A. How Speculators Can Profit from FX Trading ?
What the Exchange Rate Means The base currency is the term for the first currency in the pair.The counter currency is the term for the second currency in the pair. The exchange rate represents the number of units of the counter currency that one unit of the base currency can purchase. In a foreign exchange trade, clients are speculating on the exchange rate between two currencies. The exchange rate measures the relative value of a currency -- meaning it measures how much one currency is worth in terms of another currency.
For example, let’s suppose the exchange rate for the GBP/USD (Great British pound/United States dollar) is 1.8455. This means that 1 British pound (the first currency in the pair, also known as the base currency) is the equivalent of 1.8455 US dollars (the second member of the pair, known as the counter currency). This is the standard quoting convention for exchange rates; the exchange rate represents how much 1 unit of the base currency (first currency in the pair) can purchase of the counter currency (second currency in the pair).
So, if the GBP/USD exchange rate were to rise from 1.8455 to 1.8555, that would mean that 1 GBP would have gone from being able to purchase 1.8455 US dollars to being able to purchase 1.8555 US dollars.
Measuring Exchange Rate Movement
A pip is the unit of measurement for exchange rate movement.
The number of pips a currency pair moves determines how much a trader will earn or lose on the position.
A pip is the last significant digit in an exchange rate, and is the term used to define the unit of
measurement for exchange rate movements. The number of pips that the exchange rate moves dictates how much a trader has gained or lost through an FX trade. In the example above, if the rate moves from 1.8455 to 1.8555, the pair has risen by a 100 points or pips.
How an FX Trade Works
Any foreign exchange transaction ultimately begins with two events:
This concept is most easily explained and understood through an example of an actual trade:
Trader A wishes to speculate on GBP/USD. Believing that the GBP will rise against the USD, or that the exchange rate will move upwards, the trader places an order to buy GBP/USD at a market rate of 1.8455. In terms of volume, let’s assume that Trader A is speculating on 100,000 units of the base currency – which is the standard lot size, or trading increment, used in the foreign exchange market. Since the base currency is the first currency in the pair, we know that Trader A is speculating on the value of 100,000 British pounds with respect to the US dollar.
In this example, Trader A is buying British pounds, since he believes the pound will rise in value with respect to the US dollar. Accordingly, he finances the transaction of buying 100,000 pounds by borrowing an equivalent amount of US dollars.
For Trader A, the value of the amount borrowed is a function of the exchange rate. Since the exchange rate at the time of the transaction was 1.8455, we know that the market cost for 1 British pound was 1.8455 US dollars. Hence, 100,000 pounds cost $184,550 (1.8455 * 100,000). This borrowed amount of 184,550 USD must be paid back when the transaction is closed.
Let’s assume that Trader A is correct in assuming that the British pound would rise in value with respect to the USD, and that the exchange rate moved to 1.8555 – 100 pips above the rate at which Trader A entered. If Trader A were to close his position now, the 100,000 pounds he purchased at the onset of the transaction would be sold, and his debt of 184,550 dollars would be paid off.
At an exchange rate of 1.8555, Trader A’s 100,000 pounds are now worth 185,550 US dollars (100,000 * 1.8555). After repaying the borrowed amount of 184,550, this leaves him with a profit of $1,000.
A summary of the transaction is as follows:
Initial transaction: Purchase of 100,000 pounds at a cost of 1.8455 US dollars per pound, or a total of 184,550 USD
Final transaction: Sale of 100,000 pounds at a price of 1.8555 US dollars per pound, or 185,550 USD .
Amount of pounds initially purchased: 100,000
Amount of pounds sold through the closing transaction: 100,000
Net number of pounds: 0
Amount of dollars initially borrowed: 184,550
Amount of dollars purchased upon close of trade: 185,550
Dollars remaining after borrowed dollars are paid off: 1,000
Selling a Currency Pair Short
Traders have equal opportunities to profit regardless of whether the exchange rate is rising or falling.
The number of pips a currency pair moves determines how much a trader will earn or lose on the position.
One of the premier advantages of the foreign exchange market is that profit opportunities are equally present in all market conditions; it is just as easy to profit when the exchange rate is declining as it is when the rate is rising. If, for example, Trader A believes the pound will fall against the value of the US dollar – meaning 1 pound will buy fewer US dollars – then he can simply place an order to sell GBP/USD.
