vary in risk and time held. Picking different trade opportunities with different potential rates of return will ensure that large gains offset losses of other trades. Keep in mind that this doesn't mean blindly place trades all across the spectrum!

Your currency pairs should vary by region and crosses, minimizing unsystematic risk to small groups of countries.

Another question people always ask is how many currency pairs they should trade to reduce the risk of their portfolio. The portfolio theory for stocks tells us that after 10-12 diversified stocks you are very close to optimal diversification. However in the currency market this doesn't mean buying 12 currency pairs will give you optimal diversification, instead you need to trade currencies of different regions and importance levels (i.e. majors, crosses and more exotic currencies).

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