When you’re taking your first steps in the arena of forex trading, it’s natural that you’ll spend time unpacking the concepts, terms, and tools that are part and parcel of this unique sector. You need more than a superficial understanding of these so that you can truly apply the market analysis you read and figure out how to make your next move. First on your list, though, is getting an understanding of the trading tools which traders use all the time. When you’re learning to be a pilot, you can put off learning where the parachutes are stored, but it’s somewhat more urgent you know which dial tells you your altitude. It’s the same in trading: learning how to fine-tune the tools you’ll use most—and which come with as much risk as they do advantages, like leverage—can help you become a more confident forex trader. Let’s explore both in more detail.
Leverage
Leverage is a trading tool that’s unique to the CFD and forex trading arena that essentially allows you to open large trading deals with a relatively small investment. The goal is to maximise your trading power and thus maximise your potential profits. Sounds great, right? But leverage also cuts both ways, so in magnifying your trading power it can also magnify your losses. Let’s take a closer look at how leverage works.
Say you have $100 to invest in a particular currency pair, such as EUR/USD. Using the maximum amount of leverage—which is 400:1—you’d be able to open a forex trading deal worth $40,000. See how that works? Your $100 investment x 400:1 leverage = $40,000. This gives you 400 times as much trading power, thus increasing the potential profit you could make. But, like we said, if your trading deal were to be unsuccessful, it also means you’re liable to lose your entire investment.
Obviously, leverage requires significant experience and market understanding to be used wisely. It also requires a certain amount of money in your account in order to cover any potential losses. This amount is known as margin, and it is usually calculated in reverse to the amount of leverage you’d like to use. For example, if you wanted to open a $40,000 forex trading deal using leverage, that would require a 0.25% margin, which amounts to $100. All in all, take the time to acquaint yourself fully with the inherent risks of leverage so that you can make more aware trading decisions.
Stop-Loss and Take-Profit Orders
One of the common battles CFD traders face is figuring out when to keep their positions open and when to close them off. A trader opens a “buy” position on certain stock and finds, to his disappointment, share prices take a dip. The question he wrestles with is whether or not to hold on to his position in the hopes the market will turn in his favour, and the longer he waits, the more his losses could compound. A stop-loss order is an effective way of managing this challenge. Before he opens the deal, he sets a stop-loss order at a level – of his choice – below the current market price. Once share prices drop down to that level, his deal is automatically closed. Traders agree it’s better to actually set the order, rather than simply plan to close the deal at a certain point, for two good reasons. One, you may not be so quick off the mark to do the closing, resulting in losses to your account, and two, you may be tempted to leave the deal open a little bit longer to see if things turn in your favour, which could lead to a sticky outcome.
On the other side of the coin is a take-profit order, which ensures the gains you made won’t slide away from you. Establish for yourself what level of gains would qualify as a success and set your order to close the deal at that point. The temptation you’re sidestepping this time comes from the exhilarating prospect of your earnings growing even more. Both stop-loss and take-profit orders are traders’ means of approaching the markets with structure and discipline. Traders who use stop-losses are ingraining in themselves the habit of prudently assessing the risks of a deal relative to its rewards, rather than rushing ahead with starry-eyed optimism. They also find that there’s a load of their minds, knowing it’s not up to them to monitor every movement of the instrument throughout the day. Both stop-loss and take-profit orders take some time to get used to, especially in knowing what levels are most appropriate for you, so take plenty of time to study both.
Moving Ahead
When it comes to forex trading, losses are to be expected as much as successful trades, even for old-time traders, but having a handle on proper risk management can help you trade with more confidence and awareness in the long run. All trading comes with risk, and rather than fear it, facing it head-on with knowledge makes you a wiser trader from the outset.