This trade works in essentially the same manner as the trade to go long (buy) the pair, with the only difference being which currency is being bought and sold.
Let’s assume Trader A believes that the GBP will decline in value with respect to the USD -- in other words, that the exchange rate will fall from the 1.8455 level. Accordingly, he places an order to sell 1 lot of GBP/USD, thus borrowing 100,000 pounds and buying an equivalent amount of USD with the proceeds.
Since 1 pound can purchase 1.8455 US dollars at the time Trader A places his trade, he can purchase 184,550 US dollars with the 100,000 pounds he borrowed. As in the previous example, the borrowed amount will be repaid when the transaction is closed.
Let’s assume that Trader A is correct in his belief that the pound will fall in value against the USD, and that the GBP/USD reaches 1.8355 – a drop of 100 pips from Trader A’s entry point. Now, Trader A decides to take his profit and close out the trade. Accordingly, he must repay the 100,000 pounds that were borrowed. Since the cost of 1 pound has now dropped to 1.8355, this means that the cost of 100,000 pounds is 183,550 (100,000 * 1.8355). This amount is then subtracted from 184,550, which was the number of dollars that Trader A received when he initially placed the trade. The result is a profit of $1,000 (184,550 – 183,550).
A summary of the transaction is as follows:
Initial transaction: 100,000 pounds were borrowed and exchanged for US dollars at a rate of 1.8455 US dollars per pound, or a total of 184,550 USD
Final transaction: The borrowed amount of 100,000 pounds was repaid at a cost of 1.8355 US dollars per pound, or a total of 183,550 USD
Amount of pounds initially borrowed: 100,000
Amount of pounds repaid via close of trade: 100,000
Net number of pounds: 0
Amount of dollars initially purchased: 184,550
Amount of dollars used to pay off the 100,000 pounds that were borrowed: 183,550
Dollars remaining after borrowed pounds are paid off: 1,000
In the examples given above, Trader A had the potential to earn a profit of $1,000 when the exchange rate rose 100 pips and also when it fell 100 pips. For any currency pair in which the US dollar is the second in the pair – like the GBP/USD, EUR/USD, AUD/USD, and NZD/USD – the value of a pip is fixed at $10 per 100,000 unit lot. In the Mini account, where a mini lot is 1/10th the size of a 100k lot, the pip value is 1/10th that of the 100K account. Accordingly, the pip value for any pair in which the USD is the counter currency is fixed at $1.
B.What is the Spread?
On your trading station, you will notice that there are two prices for each currency pair. Similar to all financial products, FX quotes include a "bid' and "ask". The bid is the price at which a dealer, for example FXCM, is willing to buy and clients can sell the base currency in exchange for the counter currency. The ask is the price at which a dealer is willing to sell and a client can buy.
BID = The Price at which the Trader (You) Can Sell
ASK = The Price at which the Trader (You) Can Buy
For example, say the EUR/USD is trading at 1.2245 x 1.2248. In this case, the bid is 1.2245 and the ask is 1.2248.
The difference between the bid and ask constitutes the spread. In the above example, the spread is 3 pips, or points. This differential reflects the cost of the trade. Essentially, the market would have to move 3 pips in your favor for you to break even, and 4 pips for you to be in your profit zone.
For example, say you bought the above currency at 1.2248. If you immediately sold, you would be filled at 1.2245. This represents a loss of 3 pips. The market would have to move up 3 pips to 1.2248 x 1.2251 for you to break even, and up to at least 1.2249 x 1.2252 for you to make a profit. This is because you bought at 1.2248 and you would have to sell at 1.2249 or higher to profit.
This spread of 3 pips represents the main source of revenue for the market maker (e.g. the firm that executes your trade). Please note that there exists a spread for all tradable instruments in all markets, regardless of whether both prices are transparent. On the FX Trading Station, this cost is made visible. An easy way to think of it is that if you were trading stocks and bought stock XYZ at $50 and then wanted to sell right away, you would not be able to sell at $50. You would have to sell at a lower price. This is because of the spread, and thus represents a hidden cost of trading in many equities and futures markets.
C. What is the Margin?
Margin
If you have a standard cash stock account, you know that money should be deposited for the full amount of the position you are trading, or if you have a margin account, for at least half of the position. This is in contrast to the FX market, where only a small percentage of the actual position value needs to be deposited prior to taking on the entering the trade. This small deposit, known as the margin, is not a down payment, but rather a performance bond or good faith desposit to ensure against trading losses. The margin requirement allows traders to hold positions much larger than their account value.
Margin requirements are as low as 1% (and as low as 0.5% on the mini account), meaning for every standard lot size of 100,000 units, you must commit $1,000. However, if you wanted to control a $100,000 in the stock market, you would have to deposit at the very least, $50,000. Even in the futures market you would have to deposit at least $5,000 to control a $100,000 position.
On your trading station, you can see that there are two types of margin: usable and used. Your used margin is the amount of funds you have committed to existing positions, and your usable margin is the amount of money you have available to commit to new positions. Account equity is your account balance plus or minus any floating profit or loss.
For example, say you open an account with $10,000. At this point your account balance and equity are both $10,000, your usable margin is $10,000 and your used margin is $0, as you have yet to place a trade. Next, you buy 7 lots of USD/JPY, which requires you to maintain $7,000 in equity. Now your usedmargin is $7,000 and your usable margin is $3,000. Essentially, this means that you can sustain market losses totalling $3,000 before your account equity falls below the minimum margin requirement of $7,000, at which point the dealing desk will close all open positions. This automatic margin call feature prevents your account from ever reaching a negative account balance.
D. Types of Orders
The term "order" refers to how a trader can enter or exit a speculative position in the market. There are various ways of placing orders, and understanding the pros and cons of various order types is key to becoming a savvy trader.
To help make matters simple, let's divide orders into two categories: orders used to enter positions, and orders used to exit positions.
Orders Used to Enter Positions
Market Order
These prices represent the current market prices, and traders who choose to enter market orders would be filled at the rate they see. The key advantage of market orders is that they ensure the trader that he/she will be in the position. The key disadvantage, though, is that the trader may not get the best price he/she could have gotten had he/she used another order type. Another disadvantage -- and one that is often overlooked -- is that market orders are more conducive to being used recklessly and without discipline. Using other orders, like stop and limit orders, are better-suited for helping traders stay disciplined.
Entry Orders
For example, suppose you are trading USD/JPY, and the current quote is 120.50-55. You can place an entry order to buy at 120.15, for example, so that your order will only be filled if the market reaches 120.15. This allows you to potentially recieve a better price.
There are two types of entry orders: limit entry orders and stop entry orders.
Limit Entry Orders
Limit entry orders are classified as entry orders whereby the rate specified by the trader is either
(1) below the current market rate if it is a buy order, or, alternatively,
(2) above the market rate if it is a sell order.
Essentially, limit entry orders should be used if the trader is expecting the market to reverse its direction at a certain rate. For example, if the USD/JPY is trading at 120.50 and the trader expects it to fall to 120.15 before reversing its direction, the trader would place a limit entry to buy at 120.15. Or, if the trader expected the rate to rise to 120.70 before falling, the trader would place a limit entry to sell at 120.70. In both cases, the trader is expecting a reversal at a certain level -- and hence is using a limit entry order.
Stop Entry Orders
Stop entry orders rely on rationale that is the opposite of limit entry orders; they involve either (1) placing orders to buy above the current market rate or
(2) placing orders to sell below the current market rate.
While limit entry orders can be used if a trader is expecting a reversal, stop entry orders should be used if the trader is expecting continuation of a trend beyond a certain point. As a result, stop entry orders are often safer; they allow a trader to enter positions only after the market has reached a certain rate and confirmed the strength of the trend.
Consider an example:
Suppose the current market rate for USD/JPY is at 117.04-09; in other words, traders can enter the market to sell at 117.04 or buy at 117.09. There are two types of stop entry orders that a trader could place in such a situation:
Orders Used to Exit Positions
The following are orders that can be used to exit positions:
Limit Orders (or take profit order)
Let's assume a trader has an open position where he is long (meaning he has bought) GBP/USD at 1.5800. In such a scenario, a trader can place a limit order to determine at what rate he will close his position and take his profits. So, for instance, if the aforementioned trader was looking to capture 100 pips on the GBP/USD, he would place a limit order at 1.5900; if the market reached that rate, he would be taken out of the market, and his profit from the trade would immediately be reflected in his balance.
Limit orders are great tools to help traders maintain discipline and lock-in profits. Still, though, they may result in premature profit-taking -- meaning they may cause traders to exit positions too early with profits that are too small relative to the risk involved in assuming the position. This is a common mistake made by novice traders, and often results in them blowing up their account.
Stop-Loss Order
For example, if a trader is long USD/JPY at 121.50 with a limit at 121.70, he may wish to maximize the loss he is willing to accept by placing a stop-loss order at 121.30. In such a case, if the market reached 121.30, he would be stopped out of the position and would suffer a loss no greater than 20 pips. Similarly, if a trader is short USD/JPY at 121.50 with a limit at 121.30 and only wants to suffer a loss of 20 pips, then he would place a stop loss order at 121.70. Accordingly, if the market reaches 121.70, the trader will be stopped out of the position and would have suffered a loss no greater than 20 pips.
Stop-loss orders are one of the most highly recommended tools for traders. They are crucial to ensuring that the trader does not blow up his/her account with a single trade, and can be vital when establishing risk-reward ratios to ensure that traders are not making foolish decisions. On the downside, stop-loss orders, if not placed at the appropriate level, can result in traders being taken out of positions at a loss -- when in fact the market may reverse itself.
What the Exchange Rate Means The base currency is the term for the first currency in the pair.The counter currency is the term for the second currency in the pair. The exchange rate represents the number of units of the counter currency that one unit of the base currency can purchase. In a foreign exchange trade, clients are speculating on the exchange rate between two currencies. The exchange rate measures the relative value of a currency -- meaning it measures how much one currency is worth in terms of another currency.
For example, let’s suppose the exchange rate for the GBP/USD (Great British pound/United States dollar) is 1.8455. This means that 1 British pound (the first currency in the pair, also known as the base currency) is the equivalent of 1.8455 US dollars (the second member of the pair, known as the counter currency). This is the standard quoting convention for exchange rates; the exchange rate represents how much 1 unit of the base currency (first currency in the pair) can purchase of the counter currency (second currency in the pair).
So, if the GBP/USD exchange rate were to rise from 1.8455 to 1.8555, that would mean that 1 GBP would have gone from being able to purchase 1.8455 US dollars to being able to purchase 1.8555 US dollars.
Measuring Exchange Rate Movement
A pip is the unit of measurement for exchange rate movement.
The number of pips a currency pair moves determines how much a trader will earn or lose on the position.
A pip is the last significant digit in an exchange rate, and is the term used to define the unit of
measurement for exchange rate movements. The number of pips that the exchange rate moves dictates how much a trader has gained or lost through an FX trade. In the example above, if the rate moves from 1.8455 to 1.8555, the pair has risen by a 100 points or pips.
How an FX Trade Works
Any foreign exchange transaction ultimately begins with two events:
- One currency is being borrowed.
- The proceeds from the borrowed currency are used to finance the currency that is being bought.
- Currency pairs are typically traded in increments of 100,000 units of the base currency. A 100,000 unit increment in a currency trade is referred to as a lot. (For example, a trader who is trading 5 lots is trading 500,000 units of currency).
This concept is most easily explained and understood through an example of an actual trade:
Trader A wishes to speculate on GBP/USD. Believing that the GBP will rise against the USD, or that the exchange rate will move upwards, the trader places an order to buy GBP/USD at a market rate of 1.8455. In terms of volume, let’s assume that Trader A is speculating on 100,000 units of the base currency – which is the standard lot size, or trading increment, used in the foreign exchange market. Since the base currency is the first currency in the pair, we know that Trader A is speculating on the value of 100,000 British pounds with respect to the US dollar.
In this example, Trader A is buying British pounds, since he believes the pound will rise in value with respect to the US dollar. Accordingly, he finances the transaction of buying 100,000 pounds by borrowing an equivalent amount of US dollars.
For Trader A, the value of the amount borrowed is a function of the exchange rate. Since the exchange rate at the time of the transaction was 1.8455, we know that the market cost for 1 British pound was 1.8455 US dollars. Hence, 100,000 pounds cost $184,550 (1.8455 * 100,000). This borrowed amount of 184,550 USD must be paid back when the transaction is closed.
Let’s assume that Trader A is correct in assuming that the British pound would rise in value with respect to the USD, and that the exchange rate moved to 1.8555 – 100 pips above the rate at which Trader A entered. If Trader A were to close his position now, the 100,000 pounds he purchased at the onset of the transaction would be sold, and his debt of 184,550 dollars would be paid off.
At an exchange rate of 1.8555, Trader A’s 100,000 pounds are now worth 185,550 US dollars (100,000 * 1.8555). After repaying the borrowed amount of 184,550, this leaves him with a profit of $1,000.
A summary of the transaction is as follows:
Initial transaction: Purchase of 100,000 pounds at a cost of 1.8455 US dollars per pound, or a total of 184,550 USD
Final transaction: Sale of 100,000 pounds at a price of 1.8555 US dollars per pound, or 185,550 USD .
Amount of pounds initially purchased: 100,000
Amount of pounds sold through the closing transaction: 100,000
Net number of pounds: 0
Amount of dollars initially borrowed: 184,550
Amount of dollars purchased upon close of trade: 185,550
Dollars remaining after borrowed dollars are paid off: 1,000
Selling a Currency Pair Short
Traders have equal opportunities to profit regardless of whether the exchange rate is rising or falling.
The number of pips a currency pair moves determines how much a trader will earn or lose on the position.
One of the premier advantages of the foreign exchange market is that profit opportunities are equally present in all market conditions; it is just as easy to profit when the exchange rate is declining as it is when the rate is rising. If, for example, Trader A believes the pound will fall against the value of the US dollar – meaning 1 pound will buy fewer US dollars – then he can simply place an order to sell GBP/USD.
This trade works in essentially the same manner as the trade to go long (buy) the pair, with the only difference being which currency is being bought and sold.
Let’s assume Trader A believes that the GBP will decline in value with respect to the USD -- in other words, that the exchange rate will fall from the 1.8455 level. Accordingly, he places an order to sell 1 lot of GBP/USD, thus borrowing 100,000 pounds and buying an equivalent amount of USD with the proceeds.
Since 1 pound can purchase 1.8455 US dollars at the time Trader A places his trade, he can purchase 184,550 US dollars with the 100,000 pounds he borrowed. As in the previous example, the borrowed amount will be repaid when the transaction is closed.
Let’s assume that Trader A is correct in his belief that the pound will fall in value against the USD, and that the GBP/USD reaches 1.8355 – a drop of 100 pips from Trader A’s entry point. Now, Trader A decides to take his profit and close out the trade. Accordingly, he must repay the 100,000 pounds that were borrowed. Since the cost of 1 pound has now dropped to 1.8355, this means that the cost of 100,000 pounds is 183,550 (100,000 * 1.8355). This amount is then subtracted from 184,550, which was the number of dollars that Trader A received when he initially placed the trade. The result is a profit of $1,000 (184,550 – 183,550).
A summary of the transaction is as follows:
Initial transaction: 100,000 pounds were borrowed and exchanged for US dollars at a rate of 1.8455 US dollars per pound, or a total of 184,550 USD
Final transaction: The borrowed amount of 100,000 pounds was repaid at a cost of 1.8355 US dollars per pound, or a total of 183,550 USD
Amount of pounds initially borrowed: 100,000
Amount of pounds repaid via close of trade: 100,000
Net number of pounds: 0
Amount of dollars initially purchased: 184,550
Amount of dollars used to pay off the 100,000 pounds that were borrowed: 183,550
Dollars remaining after borrowed pounds are paid off: 1,000
In the examples given above, Trader A had the potential to earn a profit of $1,000 when the exchange rate rose 100 pips and also when it fell 100 pips. For any currency pair in which the US dollar is the second in the pair – like the GBP/USD, EUR/USD, AUD/USD, and NZD/USD – the value of a pip is fixed at $10 per 100,000 unit lot. In the Mini account, where a mini lot is 1/10th the size of a 100k lot, the pip value is 1/10th that of the 100K account. Accordingly, the pip value for any pair in which the USD is the counter currency is fixed at $1.
B.What is the Spread?
On your trading station, you will notice that there are two prices for each currency pair. Similar to all financial products, FX quotes include a "bid' and "ask". The bid is the price at which a dealer, for example FXCM, is willing to buy and clients can sell the base currency in exchange for the counter currency. The ask is the price at which a dealer is willing to sell and a client can buy.
BID = The Price at which the Trader (You) Can Sell
ASK = The Price at which the Trader (You) Can Buy
For example, say the EUR/USD is trading at 1.2245 x 1.2248. In this case, the bid is 1.2245 and the ask is 1.2248.
The difference between the bid and ask constitutes the spread. In the above example, the spread is 3 pips, or points. This differential reflects the cost of the trade. Essentially, the market would have to move 3 pips in your favor for you to break even, and 4 pips for you to be in your profit zone.
For example, say you bought the above currency at 1.2248. If you immediately sold, you would be filled at 1.2245. This represents a loss of 3 pips. The market would have to move up 3 pips to 1.2248 x 1.2251 for you to break even, and up to at least 1.2249 x 1.2252 for you to make a profit. This is because you bought at 1.2248 and you would have to sell at 1.2249 or higher to profit.
This spread of 3 pips represents the main source of revenue for the market maker (e.g. the firm that executes your trade). Please note that there exists a spread for all tradable instruments in all markets, regardless of whether both prices are transparent. On the FX Trading Station, this cost is made visible. An easy way to think of it is that if you were trading stocks and bought stock XYZ at $50 and then wanted to sell right away, you would not be able to sell at $50. You would have to sell at a lower price. This is because of the spread, and thus represents a hidden cost of trading in many equities and futures markets.
C. What is the Margin?
Margin
If you have a standard cash stock account, you know that money should be deposited for the full amount of the position you are trading, or if you have a margin account, for at least half of the position. This is in contrast to the FX market, where only a small percentage of the actual position value needs to be deposited prior to taking on the entering the trade. This small deposit, known as the margin, is not a down payment, but rather a performance bond or good faith desposit to ensure against trading losses. The margin requirement allows traders to hold positions much larger than their account value.
Margin requirements are as low as 1% (and as low as 0.5% on the mini account), meaning for every standard lot size of 100,000 units, you must commit $1,000. However, if you wanted to control a $100,000 in the stock market, you would have to deposit at the very least, $50,000. Even in the futures market you would have to deposit at least $5,000 to control a $100,000 position.
On your trading station, you can see that there are two types of margin: usable and used. Your used margin is the amount of funds you have committed to existing positions, and your usable margin is the amount of money you have available to commit to new positions. Account equity is your account balance plus or minus any floating profit or loss.
For example, say you open an account with $10,000. At this point your account balance and equity are both $10,000, your usable margin is $10,000 and your used margin is $0, as you have yet to place a trade. Next, you buy 7 lots of USD/JPY, which requires you to maintain $7,000 in equity. Now your usedmargin is $7,000 and your usable margin is $3,000. Essentially, this means that you can sustain market losses totalling $3,000 before your account equity falls below the minimum margin requirement of $7,000, at which point the dealing desk will close all open positions. This automatic margin call feature prevents your account from ever reaching a negative account balance.
D. Types of Orders
The term "order" refers to how a trader can enter or exit a speculative position in the market. There are various ways of placing orders, and understanding the pros and cons of various order types is key to becoming a savvy trader.
To help make matters simple, let's divide orders into two categories: orders used to enter positions, and orders used to exit positions.
Orders Used to Enter Positions
Market Order
- Advantage: Ensures trader that he/she will be in the position
- Disadvantage: Far greater likelihood that trader is not getting the best price for the trade, or is assuming unnecessary risk.
These prices represent the current market prices, and traders who choose to enter market orders would be filled at the rate they see. The key advantage of market orders is that they ensure the trader that he/she will be in the position. The key disadvantage, though, is that the trader may not get the best price he/she could have gotten had he/she used another order type. Another disadvantage -- and one that is often overlooked -- is that market orders are more conducive to being used recklessly and without discipline. Using other orders, like stop and limit orders, are better-suited for helping traders stay disciplined.
Entry Orders
- Advantage: Greater likelihood that the trader will get the price he/she wants.
- Disadvantage: Market may not reach the rate the trader specified, and hence the trader may miss out on the opportunity.
For example, suppose you are trading USD/JPY, and the current quote is 120.50-55. You can place an entry order to buy at 120.15, for example, so that your order will only be filled if the market reaches 120.15. This allows you to potentially recieve a better price.
There are two types of entry orders: limit entry orders and stop entry orders.
Limit Entry Orders
Limit entry orders are classified as entry orders whereby the rate specified by the trader is either
(1) below the current market rate if it is a buy order, or, alternatively,
(2) above the market rate if it is a sell order.
Essentially, limit entry orders should be used if the trader is expecting the market to reverse its direction at a certain rate. For example, if the USD/JPY is trading at 120.50 and the trader expects it to fall to 120.15 before reversing its direction, the trader would place a limit entry to buy at 120.15. Or, if the trader expected the rate to rise to 120.70 before falling, the trader would place a limit entry to sell at 120.70. In both cases, the trader is expecting a reversal at a certain level -- and hence is using a limit entry order.
Stop Entry Orders
Stop entry orders rely on rationale that is the opposite of limit entry orders; they involve either (1) placing orders to buy above the current market rate or
(2) placing orders to sell below the current market rate.
While limit entry orders can be used if a trader is expecting a reversal, stop entry orders should be used if the trader is expecting continuation of a trend beyond a certain point. As a result, stop entry orders are often safer; they allow a trader to enter positions only after the market has reached a certain rate and confirmed the strength of the trend.
Consider an example:
Suppose the current market rate for USD/JPY is at 117.04-09; in other words, traders can enter the market to sell at 117.04 or buy at 117.09. There are two types of stop entry orders that a trader could place in such a situation:
- They could place an order to sell at a price below the current market rate -- i.e. they could place an order to sell at 116.75; if the sell rate in the spot market reaches 116.75, their sell order would be activated.
- Alternatively, they can place an order to buy above the current market rate -- i.e. they could place an order to buy at 117.50, and their order would only be filled if the market reached that rate.
Orders Used to Exit Positions
The following are orders that can be used to exit positions:
Limit Orders (or take profit order)
- Advantage: Helps trader maintain discipline, and is an effective way to lock-in profits.
- Disadvantage: May lead to premature profit-taking, as traders may end up getting out of positions too soon with too little profit.
Let's assume a trader has an open position where he is long (meaning he has bought) GBP/USD at 1.5800. In such a scenario, a trader can place a limit order to determine at what rate he will close his position and take his profits. So, for instance, if the aforementioned trader was looking to capture 100 pips on the GBP/USD, he would place a limit order at 1.5900; if the market reached that rate, he would be taken out of the market, and his profit from the trade would immediately be reflected in his balance.
Limit orders are great tools to help traders maintain discipline and lock-in profits. Still, though, they may result in premature profit-taking -- meaning they may cause traders to exit positions too early with profits that are too small relative to the risk involved in assuming the position. This is a common mistake made by novice traders, and often results in them blowing up their account.
Stop-Loss Order
- Advantage: Allows trader to specify the maximum loss he/she is willing to take on a position.
- Disadvantage: Stops placed too tight may result in the trader being taken out of the market only to see the market reverse its direction and head in the direction the trader originally forecasted.
For example, if a trader is long USD/JPY at 121.50 with a limit at 121.70, he may wish to maximize the loss he is willing to accept by placing a stop-loss order at 121.30. In such a case, if the market reached 121.30, he would be stopped out of the position and would suffer a loss no greater than 20 pips. Similarly, if a trader is short USD/JPY at 121.50 with a limit at 121.30 and only wants to suffer a loss of 20 pips, then he would place a stop loss order at 121.70. Accordingly, if the market reaches 121.70, the trader will be stopped out of the position and would have suffered a loss no greater than 20 pips.
Stop-loss orders are one of the most highly recommended tools for traders. They are crucial to ensuring that the trader does not blow up his/her account with a single trade, and can be vital when establishing risk-reward ratios to ensure that traders are not making foolish decisions. On the downside, stop-loss orders, if not placed at the appropriate level, can result in traders being taken out of positions at a loss -- when in fact the market may reverse itself.
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